Accrued and Deferred Items

Nature of Accrued Income

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

Inadequacy of Cash Method of Handling Accruals

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

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

Correct Method of Handling Accruals

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

Showing of Accrued Items on Balance Sheet

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

Valuation of Accrued Items

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

Accounting for Accrued Income

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

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

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

An illustration will show the differences between the two methods.

Illustration of Different Methods of Recording Accrued Items

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

Solution—Method 1

Accrued Royalties Receivable
1916
Dec. 31$5,000.00
1917
Dec. 31(A)250.00
Royalties Income
1917
$35,000.00
Dec. 31(A)250.00

Method 2

Accrued Royalties Receivable
19161917
Dec. 31$5,000.00 Jan. 1(A)  $5,000.00
1917
Dec. 31(B)  $5,250.00
Royalties Income
19171917
Jan. 1(A)  $5,000.00 $35,000.00
Dec. 31(B)5,250.00

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

Royalties Income
19161917
Dec. 31 Accr.$5,000.00 $35,000.00
1917Dec. 31 Accr.5,250.00
Dec. 31 P. & I.  35,250.00
$40,250.00 $40,250.00
1918
Jan. 1 Accr.$5,250.00

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

Prepaid Items—Definitions and Kinds

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

Valuation of Prepaid Items

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

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

Danger of Overvaluation

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

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

Accounting for Deferred Debit and Other Items

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

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

CHAPTER XV
PERMANENT INVESTMENTS

Nature of Permanent Investments

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

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

Permanent Investments as an Aid to Operation

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

1. By practically full ownership of the subsidiary enterprise to secure complete control and so direct its policies.

2. By only a controlling ownership.

3. Through the agency of advances, particularly when, because of poor credit, the usual money markets may be closed to the borrowing company.

Valuation of Permanent Investments

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

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

Holding Company and Subsidiary Enterprises

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

Controlling Investments

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

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

Advances to Subsidiary Concerns

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

Rules for Valuation

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

Investments in Partial Holdings

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

Where investments of this kind are shown on the balance sheet at cost, it is sound policy to call attention in a footnote or otherwise to their market values, as oftentimes the market gives some indication of the condition of the company. The savings banks of the State of New York, in reporting to the State Department of Banking, must show the market value of the securities held. Usually three values are shown, viz.: market, par, and so-called investment value, to be explained later. Where the securities held are not listed on any exchange or are held closely and not traded in extensively, it is often difficult to secure reliable market quotations for them. Here cost, unless known conditions demand otherwise, seems the best basis for valuation.

Investments Producing No Income

Some investments may be of a permanent type and yet of themselves produce no income. Such are memberships on stock and produce exchanges, boards of trade, and the like, which are valuable for the privileges and prestige accruing therefrom and the business associations secured thereby. They should usually be valued at cost, thus allowing the period in which they are sold, if disposal becomes necessary, to get the profit or loss incident thereto.

Bond Values and Market Interest Rates

In connection with the valuation of bonds, some additional considerations should be taken into account. Assuming that the margin of security for the mortgage covering the bonds is ample, the value of a bond, i.e., its price on the market, is largely dependent upon the prevailing interest rate in the money market. Thus, if a bond bearing 5% interest is offered for sale in a market where the rate is 6%, it can be sold only at a discount sufficient to provide approximately 6% on the money invested. Similarly, a 6% bond offered in a 5% market should bring something more than par. It is not intended to convey the impression that whenever a bond sells below par it is because the market is demanding a higher rate than that offered by the bond; nor when a bond sells at a premium need the entire amount of the premium be a reflection of money market conditions. An additional factor is oftentimes the credit standing of the issuing company. Thus, even though a bond may be amply protected, the poor credit rating of the issuing concern will be reflected in a downward tendency of the price of the bond, for under such circumstances foreclosure proceedings preliminary to sale and conversion of the security always loom large in the background. On the other hand, bonds of the United States are often above par because of the government’s credit standing.

On the assumption that there is reasonable expectation that the bonds will be paid at maturity, their valuation on the balance sheet during the time they are held by an investor must have regard to the price paid as determined by the bond interest rate and the money market rate at the time of purchase. A bond bought at a discount and held to maturity is redeemed at par. If the bond is carried at cost until the period of redemption, that period would secure the credit for the difference between cost and par. Similarly for a bond bought at a premium, and carried at cost constantly, the period of redemption would bear the loss between cost and redemption price.

Nature of Bond Discount or Premium

To bring out more clearly the real nature of bond discount or premium, under the limitation stated above, consider a bond selling at 90 and bearing 4½% interest. This should be interpreted to mean that the issuing company, because of the low rate offered on the bond, will have to pay at maturity $1,000 for every $900 now received. It is, as it were, having to prepay $100 interest on every bond sold, in addition to its promise to pay the stipulated bond rate of interest periodically. It is selling a $1,000 security for $900 and is thus depriving itself of $100 which it might have had by contracting to pay the present market rate of interest. From the other (i.e., investor’s) point of view, he is willing to lend money at the bond rate only because he expects to be compensated by the $100 to be received in a lump sum at the maturity of the bond.

The wisdom of fixing the bond interest rate so that the bond will command either a premium or a discount hinges upon the soundness of the forecast as to the money market in the future. It is, of course, a speculative transaction. Since, then, discount on bonds is, from the standpoint of the issuing concern, a prepayment of a portion of the interest in amount sufficient to make the income rate on the bond correspond with the rates prevailing in the market, this prepayment is applicable to the whole period of the life of the bonds and should be spread equitably over that period. To accomplish this it is necessary, every time bond interest is paid, to transfer to the Bond Interest account a portion of the Discount on Bonds account, thus gradually wiping off the Discount account and making the Interest account show every period the real amount (and real rate) of interest as distinguished from the amount paid as indicated by the bond rate.

In the present discussion, the chief concern with the problem of bond discount and premium is from the point of view of the investor. Having established from the other point of view the true relation between premium and discount and bond interest, there will be considered the two additional problems as to the manner of carrying the record on the investor’s books and as to the method of valuing the investment at each balance sheet period. First, then, is the problem of making the record.

Record of Bond Investments

When bonds are purchased the record may be made in two ways. Accounts may be kept with the bonds at par, separate valuation accounts being carried for the discount or premium. An account with bond interest is also opened and sometimes one with prepaid interest on bonds, where, as is usually the case, the bonds are bought with accrued interest to date of purchase. The accrued interest, however, is more conveniently recorded as a charge in the bond interest account, thus automatically adjusting the income from the bonds when the first coupon after date of purchase is redeemed. As stated in Chapter XIV, the amount of the discount or premium is to be spread equitably over the life of the bond. The method of making an equitable distribution is a problem to which consideration will be given in later pages of this chapter. The entry to effect the distribution is a transfer entry between the premium or discount account and the bond interest account for the portion accrued as on the date of each payment on the coupons. The result of the transfer is to establish with the bond account at par a true valuation of the bonds held as on that date, and to secure the correct amount of income from bond interest to be credited to the current period.

The second method of making record of the bond investments is to record the purchases at cost in the bond account, carrying there full information as to premium or discount, no separate accounts with these being opened. When the bond interest falls due, the bond account itself is written up or down for the amount of the discount or premium accrued during the current period. The contra entry is in the bond interest account just as above. This latter method does not commend itself when the only record kept of bonds is that mentioned above. If the investments are so numerous as to require a subsidiary ledger for their record, where with each kind of bond accounts will be kept with its par, discount or premium, and interest, there is no objection to handling the controlling account on the general ledger by making the discount or premium adjustment directly to the bond account. Fuller information is given and the record is less involved, however, when handled by the first method.

Amortization of Bond Discount and Premium

The equitable distribution (technically known as “amortization”) of the discount and premium on bond investments is the essence of the problem of their valuation. There are two methods of making this distribution, termed the “straight line” and the “scientific” method. Under the straight line method the amount of the discount or premium is divided by the interest periods the bond has yet to run, and the quotient is made the amount of periodic amortization. Although not scientifically accurate, the method commends itself because of its simplicity and consequent ease of operation. Its use is allowed by the Department of Banking of the State of New York for valuing the investments of savings banks. The scientific method is based upon compound interest calculations and will be best understood by means of examples. Under this method the discount or premium is looked upon as the amount of an annuity. The portion which must be written off for any period is the present worth of the annuity on that date, taking into consideration the rate of interest and the time in interest periods the bond has still to run.

In practice, however, the amount of amortization is not found in that way. To find the periodic amortization, it is necessary to know the cost of the bond, its coupon interest rate, and the effective rate. By effective rate is meant the real income rate on the basis of the price paid for the bond. Assume that a 3% bond, interest payable January and July, has 3 years (6 periods) to run and is bought for $971.99 so as to yield 4% on the investment. At the end of the first semiannual period the actual interest received will be $15, but the real income on the investment is $19.44 because it was purchased on a 4% basis for $971.99 (2% on $971.99). Of the total discount of $28.01, $4.44 (19.44-15.00) is to be credited to the current period. The adjustment of discount brings about a new valuation of the bond, it being now worth $976.43 (971.99 + 4.44), because nearer by six months to maturity when it will be worth par or $1,000. So, for the next period the coupon is $15 and the effective income, $19.53 (2% on $976.43), hence the amortization is $4.53; and so on for the six periods, at the end of which the discount will have been completely distributed, i.e., amortized.

The following schedule shows the periodic amortization and new values of the bond:

3% bond, par $1,000; bought on a 4% basis for $971.99;
3 years to run; interest January and July.

Date Nominal
Income		 Effective
Income		Periodic
Amortization 		Value of
Bond		Discount
Adjusted
Amounts
Jan. 1, 1915$.....$.....$.....$971.99$28.01
July 1, 1915 15.0019.444.44976.4323.57
Jan. 1, 191615.0019.534.53980.9619.04
July 1, 191615.0019.624.62985.5814.42
Jan. 1, 191715.0019.714.71990.299.71
July 1, 191715.0019.814.81995.104.90
Jan. 1, 191815.0019.904.901,000.00.....
Total discount amortized$28.01  

A similar schedule for a bond bought at a premium immediately follows:

5% bond, par $1,000; bought on a 4% basis for
$1,028.01; 3 years to run; interest May and November.

Date Nominal
Income		 Effective
Income		Periodic
Amortization 		Value of
Bond		Discount
Adjusted
Amounts
May 1, 1917$.....$.....$.....$1,028.01$28.01
Nov. 1, 1917 25.0020.564.441,023.5723.57
May 1, 191825.0020.474.531,019.0419.04
Nov. 1, 191825.0020.384.621,014.4214.42
May 1, 191925.0020.294.711,009.719.71
Nov. 1, 191925.0020.194.811,004.904.90
May 1, 192025.0020.104.901,000.00.....
Total premium amortized$28.01  

The problem of amortization is thus seen to be comparatively simple when the cost of the bond, its nominal rate, and effective rate are known, and successive valuations of the bond are equally simple. The crux of the whole calculation is thus seen to be the determination of the original purchase price of the bond. At the time of the purchase of the bond the following facts are known: the par of the bond, the time it has to run, its rate of interest, and the rate of earning desired on the investment. There are three methods or formulas by which this price can be determined and they will be explained in turn. However, the development of the formulas will be more easily understood if some points in compound interest and annuity calculations applicable to the three methods of valuing the bond are first explained.

Formulas for Compound Interest

In the determination of the present worth of a sum of money at compound interest due a certain number of years hence, the following symbols will be used:

The present worth of B is manifestly A, the sum which, when placed at interest, amounts to B. At compound interest the amount to which A will accumulate in n periods is given by the formula:

From this, the present worth of $1 is seen to be 1/Rⁿ .

Formulas for Annuities

An annuity is a given sum of money placed at interest usually at the end of each successive year or period, and allowed to accumulate at compound interest for a number of periods. For bond valuations it is necessary to know the amount of an annuity and the present worth of this amount. The following terminology will be used in the solution of the problem:

The first sum, A, placed at interest at the end of the first period will accumulate for n-1 periods and, according to formula (1) above, will amount to ARⁿ⁻¹. The second sum, A, placed at interest at the end of the second period will amount to ARⁿ⁻²; etc. The last sum, A, will not accumulate and so is worth just A.

The amount of the annuity is thus seen to be the sum of the amounts of the several periodic sums. Expressed as a formula:

whence

Rⁿ⁻¹ Rⁿ⁻¹
(3) B = A —— or A ——
R - 1 r

The expression in parentheses is a geometric series whose sum may be written in the fractional form shown.

The present worth of B, i.e., of

Rⁿ⁻¹
A ——
r

is found from formula (2) above to be:

Rⁿ⁻¹
A —— divided by Rⁿ.
r

Expressed as a formula:

Rⁿ⁻¹
(4) P. W. = A ——
Rⁿr

Formulas for Bond Valuation

The method of valuing a bond makes use of the formulas (1) to (4) just established. The symbols used in the bond formulas will be:

First Method. The present value of a bond may be looked upon as the sum of two present worths, viz.: the present worth of the face of the bond and the present worth of the annuity represented by the periodic interest payments, i.e., the coupons. The present worth of the face is, according to formula (2), P/Rⁿ. The present worth of the coupon annuity is, from formula (4), seen to be

C(Rⁿ⁻¹)
Rⁿr

Hence the present value of the bond is the sum of these two present worths, i.e.:

(5) V = P + C(Rⁿ⁻¹) or Pr + C(Rⁿ⁻¹)
RⁿRⁿrrRⁿ

Second Method. Here, the determination of the amount of premium or discount which is fair payment for a bond is the point of attack. That is, using par as a basis, how much above or below par is the bond worth? The fair premium is based upon the difference between the nominal yield of the bond and the interest return in the present money market. Stated otherwise, in the case of a bond selling at a premium, the nominal interest return may be looked upon as composed of two parts, viz.: (1) a portion representing interest at the effective, i.e., current money market rate on the par value of the bond, and (2) a portion—the difference between the nominal yield and (1)—which is of the nature of an annuity for the life of the bond. The present worth of this annuity is the fair premium on the bond.

