4. Miscellaneous Methods
Criticisms of the miscellaneous theories can be brief.
(a) Maintenance Method
This method is irregular in its incidence, and under it the depreciation charge fluctuates violently between periods. Just as maintenance is subordinated to the requirements and demands of the trade, so also are depreciation costs made to depend on the same conditions. The charging of depreciation thus becomes a matter of business convenience instead of an inexorable fact of production. Just as repairs are postponed to a slack period during which maintenance charges are in consequence heavy, so does the depreciation charge increase even though actual wear and tear has decreased. Presumably the method makes charges light during the early years and heavy during the later years of the life of the asset. In a large plant with various kinds of assets, after a normal up-keep charge has been established, the maintenance method of estimating the periodic charge for depreciation for the plant as a whole may work out fairly well on the theory of averages or by accident; for maintenance is not a measure of depreciation.
(b) Replacement Method
This is not a method of measuring depreciation but rather of financing it, i.e., of making good the loss. It also is based on the law of averages, and in a large plant after the point of normal replacements has been reached it may prove a satisfactory method of accomplishing its purpose. It does not serve as a means whereby a periodic depreciation charge can be brought on the books. Furthermore, it disregards the depreciation accrued up to the point of normal replacements.
(c) Fifty Per Cent Method
This method is also based on the law of averages. Here the law is very apt to work out satisfactorily. When the point of normal replacement of the assets, to which the 50% method is applicable, has been reached, the amount of depreciation is approximately 50% of the original value of the group of assets. This amount may be booked at that time and will remain without change thereafter, for the assets are maintained constantly in that condition. As a means of valuation, the method may serve well; as a measure of periodic depreciation or as a means of distributing the depreciation cost over the product, it is inadequate.
(d) Appraisal Method
This method is also inadequate as a means of measuring the periodic cost of depreciation. The physical facts of depreciation are not usually discernible at such short intervals. A judgment of values must, therefore, almost invariably make use, consciously or unconsciously, of some of the other methods of estimating the amount of depreciation by periods. After all, all methods of measuring depreciation are appraisals. Under the appraisal method confusion between original cost and reproduction cost is almost certain to occur, for present market values usually control physical appraisals. A discussion of the relative merits of original cost and reproduction cost as a proper basis for estimating depreciation will be presented in Chapter XI.
(e) Insurance Method
This method of carrying the depreciation charge is analogous to the policy practiced by some concerns of taking care of their fire losses by carrying their own insurance. If physical conditions are such as to make such a policy advisable or prudent, it should work out satisfactorily. It should be noted, however, that the insurance method is a means of providing funds for financing replacements and renewals rather than a method of insuring an equitable distribution of the depreciation cost over the product. The method of providing funds does not need to be the same as the method of measuring the periodic cost of depreciation. The insurance method serves the former purpose but is not well adapted to the latter. Much of the criticism of the sinking fund method is here applicable.
(f) Percentage of Gross Earnings Method
Measuring periodic depreciation as a percentage of the period’s gross earnings is a convenient and fairly satisfactory method under some conditions. If the principal element is wear and tear—a service factor rather than a time factor—output may have a very direct relation to gross earnings. If the commodity dealt in is a standardized product and its price does not fluctuate to any extent or, better still, is fixed, gross earnings will be a very fair measure of output. It is true that the estimate is based on a sales valuation of output rather than its cost of manufacture, but under some conditions this is a good measure of relative output as between periods. A depreciation charge based on gross earnings may thus give an equitable distribution of the depreciation burden. In the case of public utilities, when the price of the commodity or service dealt in is fixed, an estimate based on gross earnings usually gives satisfactory results where used. In applying the method, the expected earnings during the composite life-period of the plant are estimated and depreciation costs are then prorated over periods on the basis of earnings for the period as compared with total earnings for the composite life-period; or more simply, a fixed percentage based on past experience can be applied to the earnings of each period. Some objections to the method, arising in some cases from a misunderstanding of its operation, were pointed out when an explanation of its working was given.
In some cases gross earnings bear no relation, or only the remotest, to the quantity of output or the units of service rendered. A depreciation estimate based on earnings would not in that case be logical and could not give satisfactory results.
From the above discussion of some of the merits and shortcomings of the various methods, the cogency of the introductory remarks, to the effect that no method of measuring depreciation can serve as a panacea, should be appreciated. Every depreciation problem is more or less an individual problem; sweeping generalities will not serve.
Effect on Return on Investment
Many interesting studies have been made of the effect of some of the above methods on stability of income as between periods and their effect on the return of the investment, using hypothetical data as to the earnings of the depreciating asset. Except for the purpose of fixing rates in the case of public service corporations, where the public has an interest because of the monopoly granted, stability of income should be subordinated to the fact of depreciation and not serve as a test of the merit or demerit of a method.
CHAPTER XI
RECORDING DEPRECIATION ON THE BOOKS
Methods Commonly Employed
Two methods of booking depreciation in the ledger are commonly employed. The periodic adjusting entry on account of depreciation has as its basic purpose the separation of the mixed account under asset title into its two elements—the one to show the expense element, the other to set up the true valuation of the asset. The expense element is set up under the one title “Depreciation” for all the assets. The deduction from the values as shown in the unadjusted asset account may be made either by credit entry direct to the asset account or by entry to a separate “Depreciation Reserve” account, each one of these reserves distinguished by the name of the asset to which it applies.
The latter method is preferred because thus the asset account at any time shows the original cost of the property—information of value for many purposes and worth the effort needed to maintain it distinct from other items. Under this method every wasting asset account is immediately followed by its particular depreciation reserve account, called its “valuation” account. The depreciation reserve is as much a part of the record of the asset as is the asset account itself. The two accounts are complementary, neither giving reliable information without the other. The reserve account is thus always and only a balance sheet account.
The above statement indicates the most satisfactory method of handling the various depreciation reserve accounts on the balance sheet. Although appearing on the credit side of the ledger, they are in no sense liability accounts, being interpreted always as credits to the asset account, held in suspense, as it were, in the reserve account, pending full determination of their accuracy, which governs their ultimate disposition. Thus, on the balance sheet, either only the net present value of the asset should be shown, or preferably its original cost with its value extended short, its depreciation reserve deducted, and the present value, thus determined, full-extended. Further information of some value is given if besides the amount of the reserve the rate of depreciation is shown, though this is not often done. Occasionally an entirely incorrect showing, from the viewpoint of strict form, is seen when not only are the depreciation reserves—usually in one item—shown on the right side of the balance sheet but are set up in the Net Worth section, seemingly as a part of the surplus or other true profit reserves. This practice cannot be justified on any ground except that the sheet is kept in balance—a consideration which is far removed from real essentials.
Renewals and Replacements
First Method. As to the handling of the reserve at the time of renewal of parts and replacement of the entire asset, here also two methods are met. Under the one, the original cost of the part (or whole) retired is transferred from the asset account, its salvage value as defined above being carried to a Salvage account, and the cost less salvage portion being charged to the reserve account of the asset. This clears the asset account of all capital charges on account of the part (or whole) retired. The new part (or whole) replacing it is now charged to the asset account which then represents true cost of the new asset. If it is a whole which is replaced, theoretically the charging of it against the reserve should just clear that account of all values. Practically the preliminary estimate or forecast of the amount and time of depreciation never coincides exactly with the fact of depreciation. A credit balance in the reserve indicates an overallowance for depreciation and is an item of true reserved profits, i.e., surplus; whereas a debit balance indicates an insufficient allowance and is an expense item chargeable against surplus and not current profits. This matter is treated at greater length on page 205. When the whole asset is replaced, the depreciation reserve should always be cleared of any remaining balance, as indicated above, so that the new asset and its depreciation allowance may be handled and watched unobscured by the record of any inherited sins or virtues from the past.
Second Method. The other method of handling the reserve at the time of replacement requires a comparison of the cost of the displaced asset and the cost of the new asset. The old asset account is allowed to stand untouched, but any betterment, i.e., excess of reproduction cost over original cost, is charged to it so that the asset account may show cost of the new asset. This cost, except for its betterment portion, if any, is now charged against the reserve. Both methods thus accomplish the same purpose, but the first is more direct and simpler of operation. It may be interesting to note that, in early instructions to railway accounting officers, the Interstate Commerce Commission prescribed the second method, which emphasizes the betterment feature. The present regulation is in accord with the first method.
Occasionally one finds a practice which, though based on the second method, differs in that no determination of betterment values is made, the original asset values remaining undisturbed and the entire reproduction cost being charged against the reserve account. This practice, of course, is due to a lack of understanding of the nature and purpose of the depreciation charge and its offsetting reserve, and is counter to correct principles. There is, however, seeming judicial support for it in cases of the valuation of utility properties for rate purposes. The problem is discussed in full on page 202. The entries on the general books thus present no difficulties.
Subsidiary Records
Subsidiary records should usually be kept to show the detail of the group asset accounts carried on the general ledger. Not only is this necessary to maintain an adequate check on the inventory of the group asset and control over it, but without a detailed record of items it is impossible to keep careful watch over the operation of the forces of decay and depreciation and, therefore, equally impossible to build up reliable experience data concerning each group of assets. The amount of detail necessary in the record of the plant assets is dependent upon the information desired and capable of being obtained within a limit of cost low enough to make it worth the cost. This is a matter of policy which the management must determine. It may be desirable to carry the records in much greater detail for a period than would be justifiable as a permanent policy. It may be worth while to make more or less frequent studies of particular groups of assets in order to check up the effect of the depreciation rates.
