attention to a phase of the subject that presents large possibilities.
He takes 10,000 similar articles, all of probable life-terms of 10
years, and all simultaneously installed. Assuming that of these 10,000,
100 will fail or go out of service at the end of the first year, 200
at the end of the second year, that the largest numbers will fail in
the years just before and just after the expected life-term of 10
years, and from then on, that there will be a gradual decrease in the
number of failures until the 20th year, beyond which time (double
the estimated life-period) none will remain in service—the following
table is shown, which gives in the last column at the right the life
expectancy of all remaining articles as at the beginning of a given
year.

It will thus be seen that an article which has survived its 5th year,
has at the beginning of its 6th an expectancy, not of 5 years but of
6.12 years; an article which has lived its allotted 10 years has an
expectancy of 3.67 years; and so on. Certainly Mr. Grunsky’s study,
if it serves no other purpose, at least draws attention to possible
lines of development and, read in connection with facts as to the
known length of life of many assets which have outlived their expected
terms, it draws strong attention to the need of very careful use of any
so-called mortality tables. These life history tables for assets are
similar to the mortality tables used by life insurance companies.

             TABLE OF EXPECTANCY[37]

      The probable life of each article is 10 years or
      periods. For terms other than 10 years, each year
      in the table may be regarded as a period equal to
      one-tenth of the probable life-term.

      (Based on the special hypothesis of failures as
       explained in the text)

    ========+==========================================+===============
            |           FOR 10,000 ARTICLES            | SINGLE ARTICLE
            +----------+------------------+------------+---------------
    Year or |          | Remaining Number | Remaining  |
    Period  |  Number  |  of Articles at  | Service at | Expectancy at
            |    of    |   Beginning of   | Beginning  | Beginning of
            | Failures |       Year       |  of Year   | Year or Period
    --------+----------+------------------+------------+---------------
        1   |    100   |       10,000     |   100,000  |    10.00
        2   |    200   |        9,900     |    90,000  |     9.00
        3   |    300   |        9,700     |    80,100  |     8.27
        4   |    400   |        9,400     |    70,400  |     7.46
        5   |    500   |        9,000     |    61,000  |     6.77
        6   |    600   |        8,500     |    52,000  |     6.12
        7   |    700   |        7,900     |    43,500  |     5.51
        8   |    800   |        7,200     |    35,600  |     4.95
        9   |    900   |        6,400     |    28,400  |     4.44
        10  |  1,000   |        5,500     |    22,000  |     4.00
        11  |    900   |        4,500     |    16,500  |     3.67
        12  |    800   |        3,600     |    12,000  |     3.33
        13  |    700   |        2,800     |     8,400  |     3.00
        14  |    600   |        2,100     |     5,600  |     2.67
        15  |    500   |        1,500     |     3,500  |     2.33
        16  |    400   |        1,000     |     2,000  |     2.00
        17  |    300   |          600     |     1,000  |     1.67
        18  |    200   |          300     |       400  |     1.33
        19  |    100   |          100     |       100  |     1.00
        20  |      0   |            0     |         0  |        0
    --------+----------+------------------+------------+---------------

[37] From “Valuation, Depreciation and the Rate-Base,” by C. E.
Grunsky.

Composite and Group Rates

In the practical application of the depreciation rate in a large
plant, every separate piece of property is not, of course, considered
by itself. The plant is divided into groups of similar assets,
determined roughly on the basis of life expectancy, conditions of
service, etc. Using these groups it is possible to find the rate of
composite depreciation—a figure which serves as a check over the group
depreciation. This is also sometimes called the “mean life” of the
plant. It is determined by two methods—one called the direct, the other
the dollar-year method. Assuming groups of assets of varying life
lengths and costs, the following examples show the manner of estimating
the amount of depreciation for the whole plant and also composite life;
that is, the mean average life of the individual assets when viewed not
as units but as a composite whole:

                           MEAN LIFE
                          DIRECT METHOD

    ======+=========+================+==============+=============
    Group |  Life   |    Value       |     Rate     |  Amount of
          |   in    |    to be       |      of      |   Periodic
          | Periods | Depreciated[38]| Depreciation | Depreciation
    ------+---------+----------------+--------------+-------------
       A  |     5   |    $100,000    |     20       |   $20,000
       B  |    10   |      75,000    |     10       |     7,500
       C  |    15   |      60,000    |      6⅔      |     4,000
       D  |    20   |     120,000    |      5       |     6,000
          |         |    --------    |              |  --------
          |         |    $355,000    |              |   $37,500
    ------+---------+----------------+--------------+-------------

[38] That is, cost less salvage.

Mean life is $355,000 ÷ $37,500, or 9⁷/₁₅ periods.

Under the dollar-year method, the invested values are weighted by the
length of their investment term and thus all investments are reduced to
the common basis of one dollar for one year:

                           MEAN LIFE
              DOLLAR-YEAR (OR WEIGHTED RATIO) METHOD

    =====+====+===========+=============+================+============
         |    |  Values   |Turnover Rate|Total Investment|
    Group|Life|   to be   | in Longest  | During Longest |Dollar-Years
         |    |Depreciated| Life-Period |  Life-Period   |
     (a) |(b) |    (c)    |    (d)[39]  |      (e)       |  (f)[40]
    -----+----+-----------+-------------+----------------+------------
       A |  5 | $100,000  |     4       |     $400,000   |  $2,000,000
       B | 10 |   75,000  |     2       |      150,000   |   1,500,000
       C | 15 |   60,000  |     1⅓      |       80,000   |   1,200,000
       D | 20 |  120,000  |     1       |      120,000   |   2,400,000
         |    | --------  |             |     --------   |  ----------
         |    | $355,000  |             |     $750,000   |  $7,100,000
    -----+----+-----------+-------------+----------------+-------------

[39] That is, the number of times renewal of the asset will be required
during the longest life-period of any of the assets.

[40] Dollar-years, column (f), is the product of the total invested
values as shown in column (e), and the life of each group as shown by
column (b). Thus, $400,000 invested for 5 years is the equivalent of
$2,000,000 invested for 1 year.

Column (f) ÷ column (e), (7,100,000 ÷ 750,000 = 9⁷/₁₅) gives the mean
life.

Column (e) ÷ the longest life-period, 20 years, (750,000 ÷ 20 = 37,500)
gives an annual charge for the whole plant.

What is known as “mean” age or plant expectancy as to remaining life
may be found similarly. Assume a physical appraisal made after 12
years’ life of the above assets:

                     MEAN AGE (LIFE EXPECTANCY)
                           DIRECT METHOD
    =====+====+==============+=========+============+===============
         |    | Unexpired or |Condition|Values to be| Values Already
    Group|Life|Remainder Life|    %    |Depreciated |  Depreciated
     (a) |(b) |     (c)      | (d)[41] |    (e)     |      (f)
    -----+----+--------------+---------+------------+---------------
       A |  5 |       3      |    60   |  $100,000  |    $40,000
       B | 10 |       8      |    80   |    75,000  |     15,000
       C | 15 |       3      |    20   |    60,000  |     48,000
       D | 20 |       8      |    40   |   120,000  |     72,000
         |    |              |         |  --------  |   --------
         |    |              |         |  $355,000  |   $175,000
    -----+----+--------------+---------+------------+---------------

[41] (d) = (c) ÷ (b).

Group A assets, having been twice renewed, would be in 60% condition;
Group B, 80%; Group C, 20%; and Group D, 40%.

Column (f) ÷ column (e), (175,000 ÷ 355,000 = 49²¹/₇₁%) gives the per
cent of composite depreciation already taken effect.

The mean life, as determined above, multiplied by per cent of composite
depreciation gives the mean age or portion of the mean life already
lived (9⁷/₁₅ × 49²¹/₇₁% = 4⅔).

The figure of mean or composite life may serve two purposes. First, it
forms the basis for comparison with other similar plants and is about
the only fair basis for comparison. Second, it gives the basis for
estimating the amount of annual depreciation of the plant as a whole.
This statement does not mean that individual depreciation reserves are
not to be carried for each group of assets and those charged with the
value of the asset as soon as it is discarded and renewed. But the use
of the estimated mean or composite life figure does give a control
over the amounts which should always be found in the individual group
reserve accounts, i.e., at any given time the sum of the individual
reserve account balances should be approximately equal to the amount as
shown by the reserve when calculated on the mean life basis.

The Reserve as an Index of Financial Condition

The statement is often made that a balance sheet showing depreciation
reserves points to a conservative policy in the treatment of plant
properties. Usually such a balance sheet affords little or no basis for
expressing a judgment as to conservatism or the lack of it. All that it
does show is that recognition is made of the _fact_ of depreciation.
As to its _adequacy_ or _inadequacy_, a knowledge of other factors is
necessary.

_Fluctuating Reserve._ According to successive balance sheets a
reserve may vary little from year to year, or it may show considerable
increase or decrease, and any of these conditions may be entirely
normal and express adequacy of reserve requirements. In the first case,
stability of the reserve may result because the asset is short-lived
and hence is more or less frequently replaced; or different units of
the property may have been installed at somewhat regular intervals so
that retirements from service are also somewhat regular. Under either
supposition, the charges against the reserve for the units displaced
would just about keep pace with the regular credits to reserve for
replacement purposes. In other words, that condition of the reserve for
that class of asset is the normal condition—except perhaps in the case
of a rapidly expanding plant, or other conditions not counted as normal
when the reserve requirements were put into operation—and any other
condition should lead to inquiry and investigation.

_Increasing Reserve._ In the second case where the reserve is showing
a considerable increase from year to year, that also may be a normal
condition. Long-lived assets are seldom replaced with any degree of
regularity in the annual charge against the reserve, except in the case
of very large plants where the number of such assets is correspondingly
large in proportion to their size. Here more or less regular
installations may take place as a result of an expanding business,
covering a period of approximately the same length as that of the life
of the asset. So here, too, any other than a regularly increasing
reserve must incite inquiry.

_Decreasing Reserve._ As to the third case, that of a somewhat
regularly decreasing reserve, the condition is not usually normal but
may occasionally be met in a plant where one type of equipment is being
retired and not replaced, due perhaps to a changing line of activity;
as when, for instance, a stock furniture manufacturer works gradually
into the exclusive manufacture of automobile and carriage bodies.
Some types of equipment will thus be gradually retired and their
reserves will constantly diminish, their place being taken by other
reserves covering the new type of equipment. However, this condition of
decreasing reserves, while entirely normal under certain circumstances,
being unusual, should always receive careful investigation. It is here
that mean life and mean age or composite plant depreciation are of
assistance in forming a judgment as to the general adequacy of reserves.

The Reserve in Relation to Expanding Plant

In the case of a plant the development of which is stationary, the
problem of judging the adequacy of the reserves is simple in comparison
with a plant which is expanding, resulting not only in the installation
of more of the same kind of equipment but also of equipment of other
kinds. A disturbing element is thus introduced and careful oversight of
the depreciation policy must be exercised. In all cases, intelligent
reading of the reserve and its sufficiency are internal problems based
on intimate knowledge of conditions. Lacking this knowledge no true
judgment can be made. The character of the asset, number of units in
use, dates of installation, a comparison of the assumed conditions at
date of installation with the actual conditions of the present—all are
factors to be taken into account.

Reserve as Related to Efficiency

The general relation of efficiency to depreciation has already been
discussed. As to whether the condition of the reserve is any index of
the efficiency of the service rendered by the plant unit, attention is
briefly directed to a misinterpretation of individual reserves. Experts
state that many types of equipment cannot deteriorate actually more
than a fixed per cent of their cost and continue to give efficient
service. If, say, 30% is the limit in the case of one type, this does
not, of course, indicate that, as soon as the depreciation reserve
shows an amount equal to 30% of the cost, the approach of inefficient
operation and the time of discard are at hand. It must be borne in
mind that the reserve is a device based on financial considerations
and, if properly calculated and handled, no asset should be ready for
retirement until its reserve approaches in amount the value at which
the asset is carried in its account. Nor is the point of approaching
inefficiency shown until that condition of the reserve is found.