To illustrate: A 6% bond sold in a 5% market would have a nominal yield annually of $60. All that can be secured, however, on the par value is $50. Hence, on the basis of valuation at par there is a $10 excess of nominal over market yield which would be received every period. The present worth of this $10 annuity is the fair premium which the bond will command. With the use of the previous symbols, this annuity is expressed by the quantity (C-Pr) whose present worth, as determined by formula (4) is

(C - Pr)(Rⁿ⁻¹)
rRⁿ

Therefore, the value of the bond is the face or par of the bond plus the present worth of this annuity, i.e.:

(6) V = P + (C - Pr)(Rⁿ - 1)
rRⁿ

This formula when simplified reduces to

Pr + C(Rⁿ - 1)
rRⁿ

which is identical with formula (5) and, of course, values the bond at the same amount.

Third Method. Valuation by either of the methods above is rather complex, requiring for easy solution the use of logarithm or compound interest tables. A third method, requiring only the ordinary arithmetic processes is sometimes used, although very burdensome when the periods are numerous. This is sometimes called the periodic method because working backwards from par, the value at the next preceding period is determined, and from that the next is found, and so on till the value at the desired period is reached. Reference to the second amortization schedule shown on page 270 will help in understanding the process. Using the same terminology as above and this additional:

formulas 7 to 9 below may be developed.

It was noted that any particular value of the bond is found by subtracting from the next preceding value the difference between the nominal and effective incomes. The nominal income is always based on par, and the effective on the value at the last interest period. For example, in the schedule referred to: $1,004.90-($25-$20.10) = $1,000, the $20.10 being the effective income, 2% on $1,004.90. Using symbols the above equation may be generalized as follows:

(7)P₁ - (Pc - P₁r) = P, whence P₁ = P + Pc and,
1 + r
(8)P₂ - (Pc - P₃r) = P₁, whence P₂ = P + Pc and, generalized,
1 + r
(9)Pₙ - (Pc - Pₙr) = Pₙ₋₁, whence Pₙ = Pₙ₋₁ + Pc
1 + r

This gives a working rule whereby it is possible to work back from the known value, par, by successive operations until any desired value is found. The calculation is somewhat as follows for the example used in the schedule:

1,000 + (1,000 × .025) = 1,025 = 1,004.90
1.021.02
1,004.90 + (1,000 × .025) = 1,029.90 = 1,009.71
1.021.02

Similar calculations will develop the other values in the schedule. In the case of a bond with, say, 30 periods still to run, the burdensome nature of the calculation by this method is apparent.

While commercial houses rarely need to use the algebraic formulas for calculating bond values, it is the only really correct method of valuing bonds which are held for long-time investment, and the accountant should be conversant with it. For the balance sheets of savings banks, insurance companies, and other investment concerns, scientific valuation of bonds with the attendant amortization up and down of discounts and premiums is not only theoretically correct but practical considerations, in a market such as prevails in a time of marked but temporary depression, demand that it, or some approximation to it, be used.

A discussion of the valuation of serial and short terminal bonds, or those carrying more than one rate of interest, or those redeemable by lot at various times, is beyond the scope of the present work.

Valuation of Sinking Funds

The section of the balance sheet under consideration usually includes the various funds representing the investment of reserves. Sinking funds, building funds, insurance, pension, endowment funds, and the like, are examples of this class of asset. The use of the term fund should be strictly limited to specific assets set aside for specific purposes. The problem of valuation in connection with funds will be considered under two sets of conditions, viz., when the funds are invested in a concern’s own securities and when invested in outside securities. The practical questions in connection with funds are those of finance rather than of accounting.

The determination of a policy of investment as between the concern’s own and outside securities depends on many considerations, some of which do not come strictly in the purview of the accountant. It is argued that for the sake of immediate availability, investment of funds to be used for a specific purpose at a definite time should be in the securities of other concerns over whom control does not extend. In some cases, however, provision is made in the trust deed of a sinking fund to the effect that the funds set aside shall be used to purchase the bonds to retire which the funds have been created. These bonds may be canceled or held for the sake of their income in the fund till maturity. There would seem to be no choice between a concern’s own and outside securities, provided the same standards of moral obligation are observed in both cases. If the securities purchased for the funds are the concern’s own bonds, they should as a rule be valued at cost and the premium or discount amortized over the remaining life of the security. They may, of course, be carried on the books at par and the premium charged immediately against any income in the fund. The showing on the balance sheet should be in exact accord with the facts. If the bonds have been purchased and canceled together with their coupons, the amount of such cancellations should be shown as a deduction from the bond liability. The fund is thus serving its purpose currently by reducing that liability. Any uninvested balance in the fund should, of course, be shown among the assets. When the bonds are purchased and held uncanceled for the sake of their income, it is probably better to carry them among the assets, indicating, if the information should be considered vital, that the securities in the fund are the concern’s own securities.

If the funds are invested in outside securities, these should be valued on the basis of long-time investments. If bonds, their premiums or discounts should be amortized. If, however, the credit of the issuing concern is such as to cast doubt on its ability to redeem them at maturity, other bases for valuation should be taken. It might even be necessary to set up special reserves to replenish the expected shrinkage upon realization of the securities held in the fund. A final injunction may not be out of place, to the effect that all funds should be definitely labeled so as to show their purpose.

Valuation of Investments in Land

Investments of a more or less permanent nature sometimes take the form of investments in land. This may be for the purpose of securing an income; it may be of a speculative nature, as when land is held for appreciation in value; it may be to secure room for future expansion; or it may be for the purpose of preventing a competitor from securing favorable holdings as to trade location or facilities. For whatever purpose acquired, as here considered, the land is a permanent investment and should be separated in the records from land held for operating purposes. The manner of accounting for these investment holdings is somewhat dependent on the purpose for which they are held. In most cases, particularly if the land is income-producing, at least a land expense and income account will be needed in addition to the asset account or accounts with the land.

As to the valuation of these holdings, full cost with no account taken of depreciation or appreciation in value is the correct basis. As stated in [Chapter XVII, page 307], under certain conditions the carrying charges on non-income-producing lands may be added to the value of the holdings. If lands are held over a long period to secure appreciation in value, certainly all carrying costs should be loaded on to the asset account, offset, as shown in [Chapter XVII], by a suitable reserve. Care must always be taken not to secure inflated values by these methods. If any of these holdings are disposed of, the profit or loss then actually realized must be taken into account; but no unrealized profit or loss should be brought onto the books—except, perhaps, as a balance sheet footnote.

CHAPTER XVI
MACHINERY AND TOOLS,
FURNITURE AND FIXTURES,
AND OTHER EQUIPMENT

General Considerations

The valuation of assets grouped under the head of equipment presents nothing new in principle but requires consideration of many points in the application of principles and of some features in accounting. Here the principle of value as a going concern is particularly effective. As in the valuation of prepaid expenses on a going concern basis, so here forced sale or liquidation value has no place. The business is viewed as established and as expecting to operate continuously. Capital has become tied up in certain equipment essential to the undertaking, in the sense that to dispose of it in its entirety would mean a break-up of the business. It cannot therefore be freed or put to other uses without a reconstruction of the present enterprise. Accordingly, the possible market value, as second-hand property, should not in any way influence the valuation at which this group of assets is carried on the books. Only full cost at the time of installation and depreciation, using the term in its broad sense, need be considered in the problem of valuation.

Distinction between Personalty and Real Property

The present chapter deals with such fixed asset equipment as machinery and tools, furniture and fixtures, delivery equipments, patterns, lasts, dies, maps, drawings, electrotypes, ovens, furnaces, etc., as distinguished from the more fixed group of lands, buildings, leaseholds, and the like. In the main, the point of differentiation is the legal one of personalty and real property, although the intricacies of the law on this vexed subject are never, so far as is known, reflected in the books of account, nor is it the purpose here to attempt to lay down any working rules or standards by which such differentiation can be made. There seem to be none except certain broad generalizations, each case resting on its own peculiar surroundings. Circumstances, however, may arise under which a clear-cut distinction is desirable. A bond issue supported by a mortgage on real property or on personal property may depend, although not usually, on such a distinction for a large share of its security. The margin of safety may hinge on this point. It may be desirable to be able to trace on the face of a balance sheet the particular property covered by a mortgage. And should foreclosure of the mortgage become necessary, it is, of course, essential to know exactly the property subject to the lien. These are not points under contemplation in a going concern, although the possibility of their arising should not be lost to view. Here the problem of valuation and accounting for such valuation is viewed from the standpoint of a going concern and not one facing partial or total liquidation. Furthermore, as stated above, the point is, in its final analysis, one of law and not of accounting.

It is not intended by the foregoing statement to sanction any method of keeping the records in non-accord with fundamental rulings of the law, but only to state that, so long as substantial agreement is secured, accounting has served its intended purpose. Wherever any specific property is known to be subject to a lien, it is of value to the management for the accounts to reflect the fact. There may, however, be circumstances under which it is not desirable that the accounting records give this information. Conditions must govern each particular case without prejudice, and the principle holds that so long as substantial accuracy is reflected in the accounts as to this point nothing more is necessary.

Machinery and Tools

Under this head will be included not only the assets carried under that ledger caption, but also power machinery, power transmission, shafting, connections, electric transmission cables, and the like. The term is used in a very broad sense. While all these items are subject to one general rule of valuation, usually each must be separately considered to determine the practical application of the rule. The valuation involves, of course, the factor of depreciation, and it is readily apparent that not only do different pieces of machinery differ in this respect, but the same machines in different factories will vary as to this element and even in the same factory two similar machines will not usually be affected in the same way. This may be caused by defects or differences in quality, almost invariably latent, inhering in the machine and also by the different conditions under which they are operated. As pointed out in Chapter VI on depreciation, many of these are engineering problems which the accountant alone cannot solve but the existence of which he should know. Manifestly, all that can be attempted here is to point out their existence.

Accounting Records

The valuation of machinery and tools as here contemplated is dependent largely on the accounting records. Therefore, it is desirable to keep separate records for each of the two classes. This is so because of the greater degree of fixity of the one over the other. As to tools a distinction is also made between machine tools and general shop or hand tools. Machine tools are those with which the machine does its work. Thus, cutting tools for use with any particular machine, auxiliary equipment used for some operations, but not for others, and the like, constitute a very essential and component part of the machine and should be recorded and valued with the machine even though the tools need to be replaced much more frequently than the machine. On the other hand, shop tools comprise those of general utility which are largely used by hand. Hammers, wrenches, hand shears, pliers, chisels, bits, and the like, are examples of shop or hand tools.

Where the number of machines is large, proper accounting requires a subsidiary record known as a machinery ledger or register controlled by the machinery account on the general ledger. In this subsidiary record accounts should be kept with each class of machines, and with each machine separately if the record as to the performance of any specific machine furnishes essential information.

Operation of Machine Accounts

Every machine should be charged with its full cost. Full cost is understood to include invoice price, insurance during transit, freight, duty, and drayage charges, and installation costs. The last item usually includes the platform or stand on which the machine is erected, with all costs in connection therewith, when special supports or platforms in addition to the regular factory floor are needed. The cost of attaching the machine to the power and meters for measuring its power consumption are not usually included therein, these being classed as costs of power equipment—although practice is not entirely uniform in this regard. The machine record should also show the name of its manufacturer and its order number and any other useful information such as terms and period of guarantee, estimated life, rate of depreciation to be applied, numbers and kinds of tool equipment, etc. All deductions from the value of the machine must be on the same basis of full cost. Such deductions might arise because of fire, sale, or replacement. The proper handling of the account when deductions are necessary will be explained at the close of the chapter, as the method is applicable to all classes of asset equipment.

Valuations of Machinery and Tools

The statement of the principle of valuation for machinery is simple, but the application of the rule is complex. The valuation formula for machinery is cost less depreciation. As stated above, the condition of the market has no influence on the going concern valuation of fixed assets. If the market is now lower than at the date of purchase, this simply means that more capital was then required to start operations than is now required. If the forces of competition are free to act, the margin of profit or the margin of return on the investment in machinery will be somewhat less in the one case than in the other. If the market is now higher, then the situation is in favor of the earlier investment rather than the present one. In neither case should costs of production be falsified by valuing the machinery and other equipment at any other figure than cost.

Estimate of Depreciation

Estimating the depreciation on machines is the chief and vital problem in their valuation, because depreciation is reflected in the cost of the article manufactured, being a cost of production just as truly as the raw material used. As brought out fully in [Chapter V, page 93], the so-called depreciating assets are really of the nature of deferred charges to operation and a depreciation estimate is the amount of the periodic charge against production. Because of the speculative nature of an investment in machinery (neither the quality of the machine being exactly determinable nor the conditions of its operation known), its depreciation is always an estimate. For this reason it should be based on the best possible knowledge available at the time of installation.

