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McGRAW-HILL ACCOUNTING SERIES 
F. H. ELWELL, CONSULTING EDITOB 



ACCOUNTING FUNDAMENTALS 



The quality of the materials used in the manufacture 
of this book is governed by continued postwar shortages. 



McGEAW-HILL ACCOUNTING SERIES 

F. H. ELWELL, Consulting Editor 



Blocker Cost Accounting 

Blocker Essentials of Cost Accounting 

Coleman- Elements of Accounting 

Foulke Practical Financial Statement Analysis 

Grecr and Wilcox Problems in Cost Accounting 

MacFarland and Ayars Accounting Fundamen- 
tals 

Ten/for and MilkrC.'PA. Problems and Ques- 
tions in Theory and Auditing 

Taylor and Miller Solutions to C.P.A. Problems 
Taylor and M i7kr Intermediate Accounting 



ACCOUNTING 
FUNDAMENTALS 



BT 

GEORGE A. MAcFARLAND 

Professor of Accounting, Wharton School of Finance 
and Commerce, University of Pennsylvania 

AND 

ROBERT D. AYARS 

Professor of Accounting, School of Business 
Administration, University of Pittsburgh 



SECOND EDITION 
SECOND IMPRESSION 



McGRAW-HILL BOOK COMPANY, INC. 

NEW YORK AND LONDON 
1947 



ACCOUNTING FUNDAMENTALS 

COPYRIGHT, 1936, 1047, BY THE 
MCGRAW-HILL BOOK COMPANY, INC. 



PRINTED IN THE UNITED STATES OF AMERICA 

All rights reserved. This book, or 

parts thereof, may not be reproduced 

in any form without permission of 

the publishers. 



THE MAPLE PBESS- COMPANY, YORK, PA. 



PREFACE 

This text undertakes to provide a first-year course in account- 
ing, with accepted principles of accounting arranged in an 
orderly fashion to capture the student'sRalferesif to lio'ld it, and 
to anticipate his difficulties so that unnecessary questions are 
avoided. The authors have a combined teaching experience of 
more than sixty years, including primarily students in the school 
of business but also students registered in the colleges of liberal 
arts, education, and engineering, in addition to thousands in 
evening classes. From these students they have learned the 
necessity of defining each new term and also the sequence in 
'which statements must be made in order to explain each new 
principle. 

The second edition of "Accounting Fundamentals" follows the 
outline of the earlier edition because experience has proved the 
original pattern to be both sound in theory and teachable. 
Additional illustrative material has been added to many chapters 
to strengthen and clarify the presentation, particularly in con- 
nection with such subjects as analysis of proprietorship, adjust- 
ments, bad debts, depreciation, corporations and payroll. 
Certain subjects, such as adjustments, readjustments, and bonds, 
have been summarized to crystallize student thinking. The 
problem material for the thirty chapters is entirely new, 
and several cases are provided for some topics, so that courses 
with a number of sections may have different figures for each 
group. The revised text contains six practice sets, which may 
or may not be used, at the discretion of the instructor. Practice 
Sets l-A and 1-JS are included after the problems for Chapter 
XIII. They offer a choice of practice material to review the 
subject matter to the end of that chapter. Practice Sets 2-A 
and 2-B are included after the problems for Chapter XIX. 
These two sets involve the use of subsidiary ledgers, controlling 
accounts, and columnar journals. Practice Sets 2-A and 2-JS 
are continuations of Sets l-A and 1-U, but either set 2-A or 2-5 
may be used, even though its corresponding previous set is not 



vi PREFACE 

used. Practice Set 3-A or 3-B requires the use of the voucher 
system and is concerned with a manufacturing enterprise. 
These two sets appear after the problems for Chapter XXIX. 

Special forms on which to prepare solutions to the problems and 
practice sets may be obtained from the publishers of this text, 
but almost all the problem solutions may be presented on 
standard journal, ledger, statement, or work-sheet paper. 

The authors wish to thank their colleagues for their friendly 
ad vie i and to express their sincere appreciation to Mr. Frank 
N. Willetts, instructor in accounting at the University of Pitts- 
burgh, for the excellent and exacting assistance he gave in the 
textual changes, the problems and practice sets, and the solu- 
tions. The last word of appreciation is due our students of 
recent years for their frank comments on the first edition of 
this book. Their reactions influenced the preparation of the 
revised manuscript. 

GEORGE A. MACFARLAND. 
ROBERT D. AVARS. 
PHILADELPHIA, PA., 
PITTSBURGH, PA., 
January, 1947. 



CONTENTS 



PAGE 

PREFACE v 



PROBLEMS xv 

CHAPTER I 
ACCOUNTING ITS SIGNIFICANCE 1 



Accounting defined. The enterprise. Nonprofit enterprise. 
Recording. Presenting. Interpreting. Necessity of account- 
ing. Accounting and the modern business era. Persons interested 
in accounting disclosures. The practice of accounting. Spe- 
cial divisions of accounting practice. Accounting in a business 
curriculum. 

CHAPTER II 
THE BALANCE SHEET 11 

Basic terms defined. Fundamental accounting equation. The 
balance sheet is a more detailed expression of the fundamental 
equation. Subdivisions of assets, liabilities, and proprietorship. 
The order of listing assets and liabilities. Object and use of a 
balance sheet. Form. 

CHAPTER III 
ANALYSIS OF PROPRIETORSHIP 24 

Fiscal period. Comparison of proprietorship. Balance sheet 
changes. Factors that increase proprietorship. Factors that 
decrease proprietorship. Net increase or decrease in proprietor- 
ship analyzed. Analysis of proprietorship. Solution by equa- 
tions. Significance of the chapter. 

CHAPTER IV 
THE STATEMENT OF PROFIT AND Loss 35 

Purposes of the statement of profit and loss. Income and expenses. 
Cash and accrual methods of accounting. Illustration of simple 
statement of profit and loss. Profit and loss statement termi- 
nology. Form. Dual procedure to compute net profit or loss. 
Complements the balance sheet. 

vii 



viii CONTENTS 

FAGB 

CHAPTER V 

ACCOUNTS THEIR CONSTRUCTION 50 

Definition of an account. Purpose of accounts. The ledger. 
Basic classes of accounts. Captions or account titles. Form 
and content. Relationship between the balance sheet and real 
accounts. Debit and credit schedule for real accounts. The 
construction of nominal accounts. Debit and credit schehule 
for real and nominal accounts. Forwarding account totals. 

