ACCOUNTING
THEORY AND PRACTICE

A TEXT-BOOK FOR COLLEGES AND
SCHOOLS OF BUSINESS ADMINISTRATION

BY

ROY B. KESTER, Ph.D., C. P. A.

PROFESSOR OF ACCOUNTING, SCHOOL OF BUSINESS,
COLUMBIA UNIVERSITY

VOLUME II

(SECOND YEAR)

Twelfth Printing

NEW YORK

THE RONALD PRESS COMPANY

1922

Copyright, 1918, by

The Ronald Press Company

To Nancy

As a Tribute of Love and Tender
Memory to Her Mother

PREFACE

A knowledge of the subject matter of Volume I is a prerequisite to the profitable study of the present work. Therefore, it may be well to review briefly the contents of the latter as an introduction to this book. In Volume I the attempt was made to formulate and illustrate the basic principles upon which the practice of accounting is founded. The principles of debit and credit were developed and their application explained—as related ultimately to the balance sheet and statement of profit and loss. The chief books of original entry (the voucher register excepted) and the various ledgers were described and illustrated. Columnar books, controlling accounts, methods and devices for preventing and detecting errors, methods for the proper handling of purchases, sales, cash, and trade discounts, and some phases of proportion and interest were discussed in detail.

Some special applications of accounting principles, as viewed in relation to the accounting problems involved therein, were also explained and illustrated under such heads as: notes receivable discounted and dishonored; consignments and approval sales; single and joint venture accounts; accounts current, their reconciliation and adjustment; instalment sales; sales for future delivery; single entry, its methods and the results attainable under it; etc.

From the standpoint of business organization, the accounting problems peculiar to the single proprietorship and the partnership were given full treatment. The advantages and disadvantages of the various types of organization, the rights and duties of owners among themselves and to outsiders, the accounting procedure necessary under different conditions for changing from one form of organization to another, and other like items were set forth. Underlying the entire treatment of the subject was the guiding principle that accounting is never an end in itself, that its right to existence depends solely on the service it can render from the standpoint of administrative and financial management.

In content, the present volume is primarily a study of the corporation, its accounting and financial problems, although most of the material, in so far as it consists of a statement of general principles, is equally applicable to other types of organization. The emphasis of the volume is laid upon the problem of valuation as met in the commercial balance sheet. Chapters IV to XXVII inclusive comprise this portion of the subject matter. The other chapters treat miscellaneous matters, a knowledge of which is essential to the student of accounting. These latter form parts of the work of the second year as mapped out in the author’s scheme of instruction, whereby the whole field of accounting is covered by a well-graded three-year course of study. In this scheme cost accounting should be studied concurrently and as a parallel course with the work of this second volume. Only a bare outline of some of the problems and methods of cost accounting is presented in this volume.

As to the division of the text and its use in the general scheme, it is suggested that the first twenty-seven chapters should comprise the text material for the first semester, leaving the remainder for the second semester in which the chief emphasis should be placed on the solution of problems rather than on the formal classroom lecture. Hence the text material is lessened for this semester’s work, and the student’s main effort is directed towards the application to the problems of business of the principles already established.

Instead of following the plan of the first volume in placing the practice work for the student at the end of each chapter of text, this material is presented separately in three appendices. It is believed that this will be found a more convenient arrangement.

The author desires to emphasize the need of ample practice work and at the same time to take a stand against the method of teaching accounting exclusively by the so-called laboratory or case method. A happy combination of text containing a statement of principles and showing methods of application, together with practice material intelligently made up so as to require a knowledge of principles before solution, is the desideratum in any course of instruction. Principles, theory, without application are barren and soon slip away, even if seemingly understood at the time. Practice without a thorough grounding in fundamental theory can never be sure of itself. An equitable division of the student’s time between theory and practice portions should be aimed at. In the present volume, while the time required for the practice assignments may at times seem heavy, an attempt has been made to keep it to the minimum deemed essential for adequate training either for general or professional use. It cannot be too emphatically stated that accounting as a profession ranks as to subject matter and the need for its services with the other professions. If it is to enjoy equal honor, dignity, and professional standing, teachers and practitioners must condemn without qualification the idea prevalent among many that a few months’ training suffices to turn out a finished product. Too often has such a course given point to the witticism that an accountant is a bookkeeper without a job. As stated in the preface of Volume I, a course of at least three years’ professional study is now quite generally recognized as essential. Accounting is so broad in its many ramifications that less than that gives inadequate training.

The reception accorded the first volume and the report of results achieved in the classroom, through its use leads the author to hope that this second volume may have a courteous hearing and trial. Criticisms and suggestions will be much appreciated. The author hopes to be able to offer in the not too remote future the third and concluding volume in this series on general accounting.

The author is indebted for much assistance and counsel. Acknowledgment is due Miss Nina Miller of the Columbia staff and Eric Bodine for help in gathering and preparing much of the material for Chapters XXVIII to XXXIII; to H. A. Inghram of the University of Georgia, for preparation of a large part of Appendix D; to Leo Greendlinger and David E. Boyce for the use of problems prepared by them; and to his good friend, Joseph Gill, for help in reading the proof. To S. B. Koopman and James F. Hughes of the Columbia staff in second year accounting, the author is under special obligation for many suggestions. Mr. Koopman has furnished most of the problems for Appendix B, and has collected those for Appendix C.

As with Volume I, so in shaping the content of the present volume the author has had the good counsel and ever ready help of his chief, Robert H. Montgomery, and desires again to offer goodly acknowledgment, for his debt is large.

R. B. Kester.

Columbia University,
New York City, August 5, 1918.

CONTENTS

FORMS AND CHARTS

Accounting—Theory and Practice

CHAPTER I
THE CORPORATION

The Corporation

In Volume I, Chapters XLVIII and XLIX, the fundamental characteristics of the corporation were explained and discussed briefly and some of its peculiar accounting features were set forth. Here these matters will be gone into more fully and additional aspects of this type of organization will be treated. In Volume I were explained the advantages and disadvantages of the corporate form, the procedure incident to the formation of a corporation, its charter, officers, working organization and management, the records peculiar to a corporation, the showing of proprietorship, opening the corporation’s books, booking premium and discount on stock, change from partnership to corporation, the distribution of profits, dividends, etc. Only so much of the information already presented will now be repeated as may be necessary to make the treatment here complete.

Classification and Definitions

As instruments for the transaction of business, corporations may be classified in a number of ways. First, all corporations are either public or private. Public corporations are the governmental organizations set up to transact the collective business of a city, a county, a township, or school district.

Private corporations are divided into two subclasses, stock and non-stock. Under stock corporations are included all those organized to carry on business for a profit. Under non-stock corporations are included all those organized to carry on non-profit-making enterprises, such as libraries, hospitals, religious organizations, eleemosynary undertakings, etc.

Under the head of stock corporations we may have the following subclasses: (a) industrial or manufacturing, (b) commercial or trading, (c) public utility or quasi-public, and (d) financial, i.e., banks, trust companies, insurance companies, etc.

From the standpoint of the sovereignty to which allegiance is due, corporations are either domestic or foreign. A corporation is domestic in the state in which it is organized; foreign in any other state or country. Thus corporations chartered in New York are domestic in New York and foreign in New Jersey and Canada. A foreign corporation may be at a distinct disadvantage with a domestic corporation. To obviate this, one occasionally sees a separate incorporation in every state in which a concern intends to do business. Very infrequently is a domestic corporation subject to more stringent supervision and regulation than a foreign.

From the standpoint of the fact of incorporation, corporations may be classed as (1) de jure and (2) de facto, the former comprising those which have met fully all legal requirements for incorporation, the latter comprising those which have not met fully all legal requirements but are to all intents and purposes corporations in fact.

Method of Ownership

Business corporations are sometimes spoken of as “open” or “close.” An open corporation is one in which ownership of the stock is not held closely but is being passed about, traded in, or transferred from one owner to a new. A close corporation is one in which the stock is held very closely in order to retain control and keep profits and trade secrets within a small compass of ownership. Thus some corporations are strictly family affairs; others are held by a few families or a small group.

What is known as a corporation “sole,” while little known now, virtually exists in some close corporations, as where one man holds all but two shares of stock. The incorporation of a single individual is not legally possible in this country.

The corporation, because of its peculiar advantages over other forms of business organization, has become the accepted form for most large enterprises. The gathering together of large capital funds, the ease and efficiency of management and control, continuous life, the facility of transfer of ownership, and the limited liability of the stockholders, make the corporate form attractive to the investor and absolutely necessary to the large businesses carried on today. In some states encouragement is given the small business to incorporate; in the State of New York, for example, the minimum limit of capitalization is only $500. In a few other states the old-time fear of the corporate form is still expressed in their general corporation laws in which the minimum limit for corporate capitalization is set as high as $10,000.

Working Organization

The peculiar features of the stock corporation are the method of ownership and working organization. This latter is effected through a board of directors who are responsible directly to the owners at periodic intervals. Within the board are its officers and committees to whom duties are assigned by by-laws, custom, common consent or action of the board. Under these official heads are the rank and file of the organization—department heads, clerks, employees, etc. It is not necessary to treat here this phase of the organization further.

Different Classes of Stock

The collective capital of a corporation is divided into shares of equal value. Ownership of a share or shares in a corporation is evidenced by formal certificates of stock. Each share carries with it the same privileges, powers, and duties of ownership as every other share of the same class. It represents a pro rata share of the total interest of its class. There may be several different kinds or classes of ownership within the corporation, these classes will have different privileges, and there may be other points of differentiation. The reason for setting up these different classes is almost always to secure additional capital from outside sources by making the investment as attractive as possible. Upon a reorganization, an adjustment of the various interests concerned may require a grading of ownership, a differentiation by classes in order equitably to satisfy the claims of all interested parties. These various classes of stock ownership will be discussed under the following heads:

• 1. Common
• 2. Preferred
• 3. Guaranteed
• 4. Founders’
• 5. Debenture

Common Stock

Common or ordinary stock is that which is evidence of ordinary ownership in the corporation. The share of ownership of the original organizers of the corporation is usually in the common stock. The common stockholder is a sort of remainderman, a residuary legatee. Upon dissolution, after the special claims and privileges of the other classes of owners have been satisfied, the common stockholders come in for their share. After the satisfaction of the claims of preferred owners, the common stockholders have a right to all that is left, their rights being simply residuary. They are subsequent to those of the other classes and to that extent inferior to them, though they may be more valuable.