Any estimate so made must be the subject of periodic revision. How frequently this revision should be made will depend both on the length of estimated life and the way in which actual experience compares with the expected or estimated conditions. The experience on which the estimate is based should, of course, be with the same or similar machines, gained, if possible, amid the same surroundings and conditions under which the new machine will operate. In default of such experience or as a valuable check thereon, the results of others in the use of the machine and the expert advice of those who have studied the problem of depreciation in its practical applications should all contribute to the making of this estimate.

History of Machine

This need of experience data creates the necessity of a means for gathering and preserving the data, and the machinery record above referred to serves the purpose. Therein should be set forth the complete life history of the machine—not only the original cost and the additional data given above, but also the time and cost of all replacements and all information relevant thereto and, as a memorandum, the cost of maintenance, repairs, up-keep, etc. The record is not complete without the data as to repairs. A periodic statement should also be made as to any abnormal conditions under which the machine has been operated, such as overtime, overload capacity, etc. Where possible, the output of the machine in units of product should be included in the record. Where a group or battery of similar machines is operated, the average experience of all of them is the best possible data on which to base future estimates of depreciation.

The more life histories available, the more reliable will be the average obtained therefrom. After making due allowance for changed conditions of operation, this average should prove a reliable forecast of future experience. After all, an estimate of depreciation is in many respects very like an insurance charge, and the time may come when the life histories of a sufficiently large number of machines will provide a very reliable basis for estimate at any given time of the expected life of a machine when operating conditions are known.

Standards of Operation

One phase of the modern efficiency movement relates to the study of machine operation. This has helped in the study of depreciation, in that standardized methods of use have been established. These comprise a standard speed of operation, proper periods of rest, correct methods of throwing in the power, the proper adjustment of parts for each machine; and for each kind of machine tool, the proper degree of hardness to which the cutting edge must be tempered, the speed of cutting, and the number of operations before resharpening—all these standards have been established, resulting in an average performance of maximum efficiency which may be called the normal operating conditions of the machine. Where such studies have been made and where the set standards are uniformly observed, a very reliable basis is furnished for forecasting the future. To insure the observance of these standards a permanent card should be attached to every machine, giving all the information essential to standardized operation. A copy of this standard should be made a part of the record in the machine ledger.

Abnormal Operation

To make the periodic revision of the estimate of depreciation accord with the fact or rather with the best possible estimate of the fact, any abnormal operation of the machine should be considered. Thus, if the machine has been worked overtime, say on a three-shift day instead of one-shift, or if it has been crowded beyond its capacity, if repairs have not been made when they were needed, if the wage policy has been changed from a per diem or per hour basis to a piece-work basis—all these points must be considered.

Machines which are seldom used require careful consideration. It is oftentimes necessary to include in the equipment special machines for infrequent operations and processes. The normal operation of such must be estimated for each particular factory and depreciation based on such use.

All of the foregoing points must be taken into account in connection with the operation of both machines and power equipment. In the case of the power machinery, a consideration of kind and quantity of fuel, manner of feeding and cleaning, quality of the boiler water, etc., with the set standards, forms the basis for a revision of depreciation rates and estimates.

Map of Machine Location

In connection with the machinery record, a complete map showing location and number of every machine is especially desirable. In case of fire it makes identification easy.

Methods of Application of Depreciation

In the application of depreciation, three methods are used more generally than any others. The straight line method, as discussed in [Chapter IX], is the one most widely employed. It is to be preferred to all others, giving satisfactory results and being easy of application. The fixed rate of diminishing value method also has many adherents, and depreciation based on the number of units of product turned out is a third method often used where applicable—though applicable in a very limited degree.

Under the straight line method, it may be ventured as an opinion that 10% is a fair average minimum rate and 15% to 20% an average maximum. The knowledge as to what constitutes an average rate serves little useful purpose, however, although it does give a rough estimate when spread over a large variety of machines. It has been said that from a mechanical point of view no machine can depreciate actually more than 30% and be operated efficiently. This does not, of course, mean that the depreciation reserve should never show more than a 30% offset to the value of the machine, as this would indicate too high a rate were the machine still in operation. It does mean that, according to a theoretical standard of operating efficiency, any machine which cannot fulfill at least a 70% efficiency test should no longer be used. It should be remembered that the depreciation reserve is a device for financing depreciation and nothing else.

Basis of Valuation

The basis, therefore, for the valuation of machinery is its full cost less estimated depreciation. Such an appraisal is subject to periodic revision by comparing the estimated with actual depreciation as more of the facts brought out by the period of life already expired become available. Perhaps the method of inventory, as will be explained in connection with hand tools, is best applicable to machine tools and even to certain small bench machines on the boundary line between tools and machines. However, special tools made for a particular purpose and perhaps not adapted to any other use should be charged against the job and not carried as an asset.

Scrap Material

A financial consideration in connection with machinery is the disposal of scrap material. This should be disposed of as advantageously as possible. It should be held until the market for old metals is high, if at the time of its discard prices are abnormally low.

Accounting for Tools

With regard to the method of accounting for hand and shop tools and the basis for valuing them, the additional factor of possibility of loss claims consideration. Unlike machines, which are for the most part securely attached to the premises, tools are loose, they may be carried off or lost, and so not only loss in value due to depreciation but loss from theft or carelessness must be taken account of. Unless an adequate control is established over the physical handling of loose tools, a very considerable leak may result at this point.

In accounting for tools, different practices are encountered. Thus, the Public Service Commission for the First District of the State of New York, in its Uniform System of Accounts for Gas Corporations, authorized that, “hand and other small portable tools liable to be lost or stolen shall, when first acquired and before issued for use, be carried in a suitable Materials and Supplies account; when issued, they shall be charged to the appropriate expense account. Portable tools and apparatus of special value may, however, be charged to the appropriate tangible capital account, and remain therein so long as record is kept of the persons to whom such tools and apparatus are issued and such persons are made responsible therefor.”

Sometimes the practice is found of charging all purchases of tools to an asset account for a short period of, say, two or three years, and thereafter to a suitable expense account, with a periodic revision based on an inventory about once in five or six years. Again, the Loose Tools account may be handled just as any other asset account, i.e., charged with all purchases, credited with losses, and depreciation provided for. The manner of handling the record is not vital, any method sufficing that fits particular needs. All methods must, however, take cognizance of the fundamental distinction between capital and revenue charges and provide some means by which the Loose Tools account, as an asset account, shall represent substantially correct asset values. A successful method of securing control over the physical handling of tools, where the plant is large enough to justify it, is to place all tools when purchased in the care of a stores-keeper and issue them only on authorized requisition, thus securing an accurate record of them.

Depreciation on Hand Tools

As to the valuation of hand tools, depreciation is often left out of account on the theory that, so long as a tool can be used to perform the service expected of it, it is worth approximately what it cost. Where as an adjunct to this method of valuation, a physical inventory of tools is taken periodically and all losses so shown are charged to expense, substantially correct asset values are secured. Of course, theoretically, tools are as much subject to depreciation as other similar assets, but the method of the inventory valued at cost, and therefore disregarding depreciation, is perhaps the best practical way of handling the valuation of tools, and it gives sufficiently satisfactory results for most purposes.

Valuation of Home-Made Machinery and Tools

Machinery and tools made in own factory offer a problem in valuation. It may be stated thus: Shall such be valued at the market price at the time when made, or shall valuation be the cost to manufacture? It is argued that had the machinery been purchased on the market, as is usually the case, the cost would have been market price; the machinery is worth that price and should be so valued. If the cost to make is less than the market, to bring the machine on the books at market would necessitate the taking of a profit of the difference between cost and market. No profit has been made, only a saving in capital investment. This confusion between profit and savings is referred to in [Chapter XIII].

In the long run, i.e., in the period covered by the life of the machine, it makes no difference in profits for that period whether the machine is carried at cost to make or at market, because its value is written off to depreciation during its life and the higher value means an increased depreciation charge. This will exactly offset during the period of the life of the machine the profit taken by bringing it onto the books in the beginning at market instead of cost. As a matter of principle, however, the point involved is of sufficient importance not to justify the practice. By cost to make is meant full cost, which includes materials used, labor applied, and a fair share of the overhead expenses. Whatever the cost to make, whether lower or higher than the identical equipment could be purchased for on the market, that represents the capital outlay and is the true basis for valuation, taking cognizance of depreciation for the elapsed period.

Expenditure for Rearrangement of Machinery

In connection with expenditures made in the rearrangement of machinery within the plant for various purposes, the question of the effect of it on the value at which the machinery is being carried requires some consideration. In [Chapter V] where an attempt was made to mark out broad boundary lines for capital and revenue expenditures, it was stated that any expenditure which produces greater earning capacity or without which a lessened earning capacity would result (assuming that all normal expenditures for maintenance and repairs are being made concurrently), may be treated as a capital expenditure or at least as a deferred charge to be spread over several periods.

In the case of depreciating assets, the practical identity of the two methods is apparent. Thus, if the expenditures for rearrangement of the machinery have either of the effects mentioned above, there is no serious objection on theoretical grounds to capitalizing them. Instead, however, of injecting such intangible values into the machinery account, it is far better, because more exact and accurate, to show them separately. Practical considerations demand that such expenditures shall not usually influence the valuation of machinery and a conservatism born of the fear of inflation requires that when treated as deferred charges, they should be written off as quickly as may be done without undue burden on the periods’ profits.

Definition of Furniture and Fixtures

Furniture and fixtures, as an asset title, is not clearly defined. It may include the usual tables, desks, filing cabinets, bookcases, typewriters and other mechanical equipment, safes, chairs, counters, and in addition, light, heat, and plumbing fixtures, show windows, partitioning, shelving, and the like. The account should be charged originally with all such items at full cost. Great care must be exercised in handling repairs and betterments to avoid an inflation of values. The distinction between capital and revenue expenditures as regards all such assets already acquired is usually so slight and uncertain as to justify the establishment of a policy of charging all these to expense. Otherwise, the ease of inflation is apparent. All new purchases should be charged at full cost to the asset.

Valuation of Furniture and Fixtures

The basis for the valuation of furniture and fixtures is at cost less depreciation. In applying depreciation, account should always be taken of the usually very small residual values in this class of asset. Scrap value in some cases is only as kindling wood and therefore almost or entirely negligible. In some cases of easily movable equipment, the method of the inventory as used for loose tools will give better results in valuation than an appraisal method based on cost less depreciation. One often finds the conservative practice of bringing onto the books a rapid depreciation to scrap value during the first few years, at which nominal value the asset is carried thereafter. This is a common practice in financial institutions. While not theoretically justifiable, in comparison with the opposite tendency based on too great optimism as to the life of the asset, the practice is to be commended.

The average range for depreciation of this class of asset is from 10% to 20%, estimated by the straight line method. Where premises are leased and any equipment of this kind is, according to the terms of the lease, to remain with the building, it is necessary that a depreciation rate be taken high enough to accomplish complete writing off by the end of the lease. This rule also applies if the equipment may be removed but would be in a badly damaged condition, resulting in little remaining value.

Delivery Equipment—Definition and Valuation

Delivery equipment includes all property, direct or auxiliary, used in connection with the delivery of goods both inward and outward. Horses, wagons, and harnesses, motor trucks and cars, repair parts, and repair equipment, containers, holders, and the like, are common examples of this class of asset. In the main, these assets are handled very much as all the others of the general equipment group. Valuation is on the basis of cost less depreciation for the most part, but in many instances the method of the inventory should be applied.

If horses comprise a part of the equipment, not only must depreciation due to wear and tear be reckoned, but accidental causes such as death and disablement must be given consideration. Experience in each business based on the particular kind of work to be performed and the conditions under which it is being performed furnishes the only adequate basis for estimating the depreciation rate. Thus, heavy or light draughting, speed to be maintained, kind of road on which the haul is made—cobble stones, brick, asphalt, wood blocks, or dirt—and the standard of appearance to be maintained—all these affect not only the cost of up-keep but also the rate of deterioration. Sometimes it may be safe, as with loose tools, to charge all purchases to capital for the first few years until the equipment is complete, and thereafter all renewals to revenue, depreciating the asset account, say, 20%, and maintaining it at that figure. Any marked increase or decrease in numbers would require respectively an added capital charge or a reduction of the original charge. Whether this method or the method of the inventory be used for valuation purposes, there should be a periodic appraisal by an expert horse dealer and adjustment of values based on this appraisal.

Wagons, trucks, and motor vehicles should be numbered and all accounted for periodically by physical inventory. It may be desirable in some cases to maintain a register for these, wherein the performance of each can be recorded and so compared. This is particularly desirable when a change of delivery policy is under contemplation and comparative records are needed of the performance of various types of vehicles. This class of delivery equipment is best valued on the basis of cost less adequate depreciation, with the periodic inventory as a check on numbers and condition.

Carriers and Containers—Valuation

The most difficult of all the items of delivery equipment to handle and value is that class represented by carriers and containers. These may be barrels, kegs, casks, bottles, baskets, and boxes, and are met in the brewery, dairy, bakery, laundry, and oil businesses. In some lines it is feasible and is the practice to charge the customer with the fair cost of the carrier, giving a return privilege with refund, dependent upon the condition of the returned carrier. This is good where applicable, although it necessitates having an adequate redemption fund which may be operated somewhat as a bank’s reserve is, i.e., only large enough for normal needs but capable of ready enlargement when the need arises. In other lines of business such a method of handling the container cannot be used. Here, as in the bottled milk trade, only experience will give a proper basis for estimating the depreciation through loss, theft, and breakage. The rate is almost invariably high, and liberal depreciation should be provided for. Taken all in all, throughout the various kinds of delivery equipment rates ranging from 16⅔% to 25% constitute fair average rates.