CHAPTER VI 

ACCOUNTS THEIR OPERATION 62 

Transaction. Transactions classified. Double-entry bookkeep- 
ing. Entry. Application of the debit and credit schedule. 
Proprietor's personal or drawing account. 

CHAPTER VII 
JOURNALIZING AND POSTING , 75 

The journal. The journal form. The journal entry its 
composition. The journal illustration. Posting. The ledger. 

CHAPTER VIII 

BOOKS OF ORIGINAL ENTRY 84 

The need for additional journals. Various bookj of original entry. 
Form and content. Sales journal illustrated and explained. 
Advantages of the use of the sales journal. Purchase journal 
explained. Cashbook illustrated and explained. General journal 
explained. Cross-checking. Other journals sometimes used. 
Compound transactions. Ledger references to various books. 
Correcting entries. 
/ CHAPTER IX 

THE TRIAL BALANCE 101 

Definition. Purpose. Summarizing the ledger. Form. Illus- 
trations. Trial balance does not indicate all errors. Procedure if 
trial balance does not balance. Some special tests for one error. 

CHAPTER X 

CAPITAL AND REVENUE EXPENDITURES 112 

Expenditure. Capital expenditure. Revenue expenditure. Ne- 
cessity of proper distinction. Guiding principles. Illustrations of 
application of principles. 

CHAPTER XI 

ADJUSTING THE BOOKS 122 

Incompleteness of the records. Definition and purpose. Inven- 
tory of merchandise. Inventories of supplies. Accrued items. 



CONTENTS ix 

PAOB 

Deferred items. The depreciation of fixed assets. Estimated 
bad debts. Miscellaneous adjustments. Guiding principles on 
adjustments. Coordinating illustration. Adjusted trial balance. 

CHAPTER XII 

CLOSING THE BOOKS 140 

Definition and purposes of closing the books. Closing procedure. 
The profit and loss account. Illustration. Ruling and balancing 
the accounts. The postclosing trial balance. 

CHAPTER XIII 

THE WORK SHEET ITS CONSTRUCTION AND USE 149 

Definition. The work sheet its objects and advantages. The 
work sheet its structure. The work sheet its form. Adjust- 
ments on the work sheet. Adjusted trial balance of the work 
sheet. Profit and loss and balance sheet columns. Equalizing 
the profit and loss and balance sheet columns. The work sheet 
illustration. The work sheet its use. Review of accounting 
. procedure. 

CHAPTER XIV 

INVENTORIES, ACCRUALS, AND DEFERRED ITEMS 161 

Readjusting entry defined. Inventory of merchandise. Invento- 
ries of supplies. Accrued items. Deferred items. Guiding 
principles on readjustments. 

CHAPTER XV 

BAD DEBTS, DEPRECIATION, OBSOLESCENCE, DEPLETION 176 

Bad debts. Purposes of the reserve for bad debts. Process of 
estimating the amount of bad debts. Writing off bad accounts. 
Recovery of former bad debts. Depreciation. Definition. The 
problem of depreciation. Factors influencing the amount of 
periodic depreciation. Computation of the depreciation charge. 
Straight-line method. Unit of performance method. Periodic 
treatment on the books. Reserve for depreciation account. Dis- 
posal of a fixed asset. Effect of capital expenditures on fixed 
assets. Obsolescence. Definition. Provision for gradual obso- 
lescence. Provision for sudden obsolescence. Depletion. Deple- 
tion defined. Factors influencing the amount of periodic deple- 
tion. Computation of the depletion charge. Treatment on the 
books. 

CHAPTER XVI 

BUSINESS PAPERS AND PRACTICES 200 

Promissory notes. Definition. Purpose and use of notes. Illus- 
trations of notes. Parties to a note. Indorsements. Note 



X CONTENTS 

PAOB 

accounts. Renewing notes. Dishonored and protested notes. 
Interest and discount. Definition of terms. Classes of inter- 
est. Classes of discount. The time factor in interest and dis- 
count. Computation of interest and discount. 6 per cent 
60-day method. 6 per cent six-day method. Computation of 
discount on an interest-bearing note. Entries for notes and 
interest and discount. Entries for noninterest-bcaring notes. 
Entries for interest-bearing notes. Drafts. Definition. Parties 
to a draft. Kinds of drafts. Acceptance. Purpose and use of 
drafts. Illustrations of drafts. Other forms of demand drafts. 
Entries for drafts. Trade acceptance. 

CHAPTER XVII 

BUSINESS PAPERS AND PRACTICES (Continued) 228 

Papers and practices for purchases. Purchase requisition. Pur- 
chase order. Purchase invoice. Credit memorandum. Debit 
memorandum. Bill. Papers and practices for sales. Sales 
invoice. A statement. Papers and practices for shipments. Bill 
of lading. Papers which circulate as cash. Check. Cashier's 
check. Certified check. Travelers' checks. Express money 
order. Postal money order. Bank draft. Papers arid practices 
relating to a bank account. Opening the account. Deposit ticket 
or slip. Passbook. Checkbook. Drawing a check. The bank 
statement. Outstanding checks. The statement of reconciliation. 
The reconciliation process. Illustration of reconciliation state- 
ments. Entries after reconciliation. The treatment of some 
special cash items. Voided check. Check cashed for a cus- 
tomer. Check exchanged for money. Stopping payment on a 
check. Bank overdraft. Cash over and short. Other papers and 
practices. 

CHAPTER XVIII 

THE GENERAL AND SUBSIDIARY LEDGERS CONTROLLING ACCOUNTS. . 251 
Inadequacy of one ledger. The general ledger. Subsidiary ledger. 
Controlling account. Advantages of subsidiary ledgers and con- 
trolling accounts. The operation of subsidiary ledgers and control- 
ling accounts. Debits to customers for sales. Credits to creditors 
for purchases. Credits to customers for cash receipts. Debits to 
creditors for cash disbursements. Other credits to customers 
Other debits to creditors. Other debits to customers Other 
credits to creditors. Procedure if note journals are used. Pro- 
cedure if returns and allowances journals are used. Control 
procedure for sales to proprietor. Procedure to record sales to a 
creditor and purchases from a customer. Procedure if a controlled 
account shows an opposite balance. References to other con- 
trolling accounts. 