Preferred Stock

Preferred stock has some kind of preference over the common. Such stocks differ among themselves, there being no standardized features applicable in every way to all kinds of preferred stocks. The basic purpose of the various preferences is to make the stock attractive from an investment standpoint. Common to all preferred stocks, however, is a preference as to dividends. Whenever profits have been made and have been set aside for dividend purposes, the preferred stockholders receive their dividends ahead of the common stockholders. If only sufficient profits are available to meet the requirements of the preferred stockholders and are appropriated for that purpose, the common owners receive nothing. Stock may be preferred as to assets as well as to profits. By this is meant that in case of dissolution the net assets remaining after payment of all outside claims are applied first to satisfy the interests of the owners of preferred stock and any remainder then goes to the common stockholders.

Cumulative and Non-Cumulative. Preferred stock carries with it a definitely stated minimum rate of dividend. The preferred claim to the profits may be cumulative or non-cumulative. In the one case, if profits are insufficient at any time to meet the preferred dividend requirements or are not appropriated for that purpose, the claims of the preferred owners accumulate from period to period until satisfied in full. This satisfaction must take place before the ordinary owners can have any share in the profits. The rate of accumulation is the specified minimum and usually interest on unpaid dividends is allowed when the company finally settles these preferred claims. Of course, since dividends can be declared only out of profits, no claim for preferred dividends or any other kind can exist unless sufficient profits have been made. Non-cumulative stock is stock on which the dividend claim does not, if unsatisfied at any time, accumulate from period to period. Preferred stock is cumulative unless otherwise specified.

Dividends on cumulative stock do not have to be paid just because sufficient profits have been made. Declaration of dividends rests entirely with the board of directors who may see fit to appropriate profits to other purposes. A holder of non-cumulative stock may be very unjustly discriminated against in favor of the common stockholder by the withholding of all profits for a number of periods until a large amount has been accumulated. This is then disbursed as a dividend to the common owners after the deduction of as much as may be necessary to satisfy the preferred owner for the current period. On this account a non-cumulative stock is not attractive to investors.

Participating and Non-Participating. Preferred stock may be participating or non-participating. It is said to be participating when the terms under which it is issued provide that it shall share in any dividend in excess of its own specified minimum. Thus, if it is 6% preferred, after the preferred receives its 6% the common stock receives a like dividend, and then the preferred and common may share alike or in any agreed ratio in any further dividends declared in that year. Both participating and non-participating stock is either cumulative or non-cumulative. Preferred stock is non-participating when it is limited to the rate of dividend specified in the terms of its issue.

Redeemable and Convertible. Other features met in some preferred stocks are redeemability and convertibility. Preferred stock may be issued under a contract to redeem it, after a certain length of time, at a named figure—frequently par plus one year’s dividend. Redemption may be either at the option of the holder or the company. Redemption may be serial, i.e., a certain amount called at stated intervals for redemption. Preferred stock is convertible when under the contract in the terms of its issue it may be converted into some other form of ownership or obligation. Thus, provision may be made that after a certain time has elapsed, preferred shares may be converted into common according to specified rates of conversion; or conversion into bonds of the company is sometimes provided for. Many nice adjustments may become necessary from an accounting viewpoint, when redemption or conversion take place at any ratio other than book values.

Guaranteed Stock

Stock which is issued under a guarantee to pay a specified dividend is said to be guaranteed stock. Inasmuch as dividends can be declared only out of profits, a company cannot guarantee its own stock—or rather a guarantee on the company’s own issue must always be dependent or contingent upon the earning of profits sufficient for that purpose. Stock issued by one company and guaranteed by another may with strict propriety be called guaranteed stock. Thus, a large company may enter into a contract of lease with a smaller concern whereby the compensation shall be, let us say, an 8% dividend guaranteed to all holders of the stock of the smaller concern. Such a guarantee is not contingent but becomes a lien or claim on the guarantor company, regardless of the amount of its earnings.

Founders’ Stock

In England there is issued what is known as “founders’” stock, a stock preferred as to its share of dividends. Thus, a comparatively small portion of the common stock authorized might be set aside as founders’ or promoters’ shares with the stipulation that these founders’ shares shall receive a dividend out of proportion to the ratio which they bear to the total common stock. The provision might be that these shares shall receive one-half or one-third—or any other specified share—more dividends than shall be given to the common owners. Instead of being preferred stock with specified dividend rate, it is preferred over the rest of the shares of the group from which it was originally set aside but its share of dividends is dependent upon the dividends given the rest of the shares. The par value of the founders’ shares might represent only one-twentieth of the value of the rest of the group, while their share of the dividends would be, say, one-fourth as much as that of the other shares. This preference as to amount of dividends may give founders’ shares a much higher market value than the other shares. Provision is sometimes made for their redemption, as usually there is such a marked difference between their amount ratio and their dividend ratio as compared with the other shares, that dissatisfaction among the owners results. Outstanding founders’ shares may then interfere seriously with the marketability of the other shares.

Debenture Stock

The term debenture stock is applied to a class of liabilities rather than to proprietorship items. In England debentures of various kinds are frequently used. A recent book[1] thus describes them: “In Great Britain the term ‘debenture stock’ is used to designate an unsecured loan issued in irregular amounts. If the amounts were fixed and equal, the issue would be called ‘debenture bonds’ or simply ‘debentures.’ Debenture stock is a debt of the corporation and does not resemble stock as used in this country.” Debenture stock has not proven popular in this country, although used to some extent in Canada. The Public Service Commission of the State of New York defines debenture stocks as “those issued under contract to pay absolutely thereon at specified intervals a specified return.” These stocks, while usually of limited life like bonds, are sometimes “perpetual and give the holders no right to demand the repayment of their capital, and the company no right to repay it.”[2] When issued as perpetual, they somewhat resemble capital stock, as the term stock is used in this country. Because of the fixed and absolute charge for interest—or dividends as it is sometimes called—which these stocks carry, they are much more of the nature of bonds than of a stock indicating proprietorship. Debenture stocks are therefore to be classed as liabilities.

Stock of No Par Value

A characteristic of most stock is that it bears a specified par value which must be uniform for all the shares within a class. The par value of the different classes may differ, however. In most states no regulation is made of the amount of par value. A par value of $100 is customary for industrial and commercial concerns, and of $1 for mining companies. Between those limits, and even beyond them, one finds stocks of almost any par value.

In the State of New York the issuance of stock of no par value is allowed. Both preferred and common classes may be issued without par value, but if the preferred shares have preference as to assets, the certificates for preferred shares shall state “the amount which the holders of each of such preferred shares shall be entitled to receive on account of principal from the surplus assets of the corporation in preference to the holders of other shares.” With this exception, none of the certificates may express any nominal or par value and this statement of the amount of preference is regarded as an expression of par value for this purpose. Each share is equal to every other share within its class.

Every certificate of such stock must bear plainly on its face the number of shares which it represents and the number of shares the corporation is authorized to issue. Regardless of the price paid for a share of such stock, all shares issued by the corporation shall be “deemed fully paid and non-assessable and the holder of such shares shall not be liable to the corporation or its creditors in respect thereof.”

To the heedless a named value on a certificate of stock is sometimes misleading as to the real value of the stock. The no-par-value stock overcomes this in that a prospective purchaser is at once put on his guard to find out the worth of the stock. Another advantageous feature is that the questionable practices sometimes indulged in of booking stocks sold at a discount have no place here because the stocks, having no par value, cannot be sold at a discount and the record of their sale will carry therefore the price at which they were sold. Some points in connection with booking this stock will be discussed later.

Watered Stock

So-called watered stock is stock which has a higher nominal value than the true value of the properties for which it has been issued. Thus, if $1,000,000 worth—par value—of stock is issued for the purchase of property which has a marketable value of only $750,000, the stock is said to be watered to the extent of $250,000. The bookkeeping equation requires that an equality be shown between the properties purchased and the par value of the stock, and this is usually done by inflating the value of the properties when they are brought onto the books.

Treasury Stock

Treasury stock, when the term is used properly, is stock which has been once issued as fully paid and which through purchase or gift comes back into possession of the issuing company. Stock which has never been issued should not be called treasury stock. The distinction between the two lies in the liability (or freedom from it) to further contribution, in case of need to meet the claims of creditors, on the part of stockholders who have bought their shares at less than par value.

In some states the sale of stock at less than par is forbidden. In those states where the practice is allowed, the purchaser of a previously unissued share at less than par is liable to the creditors (if the assets are insufficient to satisfy their claims) for a further contribution equal to the difference between par value and the price paid for the stock. If, though he pays less than par, the stock is issued to him by the corporation as fully paid and non-assessable, he is not liable to the corporation for any further payment to entitle him to all the rights and privileges of a shareholder; but he may be liable in case of need to outside creditors who have a right to expect always that assets of equal value to the stock issued therefor have come into possession of the corporation. As mentioned above, this trouble is obviated in the case of no-par-value stock. However, after stock has once been paid for in full, all future purchasers may hold it without liability for further contribution regardless of the price they pay for it. Because of its freedom from this liability, treasury stock has a readier marketability than unissued stock.

In some enterprises, particularly those of a speculative character where it is extremely difficult if not impossible to place a true valuation on the property to be used or exploited, the practice is very prevalent of issuing the entire authorized capital stock in payment for the properties to be acquired. The stock so issued thus becomes fully paid and its owners liable to no further contribution. To provide working capital, some portion of the stock is usually donated to the company for resale. This is sometimes called donated stock and is, of course, true treasury stock. In states where a corporation is permitted to buy its own stock, treasury stock may be acquired by purchase. Theoretically, stock which has been issued under a contract providing for redemption becomes treasury stock when redeemed and may be reissued until it has been canceled through charter provision to reduce the capital authorized. (See also pages 15, 16.)

Forfeited Stock

Stock is said to be forfeited through failure to make the agreed purchase payments on it. The laws of the different states vary with regard to the conditions under which stock may be declared forfeited. In some states the instalments paid on the stock—or all but a small amount to cover the cost of handling the transaction, or a specified portion of the amount paid in—must be returned to the purchaser. In others, the entire amount paid in may be declared forfeited. In the State of New York the provision in the law is as follows: “If default shall be made in the payment of any instalment ... the board may declare the stock and all previous payments thereon forfeited for the use of the corporation, after the expiration of sixty days from the service on the defaulting stockholder, personally or by mail directed to him at his last-known post-office address, of a written notice requiring him to make payment within sixty days from the service of the notice at a place specified therein, and stating that, in case of failure to do so, his stock and all previous payments thereon will be forfeited for the use of the corporation. Such stock, if forfeited, may be reissued or subscriptions therefor may be received as in the case of stock not issued or subscribed for. If not sold for its par value or subscribed for within six months after such forfeiture, it shall be canceled and deducted from the amount of the capital stock.” The provisions are very specific and must be carefully followed. The method of accounting is given on page 19.

