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XXIT— 1 

Modern Business 







ij t> ti 

Modern Business 



Dean, New York University School of 
Commerce, Accomits and finance 


Roland P. Falkner 

associate editors 
Leo Greendlinger, Charles W. Hitrd 

Volume Titles Authors 

1. Business and the Man Joseph French Johnson 

2. Economics of Business The Editors 

3. Organization and Control .... Charles W. Gerstenberg 

4. Plant Management Dexter S. Kimball 

5. Marketing and Merchandising . . . The Editors 

6. Advertising Principles Herbert F. de Bower 

7. Salesmanship and Sales Management . John G. Jones 

8. Credit and the Credit Man .... The Editors 

9. Accounting Principles The Editors 

10. Cost Finding Dexter S. Kimball 

11. Corporation Finance William H. Walker 

12. Business Correspondence Harrison Mc Johnston 

13. Advertising Campaigns Mac Martin 

14. Railway Traffic Edwin J. Clapp 

15. Foreign Trade and Shipping .... J. Anton de Haas 

16. Banking Major B. Foster 

17. Domestic and Foreign Exchange . . E. L. Stewart Patterson 

18. Insurance The Editors 

19. Office Management The Editors 

20. The Exchanges and Speculation . . Albert W. Atwood 

21. Accounting Practice and AunrriNG . John T. Madden 

22. Financial and Business Statements . Leo Greendlinger 

23. Investment Edward D. Jones 

24. BusixEss AND the Government . . . Jeremiah W. Jenks 



Secretary and Treasurer, Alexander Hamilton Institute, formerly 

Assistant Professor of Accounting, New York University 

School of Commerce, Accounts and Finance 




COPTRIGHT, 1918, 1919, BY 




The title and contents of this volume as well as the 
business growing out of it, are further protected 
by laws relating to trade marks and unfair trade. 
All rights reserved, including translation into 

Registered trade mark, Reg. V. S. Pat. Off., Marca 
Regiatrada, M. de F. 

Made in U. S. A. 


Twenty-five years ago it was not so important as 
at present for the average executive to be familiar 
with accounting tenninology, or to know how to read 
a financial statement. 

Such terms as capital and revenue expenditures, 
contingency reserves, qualified certification, and the 
like did not mean much to him. The growth of mod- 
ern business has changed all this. The executive of 
toda}^ is expected to have a broader knowledge of 
business than his predecessor of twenty-five years ago. 

To help the executive to read a financial or busi- 
ness statement intelligently ; to help him get a clearer 
insight into business statistics; to help him to under- 
stand how to interpret professional reports, is the mis- 
sion of this book. 

The author has avoided, as much as possible, the 
use of highly technical terms. He has attempted to 
interpret the contents of financial and business state- 
ments rather than to deal with the construction of 
such statements, as that feature is fully covered in 
the volume on "Accounting Practice and Auditing." 

Where the subject matter treated is of a contro- 
versial nature the author has endeavored to give the 
"pros" and "cons," always leaving to the reader the 
freedom of choice. In some cases the reader will find 


that one phase of such subject matter is treated in 
this volume while the other phase may be treated in 
another volume. Thus the question as to whether in- 
terest on capital is a proper charge to cost of produc- 
tion is treated in the affirmative in "Cost Finding," 
while the negative side is treated in this volume. 

As the corporate form of management, tho not 
universal, is far ahead of partnerships and individual 
proprietorships in popularity, financial budgets are 
becoming an important feature of modern busi- 
ness. For that matter, even in the case of sole pro- 
prietorships it is preferable to have the fiscal financial 
plans fully developed and properly arranged in 
budget form than to grope in darkness. So far as 
the author knows, this is the first attempt to put be- 
fore American readers information on the preparation 
of private financial budgets. To help the reader con- 
trast the private business budget with municipal 
budgets, the writer has added information on the 

The author takes this opportunity of thanking Mr. 
J. T. Madden, C.P.A., (N. Y.), Professor of Ac- 
counting at New York University, Dr. R. P. Falk- 
ner, and Mr. F. C. Russell, of the Alexander Hamil- 
ton Institute, for their valuable aid in the preparation 
of this volume. 

Leo Greendlinger. 





1. Present Need for Classified Information ... 1 

2. Classified Information Measures Efficiency . . 2 

3. Business Policies 2 

4. How Outside Factors Affect a Business Organiza- 

tion 3 

5. Financial Statements Classified 4 

6. Statistical Information 4 

7. Departmental Statements 5 

8. Purpose of Financial Statements 6 

9. Prerequisites of the Executive 6 

10. Requisites of Proper Financial Statements . . 7 

11. Financial Statements Should Be Comparative . 7 

12. Importance of the Personal Element .... 8 

13. Consideration of Outside Factors 9 

14. Executive's Reasons for a Study of Financial 

Statements 10 

15. Stockholders' Reasons for a Study of Financial 

Statements 10 

16. Information as a Guide to Legislation ... 11 



1. Purpose and Scope of Business Statistics ... 13 

2. Official and Business Statistics 14 

3. The Contents of Business Statistics .... 15 



4. Uses of Business Statistics 16 

5. How Much Information Should Department Heads 

Be Given? 16 

6. Record of Orders and Sales 17 

7. Inventory and Purchase Records Should Be Avail- 

able 18 

8. Analytical Expense Statements 19 

9. Departmental Profit and Loss Statements ... 19 

10. Results Expressed in Percentages .... 19 

11. Form of Statistical Statements . . . . . 21 

12. Statistical Comparisons 22 

13. Past and Present Performances 22 

14. Results, Year by Year 22 

15. Results, Month by Month 23 

16. Results, Week by Week 23 

17. Results, Day by Day 24 

18. Establishing Standards of Comparison ... 25 

19. The Percentage 26 

20. The Ratio 27 

21. Graphic Statements 28 

22. The Appeal to the Eye 29 

23. Curves 31 

24. Need of Caution in Interpretation .... 34 


1. Schedule of Accounts Receivable 36 

2. Statements of New Customers 37 

3. Importance from Management Standpoint of 

Notes Taken from Customers 38 

4. Schedule of Inventory 38 

6. Production Reports 39 

6. Sales Analysis 39 



7. Expense Schedules 40 

8. Cash Report 41 

9. False Statements 42 

10. Intentional Misrepresentation 43 

11. Incorrect Preparation 44 

12. Preparation of Statements for Executives . . 45 



1. General Divisions of the Income Statement . . 48 

2. Gross Sales or Gross Income 49 

3. Goods on Sale or Return 50 

4. Trade Discount on Sales 50 

5. Price Corrections 51 

6. Sales Returns 51 

7. Prepaid Charges Treated as Sales .... 52 

8. Sales of Scrap or Residuals 52 

9. Percentage Calculations 53 

10. Outward Freight and Cartage 55 

11. Service Liabilities . 55 

12. Instalment Sales 56 

13. Containers Included in Sales Prices . ... 56 

14. Other Items of Miscellaneous Income .... 57 

15. Comparisons of Sales with the Amount of the 

Final Inventory 57 

16. Distinction Between Cost and Expense ... 59 

17. Distinction Between Expenditures and Disburse- 

ments 59 

18. Elements of Cost 60 

19. Treatment of Cash Discounts on Purchases . . 61 

20. Labor . . . . 62 

21. Heat, Light and Power 63 



22. Cost of Manufacture and Cost of Sales Distin- 

guished 64 

23. Percentage Calculations Must Be Made on Correct 

Basis 65 

24. Calculation of the Turnover 66 


STATEMENTS (Contirmed) 

1. Quantity Discounts on Purchases .... 69 

2. Purchase Returns and Allowances 69 

3. Maintenance Charges . .70 

4. Selling Expenses . ' 70 

5. Rebates Allowed to Customers 71 

6. Other Selling Expenses 72 

7. Distribution of Stable and Delivery Expense . . 72 

8. Administrative Expenses 73 

9. Selling Profit and Net Profit from Operation . . 73 

10. Effect on Gross Earnings 74 

11. Operating Expense Is Not Easy to Reduce . . 74 

12. Interpretation of Net Income 75 

13. Other Income and Income Charges .... 76 

14. Treatment of Taxes and Rent 77 

15. Cash Discounts on Sales 77 

16. Insurance Expense 78 

17. Profit and Loss Credits and Charges .... 79 

18. Transfer of Net Profits 80 

19. Deficits 80 

20. Analysis of Surplus Fluctuations 81 


1. Introduction 83 

2. Distinction Between Parent and Holding Compa- 

nies 83 



3. Ownership of the Stock of a Company Does Not 

Mean Ownership of Its Assets 85 

4. Increase in Value Due to Economic Conditions 

Not to Be Recognized 86 

5. A Balance Sheet Should Disclose Financial Condi- 

tion . 87 

6. The Accountant and the Law 87 

7. Accounting Practice and the Law at Variance . 88 

8. Pertinent Facts Which Should Be Shown in Finan- 

cial Statements 89 

9. Statements in Form of Balance Sheets and Income 

Accounts 89 

10. Financial Results Stated by Means of Consolidated 

Statements 90 

11. Consolidation of Statements 91 

12. Factors Not Disclosed Except Thru the Medium 

of Consolidated Statements 92 

13. Division of Profitable Business 92 

14. Dividends Out of Capital May Remain Undisclosed 93 

15. Advances to Subsidiaries 94 

16. Failure to Provide for Operating Losses of Subsid- 

iaries Not Apparent 94 

17. Balance Sheets Should Be Consolidated ... 95 

18. Inter-Compan}^ Transactions 96 

19. Inter-Company Profits on Construction ... 98 



1. Fixed or Capital Assets 100 

2. Real Estate, or Real Property 100 

3. Plant Land Distinguished from Land Held as an 

Investment 101 

4. Valuation of Plant 'Land 101 



5. Land Improvements 101 

6. Land Investment 102 

7. The Treatment of Land as Stock in Trade . . 102 

8. The Valuation of Leaseholds and Leasehold Rights 104 

9. Mineral Land and Timber Property . . . .105 

10. Depreciation or Appreciation of Land . . . 107 

11. Important Points in the Valuation of Buildings 

and Structures 107 

12. Repairs, Renewals, Additions, Betterments and 

Replacements 110 

13. Importance of Segregating the Investment in 

Equipment 110 

14. Machinery and Fixed Tools Ill 

15. The Valuation of Furniture and Fixtures . . . 112 

16. The Principles Employed in the Valuation of Sta- 

ble and Garage Equipment 113 

17. Patterns, Drawings, and Dies 113 

18. The General Problem of Depreciation .... 113 

19. Special Factors to Be Considered in Interpreting 

a Balance Sheet 114 

20. Equipment Purchased on the Partial-Payment 

Plan 116 



1. Introduction 120 

2. Good-Will Defined 120 

3. Value of Good-Will Dependent on Location . . 121 

4. Good-Will Dependent upon the Reputation and In- 

tegrity of the Firm 121 

5. Good-Will Created by Established Monopolies . 122 

6. The Earning Power as a Factor in the Valuation 

of Good-Will 123 



7. Transferability ]24< 

8. Method of Valuing IM 

9. Factors to Be Eliminated for the Purpose of Val- 

uation 126 

10. Factors Requiring Careful Scrutiny .... 126 

11. Mathematical Results . 128 

12. Fictitious Good-Will 128 

13. When Good-WiU Is Created . . . '. . .129 

14. Is Good-Will of a Fluctuating Value.? . . . .130 

15. Adjustment of Good-Will Account in Consolida- 

tions • 132 

16. Good-Will in Consolidated Balance Sheet . . .133 

17. Patents, Trade-Marks and Copyrights . . . 134? 

18. Valuation of Patents 135 

19. Valuation of Trade-Marks 136 

20. Valuation of Copyrights 137 



1. Current Assets Defined 139 

2. Cash on Hand 139 

3. Cash in Bank . 139 

4. Investments in Stocks and Bonds 141 

5. Classification of Permanent Investments . . . 141 

6. Investments in the Stocks of Allied Companies . 142 

7. Investments in Outside Companies 142 

8. Investments of Insurance Companies and Invest- 

ment Companies 143 

9. Investments of Bankers and Brokers .... 143 

10. Treatment of Outside Investments in Bonds Dif- 

ferent from That of Investment in Stocks . . 144 

11. Securities Purchased for Speculation .... 145 

12. Investments in the Stocks of Mining Companies . 146 



13. General Considerations with Reference to Valua- 

tion of Securities 147 

14. Notes Receivable 147 

15. Trade Debtors 149 

16. Treatment of Bad Accounts 151 

17. Treatment of Miscellaneous Accounts Receivable 152 

18. Interest on Notes or Accounts Receivable . . . 152 

19. Different Methods of Providing for the Reserve 

for Bad and Doubtful Debts 152 



1. Inventories 155 

2. Valuation of the Inventory of a Trading Concern 156 

3. Should Inventories Be Carried at Cost or at Mar- 

ket Price? 156 

4. Raw Material Inventories of Manufacturing Con- 

cerns 157 

5. Work in Progress 157 

6. Finished Goods Stock Should Be Valued at Manu- 

facturing Cost 158 

7. Treatment of Merchandise Pledged as Collateral 

for Loans 159 

8. Possible Deductions from Inventory Valuations . 159 

9. Interpretation of Current Assets 161 

10. Importance of Right Relation Between Current 

Liabilities and Current Assets 161 



1. Meaning of Deferred Assets 164 

2. Organization Expenses 165 



. 166 

3. Discount on the Sale of Capital Stock . 

4. Discounts Allowed on Issue of Bonds 

5. Methods of Disposing of the Bond Discount 

6. Treatment of Premiums on Bonds 

7. Other Examples of Deferred Assets . 



1. Treasury Stock Defined 173 

2. Disposition of Donation Reserve Credit . . . 175 

3. Acquisition of Treasury Stock Below or Above 

Par 176 

4. Stock Donated to Cover a Deficit 177 



1. Liabilities Defined and Classified 179 

2. Bonded Debt 180 

3. Mortgage Debts and Bonds 183 

4. Notes Payable 184 

5. Trade Creditors ......... 185 

6. Salaries and Wages Accrued 185 

7. Other Liabilities 185 

8. Ratio of Current Assets to Current Liabilities . 186 

9. Deferred Liabilities or Deferred Credits to Income 186 

10. Contingent Liabilities 187 

11. Conclusions to Be Inferred from the Liabilities . 188 


1. Definition of Surplus 195 

2. Kinds of Surplus 195 

XXII— 2 



3. Relative Importance of Surplus and Assets . .196 

4. Sources of Surplus 196 

5. Surplus Resulting from Business Operations . . 196 

6. Importance of Distinguishing Between Capital and 

Revenue Expenditure 196 

7. Depreciation as an Element of Cost .... 197 

8. Reserves That Are Not Part of Surplus . . .198 

9. Intercompany Profits on Inventory Should Be 

Eliminated from Surplus 198 

10. Dividends of Subsidiary Companies Available to 

the Parent Company 200 

11. Surplus from Sale of Fixed Assets .... 201 

12. Profits Resulting from the Sale of Investments . 203 

13. Profits Resulting from Revaluation of Fixed As- 

sets 203 

14. Entries on Revaluation Necessary to Adjust Prop- 

erty Accounts 204 

15. Value of Fixed Assets Is Not Affected by Eco- 

nomic Conditions 205 

16. Entries to Record Increase Due to Economic 

Causes 206 



1. Surplus Contributed at the Time of Incorporation 207 

2. Distribution of Initial Surplus 208 

3. Secret Reserves 208 

4. Purpose of Secret Reserves 209 

5. Other Purposes of Secret Reserves .... 210 

6. Propriety vs. Impropriety of Secret Reserves . 211 

7. Disposition of the Surplus 211 

8. Surplus Does Not Necessarily Mean Cash . . . 212 

9. Distribution of Dividends 212 

10. Characteristics of a Dividend 212 



11. Considerations Affecting the Declaration of Divi- 

dends 214 

12. Capital Expenditures Charged Against Surplus . 214 

13. Reserves Created Out of Surplus 215 

14. Reserve Account Misnamed 215 

15. Illegal Dividends . 215 

16. Scrip Dividends 216 

17. Dividend Policies 216 



1. The Theory of the Sinking Fund 218 

2. The Sinking Fund Reserve a Charge Against Prof- 

its 219 

3. Funds Distinguished from Reserves .... 220 

4. Sinking Funds Proper 221 

5. The Investment of the Sinking Fund .... 221 

6. Treatment of Interest Earned on the Sinking Fund 222 

7. Sinking Fund and Reserve Fund Investments . . 222 

8. Insurance Funds Should Be Adequate to Meet 

Losses 224 



1. Relation of Net Income to Capital Stock . . . 226 

2. Comments upon the Above Statement .... 227 

3. Ratio of Net Income to Capital Stock . . . 228 

4. Ratio of Net Income to Total Invested Assets . 228 

5. Ratios Based on Invested Assets Are the Proper 

Ratios to Employ 229 

6. Relation of Working Capital to Total Assets . . 230 



7. Amount of Working Capital Needed Depends upon 

Nature of Business 230 

8. No Rule for Amount of Quick Assets Required by 

Corporations 231 

9. The Economic Status of Contributors of Capital 

to a Business Enterprise 232 

10. Is Interest on Capital Part of Cost of Production? 233 

11. Difficulty of Selecting Correct Rate .... 234 

12. Inflation of Inventory Values 235 

13. Cost and Income Confused 235 



1. Reasons for Consolidations 237 

2. Possible Legal Basis for Consolidated Statements 238 

3. Investments Carrying Less than Control . . . 239 

4. Carrying at Cost 239 

5. Periodic Revaluation 239 

6. The Equity in Surplus 240 

7. Treatment of Dividends 240 

8. Objection to Carrying the Investment at Cost . 241 

9. Revaluation of Investments Is Subject to Compli- 

cations 241 

10. Oppressive Tactics to Discourage Minority Inter- 

ests 242 

11. Illustration 243 



1. Premium on Investments 250 

2. Other Methods of Carrying Premium on Invest- 

ments 251 

3. Discounts on Investments 252 



4i. Treatment of Deficits Existing in Sub-Companies . 253 

5. Protection of Minority Interests 254f 

6. Capitalized Surplus 254» 

7. Method of Treating Surplus Accounts of Acquired 

Companies 255 

8. Other Phases of Capitalized Surplus . . . . 255 

9. Illustration of Capitalized Surplus .... 257 

10. Unpaid Cumulative Dividends of Subsidiaries . . 258 

11. When Control Is Not Complete 258 

12. Overcoming Disadvantages of Consolidated State- 

ments 260 

13. Interpretation of Consolidated Statements . .260 

14. Value of Individual Statements to Managing Offi- 

cials 261 

15. Credit Risk Viewpoint 262 

16. Investment Standpoint 262 

17. Other Forms of Consolidated Statements . . . 263 



1. Purpose and Definition of Budgets .... 273 

2. The Annual Budget 273 

3. Interim Reconciliation of Estimate with Costs . 274* 

4. The Final Statement 274« 

5. Value and Use of Estimates 274 

6. Budgets as a Means of Guidance . . . . . 275 

7. Special Budgets 275 

8. The Sub-Division of Budgets into Monthly Periods 276 

9. Pre-Roquisitcs of a Budget 276 

10. Budget Routine 277 

11. Sales Department's Duties as to Budgets . . . 278 

12. Budgets on Four-Week instead of Calendar-Month 

Basis 278 

13. Duties of Production Department .... 279 



14. Assembling the Data 280 

15. Checking the Data Assembled 282 

16. Interim Check on the Budget 283 

17. Other Considerations in Budget Making . . . 284t 

18. Working Back from the Income Statement . . 285 

19. Departmental Standards Required for Budget 

Making 286 



1. Development of Municipal Budgets ... 

2. Distinction Between Private Budgets and Munici- 

pal Budgets 289 

3. Borrowing by Municipal and Business Organiza- 

tions Differentiated 291 

4. Old-Time Budgets 292 

5. The Modern Budget 293 

6. The Segregated 'Budget 293 

7. The Lump-Sum Budget 294 

8. A Variation of the Lump-Sum Budget Plan . . 295 

9. The Essentials of Municipal Budget Preparation 295 

10. Legal Foundation for Budget Necessary • • • 296 

11. The Accounting Foundation in Budget Making . 297 

12. Statistical Methods in Connection with Budget 

Reports .297 

13. Budget Machinery . ' 298 

14. Determining the Tax Rate 299 

15. Transfers and Charges in the Budget .... 300 

16. Providing in the Budget for Unforeseen Needs . 300 

17. Other Public Budgets 301 

18. Some Fundamentals in Budget Interpretation . 301 

19. Extending the Scope of the Budget .... 303 





1. Criticism Due to Improper Interpretation . . 305 

2. Interpretation of an Auditor's Certificate . . 305 

3. Certification as to Values of Real Property and 

Fixed Assets . 306 

4. Certifying to the Valuation of Inventories . . 307 

5. Procedure Where Inventories May Not Be Relied 

Upon 308 

6. An Auditor is Not Entirely Absolved by Qualifica- 

tions from Responsibility 309 

7. Examples of Attempted Fraud 309 

8. Auditor's Report Regarding Statement of Re- 

sponsibility as to Trade Debts 311 

9. Interpretation of Phrase "Properly Drawn Up" . 311 

10. Omission to Furnish Auditor's Certificate in Pub- 

lished Report 312 

11. Meagerness of Information in Published Reports 313 

12. Certificate of Profit 313 

13. Reports of Appraisers 315 

14. Basis of Valuation 316 

15. Adjustment of Book Values to Appraisal Values . 317 

16. Reports of Engineers 318 

17. Conclusion 318 

Index 321 




1. Present need for classified information. — Prob- 
ably at no previous period in our economic history 
has it been so important to the business man as it now 
is to have all kinds of information about his business 
available to him in classified form. With the growth 
of modern business, with specialization and standard- 
ization of factory and office routine, it has become in- 
creasingly important that executives and their im- 
mediate subordinates should have the right kind of 
statistical information about the activities of a busi- 

The old practice of closing the books once a year 
in order to determine whether a profit had been made 
or a loss sustained is becoming obsolete. The busi- 
ness man of today wants daiJy information. He 
wants, also, that information in comparative form so 
he can tell how it compares with that of a month ago, 
or a year ago. To compete successfully with other 

business men he must know the causes that have con- 



tributed to the success of the year's sales, as well as 
the factors that have caused any loss during the year. 

2. Classified information measures efficiency. — 
Properly classified records act as a measure of effi- 
ciency. Factory superintendents and other depart- 
ment heads may endeavor to explain the reasons for 
the condition of business as disclosed by the records. 
The indisputable fact, however, remains that the rec- 
ords will point definitely to either a profit or a loss. 

With proper records before him the executive is 
enabled to determine where the responsibility for the 
condition of his plant or any department of it rests. 
He is then in a position to strengthen the weak points 
of his department heads and to help them develop their 
strong features. 

3. Business policies. — From an analytical study of 
the classified information the managerial body of a 
business enterprise is able to determine the future 
course of action. If, for example, the results show 
that a previous advertising campaign increased the 
volume of business, it is quite likely that a more ex- 
tensive advertising policy will follow. Similarly, if 
the records show that while the volume of business 
has increased, the cash receipts have not kept a pro- 
portionate pace, assuming that the terms of sale are 
the same, it is evident that there is a weakness in 
the credit department or in the credit policies. This 
result, if not offset by other factors, may call for a 
restricted policy in the expansion of credits. 

At this time more than at any other it is obvious 


that the business man must base his action regarding 
his future business pohcies upon the experience of 
past performances as shown by properly classified 
records. He must not rely on memory. 

4. How outside factors affect a business organiza- 
tion. — In interpreting a set of financial statements 
one has necessarily to put together many related but 
apparently separate facts into a general picture which 
will portray in compact form the condition of the or- 
ganization. One must, therefore, not only read into 
the statements facts taken from a set of books, but he 
must also consider unrecorded facts as well. This 
point will be discussed in greater detail later, but it is 
mentioned here to bring home the effect of unrecorded 
factors on future conditions. Such things as changes 
in selling plans, increased cost of labor, increased 
freight rates, etc., all will have a direct effect on the 
business. Any one who analyzes financial or business 
statements must estimate the probable future condi- 
tions in the light of these outside factors. Moreover, 
certain adverse results, as indicated by the financial 
statements, may be entirely explained and accounted 
for by some condition which is only temporary. 

Thus, for instance, a severe flood in a western city 
might have caused a decrease in the sales of a busi- 
ness whose greatest volume was disposed of in that 
territory. Inasmuch as the condition was only tem- 
porary in its effect, one would not be justified in bas- 
ing upon the net results shown for that year an 
opinion concerning the usual volume of business done. 


5. Financial statements classified. — As already- 
mentioned in the other volumes on accounting, the 
principal financial statement is the balance sheet. 
This statement discloses the financial condition of a 
business at a particular time. It is well for the 
reader to bear in mind at this point that a balance 
sheet is only an expression of opinion regarding the 
financial condition of a business at a given time. The 
importance of this statement will be made evident 
later on. 

The next statement in importance is the profit and 
loss, or income statement, sometimes called the profit 
and loss, or income account. This statement presents 
a history of what has occurred since the date of the 
last balance sheet. 

Each of these statements may have supporting 
schedules showing in greater detail information con- 
cerning some factor or factors of the business. In a 
large undertaking, both the balance sheet and the 
profit and loss statement will usually be prepared in 
detail as well as in condensed form. 

The condensed income statement usually reveals 
only the general tendencies of the business. One has 
therefore to refer to supplementary or explanatory 
statements that, as a rule, accompany the main state- 
ments, for the details of the various transactions. 

6. Statistical information. — To supplement the bal- 
ance sheet and income statements many forms of 
statistical statements are often prepared. These 
statements serve the purpose of explaining many of 


the items that appear in the main statements. It is 
self-evident that too much detail cannot be conven- 
iently presented in a single statement, if it is to be of 
any value. It is a well-known fact that both the eyes 
and the mind of a person reading a statement can 
grasp only a limited amount of material at any one 
time. It stands to reason, accordingly, that if one is 
confronted with many columns of figures, even the 
main essentials of the business may escape his atten- 
tion. It is therefore important to prepare special 
schedules and statistical statements apart from the 
main statements. 

As a rule, statistical statements proper take up what 
might be called the non-financial side of the business. 
Thus, for instance, plant statements are often pre- 
pared to cover the unit production, or possibly the 
unit cost. To be more concrete, a telephone com- 
pany, for example, will prepare a plant statement 
showing the amount and cost of all new construction 
work carried out. Such a statement would show in 
terms of miles the amount of wire put up, dis- 
tinguishing copper, iron, and steel wire. It will 
show also the number of exchanges, or private tele- 
phones installed, and other items of similar nature. 

Statements of this kind are often made because 
they are used as a means of throwing additional light 
on the condition of the business, showing its progres- 
sion or retrogression in what might be called the 
physical aspect of the business. 

7. Departmental statements. — Just as it is impor- 


tant to obtain classified business information on the 
condition of a business as a whole, it is equally im- 
portant to follow out the results of different depart- 
ments or of individual functions. It is thus advis- 
able to prepare special profit and loss statements 
from each department of a business. It is equally 
desirable to prepare departmental statistics. 

In order to manage his department right, the head 
should have before him regularly prepared statements 
that will keep him in close touch with the detail 
and routine of his department. A monthly con- 
densed statement, supported perhaps by weekly sum- 
maries and daily reports, giving full details of the 
revenue and expenses of his department, reveals to 
him in chronological order, the facts of all the routine 
and constructive end of his department. 

8. Purpose of financial statements. — The main pur- 
pose of a financial statement is to show the condition 
of a business in a more condensed form than is avail- 
able from an examination of all the facts shown in the 
records. This information, if arranged in an intelli- 
gible and readable form, will be used by the manage- 
ment and persons outside of the management, such 
as stockholders, bankers and investors. These state- 
ments will be examined to check up the efficiency in 
operation and in management. They will also be 
used to determine the value of the assets, the present 
financial condition, and the probable future earnings. 

9. Prerequisites of the executive. — An executive 
who is to make the most of various statements which 


are brought to his attention not only must possess a 
broad knowledge but also must be able to draw upon 
many sources of information. He must understand 
the basis upon which assets are valued, and be com- 
petent to pass upon the relative values of various ac- 
counts or groups of accounts as compared with other 
and different groups. Moreover, he must have a 
knowledge of accounting terms and their true mean- 
ing, and a knowledge of the principles underlying the 
construction of financial statements. Finally, he 
must be able to pick out the false from the true and 
to know what is omitted from a statement as well as 
what has been furnished. It will be readily seen, 
therefore, that sometimes it is vastly more important 
to deduce the information which the accounts fail 
to disclose than to understand that which they re- 

10. Requisites of proper financial statements. — 
The variety in the kinds of business and the different 
physical or artificial conditions accompanying them 
makes impracticable a single type of accounting sys- 
tem. The form of financial statement which will best 
serve the individual purposes of any concern must 
be particularly adapted to that undertaking. No 
one form of statement will be equally serviceable in 
different organizations. 

11. Financial statements should be comparative. — 
While it is clear that much information can be ob- 
tained from a single balance sheet, and from a profit 
and loss, or income statement of one period, it is 


equally obvious that changes in conditions made dur- 
ing a given period can be regarded as satisfactory 
only when they represent an improvement over a 
previous period. The effect of new policies, changes 
in management, and the like, cannot be fully meas- 
ured unless the results, as shown in statements, are 
given in comparative form. This holds true not only 
with regard to main income statements and balance 
sheets, but also as regards sub-schedules and depart- 
mental statements. By observing the effect of a par- 
ticular policy for several years the management is 
in a far better position to estimate the value and the 
effect of it. 

12. Importance of the personal element. — Mention 
has been made of the importance of outside factors in 
connection with the interpretation of financial state- 
ments. The personal element is perhaps the most 
varying as well as the most important factor. Mis- 
takes in management often offset all of the favor- 
able characteristics which a business may possess. It 
is therefore important to give proper consideration 
to the individual efficiency of every man in an admin- 
istrative position. 

Harmony and cooperation of effort is a salient fea- 
ture of the human element question. Individual stars 
will not bring success to a business unless they are 
willing to cooperate with the heads of allied depart- 

Expansion in one department at the expense of 
another or in undue proportion as compared with 


others will frequently result in internal strife or fi- 
nancial loss. 

To obtain a clear idea of the possibilities and op- 
portunities of a business, one must be able to ap- 
preciate not only its present condition but also the 
advantages and opportunities, if any, that will accrue 
to it in the future. 

13. Consider atio7i of outside factors. — Many out- 
side factors, as ah'eady stated, will affect costs and 
sales, but they cannot be discovered from the recorded 
data. The demand for most products is frequently 
an uncertain item. One must therefore ascertain 
what probable future demand will be made. The de- 
mand for specialties and commodities that are on the 
border line of staples will naturally be subject to 
great fluctuations. 

In connection with costs, the probable supply of 
raw materials is an important consideration. Assum- 
ing that there is a steady demand for the product, we 
must be sure that the cost of the raw materials will 
not rise and that supplies will not be entirely cut off. 

Labor problems are frequently the rock on which 
the success of a business is wrecked. Sources of la- 
bor, the probability of strikes, and the development 
of unions are important outside factors affecting 
costs and sales. Transportation facilities and trans- 
portation costs are likewise important in this respect. 
They must all be ascertained and considered if the 
financial results of a business are to be properly in- 

XXII— 3 


14. Executive s reasons for a study of financial 
statements. — Three considerations should lead the ex- 
ecutive to study financial statements. 

First, he must be able to get all possible data on 
the condition of his own business. That can be ob- 
tained only from reports prepared in proper form. 

Secondly, he is interested in furnishing to others 
honest and exact statements of the condition of his 

Thirdly, he should be able to read the financial state- 
ments of others so as to get a true picture in his own 
mind of the business conditions of those with whom he 

15. Stockholders* reasons for a study of financial 
statements. — Inasmuch as the stockholder has not the 
first-hand information regarding the inside factors 
which the managing officials have, he must necessarily 
read "between the lines." His chief use of the finan- 
cial statements will be to employ them in deciding 
upon the value of the services rendered by his board 
of directors. He will use the statements also to guide 
him in his control over his representatives in the man- 
agement of the company. 

The particular interest of the stockholder is in the 
payment of dividends or the return on invested cap- 
ital. He is also interested in knowing that such pay- 
ments are made from revenues earned and realized. 
He is therefore concerned to know whether the prop- 
erty has been fully maintained and whether all income 
has been honestly and faithfully recorded. 


16. Information as a guide to legislation. — The im- 
portance of classified information upon legislation is 
very seldom realized. In the recent agitation of rail- 
way employes for increased wages, the figures of cost 
varied from twenty million dollars, the estimate 
of railway employes, to one hundred million dollars, 
the estimate of the managers. There should not be 
such a wide margin between the estimates. 

We have been told that child labor was necessary 
for the existence of the cotton industry of the South. 
Reliable facts in support of this assertion have not 
been forthcoming. 

When the agitation of a ten-hour working day was at 
its height, manufacturers asserted that industry would 
be bankrupt. The outcome happily was not what the 
pessimistic manufacturers declared it would be. 

Do we know the industrial cost of a universal eight- 
hour working day? Classified information, properly 
interpreted and analyzed, will furnish an answer to 
that question. Have we not rather been content in 
many cases with the gathering of statistics and the 
tabulation of results, rather than attempting to 
analyze and properly interpret the information which 
we already have? In fact, the lack of public faitli in 
the statistics which are offered in the discussion of the 
great social and economic problems of the present 
day, arises in part from the erroneous interpretation 
and unscientific analysis, or the lack of proper inter- 
pretation and analysis, of the mass of tabulation and 
statistics which we now possess. 



What business purposes does classified information serve? 

What are the sources of the information which is useful in 
judging the condition of a business? 

How do comparative figures add to the significance of any 
financial statement? Name some of the outside factors which 
affect the interpretation of the financial statement. 

What reasons for desiring classified business information has 
the executive ? The stockholder ? 

How might facts, properly ascertained and correctly inter- 
preted, guide legislation and public administration? 



1. Purpose and scope of business statistics. — The 
reader has already been familiarized with the value 
of statistical statements as supplements to financial 
statements. By business statistics we mean the rec- 
ords that grow up out of the operations of industrial 
and mercantile establishments. As a rule, these sta- 
tistics are as varied in their contents as the different 
lines of business from which they are taken. Thus, 
the records of public service corporations will differ 
widely from those of manufacturing or mercantile es- 

When the prevailing type of business was the gen- 
eral country store, statistical records of operations 
were impracticable. As business became more and 
more specialized, accurate cost and sales records be- 
came possible. As industry became concentrated in 
its ownership, comparisons of the operations of dif- 
ferent plants under the same control was an inevi- 
table consequence. Thus was formed a body of rec- 
ords sufficiently extensive to merit the name of busi- 
ness statistics. 

The demand of the business man for information 
concerning every detail of his business has resulted in 



the invention of a large number of mechanical devices 
that permit the gathering of an increasing amount of 
statistical information. A large part of this material 
is furnished by modern accounting methods. The 
old-fashioned bookkeeping was confined in a large 
measure to recording receipts and disbursements. 
JNIodern accounting analyzes the transactions which 
give rise to these effects. It groups them in classes ; it 
measures service as well as financial results and brings 
the two into proper relations, one with the other. 

2. Official and business statistics. — Business statis- 
tics, as distinguished from government statistics, are 
the practical result of the tendencies in modern busi- 
ness toward specialization and toward an increased 
size in individual enterprises. Some modern business 
concerns have become so extensive that their adminis- 
tration, as pointed out in the Texts on factory ^nd 
office management, is in many respects comparable 
to that of cities and states, and branches of national 
governments. Indeed, it would seem that at times 
the problems of business concerns are infinitely more 
complex and difficult than those of government. 

As business approaches in its administrative prob- 
lems more and more closely the operations of public 
authorities, it is not surprising that it should avail it- 
self to a greater extent of methods which have long 
been established in government practice. From this 
adoption of government methods comes a growing use 
of statistical statements in business management, and 


the increasing frequency of definitely organized sta- 
tistical dej)artments in business concerns. 

People sometimes think of government statistics as 
being gathered to meet some fancied need or to satisfy 
an idle curiosity. It must not be overlooked that 
these statistics have their root in some real need of 
government, or the necessary basis for transacting its 

In other words, it is not mere habit or routine which 
leads the governments of the world to publish each 
year a vast quantity of books crammed with official 
statistics. On the contrary, it is done for definite, 
practical j^urposes. The larger part of these sta- 
tistics is designed as a basis for action. 

Thus the census of the United States Government, 
which involves the employment of many thousands of 
persons and the expenditure of many millions of dol- 
lars, had its origin in the necessity of determining the 
basis of representation in Congress. 

Similar illustrations are found in the statistical rec- 
ords pertaining to revenues, expenditures and public 

3. The contents of business statistics. — As each line 
of business has its own peculiar operations to record, it 
would be ridiculous to attempt, in this growing field, 
to classify' the various kinds of statistics which might 
arise. What is needed in any particular business can 
best be judged by those who are engaged in it. Ex- 
perience shows that when thought is given to this mat- 
ter the volume of records often becomes very consid- 


erable. It is quite as possible to overdo the gather- 
ing of such records as to neglect them. The informa- 
tion which can be presented in statistical form, should 
first be carefully weighed, and its value estimated be- 
fore elaborate preparations for securing such data 
are provided. 

4. Uses of business statistics. — It would be equally 
futile to seek to classify the various uses to which sta- 
tistics may be put in the conduct of a business. At 
best, a general treatment of the subject can give only 
some suggestions of this nature. This can best be 
done by a rather full treatment of their use in some 
definite phase of business administration. Because of 
their importance in the general scheme of business or- 
ganization, departmental reports have been chosen as 
the subject of this special study. 

5. How much information should department heads 
be given? — Some managers believe that the head of a 
branch should not be informed as to the amount of 
profits made by his branch. They feel that the man- 
ager might use the information as a lever for securing 
an increase in salary. If it is desired to reduce the 
apparent profits of the branch and at the same time 
allow the manager to have the results in dollars and 
cents, this can be accomplished thru the medium of an 
arbitrary overhead charge. When the statement of 
financial results is given to the branch manager, the 
gross profits will be shown. From the gross profit 
will be deducted the amount of the arbitrary charge 
for overhead, which will, of course, reduce the net 


profit. In this way, the real profitableness of the 
branch may be concealed from the branch manager, 
who will not know the details of the overhead charge. 

There is no real reason why department heads 
should be kept in the dark as to the progress which 
is made by their departments. Of course, a depart- 
ment head need not be informed as to what is going 
on in another department, nor should he be entitled 
to information as to the condition of the business as 
a whole. But, the department manager will not have 
that personal interest in initiating new policies or put- 
ting new projects into operation unless he can learn 
the financial results of these undertakings. The de- 
partment heads will be able to guide themselves in 
new projects by having at hand records of the re- 
sults obtained by previous undertakings of a similar 

6. Record of orders and sales. — The manager 
should receive a statement of the total orders each 
month, or if the department is a large one and is doing 
a large volume of business, these reports may be made 
up daily. The report should show the orders re- 
ceived up to the beginning of the present month, the 
orders of the present month, and the orders received 
during the preceding month. This information will 
be accumulated from day to day or month to month. 
From this amount should be deducted the amount of 
orders delivered and the amount of cancelations, leav- 
ing as the balance the amount of unfilled orders on 
hand at the present time. This information should be 


shown in comparative form, giving the results of one 
or more preceding years, so that the department man- 
ager can endeavor to increase his sales, speed up de- 
liveries or, if orders fall off, to determine the causes 

A similar comparative record of the sales should be 
furnished him. The sales for the current fiscal pe- 
riod up to the first of the month, the sales of the 
month, and the sales for the preceding month should 
be set forth; the record of sales should show also the 
amount of the returns and allowances to date. In ad- 
dition, the sales records of the individual salesmen and 
saleswomen in the departments should be furnished. 

7. Inventory and purchase records sJioidd be avail- 
able. — Inventory and purchase records should be fur- 
nished at periodic intervals. There is always great 
danger of a department manager's overbuying, or al- 
lowing stock to accumulate, thus tying up an unneces- 
sary amount of capital in inventories. The informa- 
tion furnished to the department managers should 
give the inventory on hand at the last report date, the 
purchases during the interval, and from the aggre- 
gate of these two amounts, the cost of the sales should 
be deducted. The last amount may be conveniently 
found, either by reducing the sales by the amount of 
the departmental mark-up, or by reducing the sales 
by the amount of average gross profits realized by the 
department in preceding periods. 

There should also be furnished to the department 
head, if he is allowed to purchase his own material or 


merchandise, a record of the amount of merchandise 
purchase orders as yet imfilled. If some of the 
purchase orders apply to the current season and 
some to a later season, this information should be 
clearly set forth. With the information as to his 
present stock, and the amount of undelivered pur- 
chase orders, the department head is enabled to guide 
himself in meeting the requirements for stock. 

8. Analytical expense statements. — The depart- 
ment manager should also be furnished with a depart- 
mental analytical statement of expenses incurred or 
charged to his department during the period. As al- 
ready mentioned if the executives do not wish the man- 
ager to know the actual net profits of the department, 
they may, of course, load this expense statement with 
an arbitrary and fixed amount of overhead. 

9. Departmental profit aiul loss statements. — The 
information with reference to sales, purchases and ex- 
penses should then be gathered together into a de- 
partmental profit and loss account or statement, ar- 
ranged in comparative form, covering similar prior 
periods, so that the department manager may be able 
to know how his department has progressed or fallen 
behind. These statements will also prove of ad- 
vantage to the department head if he is called upon 
subsequently to furnish the executives with a budget 
estimate, or the probable income and expense of his 
department for an ensuing period. 

10. Results expressed in percentages. — Percentage 
statements indicate the trend of business more clearly 


than statements worked up in dollars and cents. 
Thus, for example, the department manager should 
be given the ratio of gross profits to sales; the ratio 
of net profits to sales; the ratio of salary to sales; 
and the ratio of advertising, interest and total expense 
to sales. These expense statements, as indicated 
above, should be furnished in comparative form. The 
fluctuations in percentages constitute an accurate 
gauge of departmental or company operation, undis- 
turbed by increases or decreases in the amount of 
business done. In addition to these statements, the 
department manager should be furnished with the 
turnover of his department for the period. 

Some executives object to the expense entailed and 
time consumed in preparing these reports. The time 
consumed may be materially reduced by the intro- 
duction of printed forms, and the calculations may be 
shortened materially thru the use of calculating de- 
vices. Others say that the information would not be 
used by the department heads. Often this latter 
statement is true, because the department heads are 
not competent to analyze many of the reports that 
would be presented to them. We occasionally 
find a good merchandise man who will succeed in 
making money for his department without the aid 
of comparative reports of progress. This type of 
man, however, is rather unusual, and it may not be 
wide of the mark to say that even a good merchandise 
man can profit by a study of results presented to him 
in proper form. 


In some organizations it is customary to keep a per- 
petual inventory and stock record by sizes and quali- 
ties, and it is advantageous to furnish the head of a 
department, from time to time, with stock sheets show- 
ing the condition of the stock. He will then be en- 
abled to determine the lines or sizes or qualities, which 
are selling, and those which are moving slowly, and 
concentrate his attention on the problem of getting 
rid of the stock that is accumulating, or for which, 
perhaps, the proper demand has not been created. 

11. Form of statistical statements. — The statisti- 
cal statement is characterized by two things : first, that 
it is expressed in figures, and second, that it relates to 
a number of things of which it is a condensed sum- 
mary. The fact that a given make of automobile is 
sold for $3,000 is not statistical, but if the statement 
is that automobiles range in price from $500 to $5,000 
it has the marks of a statistical statement. It is a 
fact expressed in figures relating to automobiles in 

All statistical statements express or imply a com- 
parison. It is of the utmost importance that this 
comparison be correctly stated and that the conse- 
quences which are derived from it be rightly estimated. 

The reader will recall what was stated regarding 
fallacious statistics, at the close of the first chapter. 
Statistical errors and statistical fallacies are for the 
most part not mistakes of figures, but wrong thinking 
about figures. It is evident that no rules can be de- 
vised to save people from illogical thought; the most 


that can be done, in a negative way, is to avoid in- 
viting incorrect conclusions by the manner of stating 
the problem, and, in a positive way, to call attention 
to the need of careful analysis. 

12. Statistical comparisons. — The principal com- 
parisons with which statistics deal, concern (1) the 
same things at different times, (2) a thing in rela- 
tion to some larger thing of which it may be a part, 
and (3) one thing in its relation to something else 
which is supposed to influence it. Some of the chief 
characteristics of these principal types of comparison 
deserve brief consideration in connection with the uses 
of statistics in business. 

13. Past and present performances. — One of the 
most usual of statements which are met in business 
life, is the comparison of current results with past 
achievements, the sales of this year, month or week 
with those of last year, month or week. In all such 
comparisons the two elements should have equal 
weight, tho it is an instinctive tendency of the mind 
to regard what is more remote as something normal 
with which to compare what has more recently been 

14. Results, year by year. — Thus men of business 
will explain why this year's sales exceeded those of 
last year. It never occurs to them to explain why 
last year's sales failed to reach the level of this year's, 
tho in some cases this would be the most reasonable 
way of stating the case. It may be that this year 
represents normal conditions, while last year had ab- 
normally small sales. 


Because of this tendency to accept the earlier dates 
as normal, it is well to choose what is instinctively re- 
garded as the basis of the comparison with great care, 
and to be sure that it actually is of normal character 
for the purpose in hand. A comparison of the busi- 
ness done in 1915, for example, with that of 1914 
would not necessarily be incorrect, but might easily 
lead to false impressions. Figures for the year 1913, 
representing less disturbed business conditions, should 
be added to make the full meaning of the 1915 figures 

15. Results, month by month. — What is empha- 
sized regarding yearly results applies with equal force 
to monthly results. We must assure ourselves in 
comparing results, month by month, that there is no 
seasonal variation which would affect them. Proper 
comparisons are possible only when the corresponding 
month of a previous normal year is considered. 

A point that often escapes attention is, that when 
any given facts occur with a very even distribution 
thruout the year, the difference between one month 
and another will be very slight. Oftentimes the dif- 
ference is fully accounted for by the fact that the 
months are not of equal length. It is therefore a 
good rule, when tlie difference is slight, to reduce the 
figures to daily averages and make comparisons on 
this basis. 

16. Results, week by week. — The longer the period 
of time to which the figures relate, the more likely is 
the effect of accidental variations to be diminished. 


It is never wholly eliminated. Conversely, the 
smaller the period of time, the greater the caution 
which must be used. Comparisons of one week with 
another, whether the previous week or the correspond- 
ing week of last year, which ignore special holidays, 
weather conditions and the like, prompt to wrong con- 
clusions. To illustrate, a shoe dealer would not be 
likely to compare sales of rubbers in the first week of 
November in one year with the same week in another 
without first asking himself how the weather at the 
two periods cpmpared. The use of the obvious illus- 
tration is intended merely to call attention to the 
fact that similar conditions may in less degree bring 
similar effects, and that these are not negligible quan- 
tities. It is therefore advisable, when conclusions are 
drawn from statistics, to qualify the comparison by 
the addition of the phrase "all other things being 


17. Results, day by day. — Daily comparisons must 
be handled with the utmost care. That is obvious, be- 
cause it is so easy for some purely accidental circum- 
stances to throw these comparisons out of gear. 

In the summer of 1916, when the public was watch- 
ing day by day the figures of American exports the 
New York Journal of Commerce called attention to 
the fact that altho Saturday was a favorite sailing day 
for ocean steamers, the reported exports for Satur- 
day were invariably less than for other days of the 
week. Investigation showed that the daily returns 
reported to the press were not those that were made 


each day, but those tabulated each day. As Saturday 
was a short working day in the government offices, 
fewer figures were prepared on that day and hence the 
falhng off in exports reported. 

18. Establishing standards of comparisoii. — The 
obvious remedy for some of the difficulties noted in 
the preceding sections is to estabhsh proper bases 
for comparison. These usually take the form of a 
fair average of past conditions, but under certain cir- 
cumstances it is possible to establish a normal result 
and observe the variation of actual figures from it. 
To secure a proper basis for comparisons it may be 
necessary to take averages covering a long period of 
years. Suppose the question to concern sales of 
September, 1916. It may be necessary, in order to 
obtain the necessary basis for a judgment, to make 
calculations as complicated as those which follow: 



Year ending 

r Sept. SO 



Per cent 


Per cent 




Amount 1901-1910 

A moun t 


year's sales 


(average) $5;.'-',000 







































If in this case we had before us only the results for 
September, 1915 and 1916, the only thing we could 
see would be a falling off in tlie latter year. What 
that meant we should not be able to appreciate. If 

XXII— 4 


we added merely the figures for 1914, we might be 
still more confused. But with all the figures above 
given before us we can know the situation thoroly. 
The general volume of business has been subject to 
fluctuation. In the main it increases, but in 1914 ad- 
verse business conditions brought about a decrease. 
September sales until 1913 moved along at about the 
same rate as the business in general. In 1914 they 
were smaller compared with 1901-1910 than were the 
sales of the year. This was, it will be remembered, 
about the lowest point in business activity of that year. 
In 1915 they increased more than the general volume 
of sales; the recovery in other words gained impetus 
toward the end of the year ending September 30. 
But apparently the growth did not continue thru the 
next year at the same rate. 

19. The percentage. — One of the most frequent de- 
vices for making figures comparable is the reduction 
to percentages. This is essential when the units com- 
pared are of different sizes. That one concern has an 
advertising expense of $50,000, and another one of 
$120,000 per year, tells us nothing unless we know the 
volume of sales to which these figures relate. Even 
then we must reduce them to a common unit. 

In the illustration given in the preceding section, 
the percentage of the September sales in relation to 
the total sales tells the same story as the other figures 
but in a different way. 

In discussing a series of percentages care should be 
taken not to express the difference between the num- 


bers of the series as so much per cent unless this is 
strictly what is meant. If the series of percentages 
compared is A, 78; B, 82; and C, 96; we not infre- 
quently hear it stated that B is 4 per cent higher than 
A, while C is 18 per cent higher than A. This is not 
the fact, as these differences are points, not percent- 
ages. To express them in percentages A must be 
taken as the base, and it will be found that B is 5.1 
per cent above A, while C is 23.1 per cent above A. 
AVhen a percentage has been calculated for the 
numbers of a series, as the months of a year, or a 
quarter, and the average percentage for the whole 
period is then wanted, the mistake is sometimes made 
of calculating this average from the individual per- 
centages and not from the totals of the original fig- 
ures. The following supposed case will illustrate. 

Sales Selling Expenses Per cent 

January $56,248 $6,432 11.4 

February 38,963 5,896 15.1 

March 74,839 6,824 9.1 

1st quarter $170,049 $19,152 11.3 

The percentage given for the quarter is the cor- 
rect one based upon, the division of the total selling ex- 
penses by the total sales. Had the percentages for 
the three months been added and the total divided by 
three, the result would have been 11.9. 