As is pointed out elsewhere, while the preliminary estimate of expected life, and determination therefrom of the depreciation rate, are of great importance and the utmost skill and judgment possible should be employed, only a policy of everlasting vigilance and readjustment, in the light of new data available with the increasing age of the asset, will bring satisfactory results. To predetermine a rate and then to expect it without supervision to work out to a successful conclusion is, to say the least, foolish. Only by means of a complete record of life histories can a mass of reliable data be built up which can be made to serve as a guide for the future. The depreciation problem is an individual problem and must, from the nature of things, remain so to a marked degree. Until conditions under which the lives of assets are to be lived become more or less standardized, or so long as each concern must carry its own depreciation insurance, standard rates of depreciation will not have a controlling significance.
Grouping and Classification of Plant Assets
From what has been said it is evident that the assets of a plant must be divided into groups for the sake of simplicity and convenience in keeping record of them. The basis of grouping should be physical similarity, process, or product. Thus, all tram cars might be carried in a group, as also all machines doing the same work or process. Groups of machines performing different processes on the same product could well be treated as a depreciation unit, and likewise all buildings used for the same purpose, if of a similar type of construction. If the latter are of different types it might be desirable to keep separate records. As stated above, the information desired must govern the groups under which record of behavior and performance are kept.
A numerical or an alphabetic numeric system of classification and identification is advantageous. Each machine, piece of equipment, or other asset should be marked or tagged when installed so that any particular piece of equipment can be identified at any time. The tag should carry date of installation and the name of the maker or vendor, as well as its own identification number. By the use of a combined alphabetical and decimal numerical system, almost any possible grouping can be made according to main and auxiliary groups, processes, or products.
Form of Plant Ledger
The form of the plant register or ledger need not be elaborate. Its main subdivisions should correspond with the subdivisions of plant and equipment carried on the general ledger. Thus, if we find therein accounts with buildings (factory, store, office, etc.), machinery, furniture and fixtures for factory, store, and office, delivery equipment, etc., subsidiary records should show corresponding subdivisions. It should be a matter of fixed policy to require a periodic proof of these subsidiary records against their respective controlling accounts on the general ledger. Only thus can the inclusion of all items in both records be made certain. The control established must cover both the items of the assets record—the original cost as shown by the asset account—and the accumulated depreciation as shown by the reserve account.
Asset Record
Aside from the title and classification and identification number, the plant register should provide a record of the asset under the heads of:
1. Date of installation or adjustment.
2. Estimate of life in periods, working hours, service output, etc.
3. Original value, including installation costs.
4. Periodic depreciation burden.
5. Periodic appraisal value.
On the form shown below, provision is made for adjustment of the original estimate of depreciation. Where there is a realizable scrap value, additional columns to show scrap value and total depreciation to be written off should be provided. The form shown would have to be adapted to the method of depreciation decided upon as applicable to a particular asset. Thus, if working hours or service output are the basis, provision should be made to show the basis of calculation of each period’s depreciation burden. The following form is well adapted to make record of the asset under the straight line method of depreciation.
From “Principles of Depreciation” by Earl A. Saliers.
Plant Ledger (showing adjustment of value)
Periodic Revision of Rates
In Chapter VIII where the problems in connection with depreciation rates were discussed, a periodic testing of the effects of the particular rate employed was laid down as an essential for the application of any rate. The determination of the rate in the first place is a problem requiring expert knowledge and the most careful consideration of many factors. Hardly less important, however, for the successful operation of any depreciation scheme is the attention given to the manner of its operation and a modification and readjustment of rates to bring the theoretical expectation of the wasting of the asset into accord with its actual wasting to date.
At the beginning, when the asset is first installed the depreciation rate must be based, so far as this particular asset is concerned, entirely on contingencies. None of its life has been lived; none of its actions and behavior have yet become a matter of record. What it is apt to do can be forecast only by a study of its ancestors—heredity as modified by a reasonable expectation of change due to different environment. However, at the end of five years, say, there is available a record of service and behavior in the light of which not only can the accuracy of the forecast be judged, but also a more reliable forecast for the remainder of its service life can be made.
Frequency of Revision of Rates
Because of the conditions stated above, a periodic testing of rates should be made. How frequently this should be done depends largely on local conditions. Certainly sufficient time should be allowed to pass to secure a really worthwhile test. What constitutes a sufficient time depends largely on the expected length of life. Long-lived assets obviously need not be tested so frequently as short-lived assets; and the periods should be shortened when the asset has been serving under supernormal conditions; the intensity of its life would be a controlling factor. It is usually stated that this testing of rates and conditions should be made at least every five years in the form of an appraisal. In the physical appraisal care should be used not to allow present market prices to enter into it, else the element of fluctuation may easily be brought in to nullify or exaggerate the real results of depreciation.
Test of Condition Per Cent
At the time of reappraisal the estimated condition per cent or the expectancy as to remaining service life are the points most to be considered. C. E. Grunsky has made an interesting contribution to the study of expectancy—theoretical, it is true, in the sense that it is based on assumed hypotheses, but nevertheless of value as calling attention to a phase of the subject that presents large possibilities. He takes 10,000 similar articles, all of probable life-terms of 10 years, and all simultaneously installed. Assuming that of these 10,000, 100 will fail or go out of service at the end of the first year, 200 at the end of the second year, that the largest numbers will fail in the years just before and just after the expected life-term of 10 years, and from then on, that there will be a gradual decrease in the number of failures until the 20th year, beyond which time (double the estimated life-period) none will remain in service—the following table is shown, which gives in the last column at the right the life expectancy of all remaining articles as at the beginning of a given year.
It will thus be seen that an article which has survived its 5th year, has at the beginning of its 6th an expectancy, not of 5 years but of 6.12 years; an article which has lived its allotted 10 years has an expectancy of 3.67 years; and so on. Certainly Mr. Grunsky’s study, if it serves no other purpose, at least draws attention to possible lines of development and, read in connection with facts as to the known length of life of many assets which have outlived their expected terms, it draws strong attention to the need of very careful use of any so-called mortality tables. These life history tables for assets are similar to the mortality tables used by life insurance companies.
Table of Expectancy[37]
The probable life of each article is 10 years or periods. For terms other than 10 years, each year in the table may be regarded as a period equal to one-tenth of the probable life-term.
(Based on the special hypothesis of failures as explained in the text)
| Year or Period | For 10,000 Articles | Single Article | ||
|---|---|---|---|---|
| Number of Failures | Remaining Number of Articles at Beginning of Year | Remaining Service at Beginning of Year | Expectancy at Beginning of Year or Period | |
| 1 | 100 | 10,000 | 100,000 | 10.00 |
| 2 | 200 | 9,900 | 90,000 | 9.00 |
| 3 | 300 | 9,700 | 80,100 | 8.27 |
| 4 | 400 | 9,400 | 70,400 | 7.46 |
| 5 | 500 | 9,000 | 61,000 | 6.77 |
| 6 | 600 | 8,500 | 52,000 | 6.12 |
| 7 | 700 | 7,900 | 43,500 | 5.51 |
| 8 | 800 | 7,200 | 35,600 | 4.95 |
| 9 | 900 | 6,400 | 28,400 | 4.44 |
| 10 | 1,000 | 5,500 | 22,000 | 4.00 |
| 11 | 900 | 4,500 | 16,500 | 3.67 |
| 12 | 800 | 3,600 | 12,000 | 3.33 |
| 13 | 700 | 2,800 | 8,400 | 3.00 |
| 14 | 600 | 2,100 | 5,600 | 2.67 |
| 15 | 500 | 1,500 | 3,500 | 2.33 |
| 16 | 400 | 1,000 | 2,000 | 2.00 |
| 17 | 300 | 600 | 1,000 | 1.67 |
| 18 | 200 | 300 | 400 | 1.33 |
| 19 | 100 | 100 | 100 | 1.00 |
| 20 | 0 | 0 | 0 | 0 |
Composite and Group Rates
In the practical application of the depreciation rate in a large plant, every separate piece of property is not, of course, considered by itself. The plant is divided into groups of similar assets, determined roughly on the basis of life expectancy, conditions of service, etc. Using these groups it is possible to find the rate of composite depreciation—a figure which serves as a check over the group depreciation. This is also sometimes called the “mean life” of the plant. It is determined by two methods—one called the direct, the other the dollar-year method. Assuming groups of assets of varying life lengths and costs, the following examples show the manner of estimating the amount of depreciation for the whole plant and also composite life; that is, the mean average life of the individual assets when viewed not as units but as a composite whole:
Mean Life
Direct Method
| Group | Life in Periods | Value to be Depreciated[38] | Rate of Depreciation | Amount of Periodic Depreciation |
|---|---|---|---|---|
| A | 5 | $100,000 | 20 | $20,000 |
| B | 10 | 75,000 | 10 | 7,500 |
| C | 15 | 60,000 | 6⅔ | 4,000 |
| D | 20 | 120,000 | 5 | 6,000 |
| $355,000 | $37,500 | |||
Mean life is $355,000 ÷ $37,500, or 9⁷/₁₅ periods.
Under the dollar-year method, the invested values are weighted by the length of their investment term and thus all investments are reduced to the common basis of one dollar for one year:
Mean Life
Dollar-Year (or Weighted Ratio) Method
| Group | Life | Value to be Depreciated | Turnover Rate in Longest Life-Period | Total Investment During Longest Life-Period | Dollar- Years |
|---|---|---|---|---|---|
| (a) | (b) | (c) | (d)[39] | (e) | (f)[40] |
| A | 5 | $100,000 | 4 | $400,000 | $2,000,000 |
| B | 10 | 75,000 | 2 | 150,000 | 1,500,000 |
| C | 15 | 60,000 | 1⅓ | 80,000 | 1,200,000 |
| D | 20 | 120,000 | 1 | 120,000 | 2,400,000 |
| $355,000 | $750,000 | $7,100,000 | |||
Column (f) ÷ column (e), (7,100,000 ÷ 750,000 = 9⁷/₁₅) gives the mean life.
Column (e) ÷ the longest life-period, 20 years, (750,000 ÷ 20 = 37,500) gives an annual charge for the whole plant.
What is known as “mean” age or plant expectancy as to remaining life may be found similarly. Assume a physical appraisal made after 12 years’ life of the above assets:
Mean Age (Life Expectancy)
Direct Method
| Group | Life | Unexpired or Remainder Life | Condition % | Values to be Depreciated | Values Already Depreciated |
|---|---|---|---|---|---|
| (a) | (b) | (c) | (d)[41] | (e) | (f) |
| A | 5 | 3 | 60 | $100,000 | $40,000 |
| B | 10 | 8 | 80 | 75,000 | 15,000 |
| C | 15 | 3 | 20 | 60,000 | 48,000 |
| D | 20 | 8 | 40 | 120,000 | 72,000 |
| $355,000 | $175,000 | ||||
Group A assets, having been twice renewed, would be in 60% condition; Group B, 80%; Group C, 20%; and Group D, 40%.
Column (f) ÷ column (e), (175,000 ÷ 355,000 = 49²¹/₇₁%) gives the per cent of composite depreciation already taken effect.
The mean life, as determined above, multiplied by per cent of composite depreciation gives the mean age or portion of the mean life already lived (9⁷/₁₅ × 49²¹/₇₁% = 4⅔).
The figure of mean or composite life may serve two purposes. First, it forms the basis for comparison with other similar plants and is about the only fair basis for comparison. Second, it gives the basis for estimating the amount of annual depreciation of the plant as a whole. This statement does not mean that individual depreciation reserves are not to be carried for each group of assets and those charged with the value of the asset as soon as it is discarded and renewed. But the use of the estimated mean or composite life figure does give a control over the amounts which should always be found in the individual group reserve accounts, i.e., at any given time the sum of the individual reserve account balances should be approximately equal to the amount as shown by the reserve when calculated on the mean life basis.
The Reserve as an Index of Financial Condition
The statement is often made that a balance sheet showing depreciation reserves points to a conservative policy in the treatment of plant properties. Usually such a balance sheet affords little or no basis for expressing a judgment as to conservatism or the lack of it. All that it does show is that recognition is made of the fact of depreciation. As to its adequacy or inadequacy, a knowledge of other factors is necessary.
Fluctuating Reserve. According to successive balance sheets a reserve may vary little from year to year, or it may show considerable increase or decrease, and any of these conditions may be entirely normal and express adequacy of reserve requirements. In the first case, stability of the reserve may result because the asset is short-lived and hence is more or less frequently replaced; or different units of the property may have been installed at somewhat regular intervals so that retirements from service are also somewhat regular. Under either supposition, the charges against the reserve for the units displaced would just about keep pace with the regular credits to reserve for replacement purposes. In other words, that condition of the reserve for that class of asset is the normal condition—except perhaps in the case of a rapidly expanding plant, or other conditions not counted as normal when the reserve requirements were put into operation—and any other condition should lead to inquiry and investigation.
Increasing Reserve. In the second case where the reserve is showing a considerable increase from year to year, that also may be a normal condition. Long-lived assets are seldom replaced with any degree of regularity in the annual charge against the reserve, except in the case of very large plants where the number of such assets is correspondingly large in proportion to their size. Here more or less regular installations may take place as a result of an expanding business, covering a period of approximately the same length as that of the life of the asset. So here, too, any other than a regularly increasing reserve must incite inquiry.
Decreasing Reserve. As to the third case, that of a somewhat regularly decreasing reserve, the condition is not usually normal but may occasionally be met in a plant where one type of equipment is being retired and not replaced, due perhaps to a changing line of activity; as when, for instance, a stock furniture manufacturer works gradually into the exclusive manufacture of automobile and carriage bodies. Some types of equipment will thus be gradually retired and their reserves will constantly diminish, their place being taken by other reserves covering the new type of equipment. However, this condition of decreasing reserves, while entirely normal under certain circumstances, being unusual, should always receive careful investigation. It is here that mean life and mean age or composite plant depreciation are of assistance in forming a judgment as to the general adequacy of reserves.
The Reserve in Relation to Expanding Plant
In the case of a plant the development of which is stationary, the problem of judging the adequacy of the reserves is simple in comparison with a plant which is expanding, resulting not only in the installation of more of the same kind of equipment but also of equipment of other kinds. A disturbing element is thus introduced and careful oversight of the depreciation policy must be exercised. In all cases, intelligent reading of the reserve and its sufficiency are internal problems based on intimate knowledge of conditions. Lacking this knowledge no true judgment can be made. The character of the asset, number of units in use, dates of installation, a comparison of the assumed conditions at date of installation with the actual conditions of the present—all are factors to be taken into account.
Reserve as Related to Efficiency
The general relation of efficiency to depreciation has already been discussed. As to whether the condition of the reserve is any index of the efficiency of the service rendered by the plant unit, attention is briefly directed to a misinterpretation of individual reserves. Experts state that many types of equipment cannot deteriorate actually more than a fixed per cent of their cost and continue to give efficient service. If, say, 30% is the limit in the case of one type, this does not, of course, indicate that, as soon as the depreciation reserve shows an amount equal to 30% of the cost, the approach of inefficient operation and the time of discard are at hand. It must be borne in mind that the reserve is a device based on financial considerations and, if properly calculated and handled, no asset should be ready for retirement until its reserve approaches in amount the value at which the asset is carried in its account. Nor is the point of approaching inefficiency shown until that condition of the reserve is found.
Reserve not Based on Cost of Replacement
The question is sometimes raised as to whether reserve requirements should be based on original cost or cost of replacement new. The question usually reveals a lack of understanding both of the purpose of the depreciation charge and the means of financing depreciation. It is usually said that the reserves carried on the books are for the purpose of providing the means of financing the replacement. It is not the purpose here to go into the question of original cost versus cost of reproduction new, either as a basis for valuation of public utility properties or from the viewpoint as to where the incidence of the burden of replacement properly should rest—whether on the users of the service given by the asset to be replaced or on those using the new asset. In the private enterprise where the rights of the public are not so apparent, under present-day tenets of political and economic philosophy, only internal policies and purposes to be accomplished need be considered.
As stated above, the basic purpose of the creation of the reserve is to burden the product with depreciation charge as a real part of the cost of production. If we are concerned with real and actual costs of production, by no stretch of the imagination can replacement cost—what it might cost to replace the asset at some more or less distant time—enter into the question. It might, with equal obscurity of logic, be said that, because the labor cost is bound to be higher 10 years from now than at present, in order to get the true present cost of the product the estimated future labor cost should be taken in place of the actual present cost.
The Financing of Replacements
If one purpose of the depreciation reserve is that of financing depreciation, this can mean only that the reserve must insure provision being made so that the capital invested will not be lessened or encroached upon by the wasting of the assets in which it is invested. It is no necessary or proper purpose of the reserve to provide for increasing the invested capital. Financing the replacement of the retired asset is a separate financial problem and only concerns accountancy, so far as the records may reflect that policy. The reserve, in itself, does not furnish the means of financing any part of replacement, as was fully shown above. If the new asset is expected to cost more than the old, certainly business prudence would dictate provision for the added cost as well as ready funds of an amount equal to the original cost. The actual capital provided originally need be sufficient only for the time being; to provide more than that, if remaining idle, would be folly. If there is evidence of expansion, or if it is recognized that more will be needed—due to change in markets—for replacement purposes than was originally needed at the inception of the enterprise, provision must be made therefor.
Methods of Financing Replacements. In the financing of replacements, three courses are open:
1. Capital stock may be increased.
2. Funds may be borrowed.
3. Profits of the past may be reserved in the business and the actual value of the holdings of the owners thus be enhanced.
In the third case present dividends may be sacrificed for the sake of the future. Such reserve profits must be kept and used for the intended purpose, the purpose dictating their form as liquid or fixed. It cannot be too strongly emphasized that these are reserves of profits—not valuation or offset accounts under the title of reserves. Depreciation reserves, except they become secret reserves in the sense referred to below, have no right to serve any other purpose than that intended, viz., to provide insurance that none of the originally invested capital shall be dissipated and that the current product shall be burdened with its just share of all the materials and costs of production.
Secret Reserve
A great deal has been said about inaccuracies in the depreciation charge; the need of periodic readjustments has been emphasized. Now it is purposed to look into the effects of inaccurate charges remaining unadjusted on the books. In a desire to be on the safe side, some concerns, notably financial institutions, make very liberal provision for depreciation. Such a policy is not entirely to be condemned and is decidedly refreshing in comparison with the parsimonious allowances, begrudgingly made in some quarters. The effect of such a policy, if operated without check, is to create what is known as a “secret reserve.” The value of the asset is charged more rapidly against operation than the asset actually wastes. Hence the books show a reserve sufficient to cover the cost of asset while there are still values remaining in the asset. In other words, the business possesses an asset of value which is carried on the books as of no value. Were the real present value of the asset brought on the books, the contra credit would appear in some surplus or profits reserved account. Such would constitute a true record of the item, openly stated. So long as the asset remains concealed, i.e., without record on the books, its contra credit is also latent and constitutes a secret reserve of profits.
A too liberal depreciation policy, if recognized and adjusted at the time of a reappraisal, will require a separation from the depreciation reserve of the portion brought about by the overallowance, and its showing as a part of the surplus. When so handled, an overcharge for depreciation has no permanently bad effect except as it may show, for purposes of comparison, too high costs of production for the period overburdened. However it may be and sometimes is, used for purposes of fraud and therefore, as a fixed policy, the practice of the secret reserve is to be condemned.
Insufficient Charge
On the other side is the parsimonious policy of too low a charge or none at all. This results, whether consciously or not, in a charge against capital instead of revenue. At the close of the fiscal period the books are supposed to be brought into accord with the facts of true condition as then existing. Therefore, if the full portion of the accrued expenses is not separated from the wasting asset accounts, but is allowed to stand on the books under the title of assets, then these true expense items will still be carried hidden under the cloak of asset titles. The depreciation is thus carried as a charge against capital. The depreciation of a going concern should never be so treated; it is an operating charge, and no flight of fancy or shuffling of figures can make anything else of it.
In the case of a property, showing inflated values because of too low depreciation charges in the past, which is taken over and rehabilitated, the sums spent on the property previous to operation to put it in condition are properly capital charges. This is allowed on the theory—unfortunately, not always a fact—that the difference between the book value of the property and what was paid for it represents the estimated expenditures necessary to bring the property up to its book value. If such is not the case and full book value was given for the property, the charge is still allowed, being looked upon as in the nature of an organization expense, representing in an instance of this sort the measure of the bad bargain made. This will, of course, result in a penalty in the form of an added depreciation burden on all product from the property taken over and rehabilitated.
Appreciation as an Offset to Depreciation
If depreciation is so inevitable and the necessity of its charge so absolute, can anything be said in support of the proposal to offset depreciation against appreciation? By appreciation is meant an increase in value due to the passing of time. Judicial authority can be found in support of it in cases of valuation for rate purposes.[42] There is no question but that a realized increment in land or any other asset offsets a depreciation or any other expense charge in just the same way that any other item of income offsets an expense. There is, however, this marked difference between depreciation and appreciation: the former is an inexorable reality advancing day by day entirely independent of market fluctuations, whereas the latter is dependent on the market and usually cannot be realized until the asset is sold.
When, however, as is too often the case, the proposal to offset depreciation by appreciation is meant to justify a policy which takes no cognizance of depreciation on the books because it is offset by appreciation, no support can be found for that view. In itself it reveals an entire lack of knowledge of the purpose of the depreciation charge or a disregard of the fundamental and obvious requirements of prudence. Depreciation is one of the costs of production and without it true cost cannot be shown. Failure to show depreciation on the books would justify also the omission of a cash income item because the cash was to be spent immediately in payment of salaries—a cancellation outside the business records of income against expense which can under no circumstances be justified.
Appreciation Due to Physical Changes
There is a kind of appreciation which is not dependent on fluctuations of the market and which as surely accrues, up to a certain point, day by day as does depreciation. Properties the value of which has been enhanced by earth construction work done on them are susceptible of this kind of appreciation. “Appreciation is generally restricted to physical items, and measures their gain in value due to age, use, and properly directed labor.... It results from work not specifically charged to capital account ... and covers items not represented ... in connection with a valuation.”[43] It is found in connection with such items as roadbeds, solidification and grassing of slopes, drainage, dams, embankments, etc.
Its two forms are called solidification and seasoning, and adaptation. By the first is meant a settling and compacting of loose earth and its protection from wasting and washing away, as by the grassing of slopes, and the planting of trees and shrubs to hold the snows. When a roadbed is turned over to the operating division, it frequently is far from complete in the sense of being in a high state of efficiency, and the cost of its maintenance and up-keep during the early years of its life is much higher than during later years. This appreciation due to seasoning is difficult of valuation, but perhaps the difference in up-keep between early and later years is the best measure of it.
Appreciation Due to Adaptation to Use
“Adaptation” is a term used to cover that class of expenditures needed for the better adaptation of the property to its use. In the early stages of the development of a property many things cannot be foreseen nor can a proper basis be settled upon for a determination of the charges as between capital and revenue. The proper handling of such expenditures as those incurred for drainage requirements, better adaptation of the roadway to the surrounding topography of the country, etc., are difficult. If these costs have not originally been charged against capital, the properties may truly be said to have appreciated in value by reason of them. Items of this kind require a wise discrimination between costs of operation and capital charges. The effect of such changes is almost always lost sight of so far as physical appearance shows, and the appreciation due to them is difficult of valuation at a later time. In the case of railroads, perhaps the difference in maintenance cost as between the early and later years of the roadbed is the best index.
In the case of industrial concerns, the cost of a rearrangement of machinery and working facilities for the better and more economical handling of the product frequently results in an appreciation in value due to adaptation to use. This has already been discussed in Chapter V.
As stated above, appreciation has judicial sanction and its valuation, although fraught with many difficulties and uncertainties, has been made and the results accepted. The generally haphazard method of roughly estimating the value of an appreciation when its determination becomes necessary suggests that it were better, by far, to attempt the proper segregation of the charge between capital and revenue at the time of its incurrence, rather than to take cognizance of an appreciation in value at a later time. There are undoubtedly circumstances in which appreciation in value can be properly recognized and should be taken into the accounts not only of public utility properties but also of industrial concerns.
Unearned Increment
Appreciation in value due to so-called unearned increment is entirely a matter of market value. By this is not meant that the monetary value of this kind of appreciation fluctuates with the market; it accrues from day to day and is just as real as depreciation. Although very real, it does not become realized until the property is disposed of, a thing which is determined by business policy and does not rest on any principles of accountancy. It is not good practice to bring such unrealized values on the books. For a fuller consideration of this phase of the subject, [see Chapter XVII] where the problem is treated in connection with land and real estate.
Depreciation Policy and Stockholders
A final consideration concerns the relation of the depreciation policy to the stockholder. As stated above, a too liberal depreciation policy results in the creation of secret reserves which may be used to the prejudice of the stockholder by an unscrupulous managing clique desirous of buying minority holdings at a depreciated value or of manipulating the stock for speculative purposes. An insufficient depreciation allowance results in a false optimism, a payment of dividends out of capital, and perhaps finally in a wrecking of the property. Except for the transient, speculative shareholder, a fixed depreciation policy based on a conservatively accurate allowance is always for the best interest of the property and its owners.
CHAPTER XII
CASH AND MERCANTILE CREDITS
Introduction
In Chapter V an effort was made to establish the general principles of valuation as applicable to the main classes of assets found on the average balance sheet. In doing so, the fundamental distinctions between capital and revenue charges were set forth. In the six chapters on depreciation the general principles of depreciation and their application to problems in accounting have been developed, with particular emphasis on the problems of valuation and true costs. It is purposed now to consider in detail the various problems met in the valuation of the individual items found on the commercial balance sheet. It will be necessary also to consider the method of showing these items so as to indicate the basis of valuation and something of the financial policy employed. The various assets will be considered in the order of their appearance on the balance sheet, the arrangement being based on degree of liquidity, beginning with the most liquid.
What Cash Includes
There is little to be said about the valuation of an asset of such evident and definite value as cash. The problem here is rather one of showing the nature of the asset, although certain principles of valuation under given conditions need also to be considered.
The term cash as an item in the balance sheet usually includes all money and whatever serves as money. Thus, all legal tender of the realm, bank notes, checks, bankers’ drafts, postal and express money orders, and occasionally postage stamps and even “IOU’s” are classed as cash. Not all items, however, that may be carried on the books as cash should appear under this caption on the balance sheet. There only the current asset cash should be listed in the group of current assets. All other cash, including that held for specific purposes under deed of trust or otherwise, should, unless it is readily applicable for the cancellation of current liabilities, be shown in some other group.
Where the petty cash or working funds of all sorts are operated on the imprest system, the funds should be replenished before the books are closed and should thus be truly valued at their ledger figures. The bank account should be reconciled with the cash book, and the figure should represent the amount at which the item is to be taken into the balance sheet. This means, of course, that all properly authorized claims against cash in bank are to be treated as cash disbursed if they have been regularly issued, whether presented for redemption at the bank or not. Checks written but not yet mailed are not usually treated as cash disbursed because they are still under control. Similarly, items left at the bank for collection and deposit may be counted as cash on hand. If, however, as might happen in exceptional cases, a comparatively large amount represented dishonored items and a second attempt was being made to collect these dishonored items, the better procedure would be to omit them from the cash total and include them with the receivable items. In this connection attention should be called to the practice occasionally met with of holding the cash open for a few days after the closing date for the purpose of making a better showing as to balance on hand by means of new collections. This, of course, is a practice which cannot be countenanced under any circumstances as it is simply an effort to mislead, even though the effect may not always be bad. A balance sheet is a statement of financial condition purporting to be true as on a certain named date. The values shown therein are therefore to be those applicable to, and true on, that date and no other.
Stamps Remitted as Cash
Some concerns dealing in commodities of small value sold through the mails allow, and even encourage, payment by means of postage stamps, these in turn being used for their own correspondence and parcels post expense. The proper place to record the value of this item at the close of the fiscal period is in the inventory of office supplies or other similar heading instead of treating it as a part of the cash. This necessitates a transfer from cash to office supplies. The transfer can be accomplished in either of two ways without interfering with the usual handling of the cash whereby it is checked against the bank’s record of deposits and checks as explained in Volume I, Chapter XXXV. The customary method is to use the cash book as the place of record for the receipt of stamps and then transfer them to the stamp drawer for office use. All other “cash” being deposited in the bank, the record of cash receipts as shown by the cash book does not thus check against the record of deposits as shown by the bank. To secure this agreement, a check may be made out payable to “Cash,” “Ourselves,” or “Postage,” and passed through the bank periodically as a deposit and so secure the proper agreement between the bank’s record and the concern’s. The record of the check among the cash disbursements thus secures the proper charge to Postage or Office Supplies and also effects the proper agreement between the bank’s record and the concern’s. The use of a “postage” journal, operated on the same lines as the cash book and recording all receipts and disbursements of postage, would accomplish the same purpose and in some circumstances would be advisable.
Temporary Cash Disbursements
The practice of allowing proprietor, cashier, or others to take cash from the cash drawer and leave a memo of some sort to show responsibility or purpose is to be deprecated. Only where the principle is strictly adhered to of depositing all cash and disbursing only by check and by means of a petty cash fund handled under the imprest method, can adequate control over cash even be approximated. Where, however, such is not the practice, the problem is not that of the valuation of cash, for the memos are not cash, but of the valuation of claims receivable—a subject to be treated later in this chapter.
Disposition of Cash Funds
In the showing of cash for purposes of management, it is essential to indicate the present disposition made of the various cash funds or to show the immediacy of the control over them. Thus cash should be listed as:
- 1. Safe or drawer
- 2. Various working funds
- 3. Petty cash fund
- 4. Bank
Under “Bank” should be indicated how much is held on “current” account and how much is restricted to special purposes. Of the current balance it is desirable to show the portion subject to check for immediate needs and the portion representing surplus funds not immediately needed and therefore held to earn interest. These amounts subject to interest are almost always available on short notice, but usually only with the sacrifice of interest earnings to date.
Cash from the sale of capital stock or bond issues, or from the sale of old plant or any portion of it, under authorization from the stockholders that it be held for purchase or construction of new plant, or for other capital purposes, comprises that held for specific purposes. Sometimes even cash in the sinking funds might be included in the list. As it is usually of importance to keep the management informed as to the amounts of cash available for the various purposes stated above, an effort should be made to give this information, without too much detail, in the balance sheet if it is drawn up for internal use.
Cash Held Abroad
There remains to consider moneys held in a foreign branch and thus subject to fluctuations of exchange. In Chapter XXXI, where the subject of the foreign branch is treated, a full discussion of the problem of exchange in its relation to the accounting records will be given. Here it is sufficient to say that as between countries where exchange rates vary little, the general practice is to use an arbitrary conversion figure for incorporating the results of the foreign branch with those of the head office. This conversion figure applies to cash as well as to all other items. The use of such an arbitrary basis will give substantially correct results under the conditions named.
The assets of the foreign branch are the properties, usually and for the most part, of proprietors and stockholders residing in the country of the home office, who are concerned merely with the distribution of the earnings of the foreign branch. Profits are made in one currency to be distributed as dividends in another currency. Hence, the rate of exchange prevailing at the time of closing the books would usually give the most accurate results and should, of course, be used when exchange is not fairly stable between the two countries. It may even be conservative and advisable to set up a reserve for fluctuations in exchange, with the object of absorbing what might otherwise be too great a charge or credit to the current period’s profit and loss if a particularly unfavorable or favorable rate were prevailing on the date of conversion.
Accounts and Notes Receivable
In the valuation of accounts and notes receivable the problem is largely one of appraising the uncollectible items. The book account and note are intermediate stages in the conversion of merchandise into cash. Were they always worth their face value there would usually be no problem in their valuation except for the element of theoretical interest which is not commonly taken into account by commercial enterprises. In considering this problem of valuation, the question of the correct use of terms arises. For the sake of clearness, when showing the items on the balance sheet, attention will be first directed to this latter phase of the subject.
Objection to the Title, Accounts Receivable
The governing principle here is that only current items can be included in this group of assets when shown on the balance sheet. In accounting, as in economics, there is no distinctive scientific terminology. The economist makes use, for the most part, of every-day words and phrases. These are often open to misunderstanding and are sometimes capable of being used even for wilful misrepresentation. Recognition of this fact has made necessary a more careful definition of some terms. In the language of the street, almost any claim against outsiders may be spoken of as an “account receivable.” The term is thus so broad as not only to include current claims against customers in regular course of trade, and accrued income, such as rents, commissions, interest, dividends, etc., earned but not yet received, but also to serve as a cloak covering many other kinds of claims and deposits. Among these may be enumerated:
1. Cash deposited to cover breakage or damage to equipment in use, to guarantee the payment of prospective expense, or to guarantee good faith in the performance of a contract.
2. Moneys advanced to subsidiaries, salesmen, and other employees on account of expenses and salaries.
3. Claims against creditors for returned or damaged goods, against railroads for lost or damaged goods, and against governments for rebates, drawbacks, and the like.
4. Prepayments on purchase or expense contracts, as payments made to bind a bargain or before delivery of goods; and expenses paid in advance, such as royalties, rents, interest, etc.
5. Unpaid calls or instalments on stock subscription contracts.
6. Claims against absconding officers for property appropriated or trusts violated.
It is necessary, therefore, to employ a term of more definite meaning which cannot be misused. The word “Customer” is sometimes used and is not objectionable. However, the term “Trade Debtors” is more generally employed and will be so used here as denoting all claims against customers, clients, etc., in regular course of business. Its appearance in a balance sheet is usually evidence of a careful discrimination among the various classes of claims and is not therefore a misleading term.
Risk from Credit Losses
As stated above, the chief problem in valuing accounts and notes receivable is that of estimating bad debts. It is a matter of general experience that some of those to whom credit is extended do not pay their bills. Hence, at the close of the fiscal period it is necessary, so as not to overstate the asset, to estimate the amount which probably cannot be collected. The necessity for this is recognized in a decision of the United States Supreme Court in Providence Rubber Co. v. Goodyear, 9 Wall. 788, and has the sanction of conservative business policy.
The effect of such an estimate is that the period in which the sale is effected is made to stand the loss, and not the one in which failure to secure collection is experienced. There is a close relationship between the actual loss from bad debts and the credit policy of a concern. Where the sales force is allowed to grant credit, the loss from bad debts is almost invariably large. Where the extension of credit is controlled by a credit department, the loss is less than in the other case but depends on thoroughness of information and investigation of the risk. However much care may be exercised, there will be nevertheless some loss, but a live credit supervision should keep the loss at a minimum.
Risk and Length of Credit Period
The amount of loss, or rather the percentage of loss, is not the same for different lines of business nor even for different concerns in the same line. The normal credit period for a particular business has some relation to the loss. Thus if credit supervision and collection effort are the same for two concerns, the one with the shorter credit period will usually have the smaller loss. In a business, for example, where the credit term is 60 days, we would expect fewer uncollectible accounts than in one whose credit period extends for a year or more. As between two concerns in the same line of business, where conditions are fairly uniform, however, there should be little variation in the loss from bad debts. As pointed out in Volume I, Chapter XXXVI, the sales discount policy is for the most part a device for overcoming the element of risk in the extension of credit.
Analysis of Customers’ Accounts as the Basis for Estimate of Bad Debts
In estimating the amount of bad debts, experience within the particular business is the only safe guide. Oftentimes, however, the manager or proprietor is not the most competent person for the task. The auditor, in consultation with the manager, may often arrive at a better estimate than could someone closely connected with the business. In making the estimate, it is an aid to analyze the accounts according to the length of time they are past due. Thus, there would be, after analysis, the amount of those overdue not more than 30 days, the amount of those overdue not more than 60 days, the amount of the 60 to 90 days overdue items, those 90 days to six months, those six months to a year, and all those more than a year overdue. The total amount outstanding minus the sum of these overdue classes represents the portion not yet due. Some part of the not-yet-due portion is, of course, still subject to discount if paid within the discount term. With the claims against customers thus analyzed, a much better basis is afforded for testing the adequacy of the provision for bad debts. The various methods of estimating this provision are discussed on page 219.
It may here be noted that when making up the estimate of bad debts it is by no means always necessary to analyze the outstanding items as suggested above. Such an analysis is of value in three cases:
1. In the case of a new concern where there is no past experience on which to base the estimate.
2. In the case of an outsider—a professional auditor or other party—being called upon to make the estimate.
3. Periodically, in any business, as a check on the work of the collection department.
The value of the analysis in cases (1) and (2) is based on the principle that the longer an item is overdue, the greater is its likelihood of proving uncollectible. The need of an increasing rate for the different classes as analyzed above is apparent. In case (3) its value lies in the fact that it reveals the general effect of the collection policy and incidentally points out any change in policy. Any additional factors which may have wrought a change in the general financial situation must, of course, be taken into account.
Basis of Estimate of Bad Debts
Three methods of making an estimate of bad debts are found, in all of which a percentage of some given base is used. The various bases are respectively:
1. The amount of outstanding trade debt at the time of the balance sheet.
2. The amount of sales on credit made during the present fiscal period.
3. The total sales, both cash and credit, for the present period.
Trade Debtors as the Basis. The use of trade debtors as a base is obvious because it represents the uncollected charges from which alone can any loss from bad debts arise. The use of such a base seems correct in principle. This is so in cases where a balance sheet is made up only once a year, so that conditions as to the periodicity of the sales are practically the same from year to year. The amount of loss from uncollectible items is then somewhat nearly proportional to the amount of claims outstanding at the close of the fiscal year. But where it is necessary to make the estimate monthly, or oftener than once a year, it is very probable that at some of the intermediate periods the amount of outstanding claims will bear no logical relation to the loss from bad debts. Thus, in the garment industry the sales for practically the whole year are made within a few months, and during the other months the processes of manufacture and collection are carried on. For these reasons the amount of bad debts is not proportional to the outstanding claims at the end of each month, nor does such a base properly allocate the losses to the periods in which the sales are made. Accordingly one of the two other methods previously mentioned is used.
Sales as the Basis. Inasmuch as there cannot be any loss from bad debts in the cash sales, theoretically the credit sales provide the proper base for making the estimate. Practically, total sales, either gross or net, furnish the base most frequently employed because the total is always available without the necessity for analysis. So long as the ratio of the two kinds of sales remains fairly constant, the loss from bad debts does bear a direct relation to total sales.
Summary. It may be said with respect to the use of trade debtors as a base, that it gives satisfactory results where conditions are uniform from period to period. In its use, however, cognizance must be taken of any change in the credit policy of the business whereby the term of credit is shortened or lengthened as that in itself would tend to change the ratio of the base to the estimated loss from uncollectible items. As between credit and total sales, theory favors the former but practical considerations the latter. If for any reason the ratio of cash to credit sales should change, the change would have to be taken into consideration when making a comparison between periods of the loss from bad debts. No justification can be found for a fourth method sometimes met with, which makes the provision for bad debts bear some relation to the net profits—large if profits are large, and small or none if profits are small.
In handling the estimate of bad debts on the books, the same considerations are to be observed as in booking depreciation. Care must be exercised not to allow the reserve to grow beyond liberally estimated requirements and so create a secret reserve, nor to fall below such requirements. This must be watched closely and, if need be, the rate changed to accomplish the desired result.
Discounts and Collection Costs
In connection with the valuation of trade debtors, the problem of collection costs and cash discounts must be considered. Some authorities connect these costs directly with sales and make provision for them in the valuation of the current trade debtors; i.e., an estimate of the cost of collecting the outstanding claims and of the probable amount of loss from discounts on the amounts outstanding is deducted by means of reserves from trade debtors and so shown on the balance sheet. Where such a practice is followed, strict consistency would require that a similar credit provision be made for discounts on purchases—a practice not often advocated. The weight of opinion is in favor of taking all such costs and credits into account only when they are actually met. This accords with the treatment of these items as financial management items (explained in Volume I, Chapter XXXVI) and as therefore bearing no direct relation to sales. If, however, unusual costs of this or any other kind are anticipated, prudence demands that provision, by means of reserves, be made for them. Usually the costs average up pretty well from period to period.
Valuation of Other Receivable Items on Open Account
The problem of valuing the other classes of receivable items previously mentioned on page 215, does not differ in the main from that of trade debtors just discussed. If they are worth their face value they should be so shown. If worth less, the necessary valuation reserves should be set up. With these items the chief problem, however, is their proper showing on the balance sheet; i.e., their correct classification and a suitable nomenclature. Most of the items are not strictly current, but even their inclusion under this head is not misleading if they are carefully earmarked to show their true nature. Some of them are decidedly fixed, some are in no sense assets. In some cases even trade debtor balances as carried on the books are not strictly current. In concerns where sales are made on an instalment basis, usually the payments extend over several months and oftentimes years. The customer is charged with the whole amount and credited with the regular instalment payments as made. The portion of the outstanding balance covered by the more remote payments is thus not current. In concerns where both regular and instalment sales take place, a separation of the customers’ balances on the basis of the sales contract gives the necessary information for balance sheet purposes. The accounts of instalment trade debtors normally require a much more liberal valuation reserve than those of regular credit customers.
Loss on Notes Receivable
In some cases the expected loss because of uncollectible notes may be less than that from open accounts, due to the greater formality of the note as an instrument of credit and the probably greater loss of credit to the maker in case of dishonor. However, in making provision for bad debts, the practice is almost universal to class the two receivable items together. Such practice is undoubtedly sound. In the case of notes, the request for payment is more forceable because of the definitely stated due date and the loss of standing if unpaid after such date. In some cases the payment of notes is not pressed, nor is any extraordinary provision made for past-due items—as in industries allied with farming when an unusually bad season makes impossible the payment of notes given by farmers. Again, the practice is sometimes made of taking notes for a long overdue, open account. These have usually no better value than the accounts and must be treated accordingly.
The usual method of handling overdue notes receivable is given in Volume I, Chapter XXXVIII. As there stated, where payment is allowed to lapse, it is generally advisable to insist on the giving of new notes in place of the old. There may be circumstances in which this is not advisable, but the proper method will usually be apparent in each case.
Interest on Notes Receivable
The valuation of notes receivable—using the term to include all written promises to pay, i.e., promissory notes, accepted drafts, and the like, requires a consideration of interest. By far the larger number of notes given in trade are non-interest bearing and are not therefore worth their face value until they become due. The interest problem in the valuation of notes is thus whether the notes should be shown at their face value or present, i.e., discounted, value. Notes which are interest bearing from their date of issue are, of course, worth their face, on the assumption that the interest takes care of the discount. Where non-interest bearing notes form a very considerable item it is well to value them on a discounted basis; if their amount is small, theoretical principles of valuation give place to practical considerations and they may be valued at their face. Where notes bearing interest are valued on a discounted basis, care must be exercised not to include the interest accrued both in their face valuation and also under the head of accrued income.
Balance Sheet Titles for Notes Receivable
The problem of terminology is also met in handling notes receivable. Under the balance sheet caption “Notes Receivable” should usually be included only notes received from trade debtors, and certainly it should never represent any but current asset items. Notes received from officers and employees, of indefinite term and the payment of which will not be pressed, should be recorded under some such title as “Notes Receivable Special.” Long-term notes and those representing loans or advances of any sort should be properly earmarked, as should also loans carried on open account, salary overdrafts, and the like. The latter should be shown under Deferred Charges. These nicer points of valuation cannot be presented on a condensed balance sheet, but care should at all times be taken to make such a showing as will not be misleading and will serve the purpose for which the statement is to be used.
CHAPTER XIII
MERCHANDISE STOCK-IN-TRADE
Definition and Scope of Term
Stock-in-trade, as the term is usually understood, comprises all commodities purchased for resale. Thus, assets, which in one concern belong to the fixed asset group, may be the stock-in-trade of other concerns. In stating the principles of valuation for these assets, it is definitely to be understood that they apply only to such as are used as stock-in-trade, and not to the same items when used as fixed assets. Oftentimes the process of manufacture intervenes between the purchase of a commodity and its sale. In such a case the commodity, at the time of valuation, may be in different stages of completion. It is then usually so listed on the balance sheet under suitable titles, such as Raw Material, Goods in Process, and Finished Goods, all of which are treated as current assets. Included in the problem of valuation of stock-in-trade is the treatment of goods out on consignment, goods of others held for sale on a commission basis, and scrap material. Finally, some points to be observed in taking the physical inventory will be considered.
Valuation at Market or Cost Price
Inasmuch as stock-in-trade is purchased solely for resale or ultimate conversion into cash, it is desirable for the balance sheet to reflect the proper value of what remains on hand unsold. Such goods may have a realizable value higher or lower than cost value, from the standpoint of the market in which they were purchased, and will usually have a higher value in the market where they are to be sold. The value of all current assets to be shown on balance sheet is usually stated at the present realizable value. As applied to stock-in-trade, that must not be understood to mean sale or retail value. To value the stock-in-trade on such a basis would result in taking into the current period the profits on sales not effected until the next period; furthermore, these profits would not even be offset by the costs of making the sale. It may be laid down as a principle of business practice based on sound reason, that the period in which the sale is made should be given credit for it. Stock-in-trade must therefore be valued on the basis of its purchase or wholesale market price and according to well-established practice, either at cost or market, whichever is the lower. This principle has the support of conservative practice throughout the world.
Objections to Valuation at Less than Cost
The effect of valuing the stock-in-trade at a lower market than cost is to bring into the period’s results a loss which may never be realized, either because the change in the purchase market may not be reflected in the sale market, or because, if so reflected, the market may swing back before actual sale of the stock is made. If valuation is to be at the market when that is lower than cost, consistency would seem to demand that, when the market is higher than cost at the time of preparing the balance sheet, market value should be used and the profit occasioned thereby be credited to the current period. The answer to this argument is that operation would thus be placed on a speculative basis.
Again, it is sometimes argued that good buying is just as essential to profit-making as good selling. Accordingly, the purchasing department, with the foresight to buy in a favorable market, should receive the credit for it; if conditions are reversed, it should bear the blame, i.e., the loss. In other words, the period in which the purchase effort is expended should be credited or charged with the gain or the loss brought about by a favorable or unfavorable condition of the current market as compared with its condition at the time the purchase was made.
Anticipation of Profits or Losses Undesirable
In answer to these various contentions, it may be stated that though good buying is an essential factor in profit-making, no refinement of logic can obscure the obvious fact that goods are bought to be sold and that no profit arises until the sale takes place. All effort before the sale, whether directed towards good buying, careful storing and display, the placing of advertising, or the selection of a sales force, will come to naught unless sales are made. It would seem, therefore, that potential profit or loss on any or all effort preliminary to the actual sale has no place in the current record. From the standpoint of the profit and loss statement, this conclusion as to the policy of valuation of stock-in-trade at cost can be stated without fear of contradiction. In support of this is a direction of the Treasury Department in connection with the federal income tax returns. This reads, as revised in October, 1916: “In case the annual gain or loss is determined by inventory, merchandise must be inventoried at the cost price, as any loss in salable value will ultimately be reflected in the sales during the year when the goods are disposed of.”
From the viewpoint of the balance sheet, objection is sometimes raised—and supported by conservative practice and legal requirement as indicated above—that a balance sheet showing stock-in-trade at cost may thus very obviously under-or over-value the item, a situation not at all desirable. In this discussion, the whole problem of valuation is being treated from the point of view always of a going concern and not of one facing dissolution and the forced sale of its properties. Under these circumstances, such a balance sheet must frequently be used as the basis for asking credit, and credit extended on inflated values of current assets is not properly extended.
Method of Treatment and Summary
To meet this situation, particularly in the case of large fluctuations in the market, the true status of affairs is disclosed by appending to the balance sheet a footnote in which is stated the present market value of the inventory. Without this information, oftentimes, when the market is showing steadily rising values, as much harm and financial ruin may result through the extension of insufficient credit, as under other conditions might arise from an ill-advised inflation of credit. Sometimes the present market value is indicated by setting up a reserve out of profits, called “Reserve for Market Fluctuations in Merchandise”—or other similar title—when the market is lower than cost. This method retains the inventory on the books at cost value and so does not burden the current profit and loss, although it does lessen the amount of profits available for dividend distribution. Without doubt the policy is good in cases of extreme and somewhat permanent changes in the market.
To sum up, therefore, the valuation formula of cost or market, whichever is the lower, while based on conservatism may unnecessarily and improperly burden the current income account. Valuation at cost, on the other hand, while placing the profit or the loss in the period when realized may cause the balance sheet to present an entirely inadequate and even misleading story as the basis for credit. To remedy this, three courses are open, viz.:
1. Carry the market valuation, whether more or less than cost, in a footnote to the balance sheet.
2. In case market value is less than cost, set up a reserve out of profits equal in amount to the difference.
3. Carry in an inner column in the body of the balance sheet the present market value.
It would seem, therefore, that valuation at cost with the present market value shown on the face of the balance sheet, is the most desirable practice from every viewpoint.
Depreciation of Stock-in-Trade
Quite apart from this discussion of the proper basis for valuation, which concerns itself with marketable merchandise, is the problem of the method of handling deterioration or depreciation of stock-in-trade as distinguished from fluctuations in value. Such deterioration may result from shelf wear, use of goods for display purposes, changes in style and shape, overstocking which causes an accumulation of goods which soon are out of date or of sizes and qualities seldom used, broken lots where such will injure the sale value, and so on. Many devices, such as the “spiff” or the offer of a premium to salesmen, are employed by up-to-date merchants to keep their stocks free from these items of deterioration; but in spite of all that can be done, it usually proves impossible to keep the stock live in every particular. A valuation at cost under these circumstances would be an obvious inflation of values. If the concern had purchased that quality of goods originally with the expectation of resale, valuation at cost, under the limitations suggested above, would be the correct basis for showing. Since, however, such is not usually the case, the proper basis of valuation is now the market price—the present price at which goods of similar kinds and qualities can be bought.
It may be objected that the effect here also is unduly to burden the current period with unrealized losses, but this is not the case. The deterioration in value is a very real loss which is entirely independent of any fluctuations in the market. If goods are shelf-and window-worn from display usage, the deterioration is just as much an expense incurred for advertising as a display advertisement in a daily paper. The deterioration due to overstocking is a penalty which the current period should bear because of its poor buying effort or its inadequate sales efficiency. Thus, valuation of the inventory of any stock of goods must have regard to the effect of its present condition on its marketability. Any deterioration which renders the stock less salable is an expense to be borne by the present period and not the period in which the sale is made.
Full Costs of Stock-in-Trade
Cost having been established as the basis for valuing a stock of marketable merchandise, there must next be considered the elements of cost and their application to different classes of goods. By cost of goods is meant full cost, i.e., not only invoice price but all additional costs, needed to place them ready for sale. All costs, therefore, up to the point where goods are ready to create income are proper charges against the stock-in-trade. Customary costs of this kind are freight, drayage, insurance during transit and storage, duty, seasoning or aging costs, warehouse charges, and all similar items. The information as to these costs is usually recorded separately, but at a summary period they are loaded on the invoice cost of stock-in-trade.
In connection with this question of the proper composition of cost, attention is called to two other items sometimes requiring consideration. The first deals with the handling of cash discounts. The point at issue is as to whether the invoice figure should be recorded at the price quoted on a cash basis or on a credit basis. This point is discussed at length in Chapter XXXVI of the first volume where the conclusion reached is that the credit policy of each concern must govern the manner of making the record. If the concern has a fixed policy of buying at a cash price, that price should be the price of record; whereas if all financial and other related policies are based on a 30-or 60-day credit term, the credit price for that term should be the price of record. Particularly is this true when viewed from the sales standpoint where the fixing of the selling price is a part of the financial policy. The second point requiring consideration in connection with cost is the item of interest on the money invested in stock. At the close of the fiscal period should the stock sold and that left on hand be burdened with interest on the average amount of capital tied up in it during the period? The student is referred to [Chapter XXVI] of this book, where a full presentation of the case for and against the inclusion of interest is made.
The Distribution of Costs Over Stock-in-Trade
It should be said that, due to the particular method of handling purchasing, delivery, and storage, it frequently is not practicable to take cognizance of all items which theoretically are constituents of cost. Each concern must establish a policy relative thereto and hold to it. Having done this, it is faced at inventory time with the problem of determining the cost figure applicable to each unit of the stock remaining unsold. Certain of the costs, such as freight and cartage, have probably been incurred by different lots of miscellaneous merchandise, and to distribute the proper charges to each unit comprising the lot is difficult. Usually a certain percentage sufficient to cover that particular item of cost is spread evenly over all units remaining on hand. Occasionally, especially where the stock is homogeneous and only a few varieties are dealt in, an effort is made to prorate these costs on a more accurate basis. In loading on the freight cost, for example, a combined weight and value record might bemused or, where possible, the official freight tariff might govern. Such minute accuracy is not often needed or desirable, the flat percentage rate on value giving in most cases sufficiently correct results.
The Pricing of the Inventory
A rule-of-thumb method of valuation requires that the purchase price as carried on the last invoice of the article shall be used for pricing the inventory. This usually proves a good working rule, but often raises perplexing problems and is subject to abuse and misuse. If several purchases have been made during the period at different prices, should the last price paid govern the valuation of the portion unsold? The argument for so doing is that the portions unsold probably belong to the last lot purchased, good merchandising requiring that the old stock be sold out before the new is brought forward. That, of course, is not always the case. If it is made an inflexible rule that the price of the last lot bought shall be the price of the inventory, a dangerous tool is placed in the hands of the unscrupulous. A manager needing or desiring to make a better showing of profits might in this way make an insignificant purchase at a high price near the end of the fiscal period and so secure a much higher valuation than the cost for the whole inventory. Where the inventory is likely to contain remnants of the various lots purchased during the period, or where the condition as to an insignificant final purchase may exist, the policy of using an average price for the inventory will be more accurate in its results. The weighted average, whereby each purchase price is weighted with the volume or quantities purchased, is fairer, though more complicated than the straight average. Thus 10 units bought at $100 per unit, 15 at $90, and 3 at $110, would give a straight average of $100 but a weighted average of $95.71, (1,000 + 1,350 + 330) ÷ (10 + 15 + 3). In manufacturing establishments where the fiscal period is short, say one month, and it is desirable to keep the raw material cost as nearly uniform as possible, the method of the weighted average is to be recommended.
As mentioned above, each concern must fix its own policy as to what items shall be included in the cost of goods purchased. Whatever that policy may be, care must be exercised to make sure that the same items and no others form part of the value of the inventory. In the case of any doubtful items, instead of trusting to memory, a house classification of accounts or an accounting guide book should be drawn up so as to secure from period to period a similar handling of all items.
Valuation of Manufacturing Inventory
The whole of the foregoing discussion concerns the valuation of goods bought for resale, i.e., the inventory of a trading business. Some points in the application of the same principles to a manufacturing concern will now be considered.
Finished Goods. So far as finished goods are concerned, the principle of valuation at cost applies. What constitutes the cost of manufacture was discussed in Chapter III, from which it is evident that many other elements in addition to those which must be considered in a trading concern must be taken into account. The manufacturing cost formula comprises the three items of: (1) raw material consumed, (2) direct labor applied, and (3) factory expenses incurred, this latter item sometimes called overhead expenses. When a concern operates a detailed cost system, the valuation of the finished product is not difficult, being the goal towards which the system works. Where no cost system is used, great care must be exercised to make sure that every item of cost is calculated as accurately as possible and that a proportionate share of such costs is applied to the finished product still on hand unsold. It is sometimes urged that instead of this cost-to-manufacture price, the price at which the article could be bought on the open market should govern; or, alternatively, that the article should be valued at least sufficiently above cost to give a theoretical profit to the factory. Just as in the case of the discussion of “cost or market price” for the trading concern, the same conclusion is reached here, viz., that cost should govern, because while good manufacturing is an element in profit-making, yet no profit is made until the sale is effected. It is true that if cost to manufacture is lower than cost to buy in the open market, a real saving has been made by the policy of manufacturing rather than of buying, but a saving is quite another thing from a profit. This differentiation between a saving and a profit will be fully discussed presently. Correct accounting, therefore, requires a valuation of finished goods at cost to manufacture.
