problematical value but also because of the information which it gives
concerning the financing of the company by making a separate record.

2. RECORD AT TIME OF SALE. Assume that $250,000 of the treasury
stock is sold at 50. Inasmuch as the stock was brought on the books
at par, the portion sold must be taken off at the same figure. The
50% discount, instead of being recorded in a Capital Stock Discount
account, will be recorded as a charge against the Donated Surplus, thus
adjusting a portion of this donated surplus, recorded originally at par
value, to its realizable value. The following entry records the sale
and adjustment:

  Cash                          125,000.00
        Donated Surplus                     125,000.00
        Treasury Stock                      250,000.00

The student should understand that the customary procedure of opening
the subscription books, making the entries with subscribers for
treasury stock subscriptions, payment in cash or by instalments, and
finally, the issue of the stock, may be the procedure followed in the
sale of treasury stock just as in the sale of other stock. The net
result will, however, be as shown by the above entry.

3. RECORD OF TREASURY STOCK ON THE BALANCE SHEET. On the balance sheet
treasury stock is treated in the same way as unissued stock, namely, as
a deduction item in the net worth section of the balance sheet. Using
the above figures for illustration, the net worth section will appear
as follows:

                       _Net Worth_
  Represented by:
    Capital Stock:
      Authorized              $1,000,000.00
      Treasury Stock             150,000.00
                              -------------
      Issued and Outstanding                $850,000.00
    Donated Surplus                          275,000.00
                                            -----------
          Total Net Worth                               $1,125,000.00

=Bonds Payable.=—Generally, when a corporation borrows money on
long-term notes secured by a portion of its fixed assets, chiefly its
holdings of real estate, the notes (usually of uniform amounts so as
to make them more marketable) are called “bonds.” Thus, such notes
or bonds are frequently in $100, $500, and $1,000 denominations,
making it possible for one of limited means to take advantage of the
mortgage offered as security for the loan. Bond issues are floated
in pretty much the same way as capital stock issues, being offered
for subscription at a price depending both on the interest rate which
the bonds bear and the prevailing interest rate at the time of their
offering. Thus, if the bonds bear 5% interest and the market rate for
bonds of the same general character is 6%, an investor will naturally
not be willing to pay par for them and the company will therefore have
to sell them at such a discount as will put the yield to the investor
approximately on a 6% basis. The company, by receiving for its bonds an
amount less than par value but by being required to pay interest on the
par amount, is thus paying higher than the nominal or agreed rate.

There is thus a very definite relationship between the bond discount
and the interest rate which the bonds bear.

The accounting record of bond transactions is very similar to that of
other liability transactions, and is shown under three heads as follows:

1. SALE OF BONDS PAYABLE. Assume that a $100,000 issue of bonds
bearing 5% interest, payable semiannually, and maturing in 20 years, is
sold at 90. The record will be:

  Cash                    90,000.00
  Bond Discount           10,000.00
        Bonds Payable                100,000.00

Bonds payable are always set up at par, since that represents the
liability which must be met at maturity of the issue.

2. BOND INTEREST PAYMENT. At the close of the first six months, 2½%
interest, or $2,500, will be paid to the holders of the bonds. Since
the corporation will have to redeem its bonds at par, it has been
deprived of the use of $10,000, represented by bond discount, because
the issue was brought out at 5%. The $10,000 discount is therefore in
the nature of a lump sum interest cost incurred in advance—prepaid—and
must be spread equitably over the life of the bonds. Accordingly, at
each of the 40 interest payments during the life of the issue, a pro
rata share of this prepaid interest should be taken into account as
bond interest. The distribution of bond discount over the interest
payments made during the life of a bond issue is termed “amortization”
of the discount. Scientifically, amortization is worked out on a
compound interest basis, discussion and explanation of which are
found on page 269, Volume II. Here, all we are concerned with is the
principle involved and for the sake of simplicity the amortization
is prorated evenly over the 40 interest periods, resulting in an
additional interest charge of $250 each period. The record is therefore:

  Bond Interest            2,750.00
        Bond Discount                    250.00
        Cash                           2,500.00

3. CANCELLATION OR THE BONDS AT MATURITY. When the bonds come due and
are paid, the record is the same as the cancellation of any other
liability, viz.,

  Bonds Payable          100,000.00
        Cash                         100,000.00

=Bond Premium.=—Bonds are also often sold at a premium. As with
discount, the premium is intimately related to the interest rate which
the bonds bear. At the time of the sale of bonds, the premium is
brought on the books as a credit, which together with the par value
at which the bonds are booked, offsets the cash received from their
sale. At the regular interest periods the premium is amortized over the
life of the bonds and so results in a lessening of the periodic bond
interest charge. The student should set up the entries to record the
sale of bonds at a premium and the interest payment for such bonds.

=Sinking Fund.=—The sinking fund is a fund of liquid assets created
by periodic sums, usually of equal amounts, set aside during the
life of a bond issue or other liability to provide ready funds for
the cancellation of the liability at maturity. This method is very
commonly followed in public finance and is not infrequent in private
corporations. It is not purposed here to explain the methods of
determining what periodic sum is necessary to be set aside so that
these principal sums and their interest accumulations will provide
sufficient funds for the cancellation of the liability at maturity.
Nor will the complicated problem of sinking fund investments in the
hands of a trustee, and the expense and income arising out of it, be
discussed here. These and related problems are covered fully in Chapter
XXV, Volume II. Only the creation of the fund and its final disposition
are treated here, under two heads as follows:

1. CREATION OF THE FUND. Assume that $1,000 cash is set aside at the
end of each six months to provide for the retirement of the bonds at
maturity. The entry for this, every six months, will be:

  Sinking Fund            1,000.00
        Cash                        1,000.00

2. CANCELLATION OF THE BOND LIABILITY. The student will understand
that the cash set aside periodically for the sinking fund will be
invested in securities in order to accumulate an income, which usually
accrues to the fund. The securities in the fund must be sold just
before the maturity of the bond issue, in order to provide cash. It
will be assumed that in this instance the securities in the fund have
been sold, that the cash in the sinking fund at the time of maturity
is $101,500, and that the bond issue to be retired is $100,000. The
entries will be:

  (a) Bonds Payable                       100,000.00
            Sinking Fund                              100,000.00
  (b) Cash                                  1,500.00
            Sinking Fund                                1,500.00

Entry (b) returns to the general cash the unused cash in the sinking
fund. In case of a deficiency in the sinking fund it will be necessary,
of course, to draw on the general cash for the amount of the deficiency.

=Sinking Fund Reserve.=—It is often the policy of a corporation,
which has to provide for the redemption of a bond issue, to reserve
from the yearly profits a sum equal to the periodic payment into the
sinking fund and the accumulations of the fund during that period.
Such a policy prevents the distribution by dividends of all the
current profits to stockholders, and insures that the increase in the
assets represented by these profits will be held in the business and
so provide each period an increased amount of assets for use in the
business and ultimately, by conversion of the assets into cash, for the
use of the sinking fund. The entries crediting the sinking fund reserve
and showing its disposition at the maturity of the bonds are as follows:

  (a) Surplus (or Profit and Loss)          1,000.00
            Sinking Fund Reserve                        1,000.00
  (b) Sinking Fund Reserve                100,000.00
            Capital Surplus (or Surplus)              100,000.00

The first entry shows the periodic reservation of profits. The second
entry transfers the total profits so reserved during the life of the
bonds, back to surplus—capital surplus if it is desired that these
profits be made a part of the permanent capital of the corporation,
or to general surplus in the event that these profits are to be made
available for future dividends.

=Closing the Books of the Corporation.=—The results of the period’s
operations are summarized and the books closed in very much the same
way as with the partnership. From what has been said above, it will be
understood that there are some types of transactions to be considered
at the time of closing the corporation’s books that are not found in
the partnership and single proprietorship. These concern largely the
bond interest, the sinking fund reserve, and the dividend transactions.
Bond interest is an expense. The sinking fund reserve is a reserve of
net profits. Two methods are employed in showing the appropriation of
net profits. Under the one method the total net profit is transferred
to Surplus account, which then shows not only the profit for the
current year but also the undistributed balance of previous years.
The current appropriations of profits for whatever purpose are then
booked as a charge against Surplus. Under the other method the current
appropriations of profits are shown as charges against the net balance
in the Profit and Loss account. Any unappropriated profit remaining is
then transferred to the Surplus account.

=Dividends.=—A business is being operated always for the benefit of
its owners, to whom the profits belong. In the case of a corporation,
before the owners may secure any of the profits, a formal declaration
of dividends must be made by the board of directors. During the term of
its election the board is supreme in its management of the business.
It is intimately in touch with the condition of the business. It knows
the needs of the corporation and its obligations and must provide for
them. If, after considering all the circumstances, it decides that some
or all of the profits should be divided among the shareholders rather
than be retained in the business for purposes of expansion, it meets in
regular session and passes a formal dividend resolution.

=Ultimate Control of Stockholders.=—Thus it is seen that the board of
directors is supreme during the period of its incumbency. Its actions
are, however, subject to the review of the stockholders at their
periodic meetings, which are usually held annually. If their policies
are not favored by the shareholders, a new board, presumably one which
will carry out the will of the majority of stockholders, is elected.

=Dividends Out of Profits Only.=—It is forbidden by law to pay
dividends out of the capital of the corporation. Such payments would
encroach upon the net assets of the organization and thereby weaken
the creditors’ security for the payment of their claims. Dividends
need not be paid out of the profits of the current year, provided the
undistributed profits of former periods are still available.

=Distribution of Profits.=—The appropriation of profits in a
corporation differs, therefore, from that in a partnership. The entries
recording the appropriation of profits cover in the main two kinds: (1)
reserves, and (2) dividends. These entries are not necessarily the same
for all corporations nor for all periods. No set disposition of profits
is prescribed, authority resting with the directors. Their decision,
therefore, as recorded in the minutes of their meetings is the basis
for this group of entries. Some of the usual entries are illustrated in
the following paragraphs.

=Reserves and Dividends.=—As stated above, the two methods for handling
the appropriation of profits are: (1) as a charge against Surplus after
the net profit for the current period has been transferred to that
account; and (2) as a charge against the current Profit and Loss credit
balance and a transfer of the remaining balance, if any, to the Surplus
account.

A part of the profits may be retained in the business to provide
funds for certain future needs, as for the payment of fixed debts,
the extension of fixed plant, etc. Such items are transferred to the
credit of properly named reserve accounts. Profits for distribution as
dividends are similarly transferred to a Dividends Payable account. The
dividend is always based on the amount of outstanding stock, not on the
unissued or treasury stock. It is reckoned either as a percentage of
the par value of each share, as a 6% dividend, or as a stated amount on
each share, as a dividend of $4 or 10 cents per share.

The following illustration will show the necessary entries in
accordance with the two methods.

  PROBLEM. Assume that the net profits of
  Jackson & Co. are $25,000. The directors declare an 8%
  dividend on the outstanding capital stock of $100,000,
  and order $5,000 to be transferred to a reserve for
  buildings and $7,000 to a reserve for the cancellation
  of a bond issue.

  FIRST METHOD
  Profit and Loss                               25,000.00
        Surplus                                            25,000.00
          To transfer net profits to Surplus.
  Surplus                                       20,000.00
        Dividends Payable                                   8,000.00
        Building Fund Reserve                               5,000.00
        Sinking Fund Reserve                                7,000.00

  SECOND METHOD
  Profit and Loss                               20,000.00
        Dividends Payable                                   8,000.00
        Building Fund Reserve                               5,000.00
        Sinking Fund Reserve                                7,000.00
          To appropriate profits as per resolution
          of the directors.
  Profit and Loss                                5,000.00
        Surplus                                             5,000.00
          To transfer balance to Surplus account.

=Dividend Liability.=—The student should note that the effect of a
dividend declaration is to change a portion of the proprietorship into
a liability. Surplus is decreased and liabilities are increased. The
liability so created ranks with other liabilities, i.e., the assets of
the corporation may be used to pay the liability to its stockholders
equally with the payment of liabilities to outside creditors. The
payment of such dividend is recorded by the cancellation of the
dividend liability, as follows:

  Dividends Payable         8,000.00
        Cash                          8,000.00

Where there is more than one class of stock outstanding, it is
customary to keep separate dividend accounts with each class.