Reserve not Based on Cost of Replacement

The question is sometimes raised as to whether reserve requirements
should be based on original cost or cost of replacement new. The
question usually reveals a lack of understanding both of the purpose
of the depreciation charge and the means of financing depreciation.
It is usually said that the reserves carried on the books are for the
purpose of providing the means of financing the replacement. It is
not the purpose here to go into the question of original cost versus
cost of reproduction new, either as a basis for valuation of public
utility properties or from the viewpoint as to where the incidence of
the burden of replacement properly should rest—whether on the users of
the service given by the asset to be replaced or on those using the new
asset. In the private enterprise where the rights of the public are
not so apparent, under present-day tenets of political and economic
philosophy, only internal policies and purposes to be accomplished need
be considered.

As stated above, the basic purpose of the creation of the reserve is
to burden the product with depreciation charge as a real part of the
cost of production. If we are concerned with real and actual costs of
production, by no stretch of the imagination can replacement cost—what
it might cost to replace the asset at some more or less distant
time—enter into the question. It might, with equal obscurity of logic,
be said that, because the labor cost is bound to be higher 10 years
from now than at present, in order to get the true _present_ cost of
the product the estimated future labor cost should be taken in place of
the actual present cost.

The Financing of Replacements

If one purpose of the depreciation reserve is that of financing
depreciation, this can mean only that the reserve must insure provision
being made so that the capital invested will not be lessened or
encroached upon by the wasting of the assets in which it is invested.
It is no necessary or proper purpose of the reserve to provide for
increasing the invested capital. _Financing_ the _replacement_ of
the retired asset is a separate financial problem and only concerns
accountancy, so far as the records may reflect that policy. The
reserve, in itself, does not furnish the means of financing any part
of replacement, as was fully shown above. If the new asset is expected
to cost more than the old, certainly business prudence would dictate
provision for the added cost as well as ready funds of an amount equal
to the original cost. The actual capital provided originally need be
sufficient only for the time being; to provide more than that, if
remaining idle, would be folly. If there is evidence of expansion,
or if it is recognized that more will be needed—due to change in
markets—for replacement purposes than was originally needed at the
inception of the enterprise, provision must be made therefor.

_Methods of Financing Replacements._ In the financing of replacements,
three courses are open:

    1. Capital stock may be increased.
    2. Funds may be borrowed.
    3. Profits of the past may be reserved in the business
       and the actual value of the holdings of the owners
       thus be enhanced.

In the third case present dividends may be sacrificed for the sake of
the future. Such reserve profits must be kept and used for the intended
purpose, the purpose dictating their form as liquid or fixed. It cannot
be too strongly emphasized that these are reserves of _profits_—not
valuation or offset accounts under the title of reserves. Depreciation
reserves, except they become secret reserves in the sense referred to
below, have no right to serve any other purpose than that intended,
viz., to provide insurance that none of the originally invested capital
shall be dissipated and that the current product shall be burdened with
its just share of _all_ the materials and costs of production.

Secret Reserve

A great deal has been said about inaccuracies in the depreciation
charge; the need of periodic readjustments has been emphasized. Now it
is purposed to look into the effects of inaccurate charges remaining
unadjusted on the books. In a desire to be on the safe side, some
concerns, notably financial institutions, make very liberal provision
for depreciation. Such a policy is not entirely to be condemned and is
decidedly refreshing in comparison with the parsimonious allowances,
begrudgingly made in some quarters. The effect of such a policy,
if operated without check, is to create what is known as a “secret
reserve.” The value of the asset is charged more rapidly against
operation than the asset actually wastes. Hence the books show a
reserve sufficient to cover the cost of asset while there are still
values remaining in the asset. In other words, the business possesses
an asset of value which is carried on the books as of no value. Were
the real present value of the asset brought on the books, the contra
credit would appear in some surplus or _profits_ reserved account. Such
would constitute a true record of the item, openly stated. So long as
the asset remains concealed, i.e., without record on the books, its
contra credit is also latent and constitutes a _secret_ reserve of
profits.

A too liberal depreciation policy, if recognized and adjusted at the
time of a reappraisal, will require a separation from the depreciation
reserve of the portion brought about by the overallowance, and its
showing as a part of the surplus. When so handled, an overcharge for
depreciation has no permanently bad effect except as it may show, for
purposes of comparison, too high costs of production for the period
overburdened. However it may be and sometimes is, used for purposes
of fraud and therefore, as a fixed policy, the practice of the secret
reserve is to be condemned.

Insufficient Charge

On the other side is the parsimonious policy of too low a charge or
none at all. This results, whether consciously or not, in a charge
against capital instead of revenue. At the close of the fiscal period
the books are supposed to be brought into accord with the facts of
true condition as then existing. Therefore, if the full portion of the
accrued expenses is not separated from the wasting asset accounts,
but is allowed to stand on the books under the title of assets, then
these true expense items will still be carried hidden under the cloak
of asset titles. The depreciation is thus carried as a charge against
capital. The depreciation of a _going_ concern should never be so
treated; it is an operating charge, and no flight of fancy or shuffling
of figures can make anything else of it.

In the case of a property, showing inflated values because of too
low depreciation charges in the past, which is taken over and
rehabilitated, the sums spent on the property previous to operation to
put it in condition are properly capital charges. This is allowed on
the theory—unfortunately, not always a fact—that the difference between
the book value of the property and what was paid for it represents
the estimated expenditures necessary to bring the property up to its
book value. If such is not the case and full book value was given for
the property, the charge is still allowed, being looked upon as in the
nature of an organization expense, representing in an instance of this
sort the measure of the bad bargain made. This will, of course, result
in a penalty in the form of an added depreciation burden on all product
from the property taken over and rehabilitated.

Appreciation as an Offset to Depreciation

If depreciation is so inevitable and the necessity of its charge so
absolute, can anything be said in support of the proposal to offset
depreciation against appreciation? By appreciation is meant an increase
in value due to the passing of time. Judicial authority can be found
in support of it in cases of valuation for rate purposes.[42] There
is no question but that a _realized_ increment in land or any other
asset offsets a depreciation or any other expense charge in just the
same way that any other item of income offsets an expense. There is,
however, this marked difference between depreciation and appreciation:
the former is an inexorable reality advancing day by day entirely
independent of market fluctuations, whereas the latter is dependent on
the market and usually cannot be realized until the asset is sold.

[42] See Consolidated Gas Co. v. City of New York, 157 Fed. Rep. 855,
and 20 I. C. C. Rep. 344.

When, however, as is too often the case, the proposal to offset
depreciation by appreciation is meant to justify a policy which takes
no cognizance of depreciation on the books because it is offset by
appreciation, no support can be found for that view. In itself it
reveals an entire lack of knowledge of the purpose of the depreciation
charge or a disregard of the fundamental and obvious requirements of
prudence. Depreciation is one of the costs of production and without it
true cost cannot be shown. Failure to show depreciation on the books
would justify also the omission of a cash income item because the cash
was to be spent immediately in payment of salaries—a cancellation
outside the business records of income against expense which can under
no circumstances be justified.

Appreciation Due to Physical Changes

There is a kind of appreciation which is not dependent on fluctuations
of the market and which as surely accrues, up to a certain point, day
by day as does depreciation. Properties the value of which has been
enhanced by earth construction work done on them are susceptible of
this kind of appreciation. “Appreciation is generally restricted to
physical items, and measures their gain in value due to age, use, and
properly directed labor.... It results from work not specifically
charged to capital account ... and covers items not represented ... in
connection with a valuation.”[43] It is found in connection with such
items as roadbeds, solidification and grassing of slopes, drainage,
dams, embankments, etc.

[43] Valuation Committee of the American Society of Civil Engineers.

Its two forms are called solidification and seasoning, and adaptation.
By the first is meant a settling and compacting of loose earth and
its protection from wasting and washing away, as by the grassing of
slopes, and the planting of trees and shrubs to hold the snows. When
a roadbed is turned over to the operating division, it frequently is
far from complete in the sense of being in a high state of efficiency,
and the cost of its maintenance and up-keep during the early years of
its life is much higher than during later years. This appreciation due
to seasoning is difficult of valuation, but perhaps the difference in
up-keep between early and later years is the best measure of it.

Appreciation Due to Adaptation to Use

“Adaptation” is a term used to cover that class of expenditures
needed for the better adaptation of the property to its use. In the
early stages of the development of a property many things cannot be
foreseen nor can a proper basis be settled upon for a determination
of the charges as between capital and revenue. The proper handling
of such expenditures as those incurred for drainage requirements,
better adaptation of the roadway to the surrounding topography of the
country, etc., are difficult. If these costs have not originally been
charged against capital, the properties may truly be said to have
appreciated in value by reason of them. Items of this kind require a
wise discrimination between costs of operation and capital charges.
The effect of such changes is almost always lost sight of so far
as physical appearance shows, and the appreciation due to them is
difficult of valuation at a later time. In the case of railroads,
perhaps the difference in maintenance cost as between the early and
later years of the roadbed is the best index.

In the case of industrial concerns, the cost of a rearrangement of
machinery and working facilities for the better and more economical
handling of the product frequently results in an appreciation in value
due to adaptation to use. This has already been discussed in Chapter V.

As stated above, appreciation has judicial sanction and its valuation,
although fraught with many difficulties and uncertainties, has been
made and the results accepted. The generally haphazard method of
roughly estimating the value of an appreciation when its determination
becomes necessary suggests that it were better, by far, to attempt
the proper segregation of the charge between capital and revenue
at the time of its incurrence, rather than to take cognizance of
an appreciation in value at a later time. There are undoubtedly
circumstances in which appreciation in value can be properly recognized
and should be taken into the accounts not only of public utility
properties but also of industrial concerns.

Unearned Increment

Appreciation in value due to so-called unearned increment is entirely
a matter of market value. By this is not meant that the monetary value
of this kind of appreciation fluctuates with the market; it accrues
from day to day and is just as real as depreciation. Although very
real, it does not become _realized_ until the property is disposed of,
a thing which is determined by business policy and does not rest on
any principles of accountancy. It is not good practice to bring such
unrealized values on the books. For a fuller consideration of this
phase of the subject, see Chapter XVII where the problem is treated in
connection with land and real estate.

Depreciation Policy and Stockholders

A final consideration concerns the relation of the depreciation policy
to the stockholder. As stated above, a too liberal depreciation
policy results in the creation of secret reserves which may be used
to the prejudice of the stockholder by an unscrupulous managing
clique desirous of buying minority holdings at a depreciated value or
of manipulating the stock for speculative purposes. An insufficient
depreciation allowance results in a false optimism, a payment of
dividends out of capital, and perhaps finally in a wrecking of the
property. Except for the transient, speculative shareholder, a fixed
depreciation policy based on a conservatively accurate allowance is
always for the best interest of the property and its owners.

CHAPTER XII

CASH AND MERCANTILE CREDITS

Introduction

In Chapter V an effort was made to establish the general principles
of valuation as applicable to the main classes of assets found on
the average balance sheet. In doing so, the fundamental distinctions
between capital and revenue charges were set forth. In the six
chapters on depreciation the general principles of depreciation and
their application to problems in accounting have been developed, with
particular emphasis on the problems of valuation and true costs. It
is purposed now to consider in detail the various problems met in the
valuation of the individual items found on the commercial balance
sheet. It will be necessary also to consider the method of showing
these items so as to indicate the basis of valuation and something of
the financial policy employed. The various assets will be considered
in the order of their appearance on the balance sheet, the arrangement
being based on degree of liquidity, beginning with the most liquid.

What Cash Includes

There is little to be said about the _valuation_ of an asset of such
evident and definite value as cash. The problem here is rather one
of showing the nature of the asset, although certain principles of
valuation under given conditions need also to be considered.

The term cash as an item in the balance sheet usually includes all
money and whatever serves as money. Thus, all legal tender of the
realm, bank notes, checks, bankers’ drafts, postal and express money
orders, and occasionally postage stamps and even “IOU’s” are classed
as cash. Not all items, however, that may be carried on the books as
cash should appear under this caption on the balance sheet. There only
the current asset cash should be listed in the group of current assets.
All other cash, including that held for specific purposes under deed
of trust or otherwise, should, unless it is readily applicable for the
cancellation of current liabilities, be shown in some other group.