Bonus Stocks or Bonds

Bonus stocks or bonds are stocks or bonds given as a bonus upon the purchase of other stocks or bonds. Thus, upon the purchase of a share of preferred stock, one share of common may be given as a bonus.

Accounting for Stocks

Accounting for the original issue of stock has been treated in Volume I. There several different methods of opening the records of the corporation were given and the manner of treating premiums and discount and instalment subscriptions was shown. Here some additional problems peculiar to corporation accounting will be discussed.

Discount on Stock

In the State of New York the stock of a corporation cannot be sold below par. Where sale below par is allowed, the proper booking of the discount requires consideration. The Interstate Commerce Commission requires that discounts or premiums be shown on the books under those titles, i.e., Discount on Capital Stock and Premium on Capital Stock. This method is to be commended as being true to fact and presenting a full and sufficient record of the facts. In the case of other concerns over whose accounting practices there is no regulation, that method is honored more in the breach than in the observance. A prevalent feeling is that the appearance on a balance sheet of such an item as discount on stock is a serious reflection on the standing of the corporation and is to be avoided in any way possible. Discount on stock is not an attractive item on a balance sheet, but there is little justification for such sentiment in those states where the sale of stock at a discount is a perfectly legitimate transaction. The balance sheet ought to represent facts as they are until they change; then the new conditions should be shown. So long as the discount on stock remains a fact it should be so shown. When the discount has ceased to exist through its absorption against premium on stock or the general surplus, it should no longer be reported because it is then a matter of ancient history with which the present is not concerned.

A favorite method of charging the discount on stock to organization expense is not approved, not because it is a misnomer, for discount may well be looked upon as one of the expenses of organization, but because it is an item of sufficient importance and interest to require separate record. Charging the discount to some asset account, when payment of stock is made by property instead of by cash, is to be severely condemned. Inflation of asset values to cover up such an item cannot be justified.

Premium on Stock

The premium on stock sold above par is best recorded in a premium account which should remain on the books as a part of the permanent capital and not therefore be transferred to surplus and returned as a dividend to the shareholder. It may be legitimately used to cancel any discounts.

In the State of New York a corporation cannot issue its stock “except for money, labor done, or property actually received for the use and lawful purposes of such corporation.” A broad interpretation has been given the word labor so that under the law it may comprise both manual and mental labor and services of almost any kind legitimately received at the time of organization of the corporation or at any subsequent time. Stock may thus be used to pay for organization expense, promoters’ fees, etc.

Property Exchanged for Stock

Where stock is issued for property, no more is supposed to be issued than has a par value equal to a fair market value of the property received therefor. In valuing the property the judgment of the directors is conclusive, unless fraud can be shown. Any stock issued for property becomes full-paid and the owner is neither subject to further call by the corporation nor liable to contribution for the benefit of creditors. In all statements and reports required by law to be published, stock issued for property purchased must be so reported.

Treasury Stock Donated

When treasury stock comes into the possession of the company by donation, the entries needed to show the transactions are somewhat as indicated below, some variations from the form shown being sometimes met with. Practice varies as to the value at which treasury stock shall be brought onto the books, some concerns booking it at an arbitrary value based on an estimate as to what it will probably bring when sold; others booking it always at par. Practice varies also as to the manner of showing treasury stock on the balance sheet, some listing it among the assets at the value at which it was brought on the books; others treating it as a deduction from authorized capital, a sort of valuation account for the capital stock. These points are discussed in [Chapter XXI] and will not be treated here except to state a conclusion on which the booking of the transactions depends. Manifestly, if treasury stock is to be treated as a deduction from capital stock, it will have to be brought onto the books at par. Such treatment usually results in an inflated showing of the surplus arising from the donation until that has been adjusted to the values realized from its sale—an adjustment which cannot be completed with accuracy until all treasury stock has been disposed of. If treasury stock is to be shown among the assets on the balance sheet, it is perhaps best booked at an estimated realizable price, a method which will show the donated surplus also at an estimated realizable figure. While authorities differ on these points, the weight of opinion seems to favor booking treasury stock at par and showing it as a valuation account on the balance sheet.

For the sake of illustration assume that the stockholders donated $100,000 par value of common stock to the corporation and that $50,000 of it is sold at 60 cents on the dollar. The entries to record the transactions would be:

Other titles for Donated Surplus are “Donated Working Capital,” “Donation Account,” etc. The account “Discount on Treasury Stock, Common” will ultimately be closed against Donated Surplus, and there is no objection to making the charge for discount directly to Donated Surplus instead of as shown above, although the method shown perhaps makes more easily available the information as to the discounts allowed on sales of various portions of the treasury stock. If it is sold at one price, the charge for the discount should be direct to Donated Surplus. A balance sheet drawn up at an intermediate period, i.e., before Discount on Treasury Stock is closed, should show Donated Surplus at its adjusted figure, viz., book value less discount. After all treasury stock has been sold, the Donated Surplus account, as adjusted, will show the true surplus arising out of the donation transactions. The proper disposition of this—as to whether it should be maintained as a permanent increase in capital, be transferred to general surplus and so be made available for dividends, or be treated as a deduction from plant values on the theory that they have been overstated as originally booked—is discussed in detail in [Chapter XXI].

Bonus Stock

Bonus stock is usually treasury stock for the very good reason that, if it carried a liability for contribution in amount up to its par value, recipients of such stock might not be overly appreciative of the gift. Instead of being an incentive to purchase the securities which it accompanies as a bonus, it might act as a deterrent. Bonus stock is a gift on the part of the corporation and is therefore an expense. While custom favors recording the expense under the title “Bonus”—or even including it with organization expenses—and treating it as a deferred expense for a number of periods, a correct analysis of a bonus stock transaction may dictate other method of record. If the bonus stock is given with an issue of bonds which could by themselves be disposed of only at a discount, the difference between the market value of the bonds alone and their par value should be charged to Bond Discount, and the rest of the loss on the transaction may be charged either to Bonus account or Discount on Treasury Stock. This distinction is important, as will be seen in Chapter XX where the true nature of bond discount is discussed. When data are available for making the separation it should always be done. Thus, if a $1,000 par bond has a market price of $950 but when sold with one share ($100) of treasury stock as a bonus brings $1,000, the record should be:

The customary method of showing, as in entry (4) below, is theoretically incorrect, though it may be necessary to use it when the data needed for the other entry, i.e., (3) above, are not available.

If a bonus of treasury stock is given with the sale of preferred stock, similar treatment would make possible a showing of the portion which is really discount on stock and the portion, if any, which is true bonus. Inasmuch as discount on stock and bonus are very similar in kind and in manner of treatment on the books, nothing of real value is perhaps gained in making the separation. The ultimate disposition of the Bonus account is, as indicated above, to treat it as a deferred expense, charging it against profits as rapidly as conditions warrant. It is an undesirable item on the balance sheet or ledger and should be expunged as soon as possible.

Treasury Stock Purchased

Treasury stock which is created by purchase by the issuing company requires consideration. If the price paid is less than par, carrying the treasury stock on the books at par requires an offsetting credit account similar to the Donated Surplus account used above when the stock is created by donation. This credit account simply represents a book surplus and should not usually be made the basis for a dividend. This account may be called “Treasury Stock Surplus,” “Contingent Profit on Treasury Stock Bought,” or other title indicating the true nature of the item. When the treasury stock is resold and the discount or premium on it is charged against this surplus or credited to it, as the case may be, the balance of the Treasury Stock Surplus account will then show the realized profit or loss on the completed treasury stock transactions and may be disposed of as indicated above for Donated Surplus.

On the other hand, if the price paid by the company in the purchase of its own stock is more than par, the premium paid must be charged against general surplus because there is usually no other place for the charge unless there is still open on the books a Premium on Stock account arising out of a previous sale of stock at a premium. Purchase of stock at a premium may represent simply the payment to the owner of the stock of his share in the general surplus of the company, in which case the premium paid must be shown as a reduction of that surplus.

Redemption of Preferred Stock

Handling redemption of a preferred stock issue is exactly the same as handling treasury stock by purchase. If by contract agreement at the time the preferred stock was issued it can only be redeemed at a premium, the premium must be charged, as indicated above, to an open premium account or to general surplus. The effect is similar to the payment of a special or extra dividend at the time redemption is made.

Forfeited Stock

Payments made on stock which is declared forfeited constitute an item of surplus but of a permanent nature, i.e., not a surplus applicable to the declaration of dividends, though there may be no legal inhibition to that use. If the stock is resold any discount on the resale is properly charged against the surplus arising from the forfeiture. By way of illustration, assume that $1,000 worth of stock has been subscribed for and payments amounting to $400 have been made when the stock is forfeited for failure to pay further instalments. The stock is offered again for subscription and is sold for $900 and payment has been received in full. The entries necessary to show the above are:

Stock of No Par Value

Booking capital stock of no par value presents no new principles. Inasmuch as the stock has no fixed par value, its sale is recorded for what it fetches. There can be neither discount nor premium. Payment of the subscription may be made, just as in any other case, by means of cash, property, or services, and the same care must be exercised in placing proper valuations on the property taken over. Here there is not the danger of inflating property values to show them equivalent to the par value of the stock issued therefor. Rather, subscription for the stock is made at the figure of the fair value of the property to be turned over in payment of the subscription. In the case of no-par-value stock even greater care must be exercised to see that the contributed capital shall never be encroached upon in the declaration of dividends, and careful supervision is somewhat more difficult because the number of shares issued bears no relation to the amount of the capital stock.

Distinctive Records

The accounting and other records peculiar to a corporation are explained in Volume I, Chapter XLVIII. These records are the subscription book and subscription ledger or instalment book, the stock certificate book and stock ledger, the stock transfer book, the minute book, sometimes a dividend book, in large companies a register of transfers (which classifies the information as to transfers given in the stock transfer book, and so may serve as a convenient posting medium for the stock ledger), and a stock register (a record kept by the officially appointed registrar of the corporation, whose duty it is to see that there are no irregularities in the issue of stock and that there is no overissue). The stock register should show the amount of stock authorized and the amount issued at any given time, the balance being the stock not yet issued. A form for the stock transfer book and several forms for stock ledgers as prescribed by the Comptroller of the State of New York are shown below.[3] The two latter forms of the stock ledger are applicable only to the State of New York.

Ledger Folio 27

Transfer No. 556

Alliance Automobile Company

For value Received, I hereby sell, assign and transfer unto John H. Lansing, of Newark, New Jersey, Seventy-six Shares of the Capital Stock of the above-mentioned Company, now standing in my name on the Company books and represented by surrendered Certificates Nos. 32, 37, and 44.

Witness my hand and seal this 28th day of September, 1918.