=Other Methods of Adjusting and Closing the Books.=—It seems desirable
at this point, although the material is applicable to any type of
business organization, to discuss other methods of adjusting and
closing the books than those heretofore explained. In Chapter XXVIII
and previous chapters, the methods of handling deferred expense and
income, and of summarizing the merchandising transactions were shown.
The method given there of adjusting the ledger because of deferred
expenses rested upon a classification of the various expense accounts
to be adjusted as temporary proprietorship accounts. The method of
adjustment effected a transfer out of the current part of the account,
the asset portion of the expense, and carried it over into the next
period. The balance remaining in the account after this adjustment
shows the expense, that is, the amount of service or use, chargeable to
the current period.

Another method of handling such items is based on an asset
classification of the accounts recording them. Under this hypothesis
such account titles as Postage, Stationery, Wrapping Supplies, and
even Insurance (that is, unexpired insurance), are classed as asset
accounts. At the close of the period when the adjustments are made, it
is necessary to transfer from such asset accounts only the portions
used or consumed during the current period. The balances left in the
accounts represent the unused assets carried over into the next period.
The difference between the two methods is indicated by the two sets of
adjusting and closing entries given below.

  PROBLEM. Assume that $1,000 of insurance has
  been purchased during the current period and that at
  its close unexpired insurance is $250.

  FIRST METHOD. The adjustment of the Insurance
  account classified as an expense account is here made
  by the following entry:

  Insurance (Deferred)      250.00
        Insurance                   250.00

  The closing entry would be:

  Profit and Loss           750.00
        Insurance                   750.00

  The ledger account would show as follows:

                INSURANCE
  ===========================================================
  19—               | 19—
  Jan. 15    500.00 | Dec. 31 Deferred as unexpired    250.00
  June 15    500.00 |         Profit and  Loss         750.00
           -------- |                                --------
           1,000.00 |                                1,000.00
           ======== |                                ========
  19—               |
  Jan. 1     250.00 |

  SECOND METHOD. The Insurance account is here
  looked upon as an asset account. The only adjustment
  necessary, therefore, is to remove from it the portion
  used, the portion remaining unused being an asset. This
  is effected by the following entry:

  Profit and Loss           750.00
        Insurance                   750.00

  The ledger account would appear as follows:

                   INSURANCE
      =======================================================
      19—               | 19—
      Jan. 15    500.00 | Dec. 31 Profit and  Loss     750.00
      June 15    500.00 |

In favor of the first method it may be said that it brings out more
sharply the difference between asset and expense accounts and the need
for separating mixed accounts into their two elements of expense and
asset. The second method requires less work.

=The Trading or Selling Account.=—For the purpose of summarizing
the merchandising activities a separate account called Trading
or Merchandise Trading is sometimes used to effect the partial
summarization heretofore explained as being made in the Purchases and
Sales accounts respectively. Where so used the Trading account becomes
virtually the old Merchandise account with totals in place of details.
The following entries will show its content and the method of handling
it.

  Trading                                      10,000.00
        Merchandise Inventory                              10,000.00
          To transfer opening inventory.
  Merchandise Inventory                        12,000.00
        Trading                                            12,000.00
          To set up new inventory.
  Trading                                     100,000.00
        Purchases                                         100,000.00
          To transfer purchases for the period.
  Trading                                       3,000.00
        In-Freight and Cartage                              3,000.00
          To transfer in-freight and cartage
          expense.
  Purchase Returns and Allowances               5,000.00
        Trading                                             5,000.00
          To transfer.
  Sales                                       150,000.00
        Trading                                           150,000.00
          To transfer.
  Trading                                       6,000.00
        Sales Returns and Allowances                        6,000.00
  Trading                                      48,000.00
        Profit and Loss                                    48,000.00
          To transfer the gross profit on sales.

The Trading account is thus used as a means of separating the net
sales into its two elements: (1) income, or gross profits; and (2)
decrease of assets, or the cost of goods sold. This method makes
the Profit and Loss account a purely summary account of income and
expenses. Its chief disadvantage, however, is that a picture of the
entire operations for the period is not presented in one account. One
seldom finds the Trading account used in actual practice. It does
serve, however, as an efficient teaching device to bring out clearly
the way in which the merchandise accounts are adjusted and summarized
in order to effect a separation of the income and decrease in asset
elements.

CHAPTER XLI

HANDLING THE CASH

=General Considerations.=—In keeping record of the various properties
of a concern, the greatest care is usually exercised in accounting for
the asset cash. This is done because of the difficulty in tracing money
that is lost or stolen and the ease with which the thief may get rid
of it, due to its universal use as a medium of exchange, and due also
to its great value in comparison with its small bulk. Merchandise,
supplies, and the like, may be purloined or misappropriated, but not so
easily and profitably. Oftentimes, however, unless care is exercised
in safe-keeping it, large losses occur also in merchandise. Absolute
prevention of losses cannot be expected even with the employment of
all possible precautions, but experience shows that certain general
safeguards may be placed about both cash and merchandise. In the
ultimate analysis the best safeguard is the integrity of the employee;
still the employer should not tempt the employee by making the
abstraction of his cash an easy performance.

=Principle of the Double Record.=—A fundamental principle in the
handling of cash is to secure a double—not a duplicate—record of its
receipt and disbursement. The practice of depositing in a bank all cash
receipts and making disbursements only by check should be followed
invariably, because it secures this double record—the bank’s record and
the cashier’s record. Any discrepancy is detected whenever comparison
of the two records is made. When the bank’s record is compared with the
cash book record, the balances shown by each are seldom in agreement,
chiefly because of the outstanding checks which have not yet been
presented to the bank for payment. This requires a reconciliation of
the two balances before proof of correctness is secured, which is
usually accomplished by subtracting from the bank balance the amount
of the outstanding checks. Other adjustments are sometimes necessary.
These are explained and a form of reconciliation statement is shown on
page 475.

Most concerns object, however, to issuing checks for small amounts,
and set therefore a minimum below which they do not issue them. For
the purpose of paying smaller amounts, a petty cash fund is provided
from which disbursements are made in cash. This fund is established, in
the first instance, by a check on the general cash and is from time to
time replenished in the same way. In this manner the double record is
maintained.

=Handling the Petty Cash.=—There are two general methods of handling
the petty cash. Under the one, entry of the check creating the fund
is made as an immediate charge to some expense account and no further
accounting is required. This method is based on the theory that the
cash is to be used for petty expenses anyway, and might as well be so
charged now as later. Subsequent amounts for replenishment of the petty
cash are treated in the same way. The objection to this method, from
the accounting viewpoint, is that it results in an inaccurate record
of expense distribution and a misstatement of the facts in that it
charges to expense an item which at the time of the charge is still
a part of the general cash fund. The second and chief objection is
that it encourages in the petty cashier loose methods in handling and
accounting for the fund, as usually no strict reckoning is required.

The second method, known as the “imprest method,” is in more general
favor. This charges the original check creating the fund to an
account called “Petty Cash.” The petty cashier is required to secure
a receipted bill, sales ticket, or other voucher for every petty
cash item of expenditure, so that at all times the amount of cash in
his possession added to the receipted bills and vouchers must equal
the original amount in the fund. Usually the fund is a fixed amount,
its size depending upon the needs of the business for these small
expenditures. When the cash in the fund becomes low, the petty cashier
turns over his receipted bills to the general cashier, who issues a
check for their exact total to replenish the petty cash by the amount
of its depletion, thus restoring it to its original fixed amount.

The expenditures as shown by the receipted bills and vouchers are
classified and entered by either of the following two methods: (1)
as a charge to the several accounts through the general cash book,
offsetting the petty cash replenishing check; in this case no charge
appears in the “Petty Cash” account except the item covering the
original check; or (2) by an entry through the journal debiting the
various expenses and other items and crediting Petty Cash. This
latter method necessitates charging in the general cash book the
replenishing check to Petty Cash as an offset to the journal credit of
the same amount. Most accountants consider the postings to the Petty
Cash unnecessary—except the original—and so check both in cash book
and journal. If, however, posting to the Petty Cash account in the
general ledger is made whenever the fund is replenished, this will
serve to indicate the activity of the fund on the face of the ledger
account—information which could just as easily be obtained from the
petty cash book. The imprest method thus effects a careful accounting
of the petty expenditures.

=The Petty Cash Book.=—The petty cash book is usually a columnar
record with the amount columns to the right of the explanation space.
The first column is the receipts column, the second the disbursements
column, and the others show under appropriate titles the distribution
of disbursements. One form of the book is shown in Form 39, with
typical entries and balancing.

[Illustration: Form 39. Petty Cash Book]

Sometimes the classified summary which is made the basis of the general
cash book or journal entry referred to above, is shown in the petty
cash book, the account titles being written in the explanation column,
with the amounts opposite in the credit column underneath the $100
total. The items of this summary are then posted to the ledger, and
the debit of the replenishing check to Petty Cash on the general cash
book is “checked” in the ledger folio column. Or if the distributive
column titles give sufficiently analyzed account titles, their totals
may be posted without formal summarization, posting being shown by
the small-figure ledger page in each column, as in the illustration.
Where the petty cash book is used as a posting medium, of course no
summarization of it is made either in the journal or the general cash
book.

=Keeping the Bank Account.=—Several different methods of keeping the
bank account are in use. Sometimes the check stub is the only record
kept; in Chapter XXIII reference was made to the two methods of keeping
the account for the entry of deposits—either on the face or the back
of the stub. When the entry is made on the face, each check is usually
subtracted from the previous balance and the new balance is shown. When
deposits are recorded on the back of the stub—or on a special deposit
interleaf—check totals and deposit totals may be carried forward from
leaf to leaf without showing any balance.

A better method is to use the stub only as a memo from which to make
formal entry in the cash book columns—one for deposits on the debit
side and one for checks on the credit side. These bank columns may be
used, first, for the purpose of keeping the bank account, by showing
the totals of deposits—but not the items composing each deposit—and the
totals of the checks that have been drawn; and second, for the purpose
of furnishing weekly or monthly totals for posting to a ledger account
kept with the bank, thus making the ledger self-balancing without
having to bring in the cash book balance.

If, however, the principle of double record (explained earlier in the
chapter) is followed, there is no need of a _special_ bank deposits
column, since the total of the Net Cash column gives the amount of each
day’s deposits, and similarly the Net Cash column on the credit side
shows the checks drawn against the bank. Thus the policy of depositing
in the bank all receipts and disbursing only by check has an added
advantage in that it simplifies the keeping of the record of cash
as well as proving it. Under this method, the cash journals may be
summarized, just as the other journals, and posted to a Cash account
in the ledger. Detailed instructions for the handling of the entries,
balancing, and closing under this method are given in Chapter XXXI.

Another and rather unusual method of keeping the cash book is to carry
a Currency column on each side, supplemented by Bank columns for
deposits and checks on the debit and credit sides respectively. In the
debit Currency column are entered all receipts of money in regular
course. When the bank deposit is made up, its amount is entered as a
charge to the bank in the credit Currency column and also, as a memo,
in the debit Bank column. As checks are drawn they are entered in the
credit Bank column. Thus the balance of the Currency columns should
show the actual amount of cash in the cash drawer at any time, and the
difference between the Bank columns should show the balance in the
bank. Though somewhat complicated, the method has its advantages under
conditions where currency accumulates before being deposited in the
bank.

Of course, under all methods of keeping the cash record, the
requirement that all cash received be deposited and payment be made
only by check should be strictly adhered to.

=Entering Checks on the Cash Book.=—When all disbursements are
by check, every check drawn must be entered on the cash book and
accounted for. Entry should be made in numerical sequence with
suitable explanation of any spoiled checks. The amount of the spoiled
check may be left blank or entered as usual, but in the latter case
the spoiled check must also be included in the day’s deposits, and
the bank’s cancellation stamp must be secured. Neither the deposit
nor disbursement is posted, each entry being marked “contra” by way
of explanation. This effects an inflation of the total receipts and
disbursements, but inasmuch as the bank’s record also shows the
inflation, an adequate safeguard is secured. The new check replacing
the one spoiled is entered in regular order.