Where the petty cash or working funds of all sorts are operated on the
imprest system, the funds should be replenished before the books are
closed and should thus be truly valued at their ledger figures. The
bank account should be reconciled with the cash book, and the figure
should represent the amount at which the item is to be taken into the
balance sheet. This means, of course, that all properly authorized
claims against cash in bank are to be treated as cash disbursed if
they have been regularly issued, whether presented for redemption at
the bank or not. Checks written but not yet mailed are not usually
treated as cash disbursed because they are still under control.
Similarly, items left at the bank for collection and deposit may be
counted as cash on hand. If, however, as might happen in exceptional
cases, a comparatively large amount represented dishonored items and a
second attempt was being made to collect these dishonored items, the
better procedure would be to omit them from the cash total and include
them with the receivable items. In this connection attention should
be called to the practice occasionally met with of holding the cash
open for a few days after the closing date for the purpose of making
a better showing as to balance on hand by means of new collections.
This, of course, is a practice which cannot be countenanced under
any circumstances as it is simply an effort to mislead, even though
the effect may not always be bad. A balance sheet is a statement of
financial condition purporting to be true as on a certain named date.
The values shown therein are therefore to be those applicable to, and
true on, that date and no other.

Stamps Remitted as Cash

Some concerns dealing in commodities of small value sold through the
mails allow, and even encourage, payment by means of postage stamps,
these in turn being used for their own correspondence and parcels post
expense. The proper place to record the value of this item at the close
of the fiscal period is in the inventory of office supplies or other
similar heading instead of treating it as a part of the cash. This
necessitates a transfer from cash to office supplies. The transfer can
be accomplished in either of two ways without interfering with the
usual handling of the cash whereby it is checked against the bank’s
record of deposits and checks as explained in Volume I, Chapter XXXV.
The customary method is to use the cash book as the place of record for
the receipt of stamps and then transfer them to the stamp drawer for
office use. All other “cash” being deposited in the bank, the record
of cash receipts as shown by the cash book does not thus check against
the record of deposits as shown by the bank. To secure this agreement,
a check may be made out payable to “Cash,” “Ourselves,” or “Postage,”
and passed through the bank periodically as a deposit and so secure
the proper agreement between the bank’s record and the concern’s. The
record of the check among the cash disbursements thus secures the
proper charge to Postage or Office Supplies and also effects the proper
agreement between the bank’s record and the concern’s. The use of a
“postage” journal, operated on the same lines as the cash book and
recording all receipts and disbursements of postage, would accomplish
the same purpose and in some circumstances would be advisable.

Temporary Cash Disbursements

The practice of allowing proprietor, cashier, or others to take
cash from the cash drawer and leave a memo of some sort to show
responsibility or purpose is to be deprecated. Only where the principle
is strictly adhered to of depositing all cash and disbursing only by
check and by means of a petty cash fund handled under the imprest
method, can adequate control over cash even be approximated. Where,
however, such is not the practice, the problem is not that of the
valuation of cash, for the memos are not cash, but of the valuation of
claims receivable—a subject to be treated later in this chapter.

Disposition of Cash Funds

In the showing of cash for purposes of management, it is essential to
indicate the present disposition made of the various cash funds or to
show the immediacy of the control over them. Thus cash should be listed
as:

    1. Safe or drawer
    2. Various working funds
    3. Petty cash fund
    4. Bank

Under “Bank” should be indicated how much is held on “current” account
and how much is restricted to special purposes. Of the current balance
it is desirable to show the portion subject to check for immediate
needs and the portion representing surplus funds not immediately needed
and therefore held to earn interest. These amounts subject to interest
are almost always available on short notice, but usually only with the
sacrifice of interest earnings to date.

Cash from the sale of capital stock or bond issues, or from the sale
of old plant or any portion of it, under authorization from the
stockholders that it be held for purchase or construction of new
plant, or for other capital purposes, comprises that held for specific
purposes. Sometimes even cash in the sinking funds might be included
in the list. As it is usually of importance to keep the management
informed as to the amounts of cash available for the various purposes
stated above, an effort should be made to give this information,
without too much detail, in the balance sheet if it is drawn up for
internal use.

Cash Held Abroad

There remains to consider moneys held in a foreign branch and thus
subject to fluctuations of exchange. In Chapter XXXI, where the subject
of the foreign branch is treated, a full discussion of the problem of
exchange in its relation to the accounting records will be given. Here
it is sufficient to say that as between countries where exchange rates
vary little, the general practice is to use an arbitrary conversion
figure for incorporating the results of the foreign branch with those
of the head office. This conversion figure applies to cash as well
as to all other items. The use of such an arbitrary basis will give
substantially correct results under the conditions named.

The assets of the foreign branch are the properties, usually and for
the most part, of proprietors and stockholders residing in the country
of the home office, who are concerned merely with the distribution of
the earnings of the foreign branch. Profits are made in one currency
to be distributed as dividends in another currency. Hence, the rate
of exchange prevailing at the time of closing the books would usually
give the most accurate results and should, of course, be used when
exchange is not fairly stable between the two countries. It may even
be conservative and advisable to set up a reserve for fluctuations in
exchange, with the object of absorbing what might otherwise be too
great a charge or credit to the current period’s profit and loss if a
particularly unfavorable or favorable rate were prevailing on the date
of conversion.

Accounts and Notes Receivable

In the valuation of accounts and notes receivable the problem is
largely one of appraising the uncollectible items. The book account
and note are intermediate stages in the conversion of merchandise into
cash. Were they always worth their face value there would usually be
no problem in their valuation except for the element of theoretical
interest which is not commonly taken into account by commercial
enterprises. In considering this problem of valuation, the question
of the correct use of terms arises. For the sake of clearness, when
showing the items on the balance sheet, attention will be first
directed to this latter phase of the subject.

Objection to the Title, Accounts Receivable

The governing principle here is that only current items can be included
in this group of assets when shown on the balance sheet. In accounting,
as in economics, there is no distinctive scientific terminology. The
economist makes use, for the most part, of every-day words and phrases.
These are often open to misunderstanding and are sometimes capable
of being used even for wilful misrepresentation. Recognition of this
fact has made necessary a more careful definition of some terms. In
the language of the street, almost any claim against outsiders may be
spoken of as an “account receivable.” The term is thus so broad as not
only to include current claims against customers in regular course
of trade, and accrued income, such as rents, commissions, interest,
dividends, etc., earned but not yet received, but also to serve as a
cloak covering many other kinds of claims and deposits. Among these may
be enumerated:

    1. Cash deposited to cover breakage or damage to
       equipment in use, to guarantee the payment of
       prospective expense, or to guarantee good faith
       in the performance of a contract.
    2. Moneys advanced to subsidiaries, salesmen, and other
       employees on account of expenses and salaries.
    3. Claims against creditors for returned or damaged
       goods, against railroads for lost or damaged
       goods, and against governments for rebates,
       drawbacks, and the like.
    4. Prepayments on purchase or expense contracts, as
       payments made to bind a bargain or before
       delivery of goods; and expenses paid in advance,
       such as royalties, rents, interest, etc.
    5. Unpaid calls or instalments on stock subscription
       contracts.
    6. Claims against absconding officers for property
       appropriated or trusts violated.

It is necessary, therefore, to employ a term of more definite meaning
which cannot be misused. The word “Customer” is sometimes used and is
not objectionable. However, the term “Trade Debtors” is more generally
employed and will be so used here as denoting all claims against
customers, clients, etc., in regular course of business. Its appearance
in a balance sheet is usually evidence of a careful discrimination
among the various classes of claims and is not therefore a misleading
term.

Risk from Credit Losses

As stated above, the chief problem in valuing accounts and notes
receivable is that of estimating bad debts. It is a matter of general
experience that some of those to whom credit is extended do not pay
their bills. Hence, at the close of the fiscal period it is necessary,
so as not to overstate the asset, to estimate the amount which
probably cannot be collected. The necessity for this is recognized in
a decision of the United States Supreme Court in Providence Rubber Co.
v. Goodyear, 9 Wall. 788, and has the sanction of conservative business
policy.

The effect of such an estimate is that the period in which the sale is
effected is made to stand the loss, and not the one in which failure to
secure collection is experienced. There is a close relationship between
the actual loss from bad debts and the credit policy of a concern.
Where the sales force is allowed to grant credit, the loss from bad
debts is almost invariably large. Where the extension of credit is
controlled by a credit department, the loss is less than in the other
case but depends on thoroughness of information and investigation
of the risk. However much care may be exercised, there will be
nevertheless some loss, but a live credit supervision should keep the
loss at a minimum.

Risk and Length of Credit Period

The amount of loss, or rather the percentage of loss, is not the same
for different lines of business nor even for different concerns in
the same line. The normal credit period for a particular business has
some relation to the loss. Thus if credit supervision and collection
effort are the same for two concerns, the one with the shorter credit
period will usually have the smaller loss. In a business, for example,
where the credit term is 60 days, we would expect fewer uncollectible
accounts than in one whose credit period extends for a year or more. As
between two concerns in the same line of business, _where conditions
are fairly uniform_, however, there should be little variation in the
loss from bad debts. As pointed out in Volume I, Chapter XXXVI, the
sales discount policy is for the most part a device for overcoming the
element of risk in the extension of credit.

Analysis of Customers’ Accounts as the Basis for Estimate of Bad Debts

In estimating the amount of bad debts, experience within the particular
business is the only safe guide. Oftentimes, however, the manager or
proprietor is not the most competent person for the task. The auditor,
in consultation with the manager, may often arrive at a better estimate
than could someone closely connected with the business. In making the
estimate, it is an aid to analyze the accounts according to the length
of time they are past due. Thus, there would be, after analysis, the
amount of those overdue not more than 30 days, the amount of those
overdue not more than 60 days, the amount of the 60 to 90 days overdue
items, those 90 days to six months, those six months to a year, and
all those more than a year overdue. The total amount outstanding minus
the sum of these overdue classes represents the portion not yet due.
Some part of the not-yet-due portion is, of course, still subject to
discount if paid within the discount term. With the claims against
customers thus analyzed, a much better basis is afforded for testing
the adequacy of the provision for bad debts. The various methods of
estimating this provision are discussed on page 219.

It may here be noted that when making up the estimate of bad debts it
is by no means always necessary to analyze the outstanding items as
suggested above. Such an analysis is of value in three cases:

    1. In the case of a new concern where there is no past
       experience on which to base the estimate.
    2. In the case of an outsider—a professional auditor
       or other party—being called upon to make the
       estimate.
    3. Periodically, in any business, as a check on the
       work of the collection department.

The value of the analysis in cases (1) and (2) is based on the
principle that the longer an item is overdue, the greater is its
likelihood of proving uncollectible. The need of an increasing rate
for the different classes as analyzed above is apparent. In case (3)
its value lies in the fact that it reveals the general effect of the
collection policy and incidentally points out any change in policy.
Any additional factors which may have wrought a change in the general
financial situation must, of course, be taken into account.

Basis of Estimate of Bad Debts

Three methods of making an estimate of bad debts are found, in all of
which a percentage of some given base is used. The various bases are
respectively:

    1. The amount of outstanding trade debt at the time
       of the balance sheet.
    2. The amount of sales on credit made during the
       present fiscal period.
    3. The total sales, both cash and credit, for the present
       period.

_Trade Debtors as the Basis._ The use of trade debtors as a base is
obvious because it represents the uncollected charges from which alone
can any loss from bad debts arise. The use of such a base seems correct
in principle. This is so in cases where a balance sheet is made up
only once a year, so that conditions as to the periodicity of the
sales are practically the same from year to year. The amount of loss
from uncollectible items is then somewhat nearly proportional to the
amount of claims outstanding at the close of the fiscal year. But where
it is necessary to make the estimate monthly, or oftener than once a
year, it is very probable that at some of the intermediate periods
the amount of outstanding claims will bear no logical relation to
the loss from bad debts. Thus, in the garment industry the sales for
practically the whole year are made within a few months, and during the
other months the processes of manufacture and collection are carried
on. For these reasons the amount of bad debts is not proportional to
the outstanding claims at the end of each month, nor does such a base
properly allocate the losses to the periods in which the sales are
made. Accordingly one of the two other methods previously mentioned is
used.