George B. Goldman[L. S.]

By George Gale, Attorney.

New Certificate No. 224
Issued to John H. Lansing
Ledger Folio 84

Stock Transfer Book

Stock Book or Stock Ledger

Stock Book to be Kept by Brokers
(New York Form Prescribed by Comptroller)

Stock Book to be Kept by Corporations and Transfer Agents
(New York Form Prescribed by Comptroller)

Stock Ledger

The stock ledger is a subsidiary ledger controlled by the Capital Stock account or accounts on the general ledger. It may, of course, be made self-balancing just as any other subsidiary ledger. There has been some controversy as to whether the stock ledger is normally a credit or a debit balance ledger. In some concerns the stockholder is debited with the shares owned, and in others he is credited. Theoretically, in accordance with the principle of all other controlling accounts, the subsidiary ledger—in this case, the stock ledger—merely carries the detail of the controlling account. If, then, the controlling account is a credit balance account, the accounts on the subsidiary ledger must similarly have credit balances. Accordingly, the stockholder should be credited with his net holdings. Practically it makes little or no difference because the subsidiary ledger is no integral part of the debit and credit scheme of the general ledger. Of course, unless practical difficulties prevent, practice should always follow the theoretically correct method. No difficulty need be experienced, however, in accommodating oneself to either method of record on a subsidiary ledger. In the stock ledger the record of holdings is kept in terms of the number of shares owned rather than by the par value of the holdings.

Minute Book

Before leaving the subject of the records peculiar to a corporation, it is desired again to call attention to the keeping of a careful record in the minute book. This book should contain first a copy or duplicate of the corporation’s charter. Following this should be the by-laws of the corporation. Sufficient blank space should be left at the end of each of these documents to make record of any amendments to charter or by-laws. There should follow a complete record of the deliberations and authorizations of the board of directors as affecting the management and control of the corporation’s policy. The minute book is often the source of authority for many of the most important entries made on the books of account, and great care must be used to make the record full, complete, and accurate. Such matters as leases, purchase and sale of properties, bond issues, dividends, and other similar items should have very careful record.

Conclusion

Other features of the corporation from the accounting point of view are treated under their respective heads in later chapters. These include such items as bond issues, sinking and other funds, reserves and surplus, scrip and stock dividends and other dividend considerations.

It is proposed in the next two chapters to discuss the corporation from the manufacturing viewpoint, types of accounting records sometimes used therefor, and the elements of manufacturing costs. After that the problem of the balance sheet and the principles of valuation applicable to it will claim attention.

CHAPTER II
THE VOUCHER SYSTEM

Purchasing for the Manufacturing Business

Accounting for the business which manufactures its own product is a much larger problem than that for the concern which limits its activity to purchase and sale of a stock-in-trade. To the activities of a trading concern the manufacturing business adds those of the factory. Not only must more property, and a larger variety, be kept account of and handled so as to get the most efficient return therefrom, but also in the handling and operation of this property a somewhat distinct type of expenses is incurred. The problems of financial and factory management and control are different and more complicated than those of the trading business. The period between the expenditure of funds for the purchase of materials and the payment of expenses and the receipt of money from the sale of the finished product is much longer. More working capital must therefore be provided and its rate of turnover is less. A larger element of risk enters in. Raw materials must be worked and fashioned, machinery must be employed, a different class of labor must usually be handled, perhaps will have to be trained—these are problems calling for a special type of management for the manufacturing end of the business.

The accounting department must be organized to serve these additional demands and complexities of management and to give the needed information. The amount and cost of the materials consumed in making the product, the labor cost expended on it, and the various items of factory expense incurred, during one period as compared with the same items for previous periods—all must be kept under constant review if successful operation is to be secured.

Expansion of the Purchase Journal

To make this information available as soon as the transactions giving rise to it are entered into, a different method of gathering the information becomes necessary. Because of the fact that the purchase journal is limited to the record of purchases of stock-in-trade, and that information in regard to expenses incurred is not usually brought on the books until payment of them is made, not only do the books fail to give the service which a management has a right to expect of them but they fail to reflect many liabilities at the time they are assumed. Thus a new type of record is needed.

This has led to an extension or expansion of the purchase journal. The way in which this journal can be used so as to analyze purchases of stock-in-trade on a departmental basis has been explained and illustrated in Volume I. This new use of the purchase journal is merely an extension of the principle of analysis there developed. Instead of limiting it to a record of transactions involving purchases of stock-in-trade, every purchase transaction, whether of assets, supplies, or of service of any kind, finds this its place of first record. By introducing sufficient columns, as detailed an analysis of all the purchasing activities of the business can be secured as may be desirable. Furthermore, entry here being made at the time of the purchase rather than at the time of payment for the purchase, the books make available a mass of valuable data needed for purposes of management much sooner than it becomes available under the former restricted use of the purchase journal.

Development of Voucher System

Had the evolution of this record stopped here, the resulting gain would have been secured at high cost. The entry of all expense purchases in the purchase journal creates the necessity of opening accounts on the ledger with numerous creditors for small purchases, as well as the more important items, both to show the liability incurred and to provide a means of canceling it when payment is made. In large corporations, where oftentimes the policy of securing bids on all purchases is followed, resulting in a constant changing of firms from whom purchases are made and no regularly established trade with any of them, the burden of handling the creditors ledger becomes an increasingly heavy one with little or no gain in desirable information furnished by it. Accordingly, a further development took place which eliminated the necessity of opening regular accounts with every creditor, but instead made every transaction, whether one or many were entered into with the same individual, independent of all others. This makes possible the showing of the settlement of that transaction in the place where its original record was made, without opening up a ledger account for it. This use of the purchase journal with some slight additions has given rise to the so-called “voucher system” of handling purchases.

Definition and Description of Voucher

In a broad sense, a voucher is a statement which certifies, i.e., vouches for, the correctness of a transaction. As used in the restricted sense to which it is limited under the voucher system, it is a more or less formal document which shows a receipt for a particular bill of items. As distinguished from a receipt in general, this latter term is applied to all acknowledgments of money paid whether or not for a particular bill; whereas the essence of voucher accounting requires receipts for particular bills. At law a voucher has no more weight than an ordinary receipt, and a signed receipt is only prima facie evidence, capable of refutation, though the burden of proof of non-payment is placed on the complainant.

A formal voucher must therefore provide for a statement of the bill of which payment is being made and a place for acknowledgment of receipt of payment by the payee. Usually provision is made also for: (1) certification of the correctness of the bill by properly authorized house employee and its approval for payment; and (2) a proper distribution on the accounting records of the payments authorized, i.e., an official determination of the debit and credit entries to be made on the books.

A form of voucher is shown on pages 30, 31. On the face of the form provision is made for (1) detailed statement of bill; (2) house approval of same; and (3) receipt form to be signed by payee. On the reverse side of the voucher the distribution of the charges is provided for. This is the bookkeeper’s authorization for making the indicated entries on his books. The form is so devised that, when doubled, it is of a convenient size for filing in a vertical file.

Operation of Voucher System

When the invoice covering any purchase is received, it is held till the commodities bought arrive. After inspection and acceptance of the goods, a voucher is made out in duplicate on which is written a copy of the invoice, with the cash discount, if any, shown deducted. Vouchers are given consecutive numbering just like checks. If immediate payment is to be made, the voucher will be “approved” and check drawn for the amount. The voucher with check attached is sent to the creditor with a request that he receipt the voucher and return it. A creditor is not usually particularly interested in helping another concern keep its books and the result is that a large number of vouchers find their way into the creditor’s waste basket. It is here that the duplicate copy retained in the files serves to keep the file of vouchers complete, though it does not, of course, constitute a receipt for the payment.

Sometimes before sending the original voucher, the distribution of the charges is made on it, and it is used as the basis of the bookkeeper’s entries. An objection to this method is frequently made that the creditor is thus given some insight into the business and perhaps a more intimate view of it than may be desirable. Where such is the case, only the office copy of the voucher shows the distribution and the book entries are made from it. Both may be filed together when the original is returned, or the one may be filed numerically according to voucher numbers, the other alphabetically according to creditors’ names and so serve as an index to the numerical file.

Voucher (face)

Voucher (reverse)

In some concerns the canceled checks when returned by the bank are filed with their respective vouchers; in others, they are filed separately in their own sequence. Inasmuch as each voucher also carries its check number, cross-reference is easy.

Voucher Check

The difficulty referred to above in securing prompt return of receipted vouchers has led to the introduction of a combined voucher and check called a “voucher check.” The indorsement on the check, which is necessary for its collection, serves at the same time as a receipt of the bill. All vouchers thus ultimately find their way back through the bank. The legality of the indorsement serving also as an acceptance of the check in payment of the stated invoice has been thoroughly established, particularly when on the blank space for indorsement attention is drawn to the fact that such indorsement will constitute a receipt for the bill; or where the face of the check states that it is full payment for the invoices covered by it.

Two forms of voucher check are in use, the folded check and the single. Below are given illustrations of both. If such checks are not unduly large, banks do not object to handling them.

Because of lack of room on the voucher check, provision is not always made for showing the distribution of the charges. The single form of check can be used when a detailed statement of invoices is not desirable or when invoices carry but few items. Such a voucher check, but differing somewhat from the one shown, is frequently used for the payment of dividends to stockholders and does away with the need of a formal receipt or of signature in the dividend book.

Voucher Check—Double (face)

Voucher Check—Double (reverse)

Voucher Check—Single

Form of Voucher Register

The “Voucher Register,” or the “Accounts Payable Register,” as it is sometimes called, is the book of original entry in which the voucher and its distribution are recorded. This register is a journal so far as its scheme of debit and credit is concerned, but its record is not usually supplemented by a formal subsidiary ledger—though it may be—posting of it being limited to the general ledger. The register must provide columns for date, voucher number, name of creditor, explanation, amount, distribution, and payment. There are many different forms and rulings, the information desired never being quite the same in any two businesses, but a typical form of voucher register is shown on page 35.

Distribution of Vouchers

As soon as a purchase invoice has been approved, a voucher—sometimes called a voucher jacket where the original invoice itself is attached to it—is made for it, the distribution of the charges is authorized, and entry is made in the voucher register. All vouchers are numbered consecutively and entered in numerical sequence, which is usually also chronological sequence. The amount of the voucher is entered in the total column, Vouchers Payable or Accounts Payable, whatever the account title is on the general ledger. The next column, Purchase Discount, may or may not be merely a memorandum column, depending on the use made of it, as will be explained later.