The method just discussed is perhaps the best way of recording the
exchange of checks for cash. Sometimes a concern is asked to exchange
its check for currency, the party making the request desiring to send
the check through the mails or for some other purpose. The entry is
best made on both the debit and the credit side of the cash book with
reference “contra” in each case, but neither entry need be posted. This
makes the cash book record check against the bank record and shows the
full history of the transaction. When a check is cashed in currency, or
when a check of larger amount is received in payment of a debt and the
difference is returned in cash, no record need be made of the check, as
only the nature—not the amount—of the deposit for the day is changed
and no disbursement is made which affects the bank account. When,
however, a check is issued for “change” in lieu of currency, record
should be made, debit and credit, as shown above.

=Branch Cash—The Working Fund.=—Frequently cash working funds must be
provided for the current expenses of branches or of a factory located
at a distance from the main office. When the branch or factory keeps
a separate set of books, it must be charged with the advances of the
working fund and a careful audit of the way the fund is handled must be
made periodically, just as would be done with an independent concern.

Such cash transfers may also be handled by the imprest method as
explained above. The original advance is charged to “Factory” or
“Branch Cash,” and is deposited in the branch’s local bank to the
credit of the head office, the branch having the privilege of using
it. The branch may draw checks against the fund, sending the canceled
checks to the head office as supporting vouchers for its disbursements.
These canceled checks become the basis for the replenishing checks and
also for the charges for branch expenditures made on the head office
books.

If the branch is a selling agency making sales for cash and on account,
a modification of the system is necessary. Daily reports should be
required from the branch. Its cash receipts should be deposited daily
and a duplicate deposit ticket should be forwarded to the head office
by the bank. The bank should be asked also to forward all canceled
checks. All collections on customers’ accounts should be made from
the head office. This does not prevent the abstraction of cash before
deposit, but it at least places control or oversight of the bank
cash account in the hands of the head office and secures a careful
accounting of it.

=Safeguarding Cash—General Principles.=—Proper safeguards for the cash
should always be provided. The method of the double record—the bank’s
and the owner’s cash book—is good so far as it goes and acts as a check
on cash transactions _after_ the record is made, but does not insure
that the cash book record will be made correctly in the first place.
There are ways in which cash received may get into the cashier’s or
salesmen’s pockets instead of the cash book. No system or method has
yet been devised to prevent this entirely. Every system must rest at
some point upon the integrity of the human agent, and will fail of
its full efficiency and intended results if the agent fails in the
trust reposed in him. Every effort should be made to prevent both
petty thievery—the abstraction of small sums at every opportunity—and
systematic robbery mapped out and planned with infinite care and
detail. Only everlasting vigilance and a system of “checks” will secure
satisfactory results, as occasionally it is the _trusted_ employee who
is not true to the trust placed in him.

=Internal Check.=—By internal check is meant the method by which
employees check each other’s records, control not resting entirely
in any one clerk. Thus a system of record-making which combines the
work of the cashier and bookkeeper under one clerk or which gives the
cashier access to the ledgers is one which invites dishonesty.

Where the cashier has entire control of the cash, and besides opens the
incoming mail, makes up his daily deposits, has his pass-books balanced
periodically, and files the canceled checks, he has every opportunity
to abstract cash and falsify his records. But where he must make
detailed daily reports of the cash to the manager, treasurer, or some
other officer; where he is denied access to the records—except his own
cash record—and where his record is subject to periodic proof; where
the mail is opened first and receipts listed by an independent clerk;
where a careful system of proving receipts from cash sales and of
allowing no unauthorized deliveries over the counter is employed; where
every member of the office force is required to take a vacation during
which his work and records are cared for by other employees—there is a
very satisfactory system of internal safeguards and checks.

All these devices and systems are applicable in full only in large
concerns where minute division of duties is possible. In smaller
concerns where many duties have to be combined under one person, the
problem of safeguarding the cash and providing other measures to
prevent fraud of various sorts is more difficult. In such a concern,
at least the cash received through the mail should be listed first by
someone other than the cashier or bookkeeper, and the daily deposit
slip should be compared with this list to see that all the cash items
are included. The cash received from cash sales should also be proved
daily against the sales tickets.

=Statement of Receipts and Disbursements.=—A periodic report of cash
is usually made by means of a statement of receipts and disbursements.
This statement is an abstract or summary of the cash book, showing the
total receipts from various sources and the causes of the disbursements
and their totals. A simple form is given below:

[Illustration: Form 40. Weekly Statement of Receipts and Disbursements]

To assist in checking past deposits, an itemized record of daily
cash receipts is often kept, analyzed as to gold, silver, currency,
notes and checks. To be of value this record should be filed with the
daily deposit tickets and should be later available for purposes of
comparison.

CHAPTER XLII

NOTES RECEIVABLE AND PAYABLE

=Conditions Precedent to the Present Use of Notes and Bills.=—During
the twelfth and thirteenth centuries there was much bad money
in circulation in Europe because of the widespread practice of
coin-shaving and the entire lack of standards of purity of the coins.
If a monarch needed funds for war or government purposes, his easiest
way of getting them was to increase the amount of base alloy in the
coins of the country or to increase the rate of seigniorage. As the
former method might be resorted to several times during the reign of
one sovereign, the weight and relative purity of metallic coins had no
relation to the denominated value of the coins, and they fell under
general suspicion. Consequently, only the money dealers, who could
determine the actual value of coins by assaying them, were willing to
trade for coins. These men gradually became the custodians of moneys
for merchants, who were given receipts showing the assay value of the
coins deposited. Because the receipt represented tested and proven
value, it was a more acceptable medium of exchange than the coins
themselves.

Medieval trade was subject to many perils, chief of which was that
from robbers. Any safeguards placed about the transportation of money
from one place to another, or any method devised for settling debts
without the transportation of coin and bullion, were more than welcome.
Out of these conditions arose the method of settling debts by means
of drafts. The draft, not countenanced by law at first, had standing,
however, under the “law merchant,” the code of rules recognized by
merchants as governing commercial relations. This code was later
incorporated by statute into the law of the country.

These two kinds of paper, the one a receipt for coin which was in the
nature of a demand promise to pay, the other a counterpart of the
modern draft, were the forerunners of our promissory notes and bills of
exchange of the present day. The law with regard to the bill or draft
became settled as the result of the practice of merchants sooner than
that relating to notes.

=The Titles “Notes” and “Bills.”=—In this way, the word “bill” became
an established term. The titles “bills receivable” and “bills payable”
still cling to both classes of items. Inasmuch as the accepted bill is
practically identical with the promissory note, and the title “bill” is
so often used interchangeably with the word “invoice,” it is advisable
to use the terms _notes receivable_ and _notes payable_ instead of
bills receivable and bills payable. Some advocate the use of the title
“acceptances” in order to distinguish accepted bills from promissory
notes. Unless these two classes of paper are large enough in volume to
justify it, little advantage is secured by this separation of their
bookkeeping record. However, in the case of trade acceptances, i.e.,
acceptances based on particular sales of goods and therefore evidencing
bona fide commercial transactions as the basis for the extension of
credit, it is advisable, because of their superior rating in the money
markets, to segregate this class of acceptances from notes and other
acceptances.

=Relation of the Note to the Open Account.=—In the preliminary
discussion of the relation of the note to the open account in Chapter
XXI, it was pointed out that both the note and account are claims
against the person liable for payment; and that the one is carried
under a class title “notes receivable,” because the number of such
notes is usually small, while each account receivable is carried under
a separate title which designates the person liable for payment. The
essential difference between the two kinds of claims is that the note
is an acknowledgment of the justice of the claim and the correctness of
the amount, whereas the claim under the open account may be disputed
and in case of dispute requires outside proof; besides, the open
account may always be offset by counterclaims and sometimes by a return
of all or a part of the goods bought.

Any defenses of value under the contract for which the note was given
are good defenses as between the original parties to a note; but not
so as between the maker and a third party who is an innocent purchaser
for value. To him the maker is liable according to the exact terms
and tenor of the note. Only so could the element of negotiability be
insured and the note pass from hand to hand as money. In no other sense
is the note a preferred claim over the open account.

In case of bankruptcy a claim against the bankrupt under an open
account and a claim under a promissory note or an acceptance made by
the bankrupt before his insolvency, rank alike, both sharing pro rata
in the net assets available for the satisfaction of the total claim of
unsecured creditors.

=Relative Liquidity of the Note and Open Account.=—Compared with the
liquidity of open accounts, promissory notes have a slight advantage in
that they can more readily be turned into cash and at a better rate.
Although an assignment of open accounts is possible by hypothecating
them with a third party, the cost of such assignment is almost
prohibitive and is resorted to only where the customary sources of
credit are not available.

The legitimacy and the low cost of discounting notes greatly increase
their liquidity. Oftentimes the question of risk, i.e., the degree of
certainty of their payment when due, enters into the determination of
the relative liquidity as between open accounts and promissory notes,
but from this standpoint there is little, if any, difference between
the two claims. Occasionally a firm, which refuses to pay its debts
on open account, will meet its notes and acceptances in an effort to
bolster its credit at the local banks. This phase of the question does
not usually enter into the discounting operation, where the credit of
the discounter is the determining factor in raising money. Of course,
this may be only a temporary expedient if the note is dishonored and
charged back to the bank. In some lines of business it is very common
practice to secure notes for overdue accounts. If the Notes Receivable
account contains many such items, its liquidity is seriously to be
doubted. However, the note is usually classed as a more liquid asset
than the open account.

=Method of Recording Notes.=—As to the accounting phase, a record is
made of each note received or given, entry being to Notes Receivable
or Payable, as the case may be. If the note transactions are few in
number, the general journal is used for their record. Ample explanation
must be given as to the essential facts of date, maker, for what
received, rate of interest, due date, etc. Notes receivable must be
watched carefully, as failure to present them when due releases all
indorsers. There is nothing unusual in the entry when made in the
general journal, its debit and credit being determined as indicated in
Chapter XI.

=The Note Journals.=—Because the general journal does not lend
itself to an easy record of the essential data pertaining to note
transactions, a separate book is oftentimes kept for this purpose. This
special book may be used merely as a memorandum record for carrying the
detailed explanation of the Journal entry; or it may become a special
journal that is used as an integral part of the accounting system, and,
when so used, posting to the ledgers is made direct therefrom. The use
of this special journal is always advisable when note transactions are
numerous. A bills or notes receivable journal may be ruled as shown on
Form 41. The notes payable journal differs but slightly from the notes
receivable journal.

[Illustration: Form 41. Notes Receivable Journal (left and right hand
pages)]

If the bill book is for memorandum use only, the “Amounts Credited”
columns may be omitted. If it is a real note _journal_, its debit and
credit equilibrium is shown through summary entry at posting time. The
total debit is to Notes Receivable for the amount of that column’s
total. If it were not for the fact that sometimes notes are received
in whose face amount is included not only the credit to the customer
but an interest item as well, there would be no need of credit columns.
The note journal would then be operated just as is any simple special
journal, with a debit to Notes Receivable and the same amount credited
to the customer; but when interest is included, the note is best
recorded in an additional column, separating the credit to Customers
from that to Interest. If notes are numerous, a distributive column
in the cash book should be used for receipts from notes, in order to
secure a total posting to the credit of Notes Receivable account.

Referring to the left-hand page of the illustrated ruling (Form
41), the face amount of the note receivable is entered in the Notes
Receivable column, and the due date in one of the narrow columns headed
“When Due,” each of these columns representing a separate month. In
this way it is easy to find the total of all the notes due in a given
month and the amount of cash to be expected from their payment. For
this purpose, however, it is best to use a note journal arranged by
_months of maturity_ on the principle of a “tickler.” In such a journal
one page is reserved for each month, and the notes are entered, not
on the page for the month when received, but on that for the month
when due. Thus a note received in January and due in March should be
entered on the March page. To secure a summary of all notes received
during each month for posting to Notes Receivable account at the end
of each month, the various month pages are totaled and “recapped” on a
special page. On this “recap” page, at the end of January, say, will
be entered the total of the January page, giving the notes received in
and maturing during January; the total of the February page, giving
the notes received in January but maturing in February; etc., for each
month during the year. The grand total is the amount to be posted to
the general ledger, representing all notes received during January.

