The adjustments to be made in such cases comprise not only the most obvious ones, caused by the oversight of accruals and deferred items of various sorts, changes in inventory valuations due to an incorrect inclusion or exclusion of some items, etc., but also changes in those items which in the light of a longer experience are shown to be inaccurate. This latter class of adjustments embraces particularly the estimated items the amounts of which are not definitely determinable. As time passes, more complete knowledge may indicate insufficient or excessive estimates of such items as depreciation, bad debts, provision for contingent liabilities, and similar reserve items, the valuation of which must be corrected for an accurate showing of earning capacity. Thus a distinction must be made between summaries compiled to show the current profit and loss results and those which give a true index of earning capacity over a longer period.
Interest as a Cost of Manufacture
A controversial point with a bearing on the profit and loss summary is whether or not interest on invested capital should be included as an item of manufacturing cost. One school of thought on the subject maintains, with a considerable degree of argumentative warmth, that interest should be included; while another school takes the opposite point of view. An attempt will here be made to summarize the arguments for and against the treatment of interest as an item of manufacturing cost. The one school bases its main contention on the economic theory of profits; namely, that profits represent the balance remaining after deducting the cost of land, capital, and labor. The function of the entrepreneur, it is contended, does not in itself involve the owning of capital. Profit is the reward for combining the other factors of production and assuming the risk involved. Interest is a cost for the use of capital and it does not matter who owns the capital.
It is further contended that, in order to bring a fair return on the capital invested, the selling price must include interest on capital investment. While this contention is true, the fact remains that no manufacturer would think of fixing selling price as a matter of general policy at a figure which would not return a fair rate of interest on his investment. But why that necessitates taking into the books interest as an element of cost is not explained by this theory.
It is also argued that to determine whether it is better to manufacture or to buy goods in the open market, and whether it is better policy to manufacture by means of expensive machinery and other equipment or by manual labor, interest on investment must be considered. While these arguments also are well taken, they again offer no satisfactory justification for the showing of interest on the books. It is furthermore contended that the cost of carrying the inventories for which the purchasing, stores, and planning departments of a manufacturing concern are responsible, should be shown with interest on the money invested in them taken into consideration—this for the purpose of providing a check on the efficiency of these departments. Where also both old and new machinery is used side by side and it is desirable to compare their costs of production, the element of interest should be considered.
Further argument for the inclusion of interest as an item of cost is the fact that in numerous processes time is an important element. Thus, the smelting of ore, the tanning of leather, the curing of tobacco, the seasoning of lumber, etc., are examples of relatively lengthy processes the cost of which should include interest on the capital invested. Interest on investment is also a factor that may sometimes determine manufacturing and selling policies, especially during slack periods when production is curtailed, part of the plant stands idle, and the fixed charges on the unused manufacturing capacity need to be taken into consideration. The same argument also applies to the accumulation of a large inventory of raw materials or finished stock during a period of low prices. The soundness of such a policy can only be judged when the item of interest on the capital investment is considered.
Arguments against the Inclusion of Interest
The majority of accountants are, however, opposed to the inclusion of interest as an item of manufacturing cost. The chief objections raised to its inclusion are:
1. The difficulty of determining the rate at which interest should be charged.
2. Inasmuch as the amount of investment in current assets is difficult to determine since it fluctuates daily, is interest to be charged both on fixed investment and on current investment, or only on the fixed?