Raw Material. The valuation of the inventory or raw material is on the same basis as that of a stock of goods bought for resale, i.e., raw material is to be valued at full cost up to the point of its consumption.
Goods in Process. The valuation of partially completed goods, i.e., “goods in process,” is a much more difficult problem. To simplify the discussion these will be divided into two groups, first, goods manufactured for stock, and secondly, those made on a specific contract or for special order. To the first group the principle of cost applies without any qualification. The problem involved is that of determining what has constituted cost up to that particular stage of completion. Where a detailed cost system is in use and a production schedule forms part of the system, it is possible at almost any moment to ascertain exactly the values accumulated on any article at each stage or process of manufacture. Where definite costs are not possible, a careful estimate based on full knowledge of conditions is the best that can be done. Where parts are first manufactured for assembly into a completed whole, they should be treated as finished goods and valued at full cost up to that point.
Contracts. The second group of goods in process, viz., those manufactured to fill specific orders, or, in large construction work, contracts taken but not completed, may be valued on a somewhat different basis from that applicable to the first group. Here a sale has actually taken place and only the intervention of the closing of the books raises the question of valuation. In a case of this sort it is customary to make a careful estimate of the costs of the work or contract, up to its present state, due weight being given to remaining costs necessary to complete it and to any provision for possible contingencies. When handled in this way, the estimated profit on the work already done is said to be applicable to the current period and is therefore taken into account. In other words, the portion completed is treated as sold, after making the provisions indicated above, and is charged off the books against a corresponding part of the sale price. Hence, the valuation involved here does not concern the inventory, but the cost of goods sold.
It may be objected that, in the case of large contracts, perhaps running over a period of years, many unforeseen things may happen to wipe out any seeming profits on the completed portion, and that conservatism would demand that no profits be taken until the contract is completed or in a sufficiently advanced stage as to be reasonably sure of results. In such a case it frequently happens, however, that not only are stockholders impatient of delay, but very serious injustice may result to any who might be forced to give up their holdings before the completion of the contract. Moreover, a fair method of making payment on the contract is usually in force, the sale price often being on the basis of units of work accomplished, so that the contingencies giving rise to the objection mentioned are greatly minimized. Thus, some contracts may be on a fixed price per cubic yard of earth removed, per unit of goods manufactured, or other similar basis for periodic payment, a certain per cent being retained as a guarantee for the satisfactory completion of the whole. Again, where the price is for a lump sum, engineers representing the contracting parties may agree on the amount completed and periodical payment may be made on that basis.
This topic of uncompleted contracts will come up again for treatment when considering the profit and loss summary for the year. It is sufficient to note here that some share of the profit on the completed portion of a contract may be taken as indicated above, in which case the inventory problem may be disposed of either by adding the amount of estimated profit to the cost value of the uncompleted contract, or by treating the payments made as sales.
Contracts and Length of Cost Period
In some lines of business, orders are booked several months ahead of delivery date, the factory operations depending somewhat closely on the contracts entered into. During the period of manufacture there may be few deliveries of the product, and therefore no actual profit. Obviously, the easiest method of handling such a situation is to make the fiscal period long enough to include the greater part of the deliveries, and so leave the inventory comparatively free of goods in process. Where this method is adopted, there is no serious objection to valuing the goods still in process at the close of the period so as to take a fair portion of the profit, although conservative practice usually values them at cost. The difference in the amount of profit under the two methods is insignificant under the condition named. Under other conditions valuation at cost is the rule.
Valuation of Scrap
Raw materials are never completely used up in manufacture; portions too small for the main product, corners, odd-shaped pieces, defective pieces, etc., are usually thrown into scrap. This scrap is frequently utilized in the manufacture of side lines if a market can be developed; otherwise it may be valueless. The problem of the valuation not only of the scrap but of any product that may be made from it presents some interesting features. If the entire cost of the raw material is charged to the main product, the scrap material used in the side line costs nothing, and to charge anything for it, either on the basis of cost or some arbitrary estimate, would result in inflation. Furthermore, the cost figures of a side line which is not charged for material might at some time be made the basis for a bid on a contract too large to be filled entirely out of scrap material, and so result in a loss. On the other hand, if the main product is charged only for the material actually consumed, and the side line is compelled to bear the cost value of the material it consumes, the cost of the side line may so increase that it cannot be marketed at a profit. The lowered cost of the main product might lead, in the face of keen competition, to the cutting of its price below real cost, unless, of course, all the scrap is being utilized in the side line which is also being sold at a profit. If such is the case, the valuation of the main product, the side line, and the scrap should be on a cost basis. This is not usually the case, however. No basis for valuation can be found which will prove entirely satisfactory under all circumstances.
In the light of the conditions involved, particularly as to whether there is a constant market for the utilization of all the scrap material in the manufacture of the side line, each concern must adopt whatever policy best suits its peculiar needs. At all times the application of materials costs to the product should provide an intelligent basis for entering into future contracts. A blind use of cost figures frequently invites disaster. In cases where scrap is not utilized in a side line, it has only scrap value. The thing to guard against is the double charge for the same material, i.e., a charge to the main product and also to the side line, resulting in an inflation of values.
Inventory-Taking
There remains, as a corollary to the problem of valuation, a consideration of the method of taking the inventory, for if the count is wrong the most careful valuation per unit will not give true total value. In connection with the count of the inventory, two fundamental rules must be observed. These are: (1) make sure that everything, i.e., all stock-in-trade, belonging to the business is included; and (2) be careful that there is no duplication of count nor inclusion of any stock belonging to others.
In accordance with the first fundamental rule, care should be exercised to include all goods out for sale in other markets—these to be valued at full cost in those markets—and all goods not yet received into stock but belonging to the business. These latter include goods invoiced but not received, and goods received but not unloaded prior to the close of the period.
In accordance with the second fundamental rule, any goods of others held for sale on a commission basis must be carefully excluded from the count, as should also goods received before the close of the period but with invoices dated some time in the future. Furthermore, all goods inventoried from their invoices, i.e., all goods not taken into stock, must be earmarked so as not to be charged into the next period’s purchases. This is best accomplished by stamping the invoices as “Included in the 19.... Inventory.”
Inventory Methods. The careful organization of the physical stock to be inventoried, sorting any misplaced items, and separating them into classes, and an equally careful organization of the clerical force, acting under explicit directions based on a well-thought-out plan, are fundamentally essential to accuracy and to the prevention of any duplication of count. In some cases the use of duplicate or coupon tags proves very valuable. On these tags provision is made for recording in duplicate the number of units and condition as to salability, and they are ruled with two money columns. The tags are numbered on both parts consecutively and are charged out to the various departments, as many being issued as there are classes or compartments of goods. As the count is made of a certain class of goods, a tag is attached to the compartment or other storage place as evidence that the count has been made, after which the lower portion is torn off and sent to the office. Any missing numbers indicate omissions in the count. If the card has been lost, the duplicate still attached to its compartment will indicate the count. After all cards are accounted for, the duplicates are detached and the goods covered by them are then released for sale or other use. In taking the inventory it is especially important that where goods are below normal as to salability, their estimated per cent of normal condition be noted on the tag. This gives a basis for valuing and should show the amount of deterioration and its cause.
Perpetual Inventory
The use of a perpetual inventory system is quite general in some lines. Its operation requires almost as careful a record of stock as is made of cash, i.e., not only must all receipts be recorded but all disbursements as well. In a trading concern this record usually takes the form of a stock book of some sort, to which entry is made, as to quantities only, from the purchase and sales invoices, the balance shown at any time being the stock remaining on hand. The application of the unit value gives the value of the entire stock and so makes possible monthly statements of approximate condition. In a factory, a separate stores ledger may be operated, carrying an account with every kind of material used. This ledger is controlled by the Raw Material or Stores account on the general ledger. Entry to the stores ledger accounts is made from the purchase invoices for receipts, and from formal requisitions drawn on the stores-keeper for disbursements, i.e., for the issuance of material. The stores ledger may record not only quantities but also values, so that its balance should be the value of the stores on hand. This is possible because the material is drawn out at cost price.
Oftentimes, for retail concerns, instead of the stock book method, the percentage method of book inventories described in Volume I, page 506, gives more satisfactory results when sufficient past experience can be drawn from.
Necessity of Physical Count. It must not be assumed that a perpetual inventory system obviates the necessity of taking a physical inventory, for it does not. All that it accomplishes is to secure a closer supervision over stock between inventory times and to make possible the showing of approximate results at interim periods. Where operated, it is possible to take the physical inventory piecemeal, although there is a marked advantage in taking a complete inventory periodically. The piecemeal method means that any department can do its stock-taking during a slack time without regard to the time when other departments take theirs. Thus there is less interference with the regular conduct of business. It must be borne in mind, however, that the physical inventory is just as essential as ever because of the many inaccuracies that tend to creep into the perpetual inventory system, and furthermore because of loss, theft, over-measure, and so on, which throw the book record out of agreement with the actual count.