_Sales as the Basis._ Inasmuch as there cannot be any loss from bad
debts in the cash sales, theoretically the credit sales provide the
proper base for making the estimate. Practically, total sales, either
gross or net, furnish the base most frequently employed because the
total is always available without the necessity for analysis. So long
as the ratio of the two kinds of sales remains fairly constant, the
loss from bad debts does bear a direct relation to total sales.

_Summary._ It may be said with respect to the use of trade debtors as a
base, that it gives satisfactory results where conditions are uniform
from period to period. In its use, however, cognizance must be taken
of any change in the credit policy of the business whereby the term
of credit is shortened or lengthened as that in itself would tend to
change the ratio of the base to the estimated loss from uncollectible
items. As between credit and total sales, theory favors the former but
practical considerations the latter. If for any reason the ratio of
cash to credit sales should change, the change would have to be taken
into consideration when making a comparison between periods of the
loss from bad debts. No justification can be found for a fourth method
sometimes met with, which makes the provision for bad debts bear some
relation to the net profits—large if profits are large, and small or
none if profits are small.

In handling the estimate of bad debts on the books, the same
considerations are to be observed as in booking depreciation. Care
must be exercised not to allow the reserve to grow beyond liberally
estimated requirements and so create a secret reserve, nor to fall
below such requirements. This must be watched closely and, if need be,
the rate changed to accomplish the desired result.

Discounts and Collection Costs

In connection with the valuation of trade debtors, the problem
of collection costs and cash discounts must be considered. Some
authorities connect these costs directly with sales and make provision
for them in the valuation of the current trade debtors; i.e., an
estimate of the cost of collecting the outstanding claims and of the
probable amount of loss from discounts on the amounts outstanding is
deducted by means of reserves from trade debtors and so shown on the
balance sheet. Where such a practice is followed, strict consistency
would require that a similar credit provision be made for discounts on
purchases—a practice not often advocated. The weight of opinion is in
favor of taking all such costs and credits into account only when they
are actually met. This accords with the treatment of these items as
financial management items (explained in Volume I, Chapter XXXVI) and
as therefore bearing no direct relation to sales. If, however, unusual
costs of this or any other kind are anticipated, prudence demands that
provision, by means of reserves, be made for them. Usually the costs
average up pretty well from period to period.

Valuation of Other Receivable Items on Open Account

The problem of valuing the other classes of receivable items previously
mentioned on page 215, does not differ in the main from that of trade
debtors just discussed. If they are worth their face value they should
be so shown. If worth less, the necessary valuation reserves should be
set up. With these items the _chief_ problem, however, is their proper
showing on the balance sheet; i.e., their correct classification and
a suitable nomenclature. Most of the items are not strictly current,
but even their inclusion under this head is not misleading if they
are carefully earmarked to show their true nature. Some of them are
decidedly fixed, some are in no sense assets. In some cases even trade
debtor balances as carried on the books are not strictly current.
In concerns where sales are made on an instalment basis, usually
the payments extend over several months and oftentimes years. The
customer is charged with the whole amount and credited with the regular
instalment payments as made. The portion of the outstanding balance
covered by the more remote payments is thus not current. In concerns
where both regular and instalment sales take place, a separation of
the customers’ balances on the basis of the sales contract gives the
necessary information for balance sheet purposes. The accounts of
instalment trade debtors normally require a much more liberal valuation
reserve than those of regular credit customers.

Loss on Notes Receivable

In some cases the expected loss because of uncollectible notes may be
less than that from open accounts, due to the greater formality of
the note as an instrument of credit and the probably greater loss of
credit to the maker in case of dishonor. However, in making provision
for bad debts, the practice is almost universal to class the two
receivable items together. Such practice is undoubtedly sound. In the
case of notes, the request for payment is more forceable because of the
definitely stated due date and the loss of standing if unpaid after
such date. In some cases the payment of notes is not pressed, nor is
any extraordinary provision made for past-due items—as in industries
allied with farming when an unusually bad season makes impossible the
payment of notes given by farmers. Again, the practice is sometimes
made of taking notes for a long overdue, open account. These have
usually no better value than the accounts and must be treated
accordingly.

The usual method of handling overdue notes receivable is given in
Volume I, Chapter XXXVIII. As there stated, where payment is allowed
to lapse, it is generally advisable to insist on the giving of new
notes in place of the old. There may be circumstances in which this is
not advisable, but the proper method will usually be apparent in each
case.

Interest on Notes Receivable

The valuation of notes receivable—using the term to include all
written promises to pay, i.e., promissory notes, accepted drafts, and
the like, requires a consideration of interest. By far the larger
number of notes given in trade are non-interest bearing and are not
therefore worth their face value until they become due. The interest
problem in the valuation of notes is thus whether the notes should
be shown at their face value or present, i.e., discounted, value.
Notes which are interest bearing from their date of issue are, of
course, worth their face, on the assumption that the interest takes
care of the discount. Where non-interest bearing notes form a very
considerable item it is well to value them on a discounted basis; if
their amount is small, theoretical principles of valuation give place
to practical considerations and they may be valued at their face. Where
notes bearing interest are valued on a discounted basis, care must
be exercised not to include the interest accrued both in their face
valuation and also under the head of accrued income.

Balance Sheet Titles for Notes Receivable

The problem of terminology is also met in handling notes receivable.
Under the balance sheet caption “Notes Receivable” should usually be
included only notes received from trade debtors, and certainly it
should never represent any but current asset items. Notes received from
officers and employees, of indefinite term and the payment of which
will not be pressed, should be recorded under some such title as “Notes
Receivable Special.” Long-term notes and those representing loans or
advances of any sort should be properly earmarked, as should also loans
carried on open account, salary overdrafts, and the like. The latter
should be shown under Deferred Charges. These nicer points of valuation
cannot be presented on a condensed balance sheet, but care should at
all times be taken to make such a showing as will not be misleading and
will serve the purpose for which the statement is to be used.

CHAPTER XIII

MERCHANDISE STOCK-IN-TRADE

Definition and Scope of Term

Stock-in-trade, as the term is usually understood, comprises all
commodities purchased for resale. Thus, assets, which in one concern
belong to the fixed asset group, may be the stock-in-trade of other
concerns. In stating the principles of valuation for these assets, it
is definitely to be understood that they apply only to such as are
used as stock-in-trade, and not to the same items when used as fixed
assets. Oftentimes the process of manufacture intervenes between the
purchase of a commodity and its sale. In such a case the commodity, at
the time of valuation, may be in different stages of completion. It is
then usually so listed on the balance sheet under suitable titles, such
as Raw Material, Goods in Process, and Finished Goods, all of which
are treated as current assets. Included in the problem of valuation
of stock-in-trade is the treatment of goods out on consignment, goods
of others held for sale on a commission basis, and scrap material.
Finally, some points to be observed in taking the physical inventory
will be considered.

Valuation at Market or Cost Price

Inasmuch as stock-in-trade is purchased solely for resale or ultimate
conversion into cash, it is desirable for the balance sheet to reflect
the proper value of what remains on hand unsold. Such goods may have a
realizable value higher or lower than cost value, from the standpoint
of the market in which they were purchased, and will usually have a
higher value in the market where they are to be sold. The value of all
current assets to be shown on balance sheet is usually stated at the
present realizable value. As applied to stock-in-trade, that must not
be understood to mean sale or retail value. To value the stock-in-trade
on such a basis would result in taking into the current period the
profits on sales not effected until the next period; furthermore,
these profits would not even be offset by the costs of making the
sale. It may be laid down as a principle of business practice based
on sound reason, that the period in which the sale is made should
be given credit for it. Stock-in-trade must therefore be valued on
the basis of its purchase or wholesale market price and according to
well-established practice, either at cost or market, whichever is
the lower. This principle has the support of conservative practice
throughout the world.

Objections to Valuation at Less than Cost

The effect of valuing the stock-in-trade at a lower market than cost is
to bring into the period’s results a loss which may never be realized,
either because the change in the purchase market may not be reflected
in the sale market, or because, if so reflected, the market may swing
back before actual sale of the stock is made. If valuation is to be
at the market when that is lower than cost, consistency would seem
to demand that, when the market is higher than cost at the time of
preparing the balance sheet, market value should be used and the profit
occasioned thereby be credited to the current period. The answer to
this argument is that operation would thus be placed on a speculative
basis.

Again, it is sometimes argued that good buying is just as essential to
profit-making as good selling. Accordingly, the purchasing department,
with the foresight to buy in a favorable market, should receive the
credit for it; if conditions are reversed, it should bear the blame,
i.e., the loss. In other words, the period in which the purchase effort
is expended should be credited or charged with the gain or the loss
brought about by a favorable or unfavorable condition of the current
market as compared with its condition at the time the purchase was made.

Anticipation of Profits or Losses Undesirable

In answer to these various contentions, it may be stated that though
good buying is an essential factor in profit-making, no refinement of
logic can obscure the obvious fact that goods are bought to be sold and
that no profit arises until the sale takes place. All effort before
the sale, whether directed towards good buying, careful storing and
display, the placing of advertising, or the selection of a sales force,
will come to naught unless sales are made. It would seem, therefore,
that potential profit or loss on any or all effort preliminary to the
actual sale has no place in the current record. From the standpoint
of the profit and loss statement, this conclusion as to the policy
of valuation of stock-in-trade at cost can be stated without fear
of contradiction. In support of this is a direction of the Treasury
Department in connection with the federal income tax returns. This
reads, as revised in October, 1916: “In case the annual gain or loss is
determined by inventory, merchandise must be inventoried at the cost
price, as any loss in salable value will ultimately be reflected in the
sales during the year when the goods are disposed of.”

From the viewpoint of the balance sheet, objection is sometimes
raised—and supported by conservative practice and legal requirement as
indicated above—that a balance sheet showing stock-in-trade at cost may
thus very obviously under-or over-value the item, a situation not at
all desirable. In this discussion, the whole problem of valuation is
being treated from the point of view always of a going concern and not
of one facing dissolution and the forced sale of its properties. Under
these circumstances, such a balance sheet must frequently be used as
the basis for asking credit, and credit extended on inflated values of
current assets is not properly extended.

Method of Treatment and Summary

To meet this situation, particularly in the case of large fluctuations
in the market, the true status of affairs is disclosed by appending
to the balance sheet a footnote in which is stated the present market
value of the inventory. Without this information, oftentimes, when the
market is showing steadily rising values, as much harm and financial
ruin may result through the extension of insufficient credit, as
under other conditions might arise from an ill-advised inflation of
credit. Sometimes the present market value is indicated by setting up
a reserve out of _profits_, called “Reserve for Market Fluctuations in
Merchandise”—or other similar title—when the market is lower than cost.
This method retains the inventory on the books at cost value and so
does not burden the current profit and loss, although it does lessen
the amount of profits available for dividend distribution. Without
doubt the policy is good in cases of extreme and somewhat permanent
changes in the market.

To sum up, therefore, the valuation formula of cost or market,
whichever is the lower, while based on conservatism may unnecessarily
and improperly burden the current income account. Valuation at cost, on
the other hand, while placing the profit or the loss in the period when
realized may cause the balance sheet to present an entirely inadequate
and even misleading story as the basis for credit. To remedy this,
three courses are open, viz.:

    1. Carry the market valuation, whether more or less
       than cost, in a footnote to the balance sheet.
    2. In case market value is less than cost, set up a reserve
       out of profits equal in amount to the difference.
    3. Carry in an inner column in the body of the balance
       sheet the present market value.

It would seem, therefore, that valuation at cost with the present
market value shown on the face of the balance sheet, is the most
desirable practice from every viewpoint.