CONTENTS xi 

PAGE 
CHAPTER XIX 

COLUMNAR JOURNALS AND PETTY CASH SYSTEMS 271 

Columnar journals. Definition and purpose. Form of columnar 
journals. The use and operation of columnar journals. Columnar 
sales journal. Recording cash sales. Recording sales for a note. 
Recording C.O.D. sales. Columnar sales journal with sundries 
section. Columnar purchase journal for merchandise only. 
Recording merchandise purchases for cash, for C.O.D. and for 
notes. Columnar purchase journal with sundries section. Colum- 
nar general journal. Columnar cash receipts and disbursements 
journals. Other columnar journals. Summary of the posting 
process. Advantages of columnar journals. Petty cash systems. 
Petty cash fund. Petty cash book as a journal. Imprest system. 
Voucher system. 

CHAPTER XX 

OTHER RECORDS 296 

Auxiliary record defined. Inventory sheet. Insurance register. 
Notes receivable register. Payroll. Plant ledgers. Other auxil- 
iary records. 

CHAPTER XXI 

PARTNERSHIPS 314 

Definition. Advantages of a partnership. Disadvantages of a 
partnership. Articles of partnership. Kinds of partnerships. 
Kinds of partners. General partnership rules. Partnership bal- 
ance sheet. Partnership profit and loss statement. Distribu- 
tion of the net profit or loss. Statement of partners' capitals. 
Drawing or personal accounts of partners. 

CHAPTER XXII 
PARTNERSHIPS (Continued) 329 

Recording each partner's original investment. Entries to record 
the admission of a new partner. Goodwill. Definition. Deter- 
mining the value of goodwill. Recording goodwill. Dissolution. 
Definition and causes. The accounting problems of dissolution. 
Withdrawal or death of a partner. Realization conversion of 
assets into cash. Division of the net profit or loss of dissolution. 
Liquidation distribution of the cash. 

CHAPTER XXIII 
CORPORATIONS " 343 

Definition. Formation. Management. Comparison with part- 
nerships advantages. Comparison with partnerships disad- 
vantages. Capital stock terms defined. Stock terms defined. 
Rights of a stockholder. Capital stock accounts. Other proprie- 
torship accounts. Special books and records of corporations. 
Minute book. Subscription records. Installment scrip book. 



xii CONTENTS 

PAGB 

Stock certificate book. Capital stock ledger. Stock transfer 
journal. Proprietorship in the corporate balance sheet. 

CHAPTER XXIV 

CORPORATIONS (Continued) 361 

Entries to open the corporate records. Stock issued for cash. 
Stock issued for physical property other than cash. Stock issued 
for intangible property. Stock issued for services. Stock issued at 
a discount. Stock issued at a premium. Stock subscriptions. 
Subscriptions in default. Treasury stock. Entries for par value 
treasury stock if donated. Entries for par value treasury 
stock if purchased. Classes of treasury stock. No par value 
stock. Entries to record no par stock issues. Treasury stock 
no par. No par stock on the balance sheet. 

CHAPTER XXV 

CORPORATIONS (Concluded) 383 

Closing the books of a corporation. Surplus. Undivided profits. 
Classification of surplus. Appropriated surplus accounts. Sur- 
plus adjustments. Illustrations of surplus and capital surplus 
accounts. Surplus on the balance sheet. Statement of surplus. 
Deficit. Dividends. Definition. Declared by formal action of 
the board. Dividends paid from earnings. Declaration and 
notice of a dividend. Classification of dividends. Recording divi- 
dends out of earnings. Recording dividends out of capital. Divi- 
dends on the balance sheet. Cumulative dividends in arrears. 
Share of stock values. Market value. Liquidating value. Book 
value. The effect of dividends on the book value of stock. 

CHAPTER XXVI 

RESERVES AND FUNDS 401 

Reserves. Definition of a reserve account. Classification of 
reserve accounts. Valuation reserves. Proprietorship or surplus 
reserve accounts. Classification of surplus reserve accounts. Lia- 
bility reserves. The word reserve used incorrectly. A secret or 
hidden reserve. Funds. Definition. Definition of a fund 
account. Purposes for which funds are created. 

CHAPTER XXVII 

BONDS 420 

Definition. Some popular classes of bonds. Authority to issue 
corporate bonds. Quotation of bond prices. Bond expenses. 
Bonds sold at a discount. Bond premium. Bond interest. The 
computation of interest on a bond between interest periods. Entry 
illustrations. Some bond retirement problems. Bonds in the 
balance sheet. Subscription to bonds. Auxiliary records. Re- 
cording bonds from the investor's standpoint. Comments on 
some methods of this chapter. 



CONTENTS riii 

PAOB 
CHAPTER XXVIII 

MANUFACTURING ACCOUNTS AND STATEMENTS 438 

Elements of manufacturing cost. Account titles peculiar to a 
manufacturing enterprise. Cost of goods manufactured and cost 
of goods sold. Statements. Illustrative statements. Adjust- 
ments. Adjusting entries illustrated. Closing the books. Clos- 
ing entries illustrated. The work sheet. Work sheet illustrated. 
Comparison with cost accounting. 

CHAPTER XXIX 

THE VOUCHER SYSTEM 461 

Voucher system defined. The verification of an invoice. Defini- 
tion of a voucher. Voucher payable illustrated. Vouchers pay- 
able replace creditor's accounts. Voucher payable control account 
replaces accounts payable. The voucher register. Vouchcring an 
item to be paid immediately. Filing vouchers payable. The 
check register. The check register illustrated. The voucher 
check. Illustrations of voucher checks. Creditors' voucher index. 
Illustration of a creditor's voucher index card. Notes payable 
under the voucher system. The procedure for the partial payment 
of a voucher. Recording purchase returns and allowances. The 
vouchers payable account. Other forms of voucher register. 
Voucher register to classify purchases by departments. Voucher 
register with purchase discount column. Voucher register with 
debit distribution control account columns. Voucher register 
with sundry debit and credit columns. Sundry debit and credit 
columns in voucher register illustrated. Advantages of the 
voucher system. The journal voucher. Journal voucher illus- 
trated. Concluding comments. 

CHAPTER XXX 

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS 487 

Objectives of statement analysis and interpretation. Analysis and 
interpretation by the accounting department. Analysis and inter- 
pretation by an outsider. Persons interested in analysis and 
interpretation of financial statements. Analysis and interpreta- 
tion methods. Ratios. Analysis and interpretation of a balance 
sheet. Analysis and interpretation of a statement of profit and 
loss. Interstatement percentages and ratios. Comparative bal- 
ance sheets. Comparative profit and loss statements. Summary 
of the analysis and interpretation of the Star Stores Company. The 
determination of trends. The use of accounting analyses and 
interpretations. Concluding comments. 