This type of journal gives easy control over maturities, and forecasts
for a given month the amount of cash receipts from notes.

=Notes Entered at Face Value Always.=—Some notes are interest-bearing
from their date of issue; others only after their due date when not
paid. Even on non-interest-bearing notes, the law allows the charging
of interest for their overdue period. From the standpoint of strict
accuracy, a note payable at a future time is not worth its face value
at the time of entry, unless it is interest-bearing from date at
approximately as high a rate as the current discount rate. Its present
value is such an amount as when placed on interest will equal the face
at its due date. That value increases day by day until it reaches
par or face on the due date. Because of the practical difficulties
encountered in the numerous adjustments necessary under any other
method of entry, universal practice countenances the bringing of the
note onto the books at a slightly inflated value, i.e., face value,
at the time of entry. Face value is the amount of the credit to the
customer’s account; it shows the amount to be collected on account of
the note; and if interest-bearing, the amount on which the interest is
based. Accordingly, the note transaction is entered at its face value.
Where the note is interest-bearing and the face plus the interest is
paid at maturity, credit is in two items, one to Notes Receivable for
the face, and the other to Interest Income for the amount received as
interest.

Occasionally, the interest for the period the note is to run is
added to the amount of the debt, and the sum is made the face of a
non-interest-bearing note. The purpose of such procedure is to secure
a compounding of interest for the first period if the note is not paid
at maturity. The entry of the note on the books is a debit to Notes
Receivable for its face, and credits to the customer for the amount of
the debt and to Interest Income for the amount of the interest. Only a
credit to Notes Receivable is made when the note is paid. The credit to
Interest Income, before the interest is actually earned and received,
is necessitated by its pre-estimate and inclusion in the face of the
note. Were a balance sheet drawn up on that date, the entire amount of
this interest would be shown as deferred income.

=The Interest Accounts.=—As explained in Chapter XV, when interest
items are numerous two interest accounts are usually carried on the
ledger, one for Interest Income and one for Interest Cost. Sometimes,
however, only the one account, Interest and Discount, is carried, and
if it is desirable to separate the two classes of interest, it may
be done by entering the debit and credit totals of the Interest and
Discount account—instead of simply the balance—when the trial balance
is taken. Needless to say, bank discount—interest paid in advance—is
the only kind of discount recorded under this account title; it must
not be confused with discounts on sales and purchases, which receive
different accounting treatment.

CHAPTER XLIII

PROBLEMS ENCOUNTERED IN RECORDING NOTES RECEIVABLE AND PAYABLE

=Entries in the Account.=—The elementary discussion of entries to the
note accounts in Chapter XIV will be reviewed and amplified here.

Where the Notes Receivable account in the ledger shows each note
separately rather than the totals of the items, good practice
countenances the recording of the _credits_ in this account in
non-chronologic order. Thus, when a customer settles his promissory
note and the document is returned to him, the credit to Notes
Receivable should be entered directly opposite the original debit item.
This brings each complete note transaction on a single line and shows
at a glance which notes are outstanding, as evidenced by the blank
lines on the credit side of the account.

When, however, the credit items are entered in chronological order, the
same purpose may be accomplished by the use of an index figure for the
original debit and the corresponding credit item.

What has been said above applies equally to notes payable.

=The Discounted Note.=—In the booking of notes receivable discounted
and accepted drafts, a problem arises because of the legal right
accorded the holders of notes, in case of non-payment by the maker,
to look for payment to any or all of the indorsers, provided certain
formal requirements are complied with. Whenever a business house
transfers a note by any method of indorsement (except the qualified),
it incurs a _contingent liability_, which may become a _real liability_
if the maker of the note fails to meet the obligation at maturity.
Since it is the function of good accounting to present _all_ the
financial facts bearing on the business, it is evident that whenever a
contingent liability is incurred, it should be entered in the books of
account. Very frequently, however, this liability is ignored, with the
result that it is eventually lost sight of altogether.

The usual, though incorrect, method of journalizing a note discounted
transaction is as follows:

  Cash
  Interest Cost
        Notes Receivable

Usually when an asset is sold, a credit to the account of the asset
sold is correct, but not so in the case of notes sold, i.e., of notes
discounted. For the purpose of showing the complete facts, the entry at
the time of discount should be made as follows:

  Cash
  Interest Cost
        Notes Receivable Discounted

and at maturity when the note is paid by the maker:

  Notes Receivable Discounted
        Notes Receivable

The effect of the first entry is to set up a suspense account, Notes
Receivable Discounted, representing the contingent liability on the
discounted note. The effect of the second entry is, first, to cancel
the _credit_ of the Notes Receivable Discounted account, because upon
payment of the note by the maker the contingent liability ceases; and
second, to cancel the original _debit_ to the Notes Receivable account
which was made at the time the promissory note was received but which
remained _unchanged_ when the note was discounted, because it was still
needed to record the contingent asset which would become a real asset
in case the contingent liability became a real liability.

It has been argued that the above treatment of discounted notes
stretches the theory of debit and credit nearly to the breaking point.
It must be observed, however, that unless accounting records are so
kept as to give the necessary information, they are not serving the
purpose which justifies their existence. Any theory which prevents the
proper functioning of the records must be changed; there is no place
for it.

It would be incorrect, however, to regard Notes Receivable Discounted
as an independent liability account, because it only represents a
contingent liability. The two accounts, Notes Receivable and Notes
Receivable Discounted, must be considered together, the latter account
being set up merely for the purpose of keeping notes discounted under
review until their final status is determined. The purpose of the
Notes Receivable Discounted account is in a way similar to that of the
valuation accounts of depreciating assets. The asset account is held
at its original figure, and in order to determine the present value of
the asset, the valuation account must be referred to. Similarly, the
asset account, Notes Receivable, is held at its original figure, even
though some or all of the notes are discounted, and in order to know
the amount of notes receivable actually on hand, the credit of the
Notes Discounted account must be subtracted from the debit of the Notes
Receivable account. In the balance sheet, Notes Receivable Discounted
is not shown as a liability item, but appears as a deduction from Notes
Receivable, only the difference, representing the amount of notes
actually in possession, being extended among the assets. It should be
noted, however, that this contingent liability is oftentimes shown on
the liability side of the balance sheet, the corresponding asset, Notes
Receivable, then being separated into two items, “Notes on Hand,” and
“Notes under Discount per contra.” Banks uniformly follow this practice
in showing these and similar items.

At maturity of the note the final entry (Notes Receivable Discounted
debit and Notes Receivable credit) is placed upon the books as
illustrated above. Usually no formal notice is received by the
indorser that the note has been paid by the maker. In case the note is
dishonored, prompt notice would be sent, and failure to receive such
notice implies that the note has been duly paid.

What has been said above concerning notes applies equally to accepted
drafts, the legal character of which is identical with that of notes,
the status of the drawer of an accepted draft being the same as that
of the first indorser of a promissory note. The contingent liability
arising from the transfer of all negotiable instruments should usually
be shown.

In some instances, however, there may be good practical reasons for not
adhering to the above principle. When, for instance, a large number of
notes and acceptances are handled and the experience of the business
shows that few of them are ever dishonored, or if the matter is under
constant review by the financial manager, it might be considered an
unnecessary requirement to make use of a separate Notes Receivable
Discounted account. It must be left to the judgment of the accountant
to decide which method is preferable in connection with the needs
of the business. However, if no current account is kept to show the
contingent liability, at the end of the period the balance sheet must
be made to show the amount of discounted notes still outstanding as of
the closing date of the period.

=The Dishonored Note.=—A note is dishonored either when the maker
refuses payment upon its legal presentation at maturity or when
there is sufficient evidence that he intends to refuse. When a note
is dishonored, a formal protest is required in order to hold the
indorsers. The payee appears before a notary public or some other
officer with notarial powers, and makes oath that legal presentment of
the note has been made and that the payment was refused. The notary
then takes the note and personally presents it for payment to the
maker. If payment is still refused, the notary makes a certificate of
protest and mails notices of the protest to all indorsers desired to be
held. Such notice is sufficient basis for action to recover from the
party or parties thus notified.

In making the accounting record of a dishonored note, a number of
problems may arise. These problems deal with these two situations: (1)
when the note is dishonored in the hands of the named payee; and (2)
when the note has been discounted by him and is charged back on account
of dishonor. To illustrate the entries required, take the following two
cases:

  PROBLEM. Case 1. Promissory note made by P.
  Canning for $100. Payee, D. Johnson. Due December 15.
  At maturity Johnson presents the note for payment, but
  payment is refused.

  Case 2. Promissory note for $250 made by P. Canning.
  Payee, D. Johnson. Due December 15. Note was discounted
  by Johnson. Final holder is A. Andrews who presents the
  note for payment on December 15, but payment is refused.

  The questions arising in connection with these two
  cases may be stated as follows: What record should be
  made on December 15—

  (a) By D. Johnson in case 1.
  (b) By A. Andrews in case 2.
  (c) By D. Johnson in case 2.

  (a) D. Johnson, at the time he received the note from
  Canning, made the following entry:

  Notes Receivable                 100.00
        P. Canning                         100.00

  and on December 15, in order to show that the note is
  dishonored, he may make either of the following two
  entries:

  (1) P. Canning                   100.00
           Notes Receivable                100.00

  or

  (2) Notes Receivable Dishonored  100.00
           Notes Receivable                100.00

  Entry (1) takes the charge out of the note account and sets
  it up again as a claim on Canning’s open account. Entry
  (2) transfers the charge to a Notes Receivable Dishonored
  account. Entry (2) is theoretically a better entry than
  entry (1), because from the latter it might be inferred
  that the nature of the claim has changed from a note claim
  to an open account claim. Such change has not taken place,
  however; Johnson’s claim against Canning is still on the
  note. Therefore, entry (1) is not true to the facts.

  On the other hand, entry (1) has an important advantage over
  entry (2), because by posting entry (1) Canning’s personal
  account in the ledger is made to show the fact that one of
  his promissory notes was dishonored. This is a matter of
  very great importance, especially if Canning should again
  apply for an extension of credit.

  If the second method is adopted, it is clear that the
  posting of the entry will not show the dishonor of the note
  on Canning’s account. It is essential, therefore, that
  the bookkeeper should make a special memo of the fact in
  that account. If the bookkeeper could be depended upon to
  make such memorandum entry, the desired purpose of making
  Canning’s account show a complete record of all dealings
  with him would be accomplished. Any treatment consistent
  with accounting principles and securing a complete history
  in one place of all dealings with the same individual
  satisfies all requirements.

  (b) A. Andrews, who is the last indorsee of the note, should
  make the following entry at the time the note is dishonored:

  Notes Receivable Dishonored      250.00
        Notes Receivable                   250.00

  The Notes Receivable Dishonored account represents Andrews’
  claim against any or all the indorsers whom he wishes to
  hold responsible. Instead of this, an entry might be made
  corresponding to entry (1) discussed above.

  (c) In case the note should be charged back to Johnson,
  either by Andrews or by one of the other indorsers, he
  should make the following entries:

  Notes Receivable Discounted                  250.00
        Cash                                           250.00
  P. Canning (or Notes Receivable Dishonored)  250.00
        Notes Receivable                               250.00

  It will be noticed that these two entries completely reverse
  the two original entries made by Johnson, viz.:

  Notes Receivable                             250.00
        P. Canning                                     250.00

  at the time he received the promissory note from Canning, and

  Cash                                        250.00
        Notes Receivable Discounted                   250.00

  when he transferred the note by indorsement.

  It is to be understood that all expenses in connection with
  the dishonored note should be charged either to the personal
  account of the maker or to the Notes Receivable Dishonored
  account, as the case may be.

Where the Notes Receivable Dishonored account is used, it secures a
good analysis of the claims against customers from the standpoint of
probable realization and gives a relatively better basis for the bad
debts estimate than that offered by the other manner of treatment. Of
course, the use of such an account is limited to the ledger; it never
appears as such on the balance sheet, being included there in the
customers’ accounts with ample reserve for uncollectible items.

