Underlying Theory in the Adjustment of Merchandise Records.—Careful analysis and study of the adjustment of the merchandise records should be made in order to see the way in which the logic of the trading section of the profit and loss statement is worked out in the ledger. The record of the merchandise asset should be kept, in strict theory, in the same way as that of every other asset, namely, the accounts should be charged with the full cost of the asset and credited at cost price with the portion sold, the profit or loss on the sale being carried in a separate account. The balance of the Merchandise account would then show the value of the asset merchandise on hand at any time.
Theory, however, gives way to the practical difficulties of handling the account in this way. Therefore, periodically the mixture of asset decreases and income increases brought about through this practical method of handling merchandise records must be corrected, or “unmixed,” so that these elements will appear separately. The Purchases account, after the opening inventory, the inward freight, and the purchase returns, rebates, and allowances are transferred to it, gives the net total of the merchandise asset for the period. This net total represents two things: (1) merchandise still on hand, and (2) merchandise sold. By way of adjusting the records, the goods on hand, as shown by the physical inventory, are separated from the total and put into the Merchandise Inventory account, which shows by its title that it is an asset. That leaves in the Purchases account the cost of goods sold. The credits which should indicate the decrease in the asset, equal to the cost of goods sold, are found in the net merchandise sales, as shown by the Sales account after transferring to it the sales returns, rebates, and allowances. But these credits are here mixed with the gross profit. The portion of the net sales representing the cost of sales of merchandise should now, in strict theory, be transferred from the Sales account to the Purchases account. This transfer would effect the balancing of the Purchases account, indicating that there are no merchandise asset values in that account, these having been transferred to the Merchandise Inventory account. The result of this theoretically correct procedure would be to bring about a segregation of the merchandise records into their two elements, the asset element as shown by the Merchandise Inventory account and the income element as shown by the remaining balance in the Sales account.
Once again, however, strict theory gives place to the more practical need of requiring the accounts to give full information for management purposes. Accordingly, instead of handling them in the way just indicated, the adjustment procedure explained on [pages 118 to 120] is followed.
Handling Depreciation of Fixed Assets.—As shown in [Chapter XIII], the method of handling depreciation of assets consists of nothing more than separating the expense element from the asset element, both of which are carried currently under the title of the asset. For reasons explained in [Chapter XIII], the credit to the asset which effects the separation is not recorded in the asset account but in a supplementary account entitled “Depreciation Reserve” for the particular asset. This reserve account is an integral part of the asset record and must always be considered in connection with the asset account in determining the value of the asset. The credit entry in the reserve account is a sort of suspended credit, recorded there temporarily for purposes of information. The offsetting debit to this credit is made in the expense account Depreciation.
The adjustment entry thus effects a separation of the asset account into the two elements, (1) present value of the asset as shown by the asset account and its depreciation reserve account, and (2) the expense element recorded under the Depreciation expense account. The following illustration indicates the bookkeeping procedure:
| Furniture and Fixtures | |||
| 19— | |||
| Jan. 1 | 750.00 | ||
| Depreciation Reserve Furniture and Fixtures | |||
| 19— | |||
| June 30 (A) | 75.00 | ||
| Depreciation | |||
| 19— | 19— | ||
| June 30 (A) | 75.00 | June 30 Profit & Loss (B) | 75.00 |
| Profit and Loss | |||
| 19— | |||
| June 30 Depreciation (B) | 75.00 | ||
The asset Furniture and Fixtures, valued at $750 at the beginning of the year, is estimated by appraisal to have depreciated 10%, or $75, during the half-year. This cost or expense is charged to an account called Depreciation, and credited not to Furniture and Fixtures, but to the valuation account “Depreciation Reserve Furniture and Fixtures.” The Furniture and Fixtures account and its valuation account, taken together, show the appraisal value of $675. Thus the credit adjusting entry is made to record a decrease in asset values. The Depreciation account, carrying the debit of $75, is an expense account and is closed into Profit and Loss, just as any other expense account is closed.
The Estimate for Doubtful Accounts.—At the close of a fiscal period, when an accurate statement of the financial condition of the business is to be drawn up, all assets must be very carefully valued. The bookkeeping procedure necessary to show the correct value of fixed assets subject to depreciation has been explained. The outstanding claims against customers also require evaluation. Every business man knows from past experience that he will be unable to collect all of his outstanding accounts. He may not know which of the accounts will prove uncollectible, but he does know that there will be a loss in the sum total of these claims against customers. The amount of this estimate is based on past experience in each business.
A standard basis for the estimate is not possible because in some businesses credit is extended much more carefully than in other businesses and in some collections are followed up more vigorously than in others. In making the estimate two methods are used, one being a certain percentage of the outstanding accounts, the other being a certain percentage of the sales made during the period. Where experience shows the necessity, the loss from both outstanding accounts and notes receivable is provided for.
The same bookkeeping procedure is used here as with the estimate of depreciation. An expense account, usually entitled “Bad Debts,” is debited, and an account called “Reserve for Doubtful Accounts” is credited for the amount of the estimated loss. The effect of the entry is to separate the claims against customers into their two elements, namely, the true asset element, represented by the difference between the asset account and its valuation reserve account, and the expense element as indicated by the Bad Debts account.