PROBLEMS 511 

INDEX 747 



PROBLEMS 

CHAPTER II 512 

CHAPTER III ... 516 

CHAPTER IV 521 

CHAPTER V 526 

CHAPTER VI 530 

CHAPTER VII 534 

CHAPTER VIII . 539 

CHAPTER IX 543 

CHAPTER X ... 547 

CHAPTER XI . . 549 

CHAPTER XII ... 555 

CHAPTER XIII .561 

PRACTICE SET 1-A . 567 

PRACTICE SET 1-B . . . . . . 575 

CHAPTER XIV 584 

CHAPTER XV. ... . . . . 592 

CHAPTER XVI .. . 599 

CHAPTER XVII . 602 

CHAPTER XVIII . . 606 

CHAPTER XIX ... . . ... .611 

PRACTICE SET 2-A . . ... 619 

PRACTICE SET 2-J5 . . ... 634 

CHAPTER XX ' . . 649 

CHAPTER XXI ... . 650 

CHAPTER XXII .653 

CHAPTER XXIII . 660 

CHAPTER XXIV 662 

CHAPTER XXV 665 

CHAPTER XXVI 674 

CHAPTER XXVII 679 

CHAPTER XXVIII 685 

CHAPTER XXIX 693 

PRACTICE SET 3-A 700 

PRACTICE SET 3-5 718 

CHAPTER XXX 735 

xv 



ACCOUNTING FUNDAMENTALS 

CHAPTER I 
ACCOUNTING ITS SIGNIFICANCE 

Accounting Defined 

Accounting may be defined as the science and the art of 
systematically recording, presenting, and interpreting the 
financial facts of an individual or enterprise. 

Accounting, the science, is the classified knowledge of the 
subject the body of scientific principles which has been devel- 
oped as a result of study and experience. 

Accounting, the art, is the actual classifying and recording, 
presenting, and interpreting of the financial facts of an individual 
or enterprise. 

The Enterprise 

It should be noted that accounting deals with the financial 
facts of an individual or an enterprise. To illustrate, suppose 
a man is at one and the same time a practicing attorney at law, 
the sole owner of an automobile agency, a partner in a shoe- 
manufacturing business, and the owner of some shares of the 
capital stock of a corporation which supplies electric current to 
his community. If full opportunity is taken of the possibilities 
of accounting, there will be an accounting system for the law 
office, an entirely separate system for the automobile agency, 
another one for the shoe firm, and an independent one for the 
electric-light company. Each undertaking here mentioned is 
a separate enterprise. Accounting must be applied to each 
of these enterprises, if full information is desired about their 
respective, financial conditions and results. In addition, an 
entirely distinct system of records may be kept to show this 
man's personal or private financial transactions. 

The concept of an enterprise as a unit or undertaking for which 
financial records should be classified and kept, summarized, and 



2 ACCOUNTING FUNDAMENTALS fCh. I 

interpreted is absolutely essential in accounting. It is common, 
therefore, for each business establishment to have its own 
accounting system and to be treated as an entirely separate unit, 
something apart from its owner or owners. 

Nonprofit Enterprise 

Accounting is thought of as applying usually to a business 
enterprise operated to earn a profit, and it is in that connection 
that it will be considered in this text. However, the principles 
of the subject are applicable to, and are used in connection with, 
the financial transactions of an enterprise whether profit seeking 
or not. Thus there is governmental accounting for the nation, 
a state, a city, a school district, or other governmental unit, and 
accounting for nonprofit undertakings such as religious, chari- 
table, educational, or social organizations. Whenever a person 
or enterprise, whether profit seeking or not, has financial trans- 
actions with sufficient frequency and complexity that it is not 
safe to rely on memory alone, there is opportunity and need for 
the application of accounting principles. 

Recording 

In order that a complete record of the financial transactions of 
a business may be preserved and be available for presentation 
and interpretation, each transaction must be classified at the time 
of occurrence and be recorded according to a predetermined plan. 

Thus if merchandise is sold to a customer who does not pay 
for it, that transaction is classified to indicate that merchandise 
and claims on customers are involved. It is referred to as a 
charge sale or sale on account and is recorded perhaps on a special 
form or in a special book. If money is received from a customer 
the transaction is classified to show that cash and claims on cus- 
tomers are affected. It is referred to as a cash receipt and is 
recorded according to a plan whereby all cash received can be 
readily noted. 

The recording of transactions is commonly referred to as 
bookkeeping. Bookkeeping, or account keeping, may be 
defined as the systematic recording of the financial transactions 
of a person or enterprise. 

A person may keep his own records or may have them kept for 
him in any way which pleases him. Although crudely done, 



U ACCOUNTING ITS SIGNIFICANCE 3 

he may call the system bookkeeping. Not all bookkeeping is in 
accord with sound accounting principles and methods. Many 
individuals and organizations are satisfied with a meager book- 
keeping system. Sometimes the system is expected to show 
merely the accounts or records with the customers and creditors 
of the business; in other cases a record of cash receipts and 
disbursements is the principal object. In an enterprise where 
the owner expects the accounting department not merely to 
supply just a few facts but to be a true and complete history 
department of the business, that the results of the past may be 
utilized to explain the present and to guide the future, then the 
bookkeeping aspect of accounting is very important as a neces- 
sary preliminary to the other accounting functions. 

Presenting 

The presentation of financial facts, the second function of 
accounting, deals with the summarization of the accumulated 
recorded data and the preparation of particular reports or state- 
ments to show condition, results of operation, or other pertinent 
information with respect to the business. 

This second function of accounting covers the utilization of the 
recorded facts to ascertain the results. After the desired facts 
are obtained from the mass of bookkeeping data, they must be 
arranged and set up in the form of financial pictures which will be 
significant to all parties concerned. Recognition of the impor- 
tance of this second phase of accounting is of comparatively 
recent origin. It was not until business units were reasonably 
large and complex that there was a need for so many and varied 
reports based on the recorded facts. 

Interpreting 

The interpretation of financial facts, the third function of 
accounting, deals with the explanation and utilization of the 
reports or statements with which the second phase of accounting 
treats. 

The full significance of an accounting report or statement may 
not be apparent to those persons for whom it is prepared because 
of its necessary form or technical wording or content. It needs 
to be explained to those who must use it. Again, a particular 
statement by itself may have little meaning, and full use may not 



4 ACCOUNTING FUNDAMENTALS (Ch. I 

be made of it until it has been placed beside a similar statement 
of a prior period, or of another concern in the same field, and the 
changes or differences noted. Sometimes a statement is so 
comprehensive that the full significance of the information it 
contains is not apparent until it has been studied and analyzed, 
and percentages, relationships, and ratios determined. 

This extremely important phase of accounting deals with the 
complete utilization of statements and reports in an endeavor to 
ascertain facts with respect to financial condition or operation. 
Thus an analysis should be made to ascertain such facts as. 

Is the stock of merchandise low or excessive in relation to sales? 

Are customers' payments lagging? 

Would the elimination of certain lines of merchandise result in 

increased earnings? 
Is the business in a position to meet its obligations promptly? 

Necessity of Accounting 
If a doctor desires to know 

1. The names of patients who owe him money and the amount 
in each case, or 

2. The financial obligations he has incurred, or 

3. The nature and amount of items of value he possesses, or 

4. The amount of his earnings for any period and the sources 
thereof, or 

5. The nature and amount of his expenses, or 

6. What he is worth, or 

7. How much his worth has increased or decreased since the 
last time he determined it, or 

8. The correct information to present on his Federal Income 
Tax Return, which he, like all other citizens, must file annu- 
ally if his gross income totals more than a certain amount, 

he must make use of some of the methods and principles of 
accounting. If this is true in the case of a doctor whose financial 
transactions are usually plain and simple, it is obvious how much 
greater is the need for the application of accounting principles 
in a commercial enterprise. In a business enterprise there may 
be varied types of transactions; the number of transactions each 
day may be tremendous, may involve largt sums of money and 



Ch. IJ ACCOUNTING ITS SIGNIFICANCE 5 

many of them may be quite complicated. The student is asked 
to think of the number of financial records it is necessary for his 
local gas, electric-light, and telephone company to keep. Think 
of the business transactions which take place daily in a large 
department store, in a prominent bank, in any great business 
establishment, and the necessity of systematically recording, 
presenting, and interpreting them will be apparent. 

Accounting and the Modern Business Era 

The present business era may be characterized as a period of 
large-scale endeavor carried on mostly by corporate organiza- 
tions. It is quite common to find corporations possessed of items 
of value running into millions of dollars, with widely scattered 
plants, thousands of employees, other thousands of shareholders, 
an enormous volume of production, and a widespread field of 
distribution. The large corporation is likely to be a very 
complex unit. 

An individual or the partners of a firm owning a small business 
may have very close and intimate contact with the details of 
their enterprise, but the situation is quite different in a corpora- 
tion such as was just described. Thousands of shareholders 
take the place of the individual or the partners as owners, and a 
board of directors and group cf officers take their places as 
managers. Instruction must be given and authority delegated 
on down through the organization and to the various plant and 
office executives. Mere size alone prevents close contacts of 
those in high office with the details of operations. Accounting 
control offsets, in large part, mere size and absence of contact. 
Through reports and explanations of operations and financial 
condition, accounting control supplies information necessary to 
the management for the successful direction of the enterprise and 
for reporting to the shareholders. 

Accounting has helped to make possible the large-scale com- 
mercial establishments which are such an important part of the 
present economic order. The ever-increasing size of these 
enterprises with attending added complexity and specialization 
is, however, forcing an even greater reliance on the functions of 
accounting. The accounting department is truly the financial 
history department of a business. The data compiled by the 
accounting department are used not only to tell the financial 



6 ACCOUNTING FUNDAMENTALS [Ch. I 

story of the past but to plan for the future. Accounting records 
of past events are necessary in the preparation of budgets 
which embody plans for the control of future business activities, 
and accounting methods are necessary for the execution and 
control of budget plans. 

The place of accounting in the present economic order is 
significant in connection with the studies of a young person 
planning a career in business, public life or the professions related 
to business. The principles according to which business events 
are recorded, presented, and interpreted should be understood 
clearly. 

Persons Interested in Accounting Disclosures 

Accounting is of primary importance to owners and managers 
but its results may be of interest to others. 

1. Owners. A business enterprise is a profit-seeking endeavor. 
The measure of its success and its financial condition are of 
primary importance to its owner or owners. 

2. Managers. In a small business establishment, especially a 
sole proprietorship where one person is the owner, or in a partner- 
ship w r here two or more partners are owners, the managers arc 
likely to be the owners of the undertaking. The greater the 
size of the establishment, especially under corporate form, the 
more remote the relationship between ownership and manage- 
ment is apt to be. Accounting is an indispensable tool of 
management. Through it the financial records of the past and 
present are revealed, the results of operations disclosed and data 
supplied on which, in part, the future may be anticipated. 

3. Creditors. Persons who have debts due from a business or 
other claims upon the property of a business are called creditors. 
The creditors of a business are very much interested in its 
financial condition and its operating results. It is quite common 
for credit to be refused until the adequacy of the financial 
responsibility of the concern seeking the credit has been indicated 
through accounting statements. 

4. Prospective Investors. A person contemplating an invest- 
ment in a particular concern is naturally very much interested 
in its past and present condition and the trend of its operating 
profit or loss as exhibited in its accounting statements. 



Ch. I\ ACCOUNTING ITS SIGNIFICANCE 7 

5. Government Officials. In connection with the various 
taxes, city, county, state, and federal, to which a business may 
be subject, also in connection with the various state and national 
commissions which regulate some business establishments such 
as public utility companies, statements and returns based on 
accounting data must be filed with various officials. It is not 
uncommon for government representatives to examine the 
accounting records of these businesses. 

6. Employees. Many corporations have encouraged their 
employees to purchase shares of stock. When this has been 
done the employees are interested not only as employees but as 
shareholders as well. 

7. Citizens. The ordinary citizen should be interested in the 
financial records of his bank; of his church; of his social and 
charitable organizations; and of the public utilities, such as the 
gas, electric, telephone, transportation, and water companies 
which serve his community. Possibilities of rate or service 
changes may be reflected in the accounting statements of these 
companies. 

In a very broad way the ordinary citizen should be interested 
in financial records of the nation as well as of his city, county, 
state, school district, or other governmental units. As a voter 
and taxpayer he is a most interested party. 

The Practice of Accounting 

An accountant literally is one who understands and applies the 
scientific principles of accounting in any of its parts recording, 
presenting, or interpreting financial facts. Actually the word 
accountant connotes abilities and activities beyond those 
required for mere recording which is the work of bookkeepers, 
for an accountant is expected to be able to supervise and direct 
the work of the bookkeepers in recording, to analyze the recorded 
data, to present and interpret it, to design and install an adequate 
system for the collection of the data, and to audit the records. 