Patterns, Molds, etc.—Valuation

The last kind of equipment items requiring consideration is comprised of such items as patterns, lasts, molds, dies, drawings, electrotypes, wood cuts, forms, models, and the like. Wherever possible, these should be charged to the particular job for which they were made and not carried as assets. Unless there is a probability that the pattern, mold, etc., will serve for other uses than those for which it was made, the costs of making should be borne by the job on which it was used. This is very often not the case, however, and these items can be used for successive production. This is particularly true of a standardized product which is not apt to be much affected by change in style or the whims of a purchasing public. At the best, however, they constitute a treacherous and highly speculative asset and require careful handling to avoid inflation of value. Thus, it is easy in the publishing business to allow electrotypes, wood cuts, etc., to assume unwieldy proportions to the other assets. In manufactories of wearing apparel, the fickleness of fashions requires that patterns, lasts, and models be written down ruthlessly to the lowest possible figure. Here obsolescence is a big factor.

Under the limitations set, valuation should be based on cost with a very liberal periodic depreciation. The rate will average anywhere from 20% to 50%, though a lower rate may sometimes be proper.

Disposal of Assets

In connection with the handling of the asset and its valuation account, the disposal of all or some portion of the asset requires consideration. It is a fundamental principle that whatever is taken out of the asset account must be taken at the same cost as it was introduced into the record. Thus, an asset recorded at cost of $5,000 and sold for $4,500 would be shown as taken out of its account at $5,000, the apparent loss of $500 being recorded in a suitable expense account. If the asset has suffered depreciation between the date of purchase and sale, and the depreciation reserve shows this, that must be taken into account. Practically, it is best handled by transferring to the asset account from the depreciation reserve the part of the reserve applicable to the portion of the asset disposed of. Upon disposal there is an additional credit to the asset account of the difference between cost and the depreciation to date, i.e., the amount of this credit is the present appraised value of the asset sold, taking into account not only the recorded depreciation but the accrued as well. This brings out the true as distinguished from the apparent profit and leaves in the reserve only that portion which is applicable to the asset remaining.

An illustration will show the process of handling. Assume that the $5,000 asset is a portion of a $50,000 machinery account, for which the recorded depreciation reserve is $10,000 and the depreciation on the portion sold accrued to the date of sale is $200. The entries, necessary to effect the sale, are:

(1) Depreciation$ 200.00
Depreciation Reserve Machinery $ 200.00
Accrued depreciation to date
on the asset sold.
(2) Depreciation Reserve Machinery1,200.00
Machinery 1,200.00
To write down to appraised
value the asset sold.
(3) Cash4,500.00
Machinery 3,800.00
Profit on Sale of Machinery 700.00
To record sale of machine
and the profit on it.

CHAPTER XVII
BUILDINGS, LAND, AND WASTING ASSETS

Definition of Real Property

The movable fixed assets—paradoxical as the limiting adjectives may seem—having now been considered, the present chapter will treat of the immovable tangible fixed assets. By immovable is meant real property as distinguished from personalty, and by tangible the intention is to exclude from the present consideration such intangible items as good-will, patents, copyrights, trade-marks, franchises, and the like.

In accounting for this group of assets there is no place for the caption “real estate.” In its stead the two titles, “land” and “buildings,” are used. This is to avoid confusion and to afford a better basis for calculating depreciation. The term real estate or real property has a very definite legal connotation, but in the popular mind is held to include land and buildings. From the accountant’s point of view there is no objection to the use of the term in the balance sheet, but in the accounts themselves the two assets should be carefully separated. For the private commercial enterprise, land as a fixed asset is subject neither to depreciation nor to appreciation; whereas buildings are constantly depreciating in value. While depreciation can be calculated with fair accuracy on the combined basis, the single basis of building values is the only scientific basis. The separation of the two values is also essential for insurance purposes and the proper adjustment of fire losses. They will therefore be separately treated in this discussion.

Cost of Buildings

Buildings as fixed assets should be valued by the formula for the fixed asset group, viz., full cost less depreciation. Some points in connection with proper methods of accounting and special cases of valuation require comment.

First, as to making the proper record of cost of the buildings. Three cases must here be considered:

1. If the building is purchased outright for cash, whatever costs are incurred in securing full title and expert opinion as to the sufficiency of the title are proper charges against the building. If the building is erected on contract, the full cost of the contract and any necessary supplementary charges comprise the carrying value of the structure.

2. If the building is bought by the issue of stocks or bonds, the present value of those securities and all costs in connection with their issue should constitute the cost of the building. Determination of the present value of the securities is oftentimes a difficult matter. When sales on the market take place concurrently, that determines the price. When, as is usually the case, several existing companies are bought up or merged to form a larger company, the old stockholders are given shares in the new company for their equities in the old. The book value of their old holdings may be the basis for the issue of the new stock or the issue may be on the basis of a larger or smaller value than this. This whole question of the value of the assets taken over is equally a question of the value of the securities issued therefor. This is considered in full in [Chapters XX] and [XXI] and will be given only brief treatment here.

Manifestly all considerations relating to buildings purchased by stocks and bonds have equal application to all other fixed assets so purchased, and the treatment in later chapters will therefore be more inclusive than could be any statement of the case applicable only to buildings. It suffices to say here that usually the par value of the securities issued constitutes the value placed on the assets bought. The valuation as a rule is made by an appraisal committee from the board of directors which inspects the various properties taken over and places a value on them. In the absence of fraudulent intent, the courts will usually sanction and uphold these values as having been made by interested parties competent to act. This is the method generally used for injecting water into properties.

3. When buildings are put up by the concern itself, full cost may include not only cost of material and labor and a fair proportion of the overhead where supervision of construction is local, but all other expenses directly incurred in connection with construction. These will include architects’ fees for plans and supervision, cost of permits and licenses, interest on borrowed moneys and insurance during construction, accidents and injuries to workmen during the construction period, easements, damages, strike costs, and the like. If the structure is being erected on a site occupied by an old building, the cost of wrecking less any salvage value is a proper charge against the new structure. If bonuses have to be paid tenants in the old building to secure release of their quarters, these, too, are similar charges to the new structure. Charges such as interest and insurance during construction are capital charges only up to the point of fitting the building for occupancy and so making it an operating and income-producing unit. Thereafter these must be treated as revenue charges.

Some interesting and at times complicated situations arise when, as in the case of an office building, the structure is occupied in sections as completed. Theoretically, only the portions of the charges of this kind applicable to the completed sections now become revenue charges, the rest still being capitalized so long as sections remain uncompleted. Practically all that is desired is substantial accuracy. The items may be comparatively insignificant but when in doubt the bias should always be on the side of conservatism.

Valuation of Buildings

In the valuation of buildings a much more difficult problem is encountered after the structure is completed and repairs and alterations are made. It is the old problem of the proper differentiation between capital and revenue charges, and is particularly difficult of solution in some instances. Nothing more can be said here than was stated in [Chapter V] where the fundamental rules to be observed in distinguishing between repairs, renewals, and betterments were laid down. Changes in interior arrangement to accommodate new fixtures and equipment, or a different distribution and arrangement of existing equipment with a view to better operating conditions require particularly careful handling. Such expenses were mentioned in connection with the treatment of machinery on page 290, and the reader is referred to it. Whatever decision is reached on any doubtful item of this or a similar kind, the supporting vouchers, bills, and papers constituting the full evidence should be carefully preserved and made available for review in case of any future questioning of the charges.

Betterments on Leased Buildings

In the case of betterments made on leased buildings, provision must be made to write off their entire cost by the time of the expiration of the lease, as they almost invariably revert with the building to the owner. Sometimes the betterment, if material and so agreed as between lessee and owner, may be taken over at a depreciated value upon expiration of the lease. Here depreciation of the betterment must be provided for. Whether all or only part of the cost of the betterment is to be charged off periodically, record of this is best accomplished as an addition to the periodic rent charge.

Application of Depreciation

As stated above, the basis for valuation of buildings is at full cost less depreciation. It is the method of appraisal, although the inventory may provide a good check in the case of concerns owning many structures. A subsidiary record of buildings showing separate costs and location, or at least a map showing location, may then prove very essential, particularly in the case of fire losses. In the application of depreciation to buildings many things must be carefully considered. Not only must the depreciation of use, i.e., wear and tear and lapse of time, be considered but also obsolescence and inadequacy as factors in shortening the service life of the structure.

Buildings used for some purposes deteriorate more rapidly than when put to other uses. Vibrations, whether caused by own use or due to exterior causes, increase the rapidity of deterioration. Susceptibility to fire, explosion, and the like, due to the nature of their use, should be taken into account. It is stated that power plants operating under normal conditions provide for an entire replacement of plant every five years. Power houses depreciate more rapidly than store houses. A building put to various uses will be subject in its different parts to varying rates of depreciation. Although a composite rate applicable to the whole structure will give a satisfactory valuation, if accurate departmental costs are required it would be desirable to apply the different rates to the building values distributed over the various departments. In practice this is seldom done.

According to different authorities, rates of depreciation ranging from 1% to 5% constitute a fair average. The nature of the structure, whether occupied by owner or tenant, its location, kind of composition, etc., are additional factors for consideration. While some authoritative rates are available, no standard rates, unless compulsory, should be used without a careful study of local conditions. Structures which are temporary should, of course, be charged for their net cost, i.e., full cost less salvage value, against the product or the job which makes use of them. Other cheap structures such as mine buildings, shaft houses, temporary housings for lumber mills, and the like, should be written down very rapidly. Having practically no realizable salvage value and their life being brief, they should be charged off the books at least during the period of their use.

Buildings owned as a freehold for life, or, stated otherwise, a life interest in buildings, are not subject to depreciation, the remainderman taking the building in its condition as released by the party owning the life interest.

Accounting for Land

In accounting for land as a fixed asset used in the conduct of a business, one or more accounts may be carried as seems best. If the land is in several different plots, perhaps widely separated and each plot held with other groups of assets and under varying conditions as to taxes and other obligations, some plots being subject to mortgages and others not so subject, separate accounts with each plot would be desirable. Otherwise, usually the one account will suffice.

The record should be as complete and full as possible. Notation after the title or elsewhere, giving the description and location of the holdings, is an advantage as a means of exact reference. The various items in the account should be supported by full explanatory matter together with documents available for the analysis of the various items and proof as to their legitimacy. It should thus be possible, at any time, to determine the items comprising full cost. The purchase contract price, the attorney’s fees, and broker’s commissions or a fair portion of the purchasing agent’s salary, the costs of search and guarantee of title (if these are borne by the purchaser), notarial and recording fees, the assumption of taxes owing at date of purchase, local improvement taxes and assessments, such as sewer, water, curbing, paving, and the like—all these should be indicated with clearness and definiteness.

Where accounts with a “large number” of plots are kept, it may be advantageous to carry these accounts on a subsidiary record specially ruled to give the detailed information desired and control them all by one general ledger account. Local conditions and the information desired will determine the manner of keeping the records. In all cases, the account should carry a notation as to where the supporting legal papers and documents covering each parcel or plot may be found. This prevents much needless loss of time and worry when quick reference to those papers is desired.

Valuation of Land

The basis for valuing land with unclouded title, as a fixed asset for business purposes has already been clearly indicated. Full cost, usually with neither depreciation nor appreciation, constitutes the valuation formula. By full cost is meant complete cost in condition ready for use or, at least, up to full-title date. In addition to the items enumerated in the preceding section, there may sometimes properly be included such expenses as leveling, grading, filling, and draining. Even the costs of dikes, dams, and embankments, and in the case of railway construction the cost of the care and up-keep of growing trees planted to prevent land or snowslides, tunneling, and the like, may be carried as a part of land costs, although some of these may more accurately be recorded as improvements. In the case of mining land, the cost of stripping the surface to reach the ore body, and the cost of shaft-sinking and of tunneling are proper capital charges and may be recorded under the land account, although preferably under a development account.

Whatever costs are necessarily incurred to make the land serve its intended use are proper capital charges and should be recorded in the land account unless better purposes are served by record in some supplementary account.

Depreciation or Appreciation of Land

The relation of depreciation and appreciation to land valuation is not difficult in theory but is often very perplexing and gives rise to complicated situations in practice. In theory, so long as the land is used for its intended purpose, fluctuations in the market either up or down should not affect the valuation at which it is carried on the books. Just as with the equipment group of assets discussed in Chapter XVI, any increase or decrease in the value of the land cannot be realized so long as the land is employed in operation. Its cost represents the capital tied up in it and the amount on which profits must be earned. This is therefore the value at which it should be carried on the books. Sometimes other considerations than those of accounting influence business policy in connection with the market value of land; but so long as it is used for the business purposes for which it was purchased, full cost price should be its valuation. This may sometimes place a prospective borrower at a disadvantage when using his balance sheet as the basis for credit. A footnote or other notation giving market value will usually suffice, although such value is often difficult of determination without a disinterested appraisal.

