Basic Rules for Valuation of Balance Sheet Groups.—We may now consider the principles applicable to the valuation of the various groups on the balance sheet. In the standard form of balance sheet the assets are divided into the three groups: (1) Current, (2) Deferred Charges, and (3) Fixed.

It has been seen that the assets of the current group are used for purposes of settling debts, the payment of expenses, and the purchase of merchandise. In judging the sufficiency of these assets for this purpose, it is absolutely essential to know that the values at which they are carried will be realized when they are converted into cash. From the standpoint of conservative business management an understatement of realizable value may be made, but never an overstatement. Accordingly, the fundamental principle of valuation applicable to this group is that these assets are to be valued at cost or market, whichever is the lower. When so valued, the figures at which they are carried in the balance sheet will usually represent an amount slightly less than the amount which it is expected will be realized from their conversion into cash.

The function of the deferred charges group of assets is to secure an equitable distribution of expense charges between the current and the following period. It is only because certain expenditures have been made during the current period which will benefit the succeeding period, that it is necessary to set up this group of assets. Here the problem of valuation is, therefore, simply the problem of dividing the cost of the expenditures between the current and the next period on the basis of the benefits accruing to each. In some cases the basis of division is one of time, as where an insurance policy is purchased for a definite term. The portion of the policy which has expired during the current period is the portion of its cost to be charged to the current period, the balance being deferred to succeeding periods and therefore carried as an asset. In other cases a physical inventory is necessary to determine the distribution of the cost of expenditures, as when supplies of fuel have been purchased and not entirely consumed during the current period. The basis of the value carried over to the next period is of course a fair portion of the original cost. Market or replacement cost does not have any effect on the valuation of the deferred portion.

Fixed assets are acquired as more or less permanent equipment without which it is impossible to operate the business. The time during which an asset continues in use is the customary basis for a classification of its cost as between expenses and fixed assets. Thus, an asset acquired for purposes of business operation which, however, will be used up completely during the current period is charged immediately to some expense account, whereas an asset which will continue in use over several periods is charged to an asset account. Fixed asset purchases are never for purposes of resale. It is expected that they will continue in use until they are discarded because of failure to perform the service for which they were acquired. Neither the sale value nor the replacement cost value of such assets has, therefore, any influence on their value to the business. That value is the full cost adjusted periodically by an equitable distribution of that cost over the operations of the periods benefited by the services rendered by the asset. This principle of valuation is usually expressed by the formula, cost less depreciation.

Valuation of Assets

Cash. Cash as carried on the balance sheet is the asset which is used, without conversion, for payment of the liabilities of the business. There should, therefore, ordinarily be no problem of valuation. However, because of the practice of including checks, drafts and notes due and in course of collection, cash balances held abroad and therefore subject to the fluctuations of exchange, and other similar items in the account Cash, it is oftentimes necessary to examine all these items carefully and arrive at a figure which represents the amount expected to be realized from them.

Notes and Accounts Receivable. The claims against customers, both on note and open accounts, constitute an intermediate step in the conversion of merchandise into cash. At the time credit is extended to a customer it is expected that he will pay the amount due. The experience of every business man shows, however, that during each period there is a shrinkage in these claims due to some customers failing to pay the amounts they owe. In valuing these claims it is therefore necessary to take cognizance of the amount of the shrinkage. This amount is different in different businesses, depending on the length of the credit term, the policy as to investigation of credit risks, and on the rigor of the collections policy. On the basis of the experience within a given business, it is therefore necessary to make an estimate of the loss from uncollectible accounts.

The manner of making the record of estimated bad debts has already been explained. The reason for placing the amount by which the asset is estimated to shrink as a credit in the Reserve for Doubtful Accounts account rather than in the Accounts Receivable account has also been explained. The custom of estimating the amount of loss on the basis of the sales for the period rather than on the amount of claims outstanding at the close of the fiscal period has been referred to. Here it is desired to explain the manner of handling the reserve at the time claims are definitely determined uncollectible. Until a claim is determined uncollectible it is carried as a part of the assets, Notes or Accounts Receivable. The amount of the estimated shrinkage in these assets due to failure to collect claims is indicated by the Reserve for Doubtful Accounts account. This amount cannot be applied directly to particular notes and accounts until it is definitely known that such notes and accounts cannot be collected. When that is learned, it is necessary to transfer from the reserve account the amount needed to cancel from the books the uncollectible notes and accounts receivable. This is done by the following entry:

Problem. Assume that the accounts receivable amount to $75,000, of which it is estimated that $5,000 will not be collectible. During the succeeding period a customer owing $500 becomes bankrupt and nothing is realized on his account.