20. The ratio. — The ratio between one fact and 
another is of frequent use in official and business sta- 
tistics. Instances are shown in the per capita con- 
sumption of wheat, liquors and other commodities ; in 


railway receipts per mile of road, in costs per unit 
of product and in many others. Here again the cau- 
tion should be given that such comparisons may tell 
as much about one factor as another. Comparison of 
per capita sales of farm implements in Rhode Island 
and North Dakota for example, would not indicate 
much about the character of farming in these two re- 
gions, but chiefly that one was a farming country and 
the other was not. Sometimes such ambiguity can 
be avoided by a better choice of things compared. 
Consumption of fertilizers for example would be com- 
pared more appropriately with the acres of improved 
land in farms in the different states than with the 
number of the population. 

21. Graphic statements. — It is a variation of the 
usual statistical form of the statement when the facts 
to be expressed are not given in figures, but are shown 
in pictorial form, by means of lines, curves, surfaces 
and other geometric figures. Such graphic methods 
are coming to play a larger and larger part in the 
business world. Executives, sales managers, and ad- 
vertising men are finding a constantly increasing use 
for such methods of presentation as a means of grasp- 
ing rapidly the results of business administration 
which are vital to the work in which they are engaged. 

The use of charts and diagrams, or to borrow the 
term which the scientists have introduced into the lan- 
guage and which is making its appearance in general 
writings, of "graphs," owes its growing frequency to 
the apparent ease with which such representation of 


facts can be understood. There are many persons to 
whom series of figures carry no significant message, 
but who can readily see the proportions of things, 
their increase and decrease, and the other relations 
which are expressed by statistics, when they are shown 
in the form of the diagram or chart. It may well be 
that this applies to the majority of persons, and that 
only those trained in the use of figures can grasp their 
real significance. This, however, is a training which 
comes with practice, and because of the limitation of 
the graphic methods, is not to be overlooked. 

One of the disadvantages of the otherwise excellent 
graphic method of presenting facts is, that while the 
diagrams give to the eye a very definite impression, 
it is oftentimes difficult to reproduce this impression 
in language. In other words, diagrams as such can- 
not be quoted. On the scales in which they are 
usually presented, exact measurements are impracti- 
cable. It follows therefore, that the use of graphics is 
to emphasize a general impression, and in order that 
this impression may be as concrete as possible it is 
a useful rule, too often neglected, that the facts dis- 
played by line or solid should at the same time be 
given in terms of figures, 

22. The appeal to the eye. — The purpose of graphi- 
cal presentations is to make an ajij^eal to the eye, and 
it follows at once that this appeal must be simple and 
direct. The diagram should not impose too great a 
burden on the vision, or too fine a discrimination be- 
tween the points which are depicted. When the dia- 


gram is made by means of lines drawn to a scale, there 
is oftentimes a temptation to put too much on the 
diagram, with the result that there are often sev- 
eral interesecting lines. Without the use of color, 
and this is in most cases not available, it is very diffi- 
cult to draw, at the best, more than two or three lines 
which can be clearly distinguished one from another. 
Hence the best usage in charts of this character calls 






Figure 1. In each of these comparisons A is eight times as large as B. 

for not more than two or three lines, and this, of 
course, means a decided limitation upon the amount 
of material which can be displayed in a given space. 
Where the eye is called upon to judge relative size 
as, for instance, when the exports of different years or 
the exports of different countries are compared, the 
most effective presentation is the line diagram. The 
use of squares, circles or other surfaces, and especially 
flat representation of solid bodies, is to be avoided. 


Perhaps the greatest sinners against this rule of sim- 
phcity are those who address themselves to the least 
intelligent audience, and who in school books and in 
magazines of popular circulation, represent, for in- 
stance, the exports of different countries by pictures of 
sheep, ingots of gold, bales of cotton or hogsheads of 
wine, of different sizes. The foregoing illustration 
will make this point clear, and speaks so plainly for 
itself that additional comment is not necessary. 

23. Curves. — The most frequent way in which 
graphical statements are made is by the use of the 
line, or as it is sometimes technically called, "curve," 
in which the height of the curve from the base meas- 
ures the magnitude of the phenomenon in question, 
while the distance from the left-hand side of the page 
represents the period of time to which the facts relate. 

The rule of simplicity makes it advisable that all 
distances should be measured by the eye from the same 
base. If we disregard this rule, and try to represent 
different elements which enter into the problem by 
superimposing one on the other, with the thought that 
in this way we obtain an aggregate, the result is dis- 
astrous. Only two lines in the entire chart are clear, 
the first above the base and the line which represents 
the aggregate. The other lines cannot easily be read 
by the eye, and if we want to observe their tendency 
they must be taken out of the chart and redrawn so 
that for each of them there is a uniform base from 
which to measure the height. Where the lines are 
drawn from the same base, it is sometimes expedient 


to draw each line in a separate chart on a uniform 

The preparation of line charts requires considerable 
care lest false impressions be given. One of the fre- 
quent failings of the charts in common use is that 
they are incomplete. They give only that part of 
the chart which contains the line and do not indicate 
the distance of this line from the base. In the use of 
such partial charts it is quite possible to give very 
different impressions as to variations by changing the 
scale of the chart. This is illustrated in the four charts 
which follow, representing the same sequence of facts. 
They refer to the average price per pound of prime 
contract lard, as reported by the United States 
Bureau of Labor Statistics from 1890 to 1899. Each 
of the four lines given represents the same facts. In 
A and B the difference is in the height assigned to the 
several prices. In C and D the difference lies in the 
width assigned to successive years. 

It is plain that neither of the charts A and B is 
absolutely incorrect, but both are incomplete. In the 
case of chart A, the zero line would be approximately 
one and a quarter inches below the line indicating 10 
cents, while in the case of chart B this distance 
would be two and a half inches. The consequence of 
giving only a part of the charts is that in one case the 
fluctuations appear inconsiderable and in the other 
very marked. It will be noted that in these charts the 
same amount of space has been given for each year. 
It may also be noted that the line becomes more even 



03 CO r>- 

^ ^ Oi OD t^ coin'^ 


when a large space is given to each month, and more 
jagged when the space is reduced (Charts C and D). 

Because of these peculiarities of the lines it is well 
not to place too much reliance upon the comparison 
which results from placing side by side two charts 
which are drawn on a different scale. In such cases 
the conclusion drawn from the comparison might be 
called correct, but it is advisable also to have the 
actual figures by which to test the apparent conclu- 
sions to be drawn from the graphic statements. If 
the charts can be reduced to some common measure 
as, for instance, percentage above or below the aver- 
age for the period, the comparison becomes much 

24. Need of caution in interpretation. — Whether 
the statistical facts be expressed in figures or in charts 
too much emphasis cannot be placed upon the need of 
extreme caution in the interpretation of the facts re- 
corded. No golden rules can be devised which will 
keep a man out of the pitfalls which beset him in this 
field. But if he brings to the analysis of facts the 
qualities of caution and the habit of thoro examina- 
tion of matters from all points of view, he will find 
that statistics, whether in tabular or graphic form, are 
a powerful aid in the proper apprehension of business 


^Vliy have we seen in recent years a considerable development 
of business statistics ? 

Describe the character of the statistics which would aid a de- 
partment manager in getting the best results from his work. 


Define a statistical statement. What types of comparison does 
it commonly express or imply ? 

Name from your own experience instances in which compari- 
sons of one type or another have been used in business. 

Describe various forms of graphic presentation of statistical 
facts, and explain the advantages and disadvantages of the 
graphic method. 



1. Schedule of accounts receivable. — The reader 
has already noted that the principal statements which 
the manager will receive at the end of a stated period 
— say, a year, will be the balance sheet and the profit 
and loss, or income statement, covering the business as 
a whole for a given period. As a rule, these state- 
ments will be submitted in comparative form, and 
they will be supported by schedules that will show the 
operation of each department. 

The manager of a business will quite often require 
statements that will give information of the business 
in a form that will enable him to study certain fea- 
tures. This will depend, of course, upon the nature 
of the particular business. Frequentty, the schedule 
of accounts receivable is prepared to show the amount 
due from each customer and the time when the amount 
is due. Often, this schedule is prepared in a form to 
•show the amount of the balances from one to thirty 
days old, from thirty to sixty days old, and over sixty 
days old. 

When the number of accounts receivable is large 
and the amounts involved are comparatively small, it 



is not advisable to have a detailed schedule. In such 
cases it is better for the manager to provide an auto- 
matic separation of the delinquent accounts from the 
accounts that are in good standing, and to provide 
for a proper system of control, both for the delin- 
quent ledger and for the ledger containing the ac- 
counts in good standing. By analyzing the delin- 
quent accounts and referring to the amount of each, 
as compared with preceding periods, the manager 
will be able to check up the efficiency of the collection 

2. Statements of new customers. — A manager may 
often find it advisable to require reports on the num- 
ber of new accounts opened during the business pe- 
riod and the amount of sales to the new customers. 
He should, at the same time, have reported to him 
the names of old customers who have not purchased 
during the period, or whose purchases have fallen be- 
low those of previous periods. A sufficient amount 
of attention is usually given to this particular feature 
of a business. Investigation, however, may disclose 
unsatisfactory conditions tliat would otherwise not be 
brought to the attention of the management. The 
preparation of such a list will act as a sort of internal 
check on conditions that may inadvertently have es- 
caped the eye of the management. 

Complaints from customers, in some cases, are not 
brought to the attention of the manager. A customer 
of a house feels disgruntled at the treatment he has 
received; he may not make any complaint, but will 

7 9tJ ^^ 


place his future orders with other concerns. If the 
manager has before him the information mentioned 
above, namely, new accounts opened and old ac- 
counts from which no business has been received dur- 
ing the present period, it must prove invaluable to 

3. Importance from management standpoint of 
notes taken from customers. — When it is the custom 
to take notes from customers in settlement of their ac- 
counts, it is advisable that the amount of notes received 
from each customer be reported at regular intervals. 
It is also advisable to have reported at the same time 
the amount which such customers owe on open ac- 
counts. In addition, if any of the customers' notes 
have been discounted and have not as yet matured, 
the information on them should also be included. It 
will be readily seen that a report of this character will, 
at all times, disclose to the manager the condition of a 
customer's account. This is especially true if the ac- 
count is one which is being "nursed" by the manage- 

4. Schedule of inventory. — It is advisable that the 
management pay considerable attention to the in- 
ventory schedules that are prepared. It very often 
happens that department managers allow dead stock 
to accumulate — a condition which would have been 
disclosed had the management properly examined the 
detailed inventory. The author recommends that a 
schedule be prepared showing the amount of the in- 
ventory located in different departments or different 


warehouses, the amount of insurance carried on each 
warehouse, and so on. 

If a perpetual inventory system is maintained, the 
manager should keep in touch with any irregularities 
which may be disclosed in checking up the cost or 
book inventories by physical inspection of the stores or 
the stock room. Carelessness in charging out mate- 
rial, or in transferring it to other departments, or petty 
thieving may be the cause of these discrepancies. 
They should in all cases be investigated and corrected. 

5. Production reports. — The management should 
also receive reports of production. The quantity of 
goods, or of classes, manufactured during the period, 
should be reported by departments, or by manufactur- 
ing functions, together with the unit cost. This en- 
ables the management to inquire into the causes of re- 
duced volume of production, and locate and stop the 

6. Sales analysis. — Inasmuch as there can be no 
profit until the product is actually sold, the sales de- 
partment becomes the balance of power in any busi- 
ness establishment. Accordingly, a study of success- 
ful business houses will generally reveal the fact that 
their success is due chiefly to: a careful study of 
markets; the training of salesmen; the building of 
sales arguments; and effective advertising. 

Analysis of sales according to periods of time, ter- 
ritories, salesmen, branch offices, classes of goods, lines 
of industry, and the like, should always be available. 
Quite often, as this information is of a statistical na- 


ture and not recorded in the books of accounts, it is 
overlooked. Too much emphasis cannot be placed 
upon the fact that if this information is properly pre- 
sented and interpreted, it is bound to be a valuable 
fund of information for the progressive executive. 
To illustrate: If sales are not analyzed by territories 
and results are compared with a preceding period, it 
may be found that while the sales have increased in 
total, the firm has been losing ground in one section of 
the country, and gaining it in another. With ana- 
lyzed information on sales before him, the executive is 
in a position to know in which territories the sales have 
decreased and to concentrate upon those territories. 

In the same manner, a failure to analyze sales by 
the classes of goods will not reveal to the manager the 
particular lines which are selling and those which are 

Care must be taken, too, that the information col- 
lected prove not too costly. However, the main- 
tenance of a small statistical department, prop- 
erly equipped with mechanical devices, will, in a large 
majority of cases, pay for the installation and the ex- 
pense of operation in a short time, by reason of the 
valuable information disclosed. 

7. Expense schedules. — In almost every business 
there are certain expense items which, if properly ex- 
amined, will reveal much more information than might 
otherwise appear. It is, of course, advisable to pro- 
vide a sufficient number of expense accounts in the 
classification of accounts so that items of like nature 


only will be charged to a single expense account. 
When, however, this method has not been followed, it 
is advisable for the executive to require an analysis of 
the expense account. The miscellaneous expense ac- 
count often becomes a very tempting hiding place for 
questionable items or improper outlays. In these 
statements are set forth the various kinds of expenses 
which make up the total of this account. They may 
reveal unsuspected leaks and be the means of stop- 
ping them. 

Similarly, it is even advisable to attach certain def- 
inite earmarks to the expense account analyzed ; thus, 
expenses for advertising and sales-promotion items 
should be analyzed, if possible, by classes of goods ad- 
vertised. If this is done it is advisable to make a 
separation between advertising expense which can be 
definitely allocated to a given line of products, and 
expenses of a general advertising nature. 

8. Cash report. — The manager should have a 
proper statement of cash on hand and in banks made 
to him daily. This statement should show the re- 
ceipts, the disbursements, the balance at the beginning 
of the day, and the bank balances at the end of the 
day. Comparative figures for the preceding periods 
should also be included. 

In connection with the cash statement there should 
be included a schedule of the maturing notes receiv- 
able and of notes payable. As already pointed out, no 
figure or amount is valuable by itself. The value of 
any information in a report lies chiefly in its relation 

XXII— 5 


to other figures properly comparable with it. For 
this reason, all reports, whether daily or monthly, 
should give corresponding information for one or 
more preceding periods. 

A statement of receipts and disbursements will give 
the executive a knowledge of the manner in which the 
business organization is handling its cash transac- 
tions. A comparison of results with several pre- 
ceding periods will reveal the wisdom with which 
payments are made, and will indicate also whether or 
not financial difficulties have been encountered at dif- 
ferent times. 

9. False statements. — By false statements the 
author does not mean only intentionally misleading 
ones. They may include statements which have been 
prepared from insufficient records, or from records 
which do not present a clear view of the actual condi- 
tions of a business. 

A misconception of a balance sheet may result from 
several different causes, of which the principal ones 
are: (1) vagueness of the terminology and use of 
technical words not readily understood by the layman ; 
(2) improper accounting records on which the state- 
ment is based; (3) intentional misrepresentation of 
the management ; and ( 4 ) improperly prepared state- 

It may be admitted that technical terminology can- 
not be entirely avoided. Therefore, the layman must 
make himself acquainted with the meaning of certain 
technical terms. But when terms of a controversial 


nature are used, they should be made clear by descrip- 
tions. Certain lines of business will have accounts 
peculiar to the business, and while the technical 
phraseology in these instances cannot be entirely 
avoided, the meaning can be made more intelligible 
by means of an added description. 

That an accounting system can always furnish ab- 
solutely accurate information in all cases, no one 
would contend. The reader has already been cau- 
tioned that the best that accounting systems can do is 
to reflect the scientifically prepared estimate of condi- 
tions. This uncertainty appears principally in con- 
nection with the valuation placed on assets. The diffi- 
culties encountered in this particular connection have 
already been touched upon in previous volumes and 
will be more fully discussed in this volume later. For 
the present it is sufficient to say, that where there are 
no outside criteria and no other means of compari- 
sons with other forms, it is advisable to make a de- 
tailed study of each asset before one can pass upon 
the condition of a business as reflected in a given state- 
ment, i 

10. Intentional misrepresentatio7i. — Misrepresen- 
tations which are intentional may be accomplished 
in a number of ways. Quite often they are the result 
of a combination of the false with j ust enough truth to 
make it seem reasonable. Absolute falsehoods can be 
detected directly. But the grouping of various ac- 
counts so that the good is put with tlie bad makes it 
difficult for any one to pass a correct judgment. No 


knowledge of accounting principles will disclose this 
fact under ordinary conditions. 

11. Incorrect iweparation. — Misstatements, due to 
the incorrect grouping of accounts, the omission of 
pertinent information, and mistakes in inventory 
preparation or in pricing, will all result in false state- 
ments. Fortunately, however, the form of statement 
preparation is becoming so well systematized that er- 
rors of this nature will be easily detected. If it is 
borne in mind that there must be omissions among 
the various groups shown in any statements, a trained 
observer will easily detect false statements. 

A statement that presents too favorable a condi- 
tion should be questioned as closely as one that shows 
an unfavorable condition. By going back to figures 
and tracing them to their sources, one may often dis- 
cover the errors. 

If the profits of a particular department are un- 
usually large the executive should examine the rela- 
tive charges of the various groups of expenses. By 
comparing the relative percentages of profits in one 
department with the cost of siniilar departments, one 
may be able to pick out the section which has been 

As a case in point, if the manufacturing costs of one 
firm were found proportionately less than the manu- 
facturing costs of others in the same line, it would in- 
dicate that the cost had been arbitrarily reduced, or 
that the sales had been fictitiously increased without a 
corresponding increase being made in expenses. The 


relation among the various groups of accornts will, 
as a rule, remain fairly constant in all firms engaged 
in the same line of business. If, therefore, the rela- 
tionship is not the same, it indicates either false state- 
ments or inefficient management. A successful 
method of detecting such things is to make a compari- 
son of the present period with that of preceding pe- 
riods. As a rule, when a statement is incorrectly pre- 
pared, intentionally or otherwise, it will be obvious to 
the trained observer, because it is difficult to obtain 
relative amounts in all accounts. 

12. Preparation of statements for executives. — Un- 
doubtedly the best use for financial statements is to 
have them interpreted by the financial or accounting 
officer who is best fitted to take up that work. He 
will prepare a general summary of the condition of 
the business as a whole, in which he will call attention 
to the favorable and unfavorable conditions, as re- 
flected in the statements themselves, and endeavor to 
trace these statements back to the departments where 
they originated. 

This summary will give a detailed analysis of the 
business showing just what changes, if any, favor- 
able or unfavorable, have taken place. As a rule, the 
attention of the board of directors will be called to the 
features which the interpreting officer thinks require 
attention, and to those departments whicli have made 
a relatively poor showing. Commendation will be 
given to the departments which have done especially 


Because of his greater knowledge of accounting 
and his familiarity with the financial conditions 
of the business, the treasurer, or his assistant, is in a 
better position to analyze the condition of each de- 
partment, as shown by the records, with perhaps 
greater success than any other officer. 

Even at the present time, it is doubtful whether 
the great majority of business executives fully ap- 
preciate the importance of the accounting and statis- 
tical departments. To quote from Mr. James Logan, 
Chairman of the Executive Board of the United 
States Envelope Company: 

The processes of modern business are like the functions of 
a complicated machine and the executive must organize every 
part of his establishment as carefully as an inventor. Or- 
ganization means running the machine with all its parts in 
harmony. The management of the large corporation is or- 
ganized thought, exactly as a machine is the organized 
thought of the inventor. The executive must be a specialist 
along the lines which make for efficiency in administration. 
He must have the God-given quality — capacity for inven- 
tion or organization. There is real invention in the field of 
organization and administration the same as in the field of 
mechanics. Efficient organization is an asset which counts 
for commercial and industrial success more now than ever 


In what ways can the accounts receivable be classified and 
tabulated so as to yield useful information to the manager? 

What features may appropriately be included in an analy- 
sis of sales? 

In what ways may error, whether arising thru mistake or thru 

1 The Library of Business Practice — Volume IX, p 69. 


inadvertence, or thru intention to deceive, reveal itself in the 
financial statements? 

For what should the executive look in a financial statement of 
his business? 



1. General divisions of the income statement. — The 
income or revenue of a business undertaking is de- 
rived from the sales of its product or service, or from 
property which it owns. The income may be broadly 
classified as between primary income, sometimes called 
operating revenue, and secondary income, or non-op- 
erating revenue. The former represents income de- 
rived from the principal business in which the firm is 
engaged, while the latter consists of the income de- 
rived from the capital or property of the undertaking 
invested in outside ventures or controlled by others, 
such as interest on bonds or money loaned ; dividends 
on securities; rents, sales of by-products or sales of 
scrap material, and so on. 

As the reader has already noted, the expense of con- 
ducting the business includes the cost of materials 
consumed in producing the commodities or service 
which the undertaking offers for sale, together with 
the expenses incurred in selling the commodities or 
service, and the expenses of administration. The cost 
and expenses are also classified as between operating 



expenses and non-operating expenses. Operating ex- 
penses comprise the total cost and expense of securing 
the primary income or the operating revenues. Non- 
operating expenses may be the cost of securing non- 
operating revenue and the cost of collecting it, or they 
may be expenses purely in connection with capital in- 
vested in other activities than those in which the busi- 
ness is principally engaged. For the purpose of il- 
lustrating the method to be employed in analyzing and 
interpreting the income account or statement of an 
undertaking, a typical income account of a manu- 
facturing organization has been selected. The prin- 
ciples applied are equally applicable to a trading con- 
cern, or to any other form of business organization. 

2. Gross sales or gross income. — All goods sold, 
whether for cash or credit during the period un- 
der consideration, will be credited to the sales account. 
This account should be credited with all valid sales 
which legally transfer to the purchaser the title to 
the merchandise disposed of. Sales made "on ap- 
proval or return," or consignments shipped, should 
not be included as regular sales. 

The sales record should disclose the amount of cash 
sales and sales on credit. This information will be 
valuable when considering the relation between the 
outstanding accounts and the total charge sales of the 
period. For example, if the annual sales on credit 
amounted to one million dollars, and if the sales for 
the different months were uniform, one would next 
consider what terms of credit are usually allowed. 
Let us assume that the average term of credit allowed 


is thirty days, and that the balance sheet dis- 
closes $200,000 standing at the debit of trade debtors. 
The natural inference would be that either lax collec- 
tion methods were being employed, or else that the 
amount standing at the debit of trade debtors in- 
cluded bad, doubtful and uncollectable accounts. In 
ordinary times there will always be a fair proportion 
of customers discounting bills, so that while the goods 
may be sold on an average term of credit of thirty 
days, the aggregate of customers' outstanding ac- 
counts should be less than the amount of two months' 

3. Goods on sale or return. — If goods have been 
shipped to customers "on sale or return," or "on ap- 
proval," and have been credited to sales account and 
debited to trade debtors, the amount should be de- 
ducted from the sales as well as from trade debtors. 
The value of the merchandise in the hands of others 
should be shown as a part of the inventory. There 
should also be deducted, if necessary, a sufficient sum 
to take care of the depreciation of the goods while in 
the hands of others, waiting to be sold, and whatever 
sum it may be necessary to deduct because of shop- 
worn condition of goods, and so on. 

4. Trade discount on sales. — When it is custom- 
ary to allow trade discounts, a separate account may 
be kept for them. In this event, the credit to gross 
sales will be the gross price with an offset appearing 
in an account under the caption of "trade discount on 


sales." It is sometimes urged that an account should 
be kept for the amount of the trade discount allowed 
on sales on the theory that such an account meas- 
ures, to a certain extent, the efficiency of the sales 
manager. The sales manager who is able to keep up 
volume of sales with the smallest amount of trade 
discounts is naturally the most efficient manager. 
The author believes that this contention is of very little 
practical weight, and doubts the advisability of keep- 
ing this information, by reason of the time and labor 
necessary to do so. 

5. Price corrections. — Any adjustments that must 
be made because of errors in invoicing goods or billing 
out at erroneous prices should be corrected by debiting 
or crediting the sales account, and crediting or debit- 
ing the account of the customer according to the char- 
acter of the error. The correction of mathematical 
errors is to be distinguished from allowances made to 
customers because of claims for damages, or short 
weight, and the like. When a customer has received 
an allowance or a price concession of this nature, the 
amount should be debited to a sales allowance account. 
This is for the purpose of establishing a better con- 
trol over allowances of this character which would 
otherwise be lost sight of if merged with the gross 

6. Sales returns. — In some lines of business, the 
item of sales returns is an important one. Business 
men everywhere are trying to minimize this evil. In 
order that control may be established over items of 


this character so that the management may know at 
the end of the period what the relation is between sales 
and returns, all goods returned by customers should 
be debited to a sales returns account, and not to the 
gross sales account. It will thus be possible, at the 
end of the fiscal period, to determine just what pro- 
portion of sales are returned, and whether the evil is 
increasing or decreasing. A further analysis may 
be made to determine the amount of returns in each 
salesman's territory, as some salesmen will oversell 
their trade. 

7. Prepaid charges treated as sales. — Business 
houses in some cases are accustomed to prepay 
freight, insurance and cartage, for the accommoda- 
tion of customers, charging the amounts of these 
items in the invoice with the goods shipped. In many 
instances, these charges to customers are credited in 
their entirety to the sales account. This is bad prac- 
tice, because it overstates the amount of the sales. 
The amomits charged to a customer for freight, in- 
surance and cartage prepaid should be offset against 
the expense of the shipper in that connection. The 
sales account should not be credited with these 

8. Sales of scrap or residuals. — Sales of scrap ma- 
terial, or of by-products, should not be credited to the 
regular account, but should be handled thru special 
accounts created for them. Against the income re- 
ceived from the sales of scrap or residuals should be 
offset the cost thereof, and the net profit from the 


transactions should be taken into the income account 
as an item of miscellaneous income. 

As has already been pointed out in the Text on 
"Accounting Practice," sales to branches, or transfers 
of merchandise among departments, should not be 
included in the sales account. The reader is referred 
to that volume for the detailed treatment to be given 
to transactions of this nature. 

9. Percentage calculations. — The gross sales, there- 
fore, as reduced by the amount of returns and allow- 
ances, constitute net sales. This is the amount which 
should be used as the base for all percentage calcula- 
tions that are made on the basis of selling price. In 
this connection, it is pertinent to say that while prob- 
ably the majority of business undertakings make the 
percentage calculations in the income account by using 
net sales as a basis, it is mathematically more correct 
to use the cost of goods sold or the cost of service ren- 
dered as a basis. One method is just as good as the 
other, as long as it is borne in mind that whatever 
basis is used, it must be consistently employed thru- 
out. One must understand thoroly, however, whether 
the basis is cost of sales or selling price. 

The reader may have noticed literature that ap- 
peared from time to time on the subject of percentage 
of profits, some authors insisting that but one of the 
methods of figuring the percentage of profit is correct, 
and others taking the opposing view. The impor- 
tant point that many authors overlook is that when 
the selling price is taken as the base, the base will vary 


with the profits, since the latter are included in it. 
Yet it is recognized that the chief reason for making 
comparisons by means of percentages is to reduce the 
results to a common base. 

To quote from Dawson's Compendium; ^ 

This variation is, moreover, uncontrolled by any principle, 
being, in the case of a large proportion of profit, entirely 
disproportionate to the variation caused by a smaller rate 
of profit. As an instance, 10 per cent of profit computed 
upon the cost price is equal to 9/4i per cent when the same 
result is taken on the selling price, but if 50 per cent of profit 
on cost prices be computed upon selling prices it will only 
show 33/i per cent. Furthermore, as the sale price is com- 
posed of the cost price and the profit, the latter cannot ex- 
ceed the sale price, from which it follows that a profit based 
upon selling prices cannot exceed 100 per cent, nor even 
equal 100 per cent, if the goods have cost anything at all. 
None of these impurities or limitations exist in connection 
with a cost price percentage. Of course, a given percentage 
computed upon the cost will always show a certain other 
percentage if the same result as regards profits is computed 
upon selling prices, i.e., 10 per cent based upon cost is at 
all times equivalent to 9Ki per cent of the selling price: 
50 per cent of cost is always equal to 33^ per cent of sale 
price, and so on : Therefore, so long as the rate of profit 
is under 25 per cent, and does not vary greatly, comparisons 
of results based on selling prices will not be as misleading as 
they would be otherwise, and may be adopted without great 
danger, provided the nature of the base upon which they 
are computed is always borne in mind. It is often urged 
that a sale price percentage is adopted on the score of con- 
venience, the cost of the articles being difficult to ascertain 
on account of the difference of stocks and other obscuring 
elements. But the cost incurred in respect of the sales ef- 
fected can be obtained by a simple expedient as soon as the 

1 The Accountant's Compendium by S. S, Dawson, p. 466. 


amount of profit has been ascertained. As above stated, the 
cost and profit combined equal the selUng price — therefore, 
if the amount of profit be deducted from tlie net sales, the 
cost of the goods sold must be the result, quite independently 
of the questions of purchases, differences of stocks, etc. 

The following extract will show that the cost price per- 
centage is not only the true basis mathematically, but is 
also in accord with economic principles : — "The capitalist, 
then, may be assumed to make all the advances and receive 
all the produce. His profit consists of the excess of the 
produce over the advances ; his rate of profit is the rate which 
that excess bears to the amount advanced." (John Stuart 

10. Outward freight and cartage. — The question as 
to whether outward freight and cartage paid by a firm 
for goods sold F. O. B. destination should be deducted 
from the selling price or treated as a selling expense, 
is the cause of considerable discussion. It would seem 
that if the general custom of the concern in question 
is to deliver goods F. O. B. destination, the amount 
may be very well treated as an offset to the net sales 
in this section of the income account. When, how- 
ever, the allowances are not the general custom, but 
are under the direct control of the sales manager, it 
is better to treat the amounts paid for freight and 
cartage on shipments of goods to customers as a sell- 
ing expense. 

11. Service liabilities. — In certain enterprises it is 
customary for the service or merchandise to be paid 
for in advance. Thus, a gas company supplying gas 
to so-called "prepayment meters," or a restaurant or 
a railroad selling commutation tickets, will always 


have a greater amount of revenue received for serv- 
ice or for merchandise than has actually been dehv- 
ered to the customers. Therefore, all income or rev- 
enue received from this source may not necessarily be 
income of the present period. It will be necessary 
to determine by some fair and adequate means, what 
proportion of this revenue is to be credited to the 
current income account, and what proportion is to be 
set up as a deferred credit to income or deferred lia- 
bility, representing the service liability to be delivered 
in the succeeding period. 

12. Instalment sales. — When firms do business on 
the instalment plan, the sales account should be in- 
terpreted in the light of the practices of the firm, with 
reference to the provisions set aside for the loss on 
doubtful accounts and collection expenses in connec- 
tion therewith. It is also important to note that the 
income account of the period under review has not 
been credited with a greater amount in respect of 
such sales than may be properly taken to the credit 
of income. 

13. Containers included in sales prices. — Care must 
be used to see that the sales account does not receive 
credit for containers charged. Thus, in sales of cer- 
tain chemicals, such as anhydrous ammonia, con- 
tainers are charged with the merchandise to customers 
in the invoice. It is evident that the sales account 
should not receive credit for charges for returnable 
containers. A special reserve account should be 
opened for such credits and when, from time to time 


containers are returned, the reserve amount should be 
debited for the amount paid out in cash or credited 
to the account of the customer. When the reserve 
is large, it is advisable to create a special fund for 
it to the extent of the debits to customers in respect 
thereof, collected in cash. 

14. Othe?' items of miscellaneous income. — Oc- 
casionally, extraordinary profits result from the sale 
of land holdings, patents which are of no further use 
to the enterprise, or other assets of which it may seem 
advisable to dispose. Such unusual profits should 
not be merged with the profits from business opera- 
tion, because to do so would throw the operating 
revenues out of proportion and destroy the possibility 
of comparison. The proper practice is to state such 
items separately, under descriptive headings, and to 
carry them as miscellaneous income. Sometimes 
these items are of such an unusual nature as to con- 
stitute a direct addition to surplus and should not 
appear in the income statement at all. 

15. Comparisons of sales with the amount of the 
final inventory. — In order to determine the efficiency 
of the management, it is well to make a comparison 
between the total volume of the sales and the amount 
of the final inventory. In making this comparison, 
however, consideration must be given to the length of 
time it takes to manufacture the goods. For ex- 
ample, if a concern has annual sales amounting to 
$1,200,000, and reports an inventory on hand at the 
end of the period amounting to $500,000, the indica- 

XXII— 6 


tions on the surface are that the firm is carrying too 
much of an investment in stock in trade. This might 
appear all the more probable if it were known that the 
manufacturing process took approximately twenty 
days. The presence of this large inventory would 
indicate poor management in allowing stock to ac- 
cumulate, or the presence of a large amount of dead 
stock, or an inflation of inventory values. 

If the gross profit on trading operations were ap- 
proximately the same in the period under considera- 
tion as in preceding periods, the question of the in- 
flation of the inventory could be dismissed. Possi- 
bly, a quantity of dead stock, and goods out of style or 
fashion, may be included in the inventory at cost 
prices, or it may be that the firm has overestimated 
its requirements in the way of raw material, or may 
have manufactured too heavily, and thus has too much 
of its liquid capital invested in merchandise. 

It is not safe to draw conclusions without a further 
investigation of the facts, for it may happen that a 
large proportion of the inventory is in raw materials 
which the concern has accumulated at advantageous 
prices for use in later periods. In other instances, 
business organizations accumulate stocks of raw ma- 
terials in excess of their own requirements at ad- 
vantageous prices, which enable them to sell some of 
the raw material to other less fortunate manufac- 

The purchasing agent of one of the large public 
service corporations at the beginning of the Euro- 


pean war purchased immense quantities of raw cop- 
per at prices varying from 14 to 18 cents a pound. 
A large part of the copper was subsequently sold to 
other manufacturers who had not anticipated their 
requirements, at prices substantially over cost. How- 
ever, the comparison between the total sales and the 
final inventory ought to be made. In the light of 
other information one may judge whether or not 
the management is efficiently employing its liquid 

16. Distinction between cost and expense. — While 
all capital or value consumed in business operations 
is technically expense, the material and labor that 
enter into the manufacture of a product are usually 
known not as expenses, but as costs. General out- 
lays in a factory, other than material and labor, while 
commonly known as factory or overhead expenses, 
are also a part of costs. The selling and adminis- 
trative expenses form the technical expenses of a 

This distinction between cost and expense is not 
very clearly defined, and frequently the two terms are 
used synonymously. The distinction is one of con- 
venience rather than of necessity. The details of cost 
accounts have been covered in the Text on "Cost 
Finding." We are interested in them only in so far 
as they affect the preparation and interpretation of 
financial statements. 

17. Distinctio7i between expenditures and disburse- 
ments. — Business men in their dealings quite nat- 


urally come to regard every transaction from a cash 
standpoint. Income from this point of view is held 
to mean the receipt of so much cash, and expense is 
not considered an expense until the money is actually 
paid over. True enough, all revenue, if collected, will 
ultimately be realized in the form of cash and all ex- 
2)enses will ultimately be paid in cash. But there is 
a fallacy in considering that at any particular instant 
of time, a business is entirely on a cash basis. Ma- 
terial may be received and consumed long before it 
is paid for, and it is often paid for long before it is 
received. On the other hand, sales may be made 
which will not bring in any cash for some time. 
Therefore expenses and disbursements do not neces- 
sarily synchronize. 

18. Elements of cost. — The first element in the 
cost of the goods sold or in the operating expenses is 
the cost of the material consumed. This is found by 
adding to the inventory at the beginning of the pe- 
riod, the purchases during the period, and deducting 
from the aggregate, the amount of the raw material 
on hand at the end of it. 

All transportation charges incurred in delivering 
materials and supplies upon the premises are part 
of the cost of such materials. The expense of the 
purchasing department is often distributed over the 
purchases made, a rateable portion being assigned to 
the materials consumed, and the balance to the in- 
ventory on hand at the end of the period and is thus 
carried as a part of the inventory value of raw ma- 


terials. If an inspection department is maintained 
for the purpose of making tests of the quahty of 
the material received, the expense of this department, 
as well as the expense of the receiving department, 
form an additional element in the cost of the material 
consumed. In other organizations it is customary to 
pass the raw material thru a store room, and in this 
event, a rateable proportion of the expense of operat- 
ing the storeroom is assignable to each unit of mer- 

In practice it will usually be difficult to assign defi- 
nitely to each imit of materials or supplies consumed, 
a rateable proportion of the expense of operating the 
purchasing, inspection, receiving and storeroom de- 
partments. In many cases, the entire cost of opera- 
ting these departments during the period is charged 
as an expense of the current period. When this ex- 
pense is fairly uniform from period to period, there is 
probably no great error in following this practice, as 
it would not make any difference after the initial pe- 

19. Treatment of cash discounts on purchases. — 
Invoices for purchases are frequently subject to a 
special discount for prompt payment in cash. The 
question will arise as to whether the deductions made 
on the payment of invoices are to be applied to the 
credit of the materials purchased or are to be treated 
as secondary income. In favor of the first theory, 
it is urged that cost means the net cost to the pur- 
chaser, and therefore, the cost of raw materials, as 


shown in the operating expense account, should be 
the cost less the cash discount received. 

On the other hand, it is contended that the ability 
to take advantage of cash discounts arises solely from 
the power of the organization to command the capital 
necessary to enable it to do so. In fact, it may pay 
in many instances to borrow the funds necessary to 
discount bills promptly. Indeed in certain lines of 
business, the profit obtained from the discounting of 
bills is greater than the profit on the sale of the mer- 
chandise. If a firm could not borrow the money with 
which to discount bills, or if it did not have a suffi- 
cient amount of owned capital, it could not secure 
this advantage. The advantage is therefore one 
which arises solely because of the presence of a suffi- 
cient amount of capital, either owned or borrowed. 
If money has been borrowed for this purpose, the 
cost of the borrowed funds will appear as a deduction 
from income, or as a non-operating expense. It fol- 
lows then, that the saving made in discounting bills 
with borrowed funds ought logically to appear as non- 
operating income, or as other income. The author 
favors the second method of treatment. 

20. Labor. — Labor is the cost of the human serv- 
ice rendered in manufacturing the goods, or in pro- 
ducing the service rendered by the undertaking. The 
amount charged for labor should include not only the 
sums actually expended in cash, but also the amount 
of labor service rendered which may not have been 
paid for at the date of the accounting. 


21. Heat, light and power. — The cost of fuel used 
in developing the heat, light and power, including 
freight paid on the coal, the unloading charges 
thereof, and the cost of bringing the fuel to the point 
at which it is to be used, figure in the heat, light and 
power account. In a large manufacturing establish- 
ment, there is usually employed a gang of day la- 
borers, sometimes known as roustabouts, who are en- 
gaged in various odd duties, among which is that of 
hauling the coal from the storage pile to the stokers 
or to the boiler room. The amount of labor devoted 
to this purpose is to be charged to the fuel account. 
All water used for feed water should also be charged 
to this account. A rateable proportion of the engi- 
neer's services expended in the supervision of the 
boiler room should figure in this account and this is 
obviously true of the wages of firemen, tenders and 

Many firms keep a heat, light and power account 
as a clearing account, and distribute it upon some 
equitable basis at the end of the accounting period 
over the departments which have received the benefit 
from it. Thus, for example, if live steam is fur- 
nished to any department, it is possible to instal flow 
meters to determine the amount delivered as a basis 
for the charge. The various departments will be 
charged for light on the basis of candle power used 
in the respective departments. Heat will be charged 
for on the basis of the radiation surface. In this 
manner an attempt will be made to distribute the en- 


tire amount charged to heat, hght and power to the 
various departments which have received the bene- 
fits of these services. 

Other elements of overhead expenses have been 
fully explained in the Text on "Cost Finding," there- 
fore no detailed analysis is given here. 

22. Cost of manufacture and cost of sales dis- 
tinguished. — The difference between the cost of goods 
manufactured and the cost of goods sold should, how- 
ever, be pointed out. In arriving at the cost of goods 
manufactured, we start out with the initial inventory 
of raw material and work in process, and r.dd to the 
aggregate of these amounts, the total purchases, la- 
bor and factory expenses incurred during the period. 
From this aggregate we deduct the amount of the 
inventory of raw materials and work in process at 
the end of the accounting period. The resultant is 
the cost of goods manufactured. 

The cost of goods sold during the period, is found 
by applying to the cost of goods manufactured, the 
difference between the inventories of finished goods 
at the beginning and at the end of the period. Start- 
ing with the inventory of finished goods on hand at 
the beginning of the period, we add the cost of the 
goods manufactured during the period, and deduct 
the yalue of the finished goods on hand at the end 
of the period. The resultant will be the cost of 
goods sold. Or, to express it in another way, to 
find the cost of the goods sold, take the total pur- 
chases and add to them the labor expended and the 


factory expenses during the period, and adjust the 
aggregate by the difference between the initial and 
final inventories of raw materials, work in process and 
finished goods, adding to the aggregate found above, 
all decreases in inventory and deducting all increases 
in inventory. 

23. Percentage calculations must he made on cor- 
rect basis. — The difference between the income from 
sales and the cost of the goods sold is the gross profit 
on sales. As already shown, the percentage of gross 
profits on sales may be calculated by using as a basis 
either the cost of goods sold or the income from sales. 

The reader has already been warned in a preceding 
chapter, that percentage calculations generally should 
be made with care. Percentage calculations should 
not be made unless the conditions are such as admit 
of correct averages being taken. As a concrete illus- 
tration, in the distribution of overhead expense on the 
monthly basis, inasmuch as the base upon which the 
calculation is made will vary from month to month, 
the percentage distributions will do likewise. If a 
calculation is made upon the aggregates of a quarter, 
different rates of percentage will be obtained than if 
the calculations were made monthly. This is true be- 
cause the basic facts in each of these cases are differ- 
ent. Hence, care must be used in making percentage 
calculations to see that the facts prepared on the per- 
centage basis are capable of accurate comparison on 
that basis. When the percentage of gross profit has 
been ascertained, by whatever basis it may be cal- 


culated, the cause of any increase or decrease should 
be inquired into. 

24. Calculation of the turnover. — The turnover 
of capital invested in stock in trade is calculated by 
dividing the cost of the goods sold either by the initial 
inventory or by the average inventory for the year. 
Starting with the initial inventory, we add to it the 
purchases in a trading concern or the cost of manu- 
factured goods in a manufacturing business, and de- 
duct from the aggregate so found the inventory of 
goods on hand at the end of the period. It will be 
seen that this resultant is the material cost of the goods 
sold during the period. Divide the cost of the goods 
sold either by the initial inventory or by the average 
monthh'^ inventory and the resultant will be the turn- 
over, or the number of times which the capital in- 
vested in goods has been turned over during the pe- 
riod. Where the monthly inventories fluctuate or 
where the initial inventory may not be a fair one to 
use, it is better to take the average monthly inventory 
as the divisor. 

The ability to turn merchandise quickly indicates 
good management. Manifestly, a man who can turn 
his stock four times in a year has made more on his 
capital investment than the man who has been able 
to turn his stock only three times. Snap judgments, 
however, cannot be based on the turnover. There 
may be good and valid reasons why the turnover is 
reduced, and all the facts surrounding each individual 
case must be carefully considered. A large increase 


in inventories will naturally have a tendency to re- 
duce the turnover but, on the other hand, this might 
be offset by realizing a greater margin of profit on 
the goods that were sold. At any rate, a comparison 
of the turnover with that of preceding periods, and 
in connection with the increase or decrease in the 
gross profit from sales, will prove interesting. 

There is, too, a danger in attempting to increase the 
turnover by reducing the amount of the inventory 
carried, because in certain instances, the seller may 
not be able to keep his stock complete at all times. 
He may lose sales thru not having the goods on hand 
at the time that customers order them because he 
is over-anxious to keep the stock down to the lowest 
possible limit. Delays are often encountered in the 
receipt of merchandise, and a merchant who has lost 
the opportunity to make a sale because goods are 
out of stock has lost profits that he may never re- 
cover. On the other hand, laxity in this respect may 
also result in a loss, for it is evident that too great 
an amount of capital invested in goods on the shelves 
may eat up all, or a part of the profits, thru inte'rest 
charges. Past experience will usually enable the 
management to determine the lowest limit to which it 
may safely allow the stock to be reduced. 


What should and what should not figure in a statement of 
gross sales? How are net sales derived from them? 

State the arguments for basing the per cent of profit upon the 
cost price, and upon the sales price. 


What deductions are drawn from a comparison of total sales 
and final inventories? What cautions must be observed in draw- 
ing conclusions? 

Distinguish between cost and expense, expenditures and dis- 

Describe what enters into the heat, light and power account, 
and what purposes this account serves. 

What are the rules for calculating the turnover, and what is 
the importance of the turnover? 


STATEMENTS (Continued) 

1. Quantity discounts on purchases. — When quan- 
tity discounts on merchandise purchases are received, 
it is advisable to record them in a separate account 
and not to merge them either with purchases or with 
purchase allowances. All quantity discounts that 
have been earned during the period should be in- 
cluded in the accounts even tho they have not been 
received in cash. If this is not done, the income ac- 
count in the next period will receive the benefit of 
such rebates at the expense of the preceding period. 

Separate accounts should also be kept for raw ma- 
terial purchases and for finished parts purchased. It 
is unnecessary here to discuss more fully the pur- 
chase of materials as between direct and indirect ma- 
terial, because these matters have been treated in the 
Text on "Cost Finding." The technical distinction 
between these classes of material is of little importance 
to us for present purposes except in so far as it affects 
the comparisons. 

2. Purchase returns and allowances. — As in the 
case of sales, purchase returns and purchase allow- 



ances should be separated. While the information to 
be disclosed from these accounts is not so valuable 
as that resulting from the same practice when ap- 
plied to the sales, yet the information is likelj^ to 
prove of interest. Furthermore, no additional labor 
is involved in recording the information in detail. 

3. Maintenance charges. — Repairs and renewals of 
factory equipment, and operating and depreciation 
charges in their relation to the cost of goods sold, have 
already been fully discussed in the Text on "Cost 
Finding." The important point to be noted in this 
connection is that in a comparison of income state- 
ments over a series of years, the elements must be care- 
fully compared to see whether or not there are any in- 
creases or decreases worthy of note. If so, investiga- 
tion should be made to determine their causes. 

4. Selling expenses. — All the expenses of market- 
ing and of distributing the products are included un- 
der selling expenses. Among the items to be found in 
this group will be the salaries of the sales manager and 
his assistant, the salaries and traveling expenses of 
the salesmen, and the commissions allowed on sales 
actually made. The full amount of such expenses 
as have accrued during the period should be charged 
against the income whether or not they have been 
liquidated in cash. The amount paid for the rent 
of storerooms or warehouses for finished goods is 
properly chargeable to this group of expenses. 

Advertising expense and promotion expense in de- 
veloping new business are usually grouped under the 


caption of advertising. Included in this amount will 
be the salaries and expenses of the advertising man- 
ager and his staff. The account will also include the 
cost of printed catalogs and advertising literature, to- 
gether with the expense of advertisements in news- 
papers and magazines. For the balance sheet it is 
usually considered proper to inventory at cost, the 
amount of advertising literature on hand, and to treat 
as an inventory, space contracted and paid for in 
advance, thereby reducing the amount chargeable to 
the expenses of the period under review. The ques- 
tion as to whether or not any portion of the advertis- 
ing expense in connection with a national advertis- 
ing campaign should be treated as an asset will be 
discussed in a later chapter. 

5. Rebates allowed to customers. — Let us assume 
that a sewing machine manufacturer makes an al- 
lowance to a customer for an old machine, agreeing 
to take the machine at a price considerably in excess 
of its residual value, or in excess of its value for re- 
building. The question arises as to the disposition 
to be made of the difference between the exchange 
price allowed to the customer for the old machine 
and its residual value, or the value for rebuilding pur- 
poses. Should this be treated as a deduction from 
the net sales, or as a selling expense? It is usual to 
allow the sales manager an appropriation each year 
for this purpose, within which he must work. Inas- 
much, therefore, as the item is one under the direct 
control of the sales manager, it seems proper to charge 


to selling expenses the loss sustained on amounts al- 
lowed to customers on exchanges. 

Moreover, there is an element of advertising in the 
transaction, because when Mrs. Smith shows her New 
Era sewing machine to her neighbor, INIrs. Jones, the 
latter will probably decide that she will have to buy 
a new machine also, and an additional sale results. 

On the other hand, when there is no advertising 
feature connected with the rebate allowed to a cus- 
tomer, or when the matter is beyond the control and 
jurisdiction of the selling department, rebates may 
be more properly treated as a deduction from sales 
before arriving at income from sales. 

6. Other selling expenses. — All devices for secur- 
ing trade are properly chargeable to this general 
group of selling expenses. The loss on restaurants 
in department stores is frequently charged as adver- 
tising expense ; the costs of lectures or fashion reviews 
or daily concerts are charged to the same account. 
One department store follows the practice of charg- 
ing the advertising account and crediting the expense 
of operating its stable and delivery department with a 
fixed annual charge for advertising, because the de- 
livery wagons*carry notices of special sales, from time 
to time. 

7. Distribution of stable and delivery expense. — 
The stable and delivery expense is quite commonly 
pro-rated between incoming freight and outgoing 
freight upon a tonnage basis, or upon some other 
equitable basis. The problem of distributing de- 


livery expense is somewhat complicated, especially in 
a department store. The problem of internal ex- 
pense distribution is one of cost finding, primarily, 
and needs no further discussion at this point. 

8. Administrative expenses. — The next group of 
expenses are those which have to do with the manage- 
ment of the enterprise. They are made up of the 
expenses which cannot be directly apportioned, either 
to manufacturing or to selling activities. As a mat- 
ter of fact, however, administrative expenses are 
usually for the benefit of both the manufacturing and 
the selling departments. It is of importance to know 
that the cost of supervising the establishment is in 
proper relation to the cost of manufacture, the sell- 
ing expense and the amount of the sales. Included in 
this group will be the salaries, traveling and incidental 
expenses of the general officers and of the general of- 
fice clerks ; office supplies and expenses ; the rent of ad- 
ministrative offices ; the outlay in stationery, printing, 
telephoning, telegraphing, cabling; legal expenses 
which cannot be properly provided for elsewhere, 
and those miscellaneous and general expenses that 
cannot be properly allocated to any individual depart- 
ment or function. 

The depreciation of the office furniture may also 
be properly charged to this group of expenses. 