Depreciation of Stock-in-Trade

Quite apart from this discussion of the proper basis for valuation,
which concerns itself with marketable merchandise, is the problem of
the method of handling deterioration or depreciation of stock-in-trade
as distinguished from fluctuations in value. Such deterioration may
result from shelf wear, use of goods for display purposes, changes in
style and shape, overstocking which causes an accumulation of goods
which soon are out of date or of sizes and qualities seldom used,
broken lots where such will injure the sale value, and so on. Many
devices, such as the “spiff” or the offer of a premium to salesmen,
are employed by up-to-date merchants to keep their stocks free from
these items of deterioration; but in spite of all that can be done, it
usually proves impossible to keep the stock live in every particular.
A valuation at cost under these circumstances would be an obvious
inflation of values. If the concern had purchased that quality of goods
originally with the expectation of resale, valuation at cost, under the
limitations suggested above, would be the correct basis for showing.
Since, however, such is not usually the case, the proper basis of
valuation is now the market price—the present price at which goods of
similar kinds and qualities can be bought.

It may be objected that the effect here also is unduly to burden the
current period with unrealized losses, but this is not the case.
The deterioration in value is a very real loss which is entirely
independent of any fluctuations in the market. If goods are shelf-and
window-worn from display usage, the deterioration is just as much an
expense incurred for advertising as a display advertisement in a daily
paper. The deterioration due to overstocking is a penalty which the
current period should bear because of its poor buying effort or its
inadequate sales efficiency. Thus, valuation of the inventory of any
stock of goods must have regard to the effect of its present condition
on its marketability. Any deterioration which renders the stock less
salable is an expense to be borne by the present period and not the
period in which the sale is made.

Full Costs of Stock-in-Trade

Cost having been established as the basis for valuing a stock of
marketable merchandise, there must next be considered the elements
of cost and their application to different classes of goods. By cost
of goods is meant full cost, i.e., not only invoice price but all
additional costs, needed to place them ready for sale. All costs,
therefore, up to the point where goods are ready to create income are
proper charges against the stock-in-trade. Customary costs of this
kind are freight, drayage, insurance during transit and storage, duty,
seasoning or aging costs, warehouse charges, and all similar items. The
information as to these costs is usually recorded separately, but at a
summary period they are loaded on the invoice cost of stock-in-trade.

In connection with this question of the proper composition of
cost, attention is called to two other items sometimes requiring
consideration. The first deals with the handling of cash discounts. The
point at issue is as to whether the invoice figure should be recorded
at the price quoted on a cash basis or on a credit basis. This point
is discussed at length in Chapter XXXVI of the first volume where the
conclusion reached is that the _credit_ policy of each concern must
govern the manner of making the record. If the concern has a fixed
policy of buying at a cash price, that price should be the price of
record; whereas if all financial and other related policies are based
on a 30-or 60-day credit term, the credit price for that term should
be the price of record. Particularly is this true when viewed from
the sales standpoint where the fixing of the selling price is a part
of the financial policy. The second point requiring consideration in
connection with cost is the item of interest on the money invested in
stock. At the close of the fiscal period should the stock sold and
that left on hand be burdened with interest on the average amount of
capital tied up in it during the period? The student is referred to
Chapter XXVI of this book, where a full presentation of the case for
and against the inclusion of interest is made.

The Distribution of Costs Over Stock-in-Trade

It should be said that, due to the particular method of handling
purchasing, delivery, and storage, it frequently is not practicable
to take cognizance of all items which theoretically are constituents
of cost. Each concern must establish a policy relative thereto and
hold to it. Having done this, it is faced at inventory time with the
problem of determining the cost figure applicable to each unit of
the stock remaining unsold. Certain of the costs, such as freight
and cartage, have probably been incurred by different lots of
miscellaneous merchandise, and to distribute the proper charges to each
unit comprising the lot is difficult. Usually a certain percentage
sufficient to cover that particular item of cost is spread evenly
over all units remaining on hand. Occasionally, especially where the
stock is homogeneous and only a few varieties are dealt in, an effort
is made to prorate these costs on a more accurate basis. In loading
on the freight cost, for example, a combined weight and value record
might bemused or, where possible, the official freight tariff might
govern. Such minute accuracy is not often needed or desirable, the flat
percentage rate on value giving in most cases sufficiently correct
results.

The Pricing of the Inventory

A rule-of-thumb method of valuation requires that the purchase price
as carried on the last invoice of the article shall be used for
pricing the inventory. This usually proves a good working rule, but
often raises perplexing problems and is subject to abuse and misuse.
If several purchases have been made during the period at different
prices, should the last price paid govern the valuation of the portion
unsold? The argument for so doing is that the portions unsold probably
belong to the last lot purchased, good merchandising requiring that
the old stock be sold out before the new is brought forward. That, of
course, is not always the case. If it is made an inflexible rule that
the price of the last lot bought shall be the price of the inventory,
a dangerous tool is placed in the hands of the unscrupulous. A manager
needing or desiring to make a better showing of profits might in this
way make an insignificant purchase at a high price near the end of the
fiscal period and so secure a much higher valuation than the cost for
the whole inventory. Where the inventory is likely to contain remnants
of the various lots purchased during the period, or where the condition
as to an insignificant final purchase may exist, the policy of using an
average price for the inventory will be more accurate in its results.
The weighted average, whereby each purchase price is weighted with the
volume or quantities purchased, is fairer, though more complicated
than the straight average. Thus 10 units bought at $100 per unit, 15
at $90, and 3 at $110, would give a straight average of $100 but a
weighted average of $95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3).
In manufacturing establishments where the fiscal period is short,
say one month, and it is desirable to keep the raw material cost as
nearly uniform as possible, the method of the weighted average is to be
recommended.

As mentioned above, each concern must fix its own policy as to what
items shall be included in the cost of goods purchased. Whatever that
policy may be, care must be exercised to make sure that the same
items and no others form part of the value of the inventory. In the
case of any doubtful items, instead of trusting to memory, a house
classification of accounts or an accounting guide book should be drawn
up so as to secure from period to period a similar handling of all
items.

Valuation of Manufacturing Inventory

The whole of the foregoing discussion concerns the valuation of goods
bought for resale, i.e., the inventory of a trading business. Some
points in the application of the same principles to a manufacturing
concern will now be considered.

_Finished Goods._ So far as finished goods are concerned, the principle
of valuation at cost applies. What constitutes the cost of manufacture
was discussed in Chapter III, from which it is evident that many other
elements in addition to those which must be considered in a trading
concern must be taken into account. The manufacturing cost formula
comprises the three items of: (1) raw material consumed, (2) direct
labor applied, and (3) factory expenses incurred, this latter item
sometimes called overhead expenses. When a concern operates a detailed
cost system, the valuation of the finished product is not difficult,
being the goal towards which the system works. Where no cost system
is used, great care must be exercised to make sure that every item of
cost is calculated as accurately as possible and that a proportionate
share of such costs is applied to the finished product still on hand
unsold. It is sometimes urged that instead of this cost-to-manufacture
price, the price at which the article could be bought on the open
market should govern; or, alternatively, that the article should be
valued at least sufficiently above cost to give a theoretical profit to
the factory. Just as in the case of the discussion of “cost or market
price” for the trading concern, the same conclusion is reached here,
viz., that cost should govern, because while good manufacturing is
an element in profit-making, yet no profit is made until the sale is
effected. It is true that if cost to manufacture is lower than cost to
buy in the open market, a real _saving_ has been made by the policy
of manufacturing rather than of buying, but a saving is quite another
thing from a profit. This differentiation between a saving and a profit
will be fully discussed presently. Correct accounting, therefore,
requires a valuation of finished goods at cost to manufacture.

_Raw Material._ The valuation of the inventory or raw material is on
the same basis as that of a stock of goods bought for resale, i.e.,
raw material is to be valued at full cost up to the point of its
consumption.

_Goods in Process._ The valuation of partially completed goods, i.e.,
“goods in process,” is a much more difficult problem. To simplify
the discussion these will be divided into two groups, first, goods
manufactured for stock, and secondly, those made on a specific contract
or for special order. To the first group the principle of cost applies
without any qualification. The problem involved is that of determining
what has constituted cost up to that particular stage of completion.
Where a detailed cost system is in use and a production schedule forms
part of the system, it is possible at almost any moment to ascertain
exactly the values accumulated on any article at each stage or process
of manufacture. Where definite costs are not possible, a careful
estimate based on full knowledge of conditions is the best that can be
done. Where parts are first manufactured for assembly into a completed
whole, they should be treated as finished goods and valued at full cost
up to that point.

_Contracts._ The second group of goods in process, viz., those
manufactured to fill specific orders, or, in large construction work,
contracts taken but not completed, may be valued on a somewhat
different basis from that applicable to the first group. Here a sale
has actually taken place and only the intervention of the closing of
the books raises the question of valuation. In a case of this sort it
is customary to make a careful estimate of the costs of the work or
contract, up to its present state, due weight being given to remaining
costs necessary to complete it and to any provision for possible
contingencies. When handled in this way, the estimated profit on the
work already done is said to be applicable to the current period and is
therefore taken into account. In other words, the portion completed is
treated as sold, after making the provisions indicated above, and is
charged off the books against a corresponding part of the sale price.
Hence, the valuation involved here does not concern the inventory, but
the cost of goods sold.

It may be objected that, in the case of large contracts, perhaps
running over a period of years, many unforeseen things may happen
to wipe out any seeming profits on the completed portion, and that
conservatism would demand that no profits be taken until the contract
is completed or in a sufficiently advanced stage as to be reasonably
sure of results. In such a case it frequently happens, however,
that not only are stockholders impatient of delay, but very serious
injustice may result to any who might be forced to give up their
holdings before the completion of the contract. Moreover, a fair
method of making payment on the contract is usually in force, the sale
price often being on the basis of units of work accomplished, so that
the contingencies giving rise to the objection mentioned are greatly
minimized. Thus, some contracts may be on a fixed price per cubic yard
of earth removed, per unit of goods manufactured, or other similar
basis for periodic payment, a certain per cent being retained as a
guarantee for the satisfactory completion of the whole. Again, where
the price is for a lump sum, engineers representing the contracting
parties may agree on the amount completed and periodical payment may be
made on that basis.

This topic of uncompleted contracts will come up again for treatment
when considering the profit and loss summary for the year. It is
sufficient to note here that some share of the profit on the completed
portion of a contract may be taken as indicated above, in which case
the inventory problem may be disposed of either by adding the amount of
estimated profit to the cost value of the uncompleted contract, or by
treating the payments made as sales.

Contracts and Length of Cost Period

In some lines of business, orders are booked several months ahead of
delivery date, the factory operations depending somewhat closely on
the contracts entered into. During the period of manufacture there
may be few deliveries of the product, and therefore no actual profit.
Obviously, the easiest method of handling such a situation is to make
the fiscal period long enough to include the greater part of the
deliveries, and so leave the inventory comparatively free of goods in
process. Where this method is adopted, there is no serious objection
to valuing the goods still in process at the close of the period so as
to take a fair portion of the profit, although conservative practice
usually values them at cost. The difference in the amount of profit
under the two methods is insignificant under the condition named. Under
other conditions valuation at cost is the rule.

Valuation of Scrap

Raw materials are never completely used up in manufacture; portions
too small for the main product, corners, odd-shaped pieces, defective
pieces, etc., are usually thrown into scrap. This scrap is frequently
utilized in the manufacture of side lines if a market can be developed;
otherwise it may be valueless. The problem of the valuation not only of
the scrap but of any product that may be made from it presents some
interesting features. If the entire cost of the raw material is charged
to the main product, the scrap material used in the side line costs
nothing, and to charge anything for it, either on the basis of cost or
some arbitrary estimate, would result in inflation. Furthermore, the
cost figures of a side line which is not charged for material might
at some time be made the basis for a bid on a contract too large to
be filled entirely out of scrap material, and so result in a loss. On
the other hand, if the main product is charged only for the material
actually consumed, and the side line is compelled to bear the cost
value of the material it consumes, the cost of the side line may so
increase that it cannot be marketed at a profit. The lowered cost
of the main product might lead, in the face of keen competition, to
the cutting of its price below real cost, unless, of course, all the
scrap is being utilized in the side line which is also being sold at
a profit. If such is the case, the valuation of the main product, the
side line, and the scrap should be on a cost basis. This is not usually
the case, however. No basis for valuation can be found which will prove
entirely satisfactory under all circumstances.

