CONTENTS

CHAPTER PAGE
IThe Corporation[ 1]
The Corporation
Classification and Definitions
Method of Ownership
Working Organization
Different Classes of Stock
Common Stock
Preferred Stock
Guaranteed Stock
Founders’ Stock
Debenture Stock
Stock of No Par Value
Watered Stock
Treasury Stock
Forfeited Stock
Bonus Stocks or Bonds
Accounting for Stocks
Discount on Stock
Premium on Stock
Property Exchanged for Stock
Treasury Stock Donated
Bonus Stock
Treasury Stock Purchased
Redemption of Preferred Stock
Forfeited Stock
Stock of No Par Value
Distinctive Records
Stock Ledger
Minute Book
Conclusion
IIThe Voucher System[26]
Purchasing for the Manufacturing Business
Expansion of the Purchase Journal
Development of Voucher System
Definition and Description of Voucher
Operation of Voucher System
Voucher Check
Form of Voucher Register
Distribution of Vouchers
Posting of Summary Totals
Effect on Cash Book and Bank Account
Payment of Vouchers
Voucher Index of Creditors
Control of Vouchers Payable
Introduction of System
Purchase Returns and Allowances
Partial Payments
Handling of Notes Payable
Cash Discount on Purchases
Modifications of System
Summary of Operation and Advantages
IIIFactory Costs[49]
Difference Between Factory and Financial Accounting
Definitions of Terms
Special Purposes of Cost Records
Nature of Raw Materials and Supplies
Accounting for Material Cost
Direct and Indirect Labor
Time-Keeping Records
Pay-Roll
Safeguarding the Pay-Roll
Distribution of Labor Charges
Expense
Summary of Manufacturing Cost
IVThe Balance Sheet[60]
Business Methods under the Microscope
The Reading of the Balance Sheet
Definition
Relation Between Balance Sheet and Trial Balance
Form of Balance Sheet
Purpose and Uses
Types of Balance Sheet
Origin of English Form of Balance Sheet
Variation of English Form
Balance Sheet Titles
Grouping and Classification
Arrangement of Groups
Report and Account Forms
Valuation Accounts
Statutory Requirements as to Frequency of
Balance Sheets
Condensation of Information in the Balance Sheet
Use of Supporting Schedules
VGeneral Principles of Valuation[81]
Content of the Balance Sheet
Valuations for Rate Regulation
Valuation for Sale and Purchase
Other Kinds of Valuations
Going Concern Valuation
Kinds of Value
Source of Data as to Values
Cost Value the Usual Basis
Definition of Capital and Revenue Expenditures
Organization Expenses
Definition of Replacements, Renewals, Maintenance, etc.
Treatment of Renewal of Parts
Treatment of Cost-Cutting Changes
Asset Subject to Depreciation a Deferred Charge to Operations
Authorization of Booking Capital Expenditures
Repairs on Second-Hand Plant
Construction Costs
Distinction Between Capital and Revenue Expenditures
Often Based on Opinion
Main Groups of Asset Items
Valuation of Liability Items
Over- and Under-Valuation
The Balance Sheet an Expression of Opinion
VIDepreciation—Aspects and Definitions of Terms[99]
Aspects of Depreciation
Definitions
Authoritative Opinions
Why the Depreciation Factor Arises
Actual or Absolute Depreciation
Theoretical Depreciation
Comparison of Actual and Theoretical Depreciation
“Accounting” and “Fair” Depreciation
Complete and Incomplete Depreciation
Individual and Composite Depreciation
Physical and Functional Depreciation
Deferred Maintenance and Accrued Depreciation
Attitude of the Law
Decision of Supreme Court
Recognition of the Depreciation Factor
Distinction Between Repairs and Renewals
Depreciation and Plant Efficiency
Unit Efficiency
Depreciation and Fluctuations in Market Value
Distinction Between Depreciation and Depletion
Effect on Different Kinds of Business
VIIDepreciation—Its Causes[120]
Analysis of Causes
Age as a Cause of Depreciation
Wear and Tear of Use
Functional Depreciation
Inadequacy as a Factor
Inadequacy Through Change of Policy
Inadequacy Through Motives of Economy
Inadequacy Due to Unforeseen Development
Inadequacy Imposed from Without
Obsolescence as a Cause
Treatment of Obsolescence
Contingent Depreciation
Terminable Rights
Effective Depreciation
VIIIDepreciation—Factors of Rate Determination[136]
Fundamental Purpose of Depreciation
Depreciation a Cost of Operation
Complication of Short Fiscal Periods
The Factor of Idle Time
Depreciation a Means of Financing
Danger of the Financing Viewpoint
The Standardization of Depreciation Rates
Effect of Local Conditions
Factors in Determining Depreciation Rate
Bases of Normal Rate
Policies as to Repairs
Depreciation Rate an Engineering Problem
Attitude of Regulatory Bodies
Methods of Handling Repairs
IXDepreciation—Methods of Calculating[150]
Methods of Calculation
Factors of Calculation
Symbols to be Used
1. Proportional Methods
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. Variable Percentage Methods
(a) Fixed Percentage of Diminishing Value Method
(b) Changing Percentage of Cost Less Scrap Method
(c, d) Arbitrary Methods
3. Compound Interest Methods
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. Miscellaneous Methods
(a) Maintenance Method
(b) Replacement Method
(c) The Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Gross Earnings Method
Condition Per Cent
XDepreciation—Appraisement of the various Methods[173]
General Considerations
Ideal Basis for Distribution of Depreciation Charge
1. Proportional Methods
(a) Straight Line Method
(b) Working Hours Method
(c) Composite Life Method
(d) Service Output Method
2. Variable Percentage Methods
(a) Fixed Per Cent of Diminishing Value Method
(b) Sum of Expected Life-Periods Method
(c, d) Arbitrary Methods
3. Compound Interest Methods
General Considerations
(a) Sinking Fund Method
(b) Annuity Method
(c) Unit Cost Method
4. Miscellaneous Methods
(a) Maintenance Method
(b) Replacement Method
(c) Fifty Per Cent Method
(d) Appraisal Method
(e) Insurance Method
(f) Percentage of Gross Earnings Method
Effect on Return on Investment
XIRecording Depreciation on the Books[187]
Methods Commonly Employed
Renewals and Replacements
Subsidiary Records
Grouping and Classification of Plant Assets
Form of Plant Ledger
Asset Record
Periodic Revision of Rates
Frequency of Revision of Rates
Test of Condition Per Cent
Composite and Group Rates
The Reserve as an Index of Financial Condition
The Reserve in Relation to Expanding Plant
Reserve as Related to Efficiency
Reserve Not Based on Cost of Replacement
The Financing of Replacements
Secret Reserve
Insufficient Charge
Appreciation as an Offset to Depreciation
Appreciation Due to Physical Changes
Appreciation Due to Adaptation to Use
Unearned Increment
Depreciation Policy and Stockholders
XIICash and Mercantile Credits[210]
Introduction
What Cash Includes
Stamps Remitted as Cash
Temporary Cash Disbursements
Disposition of Cash Funds
Cash Held Abroad
Accounts and Notes Receivable
Objection to the Title, Accounts Receivable
Risk for Credit Losses
Risk and Length of Credit Period
Analysis of Customers’ Accounts as the Basis
for Estimate of Bad Debts
Basis of Estimate of Bad Debts
Discounts and Collection Costs
Valuation of Other Receivable Items on Open Account
Loss on Notes Receivable
Interest on Notes Receivable
Balance Sheet Titles for Notes Receivable
XIIIMerchandise Stock-in-Trade[225]
Definition and Scope of Term
Valuation at Market or Cost Price
Objections to Valuation at Less than Cost
Anticipation of Profits or Losses Undesirable
Method of Treatment and Summary
Depreciation of Stock-in-Trade
Full Costs of Stock-in-Trade
The Distribution of Costs Over Stock-in-Trade
The Pricing of the Inventory
Valuation of Manufacturing Inventory
Contracts and Length of Cost Period
Valuation of Scrap
Inventory-Taking
Perpetual Inventory
XIVTemporary Investments; Accrued and Deferred Items[241]

Temporary Investments
Nature of Temporary Investments
Valuation of Temporary Investments
Reserve for Investment Fluctuations
“Stock Rights” on Investments
Cost of Investments
Valuation of Bonds
Valuation of Unissued Stock
Valuation of Treasury Stock
Summary of Valuation Formula

Accrued and Deferred Items
Nature of Accrued Income
Inadequacy of Cash Method of Handling Accruals
Correct Method of Handling Accruals
Showing of Accrued Items on Balance Sheet
Valuation of Accrued Items
Accounting for Accrued Income
Illustration of Different Methods of Recording Accrued Items
Prepaid Items—Definitions and Kinds
Valuation of Prepaid Items
Danger of Overvaluation
Accounting for Deferred Debit and Other Items
XVPermanent Investments[258]
Nature of Permanent Investments
Permanent Investments as an Aid to Operation
Valuation of Permanent Investments
Holding Company and Subsidiary Enterprises
Controlling Investments
Advances to Subsidiary Concerns
Rules for Valuation
Investments in Partial Holdings
Investments Producing No Income
Bond Values and Market Interest Rates
Nature of Bond Discount or Premium
Record of Bond Investments
Amortization of Bond Discount and Premium
Formulas for Compound Interest
Formulas for Annuities
Formulas for Bond Valuation
Valuation of Sinking Funds
Valuation of Investments in Land
XVIMachinery and Tools, Furniture and Fixtures,
and Other Equipment[279]
General Considerations
Distinction between Personalty and Real Property
Machinery and Tools
Accounting Records
Operation of Machine Accounts
Valuation of Machinery and Tools
Estimate of Depreciation
History of Machine
Standards of Operation
Abnormal Operation
Map of Machine Location
Methods of Application of Depreciation
Basis of Valuation
Scrap Material
Accounting for Tools
Depreciation on Hand Tools
Valuation of Home-Made Machinery and Tools
Expenditure for Rearrangement of Machinery
Definition of Furniture and Fixtures
Valuation of Furniture and Fixtures
Delivery Equipment—Definition and Valuation
Carriers and Containers—Valuation
Patterns, Molds, etc.—Valuation
Disposal of Assets
XVIIBuildings, Land, and Wasting Assets[297]
Definition of Real Property
Cost of Buildings
Valuation of Buildings
Betterments on Leased Buildings
Application of Depreciation
Accounting for Land
Valuation of Land
Depreciation or Appreciation of Land
Appreciation of Land Values
Depreciation in Land Values
Valuation of Land Investments
Mortgages on Land
Donated Land
Land as Stock-in-Trade
Wasting Assets—Definition and Characteristics
Dividends May Include Return of Capital
Basis of Depletion Charge
Application of Income Tax to Wasting Assets
Depreciation on Buildings and Machinery of a Wasting Asset
Unusual Risks
Water Rights
Leaseholds
XVIIIIntangible Assets—Patents, Franchises, Good-Will[316]
General Considerations
Patents a Monopoly Grant
Purchase of Patents
Patents Developed Within the Plant
Patents Purchased and Not Used
Elements of Depreciation on Patents
Service Life of Patents
Booking Depreciation on Patents
Accounting Classification of Depreciation on Patents
Royalties
Relation of Depreciation Rate to Cost of Manufacture
Sale Price of Patents
Copyrights
Trade Secrets
Trade-Marks
Franchises—Definition and Kinds
Depreciation on Franchises
Organization Expenses
Good-Will—Definition and Nature
Local and Personal Character of Good-Will
Difficulty of Valuing Good-Will
Creation of Good-Will by Advertising
Valuation of Good-Will Based on Normal Profits
Valuation of Good-Will Based on Excess Profits
Valuation of Good-Will Based on Capitalization of Profits
False Good-Will to Cover Capital Deficiency
Periodic Revaluation of Good-Will
XIXLiabilities on the Balance Sheet; Current and
Contingent Liabilities[339]
Form and Valuation
Arrangement on Balance Sheet
Items Within Groups
Cancellation of Liabilities Against Assets
Inventory of Liabilities
Contingent Liabilities

Current Liabilities
Loans from Bank
General Classification of Notes
Accounts Payable
Accrued Expenses
Booking of Accrued Expenses
Deferred Credits

Nature of Contingent Liabilities
Statement of Contingent Liabilities
Notes and Drafts Transferred
Guarantees as a Contingent Liability
Long-Term Leases
Purchases for Future Delivery
Pending Lawsuits
Stock Not Fully Paid
Accumulated Dividends on Preferred Stock
Signature to Surety Bond
XXFixed Liabilities—Bonds and Mortgages[356]
Nature of Fixed Liabilities
Purpose of Fixed Liabilities
Corporation Bonds
Nature of Bonds
Difference Between Bond and Real Estate Mortgages
Kinds of Corporation Bonds
Authority for the Issue of Bonds
Financial Considerations Involved in Issue
Bonds versus Stock Issues
Accounting for Bond Issue
Entry of Issue on Books
Entry of Premium or Discount on Books
Entry of Interest Payments on Books
Relation of Bond Interest to Premium or Discount
Example of True Interest Cost
Presentation on Balance Sheet
Other Fixed Liabilities
XXICapital Stock and its Valuation[372]
Problems in Valuation
Kinds of Stock
Par, Real, and Market Values
Value Dependent upon Earning Capacity
Increase of Book Capitalization
Capitalization on Cost
The Law and Stock Issues
Treatment of Discount or Premium
Valuation of Stock Issued for Property
Valuation of Treasury Stock
Redemption and Reduction of Capital Stock
Dividend Stock
Stock Issued as a Bonus
Unissued and Treasury Stock on the Balance Sheet
Preferred Stock Covered by Redemption Contract
XXIIProfits[387]
Difficulty of Determining Profits
Economic Definition
Legal Definition
Accounting Definition
Methods of Determining Profits
The Problem a Question of Valuation
Effect of Asset Losses on Future Profits
Legal Decisions as to Asset Losses
Loss Charged Against Current Profits
Loss Treated as Deferred Expense Charge
Loss Charged to Capital
Profit on Work in Progress
Goods Made for Stock but Not Sold
Goods Made to Order
Profits on Long-Term Contracts
Profit on Goods Awaiting Delivery
Interdepartment Profits
Profits Due to Appreciation of Assets
Capital Profits
XXIIISurplus and Reserves[407]
Definition
Creation of Margin
Disposition of Profits
Reserves
Different Meanings of Reserves
Reserve for Bad Debts
Under- and Over-Estimate of Reserves
Depletion Reserves
Operating Reserves for Accrued Costs
Collection Costs Not under Contract
Sales Discounts on the Balance Sheet
Distinction Between Reserves and Accrued Items
Contingent Reserves
Deferred Income—Misuse of Term
Proprietorship Reserves
Secret Reserves
Argument for Secret Reserve
Argument Against Secret Reserve
Earmarking of Reserves
Continuity of Reserve Policy
Covered Reserves
Classification of Reserves
Legitimate Use of Surplus Account
Statement of Surplus
XXIVDividends[428]
Introduction
Disposition of Corporation Profits
Shareholders’ Rights as to Profits
Directors’ Control over Profits
Provisos as to Declaration of Dividends
Stockholders’ Rights to Dividends
Declaration of Dividends
Liability of Director
Revocation of Dividends
Payment of Dividends
Dividends Paid as Salaries
Methods of Paying Dividends
Borrowing to Pay Dividends
Dividends Paid in Property, or by Borrowing on Property
Bond and Scrip Dividends
Stock Dividends
Dividends Proportional to Holdings
To Whom Payable
Accounting Record
Relation of Capital Losses to Dividends
Liquidating Dividends
XXVThe Sinking Fund[447]
Origin and Use
Definitions
Mathematical Principles on which Based
Accumulation Based on Agreement
Effect of Settlement of Debt
Relation of Fund to Profits
Accounting for Sinking Fund
The Sinking Fund on the Balance Sheet
Entries to Sinking Fund
Booking the Trustee’s Report
Treatment of Income and Expense
Final Disposition of Fund
Treatment of Sinking Fund Reserve
Relation Between Depreciation and Sinking Fund
XXVIProblems in Connection with the
Profit and Loss Summary[466]
Interrelation of Profit and Loss and Balance Sheet
Periodic Adjustments
Interest as a Cost of Manufacture
Arguments Against the Inclusion of Interest
Problem of Charging Interest on Books
Unrealized Profits
Corporation Dividends
Discount on Bonds
Sinking Funds
Working Capital
The Correction of Closing Errors
XXVIIThe Profit and Loss Summary—Form and Content[477]
Standardization of Form
Synonymous Terms
Cost of Goods Sold—Manufacturing Concern
Cost of Goods Sold—Trading Concern
Further Differentiation of Terms
Desirability of Uniformity in Terms Used
Profit and Method of Showing
Form of Presentation—Account Form
Non-Technical or Report Form
Examples of Forms of Presentation
Form for Manufacturers and Merchants
Content and Manner of Showing
Supporting Schedules
Adjustment of Inventories
Selling Expense and Administrative Schedules
Schedules for Special Needs
XXVIIILiquidation of a Corporation[493]
Reasons for Liquidating—Partial and Complete Liquidation
Current Assets Transferred into Fixed Assets
Tying up Cash in Stocks of Material
Unwise Use of Cash for Paying Dividends
Inability to Secure Cash for Refunding Operations
Excessive Borrowing on Short-Term Securities
Losses in Conducting the Business
Loss Through Fraud, Theft, or Unavoidable Causes
Methods of Liquidation
Liquidation under Bankruptcy
Liquidation under Voluntary Dissolution
Liquidation under Receivership
Status of Creditors in Liquidation
Accounting for Liquidation
XXIXCombinations and Consolidations[507]
Reason for Combination
Types of Consolidation
Accounting for the Holding Company
Distinction between Consolidation and Merger
Formation of Consolidation and Merger
Principles of Valuation of the Constituent Companies
Fundamental Principle of Equalization of Conditions
Valuation of Partnership
Earning Capacity
Good-Will
Capitalization of a Consolidation or a Merger
Payment of Amalgamated Interests
Closing the Books of the Merged Concerns
Opening the Books of the Merger
XXXBranch House Accounting[521]
Advantages of Branch and Agency System
Agency and Branch Differentiated
Degree of Control Desired
Factors of Successful Management
Main Principles of Branch Accounting
Agency Accounts
Branch Accounting Records
Illustration of Simple Branch Accounts
Illustration of More Complex Branch Accounts
Purchases
Sales
Adjustments on Branch and Head Office Books
Example of Adjusting Entries
Reports from the Branch
Examples of Reports
XXXIBranch House Accounting (Continued)[542]
Foreign Exchange
The Accounting Problem of the Foreign Branch
Accounts Opened on Books
Handling Fluctuations in Foreign Exchange
Conversion of Branch Results
Illustrative Bookkeeping Problems
Local Supervision of the Foreign Branch
The Foreign Sales Agency
Method of Conversion of Results
The Foreign Purchasing Agency
XXXIISuspense Accounts; Numbered Accounts;
Adjustment of Fire Losses[556]

