| Royalties Income | |||
| 1916 | 1917 | ||
| Dec. 31 Accr. | $5,000.00 | $35,000.00 | |
| 1917 | Dec. 31 Accr. | 5,250.00 | |
| Dec. 31 P. & I. | 35,250.00 | ||
| $40,250.00 | $40,250.00 | ||
| 1918 | |||
| Jan. 1 Accr. | $5,250.00 | ||
An objection, not at all serious, is that under this last method the ledger will show, as on the date of the balance sheet, the current assets in two places, viz., the current assets section and the income section, instead of altogether as under the other methods. This objection is more than offset by the saving in clerical labor. There is in some quarters an all too prevalent tendency to multiply the number of accounts and increase the bookkeeper’s work without any adequate return in results.
Prepaid Items—Definitions and Kinds
Closely related to current assets, because through an overexpenditure of current funds this period a lesser expenditure will be required next period, is the class of items known as prepaid expenses or deferred charges to operation. These items are not current in the sense that they will be turned into cash shortly, but they are analogous in that a saving in the expenditures of the next period will result. Because of the ease with which they may be put to improper uses, it is best to segregate them from current assets under a suitable balance sheet caption, such as “Deferred Charges to Operation.” Where the two captions, Current and Working Assets, are shown, items of this class properly belong to the latter. Under this head will be considered such items as supplies of all sorts—office, factory, power house, stable—stationery, printing, postage, repair parts, insurance unexpired, advertising contracts and material, rent, royalties, interest and discounts paid in advance, salary overdrafts, premiums on long-term investments and discounts of long-term obligations, and sometimes organization expense, although this last item is perhaps best handled with the intangible assets.
Valuation of Prepaid Items
The purpose in considering these items at the close of a fiscal period is to secure a proper and accurate allocation of charges as between the two periods, without which true results as to profit and loss are not possible. The same argument as to these items averaging up fairly well between periods applies here as for accrued income. The only other point to be considered in connection with them is the basis for their valuation. Realizable values, i.e., what the items would bring under the hammer or at other forced sale, are manifestly inequitable. A three-year insurance policy with one year expired is to a concern which intends to avail itself of the remaining two years’ protection worth more than the surrender value of the policy calculated on the short-rate basis with perhaps the expenses of doing business also subtracted by the insurance company. Evidently to a going concern the protection enjoyed for the year just expired is worth neither more nor less than a pro rata share of the entire cost, nor are the remaining two years’ protection to be valued at a less rate because redeemable at a less rate.
Hence, a valuation based on the going concern principle is to be used for deferred charges. As indicated above, this means, when used in this connection, a pro rata valuation based on the life of the supply and the portion unused. In the case of tangible supplies the rule can be most easily applied as a unit cost figure to the unused units still on hand. That is, an inventory of supplies is taken and valued at full cost. Although nearly related to current assets, deferred charges are seldom influenced by market fluctuations after they are once purchased, because if properly classed as deferred charges they are always held for own use and never for outside sale.
Danger of Overvaluation
Care must always be exercised—even more than in handling the stock-in-trade inventory—to see that there is no padding of this class of items. To this end, before taking inventory, a general clean-up of supply materials all over the plant is an exceedingly good policy. This should result in discarding, or reducing to scrap value, all obsolete and unusable supplies. Without such a clean-up it is easy, even when motives are of the very best, to carry forward from year to year as assets supply materials which will never be used and which are therefore nothing but expense items and should be charged against operation. Only a careful periodic appraisal of supply materials and an equally careful inventory indicating their usability can give a correct basis for applying the valuation formula.
Two or three items of deferred charges need a word of further explanation. In some mining industries, notably coal and precious metals, leasing is done on a royalty basis with a minimum amount to be paid each period based on a minimum production of ore to be mined. If less than the minimum is mined, a frequent provision in the terms of the lease makes possible the application of any royalties overpaid one period against a future production of more than the required minimum. That is, no increased royalties are charged for a production over the minimum until all accumulated royalties from periods of underproduction are used up. In any period of underproduction such royalties may properly be treated as deferred charges only on condition that there is reasonable expectation that future production will increase to the point where it will consume the overpaid royalties of earlier periods. At times a company finds itself bound to such a contract, based on a minimum production, without any hope of relief because the prospect has not developed as anticipated. Under such conditions the entire periodical royalty charge is a charge against operation and must be absorbed entirely by the operations of each fiscal period.