9. Selling profit and net profit from operation. — 
The deduction of the selling expenses from the gross 
profit on sales gives us the selling profit. By de- 
ducting the administrative expenses from the selling 

XXII— 7 


profit we arrive at the net profit on operations, or as 
it is sometimes called, net income from operation. 
The three important factors to bear in mind are : ( 1 ) 
the amount of the gross income from sales, (2) the 
cost of the sales, including administrative expenses, 
and (3) the net income from sales. For the sake of 
brevity, we will hereafter refer to these three ele- 
ments as the gross income, the operating expense, and 
the net income. 

10. Effect on gross eariiings. — The gross earn- 
ings will immediately reflect a decline in prosperity. 
This is especially true in the case of a manufacturing 
or trading concern ; this decline is not so marked in the 
case of a street railway or public service corporation. 
Nevertheless, railroads immediately feel the effect of 
a business depression because of the reduced vol- 
ume of freight earnings and the lessening purchas- 
ing power of the public. It is, therefore, of im- 
portance to attempt to measure the probable effect 
of business depression on gross income, and also to 
attempt to forecast the future business outlook. 

11. Oper'ating expense is not easy to reduce. — 
Operating expenses do not, as a rule, decline in the 
same ratio as gross income. This is due to several 
causes: first, wages are usually the last thing to be 
reduced; second, a concern that has planned to manu- 
facture a certain output and has built up an organiza- 
tion for that purpose will always have a certain 
amount of overhead expense which must be carried in 
dull times as well as in prosperous times; third, the 


cost of materials, both direct and indirect, does not 
usually decline with the same rapidity as gross in- 
come. Therefore, unless the organization prunes 
very heavily the maintenance expenses and the allow- 
ances for depreciation, the net income is likely to de- 
crease in a greater ratio than the gross income. 

If the organization in attempting to reduce its op- 
erating expenses and thereby increasing the net in- 
come, has neglected to make necessary expenditures 
for maintenance, repairs and renewals, the earnings 
of the period will be overstated, and the cost of mak- 
ing good the deferred maintenance and renewal 
charges will have to be borne by later periods. 

12. Interpretation of net income. — From the net 
income the fixed charges of the corporation for in- 
terest, sinking fund requirements, if any, and divi- 
dends must be met. If too great a proportion of the 
gross income is used in operating expenses it is possi- 
ble that the net income may be insufficient in amount 
to meet the fixed charges of the firm. Bondholders 
require the assurance that the net income will amount 
to at least twice the sum required to pay interest on 
bonds and other fixed charges. Experience has 
proved this proportion to be a proper margin of 

In the case of a corporation a decline in net income 
may mean that stockholders will have their dividends 
reduced. If the corporation in its prosperous pe- 
riod, has set aside a surplus or dividend equalization 
reserve, the dividends may be paid in part out of sur- 


plus created in this way. The distribution of any 
part of this locked-up surplus will reduce the work- 
ing capital of the organization. It may, too, have a 
tendency to increase the outside borrowing, perhaps 
even to weaken the concern so that it will not be able 
to take advantage of market conditions in the pur- 
chase of raw materials, or in discounting all of its bills. 

The reader will perhaps now more fully realize the 
effect on the income account if capital items are 
charged to the revenue account, or if revenue items 
are charged to capital. In the first case, a dishonest 
board of directors might "freeze out" debenture bond- 
holders, or depress the price of stock to the disad- 
vantage of the holders. In the latter case, an appear- 
ance of apparent prosperity might be continued for 
a number of years, with the result that after a pe- 
riod of time, a drastic reorganization and a scaling 
down of bond and stock issues become inevitable. 

Sole traders and members of partnerships are, of 
course; equally as interested in comparison of gross 
and net income as are members of a corporation. 

13. Other income and income charges. — Dividends 
on stock owned or interest on bonds owned; inter- 
est on any mortgages receivable; cash discount on 
purchases; interest on notes, accounts or on bank 
deposits; rent, royalties or commissions received 
are included in other income. In fact, any item of 
income received other than that from the sale of the 
product, or from the service which the organization 
offers or renders for sale, would be taken into this 


section of the income account. When any expense 
has been incurred directly in securing this income, it 
is customary to state in the income account the ex- 
cess of the income over the expense of securing it, 
ear-marking the item "net" in the income account. 

Expense incurred for interest on borrowed funds, 
cash discounts allowed on sales of merchandise, pay- 
ments of rent, insurance, taxes or royalties would be 
included under income charges. 

14. Treatment of taxes and rent, — There is consid- 
erable difference of opinion among accountants as to 
the character of the items that should be carried under 
taxes and rent. Some authorities take the view that 
taxes and rent paid for a factory building should be 
charged as a part of the manufacturing expenses. 
Others hold that since taxes are sums paid for the 
protection of invested capital, the amounts paid are 
capital expenses and therefore have nothing to do 
with operating expense. It may be pointed out that 
operations are conducted just as efficiently in owned 
as in rented property. Moreover, a decision as to 
whether or not an organization shall own or rent its 
own plant, rests with the executives and not with the 
operating department. These questions are matters 
which each organization must settle for itself. 

15. Cash discounts on sales. — Discounts which are 
allowed to customers for the prompt payment of their 
accounts are also viewed from two standpoints. One 
is that discounts are offsets against the sales prices 
and should be deducted before stating income from 


sales; the other that the transaction is a purely fi- 
nancial one and that the allowance made for the 
prompt payment of customers' accounts reduces the 
necessary borrowing by the firm, the risk of loss on 
bad accounts, and collection expenses. 

16. Insurance expense. — Insurance expense is also 
the subject of much debate. Those who favor stating 
the insurance expense in this section of the income 
account call attention to the fact that it is a sum paid 
for the protection of capital, and therefore a capital 
expense. Others hold that this expense should be al- 
located to the individual operating functions, namely, 
fire insurance on the factory together with liability 
insurance on employes should be charged as one of 
the necessary and incidental expenses of manufactur- 
ing; the insurance paid on the stock of raw materials 
must be counted in the cost of producing the finished 
product, etc. On the other hand, attention is called 
to the fact that insurance rates are totally out of the 
control of the operating officials. Moreover, in view 
of the fact that insurance is a contract of indemnity 
which protects the capital investment of the organiza- 
tion, it is a capital charge and should be shown as a 
deduction from income. 

To the income from operations will be added the 
amount of the secondary income received, and from 
this aggregate will be deducted the amount of the 
income charges. The resultant will be the net in- 
come for the period which amount is subject to still 
further adjustment. 


17. Profit and loss credits and charges. — Items of 
miscellaneous income that do not occur with sufficient 
regularity to be shown under the heading of other 
income such as miscellaneous income or profits from 
the sales of assets or scrap material would appear un- 
der profit and loss credits and charges. 

Gn the other hand, there would be charged losses 
due to bad debts, depreciation provisions that could 
not be allocated against operating functions, and any 
other item of unusual or extraordinary loss suffered 
during the period. 

Extraordinary income or extraordinary losses 
should be apportioned among periods; that is, any 
portion of income received or any loss sustained which 
does not apply to the period under review should be 
adjusted thru the surplus or deficit account. 

In analyzing an income account care should be 
taken to see that the fixed charges are not in excess 
of the net income from operation. Occasionally, it 
will happen that a business organization has extraor- 
dinary sources of outside income, and in a year in 
which the net income is not sufficient to meet the 
fixed charges, the income from outside sources will 
be added to the net income from operations and the 
fixed charges deducted from the aggregate. This 
results in a misleading statement because it attempts 
to conceal the fact that the business has not earned 
enough net income from operations to pay its fixed 

The effect of the sinking fund reserve requirements, 


as well as other reserves, and their respective rela- 
tions to the income account are discussed in later 

18. Transfer of net profits. — In a corporation the 
balance of net profit is transferred to the surplus ac- 
count and remains as a contingent reserve or as a 
working capital of the business. From the surplus 
will be set aside various reserves. In some cases divi- 
dend equalization reserves are created, so that if in 
any year, the profits from operation are not sufficient 
to enable the corporation to pay the usual dividend, 
the dividend equalization reserve may be drawn upon. 
The balance is available for dividends, but it is not 
usual to distribute all the net profits of any one 
year. The dividends distributed are deducted from 
the surplus account and are shown as surplus adjust- 
ments. The net profits of sole ownerships and part- 
nerships are added to the owners' capital accounts. 

19. Deficits. — If the costs and expenses of a year 
have been greater than the total income received from 
all sources, the operations for that period have re- 
sulted in a deficit. If a corporation has a surplus 
created from prior periods, the defici' from opera- 
tions in the current period will, of course, be charged 
against it. If the surplus is still sufficient to allow 
the payment of the usual dividends, the board of di- 
rectors will, in all probability, make the usual dis- 
tribution. If no such surplus exists, however, the 
capital is said to be impaired. In other words, a loss 
has resulted in the net worth or in the proprietorship. 


In partnerships this reduction in the proprietorship 
is a direct charge against the partners' accounts. The 
loss from operations of a sole trader is charged to 
his capital account. However, in the case of a cor- 
poration, inasmuch as it cannot reduce its capital 
stock without conforming to certain legal formalities 
required by the statutes, it must set up a deficit ac- 
count which by its title should clearly indicate that 
the capital has been impaired. Corporation officials 
will, in certain cases, go to almost any extreme to 
avoid showing a deficit. This may be accomplished 
by neglecting to make the usual expenditures for the 
maintenance and renewal of the operating plant, or 
by erroneously charging to capital, items that should 
properly be borne by revenue. It is therefore im- 
portant when analyzing an income statement to use 
great care in making comparisons with previous years 
when there is any likelihood of this practice being 

20. Analysis of surplus fluctuations. — The conver- 
sion of a deficit from operations into a surplus in the 
succeeding period should also be carefully inquired 
into. This might in some instances be brought about 
thru an inflation of the inventory. If a comparison 
of the inventory values stated in the balance sheet 
showed that the inventory had increased in a much 
greater degree than the increase in the payable ac- 
counts, or notes, or the decreases in assets which might 
have been used to finance the purchase of the in- 
ventory, and if, at the same time, a deficit had been 


converted into a surplus, the inference might fairly be 
made that an inflation of the inventory was responsi- 
ble for the conversion of the deficit into the surplus. 
Comparisons with preceding periods will usually re- 
veal practices of this sort. An examination of a 
single balance sheet or of a single income account is 
therefore of little use. The financial condition and 
the results of operation should always be studied in 
comparative form. 


Enumerate the various items which may enter into selling ex- 
penses. How is their exact amount determined? 

Distinguish between administrative and selling costs, and ex- 
plain how they are treated in the accounts. 

Upon what does net profit from operation depend, and what 
general influences determine its fluctuation? 

What are some of the more usual charges against income from 
operation before net income can be ascertained ? 

Describe methods by which deficits in the operations of cor- 
porations are covered up in tlie books. 



1. Introduction. — Modern developments have 
brought forth new forms of business organizations, 
each of which has features pecuhar to itself. The 
accounting system and the form of financial state- 
ments adopted by the various types of business organi- 
zations should provide a clear record undisturbed by 
any unusual features of organization. As in any 
science, the general principles of accounting practice 
are fixed and remain constant under all conditions. 
The proper method of applying these principles, 
however, will vary with the individual conditions of 
each undertaking and the type of development which 
it portrays. Therefore, a discussion of consolidated 
statements must be prefaced with a clear understand- 
ing of the nature of these new forms of organization, 
the results of whose operations can best be disclosed 
thru the use of consolidated statements. 

2. Distinction between jjarent and holding com- 
panies. — There is a financial, tho not a legal dis- 
tinction between a parent and a holding company that 
is not always understood. A parent company is an 
operating company doing business under its own 
name and controlling, thru a majority of stock 



ownership, one or more corporations doing business 
in lines allied to its own. The subsidiary companies 
are new corporations, organized by the parent com- 
pany, which retains stock control for itself and sells 
the balance of the stock, if need be, to secure either 
working capital or local stockholders. 

A corporation holding a valuable patent may or- 
ganize subsidiary corporations which are practically 
selling or manufacturing agencies. The parent com- 
pany will lease the patent rights to the subsidiaries 
for use in certain territories. The parent company 
will retain at least the majority stock ownership in 
each subsidiary in exchange for the territorial rights 
in it. At the same time, the parent company may be 
engaged in business in all territories not leased. 
When all territories are leased, the parent company 
will cease to be an operating company and will then 
become a holding company of the pure type. 

The holding company is not as a rule, an operating 
company, altho in some cases it may be. Its princi- 
pal assets are the stocks and bonds of corporations 
which it controls thru a majority ownership of the 
stocks of the underlying companies. Frequently it 
may not even possess office equipment as its principal 
office may be that of one of its subsidiaries. 

The central distinction between the two types of 
companies is that a parent company organizes and 
establishes its own subsidiaries. The holding com- 
pany acquires the ownership thru stock control of 
corporations already in existence, and is organized 


primarily for the purpose of acquiring such stocks 
and thereby estabhshing a community of interest. 

In the discussion which follows, the term "holding 
company" will be used in a general sense to include 
any type of combination involving stock control which 
one corporation exercises over other corporations. 
The principles of accounting involved remain the 
same whether the group is of the holding or parent 
company type. 

3. Ownership of the stock of a company does not 
viean ownership of its assets. — Let us consider the 
legal phases involved in this type of financial organiza- 
tion. The first point to be noted is that under the 
law, ownership of stock does not mean ownership of 
assets. Thus, if corporation "A" owned all the 
stock of corporation "B" it would not be the legal 
owner of corporation "B's" physical property. The 
title to corporation "B's" physical property rests in 
the artificial person, corporation "B," and it can 
only be divested of that property by due process of 

Corporation "A," therefore, is in the same posi- 
tion as any other stockholder of the corporation. The 
right of a stockholder in the assets of a corporation is 
only equitable. The ordinary form of common cap- 
ital stock is not redeemable and the stockholders, 
while having the right to transfer their holdings, can- 
not re-exchange their stock for the assets which they 
surrendered to the company in the original exchange 
for the stock. 


Moreover, it has often been decided in the courts, 
that the income or profits of a corporation cannot be 
secured by a stockholder unless thru a formal action 
of the Board of Directors distributing them in the 
form of dividends. Therefore, we see that while a 
stockholder has an equitable right to the surplus as- 
sets of the corporations whose stock he holds, he has 
not an enforceable legal right to secure any portion 
of them until either the Board of Directors has 
formally voted a distribution of them, or until the 
corporation has taken the necessary legal steps to 
dissolve its existence. 

4. Increase in value due to economic cojiditions not 
to he recognized. — From the technical accounting 
standpoint, it is considered improper to give effect in 
the balance sheet to the increase in value of any fixed 
asset due to economic conditions. This is especially 
true if such increase is to be credited to surplus and 
made available for dividends. 

Thus, we say that a corporation should not in- 
crease the value of its plant land on its books, even 
tho it is reasonably sure that the land is worth more 
than when originally purchased. There is no inten- 
tion of making a sale and therefore the profit cannot 
be realized and the increase in value should not be 
credited to the profit and loss or to the surplus ac- 
count. Hence it would follow that, according to our 
conception of income, profits actually distributed, or 
dividends actually received by a stockholder, consti- 
tute his sole source of income. Earnings not yet paid 


out in dividends have no legal existence as income of 
the stockholder. 

The law does not prohibit a stockholder from 
carrying, as income, dividends which his company has 
declared out of capital. True, he may be called upon 
to return them if such dividends result in the defraud- 
ing of creditors, but if they merely involve impair- 
ment of capital, dividends can apparently be treated 
as income by the stockholder. In this connection, it 
should be noted that it makes no difference whether 
the stockholder owns one share or ninety-seven per 
cent of the stock of a company. 

5. A balance sheet should discJose financial condi- 
tion. — From a technical accounting standpoint, the 
balance sheet of a business purports to show the assets 
which it owns and the liabilities which it owes. Thus, 
in the case of a holding company, its principal assets 
would be the stocks and bonds of its sub-companies; 
its liabilities would probably consist of notes payable 
and collateral trust bonds or notes which have as se- 
curit}^ a pledge of the stocks and bonds of its subsidi- 
aries. Happily, the science of accounting is not 
hedged in by narrow bounds. It is ready to forsake 
the old for the new when anything is to be gained in 
clearness, economy or convenience by so doing. 

6. The accountant and the law. — Frequently, an 
accountant is compelled by law to do things which he 
knows are wrong. In common with his fellow men, 
however, he submits to the law. On the other hand, 
where he is not absolutely limited by the law, he 


adopts those methods which he knows are correct ac- 
cording to the principles of his science. 

The law, after all, is nothing more than the crystal- 
lization of human experience in the form of written 
enactment. Wlien a custom or a practice becomes 
sufficiently well established among men, it is recog- 
nized and sanctioned by an enactment. 

7. Accounting practice and the law at variance. — 
The accountant has always recognized the distinc- 
tion between revenue and cash, between expense and 
disbursements. The law, even to this day, does not 
always recognize that distinction. 

The accountant has recognized the necessity of pro- 
viding for depreciation before determining the net 
profits of a business organization. There have been 
numerous court decisions in which a provision for de- 
preciation before the ascertainment of net profits was 

The process of educating legislators, courts and a 
large number of business men in accounting methods 
has been a slow and laborious one for the accountant, 
but ha^^pily, the results of his labors are already be- 
ginning to bear fruit. Many of the principles which 
have been rejected heretofore by legislators and by 
judges have been embodied in the law thru the rul- 
ings of public service commissions. If, therefore, the 
accountant proceeds along the lines of correct prin- 
ciples, and uses scientific methods in the attainment 
of his desired ends, the fact that current legal doctrine 
or opinion does not support him, is of small impor- 


tance. He therefore justifies himself in preparing 
financial statements for organizations of the holding 
company type which have no basis or standing under 
our present legal doctrine. 

8. Pertinent facts which should be shown in finan- 
cial statejnents. — The accountant clearly recognizes 
that in preparing financial statements for any organ- 
ization he should present all the pertinent facts about 
the financial status and the result of operation of the 
organization. If he finds that the presentation of a 
statement of assets and liabilities of a holding com- 
pany as shown by its books, or the income account 
of a holding company as shown by its ledger, does not 
truly state the facts, which are of interest and im- 
portance to the stockholders, he must present the in- 
formation in such form as will properly disclose the 
facts. The accountant clearly recognizes that from 
the point of view of the stockholders of the holding 
company, the legal network of subsidiary organiza- 
tions is pure fiction. The stockholders of the holding 
company are not affected at all by the relation 
existing between the holding company and its sub- 
sidiaries, or between the subsidiaries themselves. The 
relation which the entire group has to outsiders, cred- 
itors and bondholders, alone are matters of vital im- 

9. Statements in form of balance sheets and income 
accounts. — Realizing that the balance sheet and in- 
come account of a holding company does not suffi- 
ciently show the relation of the group of companies 

XXII— 8 


to outsiders, the accountant prepares a statement to 
convey this information. These statements take the 
form of combined balance sheets and income accounts ; 
the former set forth the combined assets and habili- 
ties, eliminating inter-company transactions, and 
showing only the liabilities and capital stock out- 
standing, due to or held by, the public. Inter-com- 
pany sales and purchases are eliminated, and only 
those purchases and sales made by the group of com- 
panies from or to outsiders are included. Many dif- 
ficulties are encountered in the preparation of such 
statements, and some of these will be considered in 
the present chapter and in a later chapter dealing with 
a consolidated balance sheet. 

10. Financial results stated by means of consoli- 
dated stateinents. — We therefore see that while no 
existing law would compel a holding company to have 
its financial statements made up in the manner uni- 
versally agreed upon by accountants, and while we 
see also that there is no justification in law for the 
preparation of such statements, yet a logical applica- 
tion of the fundamental principles of the science of 
accounting requires that the financial results be stated 
thru the means of consolidated statements. These re- 
sults should be stated in such a manner as to show 
the income of the aggregation, eliminating inter-com- 
pany transactions, and to show also the financial posi- 
tion of the aggregation in so far as it is affected by 
the rights of bondholders, trade creditors and minority 


11. Consolidation of statemcfits. — In passing, it 
might not be amiss to point out, that consohdation of 
statements and consohdated statements are entirely 
dissimilar. A consolidation of statements results 
when a combination of several existing companies is 
contemplated. The promoter of this combination 
wishes to know how the consolidation will work out 
and what will be the probable condition of the new 
combination. A consolidation of statements is sim- 
ply the totaling of all items on each individual bal- 
ance sheet into one combined statement, showing the 
condition of the companies if they were to be con- 
solidated. In short it is a mere mathematical opera- 

Consolidated statements, on the other hand, are 
prepared periodically after the combination has been 
formed, to show the progress that has been made by 
the group as a whole. Their preparation brings up 
many new and interesting questions. Some of the 
problems involved are similar to those discussed in the 
chapter on branch accounts in the Text on "Account- 
ing Practice." 

It will be evident, then, upon reflection, that the 
balance sheet or income statement of a holding com- 
pany alone would simply show its own activities, to- 
gether with such earnings as are received from the 
dividends distributed by subsidiaries, and the interest 
earned on the bonds of subsidiaries. This is not suffi- 
cient information for those interested in the holding 
company. Many changes — good or bad — may have 


taken place in the group which would not be reflected 
in the holding company's statement. 

12. Factors not disclosed except thru the medium 
of consolidated statements. — There are many possible 
factors which might be entirely overlooked in examin- 
ing the financial statements of holding companies 
prepared in this manner. A brief consideration of 
some of these will give evidence of the futility of such 
a course. In this connection, it may also be men- 
tioned that there will be much data regarding the con- 
dition of the subsidiary corporations themselves 
which will not be disclosed by their own individual 
statements. Moreover, certain other factors will not 
be clearly in evidence even if one examines all of 
the statements at one time — that is, if the financial 
statement of the holding company and its subsidiaries 
are available for comparative examination. The mul- 
tiplicity of items and the difficulty of following inter- 
company transactions thruout their course renders 
such a practice of little value. 

13. Division of profitable business. — Some of the 
possible manipulations which might be practiced by 
dishonest management may now be mentioned. The 
executives of the holding company may turn over all 
the remunerative business to one subsidiary, and all 
the non-paying business to another. In this way, 
especially if there was a large majority in the com- 
pany to which the non-paying business was turned 
over, it might be possible to wreck the second com- 
pany. Or the holding company might be loaded with 


the non-paying business only. If the directors owned 
considerable stock in subsidiary corporations and had 
but a small interest in the holding company, they 
would draw large dividends from the subsidiary com- 
pany and stand but a small part of the loss of the 
holding company. Again, as more frequently hap- 
pens, the management might turn over all the un- 
profitable business to a subsidiary which would show 
a loss in operaton, while the holding company han- 
dling all the paying business would be able to show 
large profits. This would result in another sort of 
misstatement. The holding company's account 
would indicate that a profitable business was being 
done, and the investors would not know of the bad 
conditions of the subsidiary company. 

14. Dividends out of capital may remain U7idis- 
closed. — Dividends might be received from a sub- 
sidiary company which would be carried as income on 
the books of the holding company. It might happen 
also that such dividends were declared out of capital. 
The accounts of the holding company might give no 
evidence of this fact which would be difiicult to dis- 
cover from the separately stated accounts of the sub- 
sidiary company. On the other hand, dividends 
might be withheld from the stockholders of the sub- 
sidiary companies thru the majority control by the 
holding company, even tho the subsidiary could well 
afford to pay them. This would result in depressing 
the price of the holding company's stock thru reduced 
earnings, and would enable the directors or stock- 


holders who were aware of the facts, to acquh'e the 
holding company's stock at low prices. 

15. Advmices to subsidiaries. — Advances are often 
made by the holding company to a subsidiary and the 
subsidiary may in turn control other organizations to 
which it advances money. These advances may be 
carried upon the books of the lender as accounts re- 
ceivable, current advances, or notes receivable, if 
the advances are represented by notes. The debtoi 
corporation may have invested the funds in fixed as- 
sets, or it may be the intention of the debtor to liqui- 
date the advance thru an additional issue of its capital 
stock or bonded debt. 

It is evident that such advances are, in no sense, 
current assets. Or, what may be even still more un- 
favorable, the advance may have been made to the 
debtor corporation for the purpose of making good 
the operating losses. To any one examining the bal- 
ance sheet of the creditor company, it would appear 
that the creditor company had a much larger fund of 
current receivables than was actually the case. 

16. Failure to provide for operating losses of sub- 
sidiaries not apparent. — Still another form of mis- 
statement that might be indulged in would consist of 
having the holding company receive as dividends, or 
even largely over-state, the profits of the whole group 
by declaring dividends from those sub-companies 
which had made profits, while failing to charge the in- 
come account with the proper provision for losses 


which may have been sustained by other companies of 
the groujo. All of these factors contribute chiefly to 
the changes in the market prices of the capital stock 
of the holding company. By presenting information 
which is not in accordance with accounting principles 
the management would be enabled to mislead the pub- 
lic, bringing about fluctuations in the price of the 
holding company's stock tho not actually violating the 

17. Balance sheets should he consolidated. — The 
failure to consolidate the income accounts of the sub- 
sidiaries probably does not result in as great disad- 
vantage as would the failure to consolidate the bal- 
ance sheets. The failure to eliminate inter-company 
sales and inter-company purchases would of course 
result in an overstatement of purchases as well as 
sales. The failure to eliminate the inter-company 
profits represented in the inventory would naturally 
result in an overstatement of the profits for the 
period, because it will be realized that the inventory 
is an essential and important part or the income ac- 

Likewise all inter-company construction work per- 
formed by an affiliated company, and prepaid ex- 
penses of inter-company origin, should be carried in 
the consolidated statements only at cost, net of any 
inter-company profit. The expenses of one company 
are set against the earnings of another and both 
are eliminated from the consolidated statement. The 


working papers required to prepare consolidated in- 
come accounts are made up practically on the same 
basis as those covering the consolidated balance sheet 
illustrated on pages 247, 248. 

18. Inter-coinimny transactions. — To illustrate how 
these inter-company transactions are eliminated from 
the inventories, construction accounts, etc., in the con- 
solidated income account, we shall suppose that a hold- 
ing company controls, among other concerns: a min- 
ing company, "A" ; a steamship line, "B" ; a steel com- 
pany, "C"; a railroad, "D" and a rolling mill "E." 
The mine produces ore, and sells for $100,000, at a 
profit of $17,000 to the steel company (C). It is 
shipped via the steamship line ( B ) at a freight cost of 
$3,000 (profit $900). The steel company expends 
$37,000 in manufacturing this ore into steel valued at 
$150,000. It sells $50,000 worth to outsiders and 
$75,000 to the affihated company "E." This $75,000 
worth of steel is shipped to the "E" company over the 
railroad "D" at a freight cost of $3,000 (profit $600) . 
The "E" company manufactures this steel into steel 
rails at a manufacturing cost of $12,000 and derives 
a profit of $10,000. Of this $100,000 worth of steel 
rails, they sell $25,000 to outsiders and $50,000 to 
the affiliated railroad companies. The railroad has 
consumed one-half of these steel rails by the time the 
consolidated statement is to be prepared. We would 
set up our schedule of the transactions somewhat as 
follows : 


'C" COMPANY Gross Cash Inter-Co. Profit 

Purchases $100,000 $17,000 

Freight 3,000 900 

Manufacturing Cost 37,000 

Manufacturing Profit 10,000 10,000 

Total $150,000 $27,900 

Sold to Outsiders $ 50,000 $ 9,300 

Sold to Aflaiiated Companies 75,000 13,950 

Total $125,000 $23,250 

Inventory at Selling Price $ 25,000 $ 4,650 


Purchases $ 75,000 $13,950 

Freight 3,000 600 

Manufacturing Cost 12,000 10,000 

Manufacturing Profit 10,000 

Total $100,000 $24,550 

Sold to Outsiders $ 25,000 $ 6,137.50 

Sold to Affiliated Companies 50,000 12,275. 

Total $ 75,000 $18,412.50 

Inventory at Selling Price $ 25,000 $ 6,137.50 


Purchases $ 50,000 $12,275. 

Consumed 25,000 6,137.50 

Inventory at Cost Price $ 25,000 $ 6,137.50 

The consolidated statement could pick up the 
$75,000, inventories (the total of three inter-com- 
panies' inventory profits), less $16,925 of inter-com- 
pany profit. The amount of inter-company profits 
going with any sale, either to outsiders or to affiliated 
companies, depends upon the ratio of the amount of 
that sale to the total sale. 

It will be noticed that the inventories which we have 


left for each company are figured at the cost to each 
company, plus their own percentage of profit. This 
was done simply for the sake of clearness in the illus- 
tration. Of course, these inventories would not be 
carried in their own balance sheets at a figure which 
included their own profit. For the purposes of the 
consolidated statement, however, the reader will see 
that the profit is entirely eliminated. 

It is more frequently the custom to record the inter- 
company profits on the stock records at the time of 
purchase. The inventory will then show the inter- 
company profits witliout the need of such an elaborate 
schedule as given above. 

19. Inter-company pro fits on construction. — A 
slightly different situation results in connection with 
profits on inter-company construction. They must 
be charged back thru the books of the holding com- 
pany when they are paid out by the profiting cor- 
poration as dividends. If the construction was done 
for the holding company, this company will simply 
credit the dividends to the construction account. If, 
however, the construction was done for some other 
affiliated company, the transfer must be made thru 
the books of the holding company. The holding com- 
pany will credit the inter-company profits received as 
dividends, to the company for which the construction 
was done. This company will, in turn, credit the 
same amount to the asset, construction account. 

The advances between subsidiaries, or the notes 
given between subsidiaries, usually bear interest; or 


the note of a subsidiary may be discounted by the 
holding company resulting in the creation of a de- 
ferred asset, "discount paid in advance," on the books 
of the subsidiary company. It is evident, of course, 
that interest paid or earned on such inter-company 
transactions is another item to be eliminated from the 
income statement. 


Distinguish between a parent company and a holding com- 
pany. Does this distinction have any significance for accounting 
methods ? 

If Company A owns 100 per cent of the stock of Company B, 
does it own tlie assets of the latter? 

Describe the usual balance sheet of a holding company and 
compare it with a consolidated balance slieet. 

What is the value of consolidated balance sheets and income 
statements ? Describe some of the irregularities which such con- 
solidated statements may disclose. 




1. Fixed or capital assets. — The assets designated 
as fixed or capital assets are those of a permanent na- 
ture which a business organization has acquired, and 
which are generally financed thru the issue of capital 
stock or bonds. In some instances, assets of this char- 
acter are financed thru surplus, but in any event they 
represent that portion of the capital investment which 
the company does not intend to dispose of, or which 
could not be disposed of without seriously crippling 
the operation of the business. Assets, the utility of 
which lasts less than one year from the date when they 
are placed in service, ordinarily should not be included 
under this group. 

2. Real estate, or real property, — Published bal- 
ance sheets frequently show "real estate," or "real 
property," which includes land, land improvements, 
leaseholds and buildings. Real property is the right 
to use and enjoy land. Under the law of real prop- 
erty, buildings or permanent structures erected on the 
land become a part of it. While this is the legal view, 
from the accounting viewpoint a sharp distinction is 
drawn between land and buildings. The reason for 



this is that the accountant is forced to consider the 
question of depreciation in connection with buildings, 
and it is advisable to keep separate accounts for the 
component parts of the real property investment. 

3. Plant land distmguished from land held as an 
investment. — The account for plant land should be 
charged with the value of the land acquired strictly for 
the purpose of manufacturing or trading operations. 
Business firms will occasionally make investments in 
land for other purposes, such as for development in 
connection with housing schemes for employes, and 
the like. Land acquired for such purposes is essen- 
tially an investment and will ordinarily receive differ- 
ent treatment in the accounts. 

4. Valuation of plant land. — The account with 
plant land should be charged at the time of purchase 
with the actual cost of the land, whether it is paid for 
in cash or in securities. It is proper to include in the 
cost all the necessary and incidental expenses in con- 
nection with the acquisition of the property, such as 
the cost of title-searching or the registration of title, 
broker's commission or fee, the cost of recording the 
deeds and conveyancing, taxes accrued up to the date 
of the transfer of title, and other liens or assessments 
levied against the property at the date of its acquisi- 

5. Land improvements. — While the cost of improv- 
ing land or rendering it suitable for the purposes for 
which it is intended to be used, is frequently merged in 
the land account, it is generally advisable to keep a 


separate account for the cost of these improvements. 
It may be necessary to drain the land and to fill in 
swamps; it may be necessary to cut down embank- 
ments. In fact, any improvements of a permanent 
nature which add to the value of the land, and render 
it suitable for the purposes for which it is to be em- 
ployed are properly chargeable to this account. 

6. Land invest7nent. — The general principles out- 
lined in the preceding paragraph apply to land pur- 
chased primarily for investment. The cost of any 
improvements made to land investments should also 
be carried in a separate account. It must be remem- 
bered, however, that land of this character will not 
produce any revenue under ordinary conditions. 
There will be annual carrying charges for taxes and 
for interest on borrowed money, and for statistical 
purposes it is probably desirable to add expenditures 
of this kind to the value of the land. Accordingly, 
the problem is to measure the cost of this unproduc- 
tive investment. However, where the method of cap- 
italizing the ordinary maintenance expenses is fol- 
lowed, a reserve equivalent to the amount of the an- 
nual capitalized charges should be set aside out of 
profits. The reason for this is that if the land is ul- 
timately disposed of, such capitahzed charges may not 
be recovered. Accordingly, the failure to provide for 
a reserve would inflate the surplus and, in the case of a 
corporation, these capitalized expenditures would be 
made available for dividends. 

7. The treatment of land as stock in trade. — The 


treatment of land purchased by a real estate concern 
for development and subsequent sale will be different 
from that outlined above. No difficulty will be en- 
countered in transactions of this kind if we realize 
the fact that the land is similar to raw material pur- 
chased by a manufacturing concern for the manufac- 
ture of finished products. The cost of grading, street- 
openings, sidewalks, and sewer and water connections, 
all enhance the value of the property and should 
be capitalized. Taxes, interest on purchase-mbney, 
mortgages, and all carrying charges during the period 
of development may also be capitalized. 

It is customary in real estate developments to keep 
costs by plots. Each plot is then cut up into a cer- 
tain number of lots, and the total expense of the de- 
velopment divided b}^ the number of lots will be the 
cost per lot. When a sale is made, the proceeds of 
the sale are in part a realization of the capital invest- 
ment and in part a realization of profit. In order to 
determine that portion which represents a return of 
capital and that portion which may properly be taken 
to the credit of the profit and loss account, it is neces- 
sary to keep accurate costs by plots or lots. 

While capital charges ordinarily cease after the 
property is fully developed, in order to determine the 
real profitableness of the undertaking it is customary 
to caj^italize interest charges, running expenses and 
taxes even after the development has been completed. 
This is for the purpose of estimating not only the total 
cost to develop, but also the cost of carrying each in- 


dividual lot. However, if this method is followed, 
carrying charges capitalized after operations have be- 
gun should be offset by the creation of a suitable re- 
serve against the possibility of the failure to realize 
such carrying charges when the lots are ultimately 
sold. Upon the subsequent sale of lots, the reserve 
created with respect to this particular lot, or the por- 
tion of the general reserve created with respect to this 
particular lot, will be adjusted, and such portion of it 
as has been realized in the sales price of the lot will be 
released to surplus. 

8. The valuation of leaseholds and leasehold rights. 
— With reference to leaseholds, it is important to note 
the length of the life of the lease. The benefit of all 
expenditures made either for land improvements or 
for buildings upon leased land, will pass ordinarily to 
the landlord at the expiration of the lease. Conse- 
quently, any value paid for the lease, or any expendi- 
ture incurred upon leased property, must be written 
off during the life of the lease. When a party takes 
land under lease and makes extraordinary improve- 
ments, the lease frequently is drawn with a provision 
in which the landlord agrees to pay a fixed sum, at the 
expiration of the term, to the tenant for the tenant's 
improvements. This factor must be taken into con- 
sideration in valuing a leasehold. 

In other cases, a firm may have sublet its lease- 
hold rights, and the question of the valuation of the 
leasehold may arise. Ordinarily such contracts are 
not capitalized, and the question of their value would 


probably not arise except in the case of a partnership, 
when it might be necessary to determine the value of 
a deceased partner's interest. The annual income to 
be enjoyed from the lease, less all carrying charges, 
may be considered as an annuity for the number of 
years that the lease has to run, and from the compound 
interest tables the present worth of the annuity can 
be worked out. Any sum recoverable from the land- 
lord at the expiration of the term of the lease may be 
valued by finding its present worth from the com- 
pound interest tables at an assumed rate of interest. 

9. Mineral land and ti7nher property. — The prin- 
ciples of valuation are difficult to apply in cases of 
wasting assets. Every dollar's worth of ore taken 
from a mine, or every gallon of oil from an oil well, 
reduces the value of the land for the purposes for 
which it was acquired. The proceeds of sales are 
represented in part by a return of the capital invest- 
ment and in part by a realized profit. Because of 
the difficulty of arriving at these amounts, mining 
companies, as a rule, do not make any provision for 
the conservation of the capital investment, but they 
customarily pay out all the net proceeds of current 
operation as dividends. 

Where the purchase of land, containing mineral 
wealth has been financed thru an issue of bonds, there 
will usually be a provision in the indenture creating a 
sinking fund for the ultimate redemption of the debt. 

It is not generally considered desirable in mining 
companies to provide a reserve for exhaustion, for the 

XXII— 9 


reason that the creation of the reserve results in with- 
holding large sums of cash in the company's treasury. 
This fund may not be safely invested in additional 
mineral wealth; it will draw a small rate of interest 
and it may be used for speculation by the board of 
directors or otherwise mismanaged. 

JNIoreover, the approximate recovery from a gold or 
copper mine is a difficult thing to determine ; in fact, 
it probably cannot ordinaril}'^ be determined with any 
reasonable degree of accuracy. On the other hand, a 
competent geologist may be able to determine the 
approximate recovery of a coal mine. The produc- 
tion life of an oil well is purely speculative. Stock- 
holders and investors in enterprises of this character 
must realize that every dollar's worth of dividends is 
in part a return of capital investment, unless the or- 
ganization is providing a reserve for exhaustion. 
Furthermore, the investment of a reserve for ex- 
haustion in additional land may not be desirable for, in 
many instances, the carrying cost of such investments 
will prove excessive and the investors in the under- 
taking will find themselves land-poor. 

The valuation of timber properties is also a very 
difficult matter. It is true, that expenditures upon 
growing timber will usually be recovered and reflected 
in the increased size and value of the timber. How- 
ever, if scientific reforestation is not employed, the 
proceeds of sales are a return, in part, of capital in- 
vested and, in part, of net profit. 

Assets of this character are also subject to fire 


hazards, in the case of timber property, and floods in 
the case of mines. These agencies may destroy a 
large part of the capital invested or cause great loss 
to stockholders. If contingencies of this character 
have not been provided for thru the medium of ade- 
quate reserves, the investor or stockholder must 
take this into consideration in the valuation of his 

10. Depreciation or appreciation of land. — Fluc- 
tuations in the value of land, due to economic condi- 
tions, should be ignored. This has already been 
pointed out in the volume on "Accounting Practice." 
Heretofore, consideration of possible depreciation of 
plant land was not necessary. The shifting of in- 
dustry, however, may cause it to be an important 
factor against which a reserve for loss in the value of 
land may be appropriate. We are all familiar with 
loss in the value of land used for manufacturing pur- 
poses, which is caused by a relocation or shifting of 
the industry. Along the line of almost any railroad 
one may see large factories idle, because of either 
labor conditions or a shifting of the market for fin- 
ished material, or the opening up of new sources of 
raw materials, which made it more advantageous for 
the firm to abandon its present quarters and locate 
elsewhere. This contingency should be considered in 
valuing land used for plant purposes. 

11. Important points in the valuation of buildings 
and structures. — When a firm acquires buildings, 
which have already been erected, tlieir valuation will 


be fixed by the board of directors at the date of ac- 
quisition and will be based upon the amount paid for 
them. When a corporation erects its own buildings, 
it may undertake to do the work itself, furnishing the 
material, labor and supervision, or it may award the 
contract to a construction company. In the latter in- 
stance, the contract price will fix the value of the 
structure. When the organization undertakes to do 
its own construction, the cost of the structures will 
include the cost of all materials used, the cost of the 
labor necessary to erect the structure, and the cost of 
foundations and sub-structures, including water mains 
and similar items. It would be proper also to 
charge to cost of construction fees paid for the draw- 
ing of plans and specifications or supervision fees 
paid to an architect. Any proportion of the time 
spent by the administrative staff of the organization 
in supervising the work of construction may also be so 
charged. It is also proper to capitalize subsistence 
charges and transportation expenses of laborers or 
supervisors who may be employed. In fact, all the 
incidental and relevant expenses incurred in con- 
structing the buildings should be charged in this way. 

Any interest paid on borrowed money used in 
financing the construction of the building, may be 
properly charged to its cost until the building is com- 
plete and ready to operate. 

It should be noted that there are differences of 
opinion about the treatment of discounts on securities 
issued or debts incurred in financing construction. 


The best American practice, at present, does not favor 
charging this item. 

On the other hand, in England, under certain con- 
ditions, a corporation that issued stock to finance the 
construction of a building might be allowed to pay a 
reasonable dividend on the capital stock during the 
time the money was being employed in constructing 
the building and getting it ready for operation. The 
amount of the dividend so declared would be charged 
to construction account. 

Some authorities hold that interest on borrowed 
money used in construction should not be charged 
to the cost of structure. The reason advanced is that 
the method of financing the construction of a build- 
ing has nothing to do with its cost. However, the 
weight of authority at the present time seems to be op- 
posed to this theory. 

Any insurance, either fire, employer's liability or 
general liability, paid during the period of construc- 
tion is a proper charge to the construction account. 

It is sometimes necessary to demolish a structure 
for the purpose of erecting a new one. There are two 
theories about the treatment of the loss occasioned by 
the demolition of the existing structure. One is that 
the loss is a necessary £ind incidental expense in the 
erection of the new structure, and therefore should be 
capitalized in the cost of the construction. The other 
theory has supporting it the economic doctrine of the 
place value of land. It would, of course, be an un- 
wise proceeding for a concern to purchase land and 


pay for an existing structure only to demolish it to 
make way for a new establishment. In fact, a busi- 
ness undertaking would not be likely to do this unless 
it were distinctly profitable for it to have its plant lo- 
cated, or the new structure erected, upon this particu- 
lar parcel of land. 

12. Repairs, renewals, additions, betterments and 
replacements. — Any considerations of the subject of 
the valuation of building necessarily must deal with 
these items. They have been so fully discussed in the 
volume on "Accounting Practice," however, that it is 
necessary here only to call attention to the fact that 
the valuation of assets in the balance sheet must al- 
ways be considered with the qualifications that the 
business has made the proper differentiation between 
capital and revenue expenditure. 

13. Imjjortance of segregating the investment in 
equipment. — The equipment account will include the 
expenditure for building equipment and power-plant 
equipment, such as boilers, dynamos, engines, heat- 
ing plant, ventilating system, and water connec- 

It is not our purpose here to discuss at length an 
ideal classification of equipment, even if such a classi- 
fication could be prepared. It will be sufficient to ob- 
serve the general principles upon which equipment 
may be classified. One of these is according to the 
life of the equipment, that is, classifying all units with 
the same relative period of utility in special accounts, 
so as to enable the provision for depreciation to be as- 


certained more readily. It may also be classified ac- 
cording to kind. In this division under the account, 
"boilers and accessories," would be included all of the 
boilers and boiler apparatus and accessories that were 
being used in the production of steam. These would 
include the valves, main steam line, grates and flues, 
smokestacks and chimneys, and foundations and set- 
tings, together with mechanical stokers and ash re- 
movers, etc., etc. The entire investment in this class 
of equipment might appropriately be carried in one 
account. Still a third method of classifying equip- 
ment might be according to the manufacturing units. 
All property investments would be classified in the 
general ledger by operating units or plants, and a sub- 
sidiary record for each unit, setting forth classes or 
kinds of equipment, would be provided. Whichever 
method is used, it must be remembered that certain 
kinds of equipment which are installed in leased prop- 
erty may become part of the realty and may not be 
removed. Consideration must be given to this factor 
when any of the property of an undertaking is occu- 
pied under lease. 

14. Machinery and fixed tools. — Ordinarily the 
general ledger would show a machinery and fixed 
tools account, and if the investment is at all large, a 
subsidiary record should be provided for equipment of 
this class. The reader will recall that in the volume 
on "Accounting Practice" certain principles concern- 
ing the valuation of machinery and equipment were 
discussed, especially the treatment to be given to 


equipment manufactured by the organization itself. 
Tools and equipment having a period of utility of less 
than one year, should not be charged to this account. 
Because of the necessity of replacing them immedi- 
ately, it is better to charge such tools and equipment 
direct to the income account. If this practice is fol- 
lowed, the original outlay for short-life equipment 
can be capitalized and it would then represent the 
total sum necessary properly to equip the organiza- 
tion with these short-life assets. This procedure 
would avoid the unsatisfactory and time-consuming 
method of providing annually for depreciation on 
equipment of this type. 

15. The valuation of furniture and fixtures. — This 
asset may be subdivided between the furniture and 
fixtures in the manufacturing plant and that in the 
general office or in branch offices. It consists of all 
furniture, machines and devices for calculating or for 
clerical use, lighting fixtures, partitions, and the like. 
In dealing with this asset, it is not uncommon for firms 
to capitalize the expense of a complete and adequate 
outfit, and charge any annual expenditures incurred 
subsequently in renewals or replacements, direct to 
the expense account. Other organizations find more 
satisfactory the method of capitalizing all new pur- 
chases and writing off depreciation periodically. 
Most conservative organizations follow the practice 
of depreciating these assets rapidly because, if aban- 
doned, they are worth very little for scrap. A bank- 
ing organization will write down its building and fix- 


tures much more rapidly than would the ordinary 
manufacturing organization. It is true, this creates 
a secret reserve, but it is considered good business pol- 
icy in organizations of this type. 

16. The 'principles employed in the valuation of 
stable and garage equipment. — Horses and mules are 
ordinarily revalued from year to year by appraisal. 
Automobile trucks are usually depreciated at the rate 
of from 20 to 33% per cent. The balance of the stable 
equipment will ordinarily be depreciated at rates from 
1272 to 20 per cent. 

17. Patterns, drawings, and dies. — It will not be 
necessary here to amplify the discussion dealing with 
the class of assets represented by patterns, drawings, 
dies and the like, which the reader has already found 
in the volume on "Cost Finding." Care and discre- 
tion and a great deal of common sense must be used 
in the valuation of these assets. The failure to pro- 
vide adequately for depreciation is a very common 
occurrence, and if an asset of this kind appears in a 
published balance sheet for a large amount, the stock- 
holder or investigator is justified in regarding it with 
considerable suspicion. 

18. The general problem of depreciation. — Atten- 
tion has already been called, in the Texts on "Ac- 
counting Principles" and on "Accounting Practice," 
as well as in that on "Cost Finding," to the general 
subject of depreciation, its importance, the methods of 
providing for it, and the necessity of giving it due 
recognition in the accounts. Our interest at present 


lies in the general subject from the point of view of 
the interpretation of a balance sheet. 

If depreciation reserves appear on a balance sheet 
merged with other reserves or with surplus, as is very 
often the case, a just suspicion may arise that this 
method of combining the reserves and the surplus has 
been adopted because of the fact that the depreciation 
provisions are not adequate. If the reader of a pub- 
lished balance sheet has the current income account at 
hand, perhaps he may satisfy himself as to the ade- 
quacy of the depreciation provision for the current 
period. But this will not be an indication which may 
always be relied upon. Some firms often follow the 
practice of providing heavily for depreciation in pros- 
perous years and ignoring the provision during lean 

19. Special factors to he considered in interpreting 
a balance sheet. — The assets which we have described 
above comprise the tangible fixed capital of ordinary 
undertakings. It is not usual to find the elements of 
the capital assets classified in sufficient detail in a 
published balance sheet. For example, the land and 
buildings may be merged in one account, or land, 
buildings and equipment may be merged in one ac- 
count. Inasmuch as the reader of the balance sheet 
probably would not be in a position to know the value 
of the land or the building or the equipment, he would 
be at a loss to decide whether or not the amount of 
capital invested in this class of assets was excessive 
or inadequate. Neither would it be possible for him 


to determine satisfactorily the adequacy of the re- 
serves provided for depreciation. 

In other cases, the intangible fixed capital of good- 
will, patent rights, copyrights, trade-marks or fran- 
chises may be merged with the tangible fixed capital. 
In cases where this occurs it is a fair assumption that 
the intangible fixed capital constitutes a large pro- 
portion of the total value of the assets. It is to be 
noted, however, that many of the larger corporations 
now follow the practice of stating separately, in their 
balance sheets, the valuation of the tangible and the 
intangible fixed assets. Occasionally in public bal- 
ance sheets we find the tangible fixed capital grouped 
under an account, "cost of property." However, 
this is no indication of its true value. 

The relation between total fixed assets and the ag- 
gregate amount of capital and long-term debt is im- 
portant. In considering this relation, the reserve 
for depreciation may be ignored, for theoretically the 
cash which represents this reserve is available for the 
repair of any waste or decline in the value of the fixed 
tangible assets or it has been reinvested in property. 
Many organizations make the mistake of investing too 
much of their capital in costly plant, and do not leave 
enough working capital with which to conduct their 
operations profitably. It may then be necessary for 
them to raise large amounts of floating debt with 
which to finance the purchase of working and trading 
assets, pending the conversion of their current assets 
into cash. As pointed out in the Text on "Corpora- 


tion Finance," these floating liabilities may be a 
source of weakness or the cause of insolvency in times 
of panic or depression. 

If the corporation has an issue of bonds, it is im- 
portant to note just what particular property of the 
organization is pledged as security for tlie debt. In 
all probability, the land, land improvements, buildings 
and structures are specifically pledged. But in this 
connection it must be remembered that much of the 
plant and machinery and building equipment, under 
the law, is technically realty or realty fixtures, and 
accordingly may be pledged under the mortgage. 

20. Equipment purchased on the j)artial-pai/ment 
plan. — Transportation companies and other under- 
takings often acquire equipment on the partial-pay- 
ment plan. It is evident that equij^ment purchased 
under this method of financing will cost more than if 
it were paid for in cash. The difference between the 
price paid under the partial-payment plan and the 
cash price of the same equipment is the amount of in- 
terest which the seller has charged as an offset to the 
postponement of the payment date. Usualh^ it will 
not be a difficult matter to determine what the cash 
price is. Then, the number of payments being known 
and a reasonable rate of interest assumed, it will be 
possible, thru the medium of instalment loan tables, 
to determine how much of each periodical payment is 
to be ajDplied to the reduction of the debt, and how 
much represents interest. 