Suspense Accounts
Definition of Suspense Accounts—General Purpose
Reserve for Doubtful Accounts as a Suspense Account
Use of Suspense Ledger
Accounts Receivable Hypothecated
Accounting for Accounts Receivable Discounted

Numbered Accounts
Allotment of Numbers to Accounts

Adjustment of Fire Losses
The Insurance Contract
Requirements in Case of Loss
Determination of Value of Loss
Adjustment of Differences
Effect of Coinsurance Clause
Method of Record-Keeping to Facilitate Ready Adjustment
Adjusting Entries for Fire Losses
XXXIIIStatistics in Business; Private Books; Journal
Vouchers; Building Expenses and Income[581]

Statistics in Business
Value of Business Statistics
Railroad Statistics
Manufacturing Statistics
Mercantile Statistics
Use of Graphs in the Presentation of Statistics
Advantages of the Use of Graphs
Principles of Graph Construction

Private Books
Purpose and Content
Operation of Private Books

Journal Vouchers
Need for the Journal Voucher
Index to Journal Vouchers
Content of Voucher
Other Methods of Authorizing Entries

Building Expenses and Income
Allocation of Building Expense
XXXIVThe Consolidated Balance Sheet and
Profit and Loss Summary[600]
Purpose and Function
Problem of Partial Ownership
Conditions under which Used
The Setting Up of the Consolidated Balance Sheet
Showing of Intercompany Accounts
Showing of Notes Discounted
Reconcilement of Current Accounts
Valuation of Inventory
Reserve for Intercompany Profits
Valuation of Inventory—Minority Interests
Valuation of Liabilities
Showing of Capital Stock
Showing of Surplus
Showing of Deficit
Showing of Profit and Loss Summary
The Consolidated Profit and Loss Summary
Illustration of Consolidated Balance Sheet
XXXVAccounts and Reports of Receivers and Trustees[620]
Appointment of Assignee or Receiver
Appointment of Trustee
Accounts and Reports of a Receiver in Equity
Reports to the Court

Accounts and Reports in Bankruptcy Proceedings
Initial Statements Presented to the Court
Reports and Accounts of Receiver or Trustee
Liquidating Dividends
Relative Standing of the Creditors
Statement of Affairs
Basis of Valuations in Statement of Affairs
Deficiency Account
Illustration of Statement of Affairs and Deficiency Account

Realization and Liquidation Account
Evolution of the Realization and Liquidation Account
Supporting Schedules
The Question of Cash
The Handling of Valuation Reserves
Illustration of Realization and Liquidation Statement
Uses to which Realization and Liquidation Statement May be Put

Liquidation of a Partnership by Instalments
Nature of the Problem
Illustration of Liquidation by Instalments
Appendix A—Practice Work for Student—First Half-Year[655]
B—Practice Work for Student—Second Half-Year[694]
C—Miscellaneous Problems for Supplementary Work[727]
D—Review Questions[755]

FORMS AND CHARTS

Page
Stock Book or Stock Ledger[22]
Stock Book to be Kept by Brokers
(New York Form Prescribed by Comptroller)[23]
Stock Book to be Kept by Corporations and Transfer Agents
(New York Form Prescribed by Comptroller)[23]
Voucher[30], [31]
Voucher Check—Double[33]
Voucher Check—Single[34]
Voucher Register[35]
Chart Showing Actual and Theoretical Depreciation[105]
Chart Showing Progress of Uniform Depreciation
and of Diminishing Efficiency[115]
Graphic Chart—Straight Line Method[153]
Graphic Chart—Working Hours Method[155]
Graphic Chart—Fixed Percentage of Diminishing Value Method[158]
Graphic Chart—Sinking Fund Method[162]
Graphic Chart—Annuity Method[166]
Plant Ledger[193]
Branch Report to Head Office[541]
Head Office Ledger Account—Summary of Branch Expenses[541]
Chart Showing Comparison of Sales with Cost of Advertising[585]
Chart Showing Comparison of Sales with Gross Profits[586]
Chart Showing Comparison of Sales, Purchases,
and Sales Salaries[587]
Chart Showing Comparison of Sales with Cost of Sales[588]
Journal Voucher[593]
Card Index for Journal Vouchers[594], [595]

Accounting—Theory and Practice

CHAPTER I
THE CORPORATION

The Corporation

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

Classification and Definitions

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

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

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

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

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

Method of Ownership

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

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

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

Working Organization

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

Different Classes of Stock

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

Common Stock

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

Preferred Stock

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

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

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

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

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

Guaranteed Stock

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

Founders’ Stock

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

Debenture Stock

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

Stock of No Par Value

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

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

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

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

Watered Stock

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

Treasury Stock

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

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

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

Forfeited Stock

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

Bonus Stocks or Bonds

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

Accounting for Stocks

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

Discount on Stock

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

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

Premium on Stock

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

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

Property Exchanged for Stock

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

Treasury Stock Donated

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

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

(1)Treasury Stock, Common$100,000.00
Donated Surplus $100,000.00
(With suitable explanation.)
(2)Cash30,000.00
Discount on Treasury Stock, Common20,000.00
Treasury Stock, Common 50,000.00

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

Bonus Stock

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

(3)Cash$1,000.00
Bond Discount50.00
Bonus (or Discount on Treasury Stock)50.00
Bonds Payable $1,000.00
Treasury Stock 100.00

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

(4)Cash$1,000.00
Bonus100.00
Bonds Payable $1,000.00
Treasury Stock 100.00

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

Treasury Stock Purchased

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

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

Redemption of Preferred Stock

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

Forfeited Stock

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

(5)Subscribers$1,000.00
Capital Stock Subscriptions $1,000.00
(6)Cash400.00
Subscribers 400.00
(7)Subscribers400.00
Surplus from Forfeited Stock. 400.00
To transfer the forfeited
payments to Surplus.
(8)Capital Stock Subscriptions$1,000.00
Subscribers $1,000.00
To reverse.
(9)Subscribers900.00
Surplus from Forfeited Stock100.00
Capital Stock Subscriptions 1,000.00
(10)Cash900.00
Subscribers 900.00
(11)Capital Stock Subscriptions1,000.00
Capital Stock 1,000.00

Stock of No Par Value

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

Distinctive Records

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

Ledger Folio 27

Transfer No. 556

Alliance Automobile Company

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

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

George B. Goldman[L. S.]

By George Gale, Attorney.

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

Stock Transfer Book

John H. Kircher, 230 Broadway, New York
Date of
Transfer		To Whom
Shares are
Transferred		Certificate
Numbers		Number
of
Shares
Surrendered Reissued
1917
March 13W. K. Howard 15 7010
July 15Robert Moyer 7014540
July 31Harold McKain 145 40
December 3James McNeil 8517520
December 16James Archer{175}231105
{165}
December 31Balance 180
  395
Date of
Transfer		From Whom
Shares were
Transferred		Amount Paid
on Shares		Certificate
Numbers		Number
of
Shares
1917
January 10Original IssueFull-Paid 1590
March 25George Holmes” 8575
August 1Harvey Cornell”15035
August 15Howard Gaines”16050
”
September 2John Woodwell”165100
October 5Henry Simpson” 4245
  395
1918
January 3 180

Stock Book or Stock Ledger

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

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

Stock Ledger

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

Minute Book

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

Conclusion

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

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

CHAPTER II
THE VOUCHER SYSTEM

Purchasing for the Manufacturing Business

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

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

Expansion of the Purchase Journal

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

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

Development of Voucher System

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

Definition and Description of Voucher

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

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

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

Operation of Voucher System

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

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

Voucher (face)

Voucher (reverse)

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

Voucher Check

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

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

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

Voucher Check—Double (face)

Voucher Check—Double (reverse)

Voucher Check—Single

Form of Voucher Register

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

Distribution of Vouchers

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

Voucher Register (left-hand page)

Voucher Register (right-hand page)

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

Posting of Summary Totals

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

Effect on Cash Book and Bank Account

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

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

Payment of Vouchers

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

Voucher Index of Creditors

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

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

Control of Vouchers Payable

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

Introduction of System

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

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

Purchase Returns and Allowances

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

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

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

Vouchers Payable$2,150.40
Vouchers Payable $2,101.59
Purchase Returns and Allowances 48.81
To cancel Vo. #2158 and authorize
its reissue in Vo. #3245, account
of return of defective goods.

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

Partial Payments

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

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

Handling of Notes Payable

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

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

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

Cash Discount on Purchases

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

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

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

Purchase Discount $........
Vouchers Payable $........

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

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

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

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

Modifications of System

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

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

Summary of Operation and Advantages

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

Some of the advantages claimed for the voucher system are:

1. It gives a detailed analysis of all purchases.

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

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

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

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

The chief disadvantages are:

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

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

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

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

CHAPTER III
FACTORY COSTS

Difference between Factory and Financial Accounting

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

Definitions of Terms

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

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

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

Special Purposes of Cost Records

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

Nature of Raw Materials and Supplies

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

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

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

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

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

Accounting for Material Cost

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

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

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

Direct and Indirect Labor

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

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

Time-Keeping Records

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

Pay-Roll

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

Safeguarding the Pay-Roll

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

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

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

Distribution of Labor Charges

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

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

Expense

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

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

Summary of Manufacturing Cost

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

CHAPTER IV
THE BALANCE SHEET

Business Methods under the Microscope

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

The Reading of the Balance Sheet

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

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

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

Definition

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

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

Relation between Balance Sheet and Trial Balance

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

Form of Balance Sheet

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

Purpose and Uses

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

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

Types of Balance Sheet

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

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

Origin of English Form of Balance Sheet

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

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

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

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

Variation of English Form

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

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

The East and West Railway Company
Receipts and Expenditures on Capital Account
Railroads, Franchises and Capital Stock:
Other Properties$410,000.00 Common$200,000.00
Preferred75,000.00
Current Expenditures for Debenture50,000.00
Construction and Funded Debt:
Equipment65,000.00 General Mortgage Bonds150,000.00
Investments in Other Companies50,000.00 Equipment Trust Bonds100,000.00
Securities in Hands of Trustee15,000.00
Balance carried to
General Balance Sheet35,000.00
$575,000.00 $575,000.00
General Balance Sheet, December 31, 1918
Capital Account, Securities$50,000.00
credit balance$35,000.00 Prepaid Expenses750.00
Special Betterment Fund15,000.00 Accrued Income1,250.00
Accrued Expenses1,500.00 Accounts Receivable25,000.00
Dividends Payable17,500.00 Materials and Supplies10,000.00
Accounts Payable25,000.00 Cash7,000.00
$94,000.00 $94,000.00

It will be noted that the sides of the capital account follow the debit and credit order of the ledger, whereas the general balance sheet reverses that order—an inconsistency for which even the English do not attempt explanation.

Balance Sheet Titles

The title of the balance sheet is fairly well standardized. Other titles are sometimes met, such as Financial Statement; Statement of Assets and Liabilities; Statement of Resources and Liabilities; Statement of Assets, Liabilities, and Capital; Statement of Financial Condition; etc. The title “Balance Sheet” seems best. Though not so fully descriptive as some of the other titles, it is generally understood and has not the objection of inadequate descriptiveness and unwieldiness often raised against the other titles. There is a similar variation in the titles used for the three main groups of items shown in the balance sheet, viz., assets, liabilities, and net worth. Obviously, portions of some of the general titles cited apply here with equal appropriateness. In addition, we find in use or suggested as appropriate, Property and Assets, Active and Passive, Debit and Credit, Positive and Negative, Proprietorship, Capital and Surplus, Capital, etc. None of these suggested titles have met with favor in practice, but they have served the worthy purpose, perhaps, of providing fuel for academic controversy. The titles, Assets or Resources, Liabilities, and Net Worth or Capital, seem thoroughly established and seem to cover the need.

Grouping and Classification

In the matter of classification and arrangement of the items under these main groups there is room for greater diversity both in practice and in theory. The need and purpose of classification and arrangement is obvious. While any statement, list, or schedule which shows assets, liabilities, and net worth may properly be called a balance sheet, only by a careful grouping and formulation of the items can their mutual interrelations and proper dependence be shown. Not only does the bringing of similar items into groups put them in proper perspective, but the arrangement of the groups to show their relations to one another makes for a more intelligent interpretation of the balance sheet. The controlling principle underlying classification of the items into groups is, in the main, their relative degrees of liquidity. Sometimes other factors, such as emphasis, perspicacity, publicity, and so on, bring about groupings which differ somewhat from those based solely on degree of liquidity. Thus it may be desirable to call particular attention to, say, the permanent investments of a concern, to the condition of its sinking and other funds, to the amount of new construction and betterments for the current period, or to the values tied up in intangible assets. No hard and fast rule can therefore be followed; elasticity, flexibility to the desired purpose are working rules which must underlie any scheme of classification.

As to titles for the various groups, one finds many. The current assets are variously styled Quick, Floating, Liquid, Circulating. As a sub-group under Current or as a separate group we find Working and Trading assets. Other groups are Fixed or Capital, Investments, Sinking and Reserve Fund Assets, Deferred Charges to Operation, Deferred Assets, Deferred Debits, Suspense Debits, with similar titles for corresponding credit items, Contingent Liabilities—in short almost any title which seems best to fit the needs of the particular case. Some of these may need some explanation.

The distinction between current and working assets is a somewhat fine-drawn one, although well taken under certain circumstances. Where the two groups are used, current assets include the cash, receivables, and temporary investments, and the working assets group (or working and trading assets as it is sometimes captioned) includes the stock-in-trade (finished goods, goods in process, and raw materials), supplies of all sorts used in preparing the goods for sale or in making the sale, office supplies, working funds in the hands of branches and agents, and the like. The line of demarcation between the two groups is not always clearly drawn, some placing the stock-in-trade among the current assets, others putting finished stocks in the current group and process materials in the working group. There is apt to be an overlapping also between the working and the deferred charges groups, supplies of various sorts often being treated as deferred charges to operation. Capital assets are fixed assets—the plant and those assets in which the capital must first be invested before revenue can accrue. When the group of capital liabilities is shown it usually includes both the long-term obligations incurred for raising capital as well as the capital stock. This unfortunately does not recognize a distinct section for the net worth items.