=The Classification of Notes.=—The Notes Receivable account should
carry only the short-time notes of customers, and thus be a truly
current asset. Long-time notes and those secured by mortgage should
be booked under separate account titles. For a similar reason, the
notes receivable given by officers, employees, or stockholders of the
corporation should have separate booking, as these notes are given for
the purpose of making formal record and acknowledgment of indebtedness,
usually without regard to time of payment. Such notes do not constitute
easily convertible assets, and therefore should not be recorded under
the same account with short-time customers’ notes.

=Notes Receivable Out as Collateral.=—Notes receivable are sometimes
given as collateral security for a loan. When they are so used, no
bookkeeping problem is involved—though a memorandum to show their
use as such should appear in the note account, and in case a balance
sheet is drawn up, a cross-reference or a footnote should indicate
the liability secured by the notes. However, the sale of the notes to
satisfy the loan constitutes a regular business transaction, which
should be recorded in the proper manner.

=Note Renewals and Partial Payments.=—The renewal of notes and
partial payments are other features met in the accounting for notes.
The renewal of a note is rather a question of business policy than of
accounting procedure. When a note is renewed, it is usually better to
deliver up the old note and secure a new one in its stead. The accounts
should reflect the transaction by showing cancellation of the old and
receipt of the new note. If the old note is extended, a memorandum of
that fact should be entered in the ledger account.

From the financial standpoint, if neither note is interest-bearing, the
amount of the renewal note should be larger than that of the old note,
to cover the cost of deferring payment to a future date. For example,
if the old note amounts to $1,000 and is renewed two months later, the
amount of the new note should be fixed at $1,000 plus 1% interest, or
$1,010.

In accounting for partial payments, no new accounting principle is
involved. When such payments are numerous, additional space in the
note journal and in the ledger should be provided for the purpose of
facilitating the actual work of making the book record.

CHAPTER XLIV

DISCOUNTS

=Definition and Kinds.=—A discount is a deduction from a listed or
named figure. The manufacturer or wholesaler in making up his catalogue
for the trade usually enters his products at certain prices—called
“list prices”—which are not selling prices but only nominal amounts on
which the actual sale prices are based. For reasons to be explained
later, he offers buyers a deduction from list prices which is called
“trade discount.” The usual quotation of sale prices is at so many per
cent below the list prices.

Among practically all merchants it is a very common practice to bill
goods to customers with settlement allowed on an optional basis.
The goods may be billed “net,” i.e., the full amount shown in the
invoice must be paid. Since there is a relationship between the time
allowed for payment and the amount to be paid, most concerns have
an established credit term, at the end of which they expect full
settlement of the account, but, as an inducement for earlier payment,
they offer a reduction in the amount to be paid. This is stated usually
at so much per cent below the billed price, and is generally called
“cash discount.” The practice had its origin in conditions prevailing
at the close of the Civil War when business failures were numerous and
the risk on open accounts even for short credit terms was very great.

Bankers when making loans usually deduct from the face of the loan the
interest charge for the use of the money. This deduction is called
“bank discount.”

Merchants usually allow a deduction for the prepayment of a customer’s
note, and this is called “commercial discount,” to distinguish it from
bank discount, although the two kinds of discount are essentially
identical; the only difference being that in the one case a bank buys
a merchant’s note, while in the other case it is a transaction between
two commercial houses, the one buying back its own note before it is
legally due.

Trade discounts are very seldom recorded on the books, the actual
selling price and not the list price being entered. Cash discounts are
invariably recorded. If the merchant knew at the time of the sale which
optional basis of settlement the buyer would choose, he could record
the transaction at a net figure on that basis without entering the
discount portion. This would, of course, result in a varying figure at
which sales were booked. Accordingly, the almost invariable practice
is to record sales at the gross amount and show by means of the Sales
Discount account the acceptance of any lesser sum in settlement in
accordance with the sales contract. Bank discount has to be booked in
order to show the cost of the loan which is the difference between the
asset received, cash, and the asset parted with, notes. The matter of
bank discount has been treated in some detail in Chapter XLII.

=The Method and Purpose of Trade Discount.=—Trade discounts are so
universally met with in business that an extended discussion of them
will be of value to the student. As has been stated, a trade discount
is a deduction from the list price and it serves two purposes. It is
apparent that the prices listed in the catalogue cannot be changed
until a new catalogue is printed and that it would not be practicable
to print a new catalogue to make a change in selling prices. Therefore,
instead of reprinting the catalogue whenever market prices fluctuate
and a change in the list prices must be made, sheets containing the
discounts allowed from list prices are published, the expense of which
is much less than that of a new catalogue.

The other purpose served by the trade discount is in partly concealing
the real quotation. Without the rate of discount allowed from that
list, the catalogue tells nothing of the real price. In this way a
concern in publishing its catalogue does not lay itself open to the
risk of being underbid by competitors publishing later catalogues.

Prices may be quoted at a single discount or by means of a series of
discounts, each taking as its base the net amount left after deducting
the next preceding discount. Examples will illustrate:

  1. Goods listed at $250 are quoted at 20% off.
      The sale price here is $200.
  2. Goods listed at $500 are quoted at 50% and 20% off.
      50% off $500 leaves $250.
      20%  ”  $250   ”    $200—the same real sale price as in No. 1.
  3. Goods listed at $750 are priced at 50%, 33⅓%, and 20% off.
      50%  off $750 leaves $375.
      33⅓%  ” $375    ”    $250.
      20%   ” $250    ”    $200—the same as in Nos. 1 and 2.

It is apparent that the _list_ prices without the trade discounts tell
nothing as to the _real_ prices.

=Methods of Calculation.=—Short methods for calculating trade
discounts when given in a series are often employed. For a series of
only two discounts, a single rate equivalent to the two may be found
by subtracting their product from their sum—always treating them as
decimals. Thus a series of 20 and 20 is equivalent to a single rate of
36,

  (.20 + .20 = .40; .20 × .20 = .04; .40 - .04 = .36).

Another method of calculating trade discounts, and one applicable
to a series of any number of discounts, is to treat the discount off
as equivalent to one-minus-the-discount on. Thus a discount of 15%
is equivalent to 85% of the list. An additional discount of 10% is
equivalent to 90% of the new base, or 90% of 85% of the original list,
or 76.5%. Thus a continued multiplication of the “percentages on” gives
the single sale price multiplier to be applied to the list price. If
the single discount rate is desired, it is secured by subtracting the
multiplier from 1, or 100%. Take the series 60, 20, 10, and 10 off.
This is equivalent to 40, 80, 90, and 90 on, or 25.92% on

  (.40 × .80 × .90 ×. 90 = .2592).

The single discount rate equivalent to the series is, therefore, 74.08%
(100%-25.92% = 74.08%).

The _order_ in which the discounts of a series are used is immaterial,
as the order of the factors does not affect the product.

The method just illustrated develops the reason for the first special
rule given above for a series of two discounts. Let the discounts be
“_a_”% and “_b_”%. The “percentages on” are, therefore, (1 -_a_)% and
(1-_b_)% whose product, algebraically, is 1- [(_a_ + _b_)-_ab_], which
is the single “percentage on”; from which it is readily seen that the
single rate discount is _a_ + _b_-_ab_, i.e., the sum of the two rates
minus their product. Similar rules can be developed for longer series,
but they are too complicated for easy application.

There is now available a “discolog” table, an ingenious reference
table, which is operated somewhat like a logarithmic table. It gives
quickly and easily the single discount rate equivalent to any series of
discounts.

The chief value of the single rate equivalent to the discount series
is in its use for comparative purposes, as it indicates which of two
discount series is the more favorable. When a large number of selling
prices must be computed, all having the same discount series, the
single rate method of calculation also has a great advantage over the
long method, which makes use of the series. This is true especially
when the work is done with the use of a calculating machine.

=The Nature of Cash Discount—Its Basic Elements.=—Where goods are sold
on credit with a cash discount offering, four main factors of cost, not
incurred when goods are sold for cash, must be provided for. These are:

  1. Credit investigation and collection expense.
  2. Bookkeeping and billing expense.
  3. Loss from uncollectible accounts.
  4. Interest for the use of the money—credit.

The cash discount is offered to free the vendor especially from costs
(3) and (4), which are the heaviest of the four.

There is a direct relation between the credit period and the loss from
bad debts. Thus, if a credit period of 30 days results in a given
volume of such losses an extension of the credit term to 60 days would
undoubtedly result in increased losses, assuming that all factors, such
as investigation of the risk, credit supervision, collection effort,
etc., remain the same. Inasmuch as the sale price must be sufficiently
high to provide for loss from bad debts, the credit term enters into
the determination of the price.

The other of the two main factors of cost, the interest charge on the
cash sale price, represents the cost of being deprived of the use of
the capital tied up in outstanding accounts.

Thus, when a discount is offered for early settlement, under
normal conditions the controlling factors are the risk or cost of
insurance against loss from bad debts and the interest cost. Special
circumstances, however, may make it expedient to offer more or less
favorable terms of settlement. Normally, terms of 2% off if paid within
10 days, the billed price being on a 30-day credit period (2/10, n/30),
measures two things: (1) the saving secured by receipt of the money
20 days earlier; and (2) the saving in the item of bad debts expense
brought about by shortening the term for which credit is extended from
30 to 10 days. How much of the cash discount is for interest and how
much for bad debts can be seen by comparing the current interest rate,
say 6%, with the discount rate reduced to a yearly basis. A discount of
2% which effects the collection of a debt at the end of 10 days, when
the net credit term is 30 days, secures the use of the money by the
vendor 20 days earlier than the full credit term would effect. 2% for
20 days is equivalent to 36% on a yearly basis.

=Showing Cash Discount in the Trading Section.=—Opinions differ among
accountants as to the proper treatment of cash discounts in the profit
and loss summary at the close of a period. Some maintain that the
discount is a trading or selling item, and show it, therefore, in the
trading section of the statement. Their theory is that discounts on
sales partake somewhat of the nature of trade discounts, that the real
selling price is, after all, what is received for a particular bill
of goods. According to this theory, if goods are billed at $1,000,
and $980 is accepted as full settlement, the sale should be shown
only at $980 on the books. At the time of offering an optional basis
for settlement, however, the merchant does not know which basis the
customer will accept, and he therefore enters the sale on his books at
the highest offer. Later, if the customer settles on the more favorable
option, the discount he takes is logically a deduction from sales.

On the other hand, if the discount is explained as a bait offered to
secure customers, it should be treated as a selling cost. Consequently,
on either of these two theories, cash discount would have to be shown
in the trading section of the profit and loss statement, in the one
case as a direct deduction from sales, in the other as a selling cost.

=Correct Method of Showing Cash Discount.=—Other accountants maintain
that cash discount is a financial management item; that a manager,
in order to secure ready funds with which to take advantage of the
discounts offered him on his own purchases, extends to his customers
sufficient inducement to secure the early and prompt payment of their
bills. The difference between the saving on purchases payments and
the cost of securing early payment on sales, is the measure of the
efficiency of such financial policy.

While this explanation of cash discount on sales as a cost of securing
funds may have some foundation, it does not give a fully satisfactory
explanation of the practice. If cash discount has been correctly
analyzed as being composed of the two factors, interest and bad debts
expense, there can be no question as to the place of its showing. Both
factors are financial items and they should therefore be placed in that
section of the profit and loss statement. In this work cash discounts
will be treated as a financial management item.

=Account Titles for Cash Discounts.=—In booking cash discounts, two
accounts are used—one for the discounts on sales, and the other for
the discounts on purchases. Self-descriptive titles are Sales Discount
and Purchases Discount, which seem better than Discounts Allowed and
Discounts Received and other similar titles sometimes met with.

=Methods of Booking Cash Discount.=—In booking cash discounts, any one
of four methods may be used. In Chapter XIX, “The Cash Journals,” two
of these methods were shown and the explanations will not be repeated
here. Explanations of the other two methods follow.

1. Entry is made only in the cash book through the use of a
non-cash-discount column on the receipts side. This was also fully
explained and illustrated in Chapter XIX. In the illustration given
there, this discount column was not used in finding the cash balance,
because net cash columns were employed, thus making unnecessary the use
of any other column to find the cash balance.

2. Entry is made as in method 1 above, but the discount column is used
in finding the cash balance. Where, as sometimes happens, the net cash
column is omitted, the true receipts can be found only by _subtracting_
the amount of the discount from the other column totals.