The greater portion of the initial payment will be 


on account of interest, but the gradually decreasing 
principal will decrease the interest charge correspond- 
ingly, with the result that the later payments will re- 
duce the principal more rapidly. The agreement un- 
der which equipment is sold in this way usually pro- 
vides that the title shall remain in the seller until after 
a specified number of rental payments have been 
made. Then, upon the payment of $1.00 additional 
at the end of the rental period, the seller agrees to 
transfer title to the purchaser. 

During the rental period, the purchaser will have to 
bear all the maintenance charges necessary to keep the 
equipment in its original condition. It also follows 
that depreciation enters into the problem, and tliat 
the buyer will have to set aside out of his earnings an 
adequate provision for the accrued depreciation on 
the equipment which will come ultimately into his 
possession. The proper method of treating the 
periodical instalment is to set up in the balance sheet 
as an asset the amount paid each period on account of 
principal. This would be designated by a title such 
as, "Equity in equipment purchased under partial- 
payment plan," or by some other suitable and descrip- 
tive title. The balance of the periodical instalment 
should be charged to the income account. 

Inasmuch as the title remains in the seller until the 
final payment is made, objection may be raised to 
this method of treatment. The ground for the objec- 
tion would be that the equity is not an actual asset 
and would be forfeited if the purchaser failed to com- 


plete the remaining payments. While this is true, 
yet if there does not appear to be any doubt of the 
firm's ability to meet the remainder of the payments 
when due, it seems to be better to set up the equity 
in the balance sheet. 

Another method of handling the matter would be 
to express the full contractual agreement in the ac- 
counts. This would be done by setting up an asset 
account showing the cost price of the equipment in 
the equipment account, suitably ear-marked by a con- 
tra-reference to the total contractual liability due to 
the sellers. The amount of interest included in the 
purchase price could be set up as a deferred charge 
to income, and it also should be suitably ear-marked 
by a contra-reference to the contractual liability set 
up and representing the amount due to the seller. 
As each periodical payment is made in cash the con- 
tractual liability created would be reduced and cash 

Furthermore, at each periodical payment a rateable 
proportion of the deferred charge, or the deferred 
asset, for interest would be transferred to the cur- 
rent-income account; thereby the amount of the de- 
ferred asset is reduced. The amount standing at the 
debit of the equipment account, plus the amount of the 
deferred charge to income remaining on the books, 
would represent the firm's equity in the equipment, 
when offset by the balance remaining in the contrac- 
tual liability account. 



State whether the principles applicable to the valuation of 
land differ according to its uses, as plant land, as investment or 
as stock in trade of a real estate development. 

How do mining and timber companies usually treat land in 
their accounts? 

In what important respect does the valuation of buildings 
differ from that of plant land? 

Give reasons why the accounts should always segregate equip- 
ment from lands and buildings. 

What is the best method by which to treat, in the accounts, 
equipment purchased on the instalment plan? 

State some of the conclusions which may be drawn from the 
manner in which accounts may be grouped in the statement of 



1. Introduction. — It is common practice to include 
under capital, or fixed assets, such items as good-will, 
patents, francfiises and the like. Inasmuch as all 
assets of this nature are of an intangible character, 
as distinguished from real estate, buildings, plants, 
etc., the author thinks it more advisable to group 
them under a separate heading. 

2. Good-will defined. — While good-will frequently 
appears as an asset in the balance sheet of a business 
concern, there are very few who have a definite con- 
ception of its true nature, or of the proper method of 
valuing it. Good-will has been defined as that in- 
tangible quality of patronage which attaches to an 
established business and is presumed to attach to it, 
irrespective of any change of ownership. 

A better definition, perhaps, would be that good- 
will represents the present worth or capitalized value 
of the estimated future earnings of an established en- 
terprise in excess of the normal results that it might 
reasonably be assumed would be realized by a similar 
undertaking established anew. 

Guthrie, in discussing good-will, says: 



The measure of value, in pecuniary terms, of this intangi- 
ble thing is the difference between the value of the normal 
results of the working of any business or profession which 
may be established by, and as worked by, any person in any 
place, and the result of working any individual business of a 
similar character. Thus, given a business, the good-will of 
which is for disposal, there would be no valuable good-will if 
any one could do just as well by establishing a business anew. 
To start a business has its risks, which may often be de- 
scribed as very serious risks, but apart from the mere peril- 
ous risks of failing to take proper root, there is the often 
weary time — sometimes a long term of years — during which 
a sufficient connection is being got together to bring the 
business up to a standard paying basis which will give a 
good-will value, or bring a good-will value into sight. To be 
spared this period of what I may call perilous probation 
is something worth paying for, even tho its maintenance 
from this point needs the continuous energy and industry 
by which it was built up by the original proprietor. Time, 
money and anxiety saved is money made. This is what is 
worth paying for and in this degree a good-will value attaches 
to an established business. 

3. Value of good-will dependent on location. — The 
value of good-will is dependent on a number of fac- 
tors. One of them is the location of the business 
premises. A change in the movement of traffic, due 
to the opening of a subway or the relocation of a 
terminal, may result in loss of patronage. This fre- 
quently happens in the more populated centers. On 
the other hand, it is not unusual to find examples of 
businesses so well established as not to he injured 
materially by the diversion of traffic or the inconven- 
ience of reaching the business premises. 

4. Good-will dependent upon the reputation and 

XXII— 10 


integrity of the firm. — Good-will may also depend 
upon the reputation of the firm for fair dealings and 
integrity. Thus, strict fulfilment of contracts, de- 
pendable quality of the merchandise sold, employment 
of efficient salespeople, prompt deliveries, favorable 
terms of credit, are attractive features which result 
in increased patronage, frequently in spite of an un- 
favorable location, or the more extensive advertising 
of competitors. As long as the original business 
policies are continued, good-will of this type usually 
will not be affected by a change of ownership. In 
this case good-will consists of the advantage which 
the new proprietor derives from being allowed to 
represent himself as the successor of the former owner 
or owners. 

5. Good-will created hy established monopolies. — 
Good-will is often created by the monopoly enjoyed 
thru the possession of a patent right or franchise, or 
as tlie result of the demand created and the patronage 
procured thru the extensive advertising of a trade- 
mark. While the life of a patent is limited by law, 
in many instances its holder or holders may have se- 
cured a foothold from which it may be almost im- 
possible for competitors to dislodge them, even tho 
the patent has expired. 

In this connection it is well to bear in mind that 
good-will has often been used as a subterfuge to re- 
duce the rate of return on capital investment. That 
is particularly true in the case of public service cor- 


In the litigation between the City of New York and 
the Consohdated Gas Company of that city, the 
Supreme Court of the United States rendered a de- 
cision to the effect that in determining whether or 
not a legislative rate was reasonable, good-will could 
not he included as an asset. 

This decision points out that there can be no recog- 
nition of good-will in the case of a public service 
monopoly. In view of the popularity of holding 
companies the decision is well worth remembering on 
account of the effect which the further interpretation 
and enlargement of this doctrine may have. 

6. The earning jjower as a factor in the valuation of 
good-zcill.—^The fact that a business possesses a favor- 
able location and has a well-established patronage 
does not necessarily imply that a purchaser should 
be willing to pay for its good-will. If these advan- 
tages do not return in net income a rate higher than 
a fair rate of interest on the capital investment and 
the wages of management, the purchaser would be 
unwise to pay for good-will. 

The new owner will naturally expect to receive a 
greater return of income than his interest and man- 
agement expense, or at least lie will desire to see 
in the business the possibilities of receiving greater 
profits than his predecessor obtained. 

It is quite true that tlie good-will of a defunct en- 
terprise has frequently realized a fairly large sum on 
the sale of the business, but in these instances it will 
be found that the new purchaser bouglit with the 


hope of being able to overcome obvious faults of mis- 
management, and that he depended upon building up 
a successful and profitable enterprise by himself. 

In the amalgamation and consolidation of compet- 
ing companies good-will is frequently represented by 
the anticipated savings which it is hoped will result 
from the elimination of competition and the introduc- 
tion of economies in management. 

Where these anticipated savings have not been 
realized — and that is true in many cases — usuallj^ it 
will be found that the good-will which was created 
was represented by an issue of common stock that 
received no dividends. In that case it is spoken of 
as fictitious good-will. 

7. TransferabUity. — Mention has been made of the 
factor of transferability. A professional firm sus- 
tains a confidential relation with respect to its clients, 
and it is very difficult to separate the good-will of such 
a firm from the personality of the professional man. 
It may be said, therefore, that the good-will in this in- 
stance, as a transferable asset of value is almost non- 
existent. It is for this reason that courts in many 
jurisdictions refuse to recognize good-will that rests 
entirely upon individualities, and a purchaser would 
be unwise to pay a high price for it. 

8. Method of valuing. — The most common method 
of valuing good-will is the so-called year's purchase 
method. The good-will is valued upon the basis of 
a certain number of years' purchase of the annual 
profits of a selected number of preceding years, or a 


certain number of years' purchase of the excess in- 
come of that enterprise, which consists of the residue 
of profits that remains after deducting interest on 
the capital, wages of management, and the like, from 
the net profits of operation. When this method is 
used it is important to see that the years selected have 
been normal ones and that the results in future years 
are likely to approximate or to exceed past experi- 

The number of years to be considered is a matter of 
bargain between the buyer and the seller, and accord- 
ingly no general rule can be laid down to apply to all 
lines of business. The usual estimate for an ordinary 
trading business is two years' purchase of the profits. 
Where a manufacturing business is under considera- 
tion the period is usually longer, say from four to 
five years, whereas for a monopoly or a quasi-monop- 
oly the period selected is usually from eight to ten 
years, and for professional practice the period usually 
selected is one year. 

The purchase of the profits for a number of years 
is in reality the purchase of an annuity of the amount 
of the profits for the number of years selected. If 
this view is taken, the good-will will be valued by 
the so-called annuity method. Under this theory the 
good-will is assumed to have a certain definite life, and 
when the amount of the excess profits and the number 
of years during which they are to be enjoyed have 
been determined, the problem consists of determining 
the present value of the annuity for the period selected 


at a given rate per cent. This can be ascertained 
readily from compound interest tables. 

9. Factors to he eliminated for the purpose of val- 
uation. — During the period covering the years' pur- 
chase, if unusual transactions or speculative ventures 
were entered into which resulted in extraordinary 
profits, the amount of these profits should be elimi- 
nated. Such profits are not incidental to the busi- 
ness which it is proposed to acquire, and therefore 
they should be ignored. The same rule applies to any 
other unusual or exceptional items of profit. Take 
as an illustration the conditions resulting from the 
European war. 

It often happens that the owner of a business an- 
ticipates selling it and has been using exceptional 
economy in expenditures for repairs during the last 
year or two, which would naturally reduce the amount 
charged against profits. Such a practice not only is 
an ultimate detriment to the assets of the business, 
but it also results in an overstating of the profits with 
a consequent overvaluation of good- will. 

The amount of money paid for interest on borrowed 
capital should be eliminated from the expenses, for 
the reason that interest on borrowed money is a pen- 
alty which the business has had to pay for not having 
sufficient capital. The same thing applies when a 
firm has not taken advantage of discounts, by reason 
of lack of capital with which to prepay its bills. 

10. Factors requiring careful scrutiny. — It is 
necessary to see that adequate depreciation has been 


provided for, not only on the fixed assets but also on 
some of the current and deferred assets. The reader 
will see readily that if proper provision for deprecia- 
tion has not been made, the profits will be overstated 
and the good-will correspondingly overvalued. 

In determining the value of the good-will it is im- 
portant to see that all existing liabilities on contracts 
which the former owner may have entered into are 
given due consideration. Contracts may have been 
entered into prior to the date of the sale of the busi- 
ness, the completion of which may result in a loss and 
therefore affect the profits to be enjoyed by the 

Oftentimes it is found that sales on consignment or 
sales on approval have been represented in the ac- 
counts as valid sales and the full credit for profits 
has been taken into the income account. 

In other cases when municipal assessments are 
allowed by law to run for a number of years, the 
books will not reflect these obligations in any way. 
It will be noted that the annual payment or assess- 
ments of this character will seriously affect the profits, 
and if any unpaid assessments remain, due weight 
should be given to them in considering profits. 

In some instances only a portion of the business is 
disposed of by the vendor. It may be that he is to 
retain that part of the business which is earning all 
the profits, and that he is selling that portion which is 
not profitable. If tlie accounts of both branches have 
been merged and if it is impossible to extract informa- 


tion from the records as to the profitahleness of the 
individual units of the business, the determination of 
the value of the good-will becomes a very difficult 

11. Matliematical results. — The first step, there- 
fore, is to determine what the annual profits are for 
a number of years. The next step is to average them 
so as to get the average profit for one year. It is 
customary to deduct at this point interest on the 
capital invested from the amount so found. The in- 
terest rate is generally an assumed per cent per an- 
num, often six or seven per cent. This is based on 
the theory that a tangible asset in tl^c business will 
earn at least that rate of interest. In other words, 
out of the total profits realized, this particular amount 
is reserved for the normal interest which the invested 
capital would earn elsewhere. The result will be the 
excess income, which constitutes an annuity to be en- 
jjoyed for a period of years. 

12. Fictitious good-will. — The good-will account is 
sometimes used as a medium for concealing losses, the 
account being raised to an amount equivalent to or 
greater than the deficit in the income account. It 
may also represent an overissue of capital stock. In 
fact, good-will appearing in the balance sheet of many 
of the largest consolidations represents stocks and 
even bonds issued not only for all the good-will that 
the consolidated concerns actually possessed, but in 
addition all fees for banking and promotion services. 
In a few instances this account represents an exag- 


gerated forecast of the savings and economies an- 
ticipated thru the consohdation of competing con- 
cerns which unfortunately have never materiahzed. 

13. When good-will is created. — From an account- 
ant's point of view, good-will should appear on finan- 
cial statements after it has been acquired, and for the 
original cost only. 

It is held by some that when a concern has just 
commenced business and has incurred a large expense 
for advertising during the probation period, it should 
be charged to a good-will account. This is based on 
the theory that it is unfair to charge all the expense 
of large advertising appropriations and the cost of 
creating a demand for the products of the firm, 
against the profits of the year in which the expenses 
were incurred. If the expenditures mentioned above 
resulted in placing the business upon a firm founda- 
tion, and if there is a reasonable assurance that profits 
will result from the expense incurred in promoting 
the business, it is permissible to charge this extraordi- 
nary advertising expense, during the first two or three 
years, to a good-will account. This practice is based 
on the theory that the amount has been expended for 
the benefit of subsequent years, which are to receive 
the advantage of the present extraordinary expense. 

However, for safety's sake, it may perhaps, be much 
more advisable that such expenditures be carried un- 
der "Prepaid Advertising" and be written oflP in fu- 
ture years. 

Good-will should not be created arbitrarily upon 


the accounts of a business except in cases similar to 
those mentioned above. 

Neither in the case of a sole trader or partnership 
nor in the case of a corporation has this practice 
anything to commend it. An intending purchaser 
would value the good-will independently, regardless 
of its value in the balance sheet of the vendor. Bank- 
ers or credit men would ignore the items and rather 
view them with suspicion. 

14. Is good-will of a fluctuating value? — While 
good-will is an asset of the most fixed nature, in the 
sense that it could not be disposed of without seriously 
interfering with the success of the business, it is neces- 
sarily a fluctuating asset because its value is meas- 
ured by the earning power of the business, which or- 
dinarily fluctuates. It must follow that the value of 
the asset will correspondingly fluctuate. 

There is considerable discussion as to whether or 
not this is true. In a paper read before the Congress 
of Accountants — in St. Louis, in 1904 — entitled "The 
Profits of a Corporation," Mr. A. L. Dickinson, 
C. P. A., states : 

. . . As long as the earnings of a business are main- 
tained at not less than the level contemplated at date of pur- 
chase, it is impossible to allege any depreciation of value or 
the necessity of any provision therefor. On the other hand, 
if any serious depreciation has taken place, the profits are 
probably so much reduced that it is not possible to make 
such provision. Good-will is, in fact, a fixed asset whose 
value is to some extent dependent upon the profits, and its 
fluctuation being consequent on, and not a cause of, the earn- 


ings or profits, as are wasting or partially wasting assets, 
should not, therefore, to be taken into account in ascertaining 

On the other hand, in an article that appeared in 
"The Accountant" (London, December 6th, 1913), 
Mr. John Bauer makes a plea for an annual adjust- 
ment of the good-will, based upon the profits, and 
advocates the adoption of the plan because of certain 
advantages which he claims will result from it. He 
distinguishes fundamentally between asset value 
(cost) and capital value. He uses this latter term to 
represent the sum of the discounted future profits of 
the business, assuming equal annual profits. Under 
this plan the good-will account would be adjusted an- 
nually thru the surplus account or thru the proprie- 
torship account, based upon the showings of the busi- 
ness. If the business looked highly prosperous and 
the prosperity seemed likely to increase, or at least 
remain static, the good-will would be increased and 
the surplus, or proprietorship, correspondingly in- 
creased. If, on the other hand, the reverse were true, 
both the surplus and the good-will account would be 

To further support his theory he cites the case of 
a concern with tangible or physical assets worth 
$50,000, which is taken over by another company, the 
latter paying $5,000 for the good-will. On the books 
of the new company the assets will appear at a valua- 
tion of $55,000, because the second company paid 
$50,000 for tangible assets and an additional $5,000 


for the good-will. Yet a concern in all respects 
similar to the first mentioned, but ojierating inde- 
pendently, would present a balance sheet with the 
assets totaling only $50,000. If good-will is recog- 
nized in the first case, why should it not be recognized 
in the second? Mr. Bauer's plan is novel and inter- 
esting. It is doubtful, however, whether it will be 
widely accepted. As a matter of fact, the principle 
involved in Mr. Bauer's discussion is, whether or not 
assets should be valued at cost or upon the basis of 
present-day values irrespective of cost. We are of 
the opinion that a rigid cost theory of value is the best, 
for the reason that any other theory may lead easily to 
inaccuracy and manipulation, and therefore may 
work serious hardship to investors. 

15. Adjustment of good-iiill account in consolida- 
tions. — When a company takes over the assets of 
other companies, numerous adjustments on their 
books are necessary, and some of these affect the good- 
will account. For illustration, let us assume that 
Company "C" has agreed to purchase the assets of 
Corporation "A" and also the assets of Corporation 
"B." Let us assume, further, that the assets of Cor- 
poration "A" were purchased for an amount of stock 
in excess of the value of the physical assets — in other 
words, that something was paid by "C" for the good- 
will of "A." Suppose further that the assets of "B" 
were acquired for an amount of stock less than the 
book value of the physical assets. In the latter case 
the presumption may be that the assets of Company 


"B" were not worth the book value. On the other 
hand, if Company "B" were not operating at a profit, 
the new or consohdated company might be able to 
purchase its assets for less than their physical value. 
If Corporation "C" takes over the assets of Company 
"B" at their book value a surplus will result, because 
less than the book value was paid for the assets ; and if 
the assets of Company "B" were fairly worth the 
value shown by the books, the surplus would be a 
vahd one and a question arises as to the disposition to 
be made of it. 

From a legal standpoint there can be no objection 
to such a surplus being made available for dividends. 
Conservative practice, however, would favor the use of 
the surplus for the purpose of reducing the good-will 
account on "C's" books. Now, in the books of Cor- 
poration "C" the good-will will appear at a value 
equivalent to the amount paid for "A's" good-will, re- 
duced by the surplus resulting from the acquisition of 
"B's" assets. On the same principle, any increase in 
the revaluation of the tangible assets at the time of the 
purchase may well be applied to the reduction of the 
good-will account on the books of the consolidated 

16. Good-will in consolidated balance sheet. — The 
good-will account in a consolidated balance sheet will 
represent not only the aggregate of the good-will ac- 
counts in the balance sheets of the subsidiary compa- 
nies, but in addition it will represent the amount by 
which the aggregate value of the stock of the sub- 


sidiaries on the books of the holding companies exceeds 
the par value of their stock and surplus, on the date 
of the acquisition of the stock of the subsidiaries. 
For example, if the stock of one of the subsidiary com- 
panies appears on the books of the holding company 
at a value of $120 per share, and if the book value 
of the stock on the date of acquisition were $110 per 
share, the difference of $10 per share in the cost of the 
securities to the holding company, and their book 
value at the date the stock was acquired, would have 
to be adjusted thru the good-will account on the con- 
solidated balance sheet. 

17. Patents, trade-marks and copyrights. — In con- 
sidering the valuation of good-will, it is well to bear 
in mind the valuation to be placed upon such assets 
as patents, trade-marks or copyrights, because the 
rights conveyed by these grants create a monopoly in 
favor of the owner or owners. In turn, quite com- 
monly a good-will is created which, as a rule, will last 
a longer period than the legal life of the assets. This 
is because the owner of the grants during the years 
in which he enjoys a monopoly has so firmly en- 
trenched himself that competitors will not easily suc- 
ceed in dislodging him. It has already been explained 
that a patent is a grant which the Government makes 
to an inventor, conveying and securing to him the 
exclusive right to make and sell his invention for 
a limited number of years. In the United States the 
life of a patent is seventeen years and the grant may 
be renewed only by special act of Congress. While 


in this country it is not necessary to use the patent 
right in order to retain the grant, in certain foreign 
countries this is not the case. 

A trade-mark is a grant by the government whereby 
a certain design, slogan or particular label or device 
is reserved to the holder of the grant, as his exclusive 
trade-mark, and he is protected against its use by 
others. In the case of trade-marks, however, the 
owner or owners must use the design or label in order 
to be protected in it, and it is to be noted that the 
rule is different in this case from that of a patent. 
The grant has a life of thirty years, and is renewable 
for a like period. 

A copyright is a right conveying the exclusive priv- 
ilege of printing, publishing or vending copies of 
certain artistic or literary productions. A copyright 
has a life of twenty-eight years from the date on 
which it is recorded and it is renewable for a similar 
period under certain conditions. 

18. Valuation of patents. — If a patent has been 
purchased from the inventor, or from a former owner, 
the question of valuation is a simple one. The valua- 
tion of the patent is the price which the owner has 
paid for it, and this value must be amortized, at least 
during the remaining years of its legal life. As a 
matter of conservative practice it is best to write off 
the patent at less than the legal life, because of the 
fact that new inventions will generally render the 
patent valueless before the expiration of its legal life. 
Another method of writing off a patent right is to 


predetermine, as closely as possible, the number of 
units to be produced under the grant and charge the 
unit cost of each article produced with a proportion- 
ate part of the value assigned to the patent, so that the 
cost of the patent will be spread over the units pro- 
duced under the grant. 

Many business concerns maintain engineering de- 
partments which produce valuable inventions from 
time to time, and if any of them are patented it is con- 
sidered proper to charge the patent account with the 
cost of conducting the experiments and investigations 
which led to the production of the inventions. In ad- 
dition to this all fees paid in connection with the reg- 
istration are also chargeable to the patent account. 
It may be necessary for the owner of the patent to en- 
gage in lawsuits in order to protect his rights and 
prosecute infringements. If these suits are success- 
ful there is no serious objection to charging their 
cost if it is not collectible, against this patent 

19. Valuation of trade-marks. — While the actual 
cost of securing the trade-mark is insignificant, its 
value may be very great. Inasmuch as the life of a 
trade-mark is limited to the actual number of years 
during which it is to be used, it is difficult to predeter- 
mine the approximate life of the asset. When a 
trade-mark has been purchased from others and the 
cost of acquiring it has been high, it must be assumed 
that the trade-mark carries with it a certain amount 
of good-will. The same general principles which have 


been discussed in the preceding sections apply to 

20. Valuation of copyrights. — The value of a copy- 
right usually lasts for a shorter period than the legal 
life, a fact which adds to the difficulty of valuing it 
properly. When a copyright is obtained by a com- 
poser or an author the cost is insignificant. In such 
cases it is usual to write off the amount as a part of 
the expense of the first edition of the work. 

Copyrights may be purchased from a former owner, 
and in such cases a high price is often paid for them. 
It is then usual for the amount paid to be spread 
over a number of years, during which it is expected 
the public favor will be retained. These factors are 
so difficult of determination that conservative prac- 
tice requires that this asset be written off rapidly. It 
will be noticed that the life of patents, copyrights 
and trade-marks is terminable by law, whereas, that of 
good-will is not. 

Patents, copyrights and trade-marks, as balance 
sheet items, are frequently used as devices to conceal 
issues of watered stock, and when the amount ap- 
pears relatively large a question is raised at once as 
to the correctness of the valuation. In this connec- 
tion, however, it must be borne in mind that the 
good-will is often built up around a patent, a copy- 
right or a trade-mark. Therefore, while the legal 
life of the asset may have terminated, the good-will 
created as a result of the continuous use of the monop- 
olistic grant may have become very valuable. 

XXII— 11 


In the discussion of the intangible assets the au- 
thor has assumed that the statements showing these 
assets have been compiled from books that have been 
kept honestly. It is the part of wisdom, however, for 
a prospective purchaser to employ a competent ac- 
countant for the purpose of vertifying the results of 
operation and the valuation of the assets. To safe- 
guard himself it is best to procure a certificate as to 
profits and valuation of assets. 


Define good-will, and state the factors upon which it depends 
and the means by which it is created. 

What factors must be taken into consideration in valuing good- 
will? What should be disregarded? 

Describe the method of reaching a reasonable valuation for 
good-will. What are the motives which prompt an inflation of 
this account? 

What is the proper treatment of good-will in making consoli- 
dated balance sheets for a corporation and its subsidiaries? 

Can rules be formulated for the valuation of patent rights, 
trade-marks and copyrights? 

Why is conservatism especially needed here? 



1. Current assets defined. — The reader will recall 
that current assets mean assets available for the pur- 
pose of discharging current liabilities. Included un- 
der this heading are such items as cash on hand and 
in bank, notes receivable, accounts receivable, and all 
other debts due to the business, having a maturity 
date of less than one year. 

2. Cash on hand. — The cash balance in the hands 
of petty cashiers, or working funds in the hands of 
employes, form the cash on hand. Cash items or 
I. O. U's. should not be included as a part of cash. 
These funds are usually handled under the imprest 
cash system, which has been described fully in the 
volume on "Accounting Principles." 

3. Cash in hank. — Cash in bank may consist of 
amounts on deposit subject to immediate check, or it 
may be represented by certificates of deposit which 
may not be withdrawn until a certain number of days 
after notice. 

Certificates of deposit which may not be withdrawn 
until a certain number of days after notice should 
not appear in a balance sheet, imless they are suit- 



ably ear-marked to indicate the restricted character 
of the balances. 

It occasionally happens that a firm will overdraw 
its bank account by sending out checks for a greater 
amount than it has on deposit, relying on a suffi- 
cient amount of collections to make good its balance 
before the checks are presented at the bank. If the 
cash is overdrawn at the date of the balance sheet, 
the fact should be disclosed by setting up a current 
liability for the amount of the overdraft. 

Some large corporations have considerable sums 
of cash on hand which it may not be wise to place 
in temporary investments, or which may not be in- 
vested safely in merchandise purchases. Occasion- 
ally portions of the cash fund may not draw inter- 
est. It is advisable to state separately in the 
balance sheet, or in a sub-schedule to a balance sheet, 
the amount of cash balances which are not drawing 

When a concern sells securities with the under- 
standing that the proceeds are to be used for special 
purposes, the proceeds of such sales should not be 
merged with cash funds which are subject to check. 
Thus, an organization might sell some of its preferred 
stock for the purpose of financing the construction 
of an addition to its plant. Conditions may have 
changed in the meantime so that it is not considered 
desirable to proceed with the construction work. The 
corporation is under a moral obligation at least to 
keep the proceeds of the sale of such stock separate 


from its cash subject to check. It should not use the 
funds for other purposes. 

Cash deposited with sinking-fund trustees should 
not be shown as a current asset, because the amounts 
are not available for the general purposes of the or- 

4. Investments in stocks and bonds. — Investments 
in securities may be either permanent or temporary. 
Permanent investments may be investments made for 
the purpose of controlling the activities of another 
organization, or they may be fund investments of re- 
serves. Temporary investments may be illustrated 
by such cases as occur when a corporation has large 
cash resources and cannot invest them profitably in 
merchandise or obtain a reasonable rate of interest 
from depositories. In this event, the firm may pur- 
chase securities for the purpose of obtaining a larger 
income, but with the idea of being able to convert the 
securities into cash when additional cash funds are 

5. Classification of permanent investments. — Per- 
manent investments may be classified broadly as fol- 

(1) Investments in the stocks and bonds of parent 


(2) Investments in the stocks and bonds of sub- 

sidiary companies. 

(3) Investments in the stocks and bonds of allied 



(4) Investments in the stocks and bonds of out- 
side companies. 

A further subdivision might be made as between 
those which are pledged and those which are not 
pledged. A corporation may pledge its holdings of 
stocks and bonds as security for its issue of collateral 
trust notes or bonds. If any of the investments of a 
corporation have been pledged for this purpose, the 
balance sheet should disclose that fact. 

The first and second classifications have already 
been treated fully in previous chapters. 

6. Investments in the stocks of allied companies. — 
Investments frequently occur in the stock of allied 
companies. Examples of this type are: the invest- 
ment which a railroad company makes in the stock of 
an express company operating over its lines; or in- 
vestments in stocks of terminal companies and de- 
velopment projects. Such investments should be car- 
ried at cost. Conservative management requires that 
appreciation in the investment should be ignored un- 
til the time of sale, while depreciation in the value of 
the investment should be provided for thru the me- 
dium of an appropriate reserve. 

7. Investments in, outside companies. — Outside 
investments are frequently made out of surplus cash 
funds for the purpose of realizing a higher rate of 
return than could be secured from bank deposits. In 
the majority of cases, these are intended to be sold 
as soon as the business needs cash. Consequently, 


they will be treated usually as current assets if they 
are purchased with the intention of making them 
available for cash requirements. When the invest- 
ments are purchased for temporary purposes, it is 
necessarily imphed that a change in the value of se- 
curities will have a more direct effect upon the bal- 
ance sheet of the company than a change in the value 
of permanent investments. While the general rule 
that investments should be carried at cost is a safe 
one to apply even in this case, due attention should be 
given to a reserve for any possible loss in value thru 
a decline in the market price of such securities. 

8. Investments of insurance comjMnies and invest- 
ment companies. — Fire insurance companies, life in- 
surance companies and investment companies fre- 
quently are required by law to value their invest- 
ments for balance sheet purposes in accordance with 
the ruling market prices on the date of the balance 
sheet. When an organization is compelled to adopt 
this plan for its statements, it is deemed advisable to 
place the cost of the securities to the owner in a 
parenthetical reference on the balance sheet, so that 
comparison may be made between the cost and the 
present market value of securities. 

9. Investments of hankers and brokers. — Bankers 
and brokers holding investments in stocks and bonds 
are accustomed to value the securities held by them 
at the market price on the date of closing the books. 
It often happens in these cases tliat some securities 
on hand will have increased in market value, while 


others will show a loss, owing to the decline in mar- 
ket value. It is considered proper in the case of 
bankers or brokers to allow the increases to offset the 
decreases and to take any increase in the market value 
of securities to the credit of profit and loss, setting 
aside a reserve for any loss sustained on the decline 
in market value at the date of the balance sheet. 

10. Treatment of outside investments in bonds dif- 
ferent from that of investment in stocks. — The prin- 
cipal differences between stocks and bonds have been 
pointed out in the volume on "Corporation Finance," 
and it remains for us now to consider the accounting 
features with respect to bonds. It is evident that if a 
bond has been purchased at a premium and is to be 
held until its maturity, a smaller sum than the pur- 
chase price will be realized on the maturity date. The 
premium paid at the time of the purchase should be 
written off against the income received from the bond 
during its life, so that each year's income will be 
credited only with the true yield on the investment. 

For example, if the nominal rate of interest on a 
bond is 5 per cent, and if the bond sells at a premium, 
the actual yield on the bond will be a lower rate of 

Assuming that a corporation purchased $100,000 
worth of bonds bearing interest at 5 per cent, payable 
semi-annually, with five years to run before maturity, 
and that the premium paid amounted to $1,000, the 
owner must amortize the premium during the five 
years that the bonds have to run. Altho he receives 


for interest, at the semi-annual period, the sum of 
$2,500, his actual income on the bonds is only $2,400, 
and he should deduct the sum of $100 from the in- 
terest received at each period. The effective rate of 
interest in this case would be only 4.8 per cent, instead 
of 5 per cent. By reason of the premium paid, there 
has been a loss of 0.2 per cent in the interest. 

On the other hand, it is obvious that if bonds are 
purchased at a discount, the yield is higher. To 
carry out our former illustration, if the $100,000 
worth of bonds were bought at $99,000, the yield 
would be 5.02 per cent. 

11. Securities purchased for speculation. — Stocks 
and bonds are sometimes purchased on margins, for 
speculation. In this case, the assets consist of the 
right to receive the delivery of the securities upon the 
payment of the balance of the purchase price. An 
offset to this asset is the liability due to the broker 
for the full purchase price, less the margin depos- 
ited. Subject to the qualifications mentioned with 
regard to investment companies whose practice is to 
value securities for balance sheet purposes at the mar- 
ket price, securities purchased on margins should be 
carried at cost, plus the brokers' fees incidental to the 

The interest charged by the broker for the differ- 
ence between the amount deposited as margin and 
the purchase price, should be charged to the security 
account and credited to the broker's account. There 
will be an offset to the credit for interest allowed by 


the broker on the amount deposited as margin. Any 
dividends received on stocks, or interest received on 
bonds by the broker for the account of the investor, 
will be charged to the account of the broker and 
credited either to the investment account or to the 
income account, preferably the former. The differ- 
ence between the asset and the liability account will 
measure the equity of the owner in the investment. 

It is often better to credit to the asset account divi- 
dends and interest received, reducing the cost of the 
investment so that when the investment is eventually 
sold, the proprietor will be enabled to determine his 
net profit or loss on the speculative transaction, tak- 
ing into consideration all the elements that have en- 
tered into it. 

12. Investments in the stocks of mining companies. 
— It has already been pointed out that in the case of 
mining companies it is not customary to set aside a 
reserve for the depreciation of wasting assets. Divi- 
dends declared on the stocks of such companies are 
in part a return of the capital invested and in part 
a return of income. In the case of a coal-mining 
property, the investor might be able to secure infor- 
mation which would enable him to apportion approxi- 
mately the amount of the dividend received on the 
stock as between the part of it which was a return 
of the capital investment and the part which consti- 
tuted true income. But in gold-mining, copper-min- 
ing companies and oil companies it is not possible 
to do this, and hence the necessity of following a care- 


ful and conserv^ative policy with investments of this 

Investments in the stocks of timber companies may- 
have a somewhat different character, because such 
companies are often in the habit of setting aside re- 
serves for depletion or exhaustion. Often the re- 
serve set aside is reinvested in additional timber prop- 
erties or in the reforestation of the denuded land. 
The policy of the particular company in these mat- 
ters will determine the treatment to be given in the 
accounts to income received on such stocks. 

Investors in the bonds of companies whose assets 
are of wasting character are usually protected by the 
accumulation of a sinking fund. 

13. General considerations with reference to valua- 
tioji of securities. — It is always well, whenever possi- 
ble, to check investments of this character against the 
current market prices. When this cannot be done the 
cost prices of the investments should be obtained, if 
the investments are carried in the balance sheet on 
any other basis. Bonds must be considered with ref- 
erence to security of principal and with regard to the 
ability of the obligor to meet the interest payments. 
In connection with foreign investments the possibili- 
ties of profit or loss due to fluctuations in exchange 
should be considered. 

14. Notes receivable. — We must distinguish be- 
tween notes which are taken in the ordinary course 
of trade and those which are given to an organiza- 
tion for its accommodation. Kach class should be 


stated separately on a balance sheet. Notes which 
have been given by officers, directors, stockholders or 
partners should not be included in the notes receiv- 
able from trade debtors. The reason for this will be 
evident if we reflect that one who reads the balance 
sheet will assume ordinarily that the notes and ac- 
counts receivable represent amounts not collected from 
trade debtors, unless otherwise stated. It is evident 
that notes given to a merchant for his accommodation 
or notes from officers, directors or stockholders are 
not taken in the ordinary course of business, and a 
balance sheet which did not disclose the true char- 
acter of these transactions would be misleading. As- 
sets of this character are probably not as liquid as 
notes from trade debtors, or they might not be avail- 
able for the purpose of meeting current liabilities. 
The fact that notes are marked "demand notes" is 
not necessarily an indication that the debtor would 
be able to pay on demand. 

Any notes receivable which have been assigned or 
pledged as collateral security for a loan should be 
handled in the same manner as merchandise pledged 
as security for advances. It may not be inadvisable 
to point out here that the fact that a business organ- 
ization is compelled to assign its notes or accounts re- 
ceivable is not necessarily an indication of a poor 
financial standing. The establishment of bank credit 
is not always an easy matter. 

Notes receivable having more than one year to run 
should not be included under current assets. 


The value of notes receivable depends upon the 
solvency of the maker. When the maker of a note 
fails to pay it at maturity and asks frequently for an 
extension of time or for a renewal of the note, the 
holder may well be on his guard against the con- 
tingency that the amount due may not be recovered. 
It is desirable to insist that notes taken from custom- 
ers be payable at the customer's bank rather than 
at the place of business of the creditor. The reason 
for this is that the failure of the maker to pay his 
note will be called to the attention of his local bank. 
Rather than have this happen, the maker may be 
more diligent in finding the means to pay the debt 
when due than he would be if the note were payable 
at the office of the creditor. 

15. Trade debtors. — The amounts due from trade 
debtors are classified as those which are good, doubt- 
ful, or bad. By the term, "good accounts," we un- 
derstand amounts due from trade debtors which are 
not due as yet under the terms of sale, and about 
which there seems to be no doubt of ultimate realiza- 
tion. "Doubtful accounts" are amounts due from 
trade debtors who either have not paid promptly or 
about whom certain information has come to hand 
which makes it appear doubtful whether the full 
amount eventually will be realized. The term "bad 
accounts" includes those sums due from trade debtors 
who failed to pay after the ordinary means of collec- 
tion had been resorted to, or whose affairs are in the 
hands of assignees or receivers. 


The question of the valuation of accounts receiv- 
able due from trade debtors often will present a num- 
ber of difficulties. The debtors may be temporarily 
short of funds, owing to poor business conditions or 
the failure of banks in their vicinity to extend prompt 
and reasonable accommodations. In certain sections 
of the country, it is customary for customers to ex- 
pect long terms of credit. Therefore, the length of 
time that an account is overdue is not a necessary in- 
dication that the amount due will not be realized 
ultimately. Moreover, the amount being overdue 
may not be entirely the fault of the debtor. Lax col- 
lection methods and failure to render statements prop- 
erly are sometimes the cause of slow payments. 

While the method of "aging" accounts is an ad- 
mirable one to use in attempting to find out the 
real value of the amount due from trade debtors, it 
is not possible to use this method in all cases. Oc- 
casionally when a debtor becomes irregular in his 
payments, the credit man will secure a pledge of col- 
lateral of some kind to protect his firm against loss. 

For example, if the amount due at the end of the 
fiscal period is considerably in excess of the amount 
due at the beginning, the account may be open to 
suspicion. Notes charged back to the account of the 
debtor are an indication that would put one on guard. 
Checks originally given by a debtor and returned 
by the bank, marked "no funds" are another sign. 
We must consider also the circumstances and gen- 
eral financial conditions in the country or in the par- 


ticular section of the country in which the debtor's 
business is located. Thus, for example, during the 
year 1915, conditions in the South were rather se- 
rious, owing to the inability of the planters to market 
their crops advantageously. Business firms generally 
complained that they were not receiving the proper 
accommodations from their banks. It is a well 
known fact that many business houses in the North 
were financing their Southern customers at that par- 
ticular time. 

This condition, however, was only temporary and 
while it accounted for the large increase in the amounts 
due from trade debtors in many of the balance sheets 
prepared at the end of the year 1915, the situation 
in 1916 was very different. In fact, many merchants 
in the North reported that concerns in the South to 
whom they had extended accommodations or to whom 
long dating had been given in prior years, were tak- 
ing up their notes and even discounting invoices 
within ten days. This fact is mentioned merely to in- 
dicate that all the surrounding conditions and circum- 
stances must be carefully weighed in placing a value 
upon the amount due from trade debtors. 

16. Treatment of bad accounts. — Even where the 
account of a trade debtor seems to be bad, the amount 
should not be written off the ledger until the final 
discharge of the debtor in bankruptcy or the return 
of an unsatisfied execution. The reason for this is 
that, pending final adjustment in bankruptcy, the 
amount should be left open on the ledger to call the 


attention of the proper persons to the fact that the 
amount is still due. Moreover, dividends are very 
often subsequently received from accounts which had 
been considered bad, and if the amount had been writ- 
ten off entirely, an opportunity is given to the dishon- 
est cashier to appropriate these sums to his own use. 

17. Treatment of miscellaneous accounts receiv- 
able. — Amounts due from stockholders for subscrip- 
tions to stock, amounts due from officers or employes 
for loans or amounts due from partners in a partner- 
ship, should be stated separately on the balance sheet. 
If any portion of these amounts is not likely to be 
recovered, appropriate reserves should be provided. 

18. Interest on notes or accounts receivable. — 
When notes, open accounts, or advances draw inter- 
est by their terms it should be accrued up to the date 
of the balance sheet. The amount of interest accrued 
is to be shown under the heading of current assets and 
it is a proper credit to income. However, this state- 
ment needs to be qualified because it is clear that it 
would be improper to credit to income accruing in- 
terest on doubtful debts or notes receivable. While 
it may be desirable to accrue the interest for the pur- 
pose of showing the total amount due from the doubt- 
ful debtor, the amount of interest added to the doubt- 
ful debt should be credited to the income account. 
It should be carried to the credit of the reserve pre- 
viously created to measure the anticipated "loss on 
realization of the principal sum due. 

19. Different metJiods of providing for the reserve 


for had and doubtful debts. — Some provide for the 
reserve for doubtful debts on the basis of a certain 
percentage of the sales. If the firm has experience 
of past years upon which it may rely, this may be 
the proper and conservative method of providing for 
this reserve. It has an advantage in that it sets aside 
insurance for bad and doubtful debts out of the rev- 
enue received during the same period. The certain 
percentage is charged against profit and loss and 
credited to a specially ear-marked reserve account, 
and if debts become uncollectible, the amounts are 
charged against the reserve. While the reserve may 
accumulate and perhaps be larger in amount than is 
apparently necessary, yet it must be remembered that 
we have recurrent periods of dull times or panics 
during which the percentage of failures and losses 
from bad and doubtful debts is much greater than 
usual and no great harm seems to result in allowing 
the reserve to accumulate, provided the amount is not 
unreasonably large. ' 

Another method is to charge a certain per cent of 
the outstanding accounts based upon past experience 
as a reserve for doubtful debts. 

The third method is to provide for those accounts 
which when "aged" seem to be actually bad or doubt- 
ful. The process under this method is to go thru 
all the accounts that are open on the ledger and list 
them, showing those which are overdue thirty, sixty, 
ninety or more days. A reserve is set aside based 
upon the results obtained, which is estimated to be suf- 

XXII— 12 


ficient to take care of the losses. The disadvantage of 
this method is that the annual charges against the 
income account for bad debts are liable to fluctuate. 
A large amount must be provided in one year and a 
comparatively small amount in another year. Fur- 
thermore debts which apparently are good at the date 
of preparing the balance sheet may prove doubtful 
later and no reserve will have been provided for such 
a contingency out of the profit of the period during 
which the accounts were created. 


State how cash in hand is distinguished from cash in bank. 
Cite cases in which cash actually held should not figure in the 
general cash account. 

Under what circumstances should investments be valued at 
cost, and what circumstances justify a departure from this rule? 

What distinctions should be made in notes receivable as to the 
source from which they were obtained ? Why ? 

How should accounts receivable be classified for financial state- 

Explain methods of handling a reserve for bad or doubtful 



1. Inventories. — The inventories of a business un- 
dertaking are usually shown in a separate group on 
the balance sheet, under the caption of either "inven- 
tories" or "working and trading assets." Included 
in this group would be the merchandise which a trad- 
ing concern had on hand at the close of the period. In 
the case of a manufacturer it also includes the stock of 
raw material, partly finished goods, finished parts and 
purchased and finished stock. Occasionally under 
this caption will be included the inventories of post- 
age, advertising material and prepaid expenses, such 
as prepayments for advertising, insurance and inter- 

In some published balance sheets, accrued interest 
on notes and accounts receivable is included. It is 
better, perhaps, to treat unexpired insurance premi- 
ums under the caption, "deferred charges to opera- 
tions." The accruals of interest in favor of a business 
concern should be included under the group of current 
assets; prepayments of interest on discounted notes 
or other obligations should also appear undei' the 
group "deferred charges to operations." 



2. Valuation of the inventory of a trading con- 
cern. — The merchandise stock of a trading concern 
should be valued at the cost laid down in the ware- 
house or store of the concern. It is proper also to 
add a rateable j^roportion of the expenses incurred in 
the delivery of the merchandise to the storehouse, as 
well as cartage and carrying charges. On imported 
goods, the proportion of freight, marine insurance 
and duties applicable to the stock as yet unsold, may 
be carried as an asset. 

3. Should inventories he carried at cost or at mar- 
ket price? — Many authorities state that inventories 
should be carried at cost or at market price, whichever 
value is the lower. While perhaps this may be con- 
servative practice, the fact must not be lost sight of, 
that profits are not made, nor are losses sustained, 
while goods are on tlie shelves. It is obvious that a 
merchant should not carry his inventory at market 
prices if they are greater than cost, because to do so 
would be to anticipate a profit which eventually might 
not be realized. Moreover, the current period would 
receive the benefit of the inflation at the expense of 
the succeeding period, and the profit of the current 
period would consist not only of the profit on mer- 
chandise actually sold, but also of the profit taken up 
thru the inflation of the inventory. 

Wlien, however, the market price is lower than cost, 
the same principle might be applied. The loss will 
not be realized until the title to the goods has been 
transferred to a customer, and the loss, since it will 


only occur at that time, should be faced in the period 
in which it takes place. Conservative accounting 
practice, however, forces us to make provision in ad- 
vance for expected losses. While it would not be ad- 
visable to change the value of the inventory, a pro- 
vision might be made in it for the loss which is 
expected to be realized in the succeeding period, thru 
the medium of a reserve created after the profit on 
trading operations for the current period has been 

4. Raw material inventories of manufacturing con- 
cerns. — Inventories of raw material should be valued 
at purchase price, plus the cost of getting the goods 
into the factory. 

In some instances, due to careless buying, large 
stocks of raw material may have been acquired at un- 
favorable prices. There is, of course, a tendency for 
the selling price of finished goods to follow closely the 
fluctuation in the market for raw materials from 
which they are made. Thus, if a wire manufacturing 
company acquired a large stock of 20-cent copjDcr, 
and wire were selling on a 13-cent base, conservative 
practice would dictate the creation of a suitable re- 
serve for losses which it is clear will ultimately be 
sustained on the later sale of the manufactured 

Indirect materials or supplies, such as fuel, lubri- 
cating oils and packing material are subject to the 
same rules of valuation as direct materials. 

5. Work in pror/ress. — The valuation of work in 


progress is not usually a difficult matter when the 
concern is maintaining* an adequate cost system. If, 
however, no cost system is employed, the valuation 
of work in progress is a very difficult matter. The- 
oretically, the work in progress should be valued at 
the cost of the raw material and the direct labor that 
has entered into it, plus a rateable proportion of the 
manufacturing overhead, which has been consumed in 
the processing of the material. There are some au- 
thorities who object to the inclusion of the rateable 
proportion of the manufacturing overhead in the in- 
ventory valuation on the ground that this involves 
the capitalization of expense items. While this is 
true, we must remember that the inventory is being 
valued on the basis of the undertaking as a going con- 
cern. In order to prepare income accounts that will 
reflect the true profits of the undertaking as a going 
concern, it will be necessary to include the rateable 
proportion of overhead expense. 

6. Finished goods stock should he valued at manu- 
facturing cost. — The valuation of finished material 
should be on the basis of the actual cost laid down in 
the finished stock storeroom. INIany business under- 
takings carry large stocks of finished parts as well as 
completed articles. Thus, in a concern manufac- 
turing complicated machinery with interchangeable 
parts, there would be on hand at any inventory date, 
not only finished and completed machines, but also 
a large stock of interchangeable parts. Such por- 
tion of the administrative expense as is properly 


chargeable to the finished stock may be included in 
the inventory valuation. 

It therefore follows, that goods which are unsea- 
sonable, out of fashion, or which are in a shop worn 
condition, should not be valued at cost under any 
circumstances, but at a price not greater than that 
which they may be expected to realize on sale. 

The principles to be employed in the valuation of 
inventories of branches have been discussed in the 
Text on "Accounting Practice" in the chapter on 
"Branch Accounts." 

7. Treatment of 7nerc}iandise pledged as collateral 
for loans. — Merchandise is frequently pledged as col- 
lateral security for loans. It is important that the 
value of merchandise so pledged shall be set up sep- 
arately in the balance sheet, or at least that a paren- 
thetical reference be made in the balance sheet in 
respect to it. In setting up the liability for the 
money advanced to the undertaking, there should be 
a contra-reference to the asset side showing the 
amount due to creditors whose claims are secured in 
this manner. 

8. Possible deductions from inventory valuations. 
— In interpreting the balance sheet of a business, the 
inventory plays an important part. One who reads 
the balance sheet should consider the inventory on 
hand in connection with the sales made during the 
period. There should be also taken into considera- 
tion, in the case of a manufacturing concern, the 
length of time which it takes to process raw material 


into finished wares. Thus, for example, if the an- 
nual sales of an organization amounted to $1,200,000, 
and if it is known that the process of manufacture 
takes from fifteen to twenty days, while the balance 
sheet discloses an inventory of $500,000, one must 
conclude that the valuation of the inventory has been 
inflated, or that considerable dead stock is included in 
it or that poor judgment has been used in allowing 
such a large stock to be accumulated. 

Even when an inventory increase seems reasonable, 
with reference to the increase in payables or the de- 
crease in cash, a further investigation is sometimes 
necessary. It may be that a great amount of the in- 
crease will be due to the increased quantities of raw 
material on hand. It might happen that the con- 
cern was in a position to take advantage of favorable 
market conditions and purchase a year's supply of 
raw materials. Thus, a miller might purchase large 
stocks of wheat which he is in a position either to dis- 
pose of as wheat or to manufacture into flour. A 
silk manufacturer might buy large quantities of raw 
silk in a favorable market. During the European 
war, a number of electrical contractors purchased 
large stocks of raw copper, which they disposed of at 
considerable profit. Wholesale drug and chemical 
houses largely increased their stocks at the beginning 
of the European war and sold them later, realizing 
very much more than the usual margin of profit. 
These factors, therefore, must be given consideration 
before determining whether or not the inventory is 


greater than the requirements of the business, or be- 
fore coming to a conclusion that the management has 
exercised poor judgment. 