Special Divisions of Accounting Practice 

1. Designing a System. An adequate accounting system 
will furnish clear and accurate information promptly and 
economically. It should be designed to meet the needs of a 



8 ACCOUNTING FUNDAMENTALS [Ch. I 

particular enterprise. A system which may be adequate for a 
small grocery store would be totally unsuited to the needs of 
a large grocery chain. A system should be designed only after a 
thorough study of the size, kind, and volume of business done. 

2. Cost Accounting. Cost accounting is one of the most 
significant, important, and rapidly expanding fields of accounting. 
It attempts to analyze much more carefully than does general 
accounting the elements entering into the cost of producing and 
distributing goods or rendering services in order that unit costs 
may be determined and that management may be supplied with 
much more detailed information. 

3. Auditing. The field of auditing deals with the examination 
and verification of the accuracy of the accounting records of an 
individual or enterprise. 

4. Miscellaneous. Many other special duties come within 
the activities of an accountant, such as, the preparation of 
returns to a government agent; the preparation of accounts and 
statements required by the courts in cases of decedents' estates 
or bankruptcies; and special investigations for bankers, investors, 
and creditors. 

Accountants are known as private accountants, public account- 
ants, and certified public accountants. A private accountant 
is one employed by a particular enterprise. A public accountant 
is one who practices professionally and whose services are avail- 
able to an individual or enterprise in need of them. A certified 
public accountant is a person who has met the requirements of a 
state with respect to character and fitness and who has been 
granted a certificate which permits him to use the designation 
C.P.A. A C.P.A. may be engaged in either private or public 
practice. 

Accountancy is the profession of public accounting. 

Accounting in a Business Curriculum 

A student should be conscious of the pervasiveness of account- 
ing within a business establishment. The accounting depart- 
ment has contacts with all other departments production, 
advertising, selling, finance, and any others a particular enter- 
prise may have. It records their financial transactions and 
places summaries of them before the management so that the 
functioning of the entire business may be known and directed. 



Ch. I] ACCOUNTING ITS SIGNIFICANCE 9 

Accounting is not, therefore, an isolated subject to be studied by 
itself. A full appreciation of its significance and usefulness is 
not possible unless it is studied and developed in connection 
with the fields of economics, finance, statistics, industry, the law, 
and the other subjects of a business curriculum. 

QUESTIONS 

1. What is accounting? 

2. What is meant by a science? An art? 

3. What is meant by the expression systematically recording? 

4. What is an enterprise? May one person be the owner of more than 
one enterprise? Are all enterprises conducted to earn a profit? 
Name several which are not. 

5. Name ten different enterprises which exist in your community. 
Should each have an accounting system? Why? 

6. May one person be interested in the accounting statements of more 
than one enterprise? How? 

7. What do you mean by a financial transaction? Have you had any 
financial transaction with your college? Did your illustration repre- 
sent a financial transaction from the standpoint of the college? 

8. Which of the following items represent financial transactions? 
a. The sale of merchandise for cash. 

6. The sale of merchandise on account. What do you mean by on 
account? 

c. The transfer of merchandise from the shelves to the counters of 
a store. 

d. The receipt of cash from a customer in payment of a bill. What 
do you mean by a customer? A bill? 

e. A payment to a creditor. Who is a creditor of yours? 
/. The transfer of money from the cash register to the safe. 

g. Decorating the store windows with merchandise taken from the 

counters, shelves and racks. 
h. Paying salaries. 

9. Name three functions of accounting. What do you mean by 
recording ? Presenting ? Interpreting ? 

10. Are accounting and bookkeeping synonyms? If not, what is book- 
keeping? 

LI. What prompts a person to start a business enterprise? Why should 
the enterprise have an accounting system? 

L2. Why does the federal government need and use accounting? A 
bank? An attorney at law? A hospital? 

13. Does a very large business enterprise have a greater need for 
accounting than a very small business enterprise? Why? 



10 ACCOUNTING FUNDAMENTALS [Ch. I 

14. Does accounting information disclose past, present, or future facts? 
In what ways may accounting information be used in connection 
with future events? 

15. The information about a particular railroad, which is disclosed by 
the use of accounting, is of interest to what groups of persons? 
Ask yourself the same question about a bank, an insurance com- 
pany, an electric-light and power company, a department store, and 
a city. 

16. Distinguish between an accountant and a bookkeeper. 

17. What do you mean by a private accountant, a public accountant, a 
certified public accountant? 

18. Why should a person who is studying to become an accountant be 
interested in business law? In economics? In finance? In 
English grammar? 

19. Why should a person be interested in accounting, if he is studying to 
become a lawyer? A commercial banker? An investment banker? 
A governmental employee? A manufacturer? 

20. Do you believe a knowledge of accounting is helpful to a person who 
must file an income-tax return? Why? 



CHAPTER II 
THE BALANCE SHEET 

If a man were asked to present a statement to show the worth 
of his business it would be necessary for him to prepare a list 
of all the items of value owned by the business and all the amounts 
owed to it. The total of this list would be the worth of the 
business provided nothing was owed to any outsider. The excess 
of the total of this list of values owned, over the total of a list of 
amounts owed, would be the net worth of the business. A formal 
arrangement of these facts is known as a balance sheet or a state- 
ment of assets, liabilities, and net worth. 

Basic Terms Defined 

Assets are items of value owned by an individual or enterprise, 
including : 

a. Tangible items, such as money, buildings, and machinery. 

6. Intangible items, such as patents and goodwill. 

c. Rights to receive tangible assets or services from other 

individuals or enterprises, such as accounts receivable and 

notes receivable. 

Liabilities are debts or obligations to pay money or other 
assets or to render services. 

Proprietorship (capital or net worth) is the excess of the assets 
over the liabilities. It is the proprietary or ownership interest 
(equity) in the total assets involved. As the obligations to 
creditors have first claim on the assets of an enterprise, there is no 
proprietary equity if the liabilities exceed the assets. 

A balance sheet is a statement of the assets, liabilities, and net 
worth of an individual or enterprise at a given date. 

Fundamental Accounting Equation 

Since the equity of an owner in the assets of an enterprise is the 
excess of the assets over the liabilities, this relationship maybe 

11 



12 ACCOUNTING FUNDAMENTALS [Ch. II 

expressed in the form of an equation that is fundamental to an 
understanding of accounting. 

If a business has assets of $50,000.00 and liabilities of $10,- 
000.00 the ownership equity (proprietorship, capital or net 
worth) is $40,000.00 as shown below: 

Assets Liabilities = Proprietorship 
$50,000.00 - $10,000.00 = $40,000.00 
or 

Assets = Liabilities + Proprietorship 
$50,000.00 = $10,000.00 + $40,000.00 

The Balance Sheet Is a More Detailed Expression of the Funda- 
mental Equation 

To tell the owner of an enterprise that it has assets of $10,- 
000.00, liabilities of $3,000.00, and a resulting net worth of 
$7,000.00 is to give him insufficient data on which to gauge its 
present financial status or to plan for its future. He needs to 
know which items are owned and their amounts, and which 
items are owed and their amounts. 

