Accounting theory and practice, Volume 1 (of 3)

by Roy B. Kester

Kinds of Value.—It is first necessary to state the limitations within which the principles of valuation to be laid down are applicable to the commercial balance sheet. In business many different kinds of value are found and used. Thus we have the terms, sale or liquidation value, cost value, and replacement value. By the term “sale value,” when applied to a going business, is meant the value which a willing buyer offers to a willing seller. “Liquidation value” means the value or price offered for a commodity or an entire business when the concern is winding up its affairs and going out of business. Liquidation is, therefore, forced value. There is thus a marked difference between sale value and liquidation value. The term “cost value” is understood to mean the price paid for a purchased article. From the discussion of the principles of debit and credit as applied to merchandise and to fixed assets, it has been shown that the price paid should include not alone the invoice cost but the other expenditures needed to put the article purchased in such a position that it can be used by the business in the customary way. Replacement value means the cost to replace an article. It differs from first cost mainly in that the price level may have changed between the date of the original purchase and the present time. Thus, because of the changes in prices, an article, costing $1,000 in 1914, might have had a replacement cost of $1,800 in 1917, and $1,400 in 1922.

Manifestly, before the principles to be followed in valuing balance sheet items can be laid down, there must be some understanding as to what kind of value is under discussion. The kind of value used in the ordinary commercial balance sheet is termed “going concern value.” By this is meant the value which is applied to a going business—a business which expects to continue in operation, not one which expects to sell out to other owners nor one which expects to discontinue operations.

Source of Data as to Values.—In a going concern the information as to value is found chiefly in the books of account. The data in the accounting records are, of course, supported by the original documents evidencing the purchases and sales. It is a necessary corollary that if the books of account are to give reliable information as to values, a correct analysis must be made of all transactions previous to their entry. Mention was made in an earlier chapter of the necessity of a clear differentiation between capital and revenue charges and the effect of failure to make such differentiation. If at the time of an expenditure a correct classification of accounts has been made, particularly of the broad classes of assets, liabilities, and proprietorship, the accounts should reflect the true values as of the various dates of record. For purposes of detailed information it is equally necessary that a correct classification be made of the accounts affected by an entry within any of these main groups. It has been seen that because of practical difficulties no effort is made to have the accounts reflect day by day the correct value of the various items. It is considered sufficient to bring the book record into agreement with the facts in respect to value once each fiscal period, namely, at its close. The true financial condition and correct operating results are then determined.

It will thus be seen that a correct analysis of every transaction recorded in the accounts is an absolute prerequisite to the use of the accounts for determining correct values. It is very vital that a clear line of demarcation be maintained between capital and revenue expenditures—that great care be exercised that no cost is charged into the asset group of accounts unless such cost really enhances the worth of an asset. A cost incurred for the purpose of maintaining the value of the asset is an expense charge, and repairs and maintenance charges must be very carefully distinguished from replacements. Maintenance has to do with those costs which maintain an asset in good operating condition; repairs have to do with those costs necessary to put an asset in operating condition after a condition of inefficiency has been reached which the maintenance costs have not been able to prevent; a replacement cost is incurred when it becomes necessary to replace some part or the whole of an asset, neither maintenance cost nor repair costs having been able to maintain the asset in efficient operating condition. Where only a part of an asset is to be replaced, it is often spoken of as a renewal of parts. When so used, the term “replacement” is limited to the renewal or the replacement of the whole asset.

When a renewal or replacement is made, it becomes necessary to determine whether the cost of the renewal or replacement is more than the cost of the part or the whole replaced. For example, if an asset costing originally $1,000 is replaced by one costing $1,200, there has manifestly been an addition of $200 to the value of the asset. The new asset may be an exact duplicate of the old but if prices have risen so that the new actually costs more than the old, the books must record the asset at its new cost value. The amount by which a new asset or part of an asset exceeds the cost of the old asset or old part is called a betterment. A betterment is always an asset.

The student will readily see that at times it must be difficult to draw the line between repairs and replacements. In practice the line is usually drawn only when the expenditure exceeds a certain amount. This amount is not uniform and is determined by each individual business. For example, when the cost of placing the asset in efficient condition for operation is less than, say, $100, it is charged as repair cost and therefore does not increase the book value of the asset. If the cost exceeds $100, an analysis is made to determine what portion of it, if any, increases the value of the asset. The amount of the betterment is of course a charge to the asset account, while the rest of it is a charge to some expense account.

Treatment of Special Items.—In the determination of the classification of charges, some kinds of items require special consideration:

Organization Expense. The group of expenditures explained in [Chapter XXXVIII], as incident to the organization of a corporation, is recorded under the title “Organization Expenses” and is classified for purposes of the balance sheet as an asset. It is a kind of asset, however, which has no tangible value and most businesses desire to consider it more in the nature of a deferred charge to operations. It is recognized that frequently intangible assets add no strength to the business. While, therefore, in strict theory organization expenses are assets, in practice it is best to write them off against income during a period of from three to five years.

Cost-Cutting Changes. Another similar class of charges is met in costs incurred in making changes in the arrangement of building and other facilities which will tend to bring about a more economical handling of some phases of the business; for example, a rearrangement of a receiving and packing room in order to facilitate the receipt and delivery of goods. Where these costs are inconsiderable it is best to charge them against the income of the period in which they are incurred. Where, however, a big expenditure is necessary, it seems best to set the costs up under a suitable descriptive title and spread them over several periods. In other words, at the date of their incurrence the costs are treated as an asset whose value is to be written down at the end of successive fiscal periods until finally it has all been charged against the operations of the business.

Interest During Construction Period. Where a business builds its own home, all costs incurred during the period of construction are proper charges to the costs of the construction. Thus, if a mortgage or bond issue is used as a means of partially financing construction of the building, the interest paid to the mortgagee or bondholders during the period of construction is a proper charge to the building account. Costs of this kind follow the general principle laid down previously, that all costs up to the point of placing the asset in condition ready for use are proper charges to the asset.