9. Interpretation of current assets. — The aggre- 
gate of the current assets in a balance sheet should 
be compared with the amount shown in the current 
liabilities. A concern may have an excess of assets 
over liabilities and still be forced into insolvency. 
Legal insolvency is the state of being unable to meet 
maturing liabilities with the assets on hand. Bankers 
like to see the ratio of from 2 to 1 to 4 to 1 between 
the current assets and the current liabilities. On the 
other hand, judgment must be used in making this 
comparison. A firm may have invested very heavily 
in a stock of raw materials, and in order to take ad- 
vantage of the liberal cash discount allowed, it has 
seriously depleted the cash account. Consequently, 
the desirable ratio of 2 to 1 may not exist. 

Current assets are the source of dividend disburse- 
ments or withdrawals of profits, and if an undertak- 
ing cannot safely reduce its liquid assets for this pur- 
pose, the distribution of profits should be postponed. 
While a corporation that has earned profits may bor- 
row the money necessary to pay a dividend, it is ques- 
tionable whether or not such methods should be re- 
sorted to. 

10. Importance of right relation between current 
liabilities and current assets. — If the business is of a 
seasonal nature, the ideal relation between current lia- 
bilities and current assets cannot exist. Thus, for 


example, the firm might be acquiring large stocks of 
raw materials, partly finished goods and finished goods 
to sell in the following season. These amomits would 
•appear as inventories or as working and trading as- 
sets, but the liabilities therefor would be included 
mider the current liabilities. Hence, the current lia- 
bilities would be increasing in amount, while the fin- 
ished stocks on hand would not be converted into ac- 
counts receivable until a later date, because deliveries 
of manufactured goods could not be made until the 
approach of the season. For example, in the fur 
garment industry, there would be a tendency for the 
current liabilities to increase, beginning with the first 
of March and extending into July. The current as- 
sets will also decrease, and the inventories will in- 
crease. As soon, however, as deliveries are made, the 
inventories are changed into current receivables, and 
the normal relations which the credit man or banker 
likes to see between current assets and current lia- 
bilities would then be brought about. 

This fact must also be taken into consideration in 
attempting to determine the turnover of accounts re- 
ceivable. The volume of sales may vary from month 
to month, and the ratio existing between current as- 
sets and current liabilities will very often depend upon 
the peculiar conditions and circumstances surround- 
ing the particular business. 



State arguments against valuing goods in the inventories at 
their market price. What rule is to be followed in the case of 
goods in process of manufacture and finished goods in a manu- 
facturing concern? 

What significance is usually attached to a conspicuous inventory 
increase? Under what circumstances would the usual judgment 
be erroneous ? 

How does the contractor handle the problem of equalizing 
the record of income from month to month ? 

Describe how manufacturers seek to protect themselves against 
loss by speculative trading in raw materials. 

What is considered the standard ratio of current liabilities and 
current assets? Does departure from this standard necessarily 
mean poor business management? 



1. Meaning of deferred assets. — In order that a 
firm may be able to determine the actual expenses 
incurred during a period, it is necessary that all ex- 
penses applicable to that period shall be charged to 
the income accomit. Similarly, if a firm has incurred 
liabilities or paid out cash for items of expense, the 
benefit or a portion of the benefit of which will be 
enjoyed in succeeding periods, it is fair that only that 
portion which applies to the current period should 
be charged to this period. Therefore, in preparing 
the account of a going concern, expenditures which 
have been made for the benefit of later periods are 
treated as assets, and known as deferred assets. 
These assets are also sometimes called prepaid items 
or prepayments. 

It is desirable to point out that it is not always 
necessary that a cash payment should have been made 
for such items. For example, insurance may have 
been effected on the twenty-sixth of December for 
the period of one year and the amount of the premium 
may not have been paid in cash at all. The liability, 
however, should be taken up in the account and the 



premium expense should be apportioned as between 
the closing and the succeeding year; that is on the 
assumption that the organization is closing its books 
at the end of the calendar year. 

2. Organization eiTjjen^es. — There are a number 
of expenses incident to the organization of a corpora- 
tion, such as the incorporation fees, filing fees, legal 
expenses, expenditures of promoters and many ex- 
penses in connection with the issue of securities. It 
would be proper to charge to this account all the cost 
incurred in the sale of stock, printing of the certifi- 
cates, etc., but not expenses in connection with the 
issue of bonds. This class of expenditures requires 
an entirely difi'erent treatment. 

As the organization expenses will have to be in- 
curred only once during the life of the corporation, 
and as the benefit of these expenses is presumed to 
exist thruout the life of the business, it is manifestly 
not i^roper to charge them against the operating rev- 
enue of the first year. On the other hand, it is deemed 
advisable to write off the amount within a reasonable 
period, depending somewhat upon the amount of the 
initial expenditures. The usual term varies from 
three to ten years. 

While it would probably be better practice to per- 
mit an assessment of stockholders to such an amount 
as would be necessary to pay all these expenses, or 
sell the capital stock at such a premium as would en- 
able the premium to be applied to the reduction of 
these expenses, as is customary in some countries of 


Europe, it is doubtful if the practice will ever be 
adopted here. Usually, it is very difficult for an in- 
dustrial corporation in this country to sell its stock at 
par without giving a bonus of some sort, let alone 
realizing the premium for it, or organizing it under a 
plan whereby an assessment to cover organization ex- 
penses would be permitted. 

3. Discount on the sale of capital stock. — The 
laws of many states do not permit a corporation to 
issue its capital stock at a discount. As is pointed 
out in the discussion on treasury stock, the same ef- 
fect is produced by a manipulation of treasury stock 
in those states which do not permit capital stock to be 
issued at a discount. Where, however, the law per- 
mits it, the discount allowed on the par of capital 
stock should be charged to a special account and it 
may be treated as a deferred charge to expense, or 
as a deferred asset. It should never be merged with 
the organization expense. 

In its last analysis, the issue of stock at a discount 
is really the same thing as issuing stock only partly 
paid. Hence, before any dividends are distributed 
to the stockholders, the amount of the discount al- 
lowed on the original issue of capital stock, should 
be wiped out thru the surplus. The stockholders 
who acquire stock issued at a discount are, for prac- 
tical purposes, in the same status as stockholders who 
acquire only partly paid stock. While a dividend 
may be declared to the stockholders out of current 
profits earned, it is advisable that out of the initial 


dividends, an amount should be retained by the com- 
pany to wipe out the discount account. 

4. Discounts allowed on issue of bonds. — Mention 
was made in a previous section that it was improper 
to charge discount on bonded obhgations to the or- 
ganization expense account. The reason for this is 
that discount on the bonds is really an adjustment of 
the interest rate specified in the evidence of debt to 
the market rate of interest for obligations of similar 
character. For example, if a corporation issues bonds 
bearing interest at the rate of say 5 per cent and the 
market rate of interest for securities of a similar 
character is 6 per cent, it is obvious that the bonds 
must be issued at a discount. Conversely, if bonds 
bearing interest at 6 per cent are issued when the 
market rate for a debt of a similar character is bV-i 
per cent, the bonds undoubtedly can be sold at a pre- 
mium. It follows from this that if a corporation is- 
sues bonds at a discount, the effective rate of interest 
which it pays, would be the sum of the annual interest, 
specified in the bonds, as increased by a rateable pro- 
portion of the discount sustained, or as decreased by a 
rateable proportion of the premium realized. 

The unamortized discount on bonds issued at the 
date of any balance sheet, is treated as a deferred as- 
set, inasmuch as it is part of the cost of financing and 
the burden of financing should be distributed over 
the years during which the use of the borrowed funds 
is to be enjoyed. 

In the past it was the usual practice when bond 


issues were floated for the purpose of financing the 
construction or acquisition of permanent assets, to 
charge the amount of the discount to the asset ac- 
count. In its ultimate analysis, it will be seen that 
as far as the income account is concerned, this prac- 
tice is exactly the same as carrying the amount of 
the discount as a deferred asset. If charged to con- 
struction, assuming that the life of the asset is co- 
incident with that of the bond, the corporation will 
be under the necessity of increasing the amount to 
be provided for depreciation by the amount of the 
bond discount charged to capital account. As a re- 
sult, the same amount of discount would be written 
off each year, only with this difference: that if the 
discount had been charged to capital, the proportion 
written off would appear as a depreciation charge, 
whereas if it is carried as a deferred asset, it will 
be shown as an increase in the cost of carrying the 
debt. Since the purpose of accounting is to show 
facts in connection with the business in their true as- 
pect, it is evident that there can be but one logical 
treatment of bond discount, and that is as an item 
of interest or as a part of the cost of financing, to 
be considered in connection with the actual interest 
paid in cash each year. 

5. Methods of disposing of the hand discount. — 
Probably the method that is most common in prac- 
tice and at the same time the most convenient, is that 
of writing off the discount on bond issues equally 
over the years during which the bonds are to run. 


Thus, if the bonds have a hfe of twenty years, one- 
twentieth of the amount of discount sustained, would 
be charged to the income account each year. This 
is sometimes called the equal instalment method, and 
while not the most scientific, it is the easiest to apply. 

If a corporation has a surplus, it may charge the 
entire amount of the discount to surplus. In this 
event, however, the income account of the current 
year, should be charged with its rateable proportion 
of the expense of borrowed funds, and only the bal- 
ance should be charged against surplus. This method 
is objectionable on the ground that it charges the cost 
of the borrowed funds against the surplus of prior 
years, instead of against the income during those 
years in which the use of the money is to be enjoyed. 

Another method of disposing of the discoimt is to 
write off each year the proportion of the discount 
that the sum of the bonds redeemed in any year bears 
to the total amount of the bonds outstanding. 

The effective interest method is the most scientific 
and it takes into consideration the amount of the dis- 
count, the redemption charges, and the nominal rate 
of interest specified in the bonds. The effective rate 
of interest is the amount which is charged to the in- 
come accoimt each year. A pro rata portion of the 
charge is credited to the bond discount account, while 
the balance is credited to the interest payable ac- 
count. The effective rate of interest can be cal- 
culated by the use of an annuity table. This rate 
should be charged to the income account and the dif- 

XXII— 13 


ference between the effective rate and the amount 
of actual interest payable in cash, should be credited 
to unamortized discount on bonds. 

6. Treatment of premiums on bonds. — Where 
bonds are sold at a premium, the procedure is the 
reverse of that where they are sold at a discount. In 
this case, a rateable proportion of the premium ac- 
count is to be credited each year to the income ac- 
count. This is done by debiting the premium on 
bonds, which is a deferred liability or a deferred credit, 
to income in the balance sheet, and crediting either 
the interest expense account or a specially ear-marked 
account in the income statement. Where bonds are 
sold at a premium, the effective rate of interest paid 
by the business is less than the nominal rate. 

7. Other examples of deferred assets. — The doc- 
trine applied to deferred assets just mentioned is 
readily applicable to prepayment of rent, interest, 
taxes and other items of expense. Any portion may 
properly be capitalized which applies to the succeed- 
ing periods and which, from the point of view of a 
growing concern, is recoverable in benefit of service. 

Considerable discussion has arisen over the tem- 
porar}^ capitalization of the expense of national ad- 
vertising. A national advertising campaign for the 
introduction of any product is usually an expensive 
undertaking. The benefit may not be reflected im- 
mediately and as a rule it is not, but it is assumed 
that it will be realized in the future. In this con- 
nection, it must be considered that a large initial 


expense is not the only cost, but that a liberal ad- 
vertising appropriation probably will have to be made 
in each succeeding- year. The capitalization of ex- 
penditures of this kind requires careful considera- 
tion of all facts. It is usually unwise to treat this 
as an asset. The value of advertising is not ques- 
tioned, but the results of it will be expressed in in- 
creased income, and in the development of good- will. 
As the reader has already noted, the creation of good- 
will as an asset is not to be justified except when it 
is actually purchased. While the expenditure for 
national advertising campaigns may possibly be 
smnmed up broadly in the nature of a purchase of 
good-will, there is a difference in that it is impossible 
to predetermine the value of it as to benefits to be 
derived in the future, and its valuation is not made on 
the basis of past earnings. 

It is impossible to lay down a general rule for the 
valuation of this aCsset that would apply to all cases. 
The capitalization of a portion of this expense for a 
short period is justified. This is only true if one 
may reasonably assume that the advertising cam- 
paign has been carried on judiciously and if the re- 
turns seem to indicate that there is a tendency for 
new business to increase in volume. 

In any event, the amount treated as an asset should 
be set forth clearly under a special section in the bal- 
ance sheet, so as to indicate its true character. 

One must clearly distinguish between the expenses 
discussed in the preceding paragraphs and those which 


are made for the direct benefit of the next season's 
sales. Thus, advertising Hterature, expense of ad- 
vertising, or promotion expense for sales of mer- 
chandise to be sold during the next season, may 
properly be capitahzed, so that the amount may be 
charged against the income from sales in the proper 


Explain the general nature of a deferred asset. State the 
best method of handling the organization expenses of a corpora- 
tion, the discount on the sale of capital stock, and outlays for 
national advertising. 

Describe different methods of treating the discount on bonds 
sold, and conversely the premium obtained, and state the merits 
and defects of each. 



1. Treasury stock defined. — Treasury stock is that 
stock of a corporation which has once been issued 
for value and which subsequently has been reacquired 
thru purchase or thru donation or in exchange for a 
debt. The term "treasury stock" is frequently mis- 
used in place of unsubscribed stock or unissued stock. 
Treasury stock as defined above, is an asset and rep- 
resents value received, while unissued or unsubscribed 
stock does not represent value. As long as the treas- 
ury stock is held by the corporation it does not par- 
ticipate in dividends nor can it be voted at the meet- 
ings of the corporation. 

Creating treasury stock by donation from the in- 
corporators, to whom the stock was originally issued 
by the corporation as consideration for the purchase 
of assets, or for services performed, is often made 
a device for giving away stock as a bonus with 
bonds or for selling stock below par. The laws of 
some states prohibit the issue of capital stock for 
less than par, and where it is desired to do this, a 
board of directors will go solemnly thru the farce 
of voting to issue stock for property or for services 
in greater amount than the property or services are 



worth and subsequently acknowledge the donation of 
stock from those who originally received it. This 
stock the corporation may sell for any price and in 
that manner accomplish practically the issue of stock 
at a price below par. 

This procedure is perfectly legal, owing to the fact 
that the board of directors has sole authority to 
place a valuation upon assets and the courts will up- 
hold whatever valuation they do place upon assets 
acquired so long as no fraud can be proved. 

As an illustration, let us assume that the owner 
of a patent organized a corporation for the purpose 
of working his patent and received in return for the 
transfer of his patent rights, $50,000 in preferred 
stock and $50,000 in common stock. Manifestly he 
is in no better position after this procedure has been 
effected than he was in the first place and in order 
that the necessary funds with which to manufacture 
the device may be forthcoming, he donates back to 
the company part of his stock to be sold for what- 
ever price it will bring in the market. If the device 
proves to be successful and in demand, the value of 
the remaining shares he holds will be considerably en- 
hanced. Custom seems to have sanctioned the book- 
ing of treasury stock at par but if it is known at the 
time of donation what price it will bring, the stock 
may be taken up on the books at the price it is ex- 
pected to realize. The complementary credit will be 
either a capital surplus account, or stock donation ac- 
count, or a reserve for working capital account. If 


any of the stock is sold at less than the price for 
which it was booked, the difference between the price 
at which it was taken up on the books and the sales 
price realized will be adjusted thru the account which 
was credited at the time the treasury stock was orig- 
inally taken up in the accounts. 

After all the treasury stock has been disposed of, 
the corporation presumably will have cash or other 
valuable property representing the proceeds of treas- 
ury stock sold and the reserve account or the capital 
surplus account will still remain open on the books 
for the adjusted amount. 

2. Disjjosition of donation reserve credit. — The 
next question to be decided is the disposition of the 
credit in the reserve or donation account. There is 
no legal reason why this amount may not be distrib- 
uted in the form of dividends. Since this action 
would defeat the purpose of the donation if it were 
taken during the probation period of the life of the 
corporation and since the donor in all probability will 
retain sufficient control of the corporation to prevent 
its disposition for that purpose, it is probable that 
the surplus will not be disbursed in the form of divi- 
dends. Some authorities suggest that the credit be 
used to write down the inflated assets. However, in- 
asmuch as this would be an admission on the part of 
the board of directors that the assets were over- 
valued in the first place, in all probability the board 
would not take kindly to tliis suggestion. The 
amount standing at the credit of the reserve or dona- 


tion account will therefore remain until such time 
as the company is in a fairly prosperous condition 
when the amount will find its way to surplus and ulti- 
mately be distributed. 

3. Acquisition of treasi:ry stock below or above 
par. — A corporation sometimes acquires its capital 
stock in settlement of a debt due to it. The stock 
may be taken over at par value, or at a price above 
par, or at a discount. The laws of some states pro- 
hibit a corporation from acquiring its own capital 
stock while in other states this is permitted, with some 
restrictions. Thus in New York State a corporation 
may acquire its own stock provided it has a surplus 
and provided also that the action does not defraud 
the creditors. If the stock is acquired at a price 
above par it is evident that the premium paid for 
the stock constitutes in effect a distribution of so 
much of the surplus of the corporation to that par- 
ticular stockholder. Consequently, if the stock is not 
to be retired and canceled, it is probably the better 
practice to show it at its par value and charge the 
premium paid directly against the surplus account. 
If the stock has been acquired at a discount, it is 
evident that the corporation has redeemed a part of 
its capital stock lia})ility for less than par and in 
this case if the stock is not to be canceled and retired 
the treasury stock should be shown at its cost price 
in the balance sheet. If the stock is to be retired, the 
corporation has sustained a profit equal to the differ- 
ence between the par value and the price paid for 


the stock. This may be credited to the surplus ac- 
count. Where treasury stock that has once been is- 
sued has come back into the treasury and is canceled, 
it ceases to be treasury stock and reverts to the status 
of unissued stock thereby reducing the outstanding 
capital stock liability. 

4. Stock donated to cover a deficit. — The stock- 
holders of a corporation might donate back part of 
their holdings of capital stock for sale so as to enable 
the corporation to wipe out a deficit. If the corpora- 
tion is organized under the laws of a state that does 
not permit corporations to acquire their own capital 
stock, the best way for the transaction to be handled 
would be to have a trustee receive the stock for the 
l)enefit of the corporation. Then, when it has been 
sold, the proceeds will be turned over to the corpora- 
tion, which would debit its cash account and credit the 
deficit account. If the corporation is organized un- 
der the laws of a state that permits it to acquire its 
own capital stock, the treasury stock would be debited 
and capital surplus account would be credited until 
the stock was sold. When the stock is sold, cash 
would be debited and treasury stock credited. And 
the difference between the price at which the treasury 
stock was taken up upon the books and the price at 
which it was sold, would be adjusted thru the capital 
surplus account. Thus the treasuiy stock would al- 
ways appear on the books for the same value as the 
amount standing at the credit of the capital surplus 
account. When the entire treasury stock has been 


disposed of, the credit balance in the capital surplus 
account could be transferred to the credit of the deficit 
account, thus wiping out the deficit. 


What is treasury stock? How is it created and why? 
Describe the accounting processes when treasury stock is cre- 
ated thru donation of the incorporators. 



1. Liahilitics defined cmd classified. — A liability is 
a claim against a debtor whicb gives to the creditor 
a right of action at law. Liabilities are to be dis- 
tinguished from accountabilities. Thus, a factor who 
receives a consignment of goods from a shipper is 
accountable to the shipper for the goods or the pro- 
ceeds of sales. No liability, however, attaches to the 
consignee beyond that of taking ordinary care of the 
property of the shipper, until such time as he has sold 
a portion of the goods and collected the proceeds. 
Then the relation of liability arises. 

Under American practice the right hand side of the 
l)alance sheet, as we have seen, contains two classes 
of rights, those of the creditors, and those of the pro- 

The reader has seen in the Text on "Accounting 
Practice," that capital is not to be considered as a 
strict liability. I^iabilities are broadly classified in 
two groups, — fixed and current. The former are 
those lia})ilities which have more than one year to run 
from the date of the balance sheet ; the latter comprise 
those liabilities which must be liquidated out of the 
current assets and are payable at the latest within 



one year. Liabilities are also divided into funded 
debt and unfunded debt. Funded debt consists of 
debt for which definite provision for repayment has 
been made. A funded debt is usually secured by a 
mortgage or other lien. Unfunded debt is that debt 
which rests upon the general credit of the business 
and for which no definite provision for repayment 
has been made. 

This classification as between funded debt and un- 
funded debt is not adopted by all. For example, 
there are some who class debenture bonds as funded 
debt, even tho no provision may have been made for 
the ultimate repaj^ment of the debentures. 

Fixed liabilities are also called capital liabilities be- 
cause they represent the part of the capital income of 
an undertaking which has been invested in assets of a 
permanent character or capital assets. The reader 
has already seen from the Text on "Corporation 
Finance" the difficulty in many instances of deter- 
mining from the mere names the character of the vari- 
ous classes of financial instruments or evidences of 
debts which are found in practice. In the present 
volume, we are not concerned with the nature of these 
evidences of debts or with the security underlying 
them. From the accounting standpoint, we are in- 
terested in seeing that the cliaracter of the debt is 
stated clearly in the accounts. 

2. Bonded debt. — A bonded debt of a firm con- 
sists of that debt which is evidenced by an issue of 
bonds. It may be secured or unsecured and provision 


for its repayment may or may not be made. In order 
to determine the nature and kind of bonds shown in a 
financial statement, it may be necessary in some in- 
stances to obtain an abstract of the instrument and 
indenture underlying these bonds, assuming, right- 
fully, that such an instrument exists. Bonded debts 
may be secured by a pledge of real property or 
by a pledge of personal property. The distinguish- 
ing features of each class will be the security, if any, 
underljdng the debt; the rate of interest; the date 
of maturity and the interest dates. All obligations 
of a business which agree in all respects with the four 
classifications mentioned above should be shown in 
the same account. 

Where a debt is secured by a mortgage or a pledge 
of personal property, the property covered by the 
mortgage should be plainly indicated in the title of the 
account, thus, "first mortgage 5 per cent bonds," or 
"collateral trust 5 jDcr cent bonds." AVliere a mort- 
gage has been issued underlying the bonds, it is evi- 
dent that there has been a definite pledge of a fixed 
amount of the company's property and the real lia- 
bility is the amount of the mortgage and not the 
amount of the bonds which may be issued and out- 
standing. When the bonds are secured by a mort- 
gage, unissued bonds differ from unissued stock. 
The unissued bonds have a value, because underlying 
them there is a pledge of property and it would be 
preferable to treat unissued bonds in a balance sheet 
as an asset, because they represent a security which 


the officers of the organization may dispose of at any 
time. They may also be used at any time as security 
for advances or for other obligations or debts. The 
entire authorized issue of bonds would appear as a lia- 
bility for the full amount of the mortgage shown. 
Unissued stock, however, has no value, nor does value 
attach to it until it has been exchanged for cash or its 
equivalent. Therefore, it is important that the 
amount of all mortgages and pledges of property to 
secure evidences of debt be set forth clearly in the 
balance sheet. 

Where the amount of bonds issued and outstand- 
ing is less than the amount of the mortgage under- 
lying the issue, it is important to note the amount of 
the property pledged, so that any one who reads the 
balance sheet of the organization may be able to de- 
termine what assets remain unpledged. 

Overissue of bonds is usually guarded against by 
clauses in the indenture providing for registration and 
certification. The fact that these requirements have 
not been followed does not alter the status of un- 
issued bonds. Where part of the unissued bonds have 
been registered and part have not, the facts will usu- 
ally be stated in the balance sheet. The necessity of 
showing the amount of the mortgage underlying the 
bonds compels tliis treatment to be applied to unis- 
sued bonds. 

Where, therefore, more than one mortgage or lien 
exists on the whole or any part of the property of an 
enterprise, it is important to have the mortgages and 


liens listed separately in the balance sheet, and to de- 
scribe the property upon which liens attach. 

It will occasionally happen that the unissued evi- 
dences of debt secured by a mortgage of a corpora- 
tion ma}^ be given as collateral security for loans ob- 
tained from banks. When this is the case, the loan 
from the bank should be stated as a current liability, if 
it has less than a year to run. A notation showing the 
amount of bonds which have been pledged as col- 
lateral security for the loan should be appended. 

The difference between the value of the property 
which is pledged and the amount of debt evidences 
issued against it, constitutes the equity of the pro- 

In those cases in which it is not possible to show 
conveniently the nature of the debt and the property 
pledged as security in a balance sheet, a separate 
schedule should be attached to the balance sheet dis- 
closing this information. 

3. Mortgage debts and bonds. — A concern may 
mortgage its property, in which case the mortgage is 
usually given to one individual on a single bond se- 
cured by the mortgage. While the legal debt is the 
bond, and the mortgage is merely security for it, yet 
in the last analysis the real debt is the mortgage. 

Real estate mortgages are conveyances of title on 
the condition that the title of the mortgagee shall be 
defeated when the debt is paid. They are executed, 
acknowledged and recorded like a deed. Chattel 
mortgages which cover personal property do not usu- 


ally convey title. They are usually for shorter terms 
than real estate mortgages and for that reason are 
usually classified under the heading of current liabili- 
ties. In the majority of cases, chattel mortgages are 
given as additional security for merchandise pur- 
chased on credit or for movable projDerty purchased 
on credit. Thus, for example, a man may sell mer- 
chandise to a firm on open account, taking in exchange 
a chattel mortgage on the stock as additional secu- 
rity. If such mortgages are not disclosed in the 
financial statement, one who is about to grant credit 
on such a balance sheet would be greatly misled, be- 
cause the balance sheet would appear to show more 
unpledged assets than the borrower had. 

Interest on bonded debt or on mortgage debt should 
be accrued because interest accrues from day to day 
and at the time of stating the accounts, the interest 
accrued should be shown in the balance sheet as a cur- 
rent liability. 

4. Notes payable. — Classified under this head 
would be the promissory notes given by a firm to its 
creditors or issued as an accommodation to others. 
These are usually payable in less than a year, and 
therefore would be classified under the current liabili- 
ties. If the notes bear interest, the interest should be 
accrued up to the date of the balance sheet. If the 
firm has accejDted a draft or a bill of exchange, it may 
be handled in the same account, as the draft is the 
same as a promissory note for all practical purposes. 
Where it is desired to keep the two classes of instru- 


merits separate, this may be done by creating one 
accomit for notes payable and another account for 
drafts payable. 

5. Tirade creditors. — Included under this caption 
would be the amount due for merchandise or property 
purchased, as well as the amount due for expenses of 
various kinds incurred in the ordinary course of busi- 

6. Salaries and wages accrued. — This account 
would include the amount due and unpaid for claims 
of officers and employes or amounts due partners in 
respect of salaries and wages. The amount set up 
as a liability should be the amount accrued from the 
last date of payment. 

7. Other liabilities. — Taxes accrued up to the date 
of a balance sheet should be shown as a current liabil- 
ity. The account "taxes accrued," would also include 
the estimated portion of the Federal Income Tax ac- 
crued up to the date of the balance sheet. Rents ac- 
crued, royalties accrued and dividends declared and 
payable are examples of other liabilities that may be 
found in a balance sheet. 

With reference to dividends, it is to be noted that 
until the board of directors has met and actually de- 
clared and published the declaration of a dividend, 
that dividend is not a liability. It follows from this 
that unpaid dividends on cumulative preferred stock, 
not declared by the board of directors, are not a lia- 
bility of the corporation. Nevertheless, they should 
be stated in a footnote in the balance sheet, because 

XXII— 14 


the failure to do so would mislead possible investors in 
the common stock of the undertaking. 

8. Ratio of current assets to current liabilities. — 
The reader of the balance sheet of an undertaking 
win compare the ratio existing between current lia- 
bilities and current assets. For example, the balance 
of the cash account would be considered in connection 
with the amount of wages and current liabilities due. 
With reference to loans payable, one would look for 
fluctuations. Thus, during the season in which an 
undertaking is acquiring its merchandise and getting 
it ready for market, there will be a constant increase 
in the amount of the outstanding accounts and notes 
payable. At the end of the season, or at the end of 
the normal fiscal year, one would expect to see the 
accounts payable reduced to an amount representing 
perhaps current bills not yet due. One would also 
expect to find that all the bank loans had been paid 
off. If loans for a relatively large sum were out- 
standing at the end of the normal fiscal period or at 
the end of the season, it would be an indication that 
the concern was financing itself permanently on bor- 
rowed capital. This proceeding might be a danger- 
ous one, because the loan might be called at any time 
and the firm might be unable to repay it on demand. 
A business should have a sufficient amount of owned 
capital to take care of its ordinary financial needs at 
the end of the fiscal or season period. 

9. Deferred liabilities or deferred credits to in- 
come. — Deferred credits to income consist of those 


items received in the current period which have not as 
yet been earned. These items should not properly be 
credited to income in the present j)eriod and the credit 
to income is deferred until later. From the point of 
view of proprietorship, they are liabilities in that they 
represent the liability of the organization to deliver 
service in a later period. Thus, for example, a tenant 
may pay rent in advance and at the date of the bal- 
ance sheet a certain portion of the rent paid in ad- 
vance will have been earned and a portion will be un- 
earned. The portion unearned is set up as a de- 
ferred credit to income because it represents the rent 
service which the tenant is to enjoy from the landlord 
during the following period. Deferred liabilities are 
the reverse of deferred assets. 

10. Contmgent liabilities. — Contingent liabilities, 
as the reader will recall, are those which may or may 
not occur upon the happening of a certain event or 
contingency arising out of past transactions. The 
most common examples of contingent liability are 
those of liability under notes receivable which have 
been discounted and liability as guarantor of the 
principal or interest on the debt of another firm. 
The important features of the contingent liability on 
notes receivable discounted, have been considered. 
Liability as guarantor for the principal and interest 
of the debt of another is such a liability as a holding 
company might assume as guarantor of the principal 
and interest of the debt of a subsidiary. Contingent 
liabilities will be offset by contingent assets. Thus, 


the contingent asset offsetting the contingent Hability 
for a note receivable discounted is the claim which 
arises against the maker of the note if the liability be- 
comes actual. Of course, the value of the contingent 
asset depends upon the ability of the maker to pay. 
Where one has assumed contingent liability as guar- 
antor of the principal and interest of the debt of an- 
other, the guarantor usually protects himself by tak- 
ing security. If the security taken by the guarantor 
is equivalent to the amount of his liability, the con- 
tingent asset is equivalent to the contingent liability; 
otherwise, of course, a loss results. 

It is not customary to show contingent assets and 
contingent liabilities in the balance sheet proper. 
Nevertheless, contingent liabilities should be stated 
in a footnote in the balance sheet, if not included in 
the balance sheet itself. If both contingent assets 
and contingent liabilities are included in the balance 
sheet, they will be grouped under their appropriate 

11. ConcluMons to he inferred from the liabilities. — 
Having thus considered the nature, interpretation 
and the valuation of assets and liabilities, it remains 
now to consider what inferences may be drawn. The 
capital assets or the fixed assets are usually acquired 
in part by the issue of fixed liabilities and capital stock. 
In all cases there should be a reasonable equity in the 
fixed property. In other words, bondholders and 
mortgagees ought to be protected by a reasonable 
equity against the possibility of loss. What this 


equity should be depends upon circumstances, but in 
practice it should seldom be less than 25 per cent. 

Creditors on open accounts as well as bondholders 
are also interested in the relation which exists between 
current assets and current liabilities. There should 
always be a reasonable excess of quick assets over 
quick liabilities in every concern that issues mortgaged 
or bonded debts. Here, again, ratios vary because the 
conditions will vary in the different lines of business. 
In the meat packing industry, the quick assets will 
shoAV a much better ratio than in the textile industry, 
because of certain differences in the nature of the 
business transactions. At any rate, under ordinary 
circumstances, there should be at least twice the 
amount of quick assets as of quick liabilities. A 
large amount of cash on hand and a large amount of 
accounts payable might be an indication of careless 
management. If the accounts payable are subject to 
cash discounts, it might be more profitable for the 
organization to increase its loans and use the cash in 
the reduction of accounts payable thru taking ad- 
vantage of all discounts. A business cannot stand 
still for any length of time. It will either advance 
or go backward. 

Unfavorable conditions that do not show improve- 
ment will be due to the following possible causes. It 
may be that the machinery and processes which are in 
use are not the best to be had or the most modern that 
science has developed. Perhaps new blood is neces- 
sary in the sales organization or in the operating de- 


partment. Suggestions may sometimes be obtained 
from a study of the methods of competitors. 

A careful study of all those factors and an impartial 
analysis of financial statements by all those inter- 
ested in any business, will benefit not only the business 
men themselves, but also the vast army of employes 
who are dependent upon the prosperity of those who 
foot the pay-roll. 

The following is an illustration of an Income and 
Profit-and-Loss Statement and a Balance Sheet of a 
manufacturing establishment. 


General Balance sheet — December 31, 1911. 


Capital Assets: 

I,and $100,000.00 

Buildings 150,000.00 

Machinery and equipment 74,360.00 

Stoclis and bonds of controlled companies. 300,000.00 

Furniture and fixtures 90,000.00 

Good-will 150,000.00 

Total capital assets $ 694,360.00 

Working and trading assets: 

Materials. and supplies inventory $ 66,838.20 

Finished goods inventory 17i?,7:27.50 

Total working and trading assets $ 239,565.70 

Current assets: 

Cash on hand and in bank $ 43,960.00 

Accounts receivable 109,870.00 

Notes receivable 18,000.00 

Total current assets $ 171,830.00 

Sinking fund 15.000.00 


Deferred charges to expense: 

Prepaid insurance $ 7,500.00 

Advertising paid in advance 2,175.00 

Rent paid in advance ■ 100.00 

Organization expense 12,000.00 

Total deferred charges $ 21,775.00 

Total assets ' $1,142,530.70 

Capital Liabilities: 

First mortgage bonds authorized $400,000.00 

Less— unissued 200,000.00 

Issued and outstanding $ 200,000.00 

Current Liabilities: 

Accounts payable $ 5,896.00 

Notes payable 10,000.00 

Dividends payalile 40,000.00 

Interest accrued and due 10,000.00 

Interest accrued not due 2,000.00 

Royalties accrued 7,900.00 

Taxes accrued 3,500.00 

Wages accrued 1,500.00 

Total current liabilities $ 80,856,00 

Reserves : 

For depreclation^machinery and equipment $ 22,G90.00 

—buildings 48,000.00 

" —good-will 16,290.00 

Sinking fund reserve 15,000.00 

Insurance reserve 8,000.00 

For doubtful accounts 12,570.00 

Total reserves $ 122,550.00 

Capital Stock: 
Preferred : 

Authorized issue — 6,000 shares — par value 

$100 each $600,000.00 

Less unissued 700,000.00 

Issued and outstanding $500,000.00 

Common : 

Authorized, issued and outstanding — 2,000 

shares, par value $100 eacii 200,000.00 

Total capital stock, issued and 

outstanding $ 700,000.00 

Surplus— December 31, 1911- 39,124.70 

Total liabilities and capital $1,142,530.70 


Statement of Income and Profit and Loss for the year ended 
December 31, 1911. 

Gross sales $720,290.00 

Less— returns 14,063.00 

Net sales $706,227.00 

Deductions from sales: 

Trade discounts $60,386.00 


Defective goods $ 7,892.00 

Breakage 8,920.00 

Rebates 44,825.00 

Outward fgt. and ctge 7,890.00 69,527.00 

Total deductions from sales $129,913.00 

Amount realized on sale? $576,314.00 

Cost of goods sold : Schedule No. 1 420,300.00 

Gross profit on sales $156,014.00 

Selling expense: 

Salaries — sales manager and clerks $ 8,000.00 

Salesmen : 

Salaries 11,500.00 

Traveling expenses 3,300.00 

Commissions 4,000.00 

Advertising 4,580.00 

Entertaining customers 1,200.00 

Total selling expenses $ 32,580.00 

Selling profit $123,434.00 

Administrative expenses: 

Salaries of officers $25,000.00 

Salaries of general office clerks 12,000.00 

Directors' fees 1,000.00 

Printing and stationery 4,500.00 

Postage 3,060.00 

Telephone and telegraph 2,700.00 

Traveling — officers and clerks 1,500.00 

Legal expenses 4,006.00 

Total administrative expenses $ 53,766.00 

Net profit on sales — income from operations .... $ 69,668.00 


Other income: 

Interest on bonds owned $ 5,000.00 

Dividends on stocks owned (3,000.00 

Cash discount on purchases 300.00 

Interest on l)ank balances HGo.OO 

Interest on notes receivable 480.00 

Rent 1,000.00 

Total other income $ 13,045.00 

Total income $ 82,713.00 

Deductions from income: 

Interest on bonds $10,000.00 

Interest on notes payable 3,000.00 

Cash discount on sales 1,750.00 

Rent 300.00 

Insurance expense 13,000.00 

Taxes 15,750.00 

Royalties 16,555.00 

Total deductions from income $ 59,325.00 

Net income profit and loss $ 23,388.00 

Profit and loss credits: 

Profit on sale of securities $20,000.00 

Bad debts previously written off — now collected 14,000.00 

Total profit and loss credits $ 34,000.00 

Total $ 57,388.00 

Profit and loss charges: 

Provision for doubtful accounts $ 5,000.00 

Provision for depreciation of bldgs 10,000.00 

Provision for depreciation of good-will 3,000.00 

Organization expense — written off 2,000.00 

Total profit and loss charges $ 20,000.00 

Profit and loss — surplus for year $ 37,388.00 

Profit and loss — surplus at beginning of year. . . . 49,736.70 

Gross surplus at Dcceml)er 31, 1911 $ 87,124.70 

Appropriations of surplus: 

Insurance reserve $ 3,000.00 

Sinking fund reserve 5,000.00 

Dividends declared 40,000.00 

Total appropriations $ 48,000.00 

Corporate surplus at December 31, 1911 $ 39,124.70 



Schedule showing Cost of Goods Sold during Year ended 

December 31, 1911. 
Cost of goods sold: 
Manufactured cost: 
Prime cost: 

Material and supplies consumed $365,506.92 

Labor— direct 90,769.03 

Total prime cost $356,^^75.95 

Manufacturing overhead : 

Labor— indirect $ 29,207.04 

Power 9,294.26 

Factory supplies 3,987.25 

Depreciation — machinery equipment 2,713.29 

Salaries — factory manager and clerks 22,038.90 

Factory office expense 1,200.38 

Factory general expense 3,344.97 

Total manufacturing overhead $ 70,786.09 

Total manufacturing cost $427,062.04 

Finished goods — deduct increase in Inventory 6,762.04 

Total cost of goods sold $420,300.00 


State the distinction between a liability and an accountability, 
and discuss the various kinds of liabilities. 

Explain the nature of funded debt as distinguished from cur- 
rent liability. 

What accruals are to be considered as liabilities ? 

What are contingent liabilities and contingent assets, and how 
far should they be recognized in the balance sheet? 

What information can be looked for in a scrutiny of the lia- 
bilities } 



1. Definition of surplus. — By the term surplus, is 
meant the intrinsic value of all the assets of a firm, 
over and above its liabilities and outstanding capital. 
Intrinsic value is to be distinguished from reproduc- 
tive value in that the former relates to the actual cost 
of the assets acquired, less the depreciation sustained 
since acquisition, and the latter, to the cost of duj)lica- 
tion on the basis of ruling market prices. 

The author is a firm believer in the rigid cost theory 
of value in so far as the books of account are con- 
cerned. It should be borne in mind that purchase 
price may not represent the true value. This is due 
to the fact that assets can be purchased at a cost 
greater or less than the true value. Some authori- 
ties justify the use of true value based upon a prop- 
erly made appraisal as the basis for placing assets on 
the books. 

2. Kinds of surplus. — Open surplus is that which 
appears on the books in the form of surplus, reserves 
or undivided profits. 

Hidden surplus is represented in the form of secret 
reserves as a result of accumulation of profits that do 
not appear on the books. 



Surplus may also be distinguished as free and re- 
stricted. By the former is meant that form of sur- 
plus that represents profit available for distribution; 
by the latter, a profit accumulation which for one 
reason or another is to be retained in the business. 

3. Relative importance of surplus and assets. — The 
importance of the surplus accoimt is due to the fact 
that the stockholder finds reflected there the net re- 
sults of the company's operations; he measures the 
value of the company's stock by the fluctuations in the 
surplus account. The importance of using the proper 
basis for the valuation of the firm's assets thus be- 
comes apparent, for an incorrect valuation is at once 
reflected in tlie surplus account. 

4. Sources of surplus. — Broadly speaking, surplus 
may be derived from the following sources : 

(1) from profits as a result of business operations; 

(2) from a revaluation of fixed assets; 

(3) from an original investment at the time of 
organization or as a result of reorganization. 

5. Surplus resulting from business ojjerations. — 
The reader is already familiar with corporate surjjlus 
resulting from business operations. He will also re- 
call that inasmuch as a business may have primary and 
secondary operations, surplus will necessarily be either 
from primarj^ or secondary operations, or from both. 

6. Importance of distinguishing between capital 
and revenue expenditure. — It is self-evident that 
there will be an overstatement of the surplus if all the 


elements of cost have not been included in the profit 
and loss account. One of the problems in that con- 
nection is the proper allocation of expenditures to 
capital and revenue. If an expenditure that should 
have been charged to revenue is charged to a capital 
account, the assets will be increased and the expenses 
will be decreased by the same amount. Conversely, if 
an item that should have been charged to capital is 
charged to revenue, the assets will be undervalued and 
the expenses will be correspondingly overstated. 

In the first instance, the surplus will be erroneously 
increased, and in the second case it will be less than 
it should be. The general principle to bear in mind 
is that it is allowable to charge to revenue any ex- 
penditure that does not enlarge the field of opera- 
tions or that results in an increase in earning power, 
or in a decrease in the expense of conducting the busi- 
ness. Inasmuch as the application of these principles 
oftentimes is attended with difficulty, it is important 
in reading financial statements to consider what has 
been the practice of the company in connection with 
expenditures, as reflected by the surplus. 

7. Depreciation as an element of cost. — In consid- 
ering the sm'plus, the fact that depreciation is an im- 
portant element in the income accoimt must not be 
overlooked. If the depreciation of both fixed and 
circulating assets has not been provided for by 
charges against earnings, the surplus account will be 
overstated. Depreciation on fixed assets may be 
broadly viewed as a sort of rental that the operating 


department of a business pays for the use of the assets. 
Depreciation on all circulating assets, such as ac- 
counts receivable and inventory, should also be pro- 
vided for, before net profits are shown. 

8. Reserves that are not part of surplus. — It is 
maintained by some accountants that all reserves are 
a part of surplus, but such a contention is not true 
of any reserve created to measure depreciation or to 
offset an anticipated loss on the realization of ac- 
counts receivable. This holds good notwithstanding 
the fact that reserves of this character are frequently 
found on the liability side of a balance sheet included 
with other reserves. The use of reserves for the pur- 
pose of adjusting the valuation of assets in the bal- 
ance sheet is purely a question of bookkeeping expedi- 
ency. If a loss equivalent to that shown in the re- 
serve accounts has been sustained, or is anticipated, 
the shrinkage may be credited direc^tly to the asset 
account; at the same time the profits of the period 
may be reduced by the same amount, or the decline 
in value may be credited to a reserve account. When 
decreases in value are credited to a reserve account the 
record will be clearer if the reserve, being an adjunct, 
is offset against the asset affected when the balance 
sheet is prepared. 

9. Intercompany jirofits on inveniorif should he 
eliminated from surplus. — The reader will recall the 
discussion with regard to profits of holding companies 
as given in Chapter VI. Subsidiary companies fre- 
quently do business with one another and the transac- 


tions between companies will usually be invoiced at 
or near the prevailing market prices. Let us assume 
that Company A, a mining company, sells the greater 
portion of its output to Company B, which operates 
a steel mill that turns out, in the form of bars or 
blooms, material received from Company A. Let 
us further assume that the product made by Company 
B is shipped over Railroad C, owned by the holding 
company to another subsidiary, Company D, which 
operates a rod mill. Both Company B and Company 
D sell to outsiders as well as to Company E, which 
we shall assume is another subsidiary company, en- 
gaged in the manufacture of certain specialties. The 
entire output of Company E is disposed of to out- 

The subsidiaries will have on hand, included in their 
material inventories, at the close of the fiscal period, 
goods which have been purchased from other sub- 
sidiaries and upon which the latter have made a profit. 
The raw material of Company D is the finished prod- 
uct of Company B ; the finished products of Company 
B and Company D constitute the raw material of 
Company E. 

In the preparation of a balance sheet of the holding 
company, a consolidation of the assets and liabilities 
of the subsidiaries will make it possible to take up, as 
inventory of materials, certain quantities jDurchased 
from other subsidiaries, upon which the latter have 
already made a profit which is represented in the sur- 
plus accounts of the subsidiaries. Each of the sub- 


sidiaries has a separate corporate existence and, as 
far as its own accounts are concerned, has made a 
vahd profit. It is important to remember, however, 
that from the standpoint of the entire aggregation no 
profit has as yet been reahzed on that material which 
was sold by one subsidiary and remains on hand in 
the inventory of another subsidiary. 

That this is an important factor affecting surplus 
may be seen from an analysis of the balance sheet of 
the United States Steel Corporation for the year end- 
ing December 31, 1915. The inventory of raw ma- 
terial on hand in the subsidiary companies at that date, 
amounted to $161,113,900. The amount of inter- 
company profits represented in inventories of the sub- 
sidiaries on hand on the same date amounted to $20,- 

10. Dividends of subsidiary companies available to 
the jmrent company. — The dividends received by a 
holding company on the stock of subsidiaries which it 
owns may not in all cases be properly credited to the 
surplus account of the former. In many instances 
the subsidiaries whose stocks were acquired possessed 
a surplus at the time of consolidation. The price 
that the holding company paid for the stock of the 
subsidiary implied the existence of such surplus. If, 
for example, the capitalization of a subsidiary com- 
pany amounted to $100,000 with an accumulated sur- 
plus of $30,000 the purchase price of a $100 share in 
such a company would probably be about $130 per 
share. If the stock were purchased by the holding 


company at this price, it would appear in its invest- 
ment account at a value of $130,000. 

Let us assume that the holding company increases 
its surplus account to $50,000 during the next year, 
and that the board of directors votes to distribute the 
entire surplus as a cash dividend. The parent com- 
pany is the sole stockholder and receives a check from 
the subsidiary company for $50,000. But not all of 
this amount is to be considered by the holding com- 
pany as income. Only that portion of the dividend 
which represents a distribution of surplus profits 
earned since the stock was acquired can be treated as 
earnings. The reason is that the distribution of the 
entire surplus in the form of a dividend has reduced 
the value of the capital stock of the subsidiary to a 
book value of approximately $100 a share. Conse- 
quently the value of the holding company's investment 
has been reduced to $100,000. Inasmuch as this in- 
vestment is carried on the books of the holding com- 
pany at $130,000, it is clear that the dividend of 
$50,000 that is received by the holding company must 
be divided into two parts, viz., $30,000 to be credited to 
its investment account — this will reduce that account 
to $100,000; and $20,000 to be credited to its surplus 

11. Surplus from, sale of fixed assets. — Surplus re- 
sults from the sale of fixed assets when any portion of 
the fixed property is sold for an amount greater than 
the book value of that property. Sales of this char- 
acter may be broadly grouped in two classes: sales 

XXII— 15 


of isolated units, and sales of magnitude, in which the 
property disposed of consists of an integral part of 
the operating equipment. 

Before a decision is made in regard to the disposi- 
tion of such profits it is necessary to inquire whether 
or not proper provision has been made for the de- 
preciation of the remaining units of equipment. The 
fact that a profit has been realized upon the sale of an 
isolated unit of the plant equipment is not an indica- 
tion that a true profit has been realized. The price 
paid by the new owner might represent elements other 
than true value. For example, an undertaking en- 
gaged in the manufacture of war munitions might pay 
a high price for a plant particularly suited to its needs, 
in order to fill a contract which it would be unable to 
accept without securing such a plant. But if inves- 
tigation shows that the proper provision for deprecia- 
tion on the remaining units has been made, the profit 
can undoubtedly be credited to the surplus account. 
It is, however, more conservative to credit the amount 
of the profit to the reserve for depreciation provided 
on the remaining units. 

Sales of magnitude may be illustrated by the case 
of a company engaged in manufacturing office desks 
and chairs, which maintains a separate establishment 
for the manufacture of each article. Let us suppose 
that the company decides to discontinue the manu- 
facture of desks and to concentrate its energies upon 
the manufacture of chairs. If the entire plant used 
in the manufacture of desks is disposed of at a profit. 


and if the accrued depreciation on the remaining 
equipment is adequate, the entire ^^rofit that is real- 
ized may be properly credited to the surplus account. 
Such profits do not, however, constitute an addition to 
the current income account of the company, and 
should therefore appear as surplus adjustments. 

12. Profits resulting from the sale of investments. 
— Business firms from time to time acquire invest- 
ments in the securities of other companies. If such 
holdings subsequently are disposed of at a profit it is 
proper to credit the surplus account. It is assumed 
that the company will have provided a reserve for the 
decrease in the value of any other investments of this 
character that it may have. If this has not been 
done, it would be better to credit the profit realized 
on the sale of investments to a properly designated 
reserve account, since in this way the loss sustained 
on other investments may be offset. 

13. Profits resulting from, revolution of fixed 
assets. — It may be necessary or advisable for a board 
of directors to revalue the fixed assets. No matter 
how carefully a company may attempt to determine 
in advance the proper allowances for depreciation, the 
estimates are often incorrect. If the property has 
been revalued by a competent ajjpraiser, there is prob- 
ably no ob jectition to showing the increased value on 
the books. On the other hand, conservative account- 
ing practice often suggests another disposition of the 
matter. At times it is preferable to allow the values 
to remain unchanged rather than to swell the surplus 


account by credits due to revaluation. As the depre- 
ciation charges for subsequent periods may be re- 
duced, this method has all the adv^antages and none of 
the defects of the other. 

Evidently, if the appraisal should reveal the fact 
that the property has been overvalued, the surplus 
account should be charged with the amount of the 
overvaluation. It is also clear that the revaluation 
should be made in good faith, and not for the purjDose 
of wiping out a deficit from operation. In some 
instances a corporation will acquire the physical prop- 
erty of a business undertaking by giving in payment 
an amount of capital stock in excess of the value at 
which the assets stood on the books of the vendor. 
The difference between the cost price to the purchaser 
and the book value of the assets may be debited to the 
good- will account of the purchaser; or the board of 
directors may place upon the assets acquired, new 
valuations that will absorb the excess price paid. 

The practice of concealing the value of the in- 
tangible property purchased has been strongly con- 
demned, and it is interesting to note that some cor- 
porations have altered their accounts so as to disclose 
in their balance sheets the value of the intangible 
property. The subject is discussed in an interesting 
manner in an article in the Jovrnal of Accountancy 
(August, 1916) in which the author gives a list of 
the corporations that now state separately the values 
of intangible assets. 

14. Entries on revaluation necessary to adjust 


property accounts. — If the depreciation of prior 
periods was credited directly to the asset account, the 
increase in value shown by the appraisal should be 
debited to the asset account ; this would make it agree 
with the appraised value. The credit should be made 
to surplus account. If, however, the depreciation of 
prior periods was carried in a reserve account, the 
increase in the book value of the property should be 
effected by transferring as much of the excess as is 
necessary to offset the excess credit. 

15. Value of fixed assets is not affected by eco- 
nomic conditions. — -The value of the fixed assets that 
a company uses in 'its operations is not affected by 
economic conditions. This principle applies also 
when the value of fixed assets declines, or when the 
cost of duplicating fixed assets is lower than the book 
value of the assets. 

To illustrate, we will suppose that a company has 
in its equipment account a record of five engine 
lathes which cost $400 each, and on each of which 
depreciation, based upon the normal life of such ma- 
chinery, has accrued to the amount of $100. The 
fact that lathes of this kind can now be purchased in 
the open market for $27i5 each, owing to the decline 
in material and labor cost, would not justify the com- 
pany in reducing the value of the lathes upon its 
ledger. This is true so long as the lathes are serving 
the purpose for which they were purchased, and so 
long as the depreciation rate is sufficient to take care 
of the amortization of the assets to residual value at 


the expiration of their effective life. This beins^ the 
case, changes in value, that are the result of economic 
conditions should be ignored. 

16. Entries to 7' e cord increase due to economic 
causes. — It is not considered good accounting or 
financial practice to swell the surplus account with 
profit resulting from economic causes. If it is de- 
sired to give expression to the fact that the fixed 
assets have increased in value because of economic 
changes, the amount of the increase should be cred- 
ited to an account "Reserve for Appreciation," and 
not to the surplus account. Otherwise, stockholders 
would be misled into the belief that the dividends 
which they are receiving are a part of the earned sur- 
plus. It is true, however, that a corporation may 
legally reflect such increased valuation in its surplus 
account, and by disposing of an amount of capital 
stock for cash, equivalent to the increase in value, it 
may distribute the cash in the form of a dividend. 
But even in this procedure, fairness to the stock- 
holders requires that notice be given as to the source 
of the dividends. 


Define surplus and disff nguish between the several kinds of 

In what different ways can surplus arise? 

How do inter-company profits on inventory affect the calcula- 
tion of surplus.'' 

When is it proper to create surplus by revaluation of fixed 
assets? What attention should be given to changes in economic 
conditions in valuing assets ? 



1. Surplus contributed at the time of incorpora- 
tion. — Banking corporations and similar institutions* 
very often sell their initial issue of capital stock at a 
premium in order that they may begin business with 
a surplus. The amount of the premium will ordi- 
narily be credited to surplus account and the ordi- 
nary profits from operation will be carried to an un- 
divided profits account. From time to time the 
balance standing to the credit of the surplus account 
may be further augmented by certain amounts trans- 
ferred from the undivided profits account. 

This does not hold true in case of industrial or 
transportation corporations. Railroads, for instance, 
under the jurisdiction of the Interstate Commerce 
Commission, are required to credit the premium real- 
ized in this manner to a permanent surplus account 
suitably designated. 

In the re-organization of industrial corporations 
the newly organized company may acquire the assets 
of the old company, in exchange for issues of stocks 
and bonds. The par value of these stocks or bonds 
may be considerably less than the fair value of the 
assets acquired. In this event, if the assets are 



placed on the ledger of the new company at their bulk 
value, a surplus will be created equal to the difference 
between the value of the assets acquired and the par 
value of the securities. 

Surplus may also be created in the case of re- 
organization by reducing the par value of the out- 
standing stock by an amount more than sufficient to 
wipe out the impairment of capital. 

2. Distribution of initial surplus. — Surplus created 
in any of these ways should not be distributed in the 
form of ordinary dividends. Such action would 
either defeat the purpose for which it was created or 
would result in misleading stockholders who were not 
aware of the source of the dividends. It is always 
advisable when a board of directors votes to pay 
ordinary dividends, using for such purpose any part 
of the surplus created in the manner described, that 
the stockholders should be frankly advised of the fact. 

3. Secret reserves. — Two common methods of cre- 
ating secret reserves are : ( 1 ) providing for a greater 
reserve for depreciation on fixed property than condi- 
tions warrant; (2) making extended provision for bad 
and doubtful accounts. 

Banking institutions frequently provide for such 
reserves by making an understatement of the value of 
their investments. 

If items are charged to a revenue account that 
should have been charged to a capital account a secret 
reserve is created. Similarly, eliminating assets from 
the balance sheet will establish a secret reserve. 


An overstatement of a liability will, of course, re- 
duce the net worth shown in the balance sheet and 
correspondingly reduce the surplus, thereby creating 
a secret reserve. One should be careful to distinguish 
secret reserve from surplus that is the result of a con- 
servative valuation of assets. Prudence requires not 
only that assets be conservatively valued, but also that 
all losses be anticipated. 

4. Purpose of secret reserves. — The creation of 
secret reserves is often practised for the purpose of 
reducing the amoimt of the visible surplus so as to 
withhold the profits of the business and, at the same 
time, prevent stockholders from demanding distribu- 
tion of the true surplus in the form of larger divi- 

Ordinarily, secret reserves constitute a source of 
strength because extraordinary losses that could not 
otherwise be taken care of may be charged against 
them. Moreover, they enable the directors of a com- 
pany to know fairly definitely whether or not the sur- 
plus should be retained in the business. 

Another advantage of secret reserves is that they 
permit the maintenance of a uniform dividend rate 
over a period of years. For example, if depreciation 
on the fixed assets has accrued during prosperous 
years at a higher rate than is actually necessary for 
the welfare of the business, the company need not 
make any provision for depreciation when a lean year 
is encountered. Thus, in a year when earnings were 
low, there would be no necessity for providing for 


depreciation. The secret reserve could be drawn 
upon and all the earnings of the period would be 
available for dividends. The declaration of a uni- 
form dividend rate over a definite period of years 
results generally in the establishment of uniform 
prices for the securities of the company in the open 

5. Other purposes of secret reserves. — Public serv- 
ice corporations sometimes create secret reserves for 
the purpose of reducing the surplus so as to avoid 
agitation on the part of the public for a reduction of 
rates. Certain states have now adopted a uniform 
system of accounts — a system that effectually pre- 
vents this practice. But the uniform system of 
accounts does not prevent utility corporations from 
making charges to revenue, contrary to the estab- 
lished regulations, unless the capital accounts are 
thoroly audited by a commission. 

The principal objection to a secret reserve is the 
fact that it is just as incorrect from an accounting 
standpoint to undervalue assets as it is to overvalue 
them. Then, too, a secret reserve offers a temptation 
to managers to utilize this means of concealing losses 
due to speculation or mismanagement. Further- 
more, a secret reserve is sometimes the cause of injus- 
tice to stockholders who may dispose of their stock 
for less than its actual value, because the board of 
directors has never informed them of the presence 
of the secret reserve. And finally, there is the ob- 
jection that it is impossible to prepare true com- 


parisons of valuation or of earnings from the rej)orts 
of a company tliat has a secret reserve. 

6. Propriety i\v. impropriety of secret reserves. — 
While the propriety of creating a secret reserve is to 
be questioned for the reasons that have been men- 
tioned, many conservative companies provide for it. 
Furthermore, conservative business men countenance 
the practice, provided it is kept within reasonable 
limits. In the last analysis, it would seem that if the 
l)urpose of the secret reserve is good and the directors 
of the company are honest, no great harm can re- 

7. Disposition of the surplus. — As the reader 
already knows the surplus of a company may be dis- 
tributed in the form of dividends and it may be re- 
invested in the property. Surplus in the form of 
dividends may be distributed as cash, as capital stock, 
or as assets. 

An example of the distribution of surplus in the 
form of assets occurred recently in the case of a well- 
known powder manufacturing company which dis- 
tributed dividends in the form of Anglo-French 

Re-investment of surplus in the proj^erty may be 
made in the form of specific investment or general in- 
vestment. If the surplus is invested either in special 
funds or in fixed property, it is usually so ear-marked. 
If the surplus has not been invested in funds or in 
fixed property, it is generally represented in all of 
the assets. 


8. Surplus does not necessarily mean cash. — Cur- 
rent'profits are usually, altho not always, represented 
by cash or other liquid assets. The fact that a com- 
pany has a surplus is not always an indication that it 
is able to pay its debts. If the quick assets are not 
sufficient to enable the company to meet its maturing 
obligations, it may be forced into the hands of a re- 
ceiver, even tho it has a surplus. It is therefore 
important to bear in mind that the needs of a corpora- 
tion, as regards the liquid assets, largely govern both 
the management and the distribution of the surplus. 

9. Distribution of dividends. — The basic principle 
of a business organization is that it .shall make money 
for its investors. The profits of a company, as repre- 
sented by the surplus, are distributed wholly or in 
part as dividends. Upon the declaration of a divi- 
dend by the board of directors, mention is made on 
the books of the company, charging dividends de- 
clared and crediting them to a dividend payable ac- 
count. This is done in order to reflect the liability 
of the company to its stockholders. The dividend 
payable account is closed out when the cash is 
actually paid to the stockholders in which case the 
dividend payable account is charged and the cash is 

10. Characteristics of a dividend. — A dividend, to 
be legal, must be declared by the board of directors, 
or issued with the consent of all the stockholders. 
After a dividend has been declared, and notice of the 
declaration has been made public, it becomes a debt of 


the corporation and should appear in the balance 
sheet among the current liabilities. 

In a large corporation, because there are a gi'eat 
many stockholders, a resolution of the board some- 
times provides that the transfer books shall be closed 
at a definite date, and that they shall not be re- 
opened until a later date specified in the reso- 
lution. The object of this is to allow the office force 
time to draw the dividend checks as well as to make 
it possible to ascertain who are the stockholders of 

Dividends are declared as a percentage upon out- 
standing capital stock and each stockholder receives 
payment according to the amount of stock he holds. 
Dividends must be paid out of earned profits. It is 
not, however, always an easy matter to determine just 
what is meant by earned profits and the question has 
constant^ been a fruitful source of litigation. The 
stock corporation laws of some states provide sub- 
stantially that the directors of a corporation shall not 
pay dividends except from the surplus arising from 
the business of the corporation. Furthermore, they 
shall not divide, withdraw, or in any way pay to the 
stockholders, any part of the capital of the corpora- 
tion or reduce the capital stock except in the manner 
provided by law. Where this system is in effect, 
heavy penalties are assessed against any director who 
votes for the illegal payment of a dividend as well as 
against any who do not definitely indicate their dis- 


11. Conmlerations affecting the declaration of 
dividends. — The payment of a dividend involves the 
distribution of Hquid assets and therefore weakens the 
financial position of a company. Prior to the dec- 
laration and payment of the dividends, the directors 
will probably consider whether or not the company 
can safely reduce its liquid assets for this purpose. 
If it has adopted a policy of expansion, which involves 
a large increase in capital or bonded debt, or if it must 
soon meet a large maturing obligation, the directors 
will probably be conservative and withhold dividends. 
They will, perhaps, distribute a stock dividend thus 
enabling the stockholders to realize on the accrued 
profits by the sale of stocks so distributed. 

Upon analysis it will be seen that the distribution 
of a stock dividend is equivalent to the sale for cash 
of new stock by the company and the subsequent dis- 
tribution of the surplus in the form of a cash dividend. 

12. Cajntal eucpenditures charged against surplus. 
— A wise financial policy will dictate a reinvestment 
of a portion of the surplus in fixed property. There 
are certain classes of equipment essential to a cor- 
poration which are proper charges to a capital 
account, but from these the corporation will not be 
able to derive additional earnings equivalent to the 
interest on the money invested. Such equipment 
should properly be financed out of surplus. The in- 
vestment of surplus in fixed property prevents the 
sale of additional stocks or bonds. There is a conse- 
quent saving in interest charges or dividend disl)urse- 


ments which reacts ultimately to the benefit of the 
stockholders. The investment of surplus in fixed 
j)roperty also enhances the value of the capital stock. 

13. Reserves created out of surplus. — A corpora- 
tion may set aside a portion of its surplus for the pur- 
pose of establishing a pension fund. If it does, it 
will be obliged to charge the surplus account and to 
credit a pension reserve account with the amount set 
aside. An equivalent amount of cash or assets might 
be reserved in a special fund known as the pension 
fund — out of which pensions could be paid to the em- 
ployes of the company. Other special reserves might 
from time to time be created if, in the judgment of 
the board of directors, it were wise to do so. 

14. Reserve account misnamed. — Attention has 
already been called to the fact that some reserve 
accounts, such as reserve for depreciation or reserve 
for doubtful debts, are not a part of surplus. Oc- 
casionally we find on balance sheets an account called 
reserve for taxes or reserve for unearned income. 
The former is a liability and should appear among 
the current liabilities, while the latter is a deferred 
credit to income and should not be stated with the 
true reserve. 

15. Illegal dividends. — The reader has noted that 
dividends can be declared lawfully in the form of 
cash, stock or otherwise. The declaration of an 
illegal dividend or the payment of an illegal dividend 
already declared may be enjoined and stopped by 
proper action of the stockholders. 


Illegal dividends may be of three types: 

1. Those declared in disregard of the rights of some 
stockholders; for example, declaring dividends on 
common stock altho cumulative preferred dividends 
have not been paid. 

2. Those declared in violation of the charter or 
by-law provisions of the particular corporation. 
Such a provision might state that a given amount must 
be accumulated in surplus before a dividend can be de- 

3. Those which either impair the capital stock or 
threaten the solvency of the corporation. 

16. Scrip dividends. — Scrip dividends really par- 
take of the nature of a forced loan. Stockholders 
would undoubtedly prefer to have their dividends 
distributed in cash, but, if the corporation issues scrip 
to them, they are compelled to accept it. Of course, 
they can realize the scrip in cash by selling it in the 
market, but if this is done the scrip usually sells for 
much less than its face value. 

17. Dividend jmlicies. — The wise executive at- 
tempts to forecast not only the immediate, but also 
the distant future. If it appears that a business will 
need to add to its facilities in order to take care of 
an increasing volume of business, the management 
would probably wish to withhold part of the profits 
from distribution. The investment of the surplus or 
a portion of it in fixed property will have the effect of 
counteracting any mistake the management may 
have made in charging its expenditures to capital. 


Furthermore, the retention of the surjDlus for invest- 
ment in fixed property is tantamount to charging the 
expenditures directly against revenue. 

Whether or not all or part of the surplus should 
be distributed in the form of dividends will require 
careful consideration of many factors. Summarized 
they are as follows: 

1. Can the business safely reduce its liquid assets 
by the amount necessary to pay the dividends ? 

2. Is the margin between selling price and cost de- 
creasing to such an extent as to threaten the profits 
enjoyed in the past? 

3. Have all expenditures for capital accounts been 
justified and have they been bona fide expenditures? 

4. What is the company's credit position and its 
ability to raise needed sums for expansion thru the 
issue of capital stock or bonds? 

5. Is the investment market favorable? 

6. Can the profits safely stand increased fixed 
charges or increased amounts for dividend distribu- 


Under what circumstances is surplus contributed directly by 
investors and what is the object in so doing? 

How are secret reserves established and what purposes do 
they serve? 

How is the surplus distributed to stockholders? What differ- 
ent forms of dividends are used ? 

What are the chief characteristics of a sound dividend policy? 

XXII— 16 



1. The tJieory of the sinking fund. — Corporate 
bondholders require the assurance that the amount 
due to them will be paid at maturity. To accomplish 
this, the indenture provides that a certain annual sum 
shall be set aside at periodic intervals," which, when 
invested and reinvested at an assumed rate of interest, 
will amount to the principal of the debt at the ma- 
turity thereof. The fund set aside is usually placed 
in the hands of trustees, a trust company ordinarily 
being designated for this purpose. Detailed pro- 
visions are made in the indenture with reference to 
the investment of the fund and the retirement of the 
debt. The phraseology used in the majority of in- 
dentures, "the sinking fund shall be set aside out of 
profits," necessitates a charge against revenue and a 
credit to a sinking fund reserve for the amount of the 
instalment. At the same time an equivalent amount 
of cash or other assets is set aside out of the general 
funds of the company. When the bonds mature, the 
sinking fund investments are converted into cash and 
the cash used to retire the indebtedness. The inden- 
ture frequently provides that the sinking fund shall 
be invested in the very bonds which are to be re- 



deemed; the agreement may also stipulate the price 
to be paid in repurchasing the bonds. In some cases 
the bonds which are to be retired from the fund are 
drawn by lot, and cease to bear interest after the date 
of drawing. It will be seen, therefore, that the sink- 
ing fund reserve has simply served the purpose of 
withholding from stockholders a certain portion of 
the profits during the life of the bonds, and that after 
the retirement of the bonds it reverts to surplus, from 
which it was originally created. 

2. The sinking fund reserve a charge against 
profits. — The sinking fund reserve practically oper- 
ates as a depreciation reserve, by compelling the cor- 
poration to reinvest a certain portion of its profits 
in assets. The setting aside of the cash in the sink- 
ing fund constitutes, in its last analysis, a partial 
payment on the debt. The profits represented by the 
sinking fund reserve will ultimately find their way 
into fixed property investment, and thus serve to keep 
intact the original investment of the company. 
Therefore if the sinking fund reserve is large enough 
to take care of the accrued depreciation on physical 
property, the company is under no compulsion to pro- 
vide in addition a reserve for depreciation. If both 
reserves have been created simultaneously, income has 
been charged twice for the same thing. 

Inasmuch as depreciation is a legitimate charge 
against the current income account, contributions to 
the sinking fund reserve are a charge against income 
if no depreciation reserve is provided. If, however, 


a depreciation reserve is also created, contributions to 
the sinking fund reserve should be charged against 
surplus, and not against current earnings. It will 
be seen, too, that where both kinds of reserves are 
created, the depreciation reserve will provide for the 
loss in physical assets, which are due to wear and tear, 
while the sinking fund reserve results in an accumu- 
lation of profits represented by assets. The assets 
will enable the corporation to finance the necessary 
replacements of its physical property out of its 

It is important to note, in passing, that while both 
reserves may be created simultaneously, they have 
nothing in common, and are accumulated on different 

3. Funds distinguished from reserves. — A fund is 
an asset, and as its name implies, consists of an 
amount of cash or other assets, set aside from the 
general funds of the company, for a specific purpose. 
In contradistinction to a fund, a reserve is a credit 
account created by setting aside a certain portion of 
the profits or surj^lus for some specific or general pur- 

Not infrequently the reserve serves to measure the 
amount of its corresponding fund. Thus a sinking 
fund reserve might be set aside out of profits or sur- 
plus by virtue of the provisions of a mortgage inden- 
ture, and at the same time, cash or other assets equiv- 
alent to the amount of the reserve, might be set aside 
in the sinking" fund. 


An insurance reserve might be created out of rev- 
enue for the purpose of enabling a company to carry 
its own insurance. In this case the reserve would 
be created by charges to operating expenses. At the 
same time an insurance fund would be created so 
that in event of loss by fire the company would have 
the necessary cash, or its equivalent, to reimburse 
itself. If this reserve was not specifically invested 
in assets such as cash or securities, it might perhaps 
be invested in the very properties that would be de- 
stroj^ed by the fire. A fund, therefore, is always a 
debit, while the reserve is always a credit. 

4. Sinhing funds proper. — A sinking fund is an 
amount of cash set aside for the purpose of meeting 
some debt at its maturity. In the creation of a sink- 
ing fund according to scientific methods, we have a 
problem consisting of one unknown and two known 
factors. The known factors are the amount to be 
accumulated and the number of periods or instal- 
ments. The amount of the periodical instalment is 
the unknown factor and this is determined by the rate 
of interest which it is assumed will be earned on the 
fund. This is usually ascertained from compound 
interest tables. 

When the number of periods and the rate of in- 
terest are imusual, the amount of the sinking fund 
contribution can be determined by the use of loga- 

5. The investment of the sinking fund. — The 
periodical instalment set aside under the provisions 


of the sinking fund agreement is usually paid over 
to a trustee who is charged with the duty of safely 
investing it. The trustee rej)orts at regular inter- 
vals to the debtor corporation. The fund may be 
invested in gilt-edged securities or it may be invested 
in the very bonds to be redeemed, if the latter can be 
purchased under favorable conditions. 

6. Treatment of interest earned on the sinking 
fund. — The interest earned on the sinking fund in- 
vestment is a debit to the sinking fund cash account. 
The cash will be retained by the trustee and used in 
the purchase of additional bonds or for investment 
in other securities. The question as to the disposition 
of the credit of the interest earned has created some 
discussion. The credit may be placed in an account 
called "interest earned on the sinking fund" and will 
ultimately find its way into surplus. If a sinking 
fund reserve has been created, it would be better to 
credit the amount of the interest earned directly to 
the reserve account. 

Some authorities hold that the interest earned may 
be properly credited to the interest paid on the out- 
standing bonds. The author does not approve of this 
theory because the interest earned on the sinking fund 
has nothing to do with the interest on the debt. 

7. Sinking fund and reserve fund investments. — 
The method of treating sums set aside for sinking 
fund purposes in the balance sheet has already been 
discussed. It remains for us to consider here, the 
question of the valuation of securities in sinking funds 


and reserve funds. Funds of this character are 
usually created in connection with a reserve out of cur- 
rent income or surplus. Thus, a sinking fund reserve 
might be set up out of income or out of surplus and 
an equivalent amount of cash set aside in the sinking 
fund, which would ordinarily be invested in gilt edge 
securities. An undertaking might set aside out of 
its surplus, a reserve which would control and meas- 
ure the amount of cash which was set aside as a 
pension fund. In the same manner, an organization 
that decided to carry its own insurance may create an 
insurance reserve, by charges against income, and at 
the same time, set aside in an insurance fund, the 
amount of cash which would otherwise have been paid 
for insurance premiums. In other instances, how- 
ever, the funds are created without setting aside a 
portion of the surplus to measure the amount thereof. 
It is obvious, of course, that if the portion of the 
surplus account which has been temporarily locked 
up in special funds is not "ear marked," the balance 
standing in the surplus account is not free surplus. 
Ordinarily investments in special funds of this char- 
acter will be carried at cost. An increase in the value 
of the investments is not available until the same are 
sold, and it is not considered desirable to reflect in the 
balance sheet fluctuations in the value of investments 
carried in permanent funds of this character. It 
might be well, however, to state in the balance sheet, 
in a parenthetical reference, the market values of in- 
vestment carried in special funds. If the invest- 


merits are sold and the increase in value realized, the 
profit will be available either for the general purposes 
of the organization or will be added to the funds, de- 
pending either upon the contractual obligation in- 
curred in the creation of the fund, or in accordance 
with the wishes of the owners. 

If the value of investments carried in special funds 
has decreased, the decrease should be reflected in the 
reserve account or in the surplus account, if it seems 
to be a permanent decrease, or if there is likelihood 
of loss being sustained on the ultimate realization of 
the investment. On the other hand, temporary fluc- 
tuations may be ignored. 

8. Insurance funds should he adequate to meet 
losses. — In connection with insurance funds, it is 
necessary to see that the amount is adequate to meet 
the losses that might be sustained. When a cor- 
poration has a number of scattered plants, the insur- 
ance protection need not be so complete as it would 
have to be if the entire fixed property were located at 
one point. Many corporations are carrying their 
own insurance and if the fire hazard is negligible, this 
may be a profitable proceeding. Nevertheless, the 
creation of a reserve for insurance without the cre- 
ation of an accompanying fund, which will be in- 
vested in cash deposits or securities, would be danger- 
ous, because the reserve might be invested in the very 
assets which would be destroyed bv a fire. 



Explain the nature of a sinking fund and how it is operated. 

Distinguish between reserves and funds. 

What different methods of treating repurchased bonds may 
be followed in the accounts ? 

Describe the best methods of dealing with reserve fund invest- 
ments in the accounts. 



1. Relation of net income to capital stock. — It is a 
frequent custom in interpreting financial statements 
to consider that the ratio existing between net income 
and caj^ital stock is a sure index of the progress of 
the business. While this ratio discloses the ability, 
or lack of it, on the part of a corporation to pay a 
dividend, many overlook the fact that capital stock 
does not represent the total invested assets of a busi- 
ness. In many cases, the earnings which a corpora- 
tion discloses in its income statements, are due in no 
Mmall measure to large surpluses and reserves. 

Commenting upon the balance sheets of four of the 
^arge Chicago packing companies (Armour, Cudahy, 
Morris and Swift) a writer recently made the state- 
^lent that for the year 1915 the companies had earned 
over 25 per cent on the total capital of $110,000,000. 
This statement is true, but let us analyze the situ- 
ation a little further for the purpose of determining 
whether or not it really means anything. 

The following table shows the capital stock, sur- 
plus, reserves, bonded debt and current liabilities of 
each organization as reported for the year 1915: 



Armour ^ Co. Pckg. Co. Morris ^ Co. Swift ^- Co. 

Capital Stock .$ 20,000,000 $12,000,000 $ 3,000,000 $ 75,000,000 

Surplus 98,733,117 6,050,270 29,510,270 45,850,000 

Reserves 4,597,356 5,900,884 

Total owned capital. . .$118,733,117 $18,050,270 $37,107,626 $126,750,884 

Bonds $ 30,000,000 $ 3,519,000 $11,300,000 $ 24,500,000 

Current Liabilities 52,583,248 17,237,518 10,438,963 56,115,556 

Total borrowed capital.$ 82,583,248 $20,756,518 $21,738,963 $ 80,615,556 

Total combined capital.$201,316,365 $38,806,788 $58,846,589 $207,366,440 

2. Comments upon the above statement. — It will 
be noted that the financial plans of each of these 
organizations differ widely. A comparison of the 
capital stock account shows that Armour and Morris 
have raised more capital thru the issue of bonds 
than thru sale of stock; Cudahy and Swift on the 
other hand have raised more capital thru an issue 
of stock than thru the issue of bonded debt. For 
the purpose of stating the comparison on a more uni- 
form basis, let us consider the following statement, 
which shows how the capital owned and borrowed is 
distributed by percentage. 


Armour ^ Co. Pckg.Co. Morris ^ Co. Swift ^ Co. 

Capital Stock 9.937o 30.92% 5.10% 36.17% 

Surplus 49.05 15.59 50.14 22.11 

Reserves 7.82 2.85 

Total 58.98 46.51 63.06 61.13 

Bonded debt .... 14.90 9.07 19.20 11.81 

Current liabilities .. 26.12 44.42 17.74 27.06 

Total 41.02 53.49 36.94 38.87 

Combined Total ...100.00 100.00 100.00 100.00 


3. Ratio of net income to capital stock. — If we 
calculate the ratio of net income to capital stock in 
each of the individual companies, we learn that 
Armour's earnings for the year 1915 were equivalent 
to 55 per cent on the capital stock, while the earnings 
of Cudahy, Morris and Swift were respectively 6 
per cent, 77 per cent and 18.8 per cent. When the 
financial writer made his calculations, he added the 
earnings of all the companies together and divided 
by the aggregate of the capital issues to arrive at his 
percentage of 25.65 per cent. Yet, when we con- 
sider the earnings of the individual companies with 
reference to capital stock, we see that the results differ 
widely and bear no relation to the average determined 
by the financial writer. 

4. Ratio of net income to total invested assets. — 
It will be obvious that the total capital fund which 
each of these organizations employed in business, con- 
sists of its total assets. This is the capital fund which 
was turned over or employed in the business organ- 
ization, and with which these organizations earned 
their apparently enormous profits. If we calculate 
the ratio of net income to total assets, we learn that 
in the case of Armour & Company, the ratio is 5.46 per 
cent; Cudahy Packing Company, 1.86 per cent; Mor- 
ris h Co., 3.94 per cent.; Swift & Company, 6.83 
per cent. The average for all companies combined 
is 5.57 per cent. For the purpose of comparison, at- 
tention is called to the following table, showing the 
ratio of net income to capital stock and the ratio 


of net income to total assets for all the compan- 

A rmour S( Co. Pcky. Co. Morris ^ Co. Swift ^ Co. 
Ratio of net income 

to capital stock., j.5.0 6.03 77.3 18.8 

Average for all companies 25.65% 
Ratio of net income 

to total assets 5.W 1.86 3.94 6.83 

Average for all companies 5.57^c 

5. Eatios based on invested assets are the proper 
ratios to employ. — From a study of the foregoing 
figures it will be seen that comparisons on percentage 
bases are apt to be misleading if the proper basis is 
not used. It is clearly evidenced in the case of the 
packing companies that more significant comparison 
is the ratio of net income to total assets. When it is 
considered that the profits of Armour and Company 
are based on the sales turn-over of $425,000,000; that 
Swift and Company's business approximated $500,- 
000,000 Avhile that of the Cudahy Company approx- 
imated $116,000,000, the conclusion necessarily fol- 
lows that the percentage of profit on sales is very 
small, and that an enormous turn-over is necessary 
to earn the profit made. EfVen in making compari- 
son on this basis, which is the best one to use for com- 
parisons of different companies, there are a number 
of factors which are not uniform in all cases. Com- 
parisons would best be made for a series of years 
with respect to the individual companies and the pro- 
gression or retrogression reflected in them noted. 


6. Eelation of working capital to total assets. — It 
is impossible to lay down any general rules which will 
aid in determining the proper relation of working cap- 
ital to total assets. Perhaps the best rule is that the 
working capital should vary in accordance with the 
sales. This naturally leads to the question, "What 
is working capital?" Working capital is commonly 
understood to mean that portion of the liquid assets, 
free and unpledged, which a firm has available for 
employment in the business. In other words it is the 
excess of liquid assets over liquid liabilities; that por- 
tion of the liquid assets not furnished bj' creditors or 
by temporary bank loans. 

Current assets are usually acquired either thru the 
parting with other assets or by the creation of addi- 
tional floating liabilities. To ignore the floating 
liabilities is undesirable, because a large floating debt 
is usually an evidence of weakness, and always may 
be a source of danger. Therefore, working cajaital 
should be understood to mean the excess of quick 
assets over quick liabilities. 

7. Amount of working cajntal needed depends 
upon nature of business. — Just as conditions in each 
kind of business differ, so the needs of individual con- 
cerns in any line of business differ also. There is no 
doubt but that a concern handicapped by a shortage 
of working capital will not operate as efficiently as 
one with sufficient working capital at its disposal. 
Without proper working capital shortage of ma- 
terial, long credit with consequent loss of discounts. 


and many other troubles will be encountered. The 
shortage in working capital may result from poor 
managerial or financial policy, or from the distribu- 
tion of too great a portion of the profit in the form of 
dividends. Even tho a large profit has been earned 
in any given year it should not be distributed in the 
form of cash dividends at the expense of future busi- 
ness needs. 

For example, a comparatively young undertaking 
which is expanding rapidly, and which is requiring 
considerable working capital for the continuance and 
expansion of its business, must have a far larger 
amount of working capital than one which is pro- 
gressing at a uniform rate. New business must be 
financed before the old business has been collected 
upon. A continual increase in volume of business 
throws a larger burden on the concern, and necessi- 
tates corresponding increases in the amount of work- 
ing capital. 

8. No rule foj' amount of quick assets required hy 
corporatio7is. — In conclusion, it may be said that 
there is no rule that can be laid down as to the amount 
of quick assets which a corporation should endeavor 
to acquire. In a line of business in which long cred- 
its are given to customers, it is evident that a greater 
amount of working capital will be needed than in 
those lines in which shorter credits are given. More- 
over, if the terms of credit received by an undertak- 
ing are comparatively short, and the terms of 
credit allowed to its customers are comparatively 


long, a greater amount of working capital must be 

9. The economic status of contributors of capital 
to a business enterprise. — Contributors of capital 
which is employed in a business enterprise may be 
divided into four classes: 

Lonff-term creditors, such as bondholders and hold- 
ers of notes having more than one year to run. 

Short-term creditors whose debts are due in less 
than one year. 

Lessors, leasing property to a firm for a term of 
years, at stated annual rentals. 

The investors, the sole owner, the partners or the 
stockholders of a corporation, who have the control 
and management of the organization. 

Creditors of the first class have usually a lien on the 
fixed property of the organization, and receive as com- 
pensation a stated sum which is known as interest. 
This class comprises those who have had sufficient con- 
fidence in the managers of the enterprise to entrust 
their capital to them, exacting a stated and definite 
rate of compensation for its use. 

The second class consists of those who, as a rule, 
have no security for their claims, but who are still 
willing to advance their capital for a limited period 
to the managers. They may receive compensation 
in the way of interest or their compensation may take 
the form of profits realized on merchandise sold to 
the managers. 

The third class consists of those who have had suf- 


ficient confidence in the management and in the enter- 
prise to give them title to the use of their property for 
a specified number of years under a lease, and who 
have exacted compensation or their share of the profits 
of the enterprise in the form of a stated annual 

The last class embraces those who have risked their 
capital in the business enterprise for the purpose of 
reserving to themselves all of the profits that result 
after their fellow-contributors in the business enter- 
prise have been paid their stated sums. 

10. Is interest on capital part of cost of produc- 
tion? — The realization of the foregoing facts in their 
full significance will do more than anything else to 
clear up the subject of charging interest on capital 
as a part of the cost of production. The reader will 
have noted in the Text on "Cost Finding" that many 
engineers and accountants favor the method of charg- 
ing interest on capital as a part of the cost of produc- 
tion. The author holds that excepting for statistical 
purposes this practice is entirely incorrect in prin- 
ciple, for the following reasons : 

From an economic standpoint the entire profit of 
a business after the first three classes of contributors 
to an enterprise mentioned on page 232 have been 
paid, is profit from business operations. The capital 
employed by the managers in the venture cannot earn 
two kinds of income, viz., interest and profit. 

The charge for interest on invested capital as a part 
of the cost of production necessitates a bookkeeping 

XXII— 17 


entry of a debit to interest expense account, and a 
credit to an interest earning account. These entries 
cancel each other in the ]3rofit and loss summary, so 
the net result as far as the ultimate profit is con- 
cerned is the same whether the entry has been made 
or not. There is this important difference, however; 
a fictitious entry has been made in the account for 
interest expenses that will never be paid in cash, and 
for an interest income that will never be realized in 
cash. Moreover, interest on capital investment, 
being charged as a part of the cost of production, will 
load the cost of production with an element of ex- 
pense for which no liability has been incurred and 
for which a direct outlay in cash will never be required. 

11. Difficulty of selecting correct rate. — Even if it 
were assumed that the principle under discussion is 
correct, there is still another difficulty to be confronted 
in selecting a rate of interest. It is just as reasonable 
to select four per cent as it is eight per cent, but one 
can readily see that the computed cost would be dif- 
ferent in different organizations if the same rate of 
interest were not selected in both. 

If interest is to be charged for the use of capital 
the time element must be considered and the charge 
must be made only for the exact time that the money 
has been employed in production. The calculations 
involved in this would be an almost impossible prop- 
osition from a bookkeeping standpoint. 

The manner in which capital is provided cannot 
possibly affect the cost of production, for the methods 


of financing a business have no connection, direct or 
indirect, with the cost of making the product. 

12. Inflation of inventory values. — One particu- 
larly objectionable feature in charging interest as 
a part of the cost of production is that such a charge 
results in inflating inventory values. If these values 
are allowed to remain on the balance sheet, part of the 
profits will be anticipated to the extent that the in- 
ventory value includes this specific charge for interest. 
Therefore a concern that follows this practice com- 
mences to take its profit, weeks or months, perhaps, 
before the goods are offered for sale. This practice 
would have a tendency to imperil the credit of any 
concern that engages in it, because a banker who is 
approached for the purpose of loaning money to the 
concern will resent any attempt on the part of a bor- 
rower to anticipate his profits, and to inflate the bor- 
rowing value of his assets. 

It is often suggested that the element of interest, 
included in the inventory, be deducted on the balance 
sheet by the creation of a suitable reserve to take care 
of the overvaluation. This position in itself, it ^tould 
seem, ought to make clear the fallacy of the entire 
theory. Books of account exist for the purpose of 
recording what has actually taken place, and not what 
might have taken place under a set of hypothetical 

13. Cost and income confused. — Another objec- 
tion to the proposal is that the charge for interest to 
cost of production, and a corresponding credit to an 


earning account, has the effect of counting the same 
thing both as cost and as income. A consideration of 
the principles of economics will serve to clear up the 
erroneous reasoning indulged in by those who favor 
this method. There are four sources of wealth, viz., 
land, labor, capital variously employed, and business 
organization. The income derived from the four 
sources is known as rent, wages, interest and profit. 
The same capital cannot be employed to earn two 
kinds of income, that is, cajjital invested by the man- 
agers of a business enterprise cannot simultaneously 
earn both interest and profit. Clear reasoning be- 
comes possible as soon as we come back to the funda- 
mental principles of economics. 

The charge for interest on invested capital as a 
part of the cost of production should not be confused 
with the charge for interest on capital which would be 
made in a partnership relation. In the latter in- 
stance it is made for the purpose of adjusting the 
inequities of capital contributed by the various part- 
ners and not included as a part of the cost. 


Why is the ratio of net income to capital stock an inadequate 
test of the profitableness of an enterprise? . What better test 
could you propose? 

Who are the persons who contribute the capital to an enter- 
prise, and what are their respective interests? 

State the arguments against the point of view tliat the interest 
upon invested capital should be deemed a part of the cost of 



1. Reasons for consolidations. — From the Texts 
on "Organization and Control" and "Corporation 
Finance" the reader has noticed the important reasons 
for mergers, consolidations and amalgamations. The 
principal advantages claimed for these types of or- 
ganization are: reduction of managerial expenses; 
elimination or reduction of ruinous competition; ad- 
vantageous terms of financing. 

According to the advantages gained the type ©f 
organization will be of one form or another. 

The holding company, as already explained, was 
organized for the purpose of acquiring the stocks or 
other securities of affiliated companies, thus effecting 
a combination which would bear the test of legal 
scrutiny. The earlier pools and so called trusts did 
not accomplish this result to the satisfaction of big 
industrial enterprises. 

Under the newer form of consolidation each com- 
pany not only retained its corporate entity, but also 
in the eyes of the law, remained a separate corpora- 
tion. Nevertheless, the virtual consolidation of 
ownership was beyond question. Such being the 
case, the results of this ownership can only be prop- 



erly expressed in a statement of their accounts by 
consolidating the balance sheets of the "unit" com- 
panies into one balance sheet. If that is not done the 
balance sheet of the holding company would not 
furnish the owners of the corporation with the in- 
formation about its financial position to which they 
are justly entitled. 

A consolidated balance sheet, therefore, is intended 
to reveal the financial position of the whole group of 
affiliated companies, considered as one enterprise. 

2. Possible legal basis for consolidated statements. 
— In discussing the consolidated income account, at- 
tention was called to the fact that there was no legal 
basis for the preparation of such a statement, unless 
it is the theory of a true valuation of assets. It is 
evident that changes in the conditions of the assets 
and liabilities of a holding company are due in part, 
at least, to the results of operations of the subsidiaries. 
The increase in the surplus accounts of subsidiaries, 
unreduced by dividends, enhances the value of the 
stock which the holding company owns. 

While it is not a desirable practice to write up all 
assets simply because they have appreciated in value, 
yet it is a common practice to reflect in financial state- 
ments all changes that have resulted directly from 
trading oj)erations. On the theory, therefore, that 
the financial statements of a holding company should 
reflect such increases in value of its investments, we 
may eventually require by law, consolidated state- 
ments which will show the exact condition of affairs 


for the group as a whole. Appreciations in value 
other than those resulting from trading or manufac- 
turing operations would, of com-se, be omitted. 

3. Investments carrying less than control. — As a 
stockholder, the investing corporation has an undi- 
vided interest in the assets of the sub-companies to 
the extent of its holdings of stock, and it is desirable 
to show the value of this investment at its actual 
worth instead of at its cost to the purchasing com- 
pany. We have our choice of recording such invest- 
ments, by either of the following methods, 

4. Carrying at cost. — The first method is that of 
carrying the investment at its original cost to the pur- 
chaser. This plan has much to commend it from the 
conservative standpoint. This is especially true, if 
care is taken to write down the asset when its value 
has depreciated. The main objection to such a pro- 
cedure, however, is that cost and value do not remain 
constant for any length of time. 

5. Periodic revaluation. — This brings us to the 
question of whether or not a periodic revaluation of 
the investment is possible. While this might be the 
most satisfactory solution under theoretical condi- 
tions, it will not be found to work out satisfactorily 
in practice, because accuracy in the revaluation is im- 
possible. There is no true basis on which a revalua- 
tion can be made other than the actual physical in- 
ventory or market price of the stock. Tlie market 
price is dependent upon many outside factors, while 
the actual revaluation is sometimes physically impos- 


sible. At best, actual revaluation would simply be 
the opinion of men who might or might not be qual- 
ified to make the revaluation. 

6. The equity in surplus. — It is sometimes cus- 
tomary to carry the increase in surplus directly into 
the investing company's surplus account, rather than 
to set it up under a separate heading. In such a 
case, dividends declared from the combined surplus 
should be based upon the amount of current receiv- 
ables included in the current assets of the sub-com- 
pany. The practice is not to be recommended, how- 
ever, unless the investing company is certain that it 
will soon realize on a portion of its share of the other 
company's surplus. While the investing company 
has set up in its balance sheet a current asset represent- 
ing its interest in the other company, there is ordinar- 
ily no positive means of telling whether this current 
asset will be realized upon. 

A dangerous situation may result from this prac- 
tice, if dividends have been paid by the investing com- 
pany out of its equity in the net assets or surplus of 
the other corporation. If some catastrophe over- 
takes the sub-company and wipes out this surplus, 
the directors of the investing company would prob- 
ably be found guilty of paying dividends out of cap- 
ital. Therefore, great discretion must be exercised 
by directors in handling these accounts after they 
have been set up on the books. 

7. Treatment of dividends. — Dividends received 
on such an investment should be credited to the in- 


vestment instead of being treated as current earnings. 
This statement hardly requires an explanation because 
it is evident that we have already taken credit for the 
earnings when the asset was appreciated and the sur- 
plus account set up. 

If a separate surplus account is carried, then the 
amount of the dividends received must be also trans- 
ferred from this special surplus account to the free 
surplus of the receiving comj^any. 

8. Objection to carrying the investment at cost. — 
It is also evident that the practice of carrying the in- 
vestment previously described, at cost in the books 
of the holding company has another disadvantage. 
The balance sheet of the holding company will, of 
course, disclose how much of its capital has been in- 
vested in this sub-company. But the earning account 
of the holding company may not disclose the entire 
earnings of that capital. Thus, if the sub-company 
did not distribute any of its accumulated surplus in 
the form of dividends, failure to record the effect of 
this appreciation in the value of the sub-company's 
stock, due to the increased surplus, would also result 
in an understatement of the true earnings of the hold- 
ing company. 

9. Revaluation of investments is subject to com- 
jdications. — When a holding company has paid for 
stock of subsidiaries considerably more than the book 
value, complications often arise. Moreover, the 
stock or the bonds of 'the holding company may have 
been issued in payment for the securities of the sub- 


sidiary company which is acquired. The question 
then raised would be whether or not the directors in 
reappraising the value of the securities originally 
acquired, perhaps at a liberal price, should add 
to the cost thereof by means of an equity account, 
the pro-rata share of the undistributed earnings of the 
subsidiary, subsequent to the date of the acquirement 
of the securities by the holding company. While the 
valuation placed upon the stock of the sub-company 
acquired originally by the directors would probably 
never be questioned, the directors might have diffi- 
culty in proving that they were justified in creating a 
surplus, and in distributing a dividend out of it, when 
such surplus was created thru their own reappraisal 
of the securities. 

10. Oppressive tactics to discourage minority in- 
terests. — It very often haj^pens that the sub-company 
has received large cash advances from the holding 
company. The subsidiary company, having increased 
its earnings and its surplus, would probably be in a 
position to distribute a reasonable dividend. Assum- 
ing that the holding company is desirous of practising 
oppressive tactics to the disadvantage of minority 
stockholders and suddenly withdraws its advances 
from the sub-company it thereby reduces the sub-com- 
pany's cash and working capital and effectually pre- 
vents it from declaring a dividend, even tho it has 
earned profits. The holding company, in recovering 
its cash, has practically enjoyed the receipt of a divi- 


dend. This form of oppression has often been em- 

As ah'eady pointed out the failure to incorporate 
in the accounts of the holding companj^ the presence 
of this surplus results in the creation of a secret re- 
serve. This is an additional disadvantage to that re- 
sulting from the fact that equalization of the income 
of the holding company from one period to another is 
not provided for by this method. 

It is obvious that an equitable method of prepar- 
ing consolidated statements should be employed. 
The main thing to bear in mind here is the elimination 
of all inter-company transactions by the offsetting of 
the debit items of one company by the corresponding 
credit items of an affiliated company. This applies, 
of course, only to such items as represent actual 
transactions or relations between the associated com- 

11. Illustratio7i. — On pages 247 and 248 will be 
found an example of the method of preparing a com- 
paratively simple consolidated balance sheet. Con- 
sidering the items on this statement in detail, it will be 
noted that the "A" company held $81,000 in bonds is- 
sued by the "B" Company, and that "C" Company 
held $119,000 of the same bonds. As the liabihty of 
the "B" Company is offset by an asset of the same 
item on the books of "A" and "C" Companies, the 
consolidated balance sheet need not show either the as- 
set or the liability. Consequently, we eliminate 


$200,000 from our total assets and $200,000 from our 
total liabilities. In this same way, the advances to 
and from affiliated companies, dividends receivable or 
payable among the affiliated companies, and accrued 
interest on the bonds, together with demand notes, are 
set against the corresponding accounts of affiliated 
companies. A statement results which shows only the 
relation of the combined group to its stockholders and 
to the public. 

If the "B" Company, for example, were in poor 
financial condition, or had suffered heavy losses from 
operation during the year, this condition would be re- 
flected in the combined balance sheet in so far as it 
affected the standing of the group and that, after all, 
is the information which an investor or stockholder 
wishes to have. 


Balance Sheet as at 191. . 

Fixed Assets 

Land and Buildings $294,000.00 

Machinery and Equipment 178,fiOO.OO 

Investment in Bonds of Company "B" 81,000.00 

Outside Stock Investments 200,000.00 $ 75.3,600.W 

Working and Trad'mq Assets 

Materials and Supplies $ 40,140.00 

Goods in Process 48,274.00 

Finished Goods 60,800.00 155,214..©© 

Current Assets 

Cash $ 73,510.00 

Accounts Receivable 47,100.00 

Demand Xotes Company "B" 45,000.00 

Accrued Interest Receivable 1,032.75 lGfi,642.75 

Total Assets $1,075,456.75 


Capital Liabilities 

Common Capital Stock Issued and Outstand- 
ing (Authorized $1,000,000) $000,000.00 

Preferred Capital Stock Issued and Outstand 

ing (Authorized $1,000,000) 100,000.00 $ 700,000.0© 

Current Liabilities 

Loans Payable $ 3fi,000.00 

Advances by Company "C" 60,000.00 

Vouchers and Accounts Payable 58,1 30.00 

Dividends Payable 100,000.00 254,120.0© 


For Depreciation $ 34,900.00 

For Doubtful Accounts Receivable 5,000.00 

For Contingencies 36,000.00 75,900.00 

Profit and Loss Surplus 45,436.75 

Total Capital, Liabilities, Reserves and 

Surplus $1,075,456.75 


Balance Sheet as at 191 . . 

Fixed Assets 

Land and Buildings $495,000.00 

Machinery and Equipment 594,800.00 

Outside Stock Investments 150,000.00 $1,239,BOO.0« 

Workin(j and Trading Assets 

Materials and Supplies $ 56,250.00 

Goods in Process 50,600.00 

Finished Goods 75,460.00 182,310.00 

Current Assets 

Cash $122,564.76 

Accounts Receivable 92,460.00 215,024.76 

Total Assets $1,637,134.76 

Capital Liabilities 

Common Capital Stock Issued and Outstand- 
ing (Authorized $1,000,000) $1,000,000.00 

First Mortgage Bonds 6%, 1925— J. & J .300,000.00 



Current Liabilities 

Demand Notes Payable $ 45,000.00 

Loans Payable 50,000.00 

Advanced by Company "C" 00,000.00 

Vouchers and Accounts Payable 28,865.00 

Dividends Payable 25,000.00 

Accrued Interest on Bond 3,825.00 212,690.00 


For Depreciation $ 60,500.00 

For Doubtful Accounts 4,500.00 65,000.00 

Profit and Loss Surplus 59,444.76 

Total Capital, Liabilities, Reserves and 

Surplus '. $1,637,134.76 

Balance Sheet as at 191 . . 

Fixed' Assets 

Stock Investments $2,217,600.00 

10,000 Shares Common Stock "B" Co. 
6,000 Shares Common Stock "A" Co. 
1,000 Shares Preferred Stock "A" Co. 
Bonds of "B" Company 6%, 1925 J. & J.... 119,000.00 $2,336,600.00 

Current Assets 

Cash $ 941,882.75 

Advances to Subsidiaries 120,000.00 

Dividends Receivable 125,000.00 

Accrued Interest Receivable 1,517.25 1,188,400.00 

Total Assets $3,525,000.00 

Capital Liabilities 

Common Capital Stock Issued and Outstand- 
ing (Authorized $.1,000,000) $2,000,000.00 

Preferred Capital Stock Issued and Out- 
standing (Authorized $2,000,000) 1,400,000.00 $3,400,000.00 

Profit and Loss Surplus 125,000.00 

Total Capital and Surplus $3,525,000.00 



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What different methods may the holding company pursue in 
valuing stock held in subsidiaries? 

Under what conditions should dividends on the stock of sub- 
sidiaries not be credited to income of parent company? 

How can a holding company pursue oppressive tactics to dis- 
courage minority interests? 

XXW— 18 



1. Premium on Investments. — The amount paid 
for stock purchased, presumably represents the intrin- 
sic value of that stock to the purchaser; unless the 
stock was taken over at its f)ar value at the time 
that the concern was organized, it is unlikely that it 
would be subsequently acquired at that valuation. 
As already illustrated, the par value of the stock can 
be eliminated from both sides of the consolidated bal- 
ance sheet by taking the par value as shown by the 
books of the issuing company and eliminating that 
amount from the assets held by the purchasing com- 
pany, and from the combined capital stock outstand- 

The excess above par, paid by the purchasing com- 
pany is nothing more than the amount paid by it for 
the good-will and accumulated surplus of the issuing 
company. It is customary to carry this item under a 
separate heading termed "Good-will" or, better, 
"Premium on Investments in Affiliated Companies." 
The asset then stands on the books at its net cost and 
under a heading which clearly denotes its peculiar na- 
ture. In the example on pages 247 and 248, the 
reader will have noted that while the "C" Company 



carried stocks on its books at a valuation of $2,217,- 
600.00, this item was offset by a credit on the books 
of the subsidiary companies amounting to only $1,- 
700,000.00. The difference of $517,600.00 can be 
treated upon the consolidated balance sheet as good- 
will. Premiums paid for bonds {in affiliated com- 
panies only) would be handled in the same manner. 
The same method is applied to stocks and bonds of a 
subsidiary company, acquired by another subsidiary. 

2. Other 7netliods of carrying premium on invest- 
ments. — The management might not desire to carry 
this intangible asset in the consolidated balance sheet. 
In this event it would be entirely legitimate to .offset 
this item of premium on investments against the com- 
bined surplus. For instance, as has already been in- 
dicated, the net worth of a corporation is its capital 
and surplus. If the entire stock of that corporation 
is purchased at its book valuation, the premium paid 
for the stock purchased equals in effect, exactly the 
amount of its surplus at the time of the purchase. In 
the consolidated balance sheet, the items of premium 
and purchased surplus exactly offset each other. 
However, this ideal situation does not often occur. 
Purchases of securities, especially if they are paid for 
in the stock of the purchasing corporation, are nearly 
always bought on a very liberal basis. Something is 
paid for the intangible asset, good-will of the selling 
company, in addition to the book value of the net 

If, under these circumstances, we attempted to 


offset the premium against the comhined surplus, 
we would wipe out the entire surplus of the sub- 
sidiary company and still not dispose of the amount 
paid for the good-will. This method is, however, sel- 
dom resorted to. 

The item, good-will, included in the consolidated 
balance sheet will, therefore, represent not only the 
good-will shown on the books of the subsidiary com- 
pany, but in addition, the amount paid by the holding 
company, either in cash or in securities, for the good- 
will of the selling company, represented by the differ- 
ence between the cash or par value of the securities 
paid and the book value of the securities received in 

3. Discounts on investments. — A similar situation 
but with opposite results, exists when the stock 
of an affiliated company is purchased at a discount. 
A special surplus results equal to the amount of this 
discount. It is seldom either proper or desirable, 
however, to carry this item in the surplus account as 
free surplus. It is considered better to offset the 
amount of such a surplus against the good-will asset 
appearing in the consolidated balance sheet. 

If there were several corporations involved in the 
consolidation, and some stock is purchased at a pre- 
mium and some at a discount, it is better to set the dis- 
count against the premium, carrying only the net 
premium paid into the consolidated balance sheet. 
If the stock of one of the subsidiaries has been pur- 
chased at a discount, it is evident that this particular 


company was not in so prosperous a condition as the 
others. When the consohdation took place, the dif- 
ferent companies became, in effect, one organization 
and the value of one is affected by the value of the 
other. Therefore, the good-will of the combined or- 
ganization is diminished by the amount of the depre- 
ciated value of the less prosperous corporation. 

If, however, this stock was purchased at a discount 
as a result of outside factors and its actual value was 
par or higher, then the increment undoubtedly belongs 
in the surplus account. As a rule, this surplus result- 
ing from stock purchased at a discount would have to 
be applied against the deficit in the account of the sub- 
sidiary, if a deficit exists, which is quite probable, or 
the purchase of the stock could not have been made at 
a discount. If a deficit does not exist, then it is im- 
portant to be sure that some of the assets have not 
been over-valued thru failure to make adequate pro- 
vision for depreciation. 

4. Treatment of deficits existing in sub-companies. 
— In cases where a holding company purchases stock 
of a company whose balance sheet shows a deficit from 
operation, the value of the capital stock of the sub- 
sidiary company would probably be reduced to make 
up for the deficit. While the deficit is, in effect, ab- 
sorbed at the time of the purchase, any subsequent 
dividends by that corporation cannot legally be dis- 
tributed as dividends until the deficit has been made 
up. Therefore, while in the consolidated ])alance 
sheet the entire group must make uj) for the deficit 


of one company, the law will not permit the subsidiary 
company to pay dividends until it has made up its 
own deficit. 

5. Protection of minority interests. — Where a 
minority stock interest exists, the minority stockhold- 
ers have a right to their share of the profits made 
on inter-company transactions. Consequently, it is 
legitimate and necessary for the consolidated state- 
ments to show as an asset the proportion of inter-com- 
pany profits on construction, prepaid expenses, in- 
ventories and the like, which will accrue to the minor- 
ity stockliolders of the subsidiary company. The 
proportion of the surplus of the subsidiary company 
belonging to the minority stockholders may be set up 
in the balance sheet under a special heading, "Equity 
of Minority Stockholders of Company." 

6. Capitalized surplus. — In dealing with the ques- 
tion of surplus, it was pointed out that if dividends 
can be paid out of the surplus of a subsidiarj'^ com- 
panj^ without reducing the surplus below the amount 
that existed at tlie time of consolidation, such divi- 
dends constitute income to the holding company. 
Also, when the dividend reduces the amount of the 
capitalized surplus, the reduction is treated as a re- 
turn of the investment on the books of the holding 
company. The capitalized surplus then becomes a 
new figure, changed by the amount of its reduction, 
and should be considered as a new amount in all sub- 
sequent statements or calculations. 

From this, it is aparent that a holding company 


may have four kinds of surplus: free, capitalized, 
minority equity and a23propriated. 

7. Method of treating surplus accounts of acquired 
companies. — The above topics very naturally bring 
up the question of recording these transactions. No 
difficulty arises when all the stock of the subsidiary 
is owned by the holding company, and when the di- 
rectors of the holding company are also the directors 
of the subsidiary company, or at least control the 
board. They may direct that the surplus of the sub- 
sidiary company at the date of the purchase be set 
aside, and appropriately designated on its own books. 
The title of the account will then tell exactly the na- 
ture of its contents. 

When purchases of the stock of the subsidiary are, 
however, made at various times, it is seldom possible 
to set aside each portion of the capitalized surplus on 
the books of the subsidiary company, because the con- 
trol of the sub-company may not be obtained imme- 
diately. Again, the rights of the minority stockhold- 
ers enter and prohibit the splitting of the surplus ac- 
count under such conditions. But, in the consoli- 
dated statement, it will be necessary in every case to 
indicate the various additions to the capitalized sur- 
plus. Each new purchase of stock by the holding 
company carries with it a proportion of the surplus 
existing at the date the purchase price was agreed 
upon, thus increasing the item of cajoitalized surplus 
of the consolidated company. 

8. Other phases of capitalized surplus. — The same 


principle of indicating additions to the capitalized sur- 
plus holds good, even tho the 2:)urchase was not based 
directly upon the book value of the stock of the sul)- 
sidiarv company. The holding company capitalizes 
the condition of the subsidiary at the time it makes 
the purchases. Dividends out of the surplus existing 
at the time of the purchase are nothing more than a 
partial liquidation of its investment. It should be 
noted also that the date of purchase means either the 
date at which the purchase price was agreed upon, 
or the date of the financial condition forming the basis 
of the purchase price. Earnings subsequent to that 
date, even tho the entire sales contract in reference to 
stock has not been completed, may properly be treated 
as income accruing to the holding company when such 
earnings are paid to it in the form of dividends. 

No great difficulty has been confronted thus far, 
but it is not so simple to handle such transactions 
when the stock is not purchased at one time, and when 
control is secured by various purchases made at dif- 
ferent times. The basis for these purchases may be 
the stock market valuation of the stock in question. 
However, the same principles are involved, and the 
portion of the surplus accruing to each separate pur- 
chase becomes an asset of the holding company and 
must be capitalized on its books, and in the consoli- 
dated statement. Any dividends received out of 
these separate items of capitalized surplus become a 
return or liquidation of the investment. 

When the relation between the amounts of "capital- 


ized surplus" and the corresponding asset of "pre- 
mium on investments of subsidiaries" is favorable, it 
is advisable to set the capitalized surplus aside under 
a separate heading. More frequently, it must be ad- 
mitted, the premium is far in excess of the surplus at 
the time of purchase. The better showing will then 
be made if only one surplus account is carried. 

When stock in a subsidiary company is purchased, 
the surplus of that company as of the date of pur- 
chase becomes capitalized by this purchase. Any div- 
idends declared and paid by the subsidiary company 
out of this surplus may not be treated as income to 
the holding company, but rather as a reduction in the 
value of the assets, and must be treated accordingly. 
Perhaps this statement can be made clearer if we con- 
sider the theoretical situation of a holding company 
purchasing stock in a subsidiary company by giving 
its own stock in exchange. The exchange is made 
upon the basis of the par value of the stock and the 
surplus of the subsidiar}^ comj^an}^ as of the date of 
purchase. This results in the surplus of the sub- 
sidiary company being capitalized on the books of 
the holding company. 

9. Illustration of capitalized surplus. — The stock 
and surplus of the subsidiary company measure the 
net assets of that company. The holding company 
purchases the stock at book value issuing its own stock 
at par in payment. If the subsidiary company de- 
clares a dividend out of the surplus capitalized, the 
payment of this dividend decreases the amount of its 


net assets, and in turn decreases the equity of the hold- 
ing company in those net assets. Therefore, such 
dividends received by the holding company, constitute 
a decrease in the value of its investment in the sub- 
sidiary, and are not income in any sense of the word. 
They should be credited to the investment account on 
the books of the holding compan3\ 

10. Unpaid cumulative dividends of subsidiaries. — 
In preparing the balance sheet of a holding com- 
pany, there are several items which will require 
slightly different treatment from that ordinarily ac- 
corded to them. Thus, it is customary to show as a 
direct liability of a business organization, the liability 
for unpaid cumulative dividends. As dividends are 
not a liability until they have been declared by the 
board of directors, a corporation that has unpaid cu- 
mulative preferred stock dividends, need not show 
such liability directly, except as a footnote in the bal- 
ance sheet. Cumulative unpaid preferred stock divi- 
dends of subsidiaries should be similarly shown in a 
consolidated balance sheet. 

11. When control is not complete. — If the hold- 
ing company, or its subsidiary, purchases material 
from an affiliated company in which the stock control 
is not complete, the usual procedure is varied slightly. 
More extensive records are necessary to protect the 
rights of the minority stockholders in the vending cor- 
poration. Consequently, the initial transaction is car- 
ried on at cost, plus the customary profit. On the 
books of the purchasing company, the proportion of 


inter-company profit is charged back, from the asset or 
purchasing account to a separate account, in which it 
is considered as a charge against any dividend from 
such earnings that may be received from the vendor 
subsidiary. All dividends received out of inter- 
company profits must be credited to this charge. 
These charges and credits must pass thru the books of 
the holding company. All companies which are as- 
sociated must have the same accounting system, 
the same accounts and a common fiscal year. As was 
previously indicated, the inter-company profits may 
only be eliminated from the surplus and asset accounts 
in the balance sheet. 

In any event, however, the books of each company 
must be sufficiently detailed to show cost and profit on 
each sale. This information must be passed on to the 
purchaser so that he may know the amount of inter- 
company profit occurring with each inter-company 
transaction. These purchases, however, will be taken 
on the books at full cost, including the vendor's profit, 
if any is charged. All inter-company transactions 
must be recorded separately from similar transactions 
made with outsiders. 

While consolidated statements, as just described, 
give a fair and equitable picture of the condition of 
the group as a whole, they do not show the status of 
tlie individual companies. For example, the classes 
of obligations are not shown in detail. Many addi- 
tional details will often be desired by the manage- 
ment, stockholders, investors or creditors of the hold- 


ing company or its subsidiaries. In fact, the consoli- 
dated statement is open to the same objections that 
apply to any other condensed financial statement. 

12. Overcoming disadvantages of consolidated 
statements. — The disadvantages of consolidated state- 
ments may be overcome by making schedules detail- 
ing the kinds of assets and liabilities a part of the con- 
solidated statement. The same purpose would be an- 
swered by the current publication of the detailed state- 
ments of each subsidiary company. Or, when the 
number of companies involved is not too great, the 
consolidated statement itself may be made up in the 
form of the working sheet, illustrated on pages 247 
and 248. This working sheet shows the detailed ac- 
count of each subsidiary company, and the consolida- 
tion statement for all. In the published statements, 
the column headed "Eliminations," would, of course, 
be omitted. 

13. Interpretation of consolidated statements. — 
In general, the interpretation of consolidated state- 
ments is subject to the same rules as the interpreta- 
tion of any other financial statement of a single com- 
pany. There are, however, several points peculiar 
to this type of statement, which require special men- 
tion. As we have seen, the method of interpreting 
financial statements depends upon the purpose for 
which the information is to be used. There is prob- 
ably no better way of discussing the points of par- 
ticular interest in reading consolidated statements 
than to approach the topic from the three angles of 


efficienc}^ of operation and management, credit risk 
and investment standpoint. 

In a consideration of the first viewpoint, it is appar- 
ent that consolidated statements will be of most value 
if used in conjunction with detailed statements. 
Whoever analyzes the statements w^ith the idea of 
measuring the efficiency of operation and manage- 
ment will be interested in the separate results of in- 
dividual companies and departments, as well as in 
the progress of the company as a whole. 

With this end in view he will find that comparative 
consolidated balance sheets and income statements 
will show the changes in financial condition and the 
increase or decrease in total earnings. The details of 
the individual company statements will explain the 
fluctuations in the combined statement. If the hold- 
ing company group has been but recently organized, 
a comparison of the consolidated income statement 
with a consolidation of the individual income state- 
ments, prior to combination, will show at a glance 
whether or not the expected economies of consolida- 
tion have resulted. 

Also, when new corporations have been absorbed in 
the interim between statement periods, a check on the 
wisdom of such a step may be had if the condition and 
profits of that company, both before and after consoli- 
dation, are compared. The stockholder will use this 
information to control his board of directors and to 
guide him at the annual election. 

14. Value of individual statements to managing 


officials. — An executive officer, or any one else, using 
these statements as a guide to operation and manage- 
ment, would first examine the progress of the group 
as shown by the comparative consolidated statement. 
Any unusual changes would be traced back to their 
sources in the individual company. Financial condi- 
tions would be analyzed, changes investigated and the 
effect of past policies noted with a view of avoiding 
what was unsatisfactory. 

15. Credit risk viewpoint. — The banker or trade 
creditor, on the other hand, has little interest in the 
individual statements. He would use them only in 
tracing down the unfavorable conditions and estimat- 
ing the probable future effects of individual compa- 
nies on the group. He is, however, vitally interested 
in the efficiency of the management and, to this extent, 
he must estimate how much tlie future financial con- 
dition will be improved or weakened by the actions 
of the management. For this purpose, he must use 
comparative consolidated statements and compara- 
tive individual statements. His attention, then, is 
chiefly devoted to the present relation between current 
receivables and current payables, and the expected 
changes which will result from the introduction of new 
factors and from an alteration of the policies of the 
management. He looks at the statement, however, 
solely to determine group conditions. 

16. Investment standpoint. — The investor's pur- 
pose in examining the statements of a holding com- 
pany, is first to determine the security of his invest- 


ment. It must be assumed that all investments are to be 
made in the stocks and bonds of the holding company. 
If investment in a subsidiary were to be considered, 
the subsidiary's condition must be viewed in the light 
of its relations to the group. A minority investment 
under such conditions is to be a^'oided, as a stockholder 
has no certainty that the holding company will not 
manipulate the subsidiary for its own individual gain. 

An investor in a holding company will also verify 
the valuation of the fixed assets. As the valuation of 
good-will is dependent in part upon the economics of 
consolidation, he will make the same comparison as was 
described in a preceding chapter. He will closely scru- 
tinize the values of all fixed assets, both before and after 
the combination has been effected. The stability of 
earnings and estimates for the future will be disclosed 
by the comparative income statement. The individual 
and supplementary statements will only be used by 
him to elaborate and to explain the consolidated state- 
ment. Furthermore, he must decide upon the effect 
that managerial policies will haveon his investment, and 
for that purpose he will study the individual statements. 

17. Other forms of consolidated statements. — 
While the method just described is the best, it is 
not the only one employed for consolidated state- 
ments. We have already seen that if a true 
statement of facts is presented — the object of any 
and all financial statements — the form matters little. 
If all the required information can be obtained, 
the method of presenting it need be considered 


only in so far as it affects the ease with which such in- 
formation is obtainable. Sometimes individual bal- 
ance sheets, with explanatory schedules of all outside 
items represented by the accounts "investment in sub- 
sidiaries" and "advances to or from subsidiaries," will 
give all the information desired. In such a case, the 
balance sheet of the holding company will be pre- 
sented in its customary form, while separate listings 
of assets and liabilities and sources of income and ex- 
penditure, will be presented in separate schedules, 
grouped according to companies. If the amount of 
detail involved and the number of companies consid- 
ered is not excessive, this form of statement will some- 
times serve every purpose. 

As already mentioned, separate and complete 
statements may be issued for every company. The 
holding company statement, together with the finan- 
cial statement for each of the subsidiaries, would con- 
stitute a complete record of the operations of the hold- 
ing company. Such a procedure does not give the 
kind of information usually desired with that degree 
of clearness with which, it is obtained thru the use of 
the consolidated balance sheet or by a separate listing 
of the inter-company items. However, if the whole 
organization is small and the number of constituents 
is few, it may sometimes be satisfactory. 

It would, of course, be absurd to prepare a consoli- 
dated balance sheet, or a consolidation of accounts of 
companies totally dissimilar. Thus, if holding com- 
pany "A," owns the entire stock of corporation "B," 


a company engaged in manufacturing gas and elec- 
tricity, and also the entire stock of corporation "C," 
which operates a manufacturing plant, a consolida- 
tion of the assets and liabilities of the underlying 
companies in this event, would be meaningless, if not 
positively misleading. 

The following illustration shows a consolidated in- 
come and profit and loss statement as well as a con- 
solidated general balance sheet properly certified. 


Certified Public Accountants 
30 Broad Street 
New York 
chicago london, e. c. san francisco 

Harris Trust Building 30 Coleman Street Crocker Building 


Williamson Building Third National Bank Building Equitable Building 


Farmers Bank Building 

Cable Address "Hasksells" 


We have audited the general books and accounts of the 
American Smelting & Refining Company and the Ameri- 
can Smelters Securities Company for the year ended De- 
cember 31, 1912, against the related records of original entry 
and supporting documents, including monthly reports reg- 
ularly received from their various plants and mines, and 

We Hereby Certify, that, in our opinion, the accom- 
panying General Balance Sheet and Summary of Income 
and Profit & Loss correctly exhibit, respectively, the consoh- 
dated financial condition of the Companies at December 31, 
1912, and their consolidated results for the year. 

(Signed) Haskins & Sells, 
Certified Public Accountants. 

New York, March 5, 1913. 

XXII— 19 



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Since the stock of subsidiary companies is, as a rule, purchased 
at a premium, how sliall excess of price over book value of 
assets be treated in books of parent company? 

What four kinds of surplus can a holding company have? 
Explain how they differ. 

What different purposes do consolidation balance sheets serve, 
and how does this affect their construction and the explanatory 
matter which accompanies them? 



1. Purpose and definition of budgets. — The va- 
rious forms of financial and other statements, pre- 
viously discussed, deal with transactions which have 
occurred in the past. They indicate the success or 
failure of transactions already completed or in the 
course of completion. The business manager of to- 
day, however, in many cases, requires information on 
the conditions which may be expected in the future. 
This information must be in the form of a scientif- 
ically prepared and classified statement of the future, 
and not a haphazard or indefinite forecasting. It 
must be a comj^lete budget, based upon the best data 
obtainable from the recorded results of the past. 

2. The annual budget. — The annual budget is a 
detailed statement or program, outlining the financial 
plans of the management for the coming year and the 
methods by which it proposes to accomplish these 
plans. This statement calls for a careful estimate of 
the total income or revenue from sales of product or 
service, which it is expected will be realized during the 
year. It also calls for a careful estimate of the entire 
cost of operation during the year, showing separately 

273 * 


the cost of each individual department and sub-sched- 
ules of the cost of operation within departments. 

3. Interim reconciliation of estimate with costs. — 
In order that the management may be informed as to 
the actual working out of the predetermined outlay 
and income during the fiscal year, there should be fur- 
nished a periodical statement which may be made up 
semi-annually, quarterly or monthly. This state- 
ment should disclose the exact financial condition at 
the beginning and at the end of the period and the 
actual outlay of each department or operation during 
the period. A comparison of these costs with those 
for similar periods in previous years should be made. 
The balance of the appropriation, w^hich remains to 
each department for its operations during the re- 
mainder of the fiscal year, should also be shown. 

4. The final stateriient. — At the end of the fiscal 
3?^ear, the final statement should show a comparison of 
the actual results with the predetermined results. 
The revenue received on account of each departmental 
function, or unit of service, will be compared with the 
predetermined estimate, and the actual cost will be 
contrasted with the predetermined cost. 

5. Value and use of estimates. — The value and 
use which can be made of these estimates is evident 
when we realize that the success of a business enter- 
prise is dependent chiefly upon the ability of the man- 
agement to plan intelligently for the future, and that 
a large percentage of business failures is directly 
traceable to neglect in anticipating financial needs in 


time to provide for them. Construction work, provi- 
sion for the expansion of business, increased sales, ris- 
ing costs of production, etc., must be anticipated and 
provided for before they actually arise. The diversi- 
fication of industry and the constantly increasing 
necessity of depending upon indirect supervision and 
management, together with rapidly changing business 
conditions, necessitates the use of scientifically pre- 
pared forecasts. 

6. Budgets as a means of guida7ice. — A budget 
guides the executive in developing policies, by fore- 
casting the effects and results of these policies. It 
insures financial preparedness by indicating financial 
needs before they actually arise. 

The estimated needs of the different departments 
are, in turn, indicated by means of departmental 
budgets. These are grouped into one general budget, 
covering the needs of the business as a whole. The 
departmental budgets serve as guides to the depart- 
ment heads, and their operations during the period 
will be governed by their departmental budgets. 

7, Special budgets. — In addition to the general 
and departmental budgets, which may be designated 
as regular budgets, it is occasionally necessary to pre- 
pare a special budget for a particular purpose. Such 
2)urpose may be that of attempting to forecast the 
effects and results of a particular policy or of condi- 
tions in a particular department. For example, the 
management may wish to know how a proposed in- 
crease in the kinds of goods produced will work out. 


A budget may be prepared showing just how this 
change will affect the growth of the business and how 
practicable the venture will be. Special budgets are 
used at times to supplement the regular budgets when 
changes in conditions have been so extreme as to ren- 
der the original departmental budget valueless. 

8. The sub-division of budgets into montlily 
periods. — For practical use, a budget should be sub- 
divided into monthly periods. The operations of one 
department may not synchronize with those of another 
and while the budget covers the operations of the fiscal 
year, the management must forecast the conditions 
at all times between the beginning and the end of the 
year. It very frequently happens that at some time 
^vithin the fiscal year, the amount of obligations pay- 
able will temporarily exceed the amount of the cash 
and receivables available to meet them, thus making it 
incumbent upon the management to have sufficient 
funds, either owned or borrowed, to meet the imme- 
diate needs at that particular time. If the budget is 
prepared on a monthly basis, this information will be 
at hand, and the proper financial preparations can be 

9. Pre-requisites of a budget. — A satisfactory and 
efficient accounting system is a pre-requisite to the 
preparation of an intelligent forecast of future con- 
ditions. The accuracy of the budget will depend in 
great measure upon the accuracy with which past 
transactions can be interpreted. This means that in 
most cases it will be necessary to have proper cost 


records in order to ascertain with as much certaintj^ as 
possible, the cost of the goods which are expected to 
be sold during the ensuing year. 

10. Budget routine. — It is, of course, impossible 
to lay down a budget routine that will apply in prac- 
tice to every individual case. The budget informa- 
tion for each department must, of necessity, be initi- 
ated by the men who are responsible for the depart- 
ment, and who are, therefore, most familiar with the 
actual working. 

In this connection, the department head should en- 
courage a general discussion of the subject with his 
subordinates and the views of every man who can offer 
helpful advice, should be considered. The plans and 
program for the ensuing year should first be out- 
lined. A statement should be made of the antici- 
pated income or revenue to be received by the depart- 
ment, together with a careful estimate of the costs in 
minute detail. In some instances, it will be neces- 
sary to reverse the order, first to determine the cost 
and then upon the basis of the figures of the estimated 
cost to measure the appropriation which the depart- 
ment is to ask for, to cover its operations during the 
year. When this information has been carefully ana- 
lyzed and when from the experience of the past, the 
estimates of the future liave been determined, a de- 
tailed statement should be prepared by a uniform 
method, which all departments or functions will em- 
ploy. The estimate is then submitted to the execu- 
tive, usually the treasurer or president, for approval. 


In some instances, department heads may not have 
available the necessary information as to costs and, 
in this case, the records of past transactions must be 
obtained from the accounting department. The ex- 
hibit on page 287 shows merely by way of sugges- 
tion, the general budget of a small manufacturing 

11. Sales department's duties as to budgets. — 
The sales department should furnish an estimate of 
the possible output for the ensuing year based upon 
the records of the past, and influenced by anticipated 
business conditions. In this connection the effect of 
a proposed change in prices will be considered. It 
will be seen that the accurac}'^ of the estimate depends 
in a great measure upon the skill with which the gen- 
eral trend in business conditions is forecasted. In 
actual practice this will not present the same difficulty 
as it does in theory; if the budgets of previous years 
are studied in comparison with the actual results of 
the same years, mistakes in judgment will not be re- 
peated. As in other things, experience is a great 
teacher and budget makers will find that their es- 
timates will become more and more accurate from 
year to year. In the majority of cases, not more than 
from two to five per cent of the estimates will be 
found to be inaccurate. 

12. Budgets on four-week instead of calendar- 
month basis. — A recent step in accounting work and 
budget preparation has been that of basing all reports 


on four week periods rather than on calendar months. 
This plan has become especially popular in cost ac- 
counting. Its chief value lies in the fact that it fur- 
nishes a much better basis for comparison because of 
the even periods of time involved. 

13. Duties of jjroduction departjnent. — Based 
upon the estimate of the sales manager for the ensu- 
ing year, the production department will then be in 
a position to make its estimate. The purchasing de- 
partment must investigate the market conditions, de- 
termine whether the raw and indirect material may 
be procured in sufficient quantity to meet the demands 
of the anticipated orders and a forecast must be made 
of the probable prices that will have to be paid for 
such materials. It may be possible, for example, to 
purchase the entire year's supply of raw materials at 
prices much less than may be obtained later. The 
effect of such a purchase on the j^rofits of the period, 
and a comparison between the benefits to be received 
from immediate purchase of the raw materials, and 
their purchase distributed over the year should be 

The ability of the concern to finance such a trans- 
action will have an important bearing upon the pro- 
cedure to be adopted. The purchasing agent of a 
large railway supply house at the beginning of the 
European war prepared his budget upon the as- 
sumption that the price of copper would increase and 
convinced the executives that the proper thing to do 


was to anticipate the requirements for a year or more 
if the organization would be financially able to carry 
the transaction thru. 

The factory heads in the case of a manufacturing 
concern must be able to predetermine the output. It 
may be that the price of labor will vary at different 
times during the year. This is true, especially in 
certain of the garment-making industries. If sales 
and production can be predetermined with a fair de- 
gree of accuracy, it may be possible to manufacture 
during the time when labor is relatively cheaper. 

On the other hand, the budget may serve to equalize 
production over the year instead of having the greater 
part of the work concentrated in a few months. The 
manufacture of stock within the limit of estimated 
sales would reduce the stress of the heavy business 
periods and cheapen the cost of production. It will 
thus be seen that the production manager and the pur- 
chasing agent must work hand in hand so that the 
latter may plan his future purchases so as to secure 
the best possible price and the delivery of material at 
the time the production manager requires it. 

Thus we see that each department is dependent 
upon some other and that we shall have a series of 
reports, each report based in part upon the esti- 
mated needs of the other related departments, each 
one dovetailing into the others. Each departmental 
report must be complete and should be accompanied 
by explanatory schedules where necessary. 

14. Assembling the data. — The actual work of 


classifying, grouping and assembling all these reports 
into one general comprehensive budget can best be 
performed in the treasurer's department. While each 
department is preparing its estimate, the treasurer 
should make up a comparative statement in budget 
form of the actual receipts and disbursements of sev- 
eral prior periods, and also a list of all special pay- 
ments, or receipts for the next year which are, as a 
rule, known only to the financial division. Items of 
this kind will cover, for example, advances, loans, in- 
terest, investments, construction requirements or the 
possible sale of securities, either stocks or bonds. By 
the use of a comparative report of previous years' op- 
erations and the departmental estimates, the actual 
work of preparation is facilitated. 

All revenues and expenses are dependent upon four 
factors ; namely, the amount of business expected, the 
anticipated cost, general business conditions, and ex- 
traordinary plans or projects. Subject to the trend 
in general business conditions and any changes in cost, 
the expenses will increase or decrease over previous 
years in proportion to the increase or decrease in the 
amount of sales. The first step, then, is to arrive at 
a budget, based solely upon proportionate changes as 
compared with the actual conditions or transactions 
of previous periods. Increased or decreased costs, 
good or bad general business conditions, new under- 
takings, new conditions in departments, and the like, 
will each tend to alter the budget, and hence each 
must be given careful, individual consideration. 

XXII— 20 


Reference to the accounting records will often aid 
in determining the influence of these unusual circum- 
stances. The effects of previous changes will be 
clearly shown and from these we can draw inferences 
as to the effect of the present changes. In any event, 
we can estimate these changes as being a certain per- 
centage above or below normal and adj ust our budget 

To these figures must be added the items of possible 
receipts and expenditures already listed. Construc- 
tion to be financed by loans should be so designated 
in the budget, and only such portions of payments on 
account of construction or repairs as fall due in a 
budget period, should be considered. This provision 
also holds good in connection with other items, as a 
budget estimate covers only cash transactions occur- 
ring within a budget period. 

15. Checking the data assembled. — The assembled 
data should be carefully revised and checked. One 
department or function may have planned certain 
changes which call for increase in appropriation, and 
the management may disagree with the department 
head. Then it becomes the latter's duty to justify his 
expenditure — to try to "sell" his idea to the executives. 
If he succeeds in doing this, his estimate will be al- 
lowed to remain; otherwise it will have to be aban- 
doned. The production department or the factory 
superintendent may foresee the necessity of a general 
increase in the wages of factory employes ; it may be 
that heJbad not enough breadth of vision to foresee the 


necessity, and his estimate based upon past labor costs 
will have to be revised. 

The assembling" of the data, the balancing of es- 
timates, the revision by the executive of the financial 
department, the predetermination of costs within the 
limit of the receipts as fixed by the sales, constitute 
the scientific part of budget preparation. The dove- 
tailing of the schedule of one department of the or- 
ganization to those of other departments and the weld- 
ing of all into a comprehensive whole, calls for the 
exercise of prudence and judgment. The budget in 
its final form after being passed b}^ the treasurer or 
financial officer best qualified to assemble it, is sub- 
mitted to the board of directors for their examination 
and approval. 

After approval by the board of directors or by the 
management, the budget becomes the treasurer's 
financial guide. He is enabled to make such disposi- 
tion of the funds as will enable him to handle them 
most economically, and yet, always to have sufficient 
funds on hand to meet whatever payments fall due. 
This reason alone makes it necessary that the appro- 
priations of the budget be closely followed. The 
treasurer would be in constant trouble if the depart- 
mental heads were permitted to spend the money with- 
out conforming to the standard which they had pre- 
viously set. 

16. Interim check on the budget. — For this rea- 
son, therefore, the periodical statements mentioned 
above must be prepared to show the actual receipts 


and expenditures as compared with the estimated 
budget. The statements will thus act as a check on 
the company's operations and on the accuracy of the 
budget estimate. Any great discrepancy between the 
actual transactions and the estimates must result from 
one of three causes: estimates may have been care- 
lesslj" prepared; the department heads may have de- 
parted from the program which they had set ; or, un- 
usual outside conditions may have brought about the 

In any event, these discrepancies should be investi- 
gated and explained. They are signals— sometimes 
danger signals — and must not be ignored. Thus, the 
reader wull see that the budget forms a reasonably ac- 
curate forecast of the future conditions to be met by 
the management. It serves as a general guide in that 
it often, forestalls mistakes and unwise moves, or, at 
least, points them out in time to avoid great loss. 
The budget forms the basis for a revision of plans 
when changing conditions make a revision necessary. 
Unless the management has some guide by which to 
gauge the concern's progress, it will not be able to tell 
at once when a change in plans is desirable, and losses 
or misdirected efforts must result. 

17. Other considerations in budget making. — 
Even when loans are not regularly resorted to as a 
means of financing a business, it may often be found 
that demands for cash at various times during the 
year will require temporary borrowing. Borrowing 
then, within the limits of credit, forms the balancing 


medium of the budget. If the borrowings are caused 
by factors within the control of the executives, the 
raising of the loans may be avoided by abandoning 
that part of the work which necessitates the extra 

18. Working hack from the income statement. — 
In some of our large corporations, particularly the 
public service corporations, it is sometimes difficult 
to work up a budget based upon actual cash transac- 
tions. These corporations may make up an estimated 
income and expenditure statement based upon the 
principles which have just been discussed. In order 
to arrive at the actual cash transaction involved in this 
income and expenditure statement, it is necessar}^ to 
eliminate all items not represented b}^ actual cash re- 
ceipts or payments that occur during the fiscal period 
under consideration. 

This practice, however, is not to be recommended, 
because it is less accurate than the plan which we have 
outlined before, and, furthermore, does not provide 
for a monthly statement of the transactions involved. 
There seems to be little doubt that even the larger 
corporations can secure estimates from their depart- 
ment heads regarding the actual cash transactions to 
be made during the year. 

There are, perhaps, certain lines of business in 
which the budget idea may not be suitable. The gen- 
eral opinion among certain public service corporations 
for example, is that a budget is not practical. Even 
in these cases, however, an attempt is made to estab- 


lish a construction budget. The amount of quick as- 
sets available, and the amount to be secured by new 
financing will furnish the funds needed to finance new 
construction. Based upon this estimate, the con- 
struction program for the following year is outlined. 

19. Departmental standards required for budget 
making. — The departmental budgets are especially 
valuable in holding department heads to given stand- 
ards. The departments have certain allowances for 
expenditures and are required to produce certain re- 
sults in return. Any deviation from the standard 
must be due to unusual conditions or to a fluctuation 
in managerial efficiency. Often departmental budg- 
ets cover all the operations and activities of the de- 
partments by setting arbitrary limits outside of which 
the departmental manager has no authority. It is 
doubtful, however, if such rigid control is advisable 
in any but exceptional cases. 

The departmental budget also serves to equalize 
production not only according to time, but also ac- 
cording to the needs of other departments whose work 
may be related to that of the department in question. 
If the budget requirements for each department re- 
late satisfactorily to each other, then the actual work 
that is carried on in accordance with the budget re- 
quirements should interlock efficiently. 

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Explain the relation of a budget to the accounting system. 

Should the budget be made only on an annual basis or for 
sliorter intervals ? Give reasons for decision of this question. 

Describe the share of the sales department, the production 
department, and the treasurer in the preparation of a budget. 

How far is the budget idea applicable and vphat are the ad- 
vantages which result from its use.'' 



1. Development of municijjal budgets. — It has 
always been necessary for some part of the govern- 
mental agencies, either the administrative or the legis- 
lative, to prepare rough estimates of the necessary 
expenses of the corporation for the ensuing fiscal 
year. This information was used as a basis for tax 
levies. For many years, this work was undertaken 
in a haphazard and unscientific way. The gradual 
development of the science of government, the in- 
creasing demands made upon municipalities for fur- 
ther improvements, and the constantly increasing mu- 
nicipal debts of our American cities have forced the 
authorities to adopt some systematic plan for financ- 
ing and controlling the expenditures of municipal 
corporations. Furthermore the authorities realize 
that business methods, by which a complete check is 
had on all transactions and operations, are as impor- 
tant in the management of municipal activities as they 
are in business organizations. 

2. Distinction between private budgets and mu- 
nicipal budgets. — In the preparation of private budg- 
ets, the reader noticed that it was necessary to limit 
the expenditures of the fiscal period by the amount of 



the expected receipts. No such limits are placed 
upon the makers of municipal budgets. The expendi- 
tures are determined, then the revenue is adjusted 
to correspond. This statement must be qualified, for 
tax levies and other municipal charges must not be 
exorbitant. Furthermore, the tax levy is offset by 
the amount of certain incomes which municipalities 
receive for water rates, dock and ferry privileges, in- 
vestments in rapid transit enterprises, license and 
court fees, etc. 

A municipal budget, then, is a comprehensive, de- 
tailed plan or progi*am of the work to be accom- 
plished by the administration during the ensuing year, 
together with a detailed estimate of the cost thereof, 
covering all departments and all operations of the 
municipality. By the use of this plan, the taxpayers 
are enabled to check up the work of their represen- 
tatives and the chief administrative officer is enabled 
to have a check on the acts of his subordinates by hold- 
ing them to the limits of the budget. Furthermore, it 
gives the controller a record against which he may 
judge the various departmental warrants or checks, 
which are presented to him for payment. As a rule 
he has no authority to make payments in excess of the 
amount allotted in the budget to a particular depart- 
ment or division. 

To the department head, the municipal budget be- 
comes an arbitrary guide in the making of purchases 
or in operating his department. He has definite 
liniits set for him as to the expenditures which he can 


make. He knows that certain results in actual work, 
laid down at the beginning of the year in the financial 
program, are expected in return for his expenditures. 
He must not only keep his withdrawals within the 
limits of the budget, but he must obtain for these 
withdrawals a maximum of results and the completion 
of the program laid down in the original estimate. 

3. Borrowing hy municipal and busifiess organiza- 
tions differentiated. — The reader has seen that the 
private budget serves to keep the business house sup- 
plied with sufficient funds to meet its obligations. 
The municipal budget on the other hand, while serv- 
ing this purpose to a limited degree, does not always 
result in that desirable end. Municipal taxes are fre- 
quently not collected until the latter part of the year, 
while the expenditures chargeable to the budget ap- 
propriation, begin to accrue immediately. Many mu- 
nicipalities have now adopted the plan of having taxes 
payable semi-annually. This reduces the necessity 
of borrowing and results in a considerable saving of 
interest for the municipalities. In a recent address, 
Hon. William A. Pendergast, former controller of 
the City of New York, illustrated the saving which 
Xew York City made by providing for the collection 
of taxes twice a year. 

In 1906, on a tax levy of $94',000,00(), tlie city paid in in^ 
terest, on revenue bonds issued in anticipation of the collec- 
tion of taxes, $2,898,562. 

In 1909, on a tax levy of $122,750,000, the city paid in 
interest, on revenue bonds issued in anticipation of the collec- 
tion of taxes, $5,194,241. 


In 1912, under the semi-annual tax plan, on a levy of 
$150,500,000, the city paid in interest, on revenue bonds is- 
sued in anticipation of the collection of taxes, only 

Thus, it will be seen that the municipal budget does 
not seek to provide the funds at the time when they 
are needed, as is the plan of a private budget, but it 
is interesting to note that progress has been made in 
this respect, and that municipal authorities are alive 
to the evil of interest charges and large floating debts. 

4. Old-time budgets. — Under the old-time (so- 
called) budget system, each department head fur- 
nished the legislative body with a lump estimate of 
the needs of his department. This method was oj^en 
to numberless objections. Inasmuch as the appro- 
priation was made in one lump sum for the depart- 
ment, all possible avenues for misapplication of the 
funds were open. The amount which was to be ex- 
pended for salaries was not stated, nor was the amount 
to be expended for any one of the department's usual 
needs specified in the budget. Consequently, there 
was open to the head of the department the oppor- 
tunity of diverting funds, which should have been 
used for the real needs of the department, to improper 

When the legislative bodies began to prune the de- 
partment head's estimates, the department head sim- 
ply increased his estimate above the figure which he 
actually expected to get. Any reduction by the leg- 
islative body simply tended to bring his particular 


allotment down to the amount which he actually de- 

5. The jnodern budget. — The modern budget 
takes several different forms, but is founded on the 
idea of a collateral check and investigation of the 
estimates submitted by department heads. The de- 
partment heads are expected to confer with those 
qualified under them and submit an estimate whicli 
measures, as accurately as can be foreseen, the actual 
needs for the ensuing period. There are two kinds 
of budgets now in use, the segregated and the lump- 
sum, which, while varying somewhat in form, are 
practically representative of modern municipal budget 

6. The segregated budget. — The segregated bud- 
get provides a very complete and absolute check on 
the operations of every department. Departmental 
estimates are submitted on a form which calls for de- 
tailed information in support of the requests made by 
the department head. All proposed expenditures are 
itemized in detail so as to make them readily com- 
parable with the transactions of previous years. The 
definite appropriation of sums for specific purposes 
prevents the diversion of funds to objects other than 
those for which they were designated. The depart- 
ment head has a fixed allowance for salaries and other 
expenses, and there is no opportunity for him to util- 
ize any part of the appropriation for other purposes 
without securing the necessary authority for so doing. 
Under this method, estimates are in such a shape that 


they may be subjected to intelligent scrutiny by ex- 
pert examiners of a budget commission or by any one 

This method has many disadvantages which will 
often defeat its purpose: a considerable expense is 
entailed in the employment of a large clerical and 
examining staff; rigid classification will frequently 
hamper the heads of departments and handicap them 
greatly in their work; it is so inflexible that any un- 
foreseen contingencies or changed conditions cannot 
be satisfactorily provided for. On the other hand, if 
the idea of segregation is carried out with judgment, 
it will prove, as a rule, efficient in operation. 

7. The lump-sum budget. — This method is di- 
rectly opposed to the segregated budget in many of 
its features. Under this plan, the estimate for each 
department is expressed in a lump sum. However, 
to overcome the disadvantages of a lump sum appro- 
priation unsupported by further details, and in order 
still to maintain the flexibility of the operation of the 
lump sum budget, cost schedules and working plans 
are made a part of the budget. These cost schedules 
and work plans must cover the complete operation of 
the department. The current year's expenses, the 
program of work to be covered, and a working plan 
of the effects of this year's projects on ensuing years 
must be made a part of the estimate. This method 
provides for the carrying thru of new projects to 
their completion even tho the administration changes. 
The Imnp-sum budget system has shortcomings as 


well as advantages. There is no way of keeping a 
department head strictly within his appropriation, 
for, unless the cost schedules are made a mandatory 
part of the budget, he has full power to shift funds 
at his pleasure. On the other hand, as soon as the 
cost schedules are made rigid and controlling, the 
lump-sum budget becomes, in effect, a segregated 

8. A variation of the lump-sum budget plan. — 
Under this method, the appropriation is not arbi- 
trarily fixed for the entire year. In order to obtain 
the advantages of the segregated budget and the flexi- 
bility of the lump-sum budget, the budget commis- 
sion will make quarterly allotments of the appropria- 
tion for the necessary purposes during that quarter. 
This practically results in a quarterly examination of 
the department and its needs. The allotment cannot 
be made unless the budget commission is thoroly fa- 
miliar with the conditions and plans of the depart- 
ment. It results in a segregated budget, or, rather, a 
classification of expenses for the ensuing quarter. 

9. The essentials of municipal budget preparation. 
— In the first place, it is necessary in the preparation 
of a budget that the transactions of previous years be 
compared and used as a basis for the appropriation 
for the ensuing period. The estimates should give 
details with such minuteness and in accordance with 
such standard classifications as will enable the com- 
parison to be made. Second, estimates should be pre- 
pared by department heads with the aid of their sub- 


ordinates. As in a private business, every opinion of 
weight in the division or department should be called 
for at the time the estimates of the budget are first 
being made up. Third, the estimates should be sub- 
sequently examined and investigated by some person 
who is familiar with the details and needs of each de- 
partment but who is not connected with any of them. 
This may require the services of an independent in- 
vestigation bureau. Fourth, the estimates should be 
considered at public hearings at which interested tax- 
payers may discuss an}^ details to which they object or 
in which they are otherwise interested. Fifth, the 
budget should not grant a lump sum to any depart- 
ment which it may spend in any way it pleases. The 
budget should be segregated sufficiently to allow a 
reasonable check on the actions of the department 
heads. The department head should be required to 
make the best use of whatever funds are at his dis- 
posal. Sixth, the budget must be founded on law 
and based upon clear and honest accounting records. 
10. Legal foundation for budget necessary. — To 
be successful in operation, a budget, no matter what 
its form, must be founded on law. Its features of 
administrative and financial control will not operate 
to any advantage unless they are compulsory. His- 
tory furnishes one or two instances where the chief 
executive has tried to follow out a budget plan with- 
out securing the passage of a budget law. His at- 
tempts, while commendable, were not successful be- 
cause he could not secure the cooperation of the 


legislative body and of his subordinates. The law 
prescribing a system of budget preparation must be 
complete in all details and must lay down the rules of 
procedure in the most minute degree. The tempta- 
tions of public positions will frequently turn honest 
men into dishonest public employes unless some legal 
and capable check is placed on their work. 

11. The accounting foundation in budget making. 
— A proper accounting system is equally important. 
If the legal statutes pertaining to a budget system 
cover the accounting procedure, so much the better. 
A comprehensive accounting system, providing com- 
plete information regarding the detailed operation of 
every department, is necessary. Standard accounts 
and a uniform classification of expenditures for the 
various departments should be required. The records 
of actual expenditures of previous periods should be 
available for comparison with the estimated expendi- 
ture for subsequent periods. 

12. Statistical methods in connection with budget 
reports. — In municipal transactions the personal and 
financial elements are of equal importance. Personal 
service records of all employes, with detailed informa- 
tion as to their ability and past records, should be 
kept. Positions should be standardized and classified 
by competent investigators. It is not easy to find the 
right type of men to do this work, and much of the 
criticism that has been leveled at bureaus of standards 
is justified, because of the incapacity of those who 
have been entrusted with this work. There is a large 

XXII— 21 


field for the development of the use of statistical meth- 
ods in connection with budget reports. Department 
heads, in submitting their departmental estimates, and 
the budget commissions, in jjresenting a complete 
budget to the legislative body or to the public, 
should make use of graphic exhibits. Important 
points that would be lost in the maze of figures will 
show up far more clearly if pictured in graphic form. 
Unit costs, wherever obtainable, compared with the 
results of previous years, will often be interesting. 
Charts of the intangible results obtained from the 
operations of various departments will measure to 
some extent the efficiency of these departments. For 
instance, the exhibit of the fire department might 
chart the number of fires during the year, the amount 
of fire loss for each year, and comparative figures with 
the results in other cities. The police exhibit, the 
health exhibit, etc., might take much the same form. 
The savings made in operating expenses, thru the use 
of modern mechanical aids to bookkeeping and record- 
ing, might also be illustrated. 

13. Budget machinery. — We have seen that the 
first step is to have estimates from department heads 
and to require that these estimates be properly sup- 
ported by explanatory schedules and comparative 
statements of results in previous years. After the 
departmental estimates have been turned in, an inde- 
pendent investigation should be conducted by the 
budget commission or its representatives ; this investi- 
gation may be collateral with the preparation of the 


departmental estimates. In the final hearings on the 
budget, publicity is a prime essential. The com- 
plaints or suggestions of citizens should be given due 

After receiving reports from the investigators and 
hearing the public criticisms, the commission or body 
charged with the duty of preparing the budget will 
set the maximum limit for budget appropriation. 
Departmental heads will be consulted when it is pro- 
posed to reduce any budget appropriation. In cer- 
tain cases, the hands of a budget commission are tied 
by a state legislature because of the passage of special 
enabling acts or mandatory provisions. The budget 
is then usually submitted to a legislative board, which 
board has usually the power to reduce but not to in- 
crease the appropriations. 

14. Determining the tax rate. — Notwithstanding 
popular opinion, city officials in a single year can do 
very little toward increasing or decreasing the tax 
rate. Many of the expenditures are fixed in amount 
and cannot be affected by the actions of the city offi- 
cials. For instance, interest on municipal debts, 
sinking fund contributions, and the municipality's 
share of the state or county taxes are entirely out- 
side the control of the municipality. On the other 
hand, certain expenditures have been made manda- 
tory by state legislatures, and many others are semi- 
fixed because of their very nature. 

At regular intervals during the fiscal year, reports 
should be published showing the amounts appro- 


priated for the use of the various departments, the 
amount expended by the departments to date, the 
commitments against any appropriation to date even 
tho the expenditure has not, as yet, been actually paid 
in cash, and finally, the imexpended balance of the 
appropriation. Whenever work schedules form part 
of the budget, then the actual results accomplished 
should be set off against the work schedules. 

15. Transfers and changes in the budget. — The 
budget commission, or other board, having power to 
check up the operation of the budget, should also have 
full facilities for examining into details. They should 
be empowered to approve of changes in policies and 
able to increase appropriations where necessary. 
They should also authorize the transfer of funds 
when such a step is advisable. In this connection, it 
would be well to state that any transfer of funds from 
one appropriation account to another or from one 
department to another, should be made only after 
the relative needs of each department or each func- 
tion have been carefully examined. 

16. Providing in the budget for unforeseen needs. 
— It will frequently happen that estimates at the be- 
ginning of a period will not be strictly applicable thru- 
out the period. Unforeseen needs will arise in con- 
nection with some function, or, certain other functions 
may be over-estimated; for example, a serious epi- 
demic might exhaust the funds of the health de- 
partment and make necessary an increase in the ap- 
propriation. The accounting records will show all 


the surplus funds either of an individual department 
or of 'the eity as a whole. The governing board hav- 
ing charge of the preparation of the budget or its 
operation, should have power to re-allot these un- 
distributed portions wherever extra or unforeseen 
needs arise. 

17. Other public budgets. — Closely related to the 
subject of municipal budgets is the use of budgets 
in the county, state and federal governments. The 
conditions here are so different from those in cities 
that the need of budget reform has not been so notice- 
able. Indirect taxation, which furnishes most of the 
revenues of such bodies, is not felt by the public and 
is not a subject of such direct importance to them. 
The tendency of the officials of such governmental 
bodies has been to spend the amount of the revenue 
received rather than to reduce the tax rate, because 
indirect taxation usually brings in an indefinite and 
frequently an excessive revenue. The budget sys- 
tem, however, is just as essential for these forms of 
government and should be carried out. 

18. Some fundamentals in budget interpretation. — 
While the methods followed in interpreting budgets 
by officials, or by taxpayers, will vary with the budget 
system and with the individual conditions of each lo- 
cality, the reader will note a few fundamental points 
which should be observed. 