Appreciation of Land Values

When land is held over long periods in a growing community, appreciation in value almost always results; occasionally depreciation ensues. The amount of appreciation is oftentimes not as much as it seems because land with buildings on it may not be convertible to some other use at the market price of similarly located vacant land; the cost of scrapping the buildings often being as much or more than the appreciation in land value. Also, appreciation may sometimes be of a temporary character, in the nature rather of a market fluctuation. If so, the distinction must be carefully observed. Perhaps in the majority of cases requiring consideration, appreciation not only is very real but also very considerable.

It may sometimes be desired to base an issue of bonds on real estate—land and buildings—which is being carried at an old cost figure as of many years ago but which has a greatly appreciated and available market value at the present time. Prudent financial considerations would require an independent appraisal to determine the amount of the bond issue. Upon the assumption that the issue is for a larger amount than the original cost of the security, a peculiar situation arises. In showing the transaction on the books and balance sheet, not only would no margin of security appear, but even an insufficiency of security so long as the original value of the security is carried. Here it would undoubtedly be wise to bring the appraised value of the security on the books, offsetting the appreciation in value by a suitably named surplus or reserve account, such as “Reserve for Land Value Increment” or “Appreciated Land Value Surplus.” Another method and perhaps a better one where possible of application is to reorganize the concern by a sale of the old to a new company and so capitalize the increment in value of the old company’s assets.

Another financial consideration in connection with appreciated real estate values concerns the advisability of the sale of the old and the erection of a new plant on less valuable land. Usually, the appreciation of land values is not reflected in increased profits; it may even result in lessened profits due to higher rates of taxation and other expenses. If there are equally favorable locations for the particular kind of business, it may be the part of business sagacity to use the old location for rental purposes so that the benefit of the appreciation may be secured, or to sell and move to a less expensive site. In the one case the status of the land has been changed from that of an operating fixed asset to an investment, perhaps best considered permanent. In the other case, the increased value is through sale realized in a lump sum and, as a surplus item, is available for any purpose to which surplus may legitimately be applied. Of course, the amount of such surplus is the difference between the sum realized by sale and the cost of an equally efficient plant on the new site. It will usually happen that a better plant is erected, thus consuming some of the surplus arising from the sale.

Depreciation in Land Values

In a great many instances land depreciates. Decrease in value due to use will be considered under the discussion of wasting assets, page 311. When land suffers depreciation it is usually because of obsolescence or inadequacy. Due to certain natural facilities giving out, or to the removal, dismantling, or decay of artificial facilities, a site may depreciate so much as to become untenable. Business and residence property in a mining town may be of mushroom growth and have practically no value when the market, which is dependent on mining operations, declines. Ventures of this sort are recognized as highly speculative from the beginning and should be handled as such in the accounts. Wherever depreciation due to these causes can be foreseen, suitable provision should be made; otherwise the burden will fall entirely on the period when the plant has to be abandoned and this stage is usually preceded by periods of lessened profits. Depreciation of land is therefore always a local question.

Valuation of Land Investments

Business considerations oftentimes make advisable the purchase of adjoining or otherwise located tracts of land, with an eye to the future when enlarged facilities will be required. These should be carefully differentiated and segregated in the accounts from the land in use for business purposes. Some points in their valuation, in addition to those treated under the discussion of investments in land on page 278, need to be considered. Such tracts of land may usually without prejudice be valued at cost.

If later developments should turn out as originally expected, there can be no objection to loading the carrying costs of these lands, including taxes and interest on any borrowed purchase money, on their value year by year. The only reason for their purchase at the present time is because it is expected that the transaction can be more advantageously made now than later. If such should not be the case, the cost of the land proves to be higher than if purchased later. Only by loading these carrying charges can this information be developed. If the land is finally put to its intended use, no serious objection is seen in carrying it at the figure of full cost to the date of use. Because of the speculative nature of the transaction, it is usually advisable to set up a reserve of the same amount as the accumulating carrying charges. This reserve becomes free when the land is put to its intended use.

Because of the ease of inflation of values in transactions of this kind, due largely to an overoptimism as to the future and even sometimes to fraud, all such transactions must be scrutinized very carefully and ample provision against an unfavorable outcome should be insisted upon. It is interesting to note in this connection that in the case of valuations for rate-making purposes, as a usual thing carrying costs on land of this kind are not allowed as expenses to be covered by the rate of the service rendered. But when these lands come into use such expenses become a part of the cost of the service.

Mortgages on Land

Mortgages on land require consideration as affecting the manner of showing the land value. Freehold land, i.e., land held in fee simple, if afterwards mortgaged should be shown on the balance sheet at full face value with the mortgage listed among the liabilities. The liability is usually a note or other bond which in case of the deficiency of the security would be a general claim against the free assets of the concern. It is therefore best, theoretically, not to show such a mortgage as an offset to its security. In the case of the purchase of land subject to mortgage without the assumption of the mortgage as a direct liability, theoretically the mortgage may be shown as a deduction from the full land value and only the equity value of land be extended as a significant asset. This differentiation is almost entirely an academic one and is seldom seen in practice. The land is usually listed among the assets and the mortgage as a liability.

Donated Land

The valuation of donated lands presents some interesting points. A town may offer a free site to secure the erection of a plant within its midst rather than allow it to go elsewhere. Sometimes the donation may be outright and absolute; at other times it may be conditional, depending upon the doing of certain things by the donee, such as the employment of a minimum force of men for a certain number of years, or the circulation of a certain amount of advertising, or the purchase of given amounts of raw material supplied locally. In the case of an outright gift, the cost to the company is usually nil, but for the proper statement of the concern’s financial condition the land must be shown as an asset. If the acceptance of the gift necessitates the scrapping of the old plant and removal expense to the new site, such costs would provide a minimum carrying value for the land. Where this is not the case, the land might be given a nominal value, with suitable explanation.

Usually, however, neither of these methods is so satisfactory as that of bringing the land onto the books at a fair appraised value and showing the contra side of the transaction as surplus, or donated surplus, or donated land surplus. Any gift received increases the proprietorship of a concern and should be so shown, and there need be no suspicion of inflated value in such a surplus item, if conservatively set up, and with the supporting records available. Any expense in connection with the acceptance of the gift is a proper charge against the donated surplus. Aside from this, it is free surplus available for customary uses so far as this transaction is concerned.

In the case of a conditional gift subject to reversion until the satisfactory fulfillment of the condition, no title nor asset value, other than a contingent one, inheres in the land. It is not therefore proper to show any. If a condition, extending over a period of, say, five years must be met, at the end of the first year one-fifth of the time has elapsed and the condition is nearer to fulfillment—the contingency has become more nearly a fact. But until its full satisfaction and the danger of a lapse has passed, there is no value in the gift. To show the progress and status of condition, the pro rata portion of the gift may be shown periodically by a charge to Donated Land or Equity in Land, offset by an equal credit to some suitable reserve such as Donated Land Reserve or Unrealized Profit on Land. On the balance sheet the reserve would be treated as a valuation item, no value being extended among the assets. This would seem to satisfy all demands for information and show the exact status of the transaction.

Land as Stock-in-Trade

A final consideration, not logically belonging here but treated as a matter of convenience, is that of land as stock-in-trade. In the case of a land company developing a tract of land for certain purposes, the individual plots, or the whole piece if division is not contemplated, constitute its stock-in-trade and it should be valued as such, i.e., as a current asset and not a fixed. All costs necessary to put it in condition ready for the market are capital charges and should be loaded onto the cost of the lands. These include all of the usual costs mentioned in connection with land as a fixed asset, and in addition all improvement costs such as parking, the laying out of streets, roading, etc. The loss in the use of land for these purposes should be prorated over the plots, or otherwise equitably distributed. Plots of land so developed are not usually sold all at one time. Any unsold plots should be inventoried at cost. Sometimes the first plots may be sold at a loss to make the rest of the proposition move. The practice is met of loading the loss in the early sales onto the unsold plots, and it is quite common to add any carrying charges to the cost of the unsold plots.

Both of these practices are to be deprecated and opposed. They are not right in theory and serve no necessary purpose. All costs after the stage of sale is reached are operating costs—charges against revenue which should not be capitalized. It may be desirable to know at what price the unsold plots must be disposed of to cover all expenses and losses and to make a profit, but that does not justify an inflation of the carrying values of the asset. If it is desired that the books shall show this, an amount equal to these costs and losses may be added to the carrying values if offset by a valuation reserve of equal amount, the costs and losses themselves being handled as operating expenses of the current period—or spread over several periods if applicable.

Wasting Assets—Definition and Characteristics

Wasting assets, as they are usually called, are better described as assets subject to depletion. They differ from depreciating assets in that, whereas the latter wear out through use or the effect of age, wasting assets simply “give out.” They are subject to depletion because they comprise stores of raw materials and natural resources the supply of which, through being mined and disposed of, is definitely and finally diminished. The stores will in every case finally come to an end through yielding up their product. Examples of enterprises of this kind are minerals and deposits of all sorts, such as coal, gold, silver, lead, clays, slate, gravel, stone quarries, oil, asphalt, nitrate, timber, and “all growing plants yielding recurring crops, such as tea and rubber.”

Dividends May Include Return of Capital

The law recognizes the distinction by requiring in the case of depreciating assets that the decrease in value must be made good before the payment of dividends—i.e., dividends cannot be paid out of capital—while in the case of assets subject to depletion it is recognized that some portion of the dividends paid may represent a return of the capital originally invested in the undertaking.

If the latter is the policy pursued, there will be no liquidating dividends at the time of the break-up of the undertaking, inasmuch as the regular dividends have already included a return of all or some portion of the capital. If, however, it is a matter of business policy to continue the enterprise elsewhere when the present natural stores are exhausted, then the dividends should represent only profits. During the process of operation, assets in other forms which represent the capital investment of the undertaking are retained in the business. This is accomplished on the books by a charge to each period’s operations of such an amount as represents the depletion of the stores of product prepared for the market during that period and by a credit to a depletion reserve account or direct to the property or stores account.

Basis of Depletion Charge

The amount of the period’s depletion charge is reckoned by comparing the amount of product worked during the period with the total estimated amount owned. Whatever value was taken for the original purchase, that value becomes the basis for the annual or periodic depletion charge. There is, of course, a large element of speculation in some estimates of this kind. In the case of timber, the original amount purchased is easily determinable with fair accuracy by cruising; the amount cut each period is a matter of record. The ratio of the amount cut to the original amount is the portion of the original value or cost of the timber tract to be written off periodically. In the case of a mine or pit, the estimate cannot be made with an equal degree of accuracy. Competent engineers do make calculations of the amounts of available ores with sufficient certainty to warrant the expenditures of vast sums in the purchase of properties. If their estimate avails for this purpose, it can with equal certainty be made the basis for the periodic depletion charge. Nice questions arise in this connection when the property is being operated under a lease or on a royalty basis.

Application of Income Tax to Wasting Assets

Under the 1916 income tax law specific provision was made for allowing depletion and the manner of handling it is prescribed. First, for such a charge to be allowed as a deduction, it must be recorded on the books. Secondly, as soon as the depletion reserve equals the capital investment no further deduction can be made—all else is pure income. If, however, it is desirable to carry on the books as an asset the estimated amount of product still remaining in addition to that written off, it may be done, the offsetting credit being to income, which must be shown as income on the tax return for the year in which it was brought onto the books. This new value may be depleted until wiped off the books.

The law as now operated bases value of the asset subject to depletion on the value existing as on March 1, 1913, or at cost or purchase price if acquired subsequent to that date. Because the book values on March 1, 1913 seldom agreed with the estimated values, it was necessary to adjust these by charging the asset, plant, or mining property and crediting an account called “Property Surplus” with the amount of the adjustment where the estimate showed more than the book value. When dividends are paid, if it is the policy to return capital as well as profits, the charge should be made partly against operating surplus for the profits share, and partly against property surplus for the capital share.

Depreciation on Buildings and Machinery of a Wasting Asset

In addition to the depletion charge, proper allowance should be made for depreciation of the other fixed assets, such as buildings, machinery, and the like. The limit of their service life is evidently the working life of the venture, which must be estimated. If there is still operating value in the equipment at that date, this is covered by the higher salvage value taken into account when fixing the depreciation charge.

Unusual Risks

In connection with both the estimate for depreciation and for depletion, the elements of unusual risks, due to fires, floods, and the like, should be taken into account. Their effect might be to cut down the supply of available product and so increase the periodic depletion charge. Another factor, of great importance at times, is the available supply of any auxiliary product needed for the treatment of the main product. Thus, large ore bodies may remain unmined and unprofitable because of the failure of a ready supply of auxiliary material needed in the reduction, smelting, or refining of the ore. This applies particularly to iron ores.

Water Rights

Sometimes valuable water rights are acquired along with mining property, and it may be profitable to utilize them for the manufacture and sale of power long after the depletion of the mine. In that case their capital value should be separated from that of the mining venture, and retained as an investment; or a new company may be formed to carry on the power project after ceasing mining operations.

Leaseholds

On the boundary line between a depreciating asset and one subject to depletion stands a leasehold, i.e., the right of occupancy of premises for a stated term. Thus, a building may be rented for a term of years; or a piece of land may be leased for a long enough period to justify the erection of a building thereon, the building going to the owner of the land as a gift or at an appraised value, or the land may revert in its original condition to the owner upon expiration of the period of the lease, according to the contract. The payment for the lease may be an annual sum similar to a rental charge, or a bonus and an annual sum. In the latter case, the bonus should be treated as a deferred charge and spread as additional rent over the period of the lease.