Voucher Register (left-hand page)

Voucher Register (right-hand page)

From the Vouchers Payable column, distribution on the same line is made into the columns for the various accounts to be charged. To secure a complete distribution without waste of space, a Sundry Charges column is provided for entry in detail of all items of infrequent occurrence, each account to be charged being named in the explanation space to the right of this column. Following this comes the record of date and manner of payment, with a final column in which to extend at the end of the month all unpaid vouchers and so indicate the detail of the total outstanding liability. The voucher record is capable of almost indefinite expansion through the use of short-margin insert sheets. Provision can in this way be made for a large number of columns for analysis.

Posting of Summary Totals

At the end of the month, or oftener if desired, the voucher register is summarized and posted. Inasmuch as usually no subsidiary ledger is kept when the voucher system is in use, there is no day-to-day record on the ledger of the purchasing activities of the business. Accordingly, a complete double entry must be made by way of periodic summary. It was at one time thought desirable to make this summary entry through the general journal or, at any rate, by setting up a formal journal entry on the face of the voucher register. As the degree of analysis increased, the futility of such a procedure became apparent and now posting to the ledger accounts is made directly from column totals as shown in the illustration. The Sundry Charges column is posted in detail to the named accounts as indicated. Proof of distribution should always be secured by checking the total of the distributive column totals against the total of the Vouchers Payable column. In posting, the total of the Voucher Payable column is credited to its account, while the totals of the distributive columns are debited to their respective accounts.

Effect on Cash Book and Bank Account

The advantage of this periodic posting of expense column totals as compared with the detailed posting of such items from the cash book as required under the old method is apparent. The cash book is in this way relieved of all need of naming the account to be charged for each detailed entry, the proper charge having been made from the voucher register. If every transaction which will ultimately give rise to a disbursement of cash is vouchered and therefore recorded through the voucher register, there is really no need of a detailed entry of the checks on the cash book, for only their total is posted. It is perhaps more usual, however, to enter them in detail on the cash book. Entry here is, as always, chronologic, by date of payment.

Sometimes, to facilitate reconciliation with the bank account, the voucher checks are given a new series of numbers known as treasurer’s numbers when issued in payment of invoices. Where this is done, the cash book shows entry of all checks in the numerical sequence of treasurer’s numbers, just as entry in the voucher record is in the sequence of voucher numbers. Some checks are held before issue longer than others, due to different lengths of credit term, etc.; hence the need for this new series of numbers.

Payment of Vouchers

After a voucher has been made up and entered in the register, if payment is to be made immediately, it is passed for payment by the treasurer or other fiscal officer and the check is drawn and issued. Any cash discount offered is shown deducted on the face of the invoice and the check carries the net amount. Where payment is not immediate, but observance of the terms of credit is necessary to secure the discount, the voucher should be filed away in a tickler file which will automatically bring it up for attention at the proper time. The original invoice is placed in a temporary file, arranged alphabetically, until paid, when it may be removed and filed permanently with the paid voucher. Upon payment of the voucher, the check is entered among the cash disbursements and a notation is made in the payment column of the voucher register as to the date and manner of payment.

Voucher Index of Creditors

It has been stated that one of the essential features of the voucher system, as it is usually operated, is the dispensing with the formal creditors ledger. This is accomplished by treating every transaction as an independent unit, numbering it, and providing a place in the voucher register to indicate its payment, so that there is no need of a separate ledger to keep track of the cancellation of the liability. The voucher system fails, however, to give a record of volume of business done with each creditor. Furthermore, it is often desirable to make reference to past transactions with creditors. This would be very difficult without a definite knowledge of the voucher numbers under which account has been kept of the transactions with a particular creditor.

Accordingly, for the proper operation of the system an alphabetic index of creditors must be made up on which should be shown the voucher numbers relating to transactions with each creditor. This is usually of the card index type, each creditor being provided with a card on which is noted a list of the vouchers recording the business done with him. This voucher index, while not a ledger in the accepted sense, yet when operated in connection with the Payment column in the voucher register serves all the essential purposes of a creditors ledger, and the use of the “Unpaid Vouchers” column, as explained above, secures at the end of the month the detail of the summary account, Vouchers Payable, carried on the general ledger.

Control of Vouchers Payable

With the elimination of the detailed ledger record which served as a check on its controlling account on the general ledger, particular care must be exercised to see that the control account, Vouchers Payable, reflects the correct summary of all detailed liabilities. This is readily accomplished when every item that leads to a disbursement of cash is vouchered. Then the only postings to “Vouchers Payable” come, for their credits, from the total of Vouchers Payable column of the voucher register, and for their debits, from the total of Vouchers Payable column in the cash book.

Introduction of System

Some of the problems encountered in the operation of a voucher system will now be discussed, the first of which is the introduction of the system in a business where the old method of handling purchases is in use. The requirement here is the closing of the open accounts on the purchase ledger and their transfer to the voucher register. This may be accomplished in two ways—one of which requires a change in the controlling account, and the other of which does not. Under the first plan without formality, the accounts in the purchase ledger are balanced and closed by indicating in their explanation columns the transfer of the balance to the voucher register. As these accounts are entered on the voucher register, each of the items comprising the balance of an account should be given separate vouchers rather than entered under one voucher for the whole amount. This is particularly true where the different items are subject to different discount and credit terms, rendering it undesirable to pay them all at the same time. After entry on the voucher register, the amounts may be distributed to the Sundry column and charged to the controlling account, Accounts or Vouchers Payable, as the case may be. The register should now be totaled, i.e., the Vouchers Payable and Sundry columns should be added and the register ruled off. These totals, being to the credit and debit of the same account, may or may not be posted, as the balance of the controlling account is not affected. Under the second plan the register is left open, i.e., not totaled. In this way the credit to the Vouchers Payable account is included with the total to be posted at the end of the current month when the register is first summarized. This, of course, necessitates posting the corresponding debit of the amounts distributed to the Sundry column as explained above.

The new voucher system is now ready for use and current entries will be made as previously explained.

Purchase Returns and Allowances

The handling of purchase returns and allowances is awkward under the voucher system. If the goods can be inspected and accepted or adjustment secured when necessary, before the voucher for the transaction is made up, then the amount to be paid is always the amount of the voucher and no change need be made in the amounts entered and distributed on the register. Where this is done a Purchase Returns and Allowances Account is not required. This procedure, however, is not always possible, for a first inspection does not always show the true condition of goods. Adjustment of the general ledger accounts could be made by entry of the return or allowance through the general journal. That would not, however, leave any indication in the voucher register record of the fact that cancellation of the liability there shown was made by payment of a lesser amount than the one entered, and it is desirable that these two amounts be the same.

To accomplish this, entry of the allowance should be made, in small red ink figures on the upper part of the line just below the vouchers affected, entering in red the voucher number—the same as the voucher to which it applies—and the amount of the allowance, both in the Vouchers Payable column and the distributive columns affected by the allowance. These red ink items are, of course, deductions, the summary amounts of the various columns being net totals, i.e., the totals of regular items less the red figures; or two totals may be shown, one above the other, the regular and the red. Where both black and red totals are shown, both must be posted, the red as contras or offsets to their corresponding black postings. If desired, separate Purchase Returns and Allowances accounts may be opened.

An alternative method, requiring more work but handling the difficulty somewhat more neatly, cancels the original voucher by marking it paid and its check void, and issues in its stead a new one for the correct amount. The new voucher is handled regularly in the cash book, but in the register distribution is made to the Sundry column and charged to Vouchers Payable, as the purchase has already been charged from the original voucher. This charge to Vouchers Payable cancels the credit from the journal and allows the liability for the new amount to be shown in the total of the Vouchers Payable column of the register. The cancellation is best evidenced by entry in the general journal somewhat as follows:

Under this method postings to the Vouchers Payable account, instead of being limited in their origin to voucher register and cash book, will be made also from the general journal.

Partial Payments

A similarly awkward situation is met when it becomes necessary to make partial payments on a voucher. The whole system is built on the idea that each voucher is the unit according to which the record is kept. It, therefore, presupposes settlement in full of each voucher; otherwise, the efficient operation of the system is interfered with. Settlement in full is not always possible, however. Since provision is made in the register for but one line on which to show payment of the voucher, it is not possible to indicate partial payments in the allotted space, nor would such practice be desirable.

Hence, where partial payments are to be made, the original voucher must be canceled in full and two new vouchers issued in place of it—the one for the amount of the partial payment, which will thus cancel it, and the other for the unpaid balance, which will remain open until paid in full or till other partial payment is made. In the latter case the same procedure of cancellation and issuance in its stead of two vouchers must be repeated. This process of cancellation by the reissue of two new vouchers may be effected directly on the face of the voucher register by a full cross-reference between the old and the new, usually shown in the Manner of Payment column; or it may be done by formal entry on the general journal, which will then constitute the authority for the transaction. At the best, it is an awkward situation and where financial arrangements cannot be made so as to make partial payments unnecessary in large measure, the voucher system itself should be discarded as not adapted to the conditions of the business.

Handling of Notes Payable

Practice differs, under the voucher system, in the handling of notes payable. If a note is given or a draft accepted upon the purchase of goods, the liability for it will appear on the books only as a note liability, provided the purchase is recorded through some other medium than the voucher register. This medium might be the general journal or the notes payable journal. If, however, original entry of the purchase is made in the voucher register, liability for it is thereby created under the account title, Vouchers Payable. This must be shown canceled by the creation of a note liability in its place, by entry in general or notes payable journals. If the voucher check system is used, the check on the original voucher must be canceled by marking it “Void” or by running it through the bank with the day’s deposits. In either case for the sake of a complete record of check numbers, it should be entered among the cash disbursements. From all this it is evident that less work is entailed and just as complete a record made by entering the purchase originally in general or notes payable journal as suggested above.

In order to maintain proper control over the cash, when the note becomes due a check should be drawn for it rather than allow its payment to rest merely on the bank’s memo of charge against the account, where the note is made payable at the bank. If a voucher check system is in use, payment by check results in a momentary transfer of the liability from its status as a note liability to a vouchers payable—an open account—liability. Cancellation of the note is made by distribution of the voucher to the Sundry column of the register as a charge to Notes Payable; the voucher not being made or entered until the note falls due. Simultaneous entry of the check in the cash book cancels the voucher payable liability and completes the transaction.

If the note is given in cancellation of the open account which had been set up by previous entry in the voucher register, then the same procedure must be gone through, as was explained above in connection with the practice of invariably entering every purchase on the voucher register. If the note transactions are many, it would prove much less laborious to accept the bank’s memo of charge as adequate evidence of payment, this memo being given a treasurer’s number in proper sequence, where treasurer’s numbers are given to establish order of entry on the cash book. Cancellation of the notes payable liability is then posted from the cash book entry.