The interest centers quite naturally on the ex- 
penditure side of the budget more than upon the re- 
ceipt or income side. Comparison between expenses 


of preceding years, the appropriation for the coming 
year and the expenses of the current year up to the 
date of the report, together with the estimated ex- 
penses for the rest of the current year, and the de- 
partmental estimates for the complete year should be 
arranged side by side. Any differences in these 
amounts should be noted and changes from year to 
year should be watched. For example, an increase in 
personal services, supplies and the like, or a decrease 
in services other than personal, such as contract serv- 
ices, would indicate that more of the city's work was 
being done by its own employes and less by outside 

A decrease in rentals or an increase in property 
purchases might indicate expenditures for permanent 
property to replace leased property. A marked fall- 
ing off in the maintenance expenses might indicate 
that the property and equipment were not being 
properly kept up. Increased expenditure for prop- 
erty acquisition should result in an increased main- 
tenance charge in succeeding years. If this does not 
result, then the property is not being maintained 
properly. Increases in operating expenses may be 
the result of the expansion of existing functions, the 
taking on of new functions not previously performed, 
or the result of inefficiency of operation. 

The relative use of borrowed moneys for current 
expenses and for permanent improvements should be 
clearly indicated in the comparison. These are but 


a few of the many factors for which one examining 
a municipal budget must watch. They afford, how- 
ever, some indication of the manner in which such 
statements should be read. 

19. Extending the scojje of the budget. — Where 
the city is operating a municipal gas plant, a street 
railroad, or other revenue-producing property, sepa- 
rate and detailed operating statements, as well as 
balance sheets for such properties, should be pre- 
pared. The time is undoubtedl}^ coming when the 
taxpayers will receive reports of municipal operations 
disclosing (1) the financial condition of the munici- 
pality, showing its permanent assets and improve- 
ments, and the funded debt of the municipality, (2) 
its available assets in liquid form and its outstanding 
obligations and commitments — both of these state- 
ments to be prepared in comparative form, (3) the 
separation of income and capital receipts and pay- 

When these reforms have been carried out, the pub- 
lic officers of a municipality will be able to justify 
their administration. The taxpayers and the admin- 
istrative officers of the governmental body will also 
have information upon which may be determined, 
first, the character and the cost of the services ren- 
dered; second, the economy or waste in the various 
departments; third, the efficiency or inefficiency of 
public officials and employes; fourth, the financial 
condition of the municipality at any stated time ; fifth, 


a just apportionment and distribution of the tax levy 
among the various departments each of which com- 
pete for their respective allotments. 

The taxpayer will know whether or not he is re- 
ceiving his money's worth for the taxes he pays; he 
will know that his public officials are honest. He 
will know that proper provision is being made for in- 
terest and amortization of the city debt, and he will 
be able to determine in his own mind whether or not 
the administration is "making good." 


What is the fundamental difference between a private and a 
public budget? 

What part does borrowing play in a municipal budget? 

Distinguish between a segregated and lump sum budget and 
state the advantages and disadvantages of each. 

Describe the process of preparing a municipal budget. 

How far is it possible for city officials to alter the tax rate? 

What information is to be sought in examining a municipal 
budget, and how may its items be listed as to their reasonable- 
ness ? 



1. Criticism, due to improper interpretation. — 
Much of the unjust criticism that has been directed 
against accountants and ap2:)raisers in the past is due 
to the fact that reports prepared by them have not 
been properly interpreted by the business man. On 
the other hand, just criticism must be given to those 
professional men who issue reports that are so ob- 
scurely phrased or vaguely worded as to make it al- 
most impossible to determine the conclusions of the 
writer. Moreover, business men and the general pub- 
lic need to be informed of the technical meaning of 
certain terms and phrases which, thru long continued 
custom, have acquired a definite meaning or special 
significance in the business profession. 

2. Interpretation of an auditor s certificate. — In 
the Text on "Accounting Practice and Auditing" the 
reader will have noted two common forms of certifi- 
cates attached to the reports of auditors. A certifi- 
cate may vary from the simj)le phrase, "Audited and 
found correct" to the very elaborate form of certifi- 
cate which states minutely the responsibility wliicli 
the auditor assumes for the valuation and verification 
of the principal classes of assets. Therefore, in read- 



ing a report submitted by an auditor, attention should 
first be directed to the form of certificate attached. 
Quahfications, if any, should be particularly noted. 

Thus, the certificate of an auditor which states that 
the books have been audited and that amounts shown 
in the balance sheet are in agreement with the values 
stated in the ledger, means that the auditor certifies 
to the fact that the balance sheet agrees mathemati- 
cally with the figures found in the ledger of the busi- 
ness whose accounts have been audited. 

From the business man's viewpoint, such a cer- 
tificate has little value for the reason that no re- 
sponsibility is assumed by the professional auditor 
except as to mathematical agreement. Assets may 
be grossly overvalued and liabilities may be under- 
stated in the books without disclosure. A creditor or 
an investor, noting that the certificate was signed by 
a licensed auditor, seeing also that the books have 
been "audited" and that the statement put forth by 
the firm agrees with its books, might be deceived to 
his detriment into believing that such a certificate 
guaranteed the financial condition of the firm. 

3. Certification as to values of real property and 
fixed assets. — The reader has already learned that an 
auditor is not a valuer or an insurer. With what 
measure of confidence can we regard the certificate of 
the auditor as to the value assigned to fixed assets 
in a certified balance sheet? It is to be presumed 
that, if an unqualified certificate has been given in re- 
spect of the fixed assets, the auditor has either sup- 


ported the valuation by having an appraisal prepared 
by competent appraisers or is satisfied in some other 
way as to the valuation. There is no doubt but that 
an experienced auditor is able to certify satisfactorily 
to the approximate value of fixed propery in many 
cases. At least, he is competent to express an opinion 
as to the adequacy of the provision for depreciation. 
But, on the other hand, his limited ability in the field 
must be clearly recognized by the reader of his cer- 

If the certificate states that the values assigned to 
the fixed assets appear to be conservative and no 
mention is made of an appraisal, the reader must un- 
derstand that the auditor has merely exercised his 
best judgment and discretion in agreeing to the valu- 
ation. Whatever weight is to be given to his opinion 
in the matter the reader, having regard to the quali- 
fication and experience of the auditor, must determine. 

It should be noted that an expression of opinion 
relative to the adequacy or inefficiency of the pro- 
vision for depreciation is tantamount to a certification 
of the valuation of the property. 

4. Certifying to the valuation of inventories. — One 
who reads a professional report should pay particular 
attention to the certificate of the auditor in respect of 
the inventories of raw material, work in progress and 
finished goods. 

As a rule, the auditor will not be present when the 
inventory is taken, and the character of the mer- 
chandise stocks may have changed to a considerable 


extent between the time when the inventories were 
taken and the date of the auditor's investigation. 
Thus, an auditor is often obhged to accept the valu- 
ation placed upon inventories submitted to him by the 
managers. Not only has he to accept the certifica- 
tion of the management as to quantities, but often as 
to prices. 

However, even tho the auditor accepts the valu- 
ation and the quantities reported by the management 
and so states in his certificate, he is not relieved from 
the responsibility of assuring himself that the persons 
who took the stock were competent to do so and that 
they fully appreciated the importance of their re- 
sponsibility. He will, as a rule, make some investiga- 
tion into the accuracy of the method and system em- 
ployed in ascertaining the value, and the correctness 
of the pricing and of the mathematical work so as to 
satisfy himself that the results are worthy of accept- 

5. Procedure where inventories may not be relied 
upon. — Where the inventories have been taken by per- 
sons incompetent to do so; by those on whose judg- 
ment the auditor does not rely; or where, by reason 
of other circumstances, the auditor may not feel justi- 
fied in accepting the statements handed to him, he 
will state in his certificate that the inventory has been 
entered at the values assigned to it, subject to what- 
ever qualification he deems it necessary to append. 
The use of the phrase "subject to" implies that the 
auditor himself is not willing to assume the respon- 


sibility for the quantities or the valuation and one who 
reads the report must be governed accordingly. In 
some instances the auditor will certify as to the ac- 
curacy of the extensions and footings and thus assume 
responsibility solely for this part of the inventory. 

6. An auditor is not entirely absolved by qualifica- 
tions from responsibility. — Even here the auditor is 
not absolved from all responsibility for, if anything 
arises during the course of his investigation which 
would lead him to believe that the officers were at- 
tempting to commit fraud in respect of the inventory 
or any other asset, it is clearly his duty to decline to 
give even a qualified certificate. Inasmuch as an 
auditor cannot control the use of his report after it 
leaves his hands, it is questionable whether or not he 
has relieved himself of his moral responsibility even 
tho he may have absolved himself from all legal re- 
sponsibility by adroitly wording his qualifying cer- 
tificate. An auditor should certainly refuse his cer- 
tificate in cases where fraud has been attempted by 
the management for the reason that while the firm 
may agree to re-state values in those cases in which 
the auditor has discovered inflation, he will not always 
be able to ferret out all ingeniously laid schemes of 
fraud and he may thus pass over other frauds. 

7. Etvamples of attempted fraud. — Not long ago, 
in the city of New York, the management of an 
American branch of a European concern was sued 
by a salesman for breach of contract. The verdict of 
the court was in favor of the salesman and judgment 


was given to the amount of $13,000. The local man- 
agement paid the amount of the damages but charged 
the amount thereof to a personal account in the name 
of the salesman. In the trial balance submitted each 
month to the European headquarters, the amount 
paid out was reported as an account receivable. A 
firm of auditors, upon being called to investigate, 
was requested to certify to the balance sheet and when 
this item was discovered very properly declined to 
give a certificate. It subsequently developed that the 
management of the branch had also grossly over- 
valued the inventory, thereby concealing operating 
losses in the year under investigation amounting to 

In one of the recent consolidations underwritten by 
a firm of Eastern bankers, a firm of auditors was in- 
trusted with the duty of preparing balance sheets of 
the various concerns to be amalgamated for the pur- 
pose of determining the basis upon which each con- 
cern was to be taken into the consolidation. While 
auditing the accounts of one of the concerns, the firm 
of auditors was obliged to transfer the principal in 
charge of the engagement to another station and his 
successor accepted the valuation of the inventory 
without sufficient investigation. When the consolida- 
tion finally took place, inventory values to the ex- 
tent of $1,000,000 could not be located and the 
bankers underwriting the consolidation were com- 
pelled to put into the business an equivalent amount 
of cash to protect their own reputation as well as to 


protect clients who purchased securities upon their 

8. Auditor s report regarding statement of re- 
sponsibility as to trade debts. — If the report of the 
auditor contains an unqualified certificate in respect 
of the amount due from customers both on open ac- 
counts and notes, it may be assumed that not only has 
the auditor verified the amount, but that he has made 
adequate provision for all doubtful debts. Absolute 
verification of the amount due can only be obtained 
from the debtor, thru the medium of confirmation 
statements. In many instances, clients object to this 
practice of obtaining confirmation statements from 
their customers, under which circumstances the au- 
ditor cannot give an unqualified certificate. In these 
cases, other methods of verification are open to him. 
In the absence of any suspicious circumstances the 
auditor is justified in accepting the amount as stated 
in the ledger account. He will probably certify to 
the fact that, having made a test of the "accounts re- 
ceivable" and having reconciled the customers' ledgers 
with the respective controlling accounts, they appear 
to be properly stated. He will also probably com- 
ment upon the sufficiency of the provision for doubt- 
ful debts. 

9. Interpretation of phrase '^properly drawn up/* 
— The certificate of the auditor implies also that the 
balance sheet which he prepares has been drawn up 
in such a manner as to exhibit truthfully the financial 
condition of the undertaking. The term "properly 


drawn up" implies that the amounts due from trade 
debtors are not to be merged with the amounts due 
for the loans made to officers or stockholders of the 
undertaking, or to partners. It does not include 
amounts due from stockholders on unpaid subscrip- 
tions to the capital stock of the undertaking. 

Thus, the term "accounts receivable," while ordi- 
narily a broader term than that of "trade debtors" or 
"customers' accounts" should include under it only 
those amounts due from trade debtors. 

10. Omission to furnish auditor s certificate in pub- 
lished report. — The reader has undoubtedly noted 
statements in a prospectus or in the report of a com- 
pany to the effect that the accounts of a company have 
been audited by Messrs. Blank and Company, Certi- 
fied Public Accountants. The mere statement, unac- 
companied by a publication of the auditor's certificate, 
that the accounts of a company have been audited, 
should be viewed with suspicion. The auditors may 
have made all manner of qualifications in their report 
of which the stockholders, investors or creditors would 
be ignorant unless they adopted the rather unusual 
step of demanding a copy of the report. 

A dishonest board of directors may put forth a bal- 
ance sheet which, while purposely misleading, may be 
issued in such a manner as to prevent the directors' 
indictment for fraud; at the same time the statement 
may be made that the accounts of the company have 
been audited by reliable accountants. The layman, 


in the majority of cases, would be deceived by this 

11. M eagerness of information in published re- 
ports. — Criticism is sometimes heard of the meager- 
ness of information disclosed in published reports of 
auditors. It must be borne in mind that published re- 
ports should not disclose, concerning the affairs of an 
undertaking, such information as would be to the ad- 
vantage of competitors. Even tho the report may be 
meager in respect of the information disclosed, the 
stockholders may be reassured if the published bal- 
ance sheet is that of a reliable firm of auditors and if 
a favorable or unqualified certificate df the auditor is 
attached. The auditors can be depended upon to pre- 
pare such statements as the stockholders ought to 
have but which, at the same time, will not disclose 
information of vital importance to competitors. 
Hence, it is, that stockholders or creditors should con- 
sider seriously the nature of the auditor's certificate 
where the published report fails to give sufficient in- 
formation as will enable one to analyze the financial 
condition of the undertaking. 

12. Certificate of profit. — Not infrequently one 
finds in a prospectus issued to aid in the sale of se- 
curities, a statement to the effect that, based upon a 
report prepared by INIessrs. Blank and Company, 
auditors, the profit will be sufficient to provide for 
twice the amount necessary to meet interest on bonded 
debt and sinking fund charges. 



The reader must bear in mind that Messrs. Blank 
and Company, the auditors, may not have made this 
unquahfied statement, but the promoters or managers 
of the undertaking may have drawn a conclusion from 
a certificate of profit or a report prepared by the 
auditors. It is doubtful if any reliable firm of audit- 
ors would permit their own certificate of profit to be 
used for such speculative prediction. Auditors are 
justified, however, in preparing a report for the pro- 
moter or manager; the latter assumes all responsi- 
bility for the conclusions which are drawn from such 
a report. The investor must clearly understand that 
the auditors are not certifying to the profit to be 
realized in the future. 

In preparing a statement of profits, an auditor is 
justified in eliminating certain items which may ap- 
pear in the profit-and-loss account of an undertaking. 
In the first place, he may eliminate all sums paid for 
borrowed funds, on the theory that the concern in- 
tends to raise an amount of owned capital sufficient in 
amount to avoid the necessity of borrowing money. 
The sum paid for interest on borrowed capital is a 
penalty for not having a sufficient amount of owned 
capital in the business. Furthermore, the auditors 
may, for the benefit of the promoter, estimate the sav- 
ings to be anticipated as a result of combination thru 
the consolidation of selling activities and the elimina- 
tion of a great deal of the administrative expense. It 
has often happened, however, that these anticipated 
economies have not been realized and good-will based 


upon the anticipated saving in many instances has 
been greatly over-valued. 

13. Reports of airpraisers. — From time to time the 
necessity has arisen, from one cause or another, of 
determining the present-day value of mercantile prop- 
erty. The great variety of property to be valued has 
resulted in the creation of several large appraisal 
companies which have gathered together a force of ex- 
perienced engineers and valuers. These companies 
render a valuable service to the business community, 
and business undertakings are beginning to appre- 
ciate the value of the service rendered. 

The reader has already seen that the problem of 
depreciation is one of the most difficult which account- 
ants and business men are called upon to face. In 
order that it may be known whether or not proper 
provision is being made for depreciation, it is neces- 
sary to confirm by an appraisal the adequacy of the 
rates that are being used in depreciating the fixed as- 
sets of a business undertaking. 

In public utilities the question of a fair rate of 
return on the investment necessitates an appraisal of 
the fixed property used in rendering the service to 
the community for the purpose of determining the 
principal sum upon which the rate of return is to be 

The capital accounts of other business undertakings 
may have been kept in a haphazard manner and the 
clear differentiation between revenue and capital 
charges may not always have been observed. Hence, 


the necessity of determining the actual value of the 
investment in fixed assets by means of a disinter- 
ested appraisal. 

The purchaser of a business would be very unwise 
to take for granted that the book value of the physi- 
cal assets, subject to depreciation, was the actual value 
and in purchasing property of this character, the cost 
of an appraisal may be regarded as a very cheap form 
of insurance. 

Business men who may, perhaps, have had an un- 
satisfactory experience with insurance adjusters at 
the time of a fire loss realize the comparative ease with 
which their claims for loss may be proved if such 
claims are supported by a disinterested appraisal of 
competent valuers. 

14. Basis of valuation. — Appraisal companies gen- 
erally attempt to determine the value of physical as- 
sets at the cost of reproduction under present day 
prices for material and labor after deducting the fair 
amount for depreciation sustained since the acquisi- 
tion of the asset. In addition, the appraisers will 
usually indicate the insurable value which is the cost 
of reproduction less physical depreciation with a fur- 
ther deduction for the value of that portion of the 
physical assets which is not the subject matter of in- 
surance, such as foundations and excavations and sub- 
soil structures. Provision is made for keeping the 
appraisal up to date by furnishing the company with 
a list of all after-acquired assets, and re-appraisals 
are usually made at periodic intervals. 


15. Adjustment of book values to appraised values. 
— If the aj^praisal of property discloses that the value 
of any unit is less than the cost value as reduced by 
the accrued depreciation thereof, the book value should 
be adjusted to the appraised value. If the appraised 
value discloses the fact that the present-day value, 
at the cost of reproduction, is in excess of the cost less 
accrued depreciation, it would not be conservative 
practice to adjust the book value to the increased ap- 
praised value. It is not considered good practice to 
swell surplus accounts in this manner. It would be 
better to reduce the rate of depreciation in subsequent 
periods as the higher value indicates that excessive 
depreciation is being provided for. 

In this connection, however, consideration must be 
given to the fact that appraisers are generally in- 
fluenced in their consideration of value by the present- 
day costs of raw material and labor. These may be 
higher or lower than the respective costs at the time 
the assets were acquired. As has been stated, the ac- 
countants support the cost theory of value rather than 
the theory of cost of reproduction. The results shown 
by the appraisal should, as a general rule, be used only 
to correct the values of assets which appear to be 
over-stated but should not be used to change the value 
of assets which appear to be under-stated. 

The appraisal also serves to justify the values en- 
tered for fixed assets in a proof of claim in fire losses 
because a contract of insurance is n contract of indem- 
nity and the insured is entitled to recover from the in- 


surer the value of the property destroyed at the time 
of fire. 

16. Reports of engineers. — Tlie reader may be 
called upon to base his executive judgment upon the 
report of an engineer and the same care should be used 
in the interpretation of a report of this character as 
is used in interpreting the report of an auditor. The 
value of the report of an engineer depends, in large 
measure, upon his experience. In the majority of 
cases, his conclusions are subject to adjustments be- 
cause of the greater number of variables involved. 
This is especially true of mining engineering. An 
engineer's report should be prepared in collaboration 
with that of a competent geologist. 

Another important point to be borne in mind is 
that the report of the auditor usually deals with con- 
clusions based upon known facts of past experience. 
The engineer is called upon to deal with problems 
more or less speculative in their nature.- Therefore, 
there is more necessity on the latter's part for extreme 
caution in interpreting facts and determining future 
results. A liberal allowance for possible error on the 
engineer's estimates of costs should be provided for; 
it is a well-known fact that many engineers have an 
inadequate conception of costs and accounts. 

17. Conclusion. — ^The value of any report depends 
primarily upon the factors of the experience, judg- 
ment and integrity of the professional man who ren- 
ders it. Conclusions based upon proven facts should 



be clearly distinguished from opinions based upon 
speculative deductions. 


What may the auditor's certificate contain, and why should 
its wording, its contents and omission be carefully scrutinized? 

What responsibility may an auditor properly assume as re- 
spects inventories and accounts receivable? 

Meet the objection that the auditors' published reports usually 
give scanty information. Should an auditor certify to probable 
profit and if so under what conditions? 

What is the function of appraisal companies? 


Accountant, the, and the Law, 87 

Accounting Practice at Variance with 
the Law, 88 

' 'Accounting Practice and Auditing, ' ' 
53, 305 

Accounting, Principles of, Fixed un 
der all conditions, 83 

Accounting Systems, Impracticability 
of single type, 7 

Accounts, Expense, See Expense Ac- 

Accounts Receivable, 

Schedule of, 36-37; In auditor's 
certificate, 311 

Acquired Companies, Methods of 
treating surplus accounts of, 255 

Additions, Of buildings, 110 

Administrative Expenses, 73 

Advertising Expense, 

Items included in, 70-71 ; Treat- 
ment in balance sheet, 71 

Analyses, Sales, 39-40 

Analysis and Interpretation of In- 
come Statements, 48-68, 69 

Analytical Expense Statements, ] 9 

Annuity, In connection with lease, 

Appraisal, And revaluation, 204 

Appraiser's Report, 

Depreciation allowance, 315-16; 
Necessity for, 315; Basis of 
valuation, 316-17; Book value 
of assets, 316; Cheap form of 
insurance, 316; Cost of raw ma- 
terial and labor, 316-17; Keep- 
ing up to date, 316; Value in 
fire loss, 316-18; Adjustment of 
book and appraisal values, 317- 
18; Cost theory of valuation. 317; 
Fixed assets, 317-18 

Appreciation, Of land, 107 


Current, and current liabilities, 
189; And suri)lus, 196; Fixed, 
surplus from sale of, 201-03; 
Total invested, relation of net 
income to, 228-29 ; Invested, 
ratios based on, proi)er for com- 
parison, 229; And working capi- 
tal, 230-31; Quick, amount re- 
quired by corporations, 232 

Assets — continued 

See Current Assets, Fixed Assets, 
Intangible Assets 

Assets, Capital, See Fixed Assets 

Auditor, Certificate of, 

Two forms of, 305-06; Balance 
sheet, 306; Confidence in, 306- 
07; No guarantee as to financial 
responsibility, 306; Real prop- 
erty, 306 ; Valuation of fixed as- 
sets, 306-07; Value, 306-07; 
Inventories as valued in, 307— 
08 ; If inventory is unreliable, 
308; Possible qualifications of 
308-09; Responsibility for, 308; 
In cases of fraud, 309-11; In- 
flated value, cause for refusing, 
309; When to be declined, 309- 
11; Confirmation statements, 311; 
Methods of verification of trade 
debts, 311; "Properly drawn up," 
311-12; Trade debts, 311; Omis- 
sion of, 312-13; Careful consid- 
eration should be given nature of, 

Auditor, Certificate of profit of. 
Not for speculative predictions, 
313-15; Res[)onsibility for con- 
clusions drawn from, 314 

Auditor, Report of, See Auditor, Cer- 
tificate of 

Auditor, Responsibility for Certificate, 

Auxiliary Statements, 36 

Balance Sheet, 

Princii)al financial statement, 4; Of 
holding company, 87; Should 
show financial condition, 87; 
Combined, 90; Consolidated, 90; 
Of subsidiaries, 95 ; Special fac- 
tors in interpretation of, 114— 
16; Good-will, 133; And contin- 
gent liabilities, 188; Contingent 
assets, consolidated, 230-37; 

Consolidated and par value of 
stock, 250; "Properly drawn 
u])." 311-12; Auditor's certifi- 
cate, 306; May be purposely mis- 
leading, 312-13 




Bankers, Investments of, 143-44 

Bauer, John, On good- will, 131 

Betterments of Buildings, 110 


Mining companies, 105 ; Discounts 
allowed on issue of, 167-68; 
Methods of disjiosing of bond dis- 
count, 168-69 ; Premiums, 
See, Investment 

Bondholders, And relation between 
current assets and current lia- 
bilities, 189 

Book Value, 

Not always actual value, 317; Ad- 
justment to appraisal value, 317— 

Brokers, Investments of, 143-44 


Purpose and definition oi, 273; An- 
nual, 273-74; Production and, 

Budgets, County, State and Federal, 

Budgets, Municipal, 

Development, 289; Differentiated 
as compared to private, 289-90; 
Definition, 290 ; Taxpayers and 
the, 290; And the department 
head, 290-91; Function, 291- 
92; Old-time, 292-93; Modern, 
293; Segregated, 293-94; Lump 
sum, its advantages and disad- 
vantages, 294-95 ; Lump sum, a 
variation of, 295; Essentials in 
prei)aration, 295-96 ; Necessary 
legal foundation, 296-97; Ac- 
counting and statistics in rela- 
tion to, 297-98; Machinery of, 
298-99; Tax rate and the, 299- 
300 ; Transfers and changes in, 
300; Unforeseen needs, 300-01; 
Interpretation, 301-03; Scope, 

Budgets, Private, 

Regular, or general and depart 
mental, 273-75; Puri)ose of spe 
cial, 274; Subdivision, 276; Pre 
requisites, 276-77; Routine con 
nected with, 277; Sales depart 
ment, 278; Based on experience, 
278; On four-week basis, 278- 
79; Production department, 279— 
80; Assembling data, 280-82; 
Considerations affecting, 281; 
284-85; Four factors, 281; 
Accounting records, 282 ; Finan- 
cial guides, 283 ; Interim check 
on, 283-84; Checking data as- 
sembled in, 282 ; Income state- 

Budgets, Private — continued 

ment, 285; Departmental, stand- 
ards for, 286 


Distinct from land, 100-01; Cost 
of conslrnctioii. 107-8; Valua- 
tion, 107-08 ; Two theories for 
loss from demolition, 109 ; Ad- 
ditions, betterments, repairs, re- 
]]lacements, renewals, 110 

Business, Division of Profitable. 92 

Business Organization, Effect of out- 
siflp factors on, 3 

Business Statistics, 

Meaning, 13 ; Purpose and scope, 
13—14; Distinguished from gov- 
ernment, 14; Contents, 15-16; 
Uses, 16 

By-Products, Separate account for 
sales of, 52-53 


EfTect of charging items to revenue 
account, 76 ; Impairment, 80 ; 
Dividends out of, 87, 93 ; Rev- 
enue expenditure distinguished, 
196-97; Exjienditures charged 
against surjjlus. 214-15; Bor- 
rowed, in auditor's certificate, 
314; Differentiation from rev- 
enue, 315 16 
.<?»'p Working Capital 

Capital Assets, See Fixed Assets 

Capital Stock, 

Discount on sale of, 166; Relation 
of net income to, 226-28 


Of carrying charges on land invest- 
ments, 102; Of land improve- 
ments, 103 ; Furniture and fix- 
tures, 112 

Capitalized Surplus, 

Nature, 254; Various phases, 255— 
57; Liquidation of investment, 
256; Of holding companies, four 
kinds of, 255; When set under 
separate headings, 257; Subsid- 
iary company, 257; Illustrations 
of, 257-58 

Cash in Bank, What may be consid- 
ered as, 139 

Cash on Hand, Definition. 139 

Cash Report, Contents of. 41 

Certificate of Auditor, Sec Auditor, 
Certificate of 

Charges, Transportation, Element of 
cost, 60 

Classified Information, 

Importance, 1 ; Need for, 1 ; Meas- 



Classified Information — continued 

uri' of efficiency, 2 ; In determin- 
ing business iioHcies, 2 ; Influ- 
ence on legislation, 11 
ComBined Balance Sheet, 90 
Companies, Parent, distinguished 
from holding, 83-84 
See Holding Company- 
Company Reports, 

Often meager information, 313; 

Omission of auditor's certificate, 

312; Misleading balance sheet, 

312; Certificate of profit, 313-14 


Statistical, 22; Establishing stand- 
ards of, 25-26; Value, 41-42; 
Of sales and inventory, 57-58; 
Ratios based on invested assets 
should be used for, 229; Of 
actual results and costs with pre- 
determined results and costs, 
Confirmation Statements, 311 
Consolidated Balance Sheet, 90, 237- 

38, 26H-69 
Consolidated Gas Company, 123 
Consolidated Statements, 

What they show, 90 ; Necessary to 
disclose certain factors, 92; Dif- 
ferent from consolidation of state- 
ments, 91; Possible legal basis 
for, 238-39; Individual com- 
panies, 259 ; Overcoming disad- 
vantages of, 260; Interpreta- 
tion, 260-61; Individual income 
statements, 261; Various forms, 
263-72; Of income and profit and 
loss, 265-72 

Good-will, 132; Advantages, 237; 
Consolidated balance sheet, 237— 
Construction, Inter-company i)rofits on, 

Containers, Not credited to sales ac- 
count, 56—57 
Copyrights, Valuation, 134-37 
Corporation Stock and Treasury 

Stock, 173-74 

Subsidiary, 84; Profits distributed 
only by board of directors, 86 ; 
Profits, 130-31; Insurance funds, 
224 ; Quick assets required by, 

Definition, 59 ; Distinguished from 
expense, 59; Elements of, 60-61; 
Of goods sold, 64-65 ; Of manu- 
facture distinguished from cost 

Cost — continued 

of sales, 64—65 ; Land improve- 
ments, 103 ; Building construc- 
tion, 107-08; England: Dividends 
on construction, 109 ; Interest on 
construction, 109 ; Depreciation 
as element of, 197—98; Income 
confused, 235-36; Carrying in- 
vestment at original, 239 ; Rec- 
ords, prerequisite of budget, 
276-77; Interim reconciliation of 
estimate with, 274; Comparison 
of actual, with predetermined, in 
final statement, 274 

Cost-Finding, 59, 64, 69-70 


Disposition of donation reserve, 
175; Risk viewpoint concerning 
individual statements, 262 


Relation between current assets and 
current liabilities, 189 ; Trade, 
185 ; Of a business enterprise, 
four classes, 232-33; Of a busi- 
ness enterprise, economic status 
of, 232-33 

Current Assets, 

Value and interpretation of, 139— 
163 ; Advances to subsidiaries, 
94; Cash in bank, 139; Cash on 
hand, 139; Definition, 139; Over- 
drafts, 140 ; Stocks and bonds, 
141-44; Notes receivable, 147— 
49; Kinds of accounts, 149—51; 
Bad accounts, 149 ; Doubtful ac- 
counts, 149 ; Good accounts, 149 ; 
"Aging" accounts, 150; Treat- 
ment of bad accounts, 150-52 ; 
Inventory, 155 ; Right relation 
with current liabilities, 161-62, 
189; Creditors, 189; Bondhold- 
ers, 189 
See Interest, Investment 

Current Liabilities, See Current As- 
sets, Liabilities 

Customers, Statements of new, 37-38 

Dawson, S. S., 54 

Funded, 180; Unfunded, 180; 
Bonded, 180-83 ; Mortgage, 181- 

Reserve for bad and doubtful, 153- 
54; Bad, and auditor's certificate, 
311; Trade, 311-12 
Deferred Assets, 

Meaning, 164-65; Examples, 170- 




Devices to avoid showing, 81; 
Treatment in sub-companies, 253 

Delivery Expense, Distribution, 72-73 

Departmental Statements, 
Value, 6 ; Analytical, 19 


Land, 107; Failure to provide for, 
113; General problem, 113—14; 
Reserves, 114; Equipment, 117; 
Element of cost, 197-98; Impor- 
tance of making adequate pro- 
vision for, 253; Difficulty of 
problem, 315 

Dickinson, A. L., On profits, 130-31 

Directors, Board of, Only ones to dis- 
tribute profits, 212; Dishonesty, 


Value of statement of, 42 ; Distin- 
guished from expenditures, 59 


Trade, on sales, 50-51; Cash on 
purchase, 61-62 ; Advantage of 
cash, 62 ; Quantity, on jiurcliases, 
69; Cash, on sales, 77-78; On 
sale of capital stock, 166; Al- 
lowed on bond issues, 167—68 ; 
On investments, 252-53 


From surplus, 75-76 ; Out of capi- 
tal, 81, 93 ; When a return of 
capital investment, 106; Distri- 
bution, 212; Closing out divi< 
dendpayable account, 212; Char- 
acteristics, 212-13; Declaration, 
214; Illegal types, 216; Illegal, 
and stockholders, 215; Scrip, 
216; Policies, 216-17; Treat- 
ment of, 240-41 ; Sei>arate sur- 
plus account, 241 ; Unpaid cumu- 
lative, of subsidiaries, 258 

Earning Power, Good-will and, 123 

Earnings, Gross, See Gross Earnings 

Engineer, Eeport of. 

Allowance for error, 318; Collabora- 
tion with geologist, 318; Knowl- 
edge of costs and accounts, 318; 
'Mining, 318; Speculative prob- 
lems, 318; Value, depends on ex- 
perience, 318 

England, Dividends on Construction 
cost, 109 

Entries, To record increase due to eco- 
nomic causes, 206 


Short life, 111-12; Stable and gar- 
age, 113; Purchase on partial 

Equipment — continued 

payment, 116; Depreciation, 117; 
Investment should be segregated, 

Equity, In surplus, 240 ♦ 

Estimates, Value and use of, 274-75 

Expenditures, Distinguished from dis- 
bursements, 59—60; Revenue, 
and surplus, 197 


Operating, 49; Non-operating, 49; 
Distinguished from cost, 59 ; Def- 
inition, 59 ; Distribution among 
dejjartments, 60-61 ; Borrowed 
funds, non-operating, 62 ; Organ- 
ization, 165-66 
See Administrative, Expense, Adver- 
tising Expense, Delivery Expense, 
Operating Expense, Selling Ex- 

Expense Accounts, 

Desirability of classification, 41 ; 
Sufficient number should be pro- 
vided, 41 

Expense Schedules, 40-41 

"Factory and Office Administration," 

Federal Income Tax, 185 

Final Statement, 2 74 

Financial Statement, 

Interpretation, 3; Classification, 4; 
Importance to executives, 6—7, 
10 ; Purpose, 6 ; Comparative, 7— 
8; Requisites, 7; Influence of 
outside factors on, 9 ; Importance 
to stockholders, 10 ; Pertinent 
facts in, 89 

Fire Loss, Claims aided by auditor's 
certificate, 306 

Fixed Assets, 

Value and interpretation of, 100— 
119; Increase in value, 86, 205— 
06; Definition, 100; Land dis- 
tinguished from buildings, 100— 
01; Real estate, 100; Surplus 
from sale of, 201-03, 207-08 
Auditor's certificate, 306-07 
Valuation in appraiser's report, 
See Buildings, Equipment, Furni- 
ture, Land 


Capitalization, 112; Valuation, 112 

Fraud, Auditor should refuse certifi- 
cate in case of, 309—11 

Freight, Outward, method of treating, 

Fuel, How charged, 63 




Distinguished from reserves, 220— 
21; Insurance, 224 

Capitalization, 112 ; Valuation, 112 

General Summary, 45 
Geologist, Should collaborate with 
mining engineer, 318 


Definition, 120-21; Guthrie, 120- 
21 ; Depends on reputation and 
integrity, 121-22; Value of, de- 
pendent on location, 121; Created 
by monopolies, 120; Public serv- 
ice companies, 122-23 ; Used as a 
subterfuge, 122 ; Consolidated 
Gas Company, 123 ; Earning pow- 
er, 123 ; Method of valuing, 124- 
26; Personality, 124; Transfer- 
ability, 124; Extraordinary prof- 
its, 126 ; Factors to be eliminated 
in valuing, 126-28; Fictitious, 
128; Mathematical steps, 128; 
When created, 129 ; Dickinson, 
A. L., 130-31; Is it a fluctuating 
value f 130; Bauer, John, 131; 
Adjustment in consolidation, 132 ; 
In consolidated balance sheet, 
133 ; Valuation of patents, trade- 
marks, copyrights, 134-38 

Goods Returned, 50-51 

Graphic Bepresentations, 

Use of, in statements, 28-29; Dis- 
advantages, 29 ; Cautions in use 
of, 29-31; Use of curves, 31-32; 
Cautions in preparing line charts, 

Graphic Statements, 28-299 

Gross Earnings, Indications from, 74 

Gross Income, 49-50 

Gross Sales, 49-50 

Guthrie, 120-21 

Heat, Light and Power Account, Dis- 
tribution of, 63-64 
Holding Company, 

Assets, 84; Purpose, 84-85; Bal- 
ance sheet, 87; Relation to sub- 
sidiary, 89 ; Inadequate state- 
ment, 91; Dividends, 201; State- 
ment of subsidiarv, 264-65 

Impairment of Capital, 80 
Income, Primary, 48 ; Secondary, 48 ; 
Percentages, 53 ; Miscellaneous, 

Income — continued 

57; Defined from each stand- 
point, 60 ; Borrowed funds a de- 
duction from, 62; Other, 76-77; 
Federal, tax, 185; Deferred lia- 
bilities, 186-87; Profit and loss 
statement, and balance sheet, 
190-94; Cost and, confused, 235- 
Income, Charges, 

Insurance, 77 ; Royalties, 77 
Income, Gross, See Gross Income 
Income, Net, Interpretation, 75-76; 

See Net Income 
Income Statement, 

General divisions, 48-49; Factors 
not disclosed, 92 
Individual Statements, 

Value, to managing officials, 261- 
62; Comparative, and compara- 
tive consolidation statements, 
Inflation of Inventory Values, 235, 

Statistical, 4 

See Classified Information 
Initial Surplus, Distribution of, 208 
Instalment Sales, 57-58 

Included in income charges, 77 
Distribution, 78 ; Adequate to 
meet loss, 224; Corporations 
224; Appraisal, cheap form of 
Insurance Companies, Investment of 

Intangible Assets, Value and inter 
pretation of, 120-139; Good-wiU, 
120-21; Guthrie, 120-21; Valua- 
tion of patents, trade-marks and 
copyrights, 134-38 
See Good-will 

On borrowed funds included in in- 
come charges, 77; On construc- 
tion cost, 109; On notes or ac- 
counts receivable, 152; Bond, 
169; On capital, 233-34; Time 
element, 234; On borrowed capi- 
tal in auditor's certificate, 314- 
Inter-company, The, 

Construction work, 95 ; Illustration 
of transactions, 95; Profit, 98; 
Surplus, 198-200 

Purchase records and, should be 
available, 18-19; Contents of rec- 
ord 18-19; Value of schedule 



Inventory — continued 

3S-39; Final, compared with 
sales, 57-58; Inflated, 58, 82, 
235, 307; Inter-company, 97-98, 
198-200; Description, 155; At 
cost or market price, 156; Trad- 
ing concern, 156; Raw material 
and manufacturing concern, 157; 
Possible deductions from valua- 
tions, 159-61; Valuation in au- 
ditor's certificate, 307-08; Pro- 
cedure when reliable, 308— 


In land, 102; In equipment, should 
be segregated, 110; Machinery 
and fixed tools, 111-12; Classi- 
fication of permanent, 121-22; 
Stocks and bonds, 141-44; Out- 
side comjianies, 142 ; Stocks of 
allied companies, 142 ; Bankers' 
and Brokers', 143-44 ; Insurance 
companies, 143 ; Treatment of 
stocks and bonds, 144; Mining 
stocks, 146 ; Timber stocks, 147 ; 
Carrying less than control, 239 ; 
Carrying at original cost, 239 ; 
Periodic revaluation, 239 ; At 
cost, objection to, 241 ; Revalua- 
tion complicated, 241-42; Pre- 
miums, 250-52; Discount on, 252— 
53 ; Viewpoint concerning state- 
ments, 262-63 

Investment Companies, Investments 
of, 143 


Definition, 62 ; Items included in, 
62 ; Cost in appraiser's report, 

Holdings, profits from sale of, 57; 
Distinguished from buildings, 
100-01; Improvement cost, 101, 
103 ; Held as an investment, 
101; Valuation of plant, 101; In- 
vestment in, 102 ; Treated as 
stock in trade, 102-03 ; Capital- 
ization of improvements, 103 ; 
Valuation of leasehold rights, 
104; Mineral and timber, 105; 
Reserve for loss in value, 107 ; 
Depreciation and appreciation, 
Law, The 

And the accountant, 87; At vari- 
ance with accounting practice. 


Valuation of rights, 104; Income 
from an annuity, 105 

Legislation, and Municipal Budgets, 


Service, api)ortionment, 55-56 ; De- 
fined and classified, 179-80; 
American practice, 179; Ratio of 
current assets to current, 186; 
Deferred, or deferred credit to 
income, 186-87; Kinds, 186-87; 
Contingent, 187-88 ; Contingent, 
offset by contingent assets, 187— 
88; Contingent, and the balance 
sheet, 188; Conclusions, 188-94 

Logan, James, 46-47 

Lump Sum. jS'ee Budgets, Municipal 

Machinery, Investment in, 111-12 

Maintenance, Charges for, 70 

Management, Dishonest, 92 

Manipulation 92 

Manufacturing Concern, Inventory of 
raw material, 157 

Margin, Treatment of, 145-46 

Mechanical Devices, Use in Preparing 
Statistics, 14 

Mining Companies, 

Bonds, 105; Sinking fund, 105; In- 
vestment in stocks of, 146 ; En- 
gineer's report, 318. 

Minority Interests, 

Oppressive tactics against, 242-48; 
Protection, 254; Surjilus, consoli- 
dated statements, and, 254 

Monopolies, Good-will created by, 122 


And dibt, 181-82; Debts and bonds, 
183-84; Chattel, and title, 183- 
84; Real estate, 183 

Municipal Budgets, See Budgets, Mu- 

Net Income, 

Interpretation, 75-76; Amount re- 
quired by bondholders, 75 ; Re- 
lation to capital stock, 226-27; 
Ratio, to cajiital stock, 228; 
Ratio, to total invested assets, 

Net Profits, Transfer, 80 

Non-operating Expenses, 49 


From customers, 38; Promissory, 

Notes Payable, 41, 184-85 



Notes Eeceivable, 

Schedule of, included in cash report, 
41 ; Classes, 147-49 ; Interest, 

Operating Expense, 49, 74-75 
Orders and Sales, Record of, 17-18 
< rganization, Kxpcnses, 165—66 
Other Income, Items included in, 76- 

Outside Factors, Influence in Business 

Statements, 9 
Overdrafts, 140 
Overvaluation, Of assets, on auditor's 

certificate, 306 

Parent Company, 83 et seq., 200-01 

Partial Payment, Equipment, 116 


Profits from sale of, 57; Valuation, 

Percentage Statement, Value of, 19- 


Cautions in use of, 26-27; Use in 
comparative statements, 26; Cal- 
culation of, in income account, 
53 ; Must be on correct basis. 65- 
66 ; Illustration of correct basis, 

Personal Element, Importance of, 8-9 

Personality, And goodwill, 124 

Preferred Stock, Unjiaid Dividends 
on cumulative, 185 


On bonds, 169; On investment, 
methods of carrying, 250-52 

Prepaid Charges, Credited to sales ac- 
count. 52 

Price, Selling, as basis of percentage 
of profit, 53 

Primary Income, 48 

Private Budgets, 

Nature and function, 273-286; 

Means of guidance. 275 
Sre Budgets, Privjitc 


Relation to budgets, 279-80; Re- 
ports, 39 

Professional Reports, 

"Accounting Practice and Audit- 
ing," 305; Auditor's certificate, 
305-06; Interpretation, 305-09; 
Unjust criticism, 305 ; Proven 
facts disfinsruished from specu- 
lative, 318-19; Value, 318-19 
Sec Auditor. Certificate of; Engineer, 
Report of, etc. 

Profit and Loss, 

Statements, 4 ; Departmental, 19 ; 
Credits and charges to, 79-80; 
Income, 190-94 


Branch, 10; Place in accounts, 57; 
Selling, 73-74; Net, 73-74, 80; 
Corporation, 86, 130-31; Dis- 
tributed only by directors, 86; 
Inter-comi)any, ' 98 ; Extraordi- 
nary, eliminated in valuing good- 
will, 126; Dickinson, A. L., 130- 
31; Intercompany, inventory and 
suri)lus, 198-200 ; Fixed assets 
revalued, 203-04; Sinking fund, 

Promissory Notes, 184 

"Properly Drawn Up," Explanation, 


Intangible, concerning value of, 
204; Accounts, and revaluation, 
204-05; Report on mercantile, 


Reduction partnerships, 81; De- 
ferred credits to income, 187 

Prospectus, See Comi)any Reports. 

Public Service Companies, 122-23 

Public Utilities, Appraisal of fixed 
property necessary for, 315 


Finished parts. 69; Raw materials, 
69; Returned, 69-70 

Quick Assets, See Assets 

Rate, Difficulty of Selecting Correct, 

Ratio, Use of in in statement, 27-28; 

Comparisons, 229 
Raw Material, 

Purchases, 69; Inventory, 157; Cost, 

in appraiser's report, 316-17 
Real Property, See Auditor, Certificate 

of, Fixed Assets; Land 
Rebates, Allowed to customers, 71-72 
Receipts and Disbursements, Value 

of statement of, 42 

Orders, 17-18; Purchase. 18; Sales, 


Charges for, 70; Buildings, 110 
Rent, Items included under, 77 

Charges for, 70; Buildings. 110 
Replacement, Of buildings. 110 
Reports, Company, See Company Re- 
ports, Professional Reports, etc. 




For capitalization charges on 
carrying land, 103-04; Secret, 
113," 208-09, 209-11; Deprecia- 
tion, 114; For bad aud doubtful 
debts, 153-54; That is not part 
of surplus, 198 ; Created out of 
surplus, 215 ; Reserve account 
misnamed, 215; Distinguished 
from funds, 220-21 


Comparison, 22-25; By year, 22-23; 
by months, 23; By week, 23-24; 
By day, 24-25 


Profits from fixed assets, 203-04; 
Ai)praisal and, 204, 317; Invest- 
ment, subject to complications, 

Revenue, Effect of charging items to 
capital, 76 

Royalties, Included in income charges, 

Salaries, And wages accrued, 185 


Analyses, 39-40; Record of, 17-18; 
Contents of sales records, 49—50 ; 
Trade discount on, 50—51; Sejia- 
rate account for scraj) of by-jirod- 
uct, 52-53 ; Instalment, 56 ; 
Comparison with amount of final 
inyentory, 57-58; Relation of 
budgets to, 278 

Sales Account, Credits to, 49 

Sales, Gross, See Gross Sales 


Accounts receivable. 36-37; In- 
ventory, 38-39; Expense, 40-41 

Scrap, Separate account for sales of, 

Secondary Income, 48 

Secret Reserve, 113, 208-11 


Purchased for speculation, 145; 
Valuation, 147 

Selling Expense, Items included in, 
70, 72 

Sinking Fund, 
.Mining company, 105; Tlieory, 218- 
19; Reserve, a charge against 
profits, 219-20; Proper, 221; In- 
vestment of, 221-22; Reserve 
fund investments, 22—24 

Speculation, Purchase of securities, 


Income, 4 ; Statistical, 4 ; Profit 

Statements — continued 

and loss, 4 ; Departmental, 5-6 ; 
Analytical exijense, 19 ; Depart- 
mental profit and loss, 19 ; Analy- 
sis of sales, 25-26; Graphic, 28- 
29; Of new customers, 37-3H; 
False impressions from, 42-45 ; 
Dangers of inaccuracy in, 42-43 ; 
Intentional misrepresentation, 

43-44; Incorrect preparation of, 
44—45 ; Preparation of, for exec- 
utives, 45-46 ; Value of intelli- 
gent interpretation, 45—46 ; Pos- 
sible legal basis for consolidated, 
See Consolidated Statements, Fi- 
nancial Statements, Statistical 

Statistical and Graphical Statements, 

Statistical Department, Value of, 40 

Statistical Information, 4-5 

Statistical Statement, 

Preparation. 4 ; Place of, 5 ; Ob- 
jections to, 20; Form, 21-22 

Statistics, Business, See Business 

Statistics, Official, 14-15 


Common, not redeemable, 85 ; 
Treasury, 173—75; Corporation 
and treasury, 173-74; Preferred, 
185 ; Control of, when not com- 
plete ; 25«-60 

Stocks and Bonds, Investments in, 

Stocks, See Investments 


Only equitable rights in assets, 85 ; 
Minority, 242-48, 254, 258; Care- 
ful consideration to nature of au- 
ditor's certificate, 313 

Stock Ownership, Not ownership of 
assets implied, 85—86 

Subsidiary Company, 

Corporations, 84 ; Relation to hold- 
ing company, 89, 264—65 ; Ad- 
vances to, 94; Balance sheet, 
95; Operating losses, 94; Divi- 
dends. 200-01, 258; Treatment 
of deficit, 253 


Payment of dividends from, 75-76 ; 
Analysis of fluctuations in, 81— 
82; ' Definition, 195; Kinds, 
195—96; Relative importance of, 
and assets, 196; Resulting from 
business operations, 196 ; Rev- 
enue expenditure, 197; Reserves 
that are not part of, 198 ; In- 



Surplus — continued 

ter-comjtany iirofits on inventory, 
198-200; Sale of fixed assets, 
contributed at time of incorpora- 
tion, 207-08; Initial, distributio"n 
of, 208; Disposition, 211; Not 
necessarily cash, 212; Cai)ital ex- 
jienditures charged against, 214— 
15; Equity in, 240; Account of 
acquired companies, 255 
See Caijitalized Surplus 


Items, 77; Included in income 
charges, 77 
Timber Companies, 

Valuation difficult, 100 ; Invest- 
ment, 147 
Trade Creditors, 185 
Trade Debts, Auditor's report. 311 
Trade Discount on Sales, 50-51 
Trademarks, Valuation, 134-30 
Trading Concern, Inventory, 15G 
Transportation Charges, Element of 

cost, 60 
Treasury Stock, 

Definition, 173-75; Creating, by 
donation, 173-75 ; Acquisition of, 


Calculation, 66-67; Rapid, 66-67 


Buildings, 107-08; Land, 107; 
Furniture and fixtures, 112 ; 
Stable and garage equipment 
113; Patterns, drawings and 
dies, 113; Goodwill, 124 et seq.; 
Patents, trademarks and copy- 
rights, 134-38; Securities, 147; 
Inventory, trading concern, 156; 
Work in progress, 157-58; Fin- 
ished goods, 158 ; Merchandise 
jdedged as collateral, 159 ; of 
deferred assets, 164; Api)rais- 
er's report, 316; Cost theory, 
Verification of Trade Debts by Audi- 
tor, 311-12 

V/ages, Salaries and accrued, 185 
V/ork in Progress, Valuation of, 157- 

Working Capital, 

Relation to total assets, 230; 
Amount needed dejiends upon 
nature of business, 230-31 



UOV 3 19^^ 
FEB 2 7 1954 

NOV 2 3 1954 

SEP 1 b i^i^t 

FEB 5 

Form L-9-15m-7,'32 


Greendlinger - 

M72 Financial and 
V.22 business 

(Modern business) 

Sep 18. I 9 pl pur pl» 


AA 001 020 806 4