Leases may run for any period up to 99 years, 63 and 84 years being favorite terms in New York. An original lessee may sell his lease outright for a set sum sufficient to cover the remaining period of the lease, or on an annual rental basis. The set sum is calculated as the present worth of an annuity of the amount of a fair annual rental.

Where property values have greatly appreciated, a leasehold on favorable terms may have a high market value which may not appear on the books or balance sheet. If the terms of the lease call only for a periodic payment like rent, the value of the lease will not usually appear on the books. If the lease is purchased outright for a lump sum or a bonus is paid, some value for it will appear on the books. Where the balance sheet is to be used as the basis for credit, the present appraised value of the leasehold should appear, either in a footnote or preferably incorporated into the balance sheet with an offsetting reserve.

If the leasehold is carried at any value on the books, this must, of course, be depreciated or amortized by the end of the leased period. As stated above, the periodic charge for this is to the rent account and the credit to the leasehold account, writing it down directly instead of by means of a reserve. The straight line method of amortization is the easiest of application, but authorities seem to favor, on theoretical grounds, the annuity method which brings in the element of interest. If the agreement provides for the reversion of the building to the owner of the leased land, then also the full cost of the building must be depreciated over the life of the lease. Any excess of this depreciation over normal depreciation is in the nature of a rental charge but not usually of sufficient importance to require segregation. If the premises must be returned in original condition to the owner, the net costs of demolishing any structures erected thereon must be treated as expenses of the lease and provided for accordingly.

CHAPTER XVIII
INTANGIBLE ASSETS—PATENTS,
FRANCHISES, GOOD-WILL

General Considerations

The final place among the assets of the balance sheet is given to the intangible items. Because this class of assets has so frequently been used for doubtful or illegitimate purposes, whatever the value given to them they should be shown boldly in a group by themselves and not merged with the values of tangible assets. Their real value, if any, should be open to verification. To list them with tangible items on the balance sheet is apt to raise a suspicion as to their validity much more than if they are shown in a group by themselves.

Because the assets of this group are intangible is no reason in itself for the hasty judgment frequently made that therefore they are worthless. It is true, as above stated, that the doubtful uses to which they may be put have caused them to be viewed with suspicion. Yet they have an entirely legitimate use and oftentimes constitute the most valuable portion of the assets. Therefore, the values at which these intangible assets are carried on the books should always be open to investigation and capable of verification.

It is purposed here to lay down the principles of the legitimate use of intangible assets, and to point out some of the wrong uses to which they easily lend themselves. The group comprises patents, copyrights, trade-marks, formulas, receipts, franchises, organization expense, going concern value, and good-will.

Patents a Monopoly Grant

A patent is “a grant made by the government to an inventor conveying and securing to him the exclusive right to make and sell his invention for a term of years.” The purpose of the government in making such grants is to encourage and stimulate individual ingenuity along lines that will ultimately redound to public welfare. Letters of patent are in the nature of a monopoly grant but, although extreme care is taken in their issuance to see that they cover really new devices, no governmental guarantee implies that the patentee shall have free and uncontested use of his invention. If encroachment is made upon his rights under the patent, the courts are open to him for protection and similar privileges are extended to all alike. Oftentimes, until infringement proceedings have established a clear and uncontested right and property in an invention, little commercial value attaches to it. Patents therefore tend to create a monopoly in the marketable product protected by them and accordingly have value so long as the right to monopoly continues.

Purchase of Patents

The valuation of patents owned and made use of by a business should always be on the basis of cost. If owned by purchase from the inventor, the consideration paid for the patent constitutes cost. When the consideration is cash, there is no question as to the valuation at cost. When payment is made in the capital stock of the purchasing concern the problem is the same here as in the proper valuation of other fixed assets purchased in the same way, referred to in [Chapter XVII]. The federal income tax law takes cognizance of this different basis for valuation and attempts to establish a true cash basis by allowing depreciation on patents, when purchased by means of stock, only on the basis of the cash value of the stock. Prevailing practice sponsors the bringing of patents onto the books at cost, as shown either by the cash paid for them or by the par value of the stock issued for them. Except where deceit and fraud are the points at issue, no serious objection can be raised to the practice, for any overvaluation thus occasioned is absorbed in the product by means of the depreciation charge spread over the life of the patent. Any additional costs necessary to secure the full enjoyment of the rights granted under the patent are considered proper charges against the patent, as giving it additional value.

Patents Developed within the Plant

When the patent is not purchased from outside but is developed within the plant itself, only the costs of development and of securing the patent are proper charges to the asset as constituting its value. In some concerns an experimental laboratory is maintained for the purpose of working out improved methods and devices. Much of the work of such a laboratory is often fruitless so far as patentable devices are concerned, but if the entire effort is directed towards the development of patents, then the entire cost becomes a proper charge to whatever patents result from the effort. More often some portion of the laboratory organization is also used for other purposes. However developed, whether in the formal laboratory or in any other way, the full cost of development and of securing letters patent is the figure for the original valuation of the patent. This cost includes the labor and material used in the process, drawings, models—including discarded models—attorney’s fees, government fees, etc.

As in the case of purchase, all the costs, whenever incurred, of defending the right to the patent or of prosecuting for infringements constitute additional elements of value, as only by such means can the real holder be made secure in the exclusive enjoyment of his right. It is hardly necessary to point out that if such proceedings and prosecution establish the right of the other party to a device which practically destroys or greatly diminishes the worth of the contested patents, not only must such costs usually be charged against revenue but also the whole or major portion of the value at which the patent is being carried. However, where the development of patents is one branch of a concern’s organization, costs of this nature may usually be absorbed by those patents which are successful. Because inflation of values is easy at this point, a careful investigation to establish the legitimacy of all such charges is always desirable. Each case must be judged on its merits.

Patents Purchased and not Used

Patented devices are sometimes purchased with no intent to use them. This may be for the purpose of eliminating competition, of forestalling obsolescence or supersession, and so of postponing the necessity of making expensive alterations that would be required to meet threatened competition, even to the point of scrapping a valuable organization. The ethics of such practice is not under review here. Correct accounting practice justifies the addition of the purchase price of such devices to the value of the asset, patents, and its periodic depreciation in regular course.

Elements of Depreciation on Patents

Patents are subject to depreciation. At the time of their purchase or acquisition, they should be valued at full cost, as stated above. At any subsequent time, value should be calculated on the basis of full cost less depreciation. The elements of depreciation as applied to patents are (1) time lapse, (2) supersession, and (3) obsolescence.

1. Time Lapse. There is no such thing as wear and tear on a patent itself, but since the grant by the government is for a definitely prescribed term of years, as each of those years goes by there passes with it some portion of the value attaching to the exclusive enjoyment of the right for the prescribed period. In this country a mechanical patent is granted for a term of seventeen years, after which the patented device or process becomes common or public property. The period allowed for patents covering designs is three and one-half, seven, or fourteen years, depending on the application. Thus, simply through the lapse of time the value of the right diminishes.

2. Supersession. If no other causes than time lapse were operative, the problem of depreciation would be a simple one, consisting of spreading the value of the patent over its life. In addition to lapse of time and operating simultaneously with it is the possibility of supersession. Supersession as an element of depreciation is the attempt to measure the probability of the patent’s being superseded before the expiration of its term by a better machine, device, or method. The measure of this element of depreciation is always speculative but should be attempted with the best judgment possible.

3. Obsolescence. Akin to the element of supersession is that of obsolescence. Obsolescence is particularly operative in cases where the patent covers a product the life of which depends on the whims of fashion. Obviously, when the market for the product ceases, the value of the patent is gone.

From the above it is seen that the three elements of depreciation are usually operative concurrently and the rate of depreciation must take cognizance of them all.

Service Life of Patents

While the vast majority of patents become valueless before their expiration, some few may have a value beyond their protected term. It may happen that the concern using the patent has built up such an organization that competitors cannot with profit enter the field after the patent has expired; or it may have acquired the good-will of the purchasing public to such a degree that buyers come to it rather than to a competitor. In these and other ways the value of the patent may extend beyond its life. This is exceptional, however, and cannot with conservatism form the basis for estimating the service life of the average patent.

The prevailing practice authorizes writing off the value of a patent quite rapidly during the early years of its life when its earning capacity should be at a maximum, leaving only a small part of the value to be spread over its later years. This policy applies to the possession of single or separate patents. An effective method used for extending the life of a patent is the securing of auxiliary patents every few years. Thus an improvement of some part may be patented, without which the use of the original or basic patent would not be worth while. The basic patent may thus have its effective life—though not its legal life—extended almost indefinitely.

Where an additional cost, such as infringement costs, is incurred some time after the grant is made, strict accuracy would demand that these costs be spread over the remaining life of the patent. Where, however, the above policy of securing periodic improvements is in force, sufficiently accurate results are secured by wanting off at the end of each year—in the case of mechanical patents—one-seventeenth of the total values to date. In this way, by the end of the original 17-year term, there will be values left in the account which may be looked upon as applicable to the patented improvements. There is in these cases a constant overlapping of the grant periods and no serious inequity results as between fiscal periods by writing off each year one-seventeenth of the total value in the Patents account. In the case of the one original patent or an occasional improvement, the more accurate method is desirable because here the life of the patent is rather definitely limited.

If the estimated life on which the depreciation estimate is based, should prove longer than the real life, the value remaining in the asset at the end of its real life must be absorbed by the profits; i.e., charged against surplus. The Federal Income Tax Law allows this remaining value to be charged against the profits of the period in which it is written off.

Booking Depreciation on Patents

In booking the depreciation of patents, the periodic charge is to the expense account, Depreciation—or Depletion—and the credit is made either direct to the asset account or to the corresponding Depreciation Reserve account. It is sometimes argued that since the life of the patent is for a definite term, its depreciation is equally definite and the value of the asset should be written down rather than carry the estimated amount of the periodic depreciation in a reserve account. Because of the elements of supersession and obsolescence on which in the majority of cases the service life of the patent depends more than on its time grant, it is evident that determination of the amount of periodic depreciation is just as much a speculative estimate as is the case with any other asset. Either method of showing the periodic value of the patent may be used with equal propriety. If an easy determination of “total value to date” is sought, as under the policy referred to above, the information is better secured by carrying the offsetting estimate of depreciation in a reserve account. When no such purpose is to be served, it is a needless multiplication of accounts to use the reserve account.

Accounting Classification of Depreciation on Patents

A problem closely related to the valuation of patents has to do with the classification or incidence of the periodic depreciation of the patent. According to some theorists it is stated that if the patent applies to the process of manufacture—i.e., to any part of the manufacturing equipment used—the periodic depreciation is a cost of manufacturing and should be allocated to the product at that point. But if the patent covers the article itself, its periodic depreciation expense should be treated as a selling expense. Perhaps the point is well taken but the distinction is rather finely drawn. Another view requires the showing of depreciation on patents among the general administrative items, on the several grounds that there is no logical basis or method for distributing it directly to the product; that there is no direct connection between the product and this expense; and that it is a general overhead item which must be cared for out of gross earnings but cannot be applied definitely to manufacturing or selling. Failure to establish a suitable basis on which to apply the cost in practice cannot, of course, be allowed to militate against the determination of its theoretical incidence.

Royalties

An analogous problem arises in the treatment of royalties where such cover the cost of renting the patented devices of others for the purpose of manufacture. Although the general practice is to treat this expense as a cost of manufacture, it is sometimes handled as a general management expense on the ground that it represents a policy of management which has adopted the royalty method of production in preference to the outright purchase or development of the patents. The point seems not well taken, however. The value of a patent may be looked upon as a prepaid expense item which is the equivalent of royalties expense and should therefore usually be treated as a manufacturing cost. There may be instances, however, where such treatment would not be advisable on practical and perhaps theoretical grounds.

Relation of Depreciation Rate to Cost of Manufacture

Related to this problem of patent costs is the effect on manufacturing costs of the rate of depreciation of the patent. It is evident that a too rapid depreciation will result in an inequitable loading of the product made during the early years of the life of the patent as compared with that of its later life. A product made under a patent still valuable after all value has been written off the books, bears none of the burden though enjoying the benefit accruing from its being a patented article. On the other hand, if the rate of depreciation is not rapid enough, the product is then underburdened. It should constantly be borne in mind that depreciation is always an estimate. It should be the best estimate possible and subject to periodic revision where accurate results are desired. Slight inaccuracies and inequities are bound to occur and must be absorbed by the future product; the record of the past is a closed book and cannot usually be reopened.

Sale Price of Patents

The sale price of a patent, as distinguished from the value at which the owner may carry it in his accounts, frequently is based on the estimated savings in royalties which could be made by a purchaser. When a new concern is organized and patents are owned by some of the incorporators, and purchased from them, the value at which they are carried is almost always speculative and arbitrary. A valuation based on the saving in royalties has no place on the books of a concern unless that price were paid in purchase. Similarly, licenses to use patents should not be carried as an asset unless purchased by a lump sum payment even though they grant a virtual monopoly in the product.

Copyrights

Copyrights are similar to patents in that they secure to the author or publisher the exclusive right for a term of years to make and sell copies of literary or artistic productions. They are thus in nature a monopoly grant. The term for a copyright is 28 years, with a renewal privilege of 28 years if application is made within one year prior to expiration of original copyright.