Suppose the enterprise, the total figures of which are given 
above, is owned by Henry Dickson, that it occupies a rented 
property, and that the date is December 31, 19^i/^It has money 
in the safe in the amount of $250.00 and a bank balance of 
$750.00; customers John Adams and Wirt Allison owe it $600.00 
and $400.00 respectively; Samuel Harris, another customer, owes 
on a note $500.00; there is salable merchandise on its shelves and 
counters which cost $4,000.00; the showcases, counters, and 
desks are owned and are worth $2,000.00; a new delivery truck 
cost and is worth $1,500.00. The enterprise owes Henry Davis 
$800.00 and Willard Jones $600.00. It also owes $1,600.00 on a 
note which it gave to the bank. 

In listing assets and liabilities, it is desirable to use the accepted 
accounting titles which are both brief and descriptive, i.e., the 
money in the safe and 'in bank is called Cash; the claims on 
John Adams and Wirt Allison are listed as Accounts Receivable; 
the amount due from Samuel Harris on a note is indicated 
as Notes Receivable; the salable merchandise is referred to as 
Merchandise Inventory; the showcases, counters, and desks as 
Furniture and Fixtures, and the new delivery truck may be 



Ch. II] THE BALANCE SHEET 13 

called either Delivery Truck or Delivery Equipment. The 
amounts due to creditors Henry Davis and Willard Jones are 
listed as Accounts Payable, while the amount owed on a note 
is expressed as Notes Payable. 

In the following balance sheet, which expresses the facts given 
above, if a line were drawn down the center of the statement, 
the line could be compared to the equals sign in the fundamental 
accounting equation (Assets = Liabilities + Proprietorship). 

HENRY DICKSON 
BALANCE SUEET, DECEMBER 31, 19 

Assets Liabilities 

Cash $ 1 ,000.00 Accounts Payable $ 1 ,400.00 

Accounts Receivable. . . 1 ,000.00 Notes Payable 1,600.00 

Notes Receivable 500.00 Total Liabilities $ 3,000.00 

Inventory of Merchan- Proprietorship 

disc 4,000.00 Henry Dickson, Capital 7,000.00 

Furn iture and Fixtures . 2 , 000 . 00 

Delivery Equipment . . . 1,500.00 Total Liabilities and 

Total Assets $10,000.00 Proprietorship $10,000.00 

Subdivisions of Assets, Liabilities, and Proprietorship 

In the presentation of a balance sheet it is desirable and 
customary to classify and arrange the assets, liabilities, and 
proprietorship under certain general headings. 

ASSETS 

The two fundamental classes of assets are current assets and 
fixed assets. Some additional classes are deferred charges, 
investments, and intangible assets. 

Current assets are cash and other assets that will be converted 
into cash through the normal operation of the business, usually in 
less than a year. The assets are arranged under this heading 
in the expected order of convertibility. A few of the more 
customary titles to be found in this group are as follows: 

Cash, which includes coins, paper monies, bank drafts, money 
orders, checks, and any other items that a bank will accept 
for deposit. 

Accounts Receivable, which are claims on others not evidenced 
by formal written promises to pay the business. These 



14 ACCOUNTING FUNDAMENTALS [Ch. n 

claims usually arise out of sales of goods or services. A 
separate record is kept for each customer. 

Notes Receivable, which are signed promises to pay named 
sums of money to the business at some definite or determin- 
able future time, such as promissory notes and trade accept- 
ances. Trade acceptances may be titled separately. 

Accruals Receivable, which are accumulating claims arising 
out of services rendered by the business over a period of time 
but which are not yet due. An example is the accrued 
interest on a note receivable. At any time before the date 
of maturity there is an amount of accrued interest receivable, 
which represents a claim of the business but which is not due 
and will not be due until the end of the interest period. 
Another example is Accrued Rent Receivable. 

Inventory of Merchandise, which is the merchandise on hand 
at a given time. Merchandise is the name given to the goods 
purchased or produced for the purpose of being sold. The 
word inventory also means a list that shows the composition 
and the value of the stock of goods on hand. The inventory 
may be priced at cost, but usually it is priced at cost or 
market, whichever is the lower. In a manufacturing busi- 
ness separate inventories are taken for raw materials, goods 
in process, and finished goods. 

Investments represent assets owned for the purpose of exercis- 
ing control or for their investment character, such as shares of 
stock in corporations, bonds, mortgages, and real estate. If the 
investment assets are to be converted into cash within a year, 
they should be treated as current assets. If they have been 
purchased to obtain a greater return on idle funds than would 
be obtained from a bank and are readily marketable, there is no 
objection to including them with the current assets unless sub- 
stantial amounts are so invested. They may be sold and cash 
realized quickly for the payment of debts. If they are not 
readily marketable and are not temporary investments, they 
should be shown under the separate balance sheet classification, 
Investments. Investments when used as a balance sheet heading 
appears between the current and the fixed asset groups, prefer- 
ably immediately following the current assets. 

Deferred charges (deferred charges to operation or deferred 



Ch. II) THE BALANCE SHEET 15 

assets) are expenditures for supplies or services that are to be 
charged as expenses in a subsequent period or periods. Deferred 
charges include expense items that have been incurred in advance 
of the period to which they are applicable prepaid expenses, and 
other items that are treated as assets until they are charged to 
later periods. Only those deferred charges which represent 
prepaid expenses are illustrated at this time. Some of the more 
usual prepaid expense titles follow: 

Inventory of Supplies, which are supply items such as sta- 
tionery, twine, wrapping paper, packing boxes, etc., on hand 
at a given date. Separate inventory records are made of 
all consumable supplies such as fuel oil, coal, and postage. 

Prepaid Insurance (Unexpired Insurance), which is the pro- 
portionate amount of the insurance premiums paid for or 
incurred which is applicable to future periods. Prepaid 
Advertising, Prepaid Rent, and Prepaid Interest are other 
prepaid expense titles. 

In some balance sheets prepaid expenses are listed with the 
current assets, not because they are assets which are to be con- 
verted into cash but because they represent, ordinarily, cash 
paid in advance as a result of which the demands on cash will 
be reduced next period. As prepaid expenses will not produce 
cash to satisfy the debts of a business it seems advisable to treat 
them under the classification, deferred charges. 