Cash Discount on Purchases

A final problem in connection with the voucher system concerns the treatment of cash discount on purchases. As discussed in Volume I, Chapter XXXVI, a cash discount is usually treated as a financial management item, though it is sometimes looked upon as a purchase department item. The handling of the voucher register so as to record properly the purchase discount will depend somewhat upon which theory of cash discount is adhered to. It is customary to carry a Purchase Discount column in the voucher register, although this is unnecessary if one is carried in the cash book. Where both cash book and voucher register are provided with discount columns, one is usually merely a memorandum carried for the sake of easy reference.

As regards the amount at which the liability under Vouchers Payable is carried on the books, we find two methods of making up the voucher and entering it on the register. This is in turn closely related to the financial policy as to the taking of discount. If it is an invariable rule of policy always to maintain a sufficient cash balance to take advantage of all discount offerings, there is nothing seriously wrong with the practice of making up the voucher and entering it for the net amount in the Vouchers Payable column; for if the policy is adhered to, no understatement of liabilities will result. If the policy is not strictly adhered to, constant adjustment will be necessary to make the books reflect the true liability.

A voucher entered net should have the discount shown in the Discount column and the gross amount in the distributive columns. Mathematical proof of the voucher register is secured by checking the sum of Vouchers Payable and Discount columns against the sum of the distributive columns. Here it is best to treat the Purchase Discount column total as an item to be posted, and the Discount column in the cash book as a memo. As regards the income from purchase discount, the effect of entering the voucher net is to bring onto the books the purchase discount income as soon as the voucher is entered. Purchase discount is not usually looked upon as earned until payment of the bill is made and thus the right to the discount established. This method then necessitates at the close of the fiscal period an adjustment of the difference between the Discount columns in voucher register and cash book, in order to defer to the next period the discount not yet earned on all vouchers unpaid at the close of the period. This may be accomplished by the usual method of deferring income, or by the following entry, on the theory that it is better for Vouchers Payable to carry the gross amount of liability, at the end of the period, at all events.

The entry must, of course, be reversed immediately at the opening of the new period—a procedure which makes this method of adjustment of doubtful value.

If there is any failure to take the discount, after the voucher has been entered net, it becomes necessary to make up and enter a supplementary voucher for the discount, with cross-reference between the original and the supplementary vouchers. The new voucher must be distributed to Sundry column as a charge to Purchase Discount. One of the few advantages of this method is that it makes possible reconciliation with the bank account by checking the canceled checks against the voucher register, which thus carries in its Vouchers Payable column the exact amount of the check and its entries are in the sequence of voucher numbers; whereas on the cash book voucher number sequence cannot be followed. Accordingly it is unnecessary to use treasurer’s numbers on the checks in order to secure sequence of numbers in the cash book.

The customary method, and one which usually proves most satisfactory, is to make up and enter the voucher for the gross amount, using the Discount column in the voucher register merely as a memo or not at all, posting the discounts, as earned, from the cash book and using a separate series of treasurer’s numbers when the checks are entered on the cash book.

Strict adherence to the theory of cash discount as a purchase department item would require making and entering the voucher net and distributing it net. The Discount column in the register might well be changed to a “Neglected Purchase Discounts” column into which would be distributed the supplementary voucher required when discounts are not taken. Under this theory, also, the voucher may be made up and entered gross, with the discount handled as a regular purchase discount item, and the net amount distributed to the other columns. The student should work out the manner of handling all the discount contingencies under this method.

Modifications of System

A regular purchase ledger is sometimes used with the voucher system. In such cases the voucher register becomes merely an analytic purchase journal and much of the advantage of numbering every transaction is lost. Accounts may also be set up merely as memos to indicate volume of business. The voucher index, as explained above, accomplishes this in a limited way.

A hybrid voucher system is sometimes met, a sort of half-hearted affair, which gives good results but does away with the essential idea of the voucher as being a receipted bill. Under it, a house voucher—so called because it never leaves the house—is made up and used as the basis of entry. The bill is paid by independent check, which when canceled is filed with the voucher. In all respects, except that the voucher is not sent with the check to be receipted, the system is operated as a regular voucher system. An advantage claimed is that in this way all information as to distribution of the charge or use of the purchased materials or services is kept strictly within the business itself. This is done at the sacrifice of securing a receipted bill.

Summary of Operation and Advantages

By way of summary, it may be stated that a fully efficient operation of the voucher system is comprised under the following routine:

• 1. A verification of invoices.
• 2. Making up and entering the vouchers.
• 3. Filing vouchers previous to payment.
• 4. Paying vouchers.
• 5. Filing paid vouchers.
• 6. Indexing vouchers.

Some of the advantages claimed for the voucher system are:

1. It gives a detailed analysis of all purchases.

2. It saves labor by doing away with the purchase ledger.

3. It secures an up-to-date entry of all liabilities.

4. It localizes responsibility by showing authority for the auditing, payment, and entry of the items.

5. It secures a receipted bill for all disbursements of cash.

The chief disadvantages are:

1. Clumsy provision for returns and allowances, partial payments on bills, and notes payable.

2. Inadequate showing of volume of business with each creditor.

3. The giving out of information about the business which should be kept private.

It should always be borne in mind that any satisfactory method of account-keeping must be adapted to individual conditions. If efficient results are expected, a business man should beware of ready-to-wear accounting systems. There are conditions in which the voucher system gives excellent results. There are also conditions to which it is entirely unadaptable and inadequate.

CHAPTER III
FACTORY COSTS

Difference between Factory and Financial Accounting

As was stated in Chapter II, the accounting records of a concern making its own product are much more complex than those of a concern which limits its activities to the buying and selling of stock-in-trade. A much larger mass of detailed information is needed for the proper conduct of the business. In this chapter it is purposed to study in a broad way the fundamental principles involved in factory accounting and to examine some of its distinctive problems. Factory accounting does not differ in the real fundamentals of account-keeping from any other kind of accounting. Its principles of debit and credit are the same; it employs the same or similar kinds of accounting records; and the same general use is made of the records, viz., to serve as a guide in the proper management and control of the business. Its distinctive features are seen in the application of certain principles to secure special information. To understand the problems peculiar to factory accounting, it will be necessary to consider the nature of this information.

Definitions of Terms

Three elements enter into the manufacture of a product. These are material, labor, and expense. The problems of factory accounting are therefore those connected with the accounting for the costs of material, labor, and expense. Some terms used in this connection will need explanation. A standard terminology for cost-keeping is becoming fairly well established. Direct and indirect costs, prime cost, factory burden, or overhead expenses, factory cost, full cost or cost to make and sell—these are some of the terms needing definition. Direct costs are those which can be allocated directly to a specific product. They are items which can be separated from all other cost items and applied solely to a particular product. Indirect costs are those which are shared in common by the various products and so must be distributed over them on some equitable basis. Direct costs are sometimes called prime costs. The cost elements which can almost invariably be applied directly to the product are material and labor. The sum of these two items constitute, therefore, the prime or first cost of the product. The other items of cost which are incurred in the factory or with which the factory is chargeable are variously called factory expense, overhead, or burden. These indirect costs cannot be charged directly to any specific product, and so they are shared by the entire factory output.

The sum of prime cost plus factory expense constitutes factory cost, i.e., the entire cost of manufacture up to the point at which the product is turned over to the selling department for sale. This is sometimes called total manufacturing cost.

Full cost is the price at which the manufactured article can be made and sold. In other words, to the factory cost of the article must be added its equitable share of all the other costs of conducting the business and also a margin of profit in order to arrive at a selling price. These definitions indicate some of the purposes of cost-keeping. Other purposes are given below.

Special Purposes of Cost Records

To maintain adequate control over production, careful records as to consumption of material and labor must be kept, so that the cause of any marked fluctuations of the costs of the current period from those of former periods can be investigated. The determination of factory cost makes possible a comparison of the policy of manufacturing with that of buying the manufactured article on the open market. This sometimes shows that manufacture is being carried at a loss. Again, the fixing of a sale price on the article, which while covering all expenses, shall at the same time leave a margin of profit, is a prime essential in every business. To be of the greatest advantage and usefulness, cost records should not only determine factory cost but they should accumulate the data needed to predetermine the selling price with accuracy.

Nature of Raw Materials and Supplies

Materials or raw materials constitute the crude commodities or semi-manufactured articles which are to be worked upon and fashioned into a new product. It is seldom that any factory takes its material in the raw form in which it comes from nature. The product of the mines goes through many degrees and stages of refinement and at each stage of the process some of it becomes the “raw material” for another class of industry. The term is therefore relative; that which is the finished output of one factory becomes the raw material of another factory, to be worked upon and given new forms.

Auxiliary material and supplies are also made use of. Thus, certain parts such as screws, bolts, hinges, casters, fastenings, trimmings, and the like, are incorporated into the finished product without change of form or the application of any labor thereto. These also constitute a part of the raw material of the factory, their value as finished product being due to place utility rather than form utility.

Supplies are to be distinguished from raw materials. This also is a relative term. In general, material which does not directly form a part of the finished product is carried under the head of supplies. Materials used in getting ready or seasoning the raw material, i.e., auxiliary material, such as paint, putty, etc., the quantity of which used on each piece of product cannot be measured with exactitude and must therefore be spread over the entire product—these and similar items constitute manufacturing supplies. They are usually treated as a part of factory expense rather than as belonging to prime cost.

There are also factory operating supplies. These comprise the materials used in the operation of the factory. Repairs material, brooms, oil, waste, packing, nails, fuel, etc., are examples of this kind of supplies. These, of course, are classed with factory expense, also.

The raw material which enters into prime cost is thus seen to be only that which can be charged directly to the particular product. All other material is overhead or expense.

Accounting for Material Cost

The problem of applying the cost of the material directly to the job is largely a problem of systematizing which requires the careful oversight and accounting for all materials bought and used in manufacture. Two general methods are employed. Under the one, the old method of keeping record of all purchases and taking the inventory periodically to determine how much material must have been used in the processes of manufacture, is deemed sufficient. In a small factory making just one product—or a few simple products—where the conditions are such that the manager has an intimate knowledge of all processes and can exercise personal control over them, fairly satisfactory results may accrue under this method, though the amount and therefore the cost of the material consumed in the product can never be known accurately until the inventory has been taken.

The other method requires almost as accurate accounting for material as for cash. A stores room or department must be established and a stores ledger installed. As materials are purchased and come into stores, they are classified in whatever detail is desirable and charged to their respective class accounts kept in the stores ledger. As material is needed for manufacture it is drawn by properly authorized order on the stores-keeper. These orders are called “requisitions” and indicate the material needed and the job or product to which it is to be charged. The requisitions constitute the source of the credit entries to the various stores ledger accounts as well as the charges to the job or product. The balances on the stores ledger accounts thus show the amount of each class of material which should be on hand in the stores room.