A more rigid application of the principles of valuation enunciated for patents must be made for copyrights. On the books of the original grantee they should be carried at full cost which may be only the fees required in securing the copyright. For a subsequent purchaser they should be set up at full cost to him. A much smaller proportion of copyrights than of patents continue valuable for their granted term. Periodic valuations, then, require a very liberal and rapid depreciation from original value. In the accounts of publishers who make outright purchases of copyrights, extreme care is needed in keeping track of and valuing this asset, else a too optimistic outlook will result in carrying false and misleading values. Oftentimes the only satisfactory and reliable method of valuation will require an examination of each copyright owned and an independent appraisal of its worth.

Trade Secrets

Akin to copyrights are formulas for manufacture, receipts, and other trade secrets. These may constitute very valuable holdings, perhaps the most valuable of all the assets, but they are not usually carried on the books as assets under this title. A baker with a secret economical process of making yeast may have a marked advantage over competitors. An oil refiner with a process which secures a larger return of gasoline has a similar advantage over competitors without such means of refining. If costs are incurred in developing or acquiring these formulas or processes, the same reason exists for treating them as assets as in the case of patents or copyrights. If not protected in any way by the government, greater need of rapid depreciation is apparent as the discovery of the secret by others might greatly reduce its value.

Trade-Marks

A trade-mark is an earmark of ownership for advertising and selling purposes. Thus a firm may adopt a label for their products or a manner of marking or displaying them which wherever used is evidence of the make, brand, and quality of the goods. A concern enjoying a trade built up by educating the public to recognize its trade-marks and what they represent may possess therein a very valuable property. The courts of the country guarantee the rightful owner in the exclusive enjoyment of any benefits arising from the use of his trade-mark. Priority of continuous use is the factor determining rightful ownership. Such priority is most easily established through registration of the trade-mark with the government. Registration is not necessary but is offered by the government as a convenient and certain means of establishing rightful ownership. Continuous use is necessary to retain unquestioned ownership of the right.

Trade-marks must be valued at cost. Cost to develop, cost of purchase, cost to defend—all are legitimate charges to the asset. At times even some portion of the advertising expense may be capitalized under the caption “Trade-Marks.” This question and that of periodic revaluation follow so closely the principles of revaluation of good-will and the treatment of depreciation in relation thereto, that its consideration is deferred for combined treatment in later pages of this chapter.

Franchises—Definition and Kinds

A franchise is an intangible asset of considerable value in most cases. Its appearance on a balance sheet is usually limited to those of public, or quasi-public, utility companies. There it is included as an asset of value from the standpoint of rate-making rather than for ordinary commercial purposes. Such companies are usually under the close supervision and regulation of public service commissions. The latter prescribe the manner of showing the utility company’s accounts and the basis for the valuation of its assets, chiefly from the point of view of an adequate protection of the interests of the public. It is neither the purpose nor within the scope of the present volume to raise the question of the valuation of public utility companies, part of which problem would be concerned with the valuation of franchises. An attempt will be made, however, to lay down some principles of valuation from the commercial standpoint as distinguished from the rate-making standpoint, applicable to a very limited number of concerns which are not subject to state regulation, and to indicate briefly the tendency of the rulings of the best public service commissions with regard to franchises.

A franchise is defined by H. A. Foster[45] as “a privilege given by the community to a private person—or corporation—for use of the public property for the benefit of the public, and only incidentally is it the intention of the community in granting such a right, to allow the person accepting the same enough profit to insure his willingness to take advantage of it by investing in plant to make use of the grant.” To the same effect is the statement of the Federal Court in the case of the Consolidated Gas Co. of New York, 157 Fed. 373: “The franchise is but a part of the power or privilege of sovereignty allotted to a private person for the benefit of all, and only incidentally given for private emoluments.”

Franchises may be perpetual, where the grant is without time limit; limited, where the term is definitely stated; and indeterminate where the privilege granted is good “during good behavior and may be terminated by the authorities at any time by paying the fair value of the property exclusive of the franchise.” It may be noted that in Massachusetts no provision is made for buying the property of the utility company in case of revocation of the franchise. Manifestly the contract entered into with the state will influence very largely the manner of handling and the valuation of all the assets. Without regard to such contract and on the general principles of valuation as laid down for fixed assets, a franchise should be taken onto the books at full cost to acquire. Proper charges to the account would cover:

1. Lump sum payments to the state or some division thereof, applicable to the life of the franchise as distinguished from regular annual payments which are in the nature of a license or rental charge and are therefore an operating expense.

2. The full purchase price paid another company for the assignment of its rights and privileges under a franchise owned by it.

3. Legal and other fees in connection with securing the grant.

4. Any other legitimate expenses, such as the cost of securing the consent of affected property owners or of the whole community where such cost is to be borne by the petitioning company.

All of these are costs which from the standpoint of good business practice may be capitalized under the caption “Franchises.”

Depreciation on Franchises

For periodic revaluations, depreciation should be in accordance with the terms of the grant. If the grant is perpetual, no depreciation need be taken account of; if it is for a limited term, the cost of the franchise should be prorated over that term; if the grant is indeterminate, as defined above, not only should a very liberal depreciation policy be pursued with regard to the franchise but, in the case of the type of franchise granted by Massachusetts, a liberal provision for writing off all the assets should be made, unless in the execution of the law a policy of non-revocability of franchises has become fairly well fixed.

In contrast with the above, note the ruling of the Public Service Commission for the First District of the State of New York. “To this account—Franchises (Gas)—shall be charged ‘the amount (exclusive of any tax or annual charge) actually paid to the state or to a political subdivision thereof as the consideration for the grant of such franchise or right’ (Section 69 of the Public Service Commissions Law) as is necessary to the conduct of the corporation’s gas operations. If any such franchise is acquired by means of assignment, the charge to this account in respect thereof must not exceed the amount actually paid therefor by the corporation to its assignor, nor shall it exceed the amount specified in the statute above quoted. Any excess of the amount actually paid by the corporation over the amount specified in the statute shall be charged to the account ‘Other Intangible Gas Capital.’ If any such franchise has a life of not more than one year after the date when it is placed in service, it shall not be charged to this account but to the appropriate accounts in ‘Operating Expenses,’ and in ‘Prepayments’ if extending beyond the fiscal year.” To a depreciation account called “General Amortization” is to be charged, besides depreciation of tangible fixed capital, “such portion of the life of intangible fixed capital as has expired or been consumed during the month.”

Such careful regulations as to the content of intangible asset accounts are not always nor everywhere imposed at the present time. It is not putting the case too strongly to say that the reader of a balance sheet containing items about which practice is not standardized should always be on his guard to assure himself as to the content of such items in order to establish the legitimacy of their use and value.

Organization Expenses

Organization expenses are those costs necessarily incurred for the purpose of getting an enterprise under way, i.e., of putting it in readiness to do business and produce income. These expenses usually comprise such costs as state incorporation fees, attorney’s fees for drawing up the application and other papers, the cost of prospectuses, soliciting costs for stock subscriptions, fees paid promoters and organizers, cost of printing and issuing certificates of stock, cost of capital stock records, and similar items. These are necessary and unavoidable expenses without which the company cannot come into being. A company organized and ready to commence business is in a better position than one whose elements have not been brought into harmonious working. In the same way that the costs of installing machinery in position and ready for use are capitalized by being added to the value of the equipment, so may the organization expenses of a corporation be legitimately capitalized as being the measure of the amount of the greater value which these organized business elements have over the same elements unorganized. Capital has been brought together and set to work, management and plan of operation have been secured, and business is ready to begin.

Organization expenses are therefore, from the standpoint of classification, best treated as an intangible asset rather than as a deferred or prepaid expense. In strict theory the value of these costs will last as long as the corporate existence. In Italy where corporate life is limited to fifty years, it is prescribed that organization costs be prorated over the full life of the corporation. The best practice in this country requires a much more rapid writing off of these items; R. H. Montgomery[46] advocating writing them off as they occur or at most over the first two years’ operation. To one not cognizant of the many abuses which have crept in—and even frauds perpetrated—through this channel, the treatment advocated may seem harsh and severe. Perhaps no harm is done in pursuing a more liberal policy, if such expenses are carried under a proper title, if they are not used to inflate the value of the tangible assets, and if the caution stated above is observed as to the need for investigating the values of all intangible asset items. Certainly organization expense should never be used as a cloak for discount on stocks or other securities marketed.

Good-Will—Definition and Nature

The last of the intangible assets to be treated is good-will. Lord Justice Lindley, in an English case, says: “Good-will regarded as property has no meaning except in connection with some trade, business, or calling. In that connection I understand the word to include whatever adds value to a business by reason of situation, name and reputation, connection, introduction to old customers, and agreed absence from competition, or any of these things, and there may be others which do not occur to me.” The definition by George Lisle[47] is to the same general effect: “Good-will is the monetary value placed upon the connection and reputation of a mercantile or manufacturing concern, and discounts the value of the turnover of a business in consequence of the probabilities of the old customers continuing.” Good-will therefore includes every advantage connected with location, premises, reputation, personality, name, etc. That all these are elements of good-will cannot be gainsaid, but unless an earning power larger than that of a newly established competing concern goes along with these elements, no one would be willing to pay anything for the good-will of the old concern.

It sometimes happens in the case of a merger, that because of the dormant or latent good-will of the various units—or some of them—to be merged, a promoter may be willing to pay something more than the value of the tangible assets in order to acquire the various properties. Dormant or latent good-will signifies the excess earning power that would exist if it were not for poor management, an inharmonious working together of the various parts of the organization, and other similar handicaps which the new management will remove. It may be objected that until such handicaps have been removed there is no good-will; that any good-will brought into evidence through the removal of these handicaps is the good-will built up by the new concern and not the old. It cannot be denied, however, that all the other elements of good-will may have been acquired and built up by the old company and that without them the new concern would be unable to bring good-will into evidence simply by a change of management. It is true that the merger may be able to build up quickly a good-will of its own through the elimination of competition, and through the full utilization of all the advantages of the different units—such as access to supplies of raw material, favorable trade agreements of various sorts, and the like.

While there is a sense in which expected future performance as indicated above, may be an element in the determination of good-will and may be legitimately paid for as such, as a usual thing the essence of good-will lies in the ability to make a profit in excess of the normal. Past performance must be reviewed by which to judge the normality of the present profits and the probability of their continuance in the future.

Local and Personal Character of Good-Will

It should be pointed out, as a corollary to the above statement that only those elements which are transferable and are transferred can be disposed of for a price. Thus, when a business goes to the new owner, if there is apt to be a very appreciable shrinking in profits—as is the case in the transfer of some professional businesses—or if the favorable location on which in some cases depends the ability to earn excess profits cannot be turned over to the purchaser because of the expiration of the lease or other reason, good-will may not be worth much to a prospective purchaser. There is thus a local and personal character to good-will which cannot be ignored.

Difficulty of Valuing Good-Will

The valuation of good-will presents at times many complexities. The general principle of valuation at cost—and not market—may be said to apply here, too. What constitutes cost is sometimes difficult to determine. A corporation which buys out an existing business, paying an agreed sum for the good-will, should set up on the books that sum as the value of good-will. The vendor concern during the years of the establishment of its good-will, unless specific expenditures were made for that purpose, should not show any value for it on its books. In an English case, Stewart v. Gladstone, 1879, the court said: “Is it reasonable ... that a changing thing like good-will, the value of which would vary year by year according to the state of the trade ... and to the reputation which the house had acquired or had lost for integrity, punctuality, solvency, and mercantile prudence, was to be valued from year to year,” and the increase or decrease was to be treated as profit or loss for the year and distributed?

The impropriety of bringing good-will on the books unless paid for by purchase or otherwise, is established and rests on principles of sound business.

Creation of Good-Will by Advertising

There is perhaps only one case in which a concern which has not acquired good-will by purchase but has built it up for itself may with propriety set up its value on the books. Creating a demand for a product by means of extensive advertising is one of the quickest ways of building up good-will. The difference between the cost of the advertising necessary to retain a given volume of trade—which we may call the normal advertising expenditure—and the cost of the publicity required to secure that trade may be treated, in theory at least, as an expenditure on account of good-will and be so shown on the books. This is usually a difficult matter to determine at the close of the publicity campaign and before the cost of normal advertising is known, and the valuation at best is somewhat speculative. But where handled carefully and with conservatism there seems no serious objection to bringing good-will on the books at a value calculated in this way.

Unless it is possible to treat some expenditures of this sort as the direct cause of good-will, the evidence of the possession of good-will must be sought in the profit and loss record rather than in the balance sheet, as its existence would be indicated only by above-normal profits.

Valuation of Good-Will Based on Normal Profits

Valuing good-will for a purchaser is not so difficult. Two standard methods are in use, the one based on profits, the other on excess profits. According to the first, the value of the good-will is estimated as so many years’ purchase price of the net profits of the last year; or, better, the average of the last three or five years. This simply means multiplying the profits by the number of years’ purchase. The number of years to be used as a multiplier varies from one to fifteen, or twenty in some instances. Thus, if the agreement is to pay three years’ purchase of the average profit for the past five years and this average is $50,000, the price paid will be $150,000 and at that value good-will should be shown on the purchaser’s books.

Valuation of Good-Will Based on Excess Profits

The other method determines first the excess profits, i.e., the amount by which the profits of a particular business exceed the normal or average figures for that line of business. Thus, if the profits are $75,000 and normal profits are $50,000, the excess earning capacity per period is $25,000. This amount is then capitalized on some arbitrary basis, ranging in practice from the prevailing interest rate, say 5%, to 20% or even 50%. The effect of such capitalization is to apply a multiplier, as in the first method, ranging from 20 to 5 or less. Thus, if 20% is the agreed rate, the excess, $25,000 multiplied by 5 gives $125,000 as the value.