In the light of the conditions involved, particularly as to whether
there is a constant market for the utilization of all the scrap
material in the manufacture of the side line, each concern must
adopt whatever policy best suits its peculiar needs. At all times
the application of materials costs to the product should provide an
intelligent basis for entering into future contracts. A _blind_ use of
cost figures frequently invites disaster. In cases where scrap is not
utilized in a side line, it has only scrap value. The thing to guard
against is the double charge for the same material, i.e., a charge to
the main product and also to the side line, resulting in an inflation
of values.

Inventory-Taking

There remains, as a corollary to the problem of valuation, a
consideration of the method of taking the inventory, for if the count
is wrong the most careful valuation per unit will not give true total
value. In connection with the count of the inventory, two fundamental
rules must be observed. These are: (1) make sure that everything, i.e.,
all stock-in-trade, belonging to the business is included; and (2) be
careful that there is no duplication of count nor inclusion of any
stock belonging to others.

In accordance with the first fundamental rule, care should be exercised
to include all goods out for sale in other markets—these to be valued
at full cost in those markets—and all goods not yet received into stock
but belonging to the business. These latter include goods invoiced but
not received, and goods received but not unloaded prior to the close of
the period.

In accordance with the second fundamental rule, any goods of others
held for sale on a commission basis must be carefully excluded from
the count, as should also goods received before the close of the
period but with invoices dated some time in the future. Furthermore,
all goods inventoried from their invoices, i.e., all goods not taken
into stock, must be earmarked so as not to be charged into the next
period’s purchases. This is best accomplished by stamping the invoices
as “Included in the 19.... Inventory.”

_Inventory Methods._ The careful organization of the physical stock to
be inventoried, sorting any misplaced items, and separating them into
classes, and an equally careful organization of the clerical force,
acting under explicit directions based on a well-thought-out plan,
are fundamentally essential to accuracy and to the prevention of any
duplication of count. In some cases the use of duplicate or coupon tags
proves very valuable. On these tags provision is made for recording
in duplicate the number of units and condition as to salability, and
they are ruled with two money columns. The tags are numbered on both
parts consecutively and are charged out to the various departments,
as many being issued as there are classes or compartments of goods. As
the count is made of a certain class of goods, a tag is attached to the
compartment or other storage place as evidence that the count has been
made, after which the lower portion is torn off and sent to the office.
Any missing numbers indicate omissions in the count. If the card
has been lost, the duplicate still attached to its compartment will
indicate the count. After all cards are accounted for, the duplicates
are detached and the goods covered by them are then released for sale
or other use. In taking the inventory it is especially important that
where goods are below normal as to salability, their estimated per cent
of normal condition be noted on the tag. This gives a basis for valuing
and should show the amount of deterioration and its cause.

Perpetual Inventory

The use of a perpetual inventory system is quite general in some
lines. Its operation requires almost as careful a record of stock as
is made of cash, i.e., not only must all receipts be recorded but all
disbursements as well. In a trading concern this record usually takes
the form of a stock book of some sort, to which entry is made, as to
quantities only, from the purchase and sales invoices, the balance
shown at any time being the stock remaining on hand. The application
of the unit value gives the value of the entire stock and so makes
possible monthly statements of approximate condition. In a factory, a
separate stores ledger may be operated, carrying an account with every
kind of material used. This ledger is controlled by the Raw Material
or Stores account on the general ledger. Entry to the stores ledger
accounts is made from the purchase invoices for receipts, and from
formal requisitions drawn on the stores-keeper for disbursements, i.e.,
for the issuance of material. The stores ledger may record not only
quantities but also values, so that its balance should be the value of
the stores on hand. This is possible because the material is drawn out
at cost price.

Oftentimes, for retail concerns, instead of the stock book method, the
percentage method of book inventories described in Volume I, page 506,
gives more satisfactory results when sufficient past experience can be
drawn from.

_Necessity of Physical Count._ It must not be assumed that a perpetual
inventory system obviates the necessity of taking a physical inventory,
for it does not. All that it accomplishes is to secure a closer
supervision over stock between inventory times and to make possible the
showing of approximate results at interim periods. Where operated, it
is possible to take the physical inventory piecemeal, although there
is a marked advantage in taking a complete inventory periodically. The
piecemeal method means that any department can do its stock-taking
during a slack time without regard to the time when other departments
take theirs. Thus there is less interference with the regular conduct
of business. It must be borne in mind, however, that the physical
inventory is just as essential as ever because of the many inaccuracies
that tend to creep into the perpetual inventory system, and furthermore
because of loss, theft, over-measure, and so on, which throw the book
record out of agreement with the actual count.

CHAPTER XIV

TEMPORARY INVESTMENTS; ACCRUED AND DEFERRED ITEMS

TEMPORARY INVESTMENTS

Nature of Temporary Investments

The next item to be considered for valuation in the current assets
section of the balance sheet is temporary investments. These are
assets, such as stocks and bonds of ready marketability, in which
current funds are tied up temporarily. Investments in stocks and bonds
for purposes of securing business connections and privileges essential
to the most efficient conduct of the business do not belong to this
category. The term usually covers only those assets representing the
investment of temporarily surplus cash or those acquired in settlement
with debtors with the expectation of early realization. As A. L.
Dickinson[44] so well says, “such investments have no relation whatever
to the business and can be disposed of without in any way interfering
with its earning capacity, other than the loss of the dividends
thereon.”

[44] In “Accounting Practice and Procedure.”

In the case of concerns affected by seasonal changes in volume of
business, there are periods when sums of surplus cash lie unemployed,
unless the concern depends upon borrowed money to take care of seasonal
increases. Business policy, therefore, demands that the surplus cash
be put where it will earn something. Such investments are frequently
of a somewhat speculative character. In fact, other things being
equal, business acumen demands that the investment be made in those
securities in which there is a chance of gain in addition to the
regular income therefrom. It cannot be stated too strongly, however,
that safety, freedom from great fluctuations, and ready marketability
are always prime essentials to be observed in securing stocks and bonds
for temporary investment. While the procedure is unusual, there may at
times be circumstances under which such investments may be bought on a
margin basis.

Valuation of Temporary Investments

The usual rule for valuing temporary investments at the time of drawing
up a balance sheet is at cost or market, whichever is the lower.
Inasmuch as they may be needed on short notice, the information desired
is what they will be likely to realize. This is particularly true
in the case of a concern with a rapidly expanding market, for which
provision may need to be made by increasing the plant as well as the
working assets. Where reserved profits have become tied up in fixed
plant, the need for ready funds is apparent.

It may be argued that inasmuch as realizable value is the information
desired, valuation at market, whether lower or higher than cost, is the
only proper basis. The rule stated is, however, held to be the correct
one from the standpoint of conservatism and the further fundamental
objection to bringing unrealized profits into the current period, as
would result from a market valuation higher than cost. Of course, a
lower valuation than cost brings unrealized loss into the period’s
operations, but this is not regarded with the same disfavor. Where
the market price is fluctuating from day to day, as is normally the
case, the market valuation on the date of the balance sheet is perhaps
no nearer to the amount that will be actually realized than the cost
value, since cost value merely represents one of the many changing
points in the market. If a distinct market tendency in one direction or
the other were likely to continue until the time of realization on the
investments, there might be good reason for taking the profit or loss
accrued to the date of the balance sheet. However, these considerations
are of too speculative and uncertain a character to be given any weight.

There is some valid objection, on theoretical grounds at least, to
the results of the period being affected by the unrealized profits
or losses caused by taking the market valuation of temporary
investments onto the balance sheet. Valuation at cost, with a
footnote to show market value, gives all the information essential to
a full understanding of the exact condition of the investment. The
habit of adding footnotes to the balance sheet may, however, become
objectionable and the practice is to be avoided wherever possible.
Also, really essential information usually carries greater weight when
incorporated in the balance sheet figures.

Reserve for Investment Fluctuations

To meet the foregoing objection and, at the same time, that of allowing
unrealized items to affect the period’s profit and loss, use may be
made of an account called, say, “Reserve for Investment Fluctuations.”
The account should be operated in the same way as the Reserve for
Market Valuation of Merchandise discussed in the preceding chapter.
That is, if market is lower than cost, at the close of a fiscal period,
surplus is charged and the reserve credited for the difference. On the
balance sheet the reserve is treated as an offset to the investment
account carried at cost. This incorporates the market valuation as a
significant figure of the balance sheet and shows the cost for purposes
of information. The charge to surplus avoids fluctuation in the current
profit and loss results because of an unrealized item and so makes
it more useful for comparative purposes. In case market is higher
than cost, the difference is charged to the asset and credited to
the reserve. On the balance sheet, cost is thus the effective figure
and the market price is given for informational purposes. When the
investment is sold, the entry creating the reserve should be reversed
in either case. This brings on the books in the period when the sale
takes place, the actual profit or loss realized, being the difference
between cost and sale prices. The adjusting entries on account of
valuation do not thus permanently affect surplus, while the actual
profit or loss reaches surplus in the usual way—a valuable desideratum.

“Stock Rights” on Investments

It may occasionally happen that while stocks are held for purposes of
temporary investment, stock rights arise. Such a “right” is a privilege
of subscription to a new issue of stock, granted holders of stock
on a certain date, at a rate below the market quotation of the old
stock. The stock records are closed temporarily to any transfers of
stock in order to determine those entitled to these rights. Up to the
date of closing the records, the market value of the stock carries an
increased value to cover the value of the rights belonging to it, and
the stock is quoted “rights-on.” After this date the rights are dealt
in separately and quoted separately on the exchange. Stock then sells
“ex-rights.” Should the end of the fiscal period of a concern holding
stocks subject to rights fall after their issue, the stock and rights
may be booked separately, though often shown together.

An illustration will show the theoretical method of valuation of
rights. Take a corporation whose stock now sells at 125, issuing the
right to subscribe at par for additional stock to the extent of 10% of
present holdings. The case of a stockholder with fifty shares would
work out as follows:

    50 shares at $125         $6,250.00
     5   ”    at  100            500.00
    --                        ---------
    55   ”    at a cost of    $6,750.00

The average cost of one share is $122.73. Based on the former quotation
of $125, the right is seen to be worth theoretically the difference, or
$2.27. The quoted market price will usually be less.

Cost of Investments

In connection with the cost of temporary investments it may be well
to point out that cost means full cost to the purchaser, including
brokerage and other costs in connection with the purchase or subsequent
thereto. If the investment is being carried on margin, the customary
practice is to charge to the investment account the interest on the
funds borrowed by the broker to finance the transaction and to credit
thereto any dividends or interest received. The difference between
the asset account kept with the investment and the liability account
with the broker thus shows at any time the original equity in the
investment. A credit to the investment account when the stocks are
sold develops the net profit or loss on the entire transaction. There
may be circumstances under which it will be desirable to separate from
the asset account all charges and credits subsequent to the original
purchase, carrying them in a suitable expense and income account.

Valuation of Bonds

In the case where bonds are held for temporary investment, purchased
either at a premium or discount, it is not customary to take account
of amortization, because the investment is temporary. The problem
of amortization is postponed to Chapter XV, in which permanent or
long-term investments are treated.

In brokerage firms, where stocks and bonds comprise the stock-in-trade,
the same principle of valuation applies as with a merchandise stock
except that the rule of valuation at cost or market, whichever is the
lower, is applied to each _individual_ holding. In this way, decreases
in the value of one stock are not offset by increases in the value
of others as would be the case if total market and cost values for
the entire lot were first determined and then the valuation formula
applied. In this chapter the principle of valuation of stocks and bonds
as stock-in-trade is mentioned only by way of contrast.