The closing summary for the columnar cash book, explained in Chapter
XIX, shows one method of handling the discount column total. While all
other summary entries for the cash receipts are _credits_, the discount
summary is a _debit_. Because of this fact, the discount total is
sometimes shown on the disbursements side of the cash book among the
summary entries of the other columns, in which case the word “contra”
is written after the words “Sales Discount,” showing that the amount
has come from the discount column on the opposite page. Similarly for
the Purchases Discount.

The only advantage of this method is to bring all summary debit
postings on one side of the cash book and all credits on the other.
Where the cash book is operated according to method 2, the closing
summaries are made as shown in Form 42, using columns on the debit
side for Customers, Sales Discount, and Sundry; and on the credit side
for Creditors, Purchases Discount, and Sundry. As there is no net cash
column, the totals for Customers and Creditors are not all cash. To
clear them of their non-cash elements, the discounts can be subtracted
from their respective Customers’ and Creditors’ totals, and only the
net brought over into the Sundry columns; or the subtraction can be
effected by adding the discounts to the opposite side. The use of a Net
Cash column simplifies the summarization of the cash book and should
always be employed. Treatment 2 is shown only because it is sometimes
met with in practice.

=Securing Information as to Neglected Discounts.=—Some accountants have
pointed out the desirability of bringing before a manager or proprietor
the cost of his failure to take advantage of discounts offered him. To
show this cost the following method of entering a purchase has been
suggested:

  Purchases                      100.00
  Purchases Discount               5.00
        Vendor                           105.00

The _net_ amount of the bill is thus charged to Purchases, the discount
offered to Purchases Discount, and the Vendor is credited with the
billed amount. When payment is made on any of the optional bases
offered, entry is made as follows:

      (1) Vendor                     105.00
                Cash                         105.00

  or

      (2) Vendor                     105.00
               Cash                          103.00
               Purchases Discount              2.00

[Illustration: Form 42. Discount Columns Used for Cash Balance (Method
No. 2)]

In the case of entry (1), the net result of the whole purchase
transaction is a loss or expense of the amount in Purchases Discount,
because of failure to take the discount. In entry (2), if the best
option is taken, viz., the entire 5%, Purchases Discount shows no
balance; any less favorable option, say 2%, results in a debit balance
in Purchases Discount of 3%, measuring the expense incurred through
failure to take the best option. Unquestionably, the information given
a manager by this Purchases Discount debit balance will claim his
notice and immediate attention.

A sales transaction handled on a similar basis results in a Sales
Discount credit balance representing the excess of the offering of
discounts over the amount taken by customers and has to be treated as
income additional to the booked sales income.

Inasmuch as the sale or purchase, under this method, must be booked
on a cash option basis, this treatment seems to result in a departure
from true cost or in the mistake of booking only _some_ of the elements
which enter into the cost of merchandise. The price at which a merchant
can sell his product must include all direct and indirect costs and
provide a margin for profit. The sales discount offered is simply one
of these indirect costs. It cannot be more accurately estimated than
can the salesman’s salary which is a part of the sale price. It is
inconsistent practice to separate the invoice price into two elements
and term one _real_ selling price and the other sales discount cost
when the _real_ selling price is still a composite item. Rather, the
sale should be booked at its full invoiced price and actual costs
recorded as they accrue, to be closed out against Sales Income at the
end of the fiscal period.

After all, the sales policy of each concern enters largely into the
determination of its normal selling price. A concern with a normal
credit term of 30 days fixes its sale price on that basis; one with
a 60-day credit term will, in determining its sale price, take into
account the risk and interest costs of the longer credit period; and
one doing a cash business will determine its sale price accordingly.
However, as a means of furnishing the information necessary for
guidance under a particular sales policy, sales should be recorded on
the basis of the normal credit term.

To secure the information sought as to neglected discounts, it is
suggested that memorandum accounts be opened for that purpose and entry
be made of the expense only when incurred. Thus failure to take a
purchase discount would be recorded under these or similar captions:

  Neglected Purchase Discounts
        Reserve for Neglected Purchase Discounts

At the time the books are closed these memorandum accounts would be
closed against each other, having served their purpose of giving the
desired information through their inclusion in the trial balance
submitted to the manager or owner.

=Trade Acceptances and Cash Discounts.=—Brief mention should perhaps
be made of some recent discussions of the probable effect of the
extended use of trade acceptances on the practice of allowing cash
discounts. Some sellers, to whom the cash discount practice is
troublesome and unsatisfactory, welcome the use of trade acceptances
as an avenue of escape from the practice. Others have gone so far as
to say that the trade acceptance will eventually do away with cash
discounts. It should be said that the use of trade acceptances, while
attractive from the seller’s standpoint, has not as yet made a strong
appeal to buyers, largely because of the fact that it offers little
that the open account method does not secure for them and it may, on
the other hand, interfere somewhat with the taking of cash discounts.

CHAPTER XLV

BALANCE SHEET VALUATION

=The Two Problems of the Balance Sheet.=—There are two major problems
connected with the balance sheet: (1) the problem of form, and (2)
the problem of content. The form of the balance sheet, which was
discussed rather fully in Chapter III, has to do with the arrangement
of the items for the purpose of intelligent reading. It deals with the
principles in accordance with which the asset, liability, and net worth
items are to be marshaled and set up in groups and arranged within the
group with a view to facilitating the comparisons between groups and
the calculations made in judging the financial condition of the concern.

The second problem of the balance sheet, that of content, which
was also mentioned in Chapter III, concerns itself mainly with the
valuation of the items in the balance sheet, assuming of course that
all the assets and liabilities are included in the statement. A balance
sheet may be correct in form but, unless its content is reliable, it
has little or no value when judged from the standpoint of its chief
purpose, namely, that of showing the financial condition of the
concern. The problem of the form of the balance sheet has to do with
the technical or mechanical side of accounting, while the problem of
its content or the valuation of its items has to do with the questions
of the concern’s financial administration, for the solution of which
the accounting department must furnish in proper form the necessary
information.

=Kinds of Value.=—It is first necessary to state the limitations
within which the principles of valuation to be laid down are applicable
to the commercial balance sheet. In business many different kinds of
value are found and used. Thus we have the terms, sale or liquidation
value, cost value, and replacement value. By the term “sale value,”
when applied to a going business, is meant the value which a willing
buyer offers to a willing seller. “Liquidation value” means the value
or price offered for a commodity or an entire business when the concern
is winding up its affairs and going out of business. Liquidation is,
therefore, forced value. There is thus a marked difference between sale
value and liquidation value. The term “cost value” is understood to
mean the price paid for a purchased article. From the discussion of the
principles of debit and credit as applied to merchandise and to fixed
assets, it has been shown that the price paid should include not alone
the invoice cost but the other expenditures needed to put the article
purchased in such a position that it can be used by the business in the
customary way. Replacement value means the cost to replace an article.
It differs from first cost mainly in that the price level may have
changed between the date of the original purchase and the present time.
Thus, because of the changes in prices, an article, costing $1,000 in
1914, might have had a replacement cost of $1,800 in 1917, and $1,400
in 1922.

Manifestly, before the principles to be followed in valuing balance
sheet items can be laid down, there must be some understanding as to
what kind of value is under discussion. The kind of value used in the
ordinary commercial balance sheet is termed “going concern value.” By
this is meant the value which is applied to a going business—a business
which expects to continue in operation, not one which expects to sell
out to other owners nor one which expects to discontinue operations.

=Source of Data as to Values.=—In a going concern the information as
to value is found chiefly in the books of account. The data in the
accounting records are, of course, supported by the original documents
evidencing the purchases and sales. It is a necessary corollary that
if the books of account are to give reliable information as to values,
a correct analysis must be made of all transactions previous to
their entry. Mention was made in an earlier chapter of the necessity
of a clear differentiation between capital and revenue charges and
the effect of failure to make such differentiation. If at the time
of an expenditure a correct classification of accounts has been
made, particularly of the broad classes of assets, liabilities, and
proprietorship, the accounts should reflect the true values as of the
various dates of record. For purposes of detailed information it is
equally necessary that a correct classification be made of the accounts
affected by an entry within any of these main groups. It has been seen
that because of practical difficulties no effort is made to have the
accounts reflect day by day the correct value of the various items. It
is considered sufficient to bring the book record into agreement with
the facts in respect to value once each fiscal period, namely, at its
close. The true financial condition and correct operating results are
then determined.

It will thus be seen that a correct analysis of every transaction
recorded in the accounts is an absolute prerequisite to the use of
the accounts for determining correct values. It is very vital that a
clear line of demarcation be maintained between capital and revenue
expenditures—that great care be exercised that no cost is charged into
the asset group of accounts unless such cost really enhances the worth
of an asset. A cost incurred for the purpose of maintaining the value
of the asset is an expense charge, and repairs and maintenance charges
must be very carefully distinguished from replacements. _Maintenance_
has to do with those costs which maintain an asset in good operating
condition; _repairs_ have to do with those costs necessary to put an
asset in operating condition after a condition of inefficiency has been
reached which the maintenance costs have not been able to prevent; a
_replacement_ cost is incurred when it becomes necessary to replace
some part or the whole of an asset, neither maintenance cost nor repair
costs having been able to maintain the asset in efficient operating
condition. Where only a part of an asset is to be replaced, it is often
spoken of as a _renewal_ of parts. When so used, the term “replacement”
is limited to the renewal or the replacement of the whole asset.

When a renewal or replacement is made, it becomes necessary to
determine whether the cost of the renewal or replacement is more than
the cost of the part or the whole replaced. For example, if an asset
costing originally $1,000 is replaced by one costing $1,200, there has
manifestly been an addition of $200 to the value of the asset. The new
asset may be an exact duplicate of the old but if prices have risen so
that the new actually costs more than the old, the books must record
the asset at its new cost value. The amount by which a new asset or
part of an asset exceeds the cost of the old asset or old part is
called a _betterment_. A betterment is always an asset.

The student will readily see that at times it must be difficult to draw
the line between repairs and replacements. In practice the line is
usually drawn only when the expenditure exceeds a certain amount. This
amount is not uniform and is determined by each individual business.
For example, when the cost of placing the asset in efficient condition
for operation is less than, say, $100, it is charged as repair cost and
therefore does not increase the book value of the asset. If the cost
exceeds $100, an analysis is made to determine what portion of it, if
any, increases the value of the asset. The amount of the betterment
is of course a charge to the asset account, while the rest of it is a
charge to some expense account.

=Treatment of Special Items.=—In the determination of the
classification of charges, some kinds of items require special
consideration:

ORGANIZATION EXPENSE. The group of expenditures explained in Chapter
XXXVIII, as incident to the organization of a corporation, is recorded
under the title “Organization Expenses” and is classified for purposes
of the balance sheet as an asset. It is a kind of asset, however, which
has no tangible value and most businesses desire to consider it more
in the nature of a deferred charge to operations. It is recognized
that frequently intangible assets add no strength to the business.
While, therefore, in strict theory organization expenses are assets, in
practice it is best to write them off against income during a period of
from three to five years.

COST-CUTTING CHANGES. Another similar class of charges is met in costs
incurred in making changes in the arrangement of building and other
facilities which will tend to bring about a more economical handling
of some phases of the business; for example, a rearrangement of a
receiving and packing room in order to facilitate the receipt and
delivery of goods. Where these costs are inconsiderable it is best
to charge them against the income of the period in which they are
incurred. Where, however, a big expenditure is necessary, it seems best
to set the costs up under a suitable descriptive title and spread them
over several periods. In other words, at the date of their incurrence
the costs are treated as an asset whose value is to be written down
at the end of successive fiscal periods until finally it has all been
charged against the operations of the business.

INTEREST DURING CONSTRUCTION PERIOD. Where a business builds its own
home, all costs incurred during the period of construction are proper
charges to the costs of the construction. Thus, if a mortgage or bond
issue is used as a means of partially financing construction of the
building, the interest paid to the mortgagee or bondholders during the
period of construction is a proper charge to the building account.
Costs of this kind follow the general principle laid down previously,
that all costs up to the point of placing the asset in condition ready
for use are proper charges to the asset.

