g»tat0 ([JalUge of AgricttUute At ti^arnell Uninecsttg 3tl)aca. IN. f. Cornell University Library HF 5625.D5 3 1924 013 886 175 Cornell University Library The original of tiiis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924013886175 Accounting Practice and Procedure BY SIR ARTHUR LOWES DICKINSON M.A. Cantab, Certified Poblic Accountant, Fellow or THE Institute or Chartered Accountants, Fellow or the Institute or Actuaries, Member or THE Firm of Price, ^aterhoube ic Co. Sixth Printing NEW YORK THE RONALD PRESS COMPANY 1920 Copyright, 1913, by Arthur Lowes Dickinson Copyright, 1918, by Akthur Lowes Dickinson All rights reserved PREFACE The profession of accountancy is at a great disadvantage in comparison with that of law, by reason of the fact that the decisions reached on the important questions which arise from day to day are not pubhcly rendered and available as authorities for the rest of the profession, but are made privately and as a rule are accessible only to a few. In issuing this volume, therefore, it is my hope that the record it contains of some of the problems encountered in the course of twenty-five years of practice on both sides of the Atlantic may be of value to my fellow accountants and may in some measure serve to discharge some part of the debt I owe to the profession to which- 1 belong. The first eight chapters deal with problems relating to the income account and- balance sheet. These are followed by one on some problems involved in cost accounting ; while the last chapter deals with the accountant's responsibility to the public — a subject that is becoming more important every day. It has been my endeavor to avoid technicalities and so to render the book useful to the student entering the pro- fession and also to lawyers, bankers and professional men generally, who are vitally interested in accounting but have not had the accountant's training. In my practice it has been my good fortune to be in close touch, in partnership and otherwise, with many leading practitioners both in the United States and England, and in association with them to deal with many of the problems herein discussed, so that, while the responsibility for the views expressed is solely mine, the value they may possess is drawn from wider sources. A. Lowes Dickinson. October lo, 1913. iii PREFACE TO FOURTH PRINTING The author has taken advantage of the present reprim: to omit some few forms which have become obsolete or of but little value, and to make one or two other changes necessary to bring the book up to date. With the exception of these omissions and substitu- tions — which are not important — ^no change has been made in the text. A. Lowes Dickinson November i, 19 18. CONTENTS Chapter I. Bookkeeping Double-Entry Bookkeeping Impersonal Accounts Function of Impersonal Accounts Opening the Books The Trial Balance Early Bookkeeping Methods The Subsidiary Ledger Controlling Accounts Loose-Leaf Records Mechanical Aids in Bookkeeping Modern Bookkeeping Methods — Pro Forma System (1) Sales and Customers Records (2) Cash Records (3) Passing Bills for Payment (4) Creditors or Purchase Records (5) Expense and Cost Accounts (6) Journal Entries (7) General Ledger Accounts Progress of Bookkeeping Chapter II. The Balance Sheet Balance Sheet an Approximation Causes Affecting Net Worth Balance Sheet Accounts Form of Balance Sheet Order of Assets and Liabilities V VI CONTENTS Analysis of Balance Sheet Assets (1) Fixed Assets (2) Permanent Investments (3) Investment of Reserves (4) Working Assets (5) Current Assets (6) Suspense Debits Analysis of Balance Sheet Liabilities Capital Stock Funded and Unfunded Debt Current Liabilities Depreciation Suspense Credits Surplus Appropriated Surplus Profit and Loss English Requirements as to Balance Sheet Balance Sheet Forms Misleading Statements in Balance Sheets Condensed Financial Statement Statutory Forms of Balance Sheet Chapter IIL The Profit and Loss Account and the General Principles Governing Its Preparation Loss and Gain Terminology Varying Purposes of Financial Statements Classification of Activities (1) Manufacturing (2) Merchandising (3) Agency and Commission (4) Transportation (5) Banking (6) Professional Activities (7) Private Accounts Suggested Terminology Forms for Statements of Loss and Gain Items Properly Chargeable to Profit and Loss Nature of Profits Single-Entry Determination of Profits Corporate Profits Corporate Profits — English Rule Corporate Profits — American Rule Corporate Profits — General Rule CONTENTS VII Chapter IV. Balance Sheet Assets I. CAPITAL ASSETS (1) Fixed Property Land and Improvements Buildings and Structures Plant, Machinery and Fixed Tools Movable Equipment Furniture and Fixtures Patterns, Drawings, Dies, etc. Patents, Goodwill and Franchises Changes in Value of Capital Assets (2) Permanent Investments Investments for Purposes of Control Investments Controlling Facilities or Output Minor Investments Non-Income Producing Investments Advances (3) Investment of Reserves II. WORKING ASSETS (1) Stores and Supplies (2) Advances to Agents (3) Expenses Incurred in Advance of Accrual Chapter V. Balance Sheet Assets (Continued) III. CURRENT ASSETS (1) Stocks on Hand Essentials for Ascertaining Correct Profits Taking the Inventory- Cost Accounting Distribution of Expense Burden Allocation of Expenses Selling Expenses as Part of Manufacturing Cost Status of Interest Increasing Value of Seasoning Material Treatment of Carrying Charges Profits on Work in Progress Reserves for Contingencies VIII CONTENTS Book Inventories Physical Verification of Book Inventories Monthly Charges Contracts of Purchase Inventory Credits and Liabilities Accuracy of Inventory Valuations (2) Accounts and Bills Receivable Present Values of Accounts and Bills Receivable (3) Investments Unissued Stock or Bonds Issued Stock or Bonds Held in Treasury Valuation of Investments (4) Cash Cash on Current Account Outstanding Checks Restricted Cash Balances (5) Foreign Exchange Dealings in Foreign Exchange Chapter VI. Balance Sheet Liabilities (1) Capital Stock Capita) Stock Without Par Value Redemption of Capital Stock Treasury Stock Treasury Stock — English Rule (2) Bonded Debt Effective Interest Rate of Bonds Annual Income Charges Varying Conditions Affecting Annual Charge Methods of Determining Charge to Income Operation of the Various Methods of Determining Annual Charge to Income Determining Annual Charge When Proportionate Discount is Written Off Discount on Bond Issues Not a Proper Charge to Capital (3) Available Capital Resources (4) Current Liabilities (5) Contingent Liabilities CONTENTS (6) Sinking Fund Reseeves for Redemption of Debt (7) Other Provisions or Appropriations (8) Secret Reserves Chapter VII. Repairs, Renewals, Depreciation and New Construction (1) Property Expenditures Classification Reconstruction and Improvements Interest and Overhead Charges in Capital Outlay Profits on Construction Work Not Permissible (2) Maintenance Expenditures Treatment of Maintenance Expenditures by Railroads Classification of Maintenance Expenditures (3) Renewals and Depreciation General Considerations (4) Methods of Providing for Depreciation Annuity Method Straight Line Method Diminishing Balance Method Combination Method Treatment of Interest on Accumulated Depreciation Exhaustion of Minerals Amortization of Leaseholds Conclusion Chapter VIII. Special Points in Corporation Accounting and Finance (1) Accounting for Holding Companies The Consolidated Balance Sheet and Income Account Legal Status of Consolidated Balance Sheet Intercompany Profits and Accounting What is a Constituent Company? Other Forms of Consolidated Statements (2) Profits Earned Before Date of Consolidation (3) Questions Arising on the Organization of a Corporation Initial Surplus Losses on Current Assets Acquired Adjustment of Inventories on Purchase and Sale of a Business X CONTENTS Chapter IX. Some Theories and Problems in Cost Accounting Nature of Plant Constituent Elements of Cost Conditions Affecting Cost Purposes of Cost Accounting Constituent Elements of Commercial Costs Distribution of Overhead Expense Selling Costs Importance of Accurate Cost Keeping Relation of Interest and Rent to Manufacturing Cost Nature of Commercial Investments Interest and Rent Not a Manufacturing Cost Rental Charges Difficulties of Including Interest as a Manufacturing Cost Suggested Treatment of Interest in Connection with Costs Statistical Comparisons Between Production and Capital Invested Profit-sharing in Its Relation to Costs Cost as a Price Basis Chapter X. The Duties and Responsibilities of the Public Accountant (1) In Respect of the Prospectus Necessity for Accountants' Certificates English Requirements as to Prospectuses Period to Be Covered by Prospectus Treatment of Unusual Profits or Losses Fluctuations of Profits Results for Broken Periods Interest in Its Relation to Profits Salaries as Affecting Profits Depreciation and Renewals in Their Relation to Profits Varying Requirements of Statements of Profits Adjustments Estimates of Anticipated Economies Estimates of Future Earnings , Certificate of Financial Condition Certificate of Profits Without Certificate of Assets Liability of Certifying Accountant (2) In Respect of Audit Audit Practice in England American and English Practice as to Company Audits CONTENTS Canadian Audit Practice Accountant's Responsibility for Audit Certificates Qualified Certificates Accountant's Moral and Legal Responsibility (3) In Respect of Liquidation and Reconstruction Responsibility of Accountant in Case of Business Failure Causes or Conditions Leading Up to Insolvency Reorganization Appendix I. Sections of the English Law Relating to the Inspection and Audit of Accounts [Companies (Consolidation) Act, 1908]. II. Extracts from Schedule I to Companies (Consolidation) Act, 1908, Known as Table A. III. Sections of the English Law relating to Prospectuses [Companies (Consolidation) Act, 1908]. IV. Sections of the English Law Relating to Payment of In- terest Out of Capital [Companies (Consolidation) Act, 1908]. V. Sections Relating to Shareholders' Audit in the Canadian Bank Act, 1913. VI. Form of General Balance Sheet Statement as Prescribed by the Interstate Commerce Commission for Steam Roads. VII. Tentative Form of Balance Sheet Proposed by Federal Reserve Board for Merchants and Manufacturers. ACCOUNTING Practice and Procedure CHAPTER I BOOKKEEPING Bookkeeping is the essential foundation of accounting, and a thorough knowledge of its elementary principles and general methods is necessary to the proper understanding of accounting principles. While, therefore, it is not within the scope of the present book to put forth an exhaustive treatise on bookkeeping, it will serve a useful purpose to devote some space to a consideration of the principles in- volved and to modern methods of carrying these principles into effect. Double-Entry Bookkeeping The term "bookkeeping" is commonly and loosely used to describe any method of entering accounts of transactions in money, but the only scientific system which is worth notice here is that known as "double-entry bookkeeping," which is based on the fact that every transaction involves a transfer of property or its equivalent from one person to another, the terms "property" and "person" being used in the widest possible sense. This operation of receiving and 13 14 ACCOUNTING PRACTICE AND PROCEDURE giving is expressed in bookkeeping by the use of the terms "debit" and "credit" which may be thus defined : A person is debited with whatever is received from another. ' A person is credited with whatever is transferred to another. Every debit necessarily involves a corresponding credit, and after any number of transactions have been thus en- tered it follows that the sum of all the debits will exactly equal the sum of all the credits. Impersonal Accounts It is customary in treatises on bookkeeping to draw a somewhat sharp line of distinction between a personal and an impersonal account, meaning by the first an account kept with some definite person or group of persons whether cor- porate or otherwise, and by an impersonal account one which expresses merely a condition. In effect, however, all imper- sonal accounts are merely subdivisions of the personal account of the person or group of persons by or for whom the accounts are kept, who may briefly be termed the "prin- cipal." These accounts are devised, according to modern ideas, not so much for the purpose of determining the finan- cial relation of the principal to those with whom he deals (although of course this is important) as to show his own incomings and outgoings, possessions and obligations, in such full detail as will enable him best to control his affairs and to determine his own financial position. Function of Impersonal Accounts The demands of bookkeeping would be satisfied if A, carrying on a business, debited himself with all he received and credited himself with all he parted with, correspondingly BOOKKEEPING IS crediting and debiting those from whom he received and to whom he transferred. In such a case all his side of the transactions would be merged in one account only in his books; and a very detailed analysis of this ac- count, and a complete inventory of all his property and assets, would be required to furnish information of his own position, either as to profits or capital. In order to furnish continuously this detailed analysis, impersonal or nominal accounts so-called have been intro- duced, and the principle of debit and credit has been applied to them as if they were persons. Such accounts may, there- fore, be considered as a continuous and daily analysis of the principal's own account; or, from another aspect, may be treated as a division of his personality into a number of pockets, each one of which represents some specific part of his activities, and the gathering together of all of which will represent his condition. It is in this gathering together of impersonal accounts that bookkeeping passes the imaginary dividing line that separates it from accounting. The bal- ancing of the conditions surrounding each one of these accounts, and the determination of the exact bearing of each upon the position of the principal, is the duty of ac- counting. The problems involved in the determination of the value in money to be placed upon each, form the main subject of this volume. Opening the Books On the principles already outlined the principal first distributes all his property to various imaginary locations, crediting himself as the transferor, and debiting the locali- ties, each of which has a suitable name, such as Land, Build- ings, Investments, Cash, etc., with what each receives in this imaginary distribution. Similarly, he credits himself with l6 ACCOUNTING PRACTICE AND PROCEDURE amounts received by other individuals from him which at this stage represent debts owing to him, and debits himself with what he ha's received from other individuals which also represents debts owing by him to them. When this distri- bution is completed in his books the sum of all the debits, now representing various classes of property and debtors, must exactly equal the sum of all credits representing cred- itors and his own account, this latter showing his capital or worth in gross while all the remaining accounts, both debit and credit, show of what this worth is composed. This process, which is generally known as "opening the books," is followed by an exactly similar record of each subsequent transaction, each being debited and credited to the particular account concerned, whether Property, or Debtor, or Creditor. In the same way amounts due to others from himself for use of their facilities or due to him by others for their use of his facilities (such as rent, interest, wages, etc.) are debited or credited to accounts in his books representing his outgoings or incomings under their various headings, other than property, and credited or debited to the other parties to the transactions. The Trial Balance At any stage the same equation between the sums of all debits and all credits should exist if the entries have all been made with clerical accuracy, so far as the two sides, debit and credit, are concerned. Errors due to debits or credits being made to a wrong account cannot be detected by this means, but require a critical re-examination of each entry, a process which is essential at some time before a final balance is reached. This equation of debits and credits is known as a Trial Balance, and its main object is to prove the clerical accuracy of the work and to form a basis for the further critical examination required. BOOKKEEPING 17 The methods by which, under modern conditions, tiiis equation between debits and credits is reached are of con- siderable importance. Early Bookkeeping Methods The old-fashioned, routine of bookkeeping was as follows : Firstly, a record was made in a book known as a "Day Book" of each transaction as it occurred, e.g. — "Bought 100 tons of pig iron from B at $15 per ton. Accepted B's draft for $1,500." and so on. Secondly, the entries in the day book were converted into a form specifying the accounts which should be debited and credited in each particular case, known as "journal- izing" the. entry from the fact that this was entered in a book known as a "Journal," e.g. — Pig Iron, Dr. $i,Soo To B., Cr. $1,500 For 100 tons of pig iron at $15 per ton. B., Dr. $1,500 To Bills Payable, Cr. $1,500 For B's draft accepted this day. Thirdly, each side of each entry in this journal would be entered, or "posted," to a debit (left-hand) or credit (right-hand) page in a third book called a "Ledger," headed with the account name shown in the journal entry, so com- pleting the record. l8 ACCOUNTING PRACTICE AND PROCEDURE As business developed it was found that if this elemen- tary process were applied to a business of any magnitude, the work involved would be enormous; and accordingly it became customary to group transactions of similar charac- ter so that in the ledger the totals only of a number of similar transactions might be dealt with. The most important elementary examples of such group- ing are found in the "Cash Book" and the "Sales Day Book," which contain characteristics of both the day book and the ledger of our first example. The cash book is in itself in its common form a ledger account for cash, which from the fact that it is easily counted and balanced in money values, a quality possessed by no other kind of property, came to be considered of some special importance. This ledger account of cash, therefore, instead of being written up or posted from the day book to the journal, and the journal to the ledger, came to be used as a book of original entry, in place of the day book, for all cash transactions, whether incoming or outgoing, the other half of the entry being obtained by posting each individual item directly from the cash book to the ledger, thus eliminating altogether the intermediate journal. In the case of the sales day book a similar method was adopted, all sales being entered in a sep- arate day book, the items being posted directly to the ac- counts of the customers and the total to the credit of the sales account, thus again completing the double entry and entirely eliminating the journal. The Subsidiary Ledger As business increased in volume, so the opportunity for clerical error in carrying transactions through the various books and the consequent difficulty of obtaining an accurate trial balance also increased, and attempts were made at sec- BOOKKEEPING 19 tional balancing by which portions of the ledger might be proved and balanced without the necessity of dealing with the whole. This was applied firstly to the sales, which af- fected only a certain class of accounts. The ledger was divided into two portions, one of which contained only customers' accounts ; the debits to these accounts came from the sales day book, and the credits were obtained by employ- ing a separate cash book or a separate column in the general cash book for all amounts received from customers, the totals of which were carried into the general cash book or "gen- eral" column of the cash book at fixed intervals. By making separate summaries of the sales day book and sales column in the cash book, and by also keeping a separate list of all dis- counts allowed on customers' accounts, all the debits and credits which affected the sales ledger could be put together and balanced with the totals of that ledger independently of any other part of the books. Then it was found simpler, and more conducive to accuracy, to take the totals of all the individual entries and put them through the journal, which had fallen into disuse, these totals being posted to an ac- count in the main part of the ledger or "General Ledger" with some such title as "Customers Account" or "Sales Ledger Account." The process thus shortly described may be more clearly shown by an example : (i) A customers' ledger contains accounts with 100 dififerent individuals, showing on January ist a number of balances, or debts, due, aggregating say $1,500. (2) During the month of January sales are made to various customers, each of which is entered in the day book as made and subsequently posted to the debit of some account in the customers ledger (i). The day book at the end of January is added up and the total found to be $10,000. 20 ACCOUNTING PRACTICE AND PROCEDURE (3) During the month of January collections are made from customers, and entered individually, as received, in a book, and posted to the credit of the corresponding account in the ledger (i). As these postings are made a note is made in the cash book, against the cash receipt, of the amount of discount allowed. At the end of the month the cash and discount items are separately added up and found to amount to $10,200 and $300 respectively. (4) At January 31st the balances on the customers ledger (i) are again taken off and found to amount to $1,000, and it is desired to know whether or not this is the correct amount. (5) The proof is as follows: Balances at January ist (i) $ 1,500 Add — Sales for month (2) 10,000 Total $11,500 Deduct: Cash received (3) $10,200 Discount allowed (3) 300 10,500 Balance should be and is (4) , $ 1,000 The following would be specimen journal entries for such a group of transactions : Customers Account, Dr. $10,000 To Sales Account, $10,000 For total of sales for the month as shown by sales day book, p. — BOOKKEEPING 21 Discount allowed, Dr. 300 To Customers Account, 300 For discounts allowed to customers during the month as per discount day book (usually a separate memorandum column in sales cash book). Cash Account, Dr. 10,200 To Customers Account, 10,200 For cash received from customers during the month. Controlling Accounts From the nature of these entries it will be seen that all debits and credits which have been posted individually to the accounts in the customers ledger have also been posted in total through the above entries to the Customers account in the general ledger, and that consequently the balance on the latter account must always equal the sum of all balances in the former ledger. Accounts such as "Customers Account" above-men- tioned are known as "controlling accounts," and their use is now common in all large concerns and is applied not merely to sales but to any group of accounts of sufficient magnitude to make such a course desirable. Their use necessitates a number of subsidiary books or subsidiary col- umns in principal books, each one representing some separate controlling account or even some subdivision of such an account. The elementary example just given, which in- volves nothing but simple arithmetic and common sense, is 22 ACCOUNTING PRACTICE AND PROCEDURE typical of all such controlling systems and no other prin- ciple is involved therein. Loose-Leaf Records Up to this point only bound books, in which all the neces- sary entries were made, have been considered. As the mag- nitude of business concerns increased, further subdivisions became necessary if the accounts were to be kept reasonably up to date. This was at first accomplished by dividing sub- sidiary books into two or more portions for use on alternate days as books of original entry; and in the intervening periods for posting and other bookkeeping purposes. This method served the purpose for a long period and is still con- siderably used. Progressive minds, however, advanced the idea of using loose sheets for original record, which after transfer of the information to the final books of account, i.e., the ledgers, were bound up and filed away for reference purposes; and this process has been extended very largely to subsidiary ledgers and under suitable precautions even to principal ledgers. In the offices of banks and brokers and other similar institutions the original entry frequently con- sists of a rough memorandum on a small piece of paper. These, known as "tickets," have by the end of the day served all their bookkeeping purposes and are filed away in bundles for reference if need be. It would be thought that such methods must lead to a large increase in errors, but in practice this is not found to be the case, while the time saved is undoubtedly very great. The fact that by these methods the work is segregated and each class of entry grouped under the supervision of one clerk who is thoroughly familiar with it and has at short intervals to prove and balance his portion of the work, has conduced to greater care and accuracy ; and BOOKKEEPING 23 the loss of any portion of a loose original record before at least one side of it has found a more permanent abiding place, is very rare. Mechanical Aids in Bookkeeping Various mechanical devices have gradually come into considerable use in bookkeeping, such as adding machines ; combined typewriter and calculating machines; book type- writers, etc. ; all of which have entirely revolutionized book- keeping methods as they formerly existed, and while they do not call for a high order of intelligence on the part of those who are responsible for subsidiary records, they require something a good deal beyond a mere knowledge of bookkeeping on the part of those who control and interpret the final processes and results. Modern Bookkeeping Methods — Pro Forma System The following pro forma system illustrates modern book- keeping methods now in common use, without giving effect to many further refinements, particularly in the use of more mechanical devices which already find a limited but ever- extending use in large accounting organizations. (i) Sales and Customers Records Invoices to customers for sales made are typewritten in multiple copies, of which one copy is sent to the customer and another forms the sales record. These are totalled periodically by means of an adding machine after they have been individually posted to the debit of the customers account in the usual loose leaf or card ledger. The totals of the adding machine slips form the basis of a journal entry pre- pared on a loose-leaf form entitled "journal voucher," and debiting "Customers Ledger Account" and crediting the "Sales Account." Generally there will be two or more cus- tomers ledgers arranged for different groups of initial let- 24 ACCOUNTING PRACTICE AND PROCEDURE ters, such as A to E; F to L; M to O; P to S; T to Z, the invoice forms in use for each being either printed on a dif- ferent colored paper or bearing some distinctive reference mark. These invoice forms are sorted out by ledgers, sep- arate totals made of each on an adding machine, and a sep- arate controlling account kept for each ledger, either in the general ledger or in a separate subsidiary ledger which is itself controlled by one Customers Ledger account on the general ledger. In more refined systems the invoice and the entry on the debit of the customers account are made at one writing by means of a book-typewriter ; and a tabulating ma- chine attached gives the total of all invoices automatically. Detailed analyses of sales, which are now required in most businesses, will frequently be made by means of an electric sorting and tabulating machine, based upon cards punched in such manner as to record thereon all the salient facts on the original invoice. Credits to customers' accounts are handled in an exactly similar manner to the debits, the debits and credits being of course reversed. Cash receipts for sales will be entered up, as they are received, on a loose sheet which contains separate columns for cash items and discount items corresponding to each cus- tomers ledger; or in a very large business the remittances will be first sorted by ledgers and those relating to each ledger entered on a separate sheet. The daily totals of these sheets will be handed to the chief cashier after the sheets are completed, and by him agreed with an adding machine slip of the remittances which he has received and paid to bank, and will then be entered in his general cash book in separate totals for each customers ledger. The cash sheets will be sent by the entering clerk to the ledger clerks, who post the items into the corresponding customers ledgers and at the same time enter on sheets and ledgers the corresponding dis- BOOKKEEPING 25 counts. The sheets are then sent to the treasurer for fiHng in permanent binders, where they are always available for reference. Frequently the postings of debits and credits to customers' accounts are taken off, totalled and balanced daily with the adding machine lists of sales, cash sheets and credit slips so as to insure a correct balance of the customers ledgers at the end of the month. (2) Cash Records The daily totals of cash received from customers as shown upon the subsidiary sheets are entered on the prin- cipal cash book together with all other general items. This book is sometimes provided with separate analysis columns under frequently recurring headings and with a column for each bank in which the daily payments into bank are entered. If the bank accounts are numerous only one column is kept in the principal cash book for payments into banks, and this is supported by a subsidiary book containing a separate column for each bank in which debits and credits are entered in totals each day from the additions, on a bank paying-in slip, of the receipts and, on stubs of cheque books, of the payments ; the sum of the totals of all columns on this subsidiary book should alw'ays agree with the total bank balance as shown by the principal cash book. The best ac- counting practice provides for all receipts being paid into bank daily; any loose cash required being provided by a fixed sum in the hands of the cashier, which is replenished as often as may be necessary by cheques drawn for the total disbursements made thereout. Liabilities are usually paid by what is known as a "voucher cheque" or by a voucher against which a cheque is drawn. A typical form of such a voucher contains space at the top for name and particulars of account ; in the centre for details of bills supported by original invoices and 26 ACCOUNTING PRACTICE AND PROCEDURE the total payable ; and at foot for signatures of the various officials whose duty it is to pass the same for payment. On the back will be found a "card" or list of accounts to one or more of which the items on the voucher are chargeable, this list forming a complete distribution of the voucher. Against the voucher when completed the cashier will issue a cheque ; which very frequently forms an integral part of the voucher and the whole document then becomes a voucher cheque. (3) Passing Bills for Payment The most usual and approved routine through which these documents go before they are finally issued to the creditor is as follows : Bills or invoices are rendered by the shipper and are received by a designated official; upon receipt they are immediately despatched to the department which receives the goods or has incurred the expense, and are there certified as to the due receipt of the goods or services and as being correct as to quantity and quality. The invoice is then sent to the official by whom the order was given, who certifies that it is in accord with the order given and that the price is correct. It is then returned to the accounting department where all calculations are checked and it is filed under the supplier's name, attached to an "Invoice Card" on which the amount of the bill is also entered. Sometimes daily reports are made by the ordering and receiving departments to the accounting department of all goods ordered or received, and the verification of the in- voice is made in the latter. At the end of the month, or perhaps at more frequent intervals, all the invoices for each supplier are entered on the voucher, proper discounts de- ducted and the voucher sent, with the original bills attached, to the head of the consuming department for a general cer- tification. The whole docket then returns to the chief ac- countant, who enters it in his voucher record, certifies the BOOKKEEPING 27 voucher, and forwards it without the supporting bills to the cashier or treasurer for payment. (4) Creditors or Purchase Records The voucher record to which reference has already been made, is, as will be seen, ruled in columns and is a self- balancing book, the first cash column being the total amount due to the creditor and being followed by distribution col- umns arranged according to the accounts which may be re- quired. This book is frequently very bulky and much time and labor is saved by having it in loose-leaf form and in several sections, the leaves as completed being filed in binders one for each section. The double entry is obtained in the general ledger by posting the total of the first column to the credit of an account entitled "Vouchers Payable" and the totals of each of the analysis columns to the debit of the re- spective accounts afifected. The detail items in the creditors column are sometimes again posted to the credit of accounts for each creditor in a subsidiary ledger, exactly as in the case of sales ; and in such cases the payments are similarly dealt with, being entered up on separate sheets as the cheques are issued, the totals of these sheets carried daily into the general cash book and the discounts also entered in the special discount column on the sheets. More frequently, however, no ledgers are kept for creditors' accounts ; but the voucher record is itself pro- vided with a column in which the payments are entered, often even this being dispensed with and the date of pay- ment only being noted. In this case the voucher record is itself the ledger, and the open items at the end of any month taken off on an adding machine will agree with the balance on the vouchers payable account in the general ledger. An index is provided for the voucher record by which any in- dividual account can readily be found ; and this index serves 28 ACCOUNTING PRACTICE AND PROCEDURE as a reference for all the supporting data which are num- bered to correspond with the voucher. (5) Expense and Cost Accounts The vouchers are chargeable to either Property, Oper- ating or Expense accounts, which are represented by cor- responding columns in the voucher record. The labor, material and factory expense items which enter into the cost of the product in a manufacturing busi- ness are often entered in a single column of the voucher record and posted to an account in the general ledger headed "Cost Ledger" or some similar designation. The detailed items will be carried into the cost accounts from the original data before they reach the voucher register. Any cost sys- tem worth the name arrives with a considerable degree of accuracy at the cost of goods sold, which may be described as the output of the cost ledgers. In the general ledger the account controlling these cost ledgers is accordingly credited with the cost of all goods sold during the month, an account styled "Cost of Sales" being debited. It follows that the Cost Ledger account not only forms a controlling account over the cost ledgers, but itself represents the amount sunk in goods, finished or partly finished, and in materials and supplies used in their manufacture. This account therefore forms what is known as a continuous or running book in- ventory, a term to which full reference will be made in a subsequent chapter. It is only necessary here to note that the accuracy of this book inventory depends upon that of the item "Cost of Sales" which forms the credit to the account, and this again is entirely dependent on the substantial ac- curacy of the system in force for ascertaining costs. On account of the number of expense accounts required it is often customary to keep a separate subsidiary ledger, or analysis book as it is sometimes called, corresponding to BOOKKEEPING 20 one expense column only in the voucher record, this ledger being posted from the original data before they reach the voucher itself, as in the case of cost data. The correspond- ing expense account in the general ledger is a controlling account over this expense ledger or expense analysis book. (6) Journal Entries So far it will be seen that little use has been made of a journal, the totals for cash book and general ledger being posted monthly directly from subsidiary books. Such a plan is frequently adopted in practice ; but in other cases each of these totals is made the subject of a journal entry in form similar to those given on pages 20, 21. The adoption of this plan is perhaps more theoretically correct but in practice it is not found to result in greater accuracy. A journal is, however, still necessary for special entries, correction entries, and other miscellaneous matters which do not fall within the scope of any of the books or forms described. For all such entries it is usual to prepare vouchers similar to the cash vouchers already mentioned, each being certified by the proper official. Frequently these journal vouchers are pre- pared in the form of journal entries and postings are made direct therefrom. It should be noted that while they have reference primarily to the general ledger, if the general ledger account affected is a controlling account, an additional posting is also necessary to some account in the controlled ledger, and this would usually be made direct from the voucher before the latter is entered in the journal itself. The omission of such double postings is a frequent source of error in balancing books. (7) General Ledger Accounts It will be seen that by the use of subsidiary records the accounts, in the general ledger are reduced to comparatively 30 ACCOUNTING PRACTICE AND PROCEDURE few in number, each representing some general class of ac- count, and undoubtedly the ideal form of general ledger, not perhaps very frequently found in practice, would contain only one account corresponding to each heading in the periodical balance sheet and to the main headings in the Income account. A trial balance taken off such a ledger would therefore provide, by the simple process of putting down totals, a balance sheet and summarized Income ac- count. The use of such figures, however, without a period- ical examination of all the subsidiary records and a proof that the latter are in agreement with the corresponding accounts in the principal ledger, is a course not to be recom- mended. Progress of Bookkeeping The rapid sketch of a modern bookkeeping system here given must not be considered as by any means exhaustive, and is in fact only intended to show in a general way the advance that has been made of late years in general methods. Progress in this direction is continuous and rapid, particu- larly in the direction of a greater use of mechanical devices which eliminate causes of error and minimize the skill and knowledge required by the human element. This is perhaps unfortunate in that it does not call for a higher but rather a lower order of intelligence on the part of the majority of the clerks employed, but it is in line with progress in other fields; and, as in those fields, it demands the exercise of higher faculties on the part of those directing the work and interpreting the results. It is to the latter that a clear con- ception of the fundamental principles involved in the most complicated system of bookkeeping is of vital importance; and experience shows again and again that the key lies in the short phrase "Every debit must have a credit." CHAPTER II THE BALANCE SHEET The objective of a set of books kept on sound principles and with accuracy is to enable the actual financial condition to be ascertained at any time. This condition is evidenced by the values of both property owned and debts due, which are together generally described as assets ; the actual or esti- mated value of all liabilities; the surplus of one over the other, which represents the net worth or value ; and a sum- mary of the operations by which this net worth has been either created, increased or diminished. Balance Sheet An Approximation It is generally claimed that a balance sheet must represent facts, but in the strict sense this is not altogether possible in any case that can be imagined. If an individual possessing a certain definite amount of cash embarks this cash in various ventures which are all in due course liquidated, with the result that at the close of all his operations he finds himself with another definite amount of cash either greater or less than that with which he started, then he knows exactly what his profit or loss has been during the intervening period. But such a condition is an almost impossible one in practice except as applied to individual transactions. 