Valuation of Unissued Stock

Under the head of temporary investments, the company’s unissued and
treasury stocks or bonds are sometimes included. Such unissued stocks
or bonds manifestly represent an inflation of asset values, offset, it
is true, by an equal inflation of capital stock. In the first place,
conceding for the sake of argument that the inclusion of unissued
stocks among the assets is legitimate, the principle of equilibrium
requires that they be valued at par on the balance sheet, a figure
which is not cost and which may be very far from market. Again,
the company’s unissued stocks may be in no sense current assets.
Furthermore, stocks which have never been issued have no owners and
so can command no proprietorship in the enterprise. The most that can
be said about them is that they are contingent assets, showing that
certain legal formalities have been met which authorize their issue if
so desired. The remaining necessary procedure, viz., that the stock be
placed on the market and sold, is, however, the condition which must
be met to create a real asset and to create proprietorship. Until that
has been done there is neither proprietorship nor asset. Reference
to Volume I, Chapter XLIX, where the various methods of opening the
books of a corporation are illustrated, will show that the method to
be preferred is one which eliminates the account Unissued Stock from
the books. However, where it is set up, correct classification would
seem to require that it be treated as of the nature of a valuation or
offset account for capital stock. In other words, the two accounts,
Capital Stock and Unissued Capital Stock, must be read together to show
the true status of the proprietorship stockholdings. The correct method
of presentation on the balance sheet is here only indicated but will be
illustrated in Chapter XXI where the problem of valuation of capital
stock is treated.

Valuation of Treasury Stock

The case against the inclusion of treasury stock in temporary
investments is not quite so apparent, but equally convincing upon
examination. Treasury stock differs from unissued stock only in that it
has once been issued but has, through various channels, found its way
back into the possession and control of the company. While outstanding
in the hands of stockholders and under their individual control, the
increased stock proprietorship is reflected in increased assets. If
the stock comes back into the treasury through donation, the decrease
in proprietorship stockholdings is compensated by a new proprietorship
element under donated surplus. Thus, while there are not so many shares
outstanding, the value of each is enhanced by a combined or common
proprietorship in donated surplus, which reflects exactly the status
of the treasury stock. Whereas formerly there was individual control
over the stock, now that it is in the treasury, control is common or
combined. Stock proprietorship has been diminished and the balance
sheet should show it by treating Treasury Stock as an offset account
and not as a part of current assets under Temporary Investments.

As to the valuation of treasury stock at some other figure than par,
the same argument holds as in the case of unissued stock. If the
treasury stock has been acquired by purchase on the open market, its
price may be a good and sufficient basis for valuation; but even here
individual ownership and control has been exchanged for common and
combined ownership. The individual stockholdings are decreased, and
the decrease is reflected on the assets by the amount paid for the
stock. It would seem, therefore, that a showing more in accord with
the facts would require treasury stock to be treated as a deduction
from the capital stock authorized. Thus the best practice eliminates a
company’s own stocks from the list of its assets. Where such holdings
are small and insignificant, they may without any serious impropriety
be included among the assets and even under the caption “Temporary
Investment” so long as substantial accuracy obtains.

Summary of Valuation Formula

To sum up, then, the valuation formula for current investments requires
their showing at cost or market, whichever is the lower. The most
satisfactory method of applying the formula is by means of the Reserve
for Investment Fluctuations which makes possible the incorporation of
market value whether lower or higher than cost, with the differences
between market and cost carried in the reserve account. Thus the
conservatism of the valuation formula is made effective and at the
same time information is given as to the present market values of the
investment.

ACCRUED AND DEFERRED ITEMS

Nature of Accrued Income

Income derived from many different sources is never fully received at
the close of the fiscal period. For instance, of the sales made many
will still be outstanding as charges to various customers; interest
will have accrued on notes receivable and on investments held; rental
income is earned day by day but is received only periodically;
royalties based on the use of some machine or process are accumulating
where the device or process is being used but settlement is made
only periodically; and dividends on stocks or other investments may
have been declared during the current period but are not payable and
therefore will not be received until the next period.

Inadequacy of Cash Method of Handling Accruals

All these accrued items give rise to claims which must find expression
in the accounts either currently or ultimately. In the case of sales
of merchandise the customary practice is to set up the claim on the
books when the sale is made. In the case of the other items usually
no record is made until the income is actually received. Under this
method—called the cash method—it is evident that the true income cannot
be shown in the period in which it is earned and that the period in
which it is received secures the credit for it. This means not only
that the current period may at its beginning receive credit for items
of income mostly earned during an earlier period, but at its end it
will be deprived of similar earnings accruing from day to day up to its
close but not credited because their time of payment overlaps into the
next period. This method is defended as being substantially correct on
the principle of averages, i.e., those earnings which do not entirely
belong to the current period but for which credit is taken will in
the long run just about offset the earnings accrued at the end of the
period which are not taken account of.

The statement may be true and, if so, can be easily tested; but,
whether true or not, modern practice requires the _accurate_ accounting
of all claims. It is therefore required that these accrued earnings be
brought onto the books if reliable results are desired.

Correct Method of Handling Accruals

To show all earnings in the period in which they actually accrue is
called the “accrual method.” Under this method the income earned but
not received during the current period is set up among the assets, just
as in the case of sales, with this difference, however: the claim for
the broken portion belonging to this fiscal period need not be recorded
day by day but only at the end of the period. Most income items of
this sort are due, either by contract or by custom, at the end of
certain definite periods. The setting up of a claim for a broken, i.e.,
an uncompleted portion, does not mean that such a claim is on that date
legally enforceable, but that it is a claim equitably belonging to the
current period.

Showing of Accrued Items on Balance Sheet

As to the section of the balance sheet in which these accrued income
items should be shown, usually they are true current assets and should
be so listed. They frequently arise in connection with current assets,
e.g., the interest accruing on notes, stocks, and bonds held, and
are therefore just as current as the assets themselves, or even more
so. Where not so arising, as in the cases of rents, royalties, etc.,
usually the contract or customary period of settlement is so short as
to make the claims under them true current assets. Occasionally the
accrued earning is added to the value of the particular asset and so
shown in the balance sheet. A better practice, because more definite,
is to list them separately under the title, Accrued Income, Accrued
Accounts Receivable, or other similar title.

Valuation of Accrued Items

The principle of valuation of accrued income items is apparent. On the
supposition that the concern will continue in business, the accrued
income is proportioned between the two periods on the basis of the
portion of the time belonging to each period. However, this does not
mean that the portion so taken shall be valued at its face. The accrued
portion is worth as a portion neither more nor less than the whole
is worth as a whole. If there is doubt as to the ability to collect
it when it falls due, certainly the valuation placed on the accrued
portion should express that doubt. In other words, unless the claim is
fully secured by collateral or other pledges, valuation should be on
exactly the same basis as for the other receivable items, such as the
claims against trade debtors, other open accounts receivable, notes
receivable of various kinds, etc.

Accounting for Accrued Income

The accounting for accrued income presents no particular difficulties.
In addition to the two methods discussed in Volume I, pages 116 to 119,
a third which is considerably more laborious than either of them is
frequently employed, and is as follows: At the time of adjusting and
before closing the books, for every item of accrued income a separate
asset account is set up. Thus, for royalties an account, Accrued
Royalties Receivable, would record the claim on account of royalties at
the same time the accrued income from royalties is being recorded in a
suitable income account. Thus there is distinct separation of the asset
and income elements.

From this point two methods are in use for handling the subsequent
record of the item. Under the first method, the income when actually
received or legally due is recorded in the regular income account.
This thus shows an inflated figure because it is not offset by the
portion credited to the previous period, the asset account covering
this, remaining unchanged throughout the current period. At its close,
however, proper adjustment is made by adding to, or subtracting from,
the amount held over from the close of the previous period such an
amount as will make its new balance show the correct amount of accrued
income as at the close of the current period. The contra credit or
debit to the above entry, as the case may be, is of course to the
particular income account, causing it to reflect the true income for
the current period.

Under the second method, the first entries for the new year consist in
transferring all accrued income asset balances to their respective
income accounts, where they serve the purpose of automatically
adjusting the full receipt of income a portion of which was credited in
the previous period, to the amount properly belonging to the current
period. At the close of the period any adjustment on account of accrued
income is handled by debiting the asset account and crediting the
income account exactly as before.

An illustration will show the differences between the two methods.

Illustration of Different Methods of Recording Accrued Items

_Problem._ The royalties income accrued December 31, 1916, amounted to
$5,000. During 1917 payments were received on account of royalties to
the amount of $35,000. On December 31, 1917, accrued royalties were
$5,250.

_Solution—Method 1_

                  ACCRUED ROYALTIES RECEIVABLE
    =======================================================
    1916                       |
    Dec. 31          $5,000.00 |
    1917                       |
    Dec. 31     (A)     250.00 |

                       ROYALTIES INCOME
    =======================================================
                               | 1917
                               |                 $35,000.00
                               | Dec. 31     (A)     250.00

_Method 2_

                  ACCRUED ROYALTIES RECEIVABLE
    =======================================================
    1916                       | 1917
    Dec. 31          $5,000.00 | Jan. 1     (A)   $5,000.00
                     --------- |                  ---------
    1917                       |
    Dec. 31     (B)  $5,250.00 |

                       ROYALTIES INCOME
    =======================================================
    1917                       | 1917
    Jan. 1      (A)  $5,000.00 |                 $35,000.00
                               | Dec. 31     (B)   5,250.00

Of the two methods, the second is somewhat fuller and probably presents
the facts more consistently, although involving a little more book
work. From a practical standpoint where regard is had to the amount
of book work required, the method used in Volume I, pages 116 to 119,
sometimes known as the inventory method, serves all the purposes of
either of the above methods and requires much less work. By it the
above problem would appear as follows:

                          ROYALTIES INCOME
    =============================================================
    1916                          | 1917
    Dec. 31 Accr.       $5,000.00 |                    $35,000.00
    1917                          | Dec. 31 Accr.        5,250.00
    Dec. 31 P. & L.     35,250.00 |
                       $40,250.00 |                    $40,250.00
    ========           ========== | ========           ==========
    1918                          |
    Jan. 1 Accr.        $5,250.00 |

An objection, not at all serious, is that under this last method the
ledger will show, as on the date of the balance sheet, the current
assets in two places, viz., the current assets section and the income
section, instead of altogether as under the other methods. This
objection is more than offset by the saving in clerical labor. There is
in some quarters an all too prevalent tendency to multiply the number
of accounts and increase the bookkeeper’s work without any adequate
return in results.

Prepaid Items—Definitions and Kinds

Closely related to current assets, because through an overexpenditure
of current funds this period a lesser expenditure will be required next
period, is the class of items known as prepaid expenses or deferred
charges to operation. These items are not current in the sense that
they will be turned into cash shortly, but they are analogous in
that a saving in the expenditures of the next period will result.
Because of the ease with which they may be put to improper uses,
it is best to segregate them from current assets under a suitable
balance sheet caption, such as “Deferred Charges to Operation.” Where
the two captions, Current and Working Assets, are shown, items of
this class properly belong to the latter. Under this head will be
considered such items as supplies of all sorts—office, factory, power
house, stable—stationery, printing, postage, repair parts, insurance
unexpired, advertising contracts and material, rent, royalties,
interest and discounts paid in advance, salary overdrafts, premiums
on long-term investments and discounts of long-term obligations, and
sometimes organization expense, although this last item is perhaps best
handled with the intangible assets.

Valuation of Prepaid Items

The purpose in considering these items at the close of a fiscal period
is to secure a proper and accurate allocation of charges as between
the two periods, without which true results as to profit and loss are
not possible. The same argument as to these items averaging up fairly
well between periods applies here as for accrued income. The only
other point to be considered in connection with them is the basis for
their valuation. Realizable values, i.e., what the items would bring
under the hammer or at other forced sale, are manifestly inequitable.
A three-year insurance policy with one year expired is to a concern
which intends to avail itself of the remaining two years’ protection
worth more than the surrender value of the policy calculated on the
short-rate basis with perhaps the expenses of doing business also
subtracted by the insurance company. Evidently to a going concern the
protection enjoyed for the year just expired is worth neither more nor
less than a pro rata share of the entire cost, nor are the remaining
two years’ protection to be valued at a less rate because redeemable at
a less rate.