=Basic Rules for Valuation of Balance Sheet Groups.=—We may now
consider the principles applicable to the valuation of the various
groups on the balance sheet. In the standard form of balance sheet the
assets are divided into the three groups: (1) Current, (2) Deferred
Charges, and (3) Fixed.

It has been seen that the assets of the current group are used
for purposes of settling debts, the payment of expenses, and the
purchase of merchandise. In judging the sufficiency of these assets
for this purpose, it is absolutely essential to know that the values
at which they are carried will be realized when they are converted
into cash. From the standpoint of conservative business management
an understatement of realizable value may be made, but never an
overstatement. Accordingly, the fundamental principle of valuation
applicable to this group is that these assets are to be valued at cost
or market, whichever is the lower. When so valued, the figures at which
they are carried in the balance sheet will usually represent an amount
slightly less than the amount which it is expected will be realized
from their conversion into cash.

The function of the deferred charges group of assets is to secure an
equitable distribution of expense charges between the current and
the following period. It is only because certain expenditures have
been made during the current period which will benefit the succeeding
period, that it is necessary to set up this group of assets. Here the
problem of valuation is, therefore, simply the problem of dividing the
cost of the expenditures between the current and the next period on
the basis of the benefits accruing to each. In some cases the basis of
division is one of time, as where an insurance policy is purchased for
a definite term. The portion of the policy which has expired during
the current period is the portion of its cost to be charged to the
current period, the balance being deferred to succeeding periods and
therefore carried as an asset. In other cases a physical inventory is
necessary to determine the distribution of the cost of expenditures,
as when supplies of fuel have been purchased and not entirely consumed
during the current period. The basis of the value carried over to the
next period is of course a fair portion of the original cost. Market
or replacement cost does not have any effect on the valuation of the
deferred portion.

Fixed assets are acquired as more or less permanent equipment without
which it is impossible to operate the business. The time during which
an asset continues in use is the customary basis for a classification
of its cost as between expenses and fixed assets. Thus, an asset
acquired for purposes of business operation which, however, will be
used up completely during the current period is charged immediately
to some expense account, whereas an asset which will continue in use
over several periods is charged to an asset account. Fixed asset
purchases are never for purposes of resale. It is expected that they
will continue in use until they are discarded because of failure to
perform the service for which they were acquired. Neither the sale
value nor the replacement cost value of such assets has, therefore, any
influence on their value to the business. That value is the full cost
adjusted periodically by an equitable distribution of that cost over
the operations of the periods benefited by the services rendered by the
asset. This principle of valuation is usually expressed by the formula,
cost less depreciation.

=Valuation of Assets=

CASH. Cash as carried on the balance sheet is the asset which is used,
without conversion, for payment of the liabilities of the business.
There should, therefore, ordinarily be no problem of valuation.
However, because of the practice of including checks, drafts and
notes due and in course of collection, cash balances held abroad and
therefore subject to the fluctuations of exchange, and other similar
items in the account Cash, it is oftentimes necessary to examine all
these items carefully and arrive at a figure which represents the
amount expected to be realized from them.

NOTES AND ACCOUNTS RECEIVABLE. The claims against customers, both
on note and open accounts, constitute an intermediate step in the
conversion of merchandise into cash. At the time credit is extended
to a customer it is expected that he will pay the amount due. The
experience of every business man shows, however, that during each
period there is a shrinkage in these claims due to some customers
failing to pay the amounts they owe. In valuing these claims it is
therefore necessary to take cognizance of the amount of the shrinkage.
This amount is different in different businesses, depending on the
length of the credit term, the policy as to investigation of credit
risks, and on the rigor of the collections policy. On the basis of the
experience within a given business, it is therefore necessary to make
an estimate of the loss from uncollectible accounts.

The manner of making the record of estimated bad debts has already been
explained. The reason for placing the amount by which the asset is
estimated to shrink as a credit in the Reserve for Doubtful Accounts
account rather than in the Accounts Receivable account has also been
explained. The custom of estimating the amount of loss on the basis
of the sales for the period rather than on the amount of claims
outstanding at the close of the fiscal period has been referred to.
Here it is desired to explain the manner of handling the reserve at the
time claims are definitely determined uncollectible. Until a claim is
determined uncollectible it is carried as a part of the assets, Notes
or Accounts Receivable. The amount of the estimated shrinkage in these
assets due to failure to collect claims is indicated by the Reserve for
Doubtful Accounts account. This amount cannot be applied directly to
particular notes and accounts until it is definitely known that such
notes and accounts cannot be collected. When that is learned, it is
necessary to transfer from the reserve account the amount needed to
cancel from the books the uncollectible notes and accounts receivable.
This is done by the following entry:

  Reserve for Doubtful Accounts
        Notes (and Accounts) Receivable

  PROBLEM. Assume that the accounts receivable
  amount to $75,000, of which it is estimated that $5,000
  will not be collectible. During the succeeding period
  a customer owing $500 becomes bankrupt and nothing is
  realized on his account.

  The accounts will then appear as follows:

                      ACCOUNTS RECEIVABLE
  =============================================================
  Dec. 31             75,000.00 | Feb. 28                500.00

                   RESERVE FOR DOUBTFUL ACCOUNTS
  =============================================================
  Feb. 28                500.00 | Dec. 31              5,000.00

It will thus be seen that the decrease in value of the accounts
receivable as estimated by the amount in the Reserve for Doubtful
Accounts can never be applied to the asset until it is definitely
determined what particular customer’s account included in the Accounts
Receivable account is bad and must therefore be written off the books.
Inasmuch as the Bad Debts account set up at the close of each fiscal
period to indicate the loss or expense due to uncollectible accounts,
has been charged as an expense of operating for that period, it would
manifestly be duplicating the expense charge if a debt that proved
bad were charged to the Bad Debts account rather than to the Reserve
for Doubtful Accounts. Only during the first period of operation of
a business are debts, if determined bad during that period, charged
to the Bad Debts account. Even here, if it is expected at the close
of the first period to base the estimate of uncollectible accounts
on the sales for the period rather than on the amount of outstanding
accounts at the end of the period, it would be necessary to charge the
debts becoming bad during the period against the Reserve for Doubtful
Accounts account—even though at the time of the charge it contained no
credit entries—and not to the Bad Debts account. The desirability of
establishing a standard routine for the handling of all items should be
kept in mind. Best practice, therefore, demands that all debts shall
be charged against the Reserve for Doubtful Accounts whenever they
are determined to be bad, regardless of the amount held in reserve in
that account. If such practice creates a debit balance in the Reserve
for Doubtful Accounts, it is an indication that the estimate of
uncollectible accounts made in previous periods has not, as a matter
of fact, been sufficient and a larger estimate must be made for future
periods.

MERCHANDISE. Merchandise is purchased for the purpose of resale at
a profit. Sale price is dependent, in a free market, on the force
of demand and supply and not at any given time on cost. Until the
goods are sold no profit, as a matter of fact, has been secured.
Conservatism, therefore, demands that sale price should not ordinarily
be used as the basis for the inventory valuation. Unless there has
been a decided change in prices, it is the confident expectation of
the management that at least the cost price of the merchandise will be
realized when the goods are sold. Ordinarily, therefore, merchandise
will be priced in the balance sheet at cost. When, however, there has
been a change in price levels, particularly when the indication is
that there is a generally declining market and not simply a temporary
fluctuation in prices, it is the part of conservatism to value the
merchandise at its replacement cost, or even at a lower figure, if
stocks are large and market conditions are such that customers are
withholding their purchases until price levels have dropped still
further. The basic principle for valuing all current assets requires
that they be valued as nearly as possible at the realization figure.
Therefore, the amount expected to be realized governs or influences
the valuation basis. The valuation formula or rule-of-thumb method,
in accordance with which merchandise inventory is usually valued, is
expressed as cost or market, whichever is the lower. As indicated
above, there are times when exception is taken to this basis.

INVESTMENTS. Stocks and bonds representing the investment of temporary
surpluses of cash are valued on a realization basis. Inasmuch as
the tying up of cash in these securities is only temporary and it
is expected that they will be converted again into cash as needed,
the amount which can be realized from their sale on the date of the
balance sheet is the amount to be considered when judging the financial
condition on that date. A large amount of discretion must be used
in valuing these securities, because of the violent fluctuations to
which quotations on the various stock exchanges are subject. Here also
conservatism does not usually authorize value at the market if the
market is higher than the cost. Accordingly, the valuation formula is
cost or market, whichever is the lower.

ACCRUED INCOME. The income accrued on the date of the balance sheet
is determined on the basis of a fair distribution between the periods
during which the income accrues. Thus, the income from money loaned
during the current period but not due until a succeeding period must
be distributed over two or more periods. Where the income is dependent
on time, the portion applicable to the current period is determined on
a time basis. Where the income is dependent on some other basis, such
as sales or units of work done, the portion applicable to the current
period is determined by the ratio of the whole to the amount completed
during the present period. Thus, in the case of a contract entered into
to sell goods on a commission basis, the commission income accrued
during the current period will usually be based on the amount of sales
made during that period.

DEFERRED CHARGES. The valuation principle for deferred charges has
been stated above in connection with the principles of valuation to be
applied to the various groups of accounts on the balance sheet.

FIXED ASSETS. Fixed assets may usually be divided into two classes:
(1) assets not subject to depreciation, and (2) assets subject to
depreciation. The usual example of assets not subject to depreciation
is the land on which a building stands. Land used for growing crops may
easily be subject to depreciation. Land subject to the exploitation
of the natural resources under its surface is similarly subject to
depreciation. To distinguish the decrease in value of such natural
resources because of the fact that they enter into and become a part
of the commodity dealt in, the term “depletion” is used. Thus, a
coal mine or oil well decreases in value with every unit of product
taken therefrom. It is not purposed hero to discuss the principles of
valuation applicable in such cases, the assets under discussion being
limited in meaning to those of a mercantile business. (See Volume II,
page 312, for a discussion of depletion.)

The valuation formula for assets not subject to depreciation is cost.
Increase in value due to changed market conditions is not usually to be
taken account of.

The second group of assets, those subject to depreciation, are to be
valued on the basis of original cost less the amount of depreciation
accrued to the date of the balance sheet. The valuation of such assets,
therefore, requires the determination of the amount of depreciation.

Depreciation arises from several causes, the chief of which are:

  1. Wear and tear, due to use.
  2. Decrepitude or age, due to lapse of time.
  3. Obsolescence, due to a changed demand for the
      article or to an advance in the arts which makes
      the continued use of the asset uneconomical.
  4. Inadequacy, brought about by several causes, one of
      which may be the change in the market which renders
      the asset inadequate for furnishing the product or
      service in the amount required.

Obsolescence and inadequacy, because of their very nature, are
usually difficult of determination and frequently cannot therefore
be considered in determining the amount of depreciation accrued at a
given time. Where measurable they should, of course, be taken into
account. Depreciation due to lapse of time is calculable on a time
basis. Depreciation due to wear and tear is calculable on the basis
of the use to which the asset has been subjected. It is in practice
difficult to separate these two types of depreciation. The estimate
for depreciation is in the majority of cases made on a time basis.
In manufacturing establishments, oftentimes a use or output basis
proves more satisfactory. These more difficult problems met in the
determination of depreciation are discussed in Volume II. Here only the
most usual method of depreciation estimate on a time basis, known as
the straight-line method, will be explained.

For determining the periodic amount of depreciation of any asset it is
necessary to know: (1) the original cost of the asset; (2) its scrap
value, that is, the estimated value as scrap on the day it is junked;
and (3) the estimated life of the asset in years or fiscal periods. The
following symbols will be used in working out the formula:

  _V₁_ = Original value.
  _Vₙ_ = Scrap value at the end of _n_ years, its estimated life.
  _n_ = The estimated number of years in the life of the asset.
  _D_ = The amount of depreciation during a period.
  _r_ = The rate to be applied to _V₁_ in order to determine _D_.

It is apparent that _V₁_-_Vₙ_ is the amount to be depreciated over
the life of the asset. The amount to be charged off periodically as
depreciation is, therefore:

      (_V₁_ - _Vₙ_)
       ------------
           _n_

Accordingly

            _V₁_ - _Vₙ_
      _D_ = -----------   (1)
                _n_

The amount to be written off each year is thus seen to be constant. The
percentage to be applied to the original cost in order to determine the
periodic depreciation _D_ is, therefore, found by dividing _D_ by _V₁_.
Hence the formula:

            _D_
      _r_ = ----          (2)
            _V₁_

Having determined by careful estimate the method of calculating the
periodic amount of depreciation, the problem of valuation of the asset
at any given time during its life is ordinarily simple. In the case of
renewal of any parts, the question of betterment comes in and requires
careful handling. In unusual cases it may often be necessary to revise
the rate of depreciation in order to write off the betterment during
the remaining life of the asset. Depreciation is at the best but an
estimate and unless there are major betterment items it is not usually
necessary because of them to revise the estimate of depreciation.
When a renewal takes place it is theoretically necessary to determine
the value of the replaced part at the time of its replacement. The
excess of the cost of the new part over this value is the amount of
the betterment, when only the values of the old and new parts are
considered. In such cases, however, the new part will not usually
have value apart from the asset to which it is attached. In practice,
therefore, the amount of the betterment recorded is the difference
between original—not present—value of the old part and the cost of the
new part. An example will illustrate the problems involved and the
accounting treatment.

  PROBLEM. Assume that an asset—office equipment—costing
     $1,000 has an estimated life of ten years and no scrap
     value. After six years of this life it becomes necessary
     to replace a part of the asset, estimated to have cost
     originally $100, the cost of the new part being $150. At the
     time of the replacement the depreciation reserve carries an
     amount of $600.

The first step in booking the transaction is to transfer from the
reserve account to the asset account the original cost of the part
replaced. Just as in the case of bad debts, now that a part of the
asset has been discarded and the amount of the decrease in value of
the asset is definitely known, this amount held in suspense until the
present time in the reserve account must be applied as a definite
reduction in the carrying value of the asset. The entry to effect the
transfer is:

  Depreciation Reserve, Office Appliances     100.00
        Office Appliances                             100.00

The next step is to set up the cost of the new part which replaces that
discarded. This follows the usual entry at the time of purchase of any
equipment. The entry needed is:

  Office Appliances                           150.00
        Cash                                          150.00

The student will note that the office appliances account now carries
a value of $1,050, of which the $50 represents the value of the
betterment.

It might appear that since the renewal occurs at the end of six
years there has been accumulated in the reserve by that time only $60
covering this specific part, and that therefore only $60 should be
transferred from the reserve account, the other $40 being charged to a
proprietorship account to represent the additional expense or loss not
yet provided for by the depreciation charges during the past six years.
That is not the situation, however, for if the periodic depreciation
has been correctly estimated, the entire amount, $100, has already been
charged off and is therefore included in the reserve. When the asset
was originally installed and the length of its life estimated for the
purpose of determining the periodic depreciation charge, the policy
as to repairs and renewal of parts was taken into consideration. Such
estimates cannot, of course, be absolutely accurate. However, until
such time as a definite basis is given on which to check the amount
of the over-or under-estimate, it is the standard practice to charge
against the reserve the original value of the renewed part. Always
at the time of discard of the entire asset—and sometimes sooner—such
a definite basis is given and adjustment must be made in accordance
with the facts then ascertained. A problem will illustrate the
considerations involved.

Continuing the foregoing example, assume that the office appliance, now
valued at $1,050 with a reserve of $500, is discarded after ten and a
half years’ service.

At the end of the tenth year the annual depreciation charge of $105
will have brought the reserve account to a total of $920. Six months
later, at the time of discard of the asset, there will be accrued
depreciation, not yet booked, amounting to $52.50. It is, accordingly,
necessary to book this amount by means of the following entry:

  Depreciation                                  52.50
        Depreciation Reserve Office Appliances         52.50

This entry charges the current period with its share of the consumed
value of the asset. The next step is to transfer the reserve account
to the asset account, to show in that account the amount of the
inaccuracy in the depreciation estimate—the amount by which the actual
depreciation differs from the estimate. The entry is:

  Depreciation Reserve Office Appliances       972.50
        Office Appliances                             972.50

The office appliance account now shows a debit balance of $77.50, which
indicates the value or amount of the asset which has been consumed but
which has not been charged against the income of the periods during
which the asset was used. It is manifestly inequitable to charge this
amount against the income of the six months of the current period, and
it is impossible to go back and spread it over the previous periods
because their records have been closed. The charge must therefore be
made direct to the Surplus account in the case of a corporation, or to
a final section for extraordinary profits and losses of the regular
Profit and Loss account in other cases. It may be handled by this
latter method also in the case of a corporation. The entry needed is,
therefore:

  Surplus                        77.50
        Office Appliances               77.50

In case the reserve is more than the value of the asset at the time of
discard, it means that more than the cost of the asset has been charged
as expense. Accordingly, the excess represents real profit and must be
transferred to surplus. The necessary entry is:

  Office Appliances
        Surplus

GOOD-WILL. Good-will is an intangible asset depending for its value
upon the ability of a business to make more than normal profits. It is
not usual for a business to show an asset of good-will unless it has
purchased another business and has paid for the latter’s good-will. In
other words, good-will is not brought on to the books until a purchase
determines its market value. Where good-will is purchased, it is
customary to carry it at its cost value. Depreciation is not taken into
account. Because of the intangible nature of good-will and its more
or less speculative value, some businesses prefer not to show it. In
such cases it may be written off against surplus at any time and in any
amount until it has all disappeared from the books. While, therefore,
good-will is not subject to depreciation, it is subject to this writing
off process, which usually bears little or no relationship to time.
It should not be charged against the profit of any period or several
periods, but when written off should be charged direct against surplus.

=Liabilities.=—The problem of valuation of liabilities is simple.
From the standpoint of a going concern, its liabilities decrease only
when they are paid off, and increase only because of services or
assets purchased and not paid for. The main problem in connection with
balance sheet liabilities is the determination of the fact that all
liabilities are shown on the balance sheet. This oftentimes involves
the consideration of contingent liabilities. The amount of a liability
may sometimes be in dispute, in which case a careful and conservative
estimate of the probable amount must be made and shown.

=Proprietorship.=—Since proprietorship is always the difference between
assets and liabilities, the problems of valuation of proprietorship are
solved almost automatically if the valuation of assets and liabilities
have been handled properly. There may sometimes be problems in
connection with the various items in the proprietorship group. These
concern surplus, undivided profits, and various reserves. The problems
here are largely those of determining whether a company has lived up
to its contract or other agreements in the maintenance of the proper
values in the various proprietorship accounts.

=Conclusion.=—The problems of valuation are vital to any business and
intimately concern its financial integrity. In order to maintain at
least the original capital investment in a business, it is necessary
to make provision for the decrease in asset values due to different
causes. The financial management of the business must watch this
feature closely, else capital will be dissipated and the business
rendered incapable of performing the functions for which it was
organized.

CHAPTER XLVI

BUYING AND STOCK CONTROL

=Importance of Buying.=—Buying as a major function in a mercantile
concern is intimately related to, and dependent on, the other
functions of the business. Buying must always have regard to the
sales activities. To buy without reference to the ability to sell is
suicidal. Both overbuying—buying more than can be disposed of at a
profit—and underbuying—buying less than is needed to meet the sales
demand—are conditions to be avoided. Underbuying means a loss of sales.
Unless their needs are met promptly in accordance with their orders,
customers will go elsewhere. Overbuying means the unnecessary tying
up of capital in a stock of goods which increases the possibilities
of loss resulting from changes in fashions and the level of prices.
The relation of the rate of turnover to profits in merchandising was
discussed in Chapter VII. Manifestly the ideal situation, so far as
the amount of stock carried is concerned, is one in which the least
amount of capital is used to provide an adequate stock for meeting the
requirements of customers and in which the loss from unsalable stock is
reduced to the lowest level.

Many business houses fail to realize the wastes resulting from slow
turnovers. The Chamber of Commerce of the United States has called
attention to these losses and has analyzed them under the following
heads:

  1. The unnecessary use of capital in merchandise
      that could be more profitably employed in other
      productive sources.

  2. The increased cost of borrowed capital, the
      carrying of larger stocks and their slow turnover,
      necessitating the borrowing of larger amounts of
      capital for longer periods.

  3. The marking down of the sale price due to the fact
      that the goods will not move at the higher sale price.

  4. An increase in overhead expenses due to the larger
      storage and display equipment needed for goods and
      to the costs incident to handling the larger stock,
      and re-marking the stock when it is necessary to
      lower sale prices.

  5. The loss of prestige and reputation from carrying
      unstylish and shopworn goods.

=Relation between Buying and Finance.=—From what has already been
said, it is evident that there is a very necessary relation between
the buying policy of a business and its ability to finance purchases.
Even though it may be possible to increase sales, unless the business
is in a position to finance not only the additional credits extended to
customers but also the additional purchases needed to take care of the
increased sales, it will not be feasible to pursue a policy of sales
expansion and therefore of increased buying. Hence, buying cannot be
considered as a business activity by itself, but as one dependent upon
the sales activities and the financial resources of the business.

=Organization for Buying.=—In large merchandising businesses the
duties and authority of the buying department are not uniform. In
some, this department is organized entirely distinct from the selling
department; in others (and this is particularly true of the large
department stores), the buyer is head merchandise man with control
over the selling activities of the business. It is also quite usual
for the buyer to be in charge of a given department and his success
or failure to be judged by the profits he makes in that department. A
profit quota is sometimes assigned to each department, for which the
buyer is responsible. In other words, in the management of the buying
and selling activities and therefore in the control of his merchandise
stock the buyer is supreme, subject to the general limitations placed
by the financial resources at his disposal. Under the control of the
buyer, therefore, will be stock clerks, the clerks which mark and
re-mark the merchandise, and the sales force. Above and in control of
all the departmental buyers is usually an executive or high official of
the company whose chief function is to correlate the activities of the
buyers with the concern’s general buying, selling, and financial policy.

=Characteristics of the Buyer.=—To perform his functions properly, the
buyer must be a man of broad experience, with a keen sense of values
and the marketing possibilities of merchandise. On the buying side
he must have complete information as to the available sources of the
merchandise he desires to secure, both in staple and in novelty lines.
On the selling side he must know the demands of his customers and the
possibility of creating new demands. The best index of the buying power
of his customers is the volume of sales made in previous years. Past
performance, considered in connection with general trade conditions and
plans for the further development of the business, is the only basis
for judging the sales possibilities of the future. He must know the
quality of merchandise and the reliability of the people from whom he
buys. He must be a keen judge of prices. He must know the financial
resources of his own store and strive to secure the best possible
credit and discount terms.

=Buying Procedure.=—In Chapter XXII, where the goods invoice was
discussed, a typical purchasing procedure was set forth. Here only
the chief points in that procedure will be mentioned. In a large
establishment the buying requisition should be the basis of all
purchase orders. This is particularly true when the buyer does the
buying for several departments. The requisition should be made out in
triplicate by the department head, two copies going to the buyer and
one being retained in the department. Upon the issuance of the buying
order, the second copy of the requisition is returned to the department
as evidence that the goods have been ordered.

The purchase orders are made in manifold, the original going to the
vendor, one copy to the treasurer to notify him of the future need for
funds, one to the controller or accounting department, and one being
retained by the buyer as a basis for follow-up. Upon receipt of the
invoice, which usually precedes the goods, the buyer compares it with
the order and if it is found correct, he passes it to the accounting
department, where it is held until the receiving slip, showing the
receipt of goods, is received from the receiving room. If the three
documents now in possession of the accounting department, namely,
the copy of the original order, the invoice, and the receiving slip,
agree, the invoice is passed for entry on the books and is filed for
payment in accordance with the financial policy of the business. After
payment, the invoice with its supporting documents is filed. Great care
must be exercised to make sure that an invoice is not put through more
than once for payment and that every invoice represents goods properly
ordered and actually received.

=Requirements of Successful Buying.=—Successful buying rests on a
knowledge of two things: (1) when to buy, and (2) what to buy. The
timeliness of buying has regard rather to the sales requirements
than the market possibilities. Goods are bought for the purpose of
satisfying needs of customers. A knowledge of the trend of the market
is necessary but buying wholly in accordance with market trends too