This method of keeping track of materials is known as the perpetual inventory system. By its use, it is possible to know without the taking of a physical inventory how much material is being used in manufacture and the cost of it. In this way much better control is secured over materials than under the physical inventory method. In keeping track of material values, of course, inward freight, cartage, handling and stores room cost must be loaded onto the invoice cost of the materials to arrive at the full cost at which they are issued for manufacture.

Direct and Indirect Labor

The second element of prime cost is labor. In factory accounting, labor is divided into two classes, direct and indirect. These are sometimes called productive and non-productive, terms doubtless carried over from the old economics which looked upon some labor as productive and some non-productive—necessary, it is true, but rather of the nature of a necessary evil. Direct labor is a direct cost as explained above. That is, it is the labor of the workmen who apply themselves directly to the manufactured product as distinguished from the labor of those employees who plan, lay out, and supervise the work of others. Direct labor can be definitely allocated to specific product or jobs, because it is applied directly to them. Indirect labor cannot usually be allocated to a definite product because it is applied to all the product, not being employed long enough or definitely enough on any specific product to justify keeping track of the time and charging it to specific product. Direct labor is a prime cost; indirect a factory expense. It is with direct labor that our present discussion is concerned.

The problem to be solved in accounting for labor is not the determination of the total cost of labor used, as is part of the problem of accounting for materials, but the distribution of that cost over the product. Determination of labor cost, except that accrued at any time, is a comparatively simple matter because the workmen have to be paid at regular intervals. Distribution of the labor cost over the product is more difficult. This necessitates keeping a record of the amount of time spent by each workman on specific product. In that way the labor costs can be figured quickly and distributed to the various products worked upon.

Time-Keeping Records

To keep track of the workman’s time spent on each unit of product, record must be kept by means of time cards, timekeepers, time clocks, or other similar device which will show the time at which work was commenced and the time at which it was finished or when the working force is transferred to other work. The time card is arranged with space for number or name of the jobs or products worked on and the time spent on each. Use of the hour or day rate of wages paid the workman gives the labor charge to each particular product worked upon. This time card, or its equivalent, may be kept by department foreman, a special timekeeper, or by the workman himself. At the end of the week or other period, these time cards are turned into the office and they serve as the basis for making up the past week’s pay-roll or as a check against the pay-roll where some other source for the make-up of the pay-roll is used.

Pay-Roll

The pay-roll is merely a list of the names or numbers, or both, of the workmen, showing the time employed during the past period, and the rate of wages. A column to carry total amount due each workman is provided, as well as in some cases a place for the signature of the workman’s name to acknowledge receipt of payment. Provision may be made for other information, also, such as distribution of the labor cost to the specific product, but this is not usual. When the time cards of the workmen are turned in, they are checked against foremen’s reports or sick notices. The total time spent by each workman multiplied by the rate of wages gives the amount earned by each man. From this may be deducted any claims, such as insurance, rent, store charges, hospital and sick benefit, giving the net amount due the workman.

Safeguarding the Pay-Roll

Since the pay-roll is such a frequent source of error and fraud, all possible safeguards, chiefly of an internal sort, should be made use of. Where possible, workmen should be employed through an employment department to which requests for men needed should be sent. Some form of card record should be kept for office files of all men taken on—and perhaps of all men interviewed. Additions of names to the pay-roll should not be allowed without authorization, and the payment of the men should not be made by the same clerks who make up the pay-roll. The pay-roll should be checked as to mathematical correctness and, where possible, as to the content of the roster, both before and after making payment. Too often has the total of the pay-roll been changed after its correctness has been proven but before it has been presented to the treasurer to provide the funds needed, the thief pocketing the difference between the amount needed for payment of labor and the raised amount of the pay-roll. Checking before and after payment will prevent this.

If payment is by check, the total amount of the pay-roll should be transferred by check to a special bank account on which the individual checks are drawn. If payment is in currency, this will be secured by check on the bank and the pay envelopes made up from it. Before drawing the currency, the individual amounts should be analyzed to determine the denominations of the coins and currency needed for filling each envelope.

Methods of Pay-Roll Payment. On each pay envelope should be marked the name and the amount. One pay-roll clerk should count out the amounts, the other clerk verifying them and filling the envelopes. A very ingenious pay-roll machine can be used for filling envelopes with the proper amount. The total amount of the pay-roll is placed in a coin rack operated by a keyboard. As the amounts of the individual envelopes are set up on the keyboard, the coin rack delivers the correct amount into a chute which carries it to the envelope. At the same time the amount delivered is listed, making it easy, in case of error, to locate the envelope containing the wrong amount. When the envelopes are delivered to the workmen, each man should identify himself in the presence of his foreman and give receipt for his pay. This is usually done by signing the pay-roll. The clerks making payment and the witnessing foremen should sign the pay-roll. Any unclaimed envelopes are returned to the treasurer to be held a certain length of time for claiming, after which time they may be diverted to other uses, though the liability for them must still be shown.

Distribution of Labor Charges

Distribution of the labor charges may be made in several ways. The precise method must depend largely on local conditions. In a small factory making only a few products, or where cost by departments is the desideratum, the voucher register may be provided with sufficient distributive columns to meet the requirements. At the time the pay-roll check is entered, it is distributed according to the labor cost in the various departments or on the various batches of product. This dispenses with a general pay-roll or labor account on the ledger. In a larger concern or one in which a more detailed distribution is desirable in order to secure definite and accurate costs on a diversified product, distribution on the face of the voucher register might not be feasible. Here, the pay-roll check will be run through the register as a charge to pay-roll. When the desired analysis is made in accordance with workmen’s time cards or other sources of information, a general or cost journal entry is made, charging the proper accounts and crediting Pay-Roll. Or, and usually better, a “Pay-Roll Distribution Book” may be used. This book is a recapitulation of the time cards distribution sheets. Each time card must be analyzed according to jobs, product, or departments, and these distributions as summarized should as a matter of permanent record be entered in a recapitulation book. This, by being made a posting medium, becomes the pay-roll distribution book. Charges to the proper accounts are made from this book, offset by a credit of the total of the book to Pay-Roll account. Sometimes the pay-roll book itself carries distributive columns and can therefore be made to serve as a pay-roll distribution record.

Accrued Wages. Distribution of wages accrued at the end of the fiscal period is perhaps best made through the general journal, although it can without much difficulty be run through the distribution book by making two recapitulations of the last week or pay-roll period at the end of the fiscal period, the portion of the week belonging to the last fiscal period being summarized separately from the portion belonging to the next period. Both summaries, however, should be run through on the regular pay-roll voucher for that week’s wages.

Expense

The third item or element which goes into the cost of manufacture is factory expense. Under this head are included all the costs of manufacture excepting the prime cost elements of materials and direct labor. Indirect labor, factory supplies, light, heat, power, repairs and maintenance to factory buildings and equipment, depreciation on factory buildings and equipment, rent, insurance, etc., constitute the main items under this category. These are the indirect costs of manufacture because, while just as necessary as the prime cost elements, it is impossible to allocate them directly to the product. How much of the cost of light, how much of repairs cost, how much of the cost of factory supplies, etc., shall be charged to each unit of several different kinds of product constitute a problem on the solution of which depends the whole structure of accurate costing. Accurate distribution of materials and labor costs may be complex, but presents no real difficulties. It requires little more than careful and painstaking work. On the other hand, to secure an equitable basis for the distribution of factory expenses, and one which is at the same time a workable basis, is in some cases well nigh impossible.

One common basis of distribution for all the factory expenses will not usually give satisfactory results. Each item of overhead must be considered separately and will often require a distinct basis of distribution. Thus, indirect labor is sometimes distributed over product on the basis of the cost of the direct labor item in the product, on the theory that the cost of supervision is a cost of supervising the direct labor and so closely related and dependent on that cost. Under some conditions, the number of direct labor hours is used instead of the cost of direct labor. Again, the time the product is worked on in a given department is taken as the most equitable basis for distributing indirect labor costs. Power, where metered to a machine, may be charged to the product on the meter basis. Where not metered, it may be charged on the basis of the time the machine is operated. So, every item of expense must be analyzed and effort made to secure an equitable basis of distribution.

Summary of Manufacturing Cost

Each unit of product, therefore, as it comes from the factory must carry its burden of cost composed of materials, labor, and factory expense costs. The sum total of all of these costs for all products—the entire output of the factory—will be the record of manufacture on the general books, the detailed record being carried in subsidiary books. At the close of the fiscal period when the temporary proprietorship activities of the business must be summarized, an entirely distinct group or section will be devoted to the activities of the factory because these costs must be shown separately from the others. For this purpose, the first section of the profit and loss statement and account is treated as the “Manufacturing” section, and under it are summarized in two groups the prime cost elements of materials and direct labor and the factory expenses. The total of this manufacturing section gives the cost at which the manufactured product is charged to the sales department of the business, and there this item takes the place of the cost of purchases in a business which buys its stock-in-trade. A detailed explanation of the manufacturing section as a part of the profit and loss summary is given in [Chapter XXVII]. The principles of cost accounting cannot here be developed further than this mere statement of the ends sought.

CHAPTER IV
THE BALANCE SHEET

Business Methods under the Microscope

The balance sheet is occupying an increasingly large place in all affairs of business and even of state, because the state is taking cognizance of business as never before. All phases of commercial activity are under the microscope. In these war times the government is tapping every available source of revenue. Kinds of property, property values, profits, rates of profit on capital invested—all are under investigation and the publicity resulting therefrom should make for a better conduct of future business. All this is forcing home to the manufacturer and trader some very obvious but long disregarded principles of business conduct necessary to secure health and long life. And these timely lessons will be of even greater use in the struggle for world markets that is imminent. As an interested party to any condition of business, labor also is claiming the right to be heard. The public in its direct dependence on certain classes of corporations for many of its necessities and most of its conveniences is also interested in the proper conduct of those businesses. As a factor in this increasing interest and scrutiny over business enterprises, exercised both from the inside and from external sources, banks are exerting a large and beneficent influence. The extension of credit, both bank and commercial, is no longer done by haphazard rule-of-the-thumb methods as in days gone by. Every applicant for credit must prove his right to it, must show cause why he deserves it, must present evidence of financial condition and standing on the basis of which the banker, the money lender, or the seller will be justified in extending all or some portion of the credit asked.

The Reading of the Balance Sheet

Because, in these and many other ways, the balance sheet offers the readiest means of securing the necessary information, it becomes an increasingly prominent statement. Before a proper understanding of the balance sheet can be had, and therefore before it can serve the various purposes to which it can be adapted, certain principles governing its make-up, both as to form and content, should be established. A proper reading of the balance sheet cannot be made without a thorough grasp of these principles.