Arrangement of Groups

The arrangement of the groups among themselves, while showing variations, offers few important matters for consideration. Here, also, the principle of degree of liquidity controls. The arrangement is sometimes from fixed to liquid but rather more frequently from liquid to fixed. If the chief interest in the balance sheet is as to the amounts of capital invested in properties and the growth of such investments, it is claimed that the fixed asset group should be shown first. This might be the case with railways, steel corporations, and other large concerns wherein the ratio of the fixed assets to the current is large. In other concerns—and these constitute the larger number—chief interest centers in the current group. Here, the ability to pay dividends, to extend a sales market through carrying larger stocks of merchandise, to secure credit, are the items of chief moment. It is contended that in these cases, the order of the groups should be from current to fixed.

Whatever grouping is made for the assets, a similar arrangement of groups must be insisted upon for the liabilities; it is the placing in juxtaposition or the same relative positions of similar groups among the assets and liabilities which makes for an easily intelligent reading of the statement. After all, the order of the groups, as from fixed to current or vice versa, is of small importance in comparison with the similar arrangement of both assets and liabilities and with the surety of the proper content of each group. The thing to be sought is the arrangement which will facilitate comparison of similar groups. A rather serious objection to the “fixed to current” arrangement is that it almost invariably necessitates the separation of the net worth elements. Thus, capital stock and long-term bonds are grouped together at the top for comparison with the fixed assets; the remainder of the net worth—surplus and reserved profits—must be shown at the end. The group of all net worth items together compels a general scheme of logical grouping from current to fixed.

A difference as to order is also found in the placing of deferred charges to operation. Regardless of the scheme of general grouping, one frequently finds the deferred charges placed as the last group. This also seems illogical. Only items of prepaid operating expenses should be included in that group. Such prepayments, while made in the one period, are properly chargeable to the next. Their effect, therefore, is to bring about a saving of the cash and other current assets for other uses during the next period. They are thus nearly related to the current group and could without any serious violation of principle be included thereunder. For the sake of emphasis and a more open showing, they are best shown in a group by themselves immediately following the current assets.

The intangible assets, good-will, franchises, patents, etc., are usually included among the fixed assets. Where so shown they should be given unmistakable titles and are best set up at the end of the group so as not to be covered and lost among the other items. A suggested scheme of grouping which will make an intelligent showing for most purposes follows:

Assets:Liabilities:
1. Current Assets1. Current Liabilities
2. Deferred Charges to2. Deferred Income
Operation3. Fixed Liabilities
3. Investment of Reserves
4. Permanent Investments Net Worth:
5. Fixed Assets1. Capital Stock
2. Reserves of Profits
3. Surplus

The content of these groups and any further explanations necessary are treated in the chapters which follow, where the detailed application of principles is discussed.

As stated above, the important desideratum is a like arrangement of groups to facilitate comparison and care to secure the proper content of each group. Within the group itself, while the arrangement of the items is not so important, the principle of degree of liquidity should govern here too. Whatever the order of general arrangement of the groups, the same order may well be observed for the items within the group.

Report and Account Forms

Something should be said with regard to the merits of the two methods of arranging the three main classes of items, i.e., assets, liabilities, and net worth, on the balance sheet. As previously stated, the method known as the report form makes a vertical showing of the classes, while the account form shows the items in parallel columns. The one lists the assets and from their total shows the subtraction of the total liabilities which are in a subjoined list. This difference, representing net worth, is explained in detail as to the portion represented by capital stock, surplus, etc. The account form method lists the assets in one column and the liabilities and net worth in a parallel column, bringing about a balancing of the two columns.

For the report form, it may be said that this method follows the reasoning of the average business man, particularly the man unacquainted with accounts, who subtracts his liabilities from his assets to find how much his present net worth is. The account form rests on the fundamental desire, deep-rooted in the system of double-entry bookkeeping, to show the two sides in balance. It may be looked upon as the technical form and therefore well adapted for publication purposes. It secures also a convenient juxtaposition of groups for purposes of comparison. The one may be regarded as non-technical, easily within the intelligent grasp of the layman; the other as technical and addressed to those trained to read that form of statement. As previously stated, any method of showing which fails to list separately the three distinct classes of assets, liabilities, and net worth is not usually to be justified; a mixture of net worth and liabilities is bad. Omitting detail, the two following type forms meet the conditions laid down above:

Report Form of Balance Sheet
Assets
Current Assets:
Cash $........
Receivables ........
Stock-in-Trade ........ $........
Deferred Charges to Operation:
(See Schedules) ........
Investment of Reserves:
Sinking and Other Funds
Permanent Investments:
(Held for purposes of control) ........
Fixed Assets:
Plant $........
Equipment ........
Good-Will, etc. ........ ........
Total Assets $........
Liabilities
Current Liabilities:
Notes Payable$........
Trade Creditors ........
Accrued Expenses ........ $........
Deferred Income:
(See Schedules) ........
Fixed Liabilities:
Bonds$........
Long-Term Notes ........ ........
Total Liabilities ........
Net Worth$........
Represented by:
Capital Stock $........
Reserves of Profits ........
Surplus ........
Total Net Worth $.......
Account Form of Balance Sheet
AssetsLiabilities and Capital
Current Assets:Current Liabilities:
Cash$.... Notes Payable$....
Receivables .... Trade Creditors ....
Stock-in-Trade .... $.... Accrued Expenses .... $....
Deferred Charges to Operation:Deferred Income:
(See Schedules) .... (See Schedules) ....
Investment of Reserves:Fixed Liabilities:
Sinking and Other Funds .... Bonds$....
Long-Term Notes........
Total Liabilities $....
Permanent Investments ....
Fixed Assets:
Plant$.... Net Worth represented by:
Equipment.... Capital Stock$....
Good-Will, etc......... Reserves of Profit....
Surplus........
Total Assets $.... Total Liabilities and Capital $....

Valuation Accounts

Nothing has been said thus far concerning the showing of valuation accounts on the balance sheet. Two different practices are met with. Sometimes such accounts are listed with the liabilities, and there is a sense in which they may be regarded as liabilities. Rather, however, they should be looked upon as credits to asset accounts, held temporarily in suspense until they can be definitely allocated to their assets. They are offsets to show the appraised values of the various properties. As such, therefore, they are best shown as deductions from their corresponding assets with the appraised value full-extended. This applies to both the debit and the credit valuation accounts. A full discussion of these and other reserves is given in [Chapter XXIII].

Statutory Requirements as to Frequency of Balance Sheets

Excepting in the case of corporations, there are few, if any, compulsory regulations governing the frequency of balance sheets. Some of our tax laws have brought about an increasing regularity with regard to the issuance of formal statements, both balance sheet and profit and loss. England, France, and Germany require a formal statement from corporations once a year. In this country, most states require some form of statement but oftentimes the requirement is so indefinite or so inadequately or half-heartedly enforced that the statement submitted is of little value. On the other hand, some classes of financial and public service corporations are required to present full and adequate reports periodically, at least once a year. In the case of national banks five reports are asked for; in the case of savings banks in some states two reports are required.

Condensation of Information in the Balance Sheet

The relation of the formal balance sheet to the post-closing trial balance needs further consideration. It has been stated that a post-closing trial balance is essentially a balance sheet. As the purpose of the latter is to present a bird’s-eye view of financial conditions, much of the detailed information shown in the post-closing trial balance must be condensed and consolidated with similar items, so that only totals are shown on the balance sheet. Just as the purpose of the ledger is by a process of analysis to secure detailed information for use in the current control of the business, so the balance sheet by losing sight of the detail and by setting forth the fundamental currents of business life and health, provides the data for the larger aspects of control. How far this process of condensation should be carried depends largely upon the use to which the balance sheet is to be put. A statement of financial condition to be issued to the public—stockholders and outsiders—can well omit data which would be required for internal use. Care must always be taken in condensed statements to avoid consolidation of detail in such a way as to render the statement misleading. The English Companies Act of 1862 provided that the “auditors’ report should state whether in their opinion the balance sheet was a ‘full and fair balance sheet’ containing the particulars required by the company’s Articles and ‘properly drawn up so as to exhibit a true and correct view of the company’s affairs.’” This represents the proper attitude for every accountant to assume in the making of statements. This is not meant to require the publication of information which is the private property of the business. The phrase, “full and fair,” must be interpreted to mean sufficiently full, and only so much so that it will be fair to both parties. The company is entitled to withhold legitimate information the publication of which would be detrimental to it, and not to do so would be unfaithful to the proper guardianship and protection of its interests, and this in turn would bring about dissatisfaction with the management and oftentimes ill-feeling among the owners.

Use of Supporting Schedules

By means of supporting schedules, as illustrated and discussed briefly on pages 411 and 412 of Volume I, it is possible to carry condensation to almost any desired degree and still have available all necessary detail in the accompanying schedules. What items in the balance sheet should be supported by schedules and what should not, must be determined by the conditions peculiar to each case. Here again, the determination rests largely upon the use the statement is to serve. The informational content is therefore largely dependent upon the purpose for which the statement is drawn.

Balance sheets may serve any one of the following purposes:

1. Internal use by proprietor or manager.

2. Formal report to stockholders.

3. As a basis for application for credit.

4. For publication or report to regulating or supervising commissions.

5. For annual report to the state.

6. For advertising purposes to float new issues of bonds, preferred stock, etc.

When used for some of these purposes, oftentimes condensation is made a convenient method of bringing about a misrepresentation of true condition. Of course, no justification can be found for this.

Emphasis has already been placed on the necessity of choosing titles and captions which shall indicate clearly the nature and content of the transactions or data recorded thereunder. Statements of condition which are misleading, whether with intent or by chance, are to be condemned. As H. R. Hatfield[10] so well summarizes, the lack of clearness and consequent misunderstanding of the balance sheet are due in the main to three causes: (1) vagueness of terminology; (2) purposeful misrepresentation; and (3) the very nature of accounting itself which so largely rests on estimates rather than on facts of definite determination. Some of these troubles have their origin in the form of the balance sheet, the manner of showing the items; while the others inhere in its content. It is to a study of the content of the balance sheet from the standpoint of the statement of values, with the emphasis on quantitative analysis, that we now turn.

CHAPTER V
GENERAL PRINCIPLES OF VALUATION

Content of the Balance Sheet

The problems of content and valuation strike at the very heart of the balance sheet. Form, framework, and method of presentation are important and their usefulness should not be discounted. Particularly is this seen to be true from the standpoint of availability of the information presented and facility in its interpretation; but the meat of the balance sheet is its content. In connection with this, two points demand consideration, viz.: (1) what items shall be admitted to a place in the balance sheet; and (2) on what basis shall they be admitted, this latter being the problem of valuation.

The first question can be answered without much trouble. All properties owned and all liabilities incurred must find a place in the balance sheet. The properties belonging to a business include both the tangibles and intangibles, rights and claims. Most of these have cost value, some may have been gifts. All the assets must, therefore, be listed. Similarly, the liabilities, all those things which represent debts owed by the business or established claims against it, must be given place in the balance sheet. Neither from the assets nor the liabilities must there be allowed omission. As stated in Chapter IV, as to content, the balance sheet must be “full and fair.” Some classes of items, known as contingent assets and contingent liabilities, will be discussed and their place determined as they are met. The net worth items, in whatever detail desirable, must also be included.

Valuations for Rate Regulation

The second problem as to the basis on which items shall be valued for the balance sheet is our chief problem. The general question of valuation may be viewed from so many points that definition of its meaning here is necessary. Principles that are applicable to valuations for one purpose frequently cannot be made to serve another purpose. Because of the agitation in recent years relative thereto, when the problem of valuation is mentioned it is associated almost invariably with public service corporations. Most of the so-called valuation work has been done in connection with railroads, water companies, gas and light companies, etc. Here the issue of regulation is involved. Regulation of rates is price regulation and therefore regulation of profits. The purpose of valuation in connection with public utilities is the determination of the amount of investment on which rates must be so regulated as to secure a return based on fairness and equity to all parties.

Where such valuations have been made they have not proven entirely satisfactory and it is placing too great faith in human kind to expect the satisfaction of all parties with the results of any valuation. Where the properties involved have not been exceedingly complex and have been fairly well localized, results have seemed to justify the effort; but in the case of a large and complex plant covering widely separated areas and serving many and different communities, as is the situation with railroads, in the minds of many the results obtained in such instances are of doubtful value when compared with the effort and cost expended. Though much can be learned from such valuations, the principles underlying them differ at many points from those which must control in valuations as applied to commercial balance sheets. It is in connection with public service valuations that very valuable studies of the depreciation problem have been made.

Valuation for Sale and Purchase

Again, valuations and appraisals are often made in cases of prospective sale and purchase negotiations. While most of the determining principles are the same, not all apply to our problem of going concern valuation. Thus, the plant to be purchased may not be continued in its present use but must be adapted to other uses. Results secured towards controlling the market by means of this purchase may make the plant much more valuable than its physical worth. Elements of “going concern” and good-will call for valuation in the case of a purchase and sale transaction and are frequently not present in commercial balance sheet valuations. These last questions touch closely our problem and will receive careful consideration in their proper places.

Other Kinds of Valuations

There are several other kinds of valuations, all more or less closely related to commercial balance sheet valuations but differing from them in some respects because of their differing purposes and ends sought. The chief of these are: (1) valuations for purposes of fire loss adjustments; (2) valuations for purposes of liquidation to satisfy creditors and determine the owners’ equities, as in bankruptcy and voluntary dissolutions; and (3) valuations for purposes of taxation. In all of these cases, many points of similarity to, and of some differences from, our present problem are found. In the first and third kinds enumerated, there is marked similarity, but the problem in the case of the income tax is not so broad. In the second kind, the problem is entirely different, as values have to be determined on the basis of forced sale.

Going Concern Valuation

The kind of valuation to be treated here may be called “going concern” valuation. By that will be meant the values at which the various items shall appear in the balance sheet when viewed from the standpoint of a concern which expects to continue operations—a going concern as contrasted with one which is facing dissolution, reorganization, sale, or other eventuality. As stated above, the principles of going concern valuation are not distinct and separate, except in a few instances, from those governing the other types of valuation referred to. Oftentimes they are the same principles applied in the same way because the purpose is practically the same; again they are the same principles but applied differently in order to serve different purposes; and finally they are sometimes entirely distinct principles because the purpose to be served is entirely different.

It is not purposed in this treatment of valuation to set forth the points of variance and sameness with the other types; that is beyond the scope of the present volume. Endeavor will be made to set forth clearly underlying principles and their detailed application to the chief items met in the average balance sheet as viewed from the standpoint of a going concern. Elsewhere, notably in [Chapter XXXV], some principles of another type of valuation will be discussed.

In any consideration of valuation, it is necessary to seek out the sources and kinds of value to determine in the one case its basis, and in the other to establish the type of value applicable to the given conditions. Value is not of spontaneous origin; it cannot be created out of nothing. Here it is not intended to search for causes of value or to inquire into the forces back of them. The author is content to leave that to the economist.

Kinds of Value

Various kinds of value are established facts of the world of business and by their sources, as the term is used here, is meant the information which vouches for or establishes the fact of value, rather than a search for the cause of it. Thus we find, among others, the following kinds of value:

It is to be understood that these various kinds are in no sense mutually exclusive and separate; they are met in the common vocabulary of men of affairs, are construed loosely in most cases, but have quite technical connotations in some places. Any of the terms employed here will, whenever necessary, be defined. Thus, in accounting, by cost value is usually meant full cost of a product or other asset in position ready for its intended use.

Source of Data as to Values

The sources of data as to values are several. Where double-entry books are kept, the original cost of the various assets can usually be secured from the books of account, barring errors of principle and omission in making the record. If not found there (as is often the case where single-entry books are kept), the original purchase invoice gives the chief item of cost, but does not usually show any inward-carrying or placement costs. Where there is a formally established market, this may give the information as to value when no book entries are available. Quoted prices in trade catalogues or lists as of the date of purchase, offer another means of procuring the information. Sometimes, even the memory must be relied upon.