It is, of course, apparent that the valuation of good-will for prospective purchase is largely dependent upon the individual judgment of the buyer and that seldom will any two men arrive at the same valuation. As a matter of prudence, under either method the average profits for the past few years should be used rather than those of the last year. The latter may be sporadic and under conditions such as not to warrant their continuance. An average figure gives a better indication of what the business may be expected to do under normal conditions. Inasmuch as the value of good-will depends on excess earning capacity, the second method of valuation rests on better theoretical grounds than the first. Practically there is no preference, since valuation is largely a matter of personal judgment under either method.

Valuation of Good-Will Based on Capitalization of Profits

A slight variation of the second method is sometimes used. Under it the average net profits are capitalized at some agreed rate, giving the amount of money on which the average profits could be earned at the rate used. The difference between this amount and the amount of capital actually invested gives the value of the good-will. Thus, if on an investment of $250,000 net average profits are $60,000 and the normal rate for this business is 15%, $60,000 would represent a 15% income on $400,000. Good-will must therefore represent the difference between $400,000 and $250,000, or $150,000. This must evidently work out in exactly the same way as the second method if the rate used is the same. Therefore it constitutes not a distinct method, but only a variation. In the one case the difference between the average and normal profits is capitalized; in the other both are capitalized and the difference of their capitalizations is taken.

False Good-Will to Cover Capital Deficiency

A method of valuing good-will which makes it represent the difference between the value of tangible assets contributed or purchased and the par value of the stock issued cannot be countenanced at all. This use of good-will to cover up a capital deficiency is not only improper and misleading but often fraudulent. It is the favorite means by which “water” is injected into corporations. Thus, a concern desiring to capitalize at $500,000 and unable to sell its stock for more than $300,000, might carry an asset, good-will, to take care of the $200,000 discount on stock. A partnership desiring to incorporate might issue for the partnership assets stock with a par value much more than the assets taken over, and either inflate the asset values or set up a good-will account to care for the difference. This practice cannot be too severely criticized. In connection with this it should always be kept in mind that a newly organized company can never include good-will among its assets except by purchase.

Somewhat analogous to the above practice is that of increasing the capitalization of a company and issuing new shares in exchange for the old. Thus a company capitalized at $1,000,000 might increase its capital to $2,000,000, issuing two shares of the new for each share of the old. This will necessitate bringing onto the books an intangible asset, usually good-will, to cover the additional $1,000,000 of stock issued. Sometimes a real good-will may be existent as shown by the abnormal profits. In such cases, the effect of an increase of capital stock will be to keep down the rate of profit on the capital stock and so decrease the market value of each share, but not the real value of the total shares nor the amount of profit distributable to each of the holders of shares of the original issue. The purpose in such an increase of capital stock is usually an ulterior one, such as the desire to cover up real earnings in order to prevent a reduction of rates, as in the case of a public utility company. The purpose may sometimes seemingly justify the practice. The problem is mainly an ethical one and it is not proposed to discuss it here further than to say that the practice is usually to be condemned.

Periodic Revaluation of Good-Will

Periodic revaluation of good-will must next be considered. This involves a determination as to whether it is subject to depreciation. From what has been established as the essence of good-will, viz., the ability to earn excess profits, it is apparent, as stated in the case Stewart v. Gladstone on page 333, that its value must fluctuate from time to time with the earnings of the business. Because of this changing and at times doubtful value, some authorities advocate its being written off the books periodically, and a good many concerns do so write it off. The effect of this, so long as there is any value remaining in good-will, is to create a secret reserve and this is justified on the ground of conservatism. The practice is not reprehensible, though usually to be discouraged.

The weight of authority is to the effect that all purposes are best served by allowing it to remain always on the books at cost. There is no logical reason for writing it off. When profits are large, good-will is a very real asset. To write it off then is not logically consistent. When profits are small and good-will is accordingly of less value than before, it would hardly be logical to write off any amount less than its decreased value, yet the profits at such a time are rarely sufficient to stand so heroic a treatment.

As was stated above on page 330, all intangible assets should be examined carefully by a prospective purchaser as to the values at which they are being carried.

Good-will, because of the improper and misleading uses to which it has so often been put, is never above suspicion and its value should not be taken without close investigation. If it really exists, the profit and loss record will show it. That should guide as to its valuation and not the value carried on the balance sheet. Accordingly, since the asset does not depreciate but only fluctuates in value, and since it is neither prudent nor consistently possible to take these changing values onto the books, the best course for all purposes seems to be to retain good-will in the accounts always at its cost figure.

The above considerations as to the depreciation of good-will apply with almost equal weight to the depreciation of trade-marks.

In closing this chapter attention should be called to the fact that the term “going value” is used in the case of public utility companies in much the same way as good-will.

CHAPTER XIX
LIABILITIES ON THE BALANCE SHEET;
CURRENT AND CONTINGENT LIABILITIES

Form and Valuation

The problem of handling liabilities on the balance sheet is usually not so complicated as that of assets. The questions of arrangement, form, groups, and suitable nomenclature have in the case of liabilities an equal or even greater importance than that of the assets, the governing principle being clearness and fullness in the information given, with due regard to the purpose and intended use of the balance sheet.

The problem of valuation, which assumes great importance in the treatment of the assets, has normally little or no significance in the consideration of liabilities. This is due to several causes. In the first place, human nature being what it is, there is normally little danger of an overstatement of liabilities; they are usually sufficiently large, and no desire exists to make them appear more than they really are. Secondly, and likewise based on human frailty, while a concern may desire to undervalue its liabilities, the other party to the liability, the person holding the claim, can usually be depended upon to press his claim with sufficient insistence as to make the concern aware at all times of the amount of its liabilities.

From the viewpoint of a going concern, while all business experience points to a decrease and a necessary diminution in the values at which certain assets may appear on the books, no such diminution in the value of liabilities can be looked for; as legitimate claims must be met if a business is to exist as a going concern. Similarly, there is normally no tendency to inflate the liabilities by the inclusion of items which do not rank fully in this class—intangible liabilities seldom find place in any balance sheet.

On the other hand, there is frequently a very real hesitancy about the inclusion of some liability items until their claim becomes urgent or their full liability status becomes determined. Occasionally, and usually with ulterior intent, the liabilities may be inflated in value and items included therein which are fictitious; but our present concern is not with such conditions.

The one principle underlying the showing of both assets and liabilities is that their true status should be indicated. As applied to liabilities this means that they should be shown not only in correct amount but also in their true light, viz.: that all facts bearing on their relation to the business which ought to be known properly to judge conditions must be stated. The chief problem in handling liabilities is, therefore, how to show and list them so as to accomplish this purpose of truth and usually the further purpose of full truth. In a consideration of this problem, the auxiliary one of the inclusion of doubtful items among the liabilities will also receive consideration.

Arrangement on Balance Sheet

As to the classification and arrangement of liabilities on the balance sheet, it may be stated in a general way that whatever classification and arrangement are adopted for the assets, the liabilities should be shown similarly. For most purposes a standard grouping under the captions, Current, Deferred Income, Fixed or Funded, will suffice. The order of the groups as given here follows the order given for the assets. This is desirable for purposes of easy comparison, because in this way current liabilities are brought into juxtaposition with the group of assets to which current creditors must look for payment of their claims; and fixed liabilities and capital are opposed to the assets in which for the most part they have been invested.

Items within Groups

Arrangement within the group may be attempted on the basis of relative degree of liquidity of the items. This, however, is not always determinable nor is it an end to be sought; the chief desideratum is to show items in the main group to which they properly belong.

The manner of listing the items within the group is not a question of relative order so much as it is of nomenclature and clearness of expression. Thus, desirable and valuable information would be given by a separation of the items to show (1) those past due; (2) those due but not payable because of their credit term; (3) those neither due nor payable, such as accruing items; and (4) contingent liabilities.[48] It may be remarked that such an analysis is seldom seen on the ordinary balance sheet. Corporations which have to report to a regulating body may be required to give more information concerning their business than those not so regulated. For internal use the suggested analysis has undoubted merit. For public use, it is neither necessary nor usually desirable that the information be given in that form; a showing of the items under the usual titles within the group to which they properly belong being here deemed sufficient.

Cancellation of Liabilities against Assets

Occasionally the practice is met of cancelling the liabilities, or some group of them, against corresponding assets, showing only the net assets remaining. Thus, Current Assets less Current Claims might appear as an item among the assets. Even for publication purposes this would not be deemed sufficient; for the outsider as a prospective creditor or investor has a right to judge for himself the relative sufficiency of the assets to meet the claims of creditors. No basis for such judgment is offered by a cancellation of the one against the other with a showing of the net amount only. A somewhat analogous situation arises in the double-account form of statement used by some English companies. Here, the capital assets are canceled against the capital and fixed liabilities and only the net surplus—usually of capital—appears in the balance sheet proper. The criticism is not so pertinent here, however, because almost invariably the balance sheet is accompanied by the so-called capital account which shows the full detail of the net item in the balance sheet. So also, the practice is often condoned wherever an accompanying schedule shows the full facts as to assets and liabilities. As a matter of principle, it should be condemned because accompanying schedules do not always “accompany.”

Inventory of Liabilities

The principle of showing the full truth as to the liabilities raises the problem of the complete inclusion or inventory of the liabilities. Under this will be considered any adjustments that must be made in the book record in order to show the true state of the liabilities, and also the proper treatment of contingent liabilities so as to show their relation to the state of the business.

The adjustment of the book record is not usually complicated. The necessary data are for the most part available. All that is required is an analysis of each item to determine what, if any, adjustment is needed to bring the books to a true statement of conditions as on the date of the balance sheet. These adjustments fall into six main groups, only two of which appear among the liabilities, while one of the others is often based on information obtainable only from an analysis of the liabilities. These groups are:

The first three groups are discussed below, as well as another analogous group.

Accrued Expenses. These expenses comprise the liability existing at the close of a fiscal period because of expenses incurred but not settled for and oftentimes not yet due. Information as to these may be gathered—not in completeness however—from an examination of the various expense accounts and a somewhat intimate knowledge of the operations of the business. Unless a record is kept of all services being rendered to the business, it is very easy to omit some items of this kind. These will be discussed in detail under “Current Liabilities,” page 350.

Deferred Income. This income comprises the items of income received in advance of the full performance of the service required to earn it. In cases of this kind there are in the possession of the business certain assets which must be used to perform the service not yet completed in order to entitle the business to the full enjoyment of the income. That is, the property of the owners is liable for the service not yet rendered. Also, in order to make a correct showing of results as between the current fiscal period and the next, this unearned income must be carried forward for credit in the period in which the service is performed.

Premium on Bonds. Somewhat analogous to deferred income is the item of premium on bonds. As indicated in Chapter XV this is preferably treated as a direct deduction from the periodic interest payments on the bonds, because the bonds were marketed at a rate higher than the interest rate prevailing at the time of their flotation. Inasmuch as the premium must be spread over the life of the bonds, its unexpired portion will appear as of the nature of deferred income at all intermediate stages. A more detailed showing of this is given in [Chapter XX], in the discussion of the liability, bonds.

Deferred Expenses. These expenses have been explained in detail in [Chapter XIV]. Here it is to be noted that, while this group of adjustment items is always an asset, for the proper determination of deferred interest an examination of the liability, notes payable, is often necessary. Notes payable given for a loan at the bank, or given to a creditor, with prepaid interest added to the principal of the debt as a part of the face amount of the note, will give the data for calculation of the amount of interest or discount to be deferred to later periods.

Contingent Liabilities

As stated above, the second group of items under the head of inventory of the liabilities is that of contingent liabilities. It is taken for granted that all items which on the date of the balance sheet have assumed a status of full and direct liability will, of course, appear as such on the books. Here, all that can be said without trespassing on the distinctive field of auditing, is that all such items must appear. For the method of detecting their omission, whether omitted with fraudulent intent or through carelessness and inaccuracy, the student is referred to a standard work on auditing.

We have here to consider, however, a group of items the status of which is one of suspended or indeterminate liability. Expressed otherwise, they are items concerning which it is hoped—it may be even expected—that the business will never incur liability but for which in the event of certain happenings liability must be assumed. There are, of course, degrees of contingency, ranging from almost certainty to negligible remoteness. It would seem that no business man would omit the almost certain type from his books, and in case of doubt prudence demands that decision be rendered in favor of at least the greater probability.

Yet there is often seen a failure to book even the liability on account of goods purchased and shipped, but not received. If it is argued that the liability is not fully established until receipt and acceptance of the goods, every manager knows that non-acceptance of purchases is the exception, not the rule. On the other hand, upon receipt of consigned goods to be sold on account of a principal, no liability except to exercise ordinary care usually attaches to a broker until some part of the goods has been sold by him. Between these two extremes are many shades and degrees of probability, all of which in some cases are recorded as liabilities; in others none are so recorded. The importance of the information as to contingent liability on account of notes receivable discounted and discounted acceptances is now accorded general recognition. As to liability under court judgments awaiting appeal, guarantees of work and product, deposits made on contracts or bids—these and other similar matters will be treated fully in following pages.

These, then, constitute the main problems in connection with liabilities on the balance sheet. The group of current liabilities will now be considered, followed by a discussion of the nature of contingent liabilities.