Accounting theory and practice, Volume 1 (of 3)

by Roy B. Kester

It might sometimes appear that all these operating costs—the kind shown in the profit and loss statement—also add to the value of the assets of the business. Such is not the case. In a mercantile concern, business is conducted for the purpose of selling merchandise. Profit arises through the purchase of merchandise at one price and its sale at a price sufficiently higher to pay for all operating expenses and leave a margin. The cost of merchandise to the customer reimburses the proprietor for his original outlay in merchandise and for a fair portion of the operating expenses incident to the maintenance of the store. The customer is willing to pay this additional amount because it is cheaper for him to pay the merchant a margin over the cost of the merchandise sufficient to induce the merchant to conduct a market for merchandise, than to undergo the necessary expenditures—of time, expense, and inconvenience—entailed in making the purchase from the original vendor.

The economic organization of business is based on this hypothesis. In the management of a business there is a very large element of risk. The sale price of commodities at a given time is not always determined on the basis of the original cost of the commodity plus the costs of maintaining a store for its sale. Competition sometimes enters in to drive the price down below this amount. While every merchant expects in the long run to receive from the sale of his merchandise not only what he himself has paid for it but also the cost of conducting his store and a fair margin of profit, for a given period and for a given item of merchandise he may not be so fortunate.

In recording business transactions, therefore, prudence demands that the costs of operating the business be not recorded as increases in the value of the merchandise dealt in, but rather that they be set up separately and charged against the income received from the sale of the merchandise before the increase (or decrease) in the value of the assets is determined and made a part of the asset record. As merchandise is converted into cash the amount received is recorded as an increase in the asset cash. This cash includes the original cost of the merchandise plus some of the costs of operating the business. These are costs which must be incurred and they add value to the business as indicated by the willingness of the customer to pay the merchant for them. Because the added value is problematical at the time the costs are incurred, they are recorded as expenditures which must be made good out of the sale of the merchandise at a sufficiently enhanced price to cover them, i.e., they are expenses which are to be treated as deductions from sales income.

The net difference between the income and the cost of securing the income, as indicated by the expense accounts, will represent the value added to the assets of the business, and will therefore be reflected tangibly in an increase in the value of the assets by that amount. This increase will usually be reflected either in the cash holdings or in claims against customers.

It may not be out of place at this point to call attention to the fact that, as the bookkeeping record is usually handled, the only relationship between asset increases, liability decreases, and expenses (proprietorship decreases) arises from the fact that all of them are debits and are so placed because of the mathematics of the fundamental equation on which double entry rests. Assets, liabilities, and proprietorship are three distinct and separate groups of accounts related only by the logic of the proprietorship equation. As the subject of accounting is developed the student will see the increasing importance of drawing sharply the lines of division among these groups and he will see also the difficulty at times of maintaining this distinction.

CHAPTER XIII
DEBIT AND CREDIT AS APPLIED
TO MIXED ACCOUNTS

Mixed Accounts Defined.—In the course of business operations certain accounts which at the beginning of the period belong definitely to some one of the three groups, asset, liability, and proprietorship, with the progress of the period take on a mixed character. That is, included under one account title there is a mixed record of asset and expense, or other combination of two or more groups. For example, the machinery which belongs to the asset group at the beginning of the period depreciates in value day by day, both through use and the lapse of time. This daily decrease in value is of slight amount and in the management of the business it is not necessary that it be shown on the books. While it is theoretically possible to record this daily loss, practically nothing would be gained by so doing. Hence, the machinery account is allowed to carry both the asset value of the machinery at a given time and the amount of its depreciation. Only periodically, usually at the close of each fiscal period, is the account separated into its two parts, the one which shows the true asset value and the other which indicates the amount of depreciation and which is therefore the expense or proprietorship-decrease portion of the account.

In the previous chapter the way in which the Merchandise account takes on a mixed character was briefly explained. It was shown that the credit side reflected both a decrease of the asset and an increase of the proprietorship by the amount of the gross profit on the goods sold. Thus, because of the way in which accounts are kept practically, as distinguished from a theoretically correct method, which would maintain at all times a sharp line of division between assets, liabilities, and proprietorship, certain accounts are allowed to become mixed. It is the purpose of this chapter to discuss the proper handling of the more common mixed accounts.

Analysis of a Sale Transaction.—The impracticability of immediately separating each sale of goods into its two elements of cost and profit and the taking of a physical inventory as a means to this end, was discussed in [Chapter VI]. The necessity for this later separation may be made clear by analyzing a sale transaction.

Suppose an article costing $10 is sold for $12. At the time of its purchase a debit was made to Merchandise account and a credit, say, to Cash. When the article is sold, it would seem that the credit should be to Merchandise to show the decrease in that asset. However, in the sale price of $12 is included something more than the amount by which the stock of merchandise is decreased. This additional amount is the profit of $2. Hence, a credit to Merchandise of $12 would result in too large a subtraction from the asset Merchandise, if it is intended that the Merchandise account shall always show by its balance the value of the unsold stock. Theoretically the best method of entering this sale would be to debit Cash for $12, and to credit Merchandise with $10 and Profit with $2.