Present values of properties purchased formerly may be determined on the basis of original cost adjusted to take cognizance of depreciation and, sometimes, of appreciation. This adjustment is made in the light of the best available experience. The amount of the adjustment is sometimes called an “experience figure.” Stated otherwise it is an estimate made on the basis of past experience with some regard to future contingencies. This estimate may be made by some one within the organization—manager, owner, etc.—or by regular appraisal companies who specialize on this kind of work. Usually, however, the appraisal company bases its value on present cost less depreciation—a reproduction cost value.

Again, for some purposes the statement of earnings as giving the amount to be capitalized becomes the source of values. As has been seen, however, earnings themselves contain many elements which rest on estimated values. In almost all instances there is an element of speculation—an estimate—in the determination of values.

Cost Value the Usual Basis

The values which are, for the most part, shown in the commercial balance sheet are cost value or adjusted cost value. Occasionally, values which bear only an indirect relation to cost must be taken into account. The determination of cost value is sometimes a comparatively simple matter, as where the source is a purchase invoice, but more often it involves numerous other costs in addition to those shown by the purchase invoice, both definite and indefinite, i.e., estimates. It is in connection with the determination of cost that the proper segregation of the so-called capital and revenue charges is of vital importance. An effort will be made to formulate the distinction between them so as to give a working rule for their determination under most circumstances.

Definition of Capital and Revenue Expenditures

Capital expenditures may be defined as expenditures of funds or other assets on capital account. In accounting language, they may be said to be those expenditures which result in charges to some asset account. They may sometimes ultimately result in a charge to a liability account by the conversion of the asset to the decrease of the liability. Expenditures of capital may be made on account of expenses. This can occur only when revenues are insufficient to meet all expenses. Such expenditures of capital bring about an impairment of capital. As the term is generally used, however, capital expenditures have the meaning first given.

Revenue expenditures may be defined similarly as expenditures of funds or other assets on revenue account. That is, such expenditures must be booked as charges to expense accounts. They represent the expenses incurred in the earning of the revenue, and measure its cost. Just as the original capital fund, through its expenditure, must provide the plant and equipment with which to work, so the other expenditures necessary to prepare and market the product must provide the revenue out of which to meet these expenditures and secure a margin of profit; else there is encroachment upon the original capital funds.

A few other terms need definition by way of differentiation from these. The term “capital receipts” is used to differentiate receipts of funds from the sale of capital stock or the sale of capital or fixed assets, from funds or other assets received from revenue or profits sources. Thus, upon the sale of any asset which was originally purchased out of capital, the receipts therefor must first be applied to take the place of the capital expended for the asset, and any balance not used for the first purpose is then a receipt of revenue.

The term “capital expense” is sometimes used to indicate the group of expenses incurred in providing the capital needs of the business. They are the financial management expenses as the term is used in Volume I. Opposed to capital expenses are the capital income or revenue items. These are the receipts or income from portions of the capital employed otherwise than in the purchase and sale of commodities; or the income which represents savings effected through the handling of the funds of the business as distinguished from income derived from the handling of stock-in-trade. They are deductions from the financial management expenses.

Capital and revenue expenditures are thus easily differentiated on paper. It is in the application of the definition to situations as they develop in practice that difficulty is encountered. Some of these situations will be examined with the purpose of determining the application to them of the distinction between revenue and capital expenditure.

Organization Expenses

Upon the organization of a new enterprise the distinction between capital and revenue expenditures can usually be made without much difficulty. All costs incurred to put the concern in a position to earn revenue are properly treated as capital expenditures. Sufficient capital must be provided to put the undertaking on an earning basis, as otherwise it fails. These costs will include many items which upon their second incurrence must be treated as expense charges because the revenue must provide for keeping the plant in a state of efficient repair. One group of capital expenditures, usually carried on the books under the title “Organization Expense,” is often treated as a revenue expenditure as soon as sufficient revenues have accumulated to care for them conveniently. This is discussed in detail in [Chapter XVIII] on intangible assets. It is sufficient to say here that upon their incurrence organization expenses constitute capital expenditures, for no other funds are available for the purpose.

Definition of Replacements, Renewals, Maintenance, etc.

Only after the concern becomes a revenue-producer is the chief difficulty encountered in determining the proper record as between capital and revenue. In all cases of new construction and additions to the existing plant or equipment, no question arises as to the legitimacy of such capital charges. But when replacement, renewal, or betterment of existing properties take place, difficulty is met in determining the portion chargeable to the asset and the portion to be charged against revenue. The dividing line between renewals and repairs, maintenance, and up-keep is a closely drawn one, and usually an arbitrary working rule suitable to conditions must be adopted by each concern. R. P. Bolton[11] gives for some of these terms very suggestive definitions which the author quotes in full:

“Maintenance is a process of continuous attention to, and supply of, operating necessaries, including solicitous observation of the condition of the object cared for, corresponding to the protecting shelter, clothing and food supplies to living beings, in order to maintain their functions in operating condition. It includes supplies which form part of the food of the appliance. Part of the labor in attendance on machinery is involved in this element of its care.

“Up-keep is a course of partial recreation, involving the expenditure of time and money in anticipating causes of decay, of failure, or of possible injury to the object under care, corresponding to hygienic and recreative methods, often involving considerable expenditures without apparent direct results, which are or should be followed in safeguarding the general health and strength of human beings. Thus, welfare and recreation of employees is a justifiable expense of an industry. It is part of the cost of the human machine.

“Repair is the course of partial reconstruction, replacement, or renewal of worn or of injured portions, after the necessity therefor becomes apparent, and, unless brought about by accident, the need for the process is brought about by the failure or inability of maintenance, and also of up-keep, wholly to arrest the progress of decay by age or continued use. Provisions to preclude accident or to cover the cost of its results are part of the cost of repair. Health insurance of employees is a repair cost paid in advance.”

While these definitions were not intended for accounting purposes and are not fully applicable thereto, they call attention to the basic ideas of the terms. The distinctions are in some cases too finely drawn. For accounting purposes the title “maintenance and repairs” usually gives sufficiently detailed information. Repairs is a part of the process of maintenance, as is also renewals. Maintenance, from an accounting standpoint, may be defined as “the act of keeping a property in condition to perform adequately and efficiently the service for which it is used.” A. Lowes Dickinson[12] defines repairs and renewals as follows:

“Repairs. This should include all current expenditures recurring from day to day and from month to month on the general up-keep of the existing property without the renewal of any substantial part thereof, and generally all periodic repairs which are necessarily undertaken within, say, one year.

“(This caption will, of course, include certain renewals of small parts, etc., such as would be necessary to continue the useful life of any unit of building, plant, or machinery over the estimated period of its life.)

“Renewals. This should include all expenditures incurred in renewing, in whole or in part, any unit of building, plant or machinery, which tend to extend its useful life beyond the average term. These expenditures would in general be those which would only occur at long intervals of two or three years, and whose effect would last for a number of years afterwards.”

As distinguished from renewals, a replacement may be defined as “the act of replacing a plant unit which is going out of service, with a substitute which may be either identical with the unit replaced or different from it.” In accounting terminology the terms “renewals” and “replacements” are for the most part used synonymously and will be so used here.

Treatment of Renewal of Parts

In the maintenance of a property in efficient condition, repairs and renewals are constantly taking place. When for an old part or plant unit a new one is substituted, the question of betterment immediately arises. If an old machine with book value of $500 is replaced by one costing $750, the excess of $250 is classed as a betterment and is properly a charge to capital. A renewal of machine parts cannot be handled so easily. The parts of a machine are subject to diminution in value due to wear, tear, and obsolescence, along with the machine as a whole. The machine was purchased for a lump sum. What portion of the cost is applicable to each individual part is difficult to determine and must usually rest on estimate or guess. Similarly, the book value, i.e., the present depreciated value of a part, is not accurately known. Accordingly, the amount of betterment, if any, in the replacing of an old part by a new part is difficult to determine. It is here that working rules must be adopted for each concern.

Thus, it has been suggested that only when the renewal involves an expenditure of $5 or more should there be any attempt to determine the amount of betterment, every expenditure under $5 to be charged to expense. In an establishment of any size this is altogether too small an amount. The Chicago Traction System through its board of supervising engineers has established $200 as the minimum charge to capital or renewals. All transactions involving even a true betterment, if the amount is less than $200, are to be recorded as maintenance charges. As a means of simplifying the accounting, a working rule, with a minimum capital charge adapted to the conditions of each concern, serves a practical and useful purpose.

Treatment of Cost-Cutting Changes

Other kinds of expenditures which cause trouble as to their proper place of record are those incurred for the purpose of facilitating the handling of the work. They may result in an increase of capacity to earn revenue through a speeding up of production, or the result may be simply a lessening of the expense of turning out the various units of product. A test frequently applied in such cases is that of increased earning capacity. It is argued that even though nothing tangible which did not exist before has been added to the plant, there has been a rearrangement of the factors of production with a resulting co-ordination of effort, and this has increased the capacity of the plant, thus making it more valuable. Inasmuch as this value is measured by earnings, the cost incurred in securing the increase is a very proper and legitimate charge to capital. Against this argument, it may be said that plant or structural changes are always made to improve operation. To make increased earning capacity the sole test is virtually to capitalize all expenditures of this kind—a policy which would soon lead to an unconscionable inflation of assets. Only by a policy of very liberal depreciation can such values if capitalized be kept within reasonable bounds. The impropriety of charging such expenditures to the current profit and loss account is generally acknowledged.

The best practice is to handle items of this kind as deferred charges under suitable descriptive caption, instead of as charges direct to the asset account where the nature of the items is soon lost from view and the need of a high depreciation rate to write them off is soon forgotten. Thus, a rearrangement of the machinery in a plant may bring about a more economical routing of the product, or the introduction of a new machine may entail an entirely changed disposition of existing machines—all for the purpose of, and actually accomplishing, a saving in costs. Rather than a charge of the costs incurred to the asset account Machinery, a setting of them up under the title “Rearrangement Costs of Machinery,” or other similar title, shows their exact status and makes possible an intelligent writing down of them periodically in accordance with the estimated life or continuance of the savings effected. Practically this amounts to treating the costs as capital expenditures if the saving effected is judged applicable to more than the current period. The chief difference is that booking such items as deferred charges calls for specific attention to the need of a speedy writing off.

Asset Subject to Depreciation a Deferred Charge to Operations

In this connection it may be pointed out that the cost of all assets subject to depreciation may well be looked upon as deferred charges to operation, some portion of that cost being charged off at the close of each fiscal period. “So we see that capital expenditures, as distinguished from expenses, are at last an arbitrary conception. It begins with the idea that certain expenditures have an efficiency which reaches over many earning periods extending indefinitely into the future. But nothing physical would last so long, and its earning power might have even less permanence. To meet this condition we arbitrarily designate certain expenditures whose effect indefinitely outlasts the immediate earning period as ‘capital,’ and then in the same arbitrary way, through all subsequent vicissitudes, we hold them to their first value by maintenance, renewal, and depreciation charges which are borne by other expenses.”[13]

Authorization for Booking Capital Expenditures

As regards a suitable method for handling transactions which involve a separation into capital and revenue charges or a determination of the status of the transaction as between capital and revenue, proper authority should be secured for making the expenditure. Where possible, before its incurrence, authorization as to its proper booking should be given, even to the amounts where feasible, and this order becomes thus the voucher supporting the entries on the books.

Repairs on Second-Hand Plant

In one situation repair charges which are ordinarily an expense must be capitalized. Where a company takes over a plant which is badly run down and out of repair, the expenditures necessary to bring it to a state of efficient operation are capital expenditures. Such a plant resembles a partially completed plant, and the purchase price is supposed to take that fact into consideration. It is expected that additional capital will have to be sunk to rehabilitate the property and put it in a condition of repair necessary to earn revenue. Accordingly the expenditures necessary to do this are rightly treated as capital charges.

Construction Costs

A final consideration in the distinction between capital and revenue expenditures has to do with certain costs incurred during the period of original construction. We may cover the situation by a general statement to the effect that all costs necessary to produce a complete plant in condition ready to earn revenue are proper charges against capital. Thus, interest on moneys borrowed for construction purposes is a proper charge to capital, and in England it has been held that dividends in the form of interest are allowable to shareholders during the construction period. Also, such items as engineering and superintendence, law expenditures, injuries, taxes, etc., both preliminary to the construction period and during it, are to be capitalized. On the other hand, profits on own construction work are never to be counted as costs. To do so reveals a misunderstanding of the difference between a profit and a saving. The matter is discussed more at length elsewhere.

As to whether any portion of the overhead expenses has a rightful place among the assets must be determined by the conditions in each case. In original construction work, before operations begin, all overhead charges constitute a part of the cost of the assets. For betterment work and additions carried on concurrently with operation, the case is not so clear. A safe principle is to treat as capital charges all increases in overhead above what would normally have been incurred for operation only. To free operation of any portion of the regular overhead just because betterments are in progress is not recognized as a sound or conservative policy.

Distinction between Capital and Revenue Expenditures often Based on Opinion

Thus it is seen that many phases of the problem of capital and revenue expenditures are extremely difficult of determination and in their final analysis rest on estimates and opinions rather than definitely established facts. Too often it is feared that decision in matters of this kind is “influenced by unsuspected individual caprice and by considerations of the financial convenience of the moment”; for the allocation of such items may sometimes represent the margin between a profit or a loss for the current period. As is said to be true of geometry, so here there is no royal highway to the solution of these problems.

Main Groups of Asset Items

If, therefore, it can be determined what items are to be included in the balance sheet and the proper basis for their valuation can be established, the problem as to its content is well on the way to solution. Having discussed the elements and factors entering into a determination of cost value, we are in a position to state the principles of valuation applicable to the main groups of items as set up in the balance sheet. These may be listed, for the purpose of this generalization, under three heads, viz.: (1) current assets, (2) deferred charges to operation, and (3) fixed assets.

1. For the current assets, the principle of valuation may be stated as valuation on the basis of cost or market, whichever is the lower. Since speedy realization of the current assets by conversion into cash for its equivalent is the aim and expectation of every business—for on such conversion depends the ability to meet the current liabilities and so have working capital available for another cycle of purchase and sale (another turnover)—it would seem that the realization price as given by the market should govern. In the interest of conservatism and as producing certain other desirable results which will be brought out as each asset is examined in detail, cost price, if lower than market, is deemed the desirable basis for the valuation of this group. By way of explanation, it should be said that working capital as used here is the difference between current assets and current liabilities and so represents the portion free to be put to the further pursuit of business.

2. The principle of valuation involved in deferred charges to operation is simply the principle of equitable prorating between periods on the basis of a going concern. Here, not sale value, cash surrender value, or forced sale value govern, but their value to a concern which expects to continue operations.

3. For the fixed assets, the principle of valuation generally applicable may be stated as valuation on the basis of cost less depreciation. This group of assets represents the properties held for operating and without which operation could not continue. They are the very essence of the enterprise. Disposal of them would mean abandonment of the undertaking. Hence they are not held for realization and conversion into cash, and in a going concern market value has no effect on them. To a going concern they are worth at any time what they cost less the portion used up in operations to date. Therefore valuation at cost less depreciation is the proper basis for showing the fixed assets in the balance sheet.

Valuation of Liability Items

To the liability items of the balance sheet, principles of valuation are not directly applicable as such, except so far as content or inclusion and measure of quantity or amount may be said to embody considerations of valuation.

Over- and Under-Valuation

The need for correct valuations requires no comment and can best be appreciated as compared with the effects of over- and undervaluations. Particularly bad and harmful is overvaluation of the assets and undervaluation of the liabilities. The use of the balance sheet as an index of financial condition makes apparent the harm of wrongful content or valuation of the items entering into it.

The Balance Sheet an Expression of Opinion

It is thus seen that the main problem in connection with the presentation of a true balance sheet is a problem in valuation and content rather than form. From what has been said it will be evident that valuation in the vast majority of cases is not an exact science—a process of definite determination. Rather, from the nature of the data to be handled and the principles of valuation given as applicable to the various groups of data, valuation must almost always be an estimate. The determination of the value of the elements of cost, the proper differentiation between capital and revenue charges, and finally the calculation of the amount of depreciation necessary to the valuation of fixed assets—all are estimates. It is true, they are estimates based on experience, but, from their nature and the influence of local conditions in a given case, no universally applicable law of experience can be formulated. It is safe to say that two men would seldom, if ever, arrive at the same estimate of the values of given assets. Accordingly the conclusion is reached that a balance sheet is not a statement of fact but always an expression of opinion. If estimates are carefully made in the light of all available facts applicable thereto, the expression of opinion in the balance sheet will approximate as nearly as may be to a statement of fact.

Because depreciation plays so important a part in making these estimates, it seems necessary, before setting forth the detailed application of the principles of valuation to the various assets, to devote several chapters to a full discussion of the subject, chiefly as it is related to the problem of valuation but also in some of its correlated aspects.

CHAPTER VI
DEPRECIATION—ASPECTS AND
DEFINITIONS OF TERMS

Aspects of Depreciation

Depreciation is intimately related to practically all problems of valuation. The engineering profession has made many valuable investigations and contributions to the literature of the subject and constant reference to them and use of some of their findings will here be made. Most of their studies relate to the vexed and still unsettled question of the valuation of public utility properties for the sake of its bearing on the problem of fair and equitable rates to the user or consumer. Accordingly much of this material is not applicable to the accounting phases of the subject. It is purposed here to treat the question from the standpoint of accounting rather than that of engineering.

Depreciation may be considered from many viewpoints. It is involved in the problem of rate-making referred to above; it must be considered in the valuation of fire insurance adjustments; it is bound up with most questions of taxation, with all transactions involving the purchase and sale of enterprises, with negotiations for the procuring of loans, for the determination of the limitation of capitalization; and in all studies of commercial balance sheets depreciation is found to affect the value of going concerns. As stated in Chapter V, these are not always separate and distinct problems of valuation; they may and often do overlap, one basis for valuation sometimes serving several of the purposes or classes named above. The treatment of the subject will be limited in this book to the latter phase of the subject, i.e., going concern valuation, with the object of establishing certain norms and differentiating this phase of depreciation clearly from its other relations.

Definitions

A clear-cut definition of depreciation is desirable. The word in a general sense means a lessening, a decrease in value; decretion; deterioration. Various specific definitions are given, among them being: “the loss, arising from years of service, in the value of the investment in perishable property”; “expired capital outlay.” These and many other similar definitions are met with.

The term “depreciation” is frequently used when the term “amortization” would be more appropriate. R. P. Bolton[14] says: “The subject of depreciation has been greatly misrepresented, because depreciation, which is a financial result, has been confused with obsolescence, which is an economic process, and with deterioration, which is a physical condition. Either of the latter brings about depreciation, and the physical process rarely happens to be more rapid than the economic.

“An illustration of the processes involved is that of the physical deterioration and obsolescence of a work horse, the capacity of which is definitely connected with its condition, and the value of the labor of which is discounted by its up-keep and the cost of its supplies and feed. Its age is productive of reduction of capacity, but this process may be, and often is, anticipated for commercial reasons by its supersession by some other form of apparatus. The horse may be in ever so good a condition at the time when the motor displaces it, but its financial depreciation then is complete, for it could be maintained only at a loss. All the elements which come into consideration in connection with machinery will be better understood if considered in relation to such an animal, the life of which may readily extend beyond the point at which its commercial value has terminated.”

Authoritative Opinions

The special committee appointed by the American Society of Civil Engineers for the purpose of formulating principles and methods for the valuation of railroad property and other public utilities, after a study of the question covering a five-year period, presented its report at the annual meeting of the society, January 17, 1917. The question of depreciation receives full and serious consideration in this report, which although treated mainly from the rate-making standpoint offers many suggestions for the valuation of commercial balance sheets. Their statement reads:

“Perhaps there is no single subject in connection with valuation that has caused more trouble than depreciation. This has been due to various causes, perhaps not the least of which has been confusion in the use of the term. Depreciation is sometimes used to mean decretion, which is loss of service life; sometimes to mean the money allowance made in the bookkeeping to offset accruing loss of service life; and sometimes the loss of value existing at any time due to the loss of service life or any other cause. The committee will use it only as meaning the loss of value or worth of property units which are parts of going concerns. Although this may be due to many causes, the general discussion will include consideration only of those effects which, like wear and tear, age, use, and obsolescence or inadequacy, bring a physical property unit gradually to the end of its service life.”

Earl A. Saliers[15] says: “This loss of value, whether tangible or intangible in form, resulting from physical decay, or from obsolescence or inadequacy, which indicate functional decay, is known as depreciation. It necessitates repairs, renewals, and replacements. Did it not occur, every outlay on plant would add to the investment. It does not result from one cause but from many causes, and this sometimes leads to the belief that it cannot be scientifically handled. But some adequate method of handling it is not merely desirable, but necessary, to a solution of the problems arising in the valuation of public utility properties, and in the management of industrial enterprises generally.”

Henry Floy[16] says: “It (depreciation) is used broadly to mean a reduction in utility value, expressed as a percentage but more usually in dollars, due to any deterioration in physical plant by reason of: (a) normal wear and tear, (b) age or physical decay, (c) inadequacy, (d) obsolescence, (e) deferred maintenance. The term depreciation, always used in connection with a reduction in value, has, however, four distinct and separate shades of meaning, so that the term must be qualified when used in order to distinguish which one of the following meanings is intended:

“First. The annual amount, expressed as a percentage or in dollars, that should be laid aside to renew or replace the article in question at the time of its abandonment.

“Second. The annual amount, expressed as a percentage or in dollars, that should be laid aside to renew or replace the article in question at the time of its abandonment, plus the annual expense of maintenance and repair expended in removing such part of depreciation as is practicable and good economy.

“Third. The total amount—usually that estimated as necessary to be expended to put the physical property in perfect operating condition—determined by the inspection and observation of an experienced engineer, expressed in a percentage or in dollars, which must be deducted from the ‘original cost’ or the ‘cost to reproduce new,’ in order to determine the absolute, actual, present value.

“Fourth. The total amount—it may be the sum of several years of depreciation—computed from ‘expectancy of life’ tables, more or less authoritative, expressed in a percentage or in dollars, that must be deducted from the ‘original cost’ or the ‘cost to reproduce new,’ in order to obtain the theoretical, present, depreciated value. This value may be increased or reduced by the condition of the property, as determined from inspection.”

The foregoing quotations from authoritative sources not only show the efforts made to define the term accurately, but also indicate the various elements included by different writers under the term, and suggest the need of further effort toward the standardization of its meaning.

Why the Depreciation Factor Arises

The distinction made in Chapter V between capital and revenue charges draws attention to the fact that the depreciation factor arises only because the fiscal or other period when information concerning values and costs, i.e., financial condition, is desired, does not coincide with the expiration of service life of the properties used in production. If the information just referred to were not desired at intermediate periods between the date of acquisition of the asset and the date of its discard or obsolescence, its cost should be treated solely as an expense of operation to be charged to the whole period in the same way that the fuel consumed, the raw materials used, etc., are regarded as revenue charges, or costs of manufacture. Practically, therefore, depreciation must be considered because a statement of financial condition is needed at regular stages of the life of the enterprise; and furthermore because the life of the various assets used in an undertaking is not uniform in length and their life histories in consequence overlap. Some assets wear out and have to be replaced, while others have still many years of useful service in them.

Actual or Absolute Depreciation

Before considering the various elements of depreciation, an explanation of some related terms will be given. A distinction is sometimes made between “absolute or actual” and “theoretical” depreciation. Absolute depreciation is the decrease in value of an asset from its state when new, to its present condition as viewed either from the standpoint of the amount it could be sold for or from the standpoint of its serviceability. In the first place, therefore, absolute depreciation is not applicable to going concern valuations. A machine after only a short term of service becomes, from the standpoint of its salability, a second-hand article and suffers a large decrease in market value. A water-pipe or an underground telephone cable immediately after its installation and even before it is brought into service depreciates materially from the standpoint of its salability as a disconnected unit. But from the standpoint of service and operations, i.e., adaptability to its intended use, such an asset may really be more valuable than before or immediately after installation. Again, an asset because of the excellent state of repair in which it is maintained may, so far as the serviceability required of it is concerned, be practically as good as new from the date of its installation until well along towards the end of its life-term. Its actual or absolute decrease in value is very slight during the early years of its life but increases rapidly just before it is discarded. This fact is illustrated by the example of the water-pipe. Slight repairs, the replacement of parts and small units, keep it for a long period 100% efficient, but the time comes when it is completely worn out and repairs are no longer economically advisable. These two examples illustrate absolute or actual depreciation.

Theoretical Depreciation

Theoretical depreciation is based upon, and has reference to, all the factors which must be considered in taking account of depreciation. As so considered the subject is viewed from the standpoint of financing the item of depreciation (sometimes called “accounting depreciation”) rather than from that of its serviceability. The engineer attempts to determine the actual, present serviceability of the asset in comparison with its serviceability when new, and so he leaves out of account its expectancy of life due to whatever causes.

Comparison of Actual and Theoretical Depreciation

The following chart adapted from Henry Floy’s “Value for Rate-Making” admirably illustrates the difference between actual and theoretical depreciation.

Chart Showing Actual and
Theoretical Depreciation

Curves 1, 2, and 6 representing actual depreciation have been sufficiently exemplified in the foregoing explanation of actual depreciation. Curves 1 and 2 may well represent the actual depreciation of two assets as viewed from the standpoint of salability; whereas curve 6 represents the actual depreciation of an asset viewed from the standpoint of serviceability, assuming that maintenance has kept the asset practically 100% efficient during most of its life-term. Curves 3, 4, and 5 are illustrations of theoretical depreciation, the different curves representing different bases for calculating the annual amount of the decrease in value, as will be explained in [Chapter IX], “Depreciation—Methods of Calculating.” To quote from Mr. Floy’s work at length:

“The curves 3, 4, and 5 indicate several classes of ‘theoretical’ depreciation which have been quite widely used in some cases for estimating present values, but more often for determining the yearly theoretical deterioration for purposes of establishing depreciation funds, which, however, is quite a different subject. Making a theoretical estimate of the probable, future, average, annually accruing deterioration of certain property to provide an item in bookkeeping accounts of operating expense has nothing whatever to do, in making an appraisal, with fixing the definite amount of absolute, actual, or accrued depreciation which depends upon the present condition of physical property, determinable from inspection and not upon historical documents, depreciation funds, or disputed theoretical conclusions.”

In an opinion filed March 8, 1916, by the Public Service Commission of Maryland in the matter of the Chesapeake and Potomac Telephone Company of Baltimore City, an interesting commentary on the relative merits of actual versus theoretical depreciation is made. While the opinion concerns primarily depreciation from the rate-making point of view, it shows well the interrelation between the two kinds and answers so conclusively the objection often raised to accounting depreciation that it is here quoted. The statement is:

“Any theory for ascertaining existing depreciation in the plant of a public utility which confines such depreciation solely to the actual, visible, physical, demonstrable deterioration which can be seen by the human eye and measured by the human hand, must of necessity ignore that other species of deterioration which the experience of the past has demonstrated beyond peradventure exists in the property of every telephone company, although it cannot always be seen by the human eye or measured by the human hand. We refer to that tendency upon the part of all such property to become inadequate or obsolete with the lapse of time.”

“Accounting” and “Fair” Depreciation

Another distinction is sometimes made between “accounting” depreciation, previously mentioned, and “fair” depreciation or depreciation of valuation. Accounting depreciation signifies the depreciation, determined by whatever method, which has been taken into the accounts, i.e., the depreciation as shown on the books. This is approximately the same as theoretical depreciation defined above. Its point of view is that of financing the loss of value caused by depreciation so as to cover the entire loss by the time the asset is retired from active service rather than that of establishing a true actual value of the asset at intermediate periods. On the other hand, fair depreciation or depreciation of valuation is the “sum that should be deducted from original cost to date (or from estimated cost of reproduction new)[17] as a step in finding that which the courts have called ‘fair value.’” Here the point of view is essentially that of showing the true value of the asset at a given date. Determination of this is fundamentally an engineering problem in the solution of which cognizance must be taken of:

1. Accounting depreciation.

2. The managerial policy as to repairs, maintenance, and renewals.

3. The past performance and expected future performance of the asset.

4. All other factors locally present which may affect the determination of the present, existing values in the asset.

Under certain conditions fair depreciation corresponds roughly with actual or absolute depreciation as defined above.

Complete and Incomplete Depreciation

Depreciation is sometimes classed as “complete” and “incomplete.” Complete depreciation refers to those assets or properties which have been discarded because no longer capable of economical service. When their cycle comes to an end, depreciation is complete. Incomplete depreciation refers to the amount of the decrement in value of assets which are still in service. The accounting for complete depreciation requires little consideration except so far as rates of depreciation are concerned. This class of depreciation represents the accomplished fact and therefore furnishes data and statistics by which the expected depreciation of similar new assets can be calculated. The accountant, therefore, is concerned with it purely as an experimental means of forecasting the future.

Individual and Composite Depreciation

Again, depreciation is classed as “individual or unit” and “composite.” Unit depreciation is the amount of the decrease in value of the individual parts which compose the whole of a property; composite depreciation is the amount of the decrease in value of the plant or property as a whole. Its amount in dollars is the sum of all unit depreciations similarly expressed. Expressed as a percentage it represents the effect of all unit depreciations weighted by the ratio of the value of each to the whole. Thus a plant as a whole may be depreciated 20%, but the numerous units of that plant may have a range of depreciation of from 0% to 100%. Some items may be ready to be discarded and others will probably have just been newly installed.

In connection with composite depreciation the term “normal” or “average” value is used. The normal value of a plant is the average value at which it must be maintained to give efficient service. Any drop below that point results in increased cost per unit of service rendered, and is consequently evidence of poor management. Normal value may sometimes be expressed in percentage as the difference between 100%, original cost, and composite depreciation. In the case cited above, where composite depreciation is 20% the normal value would be 80%, under a proper policy of management.

Physical and Functional Depreciation

Finally depreciation is classed as “physical” and “functional,” definition of which are deferred for treatment in [Chapter VII], “Depreciation—Its Causes.”

Deferred Maintenance and Accrued Depreciation

Other terms needing definition are: “deferred maintenance” and “accrued depreciation.” The former refers to repairs which at any given time are needed for the proper up-keep but which for one reason or another have not yet been made. So long as an asset is giving reasonably satisfactory service, repairs are usually deferred to a convenient time—such as when work is slack, or until similar repairs may have accrued elsewhere, or until weather conditions have changed, or in general until the repairs can be most economically done. Similarly, accrued depreciation refers to the depreciation which has taken place between the last time an item was brought on the books and the present time. The inevitable forces causing depreciation are constantly at work bringing about the decretion of the asset day by day, but it is impracticable to reflect such condition daily. Only at the close of each fiscal period is it deemed necessary to adjust the books so that they reflect the depreciation which has taken place during the period just closed.

Attitude of the Law

Before studying the factors of depreciation it is interesting to note the attitude of the courts towards depreciation. Accountants and engineers recognized the necessity of taking account of depreciation considerably in advance of its recognition by the courts of this country. H. R. Hatfield[18] says: “France, Belgium, Switzerland, Germany, Austria all prescribe in their statutes that depreciation must be reckoned before showing profits.” The French Joint-Stock Company Law specifically requires the reservation of some portion of the company’s surplus for taking care of the depreciation of the assets. While the method may not be scientific, the principle involved is recognized as correct. But in an early English case, Lee v. Neuchatel Company, it was held, in the case of a company operating inherently wasting assets “that even depreciation by waste is not necessarily a revenue charge.”

Early decisions in this country likewise fail to sustain the propriety of depreciation charges. The cases usually cited are The Union Pacific R. R. Co. v. United States, 99 U. S. 402, and United States v. Kansas Pacific Ry. Co., 99 U. S. 455 (1878), the first not passing specifically on the question of depreciation but showing a lack of appreciation of the distinction between capital and revenue charges, and the latter stating that “only such expenditures as are actually made can with any propriety be claimed as a deduction from earnings.” The Supreme Court of California in San Diego Water Co. v. San Diego, 118 Cal. 556 (1897), and in Redlands, etc., Water Co. v. Redlands, 212 Cal. 312 (1898), refused all allowances for depreciation except necessary amounts for “maintenance and repairs during the year.” However, in Pioneer Tele, and Tele. Co. v. Westenhaver, 118 Pac. 354, the language of the court is not uncertain: “A sufficient sum should be allowed from the earnings of a utility to make good the depreciation of the plant and replace the deteriorated portions thereof, when they become so impaired that they can no longer be made useful by repair.”

Decision of Supreme Court

The United States Supreme Court recognizes the necessity for an allowance for depreciation in Mayor and Aldermen of the City of Knoxville, Appt., v. Knoxville Water Co., 212 U. S. 14 (1909), which forms the basis of judicial attitude towards the question at the present time. The decision of the court which has been supported and reaffirmed in all subsequent decisions, reads, in excerpts:

“A water plant with all its additions begins to depreciate in value from the moment of its use. Before coming to the question of profits at all the company is entitled to earn a sufficient sum annually to provide not only for current repairs, but for making good the depreciation and replacing the parts of the property when they come to the end of their life. The company is not bound to see its property gradually waste, without making provision out of earnings for its replacement. It is entitled to see that from earnings the value of the property invested is kept unimpaired, so that, at the end of any given term of years, the original investment remains as it was at the beginning. It is not only the right of the company to make such a provision, but it is its duty to its bond- and stockholders, and in the case of a public service corporation, at least its plain duty to the public. If a different course were pursued, the only method of providing for replacement of property which has ceased to be useful would be the investment of new capital and the issue of new bonds and stock. This course would lead to a constantly increasing variance between present value and bond and stock capitalization—a tendency which would inevitably lead to disaster either to the stockholders or the public, or both.”

Recognition of the Depreciation Factor

Following this decision the rules and regulations of the public service commissions of practically all the states now require that provision for depreciation be made. In the case of some of the smaller public service companies the failure to make this provision is overlooked but the practice is generally recognized as absolutely necessary. The Interstate Commerce Commission has led in this respect, although its early rulings relative thereto were strenuously objected to in some quarters. Private concerns in their contact with the government now almost invariably see the value, or at any rate the self-interest, of a deduction for depreciation. In the case of the Special Excise Tax, a Treasury decision on account of Internal Revenue provides that “deduction on account of depreciation of property must be based on lifetime of property, its cost, value, and use, and must be evidenced by a ledger entry and a like reduction in the plant and property account with respect to which depreciation is claimed.”

Similarly, the present Federal Income Tax Law recognizes allowances for depreciation, but perhaps errs in placing too stringent safeguards on the amounts to be deducted therefor, whereas the Federal Trade Commission realizes the need of liberal provision. The law reads: “That in computing net income in the case of a citizen or resident of the United States, for the purpose of the tax there shall be allowed as deduction a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business or trade. No deduction shall be allowed for any amount paid out for new buildings, permanent improvements, or betterments, made to increase the value of any property or estate, and no deduction shall be made for any amount of expense of restoring property or making good the exhaustion thereof for which an allowance is or has been made.” The depreciation allowed as a deduction from income must have actually been charged off the books. Many interesting rulings—some almost absurd if carried to their logical conclusions—have been made by inspectors and the Treasury Department on points raised as to the application of the above law to particular cases. A perusal of these decisions will well repay the student who is interested in the subject.

Distinction between Repairs and Renewals

At this point attention is called again to the need of a careful distinction between repairs (up-keep and maintenance charges) and renewals (replacements and betterments). Only a clear definition of the terms and a strict adherence to an adopted policy can prevent endless confusion and absolutely misleading results. Such a policy is necessary because in the practical handling of such items on the books the theoretical aspect of the distinction between repairs and renewals must always be modified by reason. The student is referred to the preceding chapter where more detailed treatment of this point is given.

Depreciation and Plant Efficiency

The relation of depreciation to the efficiency of a plant or an asset will now be considered. The amount of depreciation is not based on the degree of efficiency of the service rendered by the asset. In other words, a depreciation reserve is not in any sense an inverse measure of the productive efficiency of the asset to which it relates, nor does the sum of all depreciation reserves either indicate or measure the degree of efficiency of the whole plant. A comparison of present with normal value (as defined above) affords some index of productive efficiency, but there is no direct ratio between the two. In any well-maintained plant, however, the normal value is the value below which the plant cannot be allowed to fall if the standard of efficiency is to be maintained; and good management requires nothing less than this. It has been variously estimated that normal value ranges from 75% to 90% of the original cost, and in some instances runs as low as 50%. The composite depreciation of from 10% to 50% represents the limit beyond which the decrease in value cannot pass if efficient service is to be given by the plant. Usually the sum of the depreciation reserves for all the assets of the plant remains fairly constant because the large reserves against assets that are almost ready to be scrapped are offset by the smaller reserves of the assets just replaced.

Unit Efficiency

The efficiency of the unit, however, has a somewhat different relation to depreciation. Units, i.e., individual assets comprising the plant, are constantly wearing out and being replaced. The plant, aside from exceptional cases, never reaches the point where it must be discarded in its entirety and replaced as a whole. The depreciation of each unit continues until the point of inefficiency is reached, when it is scrapped and replaced. The unit frequently is allowed to drop below its margin of efficient service before being scrapped, and it may be made to render service much longer than is customary, by means of heavy repairs and a relatively high up-keep expense. When to scrap a particular unit involves a nice calculation. The heavy cost of repairs necessary to secure good service from the old unit and the possible loss through failure to accumulate a sufficient reserve must be weighed against the cost of a new unit and its up-keep and running expense. Usually the efficiency of the individual unit is very like the parson’s one-hoss shay which “ran a hundred years to a day and then of a sudden it went to pieces all at once.”

The following chart illustrates accurately the relation of efficiency to uniform depreciation, the XCY line being the efficiency curve and XY the depreciation curve. Also curve 6 of the chart on page 105 gives a good illustration of the same point. Inasmuch as the depreciation reserve must provide for the loss of the entire asset by the time it goes out of service, it is readily seen that in judging an asset from its bookkeeping record of cost and reserve there is no measure of efficiency shown therein, since a normal efficiency must be maintained by repairs at all times. The record is, however, a good index of the time when the point of inefficiency will be reached.

From “Principles of Depreciation,” by Earl A. Saliers.

Chart Showing Progress of Uniform Depreciation
and of Diminishing Efficiency

Engineers hold the opinion that machinery as a rule cannot suffer more than 25% to 50% actual depreciation and give efficient service. A depreciation reserve of anything more than that does not mean that the point of inefficiency has been reached, for the reserve is usually estimated and applied on the basis of theoretical depreciation and so takes cognizance of all its factors. It has sometimes been stated that inefficiency is a factor of depreciation distinct from wear and tear, obsolescence, and supersession. It seems a better statement of the relation to say that the point of inefficient service is the limit beyond which the three factors named cannot be allowed to operate or have effect. The need of judging the efficiency of some kinds of assets is not so apparent as of others. Thus in the case of poles, wires, conduits, and the like, efficient service is secured until they are worn out, with very little expense for up-keep. That is, such assets are normally efficient throughout their whole term of life, and the application of repairs will not appreciably extend their life nor will it affect their efficiency. In the case of other assets, such as machinery, telephone switchboards, motors, etc., the item of up-keep is a very vital one in the determination of the point or margin between efficient and inefficient service, and that in turn is an important factor in the determination of the length of service life of the asset. Thus, although efficiency and depreciation are intimately related, the degree of depreciation at a given time is not by any means an inverse measure of the efficiency of the service being rendered by an asset.

Depreciation and Fluctuations in Market Value

The relation of depreciation to fluctuation in value, due to whatever causes affect the market, also deserves consideration. Depreciation primarily refers to a decrease in value from a definite cost figure, such decrease being due to certain well-recognized causes, of which change in market value is not one. Thus, while it may be correct, through a loose use of the term, to use the expressions, “depreciation of securities,” “depreciation of real estate,” and similar phrases, and there may be no likelihood of any misunderstanding, that is not the sense in which the term depreciation is used here. Unfortunately, market fluctuations are sometimes allowed to influence depreciation charges.

Such influence may come about in three ways: (1) In valuation proceedings for the determination of rates for a public utility company, a basis frequently used is that of the cost of reproduction or renewal less depreciation. The theory is that under existing views of private property such a company has the right to the enjoyment of all increments in its own properties and therefore has a right to such rates as will earn a fair income on the present value of those properties. Depreciation based on the present reproduction cost is in this way influenced by fluctuations in market value, and the oftener a physical appraisal is made and its determined values brought upon the books, the greater will be the disturbance of the basis for the depreciation charge. (2) Occasionally the practice is met with of basing the present depreciation charge upon the estimated cost to replace the old asset. This is discussed later and is mentioned here merely to show a possible relationship between fluctuations and depreciation. (3) Finally, in the periodic adjustment of depreciation rates and charges, the estimated scrap value of the asset does affect the amount of the periodic charge. Changes in market value of scrap, which may be considered as due to causes which will continue in force rather than to the ups and downs of the market, may legitimately be reflected in the depreciation charge for the remaining life-term of the asset and must be so reflected in the interests of accuracy in any statement of true values.

Distinction between Depreciation and Depletion

Inasmuch as depreciation is not here used to apply to current assets (with one exception noted below), and fluctuations in the market value of any asset subject to depreciation need not be considered, it may be well to state the class of assets to which it does apply. In general the value of all fixed or capital assets is affected by depreciation. The term frequently used in this connection is “wasting” assets. Under this nomenclature is included any asset which wastes away or is used up. For the sake of clarity the author desires to limit the term depreciation to those assets which are clearly affected by any of the causes of depreciation as discussed in the following chapter. For those assets which are used up without any possibility of their being replaced, and the life of which cannot be prolonged by repairs and renewals, the term depletion will be used. Accordingly the term “depreciation” will be applied to mine buildings and machinery; “depletion,” to the mine. Both are wasting assets, but their waste is due to somewhat different, although vitally related, causes. No better definition of wasting assets has been formulated than that by P. D. Leake[19] who says that they “consist of all forms of exchangeable value which inevitably diminish while applied to the purpose of seeking profits, increase, or advantage otherwise than by purchase and sale.”

Effect on Different Kinds of Business

Some types of undertakings are more subject to the effects of wasting assets than others. Concerns dealing in investments, insurance of all kinds, brokerage and commission, manufacturers’ agents, banking and financial houses, professional firms, and the like, only a small portion of whose capital is tied up in fixed assets, are comparatively unaffected by the charge for depreciation. Practically all other concerns are subject to it in marked degree—manufacturers, mines, transportation companies, light, heat, and power concerns, the telephone, telegraph, and cable, construction companies, agricultural, etc. Those engaged in extracting raw materials from the ground are, with few exceptions, subject to a charge for depletion. Those with an investment in any kind of terminating rights, such as leases, patents, copyrights, non-renewable franchises for a fixed term of years, and so on, are also subject to it. Opinions differ as to whether good-will and trade-marks may properly be considered as subject to depreciation. They will not be so considered here for reasons which will be stated when the principles of their valuation are discussed.

It will be noted that thus far all examples given have been those of fixed assets. The exception already referred to is made in the case of the current asset, merchandise or stock-in-trade. The term depreciation can perhaps correctly be used in connection with merchandise, which, however, is not to be classed as a wasting asset. Due to some of the causes discussed in the next chapter, the stock-in-trade of an undertaking does truly depreciate in value. The method of accounting for such depreciation differs entirely from that used for wasting assets. Hence, the treatment of depreciation of merchandise will be considered at the same time that its valuation is discussed ([see Chapter XIII].)

Having cleared the ground with this definition of terms and the general statement of what the depreciation problem is, attention will now be directed to a consideration of the causes of depreciation, to be followed by the method of accounting for depreciation and a treatment of some points growing out of the general discussion.

CHAPTER VII
DEPRECIATION—ITS CAUSES

Analysis of Causes

Most definitions of the term depreciation set the boundaries or limits of its meaning by naming the causes. These are normally: (1) wear and tear, or physical factors; (2) inadequacy and obsolescence, or functional factors; and (3) accidents or contingent causes. This statement of causes applies specifically only to physical or tangible properties. In the case of intangible property, consisting for the most part of rights of various sorts, the controlling cause is usually merely lapse of time. The chart on the following page analyzes the various causes and shows their detailed ramifications.

Age as a Cause of Depreciation

The physical depreciation of tangible properties arises from two main causes, viz., the wear and tear from operation and the use of the asset and the wear and tear of age, known as decrepitude. Immediately upon the installation of an asset the forces of time and the elements begin their ravages even before operations begin. As H. R. Hatfield[20] trenchantly puts it, “all machinery is on an irresistible march to the junk heap,” and the statement is equally applicable to all other forms of wasting assets. The ties placed on the roadbed of a railway, conduits put in place for carrying water, gas, steam, electric current, or oil, rolling stock, poles for telephone and telegraph lines, buildings, even interior installations of various types—all are subject to the normal ravages of time and the elements, and nothing which man has been able to devise can do more than retard the inevitable. Thus, all assets decrease in value through the inevitable lapse of time. Attention should be here directed to the fact that decrepitude depends on the normal action of time and the elements, whereas accidents due to action of the elements (listed in the chart on page 121, under III, 1, b) are of an abnormal character and cannot usually be taken into full account at the time of the installation of any particular piece of property.

Causes of Depreciation[21]

A.
Tangible
Property		I.Physical 1. Wear and Tear from Operation
(a) Maintenance Policy
2.Decrepitude
(a) Action of Time and the Elements
II.Functional 1.Inadequacy or Supersession
2.Obsolescence
III.Contingent 1.Accidents (a) Negligence
Fire
Lightning
(b) Elements Wind
Water
Temperature
(c) Structural Defects
2.Diseases (a) Parasites
(b) Pollution of Water
Mineral
(c) Growths in Water-Mains Vegetable
Animal
(d) Electrolysis
(e) Crystallization
3.Diminution in Supply (a) Natural Gas
(b) Water
B. Intangible Property—Rights 1. Limited in Time
2. Abandoned

Wear and Tear of Use

The wear and tear due to use or operation usually has a much more potent effect on the service life of an asset than that due to decrepitude. The established policy as to repairs and maintenance has an important effect on this kind of depreciation. Sooner or later every machine becomes unfit for service, due to the friction of its parts, the strains to which it is subject under normal load, those of much greater effect under abnormal load, the method of applying its power, etc. It must then either be withdrawn from service and completely depreciated, or it must be repaired in an effort to lengthen its life. It should be kept in mind that the determining factor here is efficiency. The serviceability of the machine must be kept up to a recognized standard through adequate expenditures for repairs and up-keep until the cost of up-keep is disproportionate to the service rendered, or until the machine becomes so decrepid as to make its operation hazardous.

The application of theoretical depreciation to operating wear and tear must proceed with great care. This is so because of the varying factor of maintenance. If the cost of maintenance Could be standardized, experience under such standard would give a reliable basis for the calculation of the depreciation charge. Since adherence to such a standard is difficult or impossible under the conditions that are constantly arising in a given establishment, the depreciation policy must of necessity be based on actual observation and inspection by experts. The expenditure necessary to restore an asset to a state of operating efficiency is called “deferred” or “accrued” maintenance, and it is the amount of this at a given time, estimated by expert inspection, which compared with normal maintenance forms the basis for an estimate of the depreciation charge.

Functional Depreciation

Tangible property is subject also to “functional” depreciation. This means a lessening in worth or service value due to causes, other than those already treated, which interfere with and operate against the proper functioning of the asset, making it impossible to render effectively and economically the full requirements of service expected of it. This inability to fulfil its proper function may result either from inadequacy or obsolescence. “Thus the structure may suffer total depreciation and be thrown out of service, not only because through wear and tear it has reached a condition where further expenditures for repairs or attempts to make it suitable for the required service would not be economical or expedient, but also because recent improvements, or new inventions, new developments and radical changes in service, or the demands of one kind or another involving sweeping changes in the existing plant, make abandonment necessary.”[22]

Inadequacy as a Factor

Inadequacy is a condition in which the asset is found unable to meet the demands made upon it, due usually to growth of business or to some rearrangement made necessary by changed policy before the asset has reached the end of This condition is also called “supersession.” For economical operation the asset must be discarded and superseded by a larger unit. As an example, dynamos and motors of a capacity sufficient to meet all demands on them at the date of their installation may, through growth of business, prove entirely inadequate after a few years to meet the service expected of them. Inadequacy as a factor of depreciation will have no appreciable effect in cases where the demand is fairly constant and the market does not permit of much expansion. Where there is a growing community and (or) a growing appreciation of the commodity manufactured, demand may increase to a point where original judgment and expectation will be shown to have been in error and the equipment will have to be superseded if advantage is to be taken of the expanding market.

Two main factors or compelling forces may bring about inadequacy, viz., those of internal origin and those of external origin. Those of internal origin may become effective because of: (1) abandonment of original financial policy, (2) considerations of engineering economy, and (3) unforeseen development.

Inadequacy through Change of Policy

Perhaps the best illustration of the first type is that of a plant built to supply a certain commodity to the local community. A change in ownership brings about an abandonment of the original policy and a determination to provide neighboring communities with the commodity also. This change in policy frequently comes about when several smaller plants are merged under one control and the original units are found to be entirely inadequate to meet the demand. Again, when through a change in financial policy it is decided to lower the rates of a public service commodity, the original equipment may prove inadequate to meet the increased demand. It is not contended here that this type of inadequacy is to be taken into account in estimating the depreciation charge. Usually it cannot be foreseen and should therefore be provided against under the head of a general contingent reserve or appropriation of profit. If it can be foreseen intelligently, it should be taken into account in the estimate of depreciation.

Inadequacy through Motives of Economy

The second type of inadequacy may be a foreseen and calculated inadequacy. In a new community or in the case of a new commodity whose virtues are little known, it may be the part of economy and business sagacity to install originally only such equipment as will be adequate to meet the requirements during the development stage and then when the commodity is introduced and established to discard the old and install larger and more adequate structures. Although it may be foreseen with reasonable certitude that a power plant generating a thousand horse-power will be entirely inadequate in ten years, yet it may be the better business economy to scrap it at the end of ten years rather than incur the up-keep and depreciation charges on a larger plant which would give longer service. Whichever policy, according to best engineering economy, results in the lowest unit cost of product is usually the determining factor. If with all the facts and reasonable expectations under view the smaller plant is decided upon, then assuredly the depreciation due to inadequacy must be taken into consideration.

Inadequacy Due to Unforeseen Development

The third type of inadequacy, unforeseen development, has been shown to be due to an unexpected expansion of the market. This may be brought about by growth in population of the present market, growth in appreciation of the commodity manufactured, or sometimes by a lowering of transportation rates whereby new markets are opened. The very fact that this kind of inadequacy is unexpected and unforeseen makes impossible its inclusion in the current depreciation charge. This kind of inadequacy is revealed by a post-mortem determination of causes of which there were no symptoms leading to a correct diagnosis during life. The loss to be incurred through the scrapping of the property before its expected termination of service is a loss which must be borne by the future and not by the past. It is in the nature of a development cost which must be incurred if the opportunities of the new market are to be seized, and which must enter into a consideration of the advisability of making a bid for the new business.

Business policy might or might not dictate that these costs be charged against reserves of profits from the past. Theoretically they should be spread somewhat evenly over the future but in neither case can they have any place in present depreciation charges. It should be thoroughly understood that depreciation is a charge which relates always to the past, never to the future. There is no contradiction here in that a consideration of the future must help to determine the amount of waste which has taken place in the past. P. D. Leake[23] says: “It is a misconception to describe the annual provision for depreciation as a provision for future renewals, as though it has reference to the future. The annual provision for depreciation has nothing to do with the future but relates solely to the past. It is a replacement of capital in respect to past capital outlay expired in the process of carrying on the business.”

Inadequacy Imposed from Without

Inadequacy may be imposed by external forces or authority. In public service utilities this has often proved a source of expense. In the interests of a supposedly enlightened opinion—oftentimes a badly mistaken opinion—present equipment is found inadequate to meet the new demands. This type of inadequacy merges imperceptibly into obsolescence. Again, a municipality at the time of repaving the streets may require that the utility company discard present equipment and install a larger and heavier type; it may require that overhead wires be carried in underground conduits; and prudence on the part of the company may lead to the installation of larger carriers than the old. These losses—and there is almost invariably a loss to the utility company—must be charged against the future. So also, the passage of laws and ordinances in the interests of sanitation and fire protection frequently compels the private owner to discard equipment and devices before their service life has passed and install more adequate equipment.

Obsolescence as a Cause

The second factor of functional depreciation is obsolescence. By this we mean that lessening in worth which is brought about by the development of something new whereby production becomes more economical or is changed to meet new ideas, fads, or fancies of the consumer. Obsolescence may be imposed by outside forces through the exercise of the police power under circumstances analogous to those mentioned under the discussion of inadequacy brought about by external means. Municipalities and regulating commissions have speeded up the “irresistible march to the junk heap” in numberless instances. Cotton-spinning and shoe machinery, lasts and patterns of all sorts, electrical devices in particular—all have been subject to obsolescence charges. The horse car gave place to the cable car, which in its turn was displaced by steam locomotion, and today this has given way to electrically propelled street cars. The old wooden rail gave way to the rail of wood capped with a strip of steel, the light “T” steel rail, and the present heavy steel rails—changes all necessitated by changes and developments in the art and a demand for better service by the public. The stick used by the Indian to turn the ground and plant his corn has been displaced successively by hand tools of iron and steel, horse-driven plows, and the big steam and gas tractors of the present day. No industry has escaped the seemingly inevitable trend towards the displacement of the old and antiquated but not worn-out equipment, by newer, more up-to-date, and more economical equipment. Obviously the last word has not yet been spoken or the last refinement been made in the development or application of art and science to any industrial enterprise. Life means development; dry rot and retrogression are the fate of any art, any industry, any people which has reached the limit of its development.

Since, therefore, obsolescence is so common an occurrence, so absolutely a fact of general experience, it would be folly to ignore it. Many writers and some authorities have said that while obsolescence is as certain and ever present as the forces of nature, it seldom is more possible of measurement than are they. However, engineers tell us that in most cases it is possible for qualified experts to foretell with reasonable certainty the effect of obsolescence. “Those most familiar with the art know the units which will be able to serve their entire physical life, and what classes are so uneconomical or otherwise defective that some improvement must be expected.”

Treatment of Obsolescence

As to the effect of obsolescence, attention should be called to the fact that it is seldom operative to its full extent. The decision as to the exact time of discarding the old and installing the new rests on a nice balancing of many factors. Thus, the safety devices operated by hand on railroads are not displaced in a wholesale manner by those which operate automatically. In a large telephone company old switchboards are not discarded for new over the entire system at the same time. Much of the old is oftentimes allowed to serve out its life-term, and obsolescence has no effect. Under the circumstances stated above, and many similar and more complicated conditions, it requires a nice calculation to determine the actual effect of the factor of obsolescence in depreciation. Many inaccuracies, even many ridiculous conclusions, in estimates made by experts are met with, times without number. The novice thus fears even to guess as to the amount of the depreciation due to this factor. That is perhaps as it should be; there is no place here for the novice. Inasmuch, however, as the trend is to estimate the depreciation due to obsolescence, and such practice has the unqualified approval of many public service boards and at least the silent approval of our courts, it would seem that an attempt should be made to include it in the depreciation charge. As to its sufficiency or insufficiency, an amount can be estimated with as much accuracy under the head of depreciation as under that of a contingent reserve, and the former course is to be preferred in that an inevitable fact of experience in almost every industry is thereby recognized. The past, and not the future, is thus burdened with the accomplished waste. There doubtless will be instances where depreciation due to obsolescence palpably cannot be foreseen. For such there is but one of two courses, viz.: either to charge it against profits reserved out of the past, or burden the future with its cost.

Relative to the inclusion of obsolescence in the depreciation charge, the Illinois Public Service Commission says in the case of the City of Springfield v. Springfield Gas and Electric Company, March, 1916: “In view of all the facts in this case, the Commission finds that it is but reasonable, proper, and equitable to make deductions from cost new to cover accrued depreciation, both physical and functional....” The statement of the Maryland Public Service Commission in the case of the Chesapeake and Potomac Telephone Company of Baltimore City has already been cited on page 106. Quoting from the report of the Valuation Committee of the American Society of Civil Engineers: “A limited search ... indicated that inadequacy and obsolescence were included either in ascertaining the amount of depreciation to be included in cost, or to be deducted from earnings ... by the commissions of the following states: Arizona, California, Colorado, Illinois, Maryland, Massachusetts, New York, Oregon, South Dakota, Wisconsin.”

Covering this feature, i.e., the depreciation feature, in making returns to the government under the Federal Income Tax of 1916, the Commissioner ruled as follows: “The deduction for depreciation should be the estimated amount of the loss, accrued during the year to which the return relates, in the value of the property in respect of which such deduction is claimed, that arises from exhaustion, wear and tear, or obsolescence out of the uses to which the property is put.... The depreciation allowance, to be deductible, must be, as nearly as possible, the measure of the loss due to wear and tear, exhaustion, and obsolescence.”

Although not specifically mentioned, functional depreciation may be said to have the sanction of the United States Supreme Court in its decisions covering the Knoxville and Minnesota rate cases. In the case of the Des Moines Water Company v. City of Des Moines, 192 Fed. 193, September 16, 1911, the court allows both “functional and physical depreciation.”

It would seem, then, that the legality of the practice is pretty well established and the ability to compute the amount has been recognized. It is not often the case in matters of business policy and prudence such as this that the courts lead where business men and some professional men are reluctant to follow.

Contingent Depreciation

A third factor in depreciation is given in the chart on page 121 as contingent. The term would seem to indicate on the face of things that it is not a factor of sufficient definiteness and certainty to make possible its prevision and therefore the calculation of its effect. Hence it might seem that provision could be made for it only by means of a general reserve. In many individual cases and as to its application as a universally operative factor in the same sense that are use and wear and tear, the position is undoubtedly well taken. The term contingent, as here used, is meant to cover not only things which have happened and may happen again, but also things which in given localities and under known or knowable conditions are more or less inevitable. Hence while not found present in all cases, where conditions are favorable to the happening of any of the contingencies, from the standpoint of prudence and an equitable distribution of the burden of costs, provision should be made for them as one of the items comprising depreciation. Contingent depreciation may comprise three classes of contingencies, viz., (1) accidents, (2) diseases, and (3) diminution in supply.

Accidents. With regard to the first class, M. E. Cooley, in the Milwaukee Three-cent Fare Case, says: “An engine or a boiler may be wrecked and with it other machinery. This might, and probably would, involve a considerable expense for repairs or replacement, besides possibly crippling the plant in part. Cars may collide or a car may drop through a bridge. A bridge itself may fall or be carried away by floods. A storm, as a cyclone, may work havoc, entailing costs in excess of those proper to be charged to ordinary maintenance of property.” Accidents may happen either as a result of negligence or as a so-called “act of God,” i.e., the elements, or a hidden defect in the structure. With regard to depreciation from accidents it may be quoted, “There is always a certain amount of loss by accident which seems to be inseparable from the business. Usually it can be counted on in advance, and no amount of care and precaution will entirely eliminate it.”[24] The Railway Library for 1910 says that of 899 railroad accidents the various causes were:

Malicious acts 30accidents
Elements104”
Structural defects117”
Various forms of negligence  648”

In a large concern where past experience may serve as a guide to the future, depreciation of this sort can be rather accurately estimated. In the case of the rolling stock of a railroad, statistics make available the yearly loss due to accidents from whatever cause. It is argued that such losses are fairly uniform from year to year in a large system of that sort, and each year’s operation carries the burden simply by charging all repairs incident thereto against the revenues of that period. This is, of course, true in the main and may give sufficiently accurate results. The same treatment may also be applied to replacements, and if the units are sufficiently small in value in comparison with their number, practically no inequity as between periods will result. However, the Interstate Commerce Commission has ordered that depreciation reserves shall be set up for the proper handling of such accidents and this seems the better method. Statistics are available as to how frequently explosions in powder factories are apt to occur and the losses due to them, so that a manager can calculate the provision to be made on that account. Those are simply the risks of the particular business, and wherever it is known that they are applicable to any kind or group of equipment or other assets, certainly the current operations should bear their share.

After all, depreciation charges due to any causes are much of the nature of insurance which has to be carried by the enterprise itself because the risks have not yet been reduced to an insurable basis. Much as a proprietor may dislike to carry his own depreciation insurance, he is compelled to. In connection with accidents as a part of the depreciation charge, it should be noted that the product should not be charged twice for this item. If regular insurance is carried for fire, flood, tornado, earthquake, and the like, certainly those elements should be omitted from the insurance risk carried as depreciation by the concern itself.

Disease. Under certain conditions as to climate and local environment, the ravages of disease must be reckoned with. Diseases are caused by:

Losses and deterioration from these causes are quite appreciable in some enterprises. Telephone poles are subject to attack by borers and woodpeckers. “More than 50% of the weight of the wood may be removed ... without being greatly manifested upon the surface.” “At least 10% of the chestnut poles reset or replaced are injured by insects.” Railroad trestles, bridges, docks, piers, wooden shipping, and structures of all sorts are more or less subject to this kind of depreciation. Minute vegetable growths known as algae may cause a marked depreciation in a water utility. Other forms of vegetable and animal organisms sometimes cause growths in water-pipes, resulting in a partial shutting off of the capacity. Similarly, mineral growths may produce like effects. Iron oxide (common rust) and lime deposits or scale are frequent causes.

Electrolysis. Depreciation caused by electrolysis is a highly technical subject, discussion of which will not be attempted here. “Electrolysis is a chemical decomposition produced by an electric current. As applied to utilities, electrolysis is the disintegration of metal structure caused by the electrolytic action produced by stray electric currents, generally from the return circuits of single trolley electric railways.” The damage, both direct as above stated, and indirect as in the leaking of water, gas, etc., or in the flooding of adjacent premises or injury through gas explosions, is recognized by the courts, but the satisfaction granted is limited to enjoining a continuance of the injury.

Molecular Change. In some kinds of machinery subject to heavy strain and shock when in use, a disintegration of the structure itself takes place whereby its resisting power and therefore its efficiency are greatly impaired. This condition is known as a crystallization of the molecules.

Depletion. Finally depreciation due to contingent causes may be brought about by a diminution in the supply. This is more in the nature of a depletion charge and will be fully considered in connection with that subject treated on page 117.

Terminable Rights

The intangible property subject to depreciation consists of terminable or limited rights. Rights given or held for a definite period of time expire or waste away through the lapse of time. Decrepitude is the controlling factor here, and because of the definiteness of the length of time, the depreciation charge is easily calculated. Therefore provision must be made for it. Various methods, resulting in quite different charges to each period, are sometimes employed. These methods will be discussed in [Chapters IX] and [X]. Rights which are not terminable or limited—and even limited rights—may, however, be given up or abandoned. This is a situation which cannot usually be foreseen and therefore cannot be provided against except by means of a general reserve.

Effective Depreciation

One final point in connection with the causes of depreciation needs consideration. Though all of these various causes or kinds of depreciation are seldom found operative on a given asset, frequently several of them are so operative. Where this is the case their effect is not cumulative. One or the other will prove a controlling factor in determining the service life of the asset and thus the amount of its periodic depreciation. There is a close relation between the operation of the chief factors in depreciation and the scrap value of the asset. Thus, if it is estimated that physical depreciation will be complete in 8 years, obsolescence in 10 years, and inadequacy in 12 years, scrap value would be slight. If, however, inadequacy is the controlling factor, becoming operative in 8 years, with obsolescence in 10 years, and physical depreciation in 12 years, clearly scrap value might be quite appreciable. Whichever factor is the controlling one, that factor is said in a given case to constitute the effective depreciation for that asset. Thus, in the first case mentioned, physical depreciation constitutes effective depreciation and would form the basis for the estimated charge, while in the second case inadequacy is the effective factor.

CHAPTER VIII
DEPRECIATION—FACTORS OF
RATE DETERMINATION

Fundamental Purpose of Depreciation

Under the head of accounting for depreciation, which forms the subject of this and following chapters, will be considered:

1. The purpose of the depreciation charge.

2. Rates of depreciation and their relation to repairs, renewals, and replacements.

3. Methods of reckoning depreciation and their effects.

4. Handling depreciation on the books.

5. Financing depreciation and some related problems.

Though much has been written about the causes and kinds of depreciation, the necessity of considering it, and methods of calculating its amount, so far as the author knows there has been no adequate presentation of the fundamental purpose of the depreciation charge viewed both from the valuation or balance sheet point of view and the operation or profit and loss standpoint. The statement is frequently made that the purpose of depreciation and the necessity for considering it is to maintain intact the value of the original capital invested. In so far, therefore, as this necessitates a periodic charge against revenue, resulting in a retention in the business, either in a specific or floating form, of some of the revenue-producing assets, the operating or profit and loss phase of the business is affected. This secures the integrity of the original fund of capital by making the revenue receipts unavailable for distribution among the stockholders until the portion of the assets wasted away has been made good. This view of depreciation has as its actuating purpose a showing of correct values in the balance sheet, with little regard to the purposes to be served by the depreciation charge against operations. This emphasis of the problem of valuation is usually looked upon as primarily the engineering viewpoint.