Hence, a valuation based on the going concern principle is to be used
for deferred charges. As indicated above, this means, when used in this
connection, a pro rata valuation based on the life of the supply and
the portion unused. In the case of tangible supplies the rule can be
most easily applied as a unit cost figure to the unused units still on
hand. That is, an inventory of supplies is taken and valued at full
cost. Although nearly related to current assets, deferred charges are
seldom influenced by market fluctuations after they are once purchased,
because if properly classed as deferred charges they are always held
for own use and never for outside sale.

Danger of Overvaluation

Care must always be exercised—even more than in handling the
stock-in-trade inventory—to see that there is no padding of this class
of items. To this end, before taking inventory, a general clean-up of
supply materials all over the plant is an exceedingly good policy.
This should result in discarding, or reducing to scrap value, all
obsolete and unusable supplies. Without such a clean-up it is easy,
even when motives are of the very best, to carry forward from year to
year as assets supply materials which will never be used and which
are therefore nothing but expense items and should be charged against
operation. Only a careful periodic appraisal of supply materials and an
equally careful inventory indicating their usability can give a correct
basis for applying the valuation formula.

Two or three items of deferred charges need a word of further
explanation. In some mining industries, notably coal and precious
metals, leasing is done on a royalty basis with a minimum amount to be
paid each period based on a minimum production of ore to be mined. If
less than the minimum is mined, a frequent provision in the terms of
the lease makes possible the application of any royalties overpaid one
period against a future production of more than the required minimum.
That is, no increased royalties are charged for a production over the
minimum until all accumulated royalties from periods of underproduction
are used up. In any period of underproduction such royalties may
properly be treated as deferred charges only on condition that there
is reasonable expectation that future production will increase to the
point where it will consume the overpaid royalties of earlier periods.
At times a company finds itself bound to such a contract, based on a
minimum production, without any hope of relief because the prospect
has not developed as anticipated. Under such conditions the entire
periodical royalty charge is a charge against operation and must be
absorbed entirely by the operations of each fiscal period.

Accounting for Deferred Debit and Other Items

The accounting for deferred debit items proceeds along the same lines
indicated for accrued income. Nothing further need here be said than
that such items as insurance, supplies of various sorts, etc., are
frequently recorded originally as asset items instead of as expenses.
At the close of the period so much of each of them as has been used is
transferred to suitably named expense accounts and is thus taken into
profit and loss. There is no objection to this and it usually works out
very satisfactorily, although the usual practice is to treat all items
of this class as expenses rather than as assets. This method is usually
prescribed by regulatory commissions in the case of public utility
companies.

The treatment of premiums paid on long-term investments and of
discounts arising through the marketing of long-term obligations at
a figure below par is reserved for consideration in the next chapter
where their relation to the interest account and the problem of
amortization will be considered.

CHAPTER XV

PERMANENT INVESTMENTS

Nature of Permanent Investments

As distinguished from the type of investment discussed in the
preceding chapter, investments of a more or less permanent character
will next claim our attention. These may be permanent in the sense
that at the date of the balance sheet they have a long term to run
before they mature and the expectation is they will be held for a
considerable period of time; or permanency may be indicated because
ownership of the investment is necessary or, at least, a valuable
requisite to operation. Ease of conversion into cash may or may
not be a characteristic of such investments, and certainly it is
not a determining test for valuation as is the case with temporary
investments, discussed in Chapter XIV.

The necessary test is always the condition in which the company would
be placed, viewed from the standpoint of efficient operation, if the
investment were disposed of. If its efficiency or its contracted or
moral obligations would not be impaired, the investment may be said
to be of a temporary character. Examples were given in the previous
chapter. If, however, its efficiency would be materially affected,
or its continuance as a business be hampered or threatened, then the
investment must be considered as of a permanent character. This latter
type of permanent investment will be discussed first, followed by a
consideration of the long-term securities (bonds, stocks, and land)
held as investments for certain funds (such as the building fund, bond
and redemption fund, etc.).

Permanent Investments as an Aid to Operation

These permanent investments may take the form of ownership of the stock
or bonds of other corporations, as in the case of the holding company.
They may represent interests, active or silent, in partnerships; or
they may take the form of advances of working capital or funds to
other concerns. Whatever the form may be, and whether evidenced by
formal securities, collateral, or merely by open book accounts, they
serve the purpose of securing some essential facility without which
operation could not be successfully carried on. A newspaper may secure
full or controlling interest in a paper mill to insure its supply of
print paper; a railway may become a heavy owner in a terminal company
in order to give it terminal facilities; a refinery may purchase a
controlling interest in an oil production company in order to give it a
sure supply of crude oil; etc. Thus, the permanent or fixed investment
is always a means of bringing about the efficient operation of a
business. It may be effected in any one of three ways, viz.:

    1. By practically full ownership of the subsidiary
       enterprise to secure complete control and so
       direct its policies.
    2. By only a controlling ownership.
    3. Through the agency of advances, particularly when,
       because of poor credit, the usual money markets
       may be closed to the borrowing company.

Valuation of Permanent Investments

The problem of the valuation of investments under the three forms
mentioned presents some interesting features. It might seem that,
inasmuch as the investment is in the nature of a fixed asset, valuation
should always be at full cost; that market fluctuations should have no
effect. The last half of this statement is correct but the first part
needs modification. It is to be expected that a concern in purchasing
the stock of another will not pay more than it considers the stock to
be worth. The price may be more or less than the face value of the
stock, depending upon the existence of an element of good-will or the
overstatement of the assets on the books of the vendee company; or
again, where the stock is bought on the open market many other factors
may cause a variance of purchase price from par value of the stocks.

Were the investment simply an inanimate asset to be used, cost, perhaps
less depreciation, would be the proper basis for valuation. Since,
however, a corporation cannot remain stationary—it must usually record
a gain or a loss from year to year—ownership in that corporation must
accordingly suffer change from year to year. So many things can happen
to an operating corporation that cannot befall an inanimate asset held
for use that the proposal to value both on the same basis is hardly
tenable. Furthermore, if proper principles of valuation are applied
to the subsidiary concern, its true value can be determined with fair
accuracy. Accordingly, a true basis is secured for valuing it as an
investment on the books of the holding company. Any increase in value
over cost is due to the profits made by the subsidiary enterprise, and
in the case of its complete ownership by the holding company these
profits belong in full to the holding corporation. If all the profits
are disbursed as dividends to the holding company, the subsidiary
enterprise suffers no change in condition and therefore no change in
value. If, however, some of the profits are retained, this would result
in an increased value which should be reflected in the valuation of the
subsidiary enterprise on the books of the holding company. How this may
best be shown also requires consideration.

Holding Company and Subsidiary Enterprises

A holding company may have but few assets aside from its holdings in
subsidiary concerns. A balance sheet showing only these few assets and
its investments in the other concerns does not usually give much useful
information. Therefore, as the assets of the subsidiaries belong to
the holding company and really comprise its operating plant, a more
intelligent way of showing the investments of the holding company is
to combine or consolidate the balance sheets of the subsidiaries and
incorporate them in the balance sheet of the holding company in place
of the item of investments. This method is known as the “consolidated
balance sheet” and is given fuller treatment in a subsequent chapter.
Here attention is called to it merely as a device for showing the
valuation of permanent investments represented by substantially full
ownership of the subsidiary companies.

Controlling Investments

Where ownership is not complete but still controlling, the method of
the consolidated balance sheet is not so fully applicable and often
is not used. In this case the investment will appear as such on the
balance sheet with whatever adjustments in value may be necessary due
to the success or failure of the subsidiary’s operation for the past
period. Whatever profits are made enhance its value and in the enhanced
value the controlling company has a pro rata share, the effect of which
should be taken up in the valuation of its investment therein. The net
amount of the enhancement in value is the difference between the net
profit made by the subsidiary concern and that portion paid out in
dividends—in other words, the portion reinvested in the business.

This portion, i.e., such part of it as belongs to the controlling
company, may be taken up directly by charging the investment account
and crediting a proper income account; or the share of the entire net
profit belonging to the controlling company may be charged to the
investment and credited to an income account. In the event of dividends
being paid by the subsidiary company, these would be credited to the
_investment_ account of the controlling company, which account would
then show, as in the first method, the new value due to the profits
reinvested in the business. That this policy of increasing the value of
the investment is conservative and sound is apparent when one considers
that the holding company’s ownership of the subsidiary concern controls
the latter’s policies, including the dividend policy. The profit taken
onto the books of the holding company by the above method is a real,
not a book, profit.

Advances to Subsidiary Concerns

Where control is secured through the medium of advances made on open
account or by means of such advances together with ownership of stocks
and bonds, a valuation must be made of these claims separately from the
stocks owned. Where ownership is complete and valuation is shown by the
consolidated balance sheet method, intercompany accounts and claims
are, of course, eliminated and so do not show. In all cases, however,
where claims against a subsidiary arise on account of advances, or even
of sales, and these must be shown on the balance sheet of the owner of
the claims, more than average care must be taken in placing a value
on them. In the case of advances, frequently their exact status is
not known at the time when made. The record is carried in a suspense
account until its final status is determined, when record is made
accordingly. The advance may be temporary, for the purpose, say, of
enabling the subsidiary concern to take advantage of very favorable
market conditions in the purchase of raw materials, in which case,
of course, the claim is a current asset; or possibly the subsidiary
company is about to make additions to plant and equipment and is
financing the expansion temporarily by means of borrowings from the
parent company. Whatever method of permanent finance is finally settled
upon, this should convert the open-account claim of the parent company
on account of advances, into the regular securities or obligations of
the subsidiary concern. Again, it is unfortunately true that advances
to the subsidiary company often become necessary to recoup it because
of operation at a loss. This may continue with little hope of repayment
for years to come, if ever. The parent company may ultimately lose all
the funds advanced to the subsidiary company because of the latter’s
financial instability.

Rules for Valuation

Because of the many factors involved, it is apparent that no absolute
rule can be laid down for valuing the advances to a subsidiary
enterprise. Each case will require careful investigation and must be
settled on the basis thus established. If the investigation shows
the loan to be temporary with good expectation of its full return,
it should be shown at its face value among the current assets. If
the advance is to be converted into the securities of the subsidiary
concern and the latter is in good condition, the advance may be carried
at par among the fixed assets. When the securities are received they
should be valued as any other permanent stock investments, with due
regard to the basis of conversion in comparison with the value of the
securities given in settlement. If conditions upon examination are
found to be serious, it may be necessary to treat advances made as
expenses, i.e., they are of no realizable value. If the bankruptcy of
the subsidiary concern seems probable, a question of financial policy
and law arises, viz.: whether the interests of the parent company are
best conserved by allowing its claims to remain on open account and so
rank with other creditors, or to be converted into stock and rank with
those of other owners. It may be necessary to take that phase of the
matter into account when determining the value of claims against the
subsidiary concern.

Investments in Partial Holdings

For the sake of business connections, prestige, and good-will,
oftentimes more or less permanent investments are made of such a nature
or in such amounts as not to secure a controlling interest. Here,
because the reins of business control are not held by the investing
company, manifestly such an investment is on a very different basis
from those in companies whose control is held by the investor. In the
one case, business policy can be determined and made effective; in
the other case, success or failure is under the control of others.
Accordingly, the valuation of these partial holdings differs from
investments in companies entirely owned or controlled by the investor.
Where the holdings of these minor interests are not particularly
substantial in comparison with other properties owned, there is no
serious objection to valuing them at cost. They are held to secure
certain benefits, and so long as the real values of the companies
concerned are being maintained or enhanced, there is little probability
of the investment being disposed of. Market fluctuations, therefore,
should be given little or no consideration. Where, however, partial or
minor holdings form a comparatively large portion of the investments,
it may sometimes be wise to value them on the same basis as temporary
investments of a current nature. In this case the profit or loss
attendant upon bringing market values into the books should be handled
as with temporary investments.

Where investments of this kind are shown on the balance sheet at cost,
it is sound policy to call attention in a footnote or otherwise to