31 32 ACCOUNTING PRACTICE AND PROCEDURE A contractor may embark on a large piece of construction work, purchasing with cash all materials and supplies re- quired; carry through his contract and at the close sell off all the residue for cash; he then knows exactly what his position is as regards this one contract. In practice, how- ever, before one contract is completed, another is begun and plant and material used for the first are not sold but are transferred to the second, so that his activities form a con- tinuous series of overlapping operations which may never come to an end or at any rate not for a long period of years. In the meantime he desires from time to time to ascertain as far as he can what his position is and how his contracts are working out, and he must for this purpose endeavor to put some value upon all his assets and probably estimate most of his liabilities. Consequently, it follows that a balance sheet can only be an approximation to facts, the degree of approximation depending upon the skill and accuracy with which the esti- mates are made. The first necessary step to such an ap- proximation is the summary of debits and credits taken from the books of account, generally known as a trial balance. The trial balance is the work of the bookkeeper, while the conversion of this trial balance into a substantially accurate financial estimate of position, or balance sheet, is the work of the accountant. Assuming that such balance sheets have been prepared at different periods, each showing as at the date on which it was prepared the net worth of the in- dividual or group concerned, then a comparison of the dif- ference between the total of the assets and the total of the liabilities at any two separate dates shows the progress made during the period either upwards or downwards. This figure, however, by itself does not tell the story of the in- tervening period but merely shows the relative conditions at its beginning and end. THE BALANCE SHEET 33 Causes Affecting Net Worth The change shown in the net worth may be due to any or all of the following causes : ( 1 ) Appreciation or depreciation in the estimated values of the property or assets not in any way due to the activities or expenditures of the individual or group concerned, such as changes in value of land due to greater or less demand, or to discoveries of minerals; and in values of buildings, machinery or commodities due to a rise or fall in prices of labor and material since they were acquired. (2) Capital brought into or drawn out of the business during the period. (3) Gifts of property of any kind by or to the concern, not in any way connected with its business activities. (4) Loss or gain arising from the excess or deficiency of ordinary expenditures made on trading or manufacturing as compared with the income from the sale of products. (5) Loss or gain arising from excess or deficiency of ordinary expenditures on personal matters as compared with income from personal sources, such as interest on stocks or bonds, or rents. In any complete system of bookkeeping the changes due to these various causes will be clearly shown by a careful examination of the accounts kept, the last two groups being those most difficult of ascertainment in full detail. Balance Sheet Accounts In a general ledger, such as has already been outlined, an account would be kept for each generic group of assets and liabilities, and a balance account generally known as the "Profit and Loss Account" or the "Surplus Account" would include all other items. This account would be sup- ported by such subsidiary accounts as might be necessary, either kept in the same ledger and closed periodically into 34 ACCOUNTING PRACTICE AND PROCEDURE the Profit and Loss account, or kept in a subsidiary ledger or ledgers controlled by the Profit and Loss account. Form of Balance Sheet The following may be given as a specimen of a balance sheet designed to show the financial position in considerable detail and yet in a simple and understandable form : ASSETS:* Fixed Property (after deduction of estimated depreciation due to use): Land and improvements thereon, including mineral rights and development thereof, but not structures of any kind. Buildings and structures. Plant, machinery, fixed tools, permanent way for railroad, etc. Movable equipment. Furniture and fixtures. Patterns, drawings, dies, etc. Patents, goodwill, franchises, etc. Permanent Investments in stocks, shares, bonds or obligations of any kind held to produce income or other increment, or for purposes connected with the business (if any) carried on, in- cluding advances made for similar purposes but excluding in- vestment of reserves. Investment of Reserves. Working Assets: Stores and supplies for use in operations. Advances to agents for business expenses and purposes. Insurance, interest, taxes, royalties, etc., paid in advance of the period over which they accrue. Current Assets: Materials carried for sale or conversion and products partly or wholly manufactured intended for sale. Accounts and bills due from outside parties for goods supplied or short term advances made, and recoverable in cash, or its equivalent in some other class of current assets. Investments in securities of any kind held as a temporary em- ployment of surplus cash. *See Chapters IV and V for detailed discussion of balance sheet assets. THE BALANCE SHEET 35 Cash at banks on deposit and current account, and cash on hand. Suspense Debits: Consisting of discount on bonds, expenses of organization or other extraordinary losses or expenses which it is desired to write off to Income account over a period of years. LIABILITIES:* On Capital Account: Partners' capital (in a private business). Capital stock (in a corporation). Loans secured by mortgage or otherwise and running for terms of years, otherwise known as "Funded Debt." On Unfunded Debt: For capital, as distinct from current, purposes. Current Liabilities: On current bank loans and commercial paper: Secured. Unsecured. On trade bills payable. On trade accounts payable. On miscellaneous accounts payable. Accrued interest, taxes and other periodical payments. Provision for losses actually incurred, the amount of which is not definitely ascertained. Provision for contingencies likely to arise out of past opera- tions. Suspense Credits: Consisting of items which will eventually become credits to Income or Surplus but cannot be at present adjusted. Surplus: Appropriated to meet future contingencies which have not yet arisen. Appropriated for repayment of debt (by sinking fund or other- wise). Appropriated for capital expenditures. Appropriated to equalize dividends. Profit and Loss account — being undistributed or unappropriated balance of profits (or losses). *See Chapter VI for detailed discussion of balance sheet liabilities. 36 ACCOUNTING PRACTICE AND PROCEDURE Order of Assets and Liabilities Much discussion has taken place in the past as to whether a balance sheet should be drawn up with the assets on the debit side, as is the American practice, or on the credit side, as is the English practice. The balance of argument would seem to favor the latter on the theory that a balance sheet is intended to set forth the position of the owner of the prop- erty, who should therefore be credited with what he possesses and charged with what he owes. For the clear understanding and recording of his affairs, the owner distributes himself into a number of different pockets and considers that into each pocket he places some particular class of his property. According to the rules of bookkeeping he therefore debits each pocket with the value placed upon the particular class, and credits himself as the one from whom it is received. These pockets represent the various property and expense accounts in his ledger, and the corresponding credit account is himself or, as it is generally styled, "Capital Account." In the balance sheet prepared from his books he is summarizing the distribution made by totalling the amount in each separate pocket. His balance sheet shows his position in relation to his books, and he is therefore credited with the items which he has placed into those pockets and charged with those items which he has received through other pockets from other people. In other words, the English method, which seems more correct the- oretically, is "A in account with his books," while the Amer- ican method, which is the reverse, is "His books in account with A." This brings out the only really important point in this whole discussion, viz. : that every kind of account stated must be considered from the point of view of the purpose for which it is prepared. If an account is headed "A in account with B," A should be credited with what he has given to B ; while if the account is headed "B in account THE BALANCE SHEET 37 with A," it will be reversed. A familiar example is often found in a banker's pass book, in which the customer's de- posits are usually entered on the credit side and his with- drawals on the debit ; while in the depositor's own books the record is reversed — the pass book is "A in account with the bank," while the cash book is "The bank in account with A." Apart from the theory involved the matter has perhaps little importance except as illustrating the modern tendency to ignore forms and get at results which after all are the most important. By convention American balance sheets are prepared with the assets on the debit, or left-hand, side of the account, just as by convention in England they are prepared in the reverse' way. It is also usual to dispense with the signs "Dr." and "Cr." on each side of the balance sheet and instead use captions such as "Property and Assets" and "Capital and Liabilities" ; and frequently also even the fiction of sides disappears, the assets appearing on the upper part of the sheet and the liabilities on the lower, or the "reverse. In such directions as these accounting diverges sharply from bookkeeping, striving always to adopt such forms and methods as will result in statements understandable by those uninitiated into the so-called "mysteries of bookkeeping." In the strenuous field of modern business clearness is almost as important as accuracy; for a statement that is strictly .accurate so far as figures are concerned may fail of being understood by want of care in making it show clearly what is called for without a further compiling or unraveling of figures. The form of balance sheet already given will be found to lend itself to a clear statement of affairs, as the following explanatory remarks will show. It remains in subsequent chapters to consider to what extent it can achieve the much more difficult ideal of accuracy. 38 ACCOUNTING PRACTICE AND PROCEDURE Analysis of Balance Sheet Assets The first essential in clearness is that each caption should express the nature of the items included therein. The six main headings adopted are : (i) Fixed Assets. (2) Permanent Investments. (3) Investment of Reserves. (4) Working Assets. (5) Current Assets. (6) Suspense Debits. (i) Fixed Assets Fixed assets include all property which is directly pos- sessed and used by the owner himself for his enjoyment or for his business purposes, and maintained in a fixed con- dition for long periods of time subject only to wear and tear and depreciation from use. The figures in the balance sheet should be supported by detail schedules showing the amount at the beginning of the year, the additions during the year, and the deductions for depreciation due to use in the busi- ness. The conditions under which account should be taken of other kinds of depreciation or of appreciation are dis- cussed later. (2) Permanent Investments Under permanent investments is included partial or entire ownership in facilities of other persons or corporations or similar bodies the ownership or control of which is a compulsory or necessary one; either because it is a trust ownership for special purposes extending over long periods of time, or because it is so intimately connected with the owner's activities that a sale would diminish or otherwise interfere with the continuance of those activities. Under this heading should also appear advances made to such persons or corporations and employed by them, for the time THE BALANCE SHEET 39 being at any rate, in carrying on their business. These ad- vances differ in many respects from ordinary accounts re- ceivable for goods sold, for they are usually found upon inquiry to be so much locked up in fixed or working assets as to be not readily realizable and are not in fact intended to be repaid as long as the business for which the advances were made is carried on. In practice these advances are frequently and erroneously treated as accounts receivable under current assets, thereby often concealing a serious shrinkage in liquid assets which may endanger' the solvency of the concern. (3) Investment of Reserves The caption "Investment of Reserves" serves to show what proportion of any reserves which appear on the lia- bility side of the balance sheet is specifically earmarked and invested. There should not be included any part of the assets unless they are specifically segregated for the service of the reserves. Any difference between the total of the reserves and the amount of these investments represents the propor- tion of the reserves which is invested in the general assets and which can only be available by correspondingly reducing ' the latter. (4) Working Assets These assets form another class equally necessary with the first, consisting of those assets which, while they are not intended for sale, are necessarily consumed in the process of carrying on the owner's activities, whatever they may be, and are not directly represented anywhere in the results of those activities. While they are not permanent, because they are continually being consumed, their equivalent is permanent because they must be continually renewed and replaced. Thus the activities of a railroad consist in the transportation of persons and commodities from place to 40 ACCOUNTING PRACTICE AND PROCEDURE place ; and in this process coal, oil, and other supplies are con- tinually being consumed, leaving no trace behind, and as continually being replaced. In a manufacturing business the same kind of articles are being used in the same kind of way in carrying out operations on other materials, which latter, while they change their shape in the process, still remain in existence, are intended for sale and are therefore treated as current assets. Balances in hands of agents which do not as a rule exist wholly in the form of cash and are not available for the ordinary purposes of a cash balance, are perhaps on the border line between working and current assets, but conservative practice places them in the former group. The third group of items, representing payments made in advance to cover expenses of a subsequent period, and not therefore in the ordinary course of business recover- able, are also conservatively treated as a part of the working assets. This whole class is as to the value, but not as to the property, permanent capital, subject only to fluctuations due to conditions of trade ; it differs from that of fixed assets in that both the value and the property included in the latter are of a permanent nature. (5) Current Assets Under current assets are included, firstly, the property which by the aid of the fixed and working assets is being continuously converted from one form'into another, with the purpose of earning a profit by subsequent sale and con- version into cash; in this respect differing markedly from the two classes of fixed and working assets. Secondly are included the intermediary instruments, such as bills and ac- counts receivable, by means of which the conversion into cash is made ; thirdly, the equivalent of cash in the shape of realizable and temporary investments held only until an outlet for the surplus cash is found either in divisions of THE BALANCE SHEET 41 profit or in extensions of the business activities ; and fourth- ly, the cash itself. (6) Suspense Debits The term "Suspense Debits" is sufficiently defined in the subcaption. The items to be included consist entirely of those which represent no value and must sooner or later be written off entirely as losses or expenses; such for instance as debit balances on ventures or undertakings not yet com- pleted and not represented by ascertainable assets ; discounts on bonds outstanding, etc. Analysis of Balance Sheet Liabilities Among the liabilities the first item by convention is the fixed capital invested, although in theory the deduction to be first made from the total assets should be the liabilities to outside parties, the difference representing the net worth, which is made up partly of the fixed amount contributed as permanent capital and partly of the accretions thereto. The arrangement adopted is, however, convenient in that where the balance sheet is arranged on the debit and credit prin- ciple, the capital liabilities and unfunded debt for capital purposes appear opposite to the fixed and working assets in which they are invested, followed by the current liabilities which have to be provided for by the continuo.us liquidation of the current assets; the last item being the surplus (or it may be deficit, which would be a deduction or red figure) left after providing for capital and liabilities. Capital Stock It is desirable in the case of a corporation that the balance sheet should show not only the amount of capital which has actually been raised but also that which is still available if required in the future without any change in the charter. Such available capital may be either ; 42 ACCOUNTING PRACTICE AND PROCEDURE (a) Capital authorized by the charter but not yet created by any action of the corporation through its stockholders. (b) Capital authorized by the charter, created by resolu- tion of the stockholders but not yet issued by any action of the directors. (c) Capital authorized by the charter, created by res.olu- tion of the stockholders, issued by authority of the directors but not yet sold to any parties for cash and consequently still remaining in the treasury of the corporation. (d) Capital authorized by the charter, created by resolu- tion of the stockholders, issued by authority of the directors and sold to outside parties ; but upon which only a proportion of the par value has been paid, leaving the balance due in cash either immediately or v^^hen called for. It is a common practice to treat stock issued but not sold as an asset and include it among either the fixed or current assets. This practice is entirely incorrect in theory and also inconvenient in practice. In theory, treasury stock or bonds are merely so many legalized pieces of paper entitling the holder either to a certain share in the assets or to a certain lien on those assets. In neither case can such pieces of paper be in any sense assets of the corporation creating and issuing them; for the assets themselves already appear and cannot be duplicated by resolutions of stockholders or directors. In practice difficult questions arise as to the valuation of such treasury stock and bonds ; the value to the corporation is clearly the par value for which the corporation itself is liable ; the market value for which they can be sold may be either more or less, and until they are sold, and the proceeds become available for the purposes of the corporation, it is impossible to say what their value is. The real fact is that they have no value in themselves and only differ from similar securities not yet authorized in that certain clerical formali- THE BALANCE SHEET 43 ties have been completed which render them more available either- for sale when further capital is required or for pledg- ing as security for loans. This latter fact is certainly one that should be made apparent in connection with the balance sheet, and this can be done correctly and without infringing any sound principles of finance by attaching to the balance sheet an exhibit in the following form : •o Amount in 3 § T3 •a Treasury n> 3 -> 2 S re n "> ^tvj *0 i-h 0°re 3 re fti S 5^ o jr. ti* 3 SLS ** re p " a) i; Bii _ re o o o a r* a -;■■<» ^ii »^3' 3*a- £.P O K3 !-• I-* !-• l-t I-. l-» ►-» h-» !-• h-» ^-^O^00'^0\t-n-t*-C0K)i-»O^00VJ0\0i4^t*JlSii-' W ~ ~ " ' ji'Vo^'^Q aCnOCnO >oppp 50000 >oooo sOooc »-» IS) C*ii-n 0\>J OOp H- tjNj GJ en CnOUio OOOp §000 000 LnOt-nOCnOCnO 00000000 ' )-» I-* i-» H-« ►-» Kl Ni ho to to N3 e*> t*l Oj 01 i-*C>AtjTvj\o»-'tO-li.O\OOOtOC*i{-n^vO»-'taCnOv S t— » h-» J-* J-" J-* J^i,^i j^ jf=*'^-<^y y P^ J^ J^,00 CO JOp-jO C*iOO'MO\ONLn-fi..C*)tsJI\J»-'CDvO'000'^ONCn t04:^p\pop5jjUiv4\oj--4xp\poptNJC^^vO bo OJ Ln "vj !^ H-i OJ tJi b\ 00 O Ki J:^ b\ 60 O i-* C*J 0000\Oi4:*.lNJi-*0'OOOONt^-t^C>J>-*0\000 t^ooo J-* J-*J^ J^ j-* J-* J-* J-* J^i^5**>* J^J*^ Cnt.ntjitjiCnO^OOCnoi(_nont_n(_nOO 0000000000000000 pooooooooooooooo ocjoooo 00 0000 0000 0000000000000000 f-l)_t)_>l-«»-«»->^o^J^o^s^^o^o^o NJ t*i tji vj^ O"— »C*>4^(-n^O>— '^04ihO^C^^J^O 4i. ON't-noj Vi~ui"bj>o o "'\o'Kj'>-»'4^K>"^-''o'bo o\ CX>OOtOO\'— 'Ui"OtO'Mts)0\0-P>^OtO'^-Ji-»Ln to _-^ p\ 00 p _OJ Oi "»^ O K- 4k ON 00 p JNJ Ln vj *o bo bj Cn -vj Co 'h-i bj Ln b^ bo O to -t*. 0\ 00 O I-» to 0000\Ln-P*tOH-OOOOON':-n4^C*ji-'0'000 -&9 &JCO J\) 000 O-t- -60 I— ,_ii-*t_ii_-i_»i_.(_»(-*IsotOtOl\5tOt>OtOtsJtO JvlOop_>-*JO to Oj 4^. LnOv vOp>^ NJJO OJ_4^ LnOvJ^ tJiVjo"co o'tOCnVjolNJOlooKiCnVloloO^tO OCnOLnOCnOt-nOOiOCnOLnOt-nOLnOOi ppppppppoppppopppppp 00000000000000000000 00000000000000000000 Ooa\(-nto'^(-n4^tO*-"OIS>>~«^C*)i— lOOO'^O'O j:^votoooto^i-«ONOOi0 4i.OOtovjtoa\>-»0\0 tnpp\»-*p\ J-* ;vlto;MN>pOtoOOtovo 4^^ 45". O tJi 000000000000000 00 000 00000000000000000000 'to ^h-*J>0 to yii-"^J*^ CO OOp JO jPi-jfi. p\ OnJ^JMJO O^i-* \jViVjo^o1o tnVjIoVjoVjo^tOCnVj'oVj'o t/iOt-nOCnOC/iOt-nOLnOC-riOCjiOLnOCnO pppppppppppppppooopp 00000000000000000000 oooocooooooooooooooo Period }4 Year. Payments for Inter- est at 5% p. a. (aj. Effective Interest charge at 8 3-16% p.a. (b). Discount for (2) provided - (1). Surplus on purchase at less than re- demption price. Charge to Income on effective interest method. Charge to Income on equal annual In- stalment method. Charge to Income when Discount written off on Bonds outstanding method. Charge to Income when Discount charged to Profit and Loss Account. BALANCE SHEET LIABILITIES 141 u V S -3 a a s 1 n ^ .2 cm 111 1" D 8 . (5S 'S cS 3i-t a < i M i c u Ph i 1 $1,000,000 100 $11,905 $25,000 $4,000 $32,905 2 950,000 1050 95 11,310 23,750 4,000 31,060 3 900,000 1050 90 10,714 22,500 3,500 29,714 4 850,000 1050 85 10,119 21,250 3,500 27,869 5 800,000 1050 80 9,524 20,000 2,500 27,024 6 750,000 1050 75 8,929 18,750 2,500 25,179 7 700,000 1050 70 8,333 17,500 1,500 24,333 8 650,000 1050 65 7,738 16,250 1,500 22,488 9 600,000 1050 60 7,143 15,000 1,000 21,143 10 550,000 1050 55 6,548 13,750 1,000 19,298 11 500,000 1050 50 5,952 12,500 2,500 15,952 12 450,000 1050 45 5,357 11,250 2,500 14,107 13 400,000 1050 40 4,762 10,000 1,500 13,262 14 350,000 1050 35 4,167 8,750 1,500 11,417 IS 300,000 1050 30 3,571 7,500 500 10,571 16 250,000 1050 25 2,976 6,250 500 8,726 17 200,000 1050 20 2,381 5,000 7,381 18 150,000 1050 15 1,786 3,750 5,536 19 100,000 1050 10 1,190 2,500 3,690 20 50,000 $10,500,000 1050 5 1050 595 $125,000 1,250 $262,500 1,845 $34,000 $353,500 142 ACCOUNTING PRACTICE AND PROCEDURE Discount on Bond Issues Not a Proper Charge to Capital Under no ordinary circumstances is it correct to treat discount on bond issues as a charge to capital. It does not represent any property; for it is clearly incorrect to consider that the cost in cash of a piece of property varies according to the credit of the purchaser or constructor. Hence, where any such discounts have been charged to capital assets, it is essential for a proper understanding of the balance sheet that this fact should be clearly set forth. In efifect, in corporation finance such discounts are frequently included in capital expenditure, as are many other fictitious items which represent either a sanguine estimate of future gains, or mere "water"; and this is done by the fiction of the sale of the property to a new company at a largely inflated value, for a price including the par value of the bonded debt; the intermediaries in this sale then selling the bonds at the market price. This principle has been extended also to cases of reorganiza- tion efifected without any sale of assets, where the dis- counts on bonds, as well as bonuses of capital stock issued to facilitate the completion of the reorganization, have all been capitalized. These exceptions must not be taken as a justification for a similar treatment in ordinary cases of financing; and, in fact, there is no real justification for their adoption in any case, beyond that of expediency. The whole system has led in the past to many and serious abuses, and the more strict supervision of capital issues which is now being extended over certain classes of cor- porations, will tend to put a stop to it in all cases. The objection to charging discount on bond issues to Capital account must not, however, be held to include such a charge of the annual instalment of discount for the period of construction during which interest also is charged to BALANCE SHEET LIABILITIES 143 Capital account. The rate of interest chargeable to capi- tal should be the actual cost of the money, i. e., the effec- tive rate, and any approximation to this rate obtained by including that proportion of the discount which belongs to the period would be a permissible charge to capital. (3) Available Capital Resources Corporations frequently express a desire to include created but unissued stock and bonds held in treasury as assets, on the ground that these represent available capi- tal resources and are therefore of value. It is submitted that the value lies not in the par or other value of these securities, but in the fact that certain formalities necessary to their issue, and involving expen- diture of both time and money, have been complied with, and that the sale alone remains to be made. It is true that in some cases this sale may be merely a matter of a few minutes' talk with a banker, but in other cases it may be difficult if not impossible. In reality it is only on final sale that these securities become of any real tangible value to the corporation; and the intangible value resulting from their mere creation, or even their use as collateral security, is not properly represented by treating it as an asset at par or market value. This can better be shown in the schedule of capital liabilities given in Chapter II, (p. 35), and the total of the "Amount in Treasury" column for both stocks and bonds might well be inserted as a memorandum in the balance sheet after the main heading of capital liabilities, but should not be included in the totals. (4) Current Liabilities The subheadings given in the pro forma balance sheet 144 ACCOUNTING PRACTICE AND PROCEDURE in Chapter II are almost self-explanatory and call for little additional comment. Current bank loans and commercial paper should in- clude only seasonal advances, i. e., those made during the part of the year when outlays are heaviest, and repaid in due course each year as the proceeds of sales are collected. It is frequently difficult to draw a clear distinction be- tween current loans and those made for capital purposes, particularly when working capital is , provided in this way, but indications generally exist in the manner in which repayments are made which will permit of a proper classification. For instance, loans made against accounts or bills receivable, and repaid as they are collected, would clearly be current loans even though they are immediately and continuously replaced to a greater or less extent by further loans against other accounts and bills. On the other hand a continuous bank overdraft by arrangement with the bank, not of fixed amount, but varying only according to the payments and the withdrawals made in the ordinary course of business, would more properly be considered as a loan for capital purposes. Such over- drafts are very common in England, and are entirely dif- ferent from temporary overdrafts resulting from financial difficulties, which latter should be treated as a current liability. Such items as percentages retained on contracts and ac- counts for goods invoiced and at risk of purchaser, but not received, should be included under trade accounts; but where there is a trade custom to invoice goods for new season's trade some months before the same are used and before payment is due, both the liability and the asset (under the head of stock in trade) are frequently omitted. While there is the justification for this practice that the transaction is made largely for the convenience of the seller, BALANCE SHEET LIABILITIES 145 who is anxious to save storage space, and not for that of the purchaser, who would be just as willing to take de- livery at a date nearer to his requirements, it is submitted that the true position of the purchaser would be better shown by including the amount on both sides of the balance sheet. Under the heading of miscellaneous accounts payable should be included all salaries, wages, and other payments accruing and due from day to day and payable at short intervals, while other items accruing but not due until some subsequent date, such as interest, taxes, etc., would appear under the next heading of accrued items. A difficult question frequently arises as to the period to which assessments of taxes apply. Generally speaking, if the taxes — although not accrued or even ascertainable — become a charge or lien on the property at a particular date, they should be provided for as of that date, at any rate by estimate. The confusion in the same state and even in the same city is frequently great, and it is difficult to ascertain the facts as to any particular tax. The only safe rule is to err on the side of providing too much rather than too little. Provision should always be made for all known lia- bilities, even when the exact amounts are not ascertain- able. Some sort of approximate estimate can always be made, and should be included under the heading of current liabilities and not under that of surplus or reserves, for the reason that a real liability exists and should be provided for in order to show the true position. (5) Contingent Liabilities This term is used to denote a liability which may or may not arise out of transactions entered into in the past, and in the former event will result in a correspondine addi- 146 ACCOUNTING PRACTICE AND PROCEDURE tion to the assets. This addition will as a rule be of equal value to the liability, but it may be either more or less. The most usual contingent liabilities are the follow- ing: (i) Liability on bills discounted, being the obligation arising from the indorsements on the bills when dis- counted to take up the bills at their face value if the maker does not do so. In this case the liability is a defi- nite fixed value, while the corresponding asset depends on the ability of the maker of the bill to pay, and this ability must be judged and valued in the same manner as his ability to pay accounts or bills not discounted. (2) Liability on shares in corporations not fully paid up, being the undertaking to pay up the par value of the shares when called on. As this payment increases cor- respondingly the assets of the corporation, the asset value will as a rule equal the amount of the call. It may, how- ever, happen that the call is made to make good lost assets, or pay the creditors, and in such case it may repre- sent no value at all, and a corresponding reserve will be required. (3) Liability on guarantees of principal or interest of loans to other persons or corporations. If such loans are fully secured and the guarantee has eventually to be made good, at least an equivalent in property value would be acquired. If not, a reserve might be required. Two other classes of liability may be considered under this head which are of a somewhat different character. (i) Liability on contracts to make good defects in work done or goods supplied. This must always be a matter of expense without any corresponding asset, and a reserve to meet such contingent liabilities must always BALANCE SHEET LIABILITIES 147 be pro^ri4ed in full of all expected claims. In fact, this class of items should not appear at all under contingent liabilities but under current liabilities. (2) Liability on contracts for purchase or sale for future delivery. These contracts are of two kinds: (a) those in products dealt in on produce exchanges at prices which fluctuate from day to day — or speculative contracts; and (b) those made at fixed prices for future requirements of the business. The measure in the former case is the difference be- tween the future price at date of contract and date of valuation, and this may represent either an asset or liability, which is only contingent in that it differs from the asset or liability value that will ultimately accrue. It properly belongs in either current assets or current liabilities, and has no place under the heading of contingent liabilities. The latter class of items may be and are usually ignored altogether, on the ground that the contracts are made in the ordinary course of business, and that no liability really arises until the other party to the contract performs his part of it; and inasmuch as, until perform- ance, the actual value of the corresponding asset may usually be taken as equal to the liability value, this treatment is safe. Circumstances might arise — as in the case of wide fluctua- tions between the contract price and the value at the date of the balance sheet — which would require the creation of some reserve or even justify an asset value in excess of the liability. The usual method of treatment of contingent liabili- ties is by a footnote to the balance sheet under this head- ing, no values being carried into the totals of either assets or liabilities, and inasmuch as in the majority of cases values cannot be definitely stated, this method seems the most satisfactory. Alternatively, however, (i) both assets 148 ACCOUNTING PRACTICE AND PROCEDURE and liabilities are increased under the respective headings by the liability value ; or (2) main headings of "Contingent Assets" and "Contingent Liabilities" are created in the body of the balance sheet, and the values included in both totals. In the case of bills discounted a satisfactory method is to state the full amount of all unmatured bills among the current assets, deducting therefrom on the face of the balance sheet the amount discounted. (6) Sinking Fund Reserves for Redemption of Debt Sinking Fund or Debt Extinguishment Reserves are not in theory a charge against Income, for the reason that they do not represent a loss or expense, but the extinction of an existing liability. Inasmuch, however, as in most cases the only source out of which such re- demption reserve can be provided is the surplus earnings, it is quite usual to insert a provision in trust deeds that the sinking fund reserve is to be provided out of the profits of the year. The discharge of liabilities involves either a cor- responding reduction in assets, or the accumulation of other liabilities or surplus. A reduction in current assets or the accumulation of other liabilities as a substitute for bonded indebtedness, is clearly objectionable, and it is therefore desirable that the amount applied each year to sinking fund purposes should be ofifset by the retention in the business of a corresponding amount of profit, which should be transferred either to a special reserve, or in reduction of some fixed asset account by way of pro- vision for depreciation or otherwise. In the latter case it must be remembered that the provision for depreciation will be to that extent represented by capital instead of current assets, and while there is no theoretical objection to this if the depreciation account is sufficiently large, the latter necessarily ceases to be available in cash for one of BALANCE SHEET LIABILITIES 149 its principal purposes, viz., the renewal of various capital assets from time to time. If, however, part of the fixed assets is of a wasting character, the sinking fund reserve may be quite safely applied in reduction of the book value thereof, or it may with equal propriety be applied in reduc- tion of the book value of goodwill or patents. It is important to note that there is no relation what- ever between the amount of sinking fund instalment and the annual depreciation charge; it is therefore still neces- sary to calculate the latter on the usual principle, and then to consider to what extent the sinking fund instal- ment may be properly considered as available to meet this provision. The considerations here involved will appear more clearly in dealing with the subject of depreciation. (7) Other Provisions or Appropriations In considering reserves it is important to distinguish between voluntary reserves and necessary reserves; the former being mere allocations of surplus while the latter are either an actual liability or a deduction from the book value of an asset. No balance sheet can set forth clearly the true position of afifairs unless all reserves have been provided which, at the time of the preparation of the balance sheet, may be found necessary for contingencies that have actually arisen at or prior to the date to which the balance sheet relates. Such reserves are: (i) For bad debts either known, or estimated on the basis of past experience. (2) For depreciation of plant. (3) For exhaustion of minerals. (4) For reduction in value of goods on hand to cost or market price. I50 ACCOUNTING PRACTICE AND PROCEDURE (5) For damage claims in respect of events which have happened, the resulting money value of which can only be estimated. (6) For expenses incurred but not definitely ascertained in money value. The first four of these should in preparing the balance sheet be deducted from the assets to which they relate, while the last two would be included as current liabilities. On the other hand, there is no obligation to provide out of profits for contingencies that have not arisen but may arise in the future. Such provisions are evidence of prudent foresight, but have no present effect upon the surplus as a whole, and if made they should be set up as a subdivision of the general surplus account, as in the form of balance sheet given in Chapter II. Such volun- tary reserves, in addition to sinking funds already dealt with, would consist of : (a) Provision for insurance against future possible losses from fire, etc., or other insurable risks. (b) Provision for losses due to accidents that may occur in the future. (c) Provision for capital outlays representing an ap- plication of profits either in the past or future to the creation of fixed assets. (d) Provision for equalizing dividends in the future; or, (e) Provision for special expenditures to be incurred in the future. (8) Secret Reserves There is a general consensus of opinion that an over- statement of profits knowingly made is improper; but the opposite proposition as to an understatement of profits BALANCE SHEET LIABILITIES '151 has so far received little consideration, and yet it is of considerable importance. Corporations are the property of the stockholders; and therefore primarily anything which the stockholders or the directors elected by them may approve, may be considered to be within their power to decide as they like, provided that it is within the law; and it has not been suggested that there is any general law which would prohibit an understatement of profits, as it would undoubtedly prohibit an overstatement. But in- asmuch as the stocks of the majority of corporations are quoted on the stock exchanges throughout the country, the corporation is in some sense the property also of the public. It becomes, therefore, a great question to what extent it is legitimate or proper that it should publish a statement of its earnings or its position which materially underestimates either; though it is clearly within the dis- cretion of the managers or directors to make reserves to meet possible contingencies, and the constitution and by- laws of most corporations give them such powers. Secret reserves may take several forms, as writing down to a comparatively small figure valuable assets, providing excessive depreciation, providing excessive reserves for bad debts, or contingencies, valuing stocks of materials and products on hand at values largely below either cost or market, or including special reserves for future con- tingencies under the head of accounts payable. Inasmuch as the majority of industrial corporations do not publish their gross earnings, such reserves can easily be made, and are made continually in a form in which they do not appear in any way in the published accounts, and are known therefore only to the directors and managers. Each case must be judged on its own merits. Where the directors or managers have exercised a wise discretion in providing in advance for contingent losses, incident to 152 ACCOUNTING PRACTICE AND PROCEDURE the nature of the business, which cannot, from a reason- able point of view, be considered as in excess of the amounts which a wise foresight would provide, it would seem that no exception should be taken to the undis- closed provision thereof. This would apply particularly to cases in which the business conducted was of a fluctu- ating or speculative character, or in which its success was largely dependent on the maintenance of very high credit, such as a bank. Reserves in such cases may well be larger than in others where such conditions do not exist, pro- vided that they are made on the same sort of basis con- tinuously and not merely spasmodically. In all such cases the sudden disclosure of heavy deficits or losses which are clearly incident to the nature of the business but only occur at irregular intei"vals, may easily be dis- astrous to the interests of the stockholders by unduly de- pressing the market price of the capital stock, and it would seem to be not only the right but the duty of directors to protect them against such contingencies by making ample secret reserves when profits permit. Where, however, reserves are made largely in excess of any possi- ble dontmgencies, the amounts provided should be dis- closed in the Profit and Loss account and probably also in the balance sheet, so that all those interested may be in a position to form a reasonably correct opinion as to the financial position. So far as the majority of cor- porations and businesses are concerned, publicity in such matters is undoubtedly most desirable; and all reserves to meet contingencies which may occur in the future, but have not yet occurred, should be fully disclosed. CHAPTER VII REPAIRS, RENEWALS, DEPRECIATION, AND NEW CONSTRUCTION In order to insure a correct statement of the earnings and position of any business, it is essential either that its property should be fully maintained at the same standard as at the date of acquisition, or that proper provision should be made for any falling off from that standard. A little reflection will show that the first alternative is impossible in the case of a new property. After a plant has, within a short period of its original construction, reached its state of fullest efficiency, it is continually wearing out; and even though it may be a long period before the wear and tear reaches such proportions that actual renewal expenditures are either necessary or desirable, yet the shrinkage in value resulting therefrom is going on all the time, and must be reflected in the accounts. The provisions necessary either to maintain the property values, or to compensate for any falling off from the original standard, consist of repairs, renewals, and depreciation, the latter including both that due to wear and tear and that due to obsolescence. By re;ason of the fact that frequently the property is maintained by expenditures on additional construction to take the place of that worn out or abandoned, the considera- tion of construction is also involved in that of maintenance ; and further light may be thrown on the whole question by first considering which class of expenditures may be IS3 154 ACCOUNTING PRACTICE AND PROCEDURE legitimately added to capital account, the natural inference being then drawn that all other expenditures must be pro- vided for in some form out of income. ( I ) Property Expenditures Classification Expenditures on property may be broadly divided into : (a) Actual additions to the property, such as new build- ings, new engines or new tools, which did not exist before, or additions to existing articles of this class. All such expenditure would be at once admitted as a proper charge to Capital account. (b) Alterations to capital assets resulting in increased capacity or reduction in expenses of operation, or both. The treatment of this class of expenditure must depend largely on the circumstances surrounding each case. As a rule that portion of the expenditure which has resulted in additional property or increased capacity may be properly charged to Capital account, while the portion representing reconstruc- tion of a plant to keep pace with modern operating condi- tions, to prevent deterioration in the efifective operating value, or to offset the increase in costs due to the rise in the price of labor and material, would usually be chargeable to Income account either directly or through the renewal or depreciation accounts, discussed later. (c) Expenditures necessary to rehabilitate and restore to a normal working efficiency a property which has been pur- chased in a depreciated condition. These may include out- lays which under normal conditions could only be considered income charges, but under the special conditions existing may properly be treated as capital. (d) Finally, we have ordinary replacements, repairs and renewals, recurrent either at long or short intervals, and resulting neither in increased capacity nor in saving in REPAIRS, RENEWALS, DEPRECIATION 155 operating expenses. Such would always be a charge against profits, either through the depreciation account or direct, according to the nature of the outlay. In one sense, it may be said that all expenditures on assets which deteriorate from the wear and tear incidental to operating, are in the nature of deferred charges to oper- ating, and must be written ofif completely during some fixed term applicable to the particular plant under consideration. This view may be admitted as a true one of individual machine units ; but a whole plant remains in existence over long terms of years as a complete entity, and to all intents and purposes — so far as waste due to operating is concerned — may be better considered as a permanent investment, which must be kept in good and efficient going order by means of expenditures on repairs, renewals, and depreciation. Reconstruction and Improvements It may frequently happen, as for instance in large recon- struction and improvement works resulting in some partially new structures, and in others substantially repaired and renewed, that it is a difficult matter to determine what proportion of the charges should be made to income and what to capital. The proper rule is that an amount which will fairly represent either the original cost or the value now (according to the general method adopted*) of the property abandoned together with the cost of all alterations, shall be charged to Income account or to credit accounts created out of income ; the excess may fairly be capitalized. Interest and Overhead Charges in Capital Outlay A difficult problem in the proper determination of the cost of additions and improvements to property is involved in the matter of overhead charges and interest. In the case of expenditures chargeable to profits this question is of •See page 159. 155 ACCOUNTING PRACTICE AND PROCEDURE little importance, because the credits to profits in respect of such charges are offset by the debits contained in the charges. In the case of capital expenditures, however, any arbitrary addition for overhead charges and interest involves a credit to and increase in profits corresponding to the addition to capital expenditures. In a going concern a conservative course is generally adopted, and no charge is made beyond the labor and material cost for expenditures of moderate amount on additions to the property; but, on the other hand, if a new and distinct plant were in course of construction, and producing no earnings from operation, the whole of the administration expenses and the interest paid on loans raised for this special purpose would be charged to construction account; and rightly so, being necessary elements of com- pleting the work. This at once suggests the argument that what is reason- able and proper in the latter case should also be reason- able and proper in the former. The safe rule is, however, that no charges should be made to construction for overhead expenses which would have been equally incurred if there had been no such construction, and would in that case have been charged against profits ; but that, if special loans have been raised to provide funds for construction purposes, or a special staff of employees maintained for this sole purpose, the interest paid on such loans and the salaries of the special staff may properly be charged to construction account until the work under construction is in effective operation. Any other method might result in the creation of fictitious profits, which could not be realized as long as the property was operated, and might never be realized on its ultimate sale. Profits on Construction Work Not Permissible Managers of the operating departments of a factory frequently claim that they should be allowed to charge a REPAIRS, RENEWALS, DEPRECIATION 157 profit on construction work carried out for their own mills, on the ground that, if the work were done outside, they would have to pay a profit, and at the same time would set free their own facilities to carry out additional work at a profit for outside customers ; and they even go so far as to say that, if they can not charge a profit on construction work so carried out, they will in future have the work done by outside contractors. It must be admitted that this is a plausible argument, but a little further consideration will show that it is fallacious. There is here a confusion between a profit and a saving. The reason that a concern undertakes its own construction work in place of letting outside contracts therefor, is that it can by that means effect a saving in its expenditure by taking advantage of its own capital and facilities to carry .out the work, instead of using the organization and the capital of others, upon which it would have to pay a pt;ofit. The saving so effected is of considerable advantage, in that it reduces the amount of capital invested, and future earnings will represent a larger return on the investment. Moreover, it is seldom true in a well-managed going concern that the use of its facilities for construction expenditure involves giving up profitable work for outsiders, which would otherwise have been undertaken ; the situation will have been foreseen and arrangements made so that its organization may, almost automatically, expand sufficiently to provide for any increase in its operations which is likely to be thrown upon it. In the contrary case it would be difficult to find justification for increasing costs of construction because of the lack of fore- sight of the management. Moreover, if a sum be added to the cost of construction and credited to Income account, to represent the profit which would have been earned by the company if the work had been done for outsiders instead of for itself, this profit can only be made available for distri- 158 ACCOUNTING PRACTICE AND PROCEDURE bution by increasing the amount of capital contributed for new construction work ; and it can hardly be considered good financial policy to increase indebtedness or take in new partners merely for the purpose of paying dividends. The only sound principle that can be adopted is to charge to construction all costs and expenses which are directly attributable to that construction, together with a fair and moderate proportion of necessary indirect expenses and of interest actually paid, but no further amount to represent profit. It should be noted that in England the Companies ( Con- solidation) Act, 1908,* now provides that when any shares of a company are issued to provide money for construction purposes, the company may, subject to certain regulations and to the approval of the Board of Trade (a government department), pay interest on such shares to the stockholders at a rate not exceeding 4 per cent per annum during the construction period; and that the interest so paid may be added to and form part of the cost of construction. This provision does not permit of the addition to construction cost of any interest which is not actually paid out in cash. So far this question has been considered in reference to its bearing on the determination of profits. There is, how- ever, the other aspect of its bearing on values. If an asset is created by construction without including in the charge all the elements which an outside contractor would charge, the value based upon market prices will clearly be low. The saving so effected is of undoubted benefit, in that less capital has been employed upon which profit has to be earned, but the asset value is understated. On the ground already stated that no profits should be made out of construc- tion, this difference in value cannot be considered as a profit arising out of operations; but there can be no objection to treating it as surplus appropriated to capital purposes, •See Appendix IV. REPAIRS, RENEWALS, DEPRECIATION 1 59 provided always that the total book value of all assets together is not in excess of actual value. (2) Maintenance Expenditures Turning now to the consideration of maintenance expenditures, it is apparent at the outset that there are two distinct theories upon which this problem can be properly considered. Under the first method, capital is considered to have been invested, once for all, in property which is permanent and must be kept up at the expense of income, no additions being made to the capital account except for entirely new and additional property, and all expenditures on maintain- ing or replacing the existing property, irrespective of the relative values at the time of construction and of replace- ment, being charged to Income account. Under the second method, each unit of property is fol- lowed from its construction to its removal or destruction ; upon abandonment its original cost value is written off to income and the cost of the new structure which takes its place is charged to capital. Under the first method changes in 'price levels are reflected in the Income account, while under the second method they are reflected in Capital account. Over a long period of years, where prices are rising and falling alter- nately, there will be little difiference between the results of the two methods in this respect, provided that one or the other is consistently followed throughout for each class of assets ; and provided that proper provision is made under the first method for dealing with property abandoned and not replaced. If, however, prices are continuously rising or con- tinuously falling, the first method will give greater or smaller charges, respectively, to Income account, than the second, and the latter will tend to keep the Capital account l6o ACCOUNTING PRACTICE AND PROCEDURE nearer to the current level of prices than the former. The first method perhaps brings out more clearly the problem with which operating officials have to deal — namely, the maintenance of the property entrusted to them for the purposes of operation — and avoids the confusion which frequently arises between depreciation due to wear and tear (which sooner or later will have to be made good by cash expenditures), and appreciation arising from circumstances entirely outside the operations, which can never be realized so long as operations continue, and which should be dealt with as a separate question. Treatment of Maintenance Expenditures by Railroads The two methods are well illustrated by the present prac- tice of railroads where both are in use for different portions of the property. It should be noted that from the earliest days the treatment by railroad companies of renewals, replacements, and depreciation, has differed from the prac- tice general among commercial concerns. Prior to the revision of the classification of railroad accounts by the Interstate Commerce Commission beginning in 1907, rail- road accounts were kept on the theory that the capital and revenue accounts were distinct, and that the only charges to be made to the latter should be for the cost of replacing property as and when replacements were made, no provision whatever being made for property abandoned. This differ- ence in treatment was fostered in England by the legislative enactments in regard to railroads; but from an accounting standpoint it was never regarded as resting on very solid ground, and from a financial standpoint its results did not prove satisfactory. After the panic in 1893 ^^^ the numer- ous railroad reorganizations which followed, whilst the methods above noted were continued, their harmful effects were largely counterbalanced by the practice, which became REPAIRS, RENEWALS, DEPRECIATION l6l general, of charging to income or profit and loss large sums which might properly have been capitalized. ' In the classification prescribed by the Interstate Com- merce Commission, provision is made for writing off prop- erty abandoned, whether replaced or not. When equip- ment is retired the ledger value of each unit, which in the ordinary case is the original cost of the unit to the com- pany, is required to be credited to Capital account, and this value, less salvage, is required to be provided for out of current or accumulated income, except to the extent that a provision has already been made through depreciation charges. In allocating the charges between current and accumulated income, the amount of depreciation up to July I, 1907 (when provisions for depreciation were first pre- scribed), not previously written off or provided for, is to be charged to Profit and Loss account, and the remainder to operating expenses. In this procedure the second method described above is followed, and not only increased capacity, but also any variation in the price of equipment, is carried to Capital account. In the case of other replacements of entire units of property, except units of minor importance, the same basis is now prescribed as for equipment. Formerly it was re- quired that cost of renewal of the property retired, on the basis of present day prices (less salvage) should be charged to operating expenses, but the present rule was substituted as from July i, 19 14. Here the first method has been sup- planted by the second. In the case of "betterments," wnich are described as substitutions of superior parts for inferior parts, and in the case of replacements of entire units when they are of minor importance, it is required that the cost of current prices of new parts of the kind retired (less salvage) shall be charged to operating expenses. Herein changes in the physical 1 62 ACCOUNTING PRACTICE AND PROCEDURE character of the property are reflected in Capital account, but changes in prices are not; the first method is still fol- lowed. In the case of property (other than equipment) aban- doned and not replaced, its ledger value, less salvage, is required to be charged to Profit and Loss account. In the classification effective July i, 1914, the Interstate Commerce Commission made provision for depreciation of fixed improvements as well as of equipment "for the pur- pose of creating reserves which will meet or reduce the amounts otherwise chargeable, as may be appropriate, to operating expense or to profit and loss accounts to cover property retired." The use of the depreciation accounts was made optional with the carrier, but if they were em- ployed the charges were to be "based in each instance upon the percentage of original cost (estimated if not known), ledger value, or purchase price of the property determined to be equitable by the carrier's experience and best sources of information as to the actual current loss from depre- ciation." When such reserves are carried, the charge to operating expense or profit and loss accounts in the event of a retirement are reduced by the amount that has been set up in the reserve specifically in respect of the retired unit. While the special conditions on railroads render the failure to provide depreciation more defensible than in the case of most undertakings, the trend is worthy of note. ClassiHcation of Maintenance Expenditures Having disposed of these important questions, the methods of providing for the maintenance of property may be considered. Maintenance expenditures consist of: (i) Repairs. (2) Renewals. (3) Improvements which cannot be capitalized. REPAIRS, RENEWALS, DEPRECIATION 163 There are also improvements which might legitimately be capitalized, but which conservative policy desires to pro- vide for out of profits ; this class may be at once disposed of inasmuch as, being legitimate capital, they should be treated as such; charged to capital, and credited to profits appro- priated for capital purposes. The first class of expenditures will occur continuously and will usually be charged against Income as and when incurred, although occasionally repairs and renewals are gi'ouped together and treated on the basis now to be de- scribed for the latter. It is difficult to draw a hard and fast line between these three classes, as one naturally merges into the other, but the following has in practice been found satisfactory when applied with reasonable intelligence to doubtful items. (i) Repairs. This should include all current expendi- tures recurring from day to day and from month to month on the general upkeep of the existing property without the renewal of any substantial part thereof, and generally all periodical repairs which are necessarily undertaken within, say, one year. (This caption will, of course, include certain renewals of small parts, etc., such as would be necessary to continue the useful life of any unit of building, plant or machinery over the estimated period of its life.) (2) Renewals. This should include all expenditures incurred in renewing, in whole or in part, any unit of build- ing, plant or machinery, which tend to extend its useful life beyond the average term. These expenditures would in general be those which would only occur at long intervals of two or three years, and whose effect would last for a number of years afterward. (3) Improvements. This should include any expendi- tures made upon existing buildings, plant and machinery. l64 ACCOUNTING PRACTICE AND PROCEDURE other than those covered by the terms "Repairs" and "Re- newals." (3) Renewals and Depreciation General Considerations In practice it is difficult, and perhaps hardly necessary, to draw any hard and fast line between renewals and improve- ments. Renewals of plant generally carry with them some measure of improvement, and while for management pur- poses it is as well to distinguish between the two classes of expenditures, both of them must be considered as making good or arresting depreciation which has taken or might take place ; and for this purpose provisions for such improve- ments as can not be charged to Capital account will, as a rule, be made out of the fund provided to take care of renewals and depreciation as now to be described. Renewal expenditures being incurred only periodically — and in the case of a new plant only after a period of several years — while the wear and tear goes on continually, must be provided for each year by an estimated charge based on the best available information as to the life and character of the particular plant. Involved therein is the ultimate replacement of each separate unit of plant when, by reason of excessive wear and tear, want of efficiency, or obso- lescence, it ceases to be economical to operate it. There is some difference of opinion as to whether depreciation due to obsolescence on a large scale — for instance, as in the con- version of horse street railways into cable or electric rail- ways, or of an ordinary steam electric generating plant into a steam or water turbine plant — should necessarily be met out of earnings, on the ground that the savings in future cost of operation will pay for the charge. This, however, seems to be an argument in favor of providing for the loss on the change out of future rather than past earnings, for there REPAIRS, RENEWALS, DEPRECIATION 165 can be no doubt that certain property has ceased to exist. The result of such a policy was well seen in the case of the Metropolitan Street Railway system in New York, which, largely for want of proper depreciation charges, was prac- tically ruined and forced into the hands of a receiver; the reorganization involving a considerable reduction in the capital values of the property. Another objection to the postponement or abandonment of charges for accruing renewals and depreciation is to be found in the lessened operating costs and greater profits thereby shown, which, in these days of rate regulation of public service companies, must, if continued, inevitably lead to demands for reductions in rates. If an insufficient provision has been made in the past, and the resulting profits have been distributed in divi- dends at a full and reasonable, or even excessive rate, it is difficult afterwards to maintain, as an argument against rate reductions, that the provisions for depreciation, etc., have been insufficient in the past and must be largely increased in the future. In the case of Knoxville v. Knoxville Water Company, the United States Supreme Court held that the water company, having failed to provide for depreciation in the past, could not, therefore, claim a value for its property on the basis of cost to reproduce, without deduction for depreciation. The only sound principle would seem to be that no profit can be properly said to have been earned until full provision has been made on the best available data both for accruing renewals and for depreciation due to obsolescence or other causes; and, if such full provision is not made, it should be clearly understood that eventually, except for possible appre- ciation of property due to entirely extraneous causes, part qf the capital will be lost, or will have been distributed in dividends. ' It remains to consider how such provisions for renewals I66 ACCOUNTING PRACTICE AND PROCEDURE and depreciation should be dealt with. In the early life of a new plant, there will be little or no expenditure upon renewals, and a consequent accumulation to the credit of Depreciation account. After some years renewal expendi- tures to be charged against this account will increase, but there should always remain, if the provisions have been sufficient, a credit balance which will represent the difference between original cost and average efficient value; i. e., the value below which the plant cannot be allowed to fall with- out becoming inefficient. It might at first be thought that the factor of obsolescence would not begin to operate until an even later period, and in some extreme cases this may be true; but as a rule, owing to the continuous progress of science and invention, obsolescence will be as continuous as renewals, and after an increase of the Depreciation account to a figure which cannot be definitely stated but may, for the sake of example, be put at from 25 to 33 1/3 per cent of the original plant cost, expenditures will, on the average of a few years, keep pace with the addition to the Deprecia- tion account and there should be no further accumulation. The charges to the Depreciation account will vary accord- ing to which of the methods of maintaining the Capital account — as fully defined on page 159 — is adopted. Under the first method all expenditures, both for renewals and replacements, will be charged to Depreciation account, no charge will be made for property abandoned and replaced, but a charge should be made for property abandoned but not replaced. Under the second method all expenditures on renewals, as above defined, will be charged against the Depreciation account, as well as the book value of all prop- erty abandoned and not replaced, the charge to operating expenses consisting of (i) repairs as defined above, and (2) depreciation; while the cost of new property, to replace REPAIRS, RENEWALS, DEPRECIATION 167 that abandoned and charged to the Depreciation account, will be charged to Capital account. (4) Methods of Providing for Depreciation One, and the most simple, method of providing for depre- ciation, for which little or no justification exists, is by the charge of arbitrary sums from time to time, either to income or to profit and loss, as earnings and surplus permit, and upon no definite basis. Any scientific system necessitates in the first place a detailed plant inventory, divided into groups according to the estimated life, assuming ordinary repairs to be made. From these data can be calculated the amount which must be provided in a definite number of years to make up the difference between cost and scrap values at the time when the unit may be expected, in the ordinary course of events, to become obsolete. It must be noted that all such calcula- tions are purely estimates, based on past experiences so far as available; and periodical revisions of all the elements involved are necessary if the result is to work out with any degree of accuracy. There are four methods by which the amount required for depreciation as thus ascertained may be provided. ( 1 ) The annuity method ; i. e., setting aside each year a fixed annual sum which, accumulated at compound interest at some assumed rate, will provide the amount required at the end of the agreed life. (2) The straight line method, by which an equal propor- tionate part is charged each year; i. e., on an outlay of $1,000,000 with a life of twenty years, and a scrap value of $300,000, the annual charge would be $35,000. (3) The diminishing balance method, under which, in the case of an outlay of $1,000,000 with a life of twenty l68 ACCOUNTING PRACTICE AND PROCEDURE years and a scrap value of $300,000, an annual sum of 6 per cent on the balance at the beginning of each year — after deducting the depreciation of the previous year — would be provided. (4) A combination of the first two methods, by which an annuity is provided for so much of the depreciation as represents the drop from new to normally efficient value, and the straight line method is provided for the balance, which represents renewal expenditures which will have to be incurred. Annuity Method Objections to the annuity method are that it does not take into account that expenditures are continually being incurred to make good the depreciation accrued ; that these expenditures must be taken out of the fund; consequently that the fund will not remain intact during even a small part of the assumed term and that it cannot be accumulated to the estimated required amount at the end of the term. Furthermore, by the addition of interest it becomes an increasing charge against profits each year, unless, which is unhkely, the fund is specifically invested; and it would be difficult for the owners to resist the temptation to reduce the annual contributions in later years if profits were insuffi- cient for their needs. In fact this sinking fund method does not take into account the essential character of a depreciation fund — viz. : a fund set aside not for the sole purpose of providing the value of the plant at the end of a term, but for the much more important purpose of keeping the plant up to the highest standard of efficiency, and leaving it at that standard at the end of the term by continuous expenditures during the term. A further and perhaps even greater objection to the annuity method is that the accumulations are small in the REPAIRS, RENEWALS, DEPRECIATION 169 early years and large in the later years, whereas the actual fall in value of the plant will usually be greatest when it is new, and. gradually decrease as it gets older. Consequently if depreciation is provided on the annuity method, even assuming that it makes good the whole value at the end of an assumed term, the apparent net property value will, throughout the whole of that term, be in excess — and in the earlier years largely in excess — of the actual. If the property changes hands on a valuation basis, the amount of depreciation accumulated on the annuity basis will be found entirely inadequate. This principle came up for consideration in the purchase by the British Government of the National Telephone Com- pany in Great Britain. The company claimed a depreciation deduction on the annuity basis, while the government claimed the larger deduction provided by the straight line method. After hearing testimony on the subject the arbi- trator decided in favor of the contention of the government. Straight Line Method The second, or straight line method, has been found on the whole the most satisfactory for a going concern in an average condition, but for a new plant it results in a con- siderable accumulation during earlier years while the plant is getting down to its average, say 75 per cent condition, and this accumulation will in all probability not require to be expended on renewals. This method lends itself readily to a sliding scale adjust- ment by which, as is proper, the provision for depreciation may be varied in accordance with the amount of business done. If a plant is working at only 50 per cent of capacity and is thoroughly maintained, the depreciation due to wear and tear is undoubtedly much less than if it were working at 90 per cent of capacity, while that due to obsolescence is I70 ACCOUNTING PRACTICE AND PROCEDURE unchanged. On this basis, for any particular plant a sliding scale of depreciation, according to used capacity, may be prepared which will be just to both present and future own- ers, subject always to the necessarily estimated character of all depreciation allowances. Diminishing Balance Method The third method is objectionable in that it ignores to some extent the spending feature of the fund. When, how- ever, renewals made are added to capital each year and the depreciation deducted, and the depreciation for the next year is calculated on the balance so resulting, this method would give results not widely different from the second, but the rate would require to be higher. The method as thus carried out is confugAg ; the original plant value is lost sight of, and the accumulated depreciation unexpended and available for future renewals is not clearly shown. Combination Method The fourth method is a new and untried one which has been the subject of some discussion. In a quite new plant it has the advantage of diminishing the depreciation charge in the earlier years, and, provided that the annual instalments are invested outside at the assumed rate and maintained as an investment, it might be found satisfactory. If the accumulations are invested in the business, the charge against profits each year will increase so that eventually it will be quite a serious item in poor years, and there will be great temptation to draw upon it in favor of profits. The objec- tion already noted to the annuity method, viz. : that it over- states property values, applies equally to this modified form of it, for the depreciation actually accruing within the early years in respect of the fall from a new to a normally efficient value, will only be provided over a much longer term and more towards the end of that term than at the beginning. REPAIRS, RENEWALS, DEPRECIATION 171 Treatment of Interest on Accumulated Depreciation Any of the methods described will result from time to time in the accumulation of funds in excess of necessary or economical expenditures for renewals and replacements, and this accumulation at once raises the question of interest. The annuity method automatically provides for this, but in the other methods no interest charge is usually considered. The accumulated funds may either be held as unexpended cash balances on current account or on deposit, or may be invested in outside interest-bearing securities, or may be invested in the undertaking — which is the most usual case. Strictly speaking, interest on the accumulated funds should go in reduction of the annual charge to operations to the extent earned, and if earned in the business this credit to operations would be offset by a debit to Income account as a distribution of profits. When only stockholders are inter- ested in the profits there is no necessity to take into consider- ation interest on these balances, as, if earned from outside sources, it forms a credit to Income account, and if not so earned, it forms part of the profits on the business just as does surplus not distributed in dividends. In cases, how- ever, where outsiders are interested in operating profits, such as in profit-sharing agreements between public service corporations and a state or city, it is important that this principle should be carried out, as otherwise the stockholders alone will obtain the benefit of the use of the accumulated funds. The only difficulty is as to the rate of interest to be allowed; in theory this should be that proportion of the net profits — before paying interest or dividends — which the accumulated balance of the depreciation fund bears to the total capital stock, bonds, surplus, and all other funds actually invested in the business; or the rate may be taken at some figure on the average approximating thereto. 172 ACCOUNTING PRACTICE AND PROCEDURE Exhaustion of Minerals Thus far dq)reciation has been considered in respect of assets which are used for operations; there is another class of depreciation consisting of the actual consumption of subsoil products which reduces the original property value. This is more generally known as provision for exhaustion of minerals. The product taken out of the land becomes stock in trade as soon as it is extracted, and whatever the land was worth before its extraction, it is clearly worth an appreci- able amount less thereafter. The provision to be made should be on the basis of the quantity extracted, having regard to the total available, and to the realizable value of the property after the products have all been extracted. The same principle would also apply to timber lands where no provision is made for reforesting. The contention is some- times raised that no provision need be made for exhaustion of subsoil products where the amount known to be in a definite tract at the end of any period is largely in excess of that which had been discovered at the beginning of the period. This argument can not, however, be admitted except as a reason for reducing the rate to be provided. As a general principle, whatever there was in the ground, whether known or unknown, has been reduced during the period under consideration by whatever amount has been extracted ; and while the new discoveries may be accepted as reducing the necessary rate of provision for extinction from, say, one dollar to one cent per unit of quantity, the original principle that provision must be made, holds good on the smaller figure, whatever it is. It may be, of course, that the pro- visions made in earlier years have been sufficient to cover a number of future years on the basis, from the commence- ment, of the rate subsequently found to be sufficient in view of the new discoveries ; and in this case there would be no REPAIRS, RENEWALS, DEPRECIATION 173 necessity to provide further for extinction until the total production at the new rate is equal to the total amount written off. It may happen, as in oil fields and gold mines, that it is impossible to obtain any reasonable basis upon which to calculate depreciation, and in such cases it is customary to state profits before making such provision, and either to apply a proportion of the profits in purchasing or developing other areas, or to return the whole to the owners with the clear understanding that the amounts they receive represent a return of capital as well as a distribution of profits. Amortization of Leaseholds The term depreciation is frequently applied to the amor- tization of properties of which the lease only and not the freehold has been purchased. It is not, however, a correct term to apply in such cases; for the so-called purchase money, being merely rent paid in advance over the term of the lease, is the present value of an annuity for that term, the annual instalments of which should be charged against profits in due course. In practice the straight line method is frequently adopted in these cases also, and an equal annual instalment (in the case of a twenty-year lease) of one- twentieth of the purchase money is charged into operating expenses. Conclusion The present discussion of this whole subjeet is far from exhaustive and deals merely with the general principles involved. Volumes have been, and may still be, written on the detailed application of the various methods to different undertakings, and to these volumes — and to papers on the subject appearing in the many technical journals — reference should be made. 174 ACCOUNTING PRACTICE AND PROCEDURE A word of caution may not be out of place as to the essential part played by estimates in all schemes for provid- ing for current wear and tear and future renewals. The only test is actual expenditures, together with a skilled examina- tion of the physical properties. Few schemes have been in force for a sufficiently long period to provide a test of their accuracy; and organic changes by sale, reconstruction or destruction, as well as the rapid growth of land values, have all tended to confuse the issue. A few cases in special industries have tended to show that provisions for deprecia- tion have been inadequate in these cases to provide for necessary changes ; and there are other cases in which exces- sive and evident liberality has produced an opposite result. Conservative policy would, under these circumstances, aim at ample provision in years of good profits, while main- taining the estimated minimum in hard times ; such a policy builds up ample reserves which will often be useful in tiding over long periods of depression, and generally conserving and strengthening the business against unforeseen contin- gencies which may easily bring less conservative concerns to disaster. While a greater approach to scientific accuracy in all such matters is much to be desired, real safety lies rather in an ample provision than in a strictly accurate one. CHAPTER VIII SPECIAL POINTS IN CORPORATION ACCOUNT- ING AND FINANCE ( I ) Accounting for Holding Companies The now common, practice of forming large aggre- gations of capital on the basis of a control by one corporation of the whole or the majority of the stocks of a number of others, raises important accounting questions. It has generally been considered that the balance sheet of any corporation, prepared from its books and records properly kept, would disclose its true financial position ; but the development of this system of control has shown that such a balance sheet will no longer suffice for this purpose. It is important in this connection to realize the differ- ence between an investment in a company when this invest- ment represents only a small proportion of its capital stock, and an investment representing the whole or practically the whole, and carrying with it the absolute control of the operations. Thus, corporation "A" may own the whole stock of corporation "B," both carrying on a similar busi- ness. Stockholders in "A" may know this fact, but have no means of ascertaining the real position of corporation "B." "A," having the control of "B," may turn over to "B" all its unremunerative work, with the result of showing large profits on its own accounts, while the accounts of "B" show correspondingly large losses. Corporation "A" in its bal- ance sheet may carry its investments at cost, probably merged 176 ACCOUNTING PRACTICE AND PROCEDURE under the general head of "Cost of Properties," with all its other capital assets. Corporation "B" may obtain loans from corporation "A" which largely exceed its current assets, and may be expended in construction work, or even lost in operations, while corporation "A" may carry in its balance sheet these same loans as current assets recoverable on demand. The Consolidated Balance Sheet and Income Account By reason of the misleading character of the ordinary balance sheet in such cases, there has been evolved the consolidated balance sheet; the basis of which is the recog- nition of the common-sense fact that a network of com- panies connected with each other by control of stockholdings, is still in effect one undertaking, and that if the stockholders in the holding company are to have before them a clear statement of its position, legal technicalities must be brushed to one side, and the position of the holding company shown in its relation, not to these subcompanies, but to the general public. The position of the holding company can only be changed by outside influences affecting itself or its con- stituent companies, and not by any change in the relation between itself and these companies, or in the relations among the latter. The consolidated balance sheet represents the true position of the whole group of the constituent com- panies to the outside world, and is thus not the balance sheet of a corporation, but of a condition after eliminating all the relations of the constituent companies one to another. Debts due by one company of the group to another ; stocks of one company owned by another ; earnings of one company at the expense of another — are all eliminated. The amount by which the value of the stocks of any company on the books of another exceeds or falls short of the par value thereof, represents an addition to or diminution of the asset CORPORATION ACCOUNTING AND FINANCE 177 of goodwill in the final balance sheet; and as a result the capital assets in the consolidated balance sheet consist of the total physical assets of all the companies (that is, land, buildings, plant, machinery, etc.), and in addition an item of goodwill represented by — (a) The goodwill asset in the balance sheets of the separate companies, and (b) The amount by which the aggregate book value to the holding company of the stocks of subsidiary companies exceeds the par value of that stock and the surplus at the date of acquisition. Similarly, the capital liabilities represent the stocks and bonds of all the companies in the hands of the public, those owned between companies being eliminated. The consolidated earnings account is made up on the same principles. Profits resulting to one company out of sales to another are eliniinated. Only sales and purchases to and from the outside public are included, so that no profits are considered such except those made on deliveries outside the organization. In other words, the whole organization is considered as merely a series of separate works under the same ownership ; and the same accounting principles which would apply to a corporation owning several factories, are applied to the one owning the whole stocks of a number of subsidiary com- panies, which in turn own the stocks of other subsidiary companies, all the companies in the group themselves owning and operating their own factories. It will readily be under- stood that in practice the preparation of a statement of earnings exactly on the basis here laid down is a difficult matter ; but inasmuch as a neglect of these principles, so far as the Income account is concerned, only means the swelling of the totals both of gross earnings and cost of operation, it 178 ACCOUNTING PRACTICE AND PROCEDURE is not of so much importance; provided that the valuation of the stocks of goods on hand is made on the basis of actual labor, material, and expense involved therein, without in- cluding any proporjiion of the profit of the different com- panies in the organization through which these products may have come, and provided also that capital expenditures do not contain any intercompany profit. A balance sheet of a corporation, whose only or principal assets are stated to be investments in other companies, should be looked upon with suspicion, unless the names of the other companies are given, and clear statements are also given of their financial position ; and even then a collection of balance sheets can not show the true financial position of the whole group until they are all combined into one and the intercompany interests eliminated. In respect of the earnings of such a consolidation similar considerations prevail. Legally, the earnings consist of the results of the operations of the holding company, together with any dividends wh'ich may be declared on the stocks which it owns in the subsidiary companies; and so long as those stocks represent only minority interests in companies which are not in any way controlled or operated by the directors of the holding company, an Income account pre- pared in such a way would be a correct and proper statement from an accounting as well as from a legal point of view. Under the conditions, however, of majority or complete ownership, as they so commonly exist, no statement of earn- ings can be considered correct which does not show in one account the profits or losses of the whole group of com- panies, irrespective of whether dividends have or have not been declared thereby. If this principle be not insisted upon, it is within the power of the directors of the holding com- pany to regulate its profits according not to facts, but to their own wishes, by distributing or withholding dividends of the CORPORATION ACCOUNTING AND FINANCE 179 subsidiary companies ; or even to largely overstate the profits of the whole group by declaring dividends in those sub- companies vi^hich have made profits, while entirely omit- ting to make provision for losses which have been made by other companies in the group. Legal Status of Consolidated Balance Sheet It is doubtful whether there is any existing law which could legally require a corporation to make up its statement of profits on the basis here suggested ; but possibly it may eventually be found that the ordinary rule, of a reasonable valuation of assets, may be made to cover this point, for the following reasons. It is clear that whatever the value of an investment in a corporation may be at a particular date, its value at any subsequent date (other things being equal) must be greater or less by the amount of the profits or losses made and not distributed during the intervening period. Even if other conditions at the two dates are not the same, and — quite apart from any consideration of the earnings or losses during the intervening period — there is a considerable appreciation or depreciation in the investment, that apprecia- tion or depreciation must undoubtedly be more or less, respectively, by reason of profits earned or losses incurred. The change in value of the asset is at any rate partly due to the result of the operations for the purpose of which the investment is held. On the general principle, therefore, that an Income account should take into account all profits or losses resulting from the trading operations, but should not take into account the profits or losses arising from a revalu- ation of capital assets, it may eventually be held, on legal as well as on accounting principles, that the statement of earn- ings presented by a holding company is not correct unless it takes into account, by way of either a reserve or a direct addition to or deduction from the capital value of the invest- l8o ACCOUNTING PRACTICE AND PROCEDURE ment, the profits or losses made in operating the subsidiary companies. Intercompany Profits and Accounting In a large consolidation, when the subsidiaries are carry- ing on business as separate entities, and contracting and dealing with each other as independent concerns, the elimina- tion of profits on sales or transfers between companies is a somewhat difficult and complicated matter, particularly having regard to the fact that each subsidiary company is legally entitled to take up the profits on such sales, and, if there are substantial minority interests outstanding, has no right to exclude them. This difficulty has been overcome by means of an elaborate system of accounting which provides for carrying the intercompany profit through the operations as a separate item from the original cost, until such time as the finished product is sold to parties outside the consolida- tion. The method by which this result is accomplished may be shortly outlined as follows : Company A produces a raw material and sells it to com- pany B at a profit of, say, lo per cent; company B converts this raw material into a partly finished product and ships it over a railroad C, owned by the consolidation, to company D, by whom it is further manufactured and finally sold to outside parties. Company A produces material to the cost value of $100,000, and sells $20,000 of this to outside parties, $60,000 to company B, and has the remaining $20,000 in stock. Company B buys material from company A, costing $60,000, for $66,000; spends $34,000 in further manufacture; ships $70,000 of the manufactured product over railroad C to company D; sells $20,000 to outsiders, and has $10,000 in stock. Company D purchases products from company B, costing $70,000, for $77,000; pays $5,000 freight to railroad C — which costs the latter $3,500; CORPORATION ACCOUNTING AND FINANCE l8l expends $18,000 in completing its manufacture; sells $80,000 of the finished product to outsiders, and has the remaining $20,000 in stock. The books of company A require no special entries. In company B's books its Manufacturing account will stand as follows : I. C. Profit 1st Cost Total Cost of material. .. . $6,000 $60,000 $66,000 Manufacturing cost 34,000 34,000 $6,000 $94,000 $100,000 Cost of Sales : To outside parties 1,200 18,800 20,000 To Company D.. 4,200 65,800 70,000 Balance in stock. . . ., $600 $9,400 $10,000 In company D's books the Manufacturing account will be dealt with similarly, as follows : I. C. Profit 1st Cost Total Cost of material per Company B.... $11,200 $65,800 $77,000 Freight 1,500 3,500 5,000 Manufacturing cost 18,000 18,000 $12,700 $87,300 $100,000 Cost of Sales : To outside parties 10,160 69,840 80,000 Balance in stock .. . $2,540 $i7',46o $20,000 The subsidiary companies will take up in their Income accounts the whole of their profits on their sales, and will declare dividends in the usual way. Out of tjie dividends it receives, the holding company will set up $600 in respect of B's profits, and $2,540 in respect of D's profits, or a total of l82 ACCOUNTING PRACTICE AND PROCEDURE $3,140, which will be credited to an inventory reserve. In this way, all stocks on hand of all companies are, on the consolidated balance sheet, carried at net cost within the consolidation, and the consolidated income takes up no profit except on sales made to outside parties. If any of the product is used for construction work within the organiza- tion, the net cost only is used, so that no profit of subsidiary companies enters into capital expenditures. The actual process, by reason of the magnitude of the business and number of transactions, is necessarily more complicated than the simple example given, which, however, is sufficient to show the principles involved. What is a Constituent Company? One other difficult point is the determination of what is or is not a constituent company whose Profits and Losses or Assets and Liabilities should be brought into account in this manner. It is suggested that this depends partly on the proportion of stock owned, and partly upon the degree of control exercised by the holding company. When the latter owns at least a majority of the stock, operates the company, dictates its policy, and practically treats its property as its own, subject only to the right of the minority stockholders to receive a share of the profits, the conditions would appear to be such as to require the proportion of profits and losses corresponding to the stock owned to be taken up. In order to justify a consolidated balance sheet, in addition to the other conditioiis just mentioned, the ownership of at least the common stock should be substantially complete; or the balance not owned should consist either of shares left in the hands of managers or others for business purposes, or of shares the ownership of which cannot be traced. On the other hand, a mere majority ownership of stock without any effective control of the management and operation. CORPORATION ACCOUNTING AND FINANCE 183 should properly be treated as a permanent investment, sub- ject to the same rules as other investments of a similar character. The conditions under which any stock of a subsidiary company remains outstanding are of some importance, not only in determining whether the ownership of the holding company is sufficient to justify or require consolidated accounts, but also in determining what proportion, if any, of the surplus should appear on such a balance sheet as apper- taining to the minority stockholders. The proper practice is to take up as a liability the par value of the outstanding stock, together with its relative share of surplus ; but when the amount involved is small, the proportion of surplus is not always set aside. If minority stock is left outstanding by deliberate intent, as, for instance, to give managers of the company a sub- stantial interest in its results, then a share of any undis- tributed surplus clearly appertains to this outstanding stock, and the liability to be taken up, therefore, is the par value of the stock, together with the proper proportion of the accumulated surplus. Other Forms of Consolidated Statements While the consolidated balance sheet already discussed is on the whole the best method of stating the accounts of a holding company with a group of controlled subsidiaries, it is not necessarily the only one. It must be remembered always that the object of accounts is to show facts, and that any form of statement which discloses all material facts is equally permissible and proper; whether one or other of these forms should be adopted, is largely, but within limits, a matter of individual preference. Such statements are frequently prepared in a form in which there is shown, as one item in the balance sheet of the l84 ACCOUNTING PRACTICE AND PROCEDURE holding company under the heading of "Investments in Sub- sidiary Companies Controlled," the total cost to the holding company of the stocks of its subsidiary companies. This is supported by a columnar statement, each separate column of which contains the assets and liabilities of one subsidiary company under the usual and proper headings; while the total column contains a summary of all the detail columns, eliminating intercompany items, and adding or deducting the amounts by which the prices paid by the holding company for the stocks of the subsidiaries exceed or fall short of the par value of their stocks and surplus. The consolidated balance sheet shows to shareholders of the holding company the position of the interests they own or control through these shares, but it does not per- haps answer this purpose so well for either creditors of, or minority stockholders in, subsidiary companies. The con- solidated balance sheet, being a grouped balance sheet, does not distinguish between the liabilities of different companies in the group, and does not show separately the assets to which the creditors must look for the discharge of these liabilities. Similarly, the stocks outstanding in the hands of the public are shown as representing all the assets in the consolidation, and no separation is made of those appertain- ing to the stocks of any particular subsidiary company out- standing in the hands of the public. Such objections apply in a lesser degree to the balance sheet of any single company which has different classes of bonded debt, each secured on separate assets. The objec- tions in the case of the consolidated balance sheet, as in the case of any ordinary balance sheet, can be met by subsidiary schedules giving the information required, or by publishing the balance sheet of each separate company as well as the consolidated one. CORPORATION ACCOUNTING AND FINANCE 185 (2) Profits Earned Before Date of Consolidation A question of considerable importance in its bearing upon the determination of profits in a holding company, or in any corporation which has acquired a going business, is that of the proper disposition of the profits of the consolidating companies, or of the purchased business, earned prior to the date of consolidation. There is a clear rule of common sense, and probably also of law, that a corporation cannot earn profits before it exists ; when, therefore, a corporation at its organization purchases an undertaking, together with the profits accrued from a certain prior date, the whole of such profits earned prior to the date of purchase must be treated as a deduction from the purchase price, and not as a credit to Income account available for dividends. This proposition is the more evident if it be remembered that these profits exist in the form of assets included among those purchased, and that any realization thereof is merely a return to the purchasing company of a portion of the pur- chase money, i. e., of the capital of the corporation. Similar reasoning will show that where a holding corporation pur- chases the stocks of several others, all profits of the pur- chased corporations accruing up to the date of the purchase must be treated by the holding corporation as a deduction from the price paid. The subsidiary corporations can legally declare dividends therefrom; but these dividends, when received by the holding corporation, are merely a transfer to it of some of the assets included in the value of the stock it purchased, and are therefore a return of capital ; and divi- dends declared and paid by the holding corporation to its stockholders out of such profits would clearly be paid out of capital. It is important to note that the date of purchase should be taken as the date of the contract for purchase, and not the date of completion. If the purchasing corporation was in existence at the date of entering into the contract, it l86 ACCOUNTING PRACTICE AND PROCEDURE is to be presumed that the price fixed had relation to the conditions existing at that date, and that the corporation is entitled to treat as profits all earnings of the subsidiary cor- porations subsequent to that date, less any consideration, such as interest, given for those profits. But if the holding corporation had no legal existence until a later date, it is sub- mitted that, as it cannot earn profits when it is not in exist- ence, it is only entitled to distribute as dividends profits of the subsidiary corporations earned subsequent to its own incorporation, or to the purchase of the property, whichever is the later date. (3) Questions Arising on the Organization of a Corporation Initial Surplus It frequently happens that a corporation contracts to purchase property at an agreed price, which on the face of the contract is declared to be its value, and that by another clause in the contract, or by another contract, the vendors agree to provide, in addition to the property, a certain sum in cash for working capital or even for free surplus. It is sometimes maintained that this free sum so provided is a profit or surplus of the new corporation available for pay- ment of dividends if the directors so determine. It is sub- mitted that this contention is entirely unsound. Vendors are men of business, and it is not their practice to give something for nothing. A contract must be assumed to be the result of a bargain between purchaser and seller, and whatever the purchaser is to receive under the contract must be set of^ exactly against what the vendor is to receive ; and although, in the formation of a large number of modern corporations, the vendors and purchasers, through the intervention of syndicates, are one and the same, the only safe and sound CORPORATION ACCOUNTING AND FINANCE 187 method of accounting is to assume that the same principles apply as in the case of an ordinary sale. It is difficult to believe that, if such a contract formed the subject of legal proceedings, any other view could be taken than that the so-called gift for working capital was merely a return to the purchaser of a portion of his purchase money, and should be so treated in the accounts. If the reverse principle were upheld, and this gift were treated as a clear profit to the corporation and distributed in dividends, it would seem that a portion of the subscribed capital would in effect be returned to the stockholders. In a few exceptional cases properties are transferred to corporations at appraised values, and for some reason the stock and other securities issued for the properties have an aggregate par value less than the appraised value of the properties and all other net assets. Assuming that the appraisals are genuine, it would seem that in such a case the corporation commences business with a real surplus, which, however, is clearly a capital and not an income one. Such a condition can only exist when the appraisals cover sub- stantially all the assets. Losses on Current Assets Acquired Other accounting questions relating to the formation of consolidating corporations have relation to losses that may occur on current assets taken over from the vendors. The valuation of inventories for purposes of transfer from a vendor to a purchaser is frequently made on a higher basis than would be usual for a going concern, the vendor in effect stipulating for some profit on his unsold product. The excess over the fair, going value of the inventory must in such cases be considered as an addition to the fixed capital investment in the shape of goodwill. Similarly, if debts and liabilities, as is sometimes the case. l88 ACCOUNTING PRACTICL AND PROCEDURE are taken over without any guarantee from the vendor, and a loss occurs on final realization and payment, this loss may also be treated as an addition to the amount paid for good- will. These principles are in accord with those heretofore laid down, that profits and losses of a corporation are such as arise, out of its operations subsequent to the date of its formation or of the purchase of its properties, and that profits and losses appertaining to a period prior to these dates are capital items. Adjustment of Inventories on Purchase and Sale of a Busi- ness It frequently happens that the vendors have many con- tracts in force for the purchase of materials or supplies or manufactured articles, at prices differing widely from the market price at the date of sale. It is, therefore, fair both to the vendor and the purchaser in such cases that some regard should be paid to such contracts. If the vendor has made advantageous contracts a long way ahead at a time of low prices, the purchaser is certainly getting something more than the mere business contracted for; on the other hand, if such contracts for purchase are above current market prices, then the purchasing company is in a worse position than it otherwise would be. It is, however, doubtful whether it is a fair proposition as between the vendor and the pur- chaser that the market price on the date of the transfer should necessarily form the basis of a settlement between them. Some allowance must be made for the good judgment of the purchasers, and they should not be required to take over large quantities of materials on the fixed date of acquiring the property, at prices which in the ordinary course of business they might not have considered, when the trans- fer of such an inventory at the top market price may have a considerable effect on the future prosperity of the business. CORPORATION ACCOUNTING AND FINANCE 189 It is certainly, therefore, a material fact to the intending investor that he should be clearly informed on what basis of price the inventories will be acquired, and what contracts for purchase of materials or manufactured articles have been entered into at prices differing from those current. Another material factor is the amount of orders on hand for future delivery, and the prices therefor, and the proportion such orders might bear to the. possible capacity of the works. As a rule a large number of orders on hand may be regarded as a source of strength if they have been obtained in the ordinary course of business and at reasonably remunerative prices. It is, on the other hand, an easy matter to obtain orders if no regard be paid to the prices, and it might happen that an unscrupulous promoter had built up a large prospec- tive business, at totally unremunerative prices, for the sole purpose of transfer to the purchasing company. Even with- out any fraudulent intent it may be that, owing to a consider- able rise in costs, either of raw materials or labor, or both, the vendor concern may have on hand contracts taken when the range of prices was much lower, which can be filled only at considerable loss' to the purchasing company. Similarly, orders on hand' — to be completed by a fixed time — to an amount largely in excess of the actual or contemplated factory capacity, might easily be a source of loss rather than of profit to the purchaser. These are some and perhaps the more important of the questions that may arise in practice when a new corporation is formed to take over one or more businesses as going concerns. CHAPTER IX SOME THEORIES AND PROBLEMS IN COST ACCOUNTING The subject of cost accounts is one of the widest import- ance, and on its practical side calls for a fuller treatment than is possible in a general work on accounting. The economic theories involved in determining the cost of any- given article of manufacture, together with an outline of the general methods of cost accounting, and some of the more important problems involved therein, form the subject of this chapter. The term "manufacture" used in its widest sense com- prises every operation necessary to render a natural product available for use, and by so doing to give it a value based upon cost in excess of that which it had in its natural state. The elements that enter into the process of manufacture are: (i) The natural product itself — or material. (2) The subsistence necessary for the labor or service employed in converting it to use in the place where it is required, and during the time occupied in this process — or labor. In these elements nothing in the nature of profit is involved, for the reason that profit is represented by the difference between the actual cost of labor and material, and the value which the combination of labor with material 190 PROBLEMS IN COST ACCOUNTING 191 has given to the finished product, this being dependent on the demand for and supply of the particular article. The resultant value so determined may at any moment be more or less than the cost of the primary elements, and if it exceeds this cost there is a profit, which is divisible among — (i) The individuals whose joint efforts have brought this natural product into the shape for which and to the place at which the demand exists, i. e., labor. (2) The owner of the natural product and the owner of the accumulations which provide for the subsist- ence of labor during the period of manufacture, i. e., the capitalist. If, on the other hand, the selling value falls short O'f the cost, the loss must fall upon the capitalist; labor merely going without profit, except to the extent that the condition of the labor market may enable it to obtain in advance a definite sum, in lieu of its share of the prospective profit which may or may not be eventually realized. Nature of Plant At first sight it may appear that this elementary descrip- tion loses sight of the important part which land, buildings, plant and machinery play in the process of manufacture. A little consideration will show that this is not so ; but that these too fall naturally into the elements already given, each item involving the use of a natural product, and its conver- sion by means of labor over a period of time necessitating the provision of subsistence by a capitalist. For instance, the conversion of ore into manufactured steel involves the following operations : (i) Natural products consumed, i. e., ore, coal, timber, etc.; 192 ACCOUNTING PRACTICE AND PROCEDURE (2) Natural product used but not consumed, i. e., land upon which to carry on operations; (3) Labor— (a) Extracting ore in some very primitive way; (b) Smelting this ore in some equally primitive , way, and with the use of fuel of some sort, both these processes being carried out as by savages with no provided facilities ; (c) The manufacture of some kind of tools by using the natural products so far devel- oped, and so, gradually and over long periods of time, constructing plants suit- able for manufacture; (d) The actual manufacture of the articles which are of use to the community and have an exchangeable value out of which profit can be realized. A more detailed consideration of the elements of mate- rial and labor will serve to bring out the principles involved in their determination. Constituent Elements of Cost Material cost consists in the first instance of the labor employed in obtaining possession of the material in its natural state, but the value is fixed from day to day on the basis of estimates of the probable supply and demand, and of the difficulties and cost of making it available. The pur- chase price so fixed is in practice accepted as the cost, although it necessarily involves profit to the original pos- sessor and to subsequent owners through him, who are able, by virtue of the limitation in quantity available at any time, to demand a sum down rather than wait for the uncer- tainties of future profit. The purchase price thus forms PROBLEMS IN COST ACCOUNTING 193 part of the cost, and should be recouped on sale before any profit can be ascertained. Labor is a direct element of cost, represented by the provision of at least subsistence to those who perform it, and its recompense varies, by reason of the supply of or the demand for labor of different classes, from the bare cost of living to a comfortable sum in excess of that cost. In effect, then, whatever share of ultimate profits the workers might eventually receive, is in most cases compounded for by a payment in advance, leaving the entire surplus profits to accrue for the benefit of capital, which, on the other hand, also has to suffer the loss, if any. The capitalist provides from his accumulated savings either natural products for temporary use, such as land, or natural products for consumption, such as material or sub- sistence. The latter, being consumed, are an element of cost ; the former, remaining unchanged, are not ; the consideration given to the capitalist for permitting his accumulated savings to be temporarily used or consumed is a share of the ultimate profit, or interest, which in theory is not therefore an element of cost. In practice the demand for capital, like the demand for labor, is such that the capitalist is frequently able to stipulate for a fixed immediate return for the use of his accumulations; thereby, as in the case of labor, com- pounding for his share of the ultimate profit and leaving the balance, with the whole risk of loss, to the borrower. Conditions Affecting Cost The amounts so paid by way of composition for the shares of profit to labor and capital may thus become a part of the cost to those who continue to take the risk; and it follows that the commercial cost of two identical articles, the absolute or theoretical cost of which would be identical, may be widely different because of the different conditions under which the processes of manufacture have taken place. As 194 ACCOUNTING PRACTICE AND PROCEDURE an instance, in the manufacture of a complicated machine the following alternative conditions may exist : (i) The manufacturer may own iron, coal, and other mines, and may at his own factories produce everything up to the finished product. In this case his costs will include no profit except that accruing to labor. (2) He may purchase all his natural products but carry on all manufacturing himself at his own factories. In this case his costs will include the profits of the owner of the natural products as well as those of labor. (3) He may purchase from other manufacturers the whole or a portion of the parts that enter into his finished machines. In this case his costs will include not only the profits accruing to labor and to the natural products, but also the profits of any number of other manufacturers who have preferred to limit their risk at a certain point of the manu- facturing process, leaving to the final manufacturer of the complete finished product the whole of the ultimate profit or loss. It is easily seen that in the first case the manufacturer's costs are very much lower and his profits very much higher than in the other two. On the other hand, he has a greater capital investm,ent, and is taking risks by reason of the longer time involved in the manufacture and the consequent greater chance of eventual fluctuations in demand and supply. A practical illustration of these conditions may be found in a comparison between the United States Steel Cor- poration, which owns its ore and other mines, and converts these materials into finished structures, and a contracting company which buys all its finished material and itself only erects the building or plant. Purposes of Cost Accounting Turning now from the economic to the commercial PROBLEMS IN COST ACCOUNTING 195 aspect of cost accounts, the principal objects to be attained by a modern cost system may be stated as follows : ( 1 ) To ascertain the cost of the same product at differ- ent periods in the same mill or at the same period in different mills, and so to remedy inequalities in cost by reducing all to the results shown by the best. (2) By an accurate ascertainment of the cost of output, to maintain running book inventories, which will show at any time, without a physical inspection, how much of each class of materials, supplies, etc., is on hand, rendering possi- ble a reduction of stocks and capital invested to the lowest level consistent with efficiency; and at the same time avoid- ing the delay, expense and interruption to business conse- quent upon the old method of taking a complete physical inventory at a specific date in each year. (3) The preparation of statistical information as to costs of parts, quantity, and variety of output; relative efficiency of different classes of labor; and relative costs of labor and material, between different mills and periods. (4) The preparation of periodical statements of income in a condensed form, readily giving directors all material information as to the results of the business. This is, per- haps, the least important of all the objects aimed at ; and it may safely be said that the cost of a system designed merely to produce periodical statements of income, without providing for the other and far more important objects set out above, may be considered as money thrown away. Constituent Elements of Commercial Costs The elements involved in commercial cost accounts are usually somewhat as follows: Material — (i) That to which manufacturing processes are applied to convert it into some different form ; 196 ACCOUNTING PRACTICE AND PROCEDURE (2) That which is used or consumed in the proc- esses of manufacture, (a) Directly; (b) Indirectly. Labor — (i) That employed directly upon the materials under process of conversion ; (2) That employed indirectly in operations neces- sary for the manufacture but not a part of it, such as upon repairs to and upkeep of ma- chinery, buildings, or equipment. Expenses — Consisting partly of material and partly of labor, which are incidental to the carrying on of a manufacturing business, but have not any direct relation to the process of manufacturing. Wear and Tear — Or the gradual consumption of the buildings, machinery, and equipment employed in the manufacturing process — more commonly known as depreciation. Distribution of Overhead Expense The object of any system of cost accounts being to ascertain the cost of manufacture of each article or class of articles, it is clear that in a factory producing many classes of product some method must be adopted for distributing many of the items of cost over these different classes. Material in process of direct conversion and labor directly employed in such conversion present no difficulties, being easily chargeable to the process ; and the same is true of auxiliary material consumed in the process or of auxiliary labor which can be segregated at the moment. PROBLEMS IN COST ACCOUNTING 197 There is, however, a large class of items which cannot be distributed exactly, and yet are a necessary and integral part of the cost. These comprise part of the items of mate- rial and labor, and the whole of the items of expense and wear and tear, and are usually grouped under the term "overhead expense" or "burden," and distributed on a more or less arbitrary basis among the different products. This distribution involves difficult questions ; and the adop- tion of an erroneous method may easily appear to show that certain articles are manufactured at a cost well below their selling price, while a more accurate distribution would show a reverse condition. The most usual method of distri- bution is by a straight percentage on the direct labor cost, and where all products are of the same nature this may give fairly accurate results; but it is not scientific. On the other hand, a more scientific system of distribution based on an exhaustive examination of processes, with a view to determining what share each operation should bear of each class of overhead expense, and requiring an elaborate analysis thereof, may involve so much expense as to be pro- hibitive; and the final result may be found not to differ materially from the more simple and ready method of a percentage division. Modern factories are usually operated by departments, between which there are well marked divisions. Each de- partment within its own limits occupies a certain floor space, involving light and heat proportionate thereto; uses an amount of power which can be estimated within reasonable limits; and has certain labor and other costs for general assistance, cleaning, stores, and superintendence, which belong entirely to its operations in total. All these can be charged to the department and serve to determine the burden of that department. Some items, such as insurance, heat and light, may be charged to the department on the basis of 198 ACCOUNTING PRACTICE AND PROCEDURE floor space; others, such as steam or electric power, on the basis of horse-power hours worked; others again, such as general labor, on the basis of the direct labor pay-roll ; and others, such as superintendence and general expenses, on the basis of labor and material costs combined. This main division is a comparatively simple one, although the circum- stances of each case require careful study in order to deter- mine the most nearly correct method ; and if the industry is such that each department is carrying out only one class of operation, easily measured on some unit basis, the division of this burden over unit costs presents few difficulties. It is in cases where the operations in a department are of a varied and complicated nature — such, for instance, as a large machine shop — that almost insuperable difficulties arise; and in such cases it may well be doubted whether any really accurate distribution is possible. Selling Costs In considering the item of overhead expense, it is neces- sary to emphasize the distinction which must be made be- tween expenses necessary for the production of manufac- tured articles in a form in which they are ready for sale, and the expenses incurred in offering them for sale to the public and in carrying through the sales when made. The former item, as has already been shown, is an essential ele- ment of the cost of manufacture ; the latter item is an ele- ment of cost only from the point of view that without such expense the products could not be sold and the profits could not be earned. Strictly speaking, therefore, these selling expenses should be deducted from the price ultimately ob- tained for the product, and the diiiference only should be considered as the amount realized for the manufactured article. In practice this same result is often achieved in a different way by distinguishing between manufacturing PROBLEMS IN COST ACCOUNTING 199 cost and selling cost; manufacturing cost alone being employed for the purpose of valuing the product which remains on hand unsold at the time of taking an annual inventory, and selling cost being dealt with only in memo- randum form, in order that those engaged in selling the products may know the limit below which they should not be disposed of. Importance of Accurate Cost Keeping The necessity for accurate cost keeping by commercial enterprises lies in the fact that without such cost keeping, whether it be of a highly scientific nature or merely by rule of thumb, it is impossible for a manufacturer to know whether the price at which he decides to sell his articles will or will not yield a profit. The objection to rule of thumb methods is that they 'are generally quite inaccurate, except where manufacturing processes are relatively simple. In the most usual cases, where the process of manufacture is divided over a number of separate departments, each repre- senting a dififerent set of operations, any such methods can only lead to serious errors and frequently to ultimate loss. It should be noted that, while the ascertainment of accu- rate costs is essential, it does not necessarily follow that no profit can be realized by selling at a price which appears to be below such cost. In any factory equipped for a certain volume of production, the overhead charges will remain practically stationary, whether the factory be operated to its full extent or to only a small proportion thereof. It will follow, therefore, that the unit cost of manufacture, includ- ing overhead expense, will be much higher when the factory is partly operated than when it is fully operated ; and conse- quently a manufacturer can earn profits for himself by increasing his output and selling the increase at a reasonable margin over and above the direct cost excluding overhead 200 ACCOUNTING PRACTICE AND PROCEDURE ^ expense, thereby reducing his unit costs and making more profit than he would have made on the smaller output. It is, however, safe to say that it would be dangerous to attempt to carry out any such procedure without an accurate knowl- edge of direct, overhead and selling costs. Relation of Interest and Rent to Manufacturing Cost One of the most important questions involved in cost accounting has relation to the propriety of including interest and rent in costs of manufacture. It must be premised that the object of the investment of money in any undertaking is to realize a profit. The induce- ment to an individual to invest his capital in an industry, rather than in the purchase of stocks or bonds, is largely the fact that by so doing he not only can obtain remuneration for his own services, but can also obtain a higher return or rate of interest on the capital invested, although at the same time he takes increased risks. The old theory of economists has been that there is a certain rate of return on money which eliminates all elements of risk, and that this rate only should be termed interest, all additions thereto being con- sidered as compensation for the risk involved ; but no econo- mist has yet been able to say what this minimum rate is, and even in the case of what is perhaps the lowest rate known — namely, that yielded by United States Government bonds — it can not be said that the element of risk is entirely absent. The impossibility of determining this pure rate of interest apart from risk goes to show that there is in effect no such rate, but that all returns upon money invested, whether in bonds or stocks or other business enterprises, are the profits realized on the use of that money. Nature of Commercial Investments Those who invest money in business enterprises fre- PROBLEMS IN COST ACCOUNTING 20I quently, and in fact generally, make arrangements by which they join in partnership with others who also wish to invest, giving to these others a share of the resulting profits as remuneration for the capital employed. This share is deter- mined by reference to the risk which the different parties to the enterprise take ; some prefer to take security in the shape of a first charge upon the whole property, and to compound for their share of the profit by a fixed annual payment, this fixed annual payment being that which is commercially known as interest. Others are willing to take a somewhat greater risk, but do not wish to take the whole of it, and they limit their risk by taking for the capital which they contribute a preferential charge upon the earnings or profits of the business, leaving the whole of the balance available for those who take the ultimate risk; the remuneration of both these classes being known commercially as dividends. There is still another class who do not contribute capital in the ordinary sense of the word, but provide the business with facilities, such as buildings, machinery, etc., compounding with their partners by agreeing to accept a fixed annual pay- ment in lieu of the share of profits to which their contribu- tion to the capital would entitle them ; such payments being generally known as rent. All, however, whether consisting of interest, dividends or rent, are merely a division of the profits resulting from the business, and in the long run can only be met out of those profits either directly, or in some cases, owing to the nature of the relations between the different parties, by certain of them suffering an actual loss of a proportion of their share of the capital in order to carry out the bargain made with their partners. Interest and Rent Not a Manufacturing Cost The profit or return consists of the difference between the sale price of the product and the cost of producing and 202 ACCOUNTING PRACTICE AND PROCEDURE selling that product. It is clear, therefore, that interest or rent, or any other item in the nature of return upon capital invested, should not form a part of the cost of product, the ascertainment of which is a first essential to the determi- nation of the yield or return which the business gives, and out of which the divisions of profits are to be made. It is true that, as between the contributors to capital, those who take the ultimate risk may advance or commute the share of profits of others ; but this is merely a bargain between the different classes of contributors, and should not in any way affect the cost of product. If interest and rent are treated as cost of product, then the extraordinary result is shown that the cost of making a certain article (other things being equal) in a business in which the contributing interests are divided between (a) the owner of the factory, (b) the owner of capital taking a small risk, and (c) the owner of the residue of the capital, will be greater than in an exactly similar case where the residuary owner provides the whole of the capital required. It seems clear that the relations between the partners or con- tributors should not in any way affect the cost of the product ; and furthermore it would not be reasonable that a manufacturer who had, by hiring his factory, raising loans, sharing profits with his employees, and such kindred opera- tions, distributed a considerable portion of his profits, should then raise his prices to an amount in excess of his neighbor's who had decided to provide all his own facilities and not to share his profits with anybody. The principle that rent and interest are a distribution of profits is recognized in the form in which railroad accounts are now prepared, where both rentals of leased lines and interest on borrowed money of all kinds are treated as a charge against the income from operations after the same has been ascertained — that is, as a distribution of profit"?- PROBLEMS IN COST ACCOUNTING 203 Rental Charges In the case of manufacturing companies no such clear recognition of this principle is found ; and rent for factories, etc., where paid, is treated as an item of manufacturing cost or expense, while interest, an exactly similar item, is more usually treated as a charge against, or division of, profits. This method of charging rent as an expense has led to a claim that it is properly so treated, and that therefore, when a manufacturer owns his premises and pays no rent, an esti- mated amount corresponding to the value of the use should be charged into and considered as part of the cost thereof. This sounds plausible; but it is believed that a nearer approach to theoretical accuracy is to be found in the railroad practice of considering all rentals, at least when there is a natural division between rent and other service, as a charge against or division of profits. The question of rent serves to show the difficulty, if not impossibility, in practice, of laying down any hard and fast rules based upon economic principles, which are to so great an extent theoretical. Rent has so far been considered only as relating to the provision of manufacturing facilities, land, etc. ; but an industry exists in which capitalists erect build- ings, and let them out in whole or in part to others for offices, residences, and other purposes incident and necessary to busi- ness enterprise of all kinds. Rent of a factory is clearly a distribution of profit, but it is difficult in practice to make the same claim for office rents, and yet the arguments seem almost identical. A general distinction may perhaps be made between rent paid for the use of premises which form a direct and integral part of the manufacturing operations, and that paid for premises which are merely incidental thereto ; and a further distinction lies in the frequent inclu- sion in rent of a charge for other services, such as light, heat, cleaning, or elevators, or for depreciation, etc., all of 204 ACCOUNTING PRACTICE AND PROCEDURE which involve labor and profit, just as these items are in- volved in the purchase of material. No general rule can be laid down, beyond suggesting that wherever an item of rent appears to consist mainly of a direct division of profit, it should be so treated, and only considered as part of cost when it seems to be mainly a composite item of labor, mate- rial and profit representing service rendered. Difficulties of Including Interest as a Manufacturing Cost Turning to another aspect of the interest question, it is necessary to consider what rate should be adopted if it should be granted for the sake of argument that interest should be charged into costs. Is it to be the rate which should be obtained on capital invested absolutely without risk, or is it to be the rate obtained by investments in stocks or bonds, and, if so, of what class, inasmuch as the rates on these vary all the way from 2 per cent on United States Government bonds, up to 10 per cent and 15 per cent, and even 25 per cent and more, on mining and other investments? Or is it to be the reasonable rate which the particular business should return on the money invested therein ? It has been gener- ally assumed by the advocates of this course that interest at the rate of 5 per cent or 6 per cent should be charged into cost, but these rates mean nothing in themselves ; they have no bearing whatever upon the particular industry or on the rate which money can earn in specified investments outside; they are arbitrary standards which those in the commercial community have set up in their own minds. The only rate which could be justified in argument, assuming that it be correct to include any interest at all, would be the rate which the owners of the business thought they ought to obtain on the money they had invested in it. The adoption of such a rate would at once raise the question: To whom should the profit earned over and above the rate so charged PROBLEMS IN COST ACCOUNTING 205 belong? The argument would seem to be that, inasmuch as the capitalists have charged into costs and obtained for them- selves the rate which they think they ought to realize on the whole business, the balance of it — which under such pro- cedure would be called profit — does not belong to them at all, but to those who purchase goods from them or to the general public or the Government. This is a conclusion which would hardly be desired by any manufacturer. The impossibility, therefore, of determining a rate which could be successfully defended, affords another ground for the conclusion that interest is not a proper charge to costs. Some advocates of the inclusion of interest in cost pro- pose only to include interest on the fixed plant employed in manufacture ; but obviously such a course may in many cases be absolutely misleading. If, of two plants turning out the same product, one requires the employment of fixed assets of a value of $10,000 for thirty days, and the other the employment of fixed assets of $5,000 for sixty days, the interest charge introduced upon this principle will be the same in both cases, whereas the process which takes sixty days to complete will obviously involve a longer investment of working capital. But if an attempt is made to allow for interest both on fixed and working capital, the adjustment will inevitably be a very complicated and difficult one to carry out. Where interest on fixed assets alone is consid- ered, the calculation of the charge is not free from difficulty. The amount of capital employed and the time for which it was emplayed may perhaps be easily determined ; yet, unless continuous production throughout the year is possible, the interest charge based thereon will be inadequate, and any calculation to be correct must allow for the time during which the plant will normally be unemployed. Some confusion in relation to the items of rent and interest is found in the relation of the profits of a corpora- 2o6 ACCOUNTING PRACTICE AND PROCEDURE tion or an individual to the profits of the business whiAi is carried on. The latter should be identical under the same conditions of manufacture, whatever the financial arrange- ments may be, but the former are affected materially by the share of such profits which is distributed to others in the shape of rent and interest, as well as in commission or other payments dependent in any way upon profits. The inclusion of these distributions as a charge, before determining the ultimate profit accruing to the corporation or the individual manufacturer, does not thereby justify their treatment as part of the cost of product. Suggested Treatment of Interest in Connection with Costs Although it cannot be conceded that interest is a proper element in the cost of product, there is an undoubted demand for some form of statement which will give effect to the interest element, at any rate for comparative and statistical purposes. The most usual objects sought may be grouped into three classes: (1) Cases in which the lapse of time is a necessary part of the cost of production, alnd materials consequently have to be stored for long periods while a seasoning pro- cess is completed, e. g., lumber or tobacco. (2) Cases in which it is desired to give effect to varia- tions in the amount of capital employed and the term of employment in the production of different articles, or the same articles by different methods or factories. (3) Cases in which capital is expended in additional facilities with the view of cheapening cost of production, and it is desired to set off the interest on the new capital against the savings effected. In the first case, there is a substantial and necessary lapse of time between the purchase of materials and the date when PROBLEMS IN COST ACCOUNTING 207 they become useful or productive — as, for instance, in the case of seasoning lumber; and the selling value of the product, apart from market fluctuations, increases by reason of the lapse of time to an amount more than sufficient to provide for an interest charge. The arguments already adduced apply equally against treating as part of cost, any interest that may accrue on money borrowed for the pur- pose of carrying the product until it matures. In fact, the stockholders, in compounding with the lenders for interest at a fixed rate payable at a fixed time, have in effect made an advance out of their share of the profits pending realiza- tion ; and while this advance can not properly be treated as part of the cost, it may, as an asset, properly be carried for- ward as a deferred charge against profits under the category of working assets. In the other cases, the correct way of arriving at the desired result is not to charge into the cost interest at an arbitrary rate — which means little or nothing — but to com- pare the margin between the sale and cost price, or in other words the return upon each product, with the capital invested, in order to secure that return. This comparison would be a true one, would show exactly how much the capital invested really earned, and would be a good guide as to whether too much or too ' little capital was invested. Moreover, the adoption of the arbitrary rate defeats its own object, for, according as the rate adopted varies from the true rate, if there be such, so the comparisons deduced from the results will be erroneous. If the capital invested in a mercantile business should yield from 15 per cent to 20 per cent on the investment, then it is clearly erroneous to say that the operations resulting from the use of a certain machine, in which a certain definite proportion of that capital had been invested, should be charged with interest on that capital at 5 per cent, or 6 per cent, or some other rate entirely 208 ACCOUNTING PRACTICE AND PROCEDURE different from that which it is really expected to yield. As between two different kinds of machines used to produce the same product, but having different capital values, the con- clusion reached by comparing the cost including interest at 5 per cent will be entirely different from the conclusion reached by including interest at lo per cent, and neither of these rates will be anything more than a guess. Statistical Comparisons between Production and Capital Invested The demand for statistical statements of comparison between production and capital invested requires considera- tion of the following factors involved in profits : (i) The labor, material and expense cost of a unit of each class of article; (2) Facilities used in manufacture, such as land, build- ings, machinery, tools, stocks on hand and other working capital, all segregated between the differ- ent classes of articles ; (3) The time during which such facilities are in use for a unit of each class ; (4) The selling price of each unit of each class. If these elements be known, Comparisons can be made between different articles produced in the same factory, or between the same articles produced in different factories, as to the amount of fixed capital employed in different processes, and the time for which it is employed; as to the amount of working capital constantly maintained and used ; and as to the effect of further expenditures on additions and improvements with a view to cheapening cost of pro- duction. The first of the above four factors should alone enter into the general accounting books and form the basis of inventory valuations, and so of the actual profits earned ; PROBLEMS IN COST ACCOUNTING 209 the remaining factors should be dealt with only in subsidiary statistical records. The difference between the sum of all selling prices (4) and of all costs (i) will agree with the gross profit in the accounting books; and a comparison of this figure with the total capital employed, including not only fixed but circulating capital necessary for manufacturing purposes, will give the rate of return yielded by all classes of articles. The cause of any variation in this rate of return, as compared with a previous period, or of the varying rates of return on different articles in the same factory, or of the same articles in different factories, will be obtained from the detail figures. Such variations may be due either to — ( 1 ) Higher or lower cost of labor, material and expense ; (2) Greater or smaller amount of facilities used; (3) Longer or shorter time during which these facilities are used; (4) Lower or higher selling price. If interest at an arbitrary rate is included throughout in labor, material and expense costs, it means that the fluctua- tions in profit due to the first three of these variations are merged into one and can not without considerable labor be again segregated. The best measure of factors (2) and (3) would seem to be the value of the facilities used, multiplied by the fraction of the year during which they were used, and divided by 100, which product would be equivalent to interest at I per cent per annum ; the actual margin between selling price and cost of labor, material and expense divided by this product, would thus be the actual rate of return yielded by any particular class of articles, the average of such yields corresponding to the yield shown by the principal accounting records. Unused facilities would under this system appear as a factor in reducing profits, either by lack of sufficient business 2IO ACCOUNTING PRACTICE AND PROCEDURE to employ them, or by excess facilities in one portion of the plant as compared with another. The product factor corre- sponding to these unused facilities would form part of the divisor in obtaining the average yield. Comparative costs of separate operations will be reached by a consideration not only of the actual labor, material and expense cost in different periods or in separate factories, but also by a comparison of these costs with the facilities em- ployed. Thus the estimated savings to be effected in any operation by additional expenditures on construction account, should be found reflected in the reduced cost of these operations. Such a plan as that here suggested gives proper weight to all the factors entering into profits without introducino- any arbitrary rate of interest; it will be no more complicated in its working than are cost systems which are in constant use, and its complications will vary with the number of different articles produced for which separate costs are required. Profit-Sharing in Its Relation to Costs The question is frequently raised whether distribution of profits made to employees under profit-sharing schemes, or contributions to special funds, for their benefit, are proper items to include as part of manufacturing costs. This ques- tion must be answered in the negative. Labor has already received its subsistence, and this is properly included as cost ; any further distribution to labor, whether by way of a share of profit or a provision for old age or sickness, unless it be a contractual or compulsory payment entirely independent of profits, represents a further share of labor in the profit. Contractual and compulsory payments not dependent on profits, compensation for accidents and casualties arising in the course of manufacture, and pensions to retired employees PROBLEMS IN COST ACCOUNTING 211 are, however, clearly proper elements of cost. All voluntary- distributions to labor not called for by contract or law, or arising- directly out of the process of manufacture, must be considered as a further share in profits given to labor. Cost as a Price Basis Contracts are frequently entered into on the terms that the price is to be fixed at actual cost plus a percentage thereon, and disputes sometimes arise as to what constitutes cost. These disputes are almost always due to carelessly drawn contracts, the parties thereto and their legal advisers frequently having a very loose idea of the principles in- volved. The importance of a clearly drawn contract is evi- dent, in view of the conflicting views on such subjects as rent, interest, bonuses, commissions to employees, and many other similar items ; and if a proper form of contract exists no dispute is likely to arise. In the contrary case, however, the elementary principles of costs may be relied upon to solve the difificulty. If a manufacturer enters into such a contract, it must be assumed that he has all the facilities necessary for carrying it out, and no charge for the use of those facilities, other than actual wear and tear and depreciation thereof in the course of carrying out the contract, can be allowed as an item of cost. Similarly, no charge can be allowed for rent or interest, or other items, which, according to the theory laid down, represent a share of profits on the operations. It is on these items that disputes generally arise, rather than on the more complicated questions of proper distribution of burden, upon which manufacturers and contractors are usually much better informed. CHAPTER X THE DUTIES AND RESPONSIBILITIES OF THE PUBLIC ACCOUNTANT In preceding chapters a statement of accounting prin- ciples and methods has been set forth, and it has clearly appeared that in order to insure their correct application a careful study .must be made of all the facts in each particular case. This critical examination is commonly undertaken by the public accountant, who is qualified for this purpose by his training and experience, and who undertakes certain duties and responsibilities in interpreting, advising upon, and certifying to statements of account for various purposes. These duties and responsibilities may be divided as follows : ( 1 ) Those in respect of the prospectus, or the prepara- tion and certification of accounts of past results for the pur- pose of the sale of a business or the issue of new securities. (2) Those in respect of audit, or the examination, audit, and certification of the annual statements of accounts. (3) Those in respect of liquidation and reconstruction, involving the preparation of statements and reports upon the condition of a business which, by reason of financial difficulties, is put into bankruptcy or into the hands of a receiver; and the preparation of further statements and reports for the purpose of its reorganization. 212 RESPONSIBILITIES OF PUBLIC ACCOUNTANT 213 ( I ) In Respect of the Prospectus Necessity for Accountants' Certificates The application to the public to subscribe to stocks and bonds of a corporation is generally termed a "prospectus." In Great Britain, where the value of the services of public accountants is more generally recognized, it is the almost universal custom that the prospectus should contain a certifi- cate by a chartered accountant as to the earnings of a period of years, and frequently also as to the financial position. In this country this certificate is still frequently replaced by a letter from the vendors, or from the president or direct- ors of the corporation, or from the bankers who recommend the investment, stating the results of operations and the present condition. As has been already shown, the questions involved in the determination of profits are often highly technical; those relating to the proper valuation of inven- tories at the beginning and end of any specified period, the provision made for maintenance and repairs, and the distinc- tion between renewals, improvements and construction, are of vital importance ; and a departure from correct principles in these and other matters may easily make what is really a losing business appear as a comparatively profitable one. The proprietors or chief officers of the vendor concern must to a large extent rely upon their subordinates for the facts which they furnish to the bankers or to the public. They have not, as a rule, the necessary skill in accountancy to detect errors, whether of principle or of detail, in the statements submitted to them; they do not properly appre- ciate the distinction between facts and estimates, which might perhaps be more properly described as "expert guesses" ; and finally, they are interested in putting the best possible complexion upon the general state of affairs, and will naturally, and not necessarily improperly, be biased in 214 ACCOUNTING PRACTICE AND PROCEDURE cases of doubt in favor of the view which is most to their own interests. The main desire of some bankers has been to sell the stocks or bonds which they are offering to the public, and make a quick profit on the turnover. Their reputation and standing requires them to take every reasonable precaution to satisfy themselves that the investment they are offering is a thoroughly sound and reliable one ; and while it is doubt- ful if letters from or facts supplied by the vendors are suffi- cient precautions, yet, as long as the public demands no more, there is no reason why bankers should offer more. In the meantime the natural bias of the promoter helps the banker with a favorable statement, and the verification, by a public accountant might show a less favorable condition and diminish the banker's profit. It may be added that the neglect of such obvious precautions by the honest promoter makes the task of the dishonest one comparatively easy, and in the interests of commercial morality and for the better protection of the public it is interesting to note that a change is in progress in this respect, and that the certificate of a reputable public accountant is becoming a much more common feature in prospectuses, and will no doubt soon be as universal here as in Great Britain. English Requirements as to Prospectuses The English practice, with reference to the issue of prospectuses, is worth a reference. Under the English Com- panies (Consolidation) Act, 1908,* every company inviting subscriptions for capital is required to file with the Registrar of Joint-Stock Companies a copy of its prospectus, or, if there is no prospectus, a statement in lieu of the prospectus, containing the following, among other information : the names and addresses of the directors; the minimum sub- *See Appendix III. RESPONSIBILITIES OF PUBLIC ACCOUNTANT 215 scription upon which the company may proceed to allot- ment; the names and addresses of the vendors of the propel ty purchased or proposed to be purchased or acquired; the purchase price, distinguishing the amount paid for good- will; the amount of commission payable for procuring sub- scriptions for any of the capital offered for subscription ; the estimated amount of the preliminary expenses ; the amount paid or to be paid to any promoter, and the consideration for such payment ; the dates of and parties to every material contract, and the time and place at which such contracts may be inspected ; the names and addresses of the auditors ; and particulars of the nature and extent of the interest of every director in the promotion of the company or in the property proposed to be acquired. In addition, it is the regular practice in all cases, except that of an entirely new business not yet established, to incorporate in the prospectus a certificate of a chartered accountant, as to the earnings for a period of years, and frequently as to the value of the net current assets, where these are to be taken over. The Act also provides, in Section 84, that every director or promoter, or other person who has authorized the issue of the prospectus, shall be liable to pay compensation to all persons subscribing for shares on the faith of the prospectus, for any loss or damage they may have sustained by reason of any untrue statement therein, unless it is proved that there was reasonable ground for believing such a statement to be true ; or, if based on a report of an expert, that it fairly represented such report and that those responsible for the prospectus had reasonable ground for believing that the expert was competent to make the report. Period to be Covered by Prospectus In addition to such accounting questions as are directly involved in the determination of profits, there are others of 2i6 ACCOUNTING PRACTICE AND PROCEDURE equal, if not greater, importance to which due attention must be given if the prospectus is to fully disclose to the intending investor all the material facts necessary to enable him to form a judgment upon the value of the securities offered to him. Perhaps the most important preliminary matter for de- cision is the period for which results should be given in the prospectus. Those of one year, especially if that year hap- pened to be an exceptionally good one, can under no cir- cumstances be considered a fair basis. Generally it may be said that the longer the period taken, the better, with the qualification that the results should be brought down to a date as close to the publication of the prospectus as the circumstances will permit, and that greater prominence should be given to those of the last three or five years. It has frequently, happened that an undertaking has been offered for sale just at the zenith of its prosperity, or even just after the tide has turned and it is commencing to show less satisfactory results, so that figures of past profits were not a fair criterion of future prospects. On the other hand, owing to general depression of trade or other special causes — such as excessive competition — which will be avoided under the scheme proposed, it may have shown within the last year results which are less than a fair measure of its earning capacity. The responsibilities thrown upon the accountant are thus onerous. He must consider that his duties are primarily to the investor, and must be careful that the years selected and the manner in which the results of these years are grouped will disclose the real facts ; and yet in so doing he must remember that he has a duty also to the vendor, and must not make his selection in such a manner as to reflect, as permanent, conditions which are really temporary. Generally it may be said that no period of less than three years can usually be considered as giving RESPONSIBILITIES OF PUBLIC ACCOUNTANT 217 a fair basis, and that one of five years is better ; and while the results of a longer period are always a useful guide to the past history of the undertaking, they are not such a good indication of the actual condition at the present time. Treatment of Unusual Profits or Losses In setting forth the results it is imperative that extraor- dinary profits or losses not arising out of operations nor in the ordinary course of business, such, for instance, as those resulting from sales of portions of capital assets, should be either eliminated or stated separately. Particularly should regard be had to any contracts or other arrangements in force during the period examined resulting in excessive profits or excessive losses, which, from the fact that these contracts or arrangements have since been terminated, may not recur. Such profits or losses should either be eliminated or separately stated ; but which of these two courses should be adopted must depend upon the probability or possibility that similarly extraordinary results may be realized in the future. If, for instance, while certain profitable contracts have terminated, other similar ones promising good results have actually been secured, it would not be fair to the vendors to exclude the profits realized from the former. And if the business is one that depends to a very large extent upon contracts, and there is no sign of any falling off in those on hand and not commenced, it would probably not be neces- sary even to state the results separately. Fluctuations of Profits A further point of considerable importance to the pros- pective investor is that he should know whether the profits for the period covered by the examination have remained steady, have increased or decreased steadily, or have been 2i8 ACCOUNTING PRACTICE AND PROCEDURE characterized by extreme fluctuations. For this reason the certificate should always show the results of each year sepa- rately, at any rate for the last three or five years, and on no account should the average profits only be stated, unless for some reason — which is disclosed in the certificate — the profits, of separate years cannot be ascertained. Where the profits may have shown a gradual falling off, or those of the latest years are below the average, it would be most improper that the certificate should give the average without stating the actual facts year by year. From the investor's point of view a certificate in the prospectus stating merely the aver- age profits for a certain period of years should be mis- trusted, on the ground that if the business were a progressive one and there were in fact nothing to conceal, the promoters would always prefer to get the fullest possible benefit from that fact by stating the results of each year separately; if this course is not adopted it may be presumed that there is good reason for concealment from the promoter's point of view. It frequently happens, owing to delay in completing arrangements, that a considerable time elapses between the date up to which the profits are certified and that of the accountant's certificate and the issue of the prospectus. In such cases it is certainly the accountant's duty to take all reasonable steps to satisfy himself that nothing has happened in the interim to throw any doubt upon the continuance of the results to which he has certified. For instance, if in a period of, say, six months so elapsing the books should clearly show a serious diminution of profits, or even a loss, this is a material fact which the accountant might and should ascertain if he used due diligence, and which, under any ordinary circumstances, should be disclosed in his certificate. RESPONSIBILITIES OF PUBLIC ACCOUNTANT 219 Results for Broken Periods Just as it is improper to average the results of several years, so it is equally improper to average the results of a portion of a year to make up a complete year. Many busi- nesses are essentially of a seasonal character, and the results of the first six months, for instance, may be, normally, entirely different from those of the last half of the calendar year ; and even when the business is continuous through the year it is not safe to assume that the profits of, say, two unexpired months will equal the average of the previous ten. In dealing with such broken periods it is preferable, if possible, to give also the corresponding figures for the same period in the preceding year, so as to show the comparative increase or decrease. Interest in Its Relation to Profits A problem of considerable difficulty in determining the profits for a prospectus, is the proper treatment of interest paid on loans, borrowed money, or partners' capital. Speak- ing generally, it may be said that interest in whatever shape is profit; and that if the profit of carrying on a particular undertaking is to be ascertained, all interest paid out on money employed in the business should be treated as part of the profits of the undertaking, and similarly all interest received on any proportion of the capital which may from time to time be invested in outside Securities should be excluded therefrom. But in certifying results for a pros- pectus regard must be had to the conditions under which the capital required for the purposes of the business is to be raised in future. If the amount to be provided is at least equal to the maximum borrowed in the past, then the whole of the profits before deducting interest charges will be available for dividends or interest on such capital. If, on the other hand, it is proposed to provide a portion only of 220 ACCOUNTING PRACTICE AND PROCEDURE the average amount borrowed in the past, it will be neces- sary, in putting the results before an investor, to deduct therefrom the interest on the borrowed money employed in earning those profits in excess of that which the promoters intend to provide; for the new concern would then have to borrow the difference from bankers or others and pay interest on the money so borrowed, before any distribution of profits was made to those providing the capital called for in the prospectus. It is perhaps hardly necessary to add that interest on partners' capital in a private partnership is essentially a part of the profits of the business — subject to the above remarks when, as is hardly likely, a smaller amount of capital is to be provided in future. In every case the certificate given should state clearly how interest has been treated. Salaries as Affecting Profits The treatment of salaries that have been or may have to be allowed to the partners or chief managers of the busi- ness is another matter of importance. In a private partner- ship, or in a corporation in which the managers are the chief or only stockholders, it frequently happens either that they have drawn no salaries, or only small ones compared to the market value of the services rendered ; a reason being that the managers may prefer to take their remuneration in the shape of profits entirely, rather than to consider them a charge against the business before ascertaining such profits. If, therefore, the profits be certified without any provision for the salaries of those responsible for the general management in the past, it is clear that the resulting profits to the new concern must be materially less than those certified to. Consequently, it is always necessary either to specify that no provision has been made for the remuneration of future managers, or to include, as a charge against the profits RESPONSIBILITIES OF PUBLIC ACCOUNTANT 221 certified, whatever amounts are contemplated or contracted for in the future. Depreciation and Renewals in Their Relation to Profits An important factor in connection with the prospectus is the imperative necessity of stating in the certificate as to profits whether full provision for depreciation and accruing renewals has or has not been made. While it is easy to lay down this principle, it is perhaps one of the most difficult matters to determine in practice, by reason of the frequently imperfect state of the records and often of the entire absence of reliable figures of original cost, or even of any proper distinction between expenditures on improvements, additions and renewals. In a private business run on conservative lines, a large proportion of the earnings may be put back into the property in the way of improvements and betterments; and if the operations have been of a highly profitable nature large amounts are frequently charged off from time to time in reduction of capital outlays. So far as the latter items are concerned, it is easy for the accountant to separate them and adjust his statement of earnings accordingly, but where improvements and betterments have been effected as part of the ordinary operations of the plant, and charged into maintenance and repairs almost from day to day, it becomes practically impossible at a subsequent date to separate them from the proper maintenance charges. Such a practice can not be too strongly condemned, not only as concealing the true facts and making the position appear worse than it really is, but also, from the point of view of the vendor, because the impossibility of adding such expenditures back to earnings must result in his receiving a lower price for his goodwill, based on earning capacity, than he otherwise would. The mere claim by a vendor that large expenditures have been so made and charged, without a shred of support- 222 ACCOUNTING PRACTICE AND PROCEDURE ing evidence in the books as to the cost of such improve- ments, or even of the fact that they have been made, cannot be accepted by the accountant; it then becomes a question whether he can satisfy himself that the expenditures so charged, which were not directly ascertainable, have been sufficiently large to take the place of depreciation; and it will readily be seen that this is a most difficult question, involving great experience and careful judgment. Varying Requirements of Statements of Profits It should here be noted that there may be a marked difference between a statement of profits prepared for and certified to an annual meeting of stockholders, and one that is prepared for the purpose of showing to prospective investors the earning capacity, of the business. In the former case the accounts are adopted by the stockholders at each annual meeting, reserves of various kinds are made from the profits of good years to be carried forward to bad years, changes in methods of valiiations df different classes of assets are made from year to year, and, generally, the ac- counts are drawn up more with a view of determining the amount which can safely be divided among the stockholders in dividends, than of showing the actual earning capacity of the business. In the latter case, however, it is essential that the profits certified for each separate year be those actually earned from the operations of that year — any arbitrary additions or deductions due to changes in bases of valua- tions or otherwise being excluded — and that they be free also from abnormal fluctuations due to unavoidable con- tingencies, which should be provided for proportionately over a period of years. Adjustments All adjustments must be made that may be necessary to insure that the accounts fairly represent the results of each RESPONSIBILITIES OF PUBLIC ACCOUNTANT 223 separate period. It may happen that the vendor may offer to giuarantee the value of certain assets, or a maximum amount for the habilities. Such a guarantee is of value only to a purchaser taking over the physical properties at book values, and its effect is to shift the burden of any losses or omis- sions from the purchaser of the property and assets, on to the vendor. Such a transfer can not in any way affect the earning capacity, and it is essential that any losses or liabili- ties omitted on account of such guarantees should be taken into account in determining the profits. This factor may be of even greater importance when goodwill is included in the sale at a price based on a number of years' purchase of the average profits. In such a case the error in the profits due to the omission of guaranteed assets or liabilities may be multiplied many times over in arriving at the purchase money for goodwill. It' may also be noted that a change in the basis of inven- tory valuations at the end of the period, as compared with the beginning, will not only result in an erroneous statement of earning capacity, but also will affect the purchase money for goodwill. The foregoing remarks upon guarantees by the vendor are not intended to imply that such guarantees are of no value; on the contrary, a guarantee of collection of face value of book debts, as well as of the maximum amount of liabilities, should usually be required whenever the pur- chaser takes over all current assets and assumes payment of all liabilities. Estimates of Anticipated Economies It may be askfed how far an accountant is justified in certifying to estimates of the extra profits that may be real- ized as a result of economies in operation to be effected by the proposed new corporation. Generally speaking, it may 224 ACCOUNTING PRACTICE AND PROCEDURE be said that any such certificate is inadvisable and may be dangerous. Promoters are always sanguine; and experi- ence shows that such estimates are seldom realized in prac- tice, at any rate for some years to come. Extra expenses may be entailed which more than ofifset any savings effected ; and the loss of personal touch and interest on the part of the former owners, who now become mere salaried employees of a corporation, may result in less careful and more extrava- gant management. While the vendors may be still largely interested as stockholders, it may be found that they have received cash payment for a substantial part of their original investment, and that their remaining interest in the stock represents merely goodwill or similar intangible assets ; with the result that as salaried officials they may relax rather than increase their efforts. Moreover, the large capital of the modern consolidation appears to call for expenditures on elaborate offices and establishments which were previously deemed entirely unnecessary, and in fact, while the in- creased capital represents mainly goodwill, etc., it carries with it an increased expenditure in hard cash. Having in view all these possibilities, it is certainly not a wise thing for the accountant to certify to any estimate of possible economies. Estimates of Future Earnings Accountants may be asked to prepare estimates of future earnings for the purpose of publication in the prospectus, and it is well to consider whether such a request should or should not in general be complied with. It may be admitted that an accountant is perhaps in many ways par- ticularly qualified to prepare such an estimate; and if the only questions involved were the accuracy of the figures and the reasonable probability that the bases assumed would agree with future practice, no objection perhaps could be RESPONSIBILITIES OF PUBLIC ACCOUNTANT 225 taken to compliance with the request. But, on the other hand, the experience of the past is frequently no guide to the practice of the future, and many unforeseen contingencies may arise which will render the estimates entirely valueless. To bring out the difficulties more clearly, assume two special cases : Firstly. That of a factory which has not been operating to its full capacity, partly because the plant is a new one and partly because its selling organization is not fully developed. Secondly. That of a new industry which has been oper- ating in an experimental way with one or two machines, upon the experience of which it is desired to estimate the profits that would be earned in a much larger plant con- structed on the same principles. In the first case the actual operation of the plant in the past is available as a guide for the future, but in preparing estimates of results based on a much more complete opera- tion, the following points would have to be carefully considered : (i) Are the capacities of the different portions of the plant dealing with the various processes of manufacture so carefully balanced that those dealing with the final processes can be worked to their full capacity without overloading those engaged on the earlier operations ? (2) Can sufficient supplies of raw material be obtained at a reasonable cost to enable the final output to be largely increased at not more than the average cost which has pre- vailed in the past? (3) If the output is so increased, can a ready market be found for it at the average prices obtained in the past? It may happen that, by reason of competition of distant fac- tories better situated and with facilities which enable them 226 ACCOUNTING PRACTICE AND PROCEDURE to produce at lower cost, the territory in which the products of a particular factory can be sold will be restricted and unable to absorb the increased production upon, which the estimates are based. In such cases the increase could only be sold at a considerable reduction in price, which would entirely upset the estimated results. (4) For what portion of each year can the whole plant be operated to its full capacity ? And what allowance should be made for periods of idleness necessary to undertake repairs and renewals, periodical stock-taking, etc. ? ( 5 ) Where the output depends upon the speed at which the machinery is run, can a sufficient supply of suitable labor be obtained to run the whole factory at the same average speed as it has been possible to run only a portion of it in the past ? (6) What proportion would the general management and selling expenses bear to the increased output? It may happen that a large concern can not be run as economically in some departments as a small one ; and it is not always safe to assume that the same percentage of management and selling expenses which prevailed in the past| will be experi- enced in the future. (7) On the other hand, what consideration should be given to the possible reduction in cost resulting from the larger output, mainly by reason of the fuller use made of the facilities ? , It should be clear, therefore, from the above considera- tions that any estimate of future earnings must necessarily depend upon so many contingencies that it would hardly seem desirable that it should be put forth without calling specific attention to the assumptions involved; and an esti- mate with such qualifications attached would hardly be of RESPONSIBILITIES OF PUBLIC ACCOUNTANT 227 much service to the promoter and would not be incorporated in the prospectus. Inasmuch as the community is being educated to con- sider that statements emanating from a pubHc accountant deal with facts only, it may be said in conclusion that in such a case as that supposed, the accountant's duty should end with the submission on request of a carefully prepared esti- mate accompanied by all the necessary qualifications, with- out, however, any certificate thereto, leaving his client to print such estimate in the prospectus or not as he thinks fit, but without using the name of the accountant. The second case is even stronger than the first, for here there is no pretense that the factory has been operated commercially at all, the whole process of manufacture being in an experimental stage. The contingencies involved in assuming that the results obtained in an experimental stage by one or two machines could be reached on a much larger scale in a fully operated factory, are so many and so unfore- seen that it would be difficult to enumerate them ; and under these circumstances, while the accountant can for the benefit of his client check to the best of his ability any estimates that may be prepared by the manager, and may frequently be able to point out omissions therein, it is very doubtful whether he should under any circumstances whatever attach his signature to any such statement, however much he may believe in the possibilities of its realization in the future. Certificate of Financial Condition So far attention' has been restricted to the essentials in- volved in certificates of profits for prospectus purposes. It remains to consider the responsibilities of the accountant in giving certificates of financial condition for the same purpose. 228 ACCOUNTING PRACTICE AND PROCEDURE Statements of financial condition are usually in the fol- lowing form : Properties owned (showing basis of valuation) $ Current Assets : Stock in Trade Accounts and Bills Receivable Marketable Investments Cash Less: Current Liabilities consisting of Accounts Payable Net Current Assets Net Assets $ If there is any funded debt ranking in front of the securities to be issued, this also would be deducted. The fixed properties are, or should be, appraised by responsible valuers, frequently under the direction of or assisted by the accountant, and the certificate of these valuers would usually be incorporated in the prospectus, or reference made thereto. The accountant's responsibility is usually limited to the verification and certification of the current assets and liabilities; but questions may arise on stock in trade, guar- antees of debts and liabilities, contracts for purchase and sale of goods, and orders in hand, which may have an im- portant bearing on the present and future position and should not be overlooked. For the discussion of these ques- tions reference may be made to page i86 et seq. Certificate of Profits Without Certificale of Assets It may and often does happen that a certificate of profits is required without any certificate of assets, and, provided that the investigation made discloses no features in the assets or liabilities which have an important bearing upon RESPONSIBILITIES OF PUBLIC ACCOUNTANT 229 the future of the business, and should therefore be disclosed to the prospective investor, there would appear to be no reason why such a request should not be complied with. At the same time there can be little doubt that a statement of profits without assets is not a complete one and should be looked upon with some suspicion. While the accountant may be absolved from responsi- bility by his instructions, he is certainly bound by his pro- fessional duty to make his examination so complete as to enable him to ascertain for himself what the financial condi- tion is, and whether there is anything material therein which should be disclosed. Such features may be one or more of the following: ( 1 ) Accounts receivable not liquid, but tied up in loans and not readily collectible. (2) Inventories too large for the business carried on, and including large amounts of old or obsolete stock, or other doubtful items. (3) Marketable investments not really marketable. (4) Current liabilities largely in excess of current assets, or with an insufiicient margin for working capital after allowing for new capital to be introduced. (5) Large construction works in progress calling for continuous outlay. (6) Funded debt falling due at short future dates. (7) Insufficiency of the new money asked for in the prospectus to provide for these various features for at least a reasonable period in the future. It is difficult to lay down any general principle to cover this point, but an examination might reveal such a general condition that a true and full disclosure to the pros- pective investor would not be made, unless a statement of assets and liabilities, together with the requirements in the 230 ACCOUNTING PRACTICE AND PROCEDURE near future, were made in the' prospectus. If such dis- closures were not made, it might be the accountant's duty to refuse to be connected with the prospectus in any way, or to certify even to the statement of earnings. Liability of Certifying Accountant The question of the personal liability of the accountant for a certificate which he gives to vendors or purchasers, and which is published in a prospectus issued to the public, is a matter of considerable importance. The accountant is not infallible, his judgment may be at fault, and the available information may be incomplete or misleading in such a way that with all his special skill the real facts are not discover- able. It does not follow, if future results are not in accord- ance with past experience to which the accountant has certi- fied, that the latter is necessarily to blame ; but the public, to whom he is chiefly responsible, is entitled to assume that he is a man skilled in commercial and financial affairs, and par- ticularly in the accounts relating thereto ; and consequently actions or opinions on his part, which could in no way be considered as such in the case of a man without such special knowledge and training, may easily subject him to a charge of negligence. He is called upon to exercise the skill and knowledge acquired in his profession to the utmost of his ability; if by negligence he fails in this, he has committed a breach of trust, has deceived the public, and must be pre- pared to take the consequences. On the other hand, no lia- bility should attach to him for a mere error of judgment, or even for errors in facts the existence of which reasonable skill and diligence on his part would not have enabled him to ascertain. And finally the accountant should confine himself to certifying to facts, and should not attempt to deal with estimates in the making of which his special qualifications are no greater than those of other business men. RESPONSIBILITIES OF PUBLIC ACCOUNTANT 231 (2) In Respect of Audit The audit here referred to is the annual review, by persons entirely independent of the firm or corporation, of its accounts and affairs. Unfortunately this term "Audit" has obtained currency in a much more limited sense, being applied to the internal check upon transactions involved in the passing of accounts for payment ; and the corresponding term "Auditor" more often than not is applied to, or is held to describe, an individual holding the position of comptroller or chief accountant, or head bookkeeper of a corporation. It is, perhaps, worthy of consideration whether it is desir- able to continue to use the term "Audit" as applied to work done and certificates given by public accountants; but in default of any better term, and in view of the legal sanction given to its use in that respect in other countries, it is very generally adopted as applying to the work performed by the independent auditor, to enable him to certify to the accuracy of periodical statements of account. Such an audit is of far-reaching importance, not only to the directors and stock- holders of the corporation interested, but also, to the general public, who may frequently purchase the stock of the cor- poration, relying on the certificate given by the public accountant. Audit Practice in England Some important considerations affecting audit practice are suggested by the English Companies (Consolidation) Act of 1908, which was passed after an inquiry by a Royal Commission on which accountants were represented by one of their number, and which may be said to have crystallized into law the customs of the most reputable companies, adopted as the result of the forty-five years' experience under the law of limited liability in that country. Before consider- ing the provisions of this act it may be interesting and useful 232 ACCOUNTING PRACTICE AND PROCEDURE here to state shortly the history of the independent and impartial audit of the accounts of corporations in England, where the practice, starting from small beginnings, has now become universal and has at last received the indorsement of the law. Until the passage in England of the Companies Act of 1900, there was no law compelling a company registered under the Companies Act to have an audit of its accounts, with the exception of banking companies, which were re- quired under the Companies Act of 1879 to have an inde- pendent audit, evidenced by a certificate in a form which practically became the standard for all companies. The original Limited Liability or Joint-Stock Companies Act of 1862 contained in a schedule, known as Table "A," a set of "Articles of Association" (here known as "By-Laws"), which was not compulsory, but which could be adopted by any company so desiring and was binding tipon any com- pany which did not adopt an alternative set. This Table "A" exercised a great influence, and where not adopted in its entirety, became the model for the articles of association of the best companies. It included a clause requiring an annual audit of accounts by persons appointed by stock- holders ; and the elimination of this clause in any substituted articles came to be regarded with more and more disfavor, so that in time this provision became practically universal. The first stage of this audit consisted in the appointment by the stockholders, at the annual meeting, of certain of their number to conduct it. These lay auditors had no qualifications for the position, either by training or expe- rience; and while the fees paid them for their services were usually small, there can be little doubt that the money was, as a rule, wasted. The next stage appears to have been the employment by the elected auditors of public accountants to assist them in RESPONSIBILITIES OF PUBLIC ACCOUNTANT 233 their work, provision being frequently found in the articles of association permitting this, and providing that the re- muneration of the individuals so employed should be paid by the company. The next step was to recognize the fact that it was better for the stockholders themselves to make the appointment of public accountants, instead of delegating it to their own auditing committee; and the articles of asso- ciation in their most modern form usually provided that at least one of the auditors should be a public accountant. In this condition matters continued until the passage of the Companies Act of 1900, which, for the first time, gave parliamentary sanction to the practice which had already become established in the majority of cases by the action of corporations and their stockholders. The various Acts from 1862 up to 1907 are now con- solidated in the Companies (Consolidation) Act, 1908, and the provisions relating to audit are contained in Sections 109 to 114 of that Act.* The general effect of these provisions is that at each annual meeting of the company the share- holders are required to appoint one or more auditors, none of whom must be a director or officer of the company ; that these auditors shall hold office until the next annual meeting, and that their remuneration shall be fixed by the share- holders. Provision is made for appointment by the Board of Trade (a government department) in default of any appointment by shareholders. Appointment by the directors is permitted only in the case of a newly organized company ; and such appointees can hold office until the first annual meeting, with power, however, to the shareholders to remove them by a majority vote at a previous general meeting, The auditor being appointed by the stockholders, his responsibility was entirely to the stockholders; but he was subject to election each year; and cases frequently arose in •See Appendix I. 234 ACCOUNTING PRACTICE AND PROCEDURE which, owing to his making a report adverse to some action which the directors had taken, the latter, controlling the majority of stock, were able to prevent his re-election. This feature of the appointment of auditors was recognized as a defect, and the form of certificate called for in Section 23 of the Act of 1900 was also not entirely satisfactory; the Act of 1908 contains provisions safeguarding the re-election of auditors and amending the form of certificate. The present law establishes the auditor's right of access at all times to the books, accounts and vouchers of the com- pany, and empowers him to require from the directors and officers such information and explanations as he may think necessary. It requires the auditor to make a report to the shareholders, stating whether or no he has obtained all such information and explanations, and whether or no the bal- ance sheet is properly drawn up so as to exhibit a true and correct view of the state of the company's affairs, according to the best of his information and the explanations given to him, and as shown by the books of the company. The auditor's report must be read at the annual meeting, and be open to the inspection of any shareholder, who is also entitled to a copy of both balance sheet and report for a specified fee. The act also provides that no other than a retiring auditor can be elected at an annual meeting, unless previous notice has been given of the intention to nominate another person, and a copy of such notice has been given to the retiring auditor. It will be noted that there is still no provision in the law requiring that the audit should be made by a public account- ant, but it has become so universally recognized that a lay audit is worse than useless, that it is now quite the exception to find the certificate of any but a public accountant affixed to the balance sheet. RESPONSIBILITIES OF PUBLIC ACCOUNTANT 235 American and English Practice as to Company Audits There is one important point of distinction between the position of the public accountant acting as auditor of a corporation in England and in this country; viz., that in England he has always been appointed by the shareholders, while in America, at present, with a few notable exceptions, he is appointed by the directors or officers, although in most cases the directors hold the control of the company, and the appointment by the stockholders would practically have the same result. The accountant's position in such a case is, however, widely different. When appointed by the directors his legal responsibility is to them, not— as it should be — to the stockholders and to the public ; and while this should not affect his moral responsibility to the two latter, it places such limitation upon his powers as to seriously diminish his use- fulness ; for if he reports adversely upon any of the actions of the directors, they can suppress his report and publish the accounts of the company as prepared by themselves without any certificate; and the auditor has no right whatever to communicate the true facts to th^ stockholders. On the other hand, if he be appointed by the stockholders, it is not only his right but his duty to bring before them — preferably in his certificate affixed to the balance sheet, but certainly in Some way — any material facts with which they should be acquainted. Furthermore, if the directors appoint the auditor they can limit the scope of his inquiry in any way they think fit ; while appointment by the stockholders would carry with it no limitations, and the whole responsibility as to the work which he shall do or not do is thrown — and properly thrown — upon the auditor. Canadian Audit Practice Reference may here be made to the Canadian Bank Act of 19 1 3, which for the first time in the experience of Canada, 236 ACCOUNTING PRACTICE AND PROCEDURE provides for the compulsory audit of the accounts of all Canadian banks by persons appointed by the shareholders. The clauses of the Act dealing with this audit* provide that the bank managers shall select a list of not less than forty names of persons qualified to make such an audit. This list so prepared is submitted to and approved by the Minister of Finance; and thereafter the shareholders at the annual meeting of each bank are required to appoint as auditor one of the persons included in such list. Very wide powers are given to the auditor in the Act ; his duties are clearly defined and his responsibilities are undoubtedly considerable. Accountant's Responsibility for Audit Certificates The responsibility which the public accountant assumes in certifying to the accounts of a corporation is well defined in the form of certificate required by the English Companies Act of 1908, above quoted; viz., that he shall report whether, in his opinion, the balance sheet is properly drawn up so as to exhibit a true and correct view of the state of the com- pany's affairs, according to the best of his information and the explanations given him, and as shown by the books of the company. The several phrases in this certificate deserve special attention. (a) "In his opinion," as a skilled professional man, endowed with special qualifications resulting from his train- ing and experience. Every balance sheet must be largely a matter of opinion ; for example : the value of the debts receivable, the inventories of materials and supplies, and particularly of work in progress, and the division of expendi- tures between capital and revenue ; the inclusion in the books of all necessary information with regard to the affairs of the company ; the sufficiency of the provision made for main- tenance charges and depreciation, and for reserves for possi- *See Appendix V. RESPONSIBILITIES OF PUBLIC ACCOUNTANT 237 ble losses; the efficiency of the system of organization and •accounting as a reasonable protection against fraud or defalcation — all of these matters require, for their decision, skill and experience. The criticism is often made that this phrase weakens the certificate; but if the necessities of the case be considered, and if it be remembered that the opinion is one formed after an exhaustive and careful study of all the facts and evidence obtainable by a man whose whole training and experience has specially qualified him to give such an opinion, it will be seen that the words are not a mere empty phrase but an essential part of the certificate. So far from weakening the certificate, they may rather be considered as strengthening it, in that they imply that the signer has given his certificate, not with foolhardy assurance, but with a realization of the inherent impossibility of saying, absolutely, that one balance sheet is correct and any other incorrect. (b) "Properly drawn up." This implies that the differ- ent headings in the accounts submitted are proper descrip- tions of the items included thereunder: that there is no concealment of material facts, the knowledge of which is essential in enabhng the present or prospective stockholders to form a judgment of the value of the investment, and the omission of which- would be prejudicial to their interests. In deciding whether this requirement has been met, the auditor must recognize that there are often facts as to which it would be of interest and value to stockholders to be informed, but the public disclosure of which might damage the company and its stockholders, and yet which, in the opinion of the public accountant, are perfectly proper trans- actions, and in the best interests of the company. The public accountant should be the best judge as to what should or should not be disclosed, and be able to satisfy his clients that his views are correct and should be adopted. 238 ACCOUNTING PRACTICE AND PROCEDURE (c) "True and correct view of the state of the com- pany's affairs." This phrase involves, not only the clerical accuracy of the figures, but their substantial business accuracy, independently of the books, subject always to the necessary qualification that the public accountant, even with his special training and experience, is, after all, human and can not discover facts of which no trace is to be found on the books or records of which he has knowledge. Such matters as the valuation of inventories, investments, book debts, etc. ; the full estimate of all ascertainable liabilities and obligations, contingent or otherwise; the full and correct statement of the profits for the period covered by the exami- nation ; and the clear and separate disclosure therein of any unusual items not incident to the ordinary business of the company, are all involved in the term "true and correct view of the state of the company's affairs." (d) "As .shown by the books of the company." This phrase does not imply that the duties of the auditor are properly fulfilled if he satisfies himself that the balance sheet agrees with the books, as is sometimes supposed. The pre- ceding phrase, "according to the best of my information and the explanations given to me," shows clearly that a much wider duty rests upon the auditor ; namely, to satisfy himself that the balance sheet, as already stated, sets forth a true and correct view of the state of the company's affairs, according to all the information obtainable; and, further, that the books also set forth this same condition. It is, there- fore, incumbent upon the auditor, if he certifies the accounts of a company, to see that the books are correct as well as the balance sheet, and that any changes which he may have to make in the balance sheet have been properly recorded and put through the books. There are many other matters frequently touched upon jn the certificate, in addition to the above, which may be RESPONSIBILITIES OF PUBLIC ACCOUNTANT 239 described as the "Operative" phrases ; but whatever the form may be, it is essential that the certificate should be clear, specific, and, above all, accurate, and that any qualifications which it may be necessary to insert should be set forth in unmistakable terms, so as to put those who read it upon their guard, and to suggest to them the questions which shall be put to the management of the corporation if further information is desired. Qualified Certificates It may be useful here to state a few general principles in connection with the form a qualification should take. Various expressions are used, such as "accepting" or "sub- ject to" such a condition of things. The former word should imply that, while the accountant is not in a position to verify the statement to which it relates, yet he has no reason to believe that it is inaccurate in any respect; while the expression "subject to" should imply that the accountant is not satisfied with the conditions disclosed, and is prepared only to certify to the accuracy of the statement, excluding the item to which he takes exception. It must neVer be forgotten that the auditor has no right or duty to dictate the policy of the company; he can not compel it to make sufficient provision for all necessary charges, such as maintenance, depreciation, bad debt re- serves, etc., but he can and must call attention in his certifi- cate to the fact of the omission or insufficiency of any such provisions, leaving it to those interested as stockholders, or in any other capacity, to take the question up directly with the officials and satisfy themselves on these doubtful points. If the public accountant is equipped by ability and training for his duties; if the work of his subordinates is properly directed and supervised ; and if his examination has been as thorough as it should have been — in other words, if he has 240 ACCOUNTING PRACTICE AND PROCEDURE done his whole duty as a pubHc accountant — it is hardly possible, in the absence of widespread fraud, for any sub- stantial or material errors of omission or commission to be found afterwards in a balance sheet so certified. Accountant's Moral and Legal Responsibility The public accountant's responsibility in respect of his certificates is largely moral, and only to a small extent legal. It is commonly supposed that his work is a mere ascertain- ment of facts, and yet that is the simplest and frequently the smallest and least important part of the work involved in his periodical examinations. He is rather employing his trained mind and organization to make as near an approximation to actual facts as is practicable, but he has also to consider degrees of approximation ; or, in other words, it is the per- centage, and not the amount of the possible error, by which he must be guided. His legal responsibility is necessarily limited to gross errors of omission or commission, and would not extend to errors of judgment; but it must be remembered that what might be merely errors of judgment on the part of an individual without his training and expe- rience, may easily be gross errors on the part of the public accountant. (3) In Respect of Liquidation and Reconstruction The duties of the public accountant in respect of liquida- tion and reconstruction have in this country in the past been largely confined to reporting on the condition of an insol- vent concern, and on the past results, in so far as these are not already known, which have contributed to the present condition. In some few cases an accountant has been appointed receiver or manager of an insolvent business ; but this, while an important, is not a large part of his duties here, as it has been for many years in Great Britain. The RESPONSIBILITIES OF PUBLIC ACCOUNTANT 241 problems involved in such duties of management hardly have relation to accounts, and their discussion has no place here except perhaps to note that a thorough knowledge of accounts and the principles upon which they should be pre- pared is of the utmost value in their consideration and settlement. The forms of reports necessary do not materially differ from those already discussed, and the principles involved are the same. There is, however, this important difference that, in the case of liquidation followed by a break-up sale, the values to be placed upon the assets will be no longer going values, but forced sale values. Under these conditions finished products on hand will bring much less than normal selling price, partly finished products may be almost value- less, while raw materials may have a value fairly close to their cost. Accounts and bills receivable, which for a going concern may be doubtful of collection, will possibly be found altogether bad ; while all the varied items of deferred charges and other working assets will have little or no value. The values of capital assets under such conditions will in many cases shrink to a mere fraction of their book values, and even then may be unsaleable for a long period. With all this shrinkage in asset values the liabilities remain the same, and consequently concerns which might quite properly have shown some surplus of assets over liabilities as long as the business was continuing, will show a large and, to those most interested as owners or stockholders, a surprising deficit. Responsibility of Accountant in Case of Business Failure In view of the serious losses thus entailed, the public accountant, who may have been in close touch with the busi- ness for a long period before its collapse, incurs a heavy responsibility. His trained eye should be able to discover 242 ACCOUNTING PRACTICE AND PROCEDURE the tendency to failure, and often to suggest means for avert- ing the impending catastrophe. The most difficult matter for his judgment is to decide at what point it is his duty to creditors, stockholders and the public, to make such refer- ences in his public reports as will necessarily bring an end to the suspense. As long as there is a reasonable prospect of a rehabilitation without recourse to the drastic remedy of liquidation, with all the losses it entails, it would seem to be his duty to all concerned to refrain from any acts which would bring it about; but his judgment must be based on facts and probabilities, and not on mere hopes or possibili- ties such as will naturally govern the actions and decisions of the managers and partners or stockholders. A stoppage at an early stage, while it will naturally appear a hardship and will bring loss to all concerned, may easily prevent a much worse state of things, and lead to an early reorganiza- tion, which may well be much less unfavorable to all than if the business were continued unchecked to a later date. The realization of the existence of germs of insolvency at the earliest possible date is a matter of considerable difficulty. Causes or Conditions Leading Up to Insolvency The most usual of these may be summarized thus : ( I ) Continuous losses in operations leading to a shrink- age in available current assets and loss of credit. These losses may be due either to want of a sufficient amount of business at profitable prices; to bad workmanship; to in- ability — owing to inferior management and high costs — to meet competition, or to extensions of plant to an amount largely in excess of the probable demand for product. Such causes, if found out in time, can mostly be remedied; but frequently the exact cause of losses is unknown, by reason of the absence of any reliable cost accounts which would dis- close weak points and enable economies to be effected. RESPONSIBILITIES OF PUBLIC ACCOUNTANT 243 As long as working capital is ample such losses may be continued for a long time without disaster, and frequently it happens that continued hopes of improvement in general trade, to which alone such losses are frequently attributed, lead to an almost reckless continuance of business without any attempt to detect the internal evils which may be the real cause. When working capital is exhausted the same optimistic views lead to borrowing for working capital, with the only result of a worse final disaster. (2) Excessive borrowing on temporary loans to pro- vide for additional permanent assets or even for working capital. In times of financial stringency loans may be called in, and even a' concern with a moderately good business and excellent prospects of future increase, may find itself sud- denly' thrown into insolvency for want of sufficient liquid assets. This is a frequent source of insolvency, owing to the fact that temporary loans can be negotiated in good times; and even in moderately bad times they can be negotiated more easily than permanent loans. Generally it may be said that loans for short terms for the purpose of permanent im- provements and extensions of a business are a source of danger at any time, and should be considered as one of the most fruitful seeds of insolvency. (3) The expenditures out of current assets of consider- able sums on capital account, thus diminishing the former unduly, in the expectation of borrowing money or raising capital in other ways which, owing to general conditions in the money market, may be found impossible at the time the money is needed. (4) Large increases in stocks on hand or accounts re- ceivable out of proportion to the total business done, should call for careful inquiry, The reasons may be quite sound and the increase due to temporary causes, but any continuous 244 ACCOUNTING PRACTICE AND PROCEDURE increase year after year in such items, accompanied as it must usually be by a corresponding increase in current lia- bilities, or floating debt, is ground for anxiety. It points in the case of stock either to accumulation of obsolete or un- suitable goods, or to a continuous rise in prices of material and labor costs, or to bad management, and in extreme cases to deliberate fraud in overstating either quantities or prices. In the case of accounts receivable it may be due to attempts to increase business by dealing with less solvent customers, with consequent liability to heavier losses in bad debts ; to the financing of customers or others who are not strong enough for the business they are doing, or to forcing goods onto the market in times of commercial depression to an extent beyond the power of the market to absorb. (5) The payment of dividends to stockholders, or dis- tribution of profits to proprietors in excess of current earn- ings. This may amount to payment of dividends out of capital (which is illegal), when the result is an actual deficit on the Profit and Loss account. In the majority of cases, however, the dividends will be paid out of an accumulated surplus appearing on the face of the accounts. This surplus may be fictitious ; i. e., it may exist solely by reason of the overvaluation of capital or current assets, or the understate- ment of liabilities; or it may be a real surplus which has been already used for the extension of the business and which is not therefore available in a liquid form for any purpose. This would be disclosed at any time by a careful scrutiny of the asset and liability values and their composi- tion; but may not be at all obvious to directors or stock- holders without the aid of an adviser skilled in such matters, who would be able to indicate points of weakness. In the absence of deliberate bad faith or fraud on the part of directors and managers, the indications of possible danger here stated are usually ignored, owing to excess of optimism RESPONSIBILITIES OF PUBLIC ACCOUNTANT 245 or unwillingness to admit failure, and it is at this point and in the early stages that the public accountant can best exer- cise his functions, and, by advice based on neither optimism nor pessimism, but on a fair and impartial appreciation of all the facts, suggest a halt and propose remedies before it is too late. Neglect of such precautions will frequently lead from mere optimism to a refusal to see and recognize bad factors, and even to crime in order to conceal them. Reorganization Bearing in mind the heavy losses which must result from liquidation and forced sale, it is most desirable that, if liquidation comes, it should be followed as speedily as possi- ble by an honest, conservative and successful reconstruction. When this can be carried through without any stoppage of operations, the greater part of the heavy losses which must result from a forced collection of current assets and sale of capital assets, is avoided, and both creditors and stockholders largely benefit. The consideration of a plan for the reorganization of a property which has been reduced to a condition of insolvency, requires a full and accurate knowledge of all the existing conditions with regard to the property and its past and probable future earning capacity. The elements to be inves- tigated and determined will therefore be as follows : ( 1 ) The sources and nature of the gross earnings, and the prospects of any increases therein without further ex- penditures for development. (2) The cost of operation, with particular reference to the efifect thereon of bad management or bad organization, and to the possibility of remedying these conditions ; and the proportion which the cost of operation has borne and may be expected to bear to the gross earnings. 246 ACCOUNTING PRACTICE AND PROCEDURE (3) A comparison of the gross and net earnings and capitalization of the property with some actual or desirable standard, so as to determine the proportion which one should bear to the other if the reorganization is to prove successful. (4) Hence, to arrive at the total interest-bearing and dividend-paying capital which the reorganized property will stand on some fixed interest basis. (5) The rank of the different classes of obligations, having regard to the property pledged as security therefor ; the margin of security; the rate of interest; the date of maturity; the equivalent par value on the basis of the standard rate of interest adopted for all classes; and, if practicable, the extent to which the properties specifically mortgaged show sufificien't earnings to meet interest on the indebtedness secured thereon. This class of information will probably require a report from an engineer or other expert on the value and the condition of the physical property. (6) Following upon the determination of these factors, a consideration of the various separately-mortgaged divi- sions of the property, with a view to determining whether any should be abandoned to the bondholders, rather than be included in a reorganization; and here it is important to observe that the contribution of any specific piece of property to the general organization is not necessarily measured by its ability by itself to earn interest on the obligations secured thereon. Numerous other factors will enter into a considera- tion of this point, and it may easily appear that a property earning little or nothing towards payment of its obligations is sufficiently valuable to the organization, as a whole, to be retained if possible. (7) Another important factor is the amount of new money required to be introduced for the purpose of paying off the floating debt and rehabilitating the property, and the RESPONSIBILITIES OF PUBLIC ACCOUNTANT 247 best method of raising such money — whether by the issue of new prior hen securities ranking in front of or on an equahty with those issued in exchange for existing mortgages, or by assessments on junior classes of securities. In the latter case it is important that sufficient inducement be given to the junior classes, in the proportion of new securities issued for old, to induce them to pay these assessments ; while for the assessments themselves, the securities issued should represent the par value of the cash paid in on some reasonable market valuation. Upon the information and facts so ascertained will depend the final allocation to be made of new securities in exchange for old, as far as possible, in equitable proportions to the different classes of security holders, although at this final stage an element of bargain must necessarily be intro- duced by reason of the different interests involved and the necessity of the reorganization managers coming to terms, separately, with each class of holders. After this stage has been reached there will still remain the work of vesting the properties of the old concern in the new one, with probably a reduced capitalization, and usually involving an adjustment of asset values on the basis of appraisals. There may be many important questions arising in this connection, not least among which may be the installation of such a system of cost and general accounting as will enable errors of the past to be avoided and put the manage- ment in a position to retrieve the situation and convert a failure into success. A company reorganized on such a basis and placed under capable management should usually be successful, provided that all the facts outlined above are ascertained by reputable and responsible accountants and engineers, and provided that regard be had, subject to the rights of creditors, solely 248 ACCOUNTING PRACTICE AND PROCEDURE to the interests of the company, as represented by its stock- holders, instead of to those of outside parties who may be merely seeking to obtain as much as possible for themselves out of the wreck. In reorganizations in the past this latter condition has sometimes prevailed with the result that the reorganized property has shown little better results than its wrecked predecessor. CONCLUSION In concluding this review of accounting practice and procedure, and the duties and responsibiHties of the public accountant in relation thereto, it may not be out of place to call attention to the mental qualifications required by one who essays to attack and determine accounting problems. These are : ability, coupled with tact and honesty, to ascertain facts without friction and with impartiality ; a mind unbiased by previous conceptions, and free to reach inde- pendent and reliable conclusions of fact; and a will strong enough to maintain such conclusions against the arguments, opinions, or desires of opponents interested in some opposite or inconsistent conclusion, and yet to adapt such parts of their arguments as may throw new Hght on the questions at issue. With such qualities, and with the added technical training and practical experience which are equally neces- sary, the individual is in fact an accountant qualified to deal with the many questions herein discussed, and to add new principles to those which it has been the endeavor to illus- trate and explain in this volume. 249 APPENDIX I SECTIONS OF THE ENGLISH LAW RE^ LATING TO THE INSPECTION AND AUDIT OF ACCOUNTS [COMPANIES (CONSOLIDATION) ACT, 1908] INSPECTION AND AUDIT (i) The Board of Trade may appoint one or Section 109. more competent inspectors to investigate the affairs of any company and to report thereon in tion^o/^^" such manner as the Board direct — affairs of (i) In the case of a banking; company having by'fi'cfa'rd a share capital, on the application of of Trade members holding not less than one- '"spectors, third of the shares issued : (ii) In the case of any other company having a share capital, on the application of members holding not less than one- tenth of the shares issued : (iii) In the case of a company not having a share capital, on the application of not less than one-fifth in number of the persons on the company's register of members. (2) The application shall be supported by such evidence as the Board of Trade may require for the purpose of showing that the applicants- have good reason for, and are not actuated by malicious motives in requiring, the investigation; and the Board of Trade may, before appointing an inspector, require the applicants to give secur- ity for payment of the costs of the inquiry. 2t;i 252 ACCOUNTING PRACTICE AND PROCEDURE (3) It shall be the duty of all officers and agents of the company to produce to the inspectors •all books and documents in their custody or power. (4) An inspector may examine on oath the officers and agents of the company in relation to it5 business, and may administer an oath accordingly. (5) If any officer or agent refuses to produce any hook or document which under this section it is his duty to produce, or to answer any ques- tion relating to the affairs of the company, he shall be liable to a fine not exceeding five pounds in respect of each ofifence. (6) On the conclusion of the investigation the inspectors shall report their opinion to the Board of Trade, and a copy of the report shall be for- warded by the Board to the registered office of the company, and a further copy shall, at the request of the applicants for the investigation, be delivered to them. The report shall be written or printed, as the Board direct. (7) All expenses of and incidental to the in- vestigation shall be defrayed by the applicants, unless the Board of Trade direct the same to be paid by the company, which the Board is hereby authorized to do. {In re Grosvenor Hotel Company an applica- tion to prohibit the Board of Trade and the inspector appointed by them from proceeding under this section failed.) Section 110. Power of company to appoint inspectors. (i) A company may by special resolution appoint inspectors to investigate its affairs. (2) Inspectors so appointed shall have the same powers and duties as inspectors appointed by the Board of Trade, except that, instead of re- porting to the Board, they shall report in such APPENDIX 253 manner and to such persons as the company in general meeting may direct. (3) Officers and agents of the company shall incur the like penalties in case of refusal to pro- duce any book or document required to be pro- duced to inspectors so appointed, or to answer any question, as they would have incurred if the in- spectors had been appointed by the Board of Trade. A copy of the report of any inspectors ap- Section 111. pointed under this Act, authenticated by the seal ^ j.^. ^f of the company whose affairs they have investi- inspectors to gated, shall be admissible in any legal proceeding be evidence, as evidence of the opinion of the inspectors in relation to any matter contained in the report. (i) Every company shall at each annual gen- Section 112. eral meeting appoint an auditor or auditors to Appoint- hold office until the next annual general meeting, ment and (2) If an appointment of auditors is not made remunera- at an annual general meeting, the Board of Trade auditors, may, on the application of any member of the company, appoint an auditor of the company for the current year, and fix the remuneration to be paid to him by the company for his services. (3) A director or officer of the company shall not be capable of being appointed auditor of the company. (4) A person, other than a retiring auditor, shall not be capable of being appointed auditor at an annual general meeting unless notice of an intention to nominate that person to the office of auditor has been given by a shareholder to the company not less than fourteen days before the annual general meeting, and the company shall send a copy of any such notice to the retiring auditor, and shall give notice thereof to the share- holders, either by advertisement or in any other mode allowed by the articles, not less than seven days before the annual general meeting : 254 ACCOUNTING PRACTICE AND PROCEDURE Provided that if, after notice of the intention to nominate an auditor has been so given, an annual general meeting is called for a date four- teen days or less after the notice has been given, the notice, though not given within the time re- quired by this provision, shall be deemed to have been properly given for the purposes thereof, and the notice to be sent or given by the com- pany may, instead of being sent or given within the time required by this provision, be sent or given at the same time as the notice of the an- nual general meeting. (5) The first auditors of the company may be appointed by the directors before the statu- tory meeting,* and if so appointed shall hold office until the first annual general meeting, un- less previously removed by a resolution of the shareholders in general meeting, in which case the shareholders at that meeting may appoint auditors. (6) The directors may fill any casual vacancy in the office of auditor, but while any such vacancy continues the surviving or continuing auditor or auditors, if any, may act. (7) The remuneration of the auditors of a company shall be fixed by the company in gen- eral meeting, except that the remuneration of any auditors appointed before the statutory meeting,* or to fill any casual vacancy, may be fixed by the directors. Section 113. (i) Every auditor of a company shall have a Powers and "ght of access at all times to the books and duties of accounts and vouchers of the company, and auditors. shall be entitled to require from the directors and officers of the company such information and explanation as may be necessary for the performance of the duties of the auditors. ♦There is no statutory meeting except in the case of companies limited by shares. APPENDIX 255 (2) The auditors shall make a report to the shareholders on the accounts examined by them, and on every balance sheet laid before the com- pany in general meeting during their tenure of office, and the report shall state — (a) whether or not they have obtained all the information and explanations they have required; and, (b) whether, in their opinion, the balance sheet referred to in the report is prop- erly drawn up so as to exhibit a true and correct view of the state of the company's affairs according to the best of their information and the explana- tions given to them, and as shown by the books of the company. (3) The balance sheet shall be signed on be- half of the board by two of the directors of the company or, if there is only one director, by that director, and the auditors' report shall be attached to the balance sheet, or there shall be inserted at the foot of the balance sheet a refer- ence to the report, and the report shall be read before the company in general meeting, and shall be open to inspection by any shareholder. Any shareholder shall be entitled to be fur- nished with a copy of the balance sheet and auditors' report at a charge not exceeding six- pence for every hundred words. (4) If any copy of a balance sheet which has not been signed as required by this section is issued, circulated, or published, or if any copy of a balance sheet is issued, circulated, or pub- lished without either having a copy of the auditors' report attached thereto or containing such reference to that report as is required by this section, the company, and every director, manager, secretary, or other officer of the com- 3S6 ACCOUNTING PRACTICE AND PROCEDURE pany who is knowingly a party to the default, shall on conviction be liable to a fine not ex- ceeding fifty pounds. (5) In the case of a banking company reg- istered after the fifteenth day of August eight- een hundred and seventy-nine — (a) if the company has branch banks beyond the limits of Europe, it shall be suffi- cient if the auditor is allowed access to such copies of and extracts from the books and accounts of any such branch as have been transmitted to the head office of the company in the United Kingdom; and, (b) the balance sheet must be signed by the secretary or manager (if any), and where there are more than three direc- tors of the company by at least three of those directors, and where there are not more than three directors by all the directors. The Act by implication requires that there shall be annually an audit of the accounts re- sulting in a balance sheet to whose accuracy the auditors shall certify. Regulations which compel the auditor to withhold information which is material to the true state of the company's affairs are incon- sistent with the Act. The majority of the share- holders may within limits provide for secrecy as regards matters of which knowledge will come to the auditors in the course of the audit, but the limit is passed if such a secrecy is imposed as precludes the auditors from availing them- selves of all the information to which under the Act they are entitled as material for the report which under the Act they are to make on the company's affairs. APPENDIX 257 (i) Holders of preference shares and deben- Section 114. tures o^ a company shall have the same right to Rights of receive and inspect the balance sheets of the preference company and the reports of the auditors and hoMers, etc. other reports as is possessed by the holders of as to re- ordinary shares in the company. ceiptand •^ <^ ■> _ inspection (2) This section shall not apply to a private of reports, company, nor to a company registered before ^tc the first day of July, nineteen hundred and eight. APPENDIX II EXTRACTS FROM SCHEDULE I TO COMPANIES (CONSOLIDATION) ACT, 1908, KNOWN AS TABLE A DIVIDENDS AND RESERVE 95. The company in general meeting may de- clare dividends, but no dividend shall exceed the amount recommended by the directors. 96. The directors may from time to time pay to the members such interim dividends as ap- pear to the directors to be justified by the profits of the company. 97. No dividend shall be paid otherwise than out of profits. 98. Subject to the rights of persons, if any, entitled to shares with special rights as to divi- dends, all dividends shall be declared and paid according to the amounts paid on the shares, but if and so long as nothing is paid up on any of the shares in the company dividends may be declared and paid according to the amounts of the shares. No amount paid on a share in advance of calls shall, while carrying interest, be treated for the purposes of this article as paid on the share. 99. The directors may, before recommending any dividend, set aside out of the profits of the company such sums as they think proper as a reserve or reserves which shall, at the discretion of the directors, be applicable for meeting con- APPENDIX 259 tingencies, or for equalizing dividends, or for any other purpose to which the profits of the company may be properly applied, and pending such appHcation may, at the like discretion, either be employed in the business of the com- pany or be invested in such investments (other than shares of the company) as the directors may from time to time think fit. 100. If several persons are registered as joint holders of any share any one of them may give effectual receipts for any dividend payable on the share. loi. Notice of any dividend that may have been declared shall be given in manner herein- after mentioned to the persons entitled to share therein. 102. No dividend shall bear interest against the company. ACCOUNTS 103. The directors shall cause true accounts to be kept — Of the sums of money received and expended by the company and the matter in respect of which such receipt and expenditure takes place, and Of the assets and liabilities of the company. 104. The books of account shall be kept at the registered office of the company, or at such other place or places as the directors think fit, and shall always be open to the inspection of the directors. 105. The directors shall from time to time determine whether and to what extent and at what times and places and under what condi- tions or regulations the accounts and books of the company or any of them shall be open to the inspection of members not being directors, and no member (not being a director) shall have 26o ACCOUNTING PRACTICE AND PROCEDURE any right of inspecting any account or book or document of the company except as conferred by statute or authorized by the directors or by the company in general meeting. 1 06. Once at least in every year the directors shall lay before the company in general meeting a profit and loss account for the period since the preceding account or (in the case of the first account) since the incorporation of the company, made up to a date not more than six months before such meeting. 107. A balance sheet shall be made out in every year and laid before the company in gen- eral meeting made up to a date not more than six months before such meeting. The balance sheet shall be accompanied by a report of the directors as to the state of the company's affairs, and the amount which they recommend to be paid by way of dividend, and the amount, if any, which they propose to carry to a reserve fund. 108. A copy of the balance sheet and report shall, seven days previously to the meeting, be sent to the persons entitled to receive notices of general meetings in the manner in which notices are to be given hereunder. APPENDIX III SECTIONS OF THE ENGLISH LAW RELATING TO PROSPECTUSES [COMPANIES (CONSOLIDATION) ACT, 1908] PROSPECTUS (i) Every prospectus issued by or on behalf Section 80. of a company or in relation to any intended piiij,„ „£ company shall be dated, and that date shall, un- prospec- less the contrary be proved, be taken as the date t"^. of publication of the prospectus. (2) A copy of every such prospectus, signed by every person who is named therein as a di- rector or proposed director of the company, or by his agent authorized in writing, shall be filed for regis'tration with the registrar of com- panies on or before the date of its publication, and no such prospectus shall be issued tmtil a copy thereof has been so filed for registration. (3) The registrar shall not register any pros- pectus unless it is dated, and the copy thereof signed, in manner required by this section. (4) Every prospectus shall state on the face of it that a copy has been filed for registration as required by this section. (5) If a prospectus is issued without a copy thereof being so filed, the company and every person who is knowingly a party to the issue of the prospectus, shall be liable to a fine not ex- ceeding five pounds for every day from the date of the issue of the prospectus until a copy thereof is so filed. 261 262 ACCOUNTING PRACTICE AND PROCEDURE Section 81. (i) Every prospectus issued by or on behalf „ .J. of a company, or by or on behalf of any person require- who is or has been engaged or interested in the ments as to formation of the company, must state — of prospec- (^) the contents of the memorandum, with tus. the names, descriptions, and addresses of the signatories, and the number of shares subscribed for by them respectively; and the number of founders or management or deferred shares, if any, and the nature and extent of the interest of the holders in the property and profits of the company; and (b) the number of shares, if any, fixed by the articles as the qualification of a director, and any provision in the articles as to the remunera- tion of the directors; and (c) the names, descriptions, and addresses of the directors or proposed directors; and (d) the minimum subscription on which the directors may proceed to allotment, and the amount payable on application and allotment on each share; and in the case of a second or subsequent ofifer of shares, the amount offered for subscription on each previous allotment made within the two preceding years, and the amount actually allotted, and the amount, if any, paid on the shares so allotted; and (e) the number and amount of shares and debentures which within the two preceding years have been issued, or agreed to be issued, as fully or partly paid up otherwise than in cash, and in the latter case the extent to which they are so paid up, and in either case the considera- tion for which those shares or debentures have been issued or are proposed or intended to be issued; and (f) the names and addresses of the vendors of any property purchased or acquired by the company, or proposed so to be purchased or APPENDIX 263 acquired, which is to be paid for wholly or partly out of the proceeds of the issue ofifered for sub- scription by the prospectus, or the purchase or acquisition of which has not been completed at the date of issue of the prospectus, and the amount payable in cash, shares, or debentures, to the vendor, and where there is more than one separate vendor, or the company is a sub- purchaser, the amount so payable to each vendor : Provided that where the vendors or any of them are a firm the members of the firm shall not be treated as separate vendors; and (g) the amount (if any) paid or payable as purchase-money in cash, shares, or debentures, for any such property as aforesaid, specifying the amount (if any) payable for good-will; and (h) the amount (if any) paid within the two preceding years, or payable, as commission for subscribing or agreeing to subscribe, or pro- curing or agreeing to procure subscriptions, for any shares in, or debentures of, the company, or the rate of any such commission: Provided that it shall not be necessary to state the commission payable to sub-underwriters; and (i) the amount or estimated amount of pre- liminary expenses; and (j) the amount paid within the two preceding years or intended to be paid to any promoter, and the consideration for any such payment; and (k) the dates of and parties to every material contract, and a reasonable time and place aV which any material contract or a copy thereof may be inspected: Provided that this require- ment shall not apply to a contract entered into in the ordinary course of the business carried on or intended to be carried on by the company, or to any contract entered into more than two 264 ACCOUNTING PRACTICE AND PROCEDURE years before the date of issue of the prospectus; and (1) the names and addresses of the auditors (if any) of the company; and (m) full particulars of the nature and extent of the interest (if any) of every director in the promotion of, or in the property proposed to be acquired by, the company, or, where the interest of such a director consists in being a partner in a firm, the nature and extent of the interest of the firm, with a statement of all sums paid or agreed to be paid to him or to the firm in cash or shares or otherwise by any person either to induce him to become, or to qualify him as, a director, or, otherwise for services rendered by him or by the firm in connection with the pro- motion or formation of the company; and (n) where the company is a company having shares of more than one class, the right of vot- ing at meetings of the company conferred by the several classes of shares respectively. (2) For the purposes of this section every person shall be deemed to be a vendor who has entered into any contract, absolute or condi- tional, for the sale or purchase, or for any op- tion of purchase, of any property to be acquired by the company, in any case where — (a) the purchase-money is not fully paid at the date of issue of the prospectus; or (b) the purchase-money is to be paid or satis- fied wholly or in part out of the proceeds of the issue oiifered for subscription by the prospectus; or (c) the contract depends for its validity or fulfilment on the result of that issue. (3) Where any of the property to be acquired by the company is to be taken on lease, this section shall apply as if the expression "vendor" APPENDIX 265 included the lessor, and the expression "pur- chase-money" included the consideration for the lease, and the expression "sub-purchaser" in- cluded a sublessee. (4) Any condition requiring or binding any applicant for shares or debentures to waive compliance with any requirement of this sec- tion, or purporting to affect him with notice of any contract, document, or matter not spe- cifically referred to in the prospectus, shall be void. (5) Where any such prospectus as is men- tioned in this section is published as a newspaper advertisement, it shall not be necessary in the advertisement to specify the contents of the memorandum or the signatories thereto, and the number of shares subscribed for by them. (6) In the event of non-compliance with any of the requirements of this section, a director or other person responsible for the prospectus shall not incur any liability by reason of the non-compliance, if he proves that — (a) as regards any matter not disclosed, he was not cognizant thereof; or (b) the non-compliance arose from an honest mistake of fact on his part: Provided that in the event of non-compliance with the requirements contained in paragraph (m) of sub-section (i) of this section no director or O'ther person shall incur any liability in re- spect of the non-compliance unless it be proved that he had knowledge of the matters not disclosed. (7) This section shall not apply to a circular or notice inviting existing members or deben- ture holders of a company to subscribe either for shares or for debentures of the company, whether with or without the right to renounce 266 ACCOUNTING PRACTICE AND PROCEDURE in favor of other persons, but subject as afore- said, this section shall apply to any prospectus whether issued on or with reference to the formation of a company or subsequently. (8) The requirements of this section as to the memorandum and the qualification, remunera- tion, and interest of directors, the names, de- scriptions and addresses of directors or proposed directors, and the amount or estimated amount of preliminary expenses, shall not apply in the case of a prospectus issued more than one year after the date at which the company is entitled to commence business. (9) Nothing in this section shall limit or diminish any liability which any person may in- cur under the general law or this Act apart from this section. Section 82. Obliga- tions of companies where no prospectus is issued. Section 83. Restriction on altera- tion of terms men- tioned in prospectus or state- ment in lieu of prospectus. (i) A company which does not issue a pros- pectus on or with reference to its formation, shall not allot any of its shares or debentures unless before the first allotment of either shares or debentures there has been filed with the regis- trar of companies a statement in lieu of pros- pectus signed by every person who is named therein as a director or a proposed director of the company or by his agent authorized in writing, in the form and containing the particu- lars set out in the Second Schedule to this Act. (2) This section shall not apply to a private company or to a company which has allotted any shares or debentures before the first day of July, nineteen hundred and eight. A company shall not previously to the statu- tory meeting vary the terms of a contract re- ferred to in the prospectus or statement in lieu of prospectus, except subject to the approval of the statutory meeting. APPENDIX 267 (i) Where a prospectus invites persons to Section 84. subscribe for shares in or debentures of a com- . pany, every person who is a director of the com- fo'r state- pany at the time of the issue of the prospectus, ments in and every person who has authorized the nam- Pi'ospectus. ing of him and is named in the prospectus as a director or as having agreed to become a di- rector either immediately or after an interval of time, and every promoter of the company, and every person who has authorized the issue of the prospectus, shall be liable to pay compen- sation to all persons who subscribe for any sha-res or debentures on the faith of the pros- pectus for the loss or damage they may have sustained by reason of any untrue statement therein, or in any report or memorandum ap- pearing on the face thereof, or by reference in- corporated therein or issued therewith, unless it is proved — (a) with respect to every untrue statement not purporting to be made on the authority of an expert, or of a public official document or statement, that he had reasonable ground to believe, and did up to the time of the allotment of the shares or debentures, as the case may be, believe, that the statement was true; and (b) with respect to every untrue statement purporting to be a statement by or contained in what purports to be a copy of or extract from a report or valuation of an expert, that it fairly represented the statement, or was a cor- rect and fair copy of or extract from the report or valuation. Provided that the director, per- son named as director, promoter, or person who authorized the issue of the prospectus, shall be liable to pay compensation as aforesaid if it is proved that he had no reasonable ground to be- lieve that the person making the statement, report, or valuation was competent to make it; and 268 ACCOUNTING PRACTICE AND PROCEDURE (c) with respect to every untrue statement purporting to be a staterrient made by an official person or contained in what purports to be a copy of or extract from a pubUc official docu- ment, that it was a correct and fair representa- tion of the statement or copy of or extract from the document: or unless it is proved — (i) that having consented to become a direc- tor of the company he withdrew his consent before the issue of the prospectus, and that it was issued without his authority or consent; or (ii) that the prospectus was issued without his knowledge or consent, and that on becoming aware of its issue he forthwith gave reasonable public notice that it was issued without his knowledge or consent; or (iii) that after the issue of the prospectus and before allotment thereunder, he, on becoming aware of any untrue statement therein, with- drew his consent thereto, and gave reasonable public notice of the withdrawal, and of the reason therefor. (2) Where a company existing on the eigh- teenth day of August, one thousand eight hun- dred and ninety, has issued shares or debentures, and for the purpose of obtaining further capital by subscriptions for shares or debentures issues a prospectus, a director shall not be liable in respect of any statement therein, unless he has authorized the issue of the prospectus, or has adopted or ratified it. (3) Where the prospectus contains the name of a person as a director of the company, or as having agreed to become a director thereof, and he has not consented to become a director, or has withdrawn his consent before the issue of the prospectus, and has not authorized or con- sented to the issue thereof, the directors of the APPENDIX 269 company, except any without whose knowledge or consent the prospectus was issued, and any other person who authorized the issue thereof, shall be liable to indemnify the person named as aforesaid against all damages, costs, and ex- penses to which he may be made liable by reason of his name having been inserted in the pros- pectus, or in defending himself against any ac- tion or legal proceedings brought against him in respect thereof. (4) Every person who by reason of his being a director, or named as a director, or as having agreed to become a director, or of his having authorized the issue of the prospectus, becomes liable to make any payment under this section may recover contribution, as in cases of con- tract, from any other person who, if sued sepa- rately, would have been liable to make the same payment, unless the person who has become so liable was, and that other person was not, guilty of fraudulent misrepresentation. (5) For the purposes of this section — The expression "promoter" means a promoter who was a party to the preparation of the prospectus, or of the portion thereof con- taining the untrue statement, but does not include any person by reason of his acting in a professional capacity for persons en- gaged in procuring the formation of the company: The expression "expert" includes engineer, valuer, accountant, and any other person whose profession gives authority to a state- ment made by him. APPENDIX IV SECTIONS OF THE ENGLISH LAW RE- LATING TO PAYMENT OF INTEREST OUT OF CAPITAL [COMPANIES (CONSOLIDATION) ACT, 1908] PAYMENT OF INTEREST OUT OF CAPITAL Section 91. Where any shares of a company are issued for p , the purpose of raising money to defray the company to expenses of the construction of any works or pay interest buildings or the provision of any plant which itai in cer- cannot be made profitable for a lengthened tain cases, period, the company may pay interest on so much of that share capital as is for the time being paid up for the period and subject to the conditions and restrictions in this section men- tioned, and may charge the same to capital as part of the cost of construction of the work or building, or the provision of plant: Provided that — (i) No such payment s'hall be made unless the same is authorized by the articles or by special resolution: (2) No such payment, whether authorized by the articles or by special resolution, shall be made without the previous sanction of the Board of Trade: (3) Before sanctioning any such payment the Board of Trade may, at the expense of the company, appoint a person to in- quire and report to them as to the circumstances of the case, and may, 270 APPENDIX 271 before making the appointment, re- quire the company to give security for the payment of the costs of the inquiry: (4) The payment shall be made only for such period as may be determined by the Board of Trade; and such period shall in no case extend beyond the close of the half year next after the half year during which the works or buildings have been actually completed or the plant provided: (5) The rate of interest shall in no case ex- ceed four per cent per annum or such lower rate as may for the time being be prescribed by Order in Council: (6) The payment of the interest shall not operate as a reduction of the amount paid up on the shares in respect of which it is paid: (7) The accounts of the company shall show the share capital on which, and the rate at which, interest has been paid out of capital during the period to which the accounts relate: (8) Nothing in this section shall affect any company to which the Indian Rail- ways Act, 1894, as amended by any subsequent enactment, applies. APPENDIX V SECTIONS RELATING TO SHARE- HOLDERS' AUDIT IN THE CANADIAN BANK ACT, 1913 Selection of persons competent to be auditors. List to be ent to inister. M: SHAREHOLDERS AUDIT 56. The general managers of the banks (or in the absence of a general manager of any bank the official designated by him, or in default of such designation the principal officer of the bank next in authority) shall, at a meeting duly called by the president of the Association for the pur- pose before the thirtieth day of September nine- teen hundred and thirteen, and thereafter before the thirtieth day of June in each year, select by ballot persons deemed by them to be competent (no one of whom shall be a body corporate) not less than forty in number, any one of whom shall, subject to the provisions hereinafter con- tained, be eligible to be appointed an auditor under the provisions of this Act. 2. A list of persons so selected, together with their post office addresses and occupations, shall forthwith be delivered or sent by registered post to the Minister, and the Minister may, in the case of the first selection, as hereinbefore pro- vided, within ten days after the receipt of the list, and thereafter each year within sixty days after the receipt thereof, disapprove, as to eligi- bilty to be appointed auditor of a particular bank or banks, or wholly disapprove, of the selection of any person named in the listj and 272 APPENOtX 2';% <«uch person shall not, to the extent of such disapproval, be qualified to be appointed an auditor under this section. 3. The Minister shall communicate his disap- Disapproval, proval, if any, to the Association. '* any. 4. The Association shall, as soon as may be Publication after the expiry of the time given to the Min- "-5 Canada ister tor disapproval, cause the hst of persons qualified as hereinbefore provided, with their respective post office addresses and occupations, to be published in two successive issues of The Canada Gazette, and any limitation as to eligi- biUty for the auditorship of a particular bank or banks of the persons named in the list shall be stated in the advertisement. 5. No person shall be qualified to act as an Qualifica- auditor of a bank under this Act unless his name t'"?. of appears in the published list for the year, but *" "°"' this subsection shall not apply to an appoint- ment of an auditor made by the Minister in pur- suance of the provisions of this Act. 6. The shareholders shall, at each annual gen- Appoint- eral meeting, appoint an auditor or auditors, "^^"t °^ from the last published list of persons qualified, to hold office until the next annual general meeting. 7. After the appointment of an auditor or Super- auditors under the next preceding subsection session of of this section, shareholders, the aggregate of whose paid-up capital stock is equal to at least one-third of the paid-up capital stock of the bank, who in writing under their respective hands allege that they are dissatisfied with the appointment so made, may, in and by the same writing, make application to the Minister to have the person or persons so appointed super- seded, and the Minister may, after such inquiry as he may deem necessary, select an auditor or 274 ACCOUNTING PRACTICE AND PROCEDITRE Appoint- ment by Minister on application of share- holder. Officers dis- qualified. Notice required of intention to nominate auditor. Retiring auditor notified. Notice to share- holders. Vacancies. auditors instead of the auditor or auditors ap- pointed at the annual general meeting, and the auditors so appointed shall thereupon cease to be the auditors of the bank and the auditors so selected shall be the auditors of the bank until the next annual general meeting. 