The knowledge necessary for this is broadly of two kinds, viz.: (1) a knowledge of accounts, their technique, construction, and meaning; and (2) a knowledge of the principles of valuation as applied to business enterprises. The latter is not a domain of knowledge pre-empted by the accountant nor limited exclusively to his use. It touches more or less intimately all related fields of business endeavor. That is why the modern accountant needs a broad training and something more than a cursory knowledge of business practices and conditions. He should have a close acquaintance with the fundamental currents of business life, its organization and finance, and its basis in law, if he hopes to measure up to present-day requirements.

Thus not only is the accountant interested in the form and content of the balance sheet, but a proper understanding of it is valuable and increasingly necessary to all business men. In this chapter and those which follow, it is purposed to study these two problems of form and content, first establishing the broad basic principles and then showing in detail how these apply to various conditions and particular data. This chapter will concern itself with the problem of the make-up of the balance sheet so far as it relates to form.

Definition

George Lisle[4] defines a balance sheet as “a concise statement compiled from the books of a concern which have been kept by double entry, showing on the one side all the liabilities and on the other side all the assets of the concern at a particular moment of time.” Another writer says, “It is a cross-section of the business at a given instant”; and another, it is a “screen picture of the financial position of a going business at a certain moment.” As indicated by the first definition, an attempt is sometimes made to limit the term balance sheet to a statement made up from a double-entry set of books. With equal propriety it may be applied to any statement, whether made up from single- or double-entry books, or from any formal records, or from no records at all, which shows the assets and liabilities of a concern and the difference between them, i.e., the balance, as the item of net worth.

To distinguish this latter statement from the balance sheet when used in the restricted sense above referred to, the title, “statement of assets and liabilities” is sometimes used but there seems little reason for the distinction. Here the terms will be used as synonyms. The balance sheet then is a statement of financial condition as distinguished from a statement showing the operations of the business, and it is true only for a given moment of time. Theoretically the wheels of business are stopped momentarily, all operations cease, and a summary of the assets and liabilities then existing with their balance shown as net worth constitutes at that moment the balance sheet—the financial statement.

Relation between Balance Sheet and Trial Balance

A balance sheet when made up from a double-entry set of books bears a close resemblance to the trial balance. The trial balance is simply a list of ledger balances. Due to practical considerations in making the record from day to day, the ledger seldom reflects the true condition of the business, as there is no distinct separation of assets, liabilities, expenses, and income. Some accounts take on a mixed character, making necessary the periodic separation of their elements. This separation is effected by the adjusting entries explained in Volume I. A trial balance of the ledger after the adjusting entries are made contains the data for both the financial statement and the operating statement. After the operating data, i.e., the income and expenses, have been summarized through the Profit and Loss account and its balance has been transferred to some vested proprietorship account, the records left on the books relate only to assets, liabilities, and vested proprietorship. A trial balance now taken—a post-closing trial balance—contains only balance sheet items and to all intents and purposes is a balance sheet. While, as we shall see, the form in which the data of the balance sheet are presented is a matter of serious importance, any showing of assets, liabilities, and net worth constitutes a balance sheet.

Form of Balance Sheet

A balance sheet is not an account, nor is it the statement of an account. It is simply a statement of assets, liabilities, and proprietorship, arranged in whatever form best suits the purpose. Where set up in parallel columns, it is frequently called the account form; when shown vertically on the page, assets followed by liabilities and the difference indicated as net worth, it is called the report form. A balance sheet therefore being only a statement cannot properly be said to have either a debit or a credit side. It is not a complete system for the record of the transactions of a business set up in debit and credit form for the sake of proof, although on its statement of fundamental equality may rest the whole scheme of debit and credit. While usually made up from a system of double-entry books and so often spoken of as the goal of record-keeping, it may be made up from sources entirely extraneous to the books.

Purpose and Uses

The purpose of the balance sheet is, as indicated, to show financial condition. It may be made also to show the amount of profit for the period by elaborating the information given in the net worth section. If there has been during the period neither a withdrawal of any funds nor an additional investment, a comparison of net worths as at the beginning and at the end of the period will bring out the increase or decrease in net worth and therefore establish the amount of profit or loss, though telling little or nothing as to its source. If there has been withdrawal or investment or both during the period, adjustment must be made on account of these before the amount of profit or loss for the period can be determined from the balance sheet. The balance sheet may thus be made to show profit, though that is an incidental rather than an essential purpose of the statement.

As a statement of financial condition the balance sheet should make possible the determination of several facts. It may be used as the basis for short-time credit. If so, its purpose then is to show facts as to solvency. It may be used as the basis for floating a bond issue. If so, other groups of data in addition to the solvency facts must be held under view. It may be used for determining the advisability of an investment in the business. If so, its data must be examined from still another angle. In all of these cases the balance sheet must set forth clearly the relationship of the interests of the various parties in the business. The assets of a corporation are listed usually so as to show the total properties to which all the parties may look for the satisfaction of their claims. Of the claimants there are first, then, those whose claims are redeemable within a short time. Failure to meet these claims may mean insolvency. There are those also whose claims are not necessarily of immediate urgency, though they may be. Inability to meet these claims may mean bankruptcy and dissolution. Finally, the owners themselves have a proprietor’s right only to any residue of assets left after the claims of all outsiders have been satisfied or are capable of being satisfied. Thus the balance sheet may serve many purposes.

Types of Balance Sheet

As the balance sheet must serve, or can be made to serve, several definite purposes, the best way to accomplish the end in view must receive careful consideration. It is here that the question of form enters. The various problems in connection therewith will next be discussed.

As to types of form there are in the main two, the English and the Continental or American, both of them well standardized, although many variations from the types are found. The chief difference between the two types lies in the showing of assets on the right side and liabilities and capital on the left under the English form, and a reversal of the sides under the Continental form. So much useless controversy has been carried on with such a waste of effort and words over the relative merits of the two types, that a writer now scarcely dares venture into the subject. As a matter of historical interest and information to the student, an effort will be made to summarize briefly the two positions.

Origin of English Form of Balance Sheet

In the development of record-keeping a stage was passed through in which every account on the ledger was closed. Not only were the temporary proprietorship accounts cleared through the Profit and Loss account, but all the remaining asset, liability, and vested proprietorship accounts were in like manner closed into a Balance account opened on the ledger for this purpose. The Balance account, after transfer of the various accounts into it, became virtually a balance sheet and so was itself in balance. In this way the whole ledger was closed. The Balance account at this stage, so the controversialists maintain, represents, and was later adopted as, the Continental form of balance sheet. The ledger could not, of course, remain closed; it had to be reopened for the record-keeping of the next fiscal period. This was accomplished by credit entries to transfer the assets, and by debit entries to take out the liabilities and vested proprietorship. These reopening entries as appearing in the Balance account represent the English form of balance sheet.

This explanation of the origin of the two forms is ingenious and even plausible, although not synchronizing historically with the lapse of use of the Balance account. Others have attempted an explanation on purely logical grounds. These hold to the theory of the personality of accounts, which looks upon the business always as an entity distinct from its owners. Here, the English form of balance sheet is said to be the statement of account rendered by the business to its owners, whereas the Continental is the account given by the owners to the business. A. Lowes Dickinson,[5] in discussing the two forms, says: “The balance of argument would seem to favor the latter (English) on the theory that a balance sheet is intended to set forth the position of the owner of the property, who should therefore be credited with what he possesses and charged with what he owes.”

Quite opposed to this view is the position taken by an English authority, George Lisle,[6] He says: “Why ... the assets which are on the debit side (of the ledger)[7] and the liabilities which are on the credit side, as according to the principles of accounting they ought to be, should change places (in the balance sheet),[8] it is impossible to justify. The custom seems to have arisen through the influence of the forms given in Acts of Parliament, chiefly The Companies Act, 1862, which must have been prepared by those unacquainted with the theory of accounts. The Profit and Loss account is taken from the ledger, and the sides are not transposed, and there is no logical reason why the sides in the balance sheet should be reversed.... The form of balance sheet in which the assets appear upon the left side is both theoretically the correct form and in practice is the most convenient form to use.... Prior to about the passing of The Companies Act, 1862, it was the form chiefly adopted in England, but is so no longer.”

R. H. Montgomery[9] proposes a psychological explanation. He says: “The only sound reason the author can think of for the custom is that a conservative Englishman looks for his liabilities first and then looks to see if he has enough assets to discharge, them ... that the average American looks for his assets first and subsequently glances at his liabilities in order to assure himself that his excess of assets is as much as he believes it to be.” Regardless of the origin of the two types and their respective merits, a balance sheet is everywhere used to show assets, liabilities, and net worth, and less and less regard is being paid to debit and credit or left and right sides, technical form giving place to an elasticity in the method of showing adapted to accomplish definite purposes.

Variation of English Form

A variation of the English form of balance sheet is seen in the make-up of the balance sheet for British public service companies. These companies are authorized by special act of Parliament to raise money for designated purposes. The act, therefore, requires as a part of the statement of financial condition the rendering of an accounting of the receipts from sale of stock and bonds. Accompanying the financial statement, or rather as a part of it, is the statement, “Receipts and Expenditures on Capital Account,” comprising the fixed asset and liability sections of the ordinary balance sheet. Illogical as it may appear in view of the usual English practice, this account is credited with the capital stock and bonds issued to establish the undertaking, and is debited with the fixed assets in which the capital funds have been invested, the intent of the law being that the capital funds raised should be applied to purchase of fixed equipment with which to earn revenue and that all other expenditures should be made from revenue. If the fixed assets exceed at any time the fixed liabilities and capital, it means that the excess has been supplied out of revenue. If the reverse is true, it means that capital receipts are being used as working capital. Any balance is carried down to the second part of the financial statement known as “General Balance Sheet,” in which arrangement of the two sides is made according to English custom. The act authorizing this double-account form of balance sheet allows the valuation of the fixed assets always at cost, on the theory that their maintenance in a state of constant good repair and efficient working condition constitutes a charge against revenue and hence that depreciation need not be considered.

It has been suggested that the double-account form of balance sheet, or rather the law on which it rests, has been responsible for the decisions in the cases of Lee v. Neuchatel Asphalte Co. and Verner v. The General and Commercial Investment Trust, Ltd., reference to which is made later in [Chapter XXII], “Profits,” and [Chapter XXIV], “Dividends.” Here the decisions rested on the distinction between fixed and circulating assets and declared in favor of the maintenance of the capital funds invested in circulating assets but not necessarily of those invested in fixed assets. The following illustrates the double-account form: