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The Columbia University Libraries reserve the right to refuse to accept a copying order if, in its judgement, fulfillment of the order would Involve violation of the copyright law. Author: Bennett, George Edward Title: Advanced accounting Place: New York Date: 1922 COLUMBIA UNIVERSITY LIBRARIES PRESERVATION DIVISION BIBLIOGRAPHIC MICROFORM TARGET MASTER NEGATIVE « ORIGINAL MATERIAL AS FILMED - EXISTING BIBLIOGRAPHIC RECORD wm»i^lmmmm^mm^fKm Bennett, George Edward, 1889- Advanced accounting, by George E. Bennett ... 1st ed. New York [etc.] McGraw-Hill book company, inc., 1922. xiv, 661 p. 23^"'. C$4,003 1. Accounting. Library of Congress Copy 2. Copyright A 692141 O HFS625.B38S (3| 22-23899 « ."., ■H^ RESTRICTIONS ON USE: TECHNICAL MICROFORM DATA FILM SIZE: STa^ REDUCTION RATIO: r? X IMAGE PLACEMENT: lA OIAJ IB IIB DATE FILMED: /0-n-9L/ TRACKING # : m>\ o%omt INITIALS: %. 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SM*" ll >-',? *v 3M '# m .V '-^. 1= \t Ml %^« ■'",i*'»'-n?*t il |gi*> ^A.c ^;? ^ ""»«,?;," •f-,j, i- ' _-r Hi** I. . ■. Columbia IHmtierfltitp tn t|ie Cttp of ^to |9inrk LIBRARY #clbool of ^ni^ineKK flit ittontgamrrp Htdtarp of iSlccoantaticp !»'■ ADVANCED ACCOUNTING ADVANCED ACCOUNTING BY ;^muMMmnjmiiHiHiium»»lL"«m»iJMi'iH»MHiiiiiiiiiMMin TlkQrmOliR Book QxTm PUBLISHERS OP BOOKS POIV^ Ilectrical Wjrid v Engineering News -Record Pover V Engineering and Mining Joumal-Rress Chemical and Metallurgical Er^ineerir^ Hectric Railway Journal v Coal Age American Machinist "^ Ii^genieria Intemacicttial Electrical Merchandising v BusTransponation Journal of Electricity and Western Industry Industrial Ei^ineer liiHiTMrniMliiiiTMiiffim^^ GEORGE E. BENNETT. A. B., LL. M., CERTIFIED PUBLIC ACCOUNTANT; PROFESSOR OF ACCOUiItiNG COLLEGE OF BUSINESS ADMINISTRATION ' SYRACUSE UNIVERSITY First Edition McGraw-Hill book company, inc new york: 370 seventh avenue LONDON: 6 A 8 BOUVERIE ST., E. C. 4 1922 /^ 1 A c I 1 Vi) Copyright, 1922, by thJI McGraw-Hilx. Book Company, Inc. PREFACE In issuing this volume, the author hopes that the material will be found useful in connection with the problems which arise continually in the more advanced phases of accounting as prac- ticed to-day, rather than be considered a production devoted to developing an individual's pet theories. This book is presented primarily as a text, and is based on the present course in ad- vanced or second year accounting as given in the College of Business Administration at Syracuse University. It represents a conscientious attempt on the part of the author to present material for. the advanced accounting student in such a man- ner that he may secure a working knowledge of accounting practice as well as a certain ability to discuss various theories of accounting science. An endeavor has been made to present principles illustrated by a large number of examples, and problems " together with solutions, in accord with a basic plan which is the result of nearly three years of experimentation and study. The material has been worked over in the class-room with both day and evening students, both by the writer and his associates until it has seemed to be the most serviceable form for impressing prin- ciples upon the students. In view of the strenuous effort which has been made to avoid technicalities and to make the exposi- tion clear and simple, the author also ventures to hope that this book will be useful not only to college students but to all who are vitally interested in accounting. The first three chapters attempt to bridge the gap between elementary and so-called advanced accounting, which many teachers recognize as existing in most presentations of the sub- ject. It was deemed advisable to present a thorough review of elementary principles necessary in the study of advanced work since they have often been forgotten or are at least vaguely tl PREFACE remembered by the average student. Following these chapters, principles of corporate accounting are presented with consider- able stress on the legal whys and wherefores underlying them. Later, the effort has been to present material relative to financial statements, concerning which little is available in other publica- tions, although this is an essential part of the accountant's knowledge. The material relating to fiduciary work is included for the same reason. The author desires to express his indebtedness to two of his associates, Thomas J. McCormick and Philip E. Bunker, for the great care with which they have constructively criticized and assisted in the revision of the original manuscript. More- over, the author realizes that whatever value the views ex- pressed may have, has been derived from a large number of professional contacts. And the opinions expressed are often those of many whom the author considers as the highest au- thorities among present-day practitioners. It is suggested that teachers using this book for classroom instruction may find it profitable to follow the methods used in the classes at Syracuse University. After covering the material in the earlier chapters by means of considerable discussion, it is the author's custom to assign readings in the succeeding chapters to be carried on concurrently with the answering and solution of assigned questions and problems which will be found in the ap- pendix. In other words, after a satisfactory start has been made, theoretical classroom lectures are reduced to a minimum; and the classroom work revolves almost entirely around assigned questions and problems. The reason for this lies in the writer's belief that proficiency in accounting can come only through prac- tice, and that the usual theoretical classroom lectures or discus- sions are largely a waste of time. Sufficient questions and prob- lems have, therefore, been included here to present concrete situations, possible of variation by the teacher, which may be- come the basis of profitable class discussion. Moreover, the many questions and problems included will permit the assign- ments to be varied from year to year. Naturally, all books are susceptible of improvement, and if any important principle or problem in general advanced account- ing has not been covered, the author would be pleased to have PREFACE Vll his attention directed to the omission. Finally, he would be most grateful for any suggestions for the improvement of the material herein presented in order that students hereafter using this book may derive therefrom the greatest possible practical benefit. Syracuse, N. Y. September, 1922. George E. Bennett. CONTENTS T^ Paos Preface CHAPTER I.— Single and Double-Entry: Principles and Terms 1 Introduction— Accountancy Versus Accounting; Auditing— Single- Entry Bookkeeping— Internal Check— Double-Entry Bookkeep- ing—Classification of Accounts— Suspense Accounts— Ledger Ar- rangement of Accounts— Status of Journalization; Journals— Ledgers— Adjustment Account— Vouchers— Voucher System— Trial Balance— Blocking the Ledger— Articulation Statement: Abstract- ing Accounts— Financial Statements— Types of Assets— Types of Liabilities— Two Bases of Accounting— Deferred and Contingent Items— Capital Versus Deficit— Income ; Revenue; Earnings- Profit: Gross, Net, Operation, Capital— Receipts : Disbusements ; Expenses, Expenditures. CHAPTER II.— Specific Real and Nominal Accounts 26 Introduction— Cash and Cash Records— Statement of Cash Re^ ceipts and Disbursements— Notes Versus Bills— Notes Receiv- able—Dishonored Notes Receivable— Notes Receivable Discounted —Loss on Notes Receivable— Notes Receivable Register— Interest and Discount on Notes Receivable— Accounts Receivable— Bad Debts; Reserve for Bad Debts— Average Due Date— Capital and Fixed Assets— Repairs, Renewals, Replacements, Additions, Bet- terments— Wasting Assets— Land— Leaseholds— Buildings— Machin- ery— Tools— Patterns— Good Will, Patents, Royalties, Copyrights, Trademarks, etc.— Notes Payable— Purchases— Sales— Sales to For- eign Branches— Returns and Allowances; Expenses Related to Goods— Turnover— Insurance— Co-insurance and Fire Loss— Mis- cellaneous Insurance Procedures. CHAPTER III.— Partnerships; Ventures; Contracts; Manufac- turing Control Introduction— Partnership Formation— Partnership Defined— Part- nership Advantages and Disadvantages-Classifications of Partnere and Partnerships— Provisions of Partnership Agreement— Rights Duties, and Powers of Partners— Interest ; Salaries; Profits and Losses; Court Rules— Opening Entries— Partnerehip Operation- Partnership Profits-Interest on Capital Contributions-Partner- ship Dissolution-Asset Apphcation Upon Dissolution-Joint Ven- UE 60 CONTENTS \\ Pagb ture Defined— Venture Entries— Accounts Related to Contracts- Contracts Upon the Balance Sheet — Entries Upon Contractor's Records — Entries Upon Records of Contract Customer — Purpose of Discussion — Manufacturing Accounts — Cost Accounting De- fined — Cost Methods and Factory Orders — Methods of Control — Control Entries. CHAPTER IV. — Corporations: Definitions; Opening Entries . . 92 Introduction — Corporation Defined — Corporation Distinguished from Partnership — Corporation Distinguished from Joint Stock Company — Advantages of the Corporate Form of Organization — Disadv^antages of the Corporate Form of Organization — Classifica- tion of Corporations — Incorporation Procedure — Stockholders — The Corporate Charter — Capital Versus Capital Stock — Capital Stock Values— rPrimary Classes and Kinds of Capital Stock with Par Value: Common versus Preferred — Sundry Classes and Kinds of Capital Stock with Par Value — Capital Stock Issuance and Mode of Payment — Fully Paid and Partly Paid Capital Stocks- Stock Subscriptions — Stock Certificates — Issued and Unissued Cap- ital Stock — Stock ledger — Opening Entries — Stock Issued for Money Only: Fully Subscribed: One Class — Partly Subscribed: More Than One Class — Fully Subscribed: Issuance on Installment Plan — Stock Issued for Both Money and Notes : Partly Subscribed — Organization Expense — Capital Stock Premium and Discount — Treasury Stock: Definition and Status — Accoimting Treatment of Treasury Stock: Donated Stock — Accoimting Treatment of Treas- ury Stock: Purchased Stock. CHAPTER V. — Corporations: Organization; Records; Opening Entries (Continued) 137 Genesis of a Proposed Corporation — Filing the Certificate of In- corporation — Amending the Certificate of Incorporation; Rein- corporation — First Regular Meetings — Corporate Officers — Cor])0- rate Records — Minute Book — Subscription List or Register; Sub- scription Ledger — Instalment List — Instalment Receipt or Scrip Book — Stock Certificate Book — Stock Ledger or Book — Stock Journal — Stock Transfer Book — ^Bond Register — New York Stock Exchange — Stock Issued for Property — Transfer of the Business of a Sole Trader to a Corporation — Procedure by Vendor Upon the Sale of the Business of a Sole Trader or of a Partnership to a Corporation — Transfer of the Business of a Partnership to a Corp- oration — No Par Value Capital Stock — Conclusion. CHAPTER VI.— Investments: Stocks, Bonds and Mortgages . . 178 Introduction — Investments in General — Investments Other Than Securities — Accoimting for Real Estate Investments — Bond De- CONTENTS Paqb fined— Classification of Bonds— Bond and Mortgage— Registered Bonds— Coupon Bonds— Mortgage Bonds— Collateral Trust Bonds —Miscellaneous Classes of Bonds— Loans Secured by Collateral- Stock and Bond Values— Proprietorship versus Loan Investments —Speculative versus Non-Speculative Investments: Temporary versus Permanent— Bonds as Investments— Accounting for Bonds as Investments: Simple Procedure— Bond Premium and Discount; Nominal and Effective Interest Rates; Amortization and Accumu- lation—Ascertaining Present Value of a Bond— Schedule of Amortization— Accounting for Bonds as Investments: Amortiza- tion Principle. CHAPTER VII.— Depreciation ; Reserves and Reserve Funds; Sur- plus and Dividends 212 Introduction— Underiying Principle— Depreciation Defined— Fluc- tuation— Appreciation— Maintenance— Causes of Depreciation- Contingent Losses as Depreciation— Depreciation an Operating Expense: a Manufacturing Cost— Factors Considered in Deter- mining Depreciation Amount— Methods of Determining De- preciation Charges— Straight Line Method— Fixed Percentage on Diminishing Value Method— Depreciation Fund— Sum of the Year Digit Method— Sinking Fund Method— Annuity Method— Re- valuation Method— Composite Life Methods— Working Hours Method— Production or Output Method— Miscellaneous Methods —Fallacy in Theoretical Depreciation Discussion— Depreciation Rates— Booking Depreciation— Replacing or SeUing Depreciated Assets— Wasting Assets— Appraisals and Depreciation— Reserve Defined— Valuation Reserves— Surplus or True Reserves: Proprie- torship Reserves— Reserves and the Balance Sheet— Funds— Re- serve Funds— Secret Reserves— Corporate Net Worth— Classes of Dividends— Capital versus Profits ; Relation to Dividends— Sur- . plus Profits— Illegal Dividends— Mining Company Dividends- Realizing Upon Assets to Pay a Dividend— Declaring and Pay- ing Dividends— Stock and Scrip Dividends— Cumulative Dividends — Profit-sharing. CHAPTER VIII. — Corporate Obligations: Bonds Payable; Sinking Fund 256 Forms of Corporate Obligations— The Trustee and the Trust Agreement— Trustee's Certificate— Compliance with Statutes- Bond Signatures— Listing Bonds on the Exchange— Unissued Bonds and Treasury Bonds— Entries Covering the Issue of Bonds- Illustrative Problem and Solution— Payment of Bond Interest- Bond Interest and Construction— Bond Premium, Discount, and Expense— Sinking Fund— Sinking Fund Trustee— Illustrative Problems and Solutions— Annuities and Sinking Funds— Cancella- tion of Redeemed Bonds and Paid Coupons. xu CONTENTS i Paob CHAPTER IX.— Balance Sheet; Profit and Loss Statement . . 292 Introduction— Preliminary Suggestions— Balance Sheet Titb>— Balance Sheet Form— Arrangement of Balance Sheet Items; Ac- count Form of Statement— Nomenclature for Balance Sheet CUi>- tions — Current Assets: Cash— Notes, Acceptances, and Accounts Receivable — Short Term Investments — Accrued Interest — Invtm- tories— Investments— Sinking Fund— Properties— Goodwill, Pat- ents, etc.— Deferred Charges— Current Liabilities: Notes and Ac- ceptances Payable — Accounts Payable — Dividends Payable — Wages, Taxes, and Interest Accrued— Fun(l(d Debt— Deferred Credits — Reserves — Capital Stock — Surplus — Contingent Assets and Liabilities — Capital versus Revenue--Stat(>ment of Profit and Loss Title— Arrangement of Statement of Profit and Loss Items- Gross Sales— Deductions from Sales— Net Sales — Cost of Goods Sold; Cost of Manufacture and of Manufactured Product Sold— Gross Profit on Sales— SelHng Expenses— Selling Profit— General Expenses— Profit from Operations— Additional Income— Gross In- come — Deductions from Income — Net Income and Surplus at Be- ginning of Period— Profit and Loss Credits— Surplus at End of I*e- riod— Comparative Statements; Statement Statistics— Illustrative Problem and Solution. CHAPTER X.— Statement Analysis: For Credit Purposes .... 340 Introduction — Credit — Personal versus Mercantile Credit— The Credit Department and Credit Information— Borrowers' State- ments—The Audited Balance Sheet— Credit and the Balance Sheet — The Problem of Current Financing — General Principles of Analysis: Further Discussion— Cash— Notes or Bills Receivable— Acceptances— Accounts Receivable— Inventories : Materials, Sui> plies and Merchandise— Consignment Accounti^— Accrued Items as Current Assets— Deferred Charges as Current Assets— Miscellane- ous Items Considered as Current Assets— Capital or Fixed Assets- Liability Analysis: in General— Notes or Bills Payable— Accounte Payable — Capital or Fixed Liabihties— The Comparative Balance Sheet— The Statement of Fund Application— The Income Stat^ ment. CHAPTER XL— Statement Analysis (Continued): For Invest^ ment Purposes 359 Introduction— Large versus Small Scale Enterprises— General Fac- tors of Investment Importance— Publicity Through Pubhshed Statements— Fire Insurance and Corporate Assets— Fixed or Cap^ ital Assets— Land— Buildings —Machinery and Machine Tools- Furniture and Fixtures— Dehvery Equipment— Drawings, Models, Patterns, etc.— Goodwill— Patents, Trademarks, etc.— Treasury Stock and Bonds— Investments— Current Assets— Sinking and other Special Funds— Bonded Indebtedness— Current Liabihties— CONTENTS xm Pacub Capital Stock— Changing the Capitalization Form— Reserves- Surplus— Income Statement: Margin of Safety: Average Profits- Illustrative Problem and Solution— Statement of Resources and Their Apphcation— Illustrative Problem and Solution. CHAPTER XII. — Mergers versus CoNSOLroATioNs 399 Corporate Combinations— Advantages of Corporate Combination —Combination Methods— Merger versus Consolidation: General- New York- Illustrative Merger Problem: General— New York- Basis of Consolidation: Preliminary Investigation— ConsoHdation Capitahzation— CapitaHzation on Basis of Earning Power— Means Used for Paying off Interests— Illustrative Methods of Determin- ing Capitahzation: Goodwill— Illustrative ConsoHdation Problem: General Entries. CHAPTER XIII.— Parent versus Holding Companies; Consoi/- idated Statements 431 Introduction— Mergers and ConsoHdations versus Parent and Holding Companies— Parent Company Accounting— Holding Com- pany Accounting— Consolidation of Balance Sheets versus Con- solidated Balance Sheets— Law and Accounting as Related to Con- solidated Statements— Information Not Disclosed Except by Use of Consohdated Statements— Carrying Investment at Actual Value —Intercompany Accounts— Intercompany Sales— Profits Earned Prior to Date of Purchase— Premium and Discount on Investment —Goodwill on the Consohdated Balance Sheet— Minority Inter- ests in general— Intercompany Sales and Minority Interests- Alternate Form of Consolidated Balance Sheet— Consohdated In- come Statement: Content— Illustrative Problems: Consohdated Balance Sheets. CHAPTER XIV.— Fiduciary Statements 453 Introduction— Further Definitions, Terms, and Distinction^ Courts of Competent Jurisdiction— Duties of an Executor or Administrator— Will Admitted to Record or Probate— Estate As- sets—Collection and Care of Assets— Estate Debts— Estate Book- keeping—Principal (con)us) versus Income— Executor's Account- ing to the Court— Commissions— Final Duties— Illustrative Prob- lem: Apphcation of Double Entry Principles: Charge and Dis- charge Statement with Schedules— Trusts— Duties of Trustees- Relation Between Work of Executor, Administrator, and Trustee —Life Tenant versus Remainderman— Distinctions Relating to In- come—Distinctions Relating to Principal (corpus). CHAPTER XV.— Fiduciary Statements (Continued) 495 Introduction— Insolvency versus Bankruptcy— Equity Receiver^ ships— Procedure in Event of Financial Embarrassment— Assign- lav CONTENTS Page # ments in favor of Creditors— Effect of National Bankruptcy Act Upon Assignments— Bankruptcy. Receiver versus Trustee in Bankruptcy— Trustees in Bankruptcy— Content of Bankruptcy Statements— Illustrative Problem: Receivership— Statement of Affairs with Accompanying Deficiency Account— Illustrative Prob- lem: Statement of Affairs and Deficiency Account. CHAPTER XVI.— Fiduciary Statements (Continued) 518 Introduction— Basic Distinctions Reviewed— Receivership Ac- counting—Realization and Liquidation— Simple Realization and Liquidation — Realization and Liquidation Accompanied by Activ- ities of Trading or Operation— Statement of Realization and Liquidation — Illustrative Problems and Solutions. Questions and Problems 540 Index 651 I ADVANCED ACCOUNTING CHAPTER I SINGLE AND DOUBLE-ENTRY: PRINCIPLES AND TERMS Introduction.— rThe purpose of this chapter is to present a, summary review ^f some of the more important points presuma- bly discussed in the accounting work of the first year. If an elaboration be desired, the student should refer back to his first- year material: Accounta^icy Versus Accounting; Auditing. — Account- ancy is a profession having to do with the recording, verification and presentation of facts, involving the acquisition, production, conservation and transfer of values. It "comprehends the con- duct of audits, examinations, and investigations; devising and installing systems; criticizing organizations and management; an4 in some cases efiiciency work.'' Accounting is the science which treats of the systematic record, compilation and presentation in a comprehensive manner of the financial operations of a business. Auditing is the art of verifying the work done in recording, compiling, and presenting the facts concerned with business transactions, to the end that all possible information concerning the value and potentialities of the reviewed business may be presented correctly in the form of two basic statements, with their accompanying comment: 1. Balance Sheet 2. Profit and Loss Statement. Single-entry Bookkeeping. — Bookkeeping may be consid- ered as the art of keeping a systematic record of business transactions. Practically, there exist only two systems by means of which this systematic record is compiled; these have been named: 1 n 2 ADVANCED ACCOUNTING 1. Single-entry. Practically, the accountant is more likely to consider single-entry bookkeeping as representing a lack of system rather than as a system. If any system exists, it is due to the fact that double-entry has crept in, to some extent. 2. Double-entry. Under single-entry, equal charges and credits are not required for every exchange of values: 1. In its simplest form, a record is kept of transactions with persons (customers, creditors, proprietor!, and perhaps with cash, merchandise, and certain miscellaneous items of in- terest to the proprietorship element. Since few, if any, impersonal accounts are used, provision is not made for securing a Trial Balance, or for obtainmg a check on the accuracy of the work done upon the accounting records. 2. In its more complicated form, it might be any system of record keeping in which there is a lack of balance between the debit and credit entries; therefore, a single-entry sys- tem, if considered as a system, may be more complicated and more highly technical than a double-entry system. Single-entry may be considered as the first step in account- keeping development after the element of credit was introduced into business dealings. When business transactions were entirely upon a cash basis, account books were unnecessary, even a Cash Book. If an occasional credit transaction occurred, the creditor merely made out a memorandum of some sort which he held until the debtor paid, after which it was destroyed. Likewise, when the creditor above mentioned became a debtor on account, a similar memorandum was used to act as a reminder of such fact. An increasing number of credit transactions made it difficult for a record of them to be kept upon a mere memorandum basis. Therefore, the first book record came into use in which these memos were entered. Since the entries therein were made daily, this record became known as the Day Book. Cancellation of the entries therein made was effected by writing *Taid" across them. As long as the merchant "carried on" only in a small way, doing everything himself, the Day Book was all-sufficient. But as soon as he found it necessary to have a clerk who handled any money for him, he found it desirable and even necessary to I SINGLE AND DOUBLE-ENTRY 3 keep some sort of a cash record; hence, the introduction of the Cash Book, in its crudest form. Some would maintain that such a Cash Book was in its simplest form but, in the light of present existing methods of accounting tending toward efficiency and labor reduction, the opinion is ventured that today this crude form of Cash Book, — containing, say, merely the names of per- sons from whom money was received and the amounts of the daily cash sales on one side, offset on the other side by entries covering either the various things paid for in cash or persons to whom cash was paid,— is not to be considered as the simplest form but the most complicated form which it is possible to use. Subsequently, as credit transactions further increased in num- ber, the Day Book became entirely inadequate as a medium from which one could ascertain readily how much each customer owed, when one customer purchased several bills of goods at different times without paying for them. The result was that a new record came to be used, in which each customer was given a page; this was the Ledger. In addition to the customers' ac- counts, the accounts with creditors were contained therein. Like- wise, the proprietor being interested in what he himself had received from his enterprise, either in the way of cash or goods, was likely to keep an account in this Ledger with his drawings. The result was, as indicated already, that these accounts were the only ones essential to single-entry, and were all personal in their nature. Other accounts, kept upon such a Ledger for infor- mational purposes, were only of a memorandum nature, without having any particular connection with the general scheme of accounts. The only possible advantage a single-entry system could have would be simplicity, and simplicity does not exist in such a complicated form of record. Its disadvantages may be sum- marized as imder: 1. Errors that arise in the work are not detected readily, since there exists no positive check on the journalizing. 2. Since nominal accoimts are not kept, profits and losses are not shown. 3. A Trial Balance cannot be secured without rewriting the books, at least upon working papers. 4. A system of internal check is lacking. ^ 4 ADVANCED ACCOUNTING Although a single-entry system in its more simple form often is installed on purpose, as, say, in a small retail or commission business, in a professional man^s office, in a charitable institu- tion, and for a trusteeship, reasonable doubt exists as to whether such simplicity overshadows the marked advantages of even a simple double-entry system for the same case. The usual statements prepared under single-entry are: 1. Statement of Assets and Liabilities. 2. Statement of Profit Determination. The former has the appearance of a Balance Sheet but is not one, since not prepared from double-entry books. The latter is not the double-entry Profit and Loss Statement, since this cannot be prepared, unless the accounts are recast, because singhi-entry does not maintain nominal accounts. The single-entry method of calculating profits revolves around three classes of items: 1. Comparative net worths. 2. Interim drawings. 3. Interim investments. In a later chapter, the Statement of Resources and Their Application, ofttimes used in single-entry, will be considered in connection with another topic. To determine the profit or loss under single-entry for a speci- fied period of time, as a year, it is necessary to ascertain from all sources available all that the proprietor owns and subtract from the total of such ownings the total of all he owes. Since what a person owns is an asset and what he owes a liability, this method of profit determination is known generally as the *^asset and liability" method. The difference between the total assets and total liabilities represents net worth. A comparison of the amount of net worth at the end of the year with its amount at the beginning of the year represents either an increase or decrease in net worth during the elapsed period of time. This increase or decrease in net worth does not, necessarily, represent the net profit or net loss for the year. If there has been an increase, such increase is only one element of the net profit. The total profit of the year consists of two elements: 1. Net worth net increase, — ^the amount of profit left in the business (ending net worth adjusted in the amount of the new capital introduced during the year). SINGLE AND DOUBLE-ENTRY 5 2. Drawings,— the amount of profit taken out of the business. Again, with a net worth net decrease, a profit. may have been made. Because of these possibilities, the asset and liability method of profit determination operates about as follows: 1. Determine net worth at the beginning of the year. 2. Determine net worth at the end of the year. 3. Determine difference between (1) and (2), this being either an increase or decrease in net worth. 4. Add to increase in net worth, or deduct from decrease in net worth, the proprietor's drawings during the year. 5. Deduct from increase in net worth or add to decrease in net worth introductions of capital by proprietor during the year. 6. Resultant amount represents either the total profit or total loss for the year. Since in single-entry it is not possible to set up a Profit and Loss account, and the net worth comparison is the only expedient by means of which the profit or loss may be determined,— no second method existing by means of which evidence may be secured as to the accuracy of the results determined,— as in double-entry (see second section, post) ,— the greatest of care is necessary in preparing single-entry statements. In changing from single-entry to double, the steps in summary form would be about as follows: 1. Adjust the capital accounts to take up the profit or loss for the period. 2. If same books are to be used: a. Prepare Statement of Assets and Liabilities and journal- ize; and post to the Ledger only those accounts not at present thereon (in Ledger). 3. If new books are to be used: a. Prepare Statement of Assets and Liabilities and journal- ize; and post to the Ledger all the accounts appearing in such statement. Internal Check. — It is stated by most accountants that three of the objects of an audit contemplate: 1. Discovering errors of principle. 2. Eliminating mechanical errors. 3. Detecting fraud. Internal check is a method under which one employee checks 6 ADVANCED ACCOUNTING the work of another so that the entire control of a system does not rest upon any one clerk, as to certain elements concerning which the probability of fraud exists. Since under a system of internal check the probability of fraud is reduced, the amount of routine detailed checking that otherwise must be done is lessened. As cash and goods are the two assets most easily appropriated to one's fraudulent use, the system of internal check must cover all angles of each case thoroughly; for example: 1. As to cash: a. Incoming mail opened and the cash therein listed upon a Cash Sheet by some one other than the cashier or })ook- keeper. b. All receipts to be deposited in bank intact. c. Cash payments made by check, each supported by a duly authorized voucher. d. Small payments made from a petty cash fund operated on the imprest basis. e. Cashier should not have access to the customers* I^edgers and to the bills submitted customers. f. Payrolls should be carefully provided for. Changes in pay rates must be only upon written authority; the checking of each step in a payroll preparation should be by one not directly in charge of the work; paymenta should be made in the presence of a witness who, with the paymaster, should sign the payroll. 2. As to goods: a. Safeguard purchases by proper records of receipts and filled orders. b. Proper checking of purchase invoices as to number and quality of items received, extensions, and prevention of duplicate payments. c. Proper checking of sales invoices, plus comparison with customers' orders. d. Prepare correct records of all orders received and ship- ments made. e. Prepare correct records of returned goods, — ^purchases and sales. f. Allowances should be granted only upon authority. g. Proper inventory records should be maintained. SINGLE AND DOUBLE-ENTRY 7 Other points might be mentioned in connection with the above, say, as to expenses, but the illustrations given seem sufficient. Double-entry Bookkeeping.— Under this system a complete record of every business transaction is kept showing its effect upon both real and nominal accounts. It is based upon the principle that for each business transaction there must be an equal debit and credit, by means of which a constant equilibrium is maintained. At the inception of a business enterprise, the initial equation is established that Assets = Liabilities plus Capital. This equation is reflected in the set out of the accounts upon the Ledger. Each subsequent business transaction affects both sides of the equation so that, no matter what transactions occur, the equilibrium originally established will not be destroyed. The advantages of double-entry may be summarized as under: 1. A Trial Balance may be prepared from the Ledger by means of which the accuracy of the postings and the equilibrium of the accounts may be determined. 2. A Profit and Loss Statement may be prepared without re- casting the accounts. 3. Balance Sheet proof exists as to the correctness of the Profit and Loss Statement. 4. Etc., etc. The asset and liability method of profit determination may be used in connection with double-entry books of account, by com- paring one with the other, the Balance Sheets at the beginning of the year and at the end of the year. However, in double- entry, since the Balance Sheet is evidence of the correctness of the Profit and Loss statement, it is unnecessary to resort to the asset and liability method of profit determination thereunder. Double-entry requires more books than does single-entry, at least to the extent of the Journal, this being the only additional book absolutely essential. Classification of Accounts. — ^An account records under a specific heading either similar or dissimilar items relating to the same person or thing. Each account, for convenience, is divided into two portions imder each of which similar items are grouped, and each such portion is opposed to the other. Because of this and grounded upon the basic equation, the rules for I 8 ADVANCED ACCOUNTING journalizing or entering transactions into accounts, may be stated as: Debit: 1. Increase in assets 2. Decrease in liabilities 3. Decrease in proprietorship Credit: 1. Decrease in assets 2. Increase in liabilities 3. Increase in proprietorship Basically, accounts are divided into two general classes: 1. Real — Balance Sheet accounts — assets, liabilities, and vested proprietorship; accounts that represent things which have actual, tangible existence. 2. Nominal — Profit and Loss accounts — income and expenses. These accounts represent increase or decrease of net worth ; they are closed into the Revenue account, — Profit and Loss account, — ^the final result of which sets out in one account either net profit or net loss. Other classes of accounts often referred to may be sot out about as follows: 1. Personal — accounts with persons, as the various people or corporations with whom business dealings are made. 2. Impersonal — accounts other than personal, as those rec^ord- ing profits, losses, receipts, disbursements, and non-personal assets and liabilities. 3. Mixed — accounts containing elements both real and nomi- nal, as Merchandise. 4. Primary (or major) — accounts in which are recorded all transactions of a particular class; the General Ledger, more and more, is becoming a Ledger of primary ac- counts. 6. Subsidiary — accounts auxiliary to, even though not neces- sarily dependent upon, a primary account. 6. Summary — accounts in which are simimed up the data con- tained in a number of other accounts of different classes. 7. Controlling — accounts containing the totals of the debits and credits of a munber of so-called detail accounts so that the balance of the aggregate of these accounts may be dis- played at any time. Controlling accounts are not summary accounts, as the latter collect dissimilar accounts, whereas controlling accounts collect amounts of similar accounts. 8. Collective— See (7). SINGLE AND DOUBLE-ENTRY 9 Suspense Accounts. — ^Usually, such accounts record items temporarily pending the determination of their final disposition, as: 1. Unlocated Trial Balance errors. 2. Cash received with name of sender not available. 3. Differences existing between a Cash Book and the bank's records. 4. Items, the proper treatment of which is at present question- able. One such account should be used for each suspense item. Sub- sequently, if such account cannot be cleared into its proper place, its ultimate destination should be into the Profit and Loss ac- count. However, in the interim, its amount should be carried upon the Balance Sheet; this would be especially true where a C. P. A. problem is encountered that is out of balance. The suspense item should be carried as a deferred charge. Doubtful accounts and notes receivable may be carried in a Suspense Ledger, so-called. This is perfectly proper, but care should be observed to make certain that the Reserve for Bad Debts account covers this amount. Ledger Arrangement of Accounts. — ^Accounts should be arranged upon the Ledger so that the preparation of the financial statements will be facilitated. Ordinarily, such an arrangement might be about as follows: First arrangement: 1. Current assets 2. Capital assets 3. Current liabilities 4. Capital liabilities 5. Proprietorship 6. Income 7. Expenses Second arrangement: 1. Capital assets 2. Current assets 3. Capital liabilities 4. Current liabilities 5. Proprietorship 6. Income 7. Exp>enses If controlling accounts are not made use of, the customers' and creditors' accounts would be carried at the back of the Ledger. Against, or contrary to either of the above arrangements, the accounts may be grouped alphabetically upon the Ledger. Again, instead of merely carrying accounts upon a Ledger by name, a large concern, or even a small one, is apt to designate its accounts by numbers as well as by names. In such event, any one of many systems of numbering may be used. However, i 10 ADVANCED ACCOUNTING it would seem advisable hereunder, although not ordinarily done, to make sure the smaller numbers of a series are used for the accounts to which reference is most made. For example, compare the two arrangements submitted below, each of which follows a simple numbering scheme. The two arrangements cover merely the summary groupings: First arrangement: 1. Assets 2. Liabilities 3. Proprietorship 4. Income Second arrangement: 1. Expenses 2. Income 3. Proprietorship 4. Assets 5. Liabilities 5. Expenses If the advantage of the second arrangement over the first one is not entirely apparent from the above, consider the following numbering scheme in connection with the second grouping: Nos. 1-199 Expenses 200-299 Income 300-399 Proprietorship 400-499 Assets 500-599 Liabilities From the above, it is evident that the expense accounts, used the most frequently, will carry the smaller numbers. Before passing to a consideration of a subdivision of any gen- eral grouping into the more special groupings, the following basic arrangement is presented, this being in accord with the summary form of Balance Sheet arrangement shown in Chap. 9, post: 1. Expenses 2. Income 3. Assets 4. Investments 6. Liabilities 7. Reserves 8. Capital 9. Surplus 5. Deferred charges and credits The general account groupings, however made, may be subdi- vided as desired into a number of special groupings. First example: 1 Expenses 11 Operation 111 Manufacturing 112 Selling 113 Administrative 12 Non-operation Second example: 1-199 Expenses 1- 99 100-149 150-174 175-199 Manufacturing Selling Administrative Non-operation In connection with any system of numbering, it seems usual to SINGLE AND DOUBLE-ENTRY 11 indicate, at times, a departmental differentiation by means of prefixing a letter to a number to specify to what department an income or expense item belongs. Status of Journalization—Journals.— To journalize, is to classify systematically the debits and credits arising out of a business transaction. In connection with this topic, the follow- ing seem axiomatic: 1. Since all records of original entry are Journals, all entries are journal entries. 2. Since it is necessary to keep the basic accounting equation always in balance, the sum of the debits must equal the sum of the credits. Because of (1) above, the direct Ledger closing at the end of a period would seem to be absolutely in error; all closing entries should be entered, preferably, upon the Journal and be posted therefrom to the Ledger. Basically, original entries are made upon Journals, regardless of what names may be used therefor, and postings of these entries are made to Ledgers. Therefore, the basic books of account would be: 1. Journals 2. Ledgers Some bookkeepers have a habit of making monthly summary entries of each record of original entry upon the General Journal and of posting therefrom to the General Ledger. This practice seems unnecessary and a duplication of effort in that since all records of original entry in which entries are made with debit and credit distinctions are Journals, the monthly postings there- from to the General Ledger may be made direct, provided, natu- rally, that these records have been kept properly. Ledgers.— Books of original entry contain the first entry of a transaction, the record being written up in the order in which the transactions took place,— in the order of the dates upon which the transactions occurred. On the other hand. Ledgers are books containing the accounts to which these Journal entries are transferred (posted). For present purposes, all Ledgers may be grouped under three headings: 1. General Ledger 3. Private Ledger 2. Subsidiary Ledgers It seems unnecessary to discuss any of these. I 12 ADVANCED ACCOUNTING I Forms of Ledger rulings are many, their use being dependent primarily upon desirability and utility. However, it would seem that, unless an excellent reason exists to the contrary, the Ledger ruling should follow the standard form which, basically, is called the T form. And where a change from the standard ruling ap- pears in order, it would seem that the usual differentiation would consist in the addition of one or more ''balance" columns to the standard ruling. Because of the fact that a Ledger is not a book of original entry, a court will not accept it as evidence unless testimony is offered that its contents have been verified by an examination of the records of original entry; in such event, it will be con- sidered as a summary or abstract of the books of original entry. Adjustment Account. — In order to prove the accuracy of a subsidiary Ledger Trial Balance, ordinarily, one must refer to the controlling account thereover carried upon the General Ledger. Where a separate bookkeeper runs a subsidiary Ledger, having no duties in connection with the General Ledger, an expedient is resorted to by means of which this bookkeeper is not required to consult the General Ledger to prove the accuracy of his Trial Balance. The subsidiary Ledger is made self- balancing by the introduction thereon of an Adjustment account. Such account is an exact duplicate of the controlling account, but set up in reverse order. Items posted in detail to the debit of the separate accounts carried on the subsidiary Ledger are posted in total as a credit to this Adjustment account, wliereas items posted in detail to the credit of the separate accounts carried on the subsidiary Ledger are posted in total as a debit to this Adjustment account. The Ledger, therefore, is in balance by itself, — in other words, it is a self-balancing Ledger. Vouchers. — Any document may be considered as a voucher which sufficiently identifies or verifies: 1. The correctness of charges for cash paid or to be paid. 2. The correctness of credits for cash received or to be received. In any business house which boasts of a system of accounts, entries may be vouched or verified even though specific vouchers, so called, are not available. SINGLE AND DOUBLE-ENTRY For example, the following is illustrative: 13 d. Minute book e. See cash payments below e. Cash receipts f. Bills of lading g. Etc. c. Credit memos d. Etc. 1. Purchases a. Copies of orders b. Receiving clerk's records c. Checked invoices 2. Sales a. Customers' orders b. Shipping clerk's records c. Copies of invoices d. Customers' accounts 3. Returned Purchases a. Stock records b. Shipment records 4. Returned Sales a. Copies of memos and invoices covering original charge b. Vouchers covering cash refunds c. Customers' statements of settlement d. Etc. 5. Cash Receipts a. Bank pass book b. Copies of deposit slips properly bank stamped c. Receipt book stubs d. Etc. 6. Cash Payments a. Receipts b. Cancelled checks c. Pay rolls 7. Journal Entries a. Journal vouchers, properly approved b. Correspondence c. Minute book d. Approval signature of proper official against entry e. Etc. Voucher System. — The apparent predominant use of the Voucher System seems sufficient reason for a summary discussion thereof at this point. This system purports to treat creditors' accounts so that the necessity for keeping the individual accounts in a Ledger is eliminated. All invoices and expense bills are attached to what are designated as "Voucher Jackets" after the items thereon described have been checked out properly as being in order. These voucher jackets are numbered consecutively and set out the following specific information: d. Petty cash vouchers e. See Purchases above f. Etc. 14 ADVANCED ACCOUNTING 1. Name and address of creditor. 2. Items received. 3. Account or accounts to be charged either by name or by number. This seems unnecessary in a small concern where one person either makes or superintends the making and entering of vouchers. The distribution well may be made only upon the Voucher Record. As soon as a voucher has been prepared, and the miscellancious papers relative thereto attached, it is entered upon a Vouc^her Record or Register and at least the following information set down : 1. Voucher number. Vouchers are numbered consecutively as entered. 2. Date. 3. Creditor's name and address. 4. Total amount credited to either Vouchers Payable or Ac- counts Payable. 5. Distribution of the charges (debits) to the usual accounts for which separate columns have been provided, and to a Sundry column for unusual items which is divided to show both the name or number of the unusual account and the amount. When a voucher is paid, the payment thereof is made through the Cash Book in the usual way except that the charges is against the Vouchers or Accounts Payable account rather than to separate creditors' accounts. Next, such payment is indi- cated upon the Voucher Register so that one may ascertain therefrom what vouchers are still outstanding unpaid, the total of the unpaid vouchers thereon agreeing with the balance of the Vouchers Payable account upon the General Ledger after the latter has been posted completely. Formerly, when a voucher was paid, it was current practice to send out the voucher with the check, so that the former would be signed, after which it was to be returned. However, creditors were not usually sufficiently efficient or courteous in the matter of returning a voucher, so that this system proved to be de- cidedly at fault; it was necessary to rely to a considerable ex- tent upon duplicate copies of these vouchers to operate the sys- SINGLE AND DOUBLE-ENTRY 15 tem. Because of this, the use of the voucher check has proved of great value. However, one would be in error to assume that the voucher check necessarily is an outgrowth of the voucher system; the voucher check is of great value in connection there- with but may be used to advantage even where no voucher sys- tem is in operation. A voucher check may be no different from an ordinary check beyond the fact that provision is made thereon for indicating for what it has been issued in payment. Its use combines two advantages: 1. That of having evidence a certain creditor was paid. 2. That of having a creditor's signature (the indorsement) as evidence that the payment covered certain specific in- voices or bills. Voucher checks may carry either one or two numbers: 1. One number. In this case, the number thereon would agree with the voucher. But since vouchers, usually, never are paid in the order of their entry upon the Voucher Register, the voucher checks cannot be entered upon the Cash Book in consecutive order; this is a disadvantage. 2. Two numbers. When a voucher check carries two numbers, the first one would be the voucher number and the second the check or treasurer's number. Consecutive entry upon the Cash Book is possible by this means and the entry upon the Voucher Register relating thereto easily is traceable; in fact, this double numbering permits of a ready cross-index between the Voucher Register and the Cash Book. The advantages and disadvantages of the voucher system may be summarized as under: 1. Advantages: a. Labor is saved by elimination of the Creditors' Ledger. b. All purchases are analyzed in detail. c. All liabilities are booked immediately. d. Responsibility is localized because the authority for auditing, entry, and payment of items is set out. e. All payments of cash are evidenced by a receipted bill. f. An audit is expedited. 2. Disadvantages: a. The partial payment of bills and notes payable tends to break down the system. 16 ADVANCED ACCOUNTING b. Returns and allowances require more than usual hand- ling to take up properly. c. The volume of business with important creditors ib not summarized for reference purposes. d. In a business of any size, the added activities necessary relative to filing, recording, and O. K.'ing vouchers is decidedly expensive. e. Certain information of a private nature may come into unscrupulous hands because of the availability of the documents that are attached to the voucher jackets. No comment upon these advantages and disadvantages will be made herein. Confusion sometimes results on the part of the student in at- tempting to comprehend the difference between certain terms used to designate the various stages relative to a creditor's ac- count. In an attempt to clear up this matter, the followmg is offered for illustration: 1. Usually there is no difference between the terms Accounts Payable and Vouchers Payable; as between the two, the latter is preferable in connection with the voucher system. 2. At times one encounters the terms Unaudited Vouchers and Audited Vouchers upon the same set of records. The first represents creditors' claims for payment that have not passed through the routine of the internal audit procedure ; the latter represent such claims that have passed through and await payment. The accounts will be arranged to permit of proper transfer, as: A — Dr. Goods Cr. Unaudited Vouchers B — Dr. Unaudited Vouchers Cr. Audited Vouchers 3. Another possibility sometimes encountered is as per (2) above, plus the use of the term, say, Items in Transit. The reason therefor, is merely to have the books of ac(!ount reflect all liabilities as soon as incurred, as: a. Dr. Goods in Transit Cr. Items in Transit To record the liability when an order has been placed and accepted. SINGLE AND DOUBLE-ENTRY 17 b. Dr. Goods Cr. Goods in Transit To record receipt of all or part of above order. b. 1. Dr. Items in Transit. Cr. Unaudited Vouchers To book invoices received. c. Dr. Unaudited Vouchers Cr. Audited Vouchers To record vouchers audited and ready for pay- ment. Trial Balance.— Briefly, a Trial Balance is a list or table of Ledger balances, showing either debit and credit totals of each account or the debit or credit balance of each account drawn as at the end of a business day to prove the mathematical accuracy or equilibrium of the Ledger. By itself, a Trial Balance should not be taken as proof of the correctness of the Ledger since it is possible, where errors offset each other, to secure a Trial Bal- ance from a Ledger in which every entry is in error. How- ever, if a Trial Balance does not prove, it is proof positive that the Ledger is incorrect, but when it does prove, the cor- rectness of Ledger postings is inferred. The usual Trial Balance is drawn prior to commencing the process of closing; such a one contains both real and nominal accounts. Again, a Trial Balance is often prepared after the closing process is completed to make certain the Ledger is in balance prior to entering therein the transactions of the subse- quent period. Such a Trial Balance contains only real accounts and may be considered as an unclassified Balance Sheet. After a Trial Balance is found to be in balance, it properly may be called Schedule of Ledger Balances. Blocking the Ledger.— It does not seem advisable to use the ordinary methods advocated for locating an error in a Trial Balance since most of them (being more or less a matter of guess work), result in a waste of time. The analytical method of making an independent posting seems to be the only satis- factory method of locating an error after a detailed reversed checking has failed in finding the amount ; this method is used by many auditors when making an ordinary audit, and is known as ''blocking the ledger." 18 ADVANCED ACCOUNTING Assuming the bookkeeper has been accurate in entering his foho numbers, one of these methods proceeds about as foHows- The Ledger is divided into blocks of fifty or a hundred pages each, as desired. Upon a sheet of analysis paper, postings are made from the records of original entry to the columns of the analysis sheet by blocks, the postings from each book of original entry being kept separate from the others. For example, the Cash Book, would be posted, by debits and credits, to the block columns, the latter then added up, and the totals compared with the Cash Book totals corresponding thereto. By this process, the footings on the records of original entry are proved out; and the balances of each block are found as follows: 1. Secure original net balance of a block. 2. Add or deduct therefrom the debits and credits of such block and compare with the net total of the balances at the end of the reviewed period. 3. Eliminate each block that proves out. Then recheck in detail the work relating to each block that does not prove out. Even though the above method is a great consumer of time, the error eventually will be located ; therefore it is worth while. ' Articulation Statement : Abstracting AccountB.— An artic- culation statement, as to meaning, may convey more than one idea to a person's mind; but it would seem that the only meaning of practical worth such a statement should have, would be to consider it as providing a convenient means for classifying the entries for an elapsed fiscal period according to the books of original entry. Auditors often use such a statement without recognizing it by the title herein suggested, its use arising in connection with the process known as ''abstracting accounts." An auditor often will abstract a set of accounts upon working sheets rather than check out a General Ledger against a Trial Balance either prepared by the bookkeeper or by himself. Again, the method is useful to locate the error when a (Jeneral Ledger is out of balance since, as the it^ms are posted to the sheets according to account names, posting errors will be detected. Under this abstracting process, analysis paper is used that has SINGLE AND DOUBLE-ENTRY 19 plenty of columnar subdivisions. The General Ledger accounts are entered by name at the left of these sheets one under the other, at intervals sufficiently separated one from the other to permit of the inclusion of all items thereunder by postings. Next, to the right, the columns are laid out in pairs, debit and credit, one pair for each record of original entry. From the books of original entry, all items will be posted to these sheet accounts, only the totals of special columns and books being used The result secured by this process, is a skeleton General Ledger, with Accounts Receivable and Accounts Payable controlling accounts. On a second sheet of analysis paper, a working Trial Balance would be prepared. The General Ledger balances as of the beginning of the period would be entered in the first two debit and credit columns at the left; then in the next pair of columns the totals of the debits and credits of each account from the first sheet are entered on the respective lines and, finally, in the third or last pair of columns the resultant balance of each account would be entered. These final figures represent the General Ledger Trial Balance at the end of the period, which is to be checked out against the actual Ledger balances. The abstracting process commences with the Cash Book, all items being posted therefrom to the sheets, including the total receipts and disbursements. The total debits and credits then are summarized; if the summary balances, the Cash Book re- quires no footing except as to the columns from which only totals have been taken. After the work in connection with the Cash Book has been completed, the other Journals are taken up, one after the other. And after the ending Trial Balance has been proved, as found in the third pair of columns upon the second set of sheets, the remaining columns may be used for the usual working sheet closing the set of books. Financial Statements.— Nothing will be said at the present time, beyond the second paragraph below, concerning either: 1. The Balance Sheet, or 2. The Profit and Loss Statement since a considerable portion of the later work revolves around a discussion of each. The accounts shown in a Balance Sheet are valued as follows: 1. Capital assets— at cost less depreciation. .^ I I: It 20 ADVANCED ACCOUNTING 2. Current assets. a. Working assets— at cost or market whichever is lower. b. Other current assets — at estimated cash value. Each of the above statements is a statement of opinion, not one of fact: 1. Balance Sheet. The value of no asset, other than Cash, can be ascertained to a certainty. Each other asset is subject to contingencies which may change the valuation given. 2. Statement of Profit and Loss. Inventory valuations, the reserves for depreciation, and the doubtful accounts receiv- able, as to amounts, are all matters of opinion. Therefore, the net profit is a matter of opinion, tempered by the experience of the accountant. However, the opinion of a qualified accountant, as to these statements, will be sufficiently accurate to the end that, there- from, one may secure a reasonably correct idea of the condition of the business concerned. Types of Assets. — ^Assets may be divided into a number of classes, about as follows: 1. Current. These are assets which are presumed to be readily convertible into cash under the usual routine of business. They are not permanent investments but are intended for sale, — in their present condition as manufactured product or as the elements from which manufac^tured product will be made. At times, these assets are spoken of as floating, active, or circulating. 2. Quick. These are assets of the current group exclusive of securities, — ^those readily marketable and saleable, and notes and accounts given by or due from officers, stockholders, and employees; also, exclusive of deferred charges. At times, these assets are spoken of as liquid. 3. Working or trading. These are the current assets of inven- tories, — raw material, goods in process, and manufactured product; and, sometimes, supplies. 4. Capital. These are the assets of a business that are not held for sale purposes, since held as permanent invest- ments to enable the business to function for the purposes for which organized. They may be spoken of as fixed, perma- nent, or passive. SINGLE AND DOUBLE-ENTRY 21 5. Deferred charges to operation. These assets represent por- tions of expense items paid in the current period but ap- plicable to a subsequent period. 6. Accrued. These are current assets which accimiulate grad- ually with the passage of time. 7. Contingent. These are assets in what might be called an embryonic stage, becoming full-fledged assets only upon the happening of some event which at present is more or less uncertain. 8. Wasting. This type of asset loses value because the asset itself is used up; it diminishes or shrinks in direct propor- tion to: a. Operations— Natural resources such as stumpage, etc. b. Lapse of time — Patent or leasehold. A depreciating asset should not be confused with a wasting asset. Of course, both lose value, and such loss, in gen- eral, may be designated as depreciation, but the former type is not consumed, or does not shrink in size, as does the latter. 9. Secret. These represent asset values in excess of the book values thereof. Types of Liabilities.— Liabilities may be divided into a number of classes, about as follows: 1. Current. These are liabilities which must be paid at once or which will mature within a short period of time and which, presumably, are to be paid in the normal course of events. 2. Capital. These liabilities need not be paid at once since they will not mature except after the passage of a long period of time. They are of a permanent character and do not change frequently since they are intended to furnish the funds for investment in the business. They may be spoken of as fixed. 3. Deferred credits to income. These liabilities represent por- tions of income received in a current period but applicable to a subsequent period. 4. Accrued. These are current liabilities which accumulate gradually with the passage of time. 5. Contingent. These are liabilities in what might be called 22 ADVANCED ACCOUNTINO an embryonic stage, becoming full-fledged liabilities only upon the happening of some event which at present is more or less uncertain. 6. Funded. These are liabilities the payment of which has been provided for definitely; usually, they are secured by a mortgage. 7. Bonded. These are liabilities which are evidenced by a bond issue. Such liabilities may be funded or not funded, secured or not secured. Two Bases of Accounting.— There are two bases of account- ing, each of which is described briefly below: 1. Cash basis. Hereunder, income and expenses are recorded only when they affect either a. Cash or b. Personal accounts. 2. Accrual basis. Hereunder, all income and expenses are booked as incurred, rather than when received or paid in cash. Particularly, at the end of each fiscal period, care must be observed to make certain that all accruals have been placed upon the books. In adjusting the accruals at the end of the year, the procedure resolves itself into two steps : a. Reverse or write back the accrual as of the preceding January 1. b. Record the accrual as of December 31. Deferred and Contingent Items.— It usually is worth while to distinguish between accrued and deferred items. Deferred items are of two classes: 1. Deferred charges. In turn, deferred charges are of two kinds: a. Expense items which, in part, benefit future periods. The portion benefiting a subsequent period is a deferred charge. b. Expense items which, although they do not benefit future periods are deferred to be written off gradually thereover. Again, deferred charges may be separated into a further two- way division: a. Those which have a realizable value, as prepaid insurance. SINGLE AND DOUBLE-ENTRY 23 b. Those which have no realizable value, as organization expense. This distinction may be important in setting up what is known as a Statement of Fund Application, which will be discussed in a later chapter. 2. Deferred credits. These represent income items received in a current period which are applicable to subsequent periods. Therefore, the amount so applicable to future periods must be considered, as of the present moment, as a liability. Contingent items are of two classes: 1. Contingent assets. Ordinarily, these are not shown upon the books. a. Not shown upon the books. i. Pending damage suit against another, ii. Conditional bequest in a will. b. Shown upon the books. i. A note receivable which has been endorsed and discounted. This, also, is a contingent liability. 2. Contingent liabilities. Ordinarily, these are not shown upon the books. a. Not shown upon the books. i. Pending damage suit against our firm or company, ii. Surety bonds, iii. Guarantees. b. Shown upon the books. i. Notes receivable discounted. Capital Versus Deficit— Capital has two meanings dependent upon the viewpoint: 1. Economic. The total amount of wealth invested in a busi- ness, — all assets of a business. 2. Accounting. The excess of the assets of a business over its liabilities, — the proprietor's net equity. Working capital is the excess of net current assets over current liabilities. Deficit may be considered the exact opposite of accounting capital,— the excess of liabilities over assets. Income— Revenue— Earnings.— Income may be defined as the remuneration or gain which results from the use of property 24 ADVANCED ACCOUNTING and labor, and the results of business. Income may be doubly classified: 1. First classification: a.' Rent. b. Wages. c. Interest. d. Profits. 2. Second classification: a. Operating. b. Non-operating. Revenue, as a term, has a slightly different meaning from income, even though, at times, the two terms are used inter- changeably. Non-trading concerns are apt to use the term rev- enue in preference to that of income. Earnings represent income that has been secured from the sale of personal services. A public service corporation and a professional man would use this term in preference to that of revenue or income. Profit: Gross— Net— Operation— Capital.— Profit may be defined, from the accounting viewpoint, as the surplus of in- come remaining at the end of a period after all costs and ex- penses have been taken into consideration. From this view- point, accounting profit and economic profit are dissimilar: 1. Accounting viewpoint: a. Net income and net profit are assumed to be the same. 2. Economic viewpoint: a. Net income would be classified as: i. Rent, ii. Wages, iii. Interest, iv. Profit. Gross profit represents the excess of net sales price over the cost of goods sold. Net profit from operation represents the excess of gross profit over the total of the selling and administra- tive expenses. Net profit for an elapsed period represents the excess of the net profit from operation over the net deductions from income (financial expenses less financial income). A capital profit results from a change in the value of certain SINGLE AND DOUBLE-ENTRY 25 of the capital assets. It should not be shown upon the books unless the assets concerned have been disposed of in some way. Losses, qualified by prefixes as above set out, may be consid- ered the opposite of profits thus qualified. Basically, no profit should be taken unless a just cause for legal action has arisen. Receipts— Disbursements— Expenses— Expenditures.— Re- ceipts, as a term, refers to cash or other assets received during the course of business, regardless of whether they are concerned with capital or revenue. Ordinarily, however, when one speaks of ^'receipts," he refers entirely to cash. Receipts may be divided into two classes: 1. Revenue receipts. Cash or other assets received on account of the regular operation of a business. 2. Capital receipts. Cash or other assets received on account of the sale of a fixed asset, of capital stock, or of a bond issue. Where receipts is used in connection with disbursements, the two refer to cash receipts and cash disbursements, regardless of purpose. A revenue expense is an operation expense, one the result of an attempt to make a profit from business operation. A capital expense is a non-operation expense, a financial expense made necessary in providing the capital needs of a concern. A rev- enue expenditure may be considered as a revenue expense except as concerns the deferred portion thereof which will be shown upon a Balance Sheet as a deferred charge to operation. A capital expenditure is one made on account of an improve- ment, or of an addition, to the more or less permanent plant of an enterprise. A fixed charge is an expense to be met periodically without regard to the amount of business done, as bond interest. It is more or less fixed in its recurring amount. CHAPTER II SPECIFIC REAL AND NOMINAL ACCOUNTS Introduction. — It is the purpose of this chapter to review, in more or less summary form, many of the points usually dis- cussed in first-year accounting as indicated by the present chapter title. The background afforded by the review of Chap«. I, II, and III should prove of exceptional worth in bridging the gap so apt to exist between the work of the first and second years in a course in accounting. Cash and Cash Records. — If Cash be treated properly, all moneys received should be deposited in bank; and all moneys paid out should be by check, except small payments which are handled through the Petty Cash fund operated, preferably, upon the imprest basis. As concerns Cash receipts, the following points appear to be of considerable importance: 1. All incoming remittances should be listed upon a Daily Blotter by some person other than the cashier or book- keeper, and prior to turning these remittances over to the cashier for entry. 2. The bank deposit should be prepared, say, daily, beginning at a specified moment of time which will allow sufficiently for the deposit to be made before the depositary closes for the day. When the deposit is in order, the person men- tioned in (1) above should be on hand, enter upon his daily blotter the cash receipts for the day taken in over the counter, or shown on the cash register, secure a total of the two amounts and compare such total with the deposit slip. Again, upon the return of the Pass Book, this individual should scrutinize the entry therein, comparing its amount with the total referred to above. 3. All checks making up part of the cash balance on hand 26 SPECIFIC REAL AND NOMINAL ACCOUNTS 2fl should be deposited even though some have been signed by the concern. Sight drafts are considered as checks. 4. If the cashier and the bookkeeper are one and the same person, which ought not to be the case where possible to separate the two functions, the proprietor must exercise the greatest of care for his protection; the greatest of care will be defective in certain respects. At least, he can require to have turned over to himself duplicate copies of all detailed cash records; these he should keep under lock and key until audited. As concerns cash payments, the lollowing points seem im- portant : 1. Since cancelled checks, by themselves, are not sufficient vouchers covering cash disbursements, all cash payments should be supported by vouchers other than cancelled checks. 2. Missing checks always must be accounted for, after either the Pass Book has been balanced or the Bank Statement received. 3. If more than one bank account is necessary, it may be advisable to carry each with a separate depositary, rather than have them all with one bank. Likewise, if funds are carried in more than one bank, a separate Check Register for each such bank may be desirable. 4. Checks should not be drawn until they are to be delivered. The habit of drawing checks and holding them seems to be bad practice. Such checks, naturally, do not affect the accounts. In reconciling the Cash balance on hand, per Cash Book, with the balance reported by the bank, one should work from the reported bank balance, after this .has been checked up and appears in order, backward to the Cash Book balance since the latter, if correct, must appear upon the Balance Sheet when the latter is prepared. If the bank balance as at a particular moment of time should be different from the Cash Book balance, the reconciliation may assume the following form frequently used in auditing: 1. We debit, bank does not credit. 2. We credit, bank does not debit. 28 ADVANCED ACCOUNTING 3. Bank debits, we do not credit. 4. Bank credits, we do not debit. 5. Bank balance plus (1) and (3) should be equal to Cash Book balance plus (2) and (4). A cash account should be carried upon the General Ledger; in fact, all accounts necessary to the securement of a Trial Balance of the General Ledger should be found thereon. A Cash Short and Over account should hold the daily overage or short- age ascertained when the daily balance is checked against the Cash Book. The net balance thereof may be handled in one of two ways: L If the cashier is held accountable for any shortage to the end that he must make it good, the balance represents a claim against him. If an overage, he has that much on hand to apply against a future shortage. 2. If the cashier is not required to make good a small short- age, the Cash Over and Short account, ultimately, will be closed out into Profit and Loss. Payments of actual cash should be kept as few in number, and as small in amount, as possible. In this connection, the Petty Cash fund is used. This fund may be one of two types: 1. Constant balance. This is said to be operated on the imprest basis. 2. Fluctuating balance. This type of fund is not to be pre- ferred to (1) above. Cash Books may be divided into four types; 1. General Cash Records. In these, all cash transactions are booked, except those pertaining to the Petty Cash funds. There may be one record in which both receipts and dis- bursements are carried, or a number of such records. Again, the receipts may be recorded in one or more Receipt Registers which are bound separately from the record or records holding Cash disbursements,— the Check Register or Registers. 2. Petty Cash Records. Herein are recorded the expenditure of the various Petty Cash funds, one book for each fund. 3. Private Cash Book. This record is used in connection with the Private Ledger and Private Journal. SPECIFIC REAL AND NOMINAL ACCOUNTS 29 4. Casn Journal. Herein are recorded both Cash and non- Cash items. It is a columnar record which is supposed to replace all the usual records of original entry. It even may be used so as to replace the use of a General Ledger; in this case, it might be titled Cash Book — Journal — Ledger. Statement of Cash Receipts and Disbursements.— This statement may be considered as a transcript of the Cash Book for a specified period of time. It should be constructed along the following lines: 1. Balance — Beginning of period. 2. Receipts — ^properly classified. 3. Total cash available, — sum of (1) and (2). 4. Disbursements — ^properly classified. 5. Balance — end of period, — (3) less (4). This statement is not, generally, the same as a Statement of Income and Expenses: 1. The former statement represents merely a rearrangement of the information shown in the Cash Book. 2. The latter statement includes all income and expense items, whether received or paid in cash or not. Only in an activ- ity similar, say to that of a club would it be possible to have both statements include the same items, and thus they would both hold the information for a Statement of Receipts and Disbursements: a. No cash balance on hand at the beginning of the period as where, perhaps, it is the first year of existence. b. No accruals of any kind. Notes Versus Bills. — These two terms, oft^n used inter- changeably, really do not represent the same thing: 1. Note. A promissory note, — unconditional promise to pay a specified siun of money upon a fixed or determinable future date. 2. Bill: a. A draft or bill of exchange, — a written order by one person upon a second person to pay a third person the amount of money therein set out. Example: Trade ac- ceptances. b. Invoice. An invoice often is referred to as a "bill." In general, however, it seems correct to use one title as covering both,— Notes Receivable, or Notes Payable. 30 ADVANCED ACCOUNTING Notes Receivable. — A note receivable is assumed to be preferable to an open account with a debtor for three reasons: 1. It acknowledges that the amount of the debt is correct. 2. A dishonored note may wreck one's credit rating, whereas an overdue open account may not be considered of much discredit to the payer. 3. The date upon which the debt is payable is specified, whereas the due date of an open account may not be fixed except by custom. In this case, it is usual to have the collateral in an amount equal to from 25 per cent to 50 per cent of the face value of tlie note secured thereunder. Dishonored Notes Receivable. — ^When a note has been dis*- honored, practice dictates that the note should be written back into the account receivable that was credited originally when the note was received. By so doing, the account with the debtor will contain a record of the dishonor which will be of great use in granting such debtor future credit. This writing back, how- ever, does not change the status of the note claim back again to that of an account claim; the holder may sue either upon the note or upon the account. When a number of notes are taken, it becomes important not to lose sight of the fact that the credit made to a customer's account does not necessarily represent a complete settlement to that extent. In such event, the practice is followed more or less of having the Customer's Ledger ruled with two debit and two credit columns. The inside columns would be used for the note transactions and the outside columns for the regular open account transactions; only the latter would hold amounts affect- ing the Trial Balance. Notes Receivable Discounted. — Since a discounted note receivable is a contingent liability, it is in error to credit the Notes Receivable account when a note is discounted; the credit should be made to the account of Notes Receivable Discounted, this latter account being proportionately cancelled against the Notes Receivable account when notice has been received that payment of a note has been honored. The same procedure i« possible when a note receivable has been given to a creditor, since no essential difference exists between giving a note receiv- able to a creditor and discoimting it at the bank. I SPECIFIC REAL AND NOMINAL ACCOUNTS 31 On the Balance Sheet, the Notes Receivable Discounted ac- count may be handled in either of the following ways as under: 1. Deduct the balance therein from the balance of the Notes Receivable account. 2. Show on the asset side of the statement the notes in two amounts, — ^those on hand and those discounted, — and set out the discounted amount on the liability side. Loss on Notes Receivable. — Provision should be made periodically for possible loss on uncollectible notes receivable. Such provision may be computed in either one of the two fol- lowing ways: 1. Calculate the amount to be provided separately upon the note item alone. This seems preferable to the second one below. 2. Total the notes and accounts receivable, and compute the estimated provision for uncollectible items on the basis of such total. This means that the Reserve for Uncollectible Accounts covers both notes and accounts receivable. This second possibility does not appear to represent good ac- counting practice. Notes Receivable Register. — This record may or may not be considered as a Journal, -^as a record of original entry from which postings are made to the Ledger or Ledgers. 1. When not considered as a Journal. Such a record is a mere memorandum book, the note entries being made upon the General Journal and being posted therefrom. Naturally, where a large number of notes are taken, it would seem that this method of booking is not conducive to time-saving in that two operations are necessary, whereas one would suf- fice: a. The notes must each be recorded in the memo record. b. The notes must each be journalized on the General Jour- nal. 2. When considered as a Journal. One operation is sufficient hereimder. Each note is entered upon the Register and the posting, both to the detail and control accounts, may be made immediately. The same idea of recording would be followed in the case of notes payable. 'I ft' \ \ 32 ADVANCED ACCOUNTING Interest and Discount on Notes Receivable. — Before con- cluding the present discussion of notes receivable, a few remarks concerning interest and discount on notes receivable seem in order. Ordinarily, a note receivable should be booked at its face value, i. e., without considering interest from the day it is dated to the date of maturity. An exception to this treatment is found where a bank adds interest to the basic amount of the note so that its face value will be equal to the total amount due upon date of maturity ; naturally, when the bank discounts such a note it will calculate interest upon the whole amount, which means that, thereunder, interest is calculated upon interest. Bank discount is interest deducted in advance, chargeable to a prepaid Interest account, or to an account earmarked in sucli a way that the charge will not be merged in the account carried with Cash Discount, — ^the latter representing an allowance made for paying an open account promptly. Since bank discount is interest deducted in advance from the face of a note, the bank thereunder giving credit merely for the net amount remaining, the fact should be noticed that, by this means, the borrower receives proceeds in an amount lesB than the whole amount of the note, whereas, he pays interest upon the whole amount of the note. Because of this fact, the difference arises between bank discount and true discount. To calculate the latter, divide the amount of the face of the note by $1 plus interest on this $1 at the rate specified, for the time involved; the amount thus determined represents the sum the borrower should receive upon the true discount basis. Interest upon such sum for the period and rate specified, represents the amount of the true discount. Accounts Receivable. — ^As a title, this term should not be used as a Ledger account heading except, perhaps, in connection with the controlling account over the Customer's Ledger. Prac- tice, at least, will advocate the latter use of the term, even though the caption Customers' Accounts or Trade Debtors would seem preferable. If other than the accounts of customers be involved, as accounts with officers and employees, these other accounts should be set out separately by kinds. The credit bal- ances in customers' accounts represent liabilities to be set out upon the Balance Sheet under an appropriate heading. SPECIFIC REAL AND NOMINAL ACCOUNTS 33 Regardless of what one may encounter in practice, when only one Ledger is used for holding all the accounts of a business, care should be observed in sectionalizing such Ledger to the end that the customer's accounts will occupy one division by them- selves. By this means, a controlling account thereover may be carried in the division allotted to the general accounts. The same comments apply to creditors' accounts. However, the number of customers' accounts does not have to be great to justify the use of a subsidiary Ledger therefor; in fact, as soon as any justification exists for the use of a separate Ledger, the latter should be secured. Such justification would seem to exist, even when the number of accounts is small, where a Ledger rul- ing different from that of the General Ledger is desirable. In the use of a separate Ledger for customers' accounts, the account arrangement therein may depend more or less upon ex- isting circumstances. The following arrangements are illustra- tive: 1. In the order in which the accounts are opened. In connec- tion herewith an index seems necessary even though the bookkeeper, through long experience, may be thoroughly familiar with the location of various accounts. 2. Alphabetically. Such arrangement may be desirable upon either a loose leaf or card Ledger. 3. By geographical location. Give each state a particular section of the Ledger, and arrange the towns thereunder in alphabetical order; customers within each town, likewise, should be arranged in alphabetical order. In connection with this arrangement, a card index, or an index of some kind, should be kept by customers' names. 4. Etc. When drawing off a Trial Balance or an abstract of the cus- tomers' accounts, for Trial Balance purposes, it would seem that the most satisfactory method to follow would be to list the amounts in three columns: 1. Current — good. 2. Past due — short time only. 3. Doubtful. Whether or not an account actually is bad depends entirely 34 ADVANCED ACCOUNTING upon both the character of the customer and of the business; no general rule can be advanced which will cover all cases. Bad Debts : Reserve for Bad Debts. — Periodically, provision must be made for customers' accounts which app(;ar to be doubt- ful of collection. To this end, it may be highly desirable to do what is known as "aging the accounts," — preparing a list of the accounts with their balances and then, with the aid of some person familiar with the circumstances of each case, as the credit man, analyze the balances separating them into good, doubtful, and bad. The bad accounts should be charged against the R(;- serve for Bad Debts, and the reserve then should be increased sufficiently to offset the total amount of the doubtful item^. Provision for losses on bad debts is a non-operating expense, and the amount of the reserve should be considered as a valua- tion item; the Reserve for Bad Debts does not seem to be a surplus reserve, a liability reserve, or a contingency reserve. Doubtful accounts are better eliminated from the regular cus- tomers' Ledger than retained thereon; if done, they would be transferred to what might be termed a Suspense Ledger. Lik(»- wise, if desired, instead of writing a bad debt off the books, these may be included upon this Ledger also, and the individual accounts placed in the hands of attorneys for collection. In either event, a reserve account should be created of a size suffi- cient to offset the inflated asset value thereon. If the doubtful accounts are carried upon the regular Ledger, and only the ac- counts in the hands of attorneys are carried upon the Suspense Ledger, the size of the offsetting reserve for the Suspense Ledgt^r would be calculated about as follows: 14 of the total items for the current year; 1/2 of the total of the items two years old; 34 of the total of the items three years old; all those four years old charged off completely. However, to take advantage of the Income Tax Law provisions permitting bad debts to be con- sidered as expenses, the bad accounts must actually be writ- ten off. If a bad account which has been written off in one period ii collected in whole or part in a subsequent period, it would seem correct to credit the Surplus account in the amount of the collec- tion, rather than credit the Profit and Loss account, in that, when the charge was made originally, the Surplus account was affected. SPECIFIC REAL AND NOMINAL ACCOUNTS 35 1 Average Due Date. — Without discussing this topic at length, it is impossible to do more herein than present one of the rules for calculating the average due date. The rule given relates to the product method of ascertainment since it is believed that this method is simpler than any other: Select the first or last date in the account as the focal date. Multiply each item by the number of days in the period between the due date of the item and the focal date selected. Add the resultant products, securing one total for each side of the account. Subtract the smaller total from the larger and divide the remainder by the balance of the account. The resulting amount represents the number of days that the average due date is before or after the focal date. The average due date then is determined by one or the other of the following: 1. If the focal date is the first date in the account: a. If the dollar-days balance is on the same side of the account as the balance of the account, count forward. b. If the dollar-days balance is on the opposite side from the balance of the account, count backward. 2. If the focal date is the last date in the account: a. If the dollar-days balance is on the same side of the account as the balance of the account, count backward. b. If the dollar-days balance is on the opposite side from the balance of the account, count forward. Fixed and Capital Assets. — These assets, for a going concern, should be valued at cost less depreciation. The following points, relative to cost, should be of interest: 1. Cost includes all expenses incurred up to the moment when the asset is ready for use, — in place, ready for operation. 2. When a capital asset is purchased. a. Cost would include such items as cash paid, freight, duty, insurance in transit, drayage, installation, and im- provements and changes made necessary to make such asset suitable for the use to which it is to be put. b. If securities have been issued as part of the purchase price, their present value, plus the expenses in connection with their issue, would comprise a portion of the cost price. c. If securities have been issued for capital assets, as often « \ i r i^^Uto 36 ADVANCED ACCOUNTING is the case, the valuation placed upon such assets by the board of directors is final, unless fraud can be proved, d. Cash discounts secured upon the purchase of capital assets are deducted, generally, from the invoice cost thereof. 3. When a capital asset is constructed. a. Cost would include such items as material, labor, a por- tion of the overhead, fees of architect, charges for licenses and permits, insurance during construction, cost of in- juries and accidents to workmen engaged upon such work, damages, cost of strikes, interest on borrowed money during construction period, bond discount during construction period, etc. b. In general, even though bond discount and the expenses of a bond issue, should be spread (amortized) over the period during which the bond issue is outstanding, and bond discount is considered as partaking of the nature of bond interest, it would not seem justifiable to capitalize, as part of construction cost, the amortized portion applicable to the period of construction. The same is true of bond expense. However, some account- ants do not approve of the above practice. (See bonds — post. Chap. 8.) c. If the construction cost is less than market price, the asset should be valued at cost; a saving has occurred, but no profit has been made. d. If the construction cost is greater than market price, the asset may be valued in either one of two ways: i. Value at market and charge the excess against the current net profits, ii. Value at cost and reduce by a heavier than usual charge against the Depreciation account so that, when the Balance Sheet is prepared, the net carry- ing charge will be reduced to the present appraised value. If a capital asset appreciates in value, due to changes in the conditions of the market, such appreciation may or may not be booked, probably not: 1. If not booked. An unrealized profit should not be booked. SPECIFIC REAL AND NOMINAL ACCOUNTS 37 A Balance Sheet footnote relative to such appreciation may be desirable. 2. If booked. The accountants following this practice main- tain that a Balance Sheet should set out actual values, regardless of cost. Two methods of booking may be used: a. Dr. — Asset account affected. Cr. — Reserve for Appreciation. The above credit will prevent merging the amount of the appreciation into regular Surplus from there to be dis- tributed as dividends. b. Adjust the asset to present replacement value, and then adjust the Reserve for Depreciation account so that the net carrying value will equal the present appraised value. In selling a capital asset, the following should be borne in mind : 1. The credit should not be to the regular Sales account. 2. The booking procedure will be about as follows: a. Charge up the depreciation from last closing date to date of sale by debiting Depreciation account and crediting Reserve for Depreciation account. b. Charge Reserve for Depreciation account and credit the asset account affected for the amount standing as a credit balance in the Reserve account; this entry will eliminate the Reserve account amount applicable to the asset disposed of and reduce the latter to a net figure. c. The amount received in the sale then should be credited to the asset account in the amount necessary to clear the account, and the profit or loss resulting from the trans- action should be so booked that it will not affect opera- tion results; in fact, its amount is a credit or debit to Surplus. Repairs — Renewals — Replacements — Additions — Better- ments. — These items bring up certain points that are more or less difficult of interpretation: 1. Repairs. A repair is a replacement of a part of a unit which, in amount, is less than a certain figure. A repair is not supposed to increase the estimated life or value of the repaired asset ; hence, the repair amount is a revenue charge. 2. Renewals. A renewal is a replacement of a whole unit. 38 ADVANCED ACCOUNTING i The worn out asset should be cleared from the books, and the new asset entered thereon. 3. Replacements. A replacement contemplates the removal of a worn out asset and the purchase of a new one. 4. Additions. An addition is a new asset which does not replace any asset owned previously. 5. Betterments. If, when a new asset is purchased, more value is represented thereby than was represented by the asset replaced, originally, the excess represents a betterment. Wasting Assets. — These capital assets are subject to both depreciation and depletion. They comprise material resources as timber, oil, coal, stone, gold, clay, etc., properties. The accounting point here involved relates to the return of the invest- ment to the proprietors, — stockholders because, as the prop- erties are worked, there is a reduction or depletion in the asset value which is absorbed by the profits. The accounting treat- ment will be as follows : 1. Depletion may be disregarded to the extent that when divi- dends are paid a portion thereof represents a return of the capital investment. 2. Depletion may be considered. In this event, a periodic amount, equal to the proportion that the amount of asset product used bears to the total estimated amount of asset product owned, should be set aside in a Depletion Reserve so that, when the entire asset product owned has been con- sumed, the stockholders may have their capital returned to them. Take a mine, for example, as representing a wasting asset in which many people are interested. When so-called profits are paid to the stockholders in the form of dividends, it is ques- tionable whether or not these dividends really represent profits; usually, a portion thereof is a return of capital. At some time or other, no matter how rich a mine may be, the mine either will be exhausted or it will become so difficult to work that it will not pay to do so. The harder the mine is worked, the less the amoimt of ore that remains ; consequently, due to thi's working, the asset value decreases. Only when the size of the ore body is ascertain- able, which is not possible as an ordinary rule, except perhaps in the case of certain coal mines, will the dividend represent only a SPECIFIC REAL AND NOMINAL ACCOUNTS m distribution of profits; hence, practically every dividend repre- sents an unknown portion of the original investment. Land.— In addition to the points studied in connection with the earlier work, or coextensive therewith, the following points are offered concerning this asset: 1. "Land," as a term, is not synonymous with that of "real estate," since the latter term includes both land and buildings. 2. Land should be carried in an account separate from that of buildings; the two items should not be charged to the same account, even when purchased together for a specific sum. The separation of these items is due to the following reasons: a. Since land, originally, does not depreciate, whereas build- ings do, depreciation could not be calculated unless the two ite'ms are separated. b. Since land is not insured, whereas buildings are, the sepa- ration should be made so that a basis may be secured for determining insurable value. 3. If land is purchased with the idea of selling it at a later date, it is a current asset, not a capital asset. 4. Land should appear in the accounts at its fair cash value, when acquired. Such value would consist of either the actual money paid therefor, if purchased by a going con- cern, or its fair cash value if taken over when an enterprise is started; also, the cost of any permanent improvements. If interest enters in relation to purchase price, the actual amount paid, not accrued, may be regarded as a portion of the cost. 5. Land is an asset only when owned,— at least covered by the term "freehold premises"; this would include property in which there is only a life interest. Therefore, if a plant receives a gift of land upon a condition that must be ful- filled before title passes, care must be taken to book prop- erly, if at all; for example: Dr.— Land— Contingent Gift. Cr.— Reserve for Land— Contingent Gift. Only after the contingency has been fulfilled, should the asset be taken up in regular order, at a reasonable appraised value, offset by a special Surplus account which, after being 40 ADVANCED ACCOUNTING charged with the costs entailed by the gift, may be trans- ferred to regular Surplus. Leaseholds. — If land is held under a lease, one which is a long-term lease, the lease may or may not be booked. It should not appear in the accounts unless it has been paid for; then only at the price paid under the caption, say, of Leasehold, except as under : 1. It may be booked at its present value in a statement upon the basis of which the property is offered for sale. 2. It may be booked in the same manner as in ( 1 ) , in a state- ment prepared for credit purposes, because it represents an addition to net worth. A leasehold is a wasting asset. Buildings. — This item is an asset only when owned. As an asset, its booked cost may include every expense essential in making it ready for occupancy. The following items are illus- trative as part of the cost: 1. If a building replaces an old one that was useless when a piece of land was purchased, and was not considered in the purchase price, the cost of tearing down the old structure is a legitimate charge to the cost of the new one. 2. The sum paid to a tenant holding a lease upon such old building which expires beyond the time when the old building is to be razed. 3. Interest on money paid to contractors during construction period. 4. Insurance and taxes up to the time when the new structure is ready for occupancy. 5. Value paid for a building, whether in cash, in stock, or in bonds. 6. Additions to cost which distinctly add to the value (better- ments), or the excess cost of replacement value over the cost of the element replaced. 7. If bonds are sold at a discount to provide funds to erect a building, the amount of such discount should not be charged to building cost. As to depreciation, care should be taken in determining the amount thereof, especially relative to variations applicable to different portions of a building. If one part of a building is used for purposes other than those applicable to another portion of SPECIFIC REAL AND NOMINAL ACCOUNTS 41 the building, it will be necessary to keep the cost of the different portions separate one from the other, since the amount of depre- ciation on each part will not be similar; for a like reason, it may be desirable to book the cost of foundations separate from the superstructure, since the former will depreciate but slightly, if at all. If a person owns a building for life only,— has a freehold in- terest therein, depreciation may be ignored unless he: 1. Expects to live beyond the point of time that the building is serviceable, or 2. Expects to leave the property when the building no longer is usable for his purposes, or 3. Expects to replace the building in whole or in part. Again, under the circumstances where a building is on leased ground, and the condition exists that title to such building passes to the owner of the land upon termination of the lease, the en- tire building value should be charged off annually upon a pro rata basis during the life of the lease. Finally, when a building IS leased and the lessee is required to expend money thereon m order to prepare it for use, the cost of such additions and improvements should be spread over the life of the lease as an addition to the rental charge; where the lease has expired, these additions and improvements become the property of the owner. Machinery.— This asset should be booked at a value that will mclude not only the purchase price but all legitimate expenses necessary to place it upon a production basis, as: in freight and cartage thereon, setting up labor and expenses, and labor charges related to experimenting and testing up to the point where the machme runs true to form. When machinery is purchased upon the installment plan, title not passmg until a certain number of payments have been made a problem arises as to the proper recording of the payments as between capital and revenue, since interest is included as a por^ tion of each payment made: a. Determine the cash price of the asset, and the interest rate, and by means of tables ascertain the periodic per- charges '"'''"'""' '"''''"'' '"'' ''''' ''P''^'^' ^-^-^e, 42 ADVANCED ACCOUNTING I I b. Book the entire cost of the asset, by a charge to the proper asset account and a charge for interest to a de- ferred charge to operating account, offset by a credit to a liability account. c. Where each payment is made, periodically: i. Charge the liability account and credit cash, and ii. Charge Interest Expense account and credit the deferred charge to operating account for the interest portion. When machinery is made by the factory itself its value, as recorded, should consist of the actual material cost, labor cost, and a fair amount of the factory overhead. If this total value is less than the cost necessary, should the machinery be pur- chased, the difference represents a saving, not a profit; this saving will be realized eventually by the smaller yearly deprec^i- ation charge against profits. When machinery is moved from one place to another within a plant, the cost incurred may be booked separately and be spread over the period estimated as representing the life of the saving caused thereby. If the machinery items are not numerous, one or more accounts may be carried therefor upon the General Ledger, as desired. If only one account be carried, and no subsidiary Ledger used to hold the detail accounts, a book memo should be used in which a detailed list of the items may be found ; otherwise, depreciation cannot be calculated as it should be and, in case of fire, it would be difficult to prove the amount of the loss. It would seem de- sirable, in nearly all cases, to carry one Machinery account upon the General Ledger to act as a control over a so-called card Ledger or file in which each card covers one specific machine or other unit of property covered by the title "machinery," as: boilers, shafting and pulleys, belting, etc. Tools.— This asset should represent the miscellaneous small articles that are used directly on the material which is being fabricated into manufactured product, as: hammers, chisels, etc , which, when used, are held either in the hand or fastened to' a machine in some way. They should be carried in an account separate from that of Machinery. Since the depreciation of tools by the application of a fixed SPECIFIC REAL AND NOMINAL ACCOUNTS 43 rate cannot be determined m any manner that approaches ac- curacy, due to the fact that the uses to which a tool may be put are numerous and varied, it is customary to handle the reduction in value other than in a manner similar to that applied usually. In other words, when the books are closed, tools should be revalued and the book value thereof reduced to such amount. Patterns.— This asset may be of considerable importance in a manufacturing concern, in that it may represent a fairly large sum of money. Actual or frequent use would seem to be the test of whether or not a pattern has value. And even so, the cost of stock patterns should be depreciated liberally. Special patterns used in connection with a specific piece of work should be charged thereto as part of its cost. When a new design replaces one that has been used, the old patterns should be dropped from the books unless there still exists a sale for articles of the old type ; even so, it may be advisable to carry them only at a mere nominal amount. Good-will— Patents— Royalties— Copyrights— Trade- marks, etc.— Good-will will be discussed in considerable detail later in connection with consolidated statements; hence, only two points will be mentioned at this time: 1. Good-will may be said to represent or measure "the earn- ing capacity of a business in excess of a given rate of profit recognized as normal." This definition will answer for the use of this intangible capital asset in connection with the general corporate work discussed in subsequent chapters. 2. Good-will should be recorded, if at all, at its exact cost and only when purchased. This must be taken as a general statement only, in that the amount of good-will as origi- nally booked may be reduced,— or may not be made use of at all in an account by that name, as when adjustments thereof are made against specific asset accounts. (See Treasury Stock, post). Patents present considerable difficulty in the matter of valua- tion; however, an accountant should be governed only by what seemingly has been paid for them. In general, the following summary will cover the item: 1. A patent should be recorded at cost: a. The purchaser of a patent would book it at its cost to him. I 44 ADVANCED ACCOUNTING b. The inventor would record it at a cost composed of : i. Cost of producing the invention, ii. Legal fees involved. c. The owner of a patent may consider as part of its cost the expenses incurred in protecting it from infringement. A patent has no value until it is shown to be valid. 2. Patents should be depreciated heavily, regardless of use and of new patents which may be secured upon improve- ments which tend to prolong the life of the original patent beyond the usual seventeen years. It is a wasting asset. A patent may prove of no practical value within a short time due to lack of demand for the product resulting from its use or due to the fact that something new and better has been placed on the market by another. Patents are considered as expiring in seventeen years, but when this period of life is used, it would seem conservative to set up a reserve to cover the contingency of possible obsolescence due to better patents issued to others, in addition to the annual credit made directly against the asset. 3. The patent expense on machinery used in producing a cer- tain manufactured product is a manufacturing cost, where- as, if the patent covers the article sold, its expense is chargeable as a selling cost. Royalties received are non-operating income, whereas, royal- ties paid in connection with the use of a patent are manu- facturing expenses chargeable under the same principles that govern the handling of patent expense. The royalty contract must be carefully scrutinized before an attempt is made to make entries therefor. Where a certain minimum royalty has been guaranteed the holder of the patent, as a total, and the actual amount due on account of operations is less than this minimum guaranteed total, the excess must be treated as a deferred charge to be written off later against future operations, provided the royalty contract permits. Formulas or trade secrets should be booked at cost, and be de- preciated heavily, especially if not protected. Their value is related closely to the article produced inasmuch as there will be no value if the article produced has no value. Copyrights and trademarks should be recorded at cost, if at all, and should be depreciated heavily beyond the amount which SPECIFIC REAL AND NOMINAL ACCOUNTS 45 would be required by following the number of years for which each is granted: 1. Copyrights are granted for twenty-eight years, and may be renewed for a similar period, under certain conditions Very few copyrighted articles have any value at the end of twenty-eight years. 2. Trademarks, when registered, are protected indefinitely provided they are used continuously. It is not usual tc^ book a value for a trademark unless it has been purchased. A license, as to cost, is a deferred charge to be written off over the period for which the license was granted. A franchise should be recorded at cost. The matter of de- preciation depends upon circumstances: 1. If perpetual— no depreciation. 2. If for a definite period-depreciate in proportion to time elapsed. 3. If indefinite — depreciate heavily. Notes Payable.-This type of liability may be classified in two different ways: 1. First classification: a. Those with collateral. b. Those without collateral. 2. Second classification: a. Those issued for merchandise. b. Those discounted by banks. c. Those sold through brokers. d. Demand loans. e. Those of officers and employees. f. Purchase money notes. g. Accommodation notes. as^t."'^^ °?i'' ""^""^ ^°"P "^y ^ subdivided further b^tlte"' '"^ """ '"'^ ^'^^ ^' ^ *^« ~t secured A note given for accommodation creates both a contin^pnt rT pTtrmTf "^'"^*^- ^" ^^"^^^•' ^'*h-«h nTe'E P^eferabk to r. "T T^ ' transaction, it would seem preierable to make some book record thereof, as: Dr. Accommodation account Cr. Liability as Indorser 46 ADVANCED ACCOUNTING especially where an exchange of notes has taken place. Even when a note has been indorsed as an accommodation, it is possible to make use of the above entry inasmuch as this act, also, creates both a contingent asset and a contingent liability. When a time draft has been accepted, it should be booked as a Note Payable. Accounts Payable.— As concerns this liability, some of the points mentioned already in connection with accounts receivable are applicable. The term, as a title, should not be used as a Ledger account heading except, perhaps, under the two following conditions: 1. As the title of the controlling account over the creditors' Ledger. 2. As the title of an account upon the General Ledger to which is posted monthly the total of all credit transactions, no separate creditors' accounts being carried. Practice, at least, will advocate the use of this term under the above conditions even though the caption Creditors' Accounts or Trade Creditors would seem preferable. Three methods exist, in general, for carrying the open accounts with business creditors: 1. All transactions of each month are posted as a credit to one account upon the General Ledger, which is given some descriptive title. Hereunder, all creditors are treated as but a single creditor, due to the fact that as long as a busi- ness owes money, it is really immaterial to whom the money IS owed. Accounts receivable should not be handled in this way, under any circumstances, since the credit standing of each customer is a most important consideration in deter- mming whether or not more money is owed the business by such customer than should be owed, and whether or not such customer pays promptly. 2. Each creditor is given a separate account, usually upon a subsidiary Ledger, the latter being controlled by an account upon the General Ledger. 3. Combination of (1) and (2). Certain creditors are given separate accounts so that the volume of business with each such may be determined readily, whereas, concerning the others, one general account to cover all may be sufficient SPECIFIC REAL AND NOMINAL ACCOUNTS 47 Naturally, hereunder it is necessary to columnize the original records so that the above separation is made possible readily. Purchases.-Purchases and sales, and the various accounts closely allied thereto should not be recorded in the old-style Merchandise account, but should be so recorded that, from the accounts used, an intelligent statement thereof, leading to a figure representing gross profit, may be prepared without the necessity of recasting the accounts. To the extent that a concern is liable for the purchase price of the material, the bookkeeper should make proper records thereof- this means that all unrecorded purchases of the kind above referred to, when statements are drawn, should be considered as increasing the Purchases account, the Inventory and the Accounts Payable. The form of the Purchase Book depends upon the organization under review. Purchases may be classified by kinds of mate- rial, or by departments, m not at all. It may be desirable to use a Voucher Record in preference to a Purchase Book- the latter has been described briefly in the preceding chapter Under either possibility, it is necessary to have the right side of the Cash Book provided with columns in which payments, and cash discounts (unless the latter are taken up on the Purchase Record or Voucher Register) , may be entered. Provision should be made for postmg the items from this side of the Cash Book to the proper lines of the Purchase Record, even though the regular creditors Ledger is used to which postings are made in regular form; naturally, when a Voucher Record is operated, this post- mg to the proper lines thereon will be the only posting made, unless certain creditors are carried in special detail accounts Returns and allowances, related to Purchases, should be entered upon a separate record; if not, the General Journal must contain nn ff j:';^^.^^^^ the General Journal should contain a column a in! 7^^^f ^ ^^^ adjustment purposes; in fact, even where columns on the General Journal may be desirable to take care 01 possible miscellaneous adjustments. In proving up the accounts payable, where both a Purchase 48 ADVANCED ACCOUNTINO SPECIFIC REAL AND NOMINAL ACCOUNTS 49 Record is used as above indicated, and a Creditors' Ledger is maintained, a double check is secured upon the work: 1. List the open items upon the Purchase Record and secure their total. 2. This total should agree with the balance of the controlling account upon the General Ledger. 3. This total should agree with the total of the Trial Balance or abstract of the Creditors' Ledger. The procedure revolving around the placing of a purchase order, the receipt of the invoice and the goods, and the book- keeping involved, are dependent upon the particular concern under scrutiny. On the one hand, the whole procedure may be decidedly simple and, on the other, it may be more or less involved or complicated. The following example will suffice: 1. When the storekeeper discovers a certain material has reached the minimum quantity that must be on hand at all times, he notifies the purchasing department by means of a Purchase Requisition, keeping a 6arbon copy on file and making entry of such notification upon his Stores Ledger. 2. When the purchasing department receives this requisition, an order is placed, after the usual preliminaries have been met, by means of a Purchase Order, made in quadruplicate: a. Original to vendor as authority to ship. b. Duplicate retained and filed with Purchase Requisition. c. Triplicate to receiving department, as notification to expect shipment. d. Quadruplicate to storekeeper, who may make entry in the Stores Ledger account in a section for such purpose. 3. When the vendor receives the Purchase Order, he ships the material and sends along an invoice which, when re- ceived in Purchasing Department, is filed with the copy of the Purchase Order there held. 4. When the material is received, the receiving clerk will make out a Report of Material Received, after inspection, per- haps, consisting of three copies : a. Original to purchasing department. b. Duplicate to be sent storekeeper with material after same has been cleared. c. Triplicate to be retained in the files, after being receipted by storekeeper. 5. When the purchasing agent receives his copy of the Report of Material Received, it is compared with the Purchase Order and the invoice on file, after which the material is cleared to the control of the storekeeper. Perhaps the mate- rial goes immediately to storekeeper after inspection. 6. The invoice then is indorsed, and is forwarded to the accounting department for entry and payment. Sales.— All sales orders should be recorded systematically. Before a sales invoice is sent out, it should be checked against the sales order. Likewise, the shipping clerk should keep a sepa- rate record of all shipments made. The usual form of Sales Book should consist of a binder in which are contained carbon copies of the invoices sent customers. The detail postings are made from these carbon copies, whereas, the control account posting and the sales distribution would be secured from what might be called a Sales Journal which, prac- tically, might better be termed a Recapitulation of Sales. A summary presentation of some of the principles of use in connection with various kinds of sales seems in order: 1. Cash sales. Great care must be exercised to ascertain that the proper system of internal audit is in use. (See previous discussion relative to cash receipts.) One means of taking care of cash sales is to handle them in about the same way as credit sales, but in totals. A separate column is pro- vided upon the sales recap sheet, and herein each cash sale IS entered and distributed in the same manner as the charge sales are distributed. The total of this column is charged to the Cash Sales account. A similar column is provided on the Cash Book to hold the amount of payments received from cash customers. The total of this column is credited to the Cash Sales account. A credit balance in this account represents cash received for which goods have not been delivered. 2. Sales to proprietor. These may be handled in either one ot two ways: 50 ADVANCED ACCOUNTINQ a. Dr. Personal Account — Proprietor, I i Cr. Purchases, $ i At cost price. b. Dr. Accounts Receivable (Detail and control), $ i Cr. Sales. At cost price, $ fi Dr. Personal Account — Proprietor, $ ^ Cr. Accounts Receivable (Detail and control), $ f5 To clear from Accounts Receivaliie. Dr. Sales. $ i Cr. Purchases, $ j6 To clear from Sales account. This entry is unnecessary unleii the aggregate is of sufficient size to afTect sales statistics. 3. Instalment sales. The following entries are illustrative: $ ^ Dr. Instalment Accounts Receivable — 19 — Cr. Cost of goods sold, Unrealized Gross Profit — Instal- ment Accounts Receivable — 19 — To record the sale. Dr. Cash, $ ^ Unrealized Gross Profit — Instalment. Accounts Receivable — 19 — , $ ^ Cr. Instalment Accounts Receivable — Realized Gross Profit — Instalment Accounts Receivable — 19 — , To record payment on account. Dr. Realized Gross Profit — Instalment Ac- counts Receivable — 19 — , $ i Cr. Profit and Loss, To close. $ $ i $ i } The hire-purchase plan contemplates renting an article to the would-be-purchaser under an agreement that , when the required number of instalments have been paid as rent, a bill of sale will be given for the article. Title does not pass until all payments have been made, and if a payment is defaulted, the owner may recover possession of the article under the lease terms. 4. Sales on approval. No sale has taken place until the goods have been accepted. Therefore, the following entries would suffice: SPECIFIC REAL AND NOMINAL ACCOUNTS 51 I i ti s i S f< I ^ $ i Dr. Approval Accounts Receivable, Cr. Approval Sales, To record sale at sales price . Dr. Approval Sales, Cr. Approval Accounts Receivable, To record goods returned. t)T. Cash (or Accounts Receivable) { Same ' Approval Sales J Amount, Cr. Sales j s&me Approval Accounts Receivable ) Amount, To record actual sale of goods. Goods out on approval are part of the establishment inventory and care must be observed to provide for more than usual loss in value here agamst when the periodical statements are prepared 5. C. O D. sales. Regular entries upon the books of account should be made to cover these sales rather than mere memo entries : Dr. C.O.D. Account, • ^ Cr. Sales, ^ , To record C.O.D. sale. Dr. Cash, * . Cr. C.O.D. Account, m j To record collections. Delivery drivers are charged for all C. O. D. goods to be delivered by them, and offsetting credits are made only for cash received or goods returned. Adjust the C. O. D. account against the bales account at closing time. 6. Sales to branches. These are not regular sales, being ordi- nary shipments; therefore, credit such sales to a Shipment account: ^ Dr. Branch — A ^ . Cr. Branch Shipments, « j On the branch books, the offsetting entry would be: Dr. Purchases (goods), ^ « ^ Cr. Home Office^ ^ . Goods are billed to branches at cost or at some figure other ment mf ;f '' 'f " ""'"'''' "^ ^°"°"^^' ^ P-^^icS adjus ^ ment must be made on the books of the home office to take up the inventory of the branch at cost '^ ^' fhtV°'. f "*">•« delivery. Nothing need be said concerning this kind of sales unless a contract exists under which a customer can be sued. If such contract exists; 52 ADVANCED ACCOUNTING I a. The sale may be recorded, provided tlie goods are in stock ready for shipment, even though there be a delay in delivery. b. The sale should not be recorded if the goods involved have not been fabricated. However, it is usual not to record such sales until delivery has been made. Selling expenses applicable to sales not delivered may be deferred in closing the books. 8. Sales on consignment. Title to goods sent out on consign- ment has not passed; therefore, consignment sales are not regular sales. The entries covering consignments are illus- trated below, as to one method: Books of Consignor: A . B. — Consignment. To — Goods on Consignment (A.B.). To record goods shipped. A.B. — Consignment. To — Accounts Payable (cash). To record charges incurred, as freight, insurance, dray- age, etc. A.B. — Personal. To — ^A.B. Consignment. Gross proceeds as per ac- count sales. A . B. — Consignment. To— A.B. Personal. Expenses and commission as per account sales. A .B. — Consignment. To — Profit and Loss. Profit on consignment after unsold goods have been en- tered on the credit side of A.B. Consignment account. Cash. To — ^A.B. Personal. Receipt of cash to balance A.B. — Personal account. Goods on Consignment (A.B.). To — Profit and Loss. To close. Books of Consignee: Dr. None. Cr. None. Memo entry made only. XY — Consignor. To — Accounts Payable (cash). To record all expenses in- curred f)ii behalf of con- signor. Accounts Receivable (cash). To— XY— Consignor. To record sales made. XY — Consignor. To — Commission. To record commission charged. Commission To — Profit and Loss. To close out gross profit. XY — Consignof. To— Cash Payment of cash to bal- ance XY — Consignor Ac- count. SPECIFIC REAL AND NOMINAL ACCOUNTS 53 9. Loss in transit. At times, goods are lost in transit while on It foil f ■ ™ ^ '"^^^ *° *•>« '*"™ad company the foUowmg entries may result: Blank Railroad Company, To— Goods Lost in Transit, To record claim made. Cash, To— Blank Railroad Company, To record receipt of damages. Goods lost in Transit, To— Sales, This entry is made when damages are received. » t *t S i t t %i t i Likewise, the value of the goods lost in transit should be set out as such as part of the inventory, prior to receipt of damals or recovery of the goods. ^ aamages 10. Sales guaranteed. When goods sold carry a guaranty such guaranty is a contingent liability, wh^h Sght be' pr^ vided for, as to loss, by a periodical charge to Profit and SalesTo P '"' ' '''''' *« « "^'^'''t'^ '-erve account Sales to Foreign Branches.-The subject of foreign branches polntTrr "'' " """""°" *''^^^^*'' '^ -ffi^-% im- portant to require a separate chapter. However thf> fnliL- points are deemed sufficient for preLt purZI """'" 1. Arbitrage relates to the method of remitting to one foreien country through another foreign country so as to LkeT vantage of current foreign exchange rates. ^s'"us'uIlT"'' 'T correspondent in a foreign country. It IS usual to carry the account therewith in a Ledger ac- count naled with two debit and two credit columns The jns.de debit and credit columns are used for showTng va^ue in the foreign currency. When the balances are drawn the amounts are calculated at the exchange rat^ aT of ' L batTedr* '^*^- ^''^ *^° ^^^ ofUmns then a. P^fit and i^^^^^^^^ '*'"°'"* "'^^ ^ -^t^" o^ to: b Reserve for Exchange Fluctuations. .*• I, I 54 ADVANCED ACCOUNTING 4. The current assets of a foreign branch should be brought upon the books of the home office at their realizable value in American money. 5. Remittances to a foreign branch should be booked by the home office at actual cost, — rates paid. 6. Revenue items should be converted, upon the home office books, at the average rate for the period. 7. The controlling account on the home office books should be calculated at the same rate as that established at the last period. 8. When a branch receives a shipment from the home office, the latter should be recorded on the branch books at actual cost. Returns and Allowances; Expenses Related to Goods. — Purchase Returns are deductions from Purchases, and Sales Re- turns are deductions from Sales. Separate Journals should be used for each class of returns rather than recording them in the regular Purchases and Sales Books. Allowances on Purchases and on Sales may be combined with the Returns on IHirchases and on Sales, respectively, although some accountants maintain that returns should be booked separately from allowances. Freight and cartage outward may be handled in either one of two possible ways: 1. If goods are sold f. o. b. destination, such expenses may be considered as sales deductions. 2. If goods are not sold under these terms, but as f. o. b. point of shipment, such expenses may be considered as selling expenses. Purchasing department expenses are related to the cost of purchases, whereas credit department expenses are considered either as selling or administrative expenses, preferably the latter. Ordinarily, warehouse expenses are considered as selling ex- penses, but at times it may be advisable to apportion part of them as a cost of purchases. Advertising expenses are not always to be charged off currently to Profit and Loss: 1. Current advertising never should be considered except as a current selling expense. 2. Heavy outlays connected with an advertising campaign SPECIFIC REAL AND NOMINAL ACCOUNTS 55 may be considered as a deferred charge to be written off over a short period of time. Trade and cash discounts present a few points that seem worthy of being reviewed: 1. The correct treatment of trade discounts, deductions from list prices, depends upon circumstances: a. Ordinarily, they should be deducted from the invoices so as not to be taken up on the books at all. b. If a discount is in excess of the usual terms, as 2/10, n/30, a trade discount is assumed. c. If trade discounts are shown upon a set of books, they are deductions from purchases or sales. 2. Cash discounts, ^'allowances not in excess of a rate that a business could afford to pay for the use of money for the credit period," are not treated uniformly by accountants: a. Cash discounts on purchases: i. If considered as a reduction in the price of goods they are deducted from purchases, ii. If considered as concerned with the financing side of a business, they are non-operating profit This latter view seems to be the better of the two. b. Cash discounts on sales: If considered as an overstatement of sales, they are deducted from the sales. If considered as a bait offered possible customers, they are booked as selling expenses. If considered as a fine incurred on account of bad financing, or as made up of the two elements of mterest and bad debts, they are non-operating ex- penses. This last view seems to be the correct one 3. Reserves for cash discounts on purchases and on sales to cover prospective discounts that may be taken, are advo- cated by some accountants. However, it would seem that settrT "r ^'T"' *" ""^^ distinctions that are alto- as where they sum up to a considerable amount • '■ fncTsh ^7 ^''^r ^''''°"°*^ '^ deducted,'on the Bal- ance Sheet, from the Accounts Payable. 1. II. 111. 56 ADVANCED ACCOUNTING b. Reserve for Sales Discounts is deductefi, on the Balance Sheet, from the Accounts Receivable. Turnover.— Turnover may be considered as the number of times a stock of goods has been turned within a specified period of time. This number of times is determined by dividing the co^t of sales by the average amount of the inventory on hand durmg the period under review. The greater the turnover, the less need be the percentage of profit to earn a definite fixed amoiirit- of profit a year. Insurance.— The subject of insurance contains a number of points or principles that seem important enough to require at least a complete chapter. But for present purposes, the dis- cussion must be curtailed to a marked degree, and only cer- tain general principles be given. Some of these have been covered in a more or less detailed manner in the work of the first year, provided that such work represents a course in accounting rather than a course in bookkeeping which so often is presented under the guise of an accounting title. 1. Policy Register. This record should prove valuable where a number of policies are in force so that a glance at any one page will take in a number of significant facts. a. The ruling for such a register should provide for tabulat- ing the following basic information: Policy numbers. Names of insurance companies. Premiums. Policy dates. Agencies used. Expiration dates. Nature of contract. Amount of insurance. Monthly premium distribution. 2. Unexpired premiums. These represent deferred charges to operation to the extent of the unexpired portions. The expired portions are written off periodically as an expense. Expired insurance on a factory is an item of overhead, and expired insurance on manufactured product is a selling expense. Two questions arise as to the handling of the unexpired premiums: a. In case of fire. The unexpired premium, counting from the date of the fire, is not recoverable from the insurance company ; therefore, this amount should be written ofi\ SPECIFIC HEAL AND NOMINAL ACCOUNTS 57 This may be accomplished by writing into the Fire Loss account such an amount as represents the "ratio of the amount of settlement on the part of the insurance com- pany to the face of the policy." b. In case of cancellation of a policy. A certain amount of the premium paid will be returned by the company, but this amount will not be upon a pro rata basis. The premium will be recalculated on the basis of the length of the period during which it was in force, upon what is known as a "short rate" basis. Then the difference between the original premium and the recalculated amount will represent the portion of the premium that will be returned. Co-Insurance and Fire Loss.-Many fire insurance policies carry what is known as the "average" or "80 per cent co-insur- ance clause. Such a policy makes the insured a co-insurer with the insurance company for the difference between 80 per cent of the property's cash value and the face of the policy Where such a clause is in force, the amount that may be recovered from the insurance company can be computed as follows- 1. Multiply the face of the policy amount by the amount of the loss. 2. Dmde the product from (1) by the product obtained by multiplying the cash value of the property by 80 3. The result secured by (2) above, represents the amount that may be recovered. When a fire has taken place, a Fire Loss account should be opened in which should be recorded the amount of the loss suf- iered. The account would be charged with the value of the asset or assets destroyed, after depreciation thereon has been adjusted down to the date of the fire, and the portion of the depreciation reserves applicable thereto have been closed into the asset ac- counts affected; it would be charged further with any expenses arising m connection therewith, and with the unexpired portion of the cancelled insurance. The account would be credited with he allowance granted by the insurance company; further with the scrap value allotted to the ruins. The balance of the ac- count should be closed into Surplus If perpetual inventories are not kept of goods on hand, the 58 ADVANCED ACCOUNTING I amount of goods on hand as of the date of the fire must be calculated by the gross profit test. The average gross profit for a period of years is calculated. Then beginning with the last clos- ing date, a gross profit section of the Profit and Loss Statement is prepared covering the period from such last closing down to the date of the fire. The average gross profit on sales for this period, or portion of a period, is assumed to be the same as before. Hence, by working backward, to a certain extent, the missing inventory may be calculated fairly readily. Miscellaneous Insurance Procedures. — Certain other prin- ciples relating to insiu-ance, not included above, are summarized below: i. Life insurance. If a concern is the beneficiary under a straight life policy, it is customary to capitalize the cash surrender value of such policy. After three yearly pay- ments of premium have been made, a cash surrender value comes into existence, which may be booked as an asset. Subsequently, each premium payment is recorded in two portions : a. One portion representing the increase in cash surrender value is capitalized. b. One portion representing the excess of the premium over the increase in cash surrender value is charged to an expense accoimt. In the event of the death of the insured and the payment of the policy by the insurance company, the account carried with the cash surrender value would be closed and the excess of such payments over the balance in that account would be credited to Surplus account. 2. Liability insurance. Premiimis covering insurance against employees' claims for damages due to injuries are payable in advance; therefore, there will be a certain portion of the premium unexpired at the end of each period. Again, at such date, it may be necessary to make an adjustment due to either a refund on the part of the insurance company, or to the fact that after the period's payroll is known, the premium paid may be found to have been insufiicient. 3. Bonding employees. Premiums paid for this purpose usu- ally are charged out as administrative expenses. SPECIFIC REAL AND NOMINAL ACCOUNTS 59 4. Burglary insurance. The premiums paid for this protec- tion usually are charged off at once as expenses. The dis- tribution of such expenses depends upon the kind of prop- erty protected. 5. Marine insurance. This point is not of usual importance but IS covered briefly in that many C. P. A. examinations have at least one question bearing thereon. If the master of a vessel in time of distress jettisons a portion of the property m order to save the vessel and the retained por- tion of the cargo and freight, the loss suffered must be borne upon a proportional basis. Tlie above probably is the point of most importance to an accountant. 1 CHAPTER III PARTNERSHIPS, VENTURES, CONTRACTS, MANUFACTURING CONTROL Introduction.— Four major topics are discussed in the present chapter. For the most part, it has been assumed that a con- siderable portion of the work of the first year was devoted to a detailed consideration of these subjects Therefore, the cur- rent presentation acts both as a review and as an approach to the work of the subsequent chapters, most of which concerns corporations. Partnership Formation.— The legal organization of a busi- ness is the organization unit which holds property values and directs their use so that they will dovetail harmoniously with the efforts of persons. This organization unit may take one of three forms : 1. Sole proprietorship. 2. Partnership. 3. Corporation. On the other hand, the working organization of a Dusiness is concerned with the internal activities thereof regardless of its legal form of organization. A study of partnerships necessarily must resolve itself into a consideration of both phases of partner- ship organization. But in the present instance, since it is assumed the student is somewhat familiar with both these angles, from his past work, the principles presented have been condensed as much as seems possible consistent with reason. Partnership Defined.— "A partnership, as between the muH'- bers thereof, is the association, not incorporated, of two or more persons who have agreed to combine their labor, property and skill or some of them for the purpose of engaging in any lawful trade or business, and sharing the profits and losses as such between them." Definite rules to determine when, and when not, a partnership 60 PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 61 is in existence under any given set of facts, cannot be given since each case arising must be judged upon its own merits,— the facts existing thereunder. In general, however, the two following legal principles are made use of : 1. Are all the elements present which are essential to the for- mation of a legally binding contract? 2. Was there an intention, on the part of all parties concerned to form a partnership? ' If so, it would seem that the preponderance of opinion states a partnership to be in existence. Partnership, Advantages and Disadvantages.-The reasons or advantages in favor of the partnership form of organization' as opposed to that of the sole tradership, may be set out as under- 1. To secure additional capital. 2. To enlarge the scope of the business. 3. To secure the services of another, because of : a. Ability, or b. Business connections. 4. To secure a subdivision of duties, so that specialization in one particular direction may result. The disadvantages existing against the formation of a partner- ship may be summarized as follows: 1. Unlimited liability. In general, each partner is liable beyond his partnership investment to the extent of his whole ner- sonal fortune. ^ 2. Friction. Partners are most apt to find it difficult to get along harmoniously with each other 3. Deferred action. Since each partner, in general, has as much Ltir Jrr°^^"°'"*' "^ '^"^ ""^^'^ Partner, decisions LadeS a" """^ "' """" ''' ^^^ *° ^^ "^^'^ ^l-'^"' The disadvantage of partnership liability is exceedingly im- portant, except as concerns the limited partner who jeopard z" Lt r 'T*""'"* ^"' "'^'' '^ ^P-'fi« -^ his actions Tgive the ^' fnrtrf 7' ^""^ ^ '"''*y f"' ^^«'> °ther partner, is liable for the full amount of the firm's debts. This means tha' h.s private estate may be attached for such p^^L Of 62 ADVANCED ACCOUNTING course, in such event, he would be entitled to proportionate contribution from the other partners but, even so, the mere right to contribution does not mean neeessarilv thai he can enforce such right; the others may have dissipated their private fortunes prior to such attachment. 2. Incoming partners may be held liable for the debts of the old firm unless they serve notice specifically that they will not be so held. 3. Retiring partners are held liable for the debts of the firm, both due and not due, as of the date of retirement rc^gardk^sa of what might be the actions of the vendees in this respect, unless the creditors specifically agree to look to such vendees for payment. 4. Naturally, the remaining or continuing partners arc jointly liable with those who are retiring. Classification of Partners and Partnerships.-Persons forming a partnership must be competent under the law to con- tract (exclusive of corporations unless so authorized specifically in the charter) . Competent persons are : 1. Minors (since their contracts arc not void, but merely voidable') . 2. Adults. 3. Partnerships. 4. Corporations, if expressly authorized. Partners may be classified as follows: 1. General (active). These take an active part in the firm management. 2. Limited (special). These have less than full participation in firm liability. The statutes must be complied with strictly, because the limited liability is in derogation of the common law liability. 3. Dormant (sleeping). These have no part in the firm man- agement, and their connection is a secret one. They are both secret and silent. 4. Silent. These have no voice in the firm management, and they may or may not be dormant partners. 5. Nominal. Those who are held out to the world as partners, t)ut who, in reality, are partners in name only; these may PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 63 be held legally as regular partners by creditors who have granted credit to the firm on the strength of their connection. 6. Ostensible (real or public). Those who hold themselves out to the public and are known, therefore, as partners, and who, in reality, are such. 7. Secret. These partners are not known as partners, although they may be engaged actively in the business. 8. Sub-partner. An outsider who shares in the firm interest of a regular partner. He is not a member of the original firm and is not liable to its creditors. Partnerships may be divided as follows: 1. General. In these, all the partners are tenants in common, for the continued prosecution of a general line of business.' They are of two basic kinds: a. Trading. These are formed to buy, sell, and manufac- ture. b. Non-trading. These are found among brokers, profes- sional men— lawyers, accountants, etc. 2. Special. These partnerships are formed to carry out some one line of endeavor, or to transact one single piece of busi- ness; a joint venture is included hereunder. 3. Limited. These partnerships are composed of two classes of partners: a. General. Those liable for the whole of the firm debts as in a general partnership. b. Special. Those liable only for a limited amount of the firm debts, usually in the amount of their investments. 4. Joint stock company. This is a partnership in which the capital IS divided into shares which are transferable with- out the express consent of all the partners. Usually, it has a corporate name, and is governed by directors. A trans- fer of interest, war, and death or bankruptcy of its members will not necessarily terminate its existence. It is created by contract, and the law of the particular state in which it IS domiciled must be followed strictly in its formation. vi^'"''''?''! ^^ P^^^^^^^hiP Agreement.-The usual pro- mTnv'bu^tt t T '•'' '"""' ^" "" partnership agreement are many, but the following points, at least, should be covered: 64 ADVANCED ACCOUNTING 1. Date of commencement, tenn of existence, and conditions of termination prior to agreed-upon date. 2. Name of partnership and of each partner. 3. Nature and location of business. 4. Amount and form of partners' contributions, and valuation of investments other than cash. 5. Rights, duties, and powers of partners, 6. Personal drawings. 7. Interest on personal drawings and capital 8. Salaries. 9. Distribution of profits and losses. 10. Books of account, and audit thereof. 11. Arbitration of disputes. 12. Life insurance on firm members. 13. Procedure upon dissolution, including closing of books, good- will valuation, and disposal of firm name. Rights, Duties and Powers of Partners.— Every general partner is a general agent of the firm in the transaction of firm business. His acts, however, are circumscribed to the extent that, unless he has been given specific authority, by virtue either of having entire charge of the administration of the business, or because the others, for some reason, are incapable of acting, he cannot legally: 1. Act so that, thereunder, the business cannot be continued as originally agreed. He may sell all the merchandise, but not the business. 2. Confess a judgment. 3. Submit a partnership claim to arbitration. 4. Dispose of the good -will. 5. Make an assignment to a creditor or trustee. Interest— Salaries— Profits and Losses: Court Rules.— Specific agreements in respect to the above points, either written or oral, will hold. But where proof thereof is impossible, the Courts will apply the following rules: 1. As to interest allowances: a. No interest is to be allowed on investments. b. No interest is to be charged on withdrawals. c. The fact that interest is allowed on investments does PARTNERSHIPS, VENTURES, CONTRACTS, ETC. ' 65 not mean that interest is to be charged on withdrawals; the latter must be covered specifically by agreement. d. Interest is to be allowed on partners' advances and on personal payments in behalf of the firm. e The legal rate of interest applies, if no other is specified. 2. As to salaries. a. None are allowed. 3. As to profits and losses. b. These are to be shared equally. Opening Entries.-After the partnership agreement has been formed, and the amount of capital investment decided upon the opening entries are in order: ' 1. Where contributions are definite and fixed: A. Current Account, • ^ B. Current Account, « j To — A. Capital Account, | a B. Capital Account, • u To record capital investment as agreed. Cash and Sundry Assets (in detail), $ ^ To— Sundry Liabilities (in detail), | . A. Current Account, • j B. Current Account, • J To record contributions as agreed. 2. Where contributions are indefinite and fluctuating The usual example hereunder is where a partner agrees to con- tribute certam assets, as Accounts Receivable, which he guarantees to be worth the value thereon placed: Accounts Receivable, « j To— A — Capital Suspense, « j To record contingent contribution. Cash, ^ To — Accounts Receivable, . j To record collections. A — Capital Suspense, « j To— A— Capital, ^ ^ . To credit A with definite amount of capital contributed or guaranteed. A — Capital Suspense, • j To— Accounts Receivable, • j To close. ^ In admitting a partner into a firm or business, the two follow- mg^^basic pomts and their differentiations should be borne in 66 ADVANCED ACCOUNTING 1. Purchasing an interest in a business: capital not increased thereunder. The incoming partner pays over his contribu- tion to the other or others who pocket the procee • 5. Admission of a partner. 6. Bankruptcy of the firm. 7. Withdrawal of a partner. 8. Sale or transfer of a firm to another. 9. Death of a partner. 10. Insanity, bankruptcy, misconduct, or disability of a part- ner. 11. War between nations represented by the partners. Asset Application Upon Dissolution.— Under partnership law, upon dissolution, the assets are applied as folows: 1. Firm debts to outside creditors. 2. Advances or loans made by partners. 3. Return of capital, as per capital accounts. 4. Return of profit residue, if any, among the partners in the profit and loss sharing ratio. If a loss is suffered in the dissolution process, the loss must bo distributed at the point of No. 3, above, following which the capi- tal will be returned. Again, if the loss in the dissolution is so great that thereby the capital of one or more partners is wiped out and a deficit replaces it, a transfer should be made from the loan account of such partner, before the loan account is liquidated by the return of assets, so that such deficit will be cancelled. In winding up the affairs of a partnership, regardless of cause, it would seem that the following points or principles are of im- portance. Some of them should have been incorporated into the articles of agreement, but, even if not so done, it would seem advisable to consent, where necessary, to their use: 1. In case of a partner's death, the interest that the estate of the latter may have therein, as to profits, would be for the portion of the current period up to the date of death. Provision should be made for continuing the business for a certain time so as to realize as much cash as possible to pay over to such estate, or provision should be made for buy- ing out the interest of the deceased partner and paying for this, periodically, over a period of time. Likewise, from date of death to the date of final settlement it is customary to allow interest upon the deceased partner's share in the business. Again, if the firm has a certain amount of good- PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 73 Will, the estate of the deceased partner should receive some allowance for the share of the deceased partner therein 2. Upon dissolution, by retirement or death, great care should be observed m placing a value upon the firm assets, so that the mterest of the retiring partner or the estate of the de- ceased partner will not suffer. The usual rule would be to value at reproduction cost, less depreciation to date of dis- solution, regardless of book valuations. The depreciation reserves should be written off against the assets affected, but surplus reserves should be considered as part of net worth. Further, if notice of dissolution be not given to firm creditors, a retiring partner will continue to be liable for new obligations. 3. One or more of the surviving partners usually is appointed to take charge of the liquidations; even though, theoreti- cally, all partners have an equal voice and share in such Tvork. Notice must be given to all persons dealing with the firm that the partnership is being dissolved, and who IS winding up affairs; this may be through the local news- paper. Further: a. Existing contracts must be fulfilled. ^' issibir^^' '"'''^ ^^ ^''^'^"^ ""^ ^' advantageously as c. Debts and obligations must be discharged d. New contracts cannot be made unless necessary in con- nection with realizing upon the assets ^' cJT'^^' "^^ compensation, in the way of salary or Terr' '"^^' ''"^"'^' '^ ^^^ ^^^-^^^^^ -less agreed to, m which event the following may result- I. The amount may be adjusted privately between the partners. ii. The amount may be paid by representatives of the deceased partner. iii. The amount may be charged up as part of the ''qu'dation; this is to be preferred. ■ nerZlu"^ ^T^'f'' ^^' ^"*^^^«* ^^ "- retiring part- comoTetld . fl"'/ ""''''"' ^'^""'^ '° contracts un- Z on; 1?: ''"^ ""^ ""'^^'^''^^ -^ ^ -determined i A V 4* t i' I » 74 .4Df.4A'C£;d accounting a. They may be valued as of dissolution date at market price, and the estimated profit resulting from this basis of valuation distributed. b. The books may be kept open until the contracts are completed, after which the regular realization would be in order. 5. Sharing liquidation losses. Liquidation losses, and for that matter, liquidation profits, may be allocated to the various partners : a. In the capital ratios, or b. In the profit and loss sharing ratios. This would seem to be the more correct method of the two. 6. Instalment distribution; liquidation dividends. The prin- ciple herein involved is exceedingly important in that since the liquidation of a partnership is apt to be spread over a considerable period of time, the partners may wish to re- ceive by instalments from time to time what is coming to them rather than wait until everything is finally wound up, and the liquidator must protect himself from overpaying a partner unless he wishes to be personally responsible to all who may suffer by virtue of such overpayment. Since no one knows what the ultimate net realization will be, the liquidating partner or partners must proceed as if all the assets on hand, except cash, at any distribution date, are worthless. The liquidator would calculate the share of each partner, the amount to be charged against each partner, of the assumed worthless assets and, the partners whose capital accounts still show a credit balance would be the only ones entitled to share in the instalment to be paid. The distribution of such instalment would then be made in su?h a manner that, as quickly as possible, the capital ratios will be reduced to the profit and loss sharing ratios. After the capital accounts have been reduced to the point that their ratios equal the profit and loss sharing ratios, further distributions of instalments will present no problem, being made in accord with the profit and loss sharing ratios. JOINT VENTURES AND CONTRACTS Joint Venture Defined. — A joint venture exists when two or more persons combine in contributing some capital and servicq^ PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 75 on a temporary partnership basis, to participate in some par- ticular business deal involving the buying and selling of a single article, the making and selling of some particular thing, or trad- ing in a particular lot of goods, and sharing the profits or losses resulting therefrom. A joint venture is practically a partner- ship for a specific purpose, the members being partners so far as the specific transactions of the venture are concerned. As relates to these transactions, the laws of partnership apply,— as to profits, losses, salaries, and interest adjustments. It is usual for one of the members to the venture agreement to act as- manager and handle the greater portion of the work, including the record keeping, for which perhaps he receives a small per- centage on the amounts handled to remunerate him for his time and trouble. Venture Entries.— Two basic methods exist for handling the book entries relating to a venture: 1. No separate set of records is opened. Each venturer, upon his own records, records the transactions he enters into in behalf of the venture. No joint bank account is used. Eventually, each party renders a detailed statement of all . transactions entered into by him on account of the venture. The various separate statements then would be summarized into one statement, or Joint Venture account which, when agreed to as being correct, becomes the basis for settle- ment. This Joint Venture account is a Trading account in which is indicated the profit or loss from the venture. Upon the results therein shown, each venturer will adjust his own books for his share of the outcome. The balance shown upon his books will indicate the amount due to him from the others or by him to the others. 2. A separate set of records is opened. Hereunder, a joint bank account is opened, and the records are handled in the same manner as are those of an ordinary partnership. The number of accounts to be opened depends upon desirability: a. A complete classification of accounts may be established. b. An incomplete classification of accounts may be used, as: i. A Capital or Investment account for each venturer. ii. A Joint Venture account, which is charged or cred- ited whenever a Capital account is credited or charged. 76 ADVANCED ACCOUNTING t • . ! \\ V ♦ Accounts Related to Contracts.— When a contract is to be the basis for the making of book entries, from the stanrlpoint of the contractor, two problems arise: 1. The cost accounting necessary in connection therewith. This would resolve itself, primarily, under the division of specific order cost accounting as distinguished from process cost accounting. Naturally, a complete discussion of this problem must be reserved for a course in Cost Accounting, except insofar as certain control principles are reviewed in subsequent sections of the present chapter. 2. When the completion of a contract covers more than one fiscal period, the problem arises of proportioning the profit as between periods. a. Even though each period is entitled to the profit earned therein, the difficulty of estimating the profit accrued as of any particular closing date, due to the fact that a considerable risk exists in estimating the cost of com- pletion, may make it necessary or conservative to wait until the contract is completed before the profit therein is calculated. 3. Since the delay, due to (2a) above may not be acceptable, dividends thereunder perhaps being affected seriously, it- may be necessary to estimate the profit thus far made as of a current closing date. If so, the most conservative treat- ment would be in order. The cost of completion should be estimated at a figure sufficiently high to cover all ordinary contingencies. Then upon the basics of the periodical esti- mated costs, the estimated periodical profit may be calcu- lated by a prorating process. Contracts Upon the Balance Sheet.— The profit upon con- tracts preferably is considered as an operating profit, rather than allocating the item to some other section of the Profit and Loss account. If profit is to be calculated upon uncompleted con- tracts, the Balance Sheet set out would be about as follows: Uncompleted Contracts, cost to date, $ jf Estimated Profit Earned on Above, $ | $0 Deduct — ^Amounts Received on Account, "^ $ ^ Net Equity in Uncompleted Contracts, | i PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 77 Entries Upon Contractor's Records.— In view of the fact that m the student's work up to this time nothing has been men- tioned concerning contract accounting, and, also, because the prmciples mentioned in the above sections are not all sufficient, the following simple problem, and its solution, are given below. Problem.— A contractor secures a contract for $40,000.00, which will take about two years to complete. The cost is estimated to be $30,000 00 J en per cent, is to be retained by the customer until the latter is satisfied that the work completed is not defective. The estimates, covering amounts to fall due from time to time, are: 1. First year: $12,000.00; $8,000.00-Make only one entry to cover 2. Second year: $14,000.00; $6,000.00— Make only one entry to cover Required: 1. Entries on the assumption that the contract price is entered upon the books when the contract is signed, and that the profit thereon is not booked until the contract is completed. 2. Entries, on the assumption that the contract price is entered upon the books when the contract is signed, that the profit therefrom is applied to the period in which earned, and that the books are closed when the contract is half completed. Solution.--The entries presented below are illustrative only, in that great variations are found in entry making of this kind. Usually, the first ^ntry will be to charge the customer as soon as the contract is awarded. Naturally, no real account receivable comes into being at that point but only when a contract either is completed, or when a payment is due thereon, Xnl T r*'"^"^*" '" ''''^'''^- ^^^^' '"^ *^^ fi^«* '''^^^^^' the credit otten ,s made to an mcome account which is adjusted periodicaUy as to the ^ZT''l"^!"^ rf '^ ^' '^^ '^^*^^^*- However, no income is earned r^nLZ % . "''''^''^. ^ '°''*'^'*' '^^'^^'''^' «"^^ ^""'^y' theoretically, oZ ? ■ '* '' ""'"^^ ^^' *^^ customer to hold back a portion of the contract price as a guarantee against defective work, this angle is covered 1 ^' r Z^^'^'- ^^'^ ^ ^^^^^^^ ^"^^ ^^y ^ '^d- ^t the time each lat^fv '' T r '"" ^t"^^^*^^^ ^ith the last payment due, a^uming such First Assumption Second Assumption First Year Upon Signing the Contract ^""""^/xT^^''"'"^ Contracts Secured To Un^ ^ . . *'''^ ^^«- 1) ^'000 To-Uncompleted To-Uncompleted Contracts (No. 1) 40,000 Contracts (No. 1) 40 000 78 I ADVANCED ACCOUNTING For Costs of Contract — 1/2 Assumed PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 79 Contracts in Process Contracts in Process (No. 1) 15,000 (No. 1) 15,000 To — Accounts or To — Accounts or Vouchers Payable 15,000 Vouchers Payable 1 5 , 000 Upon Rendering Estimates Accounts Receivable Accounts Receivable (Contracts) 20,000 (Contracts) 20,000 To — Advances on To — Advan<'es on Contracts 20,000 Contracts 20.000 Uncompleted Con- Uncompleted Con- tracts (No. 1) 20,000 tracts (No. 1) 20,000 To — Contracts To — Contracts Secured (No. 1) 20,000 Secured (No. 1) 20,000 Upon Payment of Estimates Cash 18,000 Cash 18,000 To — Accounts Re- To — Accounts Re- ceivable (Con- ceivable (Con- tracts) 18,000 tracts) 18,000 Amount billed less Amount billed less proportion for de- - proportion for de- fective work re- fective work re- serve serve No Entry Advances on Con- tracts 20,000 To — Profit and Loss (No. 1) 3,000 Reserve for Defec- fective Work (No. 1) 2,000 Contracts in Pro- cess (No. 1) 15,000 Second Year For Costs of Contract — 1/2 Assumed Contracts m Process (No. 1) $15,000 To — Accounts or Vouchers Payable 1 5 , 000 Contracts in Process (No. 1) $15,000 To — Accounts or VoucheiH Payable 15,000 Upon Rendering E stimates Accounts Receivable Accounts Receivable (Contracts) 20,000 (Contracts) 20,000 To — Advances on To — ^Advances on Contracts 20,000 Contracts 20,000 Uncompleted Con- tracts (No. 1) To — Contracts Se- cured (No. 1) Cash To — Accounts Re- ceivable (Con- tracts) Advances on Con- tracts To — Profit and Loss (No. 1) Reserve for De- fective Work (No. 1) Contracts in Pro- cess (No. 1) Uncompleted Con- 20,000 tracts (No. 1) To — Contracts Se- 20,000 cured (No. 1) Uf)on Payment of Estimates 20,000 20,000 18,000 Cash To — ^Accounts Re- ceivable (Con- 18,000 tracts) Advances on Con- 40,000 tracts To — Profit and Loss 6,000 (No. 1) Reserve for De- fective Work 4,000 (No. 1) Contracts in Pro- 30,000 cess (No. 1) 18,000 18,000 20,000 3,000 2,000 15,000 Upon Complete Acceptance by Customer that Work O.K. Cash 4,000 To — Accounts Re- ceivable (Con- tracts) 4,000 Reserve for Defective Work (No. 1) 4,000 To — Profit and Loss (No. 1) 4,000 Cash 4,000 To — Accounts Re- ceivable (Con- tracts) 4,000 Reserve for Defective Work (No. 1) 4,000 To — Profit and Loss (No. 1) 4,000 Entries Upon Records of Contract Customer.— The con- cern which awards a contract to a contractor may or may not book the contingent asset and liability thereunder; preferably, the booking should be made. The simplest example of the method of making such record is illustrated by the entries below given covering one portion of a recent A. I. A. problem. Problem. — The portion of the problem referred to above reads about as follows: Frame any entries necessary to record the action of the directors as it appears in the minutes of the meeting of August 15, 1917, of which the following is a synopsis, and the action of the officers taken pursuant to authority conferred on them by such minutes: The president reported that he had received tenders for. a new building planned in the amount of $185,000.00. He was authorized to execute a contract accord- ingly. ' Solution.— Aa under the date of the contract executed in accord with the above authority, the entry might be as follows: Construction Account 185,000.00 To — Contracts Payable 185 , 000 . 00 80 ADVANCED ACCOUNTING I il M ti The account above credited is assumed as not being a credit to tlie contractor, because the actual liability to him is not incurred until the contract is completed or until an estimate has been received. MANUFACTURING: ACCOUNTS AND CONTROL Purpose of Discussion.— The material presented in this section is submitted for the following purposes only: 1. To review certain definitions and simple principles of manu- facturing and general cost accounting, 2. To set out certain definitions and simple principles of manu- facturing and general cost accounting of a general nature but which, it is hoped, will cause the student both to recog- nize the existence of a great specific accounting field of study and research relative to manufacturing industries and become sufficiently interested therein to devote a year or so of his time to acquaint himself thoroughly with some of the practices therein followed. It would seem that no one rightly should call himself an "accountant" until he has familiarized himself thoroughly at least with the general principles followed in industrial accounting as well as those covered in a theoretical manner in a general course in accounting. Interest in cost accounting is growing by leaps and boundR^ reflecting the increased demand by employers for accurate and helpful costs. Each industrial establishment, having internal organization problems and external market relationships, should regard a cost system as a requisite piece of administrative ma- chinery functioning to "combine the various factors of prorluction in the most advantageous proportions and relationships and to adjust his output to the market so that there will accrue (to the enterprise) a maximum net return." Manufacturing Accounts. — In a manufacturing busine«s the accounts are grouped under three main titles: 1. Manufacturing. These show the cost of materials, labor, and factory expenses that compose : a. Manufacturing or factory cost. b. Cost of manufactured product. c. Cost of finished and unfinished product on hand. d. Cost of manufactured product sold. When cost records are kept, it is usual to charge a Selling PARTNERSHIPS, VENTURES, CONTRACTS, ETC. gl account with the cost of manufactured product sold, rather than with the total cost of manufactured product which usually is the procedure followed when no cost records are kept. In both cases however, the result is the same. ' ' 2. Selling or trading. These accounts show: a. Gross sales. b. Sales returns and allowances. c. Net sales. d. Cost of manufactured product sold. e. Gross profit on sales, f. Selling expenses. g. Net profit on sales. 3. Profit and loss or administrative. These accounts set out the general administrative expenses. The total of these deducted from the net profit on sales produces the net profit on operations. And when the expenses related to the financ- ing are deducted herefrom, there remains the net profit for the period. The selling and administrative expenses, as a rule, may be esti- mated closely m advance, some enterprises, as to these, following a budgetary system under which a specific sum of money is deter On the other hand, the manufacturing cost cannot well be deter- mmed m advance, since its elements are varied, the productVon hazards are great, and the ultimate results uncertain is ]^^'iteThl°^ '"°"''' ^°' ''^''' "° "'^"•^ '"^y •'^ «°W, usually, selling price. Therefore, the amount of money which mav h» spent for materials, for manufacture, for selling'and ad JniL, .on IS circumscribed more or less, and the amount of prtrwh ch can be realized is limited, also. Note the following: Selling Price Cost to Manufacture Selling Cost Administrative Cost mated selling and administrative cost, and a definite materi.al |, 82 ADVANCED ACCOUNTING cost, if a certain amount of profit is desired, it becomes absolutely necessary to keep the cost to manufacture within the bounds of the remaining space. The same idea as the above often is expressed in another way. The average manufacturing enterprise divides itself into three logical sections: 1. A manufacturing section. 2. A selling section. 3. An administrative section. Each section, naturally, contributes certain charges toward the ultimate cost of the product which, eventually, comes into the hands of the consumer, — the purchaser: 1. Manufacturing section. a. Material. b. Direct labor. c. Factory overhead or burden. 2. Selling section. a. Selling expenses. 3. Administrative section. a. Administrative or general expenses. Therefore, note the following: Material Direct Labor Prime Cost Manufacturing Expense Factory Cost Selling Expense Selling Cost } Total Cost General Expense On the basis, of the above diagram, the following definitions seem to be in order: 1. Direct or productive labor. Services rendered directly in processing the product through the various operations. The cost of these services can be applied or assessed directly PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 83 against a given piece of product work, or a given process in connection therewith, by merely recording the time a workman commenced operations on the job or process and when he stopped. 2. Indirect or non-productive labor. Services rendered in the general conduct of the plant,— in general activities, such as stores distribution, supervision, inspection, time-keeping, planning, repair work, and promoting the general welfare of the concern. The cost of these services cannot be applied or assessed directly against any single unit of product. 3. Material. Raw materials are materials that go directly into the product,— into a particular article, job, or process. In general, the cost of raw material is the vendor's invoice plus infreight and drayage. The quantity used is deter- mined in a number of ways: a. By recording the material actually issued from stores. b. By weighing or measuring the completed article and allowing for water. 4. Prime cost. The total expenditure for raw material and direct labor of any kind that can be allocated in a spe- cific amount to a specific article, job, or process because of havmg been used directly thereon. 5. Factory overhead or manufacturing expenses. All outlays for general services such as are indicated above in (2) for indirect labor, for taxes, insurance, depreciation of factory buildmgs and machinery, power, light, heat, sundry sup- plies, etc. The cost of this item is not exceedingly difficult to ascertain, but only close study, common sense, and in- genuity will enable an accountant to distribute this over- head among the products manufactured. These overhead Items are distributable or diffusable to product in a number of ways, at best, more or less of an estimate, tempered by training and experience. The following bases are illustra- tive: a. Cost of productive labor. This probably is the oldest method of distribution. It consists of taking the total burden for a department or for the plant for a specific period and ascertaining what percentage it is of the money paid out for labor. The resultant percentage 84 ADVANCED ACCOUNTING is added to each job according to the amount of actual labor charged to it. b. Hourly burden plan. This may be more satisfactory than the percentage on wages method in that time, and not wages, is the basis for distribution. The total burden of a department for, say, a month is divided by the number of hours worked during the month, the result being what is called an "hourly constant," this to be added to each job according to the time spent thereon. c. Machine rate. Hereunder, the factory is departmental- ized and eacli department further subdivided into what are known as production centers, each machine or work bench at which a workman is employed being considered a production center. To each center are charged all ex- penses which, upon analysis, can be allocated thereto. These charges are reduced to an hourly charge, which may be termed a "rental charge." Each job passing through a production center is charged with this rental according to the number of hours worked on it. When a machine is idle, the rental charge goes on just the same, and is charged into what is known as a "supplementary rate," which later will be charged to the different jobs according to the time spent on each, or on a percentage basis. Besides the idle time, there will be included, also, in this rate the items of superintendent's salary, fore- men's salaries, and any general items which cannot be allocated to the different specific centers. Cost Accounting Defined.— Cost accounting is that branch of accounting which furnishes an accurate record of production costs and the data upon which the management may judge the efficiency of present operations and plan future actions. Costs may be determined from the general records where only one kind of an article is produced, but not otherwise, at least so far as unit costs are concerned. Not so long ago, certain accountants made a distinction be- tween cost accounting and cost finding, the latter representing a method to determine what the cost of an article should be under present conditions in advance of manufacturing the article, as against the former term which is said to be the method of de- PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 85 termining what the cost of an article actually is while the arti- cle IS bemg manufactured. However, the opinion is ventured that such a hair-splitting distinction is not followed by the best of cost authorities; it appears to be a school-room differentia- tion. The main purposes or more important uses of a modern cost system may be set out about as follows: 1. Determination of unit costs to be used as a guide in fixini selling prices. * 2. Securement of information as to what lines are profitable and what are unprofitable. 3. Determination at any time of the value of material, goods m process, and finished or manufactured product: i ! Z mamtamance of perpetual inventories 4. By means of perpetual inventories, waste in the use of ma- tenals and product may be eliminated to the end that their use will be only as intended. 5. Preparation of frequent statements of operation and con- pS rtot r ""-^^ '' — ' ^— ^es :ri. 6. Frequent statements of operation and condition permit the ready estimate of future financial requirements ™d tt! ready determination of future policy in general ' 7. Determination of efficiency variation as to operations or ^^ttrro^ab:^^' i t-*"^ -"^p"*- ^^^^^'^ m tne cost of labor, material, and overhead expense Srrxr"""^ -' ^ -» ~™^ "»- 9. Ascertainment of causes of increase or decrease in nrn duction costs as compared to former similar oX or w th the standard cost ^n thaf A\ff.. ■ "^"^^s or with plained thoroS'y " '"'* "^^ "^ '"'- 10. Determination of profit or los^ Hn^ +^ ^^ • Cost Methods and Factory Orders T>.. f c ■ . 86 ADVANCED ACCOUNTING I Two possible methods of cost finding may be installed within any particular plant, separately or in combination: 1. Process method (product method). This method may be used within an industry or within certain departments of an industry ''where there is mass production, either con- tinuous or intermittent, or both, the product rc^quiring similar operations, though perhaps varying in size, shape, appearance, and so on; or where the goods for specific factory orders are not easily distinguishable, or where they become part of a volume of output." (Walton: Cost Course). If the cost of a specific order is required, costs are distributed thereto on a quantity basis. 2. Specific order method (job or special order method). This method may be used in an industry where a special type of product is manufactured, or where standard articles are fabricated for stock. The dissimilar ord(»rs going through the plant, each calling for a special kind of ma- terial and special methods of processing, resulting in a variation in types of output, make the process method of cost finding impossible. Costs are collected for each specific order, as to material, and labor, and the overhead is distributed to each order upon some reasonable basis. Hereunder, factory orders must be issued for "the manu- facture or assembling of special articles, or the produc- tion of standard articles for stock." (Walton: Cost Course.) Under the second method, and usually under the first one, no work is begun until a factory order has been issued. These orders are of three kinds: 1. Production orders. These orders represent the authority under which the factory may commence the fabrication of the product therein called for. Again, sub-production orders may be issued, based upon production orders, in order to: a. Ascertain costs by departments, by operations, or both. b. Keep the cost of special patterns or tools needed on an order separate from the cost of the product. c. Give the departments information as to work coming through from other departments, or as authority to do work. PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 87 Again, partial production orders may be issued, based upon production orders, to fabricate a part of what the production order calls for where the quantity thereon speci- fied is greater than can be handled at one time. Cost sheets, upon which are accumulated the labor, material, and overhead expense costs, are used in connection with each of the above orders. 2. Betterment orders. When the factory itself is to do the work in connection with additions, and improvements to buildings, machinery, and equipment, betterment orders are issued and, in connection therewith, the charges for mate- rial, labor, and overhead are recorded in a manner similar to that used in connection with production orders. Cost sheets, also, may be used with betterment orders. 3. Maintenance orders. These orders account for all the manu- facturing expenses incurred in production. They are of two kinds: a. Standing. These cover the account classification of manufacturing expense or overhead. They are issued from time to time as a change is made in such classifica- tion, and "stand" during each such interim. b. Special. These cover special repair work whose cost is estimated to exceed a certain fixed sum, as $10.00. Methods of Control.— Two methods exist for keeping the accounts of a manufacturing concern, as between the general oflSce and the cost department: 1. The accounts related to the factory activities are carried on the General Ledger; the cost department is considered as a department. These factory activity accounts are of two classes: a. Controlling accounts. i. Stores, ii. Factory cost, iii. Cost of manufactured product. b. Statistical accounts. i. Payroll. ii. Manufacturing expense, iii. Manufacturing expense distributed, iv. Cost of manufactured product sold. 88 ADVANCED ACCOUNTING 2. The accounts related to the factory activities are carried on a Factory Ledger; the cost department is considered aa a separate company or branch. As concerns the factory: a. General Ledger. Only one account is carried thereon, a controlling account, that of Factory Ledger. All stores purchased, expenses incurred, and payroll money would be charged on the General Ledger to Factory Ledger. b. Factory Ledger. This would be a regular Ledger kept in the cost department, and the factory accounts thereon would be: i. Controlling accounts. 1. Stores. 2. Factory orders. a. Production. b. Betterment. c. Maintenance. 3. Cost of manufactured product. 4. Cost of manufactured product sold, ii. Statistical accounts. 1. Payroll. 2. Manufacturing expense. 3. Manufacturing expense distributed. Control Entries. — Pro forma entries illustrative of the pro- cedure indicated above in the last section would be about as shown below. Further, these entries have been grouped into four divisions or sections: 1. Material. 2. Labor. 3. Manufacturing expenses. 4. Production and sales. PARTNERSHIPS, VENTURES, CONTRACTS, ETC. 89 ■♦J a, S .2 ^ &< o G oj = fe fl i e If U 6 oH 2; C « 3 o C3 C -a ^ r c a I o a o ;z: eS s c 09 3 0) C b o r* &4 « 2 y c c 2" « OB XT b c o 9 O c 3 O S <3 09 03 I. u •a 0* 2 OS »4 2^ o 1^ c s >. 03 •2 I G -♦3 £ (^ 09 V U c > en o la O >> U ,? U^ ? i 1 H kl a Ho ■o A* c b^ oH a hi SaSo •2 a> 2i? O B 4) o-g 3 £5 I osH Ho B H If M 6 I H 5 e o Hi t H b:l el oH 2 £ "Hb if li 1^ « 1 '2 o 3 o(S -*A (x< O If o •q - u to OS H fl H fl H fl H •^ .&!? fcl Ji c W 6 1 H d 1^ oH oH 2: -** a H ** I H I a H Is |2 0*03 or =y -so o s x> 03 00 al W Oi > S cS Qj jyj kS 3 ■♦J 0; "0,2 K oH 15 S oo 08 ** a 3 £ o 3 O •^ o « o QQ -** o 3 •? (£ "O b 3 ■•-> c CS «^^ 3 fl 08 ^i -si O 00 ID OCQ (i4 B ' 3 C i 00 fl «' fl 00 S3 ♦* Z. fl £ o 3 U ^ u 7? O 8. OH 1 3 B 1-5 o u O •♦* « X O (g 3 g is Hfl 3 «« 3 O o ♦- O fc, SHA. £ o fl W o 1^ « 3 ^ o ♦^ bA. « 08 CO 9 o B fl H o fi b b "** -^ ■S H fl H fl H ^ b^! fcl «i fl| Wo i H 6 oH oH oH :z: 1? ;2; CORPORATIONS— OPENING ENTRIES 93 t CHAPTER IV CORPORATIONS: DEFINITIONS; OPENING ENTRIES Introduction. — Three general forms under which business activities are conducted have been pointed out in the accounting work thus far covered: 1. Sole proprietorship. A business conducted by an individual on his own account and for his own benefit. The general accounting principles hereunder are those usually studied in the work of the first year. 2. Partnership. A business owned by two or more individuals, and conducted on a cooperative basis for mutual benefit, the partners having a share both in its management and in its profits. The general accounting principles hereunder differ in no way from those applicable to a sole proprietor- ship, except as to the following. a. Opening entries. b. Profit sharing and distribution. c. Dissolution and liquidation. 3. Corporation. A business conducted for the benefit of thf stockholders through a board of directors, their elected representatives. The corporation owns the business and the stockholders own the corporation. Although the gen- eral principles of operative accounting practically are the same in a corporation as in a partnership and sole proprietorship, there are many principles which are pecu- liarly corporate. The greater portion of the remainder of this volume is devoted to a consideration of the principles and allied procedures peculiarly corporate in character. In connection with corporate problems, it is difficult ofttimes to distinguish clearly between law, finance, and accounting, since all three subjects overlap to an appreciable extent. Therefore, at times, reference must be made in the subsequent discussions 92 to one or both of the subjects mentioned other than account- ing. The law will be referred to frequently, both in general and as set out specifically in the New York statutes. The latter are especially representative of states considered as having the most intelligent corporate laws. In this connection, the cita- tions thereto will be abbreviated as follows : 1. General Corporation Law — G. C. L. 2. Business Corporations Law — B. C. L. 3. Stock Corporation Law — S. C. L. The subject of corporations has attracted considerable public notice during recent years, in part, because the corporate form of organization, for reasons to be noted later in detail related to permanency of organization and limited liability attaching to persons therein interested as stockholders, has simplified the complexity of modern business demands, and has made pos- sible the carrying out of many great achievements. Under cer- tain conditions, though its privileges at times have been most shamefully abused, the corporation is the "only safe, rational and efficacious means of uniting capital for the promotion of any business enterprise." Corporation Defined.— Although various definitions of a cor- poration are to be found, the only difference between them ap- pears to be in their viewpoint. The following are well-known and illustrative: 1. ''An artificial being, invisible, intangible, and existing only in contemplation of law." (4 Wharton 636.) 2. "An artificial person created for preserving in perpetual succession certain rights, which being conferred on natural persons only, would fail in the process of time." (Black- stone.) 3. "A corporation is a person which exists in contemplation of law only and not physically. It is a collection of many mdividuals united in one body under a special denomina- tion, having perpetual succession, under an artificial form, and vested by the policy of the law with the capacity of actmg in several respects as an individual, particularly of takmg and granting property, of contracting obligations and of suing and being sued, of enjoying privileges and immunities m common and of exercising a variety of politi- #1 94 ADVANCED ACCOUNTING cal rights, more or less extensive, according to the design of its institution, or the powers conferred upon it at the time of its existence." (1 Kyd 13.) 4. "A body created by law, composed of individuals united under a common name, the members of which succeed each other, so that the body continues the same, notwithstand- ing the individuals who compose it, and is, for certain purposes, considered as a natural person." (Angel and Ames on Corporations.) Numerous other definitions could be cited, if space permitted (23 Wend. 103; 57 U. S. 314; etc.), and tlie greater part of the differences of opinion and consequent discussion thereon could be harmonized satisfactorily. It is axiomatic that all powers spring primarily from the Sovereign, or the People. The People select their representatives, — the legislature. To this body is given the power to create corporations and endow them with powers, rights, privileges and immunities; subject, however, to such duties, obligations and conditions as the legislature may deem proper. These powers, rights, privileges and immunities must be within the Constitution and the law. State and Federal. It is right at this point, — relative to this power and capacity to create out of certain persons and their successors an "artificial person," a "legal entity," and giving it a name, make it a resi- dent of the State, with power to buy and sell and to exercise the other powers, rights, privileges and immunities, belonging to natural persons, — ^that the stumbling block exists for many who have discussed the subject. At its inception, the corporation is composed both of the living, existing individuals described in its charter, and their successors, whoever the latter may be. These successors are a part of the. corporation even though their identity cannot be disclosed ex- cept through the efflux of time. Succession is one of the most vital elements of a corporation. Shares of stock, being con- vertible, pass readily from owner to owner. A few weeks may be sufficient for the original incorporators to pass from the scene and be replaced by the unknown successors. Th(?refore, with reason, it is impossible to say that the corporation and its members (stockholders) are one. Because of this, the; long- established and well-authenticated definitions of a corporation CORPORATIONS^OPENING ENTRIES 95 still remain regardless of all the attempts made to erase the "legal fiction." However, it should be remembered that a corporation is an artificial being, a legal entity, entirely separate and distinct and apart from those who own and hold its capital stock just so long and so far as justice and equity deem it necessary so to be considered. When it appears clearly that this entity with all its powers, rights, privileges, and immunities tends toward some wrongful end, immediately, in equity, the corpora- tion becomes merely an association of individuals whose wrong- doing the Courts will remedy or restrain. (Spelling: Private Corporations, vol. 11, sec. 541.) Corporation Distinguished From Partnership. — Note the following comment on the difference between a partnership and a corporation (Angel and Ames on Corporations) : "The difference between a company established for private hazard and profit by an act or charter of incorporation and an ordinary co- partnership is obvious and striking. The latter is simply a voluntary contract, and the result of such a contract, whereby two or more per- sons agree to combine their property or labor, or both, for the purpose of a common undertaking and the acquisition of a common profit; and the gain or loss is to be proportionately shared between them. But this definition greatly falls short of a company established as a body corporate, which, though originating in a voluntary contract, is the result not only of that, but of its confirmation by special legislative authority. This confirmation is indispensable to enable the parties to the compact to sue and be sued, as a company, by a general name, to act by a common seal and to transmit their property in succession. One, if not the principal and main inducement, in procuring an act of incorporation is to limit the risk of the partners and to render definite the extent of their hazard; for it is a perfectly well-settled rule of law that each member of a common partnership, whether active, nominal or dormant, is the accredited agent of the others, and, as such, has au- thority to bind them, to the extent of their private property, by any simple contract he may make, either respecting the goods or business of the concern, or by negotiable instruments in its behalf to any person dealing bona fide. This personal responsibility of a stockholder is inconsistent with a perfect body corporate; and therefore, where an execution issued against a corporation by the name of * President, Directors and Company,' with special instruction to the officer to take 96 ADVANCED ACCOUNTING their bodies for want of estate, no authority was communicated to him thus to do. And the stockholders of a corporation do not become* liable as partners, on notes given by the treasurer of the corporation, merely because, after organizing under the act of incorporation, no corporate business is transacted or because the notes were given for debts l)eyond the corporate authority of the company." One must not forget, as indicated above already, that since a corporation exists as a legal fiction, independently of its mem- bers, it must derive its character from the persons who direct it. These latter, because of the fact that the nature of the corporation makes it a mere legal abstraction, must be the ones to suffer should they be guilty of misconduct under the law, and of committing in its name, what are known in law as "ultra vires acts." Corporation Distinguished From Joint Stock Company. — A joint stock company is composed of numerous partners, the ownership in the enterprise being evidenced by shares as in the case of a corporation. It has the following characteristics in common with corporations: 1. Any member may transfer his ownership interest therein without or with the consent of the other partners. 2. A board of directors controls the body so that no member, as such has agency powers to act for the company. On the other hand, it differs from a corporation in that: 1. The members are liable for the debts jointly and severally. 2. A joint stock company sues and defends in the name of an ofiicer; a corporation sues and defends in its own name. The creation of a corporation merges m the artificial body and draws in the individual rights and liabilities of the mem- bers, while the organization of a joint stock company leaves the individual rights and liabilities unimpaired and in full force. (See 7 Hill 312; 2 Denio 380). Joint stock companies, as a means of combination, have become antiquated and fallen into deserved disuse. No longer can they ])e said to exist outside of the statute; therefore, in America, they are almost obso- lete. Joint stock companies are common in England; and if the members' liability therein is limited, the name of the con- cern will have at the end of the term ''Ltd.," which means "limited." CORPORATIONS— OPENING ENTRIES 97 Advantages of the Corporate Form of Organization. — Corporate activities are subject, more or less, to certain legal and customal restrictions supposed to benefit both the corporate stockholders and outsiders having business dealings with the corporation. The sole trader, in his independent search for wealth, may do about as he pleases toward the accomplishment of this purpose so long as he does not interfere with public policy or with the rights of others. Under certain conditions, his business must be registered, and he must obey the local police regulations at all times. Partnership activities, likewise, are subject more or less to certain restrictions, both legal and customal, whose purpose is supposed to benefit both the partners and outside persons who are brought into busi- ness contact with these partners. Since the present volume is devoted primarily to corporations, the merits and disadvantages of either of the above two forms of business organization are of no present interest except by way of comparison with those of the corporate form of organization. The principal advantages gained from incorporating a busi- ness may be set out as follows: 1. Ability to secure greater capital. The corporate form of organization provides for increased capital by the sale of shares to outside investors. The small investor may invest small amounts with advantage, and the capitalist may spread his investments over a number of enterprises, each without being required to devote any time whatsoever to management problems, or without being required to as- sume the indefinite risk attached to either one of the other two forms of organization. 2. Limited liability. A stockholder's liability, in general, is limited to the amount of his stock. Even in the case of a bank, where this liability is for double the amount of stock held, such liability, nevertheless, is limited. The liability of a sole trader or partner may place his entire fortune in jeopardy. 3. Permanent organization. A corporation continues its exist- ence regardless of any change in the stockholders' personnel ; it exists for the period of time specified in the charter, unless sooner dissolved by vote of the stockholders or by 98 ADVANCED ACCOUNTING CORPORATIONS—OPENING ENTRIES 99 action of the state from which the charter was received. A sole trader or partnership organization is dissolved by the death, insolvency, insanity, or withdrawal of a member. 4. Transferability of interest. A corporate stockholder is free to dispose of his share holdings as he may see fit, as by sale or will, without the consent of the others, except in the case of a pooling agreement. Again, a stockholder can j)ledge his holdings as security for loans without prejudice to the business. A partner cannot dispose of his firm int(;rest except with the consent of the other partners, or by wind- ing up the business; neither can he pledge his partnership interest as security. 5. Improved organization efficiency. In a corporation, no stockholder, as such, may transact corporate business with outsiders. A corporation is managed by a board of direc- tors who periodically, in meeting assembled, outline the general business policy and who, between these periodical meetings, delegate the actual conduct of the business to certain officers who are given definite powers, and whose actions are subject to criticism by the entire body of stock- holders when the latter come together at their annual meeting. Dispute and dissension are common in partner- ship enterprises and difficult to eliminate, since it is not easy for two or more partners to oust another who seems unsatisfactory to them. In a corporation, it is an easy matter, relatively speaking, as compared with a partnership, for the directors or stockholders to drop an ofiicer wliose conduct is unsatisfactory. 6. Improved borrowing facilities. Frequently, a corporation, when it needs additional capital, may raise the money readily by marketing an issue of preferred stock with a preferred dividend feature making it an attractive invest- ment, or by floating an issue of bonds, by going to its own stockholders as a source of supply. Tlie stockholders who invest get the same security as an outsider and are placed in the same preferred position, in this particular, as any outside investor. If a sole trader advances money to his business beyond his original investment, his position is no more preferred thereafter than before ; being the proprietor, everything he has is at stake to satisfy the demands of creditors. If a partner advances money to his partnership, his position, likewise, is not the same as that of outside creditors, since the latter must be satisfied entirely before he has a right to the return of anything. Disadvantages of the Corporate Form of Organization.— Some of the disadvantages of the corporate form are: 1. Restriction of power. A corporation is restricted to the kind of business for which it was incorporated. The cor- porate charter (the contract entered into between the state and the incorporators) defines and limits the scope of cor- porate power. If a change in this particular is desired, the consent of the state, under whose laws the corporation was formed, must be secured. A partnership can conduct any legal business, and may change from one business to an- other without consulting the state officials. Because of this restriction as to the character of the business that may be carried on, corporations more and more are being formed With broad charter powers so as to avoid the necessity of securing frequent subsequent consent on the part of the state. 2. Limitation of credit. A new corporation may find it difficult to secure the credit necessary with which to carry on its activities. Creditors may be willing to grant credit to a firm or to individuals with their unlimited liability, but they may be reluctant to exlend the same credit to a new corporation whose liability is limited, as to its members, to the investment made therein by them. This reluctance may be so great that credit will not be granted unless the cor- porate ofiicers, as individuals, endorse the company's notes. 3. Restriction in freedom of action. If prompt action is neces- sary in a corporation to meet a contingency tliat has arisen suddenly, this will be more or less impossible where a formal meeting of the board of directors is necessary, since such meeting cannot be held without first giving due notice to each member. On the other hand, prompt action by a majority of a firm's partners may be secured readily. 4. Governmental supervision. State and federal governments, through their various boards, may exercise a control over 100 ADVANCED ACCOUNTING business corporations that is decidedly annoying, if not burdensome. 5. Inability to hold stock in other corporations. Some states prohibit one corporation from holding stock in another. 6. Majority control. One of the greatest disadvantages of a corporation is that the majority, in general, control and conduct affairs after their own ideas; on the other hand, in a partnership the majority and minority interests are pro- tected alike. However, this disadvantage may be avoided by giving the minority stockholders, at the time the com- pany is formed: a. Half the voting stock. b. The right to elect half the directors. c. The right to cumulative voting. By this means, a stock- holder has one vote for each share of stock held for each director to be elected. By this means, the minority, through pooling their votes, may secure representatives upon the board. Classification of Corporations.— The General Corporation Law of New York, which is practically the same as the statutes in many other states, specifies that a corporation shall be either: 1. A municipal corporation. 2. A stock corporation. a. A moneyed corporation. b. A railroad or other transportation corporation. 3. A non-stock corporation. a. A religious corporation. b. A membership corporation. c. Any corporation other than a stock corporation (Arti- cle 1). The above classification would seem to be complete if a fourtli grouping were added: 4. Mixed corporations. a. Cemetery corporation. b. Library corporation. c. Board-of-trade corporation. d. Agricultural and horticultural corporation. A municipal corporation includes a county, a town, a school district, a village, a city, and any other territorial state division CORPORATIONS— OPENING ENTRIES 101 which is established by law, and which exercises powers of local government. A municipal corporation is a public corporation. A stock corporation is one with its capital stock divided into shares and which, by law, may distribute dividends from its surplus profits to the holders of its shares. A corporation is not a stock corporation merely because it issues certificates which represent membership only. A moneyed corporation is one formed under or subject to the banking or insurance acts. A non-stock corporation is one whose purpose is charitable, re- ligious, educational, etc. In fact, the term includes every corpo- ration other than a stock corporation, even though the above classification would not seem to indicate such fact. Variations as to the classification of corporations would appear, in summary form, about as follows: 1. As to purpose. a. Those organized for profit. b. Those not organized for profit. 2. As to ownership. a. Public or governmental. b. Private. i. Stock companies ; those operated for profit. a. Sole— All stock held by one person, or perhaps all but a few shares held by one person. b. Close— All stock held by but few persons, and not generally traded in. c. Open— Stock freely purchased and sold. ii. Non-stock companies ; those not operated for profit. 3. As to fact of incorporation. a. De jure— Those legally incorporated. b. De facto— Those which have not met fully all the legal requirements, but which to all intents and purposes are corporations in fact. 4. As to sovereignty. a. Domestic— Those organized under the laws of the state in which they do business. b. Foreign— Those organized under the laws of a state other than that in which they do business. The corporate discussion of the present volume is concerned with private corporations organized for profit. 102 ADVANCED ACCOUNTING Incorporation Procedure. — It may be stated, in general, that the laws of the various states governing the incorporation of a company require that three or more persons must prepare the application to be filed with the Secretary of State, and that this application, after publication in an approved manner, after ap- proval by the proper officials, and after payment of the requinite fees, becomes the certificate of incorporation or the charter of the corporate body. Following this, or concurrent therewith, the stockholders complete the other necessary organization details, such as adopting the by-laws, electing the directors, and doing whatever else appears necessary to place the business at a point where it may commence to conduct its operations, after wliich operations as a corporation begin. In New York, "a certificate of incorporation must be executed by natural persons, who must be of full age, and at least two- thirds of them must be citizens of the United States and one of them a resident of this state." The above rule, however, does "not apply to a corporation formed by the reincorporation or consolidation of existing corporations, or to the reorganization of a corporation upon the sale of the property and franchises of a previously existing corporation or otherwise." (G. C. L., Art. 2, Sec. 4.) Stockholders. — The owners of a corporation are titled "stoc^k- holders." They correspond to the partners in a partnersliip. Stockholders, except as ofiicers or directors, take no active part in the corporate operations; in a partnershij), all the partners may do so, and some of them must do so. Corporate ownership is evidenced by "shares of stock," each share representing a sj)eci- fied equal part of the total corporate property capable of being owned. At common law, the stockholders have the right to make the code of rules under which the corporation is governed in con- junction with its charter and the statutes. These rules are known as "by-laws." The stockholders have a right to elect a board of directors, who are responsible to them for the manner in which the corporation is operated. In some cases, where the statutes or charter permit, or where the stockholders by lawful action give their consent, the board of directors may make the by-laws, or change them as desired. CORPORATIONS— OPENING ENTRIES 103 The Corporate Charter. — Before discussing in any way the corporate charter, it may not be amiss first to define three terms used in connection therewith: 1. Charter. An instrument by which, in the United States, the sovereign people, through the legislature as their represen- tative agents, by special grant and enactment, create bodies corporate and clothe them with miscellaneous and sundry rights, powers, privileges and immunities. 2. Franchise. A franchise is not a charter, although often spoken of as such; again, it is often used to denote the corporation itself. In reality, it is the right or privilege which is conveyed and bestowed upon the corporation by the charter. 3. Certificate of incorporation. This is a term in use since the enactment of general incorporation laws. However, it seems to be a misnomer. In the early days, all corporations were created by special enactment of the legislature and a charter in due and regular form was taken to be an absolute neces- sity prerequisite to corporate life and existence. In other w^ords, formerly all corporate existence, in the absence of general laws, was based upon the possession of a charter, and a special petition to the legislature and the latter's aflSrmative act were required in every case wherein a cor- poration was to be created. Since favoritism often crept in in the granting of these charters, the People, with well- advised insistence, began to demand that in regard to this matter of corporate creation, and in the granting of cor- porate rights, etc., there should be absolute equality to all and favoritism to none, and that citizens might, in the matter of corporate creation and endowment, obtain as an absolute right that which theretofore could be had only by petition to the legislature. This demand plus the existing need of securing the benefits which accrue to business and commerce from the aggregation of capital and the fore- stallation of death, advantages to be had only through the mstrumentality of private business corporations, compelled the various states to enact general incorporation laws. Sub- stantially, all these laws have the same features. There- fore, notwithstanding technicalities and numerous defini- 104 ADVANCED ACCOUNTING CORPORATIONS— OPENING ENTRIES 105 tions, the instrument which is either an evidence of the performance of all the formalities required by the incorpora- tion law, or a declaration of the intent and purpose of the incorporators to avail themselves of the benefits of the act, — whether it be a certificate or a declaration, or both, — is, when read and construed in connection with the law, prac- tically the same thing as a charter, because it is the legally provided substitute therefor. The charter of a corporation, whatever its name and however conferred, is a contract by and between the sovereign creating power as the party of the first part and the aggregation of persons forming the corporation and their successors, the party of the second part: Under which the creating party, the state, grants to the other party, the incorporators, within the limita- tions and restrictions of law, certain rights, powers, privileges and immunities; this contractual element extends beyond the creating power and the corporation, and exists not only between the corporation and its members, but between the corporation and the public (a sort of tripartite agreement), comprehending not only the persons named originally, but all those who may, shall, or will succeed them. Since the charter is a contract, it cannot be rescinded by the act of one party without the consent of the other. A grant of corporate privileges for a specified period cannot be resumed by the state within such period. If the charter be without limitation as to time, it is forever irrepealable. However, when the cor- porate privileges have been abused, the courts may pronounce them forfeited. In some cases, the legislature, when granting the franchises, reserves to itself the right to revoke them; if the charter contains such a stipulation, the latter is as much a part of the contract as anything else that is in it. The power to repeal sometimes is reserved absolutely, so that the franchises of the corporation may be revoked whenever the legislature may think proper. Again, the power of repeal may be reserved con- ditionally, to be exercised only in case a certain event shall happen; when such event does happen, the cliarter is repealable, whether the event be one the corporators could not control or one that could not occur without some default of their own. Capital Versus Capital Stock.— The capital stock of a cor- poration is the amount for which the company is incorporated under the law,— the amount of stock it is authorized to issue. The charter specifies how much capital stock may be issued, and this cannot be changed except by charter amendment. The total capital stock as fixed by the incorporators, usually, may be any amount desired, so long as it equals the minimum prescribed by law as the smallest amount with which a corporation may begin business. Statutory requirements governing the issuance of capi- tal stock vary from state to state. In New York, the amount of capital stock shall be "not less than five hundred dollars " (B. C. L., Art. 2.) The determination of the amount of stock which a corporation is to be authorized by law to issue depends upon a number of factors : 1. The amount needed to develop the proposition. 2. The cash value of property to be taken over. 3. The probable earning power of the new enterprise. 4. The actual earning power of the old business from which the new corporation is an outgrowth. 5. Combinations of (1-4), above. When one speaks of corporate capital as against capital stock, he should keep in mind the elementary distinction between eco- nomic and accounting capital: 1. Economic capital represents the whole fund of assets em- ployed regardless of whether or not it has been contributed by the proprietors of the enterprise or by others. Account- ing capital represents only the difference between the total asset values recorded and the third-party liabilities which eventually must be paid therefrom; it represents proprie- torship. 2. The capital of a corporation relates to the difference between the assets into which the capital contributions have been converted and the third-party liabilities resulting from the activities of the corporate personality. It is seen, therefore, that its amount would be determined in a manner similar to that followed in determining the accounting capital of a sole trader or partnership. On the other hand, capital stock 106 ADVANCED ACCOUNTING I represents the actual liability of the corporate personality to the shareholders for the capital they either have paid in or subscribed for, which must be paid in eventually plus whatever difference remains as between the above two amounts and the authorized capitalization according to the charter; the accounting capital less retained profits or i)lus deficit, where the total authorized capitalization is out- standing, should represent the amount of the capital stock. Practically every corporation organized for profit can be classed as a stock corporation. This means that the original capital assumed as necessary for financing the business is raised principally by selling shares of stock. A corporation's capital stock is divided into a number of equal units, each unit being called a "share"; a share of stock, therefore, represents a pro- portionate interest in the net worth of a corporation. Each one of these shares may or may not have a specified value; if the value is specified, such value is known as its "par value," whereas, if no value is specified, the stock is said to have *'no par value." The discussion of stock with no par value is reserved for a later chapter. Each one of these shares may have a face (par) value of almost any amount, depending upon the laws under wliich the corporation is organized. Whatever amount the par value may be, this must be uniform for all the shares within a given class. Usually, the par value is $100.00, although frequently one encounters a par value of $10.00, or less ; in industrial and mercantile companies the par value usually is $100.00, whereas, mining companies frequently have a capital stock of the par vtvlue of $1.00. In New York, each share "shall not be less than five nor more than one hundred dollars." (B. C. L., Art. 2.) Unless some excellent reason exists for so doing, it is advisable to have a par value of $100.00, since this is a most common and convenient unit to use. At any rate, the par value of any issue of stock is the amount specified in the stock certificate. Capital Stock Values. — It may be said that each share of stock has four values: 1. Par or nominal value. This is the face value printed some- where upon the face of each stock certificate. The par value of one share of stock is equal to the total authorized issue divided by the number of* authorized shares. In addi- CORPORATION^-OPENING ENTRIES 107 tion to a corporation having shares of stock with a specified par value, certain states, as New York, permit stock to be issued without a definite par value, under certain conditions to be explained later. 2. Book value. The book value of a share of stock is repre- sented by the remainder resulting from dividing the net worth of a corporation (capital stock plus surplus, or minus deficit) by the number of shares of stock actually issued and outstanding. When a corporation is organized, it is authorized to issue a limited number of shares of a stated value, but it is not required to issue all such shares beyond the legal minimum except in accord with the desires of the corporate officers or stockholders. Book value, supposedly, should be ascertainable from the Balance Sheet. 3. Market value. The market value of a share of stock is the price it will yield when sold upon the open market. This value depends primarily upon earning capacity. 4. Real value. The real value of a share of stock is the amount which its holder would expect to receive if the corporation were liquidated. The real value of a share of stock is ascer- tained from what is known as a Statement of Affairs (to be discussed in a later chapter) , a statement in which the assets are valued at what they may be expected to realize, regardless of book values. Primary Classes and Kinds of Capital Stock With Par Value : Common Versus Preferred.— The capital stock of cor- porations may be divided into a number of classes, the usual division being into two classes as follows: 1. Common stock. This is evidence of ordinary ownership in a corporation. It has no financial preference or special privileges over any other stock of the company and, gen- erally, the common stockholders are those which have the voting power. By voting power is meant the right the stockholders have in assisting in the management of the company's affairs by means of annually electing the board of directors, the latter representing, and acting for, the general body of stockholders in the conduct of the enter- prise. .,[/! 108 ADVANCED ACCOUNTING I I. 11 2. Preferred stock. This stock is entitled to first consideration in either the distribution of profits or assets, or both, over other stock of the company. As compared to common stock, it has been given, by proper procedure, a special privilege of some kind to make it more attractive than the common stock as an investment. Unless expressly provided, pre- ferred stock has no preference in the return of capital upon liquidation. Ordinarily, the preference consists in an agree- ment to pay a definite dividend out of profits before any dividend will be paid upon the common stock. The classes of preferred stock may be listed about as under: a. Cumulative as to dividends. Preferred stock designates a certain minimum rate of dividend, but if the net profits of the company are not suflScient to pay the dividend, the preferred stockholders are no better off than the common stockholders. However, when the stock is designated as cumulative, each unpaid dividend laps over into the next period to the end that it must be satisfied from the profits of succeeding periods before the owners of the common stock may share in the profits at all. b. Non-cumulative as to dividends. Preferred stock, as a rule, is cumulative but infrequently it may not be so. Hereunder, the preferred stockholders will not receive a dividend for the current period unless the net profits are sufiicient to pay the rate of dividend specified — may be considered as non-participating stock. c. Entitle holders to voting power. d. Not entitle holders to voting power — non-voting stock. e. Redeemable at a certain price on or before a date speci- fied—redeemable stock. Redemption is not possible if, by such action, creditors' interests are jeopardized. Convertible into some other form of corporate ownership, or obligation. All states do not permit a conversion into bonds of the company. In other words, a great variation exists in the kinds of preferred stock that may be issued. Because of such fact, it is advisable to make certain that each preferred stock certificate has its character indicated upon its face. The lack of such information may prove disastrous to all persons f. CORPORATIONS-OPENING ENTRIES 109 concerned; courts have held that where such information is lacking, at least to the extent of reference being made therein to the clauses in the charter authorizing the issue, the preferred stock will be preferred as to profits, but not be preferred as to anything else. Preferred stock may be issued at the time of the organization of the company and, when so done, the common stockholders do not need to authorize its issue. However, if it be issued subse- quent to the organization of the company, after the rights of the common stockholders have been established, the latter must authorize its issue. The following is the New York law relative to issuing pre- ferred and common stock (S. C. L., Art. 4) : Every domestic stock corporation may issue preferred stock and common stock and diflFerent classes of preferred stock, if the certificate of incorporation so provides, or 1. By the unanimous consent of the stockholders expressed m writing and filed in the office of the secretary of state and in the office of the clerk of the county in which the principal business oflice is located, or 2. By the consent of the holders of record of two-thirds of the capital stock, given at a meeting called for that purpose upon notice such a« IS requu-ed for the annual meeting of the corporation. A cer- tificate of the proceedings of such meeting, . shall be filed and recorded in the oflices where the original certificate of incorporation of such corporation was filed and recorded. Preferred stock, usually, is issued to provide a corporate secu- rity which is more readily salable than common stock But because of its numerous possible variations, preferred stock is available for other purposes: 1. It may represent or be used to pay for the actual value of the properties taken over by a new company, whereas, the common stock may be used to represent good-will and other mtangible properties. 2. In the incorporation of an existing partnership, non-voting preferred stock may be issued to cover the excess investment of one of the partners, and to take care of the interest of a silent partner. 3. In a consolidation of properties, preferred stock may be used m adjusting the interests of all parties equitably. It is ■A. f^ I ,1 i i 110 ADVANCED ACCOUNTING believed, however, that (1) above is to bo preferred to (3) in every way. 4. It may be used as a means of raising money rather than doing so by an issue of bonds. Not only are bonds an absolute obligation both as to interest and principal, but they must be paid upon maturity without regard to the then existing condition of finances, under penalty of foreclosure; preferred stock, at least, is only a claim against profits, being neither a debt as to dividends nor a debt as to prm- cipal. If the stock is not redeemable, it is never due as to principal Sundry Classes and Kinds of Capital Stock With Par Value. — There are many classes of stock other than the two usual kinds mentioned above. These are described briefly as follows: 1. Guaranteed stock. This stock, usually, is issued under a guaranty by some person, concern, or corporation, that a specific dividend will be paid thereon. Since dividends cnn be declared only out of profits, a company cannot guarantee its own stock except upon the condition that profits have been earned sufficient for that purpose. However, one com- pany may guarantee, under contract, a certain dividend to the holders of the stock of another company, say, a smaller one. Such a guaranty is not contingent upon the earning of profits, but is a lien against the giiarantor company regardless of what the amount of the earning of the latter company may be; it is an actual obligation to be met wlien due, exactly as any other interest or obligation. Sometimes the term is used in connection with preferred stock on which dividends are guaranteed by the action which created the issue. Such guaranteed preferred stock merely is cumula- tive preferred stock; since a dividend must be paid from profits, no debt is created if profits are not sufficient to cover such dividend. The unpaid dividends cumulate as a charge against future profits. Again, the guarantee may cover the principal, or both dividend and principal. 2. Founders' stock. This is an English type of stock issue, not found in the United States. This stock has a dividend CORPORATIONS— OPENING ENTRIES 111 preference which may cause its market value to rise con- siderably beyond that of other stock. It consists of a cer- tain small portion of the common stock which has been set aside for the founders or promoters of the company and labeled ''founders' stock," rather than being an issue of preferred stock with a dividend preference. The dividends upon this, small portion of set-aside common stock are greater than the ratio their amount bears to the whole regular stock issue. 3. Debenture stock. This is a term applied in England to a class of liabilities and not to anything signifying net worth or proprietorship. It represents "an unsecured loan issued in irregular amounts." Debenture stock is in the nature of bonds, and rightly might be called "debenture bonds" were the issues made in regular, instead of in irregular, amounts. The Public Service Commission of New York defines deben- ture stock as "those issued under contract to pay absolutely thereon at specified intervals a specified return." Deben- ture stock is not much made use of in the United States, although common in Canada. If found, it should be classed as a liability. 4. Watered stock. This has a higher nominal value than the properties for which it has been issued. If $50,000, par value, of stock is issued for assets which only have a market value of $40,000, the stock contains $10,000 of "water." Since the accounting records must show the par value of the stock issued, it is necessary to keep the basic accounting equation in balance, to offset the credit of $50,000 to the Capital Stock account by a debit of an equal amount to certain other accounts. Usually, these other accounts are those kept with the properties taken over, the values of the latter being therein recorded at an inflated amount of $10,000. The issue of this stock may be entirely justifiable and, again, its issuance rightly may be condemned. In the above case, if a going concern were incorporated, and for a number of years past its earnings were such that it is reasonable to believe earnings are sufficient to pay a divi- dend upon a capitalization of $50,000, the inflation would seem to be justifiable and proper. On the other hand, if t 112 ADVANCED ACCOUNTING CORPORATIONS— OPENING ENTRIES 113 r the capitalization were far beyond both the value of the properties and any earning power possessed, the water in the stock would not be justifiable and proper; the "water'' would be the excess of nominal value over real value. 5. Forfeited stock. This is stock which is forfeited by order of the board of directors by failure of those who have promised to buy at a certain price refusing to make good the agreed purchase payments. State laws differ markedly in regard to forfeited stock. Sometimes the amounts paid in must be returned to the persons who have made the pay- ments; again, the amounts paid in n^ed not be returned. Forfeiture only is possible where the statutes specifically grant such power. When the right is exercised, it should be for the benefit of the corporation, not for the benefit of the stockholder or stockholders. The New York law on this subject is as follows (S. C. L., Art. 4) : **If default shall be made in the payment of any instalment as re- quired , the board may declare the stock and all previous payments thereon forfeited for the use of the corporation, after the expiration of sixty days from the service on the defaulting stockholder Such stock, if forfeited, may be reissued or subscriptions therefor may be received as in the case of stock not issued or subscribed for. If not sold for its par value or subscribed for within six months after such forfeiture, it shall be canceled and deducted from the amount of the capital stock." In event of forfeiture, the corporation makes a profit which must be shown upon the books of account. 6. Treasury stock. This is stock that has been issued as fully paid, in due form, has then been reacquired, and is held by the company subject to the wishes of the directors as regards its disposition. Further will be said on this subject later. 7. Donated stock. This is stock that has been issued as fully paid, in due form, and which has been handed back to the company as a gift. When this stock is taken up on the books, it is recorded as treasury stock. 8. Bonus stock. Any stock issued as a gift to purchasers of preferred stock or bonds is bonus stock. Usually, bonus stock is treasury stock because, otherwise, the recipient 9 would be liable for the par value oi such stock. However, bonus stock may be unissued stock and no liability for its par value will be incurred, provided certain conditions are encountered. In New York, unissued stock may be issued as a bonus where necessary to float a bond issue success- fully (106 N. Y., 97). Again, such bonus is proper in the case of floating a bond issue where the par value of the bonds is greater than the actual value of the bonds plus the stock (139 U. S., 417). Canceled stock. Shares of stock that have been declared canceled, i. e., void, the result being to reduce the number of shares the company can issue. 10. Outstanding stock. Stock issued, and outstanding in the hands of the public. 11. Authorized stock. The total amount of stock, or shares of stock, which a corporation, under its charter, has authority to issue. 12. Unissued stock. The total amount of stock, or shares of stock, for which stock certificates have not been issued. No obligation rests upon a corporation to issue the full amount of its authorized issue. After the statutory requirements governing the minimum amount of stock issue have been complied with, the company may do whatever it pleases with the remaining amount so far as issuance is concerned. In reality, unissued stock is merely the right to issue stock (a potentiality) ; by itself, it has no value, and neither can be voted nor participate in dividends. Unissued stock is not treasury stock, as some would have us believe. How- ever, if stock certificates (see post) have been detached from their stubs in the stock certificate book (see post), have been signed, sealed, assigned in blank, and have been placed with transfer agents or others for sale and delivery, the shares represented should be booked both as an asset and as a liability. 13. Unsubscribed stock. Unissued stock for which no subscrpi- tion has been received. Capital Stock Issuance and Mode of Payment.— The capital stock of a corporation is issued for a consideration of some sort, 114 ADVANCED ACCOUNTING ^ the nature of which is found to vary under the different statutefs. In general, it may be said that the consideration may be: 1. Cash or its equivalent, including subscriptions that are subject to call. 2. Labor or services, including both manual and brain effort. 3. Property, at a valuation to be fixed by the board of directors. In this connection, note the New York law (8. C. L., Art. 4) : No corporation shall issue either stock or bonds except for monry, labor done or property actually received for the use and lawful purposes of such corporation. Any corporation may purchase any property authorized by its certificate of incorporation, or n«'cessary for the Uf^ ^ The Minute Book has no special form; it may be either bound or loose-leaf. The minutes may be written therein or they may Ai^r wu ',* "^ '°°'' '•'''*' ^h'^l^ afterwards are pasted in i!t TS *t T^'Y ^'"■'° ^' *^^ "«'^* convenient, it is sug^ gested that the bound form is less apt to be altered should occa- sion arise when such alteration is assumed to be desirable. In one particular instance, two years after certain resolutions were al'^l^P"" 'S! ™'°"*''; '^^ '^"''''''' fi^'^'-'K them undesir- able, emoved the original sheets and replaced these by others oTtulfH '7 different way in an attempt to reduce the amount ot the then determined income and excess profits tax The minutes of the first stockholders' meeting would cover the following major points: persons present, by-laws, purchase of property, issue of stock, recording articles of incorporation, stock assessments nomination and election of directors, etc The minutes of the first meeting of the board of directors ;ould cove^ the following prominent points: directors present, election of oflicers, minutes of incorporation, oath of secretary, bond of treasurer, issue of stock, signing of checks, subsequent meetings committees, approval of agents and agencies, salaries of officers sale of securities, powers of attorney, etc. Subscription List or Register; Subscription Ledger.-The use of these two records begins at the time a corporation is organized. Such use may be described about as follows • " *'\t ""T^^" "^ subscribers to the stock of a corporation is small. When the Journal entry is made charging "Sub- .1 ' 146 ADVANCED ACCOUNTING scribers" for the amount of the subscribed stock, it is suffi- cient to enter the name and subscription of each subscriber upon the Journal, and open an account with each one upon the General Ledger. A formal Subscription List is unneces- sary although, theoretically, it may be used. In brief, such a list records the contract existing among the subscribers whereby each binds himself to take the amount of stock set down next to his signature. 2. If the number of subscribers to the stock of a corporation is large. In this case, a Subscription List may be used as the written evidence of the contract between the subscrib- ers to take stock. However, the usual procedure will be to have a separate slip to hold the signature of each sub- scriber. And from these slips a Subscription Register will be prepared, this being a book containing the names and addresses of the subscribers and the amounts of their sub- scriptions. When the subscribers are many, the Journal entry to "Subscribers" will not carry the name and sub- scription of each subscriber, — but only a mere reference to the Subscription Register. From the Subscription Register, detailed postings will be made to each subscriber's account carried upon a subsidiary Ledger, the Subscription Ledger, this being controlled upon the General Ledger by the account of "Subscribers." And when the payments on account of subscriptions are many, the Cash Book should contain a column for Subscribers, the total of which will be credited to the General Ledger account of Subscribers. As soon as a subscription has been paid in full, the subscriber should be credited upon the Stock Ledger for the par of his stock, this credit being made even though no certificate of stock lias been issued. CORPORATIONS-ORGANIZA TION; RECORDS A form of Subscription Ledger is shown below: =^==-— — — — -— ^ ADDRESS____ 147 NAME- Date No. Shares Sub- scribed At Total Calls No. 1 25% Cash No. 2 25% April 1 No. 3 25% June 1 No. 4 25% Aug. 1 Date CaUed Paid Ctlls No. 1 25% Cash No. 2 25% April 1 No. 3 25% June 1 No. 4 25% Aug 1 Bal- ance Re- marks ') Instalment List.-The use of this list is limited, necessarily to cases where the payments for stock are called up in instal- ments. One separate record either is written or printed from either the Subscription List or the Subscription Register, as soon as a call has been made by the board of directors. Where the stock subscriptions are numerous, and are subject to calls extending over a period of a number of months an II ii * 148 ADVANCED ACCOUNTING account should be kept with every subscriber and with every instalment, in a Subscription Ledger. A form of Instalment List is submitted below: Instalment No. 2 Names No. Shares Amount Due No. Cert. Received Interest L F 2 3 4 5 6 7 Date A. Jones 100 200 200 300 400 500 1,000 2,000 2,000 3,000 4,000 5,000 1 2 3 4 5 6 1,000 2,000 2,000 3,000 4,000 5,000 8.34 B. Smith... C. Brown. . . D. Gray.... L. Wolf Z. Doe 17,000 8 34 Comprising payments of an instalment of 10 per cent of the capital stock of the Good Luck Trading Company of Syracuse, New York, called for at a Meeting of the Board of Directors on July 5, 1921, and due July 12, 1921. Instalment Receipt or Scrip Book.— This book consists of receipt forms to be filled out and signed by the secretary and treasurer as instalments are paid; in some cases, the by-laws require that the president and secretary shall sign these receipts. These blanks may be put up in book form, the receipts being attached to stubs therein like checks in a check book, or they may be just loosely padded. When the last instalment has been paid, the scrip should be taken up and certificates of stock issued in their stead. The surrendered receipts, usually, are pasted back onto their corresponding stubs. CORPORATIONS-ORGANIZATION; RECORDS A form of the above is shown below: 149 Instalment Scrip No Shares Received from. . Company Shares 1st Instalment per cent. Received the above scrip: AiV * ' ". , Dollars, Ihe same bemg the first instalment of " , " Dollars, per share, on ok , , , >-, . . ^ onares of the Capital Stock of the *u • J . " ' ' ,' Company the said shares being set aside for the above subscriber or his aligns, conditional on the fulfihnent of the terms of the subscription. President Secretary Stock Certificate Book.-This is a bound book containing the ration, to be filled out and signed in accordance with the oro- visions of the by-laws of the corporation, by the secretanr the presKlent and the treasurer, or by the secreta^ and the ^1.^'; Each certificate of stock is attached to a stub, a perforatSTne ment Scrip Book above shown. Certificates are issued to those who are entitled to full-paid shares. For convenience, these ce! tificates are numbered consecutively. A transfer form usuallv IS pnnted on the back of each certificate in order to'faXtate' the transfer or sale of the stock. lacuitate When a stock certificate is surrendered for transfer, it should BookTwh n IT'"^ '^•'^ ""^ '""^ «*"'> '^ *he Cert fic2 Book to which It belongs; the number and date of the new cer! tificate issued should be written on the stub of the old ZeTor cross reference. Infrequently, certificates are found in JooL orm m which event there is no stub, the Transfer Jou^al ^ formation supplanting that ordinarily carried thereon. i 150 ADVANCED ACCOUNTING i ii A form of stock certificate is shown below: No. No. of Shares. Issued to: Address . On: For: From whom transferred: Name : Address: On: No. of Original Certificate: No. of Original shares No. of Shares Transferred: Received the above Cer- tificate this day of ,19 Signature INCORPORATED UNDER THE LAWS OF, No. . Sharet THE COMPANY Capital Stock Common Stock — Full paid and non-assessable This certifies that, is the owner of Shares of the Capital Stock of The Company Transferable only on the books of the Cor- poration by the owner hereof in person or by attorney, upon surrender of this Cer- tificate properly indorsed. In witness whereof, the President and th« Treasurer do hereby sign this Certificate and cause it to be sealed with the seal of the Corporation, this day of , 19 (Seal) President Treasurer Stock Ledger or Book. — This book is a detailed record of the individual ownership of the shares of capital stock of a cor- poration, which should be arranged to comply with the statute provisions of the particular state under which th€ corporation came into being. It contains one account with each stockholder in which he is credited with either the total number of shares issued to him or with both the total number of shares and the total par value thereof; naturally, the latter set-out is prefer- able to the former one. The total of the balances, of these indi- CORPORATIONS^ORGANIZATION; RECORDS 151 vidual accounts represents the total capital stock issued and out- standing. The relation of this total to the account of Capital Stock carried upon the General Ledger, may be indicated as follows : 1. If the Capital Stock account records merely the total stock issued and outstanding. The total of the balances upon the Stock Ledger should always be the balance of the Capital Stock account upon the General Ledger. 2. If the Capital Stock account records the total amount of the authorized issue. Under this condition, the above ac- count will be offset by an account showing the total amount of stock unissued, as a debit balance; and the difference between these two accounts, at any time, will represent the amount of capital stock issued and outstanding. In turn, this net balance always should agree with the total of the balances upon the Stock Ledger. The above two possibilities do not take into consideration the Item of treasury stock which may appear upon the General Ledger. Smce treasury or trustee stock remains under the con- trol of the company, the account with it may be kept upon the General Ledger only. And under the second possibility above when treasury stock exists, a further adjustment must be made m reconcilmg the total of the balances upon the Stock Ledger with the account of Capital Stock upon the General Ledger To permit the ready balancing of the Stock Ledger, in fact to make this Ledger self-balancing, it is customary to carry a siim- mary account upon the Stock Ledger, as the first account therein which, at all times, shows the total number of shares issued, and their total par value if values are recorded as well as number of shares. The items in this account will be found upon the side opposite from that upon which appear each of the detail balances of the numerous stockholders; in other words, in the summary account, the balance will be on the debit side. A specially ruled Stock Ledger is preferable' although not ab- solutely required unless the law specifies a special ruling In Its simplest form, the standard double column Ledger ruling will suffice. On the credit side of each account are shown the date and number of the stock certificate, the source from whence it came, the number of shares, and the face value. The source either is original (as where original subscriber) or the name of 152 ADVANCED ACCOUNTING CORPORA TIONS-ORGANIZA TION : RECORDS 153 I ■ i the person from whom the certificate of stock was transferred. When stock is transferred, the stub of the old certificate should show the name of the person to whom the transfer is made, and the number of the new certificate issued to the transferee ; the stub of the new certificate should show the name of the person from whom it came. In this way, a cross index is se- cured by means of which one may trace the stock forward or backward. The person who transfers stock will have indicated upon the debit side of his Stock Ledger account, the name of the person to whom the transfer was made, the number of the stock certificate surrendered, the number of shares transferred, and the face value of the shares transferred. In many instances, the total number of shares indicated upon the surrendered certificate of stock will not be transferred com- pletely, but only a portion thereof. In such case, the balance representing the retained portion should be charged upon the Stock Ledger to "self," and be credited for the same amount for the certificate issued to cover the shares retained. In other words, whenever a transfer is made, the old certificate must be cancelled entirely and be charged upon the Stock Ledger, and a like number of shares must be issued and be credited thereon unless treasury stock or trustee stock is involved. As indicated above, treasury or trustee stock remains under the company's control with the result that the account therewith may be carried only upon the regular records. Only this stock which actually has been transferred out should be covered by stock certificates. The New York law requires (S. C. L., Art. 2) that every stock corporation shall keep: A book to be known as a stock book, containing the names, alpna- betically arranged, of all persons who are stockholders of the corpora- tion, showing their places of residence, the number of shares of stock held by them respectively, the time when they respectively became the owners thereof, and the amount paid thereon The stock book of every such corporation shall be open daily, during at least three business hours, for inspection by any judgment creditor of the corporation; or by any person who shall have been stockholder of record in such corporation for at least six months immediately preceding his demand; or by any person holding stocks of such corporation to an amount equal to five per centum of all its outstanding shares; or by any person thereunto in writing authorized by the holders of stock of such corporation to an amount equal to five per centum of all its out- standing shares. Persons so entitled to inspect stock books may make extracts therefrom. No transfer of stock shall be valid as against the corporation, its stockholders and creditors for any purpose until it shall have been entered in such book as required by this sec- tion, by an entry showing from and to whom transferred. Failure to comply with this law entails a fine to be paid the State in the amount of $50.00 a day for every day the corpora- tion neglects or fails to do so. If more than one class of capital stock is issued, usually, there will be one or more Stock Ledgers for each class of stock. In large corporations, loose-leaf or card forms of Stock Ledgers fre- quently are used. In connection therewith, a tickler card file frequently is found, being used as a means of check against the Ledger accounts, and as a basis for making up mailing lists for the circulation of reports, meeting notices, and the payment of dividends. Each such list must be checked in sufficient de- tail so it agrees absolutely with the actual facts as recorded; and to make doubly certain that errors will be eliminated, it is customary to have each such list certified by the secretary as being correct. Each card in the tickler file would hold the name of a stockholder, his address, and the number of shares of each class of stock held. A form of Stock Ledger is shown below: Name of Stockholder Date of Trans- fer of Shares by Above Address Trans- fer No. To Whom Trans- ferred L F Certificate Surrendered Cert. Nos. No. Shares Date of Acqui- sition of Shares Prom Whom Transferred (If original issue, state such) L F Certificate Issued Cert. No. No. Shares Bal- anoe Cr. 1 154 ADVANCED ACCOUNTING Stock Journal. — In certain states all stock transfers must be recorded in a Transfer Journal, which will consist of blank assignments to be filled out and signed by those who are trans- ferring, or by their attorneys. Again, this Journal may be used by a corporation whose stock is active, to summarize daily all the stock transactions taking place both at the office and at the offices of the transfer agents so that postings may be made quickly and accurately to the Stock Ledger. Money amounts are not used therein. In the form below, one will notice the possibility of charging a stockholder with the shares sold, and of crediting the pur- chaser; or if a certificate of 100 shares is to be split up into four certificates of 25 shares each, the original would be charged to the stockholder and, in turn, he will be credited with the same number of shares on four certificates carrying four consecutive numbers. Original stock issues may be recorded herein; when done, the entries therefor usually are made in red ink so they will be clearly distinguishable from those relating to transfers. If more than one class of stock is issued, a separate Transfer Journal may be found for each class. A form of Stock Journal is shown below: Date STOCK CERTIFICATES SURRENDERED STOCK CERTIFIC^^TES ISSUED Name of Stock Holder L F Signa- ture of Attorney No. of Cert. No. of Shares Total Shares To Whom Trans- ferred L F Resi- dence No. of Cert. No. of Shares Total Shares CORPORATIONS-ORGANIZATION; RECORDS 155 Stock Transfer Book.— The requirements of the statutes of the different states are dissimilar as relates to the Stock Trans- fer Book, a book to be kept by every corporation or its trans* fer agent. In New York, the form used must be one approved by the state comptroller. Such a record, approved as to form, is shown below, this being obtainable in most stationery stores. Date Stock Transfer Book Serial Number of Cancelled Certificate No. of Shares By Whom Surren- dered To Whom Issued Serial Number of New Certificate No. of Shares Number and Face Value of Stamps 2^ H lOfS 20^ SOff $1 92 110 $20 Value The section at the right of the form relates to the number and value of the adhesive stamps which, by law, must be affixed. In New York, there is a tax payable on the transfer of capital stock. No transfer tax is required on the original issue of the stock, this being necessary only in connection with all trans- fers of a beneficial interest. The requirements of the law are as follows (Tax Law; Art. 12, sec. 270) : There is hereby imposed and there shall immediately accrue and be collected a tax .... on the transfer of any stock, on each hundred dollars of face value or fraction thereof, two cents, except in cases where the shares or certificates of stock are issued without desig- nated monetary value, in which cases the tax shaU be at the rate of two cents for each and every share of such stock The pay- ment of such tax shall be denoted by an adhesive stamp or stamps » I 156 ADVANCED ACCOUNTING When an old certificate is surrendered to a company whose rules demand a transfer on its books in person or by duly author- ized attorney, the individual or his attorney presents the certifi- cate with the form of assignment on the back filled out or hav- ing attached a separate assignment paper. The transfer is re- corded in the Transfer Book. If the signature be not known to the transfer agent, it should be guaranteed by a responsible person, — a bank, a trust company, or a broker. The signatures on the old certificate first are mutilated before pasting it back on the stub from which it was detached originally. Next, a new certificate is issued in accord with the terms of the assign- ment to replace the old one. The holder of the new certificate will receipt therefor in the same manner as did the holder of the old one. Bond Register. — Accounting problems arise in connection with an issue of bonds which are similar to those arising in con- nection with an issue of stock, at least in many respects. Briefly, without discussing the subject of bonds in any way at this point since one chapter is reserved later therefor, it is sufficient to state that in the case of registered bonds a record of individual ownership usually is kept in a Bond Register which, in ruling, is similar to the record kept of stockholders. This record would be kept even if bonds are registered only as to principal. New York Stock Exchange. — The New York Stock Exchange is an association of brokers maintained for buying and selling securities which have been listed officially by the Exchange, thia activity being conducted for a commission remuneration. The commission charged upon both purchases and sales is one-eighth of one per centum of the par value of the security dealt in. Before the Exchange will handle any security, it must be listed in a formal manner by what is known as the Committee on Stock List. If a corporation wishes to list its stock, it makes formal application to do so and, as part of such application, a statement must be made relative to the following: 1. Organization and purpose of the corporation. 2. Amount of its capital. 3. Object behind the stock issue. 4. Current financial condition and earnings. CORPORATIONS-ORGANIZATION; RECORDS 157 Likewise, in connection therewith, copies of the following must be submitted: 1. Certificate of incorporation. 2. By-laws. 3. Resolutions of stockholders and directors as to the stock issue. 4. Contracts and leases relating to the issue of stock. All of this information must be certified to as correct by the officers of the corporation. Because of the above requirements coupled with the work of the Committee on Stock List, question- able issues of securities are barred from being listed on the Ex- change. Many other rules are enforced by the Exchange relating to a number of items too numerous to mention, but perhaps one of interest in connection with the present work is to the effect that certificates of stock or bonds which either are printed or lithographed cannot be dealt in upon the Exchange; such certi- ficates must be printed from steel plates by a firm of approved engravers. ^^ .y.^T\uTf '**' P™P«rty-It was noticed in the last chapter that the capital stock of a corporation may be paid for m property, in money, or in services. When stock is paid for in cash, the accounting involved is decidedly simple so far as valuation is concerned. On the other hand, when stock is paid Theoretically, at least, the valuation given services and pro^: erty in the fair and impartial honest judgment of the directors must be equal to the stock given therefor. Especially IthsS m the case of property since its valuation will lie^ "sua y ^^ the discretion of the directors unless fraud is present whereaL tn^d- ir^der ^^^ -^^ -'' '' -- '^ ---- If property has a certain market value which is recognized n the community, or if the value thereof is determinSe f om he original purchase records, the problem is not so diffi ul Tr the accountant. But where the property is such that S via tion IS a matter of judgment, the accountant must be on ^ard not to commit himself, when opening the books, to any eS \t I'V k t ■'t li > 158 ADVANCED ACCOUNTING in seeming to justify the valuation figures handed him. In other words, he should assume no responsibility for such valuation. The explanation of the entry should be to the effect that the; valuation is in accord with the directors' authorization as ex- pressed in the minutes. Perhaps the valuation will be that fixed by the stockholders or by an appraisal company. The following further points should be observed in booking property values: 1. A general account holding tangible values (also intangible values) should not be used. In other words, good-will, or a like intangible asset should not be merged with a plant account. 2. If the properties taken over are not indicated in detail, as to separate item valuations, a Plant and Sundry Assets account may be used to hold the charge when the properties are turned over in payment of a subscription to stock. Later, when a valuation has been placed upon the separate items of property, separate asset accounts may be debited and the collective account suggested above closed. 3. If all the details are present in the bill of sale covering the specific valuation of the detail assets secured, the Plant and Sundry Assets account really is unnecessary. Problem.— For illustrative purposes, in this connection, study the solu- tion and comment covering the following simple problem taken from a New York C. P. A. examination. The Prosperous Company is organized under the laws of the State of New York to conduct a manufacturing business. The authorized capital stock is $500,000.00, divided into $250,000.00 common and $250,000.00 preferred stock, par value of shares $100.00. Five incorporators subscribe each for one share of common stock at face value. John Peters, one of the incorporators, purchases from three manufacturing companies their complete plants for $499,500.00, and transfers said plants to the Prosperous Company for the remaining $499,500.00 of common and preferred stock and $100,000.00 of the first mortgage bonds out of a total issue of bonds amounting to $150,000.00, leaving $50,000.00 of bonds in the treasury. The incorporators then pay in cash for their respective subscriptions. The individual assets acquired are as foUows: land and buildings $75,000.00; plant and machinery, $200,000.00; tools, equipment and fixtures, $50,000.00; inventories, $100,000.00; accounts receivable 'good $28,000.00, doubtful, $5,000.00; cash, $12,000.00. ' Prepare:(a) Opening entries for the books of the Prosperous Company (b) Initial Balance Sheet showing the company's financial con- dition, $250,000.00 250,000.00 CORPORATIONS^ORGANIZATION; RECORDS Ifi® SoluHon.~The first step is to book the authorized stock issue, preceding same with a formal heading: * THE PROSPEROUS COMPANY A Corporation Organized Under the Laws, of The State of New York With an Authorized Capital Stock of $500,000.00 Consisting of $250 , 000 . 00 Preferred Stock $250 , 000 . 00 Common Stock Unissued Capital Stock— Preferred, Unissued Capital Stock— Common' To— Authorized Capital Stock— Preferred, Authorized Capital Stock— Common,' The next step is to make entry of the subscriptions of the five incorpor- ators for one share each of the common stock: Subscribers to Capital Stock— Common, $500 00 To— Subscriptions to Capital Stock— Common, $500 00 Next, it is necessary to book the take-over of the assets from John Peters A^u Tl! "'*''^ *^' """ °^ '^' ^"'^''^^ ^^"* ^^^^^'^^ «^ PI^"t and Sundry in this entry but m opemng entnes of this kind, it is desirable to make use 1. These assets must be appraised, and 2. Because the element of good-will is a frequent factor to demand con- sideration when a going business is taken over. By conforming to this practice, the books may be opened immediatelv whereas, action by the board of directors relative to the ^aluatio""f ^^^^^^^^ assets may be deferred untU convenient to take up the matter $250,000.00 250,000.00 $599,500.00 $599,500.00 Plant and Sundry Assets, To — John Peters, Vendor, To record purchase of sundry assets per bill of sale on file for: Preferred Stock, $250 , 000 . 00 Common Stock, 249 , 500 . 00 Mortgage Bonds, 100.000.00 As Above, 599,500.00 The next entry covers the issue of stock and bonds in full payment of the properties taken over. A specific discussion of bond entries fsTefeld preslnt. "" ^'' '"*'^ ^"""'^^ ^^^^^ ^'^' ^^^--^t ^orThe ti 160 ADVANCED ACCOUNTING W $599,500.00 $500.00 $500.00 John Peters, Vendor, To— Unissued Capital Stock— Preferred, $250 , 000 . 00 Unissued Capital Stock — Common, 249 , 500 . 00 First Mortgage 5 per cent Bonds, 100,000 .00 Next, the incorporators pay in their subscriptions in cash: Cash (Cash Book), ' $500.00 To — Subscribers to Capital Stock — Common, following which, stock certificates are issued requiring for entry Subscriptions to Capital Stock — Common, $500.00 To — Unissued Capital Stock — Common, The last and final entry covers the placement of the specific assets ac- quired upon the books in accord with the action of the l)oard of directors in respect 'thereto. Since accounts receivable in the amount of $5,000.00, are considered doubtful, it would be reasonable to assume that a Reserve for Bad Debts account of an equal amount was set up on the books. Also, note the item of good-will for which an account is established. This is perfectly proper under the present circumstances in that, since the con- cerns taken over were going concerns a certain amount of good-will may be assumed as being possessed by them. Since good-will is a measure of earning capacity, only an established business can possess it. Had there been no take over of a going concern, but only an embryo business com- menced, no good-will rightly could be assumed to be in existence. A further discussion of good-will is reserved for the chapter on consolidations. The entry necessary, as a final step, is as follows: Land and Buildings, $ 75,000.00 Plant and Machinery, 200 , 000 . 00 Tools, Equipment, and Fixtures, 50,000.00 Good-will, 134,500.00 Inventories, 100 , 000 . 00 Accounts receivable, 33 , 000 . 00 Cash, 12,000.00 To — Reserve for Bad Debts, Plant and Sundry Assets, To complete the solution of this problem, it is necessary only to submit the opening Balance Sheet. This is as follows: THE PROSPEROUS COMPANY BALANCE SHEET as at $ 5,000.00 590,500.00 Assets Capital Assets: Land and Buildings, Plant and Machinery, Tools, Equipment, and Fixtures, Good-will, Total Capital Assets, $ 75,000.00 200,000.00 50,000.00 $325,000.00 134,500.00 $459,500.00 ni CORPORATIONS-ORGANIZATION; RECORDS 161 Current Assets: Inventories, Accounts Receivable, $33 , 000 . 00 Less: Reserve for Bad Debts, 5,00000 28,000.00 $100,000.00 Cash, Total Current Assets, Total Assets, 12,500.00 Liabilities 140,500.00 $600,000.00 Ca pital Stock: Capital Stock— Preferred, Capital Stock — Common, Total Authorized, Issued and Outstandine Capital Liabilities : * Tl5of(K)0 wT ^ ^'" ''^''* ^''°'^^ (Authorized Total Liabilities, $250,000.00 250,000.00 $500,000.00 100,000 00 $600,00000 Transfer of the Business of a Sole Trader to a Corpora^ tion.~Nearly all corporations have their inception based upon some previously existing business. An individual starts in busi- ness on a small scale. As his activity expands, he needs more cap- ital. This capital he secures in the following ways, one or more: 1. J5y borrowing money. 2. By inducing some one to go into partnership with him 3. By inducing at least two people to join with him in form- mg a corporation; perhaps these two will take only a mini- mum number of shares commensurate with the help needed ihll f h T ^ P^^^^^^^^P^ *h« l^^ter may succeed to the end that the partners cannot control and develop it as they should The result IS that a corporation is formed to secure both more capital and the protection of a limited liability Again two or more existing business concerns may combine or consolidate into a corporation. A sole trader may coZne 4h another sole trader in the formation of a corporation he mav combine with a partnership or with a corporatl in tLioZZ tion of a new corporation; a partnership may combine withT other partnership or with a corporation'^to formTnew cZZ tion; two or more partnerships and corporations may comC two or more corporations may combine In fart iL IV variations as to the original coLtituent units eoS^^^^ ^^ formation of a new corporation are many. ^ *^^ 162 ADVANCED ACCOUNTING Some of the problems encountered in merging and consolidat- ing with the end in view of forming a new corporation are diffi- cult and intricate, and a discussion of these, exclusive of certain fundamentals, of necessity, must be omitted until a later time when the student shall have gained a certain familiarity with underlying corporate principles of accounting. Therefore, it ia the purpose at the present time to consider only the more rudi- mentary elements involved in the above,— namely, the transfer of the business of a sole trader or partnership to a corporation. Problem.— The Jones Manufacturing Company was incorporated under the laws of the State of New York to acquire and conduct the businow, heretofore operated by H. B. Jones. The authorized capital stock of the corporation is $700,000.00, divided into $400,000.00 preferred stock and $300,000.00 common stock, each class of the par value of $100.00 per share. The preferred stock is preferred as to assets; likewise, it is entitled to re ceive an 8 per cent dividend before any dividends are paid to the common stock, but after the common stock has received an 8 per cent dividend, both cWs of stock shall then participate equally in whatever dividends are to be distributed from the surplus. The foUowing is a Trial Balance drawn from the books of H. B. Jon«.. as of December 31, 1920, which is assumed to be correct: Land, Buildings, Machinery and Equipment, Furniture and Fixtures, Finished Product, Product in Process, Materials, Supplies and Sundries, Accounts Receivable, Notes Receivable, Mortgage Payable, Notes Payable, Accounts Payable, Reserve for Depreciation of Capital Assets, Capital, $ 20,000.00 30,000.00 16,500.00 2,000.00 10,400.00 13,800.00 8,000.00 1,000.00 23,000.00 6,000.00 $ 12,000.00 3,400.00 22,000.00 45, 000. (K) 48, 300. ( K) $130,70 0.00 $130,700.0 In the corporate enterprise, Jones is joined by his wife who invests in the company the same amount of capital as Jones gets common stock liJcewise, his brother introduces therein $50,000.00. The price the cor' S". K '"^r' '^ ^^^ ''' '''' P^^P^^*^^« *^ken over i^s $I5^5)0 (^ at:pV:omm?nl^^^^^^^^ '' ''' -'^-'-' ^'' '^^ ^^^ ^-P-to^ CORPORATIONS^ORGANIZATION; RECORDS 163 The stock is issued on January 3, 1921, and on January 15, the directors hold a meeting at which time the following is agreed upon, as based upon replacement values: 1. Value of land to be carried at $28,000.00. 2. Value of buildings to be carried at $64,000.00. 3. Value of machinery and equipment to be carried at $18,500.00. ' 4. Value of furniture and fixtures to be carried at $2,500.00. The reserve for depreciation of capital assets as carried in the Trial Balance is to be reduced by the amount of increases shown above except as to land. The balance of the take-over price is to be set up on the books as good-will. Required: Journal entries to record the above on the books of the Jones Manufacturing Company. Solution.— An elaborate discussion of this solution is unnecessary, in that the explanation of each entry is deemed sufficient. Usual Pro-Forma Entry (Omitte d) (1) Plant and Sundry Assets, To — H. B. Jones, Vendor, To record acquisition of sundry properties and assets, subject to certain habilities and reserves; in general, subject to decision of Board of Directors concerning the valu- ation of detail items of assets. H. B. Jones, Vendor, $150,000.00 To — Capital Stock — Preferred, Capital Stock — Common. To record issue of stock to vendor, preferred stock being issued for intrinsic value of properties and assets acquired, namely: Book value of assets, $130 , 700 . 00 Less: Reserve, 45,000.00 Balance, $ 85,700.00 Less: Liabilities, 37,400.00 Net Total— Preferred Stock, $ 48,300.00 Total, all stock, $150 , 000 . 00 Total, Preferred Stock, 48 , 300 . 00 $150,000.00 $150,000.00 $ 48,300.00 101,700.00 Net Total— Conmion Stock, $101, 700 00 (3) Subscribers to Capital Stock — Common, To — Subscriptions to Capital Stock — Common, To record subscriptions of wife and brother, as follows: $151,700.00 $151,700.00 Wife, Brother, Total, $101,700.00 50,000.00 $151,700.00 1 it I 164 ADVANCED ACCOUNTING (4) t ■I Cash, To- $151,700.00 -Subscribers to Capital Stock — Common, To record cash received on account of sub- scriptions. $151,700.00 (5) Subscriptions to Capital Stock — Common, To — Capital Stock — Common, To record issue of stock certificates to above subscribers. (6) $151,700 00 $151,700.00 Land, $ 28,000.00 Buildings, 64,000.00 Machinery and Equipment, 18,500.00 Furniture and Fixtures, 2,500.00 Good-will, 20,700.00 Finished Product, 10,400.00 Product in Process, 13,800.00 Materials, 8,000.00 Supphes and Sundries, 1,000.00 Accounts Receivable, 23,000.00 Notes Receivable, 6,000.00 To — Mortgage Payable, $12,000.00 Notes Payable, 3,400.00 Accounts Payable, 22,000.00 Reserve for Depreciation, 8,500.00 Plant and Sundry Assets, 150,000.00 To record closing account of Plant and Sundry Assets, and aet up on the books the individual asset and liabil- ity accounts, for net properties ac- quired and assumed, based upon a valuation arrived at by the Board of Directors on January 15, 1921. The amount of the good-will is calcu- lated as follows: Cost of good-wiU, $101 , 700 . 00 Deduct: Application to incre^ise land value, $ 8 , 000 . 00 Application to increase value of other assets: Buildings, $34,000.00 CORPORATIONS-ORGANIZATION; RECORDS 165 Machinery and Equip- ment, Furniture and Fixtures, 2,000.00 50000 36,500.00 App. to reduce reserve, 36,50000 $81,00 0.00 Balance, net good-will, $20,700 00 Procedure by Vendor Upon the Sale of the Business of a Sole Trader or of a Partnership to a Corporation.— Thus far in the present chapter, there has been discussed only the pro- cedure of the vendee (the corporation) when either the business of a sole trader or of a partnership has been transferred to a corporation. Since a definite course should be followed by the vendor under each of these conditions, it cannot be amiss to take the time here to present this angle of the case. In this connec- tion, the student should recall to mind the procedure to be fol- lowed where the net assets of a sole trader are transferred to a partnership since, by so doing, the present discussion will not be absolutely new and strange. Where a sale lias been made to a corporation, the course to follow, necessarily, will depend somewhat upon how the deal was effected. In general, a formal bill of sale becomes the basis of the arrangement in which are set out: 1. The assets to be transferred. 2. The liabilities to be assumed. 3. The valuations agreed upon. 4. The manner of paying the vendor. The general possibilities of procedure herein considered may be summarized roughly about as follows: 1. Valuation in take-over: a. The valuation at which the take-over is made differs in respect of the individual assets from that shown on the books of the vendor. Where the assets are transferred at a valuation different from that shown on the vendor's books, a two-way possibility exists: i. The assets are transferred at a valuation greater than the book figures, ii. The assets are transferred at a valuation less than the book figures. 166 ADVANCED ACCOUNTING Is i II In either event, the first step necessary is to adjust the book figures to the new valuations, and absorb the dif- ference, representing a profit or loss, in the Profit and Loss account; here there is a realized profit or loss which makes the absorption through the Profit and Loss account in order. The further treatment will depend, generally, upon the variation of conditions as indicated below in (2) and (3). b. The total assets transferred on the basis of a lump sum valuation, including good-will. Hereunder, the transfer will be for a lump sum in excess of the book valuation. The procedure necessary must be varied to a slight degree because such excess cannot be attributed as being attached to any specific asset or assets disposed of. One assumes, natm-ally, that the vendee has purchased the asset of good-will in addition to the tangible assets under process of sale. Especially is this true in the sale of a going concern. The first step necessary would be to book the excess to be received as a charge to the Good-will account and offset such debit by a credit either to the Profit and Loss account, or to the Capital account or accounts. Following this entry, the procedure will vary as above indicated. 2. Settlement for take over. The manner of booking the settlement separates itself along the following lines: a. Old concern considered as liquidated. Hereunder, the vendor's books will be closed by Journal entries debiting the corporation with the sum of all the assets, crediting each asset account, — and debiting each liability account, inclusive of the Capital account or accounts, and credit- ing the corporation. b. Old concern, as an enterprise, considered as accepting the stock in payment for its net assets. This method will show the settlement upon the vendor's books by changing the last entry so that the liabilities outside of the Capital accounts will be charged, and the corpora- tion credited; that a Stock account will be charged for the amount of stock received from the corporation, iand a credit to the corporation; that the Capital accounts will be charged, and the Stock account credited. CORPORATIONS-ORGANIZATION; RECORDS 167 3. Records in which entries are made. Briefly, the idea here- under may be described as follows: a. Old books of account used by the corporation. When a sole proprietorship or a partnership business is incorpo- rated, and no actual transfer of assets from one enter- prise to the other is contemplated, the old books of account may be retained and only certain changes be made therein necessitated by the incorporation. This method of handling is illustrated by the solution to the problem presented at the end of the present section. b. New books of account used by the corporation. The use of new books of account presents nothing of difiiculty with the result that their consideration will not be com- mented upon except in connection with illustrative prob- lems. In fact, the solutions to the problems already used were made from the point of view of new books being used. Problem.— The following simple C. P. A. problem illustrates the changes required in the old records when the business of a sole trader is incorpor- ated, no assets being transferred to a new set of books. A. J. Andrews has conducted a retail business for three years. His profits have been $7,000.00 fpr 1913, $8,000.00 for 1914, and $10,000.00 for 1915 before charging any salary for his own services. To obtain the capital needed to purchase the new fixtures necessary in a new store which he proposes to lease, and also to increase his stock of merchandise, he decided to incorporate on December 31, 1915, for $50,000.00 and to seU part of the capital stock. C. F. Martin agrees to purchase $20,000.00 of the stock at par and to pay for it inmiediately. It is agreed, also, that in the new corporation Andrews is to be aUowed credit for good-will equal to the sum of his profits for the past three years after deducting an annual salary of $4,000.00. Draft the Journal entries necessary to adapt Andrews' books for use as the books of the corporation, and prepare a Balance Sheet showing the condition upon completion. Andrews presents the following Ust of assets and habilities, which Martin accepts as correct: Assets: Furniture and Fixtures, book value, $6,000.00, worth $4,000.00 Merchandise, market value, $20,000.00, cost $18,000.00 Accounts Receivable, book value, $6,500.00, collectible, $6,000.00 Cash, $400.00 Liabilities: Trade Creditors, $8,900.00 Bank Loans, $1,500.00 I f« ADVANCED ACCOUNTING Solution. — The first step is to book the good-will item, its amount being calculated as under: Profits: 1913, t 7,000.00 1914, 8,000.00 1915, 10,000.00 Total, Three years' salary @ $4,000.00 •25,000.00 12,000.00 Good-will, $13,000.00 The entry for this good-will would be: Grood-will, To — ^A. J. Andrews — Capital, $13,000.00 $13,000 00 Next, the corporate stock entries may be recorded: Unissued Capital Stock, To — Capital Stock Authorized, To record authorized issue. Subscribers to Capital Stock, To — Subscriptions to Capital stock. To record subscriptions as follows: C. F. Martin, $20 , 000 . 00 A. J. Andrews, 30 , 000 . 00 $50,000.00 $50,000.00 $50,000 00 $50,000 00 Total $50,000.00 At this point it will be necessary to determine how dose the stock taken by Andrews agrees with the net amount in his Capital account, on the valuation basis used: Furniture and fixtures, booked at $6 , 000 . 00 Less: Reduction agreed upon, 2,000.00 $ 4,000 00 Merchandise (at cost), Accounts receivable, Less: Bad debts (uncollectible), $6,500.00 600.00 18,000 00 6,000 00 Cash, 400 00 Total Assets, Trade creditors. Bank loans, $8,900.00 1,500.00 $28,400.00 10,400 00 Net Assets Invested, Good-will (entry No. 1), $18,000 00 13,000 (K) Net Present Balance in Capital Account, Stock taken (see subscription entry). $31,000 00 30,000 00 Balance to Remain in Capital Account, $ 1,000.00 Upon the basis of the Ust of assets and liabihties which C. F. Martin agrees to accept as correct, it is necessary to reduce the Capital account of A. J. Andrews in accord therewith: A. J. Andrews — Capital, $2,500.00 To— Furniture and Fixtures, $2 , 000 00 Accounts Receivable, 500.00 CORPORA TI0N8—0RGANIZA TION ; RECORDS 169 When C. F. Martin pays in his cash, the entry will be: Cash, $20,000.00 To— Subscribers to Capital Stock, $20 ,000 . 00 Likewise, when A. J. Andrews contribution is booked, the entry to cover is as under: A. J. Andrews— Capital, $30 , 000 . 00 To — Subscribers to Capital Stock, $30,000 00 And the last entry necessary, will be: Subscriptions to Capital Stock, $50 , 000 . 00 To — Unissued Capital Stock, $50 , 000 . 00 If desired, in the above solution, one might short cut the entries so as to eUminate the use of the Subscription and Subscribers accounts. The final step in the solution will be to prepare the opening Balance Sheet of the corporation. This follows: RETAIL CORPORATION BALANCE SHEET as at Assets Current Assets: Cash Accounts Receivable, Merchandise (cost). Total Current Assets, Furniture and Fixtures, Good-will, Liabilities Current Liabilities: Bank Loans, Accounts Payable, A. J. Andrews: Net Assets Invested, Good-will, Stock Issued, Total Current Liabilities, Capital Stock, $20,400.00 6,000.00 18,000.00 $44,400 00 4,000.00 13,000.00 $61,400.00 1,500.00 8,900.00 $18,000.00 13,000.00 $31,000.00 30,000.00 1,000.00 $11,400.00 50,000.00 $61,400.00 Transfer of the Business of a Partnership to a Corpora- tion. — To illustrate further the transfer of a business to a cor- poration and, likewise, to show the closing entries necessary upon the books of the vendor concern, the following simple prob- lem and solution are submitted: 1 |l !<■ I I 170 ADVANCED ACCOUNTINO Problem. — Smith, Jones & Company, a partnership conducting a toy manufacturing business, and sharing profits in proportion to investments, decides to sell out to the Sterling Toy Company, whi(;h the partners have incorporated with an authorized capital stock of $175,000.00, all of which stock is to be issued to the three partners in exchange for their respective interests in the business as covered below. The contract of sale rc'fnrs only to the fixed assets and to the working and tra in !l portion or aliquot part of the entire capital excluding, however, whatever amount of capital may be allocated to some other class of stock due to the existence of some preference in relation thereto. But it should be recognized at present, in connection with plac- ing a value upon no par value stock that, where legally possible, an expedient is used of placing a value thereon which in amount is less than the value received therefor. In New York, for ex- ample, this stock cannot be issued for less than $5.00 a share, and the capital value as stated in the articles of incorporation is the minimum below which such value cannot be reduced, as by dividend payments. Hence, by taking advantage of the law, a $5.00 value often is placed upon each share regardless of what actually was received, so that dividends may l>e paid out of capi- tal if the desire exists to do so. The difference between the amount of capital paid in and the small arbitrary value booked against the no par value capi- tal stock will be carried as a special surplus, say. Capital Sur- plus. However, it would seem that if no par value capital stock is booked at the original value placed thereon, as is capital stock having a par value, which may be done, the one Surplus account would be sufficient even though both kinds of stock are in existence. As concerns the surplus, no real difference would seem to exist between par value stock and no par value stock. Donated treasury stock will b^ a rarity in that no reasonable object will be secured by any act of donation. The donation of par value stock too often represents merely an expedient to get around the legal requirement that stock shall not be issued at a discount; the use of no par value stock was designed, from one point of view, to prevent such a practice. If, however, o(;ca- sion should arise under which such stock was donated to the treasury, the donation may be booked in the Treasury Stock account by number of shares only, and no par value be shown therefor; the number of shares so carried then would be deducted from the total shown as issued in the Capital Stock account, so that, on the Balance Sheet, there would be shown the actual number issued and outstanding. If, however, the company pur- chased some of this stock and placed it in the treasury, the Tnjas- ury Stock account should show the purchase cost thereof as mmKATioKs-oaoAmATrnx, stcom m .... j-ieS tit zz^^j^:-^ each. Likewise, thek are to be ^^S.^ ? ""^ "'''"* "' »'"'•«> Havin, no pa. value. P^^entX ^^.^^ trLTZ:, "^ ^'^ heading shouId^eferrthetctXtSH'^"* %'"''''"' "' *•>« ^°™^ with no par value" have been authl>.T ^"^ °! "°'°°""' "''PiW «tock hereunder already has be^^hr^^^vtu^t"!: 'ITT' '""^ ^'^'^ problem, it is omitted here. Previously m connection with another When the preferred stock ii snW ti.. Likewise, when some of the no par ^h,! """^^ '"'"'' «•«'"'<• ^ looked, entry is necessary, about as f^Iows: "^°° '*"'*''' '"^'^ '« «"<»■ an Subscribers (or Cash) To— Capital Stock— Common * ^ And this common stook ahm.M k_ . . * ^ atock was issued ^be shown wTe:;;l:V° *'"'* *"" ^""^ ''' -"ch the Also, since the account with Cartel S^rckV'^'*'*^' "'"''• »' ^^<=^- number of shares outstanding a notafi^„r^,Tr" '^" ''°* ''^"=' *•>« itself of the number of shaZlJnT ^ """^^ '" ***« """""n* porations may be claLdTs ^°'''' '" «'°^^^^' '"^'^ '-^- 1. Those with a small capital stock. 2. Those with a large capital stock. latter comprise IZ i:^^^!^:^' ^ T'-'' ''^ .s scattered widely, and the shar s oT which are ht 7^ ''^ the various stock exchanges handled upon wHeh\rrhesre^:ndrr -tt'^''---^ '^-^- the benefits of a corS. "l^'"^ ^' ^''^'' *» attach but still retain th X " eoSr**«° ^'' ''^'^^ "ability), Will commonly ^r " cornorlTi ^7°'"'^'^ "' '°*^'««t- ^e will consist of hilel? ITcertaTn *l^*°'='^'^°'d- of which associates. Such a company is S "' °'" '^"'^ business tion met with in acZ'ng w^rk.""""" *"'" '' ''''' ''°'^- I ui 176 ADVANCED ACCOUNTINO f In a close corporation, a stockholder who does not own or con- trol a majority of the shares of capital stock is always at a disadvantage. Those in control can elect a management subser- vient to their mandates and, by so doing, keep the minority stockholders from any active connection with the company; likewise, they may refuse to declare dividends on the ground that the earnings must be put back into developing the enterprise. Again, by voting large salaries to the corporate officers, they may show a deficit at the end of the year rather than a profit out of which dividends can be declared. By keeping the minority stockholders ignorant of the actual condition of affairs, and by depriving them in divers ways of sharing in the management of the company, and of securing a periodical return upon the investment made, those in control may so discourage the minority that the latter may attempt to dispose of their holdings. And since these conditions tend to create a limited market in which such holdings may be disposed of profitably, such a disposal may prove to be impossible or, if possible, only at a marked sacrifice. Therefore, although the close corporation idea may appeal to one who desires to control corporate affairs, the one who expects only to have a minority interest therein should be extremely careful before making his investment. If the controlling interest does not play fair, though not guilty of actual fraud or gross mismanagement, the minority shareholder, even without wanting to have anything to do in the management of the company, may be so "man- handled" that his investment will, at best, be a decidedly ques- tionable one. To get around this possibility of not interesting a possible minority shareholder in a contemplated corporate enterprise, the incorporators may decide to place on the market more than one class of stock, as preferred and common. Since the preferred stockholder, ordinarily, is assured of his dividend, he may de- cide to come in. Again, the hesitancy may be removed by providing for cumulative voting; this has been discussed above. The large industrial and public utility companies are found in the second class. Their capital stock is divided into a great number of shares and the stockholders are continually changing. The stocks of these companies are dealt in upon the various COMPOEATIONS^ORGANIZATION; RECORDS 177 SlteSe'^'' ""'^^ ^^'^"^^ -"^^^-^^ they are readily remain in control only so Z^^.f^^^ ^^1 management will the management becom:s S^^^^^^ ^« -- as the annual meeting, either Tnn^^^^^^ the stockholder, voting at it may on the surfL appear ^lil^.""! '"^; ^^^^ ^^^^^ of stock held, was insiS I ''^'' ^''' ^^^ ^^^^ share possible of b ing ear^av h^^^ - compared to all the votes Ordinarily, at '.TC7o^\^n t '^^ ^"^^^^"* '''^^' tfSI CHAPTER VI INVESTMENTS: STOCKS, BONDS AND MORTGAGES Introduction. — The major topic of the present chapter relates to certain accounting principles which an investor, indi^'idual or company, should find of value. Investment accounting; and the accountancy of investment are not one and the same. The latter is a term of much narrower and technical significance than the former and is but slightly made use of herein in that this is not assumed to be a text upon mathematics. Investments in General. — At this moment, the bookkeeping necessary for the investment of a sole trader in his business, for the investments of partners in a firm, and for stockholders in a corporation, should be familiar to the student, in that the procedure in relation thereto often is referred to as contemplat- ing the opening entries. This angle of the subject is of no con- cern in the present chapter except, perhaps, by way of compari- son. Profit is the general object for which a business organization functions, regardless of its particular line. And to carr>^ out an undertaking, capital is necessary which, in amount, should be adequate. The form of this capital will \'ary, comprising the assets necessary for the purposes in mind. In the original in- stance, some will be land, some buildings, some equipment, and some cash; later, there usually will be, also, notes and accounts receivable, as well as materials and supplies and merchandise. As to each one of these items, the capital therein invested should be proportionate to needs. Cash should not be tied up to the end that current liabilities cannot readily be liquidated. If profits be made, it is presumed they will be converted into cash so that dividends may be paid. If the profits accumulated or acquired exceed a fair dividend return on inxested capital, a sur- plus is created, consisting of undivided profits. Finally,' if the 178 mVESTMmrS: STOCKS, BONDS AND MORTGAGES 179 fund of cash on hand grows hpvnnri +i.« purposes and dividends^ excLs carrvT"'^ °' ^™* different forms of assets known ! La' J a^'ln T"" w,' "'^ These invpd "r buildings. a. Stock. b. Bonds. .!• Conditional-bond and mortgage. II. Single— usual corporate bonds ExcMng item 1. ,CvI ™? ""!'' °'""'»" I'"n«~.. At best, they are temporary in charart.Pr «• been discussed fully in coMertinn „ /!*'f *^'- ^'^ce they have counting, and invofve nothS ^.^ "'^"'^''^^^ Phases of ac- tional cj;cussionir:iitt^ ^""'^ ""' ~^'>*' ^^'^*- 2. Land or buildings, collectively known as real estate Th investments arise in one of two ways • ^^ a. By direct purchase 180 ADVANCED ACCOUNTING III ( i brances, and the vendor should see to this before the sale is consummated. But in the absence of fraud on the part of the seller, the covenants of the deed of sale regu- late the rights and liabilities as between vendor and vendee. A purchase may be made subject to certain incumbrances, which latter include such items as: mort- gages, mortgage interest, taxes, assessments, mechanics' and landlords' liens, judgments, attachments, pending litigation, etc.; some of these to be binding upon third persons must be recorded and others will not entail this requirement. The prospective purchaser should ascer- tain what the incumbrances are, if any ; ignorance there- of is no defense should a controversy arise later thereon. Certain of the variations encountered in relation to the al)ove may be summarized about as follows: 1. The buyer may purchase ex all incumberances. Here the vendor must take care of them. 2. The buyer may assume all lien liabilities. In any given case, the statutes must be consulted carefully to determine whether (1) or (2) above may be carried out in its entirety. For example, the owner as of a day certain may be held liable, in some states, for the year's taxes. A vendor's creditor cannot look to the vendee for payment unless the latter has bound himself by written agreement to make such payment. Accounting for Real Estate Investments.— The procedure hereunder follows a two-way possibility: 1. If purchaser assumes existing liens. His books should show a purchase value consisting of two elements: a. Cash paid. b. Liabilities assumed. i. Existing liens assumed, ii. Purchase money mortgage. 2. If the purchaser does not assume existing liens, but leaves the vendor to take care of them. His books should show a purchase value consisting of either one or two elements: a. Cash, or b. Cash plus a purchase money mortgage. Property may be acquired in either of two ways, and tlie cost thereof, as to elements included, is dependent thereon: INVESTMENTS: STOCKS. BONDS AND MORTGAGES m 1. By purchase in the open market. This point should have rt^irrnTw^"'""^ '" '''' studentfearlier work ^ require no further comment at this time. 2. By result of foreclosure proceedings. This would per- Zl^L ''^'' *° mortgagor, and amounts paid out for taxes msurance, repairs, and improvements prior to default of mortgagor. ^ ^ thtnc^t\fT^'"' may be booked at market values rather SdTcallv bv ^IT '' ''•"" fluctuations must be adjusted creditmg or debitmg the Profit and Loss account Investment items may be carried upon the General Ledger in are oT mo^nh ""'' ^"*"^"*^- ^^^■"' " '^^ --tl " are of more than one class, separate accounts may be carried upon the General Ledger for each such class. Again Vspec Sv m large organizations, the investments may be sXTentv numerous to warrant the use of subsidiary records eSh su h controlled upon the General Ledger by the nroDer cnntJv account; and each such snM,iJ rjJZmZZTl the mformation worth-while pertaining to the assete ilit p::SyT:srb^"";^r°"•"'^'"^ property, ,t might be highly desirable to give each such niece a separate account upon a subsidiary Ledger controlled u,^n the General Ledger in the usual way. A special form o^^dger ^ould provide space for a number of notations concerning the property therein booked, as: name, location, date acou^S and how acquired. The body of each account may be Sed' int^ three major portions: investment, incumbrances, and ilme^ and each such section would be columned to show da e d^' ticulars, debits, credits, and balance ' ^ nav T*!. ^i""*^-^ ^°d •« a 'bitten promise under seal to pay a definite sum of money at a stated future time It is estate held by the issuing company. Likewise, an agreement exists to pay interest at certain periods. Bonds are issued in varying denominations, 110000 S^iOnm $1,000.00, $5,000.00, $10,000.00, and at times e;en iai^e'r. W ,i Ill It 182 ADVANCED ACCOUNTING times, for popular subscription, bonds are issued at a face value less than $100.00. In no way does a bond partake of the nature of stock. A bond is a direct corporate obligation which may or may not be given certain other rights incidental to those usually accorded a bond, as: 1. Right to participation in corporate prol&ts. 2. Voting rights, unless the statutes forbid. Classification of Bonds. — A corporation has its choice of issuing any one of a number of various kinds of bonds. It is impossible herein to discuss thoroughly each and every kind; a book on corporate finance should be studied in this connection. All bonds may be classified under four possible headings and. when considering the name of a specific bond, care should l>e taken to allocate properly such name against the correct head- ing so that such title may be the better understood. On the basis of a representative list of bonds this four-way classification may be as follows: 1. As to manner of payment: a. Coupon bonds. b. Registered bonds. i. Registered as to principal only, ii. Registered as to both principal and interest. 2. As to security: a. Mortgage bonds. b. Car or equipment trust certificates. c. Collateral trust bonds. d. Prior lien bonds. e. Debenture bonds. f. Income bonds. g. Receivers' certificates. h. Bottomry and respondentia bonds. 3. As to purposes: a. Refunding bonds. b. Consolidated bonds. c. Adjustment bonds. 4. As to conditions of redemption: a. Gold bonds. b. Convertible bonds. INVESTMENTS: STOCKS, BONDS AND MORTGAGES 183 Upon inspection, it will be noticed that the above grouping depends upon a number of things, as: 1. Nature of security. 2. Purpose of issue. 3. Conditions of payment of interest and principal. From the standpoint of an accountant, the distinction between registered and coupon bonds must be understood clearly There- fore, a considerable discussion of each of these types is shown below. Certain of the other types are discussed in a brief manner merely to give the student an inkling of the variations encountered in bond issues; the details concerning them are of considerably more interest to an investor than to an accountant Bond and Mortgage.— Another bond classification is to classify bonds as follows: 1. Single. This is one under which the obligor agrees to pay a certain sum of money to some one at a determinable future date. The usual corporate bonds are of this type 2. Conditional. This is one under which the obligation be- comes void when the obligor performs some act which otherwise, would remain in force. The simplest way to' secure a debt by mortgage is to pledge property to secure the payment of a promissory note, which has been made out m due and usual form. A mortgage, representing a condi- tional transfer of certain property, as real estate, is made out m favor of the payee named in the note who, in case the maker of the note does not fulfill the obligations he has undertaken, will commence proceedings to have the prop- erty sold m accord with both the statutes and the terms of the mortgage to the end that the proceeds from such sale may be applied toward the payment of the principal and interest due upon the note ; any residual sales amount will be turned over to the former owner of the property covered by the pledge. In New York, and in some other states, espe- cially as concerns real estate loans, it is customary to use a bond and mortgage rather than a mere note secured by a mortgage; such a bond may be classified as "conditional" in contradistinction to "single". The amount of the bond as a rule, is for a sum twice the size of the principal sum to be paid. Formerly, the full amount of the bond could be V I II < I 184 ADVANCED ACCOUNTING collected, but now, at least in New York, nothing can be collected beyond the actual amount due for principal, interest, and costs, in case the obligor fails to meet his obligation. The property which is security for the bond will be sold subject to provisions as indicated already above. Naturally, this method of raising money is of limited appli- cation; where money must be raised from a number (»f creditors, to be held for a number of years, it is unsatis- factory in that provisions are not made to make trading and transfer convenient. Hence, the form of bond obliga- tion, already considered, is preferable. Loans secured by bonds and mortgages require no difficult accounting, but provision should be made to cover all the possi- bilities that may arise. As will be noticed later, in connection with the usual types of bonds, no question arises here as to par, premium, and discount. The records should show: date of the bond, date of maturity, amount or face of the bond, interest rate, and dates on which interest is payable. If a person classifies securities as: (1) stocks, and (2) bonds, a short term note must be considered as a bond. Then, like- wise, it would seem in order to consider a note secured' by a mortgage as a bond. The ordinary term of Mortgages Receiv* able, therefore, would fall within the present grouping. Where a mortgage is taken as security for a loan, great care must be observed in keeping a complete detail record thereof; a subsidiary Ledger may be necessary therefor, if transactions are numerous. And therein, for each mortgage, the following points should be known and set out: name of mortgagor, amount of loan, date mortgage given, loan maturity date, location and general description of property mortgaged, state and county, book and page in which mortgage recorded, interest rate, interest dates, fire insurance carried on buildings— number of policy, term amount, and date of expiration, insurance company, name of person paying premium; appraised land values and building values; amount of instalment payments on loan principal: amount of interest accrued, due and paid. Such a loan should not be made for more than 80 per cent of the appraised value of the pledged property; generally, it will be less. Interest accrues from the date on which the money is paid over to the INVESTMENTS: STOCKS, BONDS AND MORTGAGES 185 mortgagor, and will be at the legal rate if no other rate is mentioned. Registered Bonds.— Registered bonds have a certain dis- tmctive feature in that their number, denomination, payee, payee's address, etc., are registered in the name of the payee on the books in the office of the issuing corporation. Transfer of ownership can be made only by executing a power of attorney upon the back of the bond or bonds in question and by entry of such transfer upon the Bond Register in the office of the issuing company. The owner of a registered bond is secure in his possession since title does not pass to the holder; he does not have to remember even the interest periods, and he runs no chance of loss due to losing coupons. Even should he lose the bond, or should it be destroyed, the registered owner may secure a new one by proving his loss, and by giving the issuing corporation a bond to indem- nify it in case a bona fide holder of the supposed lost bond puts in an appearance and holds the company to the terms of their agreement. The cost of giving such a bond of indemnity is slight. Registered bonds are printed with stubs and are bound to- gether in a manner similar to that of a Check Book or Stock Certificate Book. When a bond is issued, the stub is filled out with the name of the payee, etc. An account is opened with each bond holder in a Bond Ledger or Register and information is entered therein as suggested in the beginning of the present section. When a transfer is made, the old bond is cancelled and pasted back on its stub from which first detached. Then an entry is made in the account of the surrendering holder, and one in the account of the new bond holder. If the issue is large, and the transfers many, it is customary to make use of a Transfer Journal to expedite the labor involved in making transfers. So far as the general books are concerned the issuing com- pany merely has to debit the Cash account for proceeds received and credit a Bond account headed to indicate the particular issue involved. When interest falls due on these bonds, checks therefor are mailed to the persons whose names and addresses appear upon (■ 186 ADVANCED ACCOUNTING the Bond Register as of the date upon which the books are closed against further transfers. When interest is paid, which must be done periodically, the issuing company first will prepare a list of the bondholders from the Bond Ledger, and the amount of interest each is to receive. The total thereof is then proved against the bonds outstanding as shown on the General Ledger. Subsequently, the checks are drawn in favor of the persons whose names and addresses appear upon the Bond Register, — those whose names are shown upon the interest list. Coupon Bonds. — Coupon bonds are negotiable instruments, title passing to bearer by delivery, having a number of interest coupons (promissory notes or contracts payable to bearer) attached to them, one such coupon being payable quarterly, semi-annually, or annually, and becoming at such date a definite liability of the issuing corporation. The number of coupons attached to such a bond depends upon the number of years the bond runs and the number of interest periods within the full term. Each coupon should be detached when due, and then be pre- sented for payment, payment usually being made through the bank of the investor who holds the bond. The investor usually deposits them in his bank account, and the bank accepts them for collection. Since coupon bonds are negotiable, the holder of an interest coupon is entitled to have the interest paid to him when he presents the coupon for payment, provided it is due. A coupon does not bear interest after due date. Since these bonds usually are payable to bearer, and since the coupons are payable to bearer, title passing by delivery, the investing publico considers such bonds decidedly convenient for speculative purposes. The coupons are numbered in the order of their maturity. As coupons are paid, the issuing corporation collects and cancels them. After cancellation, the coupons are pasted into a specially prepared coupon book being kept therein as evidence that the interest has been paid. Upon this record, the coupons may be arranged in the order of their numbers, — Coupon No. 1, from all bonds being together, then Coupon No. 2, and so on. Coupon bonds, at times, may contain a clause providing for INVESTMENTS: STOCKS, BONDS AND MORTGAGES 187 their conversion into registered bonds. When a coupon bond is exchanged for a registered bond, all interest coupons past due must be detached and cancelled. Likewise, all coupons that are to mature subsequently must be attached to the bond when the latter is surrendered. The form of a coupon bond does not differ materially from that of a registered bond. It would have a different name and recite that the interest is payable upon presentation of the attached coupons as they mature. If a company has both forms of bonds outstanding, registered and coupon, care must be observed to preserve an accurate record thereof. As concerns the registered obligations, the record therefor was described in the last section; this will be entirely satisfactory. But as regards the coupon bonds, the record of ownership cannot be made entirely in a satisfactory manner, due to the fact already indicated that ownership may be trans- ferred without formality of any kind. Therefore, in the accounts, the outstanding amount of coupon bonds will be shown in one amount. It might be advisable, however, to carry upon the Registered Bond Ledger an account to show the total out- standing amount of coupon bonds. A coupon-bearer bond may have on its back a printed space in which the owner may indicate his ownership in writing. If filled out properly, this bond then may be registered upon the books of the company so that subsequently no transfer thereof will be possible until the registered owner has made a proper assignment. In this case, registration will not apply to the inter- est coupons, the latter being payable to bearer as before. Often a bond issue may be either coupon or registered at the option of the purchasers. Mortgage Bonds. — Mortgage bonds are secured by a mortgage on a company's property. Against such property, usually, they are first mortgage liens taking precedence over every other claim in every case except taxes and receivers' cer- tificates where the latter are in use. First mortgage obligations must be satisfied before second or subsequent mortgages are satisfied. A second mortgage issue may be made where the first issue is small as compared to the value of the property. Mortgage bonds are based upon a trust deed mortgaging the illl 188 ADVANCED ACCOUNTING specific property, the trustee being either an individual or a trust company, usually the latter. Collateral Trust Bonds. — These are used mostly by rail- roads. Many railroads own large blocks of stocks and bonds of subsidiary companies or proprietary^ lines. These securities are used as collateral by the main company, being placed in the hands of a trustee to form the security of tlie bonds. A col- lateral trust agreement is executed and delivered with these securities to the trustee to secure the payment of the bonds. Usually, the securities given are in excess of the bond issue. The income from these securities is used by the trustee, first, to pay the interest upon the bonds and, second, to become part of the sinking fund set up for their redemption. If the collateral consists of the stock of subsidiary companies, the bonds are no better than the stock they represent. If the collateral consists of notes receivable taken for loans made, these being secured by real estate mortgages, the mortgages are given to the trustee and bonds of convenient form are issued against them; the effect here is to separate a large mortgage into small parts to enable a small investor to place his small funds to good use, as a revenue producer. Miscellaneous Classes of Bonds. — Some of the classes of bonds not mentioned above are explained briefly hereunder: 1. Equipment bonds. These are secured by a mortgage upon a corporation's equipment. They are peculiar to railroads, in which case they are secured by a mortgage on the rolling stock. 2. Car trust certificates. These are a peculiar type of bond used by railroads to pay for their equipment, constituting a first lien on locomotives, passenger and freight cars. They are issued to an amount equal to 80 per cent of the cost of the equipment and, usually, they are in serial form, one series falling due each year. Their use permits the railroad to pay for its equipment on the instalment plan. The title to the equipment remains in the holders of the certificates until the last certificate is paid ; this means that the security increases each year in the same ratio as the company's equity. Car trust certificates carry a high rate of interest, are readily marketable but, being much in demand by large INVESTMENTS: STOCKS, BONDS AND MORTGAGES 189 investors, seldom reach the regular market. They may have coupons attached to them. 3. Receivers' certificates. When a railroad goes into receiver- ship, its affairs practically are in control of the Court. In order to meet emergency or maintenance expenditures, the Court may authorize the issuance of receivers' certificates. They are an extraordinary means made use of to protect creditors and to prevent unnecessary loss or waste of assets. Such certificates have a priority over first mortgage bonds and over all other claims. 4. Prior lien bonds. These have a prior lien upon all the assets of a corporation. Receivers' certificates are an ex- ample of prior lien bonds. 5. Adjustment bonds. Sometimes, when a railroad is in the hands of a receiver, the other bondholders may be forced to make a settlement; this leads to an issue of what are known as adjustment bonds. 6. Consolidated mortgage bonds. If a corporation has too many outstanding bond issues and business becomes bad, it may not be able to pay all the interest out of the income. When such is the case, some sort of a reorganization will be necessary for purposes of safety. Frequently, when this happens, the various outstanding bond issues are consoli- dated into one issue which carries a lower rate of interest. The bondholders accept the new bonds in exchange for the old, upon some agreed basis, because this is perhaps the only way out of a bad situation. Again, these bonds may be issued to raise new capital, to unify outstanding issues, or to retire certain outstanding issues, without the reorgani- zation element entering into consideration. 7. Refunding bonds. If a sinking fund (see discussion in later chapter) proves inadequate for redeeming maturing bonds, a new issue may be financed to fund the old outstanding issue. Such new issue would be classed as refunding bonds. The consolidated mortgage bonds above mentioned fall within this group. 8. Debenture bonds. This class of bonds has two meanings depending upon the type of the issuing corporation: 1 ilfil ■i 190 ADVANCED ACCOUNTING a. Debenture bonds of financial institutions. These bonds pledge first mortgages owned by the company which issues the instruments of credit. b. Debenture bonds of railroads, and the ordinary deben- ture. These bonds are not seciu-ed by anything, being nothing more than a formal acknowledgment of a debt, under seal. Since they carry no special pledge of cor- porate property to secure them, they may be considered as formal unsecured notes (promissory) carrying coupons to assist in the payment of interest. They constitute a charge against a corporation's general assets, not against any particular class of assets. As concerns the interest payable thereunder, they present the same gen- eral characteristics as income bonds. In England it seems that all bonds are called debentures. 9. Income bonds. These bonds partake of the nature of both preferred stock and debenture bonds in that they possess characteristics of both. They are not necessarily issued upon the security of any tangible property but depend for payment usually upon the net income of the corporation both as to principal and as to interest. It may be, how- ever, that the principal sum will be secured by a pledge of specific property, or by a preference claim against certain corporate property. Interest is payable always only out of net income, and only after all other fixed charges have been paid; in this they resemble preferred stock. Likewise, as to interest, they may be either cumulative or non-cumulative; in this, they resemble preferred stock. If non-cumulative, the coupons for any one year cannot be cashed when suffi- cient net income has not been earned wherewith to pay them. Income bonds, in the matter of security, resemble the ordinary debenture. They differ therefrom in that they constitute a first lien against profits and no dividends can be paid until they have been taken care of. 10. Deferred bonds. These are somewhat in the nature of an indefinite or perpetual loan, which may or may not be redeemed at face value. The payment of interest may be contingent upon the happening of some event ; or the inter- est may be paid at a graduated rate up to a certain point «f| INVESTMENTS: STOCKS, BONDS AND MORTGAGES 191 which, when reached, means they must be converted into active bonds. 11. Bottomry and respondentia bonds. These two classes are peculiar to shipping. A bottomry bond is a conveyance under which the owner or the master of a ship pledges his ship as security for some obligation. If the ship should be lost, the bondholder loses his security. A respondentia bond is a conveyance under which the cargo of a ship is pledged as security for some obligation. 12. Gold bonds. The principal and interest of these bonds are payable in gold coin of equal weight and fineness with the present coinage, or its equivalent. When bonds are classi- fied according to the exchange medium in which redeem- able, they would be grouped as gold bonds, silver bonds, and currency bonds. 13. Governmental bonds. The usual division of these bonds would be: a. U. S. Government bonds. These are issued by the Fed- eral Government under authority of Congress for various purposes such as carrying on war, replenishing a depleted treasury, etc. They are issued on the credit of the Government. b. State bonds. These bonds are issued by a State for public improvements. c. Municipal bonds. These are issued by cities for various purposes such as the making of public improvements, purchasing a public utility enterprise, etc. Although they are considered, as a rule, to be a good investment, the issue under a purchase contemplation should be scrutinized most carefully; if any irregularity has crept into carrying out of the statutory regulations thereon, the issue will be invalid. In contradistinction to government bonds, other bonds may be termed as "commercial." Loans Secured by Collateral.— Loans secured by collateral may be separated as follows: 1. Time loans. A time loan is made for a definite period of time; it cannot be liquidated, i. e., repaid, until maturity 192 ADVANCED ACCOUNTING unless the lender agrees thereto either for, or not for, a consideration. 2. Call loans. A call loan is not made for a definite period of time; it may be repaid at any time according to the wish of either the lender or the borrower. The collateral pledged as security for these loans may be secur- ities, or almost anything else. In any event, the pledge will have a market value higher than the amount of the loan, the excess depending upon the wishes of the lender. If the markc^t value of the collateral drops so that the excess thereof over the amount of the loan becomes less than the value as on the day the loan was negotiated, new security may be demanded to cover the existing difference. The collateral pledged may be changed at any time by the borrower provided the new collateral is as accept- able to the lender as was the original. If the borrower defaults, the collateral held by the lender may be sold, and the sales pro- ceeds applied to the extinguishment of the debt; any excels remaining after such application must be turned over to the borrower, the former owner of the collateral. The accounting for loans secured by collateral, whether time loans or call loans revolves around the method of recording the pledged collateral and of showing in the same record in connec- tion therewith the amount of the loan. In this connection a card record may prove entirely satisfac- tory, one loan per card. Each loan is given a number which is placed upon the card in the upper right-hand corner. Then the name of the borrower, his address, and the terms of the loan would be recorded. Next, information concerning the amount of the loan, per cent of margin, interest rate, date of loan, interest payment, and collateral maturity should be shown. Lastly, the body of the card would be ruled to show date given, description of collateral, quantity, market value, and total value. Each time the collateral is changed, the new particulars would be added and the old crossed off. Stock and Bond Values.— Stocks and bonds have the follow- ing distinct values, to which reference already has been made: 1. Par (nominal) value. This is the face value, the value shown on the face of the document in question. Such value may or may not be the actual value. INVESTMENTS: STOCKS, BONDS AND MORTGAGES 193 2. Market value. This is the value a security has in the open market, or when offered for sale. Such value fluctuates ac- cording to conditions, future prospects, or according to supply and demand. Ordinarily, it may be considered as the mean between the price asked and the price bid. If an investment is to be considered as permanent, the principal must be looked upon as being safe and the income there- from as being constant and reliable. Because of this fact, the market price of bonds is not apt to fluctuate as much as the market value of stocks. This steadiness permits the investor to rely upon the possibility of realizing upon them in an emergency, either through sale or by using them as collateral for a loan. In the case of stock, this possibil- ity is decidedly uncertain because just when an investor requires his stock for one of these purposes, the chances are excellent that the market will have dropped to such a point that the stock will be useless in this connection. 3. Intrinsic value. This is the actual amount which the stock- holders or bondholders will receive when the affairs of the corporation are wound up. 4. Book value. In addition to the above, stocks have what is known as book value. This is the value of the stock as shown by the corporate books ; for example, the value repre- sented by assets less liabilities. Proprietorship Versus Loan Investments.— Security invest- ments may be classified in a number of ways depending upon the viewpoint. Up to the present moment, one classification thereof has been indicated: 1. Stocks versus bonds. and to this may be added the following: 2. Proprietorship versus loan. 3. Speculative versus non-speculative. 4. Temporary versus permanent. The primary discussion in this chapter revolves around the first and second groupings as such. The others, as a matter of fact, represent merely a restatement of the first. If, when one speaks of investments, he has in mind investment securities, and nothing else, the following classification results: L Stocks. 2. Bonds. 194 ADVANCED ACCOUNTING Hereunder a short term note is considered a form of bond. If a person's investments consist of stocks, he is said to have made a proprietorship investment; whereas, if his investments consist of bonds, he is said to have made a loan investment, — an invest- ment contemplating an interest return. There is an uncertainty about a proprietorship investment in that a return will be secured therefrom only if a profit is made. Investment in the stock of a business does not necessarily mean an investment made for a definite period of time ; in fact, the length of the period is indefinite being limited, in general, only by the life of the concern whose stock is held. No return is secured from a stock investment until a dividend has been declared by the board of directors of the company represented by the stock held. The payment of dividends depends upon profits earned; if profits have not been earned, legally, no dividends should be declared. Therefore, dividends never should be ac- crued. The uncertainty of a return therefrom, and the insecurity of, a stock investment in comparison to the certainty of a return from, and the security underlying, a loan investment, make the former one of a purely speculative character. The holder has a certain proprietorship interest in the concern which gives him some voice in its management. The loan type of investment covers the advancing of funds for a definite period, anywhere from one year to fifty, during which a fixed rate of interest return will be received, and at the end of which the principal sum advanced must be refunded to the lender. Certain peculiar characteristics are noticed hereunder: 1. In general, security is demanded before the loan will be made. This security, in part, takes the form of a negotiable instnunent which becomes due at a definite future date. The investor, therefore, secures two clear-cut promises: a. A promise that the loan will be repaid on a definite future date. b. Due to the element of negotiability in the instrument as referred to, a promise that, if he so desires, he may dispose of the negotiable instrument security at any time by sale. 2. A fixed rate of return is promised in the form of interest this being a definite percentage computed upon the face INVESTMENTS: STOCKS, BONDS AND MORTGAGES 195 value of the loan. The return, therefore, may be deter- mined readily. 3. In general, specific property is pledged as security for the ultimate repayment of the loan. For example, a bond and mortgage on real estate may be given as security for the loan. 4. The holder of the security has no right of management in the business to which the loan is made. As long as no default is made concerning the provisions underlying the loan, the management can act as it sees fit, without regard to the lender, or to the views of the latter. Although the market value of a loan security may fluctuate, the fluctuation will be less than that of a proprietorship loan (stock). However, if the security is listed upon the Exchange, the fluctuation may become of such a character as to be sufii- ciently interesting to an investor who is willing to take a specu- altive chance to make money in buying and selling speculative securities. In short, the loan type of investment carries a definite and se- cured return in the form of interest, and in the ultimate repay- ment of the loan without requiring the investor to participate in any way in the management of the borrowing company. By investing in such securities, one is assured of a certain income without the bother and annoyance of participating in a business and without incurring any proprietorship risk. Advances which differ from the above second grouping of investments are not to be classified under the same subdivisions, since they are too temporary in their nature. Familiar examples of these would be: credit loans, bank loans, discounting com- mercial paper, etc. Speculative Versus Non-Speculative Investments— Tem- porary Versus Permanent.— When investments are made with the intention of retention until such time as the market value shall increase to a point at which the investor will be enabled to sell at a profit, they are considered as speculative. On the other hand, when investments are made to secure an income return therefrom, they are classed as non-speculative. For ex- ample: The laws of New York state that in the absence of II 196 ADVANCED ACCOUNTING specific instructions in deeds of trust or wills, tliose charged with the administration of trust funds must invest in: 1. ^'Bonds and mortgages on unincumbered real property in this State worth 50 per cent more than tlie amount loaned thereon. 2. The securities in which savings banks are authorized to invest." These types of investments contain no element of speculation; neither would they be classed as temporary. Speculative investments are all temporary in character, and may be divided as between: 1. Securities purchased outright. 2. Securities purchased on a margin. The first class mentioned well may be taken care of, from the point of view of record making, in accord with the ideas set forth below. The second class is discussed by itself in a separate section. The characteristics above mentioned in respect of speculative investments places them, so to speak, in the same category with goods and commodities in that, like these latter, they are held for the purpose of making a profit through a sale. Therefore, they should be booked like any other commodity, i. e., at cost. Such cost price includes brokers' fees and any other expenses incident to the purchase of the investment in question. Some persons insist such investments should be recorded at par,— at face value as shown upon the investment certificate. Sucli booking, however, would seem to be in error because of the fact that by so doing a profit or a loss, as a rule, is anticipated at the time of purchase; whereas, neither of these elements puts in an appearance until a sale is made. The record-keeping for such investments, on the whole, is a simple matter. An account may be opened upon the General Ledger with each such investment purchased, or one account may be opened thereon titled Investments or Securities, this be- ing backed up by a subsidiary record in which each investment is given a separate account. Stocks and bonds sometimes are bought upon a margin, for speculative purposes. Under such a set of facts, one has an asset consisting of the right to receive the delivery of the securities : 1 INVESTMENTS: STOCKS, BONDS AND MORTGAGES 197 when the balance of the purchase price has been paid. This asset is offset by the liability of the purchaser to the broker for an amount equal to the full purchase price, less the margin that has been deposited. Ordinarily, upon the Balance Sheet, securi- ties bought upon a margin should be carried at cost, this includ- ing the broker's fees bearing upon the purchase; investment companies, however, for Balance Sheet purposes, would value such securities at market prices. Since the broker charges interest upon the difference between the amount deposited as margin and the purchase price, provi- sion therefor must be made in the accounts. To this end, the account carried with the security in question should be charged with the amount of the interest and this charge be offset by a credit to the broker's account. Likewise, it should be remem- bered, the broker will allow interest in favor of the purchaser on the amount deposited with him as margin. This allowance is an offset to the charge for interest mentioned just above. If dividends are received on stocks or interest is received on bonds, by the broker for the account of the purchaser, the ac- counting therefor may be carried out in either one of two ways: 1. Charge the account of the broker and credit the account with the investment. 2. Charge the account of the broker and credit an income account. The first method is to be preferred to the second because, by so doing, the cost of the investment is gradually reduced so that, when the investment is sold, the owner may determine the net profit or loss on his speculation, all elements therein having been taken into consideration. At any time, the effect of the entries made in connection with margin investments should be such that the difference between the asset and the liability account will represent the net equity of the purchaser in the investment. Non-speculative investments are of two t^pes: 1. Temporary. This type contemplates a temporary source of income, as where a corporation has an abundance of cash capital and cannot profitably invest this in merchandise or secure an acceptable rate of interest from having such cash on deposit. In such event, securities may be purchased to 198 ADVANCED ACCOUNTING obtain a larger income, but with the idea of converting, at the pleasure of the corporation, these securities into cash when additional cash funds are required. 2. Permanent. This type relates to investments made in order to control the activities of another concern, or investments made of reserve funds. From this point of view, it is difficult to state, as certain writers do, that all temporary investments contain an element of speculation. It seems fully possible that a temporary invest- ment may be made in which the element of speculation is entirely lacking; but on the other hand, a speculative investment cannot be anything but temporary. If the element of speculation be eliminated entirely, it would seem that non-speculative investments may be grouped as: 1. Mortgages receivable. 2. Loans secured by collateral. 3. Stocks and bonds. a. Parent companies. b. Subsidiary companies. c. Allied companies. d. Outside companies. Investments which are temporary income producers, in general, should be recorded in the books of account at actual cost price.' This is the simplest way because no one knows exactly how long they are going to be held. As interest is collected thereon, the amount would be credited to an account of Interest Income-Investments, the total amount of this account eventually disappearing into the Profit and Loss account. When an investment of this character is sold, and a profit or loss thereon is involved, the proper accounting procedure there- for would be to credit the asset account carried with the cost price in order to clo§e it and to credit or debit a nominal account for the profit secured or loss suffered, as the case may be. The amount of such profit is a financial income item and the amount of such loss a financial expense item. There is no uniformity in booking permanent investments. The point to remember is that the procedure involved becomet INVESTMENTS: STOCKS, BONDS AND MORTGAGES 199 more complicated than indicated above on account of the fact that such investments are purchased under an intention of hold- mg them until maturity. In general, they may be recorded at cost or at par, depending upon the desires of the investor rather than upon anything else. If recorded at cost, the matter is handled as indicated above for handling investments which are temporary income producers On the other hand, if recorded at par, it may. be necessary to account for the amount of premium or discount involved in the transaction as where the purchase was made either above or below par, as the case may be. This point will be discussed later. Bonds as Investments.— As an investment security, a bond offers a fixed interest return and repayment of the principal at a specified time. Both of these factors are secured by a pledge of property which, as a rule, is in the form of a first lien. Since a bond carries with it no management responsibility, and since both the income therefrom is fixed and repayment definite as to time, the speculative element present is much less than that pres- ent when one makes a stock investment. In the latter event there is an indefinite profit return, no dividend being possible unless there are net profits available for distribution. The fundamental differences between stocks and bonds is accountable for the differences that arise in the accounting treat- ment accorded each. And this accounting treatment revolves around three definite factors which may be stated about as follows: 1. Purchase. 2. Amortization. . 3. Sale. In buying a bond and, also, in selling a bond, three factors must be considered: 1.. Par value. 2. Interest return. 3. Sales price. A bond may be purchased privately, which is more or less unusual, or it may be bought in the market. In the latter event, the market is created through the power of some Stock Ex- change, as the New York Stock Exchange; this latter organiza^ « 1 ; 200 ADVANCED ACCOUNTING tion is the principal bond market in the United States. A broker, for example, who is a member of the Exchange, will purchase a bond for a customer when ordered to do so, buying at market price, and charging one-eighth of one per cent on the par of the bond for his services regardless of what the market price may be. When a bond is bought, the sales price paid usually will include a certain amount to cover the interest that has accrued to date from the last interest payment date; hence, the buyer must take this element into consideration when booking his purchase. Accounting For Bonds as Investments— Simple Pro- cedure. — The accounting methods used for bond purchases vary with the volume of the transactions consummated and with the desires of the investor. The small investor, i. e., the person who buys a few bonds as a permanent or. a temporary investment, requires no elaborate methods of accounting; the simplest method is the best, and sufficient has been presented above, per- haps, relative thereto. He is most apt to carry such investments entirely upon a cost basis, considering any premium or discount either as a profit or a loss at the time his holdings either are sold or mature. In brief, and by way of review, the method advised is illustrated by the following account of Secm-ities Owned. SEcrmrriES Owned Debits: 1. Cost of stocks and bonds pur- chased (issues of other corpo- rations). 2. Amount of balance, if a credit to be transferred to the Profit and Loss account. When this entry has been made, the ac- count should be closed. 3. After debit entry No. 2 or credit entry No. 3 has been made, as the case may be, this account will be closed. Thus the inventory at the end of the period, as per credit entry No. 2, should be entered below closing ruling as the beginning inventory of the next period. Credits: 1 . Sales price of stocks and bonds sold (issues of other corpora- tions). 2. Inventory of stocks and bonds on hand at end of period, at cost price. 3. Amount of balance, if a debit, to be transferred to the Profit and Loss account. When this entry has been made, the ac- count should be closed. INVESTMENTS: STOCKS, BONDS AND MORTGAGES 201 If accrued interest is involved in the purchase, the purchaser must take this up separately from the cost, as of purchase date, provided he wishes his accounts kept correctly. Assume that five $1,000.00 5 per cent bonds were purchased on August 22, at 73 and accrued interest, interest being payable February 1, Ind August 1. On August 22, there would be accrued interest of $14.58, for which the purchaser must pay. In other words, the total cost of the bonds would be: $5,(X)0.00— block par @ 73, 1/8 of 1 per cent— broker's commission, Accrued interest, 5 per cent on $5,000.00 for 21 days, Total, $3,650.00 6.25 $3,656.25 14.58 $3,670.83 Of this total, $3,656.25 should be set up as the asset, and $14 58 should be recorded in an Accrued Interest account, which, later upon the next interest payment date must be credited in the amount of the accrued interest as of the purchase date- the remammg portion of the interest collected represents the amount that actually is income for the period from purchase date to February 1. However, if the investor wishes to use a more accurate account- mg procedure than has been indicated above, he may follow either of two possible courses, each of which may be considered far more elaborate than the simple procedure just presented. Each of these two possible variances in procedure will be dis- cussed in due course in the remaining portion of the present chapter. Bond Premium and Discount; Nominal and Effective Interest Rates; Amortization and Accumulation.— Before proceeding further, it seems in order to set out certain defini- tions and distinctions necessary to an understanding of what is to follow. Bonds may be purchased at par, above par, or below par. If purchased above par, they are said to have been bought at a "premium"; if purchased below par, they are said to have been purchased at a '^discount." In the example given in the last sec- tion above, the bond was purchased at a discount; and in just the same way it might have been bought at a premium, say, for 105. 202 ADVANCED ACCOUNTING The rate of interest set out upon the face of a bond is known as the ''nominal" rate of interest; it may be at any amount the issuing company desires. This nominal rate may or may not be equal to the worth of money upon the market upon the day the bond is purchased. This latter rate will be the one at which the bond will sell for if issued at par thereunder. This second rate is known as the "effective" rate, upon the basis of which is calculated the net return upon the amount of money actually invested. If a bond is purchased at a premium, the difference between its cost and par will be a loss at maturity, since at that time only par value can be collected. In other words, disregarding current market fluctuations up and down, the value of this bond will depreciate in proportion to the lapse of time between the time of purchase and time of maturity. This loss, or premium, should be spread, i. e., amortized over the life of the bond rather than be written off in a lump sum at the time the bond matures. Amortization, therefore, may be defined as, "The gradual extinguishment of the amount of an asset, . . . by prorating it over the period during which its benefit will be realized." As applied to bonds, amortization contemplates the periodical adjustment of the amount that is received as inter- est on the par of the bond, to the real interest,— that which is received upon the amount actually invested. In other words, if the premium is held as an asset, and all interest actually received is booked as income, the income must be overstated during the interim period inasmuch as when the bond is actually redeemed, the books will hold a nominal ele- ment that must be written off at that time. To avoid this lump sum loss in the final period since, as a matter of fact, it has been accumulating gradually from the date of purchase of the bond, there is written off each year against the amount re- ceived as interest a proportionate amount of the premium. This process of writing down the premium is known as "amortiaa- tion." On the other hand, if a bond is purchased at a discount, the difference between the purchase cost and par will be a profit at maturity, because then par will be collected. And applying the same reasoning here as was set out above,— that if the dis- li; 't INVESTMENTS: STOCKS, BONDS AND MORTGAGES 203 count is held as a lump sum until maturity, the books will hold a nommal element representing income which has been accumu- latmg gradually from the date of purchase of the bond, the income for the entire interim time, period by period, has not been stated correctly. The profit on the money invested should be spread i. e., accumulated,-added to the cost of the bond- little by little over its life so that at maturity the book value of the bond will have been built up (accumulated) to par This vir^'fl^'f "! ^T ^^' ^^''"^°^ ^°^ ^""^^^^ ^P the book value of the bond is known as "accumulation." Of course, in practice, bonds often are sold before maturity dates; again, they may be held for speculation rather than for purposes o investment. If either of these two possibilities be m contemplation, all the principles raised in the present section will be disregarded entirely, and the owner of a bond will carry It at cost, or even at market. If the small investor wishes a more accurate accounting pro- cedure than has been indicated, or if investments in bonds form part of the regular business operations of a concern, the first step necessary will be to keep the accounts upon an investment- value basis rather than upon a cost-value basis. Basically hereunder there is involved a more or less elaborate accounting procedure relative to amortization and accumulation plus a con- sideration of both the nominal and effective rates of interest. JNext, a decision must be reached as to the following: 1. Shall the accounting calculations be made upon an approxi- mate basis of accuracy, or 2. Shall the accounting calculations be made upon a strictly scientific basis of accuracy? This differentiation will be discussed fully after the principles have been presented leading up to such consideration. Ascertaining Present Value of a Bond.^The premium or discount on a bond represents a deduction from, or an addition to the nominal rate of interest a bond carries. The nominal ratJ of interest which the issuing company elects to have its bonds cariy may or may not be equal to the worth of money upon the market,-the interest rate at which the bonds would sell at par If issued thereunder. If the nominal rate of interest is above m 204 ADVANCED ACCOUNTING ii the effective rate (market rate), the bonds will sell at a premium- and if the rate be less, they will sell at a discount. Four elements enter into the value of a bond: 1. Sufficiency of security. 2. Rate of interest return. 3. Number of interest periods. 4. Time the bond has to run. When an investor contemplates purchasing a bond, he should keep m mind the four elements shown above plus both the nomi- nal and effective interest rates. Knowing these, he is in a posi- tion to determine whether the price asked is right. Illustrative of this, study the following problem and its different methods 01 solution. onJ^^:'^"' ^T^"^ ^' ^^^^' ^ '"^^^ ^^^"«*^^ contemplates purchasing uue uecemt^r 31, 1923, interest payable semi-annually. The bond is uJ be purcha^ upon a 6 per cent basis. How much should be paid for i^ First Solution.~The bond contains ten coupons, each for $4.00. First coupon compounded for 9 terms at 3 per cent. Second coupon compounded for 8 terms at 3 per cent. Third coupon compounded for 7 terms at 3 per cent Fourth coupon compounded for 6 terms at 3 per cent, mh coupon compounded for 5 terms at 3 per cent. Sixth coupon compounded for 4 terms at 3 per cent, Seventh coupon compounded for 3 terms at 3 per cent, ^ighth coupon compounded for 2 terms at 3 per cent. Nmth coupon compounded for 1 term at 3 per cent, Tenth coupon compounded for term at 3 per cent, Total coupons compounded to time of redemption ' Kedemption value of bond at maturity 5.219092 5.067080 4.919492 4.776208 4.637096 4.502032 4.370908 4.243600 4.120000 4.000000 I 45.855508 100 00000 $145.8555(» JLt;nd "^Z^"^^? """r^ ^"^ '^*^'"^ '^' -"'--« --d redeeming tne bond. The amount mvolved, however, is to make $140 00 plus interest t wCt Z!::t^'^'1 «enn-annuaUy,-$5.855508. Ne*^ ^^^^^Z ^ amount to SlWS855'rSvlL^^^^^^^ pS^o'^h^Ta^ 8';eTir$i*So^rond^" ''''' f'''' '''^''^^^ income of 6 per cent.'crm^lTselt^^^^^ '^^ ^^^"' ^^^^^ ^^ Second Solution.^There are ten coupons accruing interest at 3 per cent. INVESTMENTS: STOCKS, BONDS AND MORTGAGES 205 t^e^run^n^wM^r^^^ ^^^^ ^^^ «*^- - known and C, the first quantity, is the coupon, ^ f^ M lu* T^^f quantity, is the ratio to the buyer, i 03 N, the third quantity, is the number of terms in Th3 iT*'^ ""''"'"y- '" •">k''own,-the sun^ of the series ? These quantities may be arranged into the appearance of a formula- CR° - C ^ JowerTthTnoit- • ™V!,r'V"'' ''^ "'^ ^''° '"^ raised to the 10th pXt't sEc^^trfi^f It-thatV'^'r^- th'-^" ''Z ''' totellntelt on tL T" '""°"°*'' ^'''^ ^ '<«"'* -^Presenting the total mterest on the series of coupons, which is $1.375664. This interest Lta^IdTl,^ -' 3 ?tr'' °: .^If '"^ "' '""^ ""-• Now, since 3 is 33 1/3 b theLe^iv^Lgbf 63 (theeo;, r '^'*''-- ^^^'^P'^^^ ^y will reHup* IK. ™ =» uiviaing Dy .03 (the equation denominator). Nothing ^ il^ rii^hms""''''' ''''"'' '"''''''' '" ^""°« »"- -•"*-. -ept or S^viu^T^^hTh '^H T't""" °i """*'°" » *" P'<"'««d from the maturity Maturity value, par, Add-Interest due 9 terms from present, or 1 from maturity, Discount tins amount by dividing by 1.03, the effective rate - Lt b^^atuS" '^"^"^ ''' ^^- '' ''' '-^ ' ''r2Tom"t;S; '"" ^^"'^'^ '^^ ' ^"^^^ ^^^^ '--'' Discount this amount by dividing by 1.03, as above. maturitT*^ ''' '^'^ ^' ''^ '^^^ ' ^^^'^ ^^^- To secure next value, add coupon due 7 terms from present or 3 terms before maturity, present, Discount this by dividing by 1.03. Value of bond 3 terms before maturity Add coupon due 6 terms from pre8ent-4' from maturity, $100.000000 4 000000 $104.000000 $100.970873 4.000000 $104.970873 SlOl. 913449 4.000000 1105.913449 $102.828785 40000 00 1106.828785 \ 206 ADVANCED ACCOUNTING 'I ' 'i «. (i Discount by dividing by 1.03. Value of bond 4 terms before maturity, Add coupon due 5 terms from present— 5 from maturity, Discount by dividing by 1.03. Value of bond 5 terms before maturity, Add coupon due 4 terms from present— 6 from maturity, Discount by dividing by 1.03. Value of bond 6 terms before maturity. Add coupon due 3 terms from present— 7 from maturity, Discount by dividing by 1.03. Value of bond 7 terms before maturity Add coupon due 2 terms before present— 8 before maturity, Discount by dividing by 1.03. Value of bond 8 terms before maturity. Add coupon due 1 term from present— 9 before maturity, Discount by dividing by 1.03. Value of bond 9 terms before maturity. Add coupon due terms from present— 10 before maturity, Discount by dividing by 1.03. Value of bond 10 terms before maturity— at present, The present worth of the bond is seen to be the same as before, $108.53. Schedule of Amortization.— When the above bond is brought upon the books of the purchaser, the latter might follow any one of three procedures, as to booking: 1. The simple method, as explained above. 2. The amortization methods. a. Simple procedure — non-scientific. b. Scientific procedure. Naturally, since the above bond is of such a small amount, the owner is not apt to follow a more or less scientific procedure relative thereto, but if he wished to do so, the preparation of an amortization schedule would be in order. The first schedule shown below has been prepared upon what is known as the non- scientific basis. The second schedule follows the first one as t^) pnnciple, but involves a more elaborate calculation; hence, may 1103.717267 400000 1107.717267 $104.579871 4.000000 $108.579871 $105.417360 4.000000 $109.417350 $106.230437 4000000 $110.230437 $107.019842 4 000000 $111.019842 $107.786254 4000000 $111.786254 $108.530344 INVESTMENTS: STOCKS, BONDS AND MORTGAGES 207 be termed the scientific basis, in that the difference between the actual income and the effective income is calculated as ac curately as possible at each interest paying date and is used to reduce the carrying value of the bond. The scientific calculation may or may not be based upon bond tables; naturally, the element of error creeps in without their use, as will be noticed subsequently. Schedule of Amortization Period Period Coupons 4 per cent 1 $ 4.00 $ 3.147 2 4.00 3.147 3 4.00 3.147 4 4.00 3.147 5 4.00 3.147 6 4.00 3.147 7 4.00 3.147 8 4.00 3.147 9 4.00 3.147 10 4.00 3.147 $40.00 (Non-Scientific) Income Net Approximate Amortization 853 .853 .853 .853 .853 .853 .853 .853 .853 .853 $31,470 $8 530 Book Value $108,530 107.677 106.824 105.971 105 118 104.265 103.412 102.559 101.706 100.853 100.000 Schedttle of Amortizatio n 8 per cent— -Five Year Gold Bond Nothen Power Company Redeemable at Par, $100.00, on December 31. TQgg Income Rate 6 per cent Coupons Income Net Book 4 per cent 3 per cent Amortization Value 1 $ 4.00 2 4.00 3 4.00 4 4.00 5 4.00 6 4.00 7 4.00 8 4.00 9 4.00 10 4.00 $ 40.00 $ 3.2559 3.2336 3.2106 3.1869 3.1625 3.1374 3.1115 3.0849 3.0574 3.0291 $ 31.4698 $ .7441 .7664 .7894 .8131 .8375 .8626 .8885 .9151 .9426 .9709 $ 8.5302 108 107 107 106. 105. 104. 103. 102. 101. 100. 100. .5300 .7859 .0195 .2301 .4170 5795 7169 8284 9133 9707 0000 208 ADVANCED ACCOUNTING The discrepancy, in the last step, being but two points in the fourth place, is not sufficient to discredit the accuracy of the above calculation. Absolute accuracy may be secured by the use of bond tables; these should be used whenever the bond values involved are of considerable size. Accounting For Bonds as Investments — Amortization Principle. — If the investor wishes to use a more accurate accounting procedure than the simple method, such procedure will revolve around one or the other of the amortization sched- ules worked out above: 1. In accord with the simple scheme of amortization, or 2. In accord with the scientific scheme of amortization. Either one of these methods is suggested in preference to the simple method of booking in that, if the books of the investor do not consider the effective rate of interest upon his investment, he cannot tell whether a proposed sale will or will not net him a profit. And by considering the effective rate, the investor re- quires a method of record keeping different from the simple one already indicated. Under the simple scheme of amortization, the investor will take the total premiimi or discount and divide this amount by the number of periods the bond has yet to run. For example, in the previous explanation or illustration, this would be in ac- cord with the non-scientific schedule of amortization. The bond has ten periods to run. The total premium is $8.53. Therefore, the net amortization each period would be $.853. As already indicated, this method is not scientifically accurate, but suffi- ciently so for working purposes. In connection with the simple or non-scientific scheme of amortization, the accoimts to be carried will be similar, as to title, to those carried in a concern in which investments in bonds are part of the ordinary business operations, — i. e., in a concern using the scientific scheme of amortization. Likewise, the entries made therein will be the same; the only difference will be as to the amounts involved in such entries. When either the approximate, or the true, investment value of bonds is to be carried upon the books of record, the following accounts must be used: 1. One account for each bond investment, record to be made therein at par. INVESTMENTS: STOCKS, BONDS AND MORTGAGES 209 2. One account with accrued interest, if any is involved 3. One account with bond income. 4. One account with bond premium. 5. One account with bond discount. If bonds are purchased between' interest dates, a certain amount of mterest will have accrued thereon for which the pur- chaser must pay Interest on a bond, it should be remembered accrues day by day, but is not payable until the end of some fixed period Likewise, when the books are closed, accrued in- terest upon bonds held must be calculated and booked, miless the rr bTs-:."^ ""^'^ ^^^^ ^ ^^^^ '^^ ^-^^^ ^^ -^^ - o per cent first mortgage bonds due Tnlv l looo ;,,* * ^.umpany January 1, 1921 Clair Co. Light, Heat and Power Co. 5 's— 1922 S. years. Further, the formula to be used in making the calculation is more or less involved; the method would seem to be one to be favored by a theoretical mathematician, not by a practical man. Revaluation Method.— This method of dealing with depre- ciation contemplates a revaluation or appraisal of the assets at the end of each accounting period, as yearly. Hereunder, the difference between the book value at the end of the year and the value disclosed by the appraisal would be written off as depre- ciation against the operations of the year. In general, the method is not a practical one for two reasons: 1. Elaborate property records are necessary and but few con- cerns are willing to incur the expense necessary to keep such records. 2. It does not result in spreading the depreciation scientifically over the various accounting periods (see qualification in next paragraph). So far as small tools and office furniture and fixtures are con- cerned, this method seems the most desirable of all, as concerns these items, since it tends to distribute equitably the loss in value or depreciation against each year's operations. Composite Life Methods. — In public utility accounting, a composite life method is used commonly. In the first instance, in public utility accounting, the composite life of the plant as a whole is determined. Next, the annual depreciation charge is calculated so that at the end of this life period the entire value of cost less scrap will be written off. The depreciation charge may be calculated in connection with the composite life of the plant in a niunber of ways already discussed, as: 1. Straight line. 2. Diminishing value. 3. Sinking fund. The property first is classified both as to cost value less scrap, and as to age. Next, the class of property having the longest life is taken as the basis, and the number of renewals of the other classes of property during that basic period is determined. Next, the total cost of renewals in each class during that period is calculated. Next, these costs are multiplied by the years of life for each class and the product secured for each class extended DEPRECIATION; RESERVES AND RESERVE FUNDS 227 as "dollar years." The total dollar years divided by the total cost of all renewals during the period gives the composite life, or mean life, of the plant. A schedule to use hereunder would be headed about as follows: Class of property. Life. Cost of reproduction new. Scrap value. Cost new less scrap. Times renewed in . . . (base) . . . period. Dollars required in . . . (base) . . period. Dollar years. Except for the matter of determining the mean life of a plant by dollar years, this method will not differ from any of the others. Working Hours Method.— This method calculates depre- ciation upon the basis of the number of working hours estimated as representing the life of an asset. When the rate per working hour has been obtained, the depreciation for an accounting period is computed by multiplying this rate by the total number of hours the asset has been working during the period, the result secured being the total period's depreciation. This method seems most desirable from the viewpoint that the charge for depreciation conforms to the use of the asset in ques- tion, it being assumed that the depreciation will be in proportion to use. However, regardless of its desirability, the objection may be made, as in the case of the straight line method, that heavy repairs and upkeep toward the end of the asset's life are not recognized, inasmuch as the amount thereof cannot be com- puted in advance with any degree of accuracy. l>roduction or Output Method.— Hereunder, the depreciation rate is charged per unit of output. The method, to some extent, resembles the working hours plan. It is especially applicable to assets of the nature of furnaces, kilns, etc., where linings must be renewed on the basis of actual use. Again, it is particularly applicable in amortizing wasting assets such as timber stumpage, and coal or ore mines, if no distmction is to be made between the assets subject to depre- ciation and those which are of the wasting type. In the case of wasting assets, however, these decreasing in value in exact i' I I ' i 228 ADVANCED ACCOUNTING ratio to the amounts used, it is doubtful whether such decrease is depreciation. In the case of wasting assets, the charge would be made when a sale has taken place, not before. There is just as much on; on hand, for example, whether it is on the surface or under ground ; the quantity does not change until a sale has taken place. It may be stated, in conclusion, that the production method may be operated upon a sinking-fund basis rather than upon the proportional basis presented above. Miscellaneous Methods.— Depreciation methods, other than the above, may be summarized briefly, since no detailed discus- sion of any one seems necessary: 1. Arbitrary amounts are charged periodically to depreciation: a. Increasing as time passes. b. Decreasing as time passes. 2. Arbitrary amounts are written off at any convenient time. 3. Unit cost. Each unit of product has equalized thereover in the periodical depreciation charge, interest on investment, operation and repair charges, and actual depreciation. This method involves an elaborate mathematical calculation making use of the sinking-fund principle. 4. Replacement. Hereunder, no depreciation is booked, all replacements and renewals being assumed as offsetting depreciation. 5. Maintenance. Hereunder, the periodic maintenance cost of an asset measures the depreciation charge made. 6. Gross earnings. Hereunder, the amount of the periodical depreciation charge depends upon earnings. In lean years, therefore, the charge will be less than in prosperous years, since the rate is calculated upon earnings. 7. Insurance. Hereunder, actuarial principles are used. The fund accumulated or measured by depreciation charges does not come into existence until it can be used, and then it is to be used within the period in which it came into existence. 8. Fifty per cent. This method is usable only when an asset reaches the point, due to depreciation, where it must be renewed. The theory is that ordinary repairs will always keep an asset in a 50 per cent condition at least. Hence, depreciation is applicable only to the other 50 per cent. DEPRECIATION; RESERVES AND RESERVE FUNDS 229 Fallacy in Theoretical Depreciation Discussion.— In the discussions above, the assumption has been made, which is gen- eral, that an asset being depreciated will be used until scrap value is reached; herein lies the fallacy. As a matter of practice, no asset should be kept when its condition drops below 75 to 65 per cent, in other words, no asset should be kept which has depre- ciated beyond 25 to 35 per cent. If so, the repair and renewal charges will be too heavy for practical purposes, and a new asset should be secured. Again, regardless of how much care is observed in calculating a depreciation rate, many instances will be encountered where the book depreciation to date will be far in excess of actual depreciation. In other words, on the records an asset may be even down to scrap value, whereas, as a matter of fact, the asset will be in use and functioning at least 65 per cent; the deduction to be drawn, naturally, is that production costs in the past were excessive. The conclusion to be drawn would seem to be that, regardless of all the possible methods that may be, or are, used, the correct method, under many cases, has not as yet been found. Depreciation Rates.— In determining the rate of depreciation for a particular asset, no two persons would agree. In the first place, each problem presented contains dissimilar elements; hence, no specific rules for specific types of cases would seem applicable. At best, the amount to be determined upon is a matter of judgment, tempered by experience. So long as the judgment is conservative, and so long as ample depreciation is provided, the accountant should be satisfied. Although no two persons will agree in estimating depreciation rates, the following estimates are presented so that the student may have something of a definite nature for reference. The six classes of assets set out are the usual ones concerning which accountants ordinarily have to deal in practice: 1. Buildings. From IVg to 5 per cent per annum, the average being about 2^/^ per cent. 2. Machinery. From 5 to 10 per cent per annum. 3. Furniture and fixtures. From 10 to 15 per cent per annum. 4. Horses and wagons. a. Revalue at end of each year and write off the difference I 230 ADVANCED ACCOUNTING between that value and book value against operations of the current year, b. About 10 per cent per annum. Horses, alone, may average about 15 per cent per annum. 5. Automobiles. From 15 to 33V3 per cent per annum. 6. Tools and running gear. a. Revalue as indicated already above. b. From 20 to 331/3 per cent per annum. Booking Depreciation.— The following are representative methods of treating depreciation upon the books of account: 1. Charge Depreciation account and credit the asset accounts. Hereunder, the assets are written down ; hence, the cost of each written down asset is lost sight of. This is a serious objection to the method inasmuch as: a. The cost value of any asset should be its booked value. b. The cost value becomes the settlement basis with insur- ance companies in case of loss. 2. Charge Depreciation account and credit a ''pool" Deprecia- tion Reserve account, this reserve covering all classes of property. The objections to this method are about as follows: a. The net carrying value of each particular class of fixed assets cannot be determined except by analyzing the ac- count. If an account must be made over before it pre- sents an intelligent story, the account should have been revamped in the original instance before entries are booked. b. No means exists of verifying the accuracy of the increases to the account inasmuch as actual depreciation for each class of property, from time to time, cannot be checked against the booked theoretical depreciation. 3. Charge Depreciation account and credit a specific Depre- ciation Reserve account for each class of property. This seems to be the best method to adopt inasmuch as the cost value of an asset less the amount in the Depreciation Re- serve account will show the asset's net carrying value. Usually, this method is the only one used in the elementary study of accounting principles; hence, it should be familiar to all advanced students. DEPRECIATION; RESERVES AND RESERVE FUNDS 231 The Depreciation Reserve account for a particular class of assets would record the following elements: 1. Debits. a. Extraordinary or periodical renewals which tend to in- crease the original life of the plant. b. Cost value of whatever portions of the asset in question are dismantled; the offsetting credit would be against the asset account. 2. Credits. a. Provision for the accrued depreciation calculated upon the basis of the annual rates adopted ; the offsetting debit would be against the Depreciation account carried for the class of assets. b. Scrap value of whatever portions of the asset in question are dismantled; the offsetting debit would be against a scrap account representing scrap stock. 3. Balance. Represents depreciation that has accrued to date not yet made good. ' The Reserve for Depreciation account may be set out upon the Balance Sheet in either of two ways, dependent upon the view- point taken as to what such a reserve represents: 1. As a liability. This viewpoint would consider the reserve as a special liability, to be set out as such, representing a provision to cover a liability for an expenditure which must be made in the future to purchase a new asset when the old one is discarded. Hereunder, the reserve will show as a liability upon the Balance Sheet. 2. As a valuation or estimate account. Hereunder, the reserve IS an opinion of some one, assumed as being competent of the amount that an asset or class of assets has diminished m value by deterioration. It represents merely what may be considered as a suspended credit to the asset account carried m a separate account for reasons already given' Hereunder, the reserve will be shown upon the Balance Sheet as a deduction from the asset. Since depreciation should represent actual loss insofar as one may estimate the amount thereof, it seems that this view is the correct one 232 ADVANCED ACCOUNTING 1. 11. Replacing or Selling Depreciated Assets. — Two more or less elementary problems arise relative to depreciation elements which may be commented upon briefly: 1. Replacing a depreciated asset. This problem seems to pre- sent a two-way differentiation: a. Depreciated asset worn out. Charge the cost of the old asset to the Depreciation Reserve account carried. If the reserve has been calculated properly, its amount will represent the whole cost of the asset charged against profits and credited against the reserve. b. Depreciated asset not worn out. Sometimes a partially depreciated asset will be replaced by a better one, the replacing being caused by something that could not be foreseen when the original asset was secured. The old asset's remaining net value may be taken care of: By a charge to Surplus account, provided such procedure does not eliminate this account entirely. By leaving the old asset upon the books to be written off as rapidly as possible during subsequent periods or years, and by booking the new asset in a separate account. 2. Selling a partially depreciated asset. Hereunder, a two-way possibility exists: a. Sales price less than net carrying value. The difference between the cost and the price realized consists of depre- ciation charged off already and the profit or loss from the sale. The asset account should be credited to elimi- nate the cost; the depreciation reserve should be debited to eliminate the amount credited to it on account of this particular asset; and Surplus account should be charged to take up the loss suffered. Even though the above really assumes a sale as at the end of a year after the periodical depreciation has been adjusted, the procedure followed may be applied in exactly the same way to an asset disposed of before the end of a specified period. In other words, if an asset, partially depreciated, be sold between two closing dates, two possible ways exist rela- tive to the handling: DEPRECIATION; RESERVES AND RESERVE FUNDS 233 1. 11. Proceed exactly as above, without attempting first to adjust the depreciation for the partial period. Charge the whole difference, based upon the last figures shown by the books, directly to Surplus, because of the simplicity involved. First adjust the depreciation for the part of the period passed, and then proceed as indicated, b. Sales price more than carrying value. The difference in- volved represents a credit to Surplus account. Wasting Assets.— An asset subject to depreciation does not seem to be synonymous with an asset subject to waste, because the loss of value in each case does not take place in the same way. A wasting asset is represented by a mine, a timber tract, a patent, or a leasehold, for example, and, hereunder, the loss in value results because the asset itself is used up either through consumption, or through the passage of time. A depreciating asset, on the other hand, neither is used up through consumption, nor does it become reduced in size by the passage of time or use; it merely loses usefulness. Because of this difference in the character of these two classes of assets, each should be accorded a different treatment in the books of account. Estimate alone governs the loss of value in an asset subject to depreciation; hence, the use of a Depreciation Reserve account. On the other hand, since a fair degree of accuracy may be secured in determining the loss in value of a wasting asset, the use of a reserve account seems unnecessary, it being sufficient merely to write down the asset by direct credits there against. Appraisals and Depreciation.— Periodically, say, every few years, an appraisal of the capital assets of a plant should be made by experienced appraisers both as a check upon the accu- racy of the depreciation charges to date, and to establish, in turn, a correct basis for insurance claims should occasion require. It should be remembered that an accountant is not an appraiser, at least as an accountant ; in fact, accountants who believe them- selves appraisers really are assuming a knowledge of two tech- nical subjects, with the result that most of them are not proficient at either line of work. I 234 ADVANCED ACCOUNTING When an appraisal has been made, the attitude of an account- ant in relation thereto would be about as follows: 1. If net carrying value is higher than appraisal value. In this event, the depreciation reserve should be increased. 2. If net carrying value is lower than appraisal value: a. If a fraudulent motive is present to understate net worth. The depreciation reserve should be increased and, in the event of refusal by the directors to do so, the accountant should draw attention to the appraisal figures in his report. b. If no fraudulent motive is present to understate net worth. The depreciation reserve need not be increased, but the accountant should draw attention to the ap- praisal figures in his report because, if not done, he may be guilty of being a party to the understatement of a«sets which will result in the establishment of a secret reserve. (See Part 2 of present chapter.) 3. If market fluctuations have caused the appraisal to show an excess value, the books should not absorb such increase. 4. If excess past depreciation charges are responsible for the increase of the appraisal figures over net carrying value, such excess should be credited to the Surplus account. PART 2.--RESERVES AND RESERVE FUNDS Reserve Defined. — ^As ordinarily employed, the term "reserve" has no definite meaning. Basically, it may refer to either one of two possibilities: 1. A valuation account (an asset account offset). 2. An appropriation of surplus (proprietorship reserve). Sometimes, a third type is referred to which partakes of the nature of a valuation account or a true reserve, depending upon conditions. It is created, usually, by a charge to operation as in the first type above, but unless an actual liability exists, it has the characteristics of the second type. However, the two basic types above shown are a sufficient differentiation for pres- ent purposes, being those ordinarily found in business concerns. In a financial institution, concerning which this book does not deal, the term "reserve" has not the meaning accorded thereto above. Hereunder, it refers to the amount of cash and cash DEPRECIATION; RESERVES AND RESERVE FUNDS 235 items on deposit and on hand which legally may be considered as a fund held against deposits. Valuation Reserves. — A valuation reserve relates to a charge against profits with a view to covering an expected or actual loss in asset values. From the standpoint of the booked accounts, such a reserve may be said to be provided whenever a charge is made against profits without a corresponding credit being made to reduce the debit balance in an account representing an asset. The corresponding credit is made to a valuation account par- ticularly created to receive such credit. Such a valuation account never should be considered alone, but always in conjunction with the asset account that it offsets. The existence of a valuation reserve account indicates merely that there is an asset account present which, from the standpoint of the total net charge thereto, its debit balance, is assumed to be overstated. Common exam- ples of this class of reserves would be: 1. Reserves for depreciation. a. Buildings. b. Machinery. c. Etc. 2. Reserves for bad debts. a. Uncollectible accounts receivable. b. Uncollectible notes receivable. c. Cash discounts to be given. 3. Reserves for fluctuation in market values (where market drops below cost). a. Inventories. b. Securities. 4. Depletion of natural resources. a. Mines. b. Quarries. c. Timber. d. Oil. Some accountants would add another group of reserves to the above list which relates to liabilities, as, for example, reserve for taxes, reserve for wages accrued, etc. However, in view of some things which have been stated earlier, and which will be pre- sented in later chapters, the opinion is ventured that such re- serves are unnecessary inasmuch as when the liability arises Questionable as to being covered by reserves. f^ I 236 ADVANCED ACCOUNTING even though perhaps partially uncertain as to the exact amount, the booking should be as a liability. Surplus or True Reserves; Proprietorship Reserves.— A surplus or true reserve represents amounts which have been appropriated from surplus for some special purpose. As a matter of fact, it would seem correct to consider the Surplus account as a reserve, if it were not that general practice does not thus con- sider it. In other words, when a true reserve is created, it is understood, generally, that certain portions of the surplus have been set aside or reserved under particular informative titles for certain specific purposes. Common examples of this class of reserve : 1. Reserves for contingencies. a. Fire loss. b. Accidents. c. Obsolescence. d. Guarantees. e. Pending litigation. 2. General policy reserves. a. Plant extension. b. Betterments and improvements. c. Working capital. 3. Reserve for sinking fund. As these reserves stand, with the possible exception of (3), they are all part of net worth since, by book entry, they may be transferred back into unappropriated surplus and become available for dividends. In fact, at times, a reserve is set up with the express purpose in mind of providing a means to equalize dividends during lean years. An exception has been made in the case of the reserve for sinking fund in view of the fact that so many deeds of trust related to bond issues require that the sinking fund be created out of profits. Hence, the transfer back into general or free surplus would not occur. However, since the reserve is created by a direct charge to Surplus account, it is seen to be part of surplus. Sinking funds will be discussed in the next chapter. One class of reserves has not been included in the above group- ing of surplus reserves in view of the fact that their use appears, in general, to be decidedly doubtful. These reserves relate to DEPRECIATION; RESERVES AND RESERVE FUNDS 237 appreciation in fixed asset values, as land, buildings, etc. Appre- ciation should not be taken up on a set of books unless in con- nection with adjusting book figures to appraisal values where the latter are in excess of recorded values and where further such excess is not due to the overstatement of certain of the valuation reserves. And in this event, the unrealized profit should be credited to a special reserve instead of to Surplus account, so that dividends will not be paid out of the unrealized profit. Reserves and the Balance Sheet.— In interpreting a Balance Sheet, care must be observed in distinguishing between the two types of reserves mentioned, inasmuch as frequently no distinc- tion between them will be shown. This would be true especially, for example, in computing the book value of the common capital stock of a company. Funds.— This term is used correctly to designate a grouping of asset values brought together for a specific purpose. Hence, the entire stock of assets that an individual or a business enter- prise has under its control and for its specific use may be con- sidered as a fund. However, the term is used more commonly to indicate or set out a particular sub-grouping of asset values, or various sub-groupings thereof. Funds are of various kinds, and illustrations thereof may be indicated about as follows: 1. Contract obligation involved. a. The periodical withdrawal in a systematic manner of assets from the general fund of assets (which may be represented by the total asset values set out upon the left side of the Balance Sheet) for the purpose of meet- ing specific obligations which, when matured, must be paid. A fund accumulated in this manner is known, generally, as a sinking fund (see discussion in next chap- ter). The accumulation of this fund may vary with either of the following principles: i. Periodical deposits of cash are made, as yearly, from the general fund, into a special fund. And these deposits: (a) May be used at once to retire a portion of the obligation, or (b) May be held in the special fund which, peri- 23S ADVANCED ACCOUNTING odically, is increased by further deposits so that, at maturity date, the obligation can be retired. This method has no relation whatever to profits ; hence, it refers merely to a cash accumulation governed by intervals of time. b. The periodical accumulation is to be made from profits actually earned. Hereunder, it is to be noticed that profit distribution is restricted during the interval in which the fund is being increased. The use of the fund thus accumulated may be varied, also, in accord with (a-i), (a) and (b), above. 2. No contract obligation involved. Hereunder, any person or business enterprise may accumulate, convert, and use its assets for its own ends and purposes, as is deemed desirable. Since a fund, under the above conditions, may cover about any use capable of being conceived in a person's mind, it may be advisable to differentiate roughly between funds used ordinarily by corporations involving no contract obli- gation, and those used outside of corporation practice: a. Non-corporate funds. Endowment fund. This is related to some type of a non-profit organization, as a university. Here- under, a principal is accumulated, and payments are made only from the interest received from investments of the principal. Maintenance fund. This is related to property upkeep. Trust fund. This is a fund held by some one, called a trustee, for the benefit of another, called the cestui que trust (a later chapter will discuss certain angles of this particular problem), iv. Etc. b. Corporate funds. ^ i. Property improvement funds. ii. Pension funds, iii. Depreciation funds, iv. Etc. 1. n. in. DEPRECIATION; RESERVES AND RESERVE FUNDS 239 Reserve Funds.— The capital investment of a business is shown upon a set of books by an account or accounts carrying a credit balance or balances. And the sum of the balances in these accounts measures the net equity of the proprietors The elementary student, in general, will not fall into the error of statmg, for example, in the case of a corporation, that either the capital stock or surplus, as set down upon the right side of a Balance Sheet, is represented by any particular assets displayed upon the left side of the Balance Sheet. He will recognize quickly that he cannot point out particular items upon the left side and state that they are oflfsets specifically to capital stock and sur- plus. In the event where certain liabilities are present, representing debts to outsiders, he will recognize that the amount by which the assets exceed in value the amount of the liabilities represents merely net equity. Likewise, where no outside liabilities are present, m which event the whole asset fund is owned by the proprietors, he will recognize that the interest or equity of each stockholder cannot be stated in the form of specific assets unless as rarely happens, cash is the only asset in hand. Likewise, since surplus reserves are only appropriated surplus It is not difficult to comprehend that, in the ordinary course of events, no specific assets in particular will represent them Again It is not diflicult to comprehend that if sufficient assets can be changed into suitable form, these may be set aside for a specific purpose measured by certain surplus reserves already in exist- ence To restate: Particular assets need not be set aside, as an offset to surplus reserves, but they may be. Further, if the illustration be changed to that of a valuation reserve, it is possi- ble, even, to use a fund in connection therewith And when specific assets have been set aside as representing a reserve, a reserve fund comes into existence. A fund always Bhould consist of assets, and a reserve fund always should consist of assets which have been set aside particularly in connection with a reserve. Such a fund may consist of cash, but this is not necessarily so, inasmuch as it may consist of securities. Again a fund may be restricted as to use, or it may not be thus re-' Stncted. It should be remembered that no accounting connection exists I 240 ADVANCED ACCOUNTING between the creation of a reserve, even though it is possible to bring the two into existence at the same time. The possibilities hereunder are about as follows: 1. A reserve may be created without a fund. 2. A fund may be created without a reserve. 3. A reserve and a fund may be created at the same time. Finally, a fund may be accumulated by periodical appropria- tions, or it may be created entirely at one stroke. Secret Reserves. — This term refers to the understatement of a concern's net worth ; as a term, it is a misnomer, at least insofar as the meaning applied above to "reserve." The understating of the net worth of a business enterprise may be accomplished in the following ways: 1. Understating upon, or omitting from, the books of account certain asset values. 2. Overstating the liabilities. 3. Overstating the valuation reserves. A common method of understating assets is to either charge capital expenditures to revenue or to make the depreciation charges excessive. Certain organizations, particularly banks, are apt to imder- state asset values in hand, and this practice results in the crea- tion of what is known as a secret reserve. For example, it i« not uncommon practice for a bank to write the value of its building, and even its equipment, entirely off the books, so that they will not appear upon the Balance Sheet. Certain accountants seem to favor the practice of creating a secret reserve, regardless of the type of enterprise, on the ground that thereunder a fund of values is stored up which may be drawn upon in periods of depression in order to stabilize income, without drawing upon the accumulated surplus; again, a large unexpected loss may be absorbed without having the records reveal such loss. The practice of using secret reserves can scarcely be justified. If statements are supposed to be prepared to set forth the truth insofar as human endeavor and the element of time permit, the secret reserve is anything but legitimate. Accounts should tell the truth; otherwise, they serve no purpose and are useless. Theoretically, asset values should not be understated any more DEPRECIATION; RESERVES AND RESERVE FUNDS 241 than they should be overstated; if it is wrong on the one hand It IS wrong on the other. Every statement should set forth facts' regardless of whether it covers a bank or any other type of enterprise; too many misstatements of fact occur in the attempt of many accountants to follow out a policy of conservatism. The oft-repeated expression that "an accountant should never be considered m error so long as he is conservative" ought never to have been advanced. There is a limit beyond which conserva- tism does more harm than good. Further, in these days of varied taxes, especially taxes upon incomes, the facts should be stated as they are, consistent with the training and experience ordinarily assumed as belonging to the accountant who is deemed to be a qualified man in his particular line of work. PART 3.— SURPLUS AND DIVIDENDS Corporate Net Worth.-The net capital of a corporation, represented by total assets less total outside liabilities, measures the amount of the organization's proprietary interest or net worth. The Capital Stock account is the principal proprietary account in a corporation, but not necessarily the only one At the commencement of operations, it may be possible to assume a proprietary interest equal in amount to the Capital Stock but as soon as operations commence, the proprietary interest 'will be either greater or less than the capital stock. If a corporation proves to be successful, profits will be made and If these profits are not all withdrawn, the result will be an increase in proprietary interest. This increase, however, cannot be credited direct to the Capital Stock account in view of the fact that the latter is fixed in amount; hence, the necessity of providing another proprietary account therefor. This second account is known, generally, as the Surplus account. And in general it may be said that this account, when properly con- structed, should be built up by credits representing only undi- vided profits which, at the moment of booking, will be available lor purposes of distribution in the form of dividends. On the other hand, if a corporation does not prove to be suc- cessful, with the result that the surplus has been exhausted and that subsequently the losses are greater than the profits the latter should be debited to a Deficit account. This account will 242 ADVANCED ACCOUNTING carry a debit balance. Further, it is not an asset, but merely a book account explaining the difference between the assets and the sum of the liabilities plus investment. In determining cor- porate net worth, the Deficit account must be considered in connection or in combination with the other proprietorship accounts. Practically every corporation will have on its books either a Surplus account or a Deficit account, this being due to the fact that, in general, the Capital Stock account never will measure the amount of the net worth. However, surplus may be of a type other than the one advo- cated above. If the possible kinds of surplus be classified, the following will result: 1. Surplus accumulated out of past profits. In turn, this sur- plus may be divided further into: a. Appropriated or restricted surplus. b. Free surplus. This represents past profits retained which are available for dividends. 2. Surplus created by contribution. Hereunder, the creation will be due to one of the following causes: a. Sale of stock at a premium. b. Stock donation. 3. Surplus created by revaluation. Hereunder, the creation will be due to one of the following causes: a. Increasing book valuations of capital assets. b. Reducing par value of the capital stock. The cause of uniformity in accounting terminology would be aided considerably if persons had the same idea in mind when speaking of surplus. And to this end, the suggestion is made that since the average individual considers surplus as represent- ing something out of which dividends may be paid, its use, as a term, ought to be that indicated by (1-b^ above. Classes of Dividends. — Dividends, as discussed in the present chapter, relate to corporate profits which are to be distributed to the stockholders, not to certain other particular payments to be made to stockholders which often are given the title of *'divi- dends," as,— liquidating dividend. Basically, the following dis- cussion of dividends may be outlined briefly about as follows: DEPRECIATION; RESERVES AND RESERVE FUNDS 243 1. Source. a. From capital. b. From profits. 2. Manner of payment. a. Cash. b. Property. c. Bonds. d. Stock. e. Scrip. Capital Versus Profits— Relation to Dividends.— In cor- porate work, there exist two distinct funds of values: 1. Contributed capital. This fund of values is presumed to be used only for financing purposes. Further, this fund is not to be returned to the stockholders except under the follow- ing circumstances, each of which is governed by statute: a. When the capital stock is formally reduced. b. When the company is dissolved. In other words, except when reduced by the sufferance of losses, the stockholders, ordinarily, have no right tp with- draw any of this fund; the corporation has no legal right to distribute its capital to the stockholders except under either of the conditions mentioned above. This general rule, however, is subject to one exception, in the case of corporations operating by virtue of depleting some natural resource. 2. Profits. A second fund of values grows out of the operating activity of a corporation; it results from profits being earned. This fund of values may be distributed to the stockholders under certain conditions: a. The board of directors, by formal action, must declare a dividend. By such action, the board of directors, who are the representatives of the stockholders, set aside a portion of the profits that have been earned, and when this setting aside has been accomplished in due form under the law, there can be no rescinding of the action ; hence, after a dividend has been declared, payment thereof may be enforced by the stockholders, provided such declaration be made in due and legal form. 244 ADVANCED ACCOUNTING b. There must be sufficient profits on hand to meet the possible contingencies that may arise before a dividend declaration is in order. This condition, however, is not governed by the law as is the first one above. A divi- dend might be declared equal to the full amount oi the profits earned, but conservative management, for the reason just mentioned, will not favor any attempt to withdraw the entire amount of the profits from a busi- ness. Because of possible contingencies, a prudent man- agement will attempt to build up a substantial surplus margin in anticipation of the evil day; and in certain organizations this policy of conservatism is followed so consistently from year to year that eventually the Bal- ance Sheet will disclose a legitimate surplus so large* that it is many times larger than the total capital stock. Because of the shortsightedness and lack of understanding on the part of stockholders, — ^their continual clamoring for large dividends, plus their attitude that a large surplus represents something that should be paid over to them and when not so paid indicates mismanagement, — it is customary to reserve certain portions of the surplus in a manner that will make them unavail- able for dividend purposes. The result of this practice, plus the legal theory underlying the two funds referred to above, would seem sufficient reason for revamping the set out of these two funds about as follows: 1. Capital fund. This may be represented as under: a. The par value of the capital stock issued and outstanding. b. Profits appropriated by formal action for capital uses. 2. Earned profits or surplus available for dividends: a. Free surplus. b. Surplus appropriated for distribution by virtue of a specific dividend declaration in due and legal form. Surplus Profits. — The liability of corporate stockholders being limited, in general, to the amount that they have invested in a corporation, as represented by the shares of stock held, seems to be the basis for the numerous conflicting opinions of judges and accountants as to what is a corporate profit available for dividend pm*poses. Since it is a fundamental legal rule that DEPRECIATION; RESERVES AND RESERVE FUNDS 245 corporations, with the exception of companies operating in con- nection with a natural resource, must not pay dividends out of capital, it follows that dividends can be distributed only from surplus profits. No difficulty would be encountered in connection with the subject of dividends if it were possible to secure as simple an interpretation of this principle or rule as is its state- ment; however, regardless of statutes and court decisions, a satis- factory definition of the term "surplus profits" does not seem to have been offered. Accountants commonly define corporate surplus as the excess of the assets, valued conservatively, over the sum of the liabili- ties plus capital stock. Legal decisions supporting the above definition consider surplus profits as being the excess of the assets over the sum of the liabilities and capital stock, such excess being actual and not the result of an appraisal. However in delving further into the subject, a conflicting maze of decisions' is encountered, as well as decisions in conflict with generally recognized practice. The following are illustrative: 1. A concern makes a net business profit of $40,000.00, but suffers a capital loss of $50,000,00. Legally, a dividend of $40,000.00 could be paid, but prudence may not favor such a procedure. Legally, a deficit might be carried along with no attempt being made to write it off against current profits. 2. Profit secured from the sale of fixed assets may be distrib- uted as dividends. 3. A surplus profit may be secured by a company converting some of its bonds into stock at a figure above par. 4. A surplus profit may be secured by selling bonds at a pre- mium; on the other hand, premiums on stock may be distributed, but are not legally profit and, therefore, such distribution should not be considered as a dividend. Illegal Dividends.— The only point to be considered here relates to the illegal declaration of a dividend by the directors Most states have statutes which hold directors personally liable for losses suffered by company creditors due to the fact that they have reduced the capital fund through the payment of dividends Naturally, this contingency will not arise so long as creditors are paid as bills mature, but the possibility is ever present that by 246 ADVANCED ACCOUNTING !.- virtue of business reverses these outstanding obligations cannot be met. Hence, directors ever should be careful in declaring and paying a dividend. The type of statute referred to above is well exemplified by the statute existent in New York which reads as follows (S. C. L.; Art. 3, No. 28) : The directors of a stock corporation shall not make dividends, except from the surplus profits arising from the business of such corporation, nor divide, withdraw or in any way pay to the stockholders or any of them, any part of the capital of such corporation, or reduce its capital stock, except as authorized by law. In case of any violation of tlie pro- visions of this section, the directors under whose administration the same may have happened, except those who may have caused their dissent therefrom to be entered at large upon the minutes of such directors at the time, or were not present when the same hapjM'ned, shall jointly and severally be hable to such corporation and to the creditors thereof to the full amount of any loss sustained by such corporation or its creditors respectively by reason of such withdrawal, divi>?ion or reduction. But this section shall not prevent a division and distribution of the assets of any such corporation remaining after the payment of all its debt-R and liabilities upon the dissolution of such corporation or the expiration of its charter; nor shall it prevent a corporation from accepting shares of its capital stock in complete or partial settlement of a debt owing to the corporation, which by the board of directors shall be deemed to be bad or doubtful. Similarly, in the case of a corporation authorized to issue shares without nominal or par value, another section of the law states as follows (S. C. L.; Art. 2, No. 20): No such corporation shall declare any dividend which shall reduce the amount of its capital below the amount stated in the certificate as the amount of capital with which the corporation will carry on business. In any case such dividend shall be declared, the directors in whose administration the same shall have been declared, except those who may have caused their dissent therefrom to be entered upon the minutes of such directors at the time or who were not present when such action was taken, shall be liable jointly and severally to such corporation and to the creditors thereof to the full amount of any loss sustain(;d by such corporation or by its creditors respectively by reason of such dividend. An illegal dividend may be revoked any time before payment is made; further, if such dividend has been paid^ revocation is in DEPRECIATION; RESERVES AND RESERVE FUNDS 247 order only as concerns the stockholders who know that the source is illegal. Mining Company Dividends. — In the case of companies, where the value of the capital asset, — mine, quarry, timber tract, etc., — is being decreased on account of current operations, good accounting should demand the application of a portion of each period's profits against the book value of the wasting asset so that such book value will be extinguished completely at the end of its life. However, it would seem that the application of this principle is dependent upon the fact of whether or not it is possible to determine with any fair degree of accuracy the num- ber of units of product available for use. Take the case of a mining company as an example: 1. If possible to determine the available units of product with a fair degree of accuracy, the reduction, or so-called depre- ciation, may be based upon the number of units taken out, to the end that the wasting asset will be amortized over the period of its usefulness so that finally, at the end of such period, it will have been replaced from profits in another form. In this event, stockholders' dividends will not con- sist partly of profits and partly of a return of capital, in- asmuch as the capital return will be made all at one time. 2. If impossible to determine the factors mentioned above, and explanation exists to the end that the stockholders and creditors of such a company are aware of actual conditions, it would seem proper and in order to have the dividends consist of both profits and a capital return. However, al- though this practice is followed to a considerable extent, such companies being excused from following out any policy of amortization, it appears that such procedure should not be in order unless the stockholders and creditors are in- formed fully of the facts of the case to the end that they will not labor under a delusion that the entire dividend re- ceived from time to time consists of nothing but profits. Realizing Upon Assets to Pay a Dividend. — The principle that arises in connection with the matter of determining profits correctly may be considered as dividing itself into the following parts: 248 ADVANCED ACCOUNTING 1. Since it is impossible to allocate a particular asset either to the capital fund or to the profit fund, care must ])e ob- served, insofar as operations and activities are concerned, to make certain that current income will absorb all cliarges possible to the end that the capital plant may be kept intact. 2. In turn, this leads one, first, into the question of valuation of assets: a. As to current assets. i. Profits should not be anticipated. b. As to capital assets. i. Depreciation must be calculated most carefully. ii. Surplus additions secured through marking uj) the fixed asset values, if such procedure be tolerated at all, should be so earmarked that a dividend will not be declared from what is a mere book increase not offset by an actual increase in the asset fund contra. 3. Next, one should realize that, before a dividend be declared, the following points must be taken seriously into considera- tion: a. The need for additional capital may be such that avail- able profits should be used for this purpose. b. Because of depreciation, the assets may shrink to such a point that the apparent profits do not actually exist. c. Current assets are exceedingly slow of realization. Because of the above, the process of transforming or reducing profits to a specific cash fund available for dividends is somewhat difficult and complicated. In practice, therefore, where a suffi- cient realization of the importance of the above points is in order, dividends are not declared hastily. Further, after their declaration, the payment thereof will be deferred sufficiently to the end that cash may be secured and withdrawn in order to make payment. The Supreme Court decisions are vague as to what constitutes net profit. Although a general reading thereof would lead one to believe that profits must be realized in cash before a dividend may be paid, it seems reasonable to assume that such a literal interpretation is not in order in view of the fact that by so do- DEPRECIATION ; RESERVES AND RESERVE FUNDS 249 ing there would be no agreement with elementary accounting principles : 1. If accounting be done entirely upon a cash basis, the literal mterpretation would seem to apply. However, except in the smallest of concerns, a cash basis of accounting is not followed in that thereunder the exact truth relative either to financial position or to profits cannot be expressed in the accounting statements. 2. If accounting be done upon an accrual basis, this literal mterpretation could not be followed with reason,— in ac- cord with at least one elementary accounting principle, to the effect that a profit is assumed to be realized at the moment a sale is made, which means at the moment a cause of action arises, regardless of whether actual cash has been received or some other asset, as an open account re- ceivable, a note receivable, or other goods. If the directors in good faith declare and pay a dividend before profits actually are realized in cash, it appears that no liability would be incurred by them should the values out of which the dividends are expected to be paid never be realized. But even so, conservatism dictates that dividends should be paid only from realized profits. Declaring and Paying Dividends.— The directors of a cor- poration are not required to distribute profits to the stockholders unless, in their discretion, it seems proper to do so. This means that before so doing they have the specific duty of protecting the capital fund of the enterprise and in this connection they should make use of the undistributed profits in any way that seems best. And when it has been decided to declare a dividend, the provisions of the charter and of the by-laws must be fol- lowed; outside of this circumscription, in the absence of fraud, the directors control entirely the declaration of a dividend. The directors may exercise their judgment and discretion in paying dividends and when, in good faith, dividends are with- held, nothing can be done to force payment except by a ma- jority of the stockholders electing a new board of directors who will be subservient to their wishes. But if any improper with- holding can be shown, the obligation rests upon the directors to explain why a distribution is not in order; under such circum- 250 ADVANCED ACCOUNTING stances, legal action may order the declaration and payment of a dividend. Only after proper provision has been made for protecting the capital fund, should the question of profit distribution be con- sidered. Premature declaration and payment to satisfy clamor- ing stockholders temporarily may keep up current market values of stock, and result in deceiving these stockholders into believing the management successful, but the policy is a short-sighted one which: 1. Starves business development. 2. May lead into insolvency. These stockholders lose sight of the fact that a present cur- tailment of dividend payments may mean: 1. Securing the necessary working capital with which to carry on operations and which could not be secured in any other way except possibly by incurring heavy interest charges. 2. Development and expansion. 3. Payment of larger and steadier dividends in the future. The Minute Book should contain all the information relative to dividend rate, date, and manner of payment. As soon as a legal dividend has been declared by the directors, and notice has been given thereof the stockholders have a right, each to his proper pro rata share, and such right cannot be curtailed in any way by the directors. Dividend declaration may be revoked at any time by the directors up to the moment public notice thereof is issued; thereafter, revocation is not in order except when the dividends are illegal. The stockholders to whom divi- dends are payable will be those whose names appear upon the corporate records as of a certain date, — ^the stockholders of record; hence, dividends are not payable upon treasury stock. Even though certain shares of stock may be owned by some one other than the person whose name appears upon the corporate books, the dividend is payable to the stockholders of record; any error arising hereunder based upon circumstances not of record, is a problem to be adjusted between the stockholders in interest. The company is not interested beyond its records as to whether the owner of record is the actual owner of the stock or not the actual owner. The procedure in connection with the declaration and payment DEPRECIATION; RESERVES AND RESERVE FUNDS 251 of a dividend depends upon the size of the corporation in ques- tion and whether or not the stock is held by few or many per- sons: 1. Small close corporation. a. Dividend declaration is made but no formal notice pub- lished. b. The books are not closed in order to prepare the list of those to whom dividends are payable. 2. Small corporation — not a close corporation. a. The procedure hereunder follows that of the large cor- porations except that the volume of detail in connection therewith is small (see 3 below). 3. Large corporation with stock widely dealt in upon the market. a. Notice published to the effect that a dividend has been declared as of a certain date payable to the stockholders of record as of a date sufficiently far in the future to permit of the actual owners becoming stockholders of record before the date mentioned, upon which the Trans- fer Books will be closed. b. The Transfer Books are closed upon the date set, and remain closed for a certain number of days thereafter in order that the dividend list may be prepared cor- rectly. When these books are open again, transfers are made thereon in the usual way as before. c. Great care is exercised in preparing the dividend list which, when completed, must be certified to as correct by the officer who has charge of stock transfers. d. After the dividend list has been certified to as correct, it is given to the treasurer, or to whoever handles the cash payments, checks are drawn, and payment made. e. Dividends, usually, are paid by checks drawn to the order of the stockholders of record as of the date speci- fied. These checks are prepared upon the basis of the dividend list referred to above. As a rule, the voucher check is used in connection with the payment of dividends and, in a large company, such checks are designed specifically for this purpose in which, at least, the num- ber of the dividend is stamped or printed. If a special check is 252 ADVANCED ACCOUNTING printed for each dividend, the number and rate of the dividend would be printed thereon; if not, blank spaces would be left in which this information may be stamped. The advantages of using such a form of check hereunder are: 1. Proof of payment on hand in case of dispute. 2. Sufficient information on each check to make an accom- panying form letter unnecessary. 3. Indorsement by stockholder constitutes sufficient acknow- ledgment. Corporate net profits or income for a current period, prior to transfer, is found as a credit balance in a Profit and Loss account carried upon the Ledger in the usual way. From that point on, no uniformity exists either in the disposal of this balance or in booking a dividend which may be declared out of such profit. In outline form, the variations may be indicated about as follows: 1. Since corporate net profit or net loss cannot be absorbed in the Capital Stock account or accounts, its disposal from the Profit and Loss account may be as under: a. To Surplus account. b. To Undivided Profits account. From time to time round amounts are transferred to Surplus account. The balance in the Undivided Profits account is used for dividend payments. Banks follow this practice. 2. The entries in connection with declaring and paying divi- dends are simple, and are about as follows: a. Declaration of dividends (liability incurred) : 1. Surplus Account, To — Dividend Payable Account, ii. Profit and Loss Account, To — Dividend Payable Account, Surplus Account, iii. Undivided Profits Account, To — Dividend Payable Account, « i The second possibility is unsatisfactory in view of the fact that if current profit is not sufficient for dividend pur- poses, the dividend still may be paid if sufficient accumu^ lated profits are on hand ; naturally, these latter are shown in the Surplus account. Hence, charging the dividend to DEPRECIATION; RESERVES AND RESERVE FUNDS 253 the Profit and Loss account makes matters somewhat confused. b. Payment of dividends: i. Dividend Payable Account, To — Cash, S i % i Final dividend declaration always should precede divi- dend payment; never should the reverse practice be fol- lowed. Care should be observed to book the liability incurred by virtue of a dividend declaration immediately upon such declara- tion and notice thereof. An unpaid dividend is a current liabil- ity to be set out upon the Balance Sheet as such. Ofttimes, a considerable portion of a dividend payment will remain un- claimed, the issued checks being returned through the post office. In this connection, it may be advisable to send them out again by registered mail, and if still unclaimed, then to transfer them to a special fund account. Unclaimed dividends cannot be re- turned to surplus except by action of the directors. If the above expedient be followed in connection with attempting to locate the persons to whom the dividends are payable, it would seem that upon the return of unclaimed dividends to surplus, a pro- portionate amount of the special cash fund could be returned to general cash there to be available for general purposes. Stock and Scrip Dividends.— Surplus profits commonly are capitalized by the declaration of a stock dividend. In amount, such dividend cannot exceed the amount of the surplus; it is payable in capital stock, the par value thereof equaling the amount of the dividend. In other words, a stock dividend merely converts a pro rata equity of each stockholder in unappropriated profits to the tangible form of stock rights. After the conversion, the total interest of each stockholder will be the same amount as was previously shown; each stockholder's interest thereafter has increased so far as stock interest is considered, but has decreased so far as the equitable interest in surplus profits is con- cerned, the increase and decrease being of a similar amount. The advantages of issuing a stock dividend may be sum- marized as: 1. The stockholder may realize a certain amount of profit by U 254 ADVANCED ACCOUNTING \i selling some oi his new stock which would not be possible by selling the same proportionate amount of old stock. 2. Thereunder, a portion of corporate profit is capitalized for the permanent use of the concern. And in this connection, the big difference between such a dividend and a regular dividend is most noticeable; a regular dividend distributes assets that have been absorbed by the corporation as profits, whereas, a stock dividend retains these profit assets capitalizing them for corporate use. Hence, no profit dis- tribution is made. So long as a surplus profit exists, a dividend may be de- clared, even though there is not sufficient cash on hand with which to make payment. Payment may be made in assets other than cash; cash may be borrowed for dividend purposes, if con- ditions seem to warrant the use of the expedient; a stock dividend may be declared ; a scrip dividend may be declared. Scrip represents nothing but a promise to pay. It is & temporary expedient in the way of a corporate promise to pay, indicating either of the following: 1. Some document into which it is to be converted at a lat^r date. If it is impracticable to have a stock certificate or a bond ready for delivery as of a specified date, scrip will be issued. 2. Some value into which it is to be converted at a later date. Hereunder, scrip may be issued temporarily to settle a dividend, same to be redeemable in cash at a certain future date. This scrip practically may be equivalent to cash where passed readily from hand to hand. Again, the scrip may be payable in stock; hence, a stock dividend may be covered temporarily by the issue of scrip. Further, if in- terest is due and cash not available for payment, scrip may be issued. Lastly, scrip may be issued for fractional parte of a share of stock or of a bond when securities are being distributed. In the accounts, "scrip" will show up as an account with a credit balance: ■H^ 1. If it represents a deferred dividend paynaent: An Income Account, § ^ To — Dividend Scrip Account, I ^ DEPRECIATION, RESERVES AND RESERVE FUNDS 255 2. If it represents interest due to be paid for which cash funds are not available: An Expense Account, $ i To — Interest Scrip Account, $ ^ 3. If it represents the temporary coverage of a stock dividend: Surplus Account, $ ^ To — Stock Dividend Scrip Account, $ ^ 4. If it represents some document into which later conversion will be made: An Asset Account (representative of elements received for securities), $ ^ To — Stock Scrip or Bond Scrip Account, $ ^ Cumulative Dividends. — These arise in connection with preferred stock, at the time when a preferred stock dividend is passed. A number of methods exist relative to stating cumula- tive dividends which have been passed. However, since no liability exists relative to a dividend until the latter Jias been declared, it would seem that no entry relative to a passed cumulative dividend is necessary, it being sufficient merely to set it out upon the Balance Sheet as a footnote. Profit-Sharing. — This term arises when a portion of the profits of an enterprise are distributed to the employees. The term is not synonymous with that of "dividends," since the former merely represents a bonus and nothing else. The entries to cover would be about as follows: 1. Profit and Loss (or Surplus), To — Employees' Bonus, 2. Employees' Bonus, To— Cash, S i ► t CHAPTER VIII CORPORATE OBLIGATIONS: BONDS PAYABLE; SINKING FUND Forms of Corporate Obligations.— A corporation may bor- row money in a number of ways among which the following are typical: 1. Bank credit. 2. Notes. 3. Bond and mortgage. 4. Bonds. If Ihe loan is of a small amount, or is to extend only over a short period of time, or is to be secured from a relatively few persons, the evidence of such obligation will take usually the form of corporate notes. Although the cor- porate note is a formal promise to pay money, it does not have to be executed under seal, and, usually, it will run for a period less than five years. If the loan is large in amount and is to be obtained in one lump sum, the evi- dence of such obligation may assume the form of a bond and mortgage on real property. The bond and mortgage, as a rule, will involve only two parties,— the mortgagor (the borrower) and the mortgagee (the lender) ; usually, it will run for a period less than five years. Finally, if the loan is large in amount, and is to extend over a long period of time, the evidence of such obligation, usually will take the form of a bond issue. A corporate bond issue may be participated in by a large number of investors; in fact, this feature is distinctive of bond issues. A bond must be executed under seal. It may be secured, and usually is, as to repayment of principal and the payment of interest, by a lien or mortgage on specified property and, at tiines, by the creation of a sinking fund held in trust to safeguard its redemption at maturity A bond issue may run from five years to fifty years or more. The 256 CORPORATE OBLIGATIONS; BONDS PAYABLE 257 issuing corporation usually sells its bonds to the public through bankers or brokers. One of the functions of a corporation is to issue bonds. A government, likewise, has this privilege, only there is a marked difference between the two types. A government issues and sells its bonds only because the public has faith in its stability; on the other hand, a corporation issues bonds, generally, because the buying public knows they are a lien against specific tangible assets which it feels are sufficient to guarantee repayment. Therefore, a corporate bond is an obligation, a promise, under seal, admitting an indebtedness coupled with an agreement that the indebtedness will be repaid at a specified time and that in- terest thereon will be paid at an agreed rate at periodic intervals. In other words, a corporate bond is a future obligation, sold as of the present, bearing interest until date of maturity. The amoimt of the obligation of a bond issue is the par value of the bonds plus the interest that must be paid upon periodical recurring dates. The former is a Balance Sheet item, whereas, the latter is a Profit and Loss Statement item. A bond differs from an ordinary note in that its character is more formal and its terms more specific. This is because a bond runs for a longer time than a note and, therefore, must be safe- guarded carefully. A note expires within a short time and during its term the condition of the issuing company is not apt to change materially; in the case of a bond issue, the condition of the issuing company will change materially during the life of the obligation. The form of a bond, so long as it conforms to certain particulars, is more a matter of choice than anything else. The Trustee and the Trust Agreement.— As a rule, to secure the payment of these bond obligations, the issuing corporation executes a mortgage or trust deed, a collateral trust agreement, in favor of a trustee or trustees, usually a trust com- pany, to be held by the latter as security for the payment of the bonds at maturity and for the payment of the interest as called for at stated periods. If the bonds are not paid at maturity, or if the payment of interest is defaulted upon any interest payment date, the trustee or trustees will foreclose the mortgage, or sell the securities, as 258 ADVANCED ACCOUNTING the case may be, in accord with the terms and conditions of the trust, for the benefit of the bondholders. The one existing possibility, aiming toward the non-carrying out of the above proviso, is that the corporation may be able to place another bond issue on the market successfully and with the money re- ceived therefrom retire the first outstanding obligation. Trustee's Certificate.— The trust deed or mortgage contains usually a provision that a bond cannot come under its protec- tion until the trustee has authenticated it. Therefore, to each bond a trustee's certificate usually will be attached, properly executed, before the bond is handed over to the purchaser. Compliance With Statutes.— The issuance of bonds must be made in accord with statutory requirements. Extracts from the Stock Corporation Law of New York, Art. 2, covering the issue of bonds, are as follows: 1. In addition to the powers conferred by the general corporation law, every stock corporation shall have the power to borrow money . . . . ; and it may issue and dispose of its obligations for any amount so borrowed, and it may mortgage its property and fran- chises to secure the payment of such obligations, or of any debt contracted for said purposes. 2. Every such mortgage, except purchase-money mortgages and mort- gages authorized by contracts made prior to May first, eighteen hundred and ninety-one, shall be consented to by the holders of not less than two-thirds of the capital stock of the corporation, or, if the corporation is authorized to issue shares without nominal or par value, then by the holders of two-thirds of the total number of shares issued and outstanding, which consent shall be given either in writing or by vote at a special meeting of the stockholders called for that purpose, upon the same notice as that required for the annual meetings of the corporation that such consent was given hy the stockholders in writing, or that it was given by vote at a meet- ing as aforesaid, shall be subscribed and acknowledged by the presi- dent or a vice-president and by the secretary, or an assistant secre- tary, of the corporation, and shall be filed and recorded in the office of the clerk or register of the county wherein the corporation has its principal place of business. The mortgage or trust deed should contain a clause to the end that the provisions mentioned above have been complied with. And so long as the certificate mentioued remains on record uncancelled, it is final evidence of the truth of the state- I CORPORATE OBLIGATIONS; BONDS PAYABLE 259 ment of the clause above referred to. This is of considerable im- portance, at least, to bond purchasers. Bond Signatures.— The body of a bond usually is signed by the president or vice-president, and by the secretary or as- sistant secretary. The corporate seal is attached also, attested by the signature of either the secretary or the assistant-secre- tary. The coupons attached to a bond may or may not actually be signed. If the issue be a small one, the treasurer actually may sign each coupon; if the issue be a large one, such actual sign- ing may be impossible. In such case, the engraved signature of the treasurer will be used. Listing Bonds on the Exchange.— Bonds may be listed upon the New York Stock Exchange provided certain requirements have been met. All documents necessary to establish the fact that the issue has been duly authorized and issued must be filed, and the rules of the Exchange covering form, engraving, denomination, etc., must be observed. Unissued Bonds and Treasury Bonds.— The liability on account of a bond issue is set out in one account upon the financial records, such account being considered, generally, as a capital liability. An authorized issue of bonds may be sold piecemeal in various lots, or they may be disposed of in one lot. Where merely authorized, and not actually signed and sealed, it would be perfectly correct to make no record at all in the ac- counts to cover the issue. Some accountants will list unissued bonds as an asset upon the Balance Sheet, and others will deduct their amount from the authorized issue; the latter practice seems preferable in that the right to issue is shown distinctly. The importance of distinguishing between unissued bonds and treasury bonds, ordinarily, is not of much consequence, as bonds may be issued for less than par. But it would seem that where bonds have been signed and sealed, although not actually de- livered, they should be recorded otherwise than as unissued The act of signing and sealing makes at least one corporate officer specifically answerable for their proper custody if any of these bonds should be misappropriated, and fall into the hands of an innocent purchaser for value, the latter would have an enforcible claim against the corporation. Therefore, it would 260 ADVANCED ACCOUNTING seem proper to record corporate bonds authorized, signed, and sealed, as treasury bonds, to provide for their being handled with great care. Likewise, reacquired bonds may be considered as treasury bonds; these, usually, are sinking fund securities and will be discussed when that topic is considered. Transportation companies, under the rulings of the Interstate Commerce Com- mission, are required to classify authorized bonds, signed, and sealed by the mortgage trustee, as working ansets. Entries Covering the Issue of Bonds.— The entries covering the issuance of bonds, and certain practices relative thereto, may be summarized about as follows: 1. Regular issue. Hereunder, two methods of booking are available. Assume an authorized issue of $500,000.00, of which $300,000.00 are sold for cash, at par, balance unsold being unissued: a. First method: $300,000.00 $300,000 00 $500,000.00 $500,000 00 $300,000 GO Dr. Cash, Cr. Bonds Payable, Hereunder, no entry is made until cash is received. b. Second method: i. Dr. Unissued Bonds, Cr. Bonds Payable, To record authorized issue. ii. Dr. Cash, $300 , 000 . 00 Cr. Unissued Bonds, To record cash collected. The second method seems preferable to the first one for reasons already advanced favoring the formal method of recording a capital stock issue: That a complete history of the transaction is available from a reading of the ac- counts. 2. Issue upon an instalment basis. Assume for the above problem that payment was made in two equal instalments. As in the case of capital stock, the bonds should not be issued until the subscriptions are fully paid: a. Dr. Unissued Bonds, $500 , 000 . 00 Cr. Bonds Payable, $500 ,000 00 To record authorized issue. b. Dr. Bond Subscribers, $300,000.00 Cr. Bond Subscriptions, $300,000 00 To record subscriptions taken. CORPORATE OBLIGATIONS; BONDS PAYABLE 261 $150,000.00 $150,000.00 $150,000 00 $150,000.00 $150,000 00 $150,000.00 $150,000 00 $150,000.00 $150,000.00 $150,000 00 c. Dr. Instalment No. 1, Cr. Bond Subscribers, To record instalment of 50 per cent now due. d. Dr. Cash, Cr. Instalment No. 1, To record cash received upon instalment No. 1; Cash Book entry. In place of entries (c) and (d) above, the following might have been made: Dr. Cash (Instalment No. 1), Cr. Bond Subscribers, e. Dr. Instalment No. 2, Cr. Bond Subscribers, To record [instalment of 50 per cent now due. f. Dr. Cash, Cr. Instalment No. 2, To record cash received upon instalment No. 2; Cash Book entry. In place of entries (e) and (f) above, the following entry might have been made: Dr. Cash (Instalment No. 2), $150,000.00 Cr. Bond Subscriptions, $150,000.00 g. Dr. Bond Subscriptions, $300,000.00 Cr. Unissued Bonds, J300 , 000 . 00 To record issuance of bonds. 3. Bond premium and discount. Bond premium and discount should not be handled similarly to premium and discount on capital stock. Bond premium is in the nature of a lia- bility (a deferred credit) , whereas, bond discount is in the nature of an asset (a deferred debit). (But see section, post: Bond Premium, Discount, and Expense.) The Inter- state Commerce Commission requires that bond premium be carried upon the Balance Sheet as a deferred income credit, and that bond discount be shown thereon as a de- ferred charge. 4. Expenses of floating a bond issue. These may be shown in any one of the following accounts: a. Bond Issue Expense account. b. Underwriting Expense account. 262 ADVANCED ACCOUNTING c. Bond Discount and Expense account. The use of this account contemplates combining the discount and the issuing expense under one caption. It would seem not to be in error to use such an account where the expense is to be amortized over the future years. d. Organization Expense account. The use of this account does not seem proper. 5. Issuance of special types of bonds: a. Collateral trust bonds. Precede the opening entries by an entry under which the following results, relative to the amount of the collateral: Dr. Pledged Investments, $ ff Cr. Investments, $ ^ b. Equipment trust bonds: Dr. Leased Equipment, $ ff Cr. Equipment Trust Bonds, $ ^ To record total issue. Dr. Equipment Trust Bonds, % ff Cr. Cash, | ^ To record each equal instalment paid off. Dr. Equipment, $ ff Cr. Leased Equipment, $ ^ To record taking over the equip- ment with full title when a release has been secured after payment of the last instalment due. Illustrative Problem and Solution. Problem. — A corporation issued First Mortgage Bonds bearing interest at 5 per cent, dated January 1, 1917, to subscribers at $125.00 for each bond, par value $100.00. The bonds are to be paid for in three instalments: $25.00 on February 1; $50.00 on March 1; and $50.00 on April 1. The February 1, and March 1 instalments have been paid and the proper entries made on the Cash Book. You are called in to formulate the Journal entries on the two instalments. How would you make them? There were issued and sold $100,000.00 par value. (C. P. A.) Solution. — The above problem is simple in the extreme, but illustrates fairly well what has been covered above in the last section. Note the fact that the entries have been made upon the Cash Book in due and proper form, and that all that is required are the Journal entries. However, for illustrative purposes, all the entries are given, but those not required- have been thus earmarked; the entries are in Journal form: CORPORATE OBLIGATIONS; BONDS PAYABLE 263 I $100,000.00 $100,000.00 25,000.00 $25,000.00 $25,000.00 (1) Date should be that on which issue authorized Unissued First Mortgage 5 per cent Bonds, $100 , 000 . 00 To — First Mortgage 5 per cent Bonds, To record authorized issue. (2) January 1, 1917 (On assumption that this was subscribers date) Bond Subscribers, — First Mortgage 5 per cent ^o<^s, $125,000.00 To— Bond Subscriptions — First Mortgage 5 per cent Bonds, Bond Premium, To record subscriptions to above issue. (3) February 1, 1917 Instalment No. 1 — First Mortgage 5 per cent Bonds, To — Bond Subscribers — First Mortgage 5 per cent Bonds, To record first instalment due this date, representing 20 per cent of bond subscriptions. (4) Dates not known (Entry not required; being on Cash Book) ^^^^ $25,000.00 To — Instalment No. 1 — First Mortgage 5 per cent Bonds, (5) March 1, 1917 Instalment No. 2 — First Mortgage 5 per cent Bonds, To — Bond Subscribers — First Mortgage 6 per cent Bonds, To record second instalment due this date, representing 40 per cent of bond subscriptions. (6) Dates not known (Entry not required; being on Cash Book) Similar to (4) above, except as to amount. Payment of Bond Interest.— The usual handling of pay- ments covering bond interest is considered hereunder. In dis- cussing bond interest, two points come to mind: 1. Considerable already has been stated hereon in former sec- tions. Therefore, a detailed discussion appears unnecessary at this point. $25,000.00 $50,000.00 $50,000.00 264 ADVANCED ACCOUNTING 2. Variations in procedure are apparent when one considers different classes of bonds. Therefore, it seems advisable to discuss briefly the subject of interest in connection with certain different types of issues. The following is deemed sufficient relative thereto: a. Registered bonds. The interest when due would be sent to the bondholders either by the fiscal agent or by the company treasurer. Since bond interest accrues day by day, it would be correct accounting to provide therefor by proper monthly entries so that correct monthly state- ments may be prepared: i. Bond Interest, $ ^ To — Bond Interest Accrued, $ ^ To record monthly accrual, ii. Bond Interest Accrued, $ ^ To — Cash, I ^ To record semi-annual (quar- terly or yearly) payments. An alphabetical list of the holders of registered bonds who are entitled to receive interest checks should be pre- pared as of each interest-paying date. b. Coupon bonds. The same procedure as shown above apparently would answer for coupon bonds. Since many coupons are unredeemed at the end of each period, a mere booking upon the cash payment basis would seem incorrect. c. Treasury bonds. Interest upon treasury bonds requires no entry unless they are held by a trustee under a pro- vision relating to the sinking fund that he is to receive all interest and invest same. d. Guaranteed bonds. Nothing unusual will occiu- relative to these bonds unless the issuing company defaults in the payment of interest; in such event, the guaranteeing company must make payment. When this occurs, an inter-company transaction results (see post: Chap. 13). i. Entry on books of guaranteeing company: Advances to Subsidiaries, $ ^ To— Cash, $ ^ ii. Entry on books of defaulting company: Bond Interest, | ^ To — ^Advances from Parent Company, f ^ CORPORATE OBLIGATIONS; BONDS PAYABLE 265 e. Income bonds. If these are considered as being in the same class with preferred stock, as seems to be the case, the interest thereon should be booked similarly to the entries required when dividends are declared. If, on any interest-paying date, profits are sufficient to make pay- ment of the contingent interest amount due, the follow- ing entries would be in order: i. Interest — Income Bonds, $ ^ To — Interest Payable — Income Bonds, $ ff To record interest declared payable, ii. Interest Payable — Income Bonds, $ ^ To — Cash, I ^ To record interest paid. Bond Interest and Construction.—The various charges arising during periods of construction, under the rulings of the Interstate Commerce Commission and the Public Service Com- mission of New York, may be capitalized. Therefore, items like bond interest and bond discount may be thus capitalized as well as interest on loans and construction expenses. In booking these items, the following procedure would be illustrative : 1. As these items currently accumulate, charges to cover would be made to proper accounts: a. Bond Interest. b. Bond Discount. c. Interest on Loans. d. Construction Expenses. 2. Periodically, as yearly, or when the construction is com- pleted, transfers would be made from the above accounts, to either: a. Construction account, or b. Plant and Equipment account. Bond Premium, Discount, and Expense.— The Bond Premium account is presumed to hold the amount in excess of par value realized from a sale of bonds. Briefly, its amount should be written off over the life of the bonds. The account with Bond Discount and Expense is supposed to hold the cost of an issue of bonds; all expenses incident to a bond issue as well as the discount involved when bonds are sold below par. i 266 ADVANCED ACCOUNTING f One account may be used to gather these charges, as shown above, or separate accounts may be kept with Bond Discount and Bond Expense. Bond discount is considered as being an increase in the actual amount of interest paid which, however, should be written off over the life of the bonds. The premium received or the discounts allowed upon the sale of bonds is considered as a deduction from, or an addition to, the interest paid on the bonds: 1. In case of discount, the borrower is said to pay for two things: a. Interest for the use of money. b. Discount, for the use of money. 2. In case of premium, the principal sum borrowed exceeds par and, since the excess, or premium, need not be repaid at maturity, it amounts to a deduction from interest. Because of the above, most accountants agree that the pre- mium or discount should be written off over the life of the bonds in order that each accounting period may show the accurate or true cost of carrying the issue. The writing off is accomplished either by crediting or charging a proportionate amount or part to the Interest account, and thence from here to the Profit and Loss account, at the end of each fiscal period. Three methods of writing off are followed, the first of which is not in conformity with the principle indicated in the last paragraph above: 1. Write the amount off immediately either to Profit and Loss or to Surplus accounts. Since the true cost of carrying the issue cannot be shown hereunder, the method is in error. 2. Write the amount off in equal instalments over the life of the issue. Apparently, this method is in accord with the principle advanced above; but as a matter of fact, it is in error for the same reason as the first method. It does not recognize the effective rate of interest. It is known as the "straight line" method and, from a practical point of view, is used considerably. 3. The "effective rate" method seems to be the best one thus far advanced for writing off bond premium or discount. The effective rate is calculated upon the amount actually received, rather than upon the par value. The actual CORPORATE OBLIGATIONS; BONDS PAYABLE 267 amount of interest paid is charged to the Bond Interest account. Then the procedure varies as under: a. If bonds are sold at a premium. The difference between the effective (the market rate of interest) and the nomi- nal (amount actually paid) interest rates is charged periodically to Bond Premium account and credited to Bond Interest account. b. If bonds are sold at a discount. The difference between the effective and the nominal interest rates is charged periodically to Bond Interest account and credited to Bond Discount (and Expense) account. This method scientifically writes off the premium or dis- count over the life of the bonds. The method makes use of the amortization principle. Sinking Fund. — A fund always should represent an asset. A sinking fund should be created by assets in the proper converted form being set aside for the purpose for which the fund was established. Ordinarily, such purpose will be the retirement of a bond issue. Payments are made into the fund usually at regular recurring intervals by more or less regular amounts, as monthly, quarterly, semi-annually, or annually. These pay- ments either are placed in a bank, or are used for the purchase of gilt-edged securities usually by depositing with a trustee for the bondholders; in either instance, the fund, as booked, will consist of cash or of cash and securities. Naturally, increases in the fund, in part, will consist of interest, and perhaps divi- dends, collected upon the fund principal. The liability for the payment of which the sinking fund is created and accumulated may vary as to type, about as fol- lows: 1. It may be payable in one amount at the maturity date of the bond issue. 2. It may be payable in yearly instalments, the bonds to be retired thereunder being determined by the drawing of the bond numbers. The sinking fund procedure may or may not be governed by the terms of a mortgage agreement which secures an issue of bonds. In other words, the fund accumulation may or may not bear a relationship to corporate profits: 268 ADVANCED ACCOUNTING 1. Without reference to profit. Hereunder, general assets are converted and set aside by a general procedure in accord with a general plan under which the liability in question eventually will be redeemed. The mortgage will not pro- vide for the creation of such a fund from income assets. 2. With reference to corporate profit. Hereunder, the sink- ing fund procedure is made necessary by the terms of a mortgage agreement securing a bond issue: a. Where the capital plant either is subject to conditions that will reduce the longevity thereof, or is diminished on account of operations: i. The usual industrial company is more or less non- permanent, ii. A mining company, or one of similar type, will exhaust its capital plant over a period of years. Hence, it is usual, when floating a bond issue, to have the mortgage contain a provision requiring the accumu- lation of a fund out of which the bond principal will be paid at maturity because, by such provision, it is thought the bond issue will sell better and a higher price is se- curable. b. Where the capital plant remains more or less permanent, and the belief is prevalent that such plant will be more valuable at the expiration of the bond issue term than at present. Hereunder, a bond issue may be floated without reference to any sinking fund provision ; a railroad would be an example of this type of activity. The provision that a sinking fund shall be created from in- come assets is the usual requirement of a corporate mortgage backing a bond issue, inasmuch as: 1. Corporate assets are conserved. 2. The liability will be paid from earned assets, not from those comprising a portion of the assets secured through incur- ring the liability. 3. Profits cannot be distributed until after the yearly con- tribution to the sinking fund has been made; hence, a tendency toward a riotous life cannot become full grown without first providing the means for taking care that the liability will be paid when due. CORPORATE OBLIGATIONS; BONDS PAYABLE 269 4. Upon the completion of the sinking fund procedure, there will be on hand undistributed profit in the requisite amount for the use originally agreed. Sinking Fund Trustee. — The terms of a mortgage agreement securing an issue of bonds require, generally, that payments into the sinking fund be made through the mediimi of a trustee who is given the duty of taking charge of the fund for the benefit of both the bondholders and the corporation. The trustee thus designated, usually, is a trust company, and this latter acts as such for a compensation based upon a percentage of the funds handled. By virtue of the mortgage agreement requirements, above in- dicated, the asset fund thus desired is removed from the con- trol of the corporation under which its availability for the specific purpose of eventually meeting a bond obligation might be jeopardized by the incoming of general creditors' liens. In other words, corporate funds, not specifically pledged, cannot be set aside for the use of a particular class of creditors. In attempting to discuss the general variations governing sinking fund entries, it may not be amiss at this point to re- capitulate two or three principles which have been set out above: 1. A sinking fund may be created without regard to profits. If so, the fund account would be charged and, say, the Cash account credited. Increases in this fund on account of interest earnings would be credited to Profit and Loss account, and be charged to the fund account when col- lected. 2. A sinking fund may be created with regard to profits,-^ut of assets secured from profits. This requirement should operate about as follows: a. A certain amount should be reserved from profits, the effect of which will be to credit a profit appropriation account, as Sinking Fund Reserve account, and to charge Surplus (an undivided profits account) account. The balance in this reserve account indicates the amounts held back from profit for sinking fund purposes. b. The fund account then is debited with the cash or other assets sent into it from time to time. If a trustee is to take over the custodianship of the sinking fund, the 270 ADVANCED ACCOUNTING |i i' trustee will have turned over to him an amount of cash equal to the appropriation from surplus, by means of an entry charging an account with the trustee and crediting Cash account. Hence, if the booking be done properly, the amount of the sinking fund, as a charge, should be in agreement with the amount of the reserve, as a credit. The trustee may have authority to invest the sinking fund in gilt-edge securities, or he may be required only to hold the cash on hand on deposit. If securities are purchased, these latter, at least in part, may consist of the corporation's own bonds. Hence, it is possible that the fund will consist in part of cash, and in part of bonds: 1. Cash. 2. Bonds. a. Investment securities. b. Own bonds. If so, when the Balance Sheet is prepared, it would seem to be good accounting to differentiate between the two classes of bonds. If some of the company's own bonds are held, the differentia- tion in handling may be set out, as to them, as under: 1. They may be listed upon the Balance Sheet either among the assets or as a deduction from the total bonds payable outstanding; the latter handling seems preferable in that treasury bonds are assets no more than is treasury stock. The above assumes the sinking fund bonds have not been cancelled. 2. If the sinking fund bonds have been cancelled, as may be done, their amount may be handled on the Balance Sheet in either of the two possible following ways: a. Deduct from the total bonds payable outstanding. b. Show upon the Balance Sheet only the net amount of the bonds payable outstanding. This procedure is be- lieved to be the preferable one inasmuch as cancelled debts ought not to be found upon the Balance Sheet. Where the sinking fund is held in the form of either cash on deposit or securities, a certain amount of income will be derived therefrom from time to time, — as interest uix)n bank balances, CORPORATE OBLIGATIONS; BONDS PAYABLE 271 and interest (or dividends) from investments. Such income may be handled in one of three possible ways: 1. It may be payable to the corporation. 2. The mortgage agreement may provide that it should be turned over to the trustee as an accretion to the fund. Hereunder, the variation in booking may be shown as: a. Charge the collecting trustee, and credit, i. Reserve for Sinking Fund account, or ii. Sinking Fund Income account: (a) The amount may be retained herein until the trust has expired, or (b) The amount may be transferred to the reserve account. 3. It may be applied as a deduction against the next sinking fund instalment. In any event, such income represents a special profit. Premium or discount on bonds that have been purchased for a sinking fund may be handled as follows: 1. Write off immediately to Profit and Loss account, or 2. Distribute same (amortize or accumulate) over the life of the purchased bonds, under which the amount thus dis- tributed will affect the interest return. This method, natur- ally; is preferable to the first one. Likewise, fluctuations representing a profit or loss on the sale of securities should be adjusted through the account of Sinking Fund Income. In the matter of bond redemption, certain variations appear which, briefly, may be indicated about as follows: 1. Nothing may be done until the entire issue matures. 2. From time to time the trustee may use the funds under his control, go out into the market and purchase therewith some of the bonds of the company that have been offered for sale. Naturally, no definite policy in this connection can be followed inasmuch as it is uncertain whether any of the bonds will be offered for sale at the times the pur- chases are desired. This point has been mentioned above already. 3. Certain numbers of the outstanding bonds may be retired annually under the provisions of the sinking fund indenture, I IN 272 ADVANCED ACCOUNTING as by means of a drawing by lot. The bond numl)ers drawn are published, after which interest ceases to accrue upon the bonds concerned, the trustee secures the cash with which to make payment, and tlie redemption i)ro- ceeds as the bonds are presented. In view of the fact that the trustee cannot go along indefinitely holding himself ready to redeem bonds that have been called, and in view of the fact that at times, as under a large issue, many bonds will not be presented for payment within a reasonable period of time, — some being lost or the owner being dead, — be- fore the trustee turns over the cash remaining in his hands un- used, he will require a bond of indemnity to be furnished by the company to protect him against loss in case a bond is pre- sented later for payment. The amount of this indemnity bond will be usually twice the amount of the greatest possible liability for which he may be held. When the bond liability has been paid off, the books still will retain the amount or the account of Sinking Fund Reserve repre- senting, if correctly set up from actual profits, a surplus item which either may be appropriated for some special use or be used for purposes of stockholders' distribution. Hence, a reversing entry charging the Reserve account and crediting Surplus account would be in order. To summarize the portion of this chapter relative to handling maturing bonds, the following is offered: 1. Convert outside securities into cash, and write off against the Sinking Fund Income account any differences between the book values and the amounts realized from the con- version. 2. Redeem outstanding bonds from cash available. 3. Secure indemnity bond double the amount of the maximum liability before turning any remaining cash over to the company. 4. Cancel any treasury bonds in the sinking fund, and close out against the bonds outstanding. 5. Turn any remaining cash over to the regular corporate cash fund. 6. Clear the records of any remaining entries relating to the bond issue. lA t \] CORPORATE OBLIGATIONS; BONDS PAYABLE 273 To summarize the usual sinking fund provisions relative to a corporate bond issue, as covered by a trust deed, and to show in tangible form illustrative Journal entries in connection there- with, the following is offered: 1. Usual sinking fund provisions: a. Who shall be the trustees of the sinking fund. b. What amount shall be set aside periodically in the sinking fund, monthly, quarterly, semi-annually, or an- nually. c. How the money in the sinking fund shall be invested by the trustee or trustees. 2. Pro-forma entries covering sinking provisions: a. To record surplus profit set aside for sinking fund pur- poses : Surplus (or Profit and Loss Surplus), $ ^ To — Reserve for Sinking J'und, $ i b. To record periodical transfer of cash to trustee under agreement: Sinking Fund Trustee, Cash Account, $ ^ To — Cash, • A c. To record investments for sinking fund from cash avail- able, as per trustee's report: Sinking Fund Trustee, Securities Account, | ^ Premium on Sinking Fund Securities, $ ^ To— Sinking Fund Trustee, Cash Account, $ ^ d. To record expenses and compensation of trustee as per agreement: Sinking Fund Income Account, $ ^ To— Sinking Fund Trustee, Cash Account, $ ^ This entry would be in order where such items are chargeable against the fund ; but where these items are paid directly by the corporation, as may be done, the entry would be: Sinking Fund Expenses, $ ^ To— Cash, e. To record income collected by the trustee: « i Sinking Fund Trustee, Cash Account, To — Sinking Fund Income Account, Premium on Sinking Fund Securities (pro rata amortization). u ' b t • I 274 ADVANCED ACCOUNTING f. To record transfer of surplus profit for purposes of sinking fund: Sinking Fund Income Account, $ i To — Reserve for Sinking Fund, $ j§ g. To record cash received on sale of sinking fund se- curities : Sinking Fund Trustee, Cash Account, % i To — Sinking Fund Trustee, Securities Account, S ^ Adjustment must be made, also, through the Sinking Fund Income account for the loss or profit entailed. Likewise, the purchase premium or discount involved must be considered, h. To record purchase of own bonds for sinking fund: Sinking Fund Trustee, Treasury Bonds, $ ^ To — Sinking Fund Trustee, Cash Account, $ i i. To record cancellation of these treasury bonds: First Mortgage, Sinking Fund Bonds, % i To — Sinking Fund Trustee, Treasury Bonds, $ ^ j. To record payment of bonds upon maturity: First Mortgage, Sinking Fund Bonds, $ i To — Sinking Fund Trustee, Cash Account, $ i k. To record cash turned over to company by trustee: Cash, $ i To — Sinking Fund Trustee, Cash Account, $ i 1. To record disposition of reserve when bond issue paid up: Reserve for Sinking Fund, $ i To — Surplus (or otherwise as directors wish), $ jif Illustrative Problems and Solutions. — To illustrate further the booking of bonds and sinking funds, two C. P. A. problems and their solutions are shown below. The two problems selected are fair samples of those encountered in that in each one cer- tain information is lacking; and this makes it necessary for the student to determine what variation from accepted procedure shall be adopted. In any particular case, he should recognize the usual procedure and follow this to a conclusion in so far as is possible, if a variation seems necessary, his solution and comment should be such that the reader will understand exactly what he has done, and why. CORPORATE OBLIGATIONS; BONDS PAYABLE 275 Problem l-This problem is simple in the extreme, but information i« lacking a. to the maturity date of the bond issue. Naturanrrerefor^ witho7''t-'' '" '^^^^ *'^ amortization principle to the bond "ni without making an assumption; the making of such an assumotTon I entirely unnecessary. This being the ca^, fhe ex^ient hTbeen used c mpletTI but tr?- '''• TT ^^ ^'^^ ^--n^-til the soluLnt completed, but indicating just where the reductions thereof occur bnl^'^^'^T ''.^''**''''''^'^ ^ *^*^^ '^""^ «^ [1500,000.00 of 5 per cent bonds in denommations of 11,000.00 and $500.00, with interest ^avrble loTlI Jo" The""'' ^^' ''''' ^'; f ^^^ ^''^^ '^ -derwritrlrr;" 1J18, at 90 The company issued the bonds for the underwriters at Q'i and received the ca^h in payment February 1, 1918 "''^^'™*''" ^* ^^' cJl.^^^Tl^^f^?'^^^' ^^^* "*^^''^ «*^^" ^^ established a fund to be caJ^d the bond sinking fund,' to the account of which there shaU on^th^ thirty-first day of December of each year be carried a sum equa^ to 7^ earned to the account of the said fund, the company shall pay theTnterest Shan L r 7^""' 'r' ^^^""^^ ^"^' '^^ *^« balance of said rne; In January, 1919, the company purchased $10,000.00 of its bonds at 97 Ld:r98. "'^""^' ''^"- '"^ '^^^^^ ''''^ '^^ market prlfe of the Janua!;"l9To7 '"'' "'^ '^ ^""'^' '^^'^ **^^ ^^^ -^^-« ^-^ - sale omL' h^'Tl """'T- ^'' "" '^' transactions from the date of the Tan^ary 1^^^^^^^^^ ^ ^'^^ ''^^^"'^"^ *^^ ^^^^^ ^- the sinking fund in c. Show trial balance after posting above entries. (C P A ) J^^on to Problem ..-The solution is shown by „.eans\f Journal (1) Date not know n Unissued 5 per cent Bonds, To — 5 per cent Bonds Payable, To book authorized issue. (2) January 1, 191 8 Underwriters, To— Unissued 5 per cent Bonds, To record placement of entire issue with underwriters. (3) Unamortized Bond Discount, To — Underwriters, To adjust Underwriters account ta show net contract sale cost, at 90. $500,000.00 $500,000.00 $500,000.00 $500,000 00 $50,000.00 $50,000 00 276 ADVANCED ACC0VNT1NG (4) February 1, 1918 $475,000.00 $475,000.00 $35,000.00 $35,000.00 185,000.00 Cash, To — Underwriters, To record cash received by company on behalf of underwriters (5) Underwriters, $25 , 000 . 00 To— Cash, . $25,000.00 To record payment to underwriters of their profit from selling issue at 95. (6) December 31, 1918 Bond Sinking Fund, To— Cash, To record annual instalment to sinking fund being 7 per cent of par value of bonds. (7) January 1, 1918 Bond Interest, To— Bond Sinking Fund, $25 , 000 . 00 To record payment of interest due on January 1, 1919, out of sink- ing fund. The next entry should relate to the proportional extinguishment of the unamortized bond discount However, this is impossible in the problem since the maturity date of the bond issue is not given. One might make certain assumptions relative thereto, but in solving C. P. A. problems, espe- cially in an examination, the contention is advanced that assumptions should not be made unless absolutely necessary to secure a solution from the facts given. One may well point out an existing error in a given set of factai or the short-comings thereof, but to make an assumption which, at best* may be extremely far-fetched does not seem in order. (8) January, 1919 5 per cent Bonds Payable, To — Unamortized Bond Discount Bond Sinking Fund, To record purchase of $10,000.00 par value of bonds in open market at 97, which are retired and cancelled. Since exact date of purchase in January is not known, interest accrued must be ignored. $10,000.00 CORPORATE OBLIGATIONS; BONDS PAYABLE 277 $300.00 $9,700.00 Bond Interest, (9) To— Unamortized Bond Discount, To reduce amount of discount appli- cable to the $10,000.00 of bonds re- tired. If it had been possible above to adjust the Discount account when interest was paid (entry 7), the amount adjusted at this time would be less than $1,000.00 since therefrom should be deducted as to $10,000.00 par the amount already charged off. (10) n J o- 1 . ^ Dece mber 31, 1919 Bond Smking Fund, To— Cash, To record annual instalment as before. (11) xj , T , January 1, 1920 oond Interest, " To— Bond Sinking Fund, To record annual interest payment on bonds now outstanding. Had maturity date been given, the next entry would cover amortization in- stalment. (12) - , ^ January, 1920 5 per cent Bonds Payable, ~ To— Unamortized Bond Discount, Bond Sinking Fund, To record purchase of 11 bonds of $1,000.00 each from sinking fund at 98. At this moment, $10,800.00 remains in the fund: Debits: Dec. 31, 1918, Dec. 31, 1919, Total, Credits: Dec. 31, 1918, Interest, $25,000 Jan. (_,) 1919, Purchase, 9,700 Dec. 31, 1919, Interest, 24,500 $59,200 Balance, $1,000.00 $1,000.00 $35,000 $35,000 $70,000 Purchase, this entry, Balance, 10,800 10,780 20 $35,000 00 $35,000 00 $24,500.00 $24,500.00 $11,000 00 $220.00 $10,780.00 278 ADVANCED ACCOUNTING $1,100.00 11,100.00 $479, 00 00 $47»,000.00 $479,000 00 Bond Interest, ^^^^ To — Unamortized Bond Discount, To reduce amount of discount for same reasons as shown in entry (9) above, applicable to the $11,000.00 of bonds retired. At this point, a Trial Balance is to be prepared; it follows: Cash, $380,000.00 Bond Sinking Fund, 20 . 00 Unamortized Bond Discount, 47 , 380 . 00 Bond Interest, fi i , 600 . 00 6 per cent Bonds Payable, Totals, Problem 2.— This problem perhaps is a little more difficult than the first one above in that more entries are required. Likewise, as before, thc^ lack of certain information prevents the proper amortization of the bond discount and expense; this being the case, the expedient has been used of charging oflf this item at once, rather than holding the amount in abeyance until the solution is completed, — but indicating just where the periodic reductiong should occur. By so domg, a variation in solution is secured. The Standard Trust Company is appointed by the Peninsular Mining Company as trustee of a bond issue, aggregating $1,000,000.00, all Bonds oi $1,000.00 denomination, rate 5 per cent, and bearing date January 1, 1914. Bonds mature in ten equal annual instalments, beginning January 1, 1917, unless previously converted or retired. The issue is not purchased by the trustee, but is sold through Emory Davis & Company, Brokers, the company realizing 90 per cent and accrued interest less the cost of appraisal of property, printing, trustees' expenses, etc., amounting to $9,310.80. (Fees not included above). Schedule of InBtal. Due Discount Years to No. Date Amount Involved Run 12/31/14 12/31/15 12/31/16 12,81/17 1 1/1/17 $100,000.00 $10.000 00 3 13,333.33 $3,333.33 $3,333 34 2 1/1/18 100,000.00 10.000.00 4 2.500.00 2,500.00 2.500.00 12,600.00 3 1/1/19 100,000.00 10.000 00 5 2.000.00 2.000.00 2.000.00 2.000.00 4 1/1/20 100,000 00 10.000.00 6 1,666.66 1.666.66 1.666.67 1,666.67 5 1/1/21 100,000 00 10,000.00 7 1.428.57 1.428.57 1,428.57 1.428.57 6 1/1/22 100,000.00 10.000.00 8 1.250.00 1.250.00 1.250.00 1.250.00 7 1/1/23 100.000.00 10.000 00 9 1.111.11 1.111.11 1.111.11 1,111.11 8 1/1/24 100.000.00 10.000 00 10 1.000 00 1,000.00 1.000 00 1.000.00 9 1/1/25 100,000 00 10.000.00 11 909.09 909.09 909.09 009.09 10 1/1/26 100,000.00 10.000.00 12 833.33 $16,032 09 833 33 $16,032 09 833.33 $16,032 11 833.33 Totals. SI, 000, 000. 00 SIOO.OOO 00 $12,698 77 The above schedule has been prepared on what may be called the "straight line" plan as against the The first instalment, $100,000.00. matures in three years; therefore, on the straight line plan, 1 ;i of the ■0 that such account will show the true expense of borrowed capital. In other WOTds, on December 81, 1914, However, since the problem does not indicate: 1. Which of the bonds were converted into preferred stock at 90, on January 1, 1916. and 2. Which of the bonds were redeemed at 103. on January 1, 1917, it is imposrible to adjust the discount m it should be adjusted, without assuming certain thine*. And indicate that the student und««tands the case in hand. CORPORATE OBLIGATIONS; BONDS PAYABLE 279 20^1914''**'^^ '^"^ "^^ ^^^^"^ ''''^'"' *'''* ^""'^ ^""'^ ^^ *^^ ^^""^^^ ^'^ January Among other things the trust deed provides: Bonds convertible on any interest date for 6 per cent preferred stock at 90, at option of holder. Bonds may be retired out of sinking fund on any interest date at 103. at option of company. Sinking fund for payment of principal only to be based on annual produc- tion of ore at 10 cents per ton. Trustee to charge 1/4 per cent of principal on issue, and 1/4 per cent on coupons. Interest payable January 1 and July 1. The company's production for three years is assumed to be. for the purpose of this problem, 1,000,000 tons per year January 1, 1916, $100,000.00 are converted to preferred stock January 1, 1917, $200,000.00 are redeemed at 103. Formulate all necessary entries for the books of: a. Standard Trust Company, b. Peninsular Mining Company, c. Emory Davis & Company, ^atar;^l^^l7"TcT.^^^^ ''^ ^'^^^ ^'^'^^^^^^^'^^ "p ^ -^ -^^^^-« Solution to Problem ^.-The requirements of this problem contemplate entries upon three distinct sets of books: 1. The issuing company. 2. The brokers. 3. The trustee. Therefore, this solution ha^ been divided into three distinct parts. Part 1 of solvJtwn.-This portion of the solution relates to the books of the Pemnsular Mmmg Company, and has been separated into two sections: Amortization 12/31/18 12/31/19 12/31/20 12/31/21 12/31/22 12/31/23 12/31/24 12/31/25 Total 12.000.00 1,666.67 $1,666 67 1.428.57 1.428.57 $1,428.58 1.250 00 1.250.00 $1,250.00 1.250.00 1.111.11 1.000.00 909.09 833.33 1.111 11 1,111.11 1.111.11 $1,111.12 1,000.00 1.000.00 1.000.00 1.000.00 $1,000 00 090 09 909.09 909.09 909.09 909 09 833.33 833.33 833.33 833.34. 833 34 $909.10 833.34 $833.34 $10,000 00 10,000.00 10.000.00 10.000 00 10,000 00 10.000.00 10,000.00 10.000.00 10.000.00 -— — IZI ^ »»»..„. ooo.ot iJ M.M S833.34 10.000 00 .$10.198.77 $8.198.77 $6.532.11 $5.1035 3 $3.853 55 $2.742 43 $1,742.44 $833 . 34 1I^^:^i;;(rr;;i 'eflfective rate" plaa ^^^=============== ^iZl^wT""! T^T "'"*"' "^ """^^- '^ ^•^ «»*^ ^'''^ *»»« B-d Interest «xKnmt $16,032.09 must be charged to Bond Interest account and be credited to Bond Discount account. theoretical assumptions better not be made unless absolutely neces.^ in securing a solution which wiU h 'i \r 1^ 280 ADVANCED ACCOUNTING 1. Schedule of amortization covering bond discount. The specific information lacking m this problem relates to the following- a. What bonds were converted to preferred stock on January 1, 1916T b. What bonds were redeemed on January I 1917? n^^TZ""' "T.,!''?"f ft ™""'* P*"*^'" '"*^»^ti"8 «°t"«s cannot b« made, because of the lack of the above information, it is possible nevertheles. u'^^^i^ u amortisation schedule covering the discount on the bonds sold This has been done even though the problem does not definitely call for the same. (See schedule on pp. 278 and 279) 2. Entries upon the books of the Peninsular " Mining Company. For indiclter ''"''^'' '^"'"''" adjustment and closing entries are January 1, 1914 Unissued Bond8-5 per cent, ~^i , ooo . 000 . 00 lo— Bonds Payable — 5 per cent, To record authorized bond issue. Standard Trust Company, $1 , 000 . 000 00 To — Unissued Bonds— 5 per cent, To record transfer of entire issue to trustee. January 20, 1914 $1,000,000.00 $1,000,000.00 Cash, Bond Discount, Bond Expenses, Sinking Fund Expense (Trustee Fees), To — Standard Trust Company, Bond Interest (Accrued), To record sale proceeds; sale at 90, plus accrued interest, less expenses and trustee fees: Bond discount: $1,000,000.00 less $900,000.00 $100,00000 Gross cash received,$900 , 000 . 00 Bond expense, $9,310.80 Trustee fees: 1/4 per cent on total, $2,500.00 $ 11,810.80 $890,966.98 100,000.00 9,310.80 2,600.00 $1,000,000.00 2,777.78 Interest accrued: 20 days at 5 per cent, (using 4 places). $888,189.20 $ 2,777.78 Balance, cash, $890,966.98 CORPORATE OBLIGATIONS; BONDS PAYABLE 281 July 1, 1914 Bond Interest, j^. ^^ ^ ^'t^S ^''"" ^^"^' '^"^^' 62 50 To record payment to trustee of half-year interest plus 1/4 per cent commission or fee on coupons. December 31, 1914 Bond Interest, " $25,062.50 Siting Fund Expense (Trustee Fees), To— Liabilities Accrued, p «. 7? ^^* "P ^^^"""^^ P"or to closing. Profit and Loss (Sinking Fund Income), lo — Bond Discount, Bond Expenses, Sinking Fund Expense, Bond Interest, To close. The lack of proper information prevents amortiza- tion of the discount and expense of the bond issue from being taken care of as it should be. The same was true in Problem No. 1, above, and therein the unamortized amount was car- ried along to be set out in the final Trial Balance; in the present instance, to iUustrate the periodical adjustment and closing of a set of books, the entire amount has been written off at once, l^he point to re- member is, that, in any given actual case, neither procedure is satisfactory nor correct, the amortization principle being the only correct one to follow. January 1, 1915 Standard Trust Company (Sinki^^lw Trustee), Liabilities Accrued, To— Cash, To record payment to trustee of annual instalment to sinking fund for bond redemption, plus interest at 5 per cent on bonds outstanding and commission or $25,000.00 62.50 $159,158.02 $25,062.50 $100,000.00 9,310.80 2,625.00 47,222 22 $100,000.00 25,062.50 $125,062.50 282 ADVANCED ACCOUNTING fees for interest on coupons ac- crued as under 12/31/14. Profit and Loss (Surplus), To — Reserve for Sinking Fund, The trust deed apparently states nothing to the effect that the sinking fund must be set aside out of profits, but above entry made on assumption that this is desired, since it is usual so to do. The same entry, then, should be made, also, under dates of January 1, 1916, and January 1, 1917. July 1, 1915 Bond Interest, Sinking Fund Expense (Trustee Fees), To— Cash, See entry of July 1, 1914, above. December 31, 19 15 Bond Interest, $100,000.00 $100,000.00 $25,000.00 62.50 $25,062 50 Sinking Fund Expense (Trustee Fees), To — ^Liabilities Accrued, See entry of 12/31/14, above. Profit and Loss (Sinking Fund Income), To — Bond Interest, Sinking Fund Expense (Trustee Fees), See entry of 12/31/14, above. J anuary 1, 1916 Standard Trust Company (Sinking Fund Trustee) , Liabilities Accrued, To— Cash, See entry of 1/1/15, above. Profit and Loss (Surplus), To — Reserve for Sinking Fund, See entry of 1/1/15, above. Bonds Payable — 5 per cent, To— Unissued Capital Stock— Pre- ferred — 6 per cent. Profit on Bond Conversion, To record conversion of $100,- 000.00 of outstanding bonds at 90, into preferred stock — 6 per cent. The credit to the Unissued $25,000.00 62.50 $50,125.00 $25,062 50 $50,000 00 125 00 $100,000.00 25,062.50 $100,000.00 $100,000.00 $125,062 50 $100,000 00 $90,000.00 $10,000 00 CORPORATE OBLIGATIONS; BONDS PAYABLE 283 Capital Stock — Preferred ac- count assumes that the author- ized issue thereof has been spread upon the records. Like- wise, if bond discount were amortized properly, the credit of $10,000.00, as above, in part, proportionately, necessarily would be against the account of Discount on Bonds; but in view of the treatment followed in this solution, the above credit would be in order. July 1, 1916 Bond Interest, Sinking Fund Expense (Trustee Fees), To— Cash, See entry of 7/1/14. In this case, there are $100,000.00 less bonds outstanding than pre- viously. Therefore, the interest and fee charge must be less than before. December 31, 19 16 Bond Interest, Sinking Fund Expense (Trustee Fees), To — ^LiabiUties Accrued, See entry of 12/31/14, adjusted to meet reduced amount of bonds outstanding. Profit on Bond Conversion, Profit and Loss (Sinking Fund Income), To — Bond Interest, Sinking Fund Expense (Trustee Fees), See entry of 12/31/14. January 1, 1917 Standard Trust Company (Sinking Fund Trustee), Liabilities Accrued, To— Cash, See entry of 1/1/15, above. Profit and Loas (Surplus), To — Reserve for Sinking Fund, See entry of 1/1/15, above. Bonds Payable — 5 per cent. Sinking Fund Loss (Premium on Bonds Retired), $22,500.00 56.25 $22,556.25 $22,500.00 56.25 $22,556.25 $10,000.00 35,112.50 $45,000.00 112.50 $100,000.00 22,556.25 $100,000.00 I $122,556.25 $100,000 00 $200,000.00 6,000.00 ii 284 ADVANCED ACCOUNTING $206,000.00 To — Standard Trust Company (Sink- ing Fund Trustee), To record redemption of $200,- 000.00 of bonds from the sink- ing fund at 103. The above completes the entries necessary on the books of the Peninsular Mining Company. As indicated already, in an actual case, the entries shown will differ due to the fact that periodically, upon each interest paying date, there should be charged to the interest account a certain amount of the discount upon the original issue. Part 2, of solution. — The entries upon the books of the brokers, Emory Davis & Company, are as follows: January 20, 1914 $902,777.78 $902,777.78 Peninsular Mining Company — 5 per cent Bonds, To— Cash, To record purchase of $1,000,- 000.00, par value, of above bonds at 90, plus accrued in- terest. The information pre- sented in the problem does not indicate that any other transac- tions occured subsequent to purchase and sale. Part S, of solution.— The entries upon the books of the trustee, the Standard Trust Company, are given below. A question may arise as to the propriety of the adjusting entry on each December 31, covering the accrual of commission in that thecommission is said to bepayable on coupons redeemed on January 1, subsequently. However, the interest is due from the Peninsular Mining Company on December 31, and the commiflmon thereon should be attached thereto. If both items are accrued as of this date for closing purposes, the commission must be booked as a liability. Being booked as a liability, its amount is an asset to some one else, the trustee; hence, if the latter's books be kept upon an accrual basis, it seems that the asset may be taken up thereon. J anuary 1, 191 4 Peninsular Mining Company — 5 per cent Bonds, To — Peninsular Mining Company, To record issue of bonds of above company received as trustee. January 20, 1914 Cash, $902,777.78 Peninsular Mining Company (for discount), 100,000.00 $1,000,000.00 $1,000,000.00 CORPORATE OBLIGATIONS; BONDS PAYABLE 285 To— Peninsular Mining Company — 5 per cent Bonds, Peninsular Mining Company (for accrued int.), To record sale of entire above bond issue to Emory Davis & Company, brokers, at 90, plus accrued interest. Peninsular Mining Company, To— Cash (or Vouchers Payable), To record expenses of bond issue. Peninsular Mining Company, To — Commission (Fees), Cash, To record payment to above company of net proceeds of bond issue, less commission of 1/4 per cent. July 1, 1914 Cash, To — Commission (fees), Peninsular Mining Company — (Bond Interest), To record receipt from above company of cash to pay semi- annual interest charges, plus 1/4 per cent fee. Peninsular Mining Company— (Bond Interest), To— Cash, To record payment of interest coupons on bond issue of above company. December 31, 1914 Accrued Assets, ~ To — Commission (fees). $1,000,000.00 2,777.78 $9,310.80 $893,466.98 $9,310.80 $2,500 00 890,966.98 $25,062 50 $62 50 25,000 00 $25,000.00 $25,000 00 $62.50 $2,625.00 To adjust books, prior to clos- ing, of accrued asset. Commission (fees), To — Profit and Loss, To close. January 1, 1915 To — Accrued Assets, Peninsular Mining Company (Bond S. Fund), $62 50 $2,625.00 $62 50 $100,000 00 I 286 ADVANCED ACCOUNTING Peninsular Mining Company (Bond Interest), To record receipt of cash for purposes shown above. Peninsular Mining Company (Bond Interest), To— Cash, See entry of 7/1/14. July 1, 1915 25,000.00 $25,000 00 $25,000 00 Caflh, $25,062.50 To — Commission (fees). $62 50 Peninsular Mining Company (Bond Interest), 25,000 00 i See entry of 7/1/14. Peninsular Mining Company (Bond Interest), $25,000.00 \ To— Ca«h, $25,000 00 j See entry of 7/1/14. December 31, 1915 Accrued Assets, 162.50 L To — Commission (fees), $63 60 P See entry of 12/31/14. Commission (feesj, $125.00 To — Profit and Loss, $125.00 See entry of 12/31/14. > January 1, 1916 P Cash, 1 To — Accrued Assets, $125,062.50 $62 50 Peninsular Mining Company (Bond S. Fund), 100,000 00 Peninsular Mining Company (Bond Interest), 25,000.00 See entry of 1/1/15. Peninsular Mining Company (Bond Interest), $25,000.00 To— Cash, 25,000.00 See entry of 7/1/14. 1 July 1, 1916 Cash, To — Commission (fees), Peninsular Mining Company (Bond Interest), See entry of 7/1/14. Note that on January 1, 1916, $100,000.00of bonds were retired; hence, the reduction in interest and commission charges. Peninsular Mining Company (Bond Interest), To— Cash, See entry of 7/1/14. $22,556.25 $22,500.00 $56 25 22,500 00 $22,500 00 CORPORATE OBLIGATIONS; BONDS PAYABLE 287 December 31, 1916 Accrued Assets, |5g 25 To — Commission (fees). See entry of 12/31/14. Commission (fees), $112.50 To — Profit and Loss, See entry of 12/31/14. $56.25 $112.50 $122,556.25 $22,500.00 $56.25 100,000.00 22,500.00 $22,500.00 $206,000 00 January 1, 1917 Cash, To — Accrued Assets, Peninsular Mining Company (Bond S. Fund), Peninsular Mining Company (Bond Interest), See entry of 1/1/15. Peninsular Mining Company (Bond Interest), To— Cash, See entry of 7/1/14. Peninsular Mining Company (Bond S. Fund), $206,000 00 To— Cash, To record purchase and redemption of $200,000.00 of bonds of above company at 103. Annuities and Sinking Funds.— A sinking fund may be accumulated in numerous ways, the commonest and simplest being: 1. Equal periodical amounts set aside, without regard to in- terest earnings thereon. If interest be earned upon the amounts regularly set aside, such interest is sent into gen- eral income, not into sinking fund income. 2. Equal periodical amounts are set aside, as annually, which, at compound interest; will accumulate to the sum desired at the end of a certain number of years to meet the prin- cipal of the obligation then due. The second method of creating a sinking fund relates to an annuity, the annual installment so required being thus defined Likewise, since certain difficulties may arise in the calculation of its amount, it seems expedient to present certain principles related thereto which an accountant ought to comprehend. In determining the amount of a sinking fund instalment, one works with the mathematical process known as annuities.' In fact, in the present worth calculation given in a preceding chap- ^ ter in connection with bond investments the annuity principle 288 ADVANCED ACCOUNTING was used, which in that connection might be restated, from the present viewpoint, about as follows: An investor wishes to pur- chase an annuity which will return him an income of $ , ^or years. In the present instance, in determining the amount of a sinking fund instalment, two variations only will be presented, in that this volume is not presumed to be a treatise on mathematics: 1. The amount of a sinking fund instalment where interest on the debt is not considered. 2. The amount of a sinking fund instalment where interest on the debt is to be considered. Both of the above will be discussed from the point of view of payments being made at the end of each year, not at the begin- ning thereof. Calculating an annuity, which latter may be defined as the payment of a definite sum of money at regular recurring inter- vals, or as a series of payments of equal amounts due at regular intervals, is based upon the use of compound interest; hereunder, interest is earned on both the principal invested and on the interest accruing from period to period which, in turn, is invested also. The amount thus to be set aside periodically may be determined in any one of the following ways: 1. By an arithmetical procedure involving calculations more or less cumbersome. 2. By the use of annuity tables. 3. By the use of algebraic formulas. The method followed herein is an arithmetical procedure which, although cumbersome, is more readily comprehended by the average student than that which savors of algebra. If $1.00 is invested at 4 per cent for twenty years, compounded annually, the $1.00 will amount to $2.19112314, at the end of such time. This means that there is a regular annual addition of 4 cents to the original $1.00,— which, in turn, increases at 4 per cent annually. If the original $1.00 is placed in one bank account for the full period of twenty years, and the annual interest is taken thence when due and is placed in another bank account, in which account it will earn the same rate of interest as before, at the end of twenty years there will be: 1. In bank account No. 1, $1.00 2. In bank account No. 2, $1 . 19112314 CORPORATE OBLIGATIONS; BONDS PAYABLE 289 The latter amount represents an annuity of 4 cents per annum paid into bank account No. 2, for twenty years. Hence it may be said that this $1.19112314 is the value at maturity,— the ulti- mate or final value of an annuity of 4 cents for twenty years at 4 per cent. Further, herefrom, the final value of an annuity of $1.00 may be determined quickly, as under: 1^9112314X100^29.7780785 And, in turn, from the above, the final value of an annuity of any amount, under the conditions assumed, may be calculated Assume, for example, $2,000,000.00 as a basis of calculation- $2,000,000.00 divided by 29.7780785 equals $67,163.50, repre- senting the annual amount desired. Problem.— The foUowing problem has been framed to illustrate further the prmciples presented above. It is a C. P. A. problem revamped A contractor proposes to build a bridge for a certain city and accept the city's 4 per cent twenty-year bonds in the amount of $2,000,000.00 in payment What amount must be set aside at the end of each year, compounded at 4 per cent, to meet the obligation when due? The solution of this problem has been given above, the annual addition to the smking fund being $67,163.50. If a rule were to be propounded upon the basis of the above deductions, it might read as foUows: 1. Find the final value of an annuity of $1.00, for the given time and the given rate, by: a. Determining the compound interest on $1.00 for the given period at the given rate, and b. Multiply by 100 and divide by the given rate. 2. Divide the amount of the obUgation by the result secured in (1)- the annual sinking fund addition wiU equal the final amount secured' The above calculations were made without the use of interest tables- If these latter are available, the work would be reduced materially The above illustration covers the first possibility to be discussed, determin- ing the annual contribution to a sinking fund without reference to interest upon the obhgation in question. Suppose now, that this same city borrowed the $2,000,000, to carry out certain improvements, and the amount is to be repaid by equal annual instalments including both principal and interest the mterest rate being 4 per cent, and the time twenty years. Hereunder, the requirement may be stated in either of the two foUow- mg ways: 1. What equal annual payment is equivalent to $2,000,000.00, invested at 4 per cent, or 2. What annuity can be purchased for $2,000,000.00, money being worth 4 per cent per annum? Solulion.-tl.W=%2.19imU, the amount of $1.00, in twenty-years at I \! 290 ADVANCED ACCOUNTING ^ 1,932,836 50 77,313 46 69,850 04 4 per cent $2. 191 12314 X $2,000,000= $4,382,246.28, the amount of $2,000,- 000.00 in twenty years at 4 per cent. — ^ ^ = $29.7780785, the final value of $1.00, annual payment for twenty years (see above). 29 7780785 ^ $147,163.50, the amount of the equal annual payment re- quired (answer). Total amount of bonds, $2 , 000 , 000 . 00 Interest at end of first year, go 000 00 Annual payment, 147 , 163 . 50 Hence, $147,163.50 less $80,000.00 equals, 67, 163 50 the amount of the first redemption of debt. $2,000,000.00 less $67,163.50 equals, the amount of debt drawing interest in the second year. $1,932,836.50 X .04 equals, interest due at the end of second year. $147,163.50 less $77,313.46 equals, amount of second redemption of debt. The process may be continued from year to year. In each succeeding year, as the interest payment is reduced, the payment against the principal is increased. The rule deduced from the second example above might be stated as follows: 1. Determine the compound amount of the given sum for the given time at the given rate. 2. Divide by the final value of an annuity of $1.00 for the same time and at the same rate. The third and last possibility to be considered relates to determining the period of an annuity, — or determining the number of years that will be required to redeem a debt, the amount of the debt being known, as well a* the periodical amount that can be counted upon to be set aside for redemption purposes. Assume a corporation desires to borrow $25,000.00, to develop a new line. Its oflacers determine that they can count upon $2,000.00 a year to repay the obligation. How many years must the debt run, on the basis of these assumptions, money being worth 5 per cent? $2,000.00, annually paid over will liquidate the obligation of $25,000.00, with 5 per cent interest thereon, in an unknown length of time, or number or years. Restated, there exists an annuity of $2,000.00, for an unknown period of years, at 5 per cent. Further, an annuity of $1.00, will have a present worth for this same unknown period, at the same rate, in the . . $25,000.00 ^,^ ,^ ^"^^^^ ^^ 2,^.00 = *12.50. Consulting the annuity tables, one seejts for the amount nearest to $12.60, that is therein contained, on the basis of 5 per cent. This is found to be $12.46221, which, upon scrutiny, is noticed as being the present worth of $1.00 for twenty years. Hence, in round numbers, this $25,000.00 obligation may be repaid in twenty + years. CORPORATE OBLIGATIONS; BONDS PAYABLE 291 Cancellation of Redeemed Bonds and Paid Coupons.— When an outstanding bond issue has been fully paid up, and all the interest accumulated there against has been washed clean, it IS necessary to have the trust deed or mortgage discharged as of record. However, unless the corporation has followed out certain procedures during the period of the obligation's existence to the end that the trustee, legally, may become a party to the mortgage release without incurring personal liability because of the wrongful discharge of his duties, the satisfaction cannot be obtained. As bonds are paid, they should be cancelled and be kept carefully to be presented later for the personal scrutiny of the trustee. Similar treatment, likewise, should be accorded the bond coupons as they are paid from time to time. Before the trust deed or mortgage finally is discharged, the trustee will require that all coupons be presented to him for his personal examination. Since some coupons will have been lost or de- stroyed accidentally by the bondholders, and some, perhaps, will not have been presented for payment, some coupons always will be missing. The open spaces in the coupon books will show what coupons are missing and outstanding. If the trustee finds certain coupons missing, he will require a bond to be given to protect himself against a possible later presentation for payment; this bond will be double the amount of the missing coupons. If a bond issue be of considerable size and the final date of payment is far in the future, considerable difficulty may be experienced in caring for the cancelled coupons during the inter- vening period of time. The coupon books quickly become voluminous in size, and fireproof storage facilities needed in caring for them may require the incurment of considerable expense. Because of this, it is a frequent practice to destroy the accumulated cancelled coupons from time to time. To effect this destruction properly, representatives of both the trustee and the corporation will inspect the cancelled coupons, after which the latter will be burned in their presence. Subsequently, these representatives will prepare what is known as a cremation cer- tificate, covering their act, and this the trustee will accept as evidence th^t the coupons indicated thereon have been cancelled and destroyed in due form. :i m i "tl CHAPTER IX BALANCE SHEET: PROFIT AND LOSS STATEMENT Introduction. — The science of accounting resolves itself into three general branches or divisions: 1. Recordative accounting, or bookkeeping. In turn, this di- vision may be separated into three constituent elements: a. Classification. This has to do with selecting the proper titles for Ledger accounts and their functions. In short, it deals with resolving the pecuniary effects of business transactions into their proper debits and^ credits. b. Bookkeeping technique. This recordative element deals with the art of recording in proper form the classified effects of business transactions in terms of money. It represents the manual side of bookkeeping, — ^writing up the accounting records in accord with the rules of modern practice. The scope of this element commences with the opening, and ends with the closing, of a set of books (exclusive of the compilation of financial statements). c. Form and arrangement of financial statements. This ele- ment is of sufficient importance and distinctiveness to be accorded a separate treatment. 2. Constructive accounting, or the building of systems. De- termining the fundamental operating classification of ac- counts would fall under this heading, whereas, under recordative accounting the classification element is con- cerned with selecting the proper accounts, from the pre- scribed classification, in which a particular transaction is to be recorded. 3. Inspective accounting, or auditing. In the students* earlier accounting work, much time was de- voted, or should have been, to the preparation of financial statements, — ^the Balance Sheet and the Profit and Loss State- ment. The importance which may be attached to statement 292 tl BALANCE SHEET: PROFIT AND LOSS STATEMENT 293 preparation never can be overemphasized once the rudimentary basic elementary principles have been mastered. Only by means of properly prepared statements: 1. Can men at the head of large organizations ever hope to keep in touch intelligently with what actually has been, and is, going on therein. 2. Is it possible to present vital facts in a clear and effective manner concerning a business enterprise to: a. Those in control, or b. Those interested, as i. Stockholders, ii. Investors, iii. Creditors. However good an accountant may consider himself, if his completed statements be poorly drawn, the following results: 1. His reputation, should he have one, is placed in jeopardy among men who have the ability to discriminate in matters of accounting. 2. An avenue is opened for considerable misunderstanding as to just what are the actual conditions. An apparently harmless statement, poorly constructed, may become a dangerous document in the hands of those who use it. The present chapter was written because of the importance attached by the writer to this phase of accounting. Some of the more approved methods of preparing financial statements, with which the writer has come into contact in practice,--as to con- tent, form, arrangement, and terminology,— are presented for the so-called semi-mature student. Of necessity, since the science of accounting is not exact, many items are treated differently by different accountants. However, in the present instance the writer trusts that he has avoided theoretical hair-splitting distinctions. In presenting elementary principles, the instructor may violate law or practice in any way he deems desirable if his final result will justify such procedure; for example: A business may be personified, capital may be con- sidered an accountability rather than a liability, etc. But the opinion is ventured that most hair-splitting distinctions have little, if any, use in training the more advanced student to the point where he can, with intelligence, perform the duties required 294 ADVANCED ACCOUNTING .1 of him in an office of either the practitioner of merit or the discriminating business man. Preliminary Suggestions.— Before passing to the major dis- cussion of the present chapter, certain suggestions of a general nature relating to statements seem in order. These are presented below in outline form: 1. Highly technical terms and forms should be avoided where possible. Every statement should be prepared so as to be intelligible to the average person who may read it. Clear- ness of expression should be fundamental: a. Terms used should be understandable and descriptive; abbreviations should be avoided. b. Figures mean practically nothing unless explained. c. If in a major statement the detailed explanation of cer- tain items will take up too much space and tend to confuse the reader, a summary explanation will be in order thereon, with a more detailed explanation being furnished by means of either accompanying comments or supporting schedules. d. Indefinite account titles, so frequently found upon a set of books, may be changed without hesitation when a statement is prepared upon which such accounts are to appear. 2. Periodical statements should be prepared in as uniform a manner as possible, so that ready comparisons may be made between the statements of the different periods. 3. Since existing conditions may take a statement out of a general grouping and place it in a particular class all by itself, one should follow neither a stereotyped form nor be adamantine in insisting that a given illustrative statement form never should be varied; to do so would seem to indi- cate more or less incompetency, or at least a narrow-minded viewpoint. Naturally, only experience will teach one when such a change should be made. An illogical arrangement, even when the figures are accurate and each item clearly defined, will make it impossible for a statement to serve its fullest measure of usefulness. Again, those who examine a statement in proper form and logically arranged will secure a favorable impression of the ability of the compiler, BALANCE SHEET: PROFIT AND LOSS STATEMENT 295 in that attractiveness of form and of general appearance will be the first qualities impressed upon the mind of the reader when the latter scrutinizes such a statement. 4. Underscoring and indenting individual items and groups of items, so as te indicate relationships between items and groups of items, as clearly as possible, should be made use of at all times. 5. The designation given to statements is a matter of choice, but uniformity therein may be considered a necessity. The writer, for example, makes use of the following designations: a. Exhibit. This is a statement which stands by itself independent of all others. The term is followed by a letter to designate the order in which the exhibit comes; for example: i. Balance Sheet— Exhibit A. ii. Statement of Profit and Loss— Exhibit B. iii. Statement of Cost of Manufacture and of Manu- factured Product Sold— Exhibit C. b. Schedule. This is a statement which is subordinate to an independent statement. The term is followed by a num- ber to designate the order in which the schedule comes, as: Schedule 1, etc. c. Statement, This is a statement which is subordinate to a schedule. Each carries a designating number. Other methods of designation may be used and, at times, should be used. 6. Attempt to place yourself in the client's shoes, so to speak, and criticize your work from his point of view. Balance Sheet Title.— One object of keeping a set of books accurately upon sound accounting principles for a business enter- prise is te permit its actual financial condition to be ascertained at any time. Such condition is evidenced by the value of the assets owned, the actual or estimated value of all liabilities, and the surplus of one of these groupings over the other which represents net worth or insolvency. The second object of keep- ing such a set of records is te secure a summary of the operations by which this net worth or insolvency has been created, increased or diminished. ' 296 ADVANCED ACCOUNTING k The formal title given to such a statement of assets and lia- bilities, prepared from the books properly adjusted, of a business as at a given moment of time is ''Balance Sheet." The formal title given to the statement summarizing operations by which the Balance Sheet net worth or insolvency has been created, increased, or diminished, over its amount as of a prior date, in general, may be "Profit and Loss Statement." It is concerning the general form and content of these two statements that the present chapter deals. It should be remembered that in the strict sense of the word, a Balance Sheet is not a statement of facts, but only an opinion of some one regarding the items contained in it. It is an approxi- mation to facts, the degree of definiteness and accuracy th(»reof depending upon the skill and accuracy with which the estimates are made. Whenever a statement is prepared which, by common under- standing, may be called a Balance Sheet, many accountants, especially when the enterprise under review is of considerable size, will use the title General Balance Sheet, rather than merely Balance Sheet. In such event, one who reads may be led to assume that the two statements differ one from the other. As a matter of fact, as the meaning of both titles ordinarily is under- stood, no such difference exists. Since one title does not appear to be more formal than the other, — in that all Balance Sheets present the financial condition of a business as a whole, as at a particular moment of time, — it seems logical to adopt one or the other title and use this exclusively. Again, since general condi- tion is shown by a Balance Sheet, even though the title does not contain the word "General," the shorter title would seem to be the preferred one to use. Balance Sheet Form. — ^The form of the Balance Sheet is not an essential feature, except insofar as it has been discussed above in the section on preliminary suggestions. Any statement is a Balance Sheet which contains only the assets and liabilities as found on the Ledger. The variations in form may be indicated as under: 1. Account form. Hereunder, the Balance Sheet is made in one table, in which the items are arranged on each side in the order determined by their character as current or fixed. BALANCE SHEET: PROFIT AND LOSS STATEMENT 297 Although accountants differ as to whether the current or fixed items should be placed first, both sides should follow the same method of set out. 2. Double account form. Hereunder, the Balance Sheet is made in two tables. In the first table the fixed liabilities of capital, surplus, and bonds are placed, offset by the fixed assets. The difference secured will show how much of the capital and surplus has been invested permanently. This difference, or balance, is brought down into the second table as the amount of active or free capital which is avail- able for carrying on the operations of the business. In this table are listed the current liabilities and assets. This form of Balance Sheet is not ordinarily used, but would seem to be an extremely desirable form to show the fact that the business needs more active capital 3. Report or running form. Hereunder, the assets are listed and their total extended; under them the liabilities are listed and their total extended and deducted from the total of the assets. The final figure secured represents the business net worth, which then is set out below as it appears: a. In the capital accounts of a partnership, or b. In the capital stock and surplus accounts of a corpora- tion. Arrangement of Balance Sheet Items: Account Form of Statement.— Two general methods are used in arranging the Items upon the account form of Balance Sheet. Each one of these is commented upon briefly below: 1. Common and usual arrangement. Hereunder, the assets are arranged as nearly as possible in the order of their realiza- bihty, and the liabilities in the order in which they are payable, the net worth being set out last. From the stand- pomt of a bank or of a creditor this arrangement, under which the current assets are displayed at the top on the left side, and the current liabilities displayed opposite thereto at the top on the right side, permits of a ready comparison between the two groups. Likewise, hereunder it may be advisable to set out the net worth in one amount, as where the Balance Sheet is intended for a prospective purchaser. 298 ADVANCED ACCOUNTING A Balance Sheet arranged accordingly might appear about as follows for a fairly large corporation: Liabilities: Current LiabUities Funded Debt Deferred Credits (suspense credits) Reserves Capital Stock Surplus Assets: Current Assets Investments (permanent) Sinking Fund (investment of re- serves) Properties Good-will, Patents, etc. Deferred Charges (suspense debits) 2. Public Utility method of presentation. Hereunder, the fixed or capital assets appear first opposed opposite by capital stock and funded debt. Next, the other assets and liabilities are set out in about the same manner as above shown, the surplus being the last item on the right side. This method cannot be subject to criticism in any way, although not particularly common; it is followed almost entirely among public utilities. A summary form of Balance Sheet ar- ranged according to this method might appear about as follows: Liabilities: Capital Stock Funded Debt Current Liabilities Deferred Credits (suspense credits) Reserves Surplus Assets: Properties Good-will, Patents, etc. Sinking Fund (investment of re- serves) Investments (pjermanent) Current Assets Deferred Charges (suspense debits) Variations from the above are many, but it is believed that for general corporate work the methods shown are both correct and sufiicient, at least for the present. Two later chapters will illustrate certain variations therefrom, as well as subsequent sections of the present chapter. Nomenclature For Balance Sheet Captions.— The first essential in clearness is that each Balance Sheet caption should express the nature of the items thereunder included. Nothing absolutely definite exists in respect of the headings used on a Balance Sheet since accountants are greatly at variance relative thereto. Current Assets. Often, this term is used synonymously with that of quick assets, floating assets, and liquid assets. Quick BALANCE SHEET: PROFIT AND LOSS STATEMENT 299 assets, however, as a Balance Sheet caption, would seem to govern a lesser group of assets than any one of the others, especially if one refers to the form of Balance Sheet proposed by the Federal Reserve Board for merchants and manufacturers, m that temporary investments in securities, notes given by ofii- cers, stockholders, or employees, and accounts due from officers, stockholders, or employees are excluded therefrom. Since it is probably safe to state that the most prominent accounting firms prefer its use to any other caption, the term "Current Assets" would seem preferable to all the other possibilities so-called synonymous therewith. The items included under Current Assets may be grouped about as follows: 1. Cash. 2. Notes and accounts receivable. These are intermediary instruments by means of which the conversion into cash is made. 3. Short term and realizable investments in securities (usually at market value) held only until an outlet is found for the surplus cash either in the extension of business activities or in the divisions of profit. 4. Inventories. These are the properties which by the aid of the capital assets continuously are being converted from one form into another, with the purpose of earning a profit by later sale and conversion into cash. In fact, all items readily convertible into cash, representing values in which an enterprise operates, available for the purpose of financing the current operations or turnover, may be classed as current assets. Capital Assets. This item is synonymous with that of fixed assets, covering such items as plant, long-term investments, franchises, patents, good-will, etc. The capital assets relate to the acquisition and maintenance of the permanent plant or equip- ment with which an enterprise operates. Working or Working and Trading Assets. Many accountants group mventories under one or the other of these headings in preference to including them under current assets. Likewise, deferred charges to operations often are included hereunder (as insurance, taxes, etc.). Expense inventories and funds may be 300 ADVANCED ACCOUNTING treated as working assets; again, they may be considered as current assets ; again, they may be classed as deferred charges. Liabilities. Some accountants are satisfied thoroughly to use this term as the heading for the right side of the Balance Sheet; others will insist that this is in error and that such heading should be Liabilities and Capital. Whether or not capital is an accountability or a liability should be of small consequence to the student of advanced accounting. The discussion thereon is more academic than practical. Well established practice should become the rule and guide of one's actions after one reaches the turning point at which he may be considered an advanced stu- dent; let facts be facts, and eliminate whatever is non-essential and mere quibble. Accrued Liabilities. Items such as wages, interest, and taxes accrued are grouped either under the heading of "Current Lia- bilities" or separately set out under the caption of "Accrued Liabilities." If an accrual be a liability, common sense would seem to indicate or dictate that it should be so considered; although Federal taxes often are set out as Reserve for Federal Taxes, they represent an accrued liability and, in short, ought to be so considered. Reserves. Ordinary reserves, as for depreciation, and for doubtful accounts, are not liabilities, since they measure actual or estimated reduction in asset values. Therefore, although fre- quently grouped under the liabilities heading, they ought better be deducted from the assets to which they apply. Other reserves, not measuring actual or estimated asset reduction, rightly may be segregated and be included on the right side of the Balance Sheet. Deficit. This item may be found either on the left or right side of the Balance Sheet. Some say that by placing it on the left side, it is considered as an asset, and must be if capital is considered as a liability. Apparently, another academic dis- tinction is encountered here which has no practical worth. Com- mon sense will not consider a deficit as an asset even though this item may be placed among the assets; likewise, the mere inflation of the total assets figure thereby means nothing, since such figure has no interpretative importance. Many Balance Sheets show the deficit among the assets and the opinion is ven- BALANCE SHEET: PROFIT AND LOSS STATEMENT 301 tured that no accountant will jeopardize his professional stand- ing. It he has one, by so allocating it in^Tr' ^TV ^^'^-^^' ^^^^-°t asset of cash as stated m a Balance Sheet presents, if any, but little difficulty. It will consist of three principal variations : 1. Cash on current deposit with banks. 2. Cash on restricted deposit with banks or others 3. Cash m hands of ofl^cials. If the amount of available cash on deposit be of considerable size. It may be set out as "Cash on Deposit" or "Cash in Bank"- f not of sufficient consequence to justify separate discrimination' the cash may be stated as just -Cash." If the cash on deposit consists in part of funds held for special purposes, these speci funds may be stated separately from the current fund deposits In case an overdraft arises, the ordinary method would be to show Its amount as a current liability. However, sufficient rea- son may exist for allocating it otherwise : 1. An overdraft on one bank covered by outstanding checks may be deducted from the balance shown as on hand in another bank where this latter balance is greater than the amount of the overdraft; the net cash balance then will be extended out as an asset. 2. An overdraft on one bank greater in amount than the cash available in another bank would be sufficient reason for having each item shown separately upon the Balance Sheet- the overdraft should be set out as a current liability and the debit balance of a smaller amount as an asset 3. A book overdraft caused by entering checks in advance of having them sent out would seem to permit one, as of Balance Sheet date, to add back the amount of checks so entered but held to the end that the cash balance will be replenished thereby, the amount so added back being off- set by a credit to Accounts or Vouchers Payable account. I he above reasoning is based upon the fact that a bank account cannot be disposed of on or before closing date by the mere drawing of checks; to do so, the checks actually must have been mailed prior to that date. Practically, after a check has been mailed, it is no longer considered dis- IPi il 1 302 ADVANCED ACCOUNTINQ Separate cash deposits available only for interest and dividend payments, for capital expenditure, or withdrawable only after a date certain, should be stated separately with complete ex- planation as to the nature of the restriction, and the offsets thereto, if any, should be found under the caption of current liabilities. Sinking fund deposits and deposits made in order to secure special service should be set out separately, but not un- der current assets. Free cash balances should be separated so as to distinguish between cash on hand and bank balances both bearing interest and not bearing interest. Working funds representing cash held by salesmen, cashiers, etc., for the payment of current expenses or for making pur- chases may be merged as part of general cash in the amount of the cash actually on hand; all such funds may be lumped and one sum shown therefor, or they may be indicated separately. The practice of keeping the Cash Book open beyond the clos- ing date so that entries relating to receipts and payments may be made at a date later than the closing date although con- cerned with transactions of dates prior to the closing date, — so as either to show smaller amounts due from debtors or to creditors, or a larger cash balance, — is not in order from any point of view in that, by so doing, the financial position as of the correct closing date will not be the financial position shown thereunder. Current Assets; Notes, Acceptances, and Accounts Receivable. — ^All items properly grouped under this caption should be both current and liquid to the end that the aggregate will be realizable at total face value within a definite period of time, dependent upon the nature of the business. The assets hereunder represented day by day and in the ordinary cours e of business are being converted continually into some more liquid and available asset, as cash; in turn, this enables one to count upon such assets as a source from which corresponding liabilities may be met as they mature. Notes receivable and trade acceptances receivable art; so essentially similar that, in general, no separation need be made upon the Balance Sheet relative thereto. However, if a con- siderable portion of the notes relates to loans rather than to trade activities, their amount should be stated separately. Notes BALANCE SHEET: PROFIT AND LOSS STATEMENT 303 and acceptances receivable which have been discounted may be shown upon the Balance Sheet: 1. As a deduction from the gross amount on the asset side. 2. As a footnote. 3. As a current liability. Since notes receivable will not be due until a date subsequent to that as of which the Balance Sheet is prepared, conservatism will permit one to reduce their amount to a present value: 1. If a note be for a fixed sum with interest, the face value shown will be the present value. 2. If a note be for a fixed sum payable without interest, it would be permissable to reduce the face value to present value by charging an income account and crediting a dis- count or interest reserve account with the interest thereon from Balance Sheet date to date of maturity. Again, if it should appear for a given case that, before final collection, a material portion of the face value of the notes will be absorbed by collection costs, it would not be in error to make provision therefor by the establishment of a sufficient reserve- however, the interest accruing upon these notes, to be booked only as actually received, will offset this collection cost to some extent. Customers' accounts should be shown upon the Balance Sheet separate from the accounts covering loans or advances. In any instance, care should be observed to designate customers' ac- counts receivable as such rather than leave it to the reader to decide for himself whether customers' accounts are represented or others. The various classes of accounts receivable, other than cus Wrs, should each be set out separately under proper sub- headings provided the amount thereof is sufliciently large to warrant the usefulness of this added information- if these amounts are not large all may be merged into one item -Ac counts Receivable-Others (or Sundry). Customers' accounts carrying credit balances (net) should be shown as a current liability either separately or combined with the Accounts Pav- able — Trade. ^ Loans advanced secured by accounts receivable,-a pledge thereof against such loans, are common at the present time, such 304 ADVANCED ACCOUNTING Ml x loans being made up to about eighty per cent, of the value of the accounts pledged. Even though these transactions often are in the form of actual sales, it is well to consider the case as a loan. Therefore, the accounts pledged may be carried as an asset, and the balance due the pledgee or lender may be set out as a liability. When such condition is encountered, the Accounts Receivable — Customers should be shown on the Balance Slieet divided between those pledged and those unpledged. The handling of reserves for doubtful accounts receivable varies among accountants. The following treatment, howe\'er, is advocated: 1. If the reserve covers accounts specifically regarded as bad or doubtful, the amount thereof should be handled as a deduction from the accounts receivable. 2. If all bad or doubtful accounts have been written off the books, and the reserve provided represents merely a pro- vision against contingencies, it would seem proper then to consider such a reserve as a pure appropriation of surphis, in which event its amount would be shown on the right side of the Balance Sheet. Reserves for cash discounts may represent the following of a conservative policy upon the part of a concern setting them up, but since they do not become a charge at the time a sale is made, only when taken, their use would not seem to be exactly in order. Reserves covering trade discounts, freight, allowances, etc., properly may be deducted from the assets. It should be remembered that trade discounts ought always to be deducted when the charge is made upon the books. Current Assets: Short Term Investments. — The classes of investments to be grouped hereunder represent securities held under a temporary disposal of surplus cash, or those acquired in payment of debts or otherwise, and held for realization at a suit- able price; no question should exist as to their marketability, and the maturity dates thereof should not enter into considera- tion. These investments have no relation to the business what- ever, and their disposal should be possible without an inter- ference in any way with the earning capacity of the business, other than a loss of the income thereon. If they represent investments more or less permanent, or a BALANCE SHEET: PROFIT AND LOSS STATEMENT 305 ^honMt"^ or controlling interest in some other enterprise, they should be considered as a capital asset. The book value at which these securities are carried, as current assets, should not be far in excess of their market value. When the excess is small in amount, the true statement of the assets is not affected ma- erially thereby; however, when a cost valuation is used under such a condition, it would be wise to indicate somewhere upon the Balance Sheet whatever depreciation in value actually does mTv h. f ?; ^"?*"^*T ^" ^^' ^'•"" °f marketable securities may be dealt with by the creation of a Reserve for Fluctuation m Investment account: 1. This being set up out of realized or estimated profits on investments, or ' account Such a reserve never should show a debit bal- ance; the charges or credits thereto always should be suffi- cient so that by its use the asset will be maintained at market value, this being lower than cost Any securities pledged should be shown upon the Balance Sheet as such Short term investments, if possible, should be shown upon the Balance Sheet by name Current Assets: Accrued Interest.-This item may be shown Ufx>n the Balance Sheet either as one amount or separate accorl mg to the assets responsible for such accrual ..^"^'H^T'^'- I"^««t°"««-Too much information con- cermng this item cannot be shown upon the Balance Sheet Th^ Balance Sheet of a manufacturmg concern, usually, Jm group the mventories as: j^ wm 1. Finished goods. 2. Goods in process. 3. Materials and supplies. This latter item well might in- chide all supplies of a tangible nature rather than placing those of a general character under the caption of "De ferred Charges." If any merchandise be pledged, the Balance Sheet should i^ir; 'r' •''"r" P^^^^^^ ^^^''•^^ mventoriefto t;^ possible decline m value or interdepartmental profit should bl deducted from the asset. ^ Goods out on consignment, if considerable in amount, should 306 ADVANCED ACCOUNTING h be shown separately. Samples out may not be inventoried at all; if inventoried, state separately. Goods received upon con- signment have no place upon the Balance Sheet; all advances, however, in connection therewith, should be stated separately. The carrying charges of merchandise, storage, etc., are legiti- mate additions to the cost of goods on hand up to the point where the entire value of such goods equals their market value. Carrying charges either may be combined with the rest of the goods value or may be shown separately. Accurate inventory valuations are of vital import to the se- curement of a correct Balance Sheet. Therefore, it may not be amiss here to include a few general remarks relative to in- ventory valuations, since this is a matter of considerable diffi- culty involving many important questions. Until an article either has been sold or exchanged, no profit should be considered thereon; a paper profit never may be realized. In general, since a Balance Sheet should show the true financial condition of a going concern, it may be incorrect to value an inventory at actual cost in that actual cost may represent more or less than the market value; the result, therefore, would be either to overstate or understate the asset-s. However, actually to change a book valuation at cost to a market valuation is not in order, so far as the books are concerned, because the profit or loss thus set up never actually may be realized on ac- count of further changes in market value. But since no credit shall be taken for profit until the latter is realized, whereas a possible loss in the disposal of what remains unsold should be provided against out of profits actually realized on sales already made, it is considered as good accounting where cost exceeds market to set up a reserve to bring the cost value down for Balance Sheet purposes; since this asset has been acquired only for the purpose of realization at a profit, and not to be held for the permanent uses of the company, a drop in the market price means a proportionately less return than otherwise would be the case. On the other hand, it would seem logical to write up inventory values as the market advances if, when the mar- ket drops, such values are written down; however, the practice is otherwise. To begin with, profits under any event are not yet realized, and if profit be taken on a written up valuation, the BALANCE SHEET: PROFIT AND LOSS STATEMENT 307 market may fluctuate adversely before realization to the end that an actual loss may result; also, an understatement of profit not only delays a profit distribution, but at the same time it con- serves values as against an overstatement which may operate disastrously. Hence, the accepted rule for valuing current as- sets, "cost or market, whichever is the lower." However, since the cost prices of inventory assets do not fluctuate to a great extent under normal business conditions, one may say, in gen- eral, that these items will be set up at their cost. There are five essential elements in ascertaining correct profits with relation to inventories on hand: 1. The quantities on hand must be determined correctly. This may or may not be difiicult. It will not be difficult where a plant can be closed down entirely until the inventory is taken; again, but little difficulty should be encountered where a perpetual inventory record is kept which is checked up and adjusted from time to time with the actual quantity on hand. The inventory count will entail considerable difficulty where the work involved consumes considerable time and where the plant cannot be shut down. Here a systematic plan must be laid out beforehand under which duplication will be prevented. Incoming stock not to be counted must be segregated ; outgoing stock should be taken from that on hand but not yet counted. Bulk materials carried in piles must be more or less estimated unless some sort of a book inventory by quantities be kept in connection therewith. The apparent contents of a pile will be affected by moisture or by irregularities in the ground surface. To secure some degree of accuracy, the measurement of any such pile should be made by two persons independently of each other. Work in process cannot be inventoried satis- factorily unless some attempt has been made to record the labor and material put in and the finished product taken out, due consideration being given to the element of wastage. The quantity of scrap material on hand never can be valued with any degree of accuracy; and under all circumstances a liberal allowance should be made against overvaluation. 2. The actual cost of goods completed or in process of manu- 308 ADVANCED ACCOUNTING facture must be ascertained as accurately as possible. This point brings up the subject of cost accounting which can- not be treated in the present volume, it being a subjecst requiring separate study. 3. The clerical work in connection with (1) and (2) must be performed accurately. 4. Proper provision must be made in the valuations to take care of reductions in market prices whereby market price drops below cost. 5. Proper provision must be made for all stock which, for any reason, is apt to prove unsaleable. Investments.— Long-term investments should be placed here- under, as investments of general reserves, real estate not held for plant purposes, advances to constituent companies, etc. If these should be included among the current assets, it would be impossible to secure a clear view of actual facts. Securities may be carried at book value, but where b<3ok value is in excess of market value, as determined from reliable financial sources, such difference should be shown in some way. Securities j)ledged should be shown separately in some manner upon the Balance Sheet. These permanent investments, in general, control some essen- tial part of the activities carried on. The distinction between investments as current assets and those considered as capital or fixed assets is a most important one. The financial position of an enterprise may be placed in jeopardy in that in their se- curement it is necessary, usually, to withdraw a portion of the current assets from the general use of the business and, by so doing, these current assets are. diverted from the purpose for which intended,— the rapid conversion from cash into saleable products and so back again into cash. Unless, in the first in- stance, the current assets are more than suflicient for all needs, the conversion of any portion thereof into assets of a permanent nature takes that much of the current assets out of current use which in turn means that either the operations must be reduced or the liabilities increased. When an investment has been made to secure control of the operations of another business, the method of handling may be indicated about as follows: BALANCE SHEET: PROFIT AND LOSS STATEMENT 309 1. If the interest owned is substantially the whole, the Bal- ance Sheets of all such interests should be consolidated with that of the company so controlling into what is known as a Consolidated Balance Sheet (see post. Chap. 13). 2. If the interest owned is not substantial but still represents a controlling interest, the investment should be treated as an asset. When an investment has been made to secure the right to use some connection or facilities held by another, needed under the present policy of activities, the valuation will be at cost rather than otherwise, assuming at least that such cost reflects the present value of such connections and facilities from the standpoint of use. The special investment of funds set aside for the different reserves classed as appropriated surplus is common. Since the fluctuation in the value of these investments affects only the reserves m question, and since profits or losses cannot be deter- mmed definitely until the reserves are needed and the invest- ments sold, it is usual to carry them at cost ignoring all fluctu- ations of a temporary nature and of a relatively small amount Where such funds have been invested in the company's own se- curities rather than in those of some outside corporation such investment, from the point of view of a Balance Sheet, should be eliminated from both the asset and the liability sides so far as the totals are concerned. Sinking Fund.— The components of a sinking fund should be set out upon the Balance Sheet separately and whatever securi- ties are there included should be described fully. If some of the company's own bonds have been purchased from the total amount outstanding, for the redemption of which the sinking fund was created, the amount thereof may be deducted from the total bonds shown as having been issued. When these bonds however, have been cancelled, and no longer bear interest, the total amount outstanding should be reduced actually by such cancellations. The components of a sinking fund, usually, will Properties.-The items hereunder are variously grouped as ^Troperty," and 'Troperty and Plant." If the phyLaTprop! erty consists of land, buildings and equipment, either of the 310 ADVANCED ACCOUNTING above terms would seem proper. If outside investments in real estate are found and are carried separately, the property per- taining specifically to the plant should be classed as "Plant Properties." Also, if no land and buildings are owned for j)lant purposes, only equipment remains, and this should be designated as "Equipment." The basis of Balance Sheet valuation of each of these items should be indicated, — cost, cost less depreciation, reproduction cost appraised, or sound value appraised. If an appraised value affects the surplus by increasing it, the increase therein should be set out separately since distributable surplus does not exist thereunder; appreciation or inflation in property values does not represent distributable profit. Since depreciation does not apply to land, except in rare cases, the depreciation reserves are connected, in general, only with the buildings and equipment. They should be deducted from the assets to which they apply, in detail or in total, and should not be carried among the liabilities on the right side of the Balance Sheet, unless the company be a public utility. In the latter event, it is probable that, by law, the reserves must be placed among the liabilities. Where no depreciation is shown or is to be taken, such fact should be set out in a carefully worded footnote; the same would be true if it is deemed that the depreciation provision is not adequate. Land and land improvements represent either a fee owner- ship or the enjoyment of such properties under a lease. In the former event, the valuable life of expenditures made goes hand in hand with the life of the improvement; in the latter case, a limit exists equal to, more than, or less than, that life. Land improvements cover all expenditures that add a long term or permanent value and, in general, they are not subject to de- preciation from wear and tear, although they may be subject to provision for abandonment or obsolescence; the exceptions here to the general rule may be set out as under; 1. Expenditures upon growing timber. 2. Expenditures related to mine development. Expenditures relative to these exceptions must be considered especially with regard to the life of the property in relation to BALANCE SHEET: PROFIT AND LOSS STATEMENT 311 which they have been incurred. Mining expenditures must be written off either over the term set for the exhaustion of the minerals or, if the life is less than such term, over the shorter period. Expenditures upon growing timber may be capitalized only to the extent that a fair certainty exists that the ultimate value secured upon sale will cover at least the original cost, later expenditures for care and upkeep and cost of marketing! Uncertain catastrophes incident to mining and timber operations, as fires and floods, are capital losses to be guarded against by the creation of special reserves out of profits previously earned. Buildings and structures have a long life, as a rule, but one that some day must end; therefore, they are subject to regular depreciation. All the permanent facilities required and used directly in any activity, as machinery, fixed tools, etc., must be kept up con- tinuously and be replaced from time to time; therefore, they are subject to depreciation for obsolescence as well as for wear and tear. Movable equipment, equipment continuously moved from place to place as demand for their use requires, have but little obsolescence, but heavy wear, tear, and loss which makes fre- quent replacement necessary. Either heavy depreciation there agamst must be provided, or all expenditures, including what- ever amount is necessary to reduce the balance to inventory value, are written off as an operation cost; in the latter event, they are treated as working assets. Furniture and fixtures represent an" asset of little value except when actually in use, even though the estimated life may be fairly long. The carrying value thereof may be re- duced year by year by a gradual reduction charge, as ofttimes IS done, or better yet, the reduction may be abrupt in char- acter the asset being written down to a nominal or breakup value as quickly as possible. Patterns, drawings, dies, etc., are difficult of evaluation but conservatism should prompt one to make, in connection there- with, liberal allowance for wear and tear and other waste due to operation. While in use, they may be assumed as being worth their cost, whereas, when use ceases, because of changes in design, they are worth little or nothing. 312 ADVANCED ACCOUNTING Good-will, Patents, etc. — These are intangible assets and should be shown separately upon the Balance Sheet as such. If a separation between the tangible and intangible assets can- not be made to the end that these items must be stated in com- bination with the tangibles, great care should be observed to make certain that one who reads will understand that such in- tangibles are actually included. These intangible assets are very similar to one another. A patent is granted for a term of years, and the amount paid there- for, theoretically should be written off against the profits earned during those years. However, cognizance must be taken of the fact that something else may develop to change this attitude of consideration : 1. Before the original patent has expired, either a virtual monopoly may be built up or the business may be so pros- perous that its original cost may be replaced by the rea- sonable value of the good-will. 2. During the life of the original patent, many others may be taken out, each representing a modification of some kind which has the effect of extending the life of the original patent in an improved form. The cost of these later pat- ents may be relatively small as compared to the cost of the original one. Good-will must be discussed rather fully in a later chapter concerned with mergers and consolidations. Therefore, but little need be said concerning this asset at the present moment. As long as the earnings of an enterprise equal those contemplated at date of purchase, one cannot well say that there has been any depreciation in its value or that any provision for such depreciation need be made. However, if the profits have dropped seriously, the value of the asset of good-will likewise has dropped, yet whether or not provision should be made for such reduction in value is a practical problem not easily solved en- tirely from a theoretical point of view; the profits may be so much reduced that, even though the value of good-will is ques- tionable, it will not be practicable to make such provision. The value of good- will depends considerably upon profits earned, and the fluctuation therein is a result of, not a cause of, earning profits. BALANCE SHEET: PROFIT AND LOSS STATEMENT 313 Franchises are either perpetual or for a fixed term. Where perpetual, the same considerations, in general, apply as relate to valuing good-will. Where only for a fixed term, a reasonable provision should be made each year covering the reduction in value, even though the actual amount thereof may not be ascer- tainable due to the fact that they may be renewable at the end of the present term. Deferred Charges.— These items are classed variously as ''Deferred Charges," ''Deferred Debits," "Deferred Assets," and "Prepaid Expenses." The first two titles are preferable to the latter two in that the last two will not be appropriate under all conditions. In general, deferred charges are of two kinds: 1. Expenditures to be absorbed by future operations. 2. Items held in suspense awaiting final decision as to allo- cation. Ofttimes, working funds, special deposits, and miscellaneous advances will be included hereunder. Current Liabilities: Notes and Acceptances Payable.— Notes payable based upon loans should be shown separately from notes and acceptances payable to trade creditors. Secured ob- ligations may be thus indicated although where specific property be pledged, a statement relative to the pledge will be shown m connection with the asset in question. It may be advisable, also, to summarize obligations by maturity dates. Current Liabilities: Accounts Payable.— These should be grouped by classes,— trade creditors, advances, loans, etc. Credit balances in customers' accounts, where no debit balance with the same customers exist, should be shown as a current liability usually mcluded with the other trade accounts payable De- ductions on account of cash discounts which may be taken ought not to be considered. If any accounts payable be omitted with their offsetting assets, which is of infrequent occurrence, a foot- note should be included describing such. Provision should be made always for all known liabilities even where the exact amounts are not ascertainable. Some sort of approximation always can be made and, where possible, such items should be allocated as current liabilities; as a real liability exists, such items should not be set out as part of surplus or as a reserve. k *« "* 314 ADVANCED ACCOUNTING Current Liabilities: Dividends Payable. — Dividends de- clared but not yet paid as of Balance Sheet date are current liabilities. Dividends on preferred capital stock should be handled as above if the date of the Balance Sheet is immediately prior to date of payment; otherwise, the amount thereof should be allocated as a reserve. Current Liabilities : Wages, Taxes, and Interest Accrued. — ^Wages accrued represent either the actual or estimated amount of wages earned as a Balance Sheet date, but payable in the subsequent period. If wages are on hand unclaimed, their amount should be shown as "Amounts Payable," "Wages Pay- able," or "Unclaimed Wages." Taxes accrued represent taxes accrued to date but not yet pay- able; if any are due and unpaid, such amount may be shown separately as "Taxes Payable," or be included with "Accounts Payable." Provision sliould be made for Federal income taxes under the heading of "Taxes Accrued," rather than allocating them elsewhere. If all accruals relating to taxes have pot been provided for, a footnote should indicate such fact. "Taxes Paid in Advance," as an asset, should not be deducted from the liabil- ity of taxes accrued. Interest accrued may be shown in total or separately (as Interest Accrued on Bonds and Interest Accrued on Notes Pay- able). Any interest that has matured but remains unpaid should be stated separately. Interest paid in advance (as on notes discounted) should not be deducted from the interest accrued. Funded Debt. — ^Bonds, notes, or mortgages maturing in less than a year should be considered as current liabilities^; and the same would be true of long-term securities which have ma- tured but are unpaid or which will mature in a day or two. All items should be described fully, and the exact date or year of maturity should be set out carefully. Securities held in the treasury and in sinking funds would be deducted from the liabil- ities provided their .book value is the same as their par value; if not, such deduction cannot be made and such securities would be carried as assets. Deferred Credits. — This group of items represents just the opposite of deferred charges, — all receipts of income not yet earned, and receipts whose disposition has not yet been decided. BALANCE SHEET: PROFIT AND LOSS STATEMENT 315 Advance collections on sales, unredeemed coupons, etc., are cur- rent liabilities in toto, not to be hereunder included. Reserves.— Reserves for depreciation either may be deducted from the corresponding property item, or be included among the liabilities, the former method being preferable to the latter. In either event, as much detail as possible should be presented with reference thereto, rather than show in one lump sum. Reserves for bad debts, doubtful or uncollectible accounts pre- ferably are deducted from the corresponding asset item or items, although conditions may permit of otherwise handling them. Reserves for sinking funds are shown properly under the head- ing of "Surplus," representing appropriated surplus. A reserve for contingencies should represent what the title suggests. A contingency being unknown, the reserve, therefore, has no rela- tion to any known charge even of an undetermined amount. Capital Stock.— Each class of capital stock should be shown separately upon the Balance Sheet at all times. Relative to each class full information should be shown as to number of shares authorized, issued, and outstanding, plus par value, if any. The fact that preferred stock is cumulative or non-cumu- lative should be indicated, as well as the dividend rate. Sub- scriptions to capital stock should be included under the head of Capital Stock, and the uncollected balance on subscriptions should be carried as an asset. Stock of no par value should be set out as such, its carry- mg value being the consideration received therefor. Surplus.— This term in its usual meaning represents earned surplus m contradistinction to capital or special surplus The latter term refers to paid in capital in excess of the stated value of the capital stock, perhaps to donated capital, apprecia- tion of intangible values, and appreciation of properties. Again the term may be considered as indicating surplus available for distribution and held free from being used for any other purpose- care should be observed to prevent one from assuming this is the kind of surplus referred to unless such actually is the case. Although it cannot be considered improper to show a deficit on the asset side of the Balance Sheet, if a capital surplus exists an operating deficit should be deducted therefrom Some ac ' 316 ADVANCED ACCOUNTING countants will deduct a deficit from the capital stock to show actual net worth; this does not seem advisable. Contingent Assets and Liabilities.~Contingent liabilities are of two types: 1. Those which are offset by corresponding contingent assets: a. Liabilities on account of notes and drafts discounted. b. Accommodation indorsements. c. Guarantees. d. Unused letters of credit. 2. Those which are not offset by corresponding contingent assets : a. Continuing guarantees of product. b. Legal or other claims. Whenever a contingent liability is of a considerable amount, the Balance Sheet must disclose it: 1. As a footnote, or 2. Included in the body of the statement. Here the liability would be shown on the right side and the offsetting assets on the left side, the amounts thereof being included in the statement totals. Capital Versus Revenue.— Some of the basic distinctions concemmg capital and revenue are understood by the student already. However, herein, the subject will be considered, so far as possible, with reference to corporations. The successful operation of a corporation, whether viewed from the angle of an investor, an executive, or an accountant, depends upon certain prmciples of capitalization and operation. And one of the most important of these principles concerns the distinction to be made between transactions which have to do with the permanent plant,-or the capital transactions,-and those which relate to values which are continually in a state of change because of current operations,— or the revenue transactions. The transactions concerned with the operation activity of a corporation, regardless of what they may be, are separable into two distinct groups: 1. Capital transactions. These relate to the acquisition and maintenance of the permanent plant or equipment with which the corporation operates. There is a fundamental simihanty here with that portion of the entire asset fund BALANCE SHEET: PROFIT AND LOSS STATEMENT 317 designated as the capital assets, those available for the pur- chase of the permanent plant and other equipment. 2. Revenue transactions. These relate to the current opera- tions, the values in which the corporation operates. There is a fundamental similiarity here with that portion of the entire asset fund designated as the current assets, those available for financing the current operations or turnover of the business. Capital assets arise because cash or some other liquid asset IS converted into the permanent assets needed by a corporation. The entire cost to a manufacturing corporation of acquiring land erecting thereon a plant suitable to its needs, and equipping same] IS a capital charge properly carried in the accounts as a capital asset; the same would be true for a trading corporation which purchases a piece of land and erects and equips a building thereon suitable to its purposes. In each instance, a new asset IS acquired which is part of the permanent property to be used for the purpose of conducting the current operations for which the corporation was created. Again, any expenditure which results either in acquiring an addition to, or an improvement of, the permanent plant of a corporation may be capitalized. The cost of all additional land secured for building purposes should be considered a capital asset; incidental costs relating to the purchase of the land -as title investigation fees, survey fees, real estate agents' commis- sions, etc., are a necessary part of the purchase cost that should be capitahzed even though not part of the initial property pur- chase cost. The same would be true of the direct costs of build- ings and costs incidental thereto relative to architect's plans supervision of construction, etc. Likewise, anything acquired to provide the facilities necessary for transacting business as machinery, tools, fixtures, furniture, etc., are capital assets to be carried on the books at cost, such cost to be reduced by valua- tion account increases periodically by virtue of depreciation. However, the capitalization of asset values may not always be tL'^Sjl^^'^'"'^''^^^'' ^' ^^' ^^^^ might suggest; consider 1. A machine is purchased at a cost of $300.00, whereas, nor- 318 ADVANCED ACCOUNTING I r i f t I mally, its cost is $500.00. At what value should this asset be booked? If it be booked at the normal cost, a credit results which some consider as representing a profit. How- ever, since such a handling creates merely a paper profit, if profit is what it is considered, which has no relation what- ever to operation, the correct practice is to capitalize merely the actual cost. As a matter of fact, the opinion is ven- tured that no profit strictly has occurred, but merely a sav- ing, and this, naturally, should find no expression upon the books. 2. One capital asset is replaced by another which performs the same service but which, because of certain existing con- ditions, as quality, quantity, etc., costs considerably more. Thus, a small typewriter costing $50.00, may be replaced by one costing $105.00, or a wooden pipe line may be re- placed by a concrete or steel pipe line. The old value dis- carded properly represents a charge against income, where- as, the new value represents an addition to the capital plant; the result here is that the additional value repre- sented by the difference between the cost of the old asset and the cost of the new one measures the net increase in the capital plant existing after the transaction compared with what such capital plant value was previous to the transaction. All capital assets, except land, quite generally depreciate for one reason or another and, since this shrinkage in value is some- thing which always accompanies the acquisition and use of capi- tal assets for current operating purposes, such shrinkage becomes a proper charge against the income secured from such current operations. The subject of depreciation is not here considered. Finally, as to the capital assets, no recognition should be given to fluctuations in market price, because no particular effect oc- curs therefrom against the corporation holding them, so long as they are used for the purpose acquired, and so long as they are maintained in their original condition. In other words, no profit thereon should be recognized unless actually realised, and all losses which might occur due to the final discarding of a capital asset should be provided against in advance by charges against earnings. BALANCE SHEET: PROFIT AND LOSS STATEMENT 319 Revenue transactions relate to a corporation's activity in con- nection with acquiring, converting, and realizing upon the cur- rent assets, and also in connection with all the incidental opera- tion elements which may arise thereunder. In other words, even though they deal with real elements in the form of current assets, they include all operating or trading activities considered to be of a profit and loss nature. The assets acquired as a result of revenue transactions are not held for the permanent uses of a corporation, but only to be realized upon at a profit. Revenue transactions cover many things other than the secure- ment of tangible asset values. Labor must be paid for, and consumable supplies and incidental services must be secured. A manufacturing corporation purchases raw materials. These are worked upon in the various stages of the manufacturing processes with the result that as progress is made toward the finished articles, labor and supphes are consumed in connection therewith. When the completed product emerges, it represents a composite of material, labor, and supplies and, when sold, for either cash or credit, it is presumed that value comes back in an amount sufiicient to reimburse the corporation for all expendi- tures made plus a profit. It is net profit which is presumed to compensate the corporate entity for the use of both capital and current assets. The capital assets are not held for profit pur- poses; if profits are realized directly therefrom, it is a mere in- cidental matter representing the occasional disposal of a capital asset at a profit. Statement of Profit and Loss Title.-It was stated above that one of the objects of keeping a set of books accurately upon sound accounting principles for a business enterprise is to permit its actual financial condition to be ascertained at any time. Such a condition is evidenced by the Balance Sheet which for a corporate enterprise, has been discussed in more or less detail m the first portion of the present chapter. The second object of keeping a set of books accurately upon sound account- ing principles for a business concern is to permit its operations to be so summarized that an intelligent presentation may be made of the causes responsible for the creation of fhe net worth or insolvency as displayed by the Balance Sheet, or the increase or decrease therein over its amount as of a prior date Such 320 ADVANCED ACCOUNTING summarization is evidenced by the Statement of Profit and Loss which, for a corporate enterprise, particularly, will be dis- cussed in more or less detail in the remaining portion of the present chapter. Various titles are used to designate a statement of operations, the correct one to be used under any given set of conditions depending more or less upon the content of such a statement. The following are illustrative: 1. Statement of Income and Profit and Loss. This title appro- priately applies to a statement for either a trading or a manufacturing enterprise in which are included all the operations, plus surplus changes. 2. Summary of Income and Profit and Loss. This title is proper for a summary form No. 1, above, in which are shown only major group totals. 3. Statement of Income and Capital Account. This title is proper for a sole trader or partnership concern; it shows, in addition to income, a summary of the capital account or accounts. 4. Statement of Profits and Income. This title is used in an earlier production by the writer for the purpose of specif- ically assisting the more elementary student to comprehend and remember the results to be secured by a logical group- ing of items as concerns what has taken place during an elapsed period of time; further, theoretically, this title seems more accurate in its meaning than any other. How- ever, since general practice does not recognize this title to any considerable extent, nothing more will be said thereon in the present volume. 5. Statement of Income. When a statement ends with set- ting out the net income, this title appears fairly accurate. 6. Statement of Profit and Loss. This is a general title which, among accountants, is assumed to be appropriate under perhaps all the conditions where any other title above indi- cated could be used. 7. Statement of Revenue and Expenses. This title is usable in connection with all enterprises not commercial. 8. Etc., as desired. BALANCE SHEET: PROFIT AND LOSS STATEMENT 321 Since all these statements cover an elapsed period of time, the title should indicate such fact, as: !• Statement of Profit and Loss Year Ended December 31, 1921 2. Statement of Profit and Loss January 1, 1921, to December 31, 1921 Further, just as the Balance Sheet is an estimate of value only,— an expression of one's opinion thereon,— the balance of the undistributed profits or losses must be considered only as an estimate. Arrangement of Statement of Profit and Loss Items.— As stated in connection with the Balance Sheet, every statement should be prepared from the viewpoint of the layman readily understanding it. And in this connection, to a far greater extent than with the Balance Sheet, the running or report form of Statement of Profit and Loss presents a clearer idea of what has taken place than does the account form. In fact, most account- ants of repute have adopted the running form for the Statement of Profit and Loss exclusively; therefore, none other need be considered. The general outline form for any Statement of Profit and Loss is practically the same, but a great variation exists in the allocation thereon of specific items. Such variation as to the position of detail items depends upon two primary elements: 1. The theoretical training and ideas of the particular account- ant who prepares the statement. Many accounting theories still are debatable, and any one accountant should not presume that his method of treatment is the only correct one; it may be for him but, in the mind of another who is at least his equal in intelligence, if not his superior therein the former's treatment may be considered in error. 2. The case in hand may require a treatment of certain items m a way other than the usual one followed. The members of a certain association of manufacturers, for example may be agreed upon a uniform way of handling cash discounts on purchases. It would not be well for an accountant pre- paring a Statement of Profit and Loss for the business of a member of this association to depart from the accepted practice therein. Pure theorists always take issue with 322 ADVANCED ACCOUNTING ii I t what they find; the practical accountant will govern him- self primarily by the conditions encountered. Unless the issue be of major import, the latter will be loathe to tear down an accepted practice, because, by so doing, com- parative statistics may be knocked away and prove useless. Again, expediency may dictate that it is impossible to pro- duce from the accounts as found a Statement of Profit and Loss in as intelligent a form as might be desired. A basic arrangement for a Statement of Profit and Loss, in running form, for either a trading or a manufacturing corpora- tion, conforming practically to the arrangement suggested previ- ously in an earlier volume, would be about as follows: Gross Sales Deductions from Sales Net Sales Cost of Goods Sold Gross Profit on Sales Selling Expenses Selling Profit General Expenses Profit from Operations Additional Income Gross Income Deductions from Income Net Income Surplus Beginning of Period Profit and Loss Credits Gross Surplus Profit and Loss Debits Surplus End of Period This arrangement is such that the surplus at the end of the period as shown will support the item of Surplus at the end of the period as found upon the Balance Sheet. Gross Sales.— This represents the gross business done during the reviewed period. In concerns other than the usual type of trading and manufacturing, the title of Gross Sales, to repre- sent the gross business done during a certain period of time, seems in error; for example: 1. Professional practice. Since goods are not sold, only charges being made for services rendered, the caption repre- senting gross business might better be Gross Earnings or Gross Revenue. 2. Business related to approval shipments. Gross charges against customers are designated correctly as Shipments Billed. 3. Business related to contract work. Hereunder, one should distinguish between contracts completed and uncompleted contracts : a. Completed contracts. Billings representing completed f BALANCE SHEET: PROFIT AND LOSS STATEMENT 323 work only may be designated as Completed Contracts Billed. b. Uncompleted contracts. Billings representing completed portions of contracts not yet fully completed may be designated as Bills Rendered. Only in trading and in manufacturing concerns does the title of Gross Sales, representing gross business, appear to be in order. Hereunder, the item would be composed of: 1. Charges to customers, or 2. Cash sales, or 3. Both charges to customers and cash sales. Whenever a customer is billed in error, and this error later is corrected, the correction made should be reflected in the gross sales item. Sales may be shown either in one lump total, or be set out by classes of goods or by departments. Departmental transfers are not sales to be reflected upon the Profit and Loss Statement. Deductions from Sales.— In general, these deductions are of two kinds, or classes: 1. Usual: a. Returns. b. Allowances. c. Freight and express outward. 2. Unusual: a. Trade discounts. Included herein would be discounts granted a customer after he has purchased a specified quantity. A cash discount, the terms of which are such that if settlement is not made within a specified time, the discount will be given but interest will be charged,' is a trade discount. b. Delivery charges. This deduction would occur where goods are sold delivered at a uniform price. c. Revenue or excise taxes. This is a deduction only when amount is based upon sales. d. Commissions. This is a most unusual deduction, but may be found in some classes of business. Net Sales -As ordinarily understood, this item'needs no com- ment If the deductions from sales be small in amount, the first Item set out in the statement may be net sales. If the busi- il 324 ADVANCED ACCOUNTING ness is one involving goods sent out upon approval, so that gross charges are designated against customers as Shipments Billed, the net sales item probably will be called only Sales. Cost of Goods Sold ; Cost of Manufacture and of Manufac- tured Product Sold.— The items to be used in compilmg the section of the revenue statement captioned Cost of Goods Sold depend, basically, upon whether the concern is a trading or a manufacturing enterprise: 1. Trading enterprise: a. Usual set-out: Inventory, January 1, 19 — , Purchases, g a Freight and Cartage Inward, | ^ Cost of Goods Handled, Inventory, December 31, 19—, Cost of Goods Sold, b. Unusual set-out: Purchases (plus freight and cartage inward). Add: Decrease in Inventory (or Deduct: In- crease in Inventory), Cost of Goods Sold, % i In a departmentalized business, the cost of goods sold may be set out for each department, as where the sales have been thus stated, provided the person for whom the statement is prepared wishes such a handling, or it is deemed desirable by the accountant. 2. Manufacturing enterprise. One cannot be dogmatic as to what, constitutes the cost of goods sold in a manufacturing establishment, since accountants differ widely in their views upon the subject and these varying views must be given weight and serious consideration, especially under certain conditions. In general, this difference of opinion is based upon what a particular accountant wishes to have con- sidered as elements of valuation as relates to the inventory of manufactured product. However, a typical outline of the items composing the cost of manufactured product sold would be about as below; in any particular case, the amount of detail shown upon the statement depends upon either the chart of accounts used or the analysis made of BALANCE SHEET: PROFIT AND LOSS STATEMENT 325 the accounts actually in use. Likewise, it is customary in a manufacturing concern, at least, to prepare a separate statement showing the cost of goods sold, and carry into the Statement of Profit and Loss only the final figure thereon secured. Such a statement is titled Statement Showing Cost of Manufacture and Cost of Manufactured Product Sold. It was mentioned in the beginning portion of the present chapter as Exhibit C. Cost of Manufacture: Unfinished Product, Inventory, January 1, 19 — , Raw Material: Inventory, January 1, 19 — , Purchases, | Freight and Cartage In, $ Marine Insurance, j Purchase Department: Salaries and Wages, $ ^ Supplies and Expenses, $ ^ Deduct: Inventory, December 31, 19 — , Direct Labor, Manufacturing Expenses: Superintendent and Foremen Salaries, Factory OflSce: Salaries and Wages, Supplies and Expenses, Receiving Department: Wages, Supplies and Expenses, Stores Department: Wages, Supplies and Expenses, Stock Department: Wages, Supplies and Expenses^ Royalties Paid, Janitors, Watchmen, Elevator Operators, Heat, Light and Power: Wages, Fuel, Oil, Waste, etc., Current, i i % i % i % i % i % i % i % i « i $ i s i $ i S i :| 326 ADVANCED ACCOUNTING Repairs: Buildings, | ^ Machinery and Equipment, I ^ Insurance — Fire, Liability, etc. (factory), Taxes — Property (factory), Unemployed Time, Inspection, Defective Goods, Experimental Expenses, Infirmary, Sundries, Depreciation: Buildings, | ^ Machinery and Equipment, $ i Patents, j j Deduct: Scrap Sales, Deduct: Unfinished Product Inventory, Decem- ber 31, 19—, Cost of Manufactur e, Add: Manufactured Product, January 1, 19 — , Deduct: Manufactured Product, December 31, 19 — , Cost of Manufactured Product Sold, January 1, 19 — , to December 31, 19 — , $ $ $ $ $ $ % i %J % i t i U In an actual case, it is probable that, where the amount of de- tail to be shown upon the statement is as much as is set out above, certain groups thereof would be shown in total and the detail items of each such group would be presented in the form of a separate schedule. Gross Profit on Sales. — ^No comment appears necessary be- yond the fact that for a manufacturing company this item may be called Manufacturing Profit. Selling Expenses. — The items under this caption would be about as follows: • Salaries of Sales Manager and Clerks. Salaries of Salesmen. Conunissions of Salesmen. Traveling Expenses of Salesmen. Advertising. Catalogues. Customers ' Entertainment. BALANCE SHEET: PROFIT AND LOSS STATEMENT 327 Rent of Sales OflSces. Postage and Stationery. Telephone and Telegraph. Sundry Sales OflSce Expenses. Selling Profit. — No comment appears necessary. General Expenses. — These expenses are assumed to apply to the business as a whole, and frequently are designated as Ad- ministrative and General Expenses. The items under this cap- tion would be about as follows: Salaries of Officers. Salaries of General Office Clerks. Rent of General Office. Postage, Stationery, and Printing. Telephone and Telegraph. Legal Services. Public Accountants' Services. Directors' Fees. Traveling Expenses of Officers and General Office Clerks. Corporation and Capital Stock Taxes. Exchange and Collection Charges. Dues and Subscriptions. Contributions and Donations. Sundry Office Expenses. Selling and general expenses frequently are combined under one heading as where the items are relatively few in number or where the expense classification is more or less indefinite as to accuracy. If done, there will result no item of selling profit. However, for statistical purposes, at least, separate if possible. Profit from Operations. — The profit secured from the regular operations of the business is represented by the above title. Numerous other captions or titles for this item are in use, but the above is deemed all-sufficient. Additional Income. — The items hereunder included represent extraneous income secured from sources other than regular oper- ations. An illustrative list would be as follows: Cash Discounts on Purchases. Interest on Bonds Owned. Interest on Notes and Accounts Receivable. Interest on Bank Balances. Dividends on Stocks Owned. , Net Income from Real Estate. Profit from Sale of Temporary Investments. Profit from Foreign Exchange. Royalties Received. 328 ADVANCED ACCOUNTING I Commissions Received. Profit from Sale of Material, etc. Sundries. The only item requiring comment seems to be Net Income from Real Estate. The real estate here included may represent either investment real estate or real estate held for operation purposes although not part of the plant operating unit. A manu- facturing company or a mining company may own houses which are maintained to house the employees. The net income there- from is treated in two different ways depending upon the attitude of the accountant: 1. As additional income. Here it must be assumed that such tenement investments are a mere collateral matter to pro- duce additional income. 2. As a manufacturing element. Here it must be assumed that the housing of workmen is a manufacturing expense. The decision of the question for any particular case would seem to hinge upon the exact facts involved and upon notliing else. If the housing activity is necessary primarily either to re- duce labor turnover or to improve working conditions, then the logical conclusion would be to consider operating the housing property as a manufacturing element. It would be usual to show the details relative to the item, as total rentals and total operat- ing expenses in detail. Although it would seem that income from property not held for investment, but for operation pur- poses relative to housing, may be handled in either way shown above, if the net result shows a loss thereon, the second method of handling seems preferable to the first one. Gross Income. — ^This item requires no comment. Deductions from Income. — These items represent the cost of securing capital and losses chargeable against the current period's income as, for example: Cash Discounts on Sales. Interest on Bonds Payable. Interest on Notes and Accounts Payable. Bad Notes and Accounts. Amortization of Bond Discount and Expense. Loss from Sale of Temporary*Investments. Loss from Foreign Exchange. Net Loss from Real Estate. Income Taxes. Sundries. BALANCE SHEET: PROFIT AND LOSS STATEMENT 329 Net Income and Surplus at Beginning of Period.— No comment seems necessary. Profit and Loss Credits.— This group of items would cover the following: Extraordinary profits from the sale or other disposal of the fixed and capital assets. Discounts on the redemption of capital stock. Items applicable to a prior period's operations representing surplus credit adjustments. Gross Surplus. — No comment seems necessary. Profit and Loss Debits.— These items represent the con- verse of those shown above under Profit and Loss Credits, as: Extraordinary losses from the sale or other disposal of the fixed and capital assets. Premiums on the redemption of capital stock. Items apphcable to a prior period's operations representing surplus debit adjustments. Surplus at End of Period. — No comment is here necessary beyond the fact that this item should agree with the surplus shown upon the Balance Sheet prepared as of the end of the period covering which the Profit and Loss Statement has been drawn. Comparative Statements ; Statement Statistics.— The basic form of the statements above outlined may be deviated from whenever desirable ; it is only suggestive at best. Comparative statements are highly desirable at times especially where, from one year to the next, no radical change has occurred in the char- acter of the business or in the chart of accounts. Space in the present chapter does not permit of any discussion of such state- ments herein (See, post: Chap. 10). In the preparation of statements, statistics often are included, as to averages per unit produced, averages per unit sold, and the ratio of cost, expenses, and profit to sales. These statistics are of considerable interpretative value to an executive. Space does not permit of a discussion of statistics in this volume ; the reader is referred to the various books thereon now published. Illustrative Problem and Solution ProUem.~The foUowing is a Trial Balance of the General Ledger, as at December 31, 1920, of the Jones Manufacturing Corporation of New York City, which is a manufacturer of heavy machinery. Entries for I . I I i 330 ADVANCED ACCOUNTING unexpired insurance, interest paid in advance, and depreciation charges have been made, the amounts therefor ai)pearing in the Trial Balance. Note that in the working papers submitted as part of the solution, the Furplus item in the Trial Balance, after closing, is made up of two amounts, —the surplus at the beginning of the year, and the net profit for the year transferred to Surplus account. THE JONES MANUFACTURING CORPORATION Trial Balance December 31, 1920 (Before Closing) Land, Buildings, Reserve for Depreciation— Buildings, Machinery and Equipment, Reserve for Depreciation — Machinery and Equipt. Furniture and Fixtures, Patents, Inventories — January 1, 1920: Manufactured Product, Unfinished Product, Material, Notes Receivable, Accounts Receivable, First National Bank, Petty Cash, Interest Paid in Advance, Unexpired Insurance, Bonds, Notes Payable, Accounts Payable, Capital Stock, Surplus, Material Purchases, Direct Labor, Indirect Labor, Shop Supplies, Factory Expense, Heat, Light and Power, Freight and Cartage In, Insurance — Factory, Depreciation — Buildings, Depreciation — Machinery and Equipment, Depreciation — Patents, Depreciation — Furniture and Fixtures, Taxes — Factory, S 218,000.00 180,000.00 86,000.00 3,025.00 188,235.00 404,000.00 69,476.00 500,000.00 175,000.00 ,525,000.00 184,600.00 600.00 560.00 250.00 1,905,260.00 425,250.00 30,000.00 101,000.00 10,000.00 39,000.00 1,000.00 15,000.00 4,600.00 7,500.00 11,765.00 275.00 2,650.00 % 4,500.00 7,500.00 250,000.00 15,000.00 661,995.00 800,000.00 907,408.00 BALANCE SHEET; PROFIT AND LOSS STATEMENT 331 Advertising, Salesmens' Salaries, Salesmens ' Traveling Expense, Insurance— Manufactured Product, Freight and Cartage Out, Miscellaneous Selling Expense, Sales, Return Sales and Allowances, Officers' Salaries, OflBce Salaries, Stationery and Printing, Postage, General Expense, Legal Expense, Bad Debts Written Off, Interest, Discount on Sales, Discount on Purchases, 5,000 00 130,000.00 7,000.00 450.00 500.00 3,000.00 8,000.00 70,000.00 20,000.00 850.00 700.00 1,500.00 4,000.00 4,000.00 2,500.00 95,005.00 4,750,250.00 43,578.00 $7,440,231.00 $7,440,231.00 $400,000.00 75,000.00 450,000.00 Inventories, December 31, 1920: Manufactured Product, Unfinished Product, Material on Hand, Prepare the following: Balance Sheet — Exhibit A. Profit and Loss Statement — Exhibit B. Statement of Cost of Manufacture and Cost of Manufactured Product Sold— Exhibit C. In connection with the above, submit: Working papers. Solution of Problem. — This problem and solution are presented to review a number of elements related to statement preparation which should be well understood by the student who has reached this portion of his work but perhaps have been forgotten. Working Papers.— Working papers closing a set of books are in general use in a large business for the preparation of the financial statements, because they permit of ascertaining the results of the main divisions of the operating end of the enterprise, as well as its financial condition, with- out requiring first the posting of adjusting and final closing entries. The use of proper working papers will prove the mechanical accuracy of the figures throughout, and the final closing Journal entries can be made directly from it. In the present illustration, all the usual adjustments, other than goods inventories are considered as having been entered upon the books. These usual adjustments will present no difiiculty, and have been omitted; the method of booking involved is merely to charge and credit the proper accounts concerned. The working papers presented below show the following information: Trial Balance (before closing). 332 ADVANCED ACCOUNTING THE JONES MAN 0FAC Working Papbrs Accoun t Land Buildings Reaerve for Depreciation — Buildings Machinery and Equipment Reserve for Depreciation— Ma- chinery and Equipment Furniture and Fixtures Patents Inventories January 1, 1920: Manufactured Product Unfinished Product Material Notes ReceivaUe Accounts Receivable First National Bank PfettyCash Interest I^d in Advance Unexpired Insurance Bonds Notes Pkyable Accounts Plajrable Capital Stock Surplus Matoia! Purchases Direct Labor Indirect Labor Shop Supplies Factory Expense Beat, Light and Power Freight and Cartage In Insurance — Factory Depreciation — Buildings Depreciation — Machinoy and Equipment Depreciation — Patents Depreciation — ^Furniture and Futures Taxes— Factory Advertising Saleamens' Salaries Salesmeos' Travding Expense Insurance— Manufactured IVoduct Frdght and Cartage Out Miscellaneous Selling Expense fiaJeg Setura Sales and AUowanoes (Carried Forward) Trial Balanc e December 31, 19 20 (Before Closing "* $218,000.00 180.000.00 Adjust ments and Inventwies Decembtf Manufa Aooo 86.000.00 3,025.00 188.235.00 404,000 00 69.476.00 500.000.00 175.000.00 1.525,000 00 184.500.00 500.00 550.00 250.00 $4,500.00 7.500.00 (»)$404.000.00 ® 69.476.00 ©500,000.00 250.000.00 15.000.00 661.995.00 800,000.00 907,408.00 2.905,250.00 425.250.00 30,000 00 101,000 00 10.000.00 39.000.00 1.000.00 15.000.00 4.500.00 7.500.00 11.765.00 275.00 2.650.00 5,000.00 130,000.00 7.000.00 450.00 500,00 3,000.00 8.000.00 ®$500.000.00 ® 450.000.00 $2,955,250.00 425,250.00 30,000 00 101,000 00 10,000.00 39,000 00 1.000.00 15,000.00 4,500.00 7,500.00 11.706.00 2.060.00 4,750.250.00 $7,241,676.00 $7,396,653.00 $500,000.00 $1,423,476.00 $3.602.01ft.00 BALANCE SHEET: PROFIT AND LOSS STATEMENT 333 TURING CORPORATION Closinq Books 31.1920 cturing unt Selling Account Profit and Loss Account Trial Balance December 31, 1920 (After Closing) $218,000.00 180,000 00 86.000.00 3.025.00 188.235.00 $4,500.00 7.500.00 175.000 00 1.525,000.00 184.500.00 500 00 550.00 250 00 250.000.00 15.000 00 661.905.00 800.000 00 1.747.065.00 $275.00 $ 5.000.00 130.000.00 7,000.00 450.00 500.00 3.000.00 8.000.00 $4,750,250.00 $153,950.00 $4,750,250.00 $275.00 $2,561,060.00 $3,486,060.00 334 ADVANCED ACCOUNTING THE JONES MANtTFAC WoRKINa Papbbs DoMunber Trial Balance Adjustments Account December 31, 1920 and Muufa (Before Closing) Inventories Acco (Brought Fwward) $7,241,676.00 $7,396,653.00 $500,000 00 $1,423,476.00 $3,602,915.00 Officers' Salaries 70,000.00 Office Salaries 20,000.00 Stationery and Printing 850.00 Postage 700.00 General Elxpense 1,500.00 Legal Expense 4,000.00 Bad Debts Written Off 4,000.00 Interest 2.500.00 Discount on Sales 95.005.00 Discount on Purchases 43.578.00 7,440,231.00 7.440.231.00 Inventories— December 31, 1920: Manufactured Product ® 400,000 00 Unfinished Product © 75,00000 Material on Hand 450,000 JB Manufacturing Account: Unfinished Product, Inv't'y 1/1/20 ® 69.476.00 69.476.00 Unfinished Product, Inv't'y 12/31/20 ® 75.000 00 Selling Account: Manufactured Product, Inv't'y 1/1/20 (1)404.000 00 Manufactured Product, Inv't'y 12/31/20 (!) 400,000.00 $1,898,476 00 $1,898,476.00 Cost of Manufactured Product —To Selling $3,672^1.00 Net Profit on Sales— To Pl-ofit and Lobs Net Profit— To Surplus Su rplus Account Balance, December 31, 1920 (before dosing), $907, «08.00 Profit for Year 1920, 839 , 657 . 00 Balance, December 31. 1920 (after dodng), $1.747.085.00 BALANCE SHEET: PROFIT AND LOSS STATEMENT 335 TU RING CORPORA'nON Closing Books 31,1920 cturing Seffing Account $153,950.00 $4,750,250.00 Pw^fit and Lo BB Account $ 275.00 70,000.00 20,000.00 850.00 700 00 1.500.00 4,000.00 4.000.00 2,500.00 95.005.00 TVi al Balance December 31. 1920 (After Closing ) $2,561,060.00 $3,486,060.00 $43,578.00 400,000 00 75,000.00 450,000.00 75.000.00 404.000.00 400.000.00 3.507.391.00 3.597,391.00 $3,672,391 00 994.909 00 904,909.00 $5.150,250.00 $5.150.250.00 839.657.00 $1.038.487.00 $1.038.487.00 $3.486.060.00 $3.486.060.00 336 ADVANCED ACCOUNTING fi 5 $600,000.00 $500,000.00 $450,000.00 $450,000.00 Inventory adjustments (other adjustments already have been made). Distribution of accounts: Manufacturing. Selling. Administrative (Profit and Loss). Trial Balance (after closing). In connection with the above, the following adjusting entries are re- quired. These have been keyed to the Inventory — Adjustments columns on the working sheets: (1) Material Purchases, To — Material Inventory, To reverse Inventory of 1/1/20. (2) Material Inventory, To — Material Purchases, To place on books Inventory of 12/31/20. (3) Manufacturing Account, $69,476.00 To — Unfinished Product Inventory, $69,476.00 To reverse Inventory of 1/1/20. (4) Unfinished Product Inventory, $75,000.00 To — Manufacturing Account, $75,000.00 To place on books Inventory of 12/31/20. (5) SelUng Account, #404,000.00 To — Manufactured Product Inventory, $404,000.00 To reverse Inventory of 1/1/20. (6) Manufactured Product Inventory, $400,000.00 To— Selling Account, $400,000.00 To place on books Inventory of 12/31/20. With working papers constructed as above indicated, all items are readily traceable, especially the inventories. Closing entries may be made directly from items in the various colimms without the need of first posting the adjusting entries. The preparation of the Balance Sheet and the Operating Statements, in technical form, is facilitated, as all the information necessary is given. The working papers are continued below. BALANCE SHEET: PROFIT AND LOSS STATEMENT 8 8 CO 3 o a < s II -^ i ;1 338 ADVANCED ACCOUNTING THE JONES MANUFACTURING CORPORATION Profit and Loss Statement January 1, 1920, to December 31, 1920 Exhibit B Sales, $4,750,260.00 Less — Return Sales and Allowances, 8,000.00 Net Sales, $4,742,260.00 Deduct — Cost of Manufactured Product Sold, 3,601,391.00 Gross Profit on Sales, $1,140,869.00 Deduct: Selling Expense: Advertising, $ 5,000.00 Salesmens' Salaries, 130,000.00 Salesmens' Traveling Expense 7,000.00 Insurance — Manufactured Product, 450.00 Freight and Cartage — Out, 600.00 Miscellaneous Selling Expense, 3,000.00 $145,950.00 Net Profit on Sales $994,909.00 Deduct: General Expense: Officers' Salaries, 170,000.00 Office Salaries, 20,000.00 Stationery and Printing, 850.00 Postage, 700.00 General Expense, 1,500.00 Legal Expense, 4,000.00 Depreciation — Furniture and Fixtures, 275.00 97,325.00 Net Profit on Operations, $897,684.00 Deduct: Net Interest — Discount, Loss on Accounts Receivable: Interest on Notes and Ac- counts Payable, Discount on Sales, Less — Discount on Purchases, Add— Bad Debts Written off. $ 2,500.00 95,005.00 $97,505.00 43, 578 00 $53,927.00 4,000.00 Net Profit— January 1, 1920, to December 31, 1920, $ 57,92700 $839,667.00 BALANCE SHEET: PROFIT AND LOSS STATEMENT 339 THE JONES MANUFACTURING CORPORATION Statement Showtng Cost of Manufacture AND Cost of Manufactured Product Sold January 1, 1920. to December 31. 1920 Cost of Manufacture : Unfinished Product, Inventory, January 1 1920, ' Raw Material: Inventory, January 1, 1920, $ 500,000.00 Purchases, 2,905,250.00 Freight and Cartage In, j qqq qq _ , ^ $3, 406,250.00 Deduct— Inventory, December 31, 1920, 450,000.00 2,956.250 00 Direct Labor, Manufacturing Expense: Indirect Labor, Exhibit C $ 69,476.00 425,250.00 Shop Supplies, Factory Expense, Heat, Light and Power, Insurance — Factory, Taxes, Depreciation: Buildings, $ 4,500.00 Machinery and Equipment, 7,500.00 Patents, 11,765.00 $ 30,000.00 101,000.00 10,000.00 39,000.00 15,000.00 2,650.00 23,765.00 221,415.00 Deduct— Unfinished Product, Inventory, December 31 1920, ' Cost of Manufactu re, Add— Manufactured Product, Inventory, Januarv 1 1920, ' ' Deduct— Manufactured Product, Inventory, December 31, 1920, Cost of Manufactured Product Sold, January 1. 1 920 to December 31, 1920, ~ ~ $3,672,391.00 75,000.00 $3,597,391.00 404,000.00 $4,001,391.00 400,000.00 $3,601,391.00 t I I hi CHAPTER X STATEMENT ANALYSIS: FOR CREDIT PURPOSES Introduction. — The general term "statement analysis" is used as a title for the current two chapters rather than the more qualified term of "analysis of corporate statements" because, even though the corporate statement probably is the one most apt to be considered in a discussion of the present type, the basic principles primarily are the same regardless of whether a state- ment under analysis be that of a sole trader, a partnership, or a corporation. From past study, it should be remembered that two primary statements are, or at least should be, prepared periodically for a business enterprise : 1. Balance Sheet. 2. Statement of Profit and Loss (Statement of Profits and Income). Although one may be inclined to say that, in the present con- nection, the Balance Sheet is all important, it should not be forgotten that the Statement of Profit and Loss is both com- plementary and supplementary thereto; a Balance Sheet cannot be explained rightly unless accompanied by a Statement of Profit and Loss. A person may encounter one without the other and be required to pass judgment thereon, but this does not in any way refute the statement that both should be available. In considering the purposes underlying statement analysis, two viewpoints present themselves: 1. Is there a credit purpose in mind, or 2. Is there an investment purpose in mind? Although a certain similarity exists in analyzing a statement for either of these, the existent differences seem so prominent that the discussion of one purpose has been separated from a discussion of the other. If a statement is being analyzed for credit purposes, it would 340 STATEMENT ANALYSIS: FOR CREDIT PURPOSES 341 seem that one first ought to make a separation relative thereto as between credit sources. This would be about as follows: 1. The granting of credit by a bank: a. The bank in a relatively small community. Here the granting of credit depends upon the personal element, if not more, than upon the mercantile element. b. The bank in a large city. Here the personal element is further removed than under (a). Therefore, the grant- ing of credit depends more upon the mercantile element than upon anything else,— upon the ratio of good current assets to current liabilities, cold figures from which work- ing capital may be determined. 2. The granting of credit by a regular business concern. Here both the elements mentioned above are taken into considera- tion, because they have a direct bearing upon each case in hand. However, let it be remembered that when the professional accountant, especially the C. P. A., is called upon to render judgment as to a credit risk, personal protection demands that he reach a decision upon nothing except cold monetary facts ; he is not a prophet. Credit.— Business is transacted largely upon a credit basis. This comprehends the advancement of values for a promise to make a return at a later date either of the values which have been advanced, or of money. Such an advancement of values is made upon the belief that the one to whom they are advanced, the vendee, for example, will meet promptly the obligations there- under assumed; upon such belief, the vendee secures from the vendor the title, possession, and use of goods. Because of the character of the present subject, the writer has taken the liberty of considering herein certain factors not purely of an accounting nature with the underlying idea that thereunder a more comprehensive understanding of the topic will result. Credit cannot be built up in a day; it may take years to secure a great credit reputation. But one misstep, from a lapse of judgment or from a lack of prudence, may destroy that reputation in less than a day. Since credit news travels rapidly, such destruction is apt to be national as well as local. 342 ADVANCED ACCOUNTING I' • Personal Versus Mercantile Credit.— All credit is based fundamentally upon the following factors: 1. Personal credit. This is granted to individuals or concerns as such, depending properly upon the following: a. Intent or character. If a person has no intention of meet- ing a financial obligation when the latter falls due, he is deficient in morals and in character; he is dishonest. A man is truly dishonest if he intends to accept goods from another without paying the obligation arising there- under. One who knowingly extends credit to such a person cannot, in any sense, be considered prudent. Character and intent are allied closely. Even though character influences often are forgotten in passing upon a credit risk, as would be the case of a practicing accountant passing judgment upon a statement, from the business man's point of view, it would seem in error not to consider character; a borrower's credit is affected by such practices as the following: i. Tricking his bank in any way. ii. Padding his accounts, iii. Kiting checks, iv. Having a suspicious fire, v. Giving customers short measure or weight. vi. Securing some one to carry his note or open ac- count when he has pledged secretly his merchan- dise and book accounts, vii. Issuing dishonest statements, viii. Bad personal habits, ix. Engaging in some form of graft for a profit. b. Capacity or ability. The ability to make money is worth while as providing the means whereby a debt shall be paid upon maturity. It is a factor that ought not be dispensed with, from the business man's viewpoint, in passing judgment upon a credit risk. The amount of credit granted and its term should be only such as the income can meet normally. Ability alone, however, is a bad discovery in a credit risk. Ability and character go hand in hand. Character alone may command a cer- tain amount of credit, but alone it cannot settle balances STATEMENT ANALYSIS: FOR CREDIT PURPOSES 343 owing another. The capacity to settle must accompany the mtent to settle if unlimited credit is desired. At best, in most cases, personal credit granting is necessarily unscientific for lack of exact data. 2. Mercantile credit. Mereantile credit is on a better basis than personal credit. Less exclusive emphasis is placed upon intent or character, and upon capacity or ability, than upon: a. Capital or property. Definite evidence of property and earnings should be secured, and statements should be prepared regularly for examination. The classes loaned to are manufacturers, wholesalers, jobbers, and retailers. As above indicated, the business man should not deem this factor all-sufficient in granting credit; one who has capital at hand in the beginning, but neither character nor ability may not have the capital at hand when the time arrives to make settlement. The lack of char- acter and ability may cause the capital on hand at the moment credit is extended to be dissipated entirely when the settlement date arrives. b. Security or collateral. References should be utilized whenever a credit seeker is not well known; bank refer- ences are best. Personal credit may be secured by con- ditional bill of sale, by chattel mortgage, or by an assign- ment. However, even where security is offered, one should make certain that it is safe; something might be wrong with the security offered,— it might have been stolen or altered in some way or another. No two credit risks are alike; two concerns may submit exactly the same type of statement and thereon, from the accountant's viewpoint, be entitled to the same amount of credit; but in some material way these two concerns are sure to be dissimilar The elements of judgment and discrimination never should be forgotten. The Credit Department and Credit Information.-Since credit IS granted either by commereial banks or by mercantile concerns to their customers, it seems necessary to show wherein the two differ in methods as well as wherein they are similar M 344 ADVANCED ACCOUNTING \\\ The establishment of credit departments in American banks has been a slow process. This was due to the following: 1. Conservatism. 2. The lesser degree of indispensability of the loaning officers who used to constitute what might be called the credit department. 3. Most credit was granted to customers whom the officers could watch closely. Modern conditions make the possession of such a department a necessity in the larger banks which purchase much outside paper or are called upon to give credit information to corre- spondents, and desirable for most banks. In most respects the bank credit man functions like other credit men. But, if anything, he must play safer and not run the risks chanced at times by others, because the bank is using other people's money. He must know something of many lines of business, because his bank will be called upon to loan to indi- viduals and concerns in varying lines of activity. In either a trading or manufacturing establishment business operations follow a well-defined sequence: 1. Purchase of materials and supplies. This is the work of the purchasing department. 2. Storage. This is the work either of the stock or stores department. 3a. In a trading concern: a. Display of goods. 3b. In a manufacturing concern: a. Manufacturing operations. 4. Sale of goods: a. Sales department. Goods are sold upon either a cash or credit basis. b. Credit department. When a sale has been made upon a credit basis, this department passes upon the risk. In a small enterprise, a well-defined department may not be found, one man or two doing such work without the actual organization of a department for that purpose. In the manufacturing or trading enterprise, the work of the credit department or credit man comprises the "cooling process," so to speak, through which the results of the sales department STATEMENT ANALYSIS: FOR CREDIT PURPOSES 345 activities dealing with credit sales should pass in a well regulated organization. This cooling process has the following as its objects: 1. The determination of the security of both the working capital which has been advanced to customers and the profits which are dependent thereon. 2. The granting of credit. The amount of credit to be granted a customer should not be determined by the sales depart- ment. The methods of the sales department look wholly to the making of sales, and if sales enthusiasm is hindered m any way by the idea that a sale cannot be closed unless the vendee's credit first has been inquired into, the selling of goods to reliable customers would suffer to a marked degree. As a more or less secondary object, the credit department may be given the work of collecting the accounts past due If the regular monthly billing does not draw forth the cash, the credit department receives the past due accounts from the bookkeeping department, and takes the steps necessary to collect thereon usually being guided in this by the advice of attorneys. Credit information concerning a risk is secured in two ways- 1. Directly. Information secured by the credit department itself from direct information: a. The prospective customer may submit information,~a formal statement plus oral or written representations' b. Information may be secured from references and others who know the prospect,— from banks and from the trade in answer to inquiries. c. Local credit men's associations may furnish information concerning a prospective customer. d. Information may be secured from the accounting depart- ment if former dealings have been had with the pros- pective customer. 2. Indirectly. Financial ratings plus general and special re- ports may be secured from the large credit agencies which are national in scope, as: a. R. G. Dun & Company. b. The Bradstreet Company. These agencies collect information concerning the financial ■ 346 ADVANCED ACCOUNTING ability of practically every person who seeks credit. The data is collected by local representatives, and cover a variety of subjects: a. Manner in which one's business is conducted. b. Details concerning the private lives of individuals in control of business concerns. c. Information disclosed by newspaper reports and Court records concerning judgments, liens, assignments, bank- ruptcies, chattel mortgages, etc. This information is reported periodically, and upon the basis thereof a specific amount is decided upon as the financial worth of each business investigated, — individual including firm, and corporation. And upon the basis of this financial worth a specific credit rating is determined. These ratings then are com- piled and published in book form and yearly subscriptions are taken therefor, this involving the payment of an annual fee. Each subscriber may secure regular and special reports in addi- tion to the above mentioned rating service and, upon the pay- ment of special fees, may secure special service. These agencies, as a rule, maintain a collection department in various localities which is conducted by the local representative. All the data covering each borrower should be sorted and be compiled in readily accessible form. Usually, all data on an individual borrower is filed in a single folder. The net result should be that the credit department will have on hand much accurate and up to date information for ready reference. Borrowers' Statements. — Increasing numbers of credit grantors are demanding financial statem.ents irom prospective borrowers. Such statements are the backbone of the information on which banks purchase commercial paper. Less generally, but increasingly, especially in the larger cities, banks are requiring financial statements as a basis for making loans. The attempt by banks to secure paper eligible for rediscount with their Fed- eral Reserve Bank is increasing the use of such statements, especially as concerns the larger loans. These statements are used more widely in banking than in the extension of mercantile credit, but no good reason exists for advocating a continuance of such practice ; as far as possible, the granting of mercantile (credit should be upon a scientific basis. It is important that credit STATEMENT ANALYSIS: FOR CREDIT PURPOSES 347 statements should be recent, not over six months old, if possible. Credit information, in its best form, is presented by means of the two primary accounting statements: 1. Balance Sheet. 2. Statement of Profit and Loss. These should be prepared regularly and in sufficient detail to prove intelligible. All individuals or concerns who seek credit will not supply both of these statements, but it would not be insisting too much to require them to do so. These statements, sufficiently complete in detail and certified to by a qualified accountant, or very much incomplete and per- haps certified to by an unqualified practitioner, must be analyzed carefully by the credit department. At present, ideal statements are a rarity; in fact, they may be everything other than what is desired even though, as generally is known, the Federal Trade Commission, by the aid and assistance of representatives of the American Institute of Accountants, have evolved a most ex- cellent form of Balance Sheet and Profit Loss Statement de- signed to secure uniformity in the matter of credit informa- tion. The credit department analysis will include, in a broad way the following: 1. Statement comparisons. One or more past periods will be compared in detail with the present. 2. The determination of the causes which underlie the results shown. 3. The determination of general business conditions which underlie the particular line of business of which the business under scrutiny is a unit therein. The detailed analysis necessary, as concerns the items found upon such statements, will be given careful consideration later when each such item comes up for discussion. As indicated already, ideal statements are uncommon, but whether ideal or not they must be studied for what they are worth. If not inclusive of sufficient information, this latter must be secured before credit can be granted intelligently. And if such information be not forthcoming, the only sensible thing to do is to refuse credit to the applicant. Of the two statements mentioned, one finds the Balance Sheet 348 ADVANCED ACCOUNTING II submitted alone rather than with its accompanying income state- ment. It may be in a most condensed form; usually, it is thus presented. It may be without a certificate of a reliable account- ant; usually, that will be the case. Therefore, it seems that since the Balance Sheet may be the only statement submitted, it is logical to consider this first. The Audited Balance Sheet. — ^Not only are credit grantors becoming stricter in demanding that prospective borrowers pre- sent periodical statements, but they are going further in that, more and more, would-be borrowers are advised to have their books of account audited regularly, and to liave statements pre- pared therefrom, by professional accountants, particularly by a Certified Public Accountant, who should attach to the statements so prepared a certificate of audit. For the protection of the public, the Certified Public Account- ant works under a certificate or license granted by a State, and this license is presumptive evidence, until the contrary is proved, that the holder of such certificate has "a sound knowledge of general accounting theory and a broad practical training in the accounts of the numerous businesses in which the public account- ant's services may be required." In other words, the holder of such a certificate is presumed to be thoroughly competent to do this kind of work. The holder of a membership in the American Institute of Accountants would be presumed, likewise, to be equally thoroughly competent to do this kind of work. The value of a statement authenticated by a competent and impartial critic cannot be stressed too much. The certificate of a competent accountant represents the opinion of a disinter- ested party, who is assumed to know his business, concerning the condition of the enterprise under scrutiny rather than a mere compilation of figures prepared either by the concern itself or by an incompetent outsider. Statements prepared by the concern itself are inclined, even without dishonest intention, to be most liberal as concerns the cash realization of some of the company's assets. Statements prepared by incompetent outsiders are apt to reflect the attitude of the officials of the concern for whom the work is being done, rather than being an unbiased disinterested opinion of conditions. One of the first things to determine, therefore, is to notice if STATEMENT ANALYSIS: FOR CREDIT PURPOSES 349 the Balance Sheet has been certified to by a competent account- ant. Next, one must ascertain the reputation of the accountant who prepared it. In this connection, the certificate need not necessarily be from a large firm of accountants, inasmuch as the small fellow may do just as good work as the large firm. Third, one should examine the certificate to ascertain its nature. The certificate of a competent practitioner should be sufficient to insure that the statement means what it seems to mean,— that it is technically correct; it does not guarantee, however, the exact truth of the facts since, at best, the latter is only an opinion. Any limitations in the certificate, frankly expressed or implied, should be noted carefully; thus, if an auditor specifies what he has done, it is fairly certain he has done nothing else. The crucial point in any Balance Sheet presented for credit purposes usually is the inventory. The auditor may test this in various ways, as by footing sample pages, testing valuations, etc., but often this is not done. Auditors neither are appraisers nor valuers in the strict sense of the word, inasmuch as this task belongs to an appraisal company. Credit and the Balance Sheet.— The payment of a financial obligation on due date depends upon having the right kind of assets at hand with which to make payment, usually cash. Since liabilities, as a rule, must be paid in cash, a deficiency in the amount of cash so required leans toward opening a condition of insolvency, which makes the credit risk thereunder, naturally, a poor one; a full liquidation under such circumstances, as a rule, will be impossible. If credit is to be advanced, a solvent condition must be main- tained and, in determining the existence or non-existence of such a condition, the properly prepared Balance Sheet is of marked importance. A merchant who files a Balance Sheet regularly with his banker is doing one of the best things possible toward strengthening his own credit; it is really more to the advantage of a merchant to file this statement with his banker than to have the latter request it. The arrangement of the items upon a Balance Sheet depends more or less upon the ideas of the constructor toward bringing out the most salient points in connection therewith. In general, however, when a Balance Sheet is being prepared for credit pur- Il1 n 350 ADVANCED ACCOUNTING poses, or is being recasted and analyzed by a credit man through a process of elimination in order to bring out prominently certain leading features concerning financial condition, the asset and liability items thereon are separated into two fundamental groupings: 1. Current (operating). 2. Capital (fixed or permanent). The current items are of more importance to the creditor than the capital items and, therefore, require the most careful detailed discussion as against a sunmiary discussion of those grouped under the heading of "capital." The operating items bear upon solvency and upon the liquidation of liabilities in the usual course of events ; whereas, the permanent items are of secondary consideration in that, although connected prominently with cur- rent financing they are, to creditors, merely an indicator of secondary or reserve strength and security. The credit Balance Sheet should be prepared, preferably, in the account form under which the current assets are displayed in opposition to the cur- rent liabilities; such display makes possible a ready comparison between the relative values of the two totals. The difference between these two tables represents "working Capital" and, when analyzing a Balance Sheet for credit purposes, two of the first questions to be answered are: 1. What is the amount of the working capital? 2. What is the relation of the working capital to:' a. The total capital? b. The needs of the business? The probabilities as to solvency may be determined in their major import from an examination of the current assets as against current liabilities, as follows: 1. The relation of current assets to ciwrent liabilities. Credit men, ordinarily, look for a 2 to 1 ratio or condition relative to the current items ; they desire to see, in other words, $2.00 of quick assets on hand with which to discharge $1.00 of current debt. If a Balance Sheet varies from this condition, the reason therefor must be determined. The above indi- cated ratio is not an absolute standard, being simply a working rule. 2. The convertibility of assets to a realized basis. If a forced STATEMENT ANALYSIS: FOR CREDIT PURPOSES 351 sale is necessary to secure the cash with which to pay obli- gations maturing and matured, the current assets, as inven- tories, must be sacrificed to a more or less extent. 3. The extent to which liabilities may be renewed. The capi- tal assets which are not encumbered by specific liens, as a mortgage (liens falling due more than ninety days from date of the statement) , are considered only as additional security available in an emergency. Too much stress cannot be laid upon the importance of a proper analysis of the Balance Sheet. The Balance Sheet is a photograph of the business and, if not viewed correctly, the whole complexion of the risk is altered and the possibilities of use defeated. The Problem of Current Financing.— Not all current assets can be used directly for the purpose of meeting maturing obligations, because, eventually, these latter must be paid in cash. The further back one goes from cash, as an asset, toward inventories of finished or raw product, as assets, the less avail- able becomes the asset of cash for the purpose of meeting matur- ing liabilities and, the less available the cash, the less desirable becomes the risk for credit purposes. Current liabilities mature within from sixty to ninety days. Normally, notes payable may be renewed in part, but too much reliance should not be placed upon this means of replenishing the cash fund needed for liquidation purposes; an abnormal condition will throw all estimates awry. One must always count upon the fact that, even under normal conditions, a large portion of the current liabilities must be paid when due. Ordinarily, therefore, the keen business man will make use of a number of legitimate expedients to secure a current cash fund of the right size for the purposes of his organization. Of the methods used, the following three illustrate how current financ- ing is accomplished: 1. The purchase of merchandise, materials, and supplies on a credit basis. This is the usual way of doing business even though it entails the loss of cash discounts which in turn amounts to borrowing funds at a heavy rate of interest. The idea here underlying is to use the values belonging to some one else to help conduct the business, as by purchasing li ll 352 ADVANCED ACCOUNTING upon a sixty-day net basis and selling on a cash or ten-day basis. The amount of aid so received depends upon the quantities of goods found on the shelves awaiting sale as against the time they remain there. 2. Borrowing upon commercial paper. The liability arising therefrom, normally, may be carried, within a reasonable amount, for a longer period of time without a final settle- ment being necessary than the liability arising under accounts payable, because: a. Renewals thereof may be secured from time to time. b. Conversion thereof may be made upon maturity. Nevertheless, the amount of such liability should not be too large because, if so, a dangerous condition exists. Regardless of the two possibilities above shown this dangerous tendency arises because: a. Notes mature at definite times and some must then be paid even though a portion may be renewed or converted. b. When notes mature, the possibility of renewal cannot well be measured because the holders have the privilege of calling for payment. c. If notes are not paid promptly when called, they are subject to protest. d. Notes carry interest. 3. Advancement of services by employees for current opera- tions. If payday is a week later than the time at which the payroll is calculated, there exists an average continual advance by employees equal in amount to the payroll for two weeks. Part of such advance is absorbed by partly manufactured goods. General Principles of Analysis — Further Discussion. — Every concern should finance its fixed assets from its fixed (capital) or slow liabilities and preferably from its capital (pro- prietorship element) alone; it should finance its quick assets from its quick liabilities and from its capital. In the extension of long-time credit, all factors with regard to the business should be investigated carefully; for purposes of extending short-time credit, such a thorough review is unnecessary. As indicated already, the quick assets and liabilities are to be noted chiefly and be compared, the examiner attempting to STATEMENT ANALYSIS: FOR CREDIT PURPOSES 353 assure himself that the quick assets are adequately in excess of the qmck liabilities; the quick assets must repay the loan Practically all assets, as stated, are subject to shrinkage; the excess of quick assets over quick liabilities is necessary: 1. To take care of this shrinkage. 2. To provide for unexpected slowness in realizing upon the quick assets. 3. To cover unusual loss due to unfavorable business con- ditions. 4. To cover any possible contingent liabilities. 5. To provide for a factor of safety. Opinions differ as to the ratio of quick assets to quick liabili- ties, especially since some businesses require more margin than others, and since it is dependent somewhat upon whether or not the concern under scrutiny does a seasonal business. As has been indicated, 2 to 1 is the usual ratio. Some safe concerns dealing in very quickly moving staples, such as groceries or meats, may be given safely a ratio of II/2 to 1. One writer states that notes and accounts payable should be covered by cash, notes and accounts receivable, and that there should be as much merchandise besides. If cash, notes and accounts receiv- able be less than the quick liabilities named, the ratio should be at least 2i^ to 1 ; if more, the ratio safely may be less than 2 to 1,— that is, the merchandise need not equal the quick liabilities. Loans are limited sometimes in amount by the rule that the loan should not exceed one-fourth to one-third of the excess of quick assets over quick liabilities. A more reasonable rule would seem to be to decide upon the ratio to be maintained between the quick assets and the quick liabilities, as to the case in hand, and then not loan more than will permit the retention of this ratio after the loan is made. Turnover should be noted as a means of judging the activity of the business and its assets, and of comparing them with typical figures for similar businesses. Turnover is computed by dividing the average annual sales by the average inventory or stock on hand. Retail prices should be used in both cases, or cost prices should be used in both cases. The higher the turn- over, the more active the business. Where annual sales are not .11 I N i 354 ADVANCED ACCOUNTING stated, they may be deduced roughly from the accounts and notes receivable in connection with the terras of credit usually given on sales. After one ascertains that the ratio of current assets to current liabilities apparently is satisfactory, the differentiations of the report may be analyzed and compared to determine whether the satisfactory ratio will stand the acid test of scrutiny and criti- cism. The order of analysis follows personal preference but, as a rule, the assets are considered first, those of a current nature being scrutinized the most. However, the fixed or capital assets should not be forgotten because: 1. Of the amount of carrying charges, as interest, that they may involve. 2. Of the ultimate realizable value, as a source of secondary strength, that they may have. Cash. — This current asset should mean exactly what the term indicates and nothing else. The amount of cash one should find must be large enough to balance the statement properly, divided as between cash on hand and cash on deposit. A large amount of cash is taken, generally, to indicate a healthy condition al- though, if too large, it might be cause to have business sagacity reflected adversely in that the excess amount over that which actually is required ought to be earning more interest than the small percentage, if any, allowed by banks upon deposits. Again, if a large sum of cash is noticed, one should ascertain whether or not it has been accumulated for definite expenditures in the near future, — as dividend distribution, salary payments, or even cash purchases in order to take advantage of a reduction in ordinary prices charged. A continued small cash balance plus a large aggregate of out- standing obligations and sales indicate poor, if not reckless, financing. The amount of the cash fund is decidedly important from the viewpoint of current financing; maturing obligations eventually must be paid in cash, and if the cash fund proves to be inadequate disaster may not be far off, especially if a turn in the money market is at hand. In some cases, a nominal cash item is shown due to the con- cern's practice of using a large portion of its available cash to retire outstanding obligations just prior to the date of the STATEMENT ANALYSIS: FOR CREDIT PURPOSES 355 Balance Sheet. Again, cases have been found where a concern has applied its cash to the reduction of its payables without an actual retirement of that indebtedness in the amount assumed; this merely is a bookkeeping transaction by which a. reduction of an equivalent amount is made in both cash and payable items. Such practice cannot be condoned in any way because, when permitted, the submitted Balance Sheet does not show the' actual condition of the business. Business activity usually fluctuates seasonally. With a de- crease in output, indicating the introduction of a period of lessen- ing activity, there will be, normally, a decrease in the amount of cash riBquired. And when output increases, notes and accounts payable increase proportionately with the result that there should be a corresponding increase in cash. When this fund is small, it still must be large enough, in general, to meet current requirements, and to do so. Although a certain amount of cash may be secured by borrow- ing, the source is not reliable. And if borrowing is resorted to, care must be used not to overstep in waiting for the moment at which to borrow in order to save a trifle in interest; when the very last moment arrives, it may be impossible to secure funds by borrowings. In determining upon the sufficiency of the cash fund, two points of major importance must be observed: 1. The time required within which to convert unrealized cur- rent assets into cash. 2. The exact maturity dates of outstanding obligations. The longer it takes to convert current assets into cash, and the quicker the liabilities mature, the larger must be the avail- able cash fimd. Most commercial banks, in making loans to customers, en- deavor to have the latter maintain a cash balance with them equal to about 20 per cent of the amount of the loans made. A nommal cash item, therefore, compared to notes payable due banks indicates that the banks of deposit are not being treated liberally in the way of balances. One should ascertain whether the it^m of cash includes time certificates of deposit because, while these represent actual cash on deposit, they may be pledged for loans and such fact might 356 ADVANCED ACCOUNTING HI' not be shown anywhere upon the face of the Balance Sheet. When so pledged, the funds represented by such certificates are tied up until the loans mature; although such a case is unusual, it should be borne in mind. If possible, one should make sure the cash account does not include such items as demand notes, or I. (). U's, covering with- drawals, expenses or loans to officers or employees; such items are not readily available for the needs of the business. The same would be true of sums on deposit with enterprises in the process of liquidation. Notes or Bills Receivable — Acceptances. — Notes or bills receivable may originate in two ways: 1. From customers, if primarily connected with trading. 2. From actual loans made for which negotiable paper haa been received, if not directly connected with trading. In either event, if the total be large, it is necessary to know of what it consists. A business in which long time credits are given, or one in which the working capital is less than it should be, are familiar examples in which the total notes or bills receiv- able are large. Contractors, dealers in lumber, fur, silk, automo- biles, agricultural machinery, etc., will have, usually, a large portion of their current assets in the form of notes receivable, — - instalment notes. Again, a large notes receivable item may in- dicate unfavorable business conditions prevailing in the com- pany's locality. In general, a large amount thereof is an un- favorable indication; certainly, if the accounts receivable are large, there should be few notes receivable. If this item is not to be regarded with suspicion, it must not contain questionable elements, as: 1. Advances to ofl&cers, employees, stockholders. 2. Notes renewed several times. 3. Notes covering unpaid stock subscriptions. 4. Dishonored paper. 5. Kited paper. 6. Notes due from subsidiaiy or aflSliated interests. 7. Accommodation notes. 8. Hypothecated notes. Notes to which the odium of the above elements is attached should be withdrawn from the current assets and be placed STATEMENT ANALYSIS: FOR CREDIT PURPOSES 357 among the slow assets if retained at all as assets. Many of these types of notes would prove uncollectible in case of failure. Further, a certain allowance, usually, should be made, over and above that already calculated, for further depreciation of this item. This further allowance may not be indicated by writ- ing down any actual figures, being merely borne in mind when judgment is formed concerning the net value of the company's receivables. Short term notes are more desirable than long term notes. At times, notes receivable are secured by real estate or by some other collateral. When thus found, the impression arises that prompt collectibility is not possible ; consequently, if the amount be large, a word of explanation from the customer would be in order. Where companies sell their goods upon an acceptance basis, the acceptances received are available for two purposes: 1. For discount with their bankers. 2. For disposal in the open market. Under such procedure, the concern's necessity of borrowing upon their own notes is eliminated. The discount or sale of such acceptances constitutes a contingent liability unless made "with- out recourse." Accounts Receivable.-This item should not be excessive in amount, and there should be very little of them if notes receiv- able are taken largely. They should represent good live ac- counts as far as it is possible for human endeavor to so ascer- tarn. Too often, in fact, where a set of books has been more or less incorrectly kept, it is found that this item has been juggled so that the increase in surplus as shown on the Balance Sheet will equal the amount of net profit per Statement of Profit and Loss. In general, the following information should be secured from a scrutiny of this item: 1. Soundness. Have all doubtful accounts been eliminated and are they due from customers for merchandise sold in the usual course of business, or are they due from others? 2. Relation of total amount to the total of the working assets. 3. Ratio of the total both to the total sales of the period and to the terms upon which goods are sold in the branch of 358 ADVANCED ACCOUNTING trade of which the case under review is a fair representa- tive; the turnover must be correctly proportioned. 4. Conditions governing realization. 5. Proportion charged up for future delivery which, under adverse conditions and a break in prices, would prove useless as an asset. 6. Proportion pledged for loans. This is a sign that the appli- cant is hard pressed to secure credit. 7. Proportion due from affiliated concerns or from persons closely associated with the business. When a large volume of open accounts receivable is noticed, one may believe, without error, that a loss will be suffered when it is attempted to realize upon the accounts. Therefore, under such condition, a reserve should be present to cover the amount of such probable loss; if such reserve be not present, the asset value of the accounts receivable may be considered, without hesitation, as being inflated. The relation of the total amount of accounts receivable to the total of the working assets is of major importance in connec- tion with the terms under which settlement is to be made in that such relationship affects the amount of the available cash fund. Accounts which cannot be liquidated except after the passage of a considerable period of time are not as desirable as those which may be liquidated within a short interval of time. In the instalment business, for example, the proportion of the accounts receivable in relation to the inventories will be rela- tively large, whereas, in a retail business conducted on a cash basis the proportion thereof as related to inventories should be decidedly small. In the first instance, the working capital needed will be relatively large, whereas, in the latter case it will be relatively small. Since a large amount of long time accounts may encumber the ease of securing cash, and a small amount of short time accounts may assist the ready securement of cash, a small amount of short time accoimts may be more available, from the cash viewpoint, than a large amount of long time accounts. Large-sized inventories plus a large amount of ac- counts receivable indicate slow convertibility which, in turn, points out the need of a large amoimt of working capital. Indebtedness due from affiliated concerns (which concerns STATEMENT ANALYSIS: FOR CREDIT PURPOSES 359 might be operating as branches— in the case of distributors, or as producers in allied lines— in the case of manufacturers) should not be included in the quick assets, because, while they may be liquidated in part from time to time, they are more or less of a permanent character (dependent upon the line of business) , and frequently represent the investment made in the subsidiary or affiliated company. In the event of liquidation, these funds usually are not found to be of full realizable value. Inventories: Materials, Supplies, and Merchandise.— The inventory item, usually, is the most important of all the current assets and, as a rule, constitutes the major portion thereof. This item always is considered as being a quick asset, but since, as a rule, it is an asset which moves the slowest of the usual current assets, one should question closely its ready convertibility. Be- fore going further, consider the inventory of a manufacturing concern, as representing the most complicated type, and notice its components: 1. Raw materials. Many kinds of raw material may be used and most of it may be secured far in advance of the time at which it will be used. 2. Goods in process. This represents goods being fabricated but not yet completed, its value being composed of the cost of material and labor with perhaps a certain portion of the factory overhead. 3. Finished product. These are goods which are manufactured and ready for sale. 4. Miscellaneous. One of the first things to observe relates to overstocking. This may or may not represent something which is indicative of undesirability: 1. Overstocking may be due to foresightedness in making large purchases in a favorable market, or to the fact that the company is distant from its source of supply, or because of seasonal demands. 2. Overstocking may be due to shortsightedness which indi- cates bad management in that the purchase prices are so high that a price decline will come later. If such condition exists, great care must be observed before passing favorably 360 ADVANCED ACCOUNTING upon the risk, because such an overstocking may be a menace rather than a help. Again, where a concern is manufacturing machines of one sort or another, a large portion of the inventory may represent re- pair or replacement parts. Naturally, these are slow to realize cash from and harm, rather than support, the convertibility feature of the inventory. Inventories in the nature of special- ties are not as desirable as those of staple value; the former require, usually, continued advertising in order to move them. Also, staple stocks with a ready market are more available for current purposes than raw stock which must be processed before being marketed. More depreciation must be allowed for luxur- ies, novelties, and seasonable goods than for staples. Inventories should be valued at cost or market, whichever is lower. If market price at inventory date is less than cost, it is well to provide, also, for further shrinkage due to increased selling expenses, etc. Where market price is not readily deter- mined, sales price may be taken and be reduced by the percent- age of mark-up used in the business. Valuation accuracy is de- cidely important. The takers of the inventory and the methods used in taking it should be ascertained, if possible; and in this connection, the best evidence securable as to accuracy is the audit certificate of a competent accountant. All slow stock should be depreciated heavily, and all unsalable stock either should be eliminated entirely from the inventory or be given a movable valu^^tion. Inventory turnover is important ; the credit examiner should be familiar with the customary turn- over in the line of business represented by the concern whose statement is under the microscope. If goods are scattered in a number of places over the country, a most efficient main office organization is necessary to prepare the figures properly; more than ordinary care and system are necessary. More than one plant, small and large, secure their desired ratio between current assets and current liabilities by inventory juggling, and this the would-be creditor cannot discover without great difficulty, if at all. Therefore, as mentioned above, the best evidence securable as to inventory accuracy is the audit certificate of a competent practitioner, a C. P. A., or member of the American Institute of Accountants. STATEMENT ANALYSIS: FOR CREDIT PURPOSES 361 The relation of the inventories to the entire current asset fund is most important. If the amount is large and out of pro- portion to the indicated needs of the enterprise, the reason there- for may be one of the following: 1. Speculative purchasing. 2. Overstocking (commented on above). 3. Inflation in values. On the other hand, if the amount is small and out of propor- tion to the needs of the business, we have the earmarks of a hand-to-mouth policy. But in connection with the above two possibilities, it should be remembered that each particular line of business must be judged by the conditions thereunder exist- ing rather than by general rules designed to cover all lines of business endeavor. If the amount of this asset is out of pro- portion to the required current asset fund, and consists of slow moving Items, as illustrated above, the current financing of the business under survey must be considered as being weak until the contrary is proved by other conditions. Consignment Accounts.— It is important to ascertain if there are any consignment accounts included among the ac- counts receivable or in the inventory item. Merchandise out on consignment is not properly an account receivable until the merchandise is sold so that title passes from the consignor Merchandise out on consignment, not being under the direct control of the consignor company, is subject to incidental haz- ards; therefore, it should be carried under a separate classifica- tion so that the amount thereof may be taken into considera- tion separately. Accrued Items As Current Assets.— Any item representing an accrued value, one not yet due to be paid, is a legitimate cur- rent asset so far as a group heading is concerned. Since it is only human nature for a business man to show all possible asset Items upon his Balance Sheet, but eliminate therefrom all possible liability items, one must be most careful to hunt for the latter when criticizing a Balance Sheet. In other words as concerns the topic now discussed, one should make sure that the accnjed receivable items are not the only class of items included upon the statement; liability items of an accrued nature f 362 ADVANCED ACCOUNTING should be found among the current liabilities if, among the cur- rent assets, there are found asset items of an accrued nature. Deferred Charges As Current Assets. — ^These items repre- sent amounts which at present are held in suspense as assets even though they are actually expense items later to be charged against income. The frequent inclusion of these items under the general heading of current assets, from a credit viewpoint, may be in error in that a portion of such items may have no direct connection whatsoever to the specific realization of cash. In other words, deferred charges may be grouped into two classes : 1. Those which to some extent may be realized in cash. A value here exists which, in the event of insolvency, may be used to liquidate a liability. Such would be the case of insurance paid in advance. 2. Those which may not be realized in cash. These items represent a heavy expenditure during one period which is not all consumed as an expense until the next or other subsequent periods. The value here existing is uncertain, as least from the Balance Sheet point of view, and con- servative practice, in the determination of the value of a credit risk, discourages considering such assets items as having any value whatsoever. Because of this two-way possibility, it is desirable to group deferred charges under a separate heading upon the Balance Sheet so that one may not be mislead in inflating the current asset values by including thereunder items which do not refer to the direct realization of cash. Miscellaneous Items Considered As Current Assets. — Securities consisting of bonds, stocks, mortgages, and other commercial paper are good credit current assets provided they have a quick market value. If they are slow, being in the nature of a long-time investment rather than a temporary investment, they should not be considered as being current assets. The ap- pearance of this item may indicate either a speculative tendency which is undesirable, or, it may indicate the investment of sur- plus funds which is desirable and which strengthens credit stand- ing. In order to satisfy one's self as to this point, it is necessary to secure an itemized statement showing the contents of this STATEMENT ANALYSIS: FOR CREDIT PURPOSES 363 asset. Bonds or stocks of affiliated companies are not good credit assets. The relationship existing between the two con- cerns must be determined; one may have contingent liabilities or contractual relations with the other due to the ownership of such securities. Bonds or stocks of the issuing company may be found among the current assets: 1. Treasury bonds. These are bonds which have been author- ized and executed but are held in the company treasury. They are not current assets in any sense of the word and should not be shown as assets upon the Balance Sheet. They are analogous to signed promissory notes which have not been negotiated. They should be shown as a deduc- tion from the authorized bond issue. 2. Unissued capital stock. This is not an asset item from any point of view. The right of a corporation to issue capital stock is not capital; therefore, the debit offset thereto, as per the ledger, cannot be an asset. 3. Treasury stock. This item does not represent an asset, only the retirement of capital stock so far as the outside is concerned. It should be shown as a deduction from the capital stock authorized. Capital or Fixed Assets.— The relation of fixed assets to fixed liabilities is important but of only secondary interest in drawing a credit conclusion. Large values of these assets with no notes payable or other liability items requiring considerable fixed interest charges represent reserve financial strength which per- mits a current stringency in current financing to be relieved easily by borrowing: 1. Actual borrowing from creditors which contemplates the payment of fixed interest charges plus the repayment of principal at stated times. 2. Capital contributions. The method of securing funds by this means is superior to the first one above in that the two requirements incidental thereto, as indicated above, need not be considered. In considering the item of land and buildings (real estate) the first point to be covered is ownership. Are the properties f 364 ADVANCED ACCOUNTING » i owned in fee simple, or does title rest with realty holding com- panies, individuals, or others? Again, of what construction are the buildings? Are they in good operating condition and well adapted to the business, and for other than present use. Is a suflScient amount of insurance carried? Is there a sprinkler system installed? The question of depreciation is decidedly important, especially where a heavy investment in machinery is noticed. Mortgages outstanding against such properties must be given attention, as well as the amount of unpaid taxes, special assess- ments, or other liens. Sometimes statements show only an equity in real estate, — ^the value of the property less the mort- gages. This should not be in that the credit grantor should know the amount and maturity of the mortgage and the fixed interest charges. Further, there would be no use in presenting statements in detail if as to any one item only net equity should be set out as the only figure; if so, then the entire Balance Sheet could be set out as one capital item. If an increase in value is noticed, one should determine if such increase is due to additions or improvements, or to revaluation. If a steady increase in valuation is noticed from year to year, it is well to know the company's policy in this matter. Com- mercial banks do not, in general, condone the policy of borrowing money to invest in fixed assets; it is their feeling that new addi- tions, etc., should be financed either out of earnings or through increased capital investment. Assets like good-will, patents, trademarks, leaseholds, etc., are of doubtful value and should either be eliminated entirely from consideration or be given only a mere nominal value. Although considerable space might be used at this point in discussing certain things connected with fixed assets in relation to a credit risk, other than the above, these cursory remarks are deemed sufficient in that these separate items must be discussed in detail in the next chapter in connection with Balance Sheet analysis from an investment point of view. Liability Analysis— In General.— As each asset item is examined, it would be well to look for and set up the liabilities which are not shown. If a Balance Sheet carries the audit cer- tificate of a competent accountant, the credit examiner should STATEMENT ANALYSIS: FOR CREDIT PURPOSES 365 consider this as a most valuable safeguard against omissions of this character due to mistake or fraud. If the Balance Sheet lacks such a certificate, inquiry concem- mg the possible omissions of liabilities should proceed along the following lines: 1. Purchases on credit may be represented in the inventories but not be offset on the books of account by the proper credit entries thereon. The liabilities offsetting such pur- chases must be paid long before the asset represented by the inventory figures can be realized in cash. 2. Payroll accrued. 3. Interest accrued. 4. Etc. Notes or Bills Payable.— These should be only either for merchandise or for money borrowed. When the proportion is high, the Item is important. If a concern purchases on account, the notes payable covering purchases should be small, at most' A merchant should not at the same time give notes for mer- chandise, and borrow upon his single name paper; the latter normally, is supposed to permit him to pay cash and take dis- counts. The notes payable should be segregated into the classes thereof as has already been indicated previously. Odd cents in the notes payable item should put the loaner on his inquiry; it may indicate that notes have been given for merchandise. The reason may be otherwise, however, as the odd cents may be due to the subtraction of interest unearned from face values, the latter being in round sums. If a renewal policy exists, the concern's credit and general business condition will determine if the note liabilities are able to be continued or will have to be taken up at once from current funds. The con- tingent liability on notes receivable discounted should be determined. Accounts Payable.— This item should not be large if the notes payable be of considerable size, and vice versa. They should represent recent purchases. Inquiry should be made to ascertain if any collateral has been given to protect any of the payable items, since this would prejudice creditors. Inquiry should be made, also, to determine whether the greater portion of the accounts payable is due to one concern or are scattered 1 'It I . 366 ADVANCED ACCOUNTING well. If the former condition is in evidence, one should ascer- tain if there be any chance of credit relations being severed in the near future with the business with which credit is localised; should this occur, disaster may come quickly. An analysis of the accounts payable as under: 1. Accounts less than thirty days past due, 2. Accounts from thirty to sixty days past due, 3. Accounts from sixty to ninety days past due, 4. Accounts ninety days or more past due, will indicate whether the concern is falling behind in liqui- dating its accounts payable. Capital or Fixed Liabilities. — ^Any liability which falls due within ninety days may well be classed as a current liability from the standpoint of credit granting. Therefore, in analyzing the capital liabilities, the analyst should determine if any of them are going to fall due in the near future, and if they will require payment at such time. Mortgages, bonds, etc., should show due dates and, if these due dates are current, one should make sure that adequate means are provided to pay or renew. If any of these fixed liabilities will fall due in the near future, they are no longer fixed in character; they are decidedly of a current nature, unless provision has been made for renewal. When payment is made, the cash fund must be depleted there- under in exactly the same manner as if these liabilities were of the ordinary current kind. In this particular, at least, a credit Balance Sheet must differ as to arrangement of items from the Balance Sheet of the ordinary kind. The proprietorship element should not be too small as com- pared to all debts to outsiders. Bonded debt, in a sense, is intermediate, bondholders being, from one point of view, lenders and, from another point of view, often proprietors. The Comparative Balance Sheet. — This statement is most useful in bringing to light either inaccuracies or fraud in setting out the financial condition of an enterprise. By its use, items may be compared one with another to the end that: 1. Important changes in condition will be disclosed. 2. An intelligible basis is secured by means of which the right kind of questions may be asked looking toward the dis- covery of important information. STATEMENT ANALYSIS: FOR CREDIT PURPOSES 367 Again, where a Statement of Profit and Loss has not been submitted, the profit or loss of the period just passed, as of the end of which the Balance Sheet has been prepared, may be deter- mined by a comparison of Balance Sheets provided the drawings or dividend distributions of the past period are known. In preparing the Comparative Balance Sheet for present pur- poses, one might do well to proceed about as follows: 1. Take a sheet of analysis paper and list thereon by years the assets and liabilities as shown by the Balance Sheets submitted : a. List the current assets first and show total. b. List the current liabilities directly thereunder and dis- play total. c. Deduct the total of (b) from the total of (a), and bring down the resulting balance into the same column. This balance represents working capital. d. List the capital assets in the same column and show total. e. List the capital liabilities directly thereunder and display total. f. Deduct the total of (e) from the total of (d), and show resulting balance. g. Add (c) and (f) and show total. This represents the amount of net capital available for permanent purposes. h. List outstanding capital stock and the credit balances of any undistributed profits accounts, such as surplus and reserves, and secure total. This total should agree in amount with the accounting capital as shown at (g). The comparative statement prepared as above, each succeeding year bemg in the column to the right of the preceding one, will enable a person to note quickly: 1. The relative importance or weight of individual items. 2. The fluctuations in working capital. 3. The net capital available for permanent purposes. Again, such a statement will enable the credit analyst to calcu- late with ease increases and decreases from year to year. Too much emphasis cannot be placed upon following a logical pro- cedure such as has been indicated above rather than to work in a hit or miss fashion when analyzing statements for credit purposes. A definite plan of attack closes most, if not all, of the 368 ADVANCED ACCOUNTING possible avenues looking toward misrepresentation and renders available for future reference the important results that have been deduced; the haphazard approach does not promote this efficiency and is to be deplored. The Statement of Fund Application. — As an outgrowth of the Comparative Balance Sheet, the better to present the infor- mation therefrom obtained, the Statement of Fund Application is useful and valuable. However, the discussion of this statement is postponed until near the end of the next chapter the better to equalize the contents of these present two chapters. The Income Statement. — ^Although this statement is exceed- ingly important, it is usually lacking. The loaner of short-term credit desires to see not assets alone, — ^the brick and mortar, — but earning power as well, with money coming in steadily enough both to meet his note and other just current claims. Net earnings are important in this connection, as property is to be valued chiefly as a means of earning; i. e., according to its activity, and not merely something that may be put under the hammer, with losses, perhaps, all around. An income statement should show gross sales, cost of goods sold (including cost of manufacture, if any), and resultant gross profits, deductions of expense, including all charges, such as de- preciation, repairs, etc., and the resultant net profits from opera- tion; to this any outside income would be added and any finan- cial expense subtracted. When this statement is lacking, the profit and loss outcome may be determined from the Comparative Balance Sheet, as has been indicated above. CHAPTER XI STATEMENT ANALYSIS (continued) : FOR INVESTMENT PURPOSES Introduction.-In the last chapter, certain principles were presented on analyzing a statement for credit purposes. In the present chapter, statement analysis is discussed further, this time primarily from the viewpoint of an investor. Investment contemplates placing funds so that the principal will be safe and an mterest return be assured. On the other hand, specula- Zr'^ T ^^"""^ "' "° '^intelligent attempt to discount the tuture. In order to bring the present discussion within the confines of one chapter, the attention will be concentrated only upon the mdustrial enterprise, excluding all others, this classi- fica ion comprehending those engaged in manufacturing, dis- tribution and trading, and construction. It is remarkable how persons, in general, who have labored years m accumulating funds, will place part, if not all, of these funds m various types of investments after only a fe^ minuSs of cursory deliberation. Because of this fact, whether the ge^! eral market appears good or bad, many securities are for sale wh.ch are entirely out of line therewith, whose entire founda- nrn. 7 1 '' ' T' ^^"^^i^^tio^ and whose flotation de- pends entirely upon the cupidity of human nature If investors, and even speculators, would base their decision and Inl ' T"" "''''^^' '''^'^ ^^^^ ^^^^^^1' deliberate and cool analysis, the security markets would assume soon a character entirely different than they have at preset Large Versus Small Scale Enterprises.-Present economic life leans toward specialization, the elimination of waste at aH possible points Therefore, the large scale enterprise is a neces sity, Its advantages being about as follows- 1. Ease in financing. From the financier's point of view the small corporation is useless; its securities cannot be handled except for an exorbitant charge. "<*naiea 369 370 ADVANCED ACCOUNTING 2. Location. Because of its financial strength the large cor- poration may choose its location as seems best, consistent with its market and source of raw material. The small corporation, too often, like Topsy "just growed," so far as locality is concerned. Even the best of small companies will suffer in competition with a corporation which has plants and distributing agencies in all parts of the country. A corporation operating only in one community will dis- cover sooner or later that business is influenced more by local conditions than by those of national import. 3. Advertising. National advertising campaigns can be con- ducted by the large corporation, whereas, the small one, usually, is prohibited therefrom. 4. Improved and economical production methods. Large plants can take advantage of any discovery of an improve- ment in production processes tending either toward econ- omy or increase in output. 5. Purchasing in large quantities results in a lower cost. Only large scale production and distribution will permit of this. 6. The highest priced brains can be hired, without dependence in manufacturing and distribution resting upon the life or ability of any one individual. Each part of the organiaa- tion is given the advantages of the best practices of the others. Experimental and development work may be car- ried on extensively even though the cost be high. 7. Foreign trade may be developed beyond the point of great- est expectation of any small company. 8. Waste or by-products may be utilized to the best advantage in that large scale production will produce great quantities thereof to become the basis of a side-line endeavor. 9. Fire, flood, or strikes will not be apt to cripple a corpora- tion having several plants. 10. A great variety of articles may be produced in many large industrial concerns to the end that the average demand will be more dependable, usually, than where a company pro- duces only one article or a limited number of articles. General Factors of Investment Importance.— Before pass- ing on to a discussion of the specific factors involved in state- STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 371 ment analysis upon which an intelligent investment or specula- tion may be made, certain general factors may be mentioned which, although not securable from a statement scrutiny alone, nevertheless, are of marked import. These general factors are commented upon below in a summary manner: 1. Demand. Even though the industrial corporation, in gen- eral, has had no cause to promote a pessimistic attitude as to the amount of business done, fluctuations in demand will occur and may cause serious results. Therefore, certain questions pertaining to demand should be considered care- fully and be answered satisfactorily. Needless to say, the good industrial proposition, when investigated, will permit these questions to be answered in the afiirmative: a. Will sales continue and expand consistently? b. Does the business deal in a necessity? If it manufac- tures what may be classed as a luxury, one should be careful. c. Are sales made in large volume at a small profit? d. Is the business a steady one? Seasonal fluctuations are apt to be disastrous. e. Is style or fad eliminated in controlling gross receipts? 2. Diversification. The more diversified the activities of an industrial enterprise, the greater will be the opportunity to succeed. If sales are dependent upon one, or a few articles, a sharp drop in demand may spell disaster. Enter- prising concerns are feeling out the market all the time, ascertaining how long it will last, its greatest possibilities,' and what portion thereof can be taken care of keeping in mind other competitors; this information costs money to secure and only the larger companies can afford the price of such investigations. A diversified business is depend- able; unforeseen circumstances count for naught, as time and effort have provided there against; in a period of de- pression, foresight will have provided for pushing some- thing other than the standard article, perhaps something entirely new. 3. Integration. Great importance may or may not be attached to the control over permanently adequate sources of raw material; in some industries it is a most serious question 372 ADVANCED ACCOUNTING whereas, in others, the seriousness is not so pronounced. Consider the following possibilities: a. Industries controlling raw materials in all stages of manufacture have a tremendous advantage during times when the cost of raw material is high. When this prac- tice is followed, however, care must be observed not to have too much capital tied up therein; by so doing, the industrial becomes raw material poor. b. If an industry can make favorable arrangemtmts for securing raw materials as needed, the advantages of integration are unnecessary, because the control of raw materials is not indispensable. c. Certain industries may find it impracticable to own or operate sources of raw materials, as a cotton mill, or a stock yard. d. It is impossible for some industries to control raw ma- terial sources even if they desired to do so; the nature of the work done would be prohibitive. A detinning company cannot obtain unlimited quantities of scrap tin from any one company. e. Some concerns combine their interests with others of a related nature in order to secure a type of integration, as well as a reconciliation of existing contract interests. A copper company producing sulphuric acid may combine with a chemical company. 4. Competition. As competition grows keener with the in- crease in manufacturing, the profits per dollar of gross sales will grow smaller; large profits invite competition, and competition destroys large profits. 5. Dividend policy. Comparatively few people have a suffi- cient breadth of vision to be willing to postpone an im- mediate pleasiu-e for the sake of greater future enjoyment. Haste in declaring dividends often has proved disastrous. The credit of a corporation cannot be maintained by the declaration of unearned dividends. To the unsophisticated, dividends give the appearance of prosperity, but the trained analyst never should be guilty of making this mistake. Diligent attention to business coupled with the wise rein- vestment of surplus earnings have been the means of plac- STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 373 ing some of the great industrials in the enviable position they occupy to-day. The long-range financial policy look- mg toward the conservation of earnings until stable divi- dends can be paid is more to be desired than the policy swayed by the babble of the mob. 6. Financial alliances. The right management whether or not by itself financially strong will command financial backing and, m turn, financial backing, if of sufficient strength will carry through a corporation that, otherwise, would 'suc- cumb. A number of companies are economic failures, not earnmg a fair interest return upon the capital risks in- volved, but still they are decidedly alive because of strong control and financial alliances. 7. Industrial relations. Freedom from labor troubles is one of the most important elements looking toward the success of an mdustrial enterprise. A corporation should be gen- erous with its producers of business,-its workers; welfare work and profit-sharing are not only creditable but are business necessities. In judging of industrial securities trom this angle, one should ascertain satisfactorily a. Whether the company has the enthusiastic loyalty of its directors, officers, and employees. b. Whether the corporation shares its profits with its em- ployees, or offers its securities to them on attractive terms so that they may become partners in the business 8. Personnel management. The ability of corporate managers to increase sales, to lower costs, to improve the quality of the product to direct policies, and to master the financial problems of the industries with which they are connected constitutes an important element in maintaining the stand- ing of their securities; this, in turn, is dependent upon the personal equation. Corporate managers should be pre- pared for depression in times of prosperity; if they are rr;? 7.'"^' times of great prosperity, one should be careful of looking with favor upon the securities of the companies these managers represent. Again, if a com- pany has been recapitalized recently, it is of prime im- portance to know whether the management will remain the same as that which was responsible for the company's 374 ADVANCED ACCOUNTING 1 1 success in the past, assuming the old management to con- sist of large caliber men. Many concerns have failed as a result of the retirement of its founders. Publicity Through Published Statements. — Investment or speculation is not intelligently possible without there being at hand complete and frequent reports on earnings and reliable statements on financial condition, concerning the enterprise un- der consideration. If an industrial enterprise does not issue reliable and frequent information of the character indicated above, one should not be interested therein. Also, information should be available to the effect that the management has the benefit of the stockholders, as a whole, in mind. Continued publicity and conscientious responsibility are all important if an industrial proposition is to be considered at all as an invest- ment. If a corporation has its stock listed on the New York Stock Exchange, it is required to publish at least once a year an in- come statement and a Balance Sheet (consolidated, if the enter- prise requires such). These statements must be published so that they will be in the hands of the stockholders at least fifteen days in advance of the annual meeting. It is desired, also, that quarterly or semi-annual reports be published in addition to the compulsory annual report; quarterly reports of earnings are much to be desired, and no reason exists, in general, for not having them prepared. If done, the stockholders will not be at the disadvantage in which they so often find themselves as compared with the company management, who are on the inside, as where reports come through only once a year. Nearly all large corporations publish annual reports which are available upon request to the secretary. But since there exists a lack of uniformity in the requirements of present-day industrial accounting, many of these corporate statements are noteworthy for what they omit rather than for the informa- tion that may be secured from a study thereof. In prosperous times. Balance Sheets are apt to be conserva- tive. Hidden assets often are created through unwarranted re- serves for depreciation and by the acquirement of property out of surplus earnings which does not appear upon the Balance Sheets. On the other hand, in times of adversity, corporate re- STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 375 ports often must be viewed with skepticism. As earnings be- come impaired, managers are inclined to skimp depreciation, maintenance, and reserves in order to make a creditable showing.' Therefore, with the customary sequence of prosperity and de- pression, the interpretation of corporate statements usually must include a consideration of general business conditions plus the lack of uniformity in statement set-up and content. Fire Insurance and Corporate Assets.— One important fac- tor apt to be overlooked in analyzing corporate reports relates to fire msurance. In analyzing the Balance Sheet assets, one should ask himself the following pertinent questions and make certam the answers thereto are entirely satisfactory: 1. Is there any element underlying the case that is of more import than adequate fire insurance being in force? 2. If not, is there sufficient insurance in force? 3. Does the amount of insurance cover adequately fluctuations m values? 4. What would be the effect of a serious fire upon the se- curities concerning which an interest is manifested? .u^lf^^."'' ^^^'^^^ Assets.-Balance Sheet valuations covering the fixed or capital assets often are largely fictitious; in fact arbitrary figures frequently are set down upon the left side of the Balance Sheet in such amounts as will offset the actual amount of outstanding stocks and bonds found listed on the right side. The overvaluation of obsolete fixed assets,-plant machinery, and equipment,-has caused the wreck of many a promising business. Inflated valuations baffle successful ana- ysis looking toward the determination of the real asset value the amount of "water" therein contained, and whether or not the proper amount of depreciation /is being charged regularly against earnings. ' » j The discussion concerning specific fixed or capital assets separates these assets into two groupings: 1. Immovable fixed assets. These assets represent the real property elements. 2. Movable fixed assets. These assets represent the personal property elements. Land.— Real property consists of land and buildings. Fre- quently, these two items are combined under the caption of "real tm 376 ADVANCED ACCOUNTING estate." The two items should be listed separately upon the Balance Sheet if a proper interpretation thereof is to be pos- sible. Land, as a fixed asset, in general, is subject neither to depreciation nor to appreciation; buildings, on the other hand, are depreciating constantly. Again, the separation of the two items or values is essential for insurance purposes, and for the proper adjustment of fire losses should such losses occur. Since land may consist of various it'^ms, the Balance Sheet figures thereof should be supported by full explanatorv detail together with proper reference to documents supporting the analysis of the various items and the legitimacy of tlieir ex- istence. Full cost, with neither depreciation nor appn^ciation, is the valuation formula for land. Full cost contemplates com- plete cost in condition ready for use or, at least, up to full title date. Since the purchase contract price, attorney's fees, broker's commissions, or a fair portion of the purchasing agent's salary, the costs of search and title guarantee (if these be borne by purchaser), notarial and recording fees, assumption of taxes owing at date of purchase, local improvement taxes and assess- ments (for sewer, water mains, curbing, paving), and costs of leveling, grading, filling and draining, are all legitimate charges enhancing the cost of land, the greatest care must be observed by the analyst in his scrutiny of the land item not to permit too many of these additional charges to be capitalized beyond reason because, thereby the land value may be inflated greatly, although not apparently so ; inflations, particularly those on real property, are detrimental. Buildings. — ^When buildings are erected by the concern itself, full cost may include not only the cost of materials and labor, plus a fair portion of the establishment overhead where super- vision of construction is local, but all other expenses incurred directly in connection with construction. These latter expenses may include such items as architect's fees, for plans and super- vision, costs of permits and licenses, interest on borrowed money and insurance during the construction period, costs of accidents and injuries to workmen during construction, costs of easements, damages, and strike costs. Again, in this connection, the great- est care must be observed by the analyst in his scrutiny of the STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 377 buildings item to make sure the value thereof has not been greatly inflated. The valuation formula for buildings is full cost less deprecia- tion. Where a number of buildings exist, a subsidiary building record is of value to show the separate cost of each item, and from this the total value is determined. Such a record plus a map showing location of properties, is valuable in case of fire loss. In determining the depreciation of buildings, many things must be considered carefully. Not only must the depreciation of use,— wear, tear, and lapse of time,— be studied, but the factors of obsolescence and inadequacy must not be forgotten since they shorten the service life of the structures. Depreciation rates for buildings, according to different au- thorities, cover a wide range. While some authoritative rates are available, no standard rates, unless compulsory, should be used without a careful study being made of local conditions. Structures of a temporary nature should be charged at net cost (fuH cost less salvage value) against the product or the job for which they have been erected. Buildings owned as a free- hold for life (a life interest in buildings) are not subject to depreciation, because the remainderman takes the building over in its condition as released by the party owning the life in- terest. Machinery and Machine Tools.— The movable fixed assets are next to be considered. In general, these consist of those assets which are comprehended by the term ''equipment," such as machinery and tools, furniture and fixtures, delivery equip- ment, patterns, lasts, dies, maps, drawings, electrotypes, ovens, furnaces, etc. The valuation of these items presents nothing new in principle, although many points relative to the applica- tion of the principles are important. Machinery and tools, as an asset caption, include not only the assets ordinarily carried upon the ledger under the account of that name, but power machinery, power transmission, shafting, connections, electric transmission cables, and the like. The factor of depreciation is of marked import in the valuation of this asset. It is readily apparent that not only do the various pieces of machinery differ in the amount of depreciation thereon 378 ADVANCED ACCOUNTING within the same plant, but the same machines used in different plants will vary in the amount of depreciation thereon; even in the same factory two similar machines will not usually de- preciate to the same amount in the same period of time. Every machine and machine tool should be charged with its full cost, and should be valued at full cost less depreciation. Full cost is understood to include such items as invoice price, insurance during transit, freight, duty, drayage, and installation charges. In analyzing this asset, one should investigate thor- oughly the method of valuation ; one should look with skepticism upon unreasonable figures. Exercise care in eliminating from the account all intangible values such as the cost of rearranging the machinery upon the floor, as a general proposition. Furniture and Fixtures. — The items included under this account may consist of the usual tables, desks, filing cabinets, book cases, typewriters, safes, chairs, counters, and the more unusual items of plumbing fixtures, show windows, partitions, shelving, etc. The asset may be valued either on the basis of cost less estimated depreciation or on the inventory basis. In using the depreciation account in connection with the first method of valuation, one should remember that the asset usually has but small, if any, residual or scrap value; scrap value in some cases is the value the asset has as kindling wood. Where a depreciation rate is \ised by means of which to determine the value of this asset, the rate should be exceedingly liberal. When premises are leased and the terms of the lease require certain of the equipment to remain with the building after the lease expires, care must be observed to write off completely the items covered by the end of the lease period. On the whole, this account contains a value which is more or less inflated, to the end that the wide-awake analyst always will discount to a marked degree the value shown under this caption. Delivery Equipment. — This item includes all property, direct or auxiliary, used in connection with the delivery of goods both inward and outward. Horses, wagons, harness, motor trucks and cars, containers, etc., are familiar examples of this class of asset. In general, these assets are handled very much as are all the others of the equipment group. For the most part, valuation is STATEMENT ANALYSIS: FOR INVESTMENT PJJRPOSES 379 on the basis of cost less depreciation, but well may be by the application of the inventory method. Where horses comprise a portion of the equipment, not only must depreciation due to wear and tear be reckoned, but the possibilities of accident, such as death and disablement, must be given consideration. Experience in each business, based upon the particular kind of work to be performed, and the conditions under which it is being performed, furnishes the only adequate basis of valuation. Drawings, Models, Patterns, Etc.— Items such as patterns, lasts, molds, dies, drawings, electrotypes, wood cuts, forms, models, etc., comprising the last of the equipment assets to be considered, whenever possible, should be charged to the par- ticular job for which they were made and should not be carried on the Balance Sheet as an asset. Naturally, this is not often possible since these items frequently can be used for successive production. At best, however, they are a treacherous and highly speculative asset requiring the greatest of care in order not to be carried at an inflated value. Valuation should be on the basis of cost with a liberal de- preciation running, at times, to 50, or even a higher, per cent. Again, valuation may be on the inventory basis. In general, whatever the method of valuation, one cannot be too ruthless in scaling the given valuation down to the lowest possible point. Good-will.— This item often represents a baffling obstruction to the clear analysis of a corporate report in that it is merged upon the Balance Sheet repeatedly with the plant or property account. Arbitrarily, the intangible asset of good-will, repre- senting supposedly the capitalization of profits from business secured, may be carried upon the Balance Sheet at any amount whatever. In fact, such an account as "plant, good-will, etc.," usually may be considered as consisting mostly, if not entirely, of the good-will item. In general, a corporation having good- will of actual value, is not ashamed to set the account up for what it actually represents. Usually, good-will is considered an asset of diminishing value and, while examples might be given of many corporations whose good-will is constantly increasing, these same corporations prob- ably will be found to be the most industrious in washing the 380 ADVANCED ACCOUNTING i4 good-will account from their books. In other words, when a company needs its good-will asset the most in order to bolster up its Balance Sheet, it is probably worth nothing, and when it needs the asset the least, it is undoubtedly worth a con- siderable sum. Patents, Trademarks, Etc. — Honestly expressed, patents, trademarks, brands and rights are legitimately assets but, gen- erally, they are the tangible expression of an attempt to con- ceal the absence of assets of real value; they are too apt to represent an intangible something called ''good-will" or "water." The patents that are valuable are those known as basic patents, these covering an entire process or a large idea instead of a minor detail. When a patent, trademark, brand, or right is purchased by a corporation at a large but fair figure, the purchase price is the cost to be carried into the Balance Sheet under its true name, A patent is supposed to confer upon the patentee the exclusive right to make and sell the particular device described, but it does not undertake to stop infringement. Being issued for but seven» teen years, with a remote possibility of renewal, patents are essentially a wasting asset to be written down yearly to the point of extinction when the legal period has expired. However, there is a possibility existent that the benefits from a patent will not expire at the time set for the expiration of the theoretical exclusive right, since such right may create good-will which partially, at least, will offset the effect of the expiration of the patent. Trademarks, when purchased for cash value, properly may be set up as assets upon the books of account. But in the name of conservatism careful managers usually will wipe out gradually intangible asset values by annual charges against earnings. The intelligent investor is an advocate of principles of conservatism. Treasury Stock and Bonds. — These items should appear upon the Balance Sheet as deductions from their respective ac- counts of capital stock and bonds payable, thus reducing the gross amounts thereof to the point that they will indicate the amounts now issued and outstanding. Never should these items be considered as current assets or as investments. An advisable policy for an investor to follow is to inquire if STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 381 the treasury stock or bonds are being used as collateral; if so, such fact would give rise to the existence of a contingent liability. Investments.— Securities should be analyzed item by item to ascertain whether or not they are worth the value shown therefor upon the books. Securities held as permanent invest- ments properly may be carried at either original cost price or par, provided a reserve be set up to offset any reduction in value which may occur. Any appreciation in value had better not be booked, because a paper gain today may be a loss tomorrow; safety lies in listing assets at either cost or less. The securities of subsidiary and affiliated companies held by the parent company require cautious examination and valuation, because the possibilities of concealment and fraud between the books of the holding company and the books of the subsidiary are almost unlimited. The only satisfactory method of analysis would seem to lie in the examination of the separate reports of each subsidiary corporation as well as that of the parent company: 1. Examine the report of each subsidiary as carefully as though its securities were the ones primarily under scrutiny. 2. Analyze with equal care the report of the parent company. 3. Analyze a consolidated report of all the companies, includ- ing the parent corporation. Current Assets.— These assets, popularly called quick assets, are supposed to include only such as will soon become available' m cash for the purpose of meeting debts which will become due m an equally short period of time. Every current asset item is open to question until absolutely verified. Since this topic has been discussed at sufficient length in the previous chapter, as well as in the early part of this volume, it will not be dwelt upon further in the current one with the excep- tion of the next two topics below. Sinking and Other Special Funds.— Accumulations of profit set aside periodically to meet a fixed obligation maturing at a definite future date, as a bond issue, is a sinking fund. Such a fund, if in cash, accumulating in a corporation's treasury for a number of years, ofttimes is liable to prove to be a source of temptation to the officials. If kept at the disposal of the com- 382 ADVANCED ACCOUNTING pany during all the years intervening between the first payment into the fund and the maturity of the debt, more than one period of stringency and more than one time of unusual apparent specu* lative possibility will appear; then the cash in the fund may prove too great a temptation and its use be changed from its in- tended purpose. Payments into a sinking fund should be made to a trustee who shall act as an impartial custodian thereover; perhaps he will use the cash so paid in to purchase outstanding bonds in the open market, thereby reducing by this amount annually a portion of the outstanding debt. In any event, the sinking fund should represent cash, or securities purchased with the cash. If in cash, the location and guardianship should be known; if represented by securities, a schedule of the sinking fund assets should be available, with purchase and present market price. It is common practice for corporations to establish insurance funds for the protection of their property against fire and other dangers. When established, the fund should consist of cash or of marketable securities. If the latter, a Bchedule of their con^ tent should be available. Pension funds are set aside by some companies to provide pensions for employees who have grown old in service. As with other funds, the amount should be represented by cash or by marketable securities. Insurance and pension funds are not rightly considered blk free assets. They are offset in fact, if not on the books, by a probable loss in the case of the insm'ance fund and by a certain future liability in the case of the pension fund. The so-called sinking funds, some truly titled and some not, cannot be too carefully analyzed regardless of their nature ; they all involve, over a period of time, large sums of actual cash. Bonded Indebtedness. — The only fixed or capital liability relates to bonded indebtedness. Many of the best industrial corporations have outstanding bond issues, but, as a rule, if the outstanding issue is large, the investor should proceed with cau- tion; large bond issues often have proved disastrous to a promis- ing industrial company. From the standpoint of solvency, an industrial concern depends upon the form of its capitalization rather than upon its amount. Stockholders, even cumulative STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 383 preferred stockholders, may be pacified or grimly be told to wait until the strength of the treasury justifies a return; bond- holders will not wait. They demand their pound of flesh and become the source of control in case of reorganization. Careful attention should be given to the final date of maturity and, should such date occur during the current year, the com- pany's plans relative to the issue should be ascertained. Perhaps the issue will be refunded by the offering of another issue, by issuing short-time notes or debentures, or by issuing additional capital stock. Sometimes a bond issue contains a conversion clause which permits the conversion of the bonds into stock at definite periods. All such factors should be studied carefully with the end of determining satisfactorily the debt-paying abilitv of the company. Current Liabilities.--If current liabilities are larger than current assets, a floating debt exists instead of what one expects to find,— an excess of current assets over current liabilities repre- senting working capital. When a corporation is confronted with a floating debt, one may well adopt an attitude of skepticism toward It, on the possibility that a good investment proposition exiSuS. For further consideration of current liabilities, reference should be made to the previous chapter, and to the work in the earlier part of this volume, all of which have covered the topic suffi- ciently. ^ Capital Stock.— The investor should be thoroughly satisfied upon the following points with reference to the capital stock of the company m which he is interested: 1. Its authorized issue. 2. Its par value. 3. Amount of unissued stock in the treasury. 4. Dividend rate on preferred stock. 5. The cumulative feature of these dividends, and amount in arrears. 6. ':^he retirement provisions and requirements of the pre- ferred stock. If, in comparing the statements of successive years, the capital stock Item shows an increase, the analyst should determine whether this represents the securement of new funds or is merely • > i 384 ADVANCED ACCOUNTING the result of a stock dividend declared from surplus and undi- vided profits. The wording of stock certificates should be examined as care- fully as the contents of a deed. Every word must be essential. Preferred stock should be preferred as to earnings and, in case of dissolution, as to distribution of assets. If the dividends are not cumulative, such fact should be known. If any of the preferred dividends due in the past have not been paid, the possibility of payment is perhaps the most important consideration to keep in mind if a purchase of stock is contemplated. Some preferred stocks participate in all profits with the common stock by the terms of the certificate and, unless the return on the preferred stock is specifically limited, the preferred shares equally with the common after the preferred dividend has been paid in full. The book value of the common stock is a conventional measure in valuing securities. This is the theoretical value of the common stock as worked out from the Balance Sheet without any con- sideration being given to earning power. The liabilities, includ- ing the bonded debt and the preferred stock at par, are sub- tracted from the total asset fund, and the remainder divided by the number of common shares outstanding, gives the book value per share. The book value is exact only insofar as the accounts used are reliable and accurate. It is customar>% and generally only fair, to disregard intangible asset accounts as good-will in computing book value. The inclusion of such items destroys the helpfulness of the calculation. Changing the Capitalization Form. — If a large bond issue causes a burdensome drain upon a company's funds, a replace- ment of these bonds by common stock at a fair ratio of exchange is an act making for strength, in that necessary and periodic interest payments are turned into optional distributions of divi- dends. A favored method which is designed to increase the proportion of stock to bonds, as well as to attract the needed capital, is to issue convertible bonds. If a convertible 5 per cent debenture bond is purchased at 80 and may be converted into stock at par, and the stock advances from 65 to 120, for example, the price of the bond will keep company with that of the stock because, as soon as the stock is over 80, a bondholder can profit by STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 385 exchanging the bonds for stock. The purchaser of convertible bonds should read carefully the text of his security ; he may find that the attractive convertibility feature is qualified by an option of the company to retire these bonds at a limited figure. Reserves.— No cash or other special asset need be represented by the amount placed in a reserve account. A corporation may have a reserve for dividends in the amount of a million dollars and yet not be able to pay a dividend requiring only half that amount of cash. The cash may be low and yet the reserve be bona fide, its amount, from the asset side of the Balance Sheet, being diffused through the assets as a whole. Surplus.— Although a book or nominal surplus may be entirely bona fide, one should remember that financial strength depends more upon the amount of free working capital than upon anything else; seldom will surplus be available in cash assets because it does not necessarily represent anything defi- nitely tangible any more than does the ordinary reserve account. When the surplus item is shown- upon the Balance Sheet cor- rectly, it should be presented in two separate portions, so that one may not be misled into believing that non-operation surplus accumulations are operation surplus accumulations. Income Statement— Margin of Safety— Average Profits.— Earnings represent the final measure of progress in all commer- cial enterprises. The income statement shows the trend of a business during a specified period of time with the gain or loss resultant from the activities thereof. The Profit and Loss State- ment often is as lamentably incomplete as is the Balance Sheet, frequently being presented only in devitalized form. An income statement of the most promising appearance should be examined with an attitude of mind as skeptical as that of a "Down East" horse trader; but when it lacks definiteness and detail, it is al- most impossible of intelligent interpretation. Although a lack of standardization prevents what should be possible in the way of a comparison of income statements, it is true, in general, that they are more easily comprehended than are Balance Sheets. One should examine the Statement of Profit and Loss in connec- tion with the Balance Sheet pertaining thereto ; it is both supple- mentary and complementary to the Balance Sheet. Gross sales or earnings, representing total income from the 386 ADVANCED ACCOUNTING I regular corporate operations before considering and making de- ductions for costs or expenses, compared year by year, will indi- cate whether the volume of a business is improving satisfactorily from period to period, and whether the sales are consistent or subject to violent fluctuations; when used with other figures, it is of marked importance in determining the trend of actual profit. The net sales figure, too seldom available, may be a better measure to use than that of gross sales. The difference between gross sales and net sales in some lines is considerable, as where intercompany transactions and operations are involved; in such cases, it is obvious that the net sales figure is of such importance that, without it, certain valuable comparisons could not be made. The ratio of gross profits to net sales should be compared one year with another to see whether there is an increasing or a decreasing control over results. The ratio of net profits to net sales for different years should be calculated and compared. Special profits and losses should be separated from those due to normal operations, and not be consolidated therewith. The in- terest item hereunder should show separately the charges cover- ing short-time debt obligations, such as bank loans and accounts payable; if the Balance Sheet indicates a small amount of bank loans, while the income statement shows a large charge covering interest on short-time loans, it is probable that the company is- in arrears in its payments for goods, and is losing substantial interest to its trade creditors. This fact may be evidence of weakness requiring special attention. After the deductions from income have been taken care of, a corporation's income statement usually has several additional items in the nature of profit and loss charges and credits to absorb and set out. Finally, after all types of items have been considered, the profit or loss amount resulting must be trans- ferred to the Surplus account and, in turn, this final item must be reconciled with the Balance Sheet. The "margin of safety" test is useful not only in determining the strength of a corporation, but as a means of checking up other conclusions. The strength of a corporation may be esti- mated in a fair way by this test. The margin of safety is the proportion of net income remaining after all fixed charges have been paid. A company, for example, earning $10,000.00, and STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 387 having fixed charges amounting to $500.00, has left $9,500.00, or a margin of safety of 95 per cent; naturally, this concern is in a better condition than it would be if it had the same earnings and $9,500.00 fixed charges, leaving a margin of safety of only 5 per cent. No figure given out to appeal to investors is more common or more deceptive than that of ''average profits," say, for three, four, or five years. Net income for each of the years concerning which average profits are shown should be set forth if any dependence is to be placed upon the consistency of earning power. A business concerning which its management is not afraid to publish a report showing actual lean profits should be more attractive to the careful investor than the business publishing a statement containing only the always dubious mystery of "average profits." Illustrative Problem and Solution.— In order to illustrate the application of some of the principles mentioned in the present chapter, the following C. P. A. problem and a solution thereof are submitted: Problem.— John Adams, a capitalist, contemplates purchasing the stock of the American Grain Exporting Company, a corporation organized with a capital of $200,000.00, divided into 1,000 shares preferred stock and 1 000 shares common stock, par value $100.00 each, 6 per cent, dividends payable upon the preferred stock before any dividends are declared upon the common stock. This stock has been offered to Mr. Adams at $60.00 per share for the preferred and $40.00 per share for the common. You are requested to audit the books of the company and give your opinion as to the value of the stock. You find the foUowing accounts to be correct, covering a oeriod of one year. ^ ^*®^' $ 900.00 Accounts receivable:, Good,. Doubtful, Bad, Plant and machinery, Horses and wagons, ^Merchandise, inventory, Good -will, Furniture and fixtures, Expenses, Wages, X. Purchases, Claiins and rebates. Ordinary repairs, $15,000.00 4,000.00 6,000.00 $ 25,000.00 75,000.00 4,000.00 29,000.00 50,000.00 2,000.00 3,000.00 15,000.00 325,000.00 8,000.00 9,000.00 I i 388 Sales, Mortgage on plant, Accounts payable, Surplus, Capital stock, ADVANCED ACCOUNTING $260,400.00 25,000.00 42,(X)0.00 18,500.00 200, 000.00 $5 45,900.00 $545, 900.00 V Inventory submitted, $129,000.00 The company started business six years ago and built the plant and machinery and purchased the property pertaining to fixed capital. Write the report, commenting upon the advis- abiUty of the purchase and submit profit and loss statement and balance sheet, after closing the books. Solution. — The solution to the above problem is given in the following letter with attached statements: Mr. John Adams. Dear Sir: I have examined the accounts of the American Exporting Company, and the following is my opinion of the condition of this company and the value of its capital stock. Accounts Receivable. — No reserve for doubtful accounts seems to have been established. The amount of the bad debts is 24 per cent of the total accounts receivable, a percentage so large that it is apparent the bad debti represent the accumulation of more than one year's activities. I have charged off the entire $6,000.00 bad accounts, one-half of the $4.000 00 doubtful accounts, and I have set up a reserve for bad debts in the amount of $1,500.00, or 10 per cent of the good accounts receivable so* called. The accounts receivable should be examined again. Plant and Machinery. — No reserve for depreciation seems to have been set up against the plant and machinery. However, since the large repair item would seem to indicate that this asset is being maintained in good condition, I have set up a reserve for depreciation only in the amount of 5 per cent, calculated by the straight line method, equal to $22,500.00, of which $3,750.00 pertains to the current year. Horses and Wagons. — This asset should be revalued at once, especially since it is probable the units thereof were not all purchased when th« business was commenced; the setting up of a general reserve for deprecia* tion may not be sufficient. I have set up a reserve for depreciation on tht basis of 10 per cent, $2,400.00 in all, $400.00 pertaining to the current year. Merchandise Inventory. — This item should be examined very carefully, especially since the ending amount is so much larger than the amount on hand at the beginning of the year. It may be that everything here is in order and that the large amount of purchases will explain the increase. Good-will. — This item may or may not be correct; the chances are thai it is incorrect. It is impossible to pass upon this item from an examination of the figures presented; the revenue accounts for a period of at least five years past must be scrutinized. The item of surplus does not represent what the profits have been in the past, because no information is deducible therefrom as to how much of the past profits have been drawn out of the STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 389 business in the form of dividends; if it were known what dividends had been drawn out in the past, one would be able to secure some idea as to what the previous profits were. Furniture and Fixtures. — This asset should be revalued at once, since the setting up of a general reserve may not be sufficient. As in the case of the other fixed assets of a tangible nature, I have charged thereon an estimated amount to cover depreciation, on the basis of 10 per cent, $1,200.00 in all, $200.00 for the current year. Expenses.— Since the figures cover only one year, this item has been charged entirely against the profits of the current year. Wages. — See comments covering "expenses" above. Purchases. — See comments covering "expenses" above, with the ex- ception that, here, the amount has been adjusted in connection with the beginning and ending inventories. Claims and Rebates. — See comments covering "expenses" above. The item is rather large in amount in view of the fact that the figures cover one year only. I am inclined to believe that the seUing department re- quires overhauling in order to have the size of this item reduced in the future. Ordinary Repairs.— This item has been charged entirely against the profits of the current year. Sales.— The sales are too small considering the nominal capital of $200,000.00. The gross profit is only about 10.86 per cent on sales, a margin entirely too small upon which to work. Mortgage on Plant.— Nothing need be said here, because the criticisms presented above are sufficiently severe to cause the showing of a loss for the current year, and the showing of a deficit in the final balance sheet (see below). Accounts Payable.— The large size of this item may be due entirely to the large ending inventory on hand, but, as it stands, it is out of proportion to the good accounts receivable. Capital Stock.— The entire authorized issue of both the preferred and common stock has been spread upon the books. No information is given as to whether or not all the dividends on preferred stock have been paid. Such information would be valuable only from the standpoint of determin- ing what is the earning power of the corporation. Even if the preferred dividends are in arrears to a certain extent, such fact would not aflfect the existing liabiUties inasmuch as you contemplate purchasing all the stock of the company. Below are attached the following statements which I have prepared from the facts given me plus my criticisms above made: 1. Exhibit A— Balance Sheet. 2. Exhibit B— Profit and Loss Statement. 3. Exhibit C— Surplus Account, adjusted for the six years. Although the reserves set up are exceedingly reasonable m amount, the current year shows a loss of $6,783.33, and the balance sheet a deficit of $16,700.00 The tangible assets, at the figures given, are worth $200,300.00, i; 390 ADVANCED ACCOUNTING but there against are liabilities of $67,000.00. which leaves a net worth of $133,300.00. If you propose to purchase this company in order to liquidate it, the proposition would be a good speculation at the price asked, $100,000 00 provided you could realize therefrom an amount somewhere near the net worth shown just above. If you propose to purchase this company in order to develop its business proceed cautiously. Upon the facts presented, I cannot, rightly, eetimat^ the real value of the stock. Should circumstances indicate that, under your direction, the business can be extended favorably, the price asked $100,000.00, being considerably less than the apparent amount of net assets, would be a point in favor of making the purchase. The above represents my opinion in the light of the facts as I have found them. It IS impossible for me to be any more definite than I have been unless a further examination and investigation be made. Respectfully submitted, John Doe, C. P. A. BALANCE SHEET Current Assets: Cash, Accounts Receivable, Less: Reserve for Bad Debts, Inventory, Fixed Assets : Plant and Machinery, Less: Reserve for Depreciation, Horses and Wagons, Less: Reserve for Depreciation, Furniture and Fixtures, Total Tangible Assets, Good- will, Deficit, December 31 , 19^ Assets and Deficit •17,000.00 1,500.00 Ex hibit A t 900.00 15,600.00 129,000.00 $145,400.00 $75,000.00 22,500.00 $52,500.00 $4,000.00 2,400.00 1,600.00 800.00 54,900.00 Current Liabilities : Accounts Payable, Fixed Liabilities : Mortgage Payable, Total Liabilities, Capital Stock : Preferred, Common, Liabilities and Capital Stock $100,000.00 100,000.00 $200,300.00 50,000.00 16.700.00 $267,000.00 $ 42,000.00 25,000.00 $ 67,000.00 200, 000.00 $267,00000 STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 391 PROFIT AND LOSS STATEMENT Year Ended December 31. 19 — Gross Sales, Less: Claims and Rebates, Net Sales, Deduct: Cost of Sales : Inventory, January 1, 19 — , Purchases, Total Goods Handled, Inventory, December 31, 19 — , Gross Profit, Deduct : Sundry Expense^: Expenses, Wages, Repairs, Depreciation: Plant and Machinery, Horses and Wagons, Furniture and Fixtures, Bad Debts (1/6 of $6,000.00), Doubtful Accounts (1/6 of $2,000.00), Reserve for Bad Debts, Net Loss for Year, Surplus Account Balance, January 1, 19 — , Deduct: $ 29,000.00 325,00000 $354,000.00 129,000.00 3,000.00 15,000 00 9,000.00 3,750.00 400.00 200.00 1,000 00 333 33 1,500 00 Debit Adjustments: Loss — Current Year, Depreciation: Plant and Machinery (five years), Horses and Wagons (five years). Furniture and Fixtures (five year«) Bad Debts, Doubtful Accounts Receivable (five years), Deficit, December 31, 19—, $ 6,783.33 18,750.00 2,000.00 1,000.00 5,000.00 1,666.67 Exhibit B $260,400.00 8,00000 $252,400.00 225,00000 $27,400.00 34,183 33 $ 6.783 .33 Exhibit C $18,500.00 35,200 00 $16,700 00 Statement Of Resources and Their Application.-At the close of the last chapter, the Comparative Balance Sheet was mentioned; the statement to be considered in the present section apparently is a logical outgrowth of the Comparative Balance bheet, being designed to present to better advantage than is pos- 392 ADVANCED ACCOUNTING .'/ sible by means of the Comparative Balance Sheet itself the information thereon available. This statement is known by more than one name, among which are: 1. Statement of Application of Funds. 2. Statement of Fund Application. 3. Statement of Application of Resources. 4. Statement of Resources and Their Application. To the writer, the latter two titles more aptly reflect the con* tent of such a statement than any one in which the word **fund" is used. This type of statement has been used by some accountants for a number of years, but only recently has it come into more or less general use. It is apt to become even more popular, however, as time passes, when the professional accountant has reached a point, as some have, at which he realizes that there is more to his work than merely to prepare exhibits of what has been done and what are present conditions. Briefly, the advantages of such a statement would be about as follows: 1. It shows whether or not the correct rate of expenditures is being maintained as between the current and the fixed assets. 2. It shows whether working capital has been increased or decreased. 3. It shows whether diflficulty in meeting maturing obligations is due to financial weaknesfe or to the injudicious use of resources by means of which fixed capital is being increased at the expense of working capital. 4. It shows what has become of profits earned. From the angle of this statement, changes in the financial condition of a business during a specified period of time are said to be due to two things: 1. Profits, — and dividends or drawings. 2. Sale of stocks and bonds. Again, if the change in the financial status of an enterprise be analyzed properly, the analysis made should show: 1. The sources from which the assets haw been increased dur- ing the period. 2. The application of new resources secured to: STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 393 a. Payment of dividends. b. Increases in assets. c. Decreases in liabilities. Only by means of the Statement of Resources and Their Application is the above information made readily available. And, in accord with the above, this statement, however prepared, is divided into two portions or sections: 1. In one are shown the resources provided during the period from the various sources available. 2. In the other the disposal made of these additional resources is set out. Naturally, when prepared correctly, one section will balance against the other. The statement in no way is similar to that of a statement of cash receipts and disbursements, because items may be included therem which have not been received in cash and which have not been paid in cash. For example, if a person has $500.00 on deposit m a bank, he has an asset, a usable resource. If he takes $300.00 of this amount and purchases a small automobile he is changmg merely the form of a portion of the original asset held so that, for this portion, he has an asset of a different nature- his total accumulation of assets has not changed. On the other hand, instead of changing the form of a portion of his cash asset this person might purchase his car upon his promise to pay for It some time in the future; by so doing, his accumulation of assets has increased over the total held in the beginning this being caused by the use or consmnption of a certain amoi^t of his credit. To reacquire this credit, he must consume eventually a portion of his cash resources, but such consumption does not take place at the present moment; there is here the receipt of an Item not paid for in cash. Again, bonds may be issued for properties; these represent asset sources though the resources are not m the form of cash, but in the form of fixed assets Illustrative Problem and Solution.^The better to show the application of the theory with which the student is confronted at the present moment, the following simple problem is given with certain variations in method of solution which attempt to set out the steps, if they may be called such, lying in between a 394 ADVANCED ACCOUNTING simple form of statement and the form that apparently is the generally accepted or preferred presentation. Problem. — A comparative balance sheet of a certain enterprise at Decem- ber 31, 1919, and December 31, 1920. is Riven below. Upon the basis thereof, interpret the changes that have taken place in the financial position of the company between the two dates and, so far as possible, indicate how they were effected. BLANK MANUFACTURING COMPANY Comparative Ba lance Sheet December 31, 1919 and 1920 December 31 Increase Decrease Assets 1920 1919 Real estate, $ 52,000.00 $ 50,000.00 Plant and machinery, 85 , 000 . 00 85 , 000 . 00 Horses and wagons, 1 5 , 000 . 00 Patents and good-will, 20,500.00 I 2,000.00 Inventory, Accounts Reed., Cash in bank, Agency investment, 65,000.00 33,000.00 21,150.00 15.000.00 15,000.00 20,500.00 49,000.00 35,000.00 22,000.00 16,000.00 15,000.00 2.000 00 850.00 Net assets. $306,650.00 $276,500 00 $33,000.00 $ 2,850.00 mcrease m December 31 $33, 000 00 Increase 30 ,150 00 $3 3.000.00 Decrease Liabilities and Capital Capital stock, Creditors, Bills payable. Mortgage, Reserves for Depr. : Plant and machinery. Horses and wagons, Surplus available, 1920 1919 $200,000.00 $200,000.00 17,000.00 16,000.00 30,000.00 25,000.00 8,500.00 2,250 00 53,900.00 30,500.00 $ 1,000.00 25,000.00 8,500.00 2,250.00 23,400.00 $30,000.00 $306.650.00 $276,50000 $60,150.00 $30,000.00 30,150.00 Net increase in li- abilities and capital, $60,150.00 $60ri 50700 General Solution Comments.— The Comparative Balance Sheet exhibits the increases and decreases of the present period over the past period relative to the financial condition as of the end of the present period as compared with that as of the end of the past period. These changes which STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 395 have taken place in the financial condition of a business during a specified period of time are expressed upon the Comparative Balance Sheet about as follows: 1. Factors contributing to wealth increase: a. Asset increases. b. Liability (and capital) decreases. 2. Factors contributing to wealth decreases: a. Asset decreases. b. Liability (and capital) increases. Upon the basis of the above, a simple statement of summaries could be prepared, which is similar, in part, to the Statement of Profit Determination under smgle entry, as under: Increase in a^ets, $33 , 000 . 00 Add: Decrease in liabilities, 30 qqq qo Deduct: Decrease in assets. Add: Increase in liabilities. Net profit transferred to surplus, $ 2,850.00 36,750.00 $63,000 00 39,600 00 $23.400 00 The above simple statement is useless from an informational viewpoint- it does not set out specifically what has become of the profits earned plu^ what has happened to the resources on hand at the beginning of the period Smce a statement is desired which will be of more informational value than the above, one turns to the Statement of Resources and Their Appli- cation as a satisfactory solution of the problem. Three possible types of this statement will be considered, the development thereof proceeding from what may be considered not only an elementary form but one unintelligible to the average mdividual, into the second type that is somewhat better andending with the kind that, beyond doubt, should represent the accepted First Solution.— In form, the first type of statement is as simple to prepare as the anthmetical summary presented just above. It is arranged in account form, the increase in assets plus the decrease in liabiUties offsetting the decrease in assets plus the increase in Uabilities. The adjustment of capital depends upon whether an increase or decrease is noticed The figures thereof come from the increase and decrease columns of the Com- parative Balance Sheet; the latter is the basis for preparing any type of this statement. The first form of the Statement of Resources and Their Application is shown below: BLANK MANUFACTURING COMPANY Statement of Resources and T heir Application During Year Ended Decemb er 31. 1920 Resources: Decrease in Assets (Consumption) Those of Prior Period: Application of Resourc es: Increase in Assets: .Accounts Rec., $2 , 000 . 00 Real Estate, Cash, 850.00 $2,850,000 Merchandise, Those of Pri or Period : S2.000.00 16,000.00 $18,000.00 \ t i 396 ADVANCED ACCOUNTING Increase in Liabi l ities : (Credit Consu med) ; Those of Prior Period: Accounts Payable, $1 , 000 . 00 New Liabilities ; Mortgage Pay., «25,000.00 Reinvestment of Prio r Period Profit : Reserves, $10,750.00 Siirplus, 23,400.00 34,150.00 New Assets : Agency In- vestment, $15,000.00 $33,000.00 Dec rease in Liabilities: Those of P rior Period : Bills Payable, $30,000.00 60,150.00 $63,000.00 $63,000.00 Second Solution. — The second form of statement shown below requires but scant explanation. Note how its arrangement is practically the running form of the statement shown above in the first solution, except for the allocation of the current asset items. The student should study the first form of statement, tracing its development from the summary arith- metical expedient already criticized, and then compare its composition and technique of construction with the second form below. The arrangement of the second statement is more to be desired than that of the first type since therein a separation is made between the current and the fixed assets the better to calculate the increase or decrease in working capital, and because its form is understood more readily than the one submitted under the first solution. BLANK MANUFACTURING COMPANY Statement of Resources and Their Application During Year E nded December 31, 1920 Resources Provided : Increase in Liabilities: (1) Those of Prior Period: Accounts Payable, (2) New Liabilities: Mortgage Payable, (3) Reinvestment of Prior Period Profit: Appropriated for Reserves, Transferred to Surplus, Resources Appl ied: Increase in Fixed Assets: (1) Those of Prior Period: Real Estate, (2) New Assets: Agency Investment, $ 1,000.00 25,000.00 $10,750.00 23,40000 34.1 50.00 $60,150.00 $ 2,000.00 15,000.00 $17,000.00 STATEMENT ANALYSIS: FOR INVESTMENT PURPOSES 397 Decrease in Liabilities : (1) Those of Prior Period: Bills Payable, Increase (Net) in Current Assets : (1) Those of Prior Period: Merchandise, Deduct (Decreases): Accounts Receivable, Cash, 30,000 00 $16,000 00 $2,000.00 850.00 2,85000 13,15000 $60,150 00 Third Solution.— In compiling the third type or form of this statement, one commences with the resources which have been provided by the profits of the Deriod under review. Then the reserve provisions for the year must be written back, i.e., added to the net profit. If a business has made a gross profit of $5,000.00, and has expenses of $3,000.00 (excluding deprecia- tion), the profit has provided $2,000.00 in new resources, although the net profit would be much less. In fact, all mere book entries of like character must be written back; however, items Uke discount on stock and bonds, organization expense, and prepaid interest and insurance which are on the books, being carried as deferred charges (current assets), do not affect the cash or available resources. Prepaid interest, prepaid insurance, and prepaid rent are related to cash and available resources because they are concerned with working capital. An increase in a fixed liabUity upon the Comparative Balance Sheet represents resources provided, whereas, an increase in a current liability does not do so; changes in the current Uabilities only affect working capital. When a net decrease is noted in working capital and in deferred charges, such net decrease represents resources provided. If a loss shows up after the reserves are adjusted, this should be placed aa a deduction from resources provided. The statement prepared in accord with the theory of the third solution is shown below, being accompanied by a supporting exhibit prepared to show the increase or decrease in working capital. The third solution by far presents the accepted form for a Statement of Resources and Their AppU- cation. BLANK MANUFACTURING COMPANY Statement of Resources and Their Application During Year Ended December 31, 19 20 Resources Provided: 1. Surplus net profits for year ended December 31, 1920, as per Statement of Profit and Loss, ' $23 400 00 2. Provision for reserve, 10;750:00 6. Mortgage payable, 25 000 00 Total resources provided, $59,150.00 I' 398 ADVANCED ACCOUNTING W hich Were Applied in the Following Ma nner : 1. Expenditures for real estate, 2. Investment in or advance to agency, 3. Increase (net) in working capital, as summari^sed below, $ 2,000.00 15,000.00 42,1 6000 $59,160 00 Assets: Sum mary of Worki ng Capital December 31 Increase 1920 1919 Dec rease $ 2,000.00 86000 $119.150.00 $106,000.00 $16,000.00 $ 2,860.00 13,1 5000 $16,00000 $16,000.00 Inventory, $ 65,000 00 $ 49,000.00 $16,000.00 Accounts Receivable, 33 , 000 .00 35 , 000 . 00 Cash in Bank, _21 , 150 . 00 22 , 000 . 00 $1 Net Increase, LiabiHties: Creditors, Bills Payable, $17,000.00 $16,000.00 $1,000.00 30,000.00 $30,000.00 Net Decrease, $17,00000 $4 6,00000 $ 1,000.00 29,000.00 $30,000.00 $30,000 00 $30,000 00 Net Working Capital , $102,150 00 $60.000 00 $42,150 00 Net Increase in Working Capital (as above) $42,150 00 CHAPTER XII MERGERS VERSUS CONSOLIDATIONS Corporate Combinations.-At the present time, corporate combinations are met with everywhere, but especially in the industrial, transportation, and public utility fields. Competition among business enterprises of the same type is said to be an Ideal theoretical economic condition, because thereunder no one concern can raise prices to an unreasonable degree; if any one company attempted to do so, others of a similar type would lurnish the same goods at a reasonable price. This point of view, however, relates solely to the purchaser, omitting the producer entirely. Although the purchaser may be protected by circumscribing the producer in the manner indi- cated, at the same time the latter may be made to suffer in an unwarranted manner,-as where the supply of a certain product exceeds the demand therefor. Under this condition, some con- cerns will be unable to dispose of their products at normal prices- hence prices will drop to a lower level, and this lowered rate will attach Itself to all concerns making that same line of product bmce prices at this lower level cannot produce a reasonable profit' certain concerns within the particular group must suffer actual loss, whereas others will fail completely. Only after a sufficient number of concerns have failed to the end that normal conditions again are m order can the suffering survivors increase prices so as to eliminate the continuance of taking a loss When prices reach the old level, all would be well, provided they are kept there. However, in order to recuperate from the former losses, these survivors are apt to make prices soar. Nat- urally new competition is invited, with the result that sooner or later the bottom again drops out and another period of depression IS m lull swing. This upward and downward trend of prosperity needed some sort of control. The first step toward the accomplishment of 399 i I i 400 ADVANCED ACCOUNTING this end was an attempt to have competitors become parties to an agreement: 1. The so-called "gentlemen ^s agreement," under which terri- tory was divided, output restricted, or prices maintained in a uniform manner. 2. The pooling of interests looking toward a pro rata distri- bution of profits among the members of the pool. Although the basic idea here apparently was laudable, unfortunately it was carried so far that prices were increased unreasonably as before. More or less public hostility developed toward such combina- tions to the end that the Sherman Anti-Trust Law was enacted. This law looked toward: 1. The regulation of prices, and 2. The prevention of monopoly. However, the act, apparently, took no notice of the fact that unless a monopoly: 1. Controlled the sources of its raw material supply, or 2. Was a natural monopoly, it would invite competition. The field within which combinations may be formed and their formation have been limited to a marked degree through the effectiveness of both the above act and other laws designed to prohibit or control business combinations which supposedly were not operated in harmony with the public welfare. Nevertheless, since so many advantages accrue to a combination of business interests, and since many types of corporate combinations do exist at present, and will come into existence in the future, the present topic should be of considerable interest to the prospective accountant. And this seems true even though some business combinations have been declared as violating the anti-trust laws, and even though it is questionable whether or not certain others are operating contrary to these laws. Advantages of Corporate Combination. — The simplest form of combination represents the formation of a partnership by two competing sole traders. However, when an accountant refers to a combination of business interests it is unusual for him to think of anything except a combination of corporations. The advantages of practically all combinations, small or large, may be set out about as follows: MERGERS VERSUS CONSOLIDATIONS 401 1. The elimination of competition and the securement of larger profits through securing a partial monopoly and keeping sales prices at a higher level. 2. Economies looking toward expense elimination: a. Two concerns operated separately must each have a sepa- rate selling and administrative organization. When these two concerns combine in some way, it may be possible to eliminate the entire selling and administrative organi- zation of one unit. b. Each unit in the combination may be enabled to special- ize, to the end that it can confine itself to the product it can make best or most economically. This tends to give the public more satisfactory service than otherwise would be the case, at the same time eliminating dupli- cation in manufacturing and equipment. c. When specialization in product results, the opportunity may present itself to use expensive and highly specialized machinery more constantly ; this prevents such machinery possibly lying idle part of the time, thereby causing a loss. d. The combination will not require as much working capi- tal as the amount necessary were each unit operating separately. The stock of finished goods carried by sizes and pattern numbers will be much less in a combination than where each unit operates separately. e. Improved marketing facilities. The field of operation where companies function separately is much more limited than where the separate units are combined. The combination has a broader view of the field and better ability to judge of possible demand than each unit would have if operating separately. f. Business managers, through combination, secure greater facilities for dealing with labor than where no combina- tion exists. g. Through combination, the best brains and experience in each of the combined plants is made available for deal- ing with the problems confronting each plant unit. Like- wise, if necessary, the combination can go out and hire the best men obtainable, since the cost thereof will not I 402 ADVANCED ACCOUNTING have to be borne directly by any one company; it will be distributed over all the units combined, h. Better use of by-products. 3. Better facilities will be at hand for borrowing and obtaining additional capital. Combination Methods. — The various ways by means of which corporate combinations may be created are about as follows : 1. Those of scant accounting importance. a. Gentlemen's agreements. In the majority of states, until near the end of last century, it was illegal for one corporation to hold stock in another corporation with the end in view of thereby controlling its activities and operations. Because of such illegality, certain expedients were attempted to circumvent the intent of the law. The first known step in this direction was an attempt to secure a combination of companies through a mutual agreement of those persons interested in the welfare of the separate units. This method of combination has nothing of accounting interest, inasmuch as the indi- vidual units or their accounting were not affected. b. Pooling agreements. The next step in the direction of combination was known as the ^^pool." This, also, was a form of association based upon a mutual or gentlemen's agreement. Its object, in general, was to stabilize prices either by restricting output or by dividing the selling territories. This type of combination worked nicely when times were good, but when hard times approached the combination broke down; when most needed as a means of securing cooperation, it became unworkable and dissolution thereof followed. This method of combina- tion has nothing of accounting interest, since the indi- vidual units or their accounting are not affected. c. Interlocking directorates. The next step in the develop- ment of corporate combinations looked toward a more stable form of administration than that indicated above, with the result that the trust form of organization came into existence. In the beginning, this method of combi- nation took the form of a managing board of trustees. \ MERGERS VERSUS CONSOLIDATIONS 403 The companies in the combination deposited their capital stocks with these trustees and received trust certificates in exchange. Eventually, even though this form of com- bination proved greatly superior to the pooling form, court decisions caused these trusts to be dissolved. As an outgrowth of the trust idea, that of the interlocking directorates came into being. Hereunder, stockholders in two or more of the combining companies either had themselves or trusted employees elected as members of the board of directors of all the companies. To all in- tents and purposes, each company is separate and inde- pendent from each of the others, whereas in fact their management practically may be one and the same. Again, neither each individual company nor their ac- counting is affected by this method of combination, d. Lease of property. Sometimes leases are used as a com- bmation means. Inasmuch as the subject of leases has been discussed sufficiently in previous chapters, nothing further need be considered at this point. 2. Those of considerable accounting importance. In brief these combination methods may be set out about as under:' a. Mergers. b. Consolidations (when of considerable size, sometimes called amalgamations). c. Parent companies. d. Holding companies. In view of the fact that these latter four methods com- prise the remaining discussion of the present chapter and that of the next one, nothing further need be mentioned in respect thereof at the present moment. Merger Versus Consolidation— General.— Popularly the terms combination, merger, consolidation, trust, and holding company refer to one and the same thing. In fact, relatively few business men are able to distinguish clearly between these terms. Again, laws are not uniform even in this regard- in New Jersey for example, the term "merger" practically is synonymous with consolidation," whereas in New York a clear-cut distinc- tion IS made between the two. Because of this lack of uniformity 1 U I i 404 ADVANCED ACCOUNTING which borders upon confusion, the accounting problems often presented in the various C. P. A. examinations are in no way in agreement as to the terms used. If a problem is picked which states that it relates to a merger, the chances are that it really concerns a consolidation of interests, so far as the actual account- ing involved is concerned. Basically, from an accounting point of view, which, in general, is in accord with that held in legal and financial circles, a merger takes place when an eodsting corporation buys or takes over the assets and business of one or more other companies, the latter completely merging their identity into that of the vendee cor- poration. In other words, in a merger one or more concerns is absorbed by an existing company. On the other hand, when a new corporation is formed to take over the assets and business of one or more concerns, the identities of the vendor company or companies being lost or fused in that of the new vendee corporation, a consolidation takes place. In the case of a merger, the absorbing company already is an existing entity, whereas in the case of a consolidation the absorb- ing company first must be chartered before the combination can be consummated. In both instances, however, physical proper- ties primarily are dealt with and it seems to be that, because of this fact, a confusion is apt to result in that the two ofttimes are referred to under the caption of "merger." This ought not to be the case, inasmuch as, from an accounting viewpoint, each will require a different set of accounts, either at the inception of the organization or continuously thereafter. But in eitlier event, the new organization acquires the net assets of all the others which, thereafter, are dissolved. In certain accounting texts, a distinction is made at variance with the above, about as follows: 1. Combination by purchase. This corresponds practically to that covered above by the term ''merger." 2. Merger. This corresponds to that covered above by the term "consolidation." The use of the method by consolidation is not mentioned. The writer believes, however, that the distinctions indicated in the first portion of the present section are those to be followed in accord with the correctness of the termn used. MERGERS VERSUS CONSOLIDATIONS 405 Merger Versus Consolidation— New York.— Under the Stock Corporation Law of New York, section 58, the merging of stock corporations is permitted. This section reads about as follows: Any corporation lawfully owning all of the stock of any other cor- poration organized for and engaged in business similar or incidental to that of the possessor corporation may merge such other corporation with It and be possessed of all estate, property, rights, privileges and franchises of such other corporation. In the case of a merger, it is seen that all of the stock of the subsidiary company must be owned by the possessor company. In other words, there must exist a cross ownership of stock before a merger may be consummated. This cross ownership of stock is further emphasized by the fact that to effect such a merger, the possessor corporation must file in the office of the Secretary of State, under its common seal, a certificate of such ownership. On the other hand, a consolidation is seen to differ from a merger in that: Any two, or more, corporations organized for the purpose of carry- ing on any kind of business of the same or similar nature which a corporation organized under the Business Corporations Law might carry on, may consolidate into a single corporation. Therefore, in case of a consolidation, no cross ownership of stock is necessary. These requirements under the laws of New York do not differ materially from those presented under the general consideration of mergers and consolidations: 1. Merger. a. Similarity. An existing corporation is to be the absorb- ing company. b. Dissimilarity. In general, so long as an existing concern becomes the absorbing element, the cross ownership of stock is immaterial ; in New York, a cross ownership of stock is vitally important, under the law. No merger can be consummated without such cross ownership of stock. 406 ADVANCED ACCOUNTING 2. Consolidation. a. Similarity. A new corporation is to be the absorbing company. b. Dissimilarity. None. The precaution to observe in each particular instance should be in conformity to what has been indicated above. Mere words or terms used should not be taken for face value. Illustrative Merger Problem— General.— Problem. — The Successful Mining Company has made an agreement to purchase the assets of another company, subject to the lialnhties, for $1,000,000.00, not including the cash asset. Payment is to be made: cash, one-half; stock, one-half. Par value of the stock is $100.00. The balance sheet of the vendor company is as follows: Assets Cash, Accounts receivable, Ore on dump, Mine, $ 347.60 14,200.25 6,807.00 700,428.00 $720,782.85 Bank loans, Accounts payable. Capital, Surplus, Liabilities $ 32,500.00 28,370.40 600,000.00 159,912.45 $720,782.85 The vendee corporation neither has the cash nor the unissued capital stock with which to pay for the properties. It has apphed, therefore, for authority, and has received authority, to increase its capital stock to the requisite amount needed for this purpose. Further, the needed amount has been sold at par. Required : 1. Entries on books of the vendor company. 2. Entries on books of the Successful Mining Company. Solution. — There is here, apparently, a clear case of merger, as generally understood if interpreted in the light of the previous discussion. However, if one looks at a merger as involving "an entirely new company, the latter requiring a new charter to be issued to it," as some believe, this problem, beyond doubt, would fall under the grouping of "a combination by simple purchase." In fact, in accord with the manner in which the present subject has been developed, a merger and a purchase practically are the same, unless the New York law be applied. The accounting entries for a merger depend upon which set o( books is under scrutiny. In this particular case, it is necessary to be concerned MERGERS VERSUS CONSOLIDATIONS 407 $720,435.25 first with those of the vendee company. As to the vendor company, one is interested in the closing entries required. These do not differ materially from those which have been shown covering the sale of a partnership business to a corporation. Entries on the books of the vendor company. The first entry relates to charging the Successful Mining Company with the assets turned over to it: Successful Mining Company, To — Accounts Receivable, Ore on Dump, Mine, To record transfer of above assets (state date) to above company, in accord with contract of purchase and sale, and resolution of stock- holders, minute book, p. The second entry relates to the transfer of the liabilities of the vendor company to the Successful Mining Company. This requirement conforms to the usual agreement entered into in case of a merger: ; 14,200 25 5,807 00 700,428.00 $32,500.00 28,370.40 $60,870.40 Bank Loans, Accounts Payable, To — Successful Mining Company, To record assumption of payment of above liabilities on part of the above company, as part payment for the assets already set out above; being in accord with contract of purchase and sale, and resolution of stockholders, minute book, p. . The next step relates to a reconciliation of the purchase price with the actual recorded net value of the properties and assets taken over. The net value booked, as above, is $659,564.85. The purchase price agreed upon is $1,000,000.00. The difference between these two values is $340,- 435.15, representing excess of purchase price over net values as carried. This difference must be brought upon the books by an appropriate entry. In this connection it would be proper, beyond doubt, to open a Good-will account (good- will in relation to consohdations will be discussed later), but since this is a mining company it would seem to be more logical to consider that the Successful Mining Company values the mine being taken over at the difference between the net value of all the other assets acquired and the $1,000,000.00 given for the property as a whole: Successful Mining Company, $340 , 435 . 15 To— Surplus, $340,435.15 The booking could be made by means of two entries, if desu-ed, rather than the above one, as follows: first, a charge to the Mine account and a credit to Surplus account; second, a charge to the vendee company and a 40S ADVANCED ACCOUNTING credit to the Mine account. The labor thereiinder seems somewhat un- necessary, and the entry as indicated is suflBcient so long as care is taken to make the explanation thereof entirely intelligible. The account with the Successful Mining Company on the books of the vendor concern now contains a debit balance of $1,000,000.(K). This account will be cancelled when the stock and the cash are received. The transaction then is closed. 1500,000.00 600,000.00 $1,000,000.00 Successful Mining Company Stock, Cash, To — Successful Mining Company, To record receipt of 5,000 shares of the stock of the Successful Mining Company plus cash in final payment for all the assets of this company as per contract of purchase and sale and stock- holders' resolution, minute book, p. . As a final step, the books of the vendor company must be closed out. When the above entries have been made, a trial balance of the vendor's books will be as follows: Cash, Successful Mining Company Stock, Capital Stock, Surplus, I 500,347.60 500,000.00 $ 600,000.00 500,347.60 $1,000,347.60 $1,000,347.60 Therefore, an entry must be made closing the accounts as above shown, because the stockholders will receive the stock of the Successful Mining Company plus the cash on hand. Entries on the books of the vendee company. Before the Successful Mining Company can carry through this deal, it must acquire the necessary stock and cash with which to do so. Therefore, as soon as the necessary authority has been secured for increasing its capital stock, an entry would be made about as follows : Subscriptions to Capital Stock, To— Capital Stock, To record subscriptions to the 10,000 shares of the capital stock of this company, in accord with minutes of stock- holders' meeting, minute book, p. , and per articles. This entry is the first one made, on the assumption that subscrip- tions were received prior to date of booking same. $1,000,000.00 $1,000,000.00 MERGERS VERSUS CONSOLIDATIONS 409 The next entry relates to the receipt of cash from subscriptions: ^^' c, u . . $500,000.00 lo— Subscriptions to Capital Stock, jgQO 000 00 To record cash received in full pay- ment for 5,000 shares of this com- pany. When this cash is received, the deal may be carried through at once Ihe next entry covers the recording of the purchase made: Accounts Receivable, Ore on Dump, Mine, To — Bank Loans, Accounts Payable, Vendor Account, To record purchase from Vendor Company of the above assets subject to the above liabilities for a consideration of $1,000- 000.00, as per contract dated , and minutes of stock- ^ 14,200.25 5,807.00 1,040,863.15 t 32,500.00 28,370.40 1,000,000.00 holders, p. As indicated already, it is assumed the mine was valued at the difference reil«:et\h^^u;:^r ""^ '°*'" "'^^^^ *" '""•■"'^ *« "''"■"^ VendorAccount, »1, 000,000 00 — Cash, SubscripUons to Capital Stock, SOoioOO^OO fhfM''^ '"*"^ given above for the books of the vendee, it is flsumed hat the new assets and new liabilities taken over merely hive been add^ to those already on the books. Often, however, it is desirable to carry separate accounts for the assete taken over in order that thereby the succes*^ from those of the old enterprise. The same reason, naturally, is not so mportant as concerns the habilities although, at times some sp^iJitem Tr Items should be treated separately. Illustrative Merger Problem-New York.-In order to Illustrate the method of a merger as applied to a problem in accord with the laws of New York, the following A. I. A. problem IS used and a solution presented. It is a most excellent problem Illustrative o the principles set out above; the solution presented IS not official m any way, being merely the writer's interpre- tation. ^ 410 ADVANCED ACCOUNTING MERGERS VERSUS CONSOLIDATIONS b Problem. — The following items appear on the balance sheet of the Ameri- can Pin Company, June 30, 1912: land, buildings, equipment, etc., $335,000.00; capital stock of the Bronx Pin Ticket Company, par, $50,000.00; cost, $57,400.00; patents, $15,000.00; working and trading assets, $37,500.00; cash, $10,000.00; accounts receivable, $32,000.00; due from Bronx Pin Ticket Company, $375.82; deferred assets, $1,500.00; first- mortgage 6 per cent, gold bonds payable, dut^ 1922, $100,000.00; taxes accrued, $3,250.00; salaries and wages accrued, $4,327.82; accounts payable, $123,749.83; notes payable and interest, $80,125.00; interest accrued on first mortgage bonds payable, $2,500.00; reserve for depreciationjof building and equipment, $35,000.00; preferred capital stock outstanding, $75,000.00; common capital stock outstanding, $50,000.00; profit and loss surplus, $14,823.17. The American Pin Company having acquired all the capital stock of the Bronx Pin Ticket Company, the balance sheet of which appears below, it is proposed to merge the two companies as of July 1, 1912: Assets — ^Land, buildings, and equipment, etc., $260,000.00; capital stock of the Blauser Pin Tray Company carried at par, $3^,000.00; patents, $22,625.00; working and trading assets, $10,000.00; cash, $10,366.27; ac- counts receivable, $37,943.86; sinking fund, $3,236.92; deferred charges to expense, $1,200.00. Liabilities and capital — First mortgage 5 per cent, gold bonds paya))le, due 1925, $50,000.00; taxes accrued, $2,750.00; salaries and wages ac- crued, $3,147.83; due to creditors, $144,720.30; due to American Pin Company, $375.82; notes payable and interest, $31,372.53; interest accrued on first mortgage bonds payable, $1,250.00; reserve for depreciation of plant and equipment, $27,500.00; common capital stock outstandingi $50,000 00; profit and loss surplus, $69,254.57. Prepare: (a) The entries on the books of the American Pin Company. (b) The entries on the books of the Bronx Pin Ticket Company. (c) Balance sheet of the American Pin Company after the merger. Solution. — The first step would seem to be to prepare a coniiolidated Trial Balance of the two sets of books, since this will show: 1. The situation with regard to the individual companies. 2. The effect of the merger. Hence, such Trial Balance should be presented before taking up the specific requirements of the problem. It follows: AMERICAN PIN CO . CoffSOLIDATED TrUL BaLANCE (WoRKCTO ShBBT) June 30, 1912 American Bronx Pin Debits Pin Ticket Total Company Company Land, buildings, equipment. $335,000.00 $260,000.00 $596,000.00 Bronx Pin Ticket Company Stock, $50.000 par. 67,400.00 57,400.00 ©$67,400.00 Consolidated Elinunate Trial Balance $595,000.00 Pfctent^ 15,000.00 Working and trading assetfl, 37, 500 . 00 Cash. 10.000.00 Accounts receivable, 32 , 000 . 00 Due from Bronx Pin Ticket Com- pany, 375.82 Deferred assets, 1,500.00 Blauser Pin Tray Company Stock, at par. Sinking fund, Total Debits. Credits First Mortgage 6 per cent gold bonds, due 1922. $100 . 000 00 Taxes accrued. Salaries and wages accrued, 4, 327 . 82 Accounts payable, 123 , 749 . 83 Notes payable and interest. 80. 125 . 00 Interest accrued on bonds payable, 2, 500 . 00 Reserve for dei»-eciation of build- ings and equipment. 35 , 000 . 00 Preferred capital stock outstanding, 75,000.00 Conunon capital stock outstanding, 50, 000 . 00 Profit and loss surplus, 14 . 823 . 17 First mortgage 5 per cent gold bonds, due 1925, Due Amoican Pin Company, Total Credits. 22,625.00 10.000.00 10,365.27 37.943.86 1.200.00 35.000.00 $.236 92 37.625.00 47.500.00 20.365.27 69,943.86 375.82 2,700.00 35,000.00 3,236.92 ® 375.82 411 37.625.00 47,500.00 20.365.27 00.943 86 2.700.00 35,000.00 3.236.92 $488.775.82 $380.371 05 $869.146.87 $57.775.82 $811.371.05 $100,000.00 3.250.00 $ 2.750.00 6,000.00 3,147.83 144,720.30 31,372.53 1. 260.00 27,600.00 50.000.00 69,254.67 60,000 00 375.82 7,475.65 268,470.13 111,497.63 3.750.00 62,500.00 75.000.00 100.000 00 (i)$50.000.00 84.077.74 © 7.400.00 50,000.00 376.82 ® $100,000.00 6,000 00 7.475.65 268.470.13 111.497.63 3,750 00 62.500 00 75.000 00 60,000 00 76.677.74 60.000 00 375.82 «88. 775.82 $380.371 05 $869.146 87 $57.776.82 $811.371 05 The entire capital stock of the Bronx Pin Ticket Company was owned by the American Pin Company and, hence, carried on the books of the latter as an asset. Since the ownership of this stock made the merger possible, legally, with the result that the accounts could be merged, it is necessary to eliminate the stock asset from the books of the American Pin Company in order to take up thereon the assets and liabilities of the Bronx Pin Ticket Company. Further, accounts between the two companies should not be carried as assets and liabilities; hence, these items must be eliminated. The capital stock of the Bronx Pin Ticket Company is carried on the books of the American Pin Company at $57,400.00 whereas, par is $50,- 000.00. The former amount is to be eliminated from both sides of the consolidated Trial Balance. Since the conmion capital stock of the Bronx Pin Ticket Company outstanding is $50,000.00, whereas, the cost was $57,400.00, the $50,000.00 will be ehminated from the common capital stock outstanding, and the difference, *7,400.0D, which from the point of view of the merger becomes a surplus decrease, should be treated as such. Again, previous to the merger, the Bronx Pin Ticket Company owed the American Pin Company $375.82, on open account. In the merger of the two companies, ^his amount must be eliminated, since it is impossible for a company to owe itself money. On the basis of the consolidated Trial Balance, the required entries may be prepared. Requirement (a). Entries on the books of the American Pin Company. These entries are set up in summary form, rather than in detail, in order to conserve both time and space. 412 ADVANCED ACCOUNTING MERGERS VERSUS CONSOLIDATIONS i •379,995.23 375.82 $261,116 48 50,000 00 69.254.57 $375.82 $375.82 $50,000.00 7,400.00 $57,400.00 Sundry Assets, Accounts Receivable (due from Bronx Co.), To — Sundry Liabilities, Bronx Pin Ticket Co. (capital stock), Profit and Loss Surplus, To record assets, liabilities, reserves, capital, and surplus of the Bronx Pin Ticket Company per merger terms as of 7/1/12. Accounts Payable (Bronx Co.), To — ^Accounts Receivable (Bronx Co.), To eliminate offsetting accounts after merger. Bronx Pin Ticket Company (capital stock), Profit and Loss Surplus, To — Bronx Pin Ticket Company (capital stock-asset). To eliminate offsetting accounts after merger relative to capital stock. Requirement (b). Entries on the books of the Bronx Pin Ticket Com- pany, to close the books. American Pin Company, ^ To — Sundry Assets, To close asset accounts to the American Pin Company, per merger terms as of 7/1/12. Sundry Liabilities, Capital Stock, Profit and Loss Surplus, To — ^American Pin Company, To close the liabihty accounts, to American Pin Company, per merger terms as of 7/1/12. Requirement (c). Balance Sheet of the American Pin Company after the merger, as of July 1, 1912: AMERICAN PIN COMPANY Balance Sheet July 1, 1912 Assets •380,371.05 $380,371 05 •261,116.48 50,000.00 69,254.57 $380,371.05 Capital Assets: Land, Buildings, and Equipment, Less — Reserve for Depreciation, Patents, Sinking Fund, Blauser Pin Tray Company Stock, Total Capital Assete, •595,000.00 62,500.00 $532,500.00 37,625 00 3,236 92 35 ,000 00 $608,361.92 413 Current Assets: Accounts Receivable, Working and Trading Assets, Cash, Deferred Charges, Total Assets, $ 69,943.86 47,500.00 20,365.27 $137,809.13 2,700 00 $140,509.13 $748,871.05 Liabilities Capital Liabilities : 6 per cent Bonds Payable, 1922, 6 per cent Bonds Payable, 1925, Total Capital Liabilities, Current Liabilities: Notes Payable and Interest, Accounts Payable, Bond Interest Accrued, Taxes Accrued, Salaries and Wages Accrued, Capital Stock and Surplus: $100,000.00 50,00000 $150,000.00 $3,750.00 6,000.00 7,475.65 $111,497.53 268,470.13 17,225 65 $397,193.31 Capital Stock Preferred, Capital Stock Common, Surplus, Total Liabilities, $75,000.00 50,000 00 $125,000 00 ' 76,677.74 $201,677 74 $748,871 05 Basis of Consolidation— Preliminary Investigation.— When a merger or consolidation is contemplated, it is advisable to secm-e the services of an outsider,— a promoter,— in order that an acceptable basis eventually may be presented under which the change m^/ be made. In this connection, a disinterested outsider is a useful man. Since each of the interested parties is bound to have a most exaggerated idea of the value and impor- tance of his own particular plant, as related to the others con- templating coming into the combination, no one but a stranger will stand much chance of bringing each such interested party to a reasonable level on which the negotiations can continue successfully. This outsider will negotiate separately with each unit and will keep from each one the terms he has made with each of the others. Naturally, from the standpoint of the combination, it is neces- sary to calculate, upon some fair basis, the value of each unit coming into the combination. In other words, conditions must :i; 414 ADVANCED ACCOUNTING MERGERS VERSUS CONSOLIDATIONS be investigated to the end that an equalization thereof, as be- tween each incoming plant, will be secured. In this connection, two possibilities present themselves as the basis of the proposed merger or consolidation. These two possibilities are best pre- sented in the form of questions, to each of which a proper answer must be secured: 1. Should the value of the net assets of each plant be used as a basis of fixing the ratio of exchange in stock or in cash, or should the earnings of each plant over a period of years be used instead? 2. What relative value should be assigned to net assets as compared to net earnings over a period of years? One plant may have a large amount of assets but may not be able to show large earnings; on the other hand, a plant with a small amount of assets may show large earnings. Naturally, the first plant will be averse to a basis established on earnings; and the second plant will demur against a basis of exchange computed on net assets. In seeking for the truthful and correct answers to these ques- tions, an accountant often is called upon to give his ideas as to the proper basis of combination. These ideas he crystallizes into the form of statements after he has made a detailed examination of the case under review. In general, as a guide in making such investigation, he will endeavor consciously or imconsciously to keep certain things or points in mind. These may be outlined roughly about as follows: 1. Where the basis of exchange is to be computed on net asset values. a. If possible, an appraisal of properties should be made: i. By a regular appraisal company, preferably, or ii. By a committee. b. If an appraisal is not possible, the deductions to be made must be drawn exclusively from facts collected in con- nection with a careful audit, to the end that the valuation of each plant plus the equipment therein contained will be as correct as possible. Special consideration must be given particularly to capital additions: i. Capital additions, in order to be retained as such, must 415 (1) Represent actual plant values, or , (2) Increase plant capacity, or (3) Reduce production costs, ii. Capital additions in each plant must be handled in a uniform manner, especially as concerns (1) Relative age of the property and equipment in use, and (2) Depreciation. (a) It must be ample. (b) It must be calculated in a uniform way. (c) Differing elements must be madeuniform. (d) Differing conditions must be reconciled. 2. Where the basis of exchange is to be computed on net earnings over a period of years. a. How many years' profit should be averaged— two, three, four, or five? b. Earnings as against expenses. i. Each business must have its earning power com- puted for a uniform period of time, and preferably the same period of time. This period should be at least three years in length if it be possible to make it such. ii. Depreciation must be considered as indicated above. iii. Revenue expenses must not be capitalized. There- fore, capital additions must be examined as indi- cated above. iv. In the matter of production costs. (1) Where all units are engaged in similar work, they should be determined in a uniform way. (2) Where the units are engaged in dissimilar work, they must be reduced to a uniform basis. (3) Labor and overhead items must be appor- tioned in a imiform manner. (4) Selling and administrative expenses are not part of production cost. V. In the matter of inventories. (1) The methods of inventory-taking must be uniform. 416 ADVANCED ACCOUNTING MERGERS VERSUS CONSOLIDATIONS 417 I i ] r*#« (2) Due allowance must be made for old and obsolete materials. (3) Extensions must be checked carefully and parties taking same must certify to correct- ness. vi. In the matter of sales. (1) Sales in behalf of a subsequent period should be eliminated because they inflate profits of the current period. (2) Consignments-out and sales to branches are not sales. vii. Extraordinary profits and losses must be elimi- nated, viii. Interest on money loaned should not be included. 3. Where good-will enters into consideration. a. The basis for calculating the value of good-will will be anything agreed to by the parties interested. Of the many possible ways, two are of interest at this moment (further discussion of good-will is reserved to a later section) . i. Based upon profits. A certain number of years' net profits, varying from one to five, and even more, is purchased. A fair basis, at times, is found to consist of the purchase of a certain number of years' average profits ; as, two years, calculated for a period of from three to five years. ii. Based upon excess profits. This contemplates de- termining the average profits for such line of busi- ness. When this has been done, the excess, equal to the differences between the actual profits and the average, is capitalized upon some arbitrary basis, anywhere from 5 per cent up. 4. Where a partnership is a party to the combination. a. Attention must be directed specifically to items which are handled differently under partnership accounting as compared to their handling under conditions of corporate accounting. i. Salaries. Amounts representing salaries paid by corporations for work of a similar kind should be included in the Profit and Loss account, ii. Drawings and interest on investment are not to be considered in determining earning capacity. The above illustrates, in general, some of the things concerning which the accountant must be familiar when confronted by a merger or consolidation problem. The list is by no means com- plete, as this is not a book on auditing. Consolidation Capitalization. — The word "capitalization" is used with a wide scope of meaning; its application herein will conform to use as at the time a corporation is formed, when it refers to the face or par value of the stocks which the corporation is authorized to issue. Three different bases of capitalization may be used: 1. Earning power. 2. Actual cost of property. 3. Cost of reproducing property. Of these three, the first two by far seem to be the most common. In many instances, earning capacity coupled with the valuation of the tangible assets has been found satisfactory. Yet some of the largest corporations apparently are capitalized on the earning power basis, or on some variation of it. Capitalization on the Basis of Earning Power.— This basis of capitalization is built upon the fact that a corporation can earn either: 1. An unusually high rate of dividends on the actual invest- ment, or 2. The usual rate of dividends on a proportionately higher amount of investment. This point is kept in mind by many corporations for the reason that it makes possible the sale of a large amount of stock. It is not considered good financing to make the capitalization of a company only equal to the value of its tangible assets on the assumption that any simi over that value is water. A busi- ness man who does not, on the average, earn considerably more than the usual rate of interest on the actual cost of his plant would feel that he ought to go out of business and invest his money in securities. If earning capacity exists, the difference between cost of plant and earning capacity, whether it is ab- 418 ADVANCED ACCOUNTING t. I* i ( : sorbed in patents or in good-will or in some other asset, is just as legitimate an asset as merchandise, though, naturally, much more difficult to appraise. Capitalization does not, necessarily, bear any relation i>o divi- dends paid. As long as the dividends are honestly earned and properly accounted for, it makes no difference whether the capi- tal is $500,000.00, based on earning power, or $100,000.00 based on actual property investment. If $25,000.00 is earned during the year, the rate of return will be 25 per cent, if based on actual property investment, or 5 per cent, if based on earning capacity. The amount of dividends earned, however, is the same in either case; it makes no difference which capitalization is used. If stock contains water the dividend rate will be affected; therefore, the more important thing here is ^'dividends." In the final analysis, the most important feature is the relation between cash divi- dends taken out and investment. Dividends as percentages of capital stock have but little meaning. Earning capacity is uppermost in the minds of those who have the combination idea under consideration. If this were not so, a combination would not materialize. Naturally, the economies resulting from combination should increase earnings greatly be- yond the point reached when each unit was operating separately ; this means, therefore, that past earnings may in no way indicate the possibilities for the securement of future earnings. Means Used For Paying Off Interests. — In general, the methods used for paying off the interests coming into a proposed combination will depend upon: 1. The nature of the business. 2. The attitude of those who are interested in the combination. 3. The enthusiasm displayed by the promoter. The possibilities, however, will involve a combination of some of the following: 1. Bonds. a. For net assets — not advised, as fixed charges will be high. b. For tangible assets. c. For fixed assets. 2. Preferred stock. a. For net assets. b. For intangible assets. MERGERS VERSUS CONSOLIDATIONS 419 c. For working capital. 3. Common stock. a. For good-will. b. For the additional profits expected as the result of the combination. 4. Cash. a. Seldom used except to take up odd amounts remaining overdue to use of one of the above bases. Illustrative Methods of Determining Capitalization — Good-will. — ^When a business is paid for in the stock of the acquiring company, the amount of stock to be given must be determined upon an equitable basis. And as was indicated above, two elements of importance must be taken into consideration in this connection: 1. Fair value of the net assets from the viewpoint of a going concern. 2. Earning capacity. In discussing this topic further, it seems expedient at this point to make a division as follows: 1. Issue of one class of stock. 2. Issue of two classes of stock. The first consideration below will be where one class of stock is used only. After the net assets have been valued upon what is considered to be a fair basis, whether by appraisal or by ordinary mutual agreement, stock of an equal amount in par value should be allotted therefor as the purchase price. Next, the earning power must be determined in order to issue more stock. In this con- nection, it is necessary first to separate earning power into two portions: 1. Normal earning power, or normal rate of return. This must be done by agreement, after which the rate will be applied against the stock set aside for the net assets, to determine the annual dividend return therefrom or thereon. 2. Excess earning power. The remainder of the net earnings, after eliminating dividends as in (1), covering net assets, is used as a basis for calculating what amount of stock shall be given for this excess earning power. The asset value created by such excess earnings is called "good-will," inas- 420 ADVANCED ACCOUNTING 4 ^, f\ I much as the new company has taken over a concern which is established. Under such a condition, the good-will asset must be legitimate ; hence, stock may be issued for it. The valuation of the good-will asset for stock allotment has been indicated above, but is recapitulated here, as to methods of valuation, as follows: 1. Certain number of years' purchase of total profits, prefer- ably the average of a number of years, in order that normal conditions may be approached. 2. Certain number of years' purchase of total profits in excess of the agreed-upon normal rate. Again, preferably, the average of a number of years should be taken, rather than that of the last two or so. 3. Capitalization of gross income. 4. Capitalization so that each unit will receive the same earn- ings after the combination as before. From the original profits of each concern there would bo deducted the agreed dividend rate on net assets. The remainder then is capi- talized at the agreed dividend rate. To this result would be added the capital allotted previously in order to deter- mine the total capital. And, at the agreed rate of return, the income upon the total capital, as above, will equal the same amount as before the combination. Methods (2) and (4) are preferred to (1) and (3), in that the distribution seems more equitable thereunder. lUustrative Problem.— Cousider the foUowing C. P. A. problem and the writer 8 solution as lUustrative of the preferred methods above indicated I ^^""7° 'lu'^?T, T extensive dealers in plumbers' supplies, and arc located m Philadelphia; Smith & Rogers are conducting a similar business in Pittsburg, and James Watterson, of Harrisburg, Pa., is a manufacturer of an improved valve and norzle as well as several uther articles, all of which are used in the plumbing trade. The territory covered by Brown & Jones and by Smith & Rogers overlaps to some extent, and causes a sharp competition. They are both extensive customers of Watterson. Brown & Jones have assete consisting of cash accounts and merchandise amounting to $218,380.00, and store fixtures, etc., worth $4,500.00 Their liabilities, consisting of current accounts for purchases are $7,629 40 of which $2,468.00 is owing to Watterson. During the past three years their business was: Gross, $739,555.30, $850,417.84, and $1,016,228.54, respec- tively, while the net profits were for the same years: $49,411.20, $63,619.12 MERGERS VERSUS CONSOLIDATIONS 421 Smith & Rogers have quick assets of $195,620.30 and fixtures valued at $6,300.00. Their Uabihties are: Bank loans, $40,000.00; bills payable for merchandise, $24,673.00, aU in favor of Watterson; accounts payable, $18,794.28, of which they owe to Watterson, $6,287.40. During the past three years their gross business was $535,260.18, $601,341.74, and $567,- 214.96, and the net profits before payment of interest on loans were $46- 317.46, $47,934.68, and $39,184.72. ' James Watterson has quick assets of $108,496.54, a plant comprising real estate, buildings and equipment worth $76,453.83, clear of encum- brances. His liabilities consist of accounts payable $26,465.34. His sales for the past three years were $204,186.32, $230,419.28, and $248,781.20, and his net profits were $30,847.15, $35,620.96, and $42,208.41. These three concerns are desirous of consolidating their business, and want to form a corporation for that purpose. You are asked to prepare an equitable plan for the acquisition of these properties under which pay- ment will be made in stock of the new company. In doing this, show specifi- cally the valuation you place upon each business and your method of arriving thereat, together with your reasons therefor. Prepare a balance sheet showing the assets and liabihties of the new company. Solution 1.— This solution follows the first method shown above based upon a two years' purchase of the average profits for the three ye^ con- cermng which the actual profits are given. The solution, so far as capitali- zation IS concerned, is contained in the following working statement. Further, the Balance Sheet showing the assets and Uabihties of the new company may be prepared readily from the facts shown in this working statement. Debits Quick Anets, Due from Brown A Jones, Due from Smith & Rogers, Plant and Property, Fixtures, Total Debits, Credits Bank Loans, Bills Payable— Due Watter- son. Accounts Payable— Regular, Accounts Payable — Due Watterson, Capital, Total Credits, Net Profit*— Last Three Years: First Year, Second Year, Third Year, Total Profits, Solution No. 1 — Workino Statbito t Brown Smith James & Jones & Rogers Watterson Total Eliminate Net Total $218,380.00 $195,620.30 $75,068.14 $489,068.44 $489,068.44 2.468.00 2,468.00 $ 2.468.00 30.960.40 30,960.40 30,960.40 -^.453.83 76,453.83 76.453 83 10,800.00 10.800.00 4,500.00 6.300.00 $222.880.00 $201.920 30 $184.950.37 $609.750 67 $33.428 40 $576,322 27 S 40,000.00 S 40,000.00 $40,000.00 24,673.00 24,673.00 $24,673 00 $ 5,161.40 12,506.88 $26,465.34 44,133.62 44,133.62 2,468.00 6,287.40 8,755.40 8.755 40 2^5'250 60 118.45302 158,48 5.03 492,188.65 492.188.65 $222.880.00 $291.920.30 $184.950 37 $609.7.50.67 $33.428.40 $576,322.27 $ 49,411.20 $ 46.317.46 $ 30,847 15 $126,575 81 63.619.12 47.934.68 35,620.96 147,174 76 85.342.90 39.184.72 _^208^1 j66. 736.03 $198.373 22 $133.436.86 $108,676.52 $440,486.60 422 ADVANCED ACCOVNTING MERGERS VERSUS CONSOLIDATIONS Average per Year, I 66.124.41 I 44.478.95 $ 36.225.51 tl46.828.87 Good-wiU— TwoYeare'Pur- <=•»«• 1132.248.82 I 88.957.90 I 72.451.02 t293.657.74 Net Assets (as above), =«== j— ==== Good-will (as above), 293 657 74 Anticipated Capitalization, 1785.846. 39 *A Solution 2.— The first solution cannot be caUed a logical one inasmuch aa no consideration at all is given to normal profits. In the present solution, normal profits are deducted at once. The normal rate of profit assumed as agreed upon is taken as 8 per cent. In the examination room the first solution probably would be the only one possible inasmuch as therein no assumptions ought to be made; the facts given in a problem should be used as they stand. In solutions 2 and 3, certain assumptions must be made since the problem is incomplete as to information given. SOLPTIGN No. 2— WOHKINQ STAmOUIT Brown Etanith James _ . ^ . , * Jonea * Rogers Watterson Inverted Capital, per previous workini? statement. $215.250.60 S118.453 02 1158.48 5.03 Normal Profit, 8 per cent on invested capital. Average Profits per Year, per previous working statement. S 17.220.05 $ Total 492.188.1 9.476.24 % 12.678.80 | 19.375 09 $66,124.41 17,230.05 $44,478.95 9.476.24 $36,225.51 12.678.80 $48.904.36 $35.002.71 $23,546.71 $97.808.72 $70.005.42 $47,093.42 $146.828 87 $9,375.0 9 $107.453 78 $214.907 56 $492,188.65 214, 907. $• Normal Profit (as above), Ihofits in Excess of Normal Two Years' Purchase, representing Good-will, Net Assets, per previous working statement. Good-will (as above). Anticipated Capitalisation, $707.096.21 ^ Solution 3.— The third method of capitaKzation, that of capitahzing gross mcome, cannot well be illustrated by the problem in hand unless a certam assumption be made relative to the income capitalization. This will be 20 per cent. The proposed capitalization is $1,226,331.65. Net assets and capital. Average yearly income. Profit percentage, Net assets. Income at 20 par cent Total, B&J $215,250.60 66,124.41 30.719% $215.250. 60 330,622.00 S&R J. W. $118,453.02 $158,485.03 44,478.95 36,225.51 37.649% 22.857% Distribu ti on of Stock $118,453.02 $158,485.03 222,394.00 181,127.00 Total $492,168.65 146,828.87 492,188.65 734,143.00 $545,872.60 $340,847.02 $339,612.03 $r;2iB6,l3r:65 Since the total income is $146,828.87, as a yearly average, the rate of mcome will be 1 1.973 per cent. This would be distributed about as under • Brown & Jones, Smith & Rogers, J. Watterson, 11.973% of $ 545,872.60 $65.357 32 11.973% of 340,847.02 40.809.81 (discrepancy "•»73%of 339.612.03 40.661.74 adjusted here) $1,226,331.65 $146,828.87 The result upon the income hereunder as compared to previously operating alone, might be shown as follows: 423 Brown & Jones, Smith & Rogers, J. Watterson, Previous Contemplated Decreas e Increase $ 66,124.41 $ 65,357.32 $ 767.09 44.478.95 40,809.81 3,669.14 36,225.51 40,661.74 $4,436.23 . $146,828.87 $146,828.87 $4,436.23 $47436723 Naturally, hereunder, certain objections are noticed, especially in that, by operating alone, two of the concerns will make more than under the new order of things. Solution 4. — Assume, again, that 8 per cent is a normal profit return. In the first place, stock will be allotted for net assets as before: ^ B& J S&R J. W. Total $215,250.60 $118,543 02 $158,485.03 $492,188.65 Next, the further calculation will be about as foUows: Average jrr. profits. Normal profit — 8 per cent on net assets. Balance, to be capitalized. Capitalized at 8 per cent. Capital for net assets. Total capital, 8 per cent return Brown it Jones $66,124.41 17,220.05 Smith A Rogers $44,478.95 9.476.24 James Watterson $36,225.51 12,678.80 $48,904.36 $35.002.71 $23,546.71 $611,304.50 $437,533.80 215,250.60 118,463.02 $826.555. 10 $555.986.82 $ 66.124.41 I 44.478.95 $294,333.88 158,485.03 $452,818.91 S 36,225.51 Total $146,828.87 39,37509 $107,453.78 $1,343,172.18 492,188.65 $1,835,360.83 ^ % 146.828.87 Hereunder, the return will be the same after the merger as before. Hence, duplication of profits will be avoided and the objections of solution No. 3 are eliminated. Under the above four solutions or methods of determining capitalization, the issue of only one class of capital stock has been contemplated ; hence, only one rate of return has been used. However, it would seem to be more in order to find that where a combination is proposed, two classes of stock will be issued,— preferred and common,— preferred stock being issued for net assets and common stock for the so-called good-will. Where two classes of stock are in order, it would seem that two general methods exist in determining capitalization: 1. Capitalize good-will at an agreed rate on basis of total profits. This method is subject to criticism in the same way as the third one above explained. 2. Capitalize the excess profits after dividends upon the pre- ferred stock have been considered. This would seem to be the preferable method. It is illustrated in connection with the following C.P.A. problem and solution. Problem.— A company is incorporated to purchase by an issue of pre- ferred and common capital stock three concerns. A, B and C, doing the 424 ADVANCED ACCOUNTING i same class of business. It is found that the a8s<'ts (by actual valuation), the liabilities, and the average annual net profitn of each concern for the past five years, are as follows: A B C Assets as valued, $100 . 000 $60 , 000 1 1 50 , 000 Liabilities, 30,000 20,000 50,000 Annual net profits, average, five years, 10,000 15,000 8,000 It is required to know what amount of stock of the new company should be allotted to each concern as equitable compensation for net assets and good-will, and the matter is referred to you for rejjort. What should be the amount of the capital stock of the new company, and how should it ])e apportioned to A, B and C? Solution. — Before presenting a tabulated solution to the above problem, two assumptions must be made, about as follows: 1. Assume the preferred stock to be issued at per cent. 2. Assume the capitalization of good- will to be on the basis of 20 per cent. Determination of Net Assets — Preferr ed Stock C~ Total Assets as valued. Liabilities, Net assets, for which preferred stock to be issued. A 15 $100,000 $60,000 $150,000 $310,000 30,000 20,000 50,0 00 1 00,00 $ 70,000 $40,000 $100,000 $210,000 Capitalization of Excess Profits — Common Stock Average annual net profits. Preferred dividends — 6 per cent, Excess remainder. Capitalization of remainder at 20 per cent, A B $10,000 $15,000 4,200 2,400 Total $8,000 $33,000 6,000 12,600 $ 5,800 $12,600 $2,000 $20,400 $29,000 $63,000 $10,000 $102,000 \ A study of the above tabulation will show that 6 per cent dividends upon the preferred stock and 20 per cent on the common stock will provide the same income after as before. As a matter of fact, after the preferred dividends of 6 per cent have been deducted, the capitalization basis of the remaining average income matters not, since the proportion will be the same. Summary of Stock Allottment B Total Preferred stock. Common stock. Total, $70,000 $ 40,000 $100,000 $210,000 29,000 63,000 10,000 102,00 $99,000 $103,000 $110,000 $312,000 Illustrative Consolidation Problem — General Entries. — To illustrate the general book entries covering a consolidation, the following problem and solution are offered: MERGERS VERSUS CONSOLIDATIONS 425 Pro6Zem.— The Smith Manufacturing Company, the Jones Manufacturing Company, and F. McDonald, Inc., amalgamate their interests on January 1, 1920, and organize the Consolidated Manufacturing Company, with an authorized capital stock of $2,000,000.00, divided into 20,000 shares par value $100.00. ' The individual balance sheets of each respective firm, taken to represent the exact and true condition of affairs at that date are as follows: SMITH MANUFACTURING COMPANY Assets Plant and machinery. Real Estate and buildings. Furniture and equipment, Horses and trucks. Inventories: Raw material. Finished goods. Supplies, Bills receivable. Accounts receivable, Cash, $ 50,000.00 40,000.00 20,000.00 10,000.00 $120,000.00 $19,000.00 32,000.00 4,000.00 $ 55,000.00 9,000.00 12,000.00 7,000.00 Liabili ties Mortgage on plant (5 per cent interest). Bills payable. Accounts payable, Capital stock, Surplus, Capital and Surplus 83,000.00 $203,000.00 $ 25,000.00 14,000.00 24,000.00 $ 63,000.00 $125,000.00 15,000.00 140,000.0 $203,000.00 JONES MANUFACTURING COMPANY Assets Plant, equipment and machinery, $100,000.00 Real estate and buildings, 250 000 00 Horses and wagons, jg qqq qq Office equipment, g'.OOO.OO $370,000.00 Inventory of finished goods, materials, goods in pro^^ cess, and supplies, $1 18 , 000 00 Bills receivable, 22,000.00 Accounts receivable, 119 000 00 Loans receivable, 16 ! 000.00 ^^^' 30,000.00 305.000.00 $675,000.00 ktf^^B^D^^^^^ 426 ADVANCED ACCOUNTING Liabilities i Mortgage on buildings, Interest accrued on above, Bank loans, Bills payable, Accounts payable, Dividends payable, Capital stock. Surplus, Reserve for depreciations. Reserve for bad debts, $100,000.00 1,125.0 $101,125.00 $ 14,500.00 67,275.00 47,100.00 $300,000.00 87,000.00 $ 22,500.00 5,500.00 128,875.00 30,000.00 387,000.00 28 ,000.0 $676,000.00 F. Mcdonald, incorporated Assets Plant and machinery, Inventories, Accounts receivable, Cash, Accounts payable, Capital, Surplus, $ 75,000.00 76,500.00 82,500.00 66,000.00 $300,000.00 Liabilities $150,000.00 39,000.00 $111,000.00 189 ,000.0 $300 ,0000 The average yearly net profits of each respective firm, for a period ^' ^ ^-tinctl tTrpnH T '^^^' ^"^ ^^" °^^ ^^^^y« understood. To this end, It appears appropriate to summarize briefly the distinc to secure the proper viewpoint relative to the accounting nrin ciples used m this chapter; by so doing, confusion oug^not "^ 431 Ht 432 ADVANCED ACCOUNTING u r result as to understanding the exact place in corporate accounting at which consolidated statements may appear. Mergers and Consolidations Versus Parent and Holding Companies. — In accord with the idea mentioned in the intro- duction above, the following information is presented in outline form : 1. Mergers and consolidations. a. In general. i. Physical properties are dealt with. This compre- hends that the plants and other property plus the liabilities of the merging or consolidating com- panies are taken over. The new organization acquires the net assets of all the other companies, after which the latter are dissolved. b. Merger. i. The complete amalgamation of the constituent companies into a single corporation, the latter be- ing one of the constituent companies. No new corporation is formed. One company acquires title to the property of another company. c. Consolidation. i. The complete amalgamation of the constituent companies into a new corporation formed for the purp>ose of taking over the net assets and busi- nesses of the constituent companies. 2. Parent and holding companies. a. In general. i. The constituent companies are controlled through the purchase of sufficient stock so that control will be secured through a majority vote in the stock- holders' meetings. Each controlled company, as in the past, retains its separate corporate existence and operates as a distinct organization. b. Parent company. i. Both properties and securities are dealt with. A parent company arises because of one of two things: (1) It organizes a new subsidiary corporation PARENT VERSUS HOLDING COMPANIES 433 which is controlled through ownership of a majority of the voting stock, or (2) It purchases the stock of one or more corpora- tions, which thereby become its subsidiaries. ii. A parent company is an operating company doing business under its own name; each subsidiary company, also, does business under its own name in lines allied to those of the parent company. Example: In the problem previously discussed, that of the American Pin Company and the Bronx Pm Ticket Company, before the merger was con- summated, there existed an example of a parent company organization, in that the American Pin Company was an operating company and at the same time held the controlling interest in the stock of the Bronx Pin Ticket Company, its sub- sidiary. The Bronx Pin Ticket Company did business under its own name. c. Holding company. i. Only securities are dealt with, ii. A holding company is not an operating company. Its principal assets are the stocks of the corpora- tions it controls through ownership of a majority of the voting stock. Under this method, a holding company is the financial organization and the sub- sidiaries are manufacturing or selling organiza- tions. In general, it may be said that the only assets a holding company has, other than the stock of subsidiaries, would be cash and office equip- ment; it may not even have the asset of office equipment if it uses the office of one of its sub- sidiaries as a place of business. in^ZT ^^"JP^y A^^^^'^ting.-Once more it seems desirable to return to the illustration made use of above. When the prT'l\ n ^""^""^ ^""''^'^''^ "" «^ ^^' «^«^k of the Bronx th. hn t ?rT^' ^^"^ ""^^ ^^' P^^^^^«^ thereof recorded on h books o he American Pin Company? The purchase of all the stock of the Bronx Pin Ticket Company had the effect o 434 ADVANCED ACCOUNTING •I purchasing that company, but the fact remains that this actually did not happen. The Bronx Pin Ticket Company retained its separate identity, carried on business under its own name, and operated with a separate organization. Therefore, so far as the American Pin Company was concerned, the only entry required on its books would be relative to the stock purchase: Bronx Pin Ticket Company — Capital Stock, $57,400.00 To — Whatever Accounts Required Credit for Payment, 57,400.00 The stock purchased would be taken up at the price actually paid therefor, since such price is presumed to represent the actual value of the purchased stock. Holding Company Accounting. — ^If the American Pin Com- pany did not operate its own manufacturing plant, but merely purchased the stock of the Bronx Pin Ticket Company in order to control the latter and, if the stock of the American Pin Company were owned by the officers of the Bronx Pin Ticket Company, a clear case of a holding company would exist. The accounting entries required to reflect this stock ownership upon the books of the American Pin Company would be exactly the same as those shown above. But, as already indicated, a marked difference would exist between the Balance Sheets. The items of plant, machinery, equipment, accounts receivable, and even cash, as shown on a parent company's Balance Sheet would not be found upon the Balance Sheet of a holding com- pany. However, certain accounts are peculiar to a holding company as will be noticed later, particularly in connection with Con- solidated Balance Sheets ; these result from intercompany trans- actions: 1. Assets. a. Investments in subsidiaries. b. Advances to subsidiaries. 2. Liabilities. a. Advances from subsidiaries. Again, from the standpoint of the subsidiary company, in agreement with the above, the following accounts may appear: 1. Assets. a. Advances to holding company. PARENT VERSUS HOLDING COMPANIES 435 2. Liabilities. a. Advances from holding company subsidiary would remain as before. There would be how' ever a change required on the Stock Ledger, lookL to- inTor seS/i t .r^^^^^^^ ^^'^"^^ ^"^ manufactur- ing or selling activity, the holding company's chief sourrP nf income would be from the dividends of^he suSi^Z itl staff. Sometimes, these expenses must be paid by the sub sidiar,es being prorated among them as cost of services rend "ed" by the holding company to the subsidiaries. renaerea The holding company's investment in its subsidiaries is onp which practically has the character of a fixed T^^ZZeZ ndZro Tr '' ""'"' ^ '^^^^^^ ^^-p-^ exists ;u' them lit V^ subsidiaries and operate through it^ them. Again, if this controlling interest is to be sold it mZ mmmm a ?ea?'catrrhoM *'' '"''"« '"'"P^"^ '^"^ *° ^^is point, 1! Tk Tu "^'"^ company has been assumed namelv that the proper viewpoint miy be "eeutd for tt 7' "'•°'''"' consolidated statements, in order thaf fh. 1 h ^'^"="^^'°° °f be prepared properly The noints «t '' '^'"^^^^^ ""^^ discussion ma'y b'e iL Jttd S fs loTwT ""' ''' '"^'^ 1. Only a preponderating portion of the stock of the under- H \ 436 ADVANCED ACCOUNTING V 1 1 I lying companies is held by the so-called holding com- pany. 2. The so-called holding company may be an operating com- pany in which event it is not entirely a financial organiza- tion. But in any event, the pure holding company, or the hybrid, completely controls the others, known as underlying or sub- sidiary companies, to the end that, because it can elect what- ever directors and officers it chooses, it can dictate the policy to be pursued. Likewise, the principles of accounting involved in the discussion that follows remain the same whether working with one form or with the other. In other words, the term "holding company" as contemplated herein in connection with consolidated statements, is used in the more general sense as referring to any type of combination in which one corporation exercises stock control over other corporations. One corporation may hold the stock of another corporation and, in turn, this other corporation may hold the stock of a third. As a matter of fact, no limit exists as to the extent of these holdings except that set out in the certificate of incorporation or in the law. Regardless of the number of inter-ownerships, this holding function is a positive one just so long as each holding corporation controls a majority of the outstanding capital stock of the other or others. There may be, or there may not be, a minority interest, an interest held by outsiders. If 8o, these outsiders, concerning whom more will l^e said later, have little, if any, power in management; but they are entitled to propor- tionate dividend rights. Consolidation of Balance Sheets Versus Consolidated Balance Sheets. — ^When a proposition is fomented looking toward the consolidation of several companies, it is necessary first to secure a sort of bird's-eye view of the assets and liabil- ities to be involved. This is accomplished by gathering them together in a simple way into the form of a Balance Sheet, such statement being titled a "Consolidation of the Balance Sheets of Companies X, Y, Z," as on a certain date. The method of compiling this Balance Sheet is a simple one involving merely the gathering into one amount the assets and liabilities of each of the consolidating units. If X, Y, and Z have each a capital i PARENT VERSUS HOLDING COMPANIES 437 stock of $500,000.00, for example, the capital stock of the three companies combined, naturally, will be 11,500,000.00. In other words the promoter of the combination desires to know ho^ the eonsohdatzon will work out and what the probable cond't on of the contemplated combination will be; therefore, he totals aU the ,tems on each individual Balance Sheet into a comb Led statement which, when completed, shows the condition o^Se worlin \ /TP'''**'"" °^ ^^^ "^^^^" «°l"mn amounts in the woj^ng sheets for the illustrative problems lator in the present npSV'^'n"*''",' ^'""^' ^ Consolidated Balance Sheet is prepared penodacally after the combination has been formed t^ reflect oLfdTred ""'"'r '' l'^ "'^"'^ «^-P °^ -ffil-ted clpanS Z i of the rt°'''T*'r '''''' ''''''' °^ tJ^^ -«ets which the Zt be°Le' outtf ThTir Th*'^ T^'' '''' ^^^"^^"^ „»,„ * • 7 ^®®**- ^he subsequent portion of thit of the holding company only when the latter owns the entire capital stock of its subsidiaries. 2. It should never be used unless it presents a mon* correct picture of facts than does the regular Balance Sheet of the holding company. 3. If the holding company has a controlling interest in the subsidiaries, the Consolidated Balance Sheet usually will be the better way by means of which to show financial condition. 4. If the holding company has no controlling interest in the subsidiaries, its use is questionable since the holding com- pany may not control the policies of the subsidiaries. Carrying Investments at Actual Value. — Since a holding company is a stockholder in its subsidiary companies, it has, as such stockholder, an undivided interest m the net assets of its subsidiaries equal to the amount of its stock holdings. Such investments should be carried at actual worth. If such investments be carried at cost, conservatism will result provided such cost is equal to actual value. Although cost and value may be in agreement at the time of purchase, the two will never be in agreement for any length of time; value is a fluctu- ating quantity, going up and down as conditions change. If value drops, cost will be too high; if value increases, cost will be too low. If the value of such an investment depreciates, the cost could be scaled down to the same level, and no one then well could say, theoretically at least, that conservatism is not practiced. However, upon what basis shall the scaling be made? One person's word may be as good as another's, with the result that the ultimate value decided upon will not be the same if persons with differing qualifications have this task entrusted to them. But assume that the persons entrusted with such revaluation are qualified for the task in a general way. What difficulties might they encounter which will hinder them in digging out the actual truth? Suppose they decide to revalue upon the basis of the market price of the stock. What might occur? Every one knows that market values are affected by many outside con- ditions in no way related to actual facts. If, then, the market value of a particular stock is taken as a basis for revaluation, such revaluation may be absolutely incorrect. Again, suppose these men realize the possible fallacy indicated above, and, as a result, attempt a revaluation based upon actual conditions. They may be thwarted in their efforts in this direc- tion because of the physical impossibility of performance. If investments are carried at cost, another disadvantage may result, not indicated above, in that even though the holding com- pany Balance Sheet may disclose the truth insofar as concerns the amount of its capital invested in subsidiaries, the holding company earning account may be at fault in that therein the entire earnings upon such capital may not be shown. In other words, if the accumulated surplus of a subsidiary company is not fully distributed as dividends, the appreciation of such sub- sidiary company's stock value due to an increase in surplus will not be taken up on the books of the holding company, the result being that the latter's true earnings will be understated. Lastly, even though the revaluation method be resorted to, further complications might develop. Suppose the subsidiary company has been successful and has accumulated a goodly amount of undistributed profit subsequent to the time the hold- ing company acquired its stock holdings in the subsidiary. How much of such undistributed earnings should be taken up in revaluing the stock holdings? This again may be subject to the criticism of being a personal revaluation rather than one based upon actual fact. Also, if at a later date the subsidiary com- pany surplus is wiped out, the directors of the holding company 442 ADVANCED ACCOUNTING PARENT VERSUS HOLDING COMPANIES 443 I > \ may be guilty of having paid dividends out of capital. Increas- ing the investment must be offset by an increase of surphis, and dividends are paid from surplus. Too great care, therefore, cannot be exercised in preparing consolidated statements. Inter-company Accounts. — In order to prepare a Consoli- dated Balance Sheet, all the relations of the constituent com- panies with each other must be eliminated. If a person has a dollar, it makes no difference, so far as an account with liimself is concerned, as to what pocket holds that dollar; but if he has an account for each pocket, he must be careful to record the transfer correctly from one pocket to another. In other words, if Holding Company owes Subsidiary Company $10,000.00, this fact is of no importance from the standpoint of the enterprise as a whole ; what was formerly a debt owing by H Company to S Company loses its value when the accounts of the two com- panies are brought together. Capital stock, bonds, accounts receivable, accounts payable, notes receivable, notes payable, interest receivable, interest pay- able, intercompany sales, rent, loans and advances, are examples of accoimts that may require elimination in preparing a Con- solidated Balance Sheet, to the end that the relation of the enter- prise as a whole with outside sources will remain. Any form of Balance Sheet which does not eliminate such intercompany accounts, as indicated already, is greatly misleading in that it does not show the relationship of the unit as a whole to the outside public. Inter-company Sales. — One particularly interesting feature in connection with int^r-company transactions relates to inter- company sales. Frequently, when subsidiaries carry on business as separate entities, they deal and contract with each other as independent enterprises, and sales and transfers between com- panies are common. Naturally, profits are booked on these transactions which, from the standpoint of the organization as a whole are not profits at all, and must, from that point of view, be eliminated in order that the inventories may be carried at a value that is not inflated. A simple example to illustrate the principles involved is given below: Problem. — A holding company has subsidiaries consisting of three man- ufacturing units: Steel mill, tube mill, and bearing factory. The steel mill puts into process materials in the amount of $300,000.00 at cost; the labor and expense added amount to $200,000.00; the steel mill sales to the tube mill, at market price, amount to $350,000.00, upon which there is a book profit of $60,000.00. The tube mill places these materials into process and adds thereto labor and expense in the amount of $200,000.00; the tube mill sales to the bearing factory amount, at market price, to $500,000.00 upon which there is a book profit to the tube mill of $75,000.00. The bearing factory puts these materials into process and adds thereto labor and expense in the amount of $100,000.00. Upon the basis of the above figures, calculate the establishment inventory at cost. Solution. — -"V-— Steel MiU: Purchases from outside, Labor and expense added, Total cost, Sales to tube mill, Stock on hand. Book profits, sales to tube mill, Tube Mill: Purchases from steel mill. Labor and exi)ense added, Total cost, Sales to bearing factory, Stock on hand. Book profits, sales to bearing factory, Be aring Factory: Purchases from tube mill, Labor and expense added, Total cost. Inventory Summary: Steel Mill, Tube Mill, Bearing Factory, Total, Comment: Book Values Eliminate Net Cost $300,000.00 200,000.00 $500,000 00 290,000 00 $210,000 00 $300,000 00 200,00000 $500,000.00 290,00000 $210,000 00 $ 60,000.00 $60,000 00 $350,000 00 $60,000 00 $290,000.00 200,000 00 200,00000 $550,000 00 $60,000.00 $490,000.00 425,000 ■0 0(a) 46,325 00 378,675.00 $125,000 00 $13,675 00 $111,325.00 $ 75,000 00 $75,000 00 $500,000 00 $88,675 00 $411,325.00 100,000.00 100,000.00 $600,00000 $88,675 00 $511,325.00 $210,000.00 111,325 00 511,325.00 $832,650 00 (a) Note that 10.9 per cent of the book cost of goods made by the tube mill is because of the profit of the steel mill, and hence not a true cost to the tube mill. ($60,000.00 is 10.9 per cent of $550,000.00). Further will be said concerning intercompany profits under the section of ' * minority interests. ' ' ti« i>ii » !i iwi w i iiMiiBiii 444 ADVANCED ACCOUNTING PARENT VERSUS HOLDING COMPANIES 445 Profits Earned Prior to Date of Purchase.— The surplus of a subsidiary company accrued prior to the date upon wliich this company is purchased by a holding company should not be combined with the surplus accrued subsequent to such date, for inclusion upon the Consolidated Balance Sheet. In general, the surplus of a corporation represents the balance of earnings that have accumulated from operations, and which have not been paid out to stockholders. Since a surplus accumulates only as the result of operations, the holding company, prior to its organiza- tion, cannot have earned any surplus. Hence, in its consolidated Surplus account, the holding company should carry only the surplus accumulated subsequent to the date upon which the con- trolling ownership of the subsidiaries was acquired. Again, since the amount paid by the holding company for the subsidiary company capital stock represents the former's esti- mate of its equity in the subsidiary company, which is said to be represented by its capital stock and surplus at the moment of the take-over, the value of the capital stock of the subsidiary company must be eliminated from consideration by the holding company; further, the capital stock and surplus must be elimi- nated from the summarization of the books of the subsidiary company. The Surplus account, after such absorption, cannot appear again as a surplus item upon the Consolidated Balance Sheet. Further, the subsidiary company's surplus as of the take-over date becomes capitalized to the end that, if distributed as divi- dends, it must be considered in the holding company accomits as reducing the investment accounts. It is entirely improper to accord an income treatment thereto. Premium and Discount on Investments. — When a holding company purchases the capital stock of another company, the price paid is assumed to represent the former's estimate of the value of the equity in the subsidiary company's assets. This price may be greater or less than the combined capital stock and surplus of the subsidiary company: 1. If greater. The difference, generally, is assumed to repre- sent the value of the subsidiary company's good-will or other assets not found upon its Balance Sheet. If these items were in evidence thereon, it would be natural to assume that the cost of the capital stock to the holding company would be equal to the sum of the capital and surplus of the subsidiary company. 2. If less. The difference, generally, is assumed to represent the amount at which the assets of the subsidiary company are overvalued upon its books. In many instances, this difference is buried in the property accounts. Overvalua- tion may be due to a deficiency in the depreciation reserves. The above presents the usual viewpoint. However, it seems necessary to indicate other possible interpretations: 1. If the purchase has been made at a premium. Hereunder, such premium may represent: a. Good-will (as before). b. Accmnulated surplus assets. c. Discount upon the securities of the holding company issued in payment for securities in the subsidiary company. 2. If the purchase has been made at a discount: a. Good-will inflation. b. Capital surplus, where actual value at least is par, and outside conditions responsible for the discount. c. Set off against premium, where a number of subsidiaries are taken over, some at a premium and others at a discount. d. Set off against subsidiary company deficit, where the latter is present. Often it is because of a deficit that the purchase can be made at a discount. Good-will on the Consolidated Balance Sheet. — Good-will upon the Consolidated Balance Sheet may be said to be the algebraic sum of the good-will items purchased from the sub- sidiaries by the holding company. If the price paid in cash or stock for the stock of another company exceeds the sum of the par value of the purchased stock plus its proportion of sur- plus, the excess represents the amount to be charged to the Good-will account upon the Consolidated Balance Sheet. No one can say that a holding company would be willing to pay more for a controlling interest in a constituent company than the latter is worth. The excess paid, therefore, justly may be considered as having been given for good-will. ^^?^W«^9i"i*^^*" 446 ADVANCED ACCOUNTING r t Again, if a purchase price is paid which is less than the Bal- ance Sheet of the subsidiary shows as at the date of the pur- chase, one can assume, with reason, that the Balance Sheet figures of the subsidiary are inflated; the discount involved, as a rule, would be a credit to the Good-will account upon the consolidated statement. If, now, one should encounter a con- dition under which the total credits to Good-will account ex- ceed total charges, a rarity, the excess credit had better be sent to an account which, by its title, will show the amount as not being available for dividend purposes. Such an account might be a ''capital surplus" account, or it might be a valuation account since its effect is merely to offset an inflation in the asset values. The good-will elements thus far considered above relate to purchase only, that which arises at the time a purchase is made, by charging the excess of purchase price over the book value of the capital stock of the companies bought. Another separate and distinct angle of the good-will question arises in connection with the good-will items on the Balance Sheets of each of the sub- sidiary companies as at the moment they were absorbed by the holding company. These, as was noticed in the last section, are merged frequently with other items of a miscellaneous char- acter under the title of ''property." As an example of the handling of good-will, consider the following simple problem and solution. Problem. — The H (Corporation purchased all the capital stock outatandiiig of the Si, S2, and S3 corporations. The following facts are ascertained concerning these companies purchased: Company Good-will Capital Stock Surplus SI $20,000.00 $100,000.00 82 10,000.00 30,000.00 S3 none 50,000.00 Paid by H $14,000.00 4,000.00 16,000.00 $120,000.00 40,000.00 62,000.00 Calculate the amount of good-will to be placed upon the Conuolidated Balance Sheet. Solution. — In solving this problem, it would not seem unwise to take the facts as shown above in scheduled form, rewrite them and set out the coft- clusions drawn therefrom in separate columns at the right. Good- Capital Price Price Company will Stock Surplus Paid Over Under 81 $20,000 . $100,000 $14,000 $120^ $6,000 82 10,000 30,000 4,000 40,000 6,000 S3 none 50,000 16,000 62,000 $4,000 PARENT VERSUS HOLDING COMPANIES 447 Now that the facts are all together, it is a fairly simple matter to determine the good- will item for the Consohdated Balance Sheet: Debits: $20,000.00 6,000.0 $26,000.00 y SI, SI, S2, S2, Total, Credits: S3, Balance, J $10,000.00' 6,000.00 16,000.00 $42,000.00 4,000.00 $38,000.00 y / n/' The Consolidated Balance Sheet will contain an item of good-will in the amount of $38,000.00. Minority Interests in General.— As a general proposition, when a Consolidated Balance Sheet is to be prepared, the hold- ing company in question holds only a controlling interest in its subsidiaries rather than owning all the outstanding shares of stock. Therefore, there usually will be minority stockholders who have a certain interest in the subsidiary or subsidiaries in which they hold stock. Naturally, as a result, these persons should not be forgotten when the consolidated statement is pre- pared; they own a portion of the stock of the subsidiaries and a portion of their surplus. And as to the surplus, the portion owned is exactly equal to the percentage their holdings to the total outstanding capital stock of the subsidiaries in which they are interested. This minority interest in the capital should be set out in the Consolidated Balance Sheet directly below the item of capital stock issued and outstanding, as follows: Minority Stockholders' Interest in Capital Stock of Affiliated CompanieB Capital Stock (par value). $ ^ Surplus, u I ^ If the minority interests in a subsidiary company amount to any size, a separate statement should be prepared thereof to support the Consolidated Balance Sheet of the enterprise as a whole. Inter-company Sales and Minority Interests.— The principle to apply in connection with inter-company sales was noted briefly in an earlier section. Further elaboration seems neces- sary in relation to minority interests. If the holding company and its subsidiaries are regarded as it 448 ADVANCED ACCOUNTING one enterprise, it is a simple accounting principle that sales from one unit to another should have in them no element of profit. If this principle be not followed, profits will be antici- pated and inventories inflated. However, a complication arises where the interests of minority stockholders are concerned. If they are interested only in one of the subsidiaries, they have no interest in the enterprise as a whole. If sales are made by the subsidiary in which they are interested to other subsidiaries, they feel rightfully that such sales should be made at a fair profit; if not, they are being mistreated. On account of this fact, the system required to handle inter-company sales, in order to meet two differing points of view: 1. That of the enterprise as a whole, and 2. That of minority interests, must of necessity be decidedly elaborate and complicated. All sales must be booked at both cost and selling prices. When so done: 1. A Consolidated Balance Sheet may be prepared sliowing all inventories at actual cost, and 2. Statements may be prepared for each subsidiary company in which cognizance will be taken of profits on inter-com- pany transactions. Where minority interests are concerned, and inventories in- clude inter-company profits, the amount of such profit may be offset on the Consolidated Balance Sheet by a reserve of an equal amount. But if all the goods sold between the subsidiaries have been disposed of by the purchasing subsidiary, this reserve is unnecessary; costs and sales will not be correct, but the gross profit will be correct. Another point of interest in the matter of inter-company sales relates to sales of material from one subsidiary to another for purposes of construction. From the viewpoint of the undertaking as a whole, this must be on a cost basis, containing no element of inter-company profit, even though the purchasing subsidiary paid another subsidiary for the materials on a cost plus profit basis. The amount of profit involved must be determined as accurately as possible in order that it may be deducted from the construction account in the Consolidated Balance Sheet; this deduction may be made by means of a reserve set up from the consolidated profit. PARENT VERSUS HOLDING COMPANIES 449 Alternate Form of Consolidated Balance Sheet.— The usual form of the Consolidated Balance Sheet, prepared as will be illustrated in a subsequent section, beyond doubt is the best way in which a holding company should set out its accounts for statement purposes; however, it is not the only method that may be used. It is possible for the holding company to carry on its Balance Sheet its investment in a subsidiary merely as such, and support this item as thereon shown in either one of two ways: 1. Attach a Balance Sheet of the subsidiary company to that of the holding company, or 2. Summarize the financial position of the subsidiary in con- crete form directly on the face of the holding company Balance Sheet. The following example illustrates the point: Investment in the SI Manufacturing Com- pany (65 per cent Interest), Accounted for as follow s: . , Land, Buildings, Machinery, Equipment, Good-will, Inventories, Accounts and Notes Receiv- able, Cash and Other Current Assets, Total, Deduct: $325,000.00 $250,000.00 100,000.00 300,000.00 $650,000.00 $150,000.00 $500,000.00 Current Liabilities, Balance, Net Assets, 65 per cent Interest (as above), $325,000.00 Whether or not one or the other of the above methods should be used in preference to the usual technical form of statement is, as one writer on accounting has said, ''largely, but within limits, a matter of individual preference." No one can deny that such a statement does show facts and, therefore, so long as this be true, it may be permissible to use it. However, since accountants on the whole lean toward the technical form of Consolidated Balance Sheet as herein discussed, nothing further need be said concerning these possible alternate methods indicated above. Consolidated Income Statement— Content.— Basically, the same general principles must be piu-sued in preparing a Con- solidated Income Statement, the object of which is to set forth the operating results of all the related companies as a unit in their relations to outsiders. The two following points contain the substance of the entire proposition: 450 ADVANCED ACCOUNTING 1. Profits transferred from a subsidiary rompany to the hold- ing company, by way of dividends, are ignored. 2. Earnings, expenses, etc., of all subsidiaries are combined and set out as if all were one company. Illustrative Problems — Consolidation Balance Sheets. — ^In concluding the discussion of this chapter, the following graded problems and solutions are included to illustrate the principles mentioned above. It is believed that a careful study of the solutions submitted will assist materially in eliminating from the mind of the student much of the so-called apparent difficulty veiling and obscuring this type of problem. Problem 1. — The H Company, as of December 31, 1920, has the following balanpe sheet: Assets : Fixed assets, $ 65,000.00 Investments: Miscellaneous, » SI Company: Capital stock. Premium on capital stock, Current assets, Total assets, Liabilities: Capital stock, Fixed liabilities. Current Uabihties, Depreciation reserve, Surplus, Total liabilities, 19,000.00 60,000.00 600.00 24, 650 $159,150.00 $100,000.00 50,000.00 612.50 637.50 8, 000.0 $159,150 00 As of the same date, the SI Company, a subsidiary of the H Company, has the following balance sheet: Assets : Fixed assets, $60,000.00 Investments — miscellaneous, 48 , 000 . 00 Current assets, 2 , 483 68 Due from S2 Company, 727.80"^ Total assets, Liabihties: Capital stock. Fixed Uabilities, Current Uabihties, Depreciation reserve, Surplus, Total liabilities, $103,211.48 $ 66,000.00 42,000.00 860.00 097.24 2,364.24 $101,211 48 PARENT VERSUS HOLDING COMPANIES 451 Likewise, as of the same date, the S2 Company, a branch of the SI Company, has the following balance sheet: Assets: Current assets, $650 00 Liabilities: Current Uabilities, $ 22 . 20 Due SI Company, 627.80 - Total Uabilities, $650.00 Prepare consolidated balance sheet as of December 31, 1920. Solution to Problem 1. — The first point to notice is that, as between the SI Company and the S2 Company, there is a home office and a branch. Therefore, the home office control on the branch books should be in agree- ment with the branch control on the home office books. In other words, a controUing account over S2 Company should be found upon the books of the Si Company, and this control should be in exact agreement with a con- trolhng account upon the books of S2 Company over its relationship with the Si Company; the two sets of books should articulate one with the other. However, such is not the case at present and, before proceeding further, the two sets of records must be placed into agreement, one with the other. If the branch records are correct, and one must here assume that they are, as well as those of the home office, the difference between the two controls, beyond doubt, represents cash in transit, or some other current asset in transit, between the branch office and the home office as of the date of the balance sheets. The foUowing adjusting entry wiU suffice for the books of SI : Current Assets, $ 100 . 00 To — Due from S2 Company, $ioo . 00 If, in this particular case, the item in question is cash, the charge should not be made to the regular Cash account, since items in transit cannot be considered as having been received. Consider a moment a principle of branch accounting which is applied in preparing a ConsoUdated Balance Sheet, since branch accounting should be famiUar to the student. If, in the present case, a Balance Sheet were to be prepared combining the values displayed upon both the books of the main office SI, and of the branch office S2, one would proceed in accord with the elementary principles of branch accounting by combining into one statement the various asset and Uability items now shown separately and eUminating thereby, as a natural result, the controlling account as carried on each set of books. In this connection, the student is referred, also, to the elementary discussion underlying the operation of a private Ledger; commence with the completed solution relating to the opening of a private Ledger and assume that it is no longer to be used. Make the entries necessary to incorporate upon the general Ledger the information that was taken therefrom and placed in the private Ledger. When the schedule of entries is complete, note the cancellation and elimination of the two controlling accounts. As the solution of the present problem pro- ceeds, notice the use of the same principle of eUmination; it may be seen, also, in the solutions of each of the other problems included herein. This u I ' I I I'd f 452 ADVANCED ACCOUNTING principle is the most elementary one in preparing a working sheet covering the set up of a Consolidated Balance Sheet. After the adjusting entry mentioned above has been placed upon the books of the Si Company, the Consolidated Balance Sheet called for may be prepared readUy. It appears in the last column of the foUowing working sheet. This sheet should be studied carefully in order to fix in mind the simple basic principle to which reference has been made; otherwise, the solutions of the problems that follow may not be comprehended. Problem 1— Working Sheet Consolidated Aaaeta H m ^ Total Eliminate Balance Sheet Fixed Aneta, Investments: $65,000 00 $50,000.00 $115,000.00 •115,0)0 00 Miscellaneoos, SI Company: 19,000.00 48,000.00 67.000.00 67,000 00 Capital Stock. 50.000.00 60.000.00 ©$50,000.00 Pramum on Capital Stock. 500.00 500.00 , 500 00 Current Assets, 24.(50.00 2.583.68 $650 00 27.883.68 27 883 68 Due from S2 Company, 627.80 $101,211.48 627.80 © 627.80 $261,011.48 $50,627.80 Totals. 1159.150.00 $650.00 1310 383 68 Liabilities Capital Stock. $100,000 00 $55,000 00 $165,000 00 ©$50,000.00 •105 000 00/ 02 000 00 Fixed Liabilities 50,000.00 42.000.00 92,000 00 Current Liabilities, 512.50 850.00 $22.20 1.384.70 1,384 70 Dei»%ciation Reserve, 637.50 997.24 1.634.74 1.634 74 Suiplus, 8.000.00 2,364.24 10,364.24 10.364 $4X Due SI C(Hnpany, 627. 8» $650,00 627.80 © 627.80 $261,011.48 $50,627.80 Totals. $159,150 00 $101,211.48 1210. 383. It The technical form of Consolidated Balance Sheet, based upon the above working sheet, has not been presented. It contains nothing of interest beyond the figures shown in the last column of the working sheet except as to the item of Premium on Capital Stock, 1500.00. This item would be shown upon the technical form of statement in either one of the foUowing two ways, preference being in favor of the first one: 1. As goodwill. If all the stock of a subsidiary is not owned by the holding company, this method of treatment predominates. 2. As a deduction from the consohdated surplus. Problem 2.— The following problem and its solution are intended to indicate the usual items requiring elimination in the preparation of a Consolidated Balance Sheet. Likewise, the method is given of calculating the item of good-will therein to be contained. The better for the purpose in hand, all items are shown in lump sums except those to which special attention is directed. The H Company owns the stock of two operating companies, SI and S2 Just after the holding company purchased the stock of SI and 82, tht balance sheets of the three were as follows: ( PARENT VERSUS HOLDING COMPANIES 453 SI S2 $116,950.00 $129,740.00 $500,000.00 100,000.00 J 50, 000.00 4s 10,000.00 81.791.00 119,680.00 5,000.00^ .00^ 10,000.001- 1,500 300.00 $600,000.00 $265,541.00 $259,420.00 SI S2 $300,000.00 $100,000.00^/ 200,000.00 1100,000.00 $ 50,000.00 ^ 100,000.00 Debits Fixed assets. Investments: Bonds of affiliated companies. Bonds of other companies. Stocks of affiliated compam'es (cost), Sundry current assets, Demand notes of affiliated companies. Advances to affiUated companies. Accrued interest: Bonds of affiliated companies. Bonds of other companies, Totals, Credits Capital stock: Preferred, Common, Bonds: Held by affiUated companies, Held by others. Interest on bonds: * Held by affiliated companies. Held by others. Notes payable: Held by affiUated companies, Held by others. Advances payable: AffiUated compames. Sundry current UabiUties, Surplus: Reserved: Depreciation, Bad debts. Bond redemption. Free: . Available for dividends. Totals, Required: Consolidated balance sheet. Solution to Problem 2.— The solution of the above simple problem re- quires no comment beyond a study of the foUowing working sheet, since the Items to be eUminated have been carefully earmarked. Note the cal- culation of the good-wiU item. The Consohdated Balance Sheet is found in the last column of the working sheet. 2,000.00 10,000.00 -^ 15,300.00 1,035.00 50, 000.00 -K 100,000.00 1,500.00 7^ 3,000.00 5,000.00 tr 10,000.00 9,345.00 11,300.00 637.00 7,500.00 37,206.00 11,138.00 $600,000.00 $265,541.00 $259,420.00 f\ 454 ADVANCED ACCOUNTING I o CD B a o u 0) 1 a J5 n CZi I ^1 i' M i4 O SI w 8 88 2 2^^ 8 s too ^ • 8 1 H H 8 Ol oqI 1 SOO "-HUSO «-iQ O 1-1 CO 8 8 S OS 0( oo 8 8 •a £ m C -r *- • • * ej C OS CO 00 ~ ^ g a o o o_^ g >nncci 9, as ^ ft N 8 8 88 8 8 8 888 888 88 8 >m 8 88 88 88 'CO 11 I is ^a OS ft a o u kl e] o a o >>B " B ^"2 o o 03 ^ C C > o -^a •§ 88 8 8 8 8 888 8 *j P o » t: a CO 2 a CO 88 8 8 8 8 8S S •- "= S 88 88 88 88 88 SS S8 '"'=^" "'S 2S •CO w 8 88 88 88 8 S S8 '"''^" "=2 * 88 88 88 8 S 88 10 s B c8 ft a o s •a S. a o 8 ii 8 S88 g 9 MM s 8 S ^S^ 8 « . "^ ^ t^ * ^ f-» ^ 8 8 TO 8 § 3) . •• 8 5 £-§ 08 C-D a 08 O"" 08 -r 0) 2 * 5-2 fi« OO Xi fl8JQ.O S-g O • ii L. CO 0) « fc. 9/ - ^ , 01 $ a* ci-.ajffi^'^ pq »5 IS fl PARENT VERSUS HOLDING COMPANIES 455 (*) Determination of Good-will Assets taken over: SI, S2, Total book value of assets, $ 27,300.00 178,845.00 Liabilities assumed (toward outsiders) : SI, S2, Total book value of liabilities. Excess of assets taken over against liabilities assumed, Less: Surplus included in assets (purchased) : Reserved: 51, $ 1,035.00 52, 19,437.00 $ 20,472.00 Free and available: 51, $37,206.00 52, 11,138.00 48,344.00 Total Surplus, Balance, net asset values, not subject to dividends. Prices paid for net asset values, $265,541.00 259.42000 $524,961.00 206,145.00 $318,816.00 $ 68,816.00 $250,000.00 500,000.00 Balance, representing good-will, being the excess of price paid over book value of assets not subject to dividends. $250,000.00 Problem 3. — ^Although the following problem and its solution furnish a third illustration of the preparation of a simple form of a Consolidated Balance Sheet, their use herein at this point is primarily to illustrate the calculation and setting out of the interest of the minority stockholders. The H Company, as of December 31, 1920, acquired 90 per cent of SI Company stock at par and 100 per cent of S2 Company stock at 95. In each case, the H Company took up these investments into its accounts at the figures given. On December 31, 1920, after the absorption, the balance sheets of these companies were as follows: Assets H SI $ 850,000.00 $210,000.00 Fixed assets, Investments: 51 Company (par), 52 Company (95), Current assets. Deficit, Total, Liabilities Capital stock. Fixed liabilities, Current liabilities, Surplus, Total, Prepare a consolidated balance sheet. $ 48,000.00 90,000.00 47,500.00 240,000.00 65,000.00 88,000.00 20,000.00 $1,227,500.00 $275,000.00 $156,000.00 $1,000,000.00 $100,000.00 $ 50,000.00 25,000.00 50,000.00 25,000.00 2,500.00 50,000.00 81,000.00 200,000.00 75,000.00 $1,227,500.00 $275,000.00 $156,000.00 456 ADVANCED ACCOUNTING s s SCO s ^ S 8SS I I s s CO eo s 3SS8 as «=» si s s s c w c s. i $ el ;3 % CQ e S8 ©t* CQ IJ ^ 111 'S.c' 8 8 88 63 88 §8 8 888 § ^*-'i 88 8 8 8 9 8 DQl ooo 00 C4 8 s 8 o 8 8s8 8 8888 S8'SSg 888 ScSS 8888 8J5i g6^ 18 8888 8 >tOC«© I •g e 3 4J i| as." ii I >CQCO E*g I ^ f;§ i J o i i SI s I 8 ! I i § SI 8' 8 OQ g s Is is J PARENT VERSUS HOLDING COMPANIES 457 A Co. BCo. CCo. Solution to Problem 3.— The solution to this problem is presented in the following three portions: 1. ConsoUdated working sheet. 2. Calculation of minority stockholders' interest. 3. Consolidated balance sheet. Problem 4. — The following C. P. A. problem has been selected as the basis for presenting the final illustration of the preparation of a Consolidated Balance Sheet. The Jones Investment Company on June 30, X915 obtained a controlling interest in three operating companies, viz., A Co., B Co., and C Co. The Balance Sheets of the four companies as at June 30, 1916 are as follows: Debits Jones Investment Co. Investments in other companies: A Co. — 60 per cent interest (Cost $900,000.00), B Co. — 75 per cent interest at cost, C Co. — 80 per cent interest at cost Advances to A Co., Advances to C Co., Cash, Accts. Receivable, Inventories, Plant, Deficit, Total Debits, Credits Capital Stock, Jones Investment Co., Surplus, Total Credits, The Surplus and De- ficit Accounts as shown above may be analyzed as fol- lows: Balance to Jime 30, 1915, Surplus Income 6 Months to Dec. 31, 1915, $1,000,000.00 600,000.00 400,000.00 100,000.00 50,000.00 50,000.00 $ 100,000.00 $ 10,000.00 $ 50,000.00 100,000.00 50,000.00 100,000.00 200,000.00 100,000.00 50,000.00 1,000,000.00 600,000.00 400,000.00 40,000.00 $2,200,000.00 $1,400,000.00 $800,000.00 $600,000.00 $2,000,000.00 $1,000,000.00 $800,000.00 $400,000.00 100,000.00 200,000.00 300,000.00 50,000.00 150,000.00 $2,200,000.00 $1,400,000.00 $800,000.00 $600,000.00 $100,000.00 $200,000.00 $4,000.00 $100,000.00 180,000.00 46,000.00 25,000.00 ■^\ 458 Six Months to June 30, 1916, Increase in value of A Co. Stock, Dividends paid Jan. 1916, Balance June 30, 1916, *Debits indicated. ADVANCED ACCOUNTING 217,500.00 220,000.00 40,000.00* 26,000.00 100,000.00 217,500.00* 300,000.00* 50,000.00* $200,000.00 $300,000.0 $ 40,000.00*$150,000.00 Prepare a consolidated Balance Sheet of the four companies as at June 30, 1916. A Statement of the Consolidated Earnings and Surplus Account for the year to June 30, 1916 is not required, but may be submitted if desired. In preparing the Balance Sheet the following additional facts should be considered: 1. The holding Company has no other source of income than the dividends from the subsidiaries, which have been taken on to its books when received. 2. In accordance with a resolution of the Board of Directors of the Jones Investment Company the following entry was made on the holding company books at June 30, 1916. Dr. Investment in A Co., $100,000.00 Cr. Surplus, 100,000.00 3. The inventories of the A Co. includes $100,000.00 of stock purchased from B Company in 1916. The cost of these goods to the B Company was $90,000.00. 4. Part of the plant of the C Company was built by the A Company in September and October, 1915 at a cost of $80,000.00. For thi work the A Company charged the C Company $95,000.00. 5. In February 1916, part of the equipment of the B Company which was carried on the books at the cost price of $50,000.00, was destroyed by fire. The only entry that has been made in respect to this loss wiui to credit the Plant Account with the salvage of $5,000.00. Solution to Problem 4. — The first step would seem to be to prepare a working sheet and thereon spread the figures insofar as they may be ob- tained from the problem itself, namely, down through the "total" column (see working sheet below). The second step would be to prepare a schedule of adjusting entries in accord with the facts as given, and then spread these upon the working sheet in the columns provided therefor, keying such inclusion back against the schedule. These adjusting entries are as follows: 1. Surplus, To — Investment in A Company, To write down the increase in the value of the A Company holdings. $100,000.00 $100,000 00 PARENT VERSUS HOLDING COMPANIES $10,000.00 459 $10,000.00 $15,000.00 $15,000.00 $45,000.00 $45,000.00 $177,000.00 3,000.00 $180,000.00 2. Surplus, To — Inventories, To write down the inventory of A Company to the extent of the dif- ference between $100,000.00 and $90,000.00. 3. Surplus, To— Plant, To write down the value of C Com- pany plant built by A Company from $95,000.00 to $80,000.00. 4. Surplus, To— Plant, To write down the value of the B Company equipment. Cost of the equipment was $50,000.00 (as de- stroyed) whereas, only $5,000.00 has as yet been written oflF. 5. Good-will, B Company Investment, To — ^A Company Investment, To record the good-will for the Con- solidated Balance Sheet. Same is computed as below m separate schedule. Calculation of Good-will A Company investment (60 per cent), Capital stock, Surplus 6/30/15, Total, B Company investment (75 per cent) Capital stock, Surplus 6/30/15, Total, C Company investment (80 per cent), Capital stock. Surplus 6/30/15, Total, Total, After these adjusting entries have been included upon the working statement, the next step contemplates the eUminations to be made on account of intercompany transactions. The debit eliminations seem ^U-explanatory, requiring no further comment. On the credit side the tirst elimination relates to the $150,000.00 item of Jones Investment Com- pany; no question arises as to the amount thereof. The next elimination Book Value Cort Difference Good-wiU $1,000,000.00 $720,000.00 $900,000.00 $180,000.00 200.000.00 $1,200,000.00 $800,000.00 603,000.00 600,000.00 (*)3,000 00 4,000.00 $804,000.00 $400,000.00 400,000.00 400.000.00 None 100,000.00 $500,000.00 $1,723,000 00 $1,900,000.00 $177,000.00 \ 460 ADVANCED ACCOUNTING relates to capital stock; there is here a minority stockholders which must be considered, as below: Capital stock of Jones Investment Company, Add: Minority interest in capital stock of subsidiaries: A-^0 per cent of $1,000,000.00, or, $400,000.00 B— 25 per cent of 800 , 000 . 00, or, 200 , 000 . 00 C— 20 per cent of 400 ,000 . 00, or, 80 ,000 . 00 interest $2,000,000.00 680,000 00 $2,680,000.00 Total capital stock for Consolidated Balance Sheet, $4,200,000.00 less $2,680,000.00 equals $1,520,000.00, the amount of the elimination. Since only one item now remains which requires adjustment, that of surplus, the quickest and easiest way to complete the working sheet is to balance up the elimination and Balance Sheet columns by splitting the item of surplus as shown in the "total" column. The working sheet now is completed; the Consolidated Balance Sheet is found in the last column. However, the better to illustrate the technical form of such statement, especially in connection with the determination of minority stockholders' interest in capital stock and suplus, it is necessary to go a trifle further and present the Consolidated Balance Sheet in technical form. But before this can be done, it is necessary to determine the interest of the minority stockholders in the surplus. This may be done as follows: 1. Surplus balance 6/30/15. 2. Add: Income 6 months to 12/31/15, 3. Balance, Surplus at 12/31/15, 4. Less: Profit of A on plant for C, 5. Balance adjusted as on 12/31/15, 6. Less: Dividend paid on 1/1/16, 7. Balance adjusted as on 1/1/16, & Increase (or •decrease) in surplus 6/30-12/31 (#1-7, above), 9. Add: Income (or *lo68) 6 mo. to 6/30/16, 10. Balance, 11. Less: Profit of B on sales to A, Fire loss of B not on books, 12. Balance adjusted as on 6/30/16, 13. Increase (or 'decrease) in surplus 12/31/15-6/30/16, 14. Increase (or 'decrease) in surplus 6/30/15-6/30/16, 15- Distribution of increase: Jones Investment Com- pany, (60 Minority stockholders' interest, (40%) As above (14), A B C 9200,000.00 • 4,000.00 $100,000.00 180,000.00 46,000.00 8A.000.Q0 S380,000.00 $50,000.00 $125,000.00 15,000.00 $365,000.00 $50,000.00 $139,000.00 300,000.00 50,000.00 S 65.000.00 $125,000.00 •$135,000.00 •$4,000.00 $25,000.00 220,000.00 •40,000.00 25,000.00 9 85.000.00 •$44,000.00 10,000.00 45,000.00 •$95,000.00 $00,000.00 $85,000.00 $50,000.00 $220,000.00 ••05.000.00 $85,000.00 $ 85,000 00 •J09.OOO.OO $50,000.00 ) $51,000.00 (75%) •$74,250.00 (80%) $40,000.00 ) 34,000.00 (25%) •24,750.00 (20%) 10.000.00 $85,000.00 •$99,000.00 $50.000.00 < o o z QQ g PARENT VERSUS HOLDING COMPANIES I f a o O I s QQ I a 8 88 8 88 8 i I 8 8 8 8 S 8 O N iM OS O »H 8 a a a o »o 'i" CI «n a a s -3 O O O lO t >• 8 S o a ■*» •• fl I Jl-A &« < m 88 8 8 88 1-4 S Si N I 0*5© - 3 fl H •So® O 8 8 i 8 8 8 8 ■* t* 88 c 'i i o i o s T ■*> s « IS § .§ T I s ©0© © 8 88888888 § i I § ^ 2 g g i 8888 S 8 S 8 8888 2S§Si •» '^ * 8888 8 8 8 8 8 88888 8S8 I a us o o O O I o o 5 I •s ^ -< -< O 9 -w' i §^ J 8 © 8 81 8 U 8 8 8 8 8 88 S 88 8 S S 8 00 8 8 8888 8 2 S !gi ©®®® 8 8 88 8 88 to o i-< 8 8 I .^" 8 88 88 •-I CO 8 8 94 ul a o =5 H I 3 . §M •s. 8 s. 1 CHAPTER XIV FIDUCIARY STATEMENTS Introduction. — Before indicating the purpose of this chapter, the term "estate" must be defined. Webster states that the word refers to "the degree, nature and quality of interest to which one is lawfully entitled as to the ownership or use of property; the rights held by one in regard to things, as an absolute estate, a conditional estate, etc.'' An analysis of this definition, in the light of the purposes of the present and of the next two chapters, produces the following: 1. Assets and the claims thereagainst properly chargeable comprise the subject matter of an estate. 2. The condition of an individual or of an organization deter- mines how these assets and claims (properties) come into contact with accounting. 3. The condition referred to in (2) above, in which present interest is centered, is caused by one of the following: a. The decease of a person, or b. The incompetency of an individual or of an organization to hold, to administer, or to distribute the estate for the benefit of those therein interested. Likewise, the term "fiduciary accounting" must be understood clearly. When an agent accounts to his principal, as does a consignee to his consignor, a fiduciary relationship exists, a rela- tionship under which one person is charged with the administra- tion and management of at least part, if not all, of the affairs of another. Further examples, in part, are as follows: 1. A guardian charged with the management of the affairs of a ward. 2. A lunacy commission charged with the management of the estate of one who, under the law, has been declared mentally incompetent. 3. An executor under a will charged with administering and 463 464 ADVANCED ACCOUNTING distributing the estate of 'a decedent in accord with the provisions of the will. 4. An administrator appointed by a court to administer a decedent's estate where the latter died without making a will. 5. An assignee or receiver charged with administering proper- ties entrusted to his care. Fiduciary accounting, therefore, describes the accounting inci- dent to the administration of estates, such administration being imposed by a position of trust or confidence. As developed in this and in the next two chapters, the term, conforming to the divisions set out above, comprehends the following: 1. Accounting for solvent estates, a. Those of decedents. 2. Accounting for insolvent estates. a. Those which are only financially embarrassed. b. Those which are actually bankrupt. Naturally, all phases of fiduciary accounting are not covered by the above outline, but the above is deemed suflScient for the purpose of illustrating the accounting principles now to be con- sidered. In his previous work on consignmentn, the student probably noticed that the consignee, by virtue of having control of prop- erty belonging to another, exercised certain rights thereagainst which often supplanted those of the actual proprietor. The dis- cussion at the present time is concerned further with the acts, and the accounting revolving around such acts, of those who are charged with the responsibility of an estate which actually be- longs to another. One will find that the prerogatives of these persons, like those of consignees, often replace those of the actual owners. The purpose of the present chapter is to discuss briefly some of the accounting procedures and statements necessary or re- quired for recording and setting out in a comprehensive manner, at least theoretically, the financial transactions relative to the administration of the estate of a deceased person. The writer, primarily, has devoted space to a restatement of principles concerning which there will be no dispute, plus a con- sideration of some of the principles in force within only one FIDUCIARY STATEMENTS: DECEDENTS' ESTATES 465 jurisdiction. Local laws are at variance, and the prospective accountant must recognize that herein generalization has been the attitude of the writer. Further Definitions, Terms, and Distinctions. — For the purposes of the present chapter, the following definition of the term "estate" is more satisfactory than the former one of Web- ster: ''One's entire property or possessions — property left over after death — assets over liabilities, etc." A "will" is a person's solemn declaration in written legal form, signed by such person (the testator) in the presence of witnesses, whereby he disposes in whole or in part of the property of which he shall be possessed at the time of death. A will is revocable during life. The testator, after death, is referred to variously as the testator, the deceased, or the decedent. One who dies leav- ing no will is said to have died intestate. An addition to, or qualification of, a will is called a codicil; this, as Blackstone said: "May add to, take from, explain, alter, confirm, republish or revive any will with which it may be incorporated." A codicil need not be physically attached to the will, but must, by its language, identify itself with the will it is intended to sup- plement. An heir is one entitled by law to succeed to the real estate of a person dying intestate or leaving property undisposed of by will. Personal property, unless an heirloom, does not descend to heirs, but is distributed, as by the administrator, after the payment of all just debts, funeral and testamentary expenses, among the next of kin in order of relationship. One to whom real estate is bequeathed by will is called a devisee ; one to whom personal property is left is called a legatee. An heirloom is a movable chattel which, by virtue of its special relationship to the estate, descends to the heir with the lands. An executor is a testator's personal representative named in his last will and testament to execute or carry out its provisions as concerns the testator's personal estate. If a woman be named for carrying out these duties, she is called an executrix. An executor must be duly approved by the court (Surrogate, Probate or Orphans', as the case may be) having jurisdiction where the decedent last was domiciled. If a person die intestate, or if no one be named in the will as 466 ADVANCED ACCOUNTING executor, or if the executor named in the will dies or cannot qualify, the power of appointing someone to administer the estate of the decedent vests in the Court, and the one so ap- pointed, who may be either husband, widow, child or next of kin, is called the administrator or administratrix. If the Court has to appoint an administrator, because the will of the decedent makes no provision therefor, the person so appointed is known as an administrator with the will annexed. Hereunder, in the case of an administrator (excepting one with the will annexed), the law of descent in the particular jurisdiction or locality gov- erns the settlement of estate affairs, and the distribution of the remaining assets. A trustee is one who holds legal title to property subject to an obligation to apply such property in accord with the terms of a trust for a beneficiary, or cestui que trust. In the case of a decedent's estate, the trustee is named in the will, as a general proposition. The beneficiaries of an estate are those who share in the property of a decedent, either by virtue of a will or be- cause of their relationship to the decedent. Property given in trust is known as principal. The earnings from such prin- cipal during the trust period are calleelow : a. Debts due petitioner on open account. b. Stocks in incorporated companies, interest in joint stock companies, and negotiable bonds. c. Policies of insurance. d. Unliquidated claims of every nature, with their esti- mated value. e. Deposits of money in banking institutions and elsewhere. Subdivision 4.— This states the property in reversion, remain- der or expectancy, including property held in trust for the debtor or subject to any power or right to dispose of or to charge. Other items to be included are: a. All property heretofore conveyed for benefit of creditors, with amount realized thereon. b. All sums paid to counsel, and to whom, for services rendered or to be rendered in the bankruptcy proceed- ings. Subdivision 5.— This is a statement of all property claimed to be exempt: a. Military uniforms, arms, and equipment. b. Property claimed to be exempted by state laws, its valu- ation, whether real or personal, its description and pres- ent use. The state statute referred to should be indi- cated, as well as the total value thereunder exempt. Subdivision oint to keep in mind in the solving of this problem is the fact that the so-called receiver is acting in two capacities: 1. Liquidating the old business. 2. Trading. Hence, it is necessary to keep the two sets of transactions as separate, one from the other, as is possible. Outside of this one point, this problem seems lacking entirely in suflicient information to be considered of much worth. And because of this lack of information, the only separation here possible relates to the accounts receivable. The first step would seem to be to prepare a Trial Balance of the accounts so that therefrom the statements called for may be prepared. This is given below with information as to how certain of the items therein were deter- mined: Cash ($10,097.60 plus $65,448.83 plus $46,251.10 minus ($7,279.07 plus $7,956.97 plus $105,549.09 plus $1,000.00) ), Accounts receivable: Old ($218,477.15 minus $10,097.60), New ($113,435.77 minus $65,448.83), Inventory (grain at beginning). Purchases, Manufacturing expense, Selhng expense, Receiver's expense. Bank loan, Accounts payable, Sales, Sales returns, allowances, etc., Estate capital account. Totals, I 12.40 208,379.55 47,986.94 29,359.74 110,786.61 7,279.07 7,956.97 1,000.00 1,370.85 $ 46,261.10 5,237.52 114,806.62 247,836.89 $412,761 .28 $412 , 761 . 28 FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 511 The second step would be to prepare the trading statement as required; this is shown below; Gross Sales, Less: Returns, Allowances, etc., Net Sales, Less: Cost of Sales: Trading Statement $114,806.62 1,370 85 $113,435.77 Inventory, Beginning, Purchases, Inventory, End, Manufacturing Expense, Selling Expense, Profit from Trading, $ 29,359.74 110,786.61 $140,146.35 51,005.62 $ 89,140.73 7,279.07 7,956.97 Profit and Loss Statement Profit from Trading (as above), Less: Receiver's Expenses , Net Profit from Receiver's Operations 104,376.77 $9,059 00 $9,059.00 1,000.00 $8,059.00 Balance Sheet Assets Accounts Receivable: Old, New, Grain and Products on Hand,, Cash, Total, Liabilities Bank Loan, Accounts Payable, Estate Capital Account, Beginning Balance, Net Profit from Receiver's Operations, Total $208,379.55 47,986.94 $256,366.49 51,005.62 12 40 $307,384 51 $ 46,251.10 5,237.52 $ 51,488.62 $247,836.89 8,059 00 255,895.89 $307,384.51 Statement of Affairs with Accompanying Deficiency Account. — The second statement made mention of above, as covered by the title of this present section, is next to be discussed and, in this connection, from a double point of view: 1. Financial embarrassment, as where creditors cannot be paid promptly even though assets exceed liabilities. 512 ADVANCED ACCOUNTING II 2. Insolvency due to the fact that the liabilities exceed the assets. a. An individual or organization may be able to pay current obligations in the immediate present and perhaps dur- ing the near future, but because liabilities exceed assets, a time will not be far remote in which the obligations can- not be paid due to exhaustion of assets. b. An individual or organization going through bankruptcy. In each of the above cases, impending or actual in- solvency is seen. And under each of these circumstances it is necessary to secure more capital, to reorganize in some way as by a change of personnel, or to dissolve en- tirely. Regardless of the remedy, the creditors and pro- prietors are vitally interested, especially as to the rela- tion of available asset values against liabilities. Both classes of persons interested must have the financial condition of the activity so displayed that they can see clearly the probable outcome of the reorganization or the probable pro- ceeds resulting from realization. And in this connection, the creditors' claims are of first importance as to the order in which they will be met and the . percentages thereof to be paid. If an individual or an organization be insolvent, no principal, under the law, can take precedence over any creditor in the distribution of the assets. Likewise, where bankruptcy either is trying to be avoided, — as by the appointment of a friendly trustee, — or is actually contemplated, it is necessary to compare the original financial position with the possible realizable position. For such purpose, the usual Balance Sheet is entirely inade- quate, the reasons therefor being about as under: 1. Since the possibility exists that the assets are not to be continued in use by the activity, at least wholly, those not to be thus continued must be sold at whatever can be procured for them. A Balance Sheet cannot indicate what will be the amount of this estimated realization. 2. When assets are sold at a forced sale, they will pro^ different from mse f ,n the capacity of proprietor. I„ a partnership, although t^.e bus,„ess is not an equity separate and distinct f om tZe who compose It, one must keep in mind the rule of law as" gard' the marshalline of assets Rri^fl,, *i j . • "" ^egaras follows- "lUaL I ^' t''^ doctrine is state- -ciud^i a.ai„ .e ^on...^.^^:^:^^^-:^::^:^^^. ^ash, Land and buildings, ^ 500 . 00 Mortgage on land and buildings 10 , 000 . 00 Plant and equipment I «, 000 00 Creditors, ^ ^ ' 20,000.00 69,400 00 FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 515 Completed contract accounts (losses). Capital, Uncompleted contract accounts (outlay), Securities acquired in settlements, Debtors ' accounts for completed contracts. Expenses, Inventory of materials. Profit and loss (deficiency), 18,000.00 30,000.00 15,000.00 6,000.00 6,500.00 2,000.00 9,400 00 50,000.00 $117,400 00 $117,400.00 The sureties on the unfinished contracts estimate that a further outlay of $20,000.00 will be required to complete the work and realize the contract price of $40,000.00, and their offer to take over the materials on hand for $ 1 , 500.00, as part of said cost, is accepted by the receiver. Of the securities ac- quired $5,000.00 is pledged to secure $11,000.00 due creditors, and $10,000.00 is pledged to secure $9,000.00 due creditors. The company owes for taxes on real estate $100.00 and for salaries and wages of employees $1,200.00, which sums do not appear on the books. The company has discounted customers' notes for $3,000.00, of which subsequent advices indicate that $1,000.00 will be dishonored, and a debtor owing $1,500.00 on unsecured account has failed and disappeared. It is estimated that the amount realized on land and buildings will be sufficient to satisfy the mortgage only, and that plant and equipment will realize only 6 per cent of the book value. Prepare a statement of affairs and deficiency account. (C. P. A. — Md.). Solviion to Problem. — In the solution of this problem, the following com- ments should be kept in mind: 1. The problem states that " plant and equipment will realize only 6 per cent of the book value." Undoubtedly, there has been a misprint in that the 6 per cent should be 60 per cent. No matter how old a fixed asset may be, it ought to produce at least 60 per cent of its book value upon a forced sale if such book value represents actual cost. 2. The handhng of the item of taxes requires some explanation. Taxes are of two kinds: a. Personal property taxes: These always are a preferential claim to be deducted from the assets in the same manner as are salaries and wages. b. Real property taxes: These are a hen against the fixed asset to be paid from the proceeds secured from the forced sale of such asset. They would be paid first, and any deficiency in favor of the mort- gagee would be paid with the other unsecured creditors when allowed by the Court. The solution follows: 516 ADVANCED ACCOUNTING i' 1 i ff ^ 4 < < o g m I 8 8 5 1 "i S •*< V tf ■«i> « H pq « 5 < 8 S 888 ^i-i»0 O 5 -ities. U3 0*3 01 o«| 88 8 e« s Si 8 8 8 8 8 8 8 i 8 i 8 8 o 8 8 8 8 S S 8 00 8 i 8 8$ 5 n 8 8 2 .ss 08 u 1 .« I 1 a o fi 2 O 3 o «15 8 s^ c •C ISls^ OS OQ 08 c3 1 • mm 1 8 8 i » 8 5 a; s a o O "S 00 a *s o HP at 8 8 ^ >o s I I 8 8 00 <» lii FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 8 8 2 -^ 8 8 s 00 8 517 8 s I 8f^ 08 SO) (g 03 «-3 JQ g 8 "o I § a ^ si ^ *' fl ^1 I ^ la .9 an '^^ a «? o 8 CO B I .S3 OS 4) U2 a 01 i O « m a 1 3 QQ « o « 3 -a 00 8 8 8888 8 c^ 00 o ^ •8 8 CO 8 §1 8888s 88888 oo«ooa cH i e i OQ 08 a ••5 =3.9 3 if ■s 08 O O ©■•J 3 cr "O CD w 08 OS g 5S5 o ■•J s I 5 C3 O 4>> «> 08 opL, $-3^ « B 08 O « til SI si i I H CHAPTER XVI FIDUCIARY STATEMENTS (CONTINUED) Introduction.— In the last chapter the conditions underlying insolvency and bankruptcy were discussed. In addition, the following matters were presented: 1. The schedules and summary by means of which the liabil- ities and assets of bankrupts must be presented to the Court. 2. The Statement of Affairs and accompanying Deficiency Account used to indicate: a. Probable realizable financial position: the Statement of Affairs. b. Reasons for insolvency: the Deficiency account. In the present chapter, two further subjects of importfmce, relative to fiduciary- accounting, will be discussed: 1. The procedures necessary to keep the actual accounts of a trusteeship. 2. The statements used to present the results of such trustee- ship. Basic Distinctions Reviewed.— Certain basic definitions in part already referred to must be reviewed with the idea of re- membering them in connection with the work of the present" chapter: 1. Trustee. A person to whom the property of another has been conveyed either to be held by him or to be managed by him for this other person. 2. Friendly trustee. A trustee may be appointed by the court, or he may be appointed by agreement between the proprietors and the creditors; in the latter case, he is a friendly trustee." 3. Receiver. Two kinds of trustees are appointed by the Court: 518 FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 519 a. One who is appointed by a bankruptcy Court, and who follows a person temporarily appointed thereby to pre- serve the estate until he (the trustee) has been ap- pointed. The person who has thus been appointed temporarily is known as a ''receiver in bankruptcy." b. One who is appointed by a Court of Equity when an assignment has been made for the benefit of the creditors. This person is known as a "receiver in equity." In short, when a "receiver" is spoken of, the receiver in equity is probably the type to which reference is made. Receivership Accounting.— The accounting for receivers in bankruptcy is simple, in that such a receiver is appointed only temporarily, does not operate the business, and does not liquidate; he merely holds the assets until a trustee is ap- pointed. The accounting for a trustee in bankruptcy is not so simple as the accounting for a receiver in bankruptcy, but is much simpler than the accounting for a receiver in equity. His ac- counting covers the realization of the assets and the liquidation of the liabilities; infrequently, he will keep account only of receipts and disbursements. The accounting for a trustee in equity should follow along the same basis or lines as the accounting made use of under normal conditions of operation ; in fact, it will be no more complex than the latter. Transactions prior to the trusteeship should be distinguished clearly from those taking place subsequent thereto. The reasons therefor may be enumerated about as follows: 1. Receivership in equity. The activities of the trustee must be set forth clearly in order that they may be known definitely. 2. Receivership or trusteeship in bankruptcy. a. The result of the activities thereof must be set forth clearly in order that they may be known definitely. b. The assets as at the time of insolvency must be ascer- tained because these represent a fund out of which the liabilities must be paid, subject only to the necessary expenses of the asset realization activity. w 520 ADVANCED ACCOUNTING n A list, therefore, should be prepared, as at the beginning of the trusteeship, of the assets and liabilities, of the estate. The list of assets may be made up in accord with the values ex- pressed upon the books of account, or the values may be in- cluded at their appraisal worth for realization purposes if the trusteeship is such as to require this,— as where the realization is to proceed. The liabilities to be considered in this type of estate account- ing are of two kinds: 1. Outside creditors' liabilities. These are fixed definitely by the publishing of a required notice setting a specified length of time during which such claims may be presented and proved. The period of time may be governed by the Court, being extended thereby from time to time but when once ended it may be assumed that the liabilities to be met are only those which have been proved. 2. Liabilities incurred by the trustee. These would take pre- cedence over those existing at the moment of insolvency because incurred to protect the original creditors; they could not have been incurred if these subsequent creditors had rights and equities no better than those of the original creditors. Therefore, the two classes of liabilities must be earmarked clearly. The law is silent as to the manner in which a receiver or trustee shall keep his accounts. Basically, he must charge him- self with what he takes over and credit himself with that which is disposed of by himself. The old books may be con- tinued or new ones may be used. In either event, the identity of the original items must be preserved so that confusion will not result as between the claims of different rank. Again, after the assets have been appraised, the resulting shrinkages should be written off against the capital; .^kewise, the other nominal elements should be written off there against. T^e purpose here contemplated is to express upon the books eventually only the inventory value of the assets plus the liabilities. Realization and Liquidation.— When the assets of an estate, business or otherwise, are converted into cash, and this cash is FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 521 applied, after the costs of the conversion have been deducted, to liquidating the claims against such estate, a "realization and liquidation" has taken place. In the case of a receivership or trusteeship, three degrees of possibility exist relative to the activities incident thereto: L The affairs may be wound up fully, a complete piecemeal realization of its assets being involved. 2. The affairs may be wound up fully but, instead of a piece- meal realization of the assets, the enterprise is sold as a going concern. 3. The affairs may be wound up partially and, .also, be partially continued in a going manner so that, eventually, the enterprise will be restored to its owners in a healthy condition. This is a common occurrence and would arise where a friendly trusteeship comes into existence. The first two possibilities do not differ materially one from the other, for the present purpose, in the accounting required, and therefore may be referred to as a "simple realization and liquidation." The third possibility differs greatly from the other two, and therefore must be considered separately; it involves something more than a simple realization and liquidation. In describing the procedures made use of in connection with the present type of fiduciary accounting, a division is indicated along the lines mentioned immediately above: 1. The simple realization and liquidation. 2. The realization and liquidation accompanied by activities of trading or operation. Simple Realization and Liquidation. — This may involve one of two elements already mentioned: 1. The element of insolvency, as where a concern is bankrupt and must be wound up fully for the benefit of creditors. 2. The element of mere dissolution, as where a partnership is to be dissolved, the firm, for some reason or other, going out of business. In either event, two methods present themselves as to the manner in which the accoimts may be carried upon the books thereunder: 1. Keep them uniform as nearly as possible with those pre- 522 ADVANCED ACCOUNTING ■ A -m I viously kept. As assets are converted into cash, the Cash account will be debited and the asset accounts affected will be credited. As cash payments are made to creditors, the Cash account is credited and the liability accounts affected are debited. WTien all the assets have been realized upon, a balance remaining in any asset account represents a reali- zation loss, whereas a remaining balance in any liability account represents a loss to creditors. The closing of the accounts remaining open depends upon whether the business IS that of a sole trader, a partnersliip, or a corporation: a. Sole trader. Close remaining open accounts into pro- prietor's Capital account. b. Partnership. Charge losses against the partners' Capital accounts in the proportions in which they share profits and losses. c. Corporation. Debit the Capital Stock account for the shares of capital stock. turned in by the stockholders for cancellation, and close the remaining accounts through Surplus account. The losses due to realization, therefore, are chargeable to the Capital account of a sole trader, to the Capital accounts of the partners, and to the Surplus account of a corporation. The balances remaining in the liability accounts, if the realization is conducted at a loss, in the case of a sole trader, will equal in amount the debit balance remaining in his Capital account; in the case of a partnership, the amount of the unliquidated liabilities will offset the debit balances remaining in the partners' Capital accounts; and in a corporation these unliquidated liabilities will be offset by a debit balance in the Surplus account. 2. The assets and liabilities may be consolidated in an account titled "Realization and Liquidation." The operation of this account probably has been described in the students' work in connection with partnerships. If used, the account is debited with the amounts of the various assets, the respec- tive asset accounts being credited; it is credited with the liabilities, the respective liability accounts being debited. The balance of the account, if a debit, shows the amount by FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 523 which the asset values exceed the liabilities; and if the balance is a credit, such credit indicates the deficiency by which the liabilities are greater than the assets. If some cash is on hand, the item may be either included or ex- cluded from the account; it may be excluded because it is in its ultimate realizable form. It is advisable, however, to include the item and then immediately make an entry to take it therefrom, as under: Trustee's Cash Account, To — Realization and Liquidation Account, S i $ i The detail accounts receivable and payable should be carried in their respective subsidiary Ledgers, the total amounts thereof only being shown in the Realization and Liquidation account as controls over such subsidiary Ledgers. As cash is received from the realization of as- sets, the Trustee's Cash account would be charged and the Realization and Liquidation account credited. As liabilities are liquidated, the Realization and Liquidation account is charged and the Trustee's Cash account is credited. When expenses of realization are paid, the same entry would be made, as just above. When the realization and liquidation has been completed, the balance in the account of that name shows the net profit or loss resulting from the reali- zation; usually, the balance will indicate a loss. It is not usually desirable to show such losses or profits, under either case, in a Profit and Loss account. It should be remem- bered that the latter account shows the results of the operation of a business. In this winding-up process no business operation is contemplated; therefore, the results of such wind-up should not be entered in that summary account, but in what is known as a Realization and Liquidation account. When a partnership is dissolved, for example, the wind-up may continue for a long period of time, for months. Under either the first or second cases described above, it would be customary to present the results of the trusteeship in the form of a statement, this being titled ''Statement of Realization and Liquidation." This statement will be described later after cer- tain other matters have been considered. I 524 ADVANCED ACCOUNTING r- i :i ! 1;;j Realization and Liquidation Accompanied By Activities of Trading or Operation. — Under this possibility, the procedure outlined above in the last section would be supplemented by the addition and maintenance of ordinary trading accounts. These latter would be kept entirely separate, perhaps in a distinct set of records or, as is more often the case, by using the Realization and Liquidation account as already shown plus a list of accounts arising because of the added activity. Again, for example, suppose a business has become merely financially embarrassed, without being actually insolvent as contemplated under the bankruptcy act. The creditors are in- formed of the existing conditions and are asked to render what- ever assistance they can. As a rule, the creditors will rise to the occasion in order to protect their interests. If so, some out- sider, perhaps one of the creditors, will assume charge of affairs. As a trustee, this outsider is in exactly the same position as one who is going to discontinue business except that he is going to operate the concern, convert some of its assets into cash, and liquidate the claims of creditors. When this purpose has been accomplished, the business will be returned to. its proprietors. Hereunder, are two distinct propositions over which control must be kept: 1. The realization and liquidation proper. 2. The operations of the trustee. The result of each, if possible, should be secured separately, although it may not be so done as where only the combined result is set out. Since the goods inventory must be used by this added activity, one of the first things to do would be to credit its amount to the Realization and Liquidation account and charge a properly earmarked inventory account therewith. The result of this added activity should be set forth, prefer- ably, in a regular Profit and Loss account, and the balance thereof carried over into the Realization and Liquidation account therein to be combined with the result of the regular realization and liquidation. Periodically, statements would be prepared to show the net results both as to the realization and liquidation proper and as to the added activity; these statements may be prepared either separately or be consolidated into one with FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 525 separate sections which would correspond to the separate state- ments, and at the end of which would be shown in summary form the combined result of each section. Frequently, a Balance Sheet will be submitted in addition. Statement of Realization and Liquidation. — This statement has been referred to above from time to time in connection with the two types of fiduciary accounting described. It is necessary now to consider this statement briefly in order to round out the theoretical discussion of the present chapter and to lead up properly to the illustrative problems solved herein. Basically, the statement covers the transactions incident to the liquidation, being arranged in such a manner as to acquaint the reader thereof with their nature. In fact, it is prepared exactly along the lines indicated in the discussion above con- cerned with "simple realization and liquidation." When a simple realization and liquidation is contemplated, the statement is not difficult to prepare. Its sections coincide with the groupings of the items found within the Realization and Liquidation account, if the latter be used. Because of this similarity, it was deemed unnecessary to present a form of such account as part of the previous discussion. The statement often is referred to as an account since, usually it appears in account form but, naturally, it is not an account in the strict meaning of the term. If the Statement of Affairs is an estimate or prophecy, — ^what it is hoped may be done, — ^the Realization and Liquidation statement (or account) becomes the test by means of which the accuracy therein displayed is measured. For a simple realization and liquidation, the form thereof, would be about as follows : FIRM OF BLANK BROTHERS Realization and Liquidation Account as of Assets to be Realized Upon: In detail. Additional Assets Discovered : In detail. Liabilities Discharged: In detail. Liabilities not Discharged: In detail. Liabilities to be Discharged: In detail. Additi onal Liabihties Discovered: In detail. Procee ds from Realization of Assets: In detail. Assets not Realized Upon. In detail. H 526 "Hi' i ADVANCED ACCOUNTING Expenses of Realization and Liqui dation : In detail. Balance, (if debit) Net Profit on Balance, (if credit) Ne t Lo8a_on Realization and Liquidat ion. Realizati on and Liquidati on. Scrutiny of this statement will show that, if properly prepared, one can trace, for example, any asset from its original amount down through its increase or decrease during liquidation, pro- ceeds from the sale thereof, and resulting profit or loss thereon. When a realization and liquidation is accompanied by activi- ties of trading or operation, the situation encountered is an awkward one to handle if clearness is desired. The statement prepared under this condition may assume either one of the two following forms, the writer's preference being the second one. The first form suggested is similar to the one shown above with its scope slightly extended. A comparison of the two forms, one with the other, will show wherein exists the difference be- tween them. The first type of statement, showing section head- ings only, is given below: FIRM OF BLANK BROTHERS Realization and Liquidation Acco unt as of Assets to be Realized Upo n. Additional Assets Discovered. Liabilities Discharged. Supplementary Charges. Liab ilities not Discharged. Net Profit on Realization Liquidation. Liabilities to be Discharge d. Additional Liabilities Disc overed. Proceeds from Realization of Assets. Supplem e ntary Credits. Assets not Realized Upo n. and Net Lobs on Realization and Liquidation. Although the above form is the one usually made use of, seemingly it violates certain principles of accounting in its set- up in that the trustee is chargeable thereon with dissimilar elements at one and the same time, as with both profits and losses. To avoid this criticism, the statement may be prepared so that an absolute divorce is made between the realization of the original estate and the operations of the trustee. Two separate results are secured thereunder: 1. Loss on realization and liquidation. 2. Profit on the trading activities of the trustee. The determination of each of these results becomes the province FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 527 of separate sections of the statement. And these two results are brought together in a third portion of the statement in summary form, the resulting balance therein being the net profit (or loss) of the trusteeship period. It is believed that this method of solution follows more accurately the practical way in which an actual receivership is carried out than does the method indicated by the pro forma statement to which reference already has been made. A form of this type of statement is not submitted at this point, because it is made use of in the solution of the second problem following. Illustrative Problems and Solutions.— In concluding the discussion of the present chapter, three problems are given, each of which is solved in accord with the principles advanced above. The first problem illustrates the closing process involved in handling a simple realization and liquidation upon the books; it is out of this simple process that the Statement of Realization and Liquidation has been evolved. The second and third problems illustrate the Statement of Realization and Liquidation where the activity is accompanied by trading or operation. Since the statement is much more diffi- cult to prepare under this second type of realization activity,-— where a rehabilitation is contemplated of a concern financially embarrassed,— than under the first type or simple realization process, two problems are solved instead of just one. Problem 1.— On May 14, 1920, a fire destroyed the premises at 936 Osgood Street, rented by John Smith and used by him a^ a clothing store. His stock of merchandise and the store equipment, together with a Ford dehvery wagon kept in a rear shed, were insured for $1,500.00. With the exception of the Ford and the office safe, everything was either totaUy destroyed or rendered comparatively useless by fire and water. Because of the fire and the small amount of insurance carried, Mr. Smith practically was ruined and, in order to avoid bankruptcy proceedings, he called his creditors together, showed them the condition of his affairs, and then left the matter entirely in their hands for disposition. The creditors agreed that the business should be wound up under the direction of a trustee appointed by themselves. The latter was directed to collect the money from the insurance company, reaUze upon the salvaged stock and effects, collect what he could of the outstanding debts, pay the expenses incidental to windmg up the business, and distribute the balance pro rata among the creditors. The agreement was signed by the debtor and his creditors on both accounts and notes payable, and the trustee then took possession. 528 ADVANCED ACCOVNTING : 1 •)(! ^1 The books were taken from the safe and W(»re written up to and including May 20, after which the following statement was prepared therefrom: JOHN SMITH Statement of Assets and Liabilities as of May 20, 1920 Assets Cash on Deposit, $ 579.80 Merchandise, 6,230 25 Notes Receivable, 406.58 No. 1, iSOO 00 No. 2, 206.58 Total (as above). •406 58 Accounts Receivable, 1,475.85 A. Roth, $286.20 B. Walker, 227 80 C. Sobel, 689.85 D. Anthony, 70.50 E. Worms, 201 50 Total (as above), sets. $1,475 85 Total Current Ass $8,692.48 Automobile, $140 00 Store and Office Equipment, 513.00 663.00 Total Assets, $9,345.48 1 ■ .1 — t Liabilities and Capital Notes Payable, $1,315.00 Ross Brothers, $ 815 00 Bentley Sidle Co., 600 00 Total (as above). $1,315.00 Accounts Payable, 4,962.80 A. Henry, $ 360 00 C. Krafer, 140.00 B. Cohn, 640.50 D. Currie, 740 00 Mordant Co., 1,875.00 Cable Co., 1.207.10 Total (as above), $4,962.80 Total Liabilities, $6,277.80 John Smith, Capital, 3,067.68 Total Liabilities and Capital, $9,345 48 The wind up of the business was concluded on May 31, and the transac- tions of the trustee from May 20 to May 31 were as follows: 1. Wrote each debtor offering to settle at a discount of 10 per cent, a receipt in full to be given for a return settlement. 2. Received from the insurance company amount of insurance in full FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 529 which wa« pro-rated as follows: merchandise, $1,117.00; store and office equipment, $383.00. 3. Advertised sale of damaged stock and effects by auction. Paid therefor to the local papers, $122.50. 4. Received of A. Roth, $257.58, and from C. Sobel, $620.87, both in full of account. ®' f^''ni'"'/"*°.*° ^- ^°™" ^°' *^'^' ""'^ t*"* ««f« t« A. Sorensen for g^yu.uu, for which cash was received. 6. Received from B. Walker sight draft on the City Bank for $205.00 m full discharge of account. Drew on E. Worms, at his request, and allowed him a discount of $20.15. It wa^ ascertained that D Anthony had left the city with nothing but debts behind, where- abouts unknown. ^' I^LT.^'r f! ""^^^^^ ^^■^^' ^^^ a^^tioneer turned in his check for $450 25, he deducting $50.00 for his charges. Proceeds were prorated as follows: merchandise, $460.25; store and office equipment $40 00 8. Paid for clerk hire, $30.00; and for signs, hand-biUs, and expenses mcidental to auction sale, $46.90. in* ?'Tr*?^u^v "''*^' ^^^^'vaWe with City Bank receiving $360.00 net. 10. Paid the liabilities to creditors pro rata with the cash on hand after deducting fees and expenses of trustee in the amount of $328.77 and closed the remaining accounts. ' Make entries in journal form necessary to cover the above Solution to Problem l.-The entries in journal form, covering the require- Zr^V r t ^'''i^^''"' ^'' ^^''' ^"*^^- I* i« ^«""^«d that, at the time of the take over, the Ledger account balances were in agreement with the amounts found upon the statement. 1. Cash on Deposit, $1,500.00 To-Merchandise, $1,117 00 Store and Office Equipment, To record cash received from insur- ance company. Realization and Liquidation Account, To — Cash on Deposit, Advertising bills paid. Cash on Deposit, Reahzation and Liquidation Account, To — Accounts Receivable, Collections as follows: Cash 383 00 $122.. 50 $1,264.80 211.05 $122 50 $1,475.85 A. B. C. D. Roth, Sobel, Walker, Worms, E. Anthony, Total, $ 257.58 620.87 205.00 181.35 Bad Debt $1,264.80 211 015 $1,475.85 Dis count $28.62 68.98 22.80 20.15 70^50 $211 05 ' $140.00 90.00 $450.25 50.00 $460.25 40.00 530 ADVANCED ACCOUNTING 4. Cash on Deposit, $140.00 Realization and Liquidation Account, 90 . 00 To — Automobile, Store and office Equipment, Cash collected from sale of above assets. 6. Cash on Deposit, Realization and Liquidation Account, To — Merchandise, Store and Office Equipment, Receipts from auction sale, $50.00 being auctioneer's charges. 6. Realization and Liquidation Account, To — Cash on Deposit, Expenses paid. 7. Cash on Deposit, Realization and Liquidation Account, To — Notes Receivable, Notes discounted. 8. Realization and Liquidation Account, To — Cash on Deposit, Charges and expenses of trustee. At this point the realization entries havt» been completed. It remains now only for the trustee to pay off the debt**, he having $3,766.68 on hand with which to do so, this being sufficient to pay $.60 on the dollar. $76.90 $360.00 46.58 $328.77 $76.90 $406.58 $328.77 9. Accounts Payable, A. Henry, C. Krafer, B. Cohn, D. Currie, Total 360 00 140.00 640.50 740.00 $4,962.80 Mordant Co., 1 ,875 . 20 Cable Co., 1,207.10 60 per cent $ 216.00 84.00 384 30 444.00 1,125.12 724.26 N! II' $4,962.80 $2,977.68 $815.00 500.00 $489.00 300.00 $1,315.00 $3,766.68 11 Total, Notes Payable, Ross Bros., Bentley S. Co., Total, To — Cash on Deposit, Reahzation and Liquidation Account 10. Reahzation and Liquidation Account, To — Merchandise, To close. 11. John Smith, Capital, To — Realization and Liquidation Account, To close. $1,315.00 $4,653.00 $3,067.68 $3,766.68 2,611.12 $4,653.00 $3,067.68 Illustrative Problem 2. — Although this is one of the earlier C. P. A. prob- lems and, because of its type, has been used by certain others for illustrative FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 531 purposes, the problem is so well adapted as an illustration of the application of present prmciples that the writer has made use of it again; however, it is believed that the method of solution adopted does not conflict in any way with those already propounded by others. The affairs of Peter Post, a manufacturer, were in a very critical condition, for although he had an unimpaired investment of $62,500.00, and his books showed a clear increase of $6,022.00, he owed his trade creditors $25,289 00 and had only $265.00 in cash and $4,062.00 in receivable book accounts on which to rely for funds. The rest of his business estate was tied up in the following chattels, which he had acquired in an effort to keep pace with a business growth that had outrun his capital : Machinery and tools, $31,497.00; raw materials, $18,838.00; partly made goods, $31,562.00, and finished wares,' $7,587.00. It was also necessary, in order to continue operations, to have immediate cash for pay rolls and incidental expenses. A meeting of his principal creditors was called and as it appeared that the business was well established, profitable and had a sure and growing market, they decided to advance him $6,000.00 in cash for immediate needs and extend his credit in a sufficient amount to permit of the purchase of necessary materials and generally to continue operations till the present stock of materials could be made up and realized on. In order to insure the proper application of the funds and credit so pro- vided, a trustee was appointed to administer the finances till the creditors* claims were satisfied, at which time the control would revert to the proprietor. The subsequent operations under the trusteeship were as follows: Cash paid for labor, $15,725.00; for expenses, $5,430.00; for additional tools, $750.00; purchases on book account, charged to materials, $6,300.00, to ex- penses, $15,000.00; sales on book account, $72,300.00; loss on collection of book debts, $380.00; personal drawing of Peter Post, $3,500.00. The unliquidated values at the close of the trusteeship were as follows: Inventory of raw materials, $5,000.00; finished wares, $27,900.00; accounts receivable outstanding, $3,382.00, and accounts payable, $89.00. Prepare with due regard to the grouping, order and arrangement of the Items, as best calculated clearly to display the facts, (a) realization and liquidation account, (b) trustee's cash account, (c) balance sheet of business as restored to Peter Post. Solution to Problem 2 —It would seem that the first thing to do in com- mencing the solution of this problem is to prepare a Balance Sheet for Peter Post as at the moment his affairs were turned over to the trustee. By so doing, a definite point of commencement is secured from which to proceed. This statement is as follows: PETER POST Balance Sheet as of (Date when affairs turned over to trustees) Assets Cash, Accounts receivable, $ 265.00 4,062.00 532 ADVANCED ACCOUNTING FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 533 I I i \ i Finished wares, Partly made goods, Raw materials, Machinery and tools, Liabilities 7,587.00 31,562.00 18,838.00 31, 497.00 $93,811.00 81 s s s Trade creditors, Capital, Surplus, 125,289.00 $62,500.00 6,022.0 68 , 5220 $93. 811.00 The next step, which contemplates the first requirement of the problem, is to prepare the Realization and Liquidation account. It is presented on page 533. The second requirement of the problem is to prepare the trustee's Cash account. This means exactly what the term "Cash account" implies,— a record of the receipts and disbursements of cash, in this case, as made by the trustee. The opening balance represents the cash turned over by the estate to the trustee. Originally, as per the first section of the Realization and Liquidation account, this amount is shown as an asset to be realized upon. When turned over to the trustee, it is an asset realized, being shown as such; the Cash account follows: Trustee's Cash Account 19— 19— Balance taken over, $ 265 . 00 Loan from trade creditors, 6,000.00 A ccounts receivable, 72 , 600 . 00 Materials, Labor, Expenses, Tools, Accounts payable (includes loan from creditors of $6,000.00), Drawings, Balance, $ 6,300.00 15,725.00 20,430.00 750.00 Balance, $78,865. 00 $ 960.00 31.200 00 3,500.00 960.00 $78,865.00 The third and last requirement of the problem is to prei)are a Balance Sheet of the business as restored to Peter Post. Although the ordinary simple account form of statement would be sufficient for the purpose, the comparative form of statement seems more desirable in that by such use one may secure a ready comparison between the two Balance Sheets, one just before, and one just after, the trusteeship. The Comparative Balance Sheet is shown on page 534. CM 81 8 i 8 88 94 »* ^ 00 8 00 i ^ OS ■a « u3 S I 8 us 8 00 •ft 8 8 8 I o CO a g ■< o -< ■< H a -s-c 1 >.s 1^1 8 i 3 o if I S 53 M a H O I „^ s sss s s 00 CO 8 8 I 1 IS £ S I 1 f S 8 88 8 88 ■ft >ft CO 00 t^ £2 o» 00 ^ 00 ^ »H CO 8 •3 8 00 IM 4 •S 8 O m S « <^ J <: fe »* « 3 o I lU ft* s s S § 1^ S c ■^ OS CQ •X3 a at I e a 02 a eg o H 8 8 ec CO I 81 00 •ft 3 ■3 cr 1 a 9 ■S C to 1 e a C8 b B -*« vs 1 g Pi § 8 J 1 .2 o ^ I a «^ "S 1 S 3 » a ii IJ 1 3 o ;3 »3 I 534 t li H >) ■ \ ii i III !|' ADVANCED ACCOUNTING PETER PgST CiOMPAB AT TVB BaLAW CK ShEBT as of ■ Assets End I NO.OO 3,382.00 27,800.00 5,000.00 32.247.00 Beginping $ 265.00 4.062.00 7.587.00 31.562.00 18.838.00 31.497.00 Irierease $ 095.00 20.313.00 109.489 00 $93,811 00 $ 89.00 62,500 00 6,il00.00 $69,489.00 $25,289.00 62.500.00 6 ,022.00 $93,811.00 780.00 $21,758.00 24.322.00 $46,0K0 00 _$878^ $878.00 24,322.00 $25,200.00 Decrease t 680 00 31.562.00 13.838.00 $46,080.00 M6.080.00 $25,200.00 $25,200 00 $25,200.00 Cash. Accounts Receivable, Finished Wares. Partly Made Goods. Raw Materials, Machinery and Toola Total Assets, Net Decrease in Assets, Li abilities and Capital Trade Creditors, * Capital Account, Peter Post, Surplus, Total Liabilities and Capital, Net Decrease in Liabilities and Capital, Analysis of Net W ort h of Peter Poet Caintal, Beginning of Trusteeship, $62,500 00 Add— Initial Surplus, g q22 00 Baluice, Net Worth Beginning of Trustee- ■*"P' $68,522.00 Add— Net Profit on Trustee ship. $4.378 00 I^»— Drawings. 3.500 00 878.00 Balance, Net Worth End of Trusteeship, $69,400.00 Problem 3.-Me8srs. Green & Sharp, having given the fim, notes to a fnendly company as an accommodation, became embarrassed through failure of payee and appointed a trustee to realize and liquidate The foUowmg IS a statement of their condition, January 1, 19—. Assets Cash on hand and in bank, Stock of goods, Real estate, Bills receivable. Book debts receivable (includes accommodation account of payee, $58,000.00), Liabilities Mortgage on real estate, Mortgage interest accrued to January 1, 19—, Taxes, Book debts payable (includes accommodation paper of payee, $58,000.00), Bills payable, H. Maxwell, special partner, S. Green, capital, J. Sharp, capital, 500.00 20,000.00 25,000.00 5,000.00 62,000.00 $112,5 00.00 I 6,000.00 250.00 375.00 61,550.00 1,000.00 10,000.00 20,325.00 14,000.00 $112,500.00 FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 535 $ 70,000.00 108,000.00 2,000.00 10.000.00 The following is a memorandum of the trustee's transactions for the ensuing year: Purchases to complete contract orders, Sales for year for cash. Uncollected accounts Stock of goods on hand, Deceml)er 31, Bills receivable collected at a loss of $600 . 00 Book debts receivable, collected $3,600.00; balance lost. Received 75 per cent in full settlement of accommodation notes, and paid cash on account of same $48,000.00, giving renewal notes for $10,000.00. The legal fees, interest and petty expenses paid on account of accommodation paper were $2,400.00. The following payments also were made: Mortgage, with interest, and one year's interest accrued to December 31, taxes, bills payable, and book accounts payable; clerk hire, wages, and other business expenses, with allowance of $100.00 per month to each of the partners, one vear's interest at 6 per cent to special partner, interest on Green's surplus capital ($6,325.00) one year at 6 per cent, and trustee's fee of $5,000.00,— in aU, $10,000.00. The special partner had an interest of 1/10, and the general partners shared alike in the residue of the net profits and losses. On January 1, of the next year, the estate reverted to the firm. Requirements of the problem: 1. Trustee's realization and liquidation account. 2. Balance sheet at termination of trust. 3. Partners' accounts. Solution to Problem 3.— There is illustrated in this problem the risk incurred by exchanging negotiable paper as a friendly acconmiodation. By so doing, the business credit of Messrs. Green and Sharp was impaired seriously to the extent that affairs had to be placed in the hands of a trustee. The latter, in addition to realizing upon the assets and liquidating the liabilities, carried on the trading activity by buying and selling goods for cash, giving renewal notes, etc. Since the opening statement of condition of the firm is given, as at the commencement of the trusteeship, nothing further in connection therewith need be done, as a first step in the solution, except perhaps as concerns a revamping of the partners' Capital accounts. As these latter concern the partners only, the trustee is not interested in the individual amounts thereof. Likewise, since the trustee has no title to the real estate, the item has not been considered as having been turned over to the trustee. The first requirement of the problem is to prepare the trustee's Realization and Liquidation account. Although, in this connection, more than one form of statement may be used, the one selected is similar to that offered in the solution of problem No. 2, above, in that it is believed that this type of statement is subject to the least amount of criticism in comparison with the others. This account is shown on the following page. i 536 ADVANCED ACCOUNTING E 8 I i So S I s o H c a a I ^ ^ Sll ss ssss !g 81 t- N «o n CO S5 o CO p or n I •-9 a u ^ Ph i •» g I 8 a 8 88 888 8 «S « g« S 8 8^' 88 J8 of FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 537 The second requirement of the problem is to prepare a Balance Sheet as at the termination of the trust. This is given below in comparative form. Before this Balance Sheet can be prepared, it is necessary to deter- mine the cash balance on Dec. 31, 19—. Therefore, although not required by the problem, the trustee's Cash account is shown below next following the Balance Sheet. MESSRS. GREEN A SHARP Comparative Balance Sheet AflBeta Cash, Merchandise, Bills Receivable, Accommodation Papers, Accounts Receivable, Real Estate, Total Assets, Net Decrease in Assets, Liabilities and Capita l Mortgage, Mortgage Interest Accrued, Bills Payable, Liability — ^Accommodation Paper, Accounts Payable, Taxes Accrued, Total Liabilities, Capital, Combined, Total Liabilities and Capital, Net Decrease in Liabilities and Capital, as of Jl. 19 — , and January 1, 19 — December 31, 19— $19,175.00 10,000.00 2,000.00 25.000.00 January 1, 19— $ 500.00 20,000.00 5,000.00 58,000.00 4,000.00 25,000.00 Increase Decrease $18,675.00 $10,000.00 5,000.00 58,000.00 2,000.00 $56.17500 $112,50000 $10,000.00 $10,000.00 46,175.00 $ 5,000.00 250.00 1,000.00 58,000.00 3,550.00 375.00 $68,175.00 44,325.00 $56,175.00 $112,500.00 $18,675.00 56,325.00 $75,000.00 $75,000 00 $75,000.00 $ 5,000.00 250.00 1,000.00 48,000.00 3,550.00 375.00 $1,850.00 $ 1,850.00 56,325.00 $68,175.00 $58,175.00 $58,175.00 $58,17500 -§ ;a i Xi 08 >> ft* S^ u OS I 5 1^1 31 2 Mpq 1^'^ Ij 3 o ■a I I * i iil 536 ADVANCED ACCOUNTING TRUSTEE FOR MESSRS. GR EE N & SHARP Cash Account January 1, 19 Decemher 31, 19— Balance, January 1, 19 — , taken over $500.00 Add: Receipts During Year: Cash Sales, Bills Receivable, Accounts Receivable: Old Accounts, Accommodation Paper, Total Cash to be Accounted For Deduct: Disbursements During Year: Merchandise Purchases, Mortgage, Mortgage Interest (two years at 5 per cent), Taxes, Bills Payable, Accounts Payable: Old Accounts, Accommodation Paper, Legal Fees and Expenses, Clerk Hire and Wages, Trustee's Commission, Allowances: S. Green, J. Sharp, Interest on Capital: H. Maxwell, S. Green (surplus capital), Balance, December 31, 19 — , The third requirement of the problem is to present the partners' Capital accounts. These are given below in tabulated form. Again, although not required by the problem, but the better to comprehend the Capital accounts as set out, a Profit and Loss Appropriation Statement is shown, this being given next below the Capital accounts. $108,000.00 4,400.00 $ 3,600.00 43,500.00 $47,100.00 $1^9,500.00 $160,000.00 $5,000.00 $70,000.00 500.00 5,500.00 375.00 1,000.00 $ 3,550.00 48,000.00 $2,400.00 1,620.50 5,000.00 51,550.00 9,020.50 $1,200.00 1,200.00 2,400.00 $600.00 379.50 979.50 $140,825 00 $19,175 00 FIDUCIARY STATEMENTS: INSOLVENTS' ESTATES 539 88 8 88 i 8 ^ 88 i ' " o 8S CO CO CO 00 8 s? n 01 «o 1 w N Pi O i •♦J 8S§ 88 »0 OS CO oj (g) . In a 09 i-s H S 0) I u 8- « . C s s >> o o 0) (< »< ss 8 IS » »c 12 f* t* 3 — r « a 4 ej eS o n 3 5 i CO i Q hi 3S^ s o a -a s 88 S8 8 8 «» •• O o E a a o o> « t - ^ OS * Q> 2 I I « If 8 8 58 oi 6 t>. © »^ 8' "5 ZI- P4 O CO •-• 8SS c o c o 3 U3 Js- £ a a a « ■aS.f c c > O S M ^ £ 09 .1 GQ Ph ■♦^ "^^ «*- ^ a, ^ O - S ^ 2" o q *-' QQ i QUESTIONS AND PROBLEMS 541 14. i QUESTIONS AND PROBLEMS Comment : 1. Unless otherwise indicated, all questions and problems have been taken from C. P. A. examinations. 2. Exceptions to the above are indicated thus: a. American Institute of Accountants (A. I. A.) b. Other than C. P. A. or A. I. A. (*). QUESTIONS ON CHAPTER I Twenty Questions, Five Problems 1. Define the following: a. Bookkeeping. b. Double-entry bookkeeping. c. Accounting. d. Auditing. e. Internal check. 2. Define the following: a. Account. b. Account stated. c. Suspense account. d. Nominal accounts. e. Real accounts. 3. Define the following: a. Personal account!. b. Impersonal accounts. c. Mixed accounts. d. Major accounts. e. Subsidiary accounts. 4. Define the following: a. Current account. b. Collective accounts. c. Summary accounts. d. Specific accounts. e. Controlling accounts. 5. Define the following: a. Debit. b. Credit. c. Journalizing. d. Trial balance. e. Ledger. 540 8. 6. Define the following: a. Voucher. " b. Journal voucher. c. Voucher check. d. Balance sheet. e. Profit and Loss statement. 7. Define the following: a. Assets. b. Current assets. c. Quick assets. d. Capital assets. e. Passive assets. Define the following: a. Active assets. b. Capital liabilities. c. Accrued. d. Deferred charges. e. Contingent assets (A. I. A.) Define the following: a. Capital. b. Working capital. Trading account. Manufacturing profit. Capital expenditures. Why should we favor the standardization of accounting ter- minology? b. What means would you suggest as best adapted to obtain such uniformity? e. Give two examples of accounting terms that are ambiguous. (Suggest remedies. 11. a. Are the theory of accounting and the theory of common law based in any respect on the same principle? Which is the most reliable as to facts? b. What is meant by theory of accounts? 12. a. Name three objects of bookkeeping. b. What is the relation of the accountant to the bookkeeper? 13. a. State the essential principles of double-entry bookkeeping. b. Under what conditions does double-entry bookkeeping become an exact science? 14. a. What condition of oflBce organization, above all others, leads to fraud and defalcation by bookkeepers and cashiers? Support your opinion, b. Name the ten matters of special importance in devising any system of internal check in the handling of oflBce records. 15. a. What is the relation of nominal accounts to real accounts? How do these accounts fulfill the purpose for which they are created? b. What do you consider the most important account in a set of account books? Explain fully. 9. c. d. e. 10. a. m I H 542 ADVANCED ACCOUNTING m 16. a. Which group of accounts, if eliminated from double-entry book- keeping, would reduce accounts to an economic history? b. Which class or classes of accounts close into Loss and Gain (Profit and Loss) account? 17. Prepare a form of monthly summary journal entries for the books of original entry. 18. a. State the purposes of a controlling account. b. Give an illustration of the use of a controUing account. c. Give the names of several controlling accounts. 19. a. In the opening of a ledger, what principle should be followed as to the order or arrangement of the accounts? Show the advantages of the different plans, b. In what order should the accounts be arranged as they successively appear in: 1. A ledger containing all the accounts of a business. 2. A ledger containing accounts of fixed assets and fixed liabilities, as well as special, nominal, and summary accounts? 20. a. Describe a method of keeping accounts so that an independent balance of the ledger, containing only the real, nominal, special and controlling accounts, exclusive of the individual accounts of customers and of trade creditors, may be taken, b. How do you reconcile a debit to a controlling account and another debit for the same amount to an individual creditor with the fundamental principle of double-entry bookkeeping? PROBLEMS ON CHAPTER I The oflfice of a firm of traders, doing business in San Francisco, was destroyed by an earthquake. The books of account, which had been fully posted, were badly damaged. The following ledger accounts were found to be legible: Purchases, net, $69,000.00; discounts, lost, $640.00; Dis- counts, gained, $3,450.00; sales, $54,000.00; billH receivable, $33,000.00. Inquiry at the bank disclosed a balance on deposit, $129,00(1.00. Bills receivable amounting to $45,000.00 had been discounted at the bank. An audit of the checks paid by the bank showed that $99,000.00 had been paid creditors (including $60,000.00 notes payable). A balance sheet prepared at the last closing of the books was produced containing the following items: Cash, $60,000.00; accounts receivable, $126,000.00; loans receivable, $24,000.00; real estate, $90,000.00; notea re- ceivable, $78,000.00; capital, $318,000.00; notes payable, $60,000.00. Prepare a trial balance supplying the missing accounts. QUESTIONS AND PROBLEMS to open a set of double entry books and submit a trial balan close of business January 31, 1913. Draft the trial balance. Jan. 1. — Commenced business with cash capital, Deposited in bank, 3. — Bought merchandise from Jas. Harrison & Co., Sold goods to Wm. Adams, 7. — Bought merchandise from W. Smith & Co., 8. — Paid wages in cash. Sold goods to H. Allen & Co., 10. — Received check from Wm. Adams (discount, $60), Bank deposit, 11. — Paid Jas. Harrison & Co. by check (discount $135). 12. — Paid by cash, three months' rent, 13. — Bought merchandise from H. Kershaw, 15. — Paid wages in cash. Paid office exf)enses in cash, 17. — Sold goods to H. Hobson, 19. — Sold goods to Wm. Adams, 21.— Sold goods to H. AUen & Co., 22. — Paid wages in cash, Paid expenses of office in cash, 25.— Paid W. Smith & Co. by check (discount, $160), 26. — Received check from H. Allen & Co. (discount, $75), Bank deposit, 29. — Paid wages in cash. Paid office expenses in cash. 543 ce as of the $12,500.00 11,750.00 2,700.00 2,400.00 3,225.00 40.00 2,675.00 2,340.00 2,340.00 2,565 00 200 00 3,700.00 40.00 35 00 1,600.00 800 00 1,250 00 40.00 25.00 3,065 00 2,600.00 2,600.00 40 00 20.00 There was $175 cash on hand at the close of the month, the balance being M. F. 's personal expenditures. John Doe commenced business with a cash capital of $15,000.00. At the close of the fiscal period the ledger accounts were: accounts receivable, $4,312.50; merchandise debit balance, $5,062.50; accounts payable, $5,375.00; expense, $900.00. Doe's total loss was $2,775.00. Prepare a statement of assets and liabihties and the profit or loss. 4 The following statements comprise the trial balances of a business at the beginning and the end of a fiscal period, together with the volume of the transactions during said jjeriod: ; II M. F. commenced business January 1, 1913, and early in February banded you his day book with the following entries in it and requested you 544 ADVANCED ACCOUNTINO m i^^ Trial Balance Interim Trial Balance January Transactions December 31 Cash, $1,115 $16,583 $16,338 $1,360 Mdse., 5,050 17,665 26,874 $4,159 Debtors, 3,110 25,135 24,229 4,016 Fixtures, 2,800 505 3,305 Creditors $ 1,575 18,922 19,410 2,063 Loan, 500 1,000 1,500 Capital, 10,000 10,000 Interest and discount 693 360 333 Rent, 900 900 Insurance, 50 50 Salaries, 1,820 1,820 Advtg, 900 900 Carting, 1,705 1,705 Expense, 1,333 1,333 Drawings, propr., 2,000 2,000 $12,075 $12,075 $88,211 $88,211 $17,722 $17,722 a. The sales book shows sales posted to debtors to the amount of $25,135.00. b. The journal shows allowances to debtors for returns of merchandise sales, $1,015.00, and claims on creditors for returns of merchandise pur- chases, $23Q.OO; also application of debtors' balance to settle creditors' account in the amount of $9,500.00, both accounts being in the name of the same correspondent. c. The ledger shows that the nominal accounts entitled rent, insurance, and office salaries contain only cash charges, while the nominal accounts entitled advertising, cartage and expense show cash charges in the total amounts of $100.00, $200.00, and $773.00, respectively, all other charges therein being by invoice duly posted to creditors ' accounts. d. The merchandise account shows cash charges of $610.00 and cash credits of $1,509.00, for cash purchases and cash sales, respectively. e. The invoice books show invoices posted to creditors' accounts to the amount of $19,410.00. Prepare an articulation statement showing in each account the several elements of debit and credit and giving the title of the articulation account wherein the contra credit or charge appears. 5 In taking up the audit of the accounts of a company for the year ending December 31, 1912, you find that the adjustments made at the previous audit for the year 1911 have not been taken on the books, and that therefore the books are not in agreement with the audited accounts as of that date. Assuming the following were the adjustmente referred to, what, if any, QUESTIONS AND PROBLEMS 545 disposition would you make of the items at this audit, illustrating your answer with draft journal entries, viz. : To record: 1. Invoices for merchandise in transit at December 31, 1911, not on books, 2. Invoices for merchandise received but not entered, 3. Reserve for bad debts (said debts were written off in 1912), 4. Factory expense bills of 1911 not entered until January, 1912, 5. Payroll accrued at December 31, 1911, 6. Insurance premiums paid in advance at December 31, 1911, 7. Taxes for year ending December 31, 1911, not entered until May, 1912, 8. Reserve against excess valuation of inventory, December 31, 1911, 9. Depreciation not taken up on books prior to January, 1911, $5,000.00; year ending December 31, 1911, $1,000.00, 10. To write off an unlocated difference in the accounts receivable controlling account at December 31, 1911, which, however, was located and cancelled in 1912, $ 5,000.00 10,000.00 2,000.00 750 00 6,000.00 500.00 1,000.00 10,000.00 6,000.00 1,500.00 QUESTIONS ON CHAPTER H Twenty Questions, Five Problems 21. a. Describe the proof of posting method used in testing the accuracy of the ledger in single entry, b. State the process of making a trial balance of a single entry ledger. 22. a. How may a set of books be changed from single entry to double entry? b. Explain the difference between a balance sheet and a statement of assets and liabilities. 23. a. How would you reconcile the pass book balance with the cash book balance? b. Define: Cash receipts. c. Define: Disbursements. d. Define: Imprest cash system. 24. a. Under what condition would the receipts and revenues and the disbursements and expenses be alike? b. Is there any advantage in having a cash account in the general ledger, when the cash book is carefully written up and balanced? Give reasons. 25. In a certain business the cash receipts are employed in part to defray current expenses. Other disbursements are by check against funds deposited. In arranging books of account for such a business, how would you provide a clear, direct, and labor-saving record of all cash receipts and disbursements? Show the advantages of this plan. 546 ADVANCED ACCOUNTING 26. a. b. c. 27. a. 28. a. b. c. 29. a. b. 30. a. b. 31. a. b. State briefly the proper manner of conducting the bills receivable account. What is the best way of handling on the books the contingent habihty on notes receivable that have !)een discounted at the bank? State briefly the proper manner of conducting the bills payable account. An ice company sells coupon books to its customers; the coupons are used in paying for ice delivered. These coupon books are paid for m advance by the customers. What accounts should »)« opened on the company's books to record such transactions and how should the sale of coupons and dehveries of ice appear thertMU? State in the form of journal entries transactions for accommodation paper indorsed by the firm when coupon bonds are received a^s security. Give a brief definition and explanation (using an illustration) of a trade acceptance. State wherein a trade acceptance differs from 1. A sight draft. 2. A promissory note. Summarize the advantages of a trade acceptance to 1. Seller. 2. Buyer. Describe two forms of sales ledger and the process of entering the sales m each. Explain the advantages of each form. The Blue Ribbon Jewelry Company takes an inventory of stock preparatory to closing the books at the end of the year. If called m as auditor, how would you treat the deduction by the Blue Ribbon Jeweb-y Company of $15,000.00 from the total of its inven- tory, as representing doubtful and uncollectible accounts? Show the form of a purchase ledger for a mercantile concern and state whether you would recommend the use of a bound or looae- leaf book, giving reason. Describe at least four methods, with forms, for recording invoices payable and state your preference. Explain fully in what way, if at all, the profit on sale of real estate should enter into the trading and profit and loss statements of a mercantile concern. Give reasons for including or excluding. The North and South Railroad Company has demolished its old wooden station at a certain city on its line and has erecl^ in its place a larger and more ornate structure of brick and stone at a cost of $100,000.00 in excess of the book value of the old building, after deducting the salvage. Bearing in mind that this expendit^ of $100,000.00 does not materially increase the earning capacity nor decrease the operating expenses of the company, what disposition should be made of this item in the accounts? State the general prmciples that should govern an accountant in deaUng with this class of expenditure, whether occurring in a raihroad or any other QUESTIONS AND PROBLEMS 547 32. a. b. c. 33. a. b. 34. a. i99. a. 36. a. b. c. 37. a. b. 38. a. b. How would you treat cash discounts on capital expenditures, such as for new machinery? Explain the distinction between replacements and renewals, giving also your idea as to the proper method of recording such transactions on the books of a manufacturing corporation. Is it proper to capitahze interest paid on money borrowed to provide for construction? Explain. Define: Good- will. Give your ideas as to the treatment of good-will in accounts. Would this treatment be the same if the concern were losing money? A firm of brick makers under the term of their twenty-year lease agreed that at the close of the term they would level the ground, cover it with soil and generally restore it to previous conditions for agricul- tural purposes. State how you would deal with this liability in preparing a statement of the firm, provided you found that none of the work in question had been performed and no provision made therefor, knowing that five years of the lease have expired. ^ In order to secure a particular parcel of leasehold property on which to erect its operating plant, a corporation paid a bonus of $5,000.00, the annual rental under the lease being] $50,000.00, the lease run- ning for a period of twenty-one years, with the privilege of renewal for a second period of twenty-one years, but at an increased rental of $60,000.00 a year. How should such expenses be treated on the company's books? Submit pro forma entries covering an incidental shipment of goods to a factory, prepayment of freight, receipt of advances, receipt of account sales with cash to cover balance due, and closing of account. State two ways of treating consignments inward, when goods are to be sold subject to commission at the price at which they are consigned. Give the arguments for and against each method and your views thereon. Define: Turnover. What is meant by percentage on turnover and how is it ascertained? Explain fully in what way, if at all, overvaluation of opening inventory should enter into trading and profit and loss statement, with reason for inclusion or exclusion. Describe a means for the protection of a manufacturing company in the purchase of necessary materials and supplies and in the payment of such materials and supplies. In handling large factory payrolls, which do you consider the better practice for the prevention of fraud, the taking of receipts from each employee for the amounts paid or the establishment of a good system of accounting for handling payrolls. Give reasons and explain why you think one method is better than the other. Explain what is meant by an arbitrage and cite an example. Indicate three ways through which the foreign indebtedness or claim of a New York merchant may be liquidated. 548 ADVANCED ACCOUNTING 39. a. b. r I In stating an account with a foreign firm, how should uiimatiired acceptances be treated with respect to rates of exchange? What is the difference, theoretically, between expenditures by a manufacturing concern for fire and burglar insurance, health and accident insurance and watchmen? In which section of a profit and loss account should each item be allocated? A corporation manufacturing explosives was compelled to pay exorbitant rates for a very limited amount of insurance, and in consequence was obUged to install an automatic sprinkler system at a cost of $75,000.00. This additional fire protection enabled it to secure a full Une of insurance, though in mutual companies and at a much lower rate than was obtainable prior to such installation. At the end of the fiscal year the company received dividends from these mutual insurance companies aggregating $2,000.00. To what account should the cost of the sprinkler system be charged and to what account should the dividend be credited? State your reasons fully. 40. a. The president of a corporation engaged four salesmen on a salary and a profit-sharing basis. To one he gave 40 per cent of the profits, to the other three, 20 per cent each. The profits of the corpora- tion were $102,608.18. Show proportion of profits payable to each salesman, b. State the process of closing a ledger (general ledger). PROBLEMS ON CHAPTER U The books of the Butter, Egg and Cheese Company, with an authorized and outstanding capital stock issue of $25,000.(X), are kept by single entry. It annually inventories all its assets and UabiUties and from suc^h inven- tory prepares a financial statement. At December 31, 1913, this inventory is as follows: OflBce, cash. Balance, bank A, Accounts receivable, Ten shares in competing company, Plant and equipment, Merchandise inventory, Prepaid expenses, Overdraft, bank B, Accounts payable. Mortgage payable, $ 1,584 00 10,824.00 29,521 00 1,000 00 64,938.00 21,737.00 5,081.00 5,003 00 19,747.00 25,000.00 20,000.00 Notes payable. From a comparison of the financial statements at the beginning and end of the year, you find that the item of "plant and equipment" is stated in an amount less by $11,460.00 than it was at the beginning of the year, plus additions during the year. QUESTIONS AND PROBLEMS 549 The financial statement for the beginning of the year showed a surplus of $35,703.00. From your analysis of the disbursements and unpaid accounts payable at beginning and end of year, you find total purchases amounting to $661,910.00, and expenses for salaries, wages, supplies, repairs, etc., amounting to $120,115.00. The purchases, however, included $450.00 paid out for John Smith, an em- ployee, for which he has not reimbursed the company, and the total expense of $120,115.00 included $250.00 in the hands of a buyer as a working fund. The inventory of merchandise at the beginning of the year was $18,125.00 and of prepaid expense was $2,653.00. There was cancelled on the customers ' ledger during the year $3,206.00 of uncollectible accounts. There was paid for interest and discount on notes payable, $1,061.00. and for interest on mortgage, $1,500.00. A 10 per cent dividend was declared but not paid. From the foregoing prepare: a. Balance sheet as at December 31, 1913. b. Profit and loss statement, exhibiting net sales, cost of sales, and gross and net profit for the year. Prepare a statement showing the amount of the ledger assets as of January 1, 1910; add to this statement the increase of the capital stock and the income for the period; deduct from the statement the disbursements of the period, concluding with a balance sheet showing total assets as of June 30, 1910. The Turnwell Trading Co. Trial Balance January IQIO Cash Credited Receipts to Profit from January 1, and Loss June 30, J..7XV 1910 1910 Land and buildings. $30,000.00 Horses, wagons, harness, 5,000 00 Investment bonds. 10,000.00 Inventory, merchandise. 11,000.00 Stable supplies, 150.00 Cash, 17,500.00 Accounts receivable. 14,800.00 $36,000.00 Interest on investment. 400.00 $ 490.00 Increase in inventory, mdse. 500.00 Capital stock. 5,000 00 Interest on bank balances, 80.00 80.00 Sales, 38,500.00 $88,450.00 $41,480.00 $39,570 00 550 ADVANCED ACCOUNTING QUESTIONS AND PROBLEMS 551 4 H !! i Mortgage payable, Accounts payable, Interest on mortgage, Salaries of salesmen, Surjjlus, Capital stock. Purchases, Freight, Stable supplies, Advertising, Administrative expenses. Horse, wagon, harness. Trial Balance January 1, 1910 $12,000.00 9,000.00 17,450.00 50,000.00 Cash Disburse- ments from January 1, to June 30, 1910 I 3,500.00 22,500.00 150.00 1,500.00 425.00 200.00 50.00 6,500.00 300.00 Charged to Profit and Loss June 30, 1910 $88,450.00 $35,125.00 $ 210 00 1,575 00 20,000 00 425 00 235 00 50 00 6,500 00 $28,995.00 8 A cloak manufacturing concern, turning out but one grade of cloaks c aims to have been robbed on the night of AprU 16, and forthwith filefl a damn under a burglary insurance policy it was carrying. The proof of the loss filed by the assured (contained two items vi« • 300 cloaks valued at $12,000.00, and 1,000 yards of silk stated to be worth ♦l,uUO.OO. The insurance company being notified of the loss, immediately ordered an mventory to be taken, which was done on the morning of the 17th and disclosed the following: ' 1,250 cloaks. 6,250 yards of cloth. 2,500 yards of silk. On the same day you were called in by the insurance company to examine the books for the purpose of proving or disproving the claim, when th^ followmg mformation was obtained: 1. That a complete inventory had been taken on January 1, 1913, of the cloaks, cloth, and silk on hand at that date, the inventory sheets of which had subsequently been lost or destroyed. However, the books showed that the total valuation was $32,675.00, and the firm's repre- sentatives assured you that this was correct and that the inventory had been properly valued at cost prices which had not fluctuatixl since. 2. That the cloth and silk purchases subsequent to January 1913 hai, and $4.86^, respectively. Prepare a balance sheet of the New York books after closing and a state- ment of assets and liabilities of the Liverpool branch consolidated with the New York books. Close the books at the rate of exchange on the last day of the fiscal period, which is $4.87^^, conversion of remittances to be made at the average rate for the four bills. QUESTIONS ON CHAPTER HI Twenty Questions, Five Problems 41. Analyze and discuss the following clause taken from a certain partner- ship agreement: "VIII. And it is further agreed that the said party of the second part is to pay to the said party of the first part the sum of three thousand dollars ($3,000.00;; for which the said party of the second part shall receive a one- third (1/3) interest in said business of the said party of the first part." 42. Give a rule for adjusting partners' accounts: a. When the gains or losses are to be divided in proportion to each partner's investment and the time it remains in use. b. When the proportion of gain or loss is fixed, and interest is calculated on excess or deficit of capital. 43. Where do a joint stock company and a copartnership differ in method of profit distribution? a. Explain fully in what way, if at all, partners' salaries should enter into trading and profit and loss statements, with reason for inclusion or exclusion. b. Explain fully in what way, if at all, partners' drawings should enter into trading and profit and loss statement, with reason for inclusion or exclusion. 45. A, B, and C are equal partners, each having subscrbied $5,000.00 to the partnership. A pays in $3,000.00, leaving $2,000.00 still due the partner- ship on his capital account. It is agreed for the present that this $2,000.00 can remain unpaid, provided A pays interest on the same, which he does. Later a dispute arises as to how this interest shall be credited. A claims that it should be included with the earnings of the business, the profits of which are to be divided equally among the 44. QUESTIONS AND PROBLEMS 553 three partners. B and C claim that this interest should be divided between them only, as they fully lived up to their obligations under the partnership agreement, while A had only partially done so. To what account should the interest on the deferred payment be credited? 36. What method should be pursued in adjusting interest on capital among partners whose investments differ in amount? Give reasons for such book entries as you would recommend in the premises. 37. a. How may a partnership terminate? Name the different ways. b. As the bookkeeper of a firm that had no articles of copartnership, what would be your duty on learning of the death of a partner? 38. Detail a scheme for keeping shipping accounts so that the true and exact condition of each venture can l:>e shown at any time. Give entries for every phase of shipping transactions, including advances to shipper by consignee, and state the object and effect of each entry. 49. To what extent, if any, should executory contracts be reflected on the general ledger of an enterprise? 50. A firm of contractors enters into contracts for the erection of several buildings constituting an operating plant. For certain of the buildings contracts specify a fixed price, while in other instances the contractor's comi>ensation is to be actual cost, plus 10 per cent thereon. In what manner should the unfinished contracts be valued at the close of the fiscal year? 51. At the date of a partnership settlement two contracts are in hand and uncompleted; one for $1,200.00, estimated to cost $900.00, is three- quarters finished and is already charged up to the customer at $1,200.00 as of date of contract; the other for $2,(XX).00, estimated to cost $1,500.00, is half finished, and no entry has been made therefor. Suggest entries necessary to adjust these accounts so that anticipation of profits shall not occur. 52. Describe a system of accounts suitable for a firm of contractors that does work on contract for a fixed sum and also on cost and percentage. 53. A contractor engages to erect a building for $250,000.00 and his estimates indicate a profit to him of $25,000.(K) in the transaction. He receives during the fiscal year payments aggregating $85,000.00 on the architect's certificates showing that $100,000.00 worth of work has been done. Ought any of the contemplated profits to be carried into the accounts for that year and if so, how much? 54. a. What is understood by "cost" or "factory" accounting? b. Name the principal elements of manufacturing cost. 0. State wherein manufacturing or factory costs differ from commercial or selling costs. 55. Define the following terms: a. Storekeeper. b. General charges. c. Writing off. d. Storeroom. e. Stores. f. Cost of production. i 554 g. h. 56. a. I(i b. c. 57. a. b c. ADVANCED ACCOUNTING By-product. Prime cost. State generally how the books of a firm doing a manufacturing business would differ from those kept by a trading concern as to (1) books of record; (2) ledger accounts. How would you classify the accounts in preparing a statement of a manufacturing business? What is shown in the cost books? Show the method and the advantages in cost accounting of the process of articulating the general ledger, factory ledger, and stores ledger by summary accounts. . Define: Cost sheet. Write out in detaU the general instructions for taking the inventory of raw materials, work in process, and finished goods of a small company manufacturing automobiles. Show the general divisions that the inventory requires and provide against errors in recording the items. ^ What test should be made of the prime cost of manufactured goods to guard against loss of raw material through theft by employees? A manufacturing company imports its raw materials and purchases exchange on Europe for use in payment therefor. How should the exchange account be treated with resr>ect to the cost of production? In the preparation of a manufacturing and trading account and a balance sheet, state on what basis the foUowing asset should be valued: Manufactured product. Give fully your reason. Define: Work in process. How should the partly manufactured goods be valued for use in a balance sheet? How should the completely manufactured goods be valued for use m a balance sheet? What classes of salaries and wages should be charged directly against the cost of manufacture? Define: Nonproductive cost. A manufacturing corporation carries on its books an unappUed balance of overhead expenses, which it adds to the inventory when closing the accounts. Is this correct in principle? Explain. PROBLEMS ON CHAPTER m 11 •■r'^'l^^?^^* merchandise to the amount of 112,000. X contributed !J'^'^' Y S4,500.00. They afterwards sold Z a one-third interest for «b,UU0.00. How much of this amount should X and Y receive respectively m order to make X, Y, and Z equal partners, assuming: a. Money paid into the business with no good-will. b. Money paid into the business with good-will. c. Money not paid into the business. 58. a. b. c. 59. a. b. c. 60. a. b. c. QUESTIONS AND PROBLEMS 555 12 The firm of A and B have the following statements: Store, Accounts receivable, Cash, Furniture and fixtures. Merchandise, S15,000.00 12,000.00 9,000.00 2,800.00 37,000.00 Accounts payable, Bills payable, A, Capital, B, Capital, Miscellaneous equipment, 4 , 200 . 00 $80,000.00 $10,000.00 5,000.00 30,000.00 35,000.00 $80,000.00 C is admitted as a special partner with the following arrangement: C is to contribute $30,000.00, and to be entitled to one-third of the profit for one year. Before making the contribution, the following changes are to be ms^de in the books: Store to be marked down 5 per cent; allowance for doubtful accounts to be created amounting to 2 per cent; merchandise to be revalued at $35,000.00; furniture and fixtures to be valued at $2,500.00. At the end the amount of good- will to be fixed at three times the net profits for the year in excess of $20,000.00, this good-will to be set up on the books, the cor- responding credit being to A and B equally, — A, B, and C each to draw $3,000.00 in cash, the remaining profits to be carried to their capital accounts. During the year the following transactions took place : Merchandise bought on credit, $240,000.00; cash purchases, $25,000.00; cash sales, $125,000.00; sales on credit, $175,000.00; accounts payable paid (face, $245,000.00, dis- count 2 per cent), $240,100.00; accounts receivable collected (face, $170,000.00, all net except $50,000.00, on which 2 per cent allowed), $169,000.00; buying expenses, paid cash, $1,500.00; selling expenses, paid cash $21,000.00; delivery expenses, paid cash, $9,000.00; management expensesl paid cash, $4,500.00; miscellaneous expenses, paid cash, $3,000.00; interest on notes payable, paid cash, $250.00; partners each withdrew $3,000.00 cash as agreed. In closing the books for determining profits and good- will, the following were agreed upon: Value of merchandise on hand, $60,000.00; depreciation on store, $285.00; additional aUowance for doubtful debts, $165.00; furniture and fixtures written down, $200.00. Good-will having been estimated and duly entered, C then contributes enough cash so that his capital account equals just one-third of the total capital. Prepare statements showing how the accounts are to be adjusted and the balance sheet after the final adjustment. (A. I. A.) 13 On April 30, 1911, St. John and Company and Carpel Brothers enter into a joint venture agreement. They each contribute $4,000.00 with which they pay for goods that are shipped on May 1 to John Doe of San Francisco. St. John and Company advance $400.00 to defray freight and incidental expenses. John Doe, the consignee , is allowed 10 per cent on the cost of the goods and is to sell them at whatever price he can obtain for them. 556 ADVANCED ACCOUNTING I I ; r It !■. On June 1, 1912, on the strength of a report sent by wire Camel Rrnf h«^ a check for $11 m^ ;ifh " ^ u^""""*"^ "'"^'^^ f^"" '^'^ «<"»'«■«« a cfteck for »11,200.00 aU the goods being «,ld; on the same day St. John and Company settle with Carpel B„,thers. Interest at 6 per cnt is al owed on all transactions affecting the partners in .he venture (Construe vTur ledger account m such a manner that they will explain ully wha Zk place, and make a cross reference possible.) 14 for^$S m ™v^J "^"l' '"*'? ^^'"^ ^' "" *''* P^rf^n^'^nee "f a contract tor JSO.OOOXX), payable m two mstalments of $25,000.00 each, the first of which ZTt^V T^'^'Tr' "" ^^'^^ P"'' "' "^^ ^o* but subject t^ ,0 "r cent to be retemed by the party of the secoml part as security for the c^ tmuafon of the undertaking; the second, together with the security reUiZ' as aforesaid, >s to be paid on final acceptance of the completed work A haaa capital of $4,000.00 available for payment of Ishnr »l,; k insufficient Wo th„^f„^ * i • j'o.ymeiii, oi labor, which proves The first instalment on the contract falla A„„ o„j • -j which dat« there has been expended^ bvT:' \ . ' f "^ °" ^^^ '• "* Show by skeleton ledger accounts the cash payable by A to R ,nd r 15 offiTe'of'^t'x'f Z*7 ^' *'' "rf ""* "' ""''"' '« «"-««" *« the main JanuarJ ^ig^O:^' ^ '''"^'^^- ''' ''^'^'y <=<«'. ^^ows the following facts dislTbul!:^TiT67.*rd*''"" ""'*^"''''' *'^'^-^»= -««- ""P-<1 -d 1 1 ^^9 T^'f ', ; ' '^"^ '" P''<"=*^' "* Pfim« «ost, $62,258 61 dIus Sd?oot Sir^^^' ^^^ ^^'^^-^ ^- -n;„t:LrE «7j^7^'ar'''' ^''' Pf chases of raw material for the year an^ounted to llSe!%sem7 of^T'^V''^ rn.n.,em.nt charge^ S53, 695; fairy expenses, 136,967.08. The cash receipts for one year's rent of loft were QUESTIONS AND PROBLEMS 557 $1,200.00 and for eleven months ' sale of power, $330.00, the twelfth month being unpaid. The raw materials consumed for the period amounted to $64,188.33; management charges distributed, $55,761.90; factory expenses distributed to cost amounted to $43,033.23. There was also a loss on machinery replacements of $107.50. The finished product output for the year amounted to $324,583.43, including all costs. The transfers to the main office were $338,297.90. At the close of the period, December 31, 1910, there remained unpaid and undistributed to goods in process the regular factory payroll for three days, amounting to $2,857.93, and also 1,500 hours of operatives' overtime at an average rate of 45 cents per hour, payable on a basis of 2>^ hours' over- time as the equivalent of 3^ hours' regular time. Raise all the factory ledger accounts affected and show final trial balance. QUESTIONS ON CHAPTER IV Twenty Questions, Five Problems 61. a. What is a corporation, and how is it formed? b. How does it differ from a joint stock company? c. What are the distinguishing characteristics of the corporation as compared with other forms of business organization? (A. I. A.) d. What is a close corporation? 62. Define the following: a. A sole corporation. b. A corporation aggregate. c. An eleemosynary corporation. d. A public corporation. e. A private corporation. 63. a. State the advantages and disadvantages of conducting a mercantile business as a corporation as compared with a partnership? b. What is the difference between capital and capital stock? Explain fully (*). 64. a. What are the underlying principles of corporation accounting? b. Name accounts and use of each that are peculiar to corporation accounting. 65. a. Name the various forms of capital stock and how created, stating the rights and privileges of each. c. How would you proceed to determine the book value of capital stock? 66. A corporation has the following items in its balance sheet: accounts payable, accounts receivable, cash, capital stock, expense accrued not due, expense paid in advance, good-will, merchandise, machinery, notes payable, patents, real estate, reserve for depreciation on plant, surplus, trade marks, and treasury stock. You are asked to figure the value of the stock. State which items you would take to get the gross, and which items you would deduct from \ 558 ADVANCED ACCOUNTING 67. 68. 69. 71. ■'A 11 »; i the gross to get the net amount, and how you would obtain the value of each share. a. Why is it necessary that the authorized amount of the capital stock of a corporation always should appear upon the books? (*) b. How may preferred stock be created after the organization of a corporation ? ( *) a. In its prospectus a corporation represents that it has an issue of "cumulative, non-voting, non-participating, six per cent preferred stock." Give your interpretation of this expression. b. How should stock placed with fiscal agents for sale be treated? (*) a. State the entries necessary to open a set of corporation books so that the assets may appear properly on the ledger. b. A corporation is organized under the laws of this state (N. Y.), with an authorized capital of $50,000.00 divided into shares having a par value of $100.00 each. Six men agree to subscribe to ten shares each. Omitting the explanations that should accompany original entries, draft three types of opening entries for the corporation and point out which one you would favor. Give reasons. 70. a. When is a stock subscription binding? (*) b. What is the liability of a stockholder as to stock subscriptions? c- How should uncalled subscriptions be treated in the balance sheet? a. May a subscriber to capital stock, part of the purchase price only being paid, surrender his shares and cancel his obligation? (*) b. How should money received on account of stock subscriptions and forfeited by nonpayment of instalment-s as they matunt, be treated on the books of the corporation? a. What are organization expenses? (A. I. A.) b. How should organization expense be treated on the books of a corporation? c. At what point do expenses cease to be organization ex})ense8 and become operating expenses? (A. I. A.) 73. What is treasury stock, and state the difference, if any, between that and stock authorised but not issued. At what price may either be sold? How should they appear on the liooks of account? 74. a. Mention and explain two common views concerning the treatment of donated capital stock. (A. I. A.) b. Prepare journal entry for retiring treasury stock of the par value of $100.00 acquired at $50.00 and the book value of $125.00. 75. A company has acquired at $90.00 per share one hundred shares of its own capital stock, of the par value of $100.00 per share. Its balance sheet shows treasury stock $9,000.00. Is thin correct? If so, why? If not, state how you would adjust the books. 76. a. How should the discount and premium arising from the sale of a company's own securities held in its treasury (consider as capital stock) be treated on the books? Give examples, b. Is it proper for a corporation to pay a dividend out of surplus arising from the sale of treasury stock at a premium? Why? 72. QUESTIONS AND PROBLEMS 559 77. Make the entries necessary to record each of the following (*): a. A, B and C form a corporation for $50,000.00, authorized capital stock. A subscribes for 250 shares, B for 125 shares, and C for 125 shares. The subscriptions are made January 2, 1920, and the cash is paid in in full on February 15. b. In (a) above. A, B and C each subscribed for 125 shares. c. In (b) above, 50 per cent is to be paid in in cash on allotment, and the other 50 f>er cent whenever called. d. In (a) above, A, B and C, on February 16, each donated twenty-five shares to the corporation for securing working capital. This donated stock was sold on February 18, for $80.00 a share. 78. The Jones Manufacturing Company was organized with a capital stock of $200,000.00, divided into 2,000 shares, par value $100.00 each. 60 per cent of this stock has been subscribed, which is to l^e paid for in instalments of $50.00. The first instalment has been received in cash. Required: a. Opening entries not using instalment accounts. b. Opening entries using instalment accounts (*). 79. The Syra Oil Company was organized with an authorized capital stock as follows: Guaranteed stock, $200 , 000 . 00 Preferred stock, 200,000.00 Common stock, 600,00000 Total, SI. 000, OOP. 00 The transactions relative to the above are as follows: a. $150,000.00 of the guaranteed stock has been subscribed and paid for in cash. b. $140,000.00 of the preferred stock has been subscribed, and $128,- 000.00 has been paid for in cash. c. $150,000.00 of the common stock has been issued as a bonus to the purchasers of the guaranteed stock. $200,000.00 of the common stock has been sold and paid for in cash. $200,000.00 of the remaining common stock has been subscribed for, being payable in two instalments of $50.00 each, payable in 60 and 90 days. $100,000.00 of the common stock issued as a bonus has been donated to the treasury. Required: 1. Entries in journal form to cover the above conditions. 2. Trial balance of opened ledger (*). 80. A corporation is organized with an authorized capital stock of $30,- 000.00 of which only $20,000.00 is sold, and stock certificates issued therefor. Two conflicting methods of recording the capital stock on the books are suggested: a. Treasury stock to Capital, $30,000.00; Cash and Properties to Treasury Stock, $20,000.00. b. Cash and Properties to Capital Stock $20,000.00. Which method is correct and why? d e. f >»/' 560 ADVANCED ACCOUNTING PROBLEMS ON CHAPTER IV 16 The Brookline Coal and Lumber Company was organized under the laws of the state of New York by John Potter, Harry Berg, and Walter Joseph, who signed the certificate of incorporation and subscribed for ten shares each on June 15, 192L The certificate of incorporation was filed by the Secretary of State on July 1, 192L The authorized capital stork amounted to $100,000.00, divided into 1,000 shares, par value $100.00 t3ach. The incorporators paid their subscriptions on July 1. The organization tax and filing fees amounted to $69.20. During the subsequent four months, the following transactions occurred: July 18. — John Dolan purchased 100 shares of stock for cash. Aug. 8. — Arthur Hoople subscribed for five shares and paid 25 per cent on account. Aug. 16. — ^John Potter subscribed for 200 shares and paid 25 per cent on account; Harry Berg subscribed for 200 shares and paid 25 per cent on account; Walter Joseph subscribed for 100 shares and paid 25 per cent on account. Aug. 23. — ^I^and for the yard was purchased from Andrew Pugh for 100 shares of stock. Sept. 5. — $3,000.00 was paid Stona & Son, contractors, on account of trestle and of buildings, the total price being $25,000.00. Sept. 8. — The subscribers of August 16, paid 25 per cent on account of stock Sept. 10. — $10,000.00 was paid contractors on account. Sept. 12. — The patents for a road culvert in demand by certain leading railroads were purchased from Richard Harding for fifty shares of stock. Sept. 19. — Wagons and other equipment were purchased for $10,000.00, $4,500.00 down and notes for the balance. Sept. 28. — The subscribers of August 16, paid their balances due on account of subscriptions as follows: John Potter, cash in full. Harry Berg, cash in full. Walter Joseph, note for $5,000.00. Oct. 8. — Paid balance due contractors. Oct. 14. — W^alter Morris, attorney, sends bill for organization services, $600.00. Oct. 15. — Harold Bently subscribed for fifteen shares of stock and paid 50 per cent on account. Oct. 20. — ^Arthur Hoople refused to make further payments on account of his subscription, and the latter was cancelled. On the basis of the above, prepare: 1. Opening journal entry for general books. 2. The accounts showing transactions on general books. 3. Balance sheet, October 31, 1921. (*) QUESTIONS AND PROBLEMS 17 561 A corporation is formed on January 2, 1920, with a nominal capital of $2,000,000.00, shares being of the par value of $100.00. The first issue is 15,000 shares, $25.00 per share being due upon application; $15.00 more bemg on allotment on January 15; $20.00 due on February 1; $20.00 due on February 15. 14,500 shares were applied for. On January 15, 13 000 shares were allotted. ' ' Present the entries in journal form necessary to record the above facts in logical sequence (*). 18 A corporation having issued its capital stock at par buys 1,000 shares at 95. It later sells 500 of these shares at 98, and 300 at 85, and 200 at 101. Give the journal entries covering these transactions. How should the items appear on the balance sheet immediately after purchasing the stock, and immediately after each of the sales? (A. I. A.) 19 A corporation is formed, and places a certain number of shares of its capital stock (par value $1.00 per share) on the market, to be sold at 35 cents per share, with the understanding that there is to be no forfeiture of any money paid in, but if the subscriber l^ecomes delinquent for any instal- ment, a pro rata number of shares equal to the amount of the instalment shall immediately revert to the company. **A" subscribes for 1,000 shares and pays: Instalment No. 1, 12)^ cents. Instalment No. 2, 5 cents. Then transfers his interest to "B" who does not pay: Instalment No. 3, 2}^ cents. Instalment No. 4, 2}4 cents. Instalment No. 5, 7}^ cents. But does pay: Instalment No. 6, 5 cents. How many shares is "B" entitled to, and in the aggregate how much do "A" and "B" pay to the company? 20 The Zero Manufacturing Company (incorporated under the laws of New Jersey) has a capital of $40,000.00, which is held as follows- A $21 000 00 B $2,000.00, C $8,500.00, and D $8,500.00. On December 31, 1920 there is an undivided surplus of $34,576.00. A disposes of his entire interest in the concern for $35,000.00, which is paid to him by the company out of the company funds. The company then agrees with B to pay him for his holdings at their book value, as determined immediately after the retire- ment of A. k 562 ADVANCED ACCOUNTING ¥ \ I \i \ Draft entries in journal form, covering the above transactions, showing amount paid to B, and state the value of the stock remaining in the names of C and D. QUESTIONS ON CHAPTER V Twenty Questions, Five Problems 81. a. Describe the steps necessary for the formation of a bufiiness cor- poration. State what is requisite ft)r the validity of a contract by a corporation, b. In organizing a general business corporation, what must b(^ the general qualifications of those executing the certificate of incor- poration? By whom is the certificate of incorporation executed, to whom sent, and with whom filed? How are the officers of a stock corporation chosen? Must they be directors? How are their powers prescribed? 82. a. Define the following terms: 1. Good-will. 2. Franchise. 3. Common stock. 4. Preferred stock. 5. Watered stock. b. Differentiate unsubscribed stock, unissued stock, issued stock, and treasury stock. 83. a. What is meant by ultra vires in regard to the act of a corporation? Explain, and give an example of such an act . b. May the board of directors of a cor|M>ration delegate its authority to agents or a quorum composed of less than a majority of its members? Explain. May a director vote by proxy at a meeting of a board of directors? 84. a. Under what circumstances may a company reduce its capital stock? (♦) b. Give the journal entry necessary to cover the retirement of $50,- 000.00 preferred stock at 110, same btjing in accord with the original sale terms and conditions (*). 85. Journalize and show balance sheet allocation covering the following transaction: A corporation sells $100,(KX).00 of its preferred capital stock at 115; no part of the premium is available for dividends (*). 86. Give method of handling the following items on the books of a cor- poration: (*) a. Discount on stock. b. Premium on stock. c. Common stock issued as a bonus with sale of preferred stock. 87. a. List books and give purpose of each, used by a corporation but not by a partnership, b. What knowledge must a transfer agent possess in order to safe- guard his company in the transfer (»f its certificat/es of stock? ^ QUESTIONS AND PROBLEMS 563 88. a. Describe how the stock ledger (shares ledger) of a corporation is kept. b. State the full procedure leading up to the entry of the following transactions in the shares of a corporation, the par value of which is $100.00. April 5, 1901, James Williamson received certificate No. 75 for 100 shares full paid. May 3, 1901, James WiUiamson requests a transfer to Geo. T. Jenkins of 30 of his 100 shares. Outline a form of stockholders' ledger and properly enter above items therein. 89. A corporation has four classes of stock for each one of which a stock ledger is carried. A number of persons own shares of more than one class of stock. How may duplication be avoided in such matters as mailing annual reports, notices of stockholders' meetings, etc.? Outline in detail the method you suggest. (*) 90. A customer of a certain corporation owes it $5,000.00 and the company finds it impossible to collect such debt in due course. However, this customer is a stockholder of the corporation and, to cancel such debt, offers to pay same by transferring over capital stock certificates of a total par value of $5,000.00. The oflFer is accepted. Make journal entry upon the corporate books in respect of the above. (*) 91. a. Submit rulings of transfer journal suitable to record heavy transfers of a listed stock and all necessary transfer records to be used there- with. Explain fully the use of each record and its relation to the others. b. What method would you adopt to 'prove the outstanding certificates of stock to be correct as represented on the transfer ledger? 92. A company whose stock is widely distributed and much dealt in, increases its capital stock of $500,000.00 by a stock dividend of 100 per cent. Some years subsequently an original stockholder brings suit for elimination from the capital stock of what he claims is " water." How can the stock issued as dividend be eliminated from the $1,000,000.00 of stock outstanding? 93. What, in your opinion, is the correct method of recording on its books of account the purchase of property and plant by a corporation where payment is made in capital stock of the purchasing company, the par value of such stock being greatly in excess of the actual value of the assets acquired? 94. A corporation organized under the laws of the state of New York has an authorized capital of $200,000.00, consisting of 1,000 shares common and 1,000 shares preferred stock, par value $100.00 each. Patents were acquired of a patentee for $50,000.00 common and $50,000.00 preferred stock. The patentee donated one-half of each issue to the company for its use in securing working capital. Show entries necessary to record these transactions. 95. A corporation is organized under the laws of the state of Michigan, with a capital stock of $250,000.00, of which $100,000.00 is preferred and $150,000.00 is common stock, shares $100.00 each. The purchasers of preferred stock at par are to receive an equal amount of common i 564 ADVANCED ACCOUNTING % W 97. stock free; all the preferred stock is subscribed and paid for, leaving $50,000.00 common stock unsubscribed. It is found that the remaining common stock cannot be sold for sufficient cash for requirements and the holders of preferred stock donate to the treasury 1.50,000.00 of their common stock. The common stock is sold at 50^ on the dollar. 96. A company is formed with a nominal capital of $500,000.00, in 50,000 shares of $10.00 each. Of these, 40,000 are issued and subscribtnl for. $1.00 per share is payable on application, and $2.00 per share on allot- ment. A call of $3.00 per share is made four months after the date of allotment and a further call of $3.00 three months after the date of the first call. The deposit, with the amount per share due on allotment, is paid in full, but in respect to the first call $110,000.00 only is received, and on the second call $95,000.00 only. The amounts received are paid into the company's banking account. Prepare journal entries to record the above transactions. a. On the books of a partnership which is about to be taken over by a corporation, is the following account: A— Drawings, $1,475.00.00. What is to be done with the balance thus shown? (♦) b. The Best Store Company was incorporated for $50,000 00 on March 15, 1918, by the three partners, A, B, and C. The change in organi- zation was not given effect upon the books of the company. Pro- prietary interest on January 1, 1918, was $75,000.00. The profits for the year 1918, determined in January, 1919, are found to be $10,000.00. Specifically state how you would correct this condition on the books of the Company when you called in in February 1919. a. What is the principle underlying capital stock of no par value? b. Outline the accounting procedure connected with stock of no par value as to the following: (*) 1. Stock donated to treasury. 1. Original issuance. . 2. Stock donated to treasury. 3. Stock purchased for treasury. 4. Reflection of each of the above upon the balance sheet (*). c. How should no par value capital stock appear on the l)alance sheet of the owner thereof? (*) a. A corporation is formed whose capital stock has no par value. Shares issued, 1,000; assets, $8,000.00; liabilities, $4,000.00. Pre- pare the journal entries to open the books. b. In setting up the balance sheet of a corporation which has an issue of 100,000 shares of stock of no par value but a stated value of $5.00 a share and an excess of assets over liabilities of $1,500,000.00, how would you show the capital on the balance sheet? A. B. has a chance to buy 49 per cent of the stock of the Johnson Sales Company. All of the stock is now owned by C. J., and he will con- tinue to hold the balance of 51 per cent. A. B. is anxious to invest* as the business is very profitable, but hesitates for fear that C. J., who is heavily involved in outside matters, may be forced to sell his stock, 98. 99. 100. QUESTIONS AND PROBLEMS 565 and that the new owners might try to "freeze him out." C. J. has offered to protect A. B. as far as possible in this respect. What would you advise A. B. to do? PROBLEMS ON CHAPTER V 21 The Glenvale Coal Company was organized in New York on July 1, 1921, with an authorized capital stock of $50,000.00, divided into $25,000 00 preferred and $25,000.00 common, 2,500 shares of each class, par value of each share $10.00. The certificate of incorporation was filed July 6, 1921 At a meeting of the directors held July 7, 1921, there was acquired from G. C. Molton, A. B. Kershaw, and C. D. GUbert, at a valuation of $25,000.00, all their right, title and interest in certain land held by them, paralleling the tracks of the N. Y. C. RaUroad, upon which the coal yard was to be situated, same paid for in common stock. In order to raise the necessary funds with which to commence operations, these three persons donated to the company 49 per cent of their holdings, or 1,225 shares of common stock. The stock was sold from time to time, in blocks of two shares preferred and one share common, for $25.00 a block. In all, $2,500.00 was received by this means. Likewise, other stock was disposed of as foUows: In payment of surveying land Hnes, ten shares of common ^ock at par; m payment for attorney's services, organization taxes, and filing fees, bill rendered, $400.00; fifty shares of common stock. Frame Journal entries opening the books of the Glenvale Coal Company and present initial balance sheet. (*) * 22 John Doe owns a lumber miU business with property valued as foUows: Real estate, $100,000.00 Plant, etc., 79,000.00 ' ^""^ber, 93,500.00 Doe, Smith, Brown, Jones and Robinson organize a corporation with an authorized capital of $1,000,000.00 divided into 10,000 shares of par value of $100.00 per share, under the following conditions: Doe is to receive 1,000 shares for real estate, 790 shares for plant, and 935 for lumber— fully paid up stock. Smith subscribes for 1,500 shares. Brown subscribes for 1,500 shares. Jones subscribes for 1,500 shares. Robinson subscribes for 775 shares. One thousand shares are to be placed in the treasury for future disposition, and 200 shares fully paid up stock is to be given to each incorporator for the cash payment of 10 per cent of par value, in consideration for services i?^ u °'*«*^^^**^^ o^ *he company. Each incorporator then donates 100 shares to the company for sale to produce working capital. Draft the entries required, and present resulting trial balance. (^•.r. 566 'r; .' ,:t Ml III ADVANCED ACCOUNTING 23 QUESTIONS AND PROBLEMS 567 The Prosperous Manufacturing Company, a corporation, wa« organized July 1, 1914, with an authorized capital stock of $215,000.00, i)ar value of the shares $100.00 each, for the purpose of manufacturing novelties. The five incorporators subscribed and paid for five shares each; organization expenses were incurred to the amount of $5,(KX).00, and were paid for in stock; the balance of the stock was disposed of on the following (conditions: 10 per cent upon subscription, and three equal calls for the balance at thirty, sixty, and ninety days. On July 31, the Prosperous Manufacturing Company secured an option for thirty days on the plant of A. and B. for $10,000.00, agreeing to take over the assets exclusive of cash and assuming the liabilities of the partner- ship BS at July 31, for the sum of $200,000.00 payable $90,000.00 imme- mediately after taking over the business and the balance in ninety days. At the expiration of the option, the corporation took the plant as agreed. The following is a transcript of A. and B.'s ledger balances as at July 31, 1914: land $30,000.00 ■KM u- 20,000.00 Machinery, r. nno 00 Furniture and Fixtures, ' 1!!; ^ r» Tv/r„f«,;oi 10,000.00 RawMaterial, ^^^^ Fished Goods, 10,000.00 ^"PP^®^' 9'^ nnn no Accounts Receivable, o ' onn nn ^ , o, JUU.UU M^rt'gage on Buildings. ^o '^ ^ Reserve for Depreciation-Machinery, nm nn Reserve for Bad Debts, , I ' ^ nn Accounts Payable, )^^'^^ t* 51,880.00 B, During the interval, A. and B., with the consent of the corporation, had sold finished goods for $5,000.00, which was 25 per cent above cost. The subscriptions to the stock of the corporation were met on call with the exception that on the second call a subscriber for twenty-five shares notified the corporation that he was unable to complete his agreement and he was released without further liabUity. The forfeited stock was sold for cash at par. From the foregoing, draft: a Journal entries necessary to close the books of the partnership. b Journal entries necessary to open the books of the corporation and to show all transactions on the Prosperous Manufacturing Company s books. $ 300.00 2,675.00 c. Balance sheet of the Prosperous Manufacturing Company, September 1, 1914. 24 Smith and Rogers were partners in an ice business, sharing profits and losses equally. A transcript of their general ledger as of December 31, 1921, was as follows: Cash, Accounts Receivable, Smith-Loan Account, $7 100 00 Rogers-Loan Account, 250 00 Smith-Capital Account (excess of loss over capital) , 1 , 845 . 00 Rogers-Capital Account (excess of loss over capital), 1 , 845 . 00 Operation Expenses (earnings deducted), 600.00 Sundry Expenses, 35 oo $7,350.00 $7,350.00 The two partners agree to sell out to the Eriez Ice Company, chartered under the laws of New York, as of January 1, 1922, in consideration of forty- five shares, of this company's capital stock, the total issue being $5,000.00, each share of the par value of $100.00; also, as part of this consideration, $500.00 in cash was to be paid to them. The Eriez Ice Company agrees to assume the payment of all the outstanding liabihties, including the amounts shown in the loan accounts of the partners. The partnership books were used by the corporation, the latter going ahead and using them without making any entries relating to the organiza- tion of the corporation or concerning the assets acquired. One of the incorporators, in payment of his subscribers' shares, paid in $500.00, which was credited to the loan account of Smith and appears in the total set out in the trial balance shown above. The capital accounts and the expense accounts, as shown in the above transcript, were closed out subsequently by the company to the profit and loss account. The cash payment to be made to Smith and Rogers, as part of the purchase price, has not taken place. Required: 1. All entries necessary to place the books of the corporation in order. 2. Trial balance of the adjusted ledger. (*) 25 The Nitrite Deposits Company is incorporated locally to take over the business in Chile of Messrs. W. E. Greetham and S. O. Else. The assets of the partnership are valued at $1,000,000.00 exclusive of any good-will. The company is incorporated with a nominal capital of $2,000,000.00 in shares of $100.00 each, of which the vendors receive 15,000 shares; the remainder are issued to the public at par. The vendors enter into an agreement by which they hand back 2,000 shares as a gift to the company after the issue to the public has been eflfected. u ..^ 568 ADVANCED ACCOUNTING QUESTIONS AND PROBLEMS 569 1 < ^1 ':! P The board decided to take these shares up on the books at $50 00 each which was done. During the year, however, the shares were soYd and reahzed an average price of $90.00 a share ' QUESTIONS ON CHAPTER VI Twenty Questions, Five Problems 101. State in the form of a journal entry on the books of John Brown the following transaction: Instalment notes given by him on purchase of real estate; face of 103. Define: 1. Registered bond. 2. Coupon bond. 3. Mortgage bond. 4. First mortgage bond. 5. CoUateral trust bond. 6. Income bond. 104. Define: 1. Second mortgage 6 per cent serial goltl bond. 2. Guaranteed bond. 3. Debenture bond. 4. Serial bond. 5. Underlying bond. 105. A certified pubUc accountant, having performed the duty at the close ^several years, fJces up for the year just past the examination of bonds-the property of an institution. At his last exammation he found coupon bonds in three classes, -registered as to principal registered a^ to principal and income, and unregistered. In his examination of the books of account of the institution, he found that bonds had been bought during the year. To make an efficient exami- cl^?'' "^""'^ expeditious way, how might he treat these various 106. A $10,000.00 5 per cent semi-annual coupon (bond) is bought on a 1 07 t^l'^^i f ' "^"^ ^^ ^^^'' ^^'^^^^ ^'*^^t did it cost? (A. I. A ) 107. If a bond reads at 4 per cent, but the amount which will be received is in« TTn *^^/^'^«^l P^^' ^»^at i« the actual percentage of cost income? 108. How ^o^d you record on the books of account the purchase of securi- ties which had been only partially paid for? 109. The Oak Furniture Company placed $50,000.00 of its undivided earn- ings in the hands of a broker to invest in United States 4 per cent bonds. The bonds were for $1,000.00 each and cost 101^, commission H 110. Prepare detailed entries to record properly the transaction on the company's books. A manufacturer makes extensive investments in stocks and bonds, buying and selling from time to time as the market conditions warrant and clearing all such transactions through his regular books of account. How should such transactions be isolated from his manufacturing operations and what books and accounts should he employ to record the details of the principal and income from such investments? 111. What is the advantage of amortization in regard to the valuation of bonds? 112. A firm purchased ten $1,000.00 bonds at 97^, due January 1,1915, bearing 5 per cent interest, payable semi-annually. What procedure would you adopt to care for the discount at maturity? 113. How should the interest received on a bond bought at a premium be treated? 1 14. In case of bonds purchased at a premium or at a discount, to be held until maturity, state how the price should be disposed of on the books at purchase, at maturity, and at any intervening time. 115. Sketch the form of a bond ledger which will provide the purchaser of a bond at a premium with a perpetual detail record of each bond transac- tion. 116. A corporation has a number of investments in stocks and bonds which are listed, and have a definite market price from day to day. It carries them at their cost prices in the ledger and wishes to retain these cost prices, but at the same time wishes to have them show in the balance sheet at the market prices. State a convenient method of doing this without changing the cost values in the ledger. 1 17. Classify the Income from Stocks and Bonds Owned account properly, according to the subdivision of assets, liabilities, proprietary interest, income and expenses under which it should be grouped. 118. Where would you place the Appreciation of Securities account in the Income and Profit and Loss accoimt? 119. Explain fully, in what way, if at all, loss on bonds held and disposed of during the period should enter into the trading and profit and loss statements of a mercantile concern. Give reasons for including or excluding. 120. In preparing a balance sheet of a corporation how would you classify or deal with securities representing: 1. An interest in a competing company. 2. The entire ownership of a plant. 3. An investment of a temporary surplus of cash. (A. I. A.) PROBLEMS ON CHAPTER VI 26 In Mr. Jones' private ledger he keeps accounts with each investment he makes, one of which is an investment of 1,000 shares (par value $100.00) of the A. B. Company which he acquired in July, 1914, for $85,000.00. After 570 ADVANCED ACCOUNTING \\i this date and up to December 31, 1918, he makes further purchases and sales of this stock. A certified public accountant called in to prepare Mr. Jones' income tax return for 1918 finds that these and other transactions have been written up in the following manner, no effort to show the profit of the sale of 1,000 shares on June 1, 1918, having been attempt(^d. Investment A. B. Company Account Debits Credits July 1, Dec. 31, May 31, Nov. 30, De3. 31, July 1, Feb. 28, Dec. 31, June 1, $85,000.00 15,000.00 150,000.00 1914. — 1,000 shares purchased, 1914. — Entry to carry this stock at par, 1915. — Purchased 1,500 shares at par, 1915. — Sold 300 shares at 125, 1915. — Profit and loss — profit on sale o| 300 shares, 7,500.00 1916. — Stock dividend of 50 per cent on 2,200 shares declared from profits, accumulated prior to Mar. 1, 1913, 110,000 .00 1917.— Sold 700 shares at 110, 1917. — Profit and loss — ^profit made on sale of 700 shares, 7 , 000 . 00 1918.— Sold 1,000 shares at 125, $ 37,500.00 77,000.00 125,000.00 Rewrite this entire account to show how it should have been kept iii order to show actual profit on each sale and al«o calculate the actual profit on the last sale of 1,000 shares. What is the book value of the total shares on hand, December 31, 1918? (A. I. A.) 27 a. Determine the price of a 4^ per cent bond in the amount of 110,000.00, with four years to run, purchased so as to net '61^ per cent. The interest is payable semi-annually. Construct a schedule of amortization. b. A city issues 100 5 per cent bonds, par value $1,000.00 each, payable semi- annually. These bonds are payable in forty equal annual instalments, yield- ing 4 per cent on the investment. What is the purchase price? (*) c. Suppose in (b) above, 4 per cent bonds had been issued, interest payable semi-annually, to yield 5 per cent on the investment. What would then be the purchase price? (*) There were purchased December 31, 1919, $100,000.00 of Brownsville 4 l/2s for $103,394.43 ex interest. On June 30, 1921, half of the bonds were sold for $52,418.55 ex interest. Given that the bonds are semi-annual and that the price paid in is such as to net the investor 4 per cent, i.e., 2 per cent semi-annually, present an analysis of the bond ledger account as it would appear at the close of business, December 31, 1921. QUESTIONS AND PROBLEMS 29 571 X & Y are dealers in bonds and securities, sharing profits and losses in the proportion of X three-fourths and Y one-fourth. They employ Z to sell securities, agreeing to pay him, in lieu of a salary, an amount equal to 25 per cent of the net profits to be divided between the partners. During the period of Z's employment, the firm purchased $100,000.00 Topeka Traction Company first mortgage 5 per cent bonds, on a 3 per cent basis. The bonds mature in one year and one-half. Interest is payable semi- annually. These bonds are held by X & Y until maturity. Prepare statement of the Topeka Traction Company bond accounts, showing cost, amortization and interest. The total profit to be adjusted in the contract with Z is $15,000.00. Show the division of this profit. 30 The Patriotic Emblem Company, wishing to contribute to the success of the liiberty Loan, agrees to accept subscriptions for the bonds from its employees and arranges that payments may be made either in cash on July 2, or in twelve monthly instalments beginning that day. On June 1, cash subscriptions for one hundred $100.00 registered bonds and two hundred $50.00 bearer bonds were received; also subscriptions for 480 $50.00 bearer bonds payable on the instalment plan. A remittance for 2 per cent of the total subscriptions was sent immediately to Safe & Trust, Bankers, through whom the Patriotic Emblem Company applied for the bonds. Payments to the bankers for the balance are to be made as follows: June 28, 18 per cent on instalment subscriptions; July 2, balance of cash sub- scriptions; July 30, 20 per cent on instalment subscriptions; August 15, 30 per cent, and August 30, 30 per cent on instalment subscriptions. The bonds are dated June 15, 1917, and bear interest at S}4 per cent per annum from that date, payable semi-annually, on December 15, and June 15. Interest at the same rate is to be calculated on unpaid instalments from June 15, 1917, both on the accounts with the bankers and with the subscribers. It is assumed that the bonds are delivered on September 15, 1917, to the Patriotic Emblem Company, who holds the ones subscribed for on the instalment plan, pending completion of payments. In October, 1917, certain employees find it impossible to continue their payments, and the Patriotic Emblem Company agrees to take over their subscriptions. On October 31, the company refunds to these subscribers all payments made by them, plus interest to date. The par value of the cancelled subscriptions is $1,200.00. Show ledger accounts necessary to record the foregoing transactions on the general books of the Patriotic Emblem Company, and make all entries, including interest. The cash account may be omitted. Describe method of handling accounts with individual subscribers. (*) h 572 ADVANCED ACCOUNTING QUESTIONS ON CHAPTER VII Twenty Questions, Five Problems 121. a. What is depreciation? b. What are your views as to the necessity of a provision for depre- ciation on fixed or capital assets? c. From an audit of a public service corjwration it is found that no depreciation of capital assets has been provided by a charge against earnings, the oflScials believing that appreciation of certain real estate offsets a fair amount of depreciation. Is this a proper disposal of the matter? Give reasons. (A. I. A.) 122. a. Do you consider it good accounting practice to charge oflF deprecia- tion on machinery in years when the oi>eration of the plant results in a loss? Give reasons. b. What is the difference, if any, between depreciation, obeolescence and depletion? c. A company manufacturing tin tags charges to cost of manufacture (as depreciation) one-fourth of the cost of the stamping machine, which had been in service about one year. The life of this machine was estimated to be ten years, but owing to the discovery by a competitor of a new method of stamping, which, while still imperfect, promises to revolutionize the business, the stamping machine now in use will probably be obsolete within a period of three years. What would you say concerning the propriety of the above charge to prime cost? 123. a. Define the difference between fluctuation and depreciation in the value of assets. b. Name three of the principal elements that cause obsolescence. c. Name the advantages or disadvantages of the following methods of bringing on to the books of a company the depreciation on its machinery: 1. Crediting machinery account with 10 per cent of the balance of the account each year and charging profit and loss. 2. Crediting a reserve for machinery depreciation with 10 per cent of the balance of the account each year and charging profit and lose. How can you combine the best features of both the above methods? 124. a. A public service corporation that regularly sets aside from its profits a suflBcient amount to provide, for depreciation removes part of its old plant and replaces it with a larger and more costly one. The old plant is sold for scrap. How should the cost of the new plant and the proceeds from the sale of the old plant be treated in the accounts of the company? Give reasons. b. How should expenditures for repairs or replacements 1j€ treated insofar as they relate to the question of depreciation? c. You are asked by a client to discuss with him the (juestion of reserves for depreciation and depletion of his various ca])ital assets. State your position on this subject and enumerate the considerations you would advance in support thereof. Would you, or would you QUESTIONS AND PROBLEMS 573 not, be guided by the rules laid down by the internal revenue authorities in deciding upon the rates to be used? 125. a. What classes of property, if any, in your opinion, are exempt from depreciation? b. If asked to give advice concerning the proper rates per cent, to be adopted in providing for the account for depreciation on buildings, machinery, tools, etc., what could you recommend? c. A machine costing $81.00 is estimated to have a life of four years, with a residual value of $16.00. Prepare a statement showing the annual charge for depreciation according to each of the following methods: 1. Straight line. 2. Constant percentage of diminishing value. 3. Annuity method. (For convenience in arithmetical calculation assume the rate of interest to be 10 per cent.) Discuss the significance of each of the methods. (A. I. A.) 126. a. To what extent should an auditor hold himself responsible for the correctness of depreciation? b. The book value of the plant of a corporation has been reduced to merely a nominal sum. Under this condition, state: 1. Whether, periodically, a reservation should be made of an amount estimated to cover depreciation. The reasons supporting your answer. In the event of a difference of opinion between auditor and directors concerning the rate of depreciation on plant and machinery as would involve an important alteration in the proposed rate of dividend, how can the matter be settled to the satisfaction of both parties? Define: Reserve account. b. How may a reserve account be properly estabUshed and for what purpose? What, if any, contra account should be maintained? Under what circumstances should these accounts be maintained? Why? c. Explain the difference between real reserves and nominal reserves. Give two examples of each. (A. I. A.) d. From the viewpoint of a balance sheet, what is the logical place of: 1. Reserves for depreciation of physical assets, created by charges to operations. 2. Operating reserves. 3. Reserves for redemption of liabilities. 4. Reserves for contingencies. Give reasons for your opinion. a. How would a reserve affect the book value of capital stock? b. Explain "contingency reserve." How would it affect the book value of capital stock? c. Classify reserve for income and excess profits taxes according to 2. c. 127. a. 128. 174 ADVANCED ACCOUNTING !i the subdivision of assets, liabilities, proprietary interest, income and expense under which it should be grouped. d. A corporation owns nearly all of a block of land. The remaining portion is purchased subject to an exmting lease. The corporation sets aside out of surplus an amount believed to be sufficient to extend its plant over the entire block at the expiration of the lease. What ledger title should be given to the amount set aside and how should the amount be set up in the balance sheet? (A. I. A.) 129. a. An interurban railway company, wishing to provide against possible accidents, adopted the plan of depositing 2 per ami of their gross receipts each month in a local savings bank as a reserve for that purpose, charging the funds so set aside to an account which they designated "reserve for a<'cidents." The total fund for the year amounted to $4,869.26, out of which they paid $950.00 for accidents occurring and settled during the twelve months, debiting such payment to accident account, and leaving cash balance in the bank on December 31, of $3,919.26. The bookkeeper endeavored to close the books by showing the $4,869.26 as a charge against operating for the year arising out of accident liability, carrying over the balance in bank ($3,919.26) to provide for future accidents, and making a corresponding credit to the "reserve for accidents" account. This left the company with cash assets of $3,919.26 not represented on the books. Wherein did the bookkeeper err, and what entries should have been made to show the transaction correctly? b. You are employed to make an audit by a stockholder who believes the management of the corporation is piling up large secret reserves with the view of buying up the stock of the minority holders. You are given free access to the books. Explain in detail what investi- gations you would make to determine the truth or falsity of this belief. 130. a. Define: Reserve fund. b. Distinguish between a reserve account and a reserve fund. c. If asked to criticize a balance sheet prepared by a client's l)ook- keeper, state what you would say regarding the following caption found on the liability side of the balanose of acquiring and conducting a cemetery, and starts business on that date with a capital stock of $100,000.00 paid for in cash. The company first purcliases forty acres of land within easy access of a lai^ city, paying for same at the rate of $1,000.00 per acre. It proceeds to expend considerable sums of money in the purchase and planting of trees and shrubs, laying out drives and path- ways, sodding, building of glass houses, etc. The policy of the company is to withhold the selling of burial lots until after January 1, 1915, so a« to allow the trees and shrubs to become more fully grown and in the expectation that with the growth of the city their proi>erty will become more valuable. In the year 1915, the company commences selling burial lots, and all lots are sold under a special provision whereby the company agrees to QUESTIONS AND PROBLEMS 579 apply 50 per cent of all cash received on sales in the purchase of 4 per cent bonds, until a total of $150,000.00 of such bonds shall have been so purchased. The agreement further provides that after all lots have been sold the company will wind up its affairs and the above bonds, amounting to $150,- 000.00, shall be given to the city, which shall use the income of such bonds for keeping up the cemetery. It is the custom of the company not to purchase bonds until after the close of each fiscal year and after the total sales of that year have been determined. In March, 1920, the directors of the company find that, while they believe the books to be in balance, no proper entries have been recorded showing total cost of their investment, and that no entries have been made with respect to the fund of $150,000.00, from which said bonds are to be purchased. While cash dividends have been declared and paid, the direc- tors are in ignorance of what their profits actually have been and how much of the dividends so received have been out of their profits and how much in the nature of liquidating dividends, representing a return of their original investment. They, therefore, employ a certified public accountant to determine all these matters and to make the necessary entries on their books and render report to them. After determining the clerical accuracy of the books, the accountant draws off the two trial balances given below, and from them prepares the necessary entries and obtains the information required by the directors. Trial Balances Debits: Real estate, Improvements, Bonds, Administration expense, Upkeep of cemetery. Dividends paid. Cash, Credits: Interest account representing interest at 4 per cent on unexi>ended cash during development period. Bond interest account. Sale of lots. Capital stock. Jan. 1, 1915 Jan. 1, 1920 $ 40,000 00 $ 40,000 00 45,000.00 45,000.00 125,000.00 46,000.00 45,000.00 130,000.00 40,800.00 20,000.00 7,00000 $112,000.00 $471,800.00 $ 12,000.00 $ 12,000.00 9,800.00 350,000.00 100,00000 $112,000.00 $471,800.00 100,000.00 An inventory of their unsold lots as on January 1, 1920, shows that they have ten acres left unsold of equally desirable character with that already sold. Draw up entries, prepare profit and loss statement for period and balance sheet as on January 1, 1920, in same manner as if you had been the accountant engaged. In any interest calculation use 4 per cent simple interest. i 580 ADVANCED ACCOUNTING 34 out of the net earnings of the company, a dividend for the h„lf ? . 4 per cent on the preferred stock of Sinnnnn no J, half-year, of stoek of tlOO 000 00 T^ere^., K »100,000.00 and 3 per cent on the common an undivid^Z^ce JfZi^o^'.^'TT^"'!'''"''''''^' '-»'->•<'- th. trial balance is found to belfoCs? **' '"' """"' °' ''"' '^'- Debits: Real estate and buildings, Plant and machinery, Patents and good-will, Inventory, Purchases, Labor, Coal, Salaries — general, Salaries — management, Insurance, Allowances, Freight, Discount and interest. Cash in bank. Investments, Miscellaneous expense, Book debts. Preferred stock in treasury, Repairs, $ 32,500 00 40,000 00 80,000 00 29,000 00 «2,500 00 X«,000 00 6,000.00 11,000 00 6,000 00 875 00 B, 250. 00 1,500.00 750 00 8,000 00 16,500 00 4,300.00 42,000.00 6,000.00 1,000.00 Credits: Preferred stock. Common stock, Sales, Notes payable, Accounts payable. S459, 175.00 JIOO.OOO.OO 100,000.00 219,175.00 26,000.00 14, 000.0 S459.175 00 shS'from ^L"''V"''*"-**- ^Po^'Profit and loss statement andWanc. rate of 7U ^r o^^' ^™* "'^f' '" '^^ '""""'"*« *" depreciation a thi .^.t^^^^k^^L-Sdetrbad^t^'a^^^^ in the balance sheet for the dividend as stated. ^ QUESTIONS AND PROBLEMS 35 581 A syndicate having invested in a coal property, presents the following balance sheet: Assets Liabilities 141. a. b. c. Acreage, $1,500,000.00 Capital stock, $1,000,000.00 Physical equipment, 500 , 000 . 00 Bonds— 1st Mtg. 5s, 1 , 000 , 000 00 The syndicate estimates it will mine and sell 1,250,000 tons per year, and the life of the mines at this rate will be twenty-five years. The surface acreage is not marketable. It will require $50,000.00 expended annually in additional equipment. This physical equipment will have no salvage value at the expiration of twenty-five years. The bonds are to be called and paid at the rate of $40,000.00 per annum. At what profit per ton over direct cost of mimng must the coal be sold, so that a dividend of 7 per cent can be paid yearly on the stock and leave at the close of business, twenty-five years hence, sufficient convertible assets to pay the stockholders in cash the par value of their stock? Explain. Make a statement winding up the syndicate's affairs, assuming the general correctness of the estimates. QUESTIONS ON CHAPTER Vm Twenty Questions, Five Problems Do unsold treasury bonds constitute a liability? Why? Do unsold bonds of a railroad company constitute a liability? If they do, under what accounts would they appear on the ledger? The ledger of a corporation has an account entitled: "First Mort- gage Bond Scrip," showing a credit balance of $967.54. What does this balance represent and how would you treat the item in the balance sheet? 142. Formulate the entry in respect of the following: Preferred stock of $1,000,000.00 taken up by an issue of first mortgage 6 per cent bonds carrying the same value, in accord with a resolution adopted by the stockholders in lawful meeting assembled. (*) 143. A certain manufacturing company disposed of its entire $50,000,000.00 issue of first mortgage 6 pe* cent bonds at 90, the proceeds of which were used to pay for the obligations growing out of the construction of a new plant. Formulate the entries in respect of the above, and indi- cate how the discount item should be dealt with upon the books of account. (*) 144. A corporation borrows $120,000.00 for a period of ten years to pay off an existing loan at a higher rate of interest, paying therefor in brokerage and costs $2,750.od. How would you treat this item on the books? 145. a. Define bond discount and bond premimn. How should each be treated in the annual statement of a concern? b. If a company sells its own bonds at a premium, is the premium received a legitimate profit of the company? a. "Discounts and premiums on bonds are in effect an addition to or a deduction from the interest rate paid on the bonds over their 146. 582 ADVANCED ACCOUNTING QUESTIONS AND PROBLEMS 583 147. a. i \m i' life." (Dickinson.) Defend and illustrate this statement in view of your definition of interest. b. What proportion of $15,000.00,— commission paid for negotiating a sale of bonds, to run ten years, — should be treated m an a«sset at the end of the first year? Give reasons. How would you deal with Bond Issue Expanse account in preparing the annual accounts of a company? Comment briefly on any points which would need special consideration. (A. I. A.) b. The Bristol Manufacturing Company issued and sold on the 1st of January, 1^— , to A and B (fifty to each at the same price), first mortgage bonds of $500.00 each, bearing interest at 4 per cent per anmmi, and received $48,000.00 in cash. What records of the transactions should be made, and in what books? 148. a. Outline an entry recording bond interest due but not paid at time of making the entry. What are the advantages of such an entry? b. How would you disclose on the balance sheet dated December 31, bond interest due January 1? 149. Formulate the entries in respect of the following: a. Interest accrued for eight months upon an outstanding issue of first mortgage 6 per cent bonds in the amount of $8,00(),(XX).0(). b. Six months' interest of the above matured upon December 31, 1921, and 90 per cent of the interest coupons were preeiented for redemption on January 2, 1922. Indicate how each of the above should be set out in a balance sheet dated December 31, 1921. (*) 150. A company, having $500,000.00 of debentures, bearing 5 per cent in- terest, which have been in existence for some years, and which are repay- able February 1, 1920, arranges to provide the necessary capital by the issue, at par, of $500,000.00, 4 per cent permanent debenture stock, the interest on which runs from January 1, 1920; the accounts of the company are made up to June 30, 1920. What, in your opinion, is the proper amount of debenture interest to be charged against the profits of the half year? Give the reasons upon which ycmr opinion is based. 151. a. A concern has an authorized issue of bonds to the amount of $100,000.00; $40,000.00 are sold at par, $10,000.00 are sold at 10 per cent premium, $30,000.00 are put up as collateral to a $25,000.00 loan at the bank, and $20,000.00 are on hand. Prepare a balance sheet showing the above transactions, supplying the other needed accounts, b. A company authorizes its oflBcers to borrow for its account $100,000.00 and give as security $200,000.00 of the first mortgage bonds of the company. How should this transaction be treated in the balance sheet? 152. a. A corporation has issued $1,000,000.00, 5 per cent debenture bonds redeemable at par, out of profits, at the end of twenty years. State what method should be adopted to provide for such redemption so that each year's profit may bear its due proportionate burden of contribution, b. What entries would you, as auditor, deem proper to record the redemption of bonds by a company with the cash deposited with its fiscal agent, where such bonds were cancelled? 153. a. Formulate the journal and cash book entries in respect of the follow- ing: On July 1, 1920, $300,000.00 of first mortgage 6 per cent bonds were retired. These bonds matured on July 1, 1925. The bonds were retired at 1023^, in accord with the terms and conditions of the trust deed covering the property securing the issue. (*) b. What advantage, if any, has the serial plan of paying bonds over the sinking fund plan? 154. a. A corpK)ration having. issued first mortgage bonds in the amount of $50,000.00, sets aside out of profits $5,000.00 each year and pays off at par bonds to a similar amount. How shaU these items appear in a balance sheet at the end of five years? b. What reason can you give for the creation of a reserve for a sinking fund when the reserve is not to be funded? 155. a. A sinking fund reserve is created out of annual earnings. How is the book value of the company's stock affected by such policy? Explain, b. How should a reserve account and a sinking fund, both relating to the redemption of the same debt, be simultaneously operated? What purpose is accomplished thereby and how do said accounts respectively app>ear on the balance sheet? 156. a. Are sinking fund reserve appropriations a satisfactory protection to the bondholder? b. If asked to criticize a balance sheet prepared by a client's book- keeper, state what you would say regarding the following caption found on the liability side of the balance sheet: ** Reserve Fimd for Redemption of Bonds— $50,000.00." Explain fully. 157. a. Should a reserve fund be invested in interest-bearing securities? State the custom. If so invested, what account should be credited with the income? b. What is the effect on a business of a sinking fund? 158. Argument has been strongly urged that aside from any question of possible mismanagement, or of the difficulty of making satisfactory investments to yield the same rate as is paid on the bonds, a sinking fund for bonds is more expensive than an arrangement for the serial payment of bonds. This is illustrated by the case of $20,000.00 5 per cent bonds. If these are paid off in a series, one each year, the total payment made will be principal $20,000.00, interest $10,500.00, total $30,500.00. The annual sinking fund to pay these bonds would on a 6 per cent basis amount to $604.85, making in twenty years $12,097.00, and the interest paid on the bonds would be $20,000.00, total payments $32,097.00. The apparent excess burden is accordingly $1,597.00. Discuss the above argument and show clearly just what the figures mean and in what the apparent saving actually consists. (A. I. A.) t: 584 ADVANCED ACCOUNTING 159. You are auditing the accounts of a corporation and you find the following entries in one month without sufficient explanation- 'D.^Ci. 1 T _ f 8,333.33 100,000.00 100,000.00 100,000.00 100,000.00 100,000.00 $ 8,333 33 100,000 00 100,000.00 100,000 00 100,000 00 100,000.00 Profit and Loss, To — Accrued Sinking Fund, Accrued Sinking Fund, To — Reserve for Sinking Fund, Union Trust Company, Trustee, To — Accounts Payable, Accounts Payable, To — Cash, Sinking Fund No. 1, To — Union Trust Company, Reserve for Sinking Fund, To — Profit and Loss, What would you conceive the situation to be and what recommendation would you make? 160. a. From a theoretical point of view, are the contributions tf) a sinking fund a proper charge against profits? Give your reasons, b. Under the conditions of a general mortgage given by the Red Clay Brick Company to protect its issue of bonds, provision is made for payments to the trustee at stated periods, which, together with all accretions from interest and profits, are to be held and disbursed by the trustee as one fund. Should any distinction be shown on the books of the brick company between interest and profit so obtained? If so, give reasons. PROBLEMS ON CHAPTER Vm 36 The Smith and Jones Manufacturing Company issued $200,000.00 of first mortgage fifty-year, 5 per cent sinking fund bonds which were marketed at 981^, 1 per cent commission, and expended the entire proceeds in the erection of theu- plant. The discount and commission were charged to Unamorti»ed Debt Discount and Expense account, to be subsequently charged to Profit' and Loss, proportionately, during the life of the bonds. Five years later the company was enabled, owing to a disturbance in the financial market' to purchase $50,000.00 of said bonds for Sinking Fund account at 96. Prepare the necessary journal entries to record correctly the above transactions of the company. 37 The shareholders of a company with bonds outstanding of $500,000.00 bearmg mterest at 5 per cent per annum, resolve to provide for paying off the same when they faU due on December 31, 1928, by investing $50,000.00 per annum out of the profits and allowing same to accumulate with interest- this arrangement to commence with the balance sheet for the year ending QUESTIONS AND PROBLEMS 585 December 31, 1920. Show the "Bond Redemption Account" on December 31, 1924, on the assumption that on December 31, 1920, and on the same day each year following, the $50,000.00 referred to was invested in 4 per cent rail- road bonds at par, that the interest thereon to June 30, and December 31, in each year was received in July and January following, and was allowed to accumulate in the bank until December 31, and June 30, following, respect- ively, when it was invested in the same class of securities at the same price in multiples of $1,000.00. 3a Corporation A issues fifty bonds, par value $50,000.00, bearing 5 per cent interest, payable annually. The bonds are numbered serially, and are to be retired in consecutive groups of ten each year. They are to be sold at date of issue for an average price of $950,00. a. Submit, in form of ledger accounts, all entries required to handle this bond issue, in what you consider the most equitable manner, from date of issue to retirement. b. Corporation B buys bonds Nos. 21 to 40, inclusive, on date of issue, at $950.00 each, and sells Nos. 21 to 30, at the end of two years, for $1,000.00 each. The other ten bonds are retired when due. Submit in the form of ledger accounts, all necessary entries in Corporation B's books for handling the matter in what you consider the most equitable manner. 39 At the beginning of its fiscal year, a certain corporation issued bonds for the purpose of purchasing machinery with the proceeds. These bonds were secured by a mortgage against the machinery, which required that $5,000.00 was to be set aside annually out of net profits to accumulate a sinking fund with which to retire the bonds. The general manager of the company was under a contract which pro- vided as follows: 1. He was to receive annually, in addition to his salary, a 5 per cent bonus from the profits for the year. 2. This bonus was to be calculated before the sinking fund instalments were charged against the earnings. At the end of this fiscal year, it was agreed by all concerned, upon advice of the auditor, that the machinery mortgaged for the benefit of the bond- holders should be depreciated $8,000.00 to cover estimated decrease in value, and that a reserve in such amount should be established. The credit balance in the Profit and Loss account at the end of the year, representing profits for the year prior to adjustments covering bonus, sinking fund instalment, and depreciation reserve, amounted to $23,540.00 Prepare all journal entries deemed necessary in respect of the above. (*) 586 ADVANCED ACCOUNTING I The Virginia Coal Company was originated on January 1, 10l8, began operations about January 7, 1918, and kept an ordinary set of books (by double entry) but did not close their accounts at the end of any fiscal year. After an examination and verification of all accounts stated in the Trial Balance, they are accepted as correct, except that termed "Sinking Fund Payments" ($22,500.00). The mortgage securing bonds to the amount of $200,000.00 contains a sinking fund clause providing that the company shall deposit semi-annually with the Sinking Fund Trustee 5^ per ton on all coal mined; such payments shall be made to trustee during January and July of each year for the pre- ceding six months' period. Money so deposited is to be applied, as soon as practicable, to purchase bonds at not exceeding 115, and accrued interest; compensation and expenses of trustee are also to be paid from the sinking fund. Bonds, when redeemed, cannot be cancelled, but are to be held by trustee who shall collect the semi-annual interest thereon and apply to the same purposes as the 5^ per ton payments. Bonds are dated January 1, 1918, run for 20 years and bear interest at 6% per annum, payable January 1 and July 1 of each year. Payments to sinking fund trustees (the General Trust Company) have been as follows: July 27, 1918 Payment for 6 months ended 6/30/18, 5i per ton on 120,000 tons, $ 6,000.00 Jan. 24, 1919 Payment for 6 months ended 12/31/18, 5ff per ton on 150,000 tons, 7,500.(X) July 28, 1919 Payment for 6 months ended 6/30/19, 5^ per ton on 180,000 tons, • 9,000 00 $22,500 ~00 On January 30, 1920, the company paid to the General Trust Company (S. F. Trustee) $5,500.00 for sinking fund payment for the 6 months ended December 31, 1919, being 5^ per ton on 110,000 tons. The General Trust Company submitted statements of receipts and dis- bursements for account of the Sinking Fund to date (January 31, 1920) as follows: Cash Received to Decembe r 31, 1919'j July 27, 1918 S. F. deposit for six months ended 6/30/18, 120,000 *onsat5ff, I 6,000 00 Jan. 5, 1919 January 1919, coupons on five bonds, 150.00 Jan. 24, 1919 S. F. deposit for six months ended 12/31/19, 150,000 tons at 5ff, 7,500 00 July 3, 1919 July 1919, coupons on twelve bonds, 360.00 July 28, 1919 S. F. deposit for six months ended 6/30/19, 180,000 tons at 5fi, 9,000 00 $28,010^ QUESTIONS AND PROBLEMS 587 Cash Disbursements to De cember 31, 1919 Aug. 16, 1918. — Bonds redeemed — 5,000 at 110, Commission at ^ per cent, Accrued interest, Feb. 15, 1919.— Bonds redeemed: 4,000 at 108, 2,000 at 110, 1,000 at 112, Commission, Accrued interest, Aug. 12, 1919. — Bonds redeemed: 9,000 at 90, 1,0(X) at par, Commission, Accrued interest, Dec. 31, 1919. — Compensation of trustee, Advertising, $5,500.00 12.50 37.50 $5,550.00 $4,320.00 2,200.00 1,120.00 $7,640.00 17.50 52 50 $8,100.00 1,00000 $9,100.00 250 00 70.00 $7,710.00 $ 100.00 50 00 9,420.00 150 00 $2 2,830 .00 $ 180.00 Cash balance in hands of trustee, December 31, 1919, Received in January, 1920, viz: S. F. deposit for 6 months ended 12/31/19, 110,000 tons at 5^, $5,500.00 Coupons on 22 bonds in S. F., ^ 660.00 Interest allowed on balance to 12/31/20, ' 1(X) 00 $6 260 00 $6,44000 Prepare entries to state properly on the books of the Virginia Coal Company all sinking fund transactions. QUESTIONS ON CHAPTER IX Twenty Questions, Five Problems 161. a. Define a trial balance. b. Describe the process of taking a trial balance. c. What is the function of a trial balance? d. Do you consider the use of a trial balance necessary? 162. a. In case of a discrepancy in a trial balance, how may the accountant ascertain which side is erroneous? b. When accounts are in equilibrium, what may be said as to their correctness? c. What deductions may be safely drawn from a trial balance repre- sentmg intrinsic values and true economic history of the transac- tions of a given period? 163. a. How should the foUowing inventories be valued for the purposes of a balance sheet at any given date* 1. Finished products. 588 ADVANCED ACCOUNTING 2. Goods in process of manufacture. 3. Raw materials. b. On the balance sheet prepared by you from the books of a client, state which items are matters of fact and which matters of opinion. 164. a. State the difference between: 1. Receipts and revenue. 2. Expense and disbursements. b. Define each of the following terms: 1. Capital expenditure. 2. Repair and upkeep expenditure. 3. Deferred charges. 4. Capital receipts. 165. Indicate how you would distribute the foUowing as between capital and revenue accounts: a. Extensive repairs made to the equipment of a power house in the total amount of $5,325.00. b. Remodeling of a boiler house at a total cost of $4,500.00; also, extending same at a total cost of $6,200.(X); both of these being done in order to install a larger and more modern type of vertical boilers. (•) 166. Indicate how you would distribute the following expenditures: a. Profit of $10,000.00 from the sale of stock of another company held as an investment. The broker's commission in connection with the transaction was $750.00. b. Loss of $500.00 from the sale of certain bonds held as an investment. Loss of $5,000.00 from the sale of certain real estate which was not required because of moving the plant to another locality. (*) In closing the books of a firm it is found that the accounts receiv- able include $5,000.00 of worthless accounts, and $10,000.00 of doubtful accounts. The firm decides to deduct from the gross ^ profits $15,000.00 for these items. What would you consider the best method of carrying these items on the general ledger? b. In the case of a company which pubhshes an annual balance sheet but no profit and loss account, state whether or not you would recommend to your client that the profits earned during the year, less dividends paid, be shown on the face of the balance sheet! Give your reasons. (A. I. A.) 168. In preparing a balance sheet as of December 31, 1921, of a certain company, how would you treat the following, and why? a. Estimated cost $26,000.00 to replace defective parts of machines manufactured and sold and shipped during the three years ending on the above given date. (*) b. Estimated amount $11,000.00 recoverable from the company which furnished these parts to us, our contract with them providing that all parts furnished and proving defective within two years from date of shipment are to be replaced free of charge or are to be paid for in cash at reproduction cost. (*) QUESTIONS AND PROBLEMS 589 167. c. a. 169. a. Set up a form of working paper that will enable an auditor to adjust a trial balance of January 1, with a profit and loss account and a balance sheet of a subsequent period without recourse to journal entries, b. Is the form of a balance sheet a matter of principle or convention? 170. How should the following items be dealt with in closing the books on December 31, 1921: (*) a. Liabilities of $19,202.22 relating to the period prior to the above date, and not taken up onto the books until in January, 1922. All items contained in this total represent current running expenses of a general nature. b. The inventory at December 31, 1921, was taken up on the books at cost, in the amount of $562,891.13; the market value of this inventory was $537,688.29. c- Investments in other companies were taken up on the books at market, in the amount of $232,456.18, whereas, cost was $197,- 243.96. 171. a. Define each of the following terma: 1. Surplus. 2. Undivided profits. 3. Inventory reserves b. State the difference between: 1. Plant renewal and replacement and plant repair. 2. Adjustment entries and closing entries. 172. a. How should the following be set out in the balance sheet of a com- pany: (*) 1. Depreciation reserve. 2. Sinking fund reserve. 3. Preferred stock dividends in arrears. b. Explain the difference between cost and book value. 173. a. What constitutes selling cost? b. Should freight-out be shown as a deduction from gross sales, as an addition to the cost of goods sold, or as a selling exi>ense? Why? c. Distinguish between the items allocatable to the trading account and to the profit and loss account. d. Distinguish between gross profit and net profit. 174. a. How should the following items be distributed in the accounts of a company: (*) 1. Bonuses paid to oflScers and employees, $15,000.00. 2. Purchase of $100,000.00 of the preferred stock of the XYZ Company, for $120,000.00, this being the purchase of the total par value of the stock issued by the XYZ Company. b. May any fluctuation in the value of permanent assets be permitted to affect the result of the profit and loss account? Give reasons. 175. a. In making up a profit and loss statement at the close of a fiscal year, are you stating a fact or an opinion? Give reasons? b. What are the limitations, if any, of a balance sheet? 590 ADVANCED ACCOUNTING 176. a. A company shows among its assets $2,675.00 as unexpired insurance on January 1, 1922. On February 1, 1922, the plant is destroyed * by fire and a total loss of $57,875.00 occurs, which the insurance company pays. How would you treat the $2,675.00 unexpired insurance item? b. A manufacturing corporation having several plants decides to shut down one plant because it cannot be run economically. Under what classification in the operating statement would you include the expenses attending the care and upkeep of the idle plant? 177. a. What is meant by turnover? Illustrate its modem usefulness, b. Why must the revenue account be completed before a balance sheet can be prepared? 178. a. State two different theories in relation to the presentation of a balance sheet as far as classification is concerned. What is the reasoning on which they are based? b. What is the mechanism of the double form balance sheet? Explain the connection between its sections, stating the theory of the organism. 179. a. Distinguish between the following: 1. Contingent asset and contingent liability. 2. General balance sheet and comparative balance sheet, b. When do revenue expenditures create assets? 180. a. In auditing the accounts of a manufacturing company would you consider it proper to allow the profit and loss account to be credited with profit on uncompleted work? b. What accounts on the ledger are generally considered as "deduc- tions from income " ? Why ? As " other income ' ' ? PROBLEMS ON CHAPTER IX 41 Trial Balance of the General Ledger of John Doe, Civil Engineer, December 31, 1911 $10, 572 .44 M an hattan Construc- 1,054.68 tion, Report No. 1, Sewanee 6,000.00 Creek Raiboad, 15,457.50 Report No. 2, Engle- 3,000.00 wood Reservoir, Report No. 3, Long 13 , 000 . 00 Acre Library, 15 , 361 . 32 Connecticut Tramways 9,800.00 Company, 1 , 060 . 00 Earnings — consulting Report fees, Cash, Furniture and fixtures, Real estate (Ruther- ford home), Investments in stocks, Investments in bonds, Missouri Pacific — margin account, Accounts receivable, General expense. Interest, Sharj) & Co., brokers, Sto<;kH and bonds. Capital, $75,305 94 $ 5,000.00 5,300.00 4,600.00 3,200.00 1,960.00 2,000.00 16,000.00 11,310.00 4,300.00 21,745.94 QUESTIONS AND PROBLEMS 591 Analyses: General expense— Salaries: John Doe, $6,000.00, other salary $1,800.00; rent $1,000.00; advertising $600.00; cables and telegrams $90.00; stationery and printing $110.00; other expenses $200.00. Interest— Debited with $1,300.00 charged by Sharp & Co., brokers, on margin account; reduced by dividends of $390.00, credited by Sharp & Co. on margin account. Balance on loans since repaid. Manhattan Construction Co. — Represents consulting fees received during the year 1911, the contract running from month to month, with no expense to John Doe. Reports 1-3 — Are completed and delivered. Account contains fees, less expenses. Connecticut Tramways Co.— Represents $2,000.00 received November 1, 1911, and expenses of $50.00; according to terms of contract, John Doe is to act as consulting engineer for ten months and to receive altogether $5,000.00. Report Fees — Fees received under contract for report, $9,000.00 received on contracts on which no work has been done; balance is earned. Stocks and Bonds — Are sold. Account represents balance. Additional Facts— Dividends on stocks received during the year amount to $1,985.00 of which $1,000.00 was applied to the account Investment Stocks and $985.00 was applied to Stocks and Bonds sold. Prepare: a. A balance sheet at December 31, 1911. b. An income statement showing John Doe's true earning power as a civil engineer. c. The journal entries supporting your adjustments of the books, if any. Black and White were partners upon the following terms: 1. They were to receive 5 per cent interest upon their respective partnership capital. 2. They were to receive partnership salaries as follows: Black, $250.00 per month and White, $100.00 per month, and they were to draw no further sums, pending the ascertainment of profits. 3. Depreciation at 10 per cent per annum to be written off plant and machinery as standing on the books at the close of the year. 4. Provision at 5 per cent (for doubtful accounts) to be reserved for all accounts receivable, not including, however, bills receivable. 5. The net profit or loss to be shared as follows: Black, two-thirds, and White, one-third. On November 30, 1915, the following was the trial balance of the firm's books, which were kept by double entry: Partners' salary account, Purchases, Investments (at cost). Wages, $ 3,850.00 127,310.00 6,150.00 19,205.00 $75,305.94 I I 592 ADVANCED ACCOUNTING John Jones & Co., Jas. Smith & Son, Wm. Owen, Legal expenses, Cash, Bank, Real estate. Machinery and plants, Bills receivable. Manager's and clerks' salaries. Office expense. Discount, Inventory, Jan. 1, 1915, Rent (eleven months), Albert Black (Capital account on 1/1/15), Benjamin White (Capital account on 1/1/15), Dividends received on investments, Bills payable. Sales, Roberts Bros., Robinson & Co., J. Green & Son, 17,130.00 35,695.00 18,120.00 130.00 50.00 6,025.00 103,205.00 27,200.00 2,510.00 4,725.00 540.00 1,070.00 19,210.00 3,300 00 I 21,000.00 7,500.00 150.00 19,076.00 242,806.00 41,216.00 28,840.00 34,840.00 $395,425.00 $395,426.00 Amend the foregoing balances so far as may be necessary by following transactions for the month of December, 1915: Dec. 2. — Purchased from Roberts Bros, on credit, 8. — Paid taxes, 9. — Paid Robinson & Co. (after deducting discount of $60.00), 10. — Paid bill payable to H. Brown & Co., 11.— Received from J. Smith&Co. (less discount of $210.00), 12. — Sold Wm. Owen (on credit), 15. — Purchased from J. Green & Son (on credit), 16.— Bought gas engine from Al-Ki Gaa Engine Co. (on Credit), 17. — Paid wages, 21. — Paid taxes, 24. — Paid premium on fire insurance policy for year ending Dec. 24, 1916, 30. — Received for sale of investments, 31. — Paid office salaries. Paid office expenses, Paid wages, Sold James Smith & Co. (on credit), posting the $39,206.00 705.00 1,200.00 500.00 4,740.00 5,000.00 17,106.00 1,750.00 2,210 00 106.00 526.00 6,000.00 1,800.00 100.00 2,200.00 5,246.00 All the above payments were made by check, and all amounts received were paid into the bank upon receipt. The stock on hand on Dc^cember 31, Ti QUESTIONS AND PROBLEMS 593 from the books of the Moore & 1914: f 100.00 3,000.00 150,000.00 10,000.00 50,000.00 200,000.00 50,000.00 5,000.00 5,000.00 2,000.00 5,000.00 900,000.00 20,000.00 25,000.00 10,000.00 5,000.00 5,000.00 2,000.00 1,500.00 300,000.00 3,000.00 2,000.00 3,000.00 50,000.00 20,000.00 11,000.00 10,000.00 12,000.00 $1,150,000 00 20,000 00 1,000 00 200,000.00 1915, was agreed by the partners as worth $17,000.00. The outstanding rent due to Benjamin & Lewis for December, $300.00, and the partners' drawmgs for the same month must be provided for. After making aU adjustments provided for in the clauses of the partnership agreement balance the books as at December 31, 1915, and prepare trial balance; alflci prepare an mcome and profit and loss statement and balance sheet. 43 The following trial balance was taken Smith Hardware Company, December 31, Cash on hand. Cash in bank. Sales, Discounts on purchases. Interest on notes receivable, Accounts receivable. Notes receivable. Capital stock, Real estate. Buildings, Equipment, Horses, wagons and harness, Motor trucks. Insurance, Taxes, Purchases, Discounts on sales — cash, Wages of men in warehouse, Salaries of department managers. Salaries of office assistants. Drivers, teamsters, etc.. Horse feed. Auto expense. Inventories, Jan. 1, 1914, Inventories, horse feed, auto accessories, etc., Jan. 1, 1914, Inventories, stationery, advertising, etc., Jan. 1, 1914, Office supplies, stationery, etc.. Advertising, Salesmen's salaries. Salesmen's commissions. Interest on notes payable. Dividend on capital — 6 per cent, Notes payable, Accounts payable. Real estate — not used in the business. Investment in Union Hotel Co. (at cost), 150,000.00 50,000.00 250,000.00 150,000.00 w 594 ADVANCED ACCOUNTING Sprinkler system — at face of contract, Surplus, Liability on sprinkler sj'stem, 10,000.00 290,600.00 8,000.00 12,069,600.00 $2,069,600.00 On December 31, 1914, the company authorized the issue of $300,000.00 cumulative 7 per cent preferred stock and sold wame to the Grand Investment Company at 90, giving also a bonus of $30,000.00 common stock. $70,000.00 conmion stock was sold to the present stockholders at par, the total issue of common stock being $300,000.00. Of the proceeds of these sales $150,- 000.00 was to be expended on new buUdings, the balance to be retained for working capital. On January 2, 1915, a dividend of $40,000.00 was declared, i»ayable on January 15, 1915. The inventories at December 31, 1914, were: Merchandise, $325,000.00 Horse feed, auto accessories, etc., 1,000.00 Stationery, advertising, etc. , i , 500 00 Of the insurance paid $500.00 appUes to the year 1915; aliio $1,500.00 of the taxes. The sprinkler system was installed on July 1, 1914. Of the contract price $2,000.00 was paid on that date and $2,000.00 is payable on the first day of August, 1915, 1916, 1917, 1918. $2,000.00 of interest applies to the period subsequent to January 1, 1915. The depreciation of buildings for the year is $10,000.00 and of equipment $5,000.00. The real estate not used in business has appreciated $50,000.00, while that used in business has been appraised at $75,000.00. From the foregoing trial balance and data prepare a statement of income and profit and loss for the year and a balance sheet as at December 31, 1914. 44 The following is the trial balance of the ledger Company, at the close of business on December Capital stock. Work in process 12/31/19, Materials inventory 12/31/19, Finished product 12/31/19, Une3^ired insurance, Taxes, Materials purchased, Insurance, Interest, Accounts payable. Accounts receivable. Traveling expenses. Factory supplies. Office expenses. Selling expenseSi of the Jones Manufacturing 31, 1920: $150,000.00 $ 53,689.39 10,767.87 115,453.90 5,458.00 2,937.50 160,691.26 4,567.80 4,200.00 45,897.57 3,654.62 5,670.03 4,790.82 8,798.46 23,570.98 QUESTIONS AND PROBLEMS 595 Petty cash, Power, Cash in bank, Notes payable, Labor, Machinery and equipment, Factory expense. Discount on sales, Freight-out, Freight-in, Discount on purchases. Salesmen's commissions, Taxes prepaid, Repairs, Rent, Salaries, Interest prepaid. Reserve for depreciation, Sales, Surplus, 200.00 6,400.00 3,609.00 186,568.43 124,357.00 51,800.05 3,675.47 2,657.80 2,748.56 6,600 66 672.80 5,346 00 12,000.00 34,846.00 345.00 50,000.00 7,896.41 29,670.00 562,109 70 45,156 9 T., ^ ^. $868,403.99 $868,403.99 Notations: — * 1. Inventories on hand: materials, $10,434.22; work in process, $56,542 14' finished product, $70,470.89; supplies, $3,567.90. 2. Prepaid interest amounts to $350.00; prepaid taxes amount to $578 00- unexpired insurance, $987.56. ' 3. Reserve for depreciation to be increased 5 per cent of the total fixed assets. 4. Reserve for uncollectible accounts receivable to be 2 per cent of the total accounts receivable. 5. Insurance, taxes, and rent are to be divided 3/5 to the factory 1/5 to trading, and 1/5 to administration. ' Required : 1. Working sheet with accompanying schedules of adjusting entries. 2. Statements: a. Balance sheet. b. Statement of profit and loss. c. Statement showing cost of manufucture and cost of manufactured product sold. At the close of its fiscal year, December 31, 1915, the trial balance of the rslau-I'ace Company was as follows: Real estate, $ 225,000.00 Fixed machinery, 150,000.00 Movable equipment, jg qqq qq Shaftings, pulleys, etc., 10*500 00 Stable equipment, 3 ,' 500 . 00 Office equipment, 2 915 on 596 ADVANCED ACCOUNTING Drawings and patterns, 9,000.00 Patents, 75,000.00 V Capital stock, $ 500,000.00 i First mortgage bonds. 100,000.00 . Profit and loss, , Surplus, 86,140.00 ^ Dividends, 300.00 •^ Interest on bonds, 6,000.00 >■ Other interest paid, 1,323.10 t Interest received, 2,469.50 t Cash discount on purchases, 13,389.52 , Cash discounts on sales. 2,861.50 - Sales, 1,540,816.75 * Return sales, 8,258.25 ' Ca«h, 27,750.65 - Bills receivable, 60,750.00 . Accounts receivable, 298,650.25 . Raw materials, 622,190.90 • Finished goods, Jan. 1, 1915, 62,735.06 V Goods in process, Jan. 1, 1915, 24,747.27 » Fuel, 38,688.28 ,^ Insurance, 4,000.00 Taxes, 6,000.00 * Bills payable. 40,000.00 ^ Accounts payable, 46,585.85 1- Reserve for depreciation: V Machinery and equipment. 60,000.00 Buildings, 30,000.00 ' Patents, 22,058.80 Bad accounts. 6,240.75 K Salaries — OflScers and clerks (general). 66,150.00 General office supplies, 2,950.75 Postage, telegraph, and telephone. 1,560.00 Miscellaneous general expenses, 850.00 I,- Advertising, 35,000.00 i Salaries and expenses — salesmen. 72,350.31 t Agents' commissions, 30,141.40 . Credit department salaries. 7,560.00 Miscellaneous expenses — Selling, 610.00 Stable expenses, 3,963.46 V Direct labor (manufacturing), 508,311.39 V Indirect labor (manufacturing). 44,981.01 «- Superintendence — Factory, 6,000.00 ' Factory supplies. 8,547.18 " Repairs — Machinery and equipment, 7,418.52 ^ Repairs of buildings. 2,860.47 ^ Power, heat, and light, 2,875.80 $2,438,001.45 $2,438,001.45 QUESTIONS AND PROBLEMS 597 You are to take into consideration the following facts: 1. Real estate, machinery and other factory equipment, and patents are stated at cost. 2. Of the real estate, $25,000.00 is for land, and $200,000.00 is for buildings. 3. All capital stock authorized has been issued and is outstanding. . 4. Allowances for depreciation are : Machinery and factory equipment, $15,000.00. Buildings, 3 per cent of cost. Patents, 1/17 of cost. 5. $15,000.00 is to be set aside as a reserve for bad accounts. 6. Ten per cent, of the book value of stable equipment and office equip- ment, and one-sixth of the book value of drawings and patterns are to be charged oflf. 7. Inventories at the close of the fiscal year were: Raw materials. Finished goods. Goods in process. Fuel, Factory supplies. Office supplies. Prepaid insurance, 8. The accruals are: Taxes, Direct labor. Indirect labor, Interest on bonds. Advertising, $63,580 40 58,864.56 27,024.52 4,823 43 1,525 00 500 00 500.00 ; 7,000 00 12,618 75 2,040 50 1,000 00 4,718.50 $27,377.75 9. The depreciation of stable equipment (see it€m 6) is to be charged to stable expenses, and one-third of the latter is apportioned to manufac- turing expenses, and two-thirds to selling expenses. 10. The cost of fuel used is to be charged to power, hght, and heat. 11. Maintenance of real estate is to be charged with cost of repairs to buildings, depreciation of buildings, 20 per cent of taxes for the year, and $1,000.00 for insurance. The total cost of such maintenance is to be shown as an item of manufacturing expense on the statement of cost of sales. 12. The portion of insurance remaining after charging maintenance of real estate is to be allocated to manufacturing expenses. 13. Thirty per cent, of the taxes for the year is to be apportioned to manufacturing expense and 50 per cent is to be charged to income. 14. Of the salaries of officers and clerks (general), $3,600.00 should be apportioned to selling expenses. 15. Amongst the bills receivable is a note for $5,000.00, pertaining to a previous fiscal year, which is considered to be worthless. No pro- vision was made for such loss. 598 ADVANCED ACCOUNTING 16. Regardless of theory, cash discounts on purchases and salew are to be treated as pertaining to income. 17. On December 10, 1915, a dividend of 10 per cent on the capital stock was declared and made payable on January 10, 1916, for which no entry was made prior to taking off the trial balance. Given the foregoing information, you are asked to prepare the following statements in approved form for the information of your clients: a. Cost of sales. b. Profit and loss, showing (1) the gross pro6t and the per cent, of same on sales; (2) the selling expenses and per cent, of same (»n the gross profit; (3) the general expenses and the jx^rcentage that such -expenses bear to the gross profit; and (4) the net profit and the p«?r cent, of same on sales. c. Balance sheet, showing the surplus at the beginning of the fiscal year and the amount at the close of the year. 181. b. 182. a. 183. a. QUESTIONS ON CHAPTER X Twenty Questions, Five Problems What significance would you attach to the fact that in a two million dollar manufacturing concern, the cash on hand and in bank amounts to $3,167.22? Why? What is meant by marshalling the accounts of a balance sheet? The Good Music Company, vendors of all kinds of musical instru- ments, shows on its balance sheet notes receivable equal to about 2/3 of the total assets. What deductions do you draw from this fact? (♦) Is strict accuracy necessary as to the facts possible in a balance sheet? Why? As between two consecutive years, it is noticed that the item of accounts receivable upon a comparative balance sheet ha« decreased nearly $20,000.00. What might such a decrease indicate? (♦) b. Give the method of preparing a balance sheet where ledgers have not been closed. 184. a. In a wholesale dry goods concern, the net sales for 1920 were $1,495,000.00. The balance sheet for the year showed an accounts receivable item of $373,500.00. Does any connection exist between these items to which attention should be directed when analyzing the balance sheet for credit purposes? (*) b. On what important points will the balance sheet of a trading and non-trading company differ? 185. a. The merchandise item upon a certain balance sheet, allowing for the usual profit, is about 1/3 the sales for the past year. Does this fact have any significance in the granting of credit to this enterprise? (*) b. Outline the forms of the profit and loss statement and of the balance sheet as submitted by the Federal Reserve Board in their proposal for a uniform system of accounting to be adopted by manufacturing and merchandising concerns. QVESTff^NS AND PROBLEMS 599 187. 186. The inventory item in the balance sheet of a leather manufacturer is shown subdivided as follows: Finished leather and cut soles, $442,891 .27 Leather in process, 246 , 742 . 30 Leather on consignment, 1 10 , 22 1 . 80 Rawhides, 75,438.19 Tanning and other supplies, 82,664 28 $957 , 957 . 84 Can you offer any criticism on the above? If so, what? a. In a statement of a meat packing house, the asset of merchanidse is equal to about 1/12 of the sales for the year. Is this as it should be? (*) b. What items would you designate as "quick assets"? 188. a. In the balance sheet of a wholesale dry goods concern, out of a total amount of fixed assets of $50,000.00, the item of furniture and fixtures equals $21,000.00. The remaining fixed assets consist of real estate $10,000.00, and outside investments of $19,000.00. What conclusion may be drawn from the above? (♦) b. Give two examples of fixed assets in a business which become floating assets in another business. 189. One of the footnotes to a certain balance sheet reads: "Insurance 1920-1921—85 oer cent." Explain the meaning of this footnote. (♦) 190. In a certain balance sheet the cash item is twice the size of the accounts payable; likewise, the notes payable item amounts to $250,000.00. What deductions may be drawn from the above facts standing by themselves? Would your answer be the same if the notes payable item amounted to $210,111.00? 191. a. What features should one expect to be in evidence in a good balance sheet of a department store? (•) b. Give instances of the manner in which fixed assets and floating assets affect the stabUity and the credit of a business. 192. a. In a statement submitted to a bank by a plumbers' supply house, out of a total amount of assets of $550,000.00,— the inventory consists of $280,000.00, the notes receivable of $35,000.00, and the accounts receivable of $200,000.00,— in round numbers. What comments would you make upon these items? (*) b. What is the theory applying to deferred debits shown in a balance sheet? 193. The balance sheet of a firm is summarized as follows: Assets: Cash, stock and accounts receivable, Manufacturing plant. Liabilities: Notes and accounts payable, Capital, $67,500.00 15,00000 $49,500.00 33,000.00 $82,500.00 $82,500.00 Would you consider this firm solvent? Give reasons for your answer. 600 'ADVANCED ACCOUNTING 194. Draw up a short report on the following balance sheet, criticizing such items as you consider abnormal : Buildings, Machinery, Sundry stock, Cash, Bills receivable. Customers, $87 , 500 . 00 Capital and surpl us, $ 1 55 , 000 . 00 Good-will and patents, 30,000.00 $250,000.00 12 , 500 . 00 ( ^urrent habihties, 90,000.00 Suspense account, 3,200.00 6,800.00 20,000.00 87,500.00 7,500.00 $250,000.00 195. Arrange the following in a balance sheet for presentation to a banker: Furnitiu-e and fixtures, $15, 000 . 00 Stock of merchandise at cost, 50,000.00 Accounts receivable, 35 , ooo 00 Officers' accounts, 30,000.00 Bonds owned, 10 , 000 . 00 Capital stock, Accounts payable. Trade notes payable, Surplus, $75,000.00 20,000.00 40,000.00 5,000.00 $140,00000 $140,000.00 196. The High Pressure Valve Manufacturing Company submit tho following balance sheet taken from their books in connection with the facts enumerated; the organization is highly skilled and dependent upon cooperation. Give your recommendations as to what should be done to serve the interest of the business: Plant, $14,500.00; accounts receivable, $4,000.00; ciwh, $1,510.00; capital stock, $15,000.00; loan payable, $3,000.00; accounts payable,' $4,000.00; notes payable, $3,500.00; sales, $16,000.00; cost of sales] $10,000.00; general expense, $2,000.00; selling expense, $3,500.00; deductions from income, $4,000.00. The valves are in demand and in general use. 197. Jones, a trader, commences business July 1, 1920, with a capital consisting of caah, $100,000.00; land and buildings worth $80,000.00, subject to a mortgage of $30,000.00. An abstract of his books July 1, 1921, discloses the following accounts: Purchases, $75,000.00; sales, $90,000.00; cash expenses, $15,000.00; cash drawings, $8,000.00; profit and loss debit, $5,000.00; sinking fund, $5,000.00; goods returned to creditors, $4,000.00; returned sales, $3,000.00; contingent fund, $2,000.00; reserve for bad debts, $5,500.00; due sundry creditors, $61,000.00; sundry customers, $34,480.00; discounts allowed customers on accounts paid, $520.00; no goods were sold to creditors or purchased from customers. Inventory July 1, 1921, $7,000.00. Interest on mortgage 6 per cent- Supply the missing accounts, and furnish an adjusted trial balance from which the usual statements may l)e prepared. (*) QUESTIONS AND PROBLEMS 601 198. An auditor is called upon to verify a balance sheet and upon investi- gation he finds that unexpired insurance, interest paid in advance on discounted notes, taxes accrued, interest accrued on demand notes, bonded indebtedness, royalties, etc., are not included in the same. He is informed that it has not been the custom of the corpora- tion to include in their balance sheet such items, as they offset one another, and that the directors do not desire any change in the practice they have adopted. Discuss this proposition, stating reasons for your conclusions. 199. A corporation wishes to get figures of its earnings early each month. Besides its regular income, it has bonds and stocks from which the interest and dividends are received either quarterly or semi-annually. It has trouble in getting some of its exp)ense bills promptly, as some come in quarterly, semi-annually, and even yearly. State the method of getting out promptly with as little work as possible these monthly figures. 200. a. Under what circumstances, if any, may capital expenditures be charged against revenue? b. In the audit of the accounts of a corporation for a year in which the business has made a loss and at the close of which no profits are available for dividends, would you consider it your duty to direct the same attention as usual in distinguishing between expenditure on fixed assets chargeable to capital and that charge- able against operations? Give your reasons. c. Expenditures are made by a corporation for items of each of the following classes: (a) Taking down a machine in one part of a factory, moving it and putting it up in another part; (b) expenses of incorporating the company, including State charges and lawyer's services; (c) brokerage on purchase of a piece of property; (d) commis- sion on an issue of debenture bonds; (e) costs attending a mortgage; (f) furniture and fittings of a city office and salesroom; (g) cost of patents, including solicitor's charges and government fees. Which items should be charged to capital and which to revenue? State reason for your answer in each case. PROBLEMS ON CHAPTER X 46 You are employed to prepare a statement for credit purposes from figures submitted to you in a letter from the Western Manufacturing Company. Their letter submits figures and data as follows: Their plants stand at cost price, $90,600.00. They have set up a reserve for depreciation of $15,300.00. There is a mortgage of $30,000.00 on the plant and interest on the mortgage is at 6 per cent and is paid to within three months of date of your proposed statement. They hold $15,000.00 of notes receivable and have discounted at bank $37,500.00. Accounts t 602 ADVANCED ACCOUNTING receivable they consider good, amount »27nnnnn • i j- due from employee on personal ^ooZt KT,^^tht:lf"^ . ^''^'^ subject to 6 per cent discount if paid at due dateTnr*n f^^,^ ™"^ ""^ due. Suspense ac<-ounte amount to »i (L m ^ »15,0(XI.OO is now past beUevedtobegood. A new machin^ ^ ^ ' f ^' "*"' °' "^ich are which cost ,,,Lm. Th:;hTv:tdt: TnVtetrt ^r f^^'^^^^^^ Co., but say it wiU be paid when d..P 1 '*/'"^ J9,000.00 for .Smith and 000.00, insurance amouiTto l^f^ /"<="""*« P^yaWe amount to $6;!,- They owe a note at ban",^^ T T** ^T "' '"°"*'" *" ^""• fifty shares of stock in a commnv fZ,?^ I*^* E""^ *° '^''**- They own cost ,4,200.00, and a^e ^rum^e^T t ToSs"' t'''^ T*^ "'''''• '^'"'^ at a selling price of 10 per cent more tha^c^t Th ^""""^"'y *>« taken You are not asked to accept Tv r^Tn ^ r. ^ ' T""'"*' *° »2fl,400.0(). ment but simply to premTtbZlTr !' VV^^ ^'^'"'■^ '" ^^e statc- their letter. ^ ^ *^^ statement m the best form you can from 47 yield very large pr' »". the statement for the bauker'alTcol'Tntti^ronSmTh ^""''^ ant's standpoint. ""eny on it from the account- Real estate, Capital stock, Machinery, Advances on contract*, Buildings, Accounts payable, Work in process, Surplus, Material and supplies. Cash, Good- will. Deferred charges. Accounts receivable, July 31, 1917 S 90,000.00 10,000.00 40,000.00 10,500.00 8,000.00 3,500.00 30,000.00 2,100.00 4,200.00 «100.000 00 50,000.00 42,000.00 6,300.00 ?1^5^3oo^ ITMliooToo 48 t^l^^JTllZ:^""'''' ^^-- ^-' ^-- 'y -^-^ '- QUESTIONS AND PROBLEMS XYZ COM PANY Balance Sh eet December 31, 1921 — -♦ ' Assets Real Estate, Buildings, Plants, Machinery, Equipment, and other Permanent Investments, including Good- will. Investment in Stocks and Bonds at cost (Market value! $60,000.00), Current Assets: Inventories: Raw Materials, $170,000.00 Finished Product, at sales price, less 5 per 603 $1,000,000.00 100,000.00 cent discount. Consignments (selling value), Supplies (estimated). 100,000.00 50,000.00 200,000.00 $520,000.00 125,000.00 Accounts and Bills Receivable, including Advances to Employees, Stocks in the Treasury (Unissued) : Preferred, $150,000.00 Common, 1 37,225.00 287,225.00 225,500.00 Investments in Subsidiary Companies, Cash and Miscellaneous Items, 50,50000 1,208,225 $2,308,225.00 Liabilities Capital Stock: Preferred, Common, Bonds and Bankers ' Loans (Bonds outstanding $200,000.00), Current Liabilities: Accounts Payable, Other Indebtedness, Accrued Items, Reserves: For Depreciation, Less — Renewal Expenditures Written oflF, Balance (Debit), For Bad Debts, For Contingencies, Surplus (less dividends paid), including Appre- ciation in Real Estate and other Capital Assets and Profit on Inventorying Raw Materials at market price. $500,000.00 750,000.00 575,000.00 $ 15,225.00 231,000.00 2,000.00 $ 50,000.00 65,000.00 $ 15,000.00 20,000.00 5,000.00 248,225.00 10,000.00 225,000.00 $2,308,225.00 604 ADVANCED ACCOUNTING 49 From the following figures of net sales, costs and expenses prepare a statement, accounting for the shrinkage in profits in 1920, and showing in dollars and cents what portion of such shrinkage is due to decreased sales and what portion is occasioned by the various variations in cost and expense items: Materials, Direct labor, Indirect labor. Factory expenses, Trading expenses, Oflfice expenses, Net Sales, 1920 $230,500.00 78,500.00 6,725.00 27,500.00 23,500.00 10,50000 $390,750.00 1919 $265,335.00 108,228.75 8,379.00 26,999.00 20,947.50 ^11,637.50 i465,500.00 50 The bookkeeper of a manufacturing concern could produce only the following statement from its records on January 1, 1920: $ 4,622.89 10,000.00 17,500.00 8,469.10 15,000.00 4,289.34 5,000.00 5,423.23 2,436.28 393.75 282.40 832.14 Manufacturing expenses. Capital stock. Plant and equipment. Gross sales, First mortgage bond (due December 31, 1920), Materials and supplies (inventory). Notes payable, Accounts receivable. Accounts payable, Interest on bonds (seven months). Interest on notes and accounts payable, Cash, On January 1, 1920, the management changes, and you are later retained as a public accountant to conduct an examination and prepare a balance sheet as of January 1, 1921. You find that during the preceding year the directors have subscribed in cash to $7,500.00 additional capital stock and have retired all the notes and old accounts payable and that no interest was paid on these accounts for the year. You also find that the plant and the equipment was revalued at $15,000.00 and 5 per cent of this amount was charged off to provide for depreciation, while an additional 2}4 per cent was ordered placed in reserve account to cover repairs and renewals, the entire 7H per cent being charged direct to profit and loss. The bond outstanding feU due on December 31, 1920, and was paid, principal and interest, in cash. An inventory of material and supplies placed their value at $2,328.19, the practice being to charge aU purchases direct to manufacturing expenses and credit back the amount of the inventory. The accounts payable (all for material and non-interest bearing) amount o $546.28. QUESTIONS AND PROBLEMS 605 Of the accounts receivable January 1, 1920, $4,968.18 was collected and the balance charged off as uncollectible. In addition to the material used from stock diu-ing the year and the amount still due for material purchased, the manufacturing expenses were $3,720.52, all paid in cash, the total manufacturing expenses being 31 per cent of the gross sales for the year ending January 1, 1921. Of these 91.3 per cent were collected in cash and the balance, all of which is considered good, remains on the books in accounts receivable. Produce a comparative balance sheet of January 1, 1921-1920, and state the amount of the gross sales for the year. QUESTIONS ON CHAPTER XI Twenty Questions, Five Problems 201. Redraft the following statements, if incorrect. Interest on capital to be 5 per cent per annum: Balance Sheet Accounts payable. Notes receivable, Capital — partners, 6/31/19—, Net profit. December 31, 19 — $ 5,400.00 Accounts receivable, 3,200.00 Cash, Bank loan, 10,000.00 Inventory 12/31/1^—, 8.000.00 Notes payable, $26,600.00 $10,200.00 4,700.00 5,000.00 5,000.00 1,700.00 $26,600.00 Profit and Loss Statement Six Months Ended December 31, 19 — Purchases, $27,000.00 Sales, Inventory, 12/31/19—, 5 , 000 . 00 Interest on capital. Drawings, Rent, Salaries, Wages, General expenses, Interest on loan, Net profit, 2,500.00 Inventory, 7/1/19—, 500 . 00 Commissions, 1,500.00 4,750.00 900.00 125.00 8,000.00 $40,025.00 500.00 8,250.00 1,500.00 $50,275.00 $50,275.00 202. a. In determining the value of a business, would you base your decision chiefly upon the balance sheet or upon the statement of profit and loss? Give reasons for your answer. (*) b. What is your interpretation of the difference between the total debit balances and the total credit balances of the accounts belong- ing to the capital division and to the current division of a balance sheet? 203. Discuss "going value" in the following case: A certain corporation of a public service nature with all its property in one state is incorpor- ated in another state. It has outstanding securities in the amount of 606 ADVANCED ACCOUNTING $40,000,000.00, while the appraised value of its property is $32,000 000.00. In making application for a charter in the state in to the $32,000,000.00 appraised value of its property it has a -Roing value of an additional $8,000,000.00, which brings its total property up to the amount of its outstanding securities (*) 204. What is your understanding of the foUowing terms used in connection ' with corporate accounting: (*) a. Fixed charges. b. Maintenance expenditures. c. Replacement expenditures. 205. a. A certain manufacturing concern makes various kinds of equipment for use m its own plant and charges them to the fixed asset accounts at market value, which is in excess of cost, and credits the difference to profit and loss of the period in which the various equipment were manufactured. Criticize, if necessary. (*) b. FVom an accountant's point of view, what are the most important things in a balance sheet? (*) 206. Which of the following charges are proper additions to the plant account: (*) a. Interest on bank loans, •j o250.00 8,650.00 $220,250 00 $2 93,950.00 $187,300 00 QUESTIONS AND PROBLEMS 621 $100,000.00 $150,000.00 36,100.00 750.00 1,400.00 82,000.00 86,075.00 850.00 825.00 2,200.00 54,000.00 $72,000.00 42,000.00 70,230.00 1,220 00 600.00 1,250.00 $220,250 00 $293,950.00 $187,300.00 Capital stock, Brown capital account. Smith capital account. Accounts and notes payable, Interest accrued, Taxes accrued. Labor unpaid, Surplus, Yearly Earnings First year. Second year, Third year. Fourth year, Fifth year. Total, Prepare the following: 1. Opening journal entries on the books of the Progressive Manufacturing Company. 2. Balance sheet after giving effect to entries referred to in (1). 3. Necessary journal entries to close the books of the respective vendors. 60 The Excelsior Gas Company is incorporated on January 1, 1920, with an authorized capital of $300,000.00 (% preferred [and }i common, all the shares being of the par value of $100.00) to acquire and conduct the business of the Bradford Gas Company, whose general balance sheet shows the follow- ing on December 31, 1919: $37,500.00 48,700.00 43,400.00 36,200.00 59,200.00 $42,700.00 31,800.00 39,600.00 46,100.00 39,800.00 $33,400.00 26,900.00 27,350.00 31,600.00 30,750.00 $225,000.00 $200,000.00 $150,000.00 Buildings, machinery and equipment, Mains, conduits, meters and connections, Franchises, rights, privi- leges, etc.. Materials and supplies, Tools and emergency equipment. Cash, Accounts receivable, Notes payable, $100 , 000 . 00 Accounts payable, Capital stock, 70,000.00 Surplus, 50,000.00 15,000.00 10,000.00 11,800.00 35,200.00 I 10,000.00 52,000.00 200,000.00 30,000.00 $292,000.00 $292,000.00 On January 15, 1920, all the preferred and common stock of the Excelsior Gas Company was issued to the twenty stockholders of the Bradford Gas Company, in exchange for their holdings of stock of the latter company, in the proportion of one share of preferred and one share of common for each share of stock exchanged. At a meeting of the board of directors of the Excelsior Gas Company, \i^ 622 ADVANCED ACCOUNTING held January 20, 1920, it was resolved to carry out the provisions of a plan of merger in accordance with which the Bradford Gas Company was to transfer its assets and liabilities to the Excelsior Gas Company, and sur- render its charter. A certificate of merger wa* issued at the cloae of the meeting. At the meeting held January 31, 1920, the board of directors of the Excelsior Gas Company resolved to open accounts on the general books of the company, with the individual assets and liabilities taken over and assumed, at the figure shown by the balance sheet of the Bradford Gas Company on December 31, 1919, with the following exceptions: (a) fran- chises, etc., to be raised to $70,000.00; (b) surplus not to be carried. As to the January op)erating transactions, they were recorded in special books, in order that they might be embodied at the proper time in the books of the Excelsior Gas Company. Prepare: a. Chronologic journal entries reflecting on the books of the Excelsior Gas Company the dififerent stages of the merger. b. A journal entry closing the books of the Bradford Gas Company. QUESTIONS ON CHAPTER XIH Twenty Questions, Five Problems 241. Define the following: a. Holding company. b. Subsidiary company (A. I. A.) c. Consolidated balance sheet. d. Intercompany profits. (*) 242. Explain the theory and practical use of a consolidated balance sheet. 243. Upon what basis should the outstanding stock of subsidiary companies be taken in a consolidated balance sheet? 244. a. When a number of corporations are operating under their own charters, but are managed and controlled by one other corporation, how would you state the results of the business when the controlling corporation owns all of the stock of the other corporations? b. How will you handle on the consolidated balance sheet capital stock of one of the subsidiary corporations, part of which is in the hands of the public? 245. In making up a consolidated balance sheet of a holding or parent company and two subsidiary companies where, in the case of one of the subsidiary companies, its entire capital stock has been acquired at less than par, and in the case of the other, at a substantial premium, how would you deal with such discount and premium, respectively, in the consolidated balance sheet? 246. If in consolidating the accounts of a holding company and its subsidiary companies, you find that in the case of one of the subsidiary companies the holding company owns only 60% of its voting stock, state briefly how you would treat this subsidiary company's accounts in the con- solidated balance sheet and why your proposed treatment reflects QUESTIONS AND PROBLEMS 623 the true financial position of the combined companies more clearly than other methods with which you may be familiar. (A. I. A.) 247. In preparing a balance sheet and income account for a holding com- pany, which embraces the operations of several subsidiary corporations, what items on the subsidiary books, if any, should be omitted from the consolidated statements? 248. a. State briefly what you would do if the accounts payable, amounting to $280,000.00, include a balance of $100,000.00 due to an affiliated company. b. How would you treat guarantee of payment of interest on bonds issued by a subsidiary company in the balance sheet of a company j'ou were auditing? 249. A parent company holding notes receivable from a subsidiary company to the extent of $100,000.00, indorses and discounts said notes with its bankers, thus creating a contingent liability thereunder. In preparing a consoUdated balance sheet of the two companies, state how and where the liability would appear. 250. The A Company buys on January 1, 95 per cent of the stock of the B Company. The balance sheet of the latter company on that date is as follows: Assets: Property account, Current assets, Liabilities: Capital, Surplus, Current liabilities, $ 500,000.00 850,00000 $1,350,000.00 $1,000,000.00 100,000.00 250,0000 $1,350,000 00 The A Company pays par for 91 per cent of the stock and 120 for 5 per cent of it. During the next six months a doubtful claim of the B Company, which prior to January 1 bad been written off, turns out to be good and $5,000.00 cash is realized on it. At the end of the first six months B Company has made $100,000.00 net profit from operations, and a dividend of $200,000.00 is paid. In making up a consolidated balance sheet of A Company and its subsidiary at January 1 (date of purchase), state, giving briefly your reasons, how you would treat: a. A Company's interest in the B Company; and at July 1. b. The doubtful claim recovered. c. The dividend paid. d. The interest of outside B stockholders in B Company. (A. I. A.) 251. Three corporations are consolidated by acquiring all the capital stock of the said companies, with the exception of 10 shares of the smallest corporation. The new company acquires all the assets and assumes all the habilities of the smallest company and closes its plant. How i ■•^:^ -^ - 624 ADVANCED ACCOUNTING should this state of affairs be treated by the accountant in opening the books of the new company? 252. A holding company owns 90 per cent of the capital stock of a sub- sidiary company. The directors of the subsidiary company pass a resolution appropriating surplus earnings as dividends and direct the treasurer to remit to the holding company whenever sur|)his funds are available. The subsidiary company earns $40,000.00, which it pays to the holding company. What are the rights of the interested parties and how should they be set forth in a brief report? 253. In the process of consolidating several competing estabhshments, Corporation A, the holding company, acquires $98,000.00, out of a total of $100,000.00, of the capital stock of Company B. At the time of the purchase the balance sheet of B Company showed surplus and undivided profits of $50,000.00. Company A bought the stock of B at 200 per cent. Almost immediately after the purchase Company B paid a cash dividend of 25 per cent. In what ways would the pay- ment of this dividend affect: a. The balance sheet of B. b. The balance sheet of A. c. The consolidated balance sheet of A and its subsidiary companies. Give your reasons for your answer. (A. 1. A.) 254. In examining the accounts of a department store corporation, you find that it is the owner of the capital stock of another department store corporation; the stock is carried on the books of the parent cor- poration at par. Quarterly dividends have been regularly received. What further information would you require before certifying the balance sheet and income account of the parent corporation? 255. A holding company owns the stock of a subsidiary company, for the purchase of which it issued two shares of its own stock for each share of the subsidiary company's stock. The assets of the subsidiary company were sold and after the debts of such subsidiary company were Uquidated, the balance remaining was paid in cash to the holding company. How should the cash so received be treated on the books of the holding company? 256. A company owns all of the capital stock of another company. The latter company has outstanding an issue of bonds not guaranteed by the company holding the stock. The assets of this subsidiary company are deemed insuflBcient to cover the bonds, so that its capital stock has no value. The owning company desires the auditor to prepare its balance sheet, setting up the assets of this subsidiary company along with other assets directly owned, and the bonds as liabilities. Is it proper for him to do so imder the circumstances? Give reasons for your answer. 257. In a combination of companies into one, how should an underlying company charge out its product to another imderlying company which will use it as raw material? 258. In auditing the accounts of the Brown Manufacturing Company, you find that it owned the controlling interest in the Smith Foundry QUESTIONS AND PROBLEMS 625 Company. In addition to making cash advances the Brown Company shipped goods to the Smith Company. At the end of the year, namely, December 31, 1920, you find that the Smith Company appeared as a debtor for $50,000.00. On January 2, 1920, the Brown Company had received from and credited the Smith Company with notes receivable of $20,000.00. These the Brown Company discounted and on the due date, namely, July 2, 1920, took them up, thereafter receiving new notes from the Smith Company. These were due on September 2, and the procedure of July 2 was followed. These notes taken in exchange were payable on February 2, 1921, and were discounted by the Brown Company immediately upon receipt, namely, on September 2. How should the Brown Company balance sheet of December 31, 1920, show the position at that date? Give the reason for your answer. If there is any as set, how much is it, ^nd under what heading should it be included in the balance sheet; that is, under current, working, or what? 259. When would be the proper time for a holding company to declare dividends? 260. Immediately after organization, a corporation takes over certain highly speculative properties, issuing therefor its entire capital stock. Subsequently, three-fourths of the stock issue was returned to treasury for the purpose of providing wq^king capital. Mu3h of this was underwritten at a very low figure and none was sold at par. At the end of the first year, the books showed fair profits from opera- tion, but dividends in excess of earnings had been distributed to stockholders. Early in the second year, the properties had been developed sufficiently to indicate wonderful probabilities and the prospect was used com- mercially to such an extent that market trading was active at figures greatly in excess of par. At this time, the corporation trades its balance of treasury stock holdings for control in a holding company whose balance sheet indicated a book value of less than par. What was the price paid for control in the holding company? PROBLEMS ON CHAPTER XHI 61 Four corporations. Si, S2, S3, and S4, are controlled by corporation H. These four companies operate separately, buying and selling both to outside parties and to each other. Over a certain period of time, the operations are as follows: SI purchapes raw material fron^ the outside in the amount of $100,000.00. It sells $20,000.00 of this, at cost, to outside parties, and $66,000.00 to S2, at a cost of $60,000.00. S2 expends $34,000.00 in manufacturing labor and expense on the purchases from SI, after which it sells $20,000.00 of its goods, at cost, to outside parties, and $70,000.00 to S4, for which S4 paid 626 ADVANCED ACCOUNTING S2 $77,000.00 S4 received these eoods over the raikoad of S3 and paid the latter $5,000.00 in freight charges upon which there was a profit of $1,500.00. S4 expends $18,000.00 in manufacturing labor and expense after which it sells $70,000.00 of its goods at cost, to outside parties. H For the purpose of the consoUdated balance sheet and profit and loss statement of H, determine: a. First cost of product sold. b. Intercompany profit on sales. c. Stock on hand. (*) 62 The following are trial balances aa of Deceml>er 31, 1920: H Company: Real estate, Machinery and equipment, Accounts receivable, Cash, Inventories, December 31, 1920, Shares— S Company (300, par $100.00), S Company current account, $200,000 00 100,000.00 50,000.00 10,000.00 75,000.00 35,000.00 5,000.00 Notes payable. Accounts payable, Capital, Surplus: Balance, Profit for year 1920, Totals, S Company: Furniture and fixtures, Inventories, December 31, 1920, Accounts receivable. Cash, Treasury stock (100 shares at cost), H Company drafts accepted and discounted, Accounts payable, H Company current account. Capital stock (500 shares, par $100.00), Surplus, $89,500 00 189,500.00 The stock on hand of S Company was manufactured by H Company and was billed to S Company at 10 per cent in excess of cost, at which value it was taken into the inventory. The difference in the inter-company current accounts consists of a note issued by S Comjiany in settlement of a claim for damages but not entered on the books, being paid by H Company. The directors of S Company declared a dividend of VA per cent on December 15, 1920, payable January 15, 1921, which has not been entered on the books $ 20,000 00 30,000.00 400,000.00 19,000 00 6,000 00 $475.00000 $4 75.000 00 $ 3.500.00 25.000.00 45.000.00 5.000.00 11.000 00 $ 5,000.00 10,000 00 4,500.00 50,000 00 20,000.00 QUESTIONS AND PROBLEMS 63 627 Company A purchased on January 1, 1921, the entire capital stock of Company B at $175.00 per share, and the entire stock of Company C at $80,00 per share. You are handed the balance sheet as understated at June 30, 1921, and are requested to prepare a consolidated balance sheet of the A Company and its subsidiaries at that date. Balance Sheets Company A: Property and good-will. Stock of subsidiary companies. Current assets. Capital stock. Current liabilities, Surplus January 1, Undivided profit for one-half year, Company B: Property and good-will. Current assets. Capital stock. Current liabilities. Surplus January 1, Undivided profit for one-half year. Company C: Property (as appraised January 1, 1921), $1 . 130 , 000 . 00 Current assets, 180 , 000 . 00 Capital stock. Current habilities. Surplus January 1, Undivided profit for one-half year. $ 850,000.00 1,500,000.00 700,000.00 $2,250,000.00 150,000.00 525,000.00 125,000.00 $3,050,000.00 $3,050.000.00 $ 650,000.00 60,000.00 $ 400,000.00 10,000.00 200,000.00 100.00000 $ 710,000.00 $ 710,000.00 $1,000,000.00 240,000 00 30,000.00 40.000.00 $1.310,000.00 $1,310.000.00 There are no inter-company accounts or inventories. 64 From the following three trial balances prepare a consolidated balance sheet as at December 31, 1921, in the form you would draw it up for presen- tation to the stockholders of the parent company (the S. R. Company) showing as separate items therein: a. The total good-will of the coipbined companies. b. The net profits accruing to the new corporation (to the S. R. Co.). S. R. Company: Preferred stock, $1,500,000 00 Common stock, 1 , 500 , 000 . 00 I ,1 I 628 ADVANCED ACCOUNTING Investments in subsidiary companies — 4,000 shares of stock of L. W. Co. and 4,000 shares of stock of S. B. Co., both of $100.00 each at cost, Accounts payable. Dividends from subsidiary companies. Administration expenses, L. W. current account, S. B. Company advances, Cash, Organization expenses, L. W. Company: Properties and plant. Good-will, Investment in S. B. Co.— 2,000 shares of a par value of $100.00 each, cost $300,000.00, Inventories, Receivables, Cash, Capital stock (4,000 shares), Accounts Davable, S. B. Company, Surplus (includes $100,000.00 added to book value of investment in S. B. Co.), S. R. Company, QUESTIONS AND PROBLEMS $2,500,000.00 25,000.00 100,000.00 150,000.00 270,000.00 75,000.00 20,000.00 100,000.00 $3,120,000.00 $3.1 20.0()0.00 $ 325,000.00 250,000.00 400,000.00 250,000.00 195,000.00 90,000.00 $400,000.00 125,000.00 175,000.00 710,000.00 100,000.00 S. B. Company: Good-will, Property and plant, Inventories, Receivables, general, L. W. Company, Cash, Capital stock (6,000 shares). Accounts payable, S. R. Company, Surplus or deficit, $ 875,000.00 $ 875,000~:0Q In the preparation of your consolidated balance sheet be guided by the following assumed tacts: 1. That the S. R. Co. was formed on March 28, 1921, and acquired its stock ownership in the two subsidiary companies, as shown in its trial balance on April 1, 1921. 2. That at January 1, 1921, the L. W. Company had a surplus of $605,000 00 ^d the S. B. Company a deficit of $50,000.00. $1,510,00000 $1,510,000:00 $ 60,000.00 325,000.00 190,000.00 105,000.00 195,000.00 10,000.00 $ 600,000.00 90,000.00 150,000.00 35,000.00 629 3. That no inventory wa^ taken of either the L. W. Company or the S B Company between January 1 and December 31, 1921, the busbess of the companies being continued without interruption notwithTnlJ 4 That n'"' ? T'"^^ ^' *'^ ^"P^*^* «*-^ - -d-ated above ' d^v^denTof $^00(^^^'^^ 'VfV''' ^- ^^ ^^^^^^ ^^-^-^ * taktntpi^re'Zr. 7^ eitarb:r^^^^^^^ '' Jn^the^^ wTr " '""^ ""'"' "^"'"'^'^ ^*^^^ *b« S. B. Company trans tand!^^^^^^^^^ "^'T'' ^ ^ *^^'^«^' merchandiL in transit and a^ to the remaining $10,000.00, a charge for rental of w«r«- house for the last six months of 1921, whi^h ha« been c^^td ^^^^ rent account on the books of the S. B. Company. *^ '^"^ fin 1 .'1^ ? estimated on reliable authority which may be accepted a^ W that from January 1, to March 31, 1921, the net^pS o^ th" L S R T""^ """T'^'^ *^ $30,000.00, while during the same Ir^ the b. B. Company lost $15,000.00. ^ De!:l!r;L:T9^'r '"^^ '^^^^^^ ^^ ^^^^^^^^ ^ -^ ^*« -^-^-es at Debits Co. A Cash, Accounts receivable, Notes receivable, Inventory, raw material 1/1/20, Purchases, raw material. Labor, Manufacturing expenses. Selling expenses. Administrative expenses. Inventory, goods in process 1/1/20, Inventory, finished goods. 1/1/20, Plant and equipment, Investment in stock of Com- pany B, Investment in stock of Com- pany C, Credits Capital stock. Notes payable. Accounts payable, $ 75,000.00 $ 350,000.00 200,000.00 150,000.00 650,000.00 450,000.00 190,000.00 85,000.00 45,000.00 Co. B 50,000.00 $ 190,000.00 60,000.00 105,000.00 400,000.00 320,000.00 190,000.00 40,000.00 25,000.00 Co. C 60,000.00 420,000.00 40,000.00 160,000.00 510,000.00 370,000.00 205,000.00 75,000.00 35,000.00 80,000.00 70,000.00 75,000.00 90,000.00 900,000.00 875,000.00 1,200,000 00 65,000.00 400,000.00 80,000.00 750,000.00 $5,340,000 00 $1,915,000^ $"277807000:00 $3,000,000.00$ 500,000.00$ 800,000.00 110,000.00 80,000.00 60,000 00 100,000.00 65,000.00 250,000 00 630 k. I;!** ADVANCED ACCOUNTING Bonds payable, Premium on bonds, Reserve for depreciation, Sales, Surplus, The inventories at December 31, 1920 were: 500,000.00 5,000.00 100,000.00 60,000.00 112,500 00 1,400,000.00 1,050,000.00 1,250,000 00 _ 125,000.00 160,000.00 307,500 00 $5,340,000.00 11.915,00000 $2,780,000.00 Co. A Co. B Co. C $175,000.00 80,000.00 145,000.00 $210,000.00 85,000.00 105,000.00 Raw material, $280 , 000 . 00 Goods in process, 95 , 000 . 00 Fmished goods, 135 , 000 . 00 Company A purchased the entire stock issues of Companies B and C at January 1, 1920, at the prices shown in the trial balance. During the year each of the three companies declared and paid a 5 per cent dividend. Company A took up its dividends from Compames B and C by credits to surphis. The various entries for the dividends were the only entries atfectmg the surplus accounts during the year. At December 31, 1919, Company A's inventory of raw material included goods purchased from Company B at a price of $60,000.00, the cost thereof to Company B being $40,000.00. At the same date Company B's inventory of raw material included goods n •on'?^ J f^^ ''''^^ Company C $160,000.00. Company B still owes $30,000.00 on these purchases, the indebtedness being included in the accounts payable. «-?m (^ m^^^^^ ^'^T-^ ^ '^^^ ^^^ *^ ^^^P^^y A at a cost of $300,000.00 and at a selhng price of $375,000.00 Company A made cash advances totaling $400,000.00 to Company B during the year. These sales just mentioned were charged against the advances account, the $25,000 00 balance of which is included in Company B's accounts payable. The mventories at December 31, 1920, include inter-company profits as Company A, Company B, Raw Material $20,000.00 30,000.00 Goods in Process $6,000.00 6,000.00 Finished Goods $4,000.00 5,000.00 Company A's bonds were issued July 1, 1920. They bear 5 per cent interest, payable semi-annuaUy and mature in five years. No interest has Deen paid. AUow depreciation at 5 per cent per annum on the cost of the fixed assets. Prepare the following consolidated statements: Cost of goods manufactured and sold. Profit and loss statement. QUESTIONS AND PROBLEMS 631 Surplus statement (showing as the final balance therein the surplus balance appearmg m the consolidated balance sheet). Balance sheet. (A. I. A.) li- QUESTIONS ON CHAPTER XIV Twenty Questions, Five Problems 261. What are fiduciary accounts? Give three examples 262. It has been stated by a writer on accounting that single (or simple) entry is the basis of aU fiduciary accounting. Do you agree? State your reasons. l^A' wf f /'''* differentiate executor, administrator, trustee. cuterl? ^''^°*'^^ elements are involved in the accounting of exe- 265. On what are the accounts of an executor based? 266. Describe the method of keeping the accounts of an executor and state what books are necessary for the purpose 267. Define: a. Intermediate account. b. Final accounting. c. Corpus. (A. I. A.) d. Income. (A. I. A.) 268. In what books should an administrator keep his accounts? What if any, special ruhng would you suggest? Illustrate. 269. You are retained to open books for the executor of A. B deceased wo^Trd ' 'r'^ ''^' T "^"^' P'^^"- ^^^ *^^ accounts thatl^u would ordinarily open. State from what documents you would get o^n i^^,^«^^<^>^^ o^ which to found book entries. ^ piLt^h^ tok'^^^^^^ ^^^^^ ^^ ^^^^"^' -^^' ^-' - - «--^ -H a. Funeral expenses. b. Executor's expenses. c. Profit or loss on sale of investments. d. Cash dividend on investment of executor. e. Cash dividend on investment of testator. f. Cash legacies. g. Property legacies. h. Quarteriy allowance to widow "'' Srpu'^'*nfT*""' '""' ,^<»'»''>'«t'»to"' account* be stated for usuaUy include? What are assets of the estate? When are divi- dends mterest and rente U> be treated a« principal? Wi^hwh^t 272 ^*'':,«^«'="*«^ charge himself ? For what does he take ^Adit? 272. Define the nature of the items you would except to find in the profit 273 ^?f/7,^'""'"''t "^k^Pt by the executor and t^stee of a large esUte l^tb.T eomPos'tion of the "account" of an executor Jr^ 274 Wl Z?'"'" **■« '""""te relation of its components 274. John Brown d.ed, leaving an estate consisting of realty'^nd^^onalty 632 ADVANCED ACCOUNTING m hi and in his will named George Green as executor and trustee. Under the will the executor was vested only with the naked power of sale (so far as the realty was concerned), the whole estate being devised in trust for the benefit of a sole legatee. George Green, as exe(;utor, sold a certain parcel of realty to William Smith, for $3,000.00, the full amount in cash. He subsequently, as trustee, advanced Smith $2,000,00 a« a builder's loan, receiving as security a first mortgage on the property, including the improvements. As a protection he further received from Smith a policy of insurance for $2,500.00 to protect the mortgage. Two years later Smith defaulted in the payment of his interest and taxes and would pay no attention to the tnistee's requests that he make such payment. Smith's continued neglect resulted in foreclosure proceedings, brought by the trustee, which terminated in the trustee's obtaining title to the property. The back interest, taxes, and fore- closure expenses amounted to $375.00. In a spirit of revenge Smith set fire to the house and caused its total destruction. The trustee obtained $2,500.00 from the insurance company in settlement of the loss, and subsequently sold the lot for $2,000.00. State briefly the necessary entries to be made by the executor and trustee to record properly the amounts so received. 275. The will of William Christy provided for a division of his estate into three equal parts, of which one part was to be paid in cash to John Christy, and one part to James Christy, and one part was to be held in trust for the benefit of Thomas Christy, who was to receive the income therefrom. January 1, 1921, the executors had $100,000.00 cash in bank, representing the amount realized from the bulk of the testator's estate. The executors paid to John and James Christy $30,(K)0.00 each and lent '$30,000.00 on a real estate mortgage at 6 per cent interest. Prepare necessary ledger accounts for the books of the executors. 276. A person dies, leaving a will disposing of a personal estate that is valued by the appraisers at $36,470.00. All but $209.00 is disposed of by the executor, who realizes $32,131.00. This together with $2,187.00 of income received during the administration of the estate, constitutes the full sum to be accounted for. The testamentary and funeral expenses amount to $512.00. Debts of the estate to the amount of $1,500.00 are presented and satisfied. Expenses of $700.00, including trustee's commissions, are paid and the sum of $30,000.00 is divided among the heirs. Prepare in customary form a summary of the executor's accounting, and a cash account. 277. A dies, leaving a small estate. In his will he directed the creating of a separate trust for each of his two married daughters and also provided that the residuary estate should be divided between the two daughters, share and share alike, on the death of the widow who was made a life tenant of the residuary estate. When called on by the executor to prepare his accounts for filing you find that, as the income from the residuary estate was not suflBcient to pay administration expenses and to maintain the widow as she had been accustomed to live, the executor had made a loan to the widow from the principal of the estate 1^ QUESTIONS AND PROBLEMS 633 and had taken as security non-income producing collateral, the loan being made without interest. Was the executor authorized to make such a loan, and, if so, how should it be stated in the executor's ac- counting? 278. In the administration of an estate, the executor is required to construct an iron fire escape on the front of the building in order to remove a violation filed by the fire department of the city. Should such expense be charged to principal or to income account? Give reasons. 279. As an executor of an estate you receive ten shares of stock as a dividend on 100 shares of the same stock held by the estate, said ten shares being a distribution of earnings, one-half of which accrued prior to the death of the testator and one-half since his death. Does such stock belong to the hfe tenant or to the remainderman? Explain. 280. If called upon to prepare a trustee's accounting, state how you would handle the following items: The trustee sold two East and West Railroad Company first mortgage 4 per cent bonds which he had received from the testator as a part of the estate and which were included m the inventory at $2,000.00. These bonds were sold for $1,800.00, and $1,600.00 of the proceeds were reinvested in North and South Radroad Company three-year 6 per cent notes, maturing in two years from the date of purchase. These notes were redeemed by the North and South Railroad Company at par, $2,000.00. How would you treat the gam of $400.00, resulting from the purchase of the short term notes? PROBLEMS ON CHAPTER XIV 66 A dies on June 1, 1918, at which time his estate consisted of the following: Inventory Realized Caah, $ 43,500.00 75,000.00 $ 79,000.00 1st mtge Mo. Pac. 6 per cent bonds, interest payable April 1 and October 1, Mortgage loans-^ per cent, interest payable March 1 and September 1. All interest due hasi been paid, Loans to sundry persons. Preferred stock— Acme Mfg. Co., at par, Notes receivable— interest at 5 per cent, paid to May 1, 1918, Investment in the firm of K & L, Household goods, $27 Mo!oo"^^'^'*'^' '° *^^ ^'^''''''^ ""^ S24,000.00, actually were found to be The following legacies were mentioned in the will- 3. Chas. Moe, 3,000.00 2,000.00 40,000.00 39,000.00 125,000.00 30,000.00 34,000.00 1,200.00 36,000.00 24,000.00 128,000.00 29,000.00 36,000.00 634 ADVANCED ACCOUNTING f J^T'f! ^""^"^^^ '"''« 11,100.00; surrogate court costs were »2,400 00- fees of attorney and accountant were $1,000 00 •-•,»w.uu, Au^st'SloTr '"''' °" ''"'^'* '"' '"''- ''"'' *''^ '^«'''''*« ''^^ P^ • j. ai.cuuuiant, $i,»oo.OO; cost of executor's m327i)^„ H T"*" ^^"^ "^ '"""^^^ »''' of bonds and ,3L *2 28f7v'- . /""^ mortgages paid, $98,915.00; sale of fur^ture ete $2,285.75; interest on bonds and morteaees XAl 97n vx. . 7^ '^"'*' **f' posits with trust companies, $l,275.rrenT$lf2im-^'- TT "^ '^'^ and stocks, $37,918 50 $17,250.00; dividends on bond* t.e foregoing tran^ctions, iLLdinSlorofTht s^^X t^ ^^ Prepare, with the distinction as to Drinomfll ar.A • statement of the executor's accou" , ^how ngthi amoZ"^^.'' '"""^'^ commission and the amount due the residuafy legaZ ' ''"""""^ " n •■' QUESTIONS AND PROBLEMS 635 »nH f ^K ^1^ *"" '""^""^ °"" •**"«•'*«'' Doris, and two sons, Henry and Arthur all of age. Her will directs that after the discharge of aS .tTu"A'' ?**'" *•'*"' '^^ ^ P'"^"* ^ trust for FrederS^a wLt^r tr t^ Mnf '^'^''^r*^^' '50.00000, the income of which is t^ betS for the child's support by the guardian appointed under the trust ^d^ pnncpal to be paid over to her when she becomes of age. Tr^mlder $7,400.00. appraised at $2,000.00, and jewelry appraised at inWtlo^oni"'^'' T";^' »50,000.00 at 5. per cent, is in arrears of T^^L XJ ' f "1 f<"«''°«'^ proceedings are commenced by the executor, with the result that on an immediate settlement the estate re^lize^ to the guardian of Fredericka Winter. The February and August semT ofTo^'S^"^? V' TT r ' "^^ "*''* ■" *"« *- -maining Tort^^ of $100,00X00 each and the January and July interest on the registered $9^^^ ^TW '" '^'^'^f ----•' -d the bonds are forthwith ^dS e!^ toHen J^LT u ^"^^ »30.000.00 to Doris, and $10,000.00 ^t as^3 "ft r respectively, on account of their interests. Doris a^d all f he her legacy, household furniture $5,000.00, clothing $900.00, pLt^ his iC^ the appraised valuation. Each of the sons takes a^ ^ L 'f«^y °°« "f the remaining bonds and mortgages. clo^ne $rL fjf* Z'T't'^ *'^"'*^ ""* ^"^^"^ ^'^ $15,000.00, the Svei fronir in ' T ^°T ""'* """^^ *^'^'^- ^here is aUo re- ^nnl?^ ?"' company for interest on deposit, $350.00. The executor lees wa« fixed by the will at $2,500.00. s.n?'.?^'^ * summary accounting showing the cash in hands of executor atv^drrrd.'^'^'^^ ^ "^' °^ ^'^ '^^ ^^ ^^^ ^^^- ^' ^^« ^^-^"L^ i 69 1. Wm. Doe his brother was made executor. 2. A legacy of SIO^.OO, and his personal jewelry to go to his son, George 3. A legacy of $5,000.00, and his electric automobUe to go to his dau^^i 4. That his widow, Mary M. Doe, should receive a legacv of $5 000 00 and a sum additional thereto sufficient to pay all hous;hold e^nS due and accrued at the time of his death. expenses 636 ADVANCED ACCOUNTING 5. That his widow, Mary M., shall be paid an allowance of $7,200.00 per annum, and to have full possession and u«e of the homestead property from the date of his death to the final distribution of the estate. The annual allowance herein provided to be paid in quarterly payments, the first payment to be made three months from the date of his death. 6. That the executor should use his best judgment in the disp«3sition of such assets as might be necessary to liquidate the liabihties of the estate, to make immediate payment of the initial legacies to his widow, son and daughter, and to make the quarterly payments to his widow as provided in paragraph 5. 7. That the executor shall have authority to sell property of the estate and to take in payment therefor either cash or securities but that the executor is not of authority to invest the proceeds of proi)erty sales. 8. That during the term of executorship, the executor shall receive $4,800.00 per year in payment for all services (in Heu of all fees and commissions) but such salary not to include necessary expenses of the executor. 9. That the final distribution of the estate should be made aa soon as possible and should be as follows: 14 to the widow, Mary M. }4 to the son, George. }4 to the daughter, Kate. On March 15, 1921, WiUiam Doe filed evidence of executorship. On April 1, 1921, the executor filed with the court the following inventory of the estate of John Doe. Inventory April 1, 19 21 Fi led by Wm. Doe, Exec utor Property Homestead grounds and buildings, Renting real estate. Unimproved real estate. Rents due for March, Cash received for February rent, Stock of the C. O. D. Rv. Co., Certificates of deposit dated December 31, 1920, at 4 per cent interest, figured quarterly, Cash in bank, checking account. Personal jewelry, Electric automobile, Note receivable, dated December 1, 1920, for one year, in- terest rate 6 per cent, payable semi-annually, 4 per cent bonds of the Chicago Street Ry. Co., par $1,000.00, interest payable January and July, Note receivable, drawer Wm. Doe, due July 1, 1921, without interest. Total, Appraised Value $ 40,000.00 100,000.00 80,000.00 500 00 500,00 10,000.00 6,000.00 2,000 00 300.00 1,000.00 4,000.00 30,000.00 1,000 .00 $275,300 00 QUESTIONS AND PROBLEMS 637 Debts Mortgage held by Trust Co. on renting real estate, due Sep- tember 1, 1921, interest rate 6 per cent payable annually, Note held by Commercial Bank— dated February 1, 1921, for four months at 6 per cent. Accrued household expenses for February, Accrued household expenses for March, Unpaid funeral expenses. Sundry personal debts of John Doe, Total, $20,000.00 1,000.00 150.00 150.00 700.00 500.00 $22,500.00 During the period of executorship, in addition to the specific transactions required by the provisions of the will and the ordinary transactions which do not reqmre special mention, the following transactions took place: 1. The revenue producing real estate was sold on September 1 1921 for the sum of $110,000.00 cash. The purchaser assumed all unpaid taxes. The monthly rents ($500.00 per month) had been collected to the time of sale. 2. Notes receivable were collected when due. 3. The Chicago Street Ry. Co. bonds were sold on May 1 1921 for 102 and accrued interest. ' ' ^* 1^,00^''^^ ^^ ^^^ executor amounting to $850 were paid on March 5. The salary of the executor was paid on March 31 1922 6. The executor paid repair and unkeep expenses on revenue producing property amounting to $900.00. 7. The executor paid taxes on unimproved real estate for the calendar year 1921 amounting to $3,600.00. (Do not capitahze in solution). 8. The executor paid taxes on the homestead property for the calendar year of 1921, amounting to $1,800.00. 9. A dividend of 5 per cent was received on the stock of the C. O D Rv Co. for the year 1921. ' ^* MSr^2^^ '^'"^' '''"' "°* '^""^'^ ^^ ""^ '^'^ "''^ °° '•'""* On March 15 1922, the executor, having paid aU of the old habilities of the estate, filed a report settng forth the transactions of the executor and setting forth a pUn of final distribution of the estate in accordance wHh the t^rms of the wJl The plan of distribution was approved by aU kgat^ and the court on March 31, 1922, the current liaMities were liS^' the divjsion of the estate wa« accompUshed and the executor disch^d The following informaUon is to be submitted either in the form of separate schedu es, or m one large schedule arranged in columnar form 1. AssetsandUabilitiesof theestateof John Doeatthe time of his decease 2. Cash receipts and disbursements from the decease of John Doe to the close of the executorship, excluding final division of the estate ofThe 111" '"^' "' '^ ^"^ ^'"''="^'' *^'='"'^« fi"'^ '^tribution 4. Liabihties Uquidated by the executor. 638 ADVANCED ACCOUNTING 5. Expenses of the estate from the decease of John Doe to the close of the executorship. 6. Revenues of the estate from the decease of John Doe to the close of the executorship. 7. Legacies to the widow, Mary M., excluding final distribution of the estate. 8. Legacies to the son, George, excluding final distribution of the estate. 9. Legacies to the daughter, Kate, excluding final distribution of the estate. 10. Residual assets owned by the estate and distributed to legatees on March 31, 1922. 11. Use your total figures and submit proof of the accuracy of your solution. A division of the residual assets according to the terms of the will is not required. 70 Upon the death of a retired business man in June, 1920, a will is found conveying real and personal property aggregating $300,000.00 to the widow, who is his second wife, for her life, and upon her death to four children in equal shares. It is discovered after his death that his first wife had left to her two children, Henry and Enmia, $20,000.00, consisting of securities for $10,000.00 bearing 6 per cent interest, and uninvested cash of $10,000.00. The father had regularly collected the semi-annual interest on the investment, but there was no evidence as to his disposition of the cash portion of the bequest. Exactly ten years elapsed between the death of his first wife and his own death, so that he had collected twenty items of interest, the last one just before he died. Henry and Enmia were of age at the time of their father's death, and had never been informed of their legacy. Prepare a statement showing what would accrue to each of the four children at the death of the widow, who died immediately after her husband, including the amounts to which Henry and Emma would be entitled on account of their mother's estate. Exclude and do not consider any accrued income of the estate unexpended. Use interest rate of 5 per cent. QUESTIONS ON CHAPTER XV Twenty Questions, Five Problems 281. a. What is a receiver? b. What is his first duty on taking possession of profit or trust funds committed to his care? 282. a. What elements enter a statement by a receiver? b. Prepare an exhibit showing the construction of a receiver's state- ment. 283. Give the names of the general accounts to be used and state brieBy how you would proceed to open a set of books for the receiver of a smaU manufacturing concern, the court having issued an order that QUESTIONS AND PROBLEMS 539 the receiver shall continue manufacturing in order to utihze to the best advantage the work in process and the raw material. 284. A trading company votes to go into voluntary hquidation, the direc- tors (three m number) being appointed trustees, to reahze on the assets and pay the debts. What change, if any, should be made in the bool^ of the corporation and how should the trustees' transactions be recorded? 285. Outline accounting procedure necessary to prepare schedules in bankruptcy under the United States Bankruptey Act. State schedules m their order and give substantiaUy what each contains 286. a. If appointed an assignee for a corporation, what would you con- sider to be your first duty? b. How should the assignee's account be prepared for submission to the court? 287. a. What is the duty of the assignee's accountant in the case of an assignment? How is the inventory stated? What are included in the schedules? b. What does the summary of account usually include? With what ,«. A ^''^ T^l^ ''^^''^^ ^'^^^'^ ^^" ^^^* does he take credit? 288. An assignee has been appointed for an insolvent manufacturing corporation whose habihties and assets consist of its capital stock notes and accounts payable, unpaid wages, cash, notes and account^ receivable? raw materials, supplies, finished goods, stock in process plant and balances against "branches." The assignee is, temporarily' to handle the property "as a going concern." You are placed in relttf^e to ^''''''''''^' ^^** ^^ ^^^ ^* ^^^ ^ ^ taken by you a. The Kabilities. b. The assets. c. What ledger accounts should be set up in the books of the assignee? r^Recei^era^ ''^''^^ methods of stating the accounts respectively of: b. Assignees. c. Trustees in bankruptey. State in what essential respects they differ. 290. What statements are drawn up to present the affairs of an insolvent busmess? Give a form of such a statement without figures. ^ 291. a. Define and describe: 1. Statement of affairs. 2. Deficiency account. b. Show wherein the following differ: 1. Revenue account. 2. Trading account. 3. Profit and loss account. 4. Deficiency account. 292. a. What is the primary object of a statement of affairs? (♦) b. To what various uses may such a statement be put? (♦) 289. 640 ADVANCED ACCOUNTING QUESTIONS AND PROBLEMS 641 I ' 293. Differentiate fully between a balance sheet and a staf(>ment of affairs. (*) 294. What facts should be made clear in a statement of affairs? What conclusion is shown in the final balance? 295. a. What are preferred claims? Cite examples, b. Are there any circumstances under which «ertain liabilities may take precedence over a first mortgage? 296. a. What are the sources of information upon which stattnnents of affairs are based? b. Define the following terms and show how they should be treated in the preparation of a statement of affairs: 1. Unsecured liabilities. 2. Partially secured liabilities. 3. Secured liabilities. 4. Contingent liabilities. 6. Preferential liabilities. 297. Set up a deficiency account, explaining the points involved. 298. What basis would you suggest for valuing the assets for the purpose of constructing a statement of affairs? 299. In preparing a statement of affairs, against what account or accounts should be offset the contingent liability on notes receivable dis- counted?. 300. You are instructed by the receiver of an importing and trading concern to examine the accounts and report to him upon: a. The financial position of the concern. b. The causes that have mainly contributed to the failure. In your answer prepare a statement of the assets and liabilitieB in such form as you think should be used for the information of the receiver and the creditors and under (b) state the matters to which you would direct their attention, having in mind the nature of the business and how you would proceed with your investigation. PROBLEMS ON CHAPTER XV 71 The accounts of a partnership include: Cash, Merchandise, Accounts receivable, Notes receivable, Machinery, Real estate, Investments, Mortgage payable on real estate. Notes payable, Accounts payable. Taxes due. $ 1,400 00 15,000 00 20,000 00 4,000 00 7,000 00 6,000 00 2,500 00 3,000.00 16,000.00 35,000 00 600.00 Wages due, 1,000.00 Rent due, 700.00 Notes receivable discounted, 3 , 000 . 00 Partners' accounts, ♦ 12,000.00 All the investments are pledged as collateral on $1,500.00 notes payable. Of the accounts receivable, $1,000.00 are considered bad, $2,500.00 doubtful and worth 50 per cent of book value, and the balance good. Real estate is undervalued 10 per cent. Merchandise is subject to a discount of 25 per cent. Machinery is overvalued 25 per cent. $2,000,00 notes receivable discounted have been paid by makers. Expense of liquidation estimated to amount to $1,500.00. The partners have personal estates valued at $4,000.00. Prepare such statements as seem desirable under the circumstances, and state probable amount for distribution among creditors. 72 The officers of the A company find that they are unable to meet current obligations and a receiver is appointed on April 28, 1919. The receiver calls for an inventory and a statement as at date of app)ointment, which is given as follows: Assets Machinery and equipment, Consigned merchandise. Merchandise at mill. Cash, Accounts receivable. Unexpired insurance. Employees Liberty bonds, Liabilities Reserve for depreciation, J. Smith & Co., Bank loans. Acceptances, Bank overdraft. City taxes accrued. Collateral notes payable, Mortgage on machinery. Accrued interest on mortgage (to date), Lease — machinery. Accrued interest on lease agreement, Accounts payable. Capital stock common. Capital stock preferred, Surplus, $507,300 00 220,000 00 115,000 00 800.00 , 1,400 00 800 00 4,700.00 $850,000.00 $ 7,300.00 260,000.00 105,000.00 15,000.00 1,000 00 4,000.00. 4,700.00 100,000.00 3,000.00 30,000.00 10,000.00 110,000.00 100,000.00 100,000.00 10,000.00 $860,000.00 **.' ?? 642 ADVANCED ACCOUNTING QUESTIONS AND PROBLEMS 643 On November 20, the receiver having disposed of all assets for cash (except consigned merchandise and $400.00 accounts receivable which were considered doubtful) calls upon you to prepare an interim statement for the information of ♦the stockholders and creditors. He leaves the form to your judgment but sugifcsts that it be as concine as possible and that you show his valuations, as well as book value, at date of receivership. He also wants a summary of his transactions not neces- sarily to include profit or loss showing, and finally wants statements to show conditions as they are at date you are called in. You find that the collateral notes payable were for accommodation of employees and were secured by the depvosit of bonds, also the property of employees as per statement. The bonds have now been delivered to the employees and the notes paid by them. The court has authorized payments of the city taxes and accrued interest of $400.00, which latter amount has been omitted from the statements but included by receiver in his valuation statement. Federal taxes were also found to be due and were also paid (amount $1,000.00) The lease covered machinery worth $30,000.00, but the firm that furnished this machinery has accepted a release of the A company's equity in this machinery as full payment of notes under lease agreement and the accrued interest. The receiver finds that J. Smith & Co.'s account represents advances on the entire consigned merchandise and that this merchandise has been pledged to secure this claim in part (to the extent of value of merchandise). Receiver accepts book value for purpose of his records. After removal of the leased machinery the remaining machines and equipment were sold for $200,000.00, and the mortgage (and accrued interest to date of payment, $5,000.00) were paid in full. (Receiver's original value placed on machinery was $200,000.00). The merchandise at the mill was valued by the receiver at $75,000.00, but after six months' operation the amount on hand was sold without inventory for $25,000.00. The accounts receivable were valued by the receiver at $1,000.00 and the amount was in fact realized in cash, the balance appearing doubtful (estimated to be worth 50 cents on dollar). Unexpired insurance is accepted by receiver at book value. November 10, a rebate of $100.00 was received and all policies were cancelled. Upon comparing the statement with the books you find accounts payable understated $10,000.00 in the statement given receivier because of an error on the part of a bookkeeper when closing the books at April 28. Claims were duly filed for entire amount owing (except $10,(XX).(X) accounts payable). An account in purchase ledger was disallowed and is in dispute (amount, $5,000.00). The receiver sold merchandise to the amount of $75,000.00 all of which had been paid for. Other receipts were rent for portion of building — sublet, $1,000.00; unclaimed wages, $500.00; interest on bank accoimt to November 20, 1919, $200.00; cash surrender value of insurance policy on life of treasurer, $1,000.00. Other payments were receiver's accounts payable, $50,000.00; taxes, $3,000.00 (assessed since receivership); rent, $2,000.00; legal expense, $5,000.00. No fee has been allowed receiver or will be considered in your statement. An analysis of the ledger determines the fact that only the following bills and expense vouchers had been carried through the invoice register since receivership, and all had been paid promptly, viz.: labor, $20,000.00; materials, $20,000.00; shop expense, $3,000.00; heat and power, $2,000.00; freight, $1,000.00; general expense, $4,000.00. (A. I. A.) 73 Jones & Robinson, merchants, are unable to meet their obligations. From their books and the testimony of the insolvent debtors, the following statement of their condition is ascertained: Cash on hand, Debtors: $1,000.00 good; $600.00 doubtful, but estimated to produce $200.00; $1,000.00 bad, Property, estimated to produce $9,000.00, Notes receivable, good. Other securities: $3,000.00 pledged with partially secured creditors; remainder held by the fully secured creditors, Jones, drawings, Robinson, drawings, Sundry losses, Trade expenses, Creditors, unsecured. Creditors, partially secured, Creditors, fully secured. Preferential claims: wages and taxes, Jones, capital, Robinson, capital. $ 5,500.00 2,600.00 14,000.00 4,250.00 28,000.00 9,000 00 8,400.00 13,500.00 7,400.00 25,000.00 23,900.00 17,000 00 700.00 10,000.00 16,050.00 Prepare a statement of afifairs, showing the liabilities and the assets with respect to their expected realization and payment; also a deficiency account, showing such of the above stated particulars as would account for the deficiency shown by the statement of affairs. 74 On June 30, Ward & Parker, merchants, announce their inability to meet their obligations, and make an assignment for the benefit of creditors. From an examination of their books, supplemented by other information, their condition appears as follows: Liabilities Creditors, unsecured, $31 , 250 . 00 Creditors, partly secured, 29 875 00 Creditors, fully secured, 21 250.00 Taxes and Wages of Employes (preferential), 875.00 n^iMBik.^ 644 ADVANCED ACCOUNTING Assets < Cash on Hand, Chattels, Bills Receivable, Warehouse Receipts and other securities. Sundry Debtors, Los ses Profit and Loss Account, sundry losses^ Trade Expenses, current period. Personal Ward, Capital Account, Cr., Ward, Personal Drawings, Dr., Parker, Capital Account, Cr., Parker, Personal Drawings, Dr., Accounts Receivable show. Bad Accounts, Doubtful Accounts, Expected to Produce, The securities are in the hands of creditors pledged to of their accounts, viz.: In hands of partly secured creditors. In hands of fully secured creditors. The chattels are expected to realize. Prepare a statement of affairs and a deficiency account. 75 The RepuWican Asphalt Contracting Company HDd the receiver, when taking possession, finds show: Liabih'ties: Bills payable. Creditors open accounts, Mortgage on real estate and improvements. Mortgage on contracting equipment. Capital stock subscribed, ' uqo Less not paid up, q ' I 6,876.00 17,500.00 5,312.00 35,000.00 3,250.00 •16,87.V00 9,250.00 •12,500 00 11,250 00 20,062 00 10,500.00 3,250 00 1,250 00 750 00 250 00 secure payment I 3,750 00 31,250 00 11,250 00 is forced into liquidation, the books of ac<^ount to 118,000.00 75,500.00 17,500.00 7,000.00 000 00 500.00 Assets: Cash in bank and office. Bills receivable. Debtors' accounts. Bonds and warrants. Real estate and improvements, Manufacturing plant. Contracting equipment. Uncomplete contracts (cost). Inventory of materials and supplies, lOO 97,500 00 $216 ,000.00 S 700.00 4,300 00 8,200.00 23,000 00 36,000.00 24,000.00 14,000.00 41,000.00 3. 500.0 $153,700.00 QUESTIONS AND PROBLEMS 645 of J2*'5'o^''m wnr '° ?? ^K^''"^'^ '''''''^'' ""'^^"^ ^^^^ ^^ expenditure price of $60,000.00, and their offer of $2,750.00 for the inventory of the material and supphes as paxt of said expenditure, is accepted by the receiver tLI company owes for personal taxes and adjustment of employe^^ LbUitv rL3tZte/l^Oo'^' T^' "^^^^^^^^^' ^^^ unpaid' laL^ accout^ ThT h-n *^'^^;^' ^^«*^ ^^«"«^ do not show on the books of account. $3,500.00 due creditors, and $20,000.00 of the bonds and warrants have been given as security for $33,000.00 due creditors; $1,000.00 of the bills receivable 18 subsequently dishonored. receivable The receiver finds that $1,100.00 of the debtor's accounts is collectible «4'^ nn J^!^ ^""^ improvements (book value $35,000.00) realizes eoulZr/.r r?^^\^^' ^ ^' '"^* °^ ^^' ^^ ^^1"«> contracting equipment 35 per cent of book value. Prepare a statement of aflFairs and deficiency account. QUESTIONS ON CHAPTER XVI Ten Questions, Five Problems 301. Distinguish between assignee, receiver, and trustee, and state their respective duties. 302. Describe the following and show wherein they differ: a. Trial balance. b. Balance sheet. c. Statement of affairs. d. Realization and h'quidation account. 303. What statement is drawn up at the end of a receivership to show the 304 ^tll "T' ''T " '°"° "' «"<"' »'**«"'-'' -*•>»"* fiP^ 3^^' St 7^h 7°"*<'"<'° '«*''« reaUzation and liquidation account used? 305. State the theory and the practical uses of a realization and liquidation Xali^ * ** *"" '""**'"*" '" "^"^ it may be used with 306. What are the sources of information upon'which the reaUzation and liquidation accounts are produced? 307. When preparing a statement of reaUzation and liquidation in the case of a company dissolving iteelf, how would you treat reserves Z depreciation? State three methods of treating the matter and Jvl reasons for your preference. * 308. A trading corporation votes to go into voluntary Uquidation the directors (three m number) being appointed trusts, to realL on tioL'^be'^rtrl^^ ""'°''*''"' '""' ""^ ^"""^'^ '"^ '^^' *— 309. OuUine the accounting procedure necessary to prepare schedules in , , „ n- ? ti ?•* ^^' substantially what each should contafa. Sl'in^ ^r'° *^' ^t^t^mente drawn up to present the affairs J, 1 f^ f^ *"** ^"^ '*"'"'° "P "* *« ^''d of > receivershfa . to show the receiver's operations. (•) »=™up 646 ADVANCED ACCOUNTING PROBLEMS ON CHAPTER XVI 76 Walter Hopkins, while perfectly solvent and doing a profitable mami- factunng business bad so tied up his capital in plant and materials that he was unable to pay his debts and wm on the point of suspending for want of funds to pay for labor, and his creditors were preparing to commence legal proceedings to enforce a settlement. The condition of his aflfairs at thi» time was as follows: Balance Sheet Assets Plant, Cash, $25,198.00 Creditors, 212.00 Capital, Liabilities Materials, raw and partly finished, 40,400.00 Finished goods, 6 , 070 . 00 Accounts receivable, 3 , 250 . 00 $75,130.00 Surplus, $20,230.00 50,000.00 4,900.00 $75,130.00 At a meetmg of creditors he said that whUe his plant was entirely efficient, It was all of special character and would reaUze on forced sale only the value of scrap, that the unfinished goods would require the employment of skill and processes known to him only, and that while forced suspension would yield to his creditors not over 50 per cent, it would ruin him absolutely The creditors decided to advance him a loan of $5,000.00 to continue opera- tions and aUow him additional credit for materials and expenses. A trustee was appointed to see that the proceeds were used solely for the recuperation of the business. The subsequent operations under the supervision of the trustee were as follows: •liT^^^^^ ^"^ ^'^''^ account, charged to materials $5,100.00, to expense, $12,100.00; sales on book account $57,802.00; losses on bad debts $300 00- cash receipte (loan from creditors) $5,000.00; settlement from debtors $58,100.00; cash payments for labor $12,500.00; for expense $4,350.00- for plant $600.00. Creditors $42,030.00; Walter Hopkins, personal drawings, $3,000.00. There remained raw materials $4,000.00, finished goods $22,388.00. Prepare: a. Realization and Liquidation account. b. Trustee's cash account. c. Balance sheet of the estate as restored to Walter Hopkins. 77 A, B, C and D, partners sharing profits equally, decide to dissolve part- nership and on December 31, 19—, appoint a liquidator and transfer all assets to him. He is to receive for his services 5 per cent of the cash collected by him in the liquidation of the assets. The liquidator is also to be allowed the expenses paid by him in the liquidation of the business as follows: QUESTIONS AND PROBLEMS 647 Clerk hire. Rent, $1,000.00 MisceUaneous expenses, Tm ^ .nltw!!i' "^'^^t-^^ i^' ^ ^^^ P*^^ ^'^^ ^" tte notes and accounte we^ collected excepting $3,200.00 of worthless and uncoUectible accouX Thl furniture and fixtures brought 12 800 no onH fK« «. u ^..^^^^^' ^ne $18 000 00 r.«.,h tk! k 1 *^'^'^' ^'^^i *be merchandise was sold for $18,000.C»cash. The balance payable to partners was distributed on Decem- ber 31, 1^ No interest is to be figured on the partners' accounts or on the moneys m the possession of the liquidator. Prepare cash Tcount of hqmdater, statement showing expenses and losses in hquidation and stltl ment o^the partneis' accounts. The baknce sheet of the firm on I^ceml^ ^1> 19 — , was as follows: ^^cmuer Furniture and fixtures, $3,500.00 Notes payable. Merchandise inventory, 20,500.00 Accounts payable Notes receivable, 14,000.00 Accrued interest on Accounts receivable, 38,000.00 notes payable. Unearned insurance pre- Accrued taxes nuum expiring in 19-, 800.00 A 's account, ^^^* 7,500.00 B's account, " C's account, D's account) $ 5,000.00 38,740.00 $84,300.00 80.00 480.00 16,000.00 8,000.00 10,000.00 6,000.00 $84,300.00 78 Harvey Brothers became financially embarrassed and a trustee w«« thTct^^trs^"^^ '' ''''' "^ "^'^ ^'^^^ ^' *^^^ ^^^- ^- ^^eaZ thel\rncttlfrfol^ ''' ^-^^^ — ^- -- «^- by Assets Cash on hand and in bank, Bills receivable, ,jg ^^ Accounts receivable, /^no Machinery and tools, . ^,ouu. UO Merchandise inventory, -» Real estate. $ 1,006.50 22,500.00 6,000.00 4,350.25 20,000.00 $537856:75 Bills payable, Accounts payable. Notes receivable discounted, Loan payable. Mortgage on real estate. Taxes due. Mortgage on machinery and tools, Capital, Liabilities $6,000.00 Q>000 00 $15,000.00 10,000.00 1,000.00 15,000.00 315.00 5,000.00 7j^641.75 *53,856.75 ; 648 ADVANCED ACCOUNTING In order advantageously to realize on all asset^s, the trustee purchases merchandise to the amount of $10,000.00, and during the year collected $21,350.00 cash for sales. The book debte reaHzed $3,950.00. Of the bills receivable entered in the balance sheet as $18,000.00 there was on hand only $8,000.00, the balance of $10,000.00 having been discounted with the bank and which are represented on the Hability side by the item notes receivable discounted. The $8,000.00 notes on hand realizeti the full sum, while of the $10,000.00 discounted with the bank only 70 per cent could be realized the balance was lost. The bills payable, accounts payable, taxes, and interest on mortj^ages, (5}4 per cent) were paid in course of settlement. Current expenses were as foUows: Salaries, $1,000.00; office expenses, $800.00; legal fees, $1,200.00; withdrawals for private us3 by the owners, $2,000.00; trustee's commission, $2,000.00. On January 1, 1921, the trustee surrendered charge of the estate and paid over the cash balance on hand. There remained on that date merchandise on hand, $5,600.00. Prepare a realization and liquidation account, a trustee's cash account, and a balance sheet of the estate at termination of trust. 79 James Stetson is appointed trustee of the manufacturing business of John Brightlawn, for the purpose of rehabilitation. On taking charge he finds that the available assets are: Cash in bank, $356.00; accounts receiv- able (a) good, $3,712.00; probably uncoUectible, $350.00. The working and trading assets consist of: Raw materials, $17,258.00; sundry manufacturing supphes, $700.00; finished goods, $8,000.00; goods in process, $30,945.70. Other assets comprise: Machinery and machine tools, $41,000.00; shop and hand tools, $1,300.00; deferred debits to manufacturing, $530.00. The liabihties are: Creditors' accounts, $39,700.00; wages accrued, productive, $500.00, unskiUed $230.00. The transactions under the trusteeship are as follows: Loaned by cred- itors for immediate needs, $7,000.00. Purchased on book accounts: raw materials, $8,300.00; sundry manufacturing suppUes, $9,500.00. Factory ex- pense: Paid in cash $1,300.00; incurred as a hability to creditors and sub- sequently hquidated, $2,100.00. The doubtful accounts receivable proved worthless. Cash paid for: Productive labor $16,000.00; unskiUed labor, $2,500.00; general expense, $8,000.00; additional shop tools, $609.00; freight mward, on raw materials manufactured and sold, $60.00. Interest allowed to creditors on their accounts amounted to $143.10. The trustee advanced $4,300.00 to John Brightlawn on accountof expected profits; the sale of fin- ished wares amoimted to $91,000.00. At the close of the trusteeship, the trustee's books show the working and trading assets to be: Finished goods, $11,000.00; goods in process, $10,450.00; raw matenals, $1,945.70; manufacturing supphes, $395.25. There is be^ sides an amount of $750.10 representing factory expenses unapphed. The creditors' accounts show a balance of $1,650.30. wliile the uncollected QUESTIONS AND PROBLEMS 649 accounts receivable amount to $2,975.36. The shop and hand tools amount to $1,609.00. Prepare an account which, while respecting the fiduciary character of the relations of the trustee and the proprietor of the business, will reflect logically and clearly the result of J. Stetson's administration. ao The following is the trial balance of the Raw Deal Company, June 1 1911 on which day the directors of the company resolve that the secretary of the company be authorized to call a meeting of the stockholders to vot^ on the immediate dissolution of the company: ^^"^' ^ 15,000.00 *Bond secured by Building and realty fixtures, Machinery and ma- chine tools, Shop and hand tools (in store). Furniture and person- alty fixtures. Raw materials and freight thereon, Accounts receivable, Cash in bank and offices, 40,000.00 35,000.00 5,000.00 9,700.00 10,350.00 23,400.00 11,320.00 $149,770.00 mortgage 6 per cent, $ 26,000.00 Interest accrued on bond secured by mortgage. Accounts payable. Reserve for deprecia- tion of building, Reserve for deprecia- tion of machinery. Reserve for deprecia- tion of furniture and fixtures, Surplus, Capital stock, au- thorized, issued and outstanding, 312.00 21,700 00 5,300.00 8,000.00 5,100.00 23,358.00 60,000.00 $149,770.00 * Buildings and realty fixtures pledged thereunder. fJ^^^J^"^^tt"^' '"''*^''^ """^ ^'^^ ^^ ^^y 1' 1911' ^^d the dissolution took place The company sold the building and its equipment to the l\nrk I^ottr -^ ^ '' ""^^ ^^' ''''' ^- ^^--^- 1' 1-1' the Debits: Building and realty fixtures, $7,363.00; machinery, $25,340 00- shop and hand tools, $2,100.00; furniture and fixtures, $3,700.00- accounts receivable, $23,130.00; raw materials, $7,950.00 ' accounts Credits: Accounts payable, $21,700.00; expenses, $1,530.20. Prepare: a. The journal entries aflFecting the dissolution of the company b. A statement of realization and liquidation that will show the percent received by the stockholders on their holdings. INDEX Abstracting accounts, 18 receivable, 33, 34 Accommodation notes, 45, 46 Account, deficiency, 511-17 working capital, 133 arrangement for balance sheet, 10 numbers, 10, 11 valuation, 19 Accountancy defined, 1 Accounting, bonds as investments. 199-211 branches of, 292 capital, 23 consolidations, 432-62 defined, 1 fiduciary, 463-539 holding company, 434-6 merger, 432-62 parent company, 433-4 receivership, 519^21 Accounts, abstracting, 18 adjustment, 12 intercompany, 442 payable, 46, 47 receivable, 32-4 Accrual basis of accounting, 22 Accrued assets, 21 liabihties, 21, 300, 314 Acts of bankruptcy, 502-3 Accumulation, 201-3, 206-11 Active assets, 20 Additional income, 327-8 Additions, 38 Adjustment account, 12 Administrator defined, 465-6 Administratrix defined, 465-6 Advantages of corporation, 97-9 double-entry, 7 Advertising expenses, 54 d51 Amending incorporation certificate 139 Amortization, 201-3, 206-11 Analysis of credit statements, 340-68 Analysis of investment statements 369-99 Annuities and sinking funds, 287- 90 Application of resources statement 391-98 Appraisals and depreciation, 233-4 Appraisers of an estate, 46^70 Appreciation, 216 Approval sales, 50, 51 Arrangement of accounts for balance sheet, 10 Arrangement of ledger accounts, 9 Articulation statement, 18 Asset and liability method of profit determination, 7 Assets, accounts receivable, 357-9 accrued, 21, 361-2 active, 20 bonds, 380-1 buildings, 40-1, 376-7 capital, 20, 299, 363-4, 375 cash, 301-2, 354-6 circulating, 20 consignments, 361 contingent, 21, 316 current, 20, 301-8, 381 deferred charges, 21, 313, 362 delivery equipment, 378-^ savings, 379-80 fire insurance, 375 fixed, 20, 363-4, 375 floating, 20 fimds, 381-2 furniture, 378 good-will, 43, 312, 445-7 inventories, 30&-8, 359-61 652 INDEX Assets, investments, 178-211, 304- 5, 308-9, 381, 440-2 land, 39-40, 375-6 liquid, 20 machinery, 41-2, 377-8 notes, acceptances, accounts re- ceivable, 302^, 356-7 passive, 20 patents, 43, 312, 380 patterns, 43, 379-80 permanent, 20 properties, 309-10 quick, 20 secret, 21 sinking fund, 267-90, 309 stock, 380-1 trademarks, 44-5, 380 trading, 20 types, 20, 21 wasting, 21, 38, 39, 233 working, 20, 29^300 working funds, 302 Assets and liabilities, statement of, 4,5 Assignment in favor of creditors, 500-1 Audited vouchers, 16 Auditing defined, 1 Average due date, 35 B Bad accounts receivable, 33, 34 Balance sheet account arrangement, 10 Balance sheet accounts, 8, 292-340 captions, 298-300 comparative, 366-8 consoUdated, 431-62 form, 296-8 titles, 295-6 unclassified, 17 Bank deposit preparation, 26 Bank discoimt, 32 Bank statement reconciliation, 27-8 Bankruptcy, 496-8 act, 501-2 acts, 502-3 Bankruptcy, statements, 505-9 trustees, 50.'i-5 Basic accounting equation, 7 Basis of consolidation, 413-17 Beneficiary defined, 466 Betterment, 38 Bill of exchange, 29 Bills versus notes, 29 Blocking the ledger, 17, 18 Blotter, cash, 26 daily, 26 Board of directors, 102 Bond register, 156 Bonded Uabilities, 22 Bonding insurance, 58 Bonds, classification, 182-3 collateral trust, 188 conditional, 183^ coupon, 186-7 defined, 181 discount, 265-7 entries, 260-87 expense, 265-7 interest, 263-5 investments, 199-211 listing on exchange, 259 mortgage, 187-8 nominal and effective interest rates, 201-3 premium, 265-7 premium and discoimt, 201-3 present value, 203-6 registered, 185-6 signatures, 259 single, 183 simdry kinds, 18^91 treasury, 259-60 trust agreement, 257-8 unissued, 25^-60 values, 192-3 Booking depreciation, 230-1 Bookkeeping defined, 1 Bookkeeping, estate, 473-6, 479- 82 Books of account, cash book, 2, 3 day book, 2, 3 ledger, 3 Book value, 107 INDEX 653 Branch remittances, 54 sales, 51, 53 Buildings, 40, 41, 37&-7 Burglary msurance, 59 By-laws, 102 C Call loans, 192 Capital, accounting, 23, 105-6 defined, 23 economic, 23 working, 23 Capital assets, 20, 299 construction, 36, 37 foreign branch, 53, 54 sale, 36, 37 valuation, 35-7 Capital expenditure, 25 Capitalization changes, 384-5 CapitaUzation of consolidation, 417- 24 Capital liabilities, 21 Capital profit, 24 receipts, 25 Capital stock, 105, 106, 315, 383-4 classes, 107-14 no par value, 173-5 premium and discount, 128-30 subscriptions, 115, 116 values, 106, 107 Capital versus revenue, 316-9 Cash, 301-2, 354-6 internal system of check, 6 Cash account on general ledger, 28 Cash basis of accounting, 22 Cash blotter, 26 Cash discounts, 55, 56 Cash journal, 29 Cash payments, internal check, 5-6, 27-8 Cash receipts, internal check, 26-8 Cash receipts and disbursements, 29 Cash sales, 49 Cash short and over account, 28 Cash surrender value, 58 Causes of depreciation, 217-8 Certificate of incorporation, 103, 104 139 Certificates of stock, 116-8 Charge and discharge statement, 482-5 Charter, 103, 104 Check, internal, 2, 5-6, 27-8 voucher, 15 Circulating assets, 20 Classes of accounts, adjustment ac- count, 12 balance sheet, 8 collective, 8 controlling, 8 impersonal, 8 major, 8 mixed, 8 nominal, 8 personal, 8 primary, 8 profit and loss, 8 real, 8 subsidiary, 8 summary, 8 suspense, 9 Classes of capital stock, 107-14 Classes of ledgers, 11 Classes of Uabihties, 21, 22 Classification of accounts defined, 7 Classification of bonds, 182-3 Classification of corporations, 100 101 Closing books, working papers for 332-6 C. O. D. sales, 51 Codicil defined, 465 Co-insurance, 57, 58 Collateral trust bonds, 188 Collective accoimts, 8 Combination by purchase, 404 Committee on stock list, 157 Commodity investments, 179 Common stock, 107 Comparative balance sheet, 366-8 Conditional bonds, 183-^ Consignments, 52, 361 ConsoUdated statements, 431-62 ConsoHdations, 432-62 654 INDEX Construction and bond interest, 265 Construction of fixed assets, 36, 37 Contents of bankruptcy statements, 505-9 Contingent assets, 21, 316 Contingent items, 22, 23, 316 Contingent land gift, 39, 40 Contingent liabilities, 21, 53, 316 Contingent losses as depreciation, 218 Contracts, balance sheet set out, 76 entries, 77-9 Controlling accounts, 8 Controlling cost records, 87-91 Copyri^ts, 44, 45 Corporate officers, 143 records, 143-56 Corporation advantages, 97-9 Corporation amending certificate, 139 Corporation by-laws, 102 Corporation cancellation of redeemed bonds and coupons, 291 Corporation capital, 105, 106 Corporation capital stock, 105, 106 Corporation certificate of incorpora- tion, 103, 104 Corporation-charter, 103, 104 Corporation combinations, 399-403 Corporation committee on stock list, 157 Corporation defined, 93, 94 Corporation directors, 102 Corporation directors' powers, 140-2 Corporation disadvantages, 99, 100 Corporation dividends, 241-55 Corporation filing incorporation cer- tificate, 137-9 Corporation franchise, 103, 104 Corporation incorporation procedure, 102 Corporation, joint stock company distinguished from, 96 Corporation merger versus consolida- tion, 399-431 Corporation no par value capital stock, 173-5 obhgations, 256-90 INDEX Corporation officers, 143 Corporation opening entries, 119- 28 Corporation, partnership distin- guished from, 95, 96 Corporation records, 143-56 Corporation shares of stock, 102 Corporation stockholders, 102 Corporation stock issued for prop* erty, 157-61 Corporation stock ledger, 119 Corporation stock premium and dis* count, 128-30 Corporation stock values, 106, 107 Corporation, transfer of business of partnership, 169-73 Corporation, transfer of business of sole trader, 161-5 Corporation, treasury stock, 130- 6 Corporation, vendor's procedure on sale to corporation, 16^-9 Corporation classification, 100, 101 Cost accounting, betterment orders, 87 control methods, 87-91 defined, M maintenance orders, 87 order method, 86, 87 orders, 85-7 process method, 86 production orders, 86 purposes, 85 Cost finding, 84 Cost of goods sold, 324-6 Cost of manufactured product sold, 339 Coupon bonds, 186-7 Courts of competent jurisdiction — estates, 467 Credit department expense, 54 Credit statement, 340-68 Cumulative dividends, 255 Cumulative stock, 108 Current assets, 20, 301-«, 381 foreign branch, 54 Current financing, 351-2 Current liabilities, 21 655 Daily blotter, 26 Day book, defined, 2-3 Decedents' estates, 463-95 Declaring and paying dividends, 247-53 Deductions from income, 328-^ Deductions from sales, 323 Deferred charges, 21, 313, 362 Deferred credits, 314-5 Deficiency account, 511-17 Deficit, 23, 300 Deferred charges to operation, 21 313, 362 Deferred credits to income, 21, 314^-5 Deferred items, 22, 23, 313-5, 362 Dehvery equipment, 378-9 Depletion, 38, 39 Depreciation, 212-34 buildings, 40, 41 causes, 217-8 land, 39, 40 leaseholds, 40 machinery, 41-2 patents, 44 patterns, 43 tools, 42, 43 Depreciation as operating expense, 218-9 Determining depreciation charges 221-30 ' Devisee defined, 465 Direct labor, 82 Directors, 102 powers, 140-2 Disadvantages of corporation, 99, 100 Disbursements, 25 Discount, bank, 32 bond, 265-7 cash, 55-6 stock, 128-30 trade, 55 true, 32 Discount and interest on notes re- ceivable, 32 Discount on investments, consoU- dated statements, 441 5 IHscounted notes receivable, 30, 31 Dishonored notes receivable, 30 Dividends, 242-55, 314 and surplus, 241-55 Double-entry, advantages, 7 basic records, 7 changing from single-entry, 5 defined, 1 Doubtful accounts receivable 34 Draft, 29 Drawings, 379-80 Due date, average, 35 - Duties of administrator, 467-8 Duties of executor, 467-8 Duties of receiver. 498, 519 Earnings, 23, 24 Economic capital, 23 Equipment, dehvery, 378-9 Equity receivership, 498-9 Estate, appraisers, 469-70 assets, 46^72 bookkeeping, 473-76, 479-82 corpus, 476, 493-95 debts, 472-3 decedents, 463-95 defined, 465 income, 466, 490-93 insolvent, 496-539 principal, 466, 493-5 Executor defined, 465 Executor's accounting to court, 477-9 Executrix defined, 465 Expenditures, 25 Expense, advertising 54 credit department, 54 financial, 24 non-operation, 25 purchasing department, 54 warehouse, 54 Expenses, 25 advertising, 54 cost of goods sold, 324r-6 general, 327 manufacturing. 325-6 selling, 326-7 656 INDEX F Factors determining de{»^ciation amount, 219-21 Factory overhead, 83 Fiduciary statements, 463-539 Filing certificate of incorporation, 137-9 Financial expense, 24 Financial income, 24 Financial statements, 19 Fire Insurance, 375 Fire loss, 57-8 Fixed assets, 20 construction, 36, 37 foreign branch, 53, 54 sale, 36, 37 Fixed and capital assets valuation, 35-7 Fixed charges, 25 Fixed liabilities, 21 Floating assets, 20 Fluctuation, 215-6 Foreign branch sales, 53, 64 Forms of business, 92 Formulas, 44 Franchise, 45, 103-4 Friendly trustee, 518 Fully paid stock, 114, 115 Fund £HW:)hcation statement, 368, 391-8 Funded debt, 314 Funded liabilities, 22 Funds, 237-240, 302 working, 302 Future delivery sales, 51, 52 G General expenses, 327 General factors of investment enter- prise, 370-4 Goods, internal system of check, 6 in transit account, 16 Good-will, 43, 312, 445-7 consoUdated statements, 445-7 Gross profit, 24 Gross sales, 322-3 Guaranteed sales, 53 Heir defined, 465 Hire purchase plan, 50 Holding companies, 431-63 Illegal dividends, 245-7 Impersonal accounts, 8 Income, 23, 24 financial, 24 and expenses, 29 Incorporation certificate, 103, 104, 139 amended, 139 filed, 137-9 Incorporation procedure, 102 Indirect labor, 83 Insolvency, 496-8 Instalment records, 147-9 Instalment for sinking fund, 287-90 machinery purchase, 41, 42 sales, 50 Insiunnoe, 56-9 Insurance, bonding, 58 burglary, 59 cash surrender value, 58 liabUity, 58 life, 58 marine, 59 register, 56 short rate, 57 Inter-company accounts, 442 Inter-company sales, 442-3, 447--8 Interest and discount on notes re- ceivable, 32 Internal check, system described, 2, 5-6, 27-8 Intestate defined, 465 Inventories, 305-8, 359-61 approval sales, 51 goods lost in transit, 53 Investment statement, 369-^ INDEX 657 Investments, 178-211, 304-5, 308-9, 381,440-2 Invoice, 29 Items in transit account, 16 Jettison of vessel's property, 59 Joint stock company, corporation distinguished from, 96 Joint ventures, 74-5 Journal, cash, 29 stock, 154 Journalizing defined, 11 Journahzing rules, 8 K Kinds and classes of capital stock. 107-14 Labor, direct, 82 indirect, 83 productive, 82 Land, 39-40, 375-6 Large versus small business, 369-70 Leaseholds, 40 Ledger, arrangement of accounts, 9 blocking the ledger, 17, 18 factory, 87, 88 stock, 150-3 Ledger arrangement, accounts re- ceivable, 33 Ledgers, accepted as evidence, 12 classes, 11 defined, 11 self-balancing, 12 Legal organization, 60 Legatee defined, 465 Letters of administration, 468 Letters testamentary defined, 468 Liability insurance, 58 LiabiUties, 300, 313-5, 364-6 accounts payable, 313, 365-6 Liabilities, accrued, 21, 314 bonded, 22, 382 capital, 21, 366 contingent, 21, 316 current, 21, 383 deferred credits to income, 21 314-5 dividends payable, 314 fixed, 21, 366 funded, 22, 314 notes and acceptances payable. 313, 365 License, 45 Life insurance, 58 Life tenant, 488-90 Liquid assets, 20 Liquidation and realization, 521-39 Loan investments, 193-5 Loans secured by collateral, 191-2 Loss in transit, 53 Loss on notes receivable, 31 Machinery, 41, 42, S77-S ledger, 42 Major accounts, 8 Manufacturing, account groups. 80 81 ' expenses, 83 seUing price components, 81 control, chap. 3 Margin of safety, 385-7 Marine insurance, 59 Market value, 107 Material, 83 received report, 48, 49 Merger versus consolidation, 432-62 Mergers versus consolidations, 399- 431 Methods of depreciation determinar tion, 221-30 Mining company dividends, 247 Minority interests, consohdated state- ment, 447 Minute book, 145 Mixed accounts, 8 658 INDEX Mortgage bonds, 187-8 Mortgages receivable, 184-5 INDEX 659 N National bankruptcy act, 501-2 Net profit, 24 Net sales, 323-4 Net worth, single entry, 4, 5 New York Stock Exchange, 156 Nominal accounts, 8 Nominal and real accounts, chap. 2 Nominal value, 106, 107 Non-cumulative stock, 108 Non-operation e3q)ense, 25 Non-speculative investments, 195-9 No par value capital stock, 173-5 Notes, acceptances, accoimts re- ceivable, 302-4, 356-7 Notes and acceptances payable, 45, 46, 313 Notes, acconmiodation, 45-6 payable register, 31 receivable, 30 discounted, 30, 31 dishonored, 30 interest and discount, 32 loss, 31 register, 31 versus bills, 29 Numbering accounts, 10, 11 O OflBcers of corporation, 143 Opening entries, corporation, 11^ 28 Operation profit, 24 Orders, betterment, 87 maintenance, 87 production, 87, 88 Organization, legal, 60 working, 60 Original entries, 11 Overdrafts, 301 Overhead, 83 distribution methods, 83, 84 Parent versus holding companiefl, 431-62 Passive assets, 20 Partly paid stock, 114, 115 Partners, classification, 62, 63 rights, duties, powers, 64 Partnershifis, chap. 3 Partnership advantages, 61 agreement contents, 63, 64 Partnerships, classification, 62, 63 Partnership, corporation distin- guished from, 95, 96 Partnership defined, 60 disadvantages, 61 ,62 dissolution, 71, 74 interest allowances, 64, 65 interest on capital, 70 investment to secure interest, 66 opening entries, 65-7 operation, 68 profit and loss, 65 profits, 68-9 purchasing interest, 66 in profits, 67 salaries, 65, 68 Par value, 106, 107 Passive assets, 20 Patents, 43, 312, 380 Patterns, 43, 37^80 Payment of dividends, 247-53 Period of an annuity, 290 Permanent assets, 20 Permanent investments, 195-9 Personal accounts, 8 Petty cash, 28 Premiimi bonds, 265-7 Premium stock, 128-30 stock, 128-30 Powers of directors, 140-2 Preferred stock, 108, 109, 110 Premium on investments, consoli« dated statements, 444-5 Preparation of bank deposit, 26 Primary accounts, 8 Prime cost, 83 Private cash book, 28 I'M )l y/ Probating a will, 468 Problems, chapter 1, pp. 542-5 (1- 5) 2, 548-52 (6-10) 3, 554-7 (11-15) 4, 560-2 (16-20) 5, 565-8 (21-5) 6, 569-71 (26-30) 7, 577-81 (31-5) 8, 584-7 (36-40) 9, 590-8 (41-5) 10, 601-5 (46-50) 11, 610-3 (51-5) 12, 617-22 (56-60) 13, 625-31 (61-5) 14, 633-8 (66-70) 15, 640-5 (71-5) 16, 646-9 (76-80) Productive labor, 82 Profit, 24 capital, 24 gross, 24 net, 24 operation, 24 statement of determination^ 4, 5 Profit and loss, asset and hability method of determination, 4, 5 accounts, 8 credits, 329 debits, 329 statement, 292-340 consolidated, 449-50 item arrangement, 321-9 titles, 319-320 Profit-sharing, 255 Profits and dividends, 243-5 Promissory note, 29 Properties, 309-10 Proprietor sales, 49 Proprietorship investments, 193-5 Purchase book, 47, 48 Purchase order, 48 Purchase requisition, 48 Purchase returns and allowances, 47, 54 Purchases, 47, 48, 49 Purchasing department expense, 54 Questions, chap. 1, pp. 540-2 (1-20) 2, 545-8 (21-40) 3, 552-4 (41-60) 4, 557-9 (61-80) 5, 562-5 (81-100) 6, 568-9 (101-20) 7, 572-7 (121^0) 8, 581^ (141-60) 9, 587-90 (161-80) 10, 598-601 (181-200) 11, 605-10 (201-20) 12, 613-7 (221-40) 13, 622-5 (241-60) 14, 631-3 (261-80) 15, 638-40 (281-300) 16, 645 (301-10) Quick assets, 20 I Rates of depreciation, 229-30 Real accounts, 8 Real and nominal accounts, chap. 2 Real estate investments, 180-1 Real value, 107 Realization and Uquidation, 521-^ Recapitulation of sales, 49 Receipts, 25 Receiver defined, 519 Receivership, equity, 498-9 accounting, 519-21 Reconciling bank statement, 27-8 Register for bonds, 156 Register for insurance, 56 Register for notes payable, 31 Register for notes receivable, 31 • Registered bonds, 185-6 Remainderman, 488-90 Renewal, 37, 38 Reptdrs, 37 Replacements, 38 Replacing depreciated assets, 232-3 Report of material received, 48, 49 Requisition for purchase, 48 Reserve for appreciation, 37 Baserve for bad debts, 34 660 INDEX Reserve for cash discounts, 55, 56 Reserve for exchange fluctuations, 53 Reserves, 300, 315, 385 and reserve funds, 234, 241 Returns and allowances, purchases, 47 Revenue, 23, 24 expenditure, 25 receipts, 25 versus capital, 316-9 Royalties, 44 Rules for journalizing, 8 S Sale of fixed assets, 36, 37 Sales, 49-54 approval, 50, 51 branch, 51 cash, 49 C. O. D., 61 consignments, 52 deductions, 323 Foreign branch, 53, 54 future delivery, 51, 52 gross, 322-3 guaranteed, 53 hire purchase plan, 50 instalment, 50 inter-company, 442-3, 447-8 net, 323-4 proprietor, 49 returns and allowances, 54 book, 49 orders, 49 recapitulation, 49 Schedule of ledger balances, 17 Scrip dividend, 254-5 Secret assets, 21 Secret reserves, 240-1 Securities, 178-211 Self-balancing ledgers, 12 Selling depreciated assets, 232-3 Selling expenses, 326-7 future delivery sales, 52 Shares of stock, 102 Short and over account for cash, 28 Short rate insurance basis, 57 Sight drafts as checks, 27 Smgle bonds, 183 Single-entry, advantage, 3 changing to double-entry, 5 defined, chapter 1 disadvantages, 3-4 principles, chap. 1 statements, 4, 5 where used, 4 Sinking funds, 267-90, 309 Specific real and nominal accounts, chap. 2 Speculative investments, 195-99 Statement of affairs, 107 Statement, affairs, 511-7 appUcation of resources, 391-8 articulation, 18 charge and discharge, 482-5 of affairs, 511-7 of assets and liabilities, 4, 5 of cash receipts and disbursements, 29 Statements, consoUdated, 431-62 articulation, 18 balance sheet and profit and loss, 292-340 comparative balance shc^et, 366-8, 391-2 consolidated, 431-62 cost of manufactm^d product sold, 339 credit, 340-368 fiduciary, 463-539 financial, 19 fund application, 368, 391-8 income, 368 investment, 369-99 of income and expenses, 29 of profit and loss, 31^29 of profit determination, 4-6 opinion, 20 pubhcity through, 374-5 resources and their ai)plication, 391-8 Stock, 380-1 certificate book, 149 ,150 certificates, 11&-8 dividend, 253-4 exchange, 156 ■ »r 1 INDEX 661 Stock, holders, 102 issued for property, 157-61 journal, 154 ledger, 119, 150-3 list committee, 157 premiums and discount, 128-30 subscriptions, 115, 116 transfer book, 155, 156 treasury, 130-6 Subscription records, 145-7 Subsidiary accoimts, 8 Summary accounts, 8 Simdry kinds of bonds, 188-91 Surplus and dividends, 241-55 Surplus, 315-6, 385 reserves, 236-7 Suspense accounts, 9 . bad debt reserve, 9 Temporary investments, 195-9 Testator defined, 465 Time draft, 46 Tune loans, 191-2 Tools, 42, 43 Trade discounts, 55 Trademarks, 44-5, 380 Trade secrets, 44 Trading assets, 20, 299-300 Trading of trustee, 518-39, 524-39 Transfer of business of sole trader to corporations 161-5 Transfer of partnership to corpora- tion, 169-73 Transit loss, 53 Treasury stock, 130-6 Trial balance, 2, 17 True discount, 32 Trust agreement, 257-8 Trustee defined, 466, 518 Trustees, 487 in bankruptcy, 503-5 Trustee's trading, 518-39 Trusts, 486-7 Turnover, 56 Type of assets, 20, 21 Types of assets, 20-1 Tjrpes of cash books, 28-9 Types of liabiUties, 21, 22 Two bases of accounting, 22 Two systems of bookkeeping, 1-2 U Unaudited vouchers account, 16 Unclassified balance sheet, 17 Unexpired insurance premiums, 56-9 1 Valuation of balance sheet accounts, 19 Valuation of fixed and capital assets, 35-7 Valuation reserves, 235-6 Vendor's procedure on sale to cor- poration, 165-9 Vessel jettison, 59 Voting trust, 142 Voucher record, 47, 48 Voucher check, 15 jackets, 13, 14 numbers, 15 record, 14, 15 Voucher system, advantages, 15 disadvantages, 15, 16 description, 13 Vouchers, audited, 16 defined, 12 vouching entries, 13 payable accoimt, 16 W Warehouse expense, 54 Wasting assets, 21, 38-9, 233 Working assets, 20, 299-300 Will defined, 465 Will probated, 468 Working and trading assets, 299-300 Working capital, 23, 133 Working funds, 302 Working organizations, 60 Working papers closing books, 332-6 i 1 ■] FEB 8 102? 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