8. If an appointment of auditors is not made at an annual general meeting, the Minister shall, on the written application of a shareholder, ap- point an auditor or auditors of the bank to hold office until the next annual general meeting, and the Governor in Council shall fix the remunera- tion to be paid by the bank for the services of the auditor or auditors so appointed. 9. A director or officer of the bank shall not be capable of being appointed auditor of the bank. 10. A person, other than a retiring auditor, shall not be capable of being appointed auditor at an annual general meeting unless written notice of an intention to nominate that person to the office of auditor has been given by a shareholder to the bank at its chief office, not less than twenty-one days before the annual general meeting, and the bank shall deliver a copy of any such notice to the retiring auditor, if any, and shall give notice of the names of the persons eligible for nomination at the said meeting, and by whom such persons are re- spectively intended to be nominated, to every shareholder of the bank, by mailing the notice in the post office, post paid, to the last known post office address of the shareholder as shown by the records of the bank, at least fourteen days prior to the annual general meeting. 11. If any casual vacancy occurs in the office of auditor the surviving or continuing auditor or auditors, if any, may act, but if there is no APPENDIX 275 surviving or continuing auditor, and such va- cancy has occurred more than three months be- fore the annual general meeting, the directors Special shall, as hereafter in this section provided, call meeting. a special general meeting of the shareholders for the purpose of filling the vacancy. 12. Before calling such special general meet- Public ing the directors shall, as soon as may be after notice by the vacancy occurs, give public notice by ad- mem"^"^^" vertisement in six consecutive issues of one or more daily newspapers published in the place where the chief office of the bank is situate, and if no daily newspaper is published at that place, then by advertisement in two consecutive issues of a newspaper published weekly in that place, of the vacancy in the office of auditor, and that the vacancy will be filled in the manner provided by this Act. 13. A person shall not be capable of being ap- Notice of pointed auditor to fill such vacancy unless nomination notice of an intention to nominate that person to the office of auditor has been given by a shareholder to the bank at its chief office within ten days after the last pubhcation of the notice called for by the next preceding subsection. 14. The directors shall, as soon as may be Special after the expiry of the ten days mentioned in general the next preceding subsection, call a special gen- ^^^ '"^' eral meeting of the shareholders for the purpose of filling the vacancy, and notice of such meet- Notice to ing, specifying the object, and stating the names share- of the persons eligible for nomination, and by whom such persons are respectively intended to be nominated, shall be given to every share- holder of the bank by mailing the notice in the post office, post- paid, to the last known post office address of the shareholder as shown by the records of the bank, at least fourteen days prior to the date fixed for the meeting. to fill vacancy. holders. 276 ACCOUNTING PRACTICE AND PROCEDURE Appoint- ment of auditor by- Minister in case of vacancy. Remunera- tion. Powers and rights of auditors. Audit of branches or agencies. 15. If the vacancy contemplated by subsec- tion II of this section is not filled in the man- ner provided, or if a casual vacancy occurs in the office of auditor less than three months be- fore the annual general meeting, the Minister in the former case shall, and in the latter case may, on the written application of a shareholder, ap- point an auditor or auditors to hold office until the next annual general meeting, and the Gov- ernor in Council shall fix the remuneration to be paid by the bank for the services of the auditor or auditors so appointed. 16. The remuneration of auditors appointed by the shareholders shall be fixed by the share- holders at the time of their appointment, and in the event of such appointees being superseded and other auditors selected, as provided by sub- section 7 of this section, the remuneration so fixed shall be divided between them according to the length of time they respectively are auditors of the bank. 17. Every auditor of a bank shall have a right of access to the books and accounts, cash, securities, documents and vouchers of the bank, and shall be entitled to require from the direc- tors and officers of the bank such information and explanation as may be necessary for the performance of the duties of the auditors. 18. If the bank has branches or agencies it shall be sufficient for all the purposes of this section if the auditors are allowed access to the returns, reports and statements and to such copies of extracts from the books and accounts of any such branch or agency as have been trans- mitted to the chief office, biit the auditors may in their discretion visit any branch or agency for the purpose of examining the books and accounts, cash, securities, documents and vouchers at the branch or agency. APPENDIX 277 19. It shall be the duty of the auditors once Duty of at least during their term of office, in addition ^u^'*,°''^*? to such checking and verification as may be and%e^Hfy necessary for their report upon the statement securities, submitted to the shareholders under section 54 of this Act, and at a different time, to check the cash and verify the securities of the bank at the chief office of the bank against the entries in regard thereto in the books of the bank, and, should they deem it advisable, to check and verify in the same manner the cash and securi- ties at any branch or agency. 20. The auditors shall make a report to the Report of shareholders — auditors to (a) on the accounts examined by them ; holders. (b) on the checking of cash and verification of securities referred to in the next pre- ceding subsection; and, (c) on the statement of the affairs of the bank submitted by the directors to the shareholders under section 54 of this Act during their tenure of office; and the report shall state — (a) whether or not they have obtained all the Particalars. information and explanation they have • required; (b) whether, in their opinion, the transac- tions of the bank which have come un- der their notice have been within the powers of the bank; (c) whether their checking of cash and veri- fication of securities required by sub- section 19 of this section agreed with the entries in the books of the bank with regard thereto; and, (d) whether, in their opinion, the statement referred to in the report is properly drawn up so as to exhibit a true and correct view of the state of the bank's affairs according to the best of their 278 ACCOUNTING PRACTICE AND PROCEDURE Attached to annual statement and read. Audit and report on further statements. Particulars. Attached to statement and read. Copies. Examina- tion by auditor appointed by Minister. information and the explanations given to them, and as shown by the books of the bank. 21. The auditors' report shall be attached to the statement submitted by the directors to the shareholders under section 54 of this Act, and the report shall be read before the shareholders in the annual general meeting. 22. Any further statement of the afifairs of the bank submitted by the directors to the shareholders under section 55 of this Act shall be subject to audit and report, and the report of the auditors thereon shall state — (c) whether or not they have obtained the information and explanation they have required ; (&) whether, in their opinion, such further statement is properly drawn up so as to exhibit a true and correct view of the afifairs of the bank, in so far as the by- law requires a statement thereof, ac- cording to the best of their information and the explanations given to them. and as shown by the books of the bank. 23. The report shall be attached to the fur- ther statement referred to in the next preceding subsection, and shall be read before the share- holders at the meeting to which such further statement is submitted, and a copy of the state- ment and report shall be sent by the directors at and after the meeting to any shareholder ap- plying therefor. auditors' report to minister 56A. The Minister may direct and require any auditor appointed under the next preceding section of this Act, or any other auditor whom he may select, to examine and inquire specially into any of the afifairs or business of the bank, APPENDIX 279 and the auditor so appointed or selected, as the case may be, shall, at the conclusion of his ex- amination and inquiry, report fully to the Min- ister the results thereof. 2. For the purposes of this section the Powers of auditor appointed or selected as aforesaid shall ^"^itor. have all the rights and powei-s given to an auditor under the next preceding section. 3. For the performance of the duties im- Remunera- posed by this section the auditor shall be paid as *'°"- remuneration, out of the Consolidated Revenue Fund, such sum as the Governor in Council may direct. 4. The person selected by the Minister un- To be der this section shall, for the purposes of section ''^j^q^ 153 of this Act, be deemed to be an auditor of of bank, the bank. APPENDIX VI FORM OF GENERAL BALANCE SHEET STATE- MENT AS PRESCRIBED BY THE INTER- STATE COMMERCE COMMISSION FOR STEAM ROADS ASSETS Investments : Investment in Road and Equipment Improvements on Leased Railway Property Sinking Funds Total Book Assets at Date (in short column) Carrier's Own Issues at Date (in short column) Other Assets at Date (in long column) Deposits in Lieu of Mortgaged Property Sold Total Book Assets at Date (in short column) Carrier's Own Issues at Date (in short column) Other Assets at Date (in long column) Miscellaneous Physical Property Investments in Affiliated Companies: (a) Stocks (b) Bonds (c) Notes (d) Advances Other Investments : (a) Stocks (b) Bonds (c) Notes (d) Advances (e) Miscellaneous Total Current Assets : Cash Demand Loans and Deposits Time Drafts and Deposits Special Deposits 280 APPENDIX 281 Total Book Assets at Date (in short column) Carrier's Own Issues at Date (in short column) Other Assets at Date (in long column) Loans and Bills Receivable Traffic and Car-Service Balances Receivable Net Balance Receivable from Agents and Conductors Miscellaneous Accounts Receivable Material and Supplies Interest and Dividends Receivable Rents Receivable Other Current Assets Total Deferred Assets : Working Fund Advances Insurance and Other Funds Total Book Assets at Date (in short column) Carrier's Own Issues at Date (in short column) Other Assets at Date (in long column) Other Deferred Assets Total Unadjusted Debits : Rents and Insurance Premiums Paid in Advance Discount on Capital Stock Discount on Funded Debt Property Abandoned Chargeable to Operating Expenses Other Unadjusted Debits Securities Issued or Assumed — ^Unpledged (in short column only) Securities Issued or Assumed— Pledged (in short column only) Total LIABILITIES Stock : Capital Stock Book Liability at Date (in short column) Held by or for Carrier at Date (in short column) Actually Outstanding at Date (in long column) Stock Liability for Conversion Premium on Capital Stock Total 282, ACCOUNTING PRACTICE AND PROCEDURE Governmental Grants : Grants in Aid of Construction Long Term Debt: Funded Debt Unmatured Book Liability at Date (in short column) Held by or for Carrier at Date (in short column) Actually Outstanding at Date (in long column) Receiver's Certificates Non-Negotiable Debt to Affiliated Companies : (a) Notes (b) Open Accounts Total Current Liabilities: Loans and Bills Payable Traffic and Car-Service Balances Payable Audited Accounts and Wages Payable Miscellaneous Accounts Payable Interest Matured Unpaid Dividends Matured Unpaid Funded Debt Matured Unpaid Unmatured Dividends Declared Unmatured Interest Accrued Unmatured Rents Accrued Other Current Liabilities Total Deferred Liabilities: Liability for Provident Funds Other Deferred Liabilities Total Unadjusted Credits : Tax Liability Premium on Funded Debt Insurance and Casualty Reserves Operating Reserves Accrued Depreciation — Road Accrued Depreciation — Equipment APPENDIX 283 Accrued Depreciation — Miscellaneous Physical Property- Other Unadjusted Credits Total Corporate Surplus : Additions to Property through Income and Surplus Funded Debt Retired through Income and Surplus Sinking Fund Reserves Miscellaneous Fund Reserves Appropriated Surplus Not Specifically Invested Total Appropriated Surplus Profit and Loss — Balance Total Corporate Surplus APPENDIX VII TENTATIVE FORM OF BALANCE SHEET PRO- POSED BY FEDERAL RESERVE BOARD FOR MERCHANTS AND MANU- FACTURERS ASSETS Cash: I a. Cash on Hand — currency and coin $ lb. Cash in Bank $ Notes and Accounts Receivable : 3. Notes Receivable of Customers on Hand (not past due) $ . 5. Notes Receivable Discounted or Sold with Indorsement or Guar- anty 7. Accounts Receivable, Customers (not past due) 9. Notes Receivable, Customers (past due ; cash value, $ ) II. Accounts Receivable, Customers (past due; cash value $ ) Less: 13. Provisions for Bad Debts $ 15. Provisions for Dis- counts, Freights, Al- lowances, etc Inventories : 17. Raw Material on Hand $. 19. Goods in Process 21. Uncompleted Contracts. $ Less — Payments on Account thereof 23. Finished Goods on Hand 284 APPENDIX 285 Other Quick Assets (describe fully) : $ Total Quick Assets (excluding all investments) $. Securities : 25. Securities Readily Marketable and Salable Without Impairing the Business $ ■z-j. Notes Given by Officers, Stock- holders, or Employees 29. Accounts Due from Officers, Stock- holders, or Employees Total Current Assets $ . Fixed Assets : 31. Land Used for Plant $ 33. Buildings Used for Plant 35. Machinery 37. Tools and Plant Equipment 39. Patterns and Drawings 41. Office Furniture and Fixtures 43. Other Fixed Assets, if any (de- scribe fully) $ Less: 45. Reserves for Depreciation Total Fixed Assets Deferred Charges: 47. Prepaid Expenses, Interest, In- surance, Taxes, etc Other Assets (49) Total Assets $. 286 ACCOUNTING PRACTICE AND PROCEDURE LIABILITIES Bills, Notes, and Accounts Payable: Unsecured Bills and Notes : 2. Acceptances Made for Merchan- dise or Raw Material Pur- chased $ 4. Notes Given for Merchandise or Raw Material Purchased 6. Notes Given to Banks for Money- Borrowed 8. Notes Sold Through Brokers ID. Notes Given for Machinery, Ad- ditions to Plant, etc 12. Notes Due to Stockholders, Offi- cers, or Employees $ . Unsecured Accounts : 14. Accounts Payable for Purchases (not yet due) $ 16. Accounts Payable for Purchases (past due) 18. Accounts Payable to Stockhold- ers, Officers, or Employees Secured Liabilities : 2oa. Notes Receivable Discounted or Sold with Indorsement or Guaranty (contra) $ 2ob. Customers' Accounts Dis- counted or Assigned (contra) 20c. Obligations Secured by Liens on Inventories 2od. Obligations Secured by Securi- ties Deposited as Collateral 22. Accrued Liabilities (interest, taxes, wages, etc.) Other Current Liabilities (describe fully) : $ Total Current Liabilities $. APPENDIX Fixed Liabilities : 24. Mortgage on Plant (due date ) $. 26. Mortgage on Other Real Estate (due date . . . . ) 28. Chattel Mortgage on Machinery or Equipment (due date ....).. 30. Bonded Debt (due date ) 32. Other Fixed Liabilities (describe fully) : $. Total Liabilities. Net Worth : 34. If a Corporation — (a) Preferred Stock (less Stock in Treasury) $. (b) Common Stock (less Stock in Treasury) (c) Surplus and Undivided Profits $. Less: (d) Book Value of Good- Will .... $. (e) Deficit 287 Total $. 36. If an Individual or Partnership — (a) Capital $ (b) Undistributed Profits or Deficit Total $. INDEX Account, income, and consolidated balance sheet, 176 profit and loss, 33, 47, SS-74 (See also "Profit and Loss") Accountant, duties and responsibilities of, 212-248 in respect of audit, 231-240 audit certificates, responsibility for, 236 Canadian practice, 235 company audits, American and English practice, 235 English practice, 231, 235 moral and legal responsibility, 240 qualified certificates, 239 in respect of liquidation and reconstruction, 240-248 insolvency, conditions leading up to, 242 responsibility of accountant, 241 liquidation reports, 241 reorganization, 245 in respect of prospectus, 213-230 adjustments, 222 certificate of financial condition, 227 certificate of profits without certificate of assets, 228 depreciation and renewals in their relation to profits, 221 English requirements as to prospectuses, 214 estimates of anticipated economies, 223 estimates of future earnings, 224 fluctuations of profits, 217 interest in its relation to profits, 219 liability of certifying accountant, 230 necessity for accountants' certificates, 213 period to be covered by prospectuses, 215 results for broken periods, 219 salaries as affecting profits, 220 statements of profits, varying requirements of, 222 treatment of unusual profits or losses, 217 Accountant's qualifications, 249 289 290 INDEX Accounting and finance, corporation, 175-189 (See also "Corpora- tion accounting") Accounting for holding companies, 175-184 (See also "Holding companies") Accounts, balance sheet (See "Balance sheet") controlling, 21 English law as to, 259-260 expense and cost, 28 general ledger, 29 impersonal, 14 personal, 14 Accounts and bills receivable, 114-116 Accounts payable, miscellaneous, 145 Accounts receivable, as cause of insolvency, 243 Additions and improvements to property, 154, 155 profits on, 156 Adjustment of inventories on transfer of business, 188 Advances, 86 to agents, 90 Agency and commission, profit and loss account, 59 Agents, advances to, 90 American practice as to company audits, 235 American rule as to corporate profits, 72 Amortization of leaseholds, 173 Analysis, of balance sheet assets, 38-41 (See also "Assets") current assets, 40 fixed assets, 38 investment of reserves, 39 permanent investments, 38 suspense debits, 41 working assets, 39 of balance sheet liabilities, 41-47 (See also "Liabilities") capital stock, 41 current liabilities, 43 depreciation, 44 funded and unfunded debt, 43 profit and loss, 47 surplus, 45 appropriated, 46 suspense credits, 45 Annual income charge, interest on bonds, 134-141 methods of determining, 137-141 varying conditions affecting, 135 INDEX 291 Annuity method of providing for depreciation, 167, 168 accumulations, 168 expenditures, 168 objections to method, 168 Appropriated surplus, 46 Appropriations, 149 (See also "Reserves") Assets, balance sheet, 34-41, 75-126 analysis of, 38-41 capital assets, 75-88 fixed property, 75-82 buildings and structures, 11 changes in value of, 80 furniture and fixtures, 78 land and improvements, 76 movable equipment, 78 patents, goodwill and franchises, 19 patterns, drawings, dies, etc., 78 plant, machinery and fixed tools, 11 investment of reserves, 87 permanent investments, 82-87 advances, 86 investments for purposes of control, 83, 85 minor investments, 85 non-income producing investments, 86 current assets, 40, 93-126 accounts and Dills receivable, 114-116 present values, 115 cash, 118-120 on current account, 119 outstanding cheques, 119 restricted cash balances, 120 foreign exchange, 120-126 dealings in, 125 investments, 116-118 issued stock or bonds in treasury, 117 unissued stock or bonds, 116 valuation of investments, 117 life insurance company, 118 stocks on hand, 93-114 book inventories, 108 physical verification of, 110 carrying charges, treatment of, 106 contracts of purchase, 112 cost accounting, 99 292 INDEX Assets, balance sheet (Continued) Current assets (Continued) Stocks on hand (Continued) distribution of expense burden, 100 expenses, allocation of, 102 increasing value of seasoning material, 104 interest, status of, 103 inventory credits and liabilities, 112 inventory, taking the, 96 inventory valuations, accuracy of, 113 monthly charges. 111 profits, essentials for ascertaining correct, 96 profits on work in progress, 106 reserves for contingencies, 108 selling expenses as part of cost, 102 fixed assets, 38 (See also "Fixed property" above) investment of reserves, 39, 87 order of, 36 permanent investments, 38 (See also "Permanent investments ' above) wprking assets, 39, 88-92 advances to agents, 90 expenses incurred in advance of accrual, 91 royalties, 92 stores and supplies, 89 Assets, certificate of profits without certificate of, 228 current, losses on, 187 guarantee of, 223 Audit, accountant's duties and responsibilities, 231-240 audit certificates, responsibility for, 236 Canadian practice, 235 company audits, American and English practice, 23S English practice, 231, 235 moral and legal responsibility, 240 qualified certificates, 239 English law as to, 251-257 shareholders', Canadian Bank Act, 272-279 B Balance sheet, 31-54 accounts, 33 an approximation, 31 INDEX 293 Balance sheet (Continued) assets, analysis of, 38-41 (See also "Assets") current assets, 40 fixed assets, 38 investment of reserves, 39 permanent investments, 38 suspense debits, 41 working assets, 39 consolidated, 176-184 and income account, 176 legal status of, 179 other forms, 183 English requirements, 48 financial statement, condensed, SO forms of, 34, 48 proposed for merchants and manufacturers, 284-287 statutory, 51 steam roads, 280-283 liabilities, analysis of, 41-47 (See also "Liabilities") capital stock, 41 current liabilities, 43 depreciation, 44 funded and unfunded debt, 43 profit and loss, 47 surplus, 4S appropriated, 46 suspense credits, 45 misleading statements in, 49 net worth, causes affecting, 33 order of assets and liabilities, 36 Bank loans, current, 144 manner of repayment, characteristic of, 144 Banks, profit and loss account,- 60 Bills, discounted, 146 Bills receivable, 114-116 Bonds, 116-118, 133-143 annual income charge, 134-141 methods of determining, 137-141 varying conditions affecting, 135 discounts and premiums on, 66, 134, 135, 142 interest rate on, 66, 134-141 issued, held in treasury, 117 of life insurance company, valuation of. 118 unissued, 116, 14i 294 ™°^^ Book inventories, 108 physical verification of, 110 Bookkeeping, 13-30 controlling accounts, 21 double-entry, 13 early bookkeeping methods, 17 impersonal accounts, 14 loose-leaf records, 22, 23 mechanical aids in bookeeping, 23 modern bookkeeping methods — pro forma system, 23-30 cash records, 25 creditors' or purchase records, 27 expense and cost accounts, 28 general ledger accounts, 29 journal entries, 29 passing bills for payment, 26 sales and customers' records, 23 opening the books, IS personal accounts, 14 progress of bookkeeping, 30 subsidiary ledger, 18, 29 trial balance, 16 Books, cash book, 25 cost ledger, 28 expense analysis book, 28 loose-leaf or card ledger, 22, 23 opening the, IS voucher record, 26 Borrowing, excessive, as cause of insolvency, 243 Buildings and structures, 11 Burden, expense, 100, 196 Canadian audit practice, 235 Canadian Bank Act, requirements as to shareholders' audit, 272-279 Capital assets, 75-88 (See also "Assets") Capital invested, comparisons between production and, 208 Capital outlay, interest and overhead charges as part of, ISS Capital, payment of interest out of, English rule, 270, 271 Capital resources, available, 143 Capital stock (See "Stock, capital") Card ledger, 22, 23 INDEX 295 Cash, 118-120 on current account, 119 outstanding cheques, 119 restricted cash balances, 120 statement of, in a balance sheet, 118 Cash book, 25 Certificate, accountant's, audit, accountant's responsibility for, 236, 240 qualified, 239 liability of accountant for, 230 necessity for, 213 of anticipated economies, 223 of financial condition, 227 of future earnings, 224 of profits, 222 without certificate of assets, 228 Charges, annual income, 134-141 carrying, 106 interest (See "Interest") monthly, for material. 111 rental, 203 Cheques, outstanding, 119 voucher, 26 Classification, of activities in respect to profit and loss, 56-62 of assets and liabilities, 36 of maintenance expenditures, 162 of property expenditures, 154 Combination method of providing for depreciation, 168, 170 Commercial costs, constituent elements of, 195 Commercial investments, 200 Commercial paper, 144 Commission business, profit and loss account, 59 Consolidated balance sheet, 176-184 and income account, 176 legal status of, 179 other forms, 183 Constituent companies, 182 Construction work, 153-158 issue of shares for, English rule, 158 profits on, 156 296 INDEX Contingencies, reserves for, 108 Contingent liabilities, 145 Contracts, effect of terms on costs, 211 liability under, for labor or goods, 146 of purchase, 112, 147, 188 adjustment of inventories, 188 percentages retained on, 144 Control, investments for purposes of, 83, 85 Controlling accounts, 21 Corporate profits, 68-74 American rule, 72 English rule, 68 general rule, 73 Corporation accounting and finance, 175-189 accounting for holding companies, 175-184 consolidated balance sheet and income account, 176 constituent companies, definition of, 182 intercompany profits and accounting, 180 legal status of consolidated balance sheet, 179 other forms of consolidated statements, 183 organization of holding corporation, questions arising, 186-189 adjustment of inventories on transfer of business, 188 initial surplus, 186 losses on current assets acquired, 187 profits earned before date of consolidation, 185 Cost accounting, theories and problem, in, 99, 190-211 comparisons between production and capital invested, 208 conditions affecting cost, 193 constituent elements of commercial costs, 195 constituent elements of manufacturing cost, 192 cost as a price basis, 211 distribution of overhead expense, 196 elements of manufacturing, 190 importance of accurate cost keeping, 199 interest and rent, relation to manufacturing cost, 200, 201, 204 interest, suggested treatment in connection with costs, 206 nature of commercial investments, 200 nature of plant, 191 profit-sharing in its relation to costs, 210 purposes of cost accounting, 194 rental charges, 203 selling costs, 102, 198 Cost ledger, 28 INDEX 297 Credits, principles involved, 14 suspense, 45 Current assets, 40, 93-126 (See also "Assets") Current liabilities, 43, 143 bank loans and commercial paper, 144 miscellaneous accounts payable, 145 percentages retained on contracts, 144 taxes, 145 Customers' records, 23 D Debits, principles involved, 14 suspense, 41 Debt, bonded, 133-143 (See also "Bonds") funded and unfunded, 43 reserves for redemption of, 148 Depreciation, 44, 164, 167-174, 221 methods of providing for, 167-174 amortization of leaseholds, 173 annuity method, 167, 168 combination method, 168, 170 diminishing balance method, 167, 170 exhaustion of minerals, 172 interest on accumulated depreciation, 171 straight line method, 167, 169 relation to profits, 221 Dies, drawings, patterns, etc., 78 Diminishing balance method of providing for depreciation, 167, 170 Discounted 'bills, 146 Discounts and premiums, on bonds, 66, 134, 135, 142 on stock, 127 Discounts on bonds not a proper charge to capital, 142 Distribution of expense burden, 100, 196 Dividends, and reserve, English law, 258-260 distribution, American rule, 72 English rule, 68 general rule, 73 in excess of current earnings, as cause of insolvency, 244 298 INDEX Double-entry bookkeeping, 13 Drawings, dies, patterns, etc., 78 Duties and responsibilities of accountant, 212-248 (See also "Ac- countant") E English audit practice, 231, 235 English law, extracts relating to — accounts, 259, 260 dividends and reserves, 258-260 inspection and audit, 251-257 payment of interest out of capital, 270, 271 prospectuses, 261-269 English requirements as to — balance sheet, 48 corporate profits, 68 issue of shares for construction purposes, 158 prospectuses, 214 treasury stock, 133 Estimates, of anticipated economies, 223 of future earnings, 224 Exchange, foreign, 120-126 Expenditures on property, 154-174 (See also "Property") Expense analysis book, 28 Expense and cost accounts, 28 Expense burden, distribution of, 100, 196 Expenses (See also "Cost Accounting") allocation of, 102 incurred in advance of accrual, 91 selling, as part of manufacturing cost, 102 F Failure, business, duties and responsibilities of accountant in case of, 240-245 Federal Reserve Board, balance sheet proposed for merchants and manufacturers, 284- 287 Finance and accounting, corporation, 175-189 (See also "Corpora- tion accounting") Financial condition, certificate of, 227 Financial statement, condensed, 50 Steam roads, 280-283 varying purposes of, 55 INDEX Fixed assets, 38, 75-82 buildings and structures, 71 changes in value of, 80 furniture and fixtures, 78 land and improvements, 16 movable equipment, 78 patents, goodwill and franchises, 19 patterns, drawings, dies, etc., 78 plant, machinery and fixed tools, 11 Fixtures, 78 Fluctuations of profits, 217 Foreign exchange, 120-126 Forms (See "Statements") Franchises, goodwill and patents, 19 Funded and unfunded debt, 43 Fund, sinking, 148 Furniture and fixtures, 78 Future earnings, estimates of, 224 General ledger accounts, 29 Goodwill, patents and franchises, 79 Guarantee of assets or liabilities, 223 Guarantees on loans, 146 H Holding companies, accounting for, 175-184 consolidated balance sheet and income account, 176 constituent companies, definition, 182 intercompany profits and accounting, 180 legal status of consolidated balance sheet, 179 other forms of consolidated statements, 183. organization of corporation, questions arising, 186-189 adjustment of inventories on transfer of business, 188 initial surplus, 186 losses on current assets acquired, 187 profits earned before date of consolidation, 185 299 Impersonal accounts, 14 Improvements, 76, 154, 155, 163, 164 profits on, 156 300 INDEX Income, 63 account, and consolidated balance sheet, 176 annual charge, interest on bonds, 134-141 methods of determining, 137-141 tables, 140, 141 varying conditions affecting, 13S Initial surplus, 186 Insolvency, accountant's duties and responsibilities in case of, 240-245 causes or conditions leading up to, 242 Intercompany profits and accounting, 180 Interest, and rent, relation to manufacturing cost, 200, 201, 204 charges in capital outlay, 155 on accumulated depreciation, 171 on bonds, 66, 134-141 annual income charge, 134-141 methods of determining, 137-141 varying conditions affecting, 135 payment of, out of capital, English rule, 270, 271 relation to profits, 219 savings effected by additional facilities, 206 status of, 103 treatment of, in connection with costs, 206 Interstate Commerce Commission, statement prescribed for steam roads, 280-283 Inventory, accuracy of valuation, 113 adjustment of, on transfer of business, 188 book, 108 physical verification of, 110 credits and liabilities, 112 taking the, 96 Investments, 116-118 commercial, 200 issued stock or bonds held in treasury, 117 permanent, 38, 82-87 advances, 86 investments for purposes of control, 83, 85 minor investments, 85 non-income producing investments, 86 reserves, 39, 87 unissued stock or bonds, 116 valuation of, 117 life insurance company, 118 INDEX Invoice, 23 Invoice card, 26 Issued stock or bonds held in treasury, 117, 130 J Journal entries, 29 Journal voucher, 23, 29 Land, improvements on, 76 (See also "Improvements") Leaseholds, amortization of, 173 Ledger, expense, 28 general, accounts in, 29 loose-leaf or card, 22, 23 subsidiary, 18, 29 Legal responsibility of accountant as to audit certificates, 240 Liabilities, and credits, inventory of, 112 guarantee of, 223 Liabilities, balance sheet, 41-47, 127-152 analysis of, 41-47 appropriations, 149 available capital resources, 143 bonded debt, 133-143 annual income charges, 134-141 varying conditions affecting, 135 discount on bond issues, 142 , effective interest rate on bonds, 134 methods of determining annual charge to income, 137-141 capital stock, 41, 127-133 discounts and premiums on, 127 railway companies, requirements for, 130 redemption of, 129 steamship companies, requirements for, 130 treasury stock, 130 English rule, 133 without par value, 128 contingent liabilities, 145 bills discounted, 146 contracts, liability under for labor or goods, 146 of purchase, 147 guarantees on loans, 146 shares not fully paid, 146 301 302 INDEX Liabilities, balance sheet (Continued) current liabilities, 43, 143 bank loans and commercial paper, 144 miscellaneous accounts payable, 14S percentages retained on contracts, 144 taxes, 145 depreciation, 44 funded and unfunded debt, 43 order of liabilities, 36 profit and loss, 47 secret reserves, ISO sinking fund reserves for redemption of debt, 148 surplus, 45 appropriated, 46 Liability of certifying accountant, 230 Life insurance company, reserve for fluctuations in value of bonds, 118 valuation of bonds, 118 Liquidation and reconstruction, accountant's duties and responsi- bilities as to, 240-248 (See also "Accountant") Loans, bank, current, 144 guarantees on, 146 Loose-leaf records, 22, 23 Loss and gain terminology, 55 suggested, 62 Losses due to shrinkage of current assets, 187, 242 Losses or profits, on sale of property, 65 unusual, 217 M Machinery, plant and fixed tools, 11 Maintenance expenditures, 159-164 classification of, 162 treatment of, by railroads, 160 Manufacturing, elements of, 190 profit and loss account, 57 Manufacturing cost, as a price basis, 211 constituent elements of, 195 inclusion of rent as a, 203 profit-sharing in its relation to, 210 relation of interest and rent to, 200, 201, 204 selling expenses as part of, 102 INDEX 203 Material (See "Stock on hand") Merchandizing business, profit and loss account, 58 Merchants and manufacturers, form of balance sheet proposed by Federal Reserve Board, 284-287 Methods, modern bookkeeping— pro forma system, 23-30 (See also "Bookkeeping") Methods of determining bond interest charges to income, 137-141 operation of, 138 table, 140 when proportionate discount is written off, 139 table, 141 Methods of providing for depreciation, 167-174 (See also "Depre- ciation") Minerals, exhaustion of, 172 Alines and timber, expenditures upon, 76 N Net worth, causes affecting, 32 Non-income producing investments, 86 O Opening the books, IS Organization of holding corporation, questions arising, 186-189 adjustment of inventories on transfer of business, 188 initial surplus, 186 losses on current assets acquired, 187 Outstanding cheques, 119 Overhead and interest charges in capital outlay, ISS Overhead expense, distribution of, 100, 196 Par value, stock without, 128 Patents, goodwill and franchises, 79 Patterns, drawings, dies, etc., 78 Payment of interest out of capital, English rule, 270, 271 Permanent investments, 38, 82-87 (See also "Investments") Personal accounts, 14 Physical verification of book inventories, 110 Plant, machinery and fixed tools, 17 Premiums, on bonds, 66, 134, 135 on stock, 128 304 INDEX Private accounts, 62 Production, comparisons between capital invested and, 208 Professional accounts, 61 Profit and loss account, 33, 47, 5S-74 classification of activities, 56-62 agency and commission, 59 banking, 60 manufacturing, 57 merchandising, 58 private accounts, 62 professional accounts, 61 transportation, 59 corporate profits, 68-74 American rule, 72 English rule, 68 general rule, 73 forms for statements of loss and gain, 63 items properly chargeable to profit and loss, 65 discounts and premiums on bonds, 66 profits or losses on sale of property, 65 loss and gain terminology, 55 suggested, 62 nature of profits, 67 single-entry determination of profits, 67 varying purposes of financial statements, 55 Profit and loss statement, 63, 222 Profits, certificate of, without certificate of assets, 228 corporate, 68-74 American rule, 72 English rule, 68 general rule, 73 depreciation and renewals in their relation to, 221 earned before date of consolidation, 185 essentials for ascertaining correct, 96 fluctuations of, 217 intercompany, 180 interest in its relation to, 219 nature of, 67 on construction work, 156 on work in progress, 106 or losses, on sale of property, 65 unusual, 217 INDEX 305 Profits (Continued) salaries as affecting, 220 single-entry determination of, 67 statements of, varying requirements, 222 Profit-sharing in its relation to costs, 210 Property, fixed, 38, 7S-82 (See also "Assets") profits or losses on sale of, 65 Property expenditures, 154-174 classification of, 154 interest and overhead charges in capital outlay, 155 maintenance expenditures, 159-164 classification of, 162 treatment of, by railroads, 160 methods of providing for depreciation, 167-174 amortization of leaseholds, 173 annuity method, 167, 168 combination method, 168, 170 diminishing balance method, 167, 170 exhaustion of minerals, 172 interest on accumulated depreciation, 171 straight line method, 167, 169 profits on construction work, 156 reconstruction and improvements, ISS renewals and depreciation, 164 Prospectus, accountant's duties and responsibilities as to, 213-230 adjustments, 222 certificate of financial condition, 227 certificate of profits without certificate of assets, 228 depreciation and renewals in their relation to profits, 221 English requirements as to prospectuses, 214 estimates of anticipated economies, 223 estimates of future earnings, 224 fluctuations of profits, 217 interest in its relation to profits, 219 liability of certifying accountant, 230 necessity for accountants' certificates, 213 period to be covered by prospectuses, 215 results for broken periods, 219 salaries as affecting profits, 220 statements of profits, varying requirements of, 222 treatment of unusual profits or losses, 217 English law as to, 261-269 3o6 INDEX Purchase, contracts of, 112, 147, 188 records, 27 Q Qualifications of accountant, 249 Qualified certificates, 239 R Railroads, requirements as to treasury stock, 130 treatment of maintenance expenditures by, 160 Receipts from sales, cash, 24 Reconstruction and liquidation, accountant's duties and responsi- bilities as to, 240-248 Reconstruction of property, 155 profits on, 156 Redemption, of debt, sinking fund reserves for, 148 of stock, 129 Renewals, repairs, depreciation, and new construction, 153-174 (See also "Property expenditures") Rent and interest, relation to manufacturing cost, 200, 201, 204 Rental charges, 203 Reorganization, 245 Repairs, renewals, depreciation, and new construction, 153-174 (See also "Property expenditures") Reports (See "Statements") liquidation, accountant's, 241 Reserves, difference between voluntary and necessary, 149 dividends and English law, 258-260 for contingencies, 108 investment of, 39, 87 secret, 150 sinking fund, for redemption of debt, 148 Responsibilities and duties of public accountant, 212-248 (See also "Accountant") in respect of audit, 231-240 in respect of liquidation and reconstruction, 240-248 in respect of prospectus, 213-230 Responsibility, accountant's, for audit certificates, 236 moral and legal, 240 Revenue, 63 INDEX 30; Royalties, 92 Rules of considering profits, 68-74 American rule, 72 English rule, 68 general rule, 73 Salaries as affecting profits, 220 Sale of property, profits on, 65 Sales and customers' records, 23 Scrap material, valuation of, 99 Secret reserves, 150 Selling cost, 198 as part of manufacturing cost, 102 Shareholders' audit, extracts from Canadian Bank Act, 272-279 Shares (See "Stock") Single-entry, 67 Sinking fund reserves for redemption of debt, 148 Statement, balance sheet, 34, 48, 51 analysis of assets, 38 analysis of liabilities, 40 consolidated, 176-184 proposed for merchants and manufacturers, 284-287 steam roads, 280-283 varying purposes of, 55 condensed, SO loss and gain, 63 of profits, varying requirements of, 222 Steam roads, statement prescribed, 280-283 Steamship companies, requirements as to treasury stock, 130 Stock, capital, 41, 117, 127-133, 143, 146 discounts and premiums on, 127 issued, held in treasury, 117 not fully paid, 146 redemption of, 129 treasury, 130 English rule, 133 unissued, 116, 143 without par value, 128 Stock on hand, 93-114, 243 as cause of insolvency, 243 3o8 INDEX Stock on hand (Continued) book inventories, 108 physical verification of, 110 carrying charges, treatment of, 106 contracts of purchase, 112 cost accounting, 99 distribution of expense burden, 100 expenses, allocation of, 102 increasing value of seasoning material, 104 interest, status of, 103 inventory credits and liabilities, 112 inventory, taking the, 96 monthly charges. 111 profits, essentials for ascertaining correct, 96 profits on work in progress, 106 reserves for contingencies, 108 selling expenses as part of cost, 102 Stores and supplies, 89 Straight line method of providing for depreciation, 167, 169 Subsidiary cash book, 25 Subsidiary companies (See "Holding companies") Subsidiary ledgers, 18, 29 Supplies and stores, 89 Surplus, 33, 45, 63 appropriated, 46 initial, 186 Suspense credits, 45 Suspense debits, 41 System (See "Method") T Tables, annual charge to income, 140, 141 Taxes, 145 Terminology, loss and gain, 55 ' suggested, 62 Theories and problems in cost accounting, 190-211 (See also "Cost Accounting") Tools, fixed, n Transportation, profit and loss account, 59 Treasury stock, 117, 130, 133 Trial balance, 16 U Unfunded debt, 43 Unissued stock or bonds, 116, 143 INDEX 309 Valuation, of inventory, 113 of investments, 117 life insurance company, 118 of stock on hand, 93-114 Voucher, 25 journal, 23, 29 Voucher cheque, 26 Voucher record, 26 W Work in progress, valuation of, 98 Working assets, 39, 88-92 (See also "Assets")