Depreciation a Cost of Operation

On the other hand, many students of the problem view the depreciation charge as incurred for the sole purpose of determining the correct costs of doing business. Unquestionably, depreciation is a cost of production. A portion of the service life of equipment goes into each unit of the product, and depreciation constitutes a cost which must be borne by the product with as much reason as the labor power that fashions and forms it and the raw material out of which it is made. To determine a cost of production and a profit without the inclusion of the depreciation charge would be, as R. H. Montgomery[26] says, just as logical as “to state that a candy manufacturer had earned a net profit of $100,000 and that out of said $100,000 there had been set aside $20,000 to pay for the sugar consumed in the manufacture of the product. The use of that which is consumed is a loss or expense. Machinery is consumed; sugar is consumed. You cannot say that one is an operating expense and the other is an item which need not be ascertained nor taken into account until the net profit is shown.... If the provision for depreciation is an item which cannot be included among the costs of operation, there is something wrong.”

This view of depreciation attempts to show the correct costs in the profit and loss statement of operations, without much regard to its effect on the balance sheet except that, in so far as every charge against operations is reflected among the assets, the fact of its inclusion as an operating cost automatically works also as a means of declaring correct values. Under this view—which may, without any misstatement perhaps, be called the accountant’s viewpoint—the emphasis is placed on the effort to show true costs of the product, and only incidentally a true valuation of the assets.

Complication of Short Fiscal Periods

Theoretically there is no conflict of views here—only a difference in emphasis. It is purposed, however, to show some of the practical difficulties encountered in the full application of either view. As has been stated in an earlier chapter, the ideal time in so far as depreciation is involved for the determination of financial results would be the time when all the elements of production entering into the product have been completely used up—if this were possible. There would then be no troublesome problems as to inventories, accruals, or deferred charges. The fiscal period would coincide with the natural service-life periods of all the producing elements. The problem of depreciation would then be a simple one, and the entire value of the equipment would be a charge to the product turned out during its life-period. Such a method of determining the financial results of an enterprise is, of course, merely fanciful. There is always, and will be always, an overlapping of the life-periods of the various units of a plant. Furthermore the practical necessities of modern business and competition require a much shorter fiscal period with a more frequent figuring of results and showing of condition. It is due to this shortening of the fiscal period to one month, six months, or a year that the difficulties of the depreciation problem arise and inaccuracies of statement are consciously or unconsciously made.

The handling of the problem hinges on the answer to the question as to the correct basis for the distribution of the depreciation charge. Shall a fiscal period of arbitrary length be used as the basis for determination of the service life of the operating equipment? Or shall the life of inanimate equipment be measured in terms of units produced, service rendered, results achieved, just as human life and age may be measured in terms of intensity of thought and action? It is unfortunately true that once the depreciation charge is settled, this same charge is constantly applied with little adjustment to changing conditions. Thus, varying intensity of service is not reflected in the periodic charge.

The Factor of Idle Time

Were it possible to foretell length of service life in terms of units of product instead of units of time, a much better approximation to actual results would be secured. And this very thing is attempted under almost all methods of estimating depreciation. The life-period of the equipment is estimated on an assumption of average, normal use of the equipment—an assumption which will give good practical results when and so long as operations are normal or average. When, however, a period of depression comes and much of the equipment is idle, it is clear that that period would be burdened unduly with a depreciation charge based on years or months of service life. On the other hand, a period of feverish activity would not bear its just share of the burden of wasting assets. The period which is really overburdened must necessarily reflect it as an undervaluation of the assets—more has been charged off than has been used up; while the opposite is true of an underburdened period. Of course, on the theory of averages, by the end of the life-period of an asset all inequalities would be ironed out. Some methods of cost-keeping take this factor of intensity into account and spread the depreciation charge on a man-hour or machine-hour basis, which proportions it somewhat equitably to the product turned out by the use made of the machine and not to its elapsed life in days or months. The best that can be hoped for is as near an approximation to the truth as possible.

Depreciation a Means of Financing

Another view of the purpose of the depreciation charge is that it is a method or means of financing depreciation as it is sometimes termed. Under this view the effect of the depreciation charge on intermediate periods is lost sight of and it is used solely as a means of securing a sufficient contribution in hand at the end of the service life of the asset to finance its replacement. In other words, no attempt is made through the periodic depreciation charge to secure an accurate or necessarily true statement of the values of the assets, nor to see that the product of a given period is burdened with its just share of all costs, though this may be an incidental purpose. H. V. Hayes[27] in discussing this phase of depreciation says:

“It is argued that the plant unit ‘deteriorates’ year by year and that this ‘deterioration’ is the true measure of the ‘depreciation’ in the value of the unit during the intermediate years of its life, and, being a physical condition of the plant, can in no way be measured by the purely financial considerations upon which the reserves for depreciation necessarily must be based. Such a line of reasoning is absolutely faulty. Any attempt to reconcile ‘deterioration’ with ‘depreciation’ at any intermediate period in the life of the plant of an undertaking, is not only unnecessary but futile. The error in such an attempt arises from a failure ... to recognize the fact that ... if definite agreement has been reached as to the serviceable life (of the asset), the physical ‘deterioration’ of the unit, at any time during its life, can be a matter affecting its intrinsic value in no way whatever.”

Danger of the Financing Viewpoint

The above statement is a fair presentation of the case for depreciation as a financing device. It would seem, however, that the exponents of this view lose sight of the inevitable fact that the depreciation charge is pro tanto an evaluator of the wasting asset during the intermediate period of its life. Therefore a logical conclusion to be drawn from the view as expressed in the quotation above, would be the countenancing of any method by means of which provision could be made to replace the asset by the end of its life, no matter whether the charge was spread evenly over its life, was made all in one year, or was made to depend on the amount of the net profits at the end of a given year. This latter alternative is a dangerous policy, always to be deprecated, for depreciation is a cost of production to be taken account of before profits can be determined.

After all, it may be said without fear of serious contradiction that all three views, i.e., the engineering, the accounting, and the financing viewpoints, must be held in mind in any adequate treatment of the depreciation charge. The important point from the commercial and accounting standpoint is to secure a fair and equitable charge to each unit of product, regardless of whether or not the burdens of each fiscal period are equal. This is particularly evident when wear and tear from use is the effective factor in depreciation—and it is also contended that the factors of obsolescence and inadequacy may be as successfully and relevantly estimated in terms of business output as in years. If this results in an accurate valuation of the asset—and it is conceded that from the engineering viewpoint it may sometimes so result—the inaccuracy is of minor importance. According to the general law for the valuation of fixed assets, changes in the market need not and should not, as a general thing, affect the values at which the assets are carried on the books of a going concern. It is, of course, a corollary to the main proposition that this treatment also makes adequate provision for financing the fact of depreciation. Various methods and means for the accomplishment of these purposes are given in [Chapter IX].

The Standardization of Depreciation Rates

The determination of the rate of depreciation of a given asset is essentially an engineering problem. But as the accounting for depreciation is dependent on the rate, and the records of the accounting department must furnish much of the information for estimating the rate, the whole problem of fixing depreciation rates will be considered under the one head. Much study and effort to reduce all the conditions under which assets depreciate to a common basis and so to a definitely stated rate for each set of conditions, have, so far, come to naught and all qualified experts say without reserve that the rate of depreciation is an individual problem. It is to be hoped that a further gathering of statistics as to expectations of life of different assets under varying conditions will ultimately furnish tabulations, corresponding to insurance tables, according to which under known and expected conditions a fairly accurate rate of depreciation for a particular asset may be made. Unlike insurance rates, however, the depreciation rate once established will not necessarily remain constant, but must be subject to a periodic revision in the light of new data and conditions.

Effect of Local Conditions

Many factors enter into the rate of depreciation. They may be classed roughly as “stable or normal” factors and “contingent” factors. It should be constantly borne in mind that in the present state of the actuarial development of the subject, general rates, i.e., rates which will apply without readjustment, cannot be determined. For the determination of individual rates local conditions are always the controlling factor. An illustration in point is given by Henry Floy,[28] showing the varying rates used by thirty-one different concerns for the depreciation of their rolling stock equipment. The methods vary in almost every case, comprising annual charges of an arbitrary amount, per cent of the original cost, cents per car mile, arbitrary deductions from income irregularly applied, per cent of gross earnings, per cent of present estimated values. Reduced to a common basis, the per cent methods show a range of expected life varying between ten and one hundred years. While it is improbable that had the determination of the depreciation rate for the different concerns been in the hands of the same expert, there would have resulted these bewildering variations in method, still it does bring out in strong relief the fact, well recognized by experts but so often lost sight of by those unacquainted with the technical phases of the problem, that local conditions are a controlling factor; and that until local conditions can be somewhat standardized there is no hope of establishing rates of depreciation which will be of general application.

Factors in Determining Depreciation Rate

In the determination of rates the factors to be taken into account are:

1. Normal operating conditions.

2. Normal load or normal intensity of operation.

3. Normal repairs policy.

4. Normal climatic conditions.

These constitute the most important stable or normal factors. Among the contingent elements, the most important are:

5. Probable misuse and neglect brought about by the demands of the trade, resulting in a change in the factor of normal intensity.

6. Probable change in ownership and consequent change in policy.

7. Probable change in the requirements of the market, necessitating an adaptation of the equipment to uses for which it was not originally intended.

At the time of installation the rate of depreciation must be based only on the normal factors—things which can with reasonable certainty be counted on. At intermediate periods in the life of the asset, a physical inspection should be made to compare the actual depreciation of the property with the estimated. If, then, it is found that any contingent factors have become real or reached the point of reasonable expectancy, these provide the basis for an adjustment of the rate for the remaining life-term of the asset.

Basis of Normal Rate

With regard to the normal rate, the following items demand first consideration:

—all these being of greater or less effect, according to the time of daily usage and lack of periods of rest.”[29]

Policies as to Repairs

Without doubt the most important single factor in the determination of the depreciation rate is the normal policy as to repairs and maintenance. Physical deterioration is constantly at work. If this is counteracted by a liberal maintenance policy, not only is more efficient service secured but a longer service life is thereby insured. As soon as repairs are needed, although the efficiency of the asset may not be immediately impaired, the rate of deterioration is much accelerated unless the condition is corrected. Deterioration takes place day by day, but repairs obviously cannot be made at such short intervals—both because of the difficulty of detection and also because such a policy would not be economically practical. Every concern must consider its own peculiar problems and determine from these what shall constitute its normal repairs policy, and so far as possible this should be adhered to. The charges for repairs are bound to be of a more or less irregular character. Their handling is discussed on page 147.

Regardless of what the established policy as to repairs may be, conditions are sure to arise which make strict adherence to it impossible. There may occasionally be lack of funds at the time repairs are customarily attended to; it may be impossible to get the expert labor needed or the parts to replace worn-out units; or, and of oftenest occurrence, the need of repairs may coincide with a period of intense activity when the plant is being worked to its limit and in consequence there is no opportunity for making repairs. It is clear that rates based on one shift and the normal use of equipment during eight hours would be inadequate for three shifts and twenty-four hours of use; for in addition to a threefold intensity of operation this makes impossible adherence to the normal repairs policy based on an eight-hour schedule.

Depreciation Rate an Engineering Problem

From the above discussion it is apparent that the determination of rates is essentially an engineering problem. The accountant, however, needs a knowledge of the fundamental considerations and requirements of fixing depreciation rates and an appreciation of the difficulties of the problem. As Henry Floy[30] says: “What engineer is able to foretell the misuse and neglect or care and high degree of maintenance that any given apparatus or ... property as a whole will receive, even during the next five or ten years, with vicissitudes of climate, load conditions, changes of management, and requirements of the public?” On the other hand, in the opinion of another prominent engineer, “Consideration of these matters (misuse, neglect, etc.) may eventually form the basis for a systematic appraisal of the probabilities of life, or average of the risks, which would provide a method for the insurance of the life of machinery.”

The author does not attempt to discuss the relative merits of the two contentions other than to point out the fact that engineers are not discouraged in spite of the many contingencies and uncertainties inherent in the problem. They are constantly gathering data from which conclusions as to rates are being formed, the use of which is being compelled by regulating bodies. It is possible that the problem will ultimately be worked out on some kind of an insurance basis.

Attitude of Regulatory Bodies

At the present time the attitude of most regulatory bodies—public service boards, federal commissions, and tax officials—is well expressed by a regulation of the Public Utility Commission of New Jersey which says that, “Until otherwise prescribed, the amount estimated to be necessary to cover such wear and tear and obsolescence and inadequacy as have accrued during any month shall be based on a rule to be determined by the accounting corporation; such rule may be derived from a consideration of the said corporation’s history and experience. A general statement of the rule in use by each company, together with the general information upon which it is based, is to be filed with the Board of Public Utility Commissioners.” The trend at the present time is towards a more thorough supervision of depreciation rates on the part of many public service boards, and the future will undoubtedly see interesting developments.

Methods of Handling Repairs

Three distinct practices are met with in handling repairs and renewals on the books. The most general method is dictated by ease of application and rests on the theory of averages, viz.: that the amount of repairs annually recurring for depreciating equipment in all degrees of deterioration and all stages of decay and age is a fairly constant figure which secures an equitable distribution over the product of the different years. The larger the plant and the greater the variety of the equipment used, the more nearly does this work out as expected.

Further consideration will be given to this point in the discussion in [Chapter X] of the effect of the various methods used for calculating depreciation on the equality of the distribution of the charge.

Another method, used in plants where a very accurate determination of the costs of production is desired, has as an outstanding feature a preliminary estimate, made at the time of installation, of the expected amount of repairs needed during the entire life of the asset. Periodically this estimate, or proportional share thereof, is brought on the books as a charge to Repairs and credit to Reserve for Repairs and so is spread evenly over the service life of the asset. As repairs are actually made, the cost of these is not charged against operation but against the reserve created for that very purpose. At a given time, the status of the reserve account shows: (1) if the equipment has just been placed in a normal state of repair, the under-or over-estimate of the amount of actual repairs needed, or (2) if the equipment is not in repair, the reserve account gives an index of the probable amount of deferred maintenance. Both items of information are of value in the proper management of properties. It is to be expected, of course, that during the early years of the life of an asset there will be a fairly large credit balance in the reserve because repair charges are light. The credit balance so accumulated will be needed during the later years when the costs of maintenance become heavier.

The third method, which is a variation of the second, has as its characteristic feature the inclusion of the repairs cost with the depreciation charge. This likewise necessitates a preliminary estimate of the amount of expected repairs during the life of the asset. Instead of being handled separately, it is added to the depreciation rate and in this way charged against the product. This method has been prescribed in the case of some utilities in England but is not much used here. Under this method two depreciation estimates of probable life are necessary, viz.: (1) maximum life brought about by an inclusion of repairs, renewals, etc., and (2) minimum life without such repairs. By this it is not meant that other methods of calculating the depreciation rates fail to take cognizance of the repairs factor, but that this method specifically calls attention to it and includes it in the charge made. It seems best for regulatory boards to make a separate book record of repairs and depreciation, thus insuring against any oversight of the factors of depreciation and also insuring the correctness of a statement of condition.

CHAPTER IX
DEPRECIATION—METHODS OF
CALCULATING

Methods of Calculation

Many methods of reckoning depreciation have been devised; some good, some bad, and some too theoretical and involved ever to serve the practical needs of business. It is proposed here to explain those methods which have found most favor and, in Chapter X, to discuss their effects from the standpoint of the true purpose of any scheme of depreciation.

There are several ways in which the depreciation calculation can be made, and the methods may be classified broadly, though with some overlapping, under four heads. These classes are:

Factors of Calculation

The factors which must be known under most methods of calculation are:

By original cost is meant full cost of the asset in position ready for use. By scrap value is meant the estimated value of the asset at the time of its discard, when removed from position and ready for sale or other mode of disposal. This is sometimes called its salvage value as distinguished from its value while still in position to render service but awaiting discard or break-up. By estimated service life is meant the time during which the asset will be used for service. This may be expressed in ordinary units of calendar time, such as the year; or in units of service time, such as working hours; or finally in units of output, such as tons, cubic feet, kilowatt hours, etc.

Symbols to be Used

For purposes of notation and reference the following symbols will be used:

It should be noted that the foregoing factors are all estimates, with the exception of original cost, and that when making these estimates the principles of depreciation as discussed in preceding chapters must be taken into consideration. Thus, a decision must be made as to whether physical or functional depreciation is the controlling factor in determining service life. In the determination of service life, the policy as to repairs, renewals, and maintenance has a very important bearing. In fixing the scrap value, the relation of inadequacy, obsolescence, wear and tear, and age to the values remaining in the asset must be considered.