Fixed assets are relatively long-lived assets necessary in the 
operation of the business and not convertible readily into cash. 
They are not stationary but are "fixed" from the standpoint of 
the permanence of the investment in them. Such assets are not 
held for sale but are utilized in the conduct of the business. They 
usually decline in value because of wear and tear and the develop- 
ment of more modern equipment. Several of the most common 
examples follow: 

Land, which is the ground owned and needed for the conduct of 

the business. 
Buildings, which are the edifices owned by and used in the 

conduct of the business. 
Machinery, which is the title for all machine equipment used 

for manufacturing. 



16 ACCOUNTING FUNDAMENTALS [Ch. II 

Furniture and Fixtijres, which are the chairs, desks, cabinets, 

and similar equipment necessary for the efficient operation 

of the business. It is ordinary practice to separate this 

asset into: 

Store Furniture and Fixtures, which are the cash registers 
and the showcases, counters, bins, and other equipment 
used for the display or the selling of goods. 

Office Furniture and Fixtures, which are the filing cabinets, 
adding machines, desks, chairs, safes, and other equip- 
ment needed for the efficient administration of the office. 
Delivery Equipment, which includes motor trucks and horses 

and wagons used to transport goods to and from the 

business. 
Patterns, which are the models from which the product is to be 

made. 
Patents, which are the exclusive rights granted by the govern- 

ment to make and sell new inventions or processes. 
Trade-marks, Copyrights, Franchises, Leaseholds, Licenses, 

and Goodwill are other intangible asset titles that may be 

listed as fixed assets. 

Intangible assets, such as patents, goodwill, and the others 
indicated above, may be placed, in fact many accountants feel 
they should be placed, under a separate balance sheet classifica- 
tion, intangible assets. However, the accountant does not place 
all intangible assets under that caption. For reasons previously 
explained, some intangibles, like receivables, are classified as 
current assets, whilo others, like prepaid insurance, are treated 
as deferred charges. 



The two fundamental classes of liabilities are current liabilities 
and fixed liabilities. An additional class is deferred credits. 

Current liabilities are those debts or obligations that are to be 
satisfied usually in less than a year. The more common examples 
of this group follow: 

Accounts Payable, which are current debts not evidenced 
by formal written promises to pay. These claims usually 
arise out of purchases of goods or services. A separate 
record is kept with each creditor. 



Ch. IIJ THE BALANCE SHEET 17 

Notes Payable, which are written promises of the business to 
pay named sums of money to other persons or enterprises at 
some definite or determinable future time. Usually only 
notes with a maturity date less than a year away are included 
in the current liability group. 

Accruals Payable, which are accumulating debts arising out 
of services rendered to the business over a period of time 
but which debts are not due. Wages accrue from day 
to day and at any date between paydays there is an amount 
of Accrued Wages Payable which represents a debt of the 
business, but which debt is not due and will not be due until 
the end of the wage period. Accrued Interest Payable and 
Accrued Taxes Payable are other illustrative titles of 
accruals payable. 

Deferred credits (deferred credits to income or deferred liabil- 
ities) represent (#sh receipts or receivables of one period that will 
be earnings of a subsequent period or periods. This type of 
liability is satisfied usually in products or by rendering services. 
Many firms do not have any deferred credits. Examples are: 
Interest Collected in Advance, Subscriptions Collected in 
Advance, Rentals Received in Advance, Unearned Insurance 
Premiums. The illustrations cited might appear as liabilities 
in the balance sheets prepared respectively for banks, publishers, 
landlords, and insurance companies. 

Fixed liabilities are debts with a maturity date usually more 
than a year away. These liabilities arise ordinarily at the time 
fixed assets are purchased. When the maturity date of any 
liability which has been classed as a fixed liability is less than a 
year distant, it should be classed as a current liability if it is to 
be paid out of current assets. Long-term Notes Payable are 
fixed liabilities and two even more common ones are: 

Mortgage Payable, which is the title used to indicate an 
indebtedness secured by a conditional conveyance of the 
title to property with the proviso that the conveyance shall 
be void on payment of the principal and interest within a 
certain period. Usually the security is real estate, and the 
mortgage is recorded in the office of the County Recorder of 
Deeds. 



18 ACCOUNTING FUNDAMENTALS [Ch. II 

Bonds Payable, which are written promises, issued under 
seal, to pay the principal of a debt at the maturity date 
and the interest at regularly recurring intervals. They 
differ from notes in that the latter are usually for a short 
term. There are many kinds of bonds; some have specific 
property pledged to secure them, others are just general 
unsecured promises to pay. When backed by a mortgage 
or lien on specific property the mortgage is usually made 
out to a trustee representing the various bondholders. 

Contingent Liabilities are to be considered in a later chapter. 

PROPRIETORSHIP 

Proprietorship represents the equity of the owner in the assets. 
It is the amount of the net worth the excess of the assets over 
the liabilities. If a business is owned by one person, it is termed 
a sole proprietorship. The expression of proprietorship for a part- 
nership and for a corporation will be explained in later chapters. 

The Order of Listing Assets and Liabilities 

There is no standard of practice or theory with respect to the 
order to be followed in listing the classes of assets and liabilities 
on the balance sheet. Some accountants favor starting the 
assets with the fixed group since that is the class of assets in 
which the stockholders or possible investors may be most inter- 
ested, as it represents the permanent assets of the concern. 
Others favor the plan of placing the current assets first, since that 
group is most interesting to creditors because it exhibits the 
ability of the establishment to meet its obligations. This plan, 
not alone for the reason here citod, seems to be increasing in 
appeal and use. Regardless of the order in which assets are 
listed, the same plan should be followed for liabilities, so that 
corresponding groups of assets and liabilities appear in contrast. 

Object and Use of a Balance Sheet 

The primary object of a balance sheet is to set forth in orderly 
fashion the financial condition of a business at a particular date, 
in order that the owner may see the composition of his net worth, 
the banker and trade creditors may determine the solvency of the 
concern and its ability to satisfy their claims when due, and 



Ch. II] THE BALANCE SHEET 19 

the prospective buyer or investor may satisfy himself as to the 
security of an investment in the enterprise. 

To accomplish this object the balance sheet must exhibit the 
financial condition of the business at a stated time so that the 
respective values of the assets, liabilities, arid proprietorship 
will be shown clearly by classes and by items. It is not sufficient 
to know that a business has a net worth of $20,000.00. The 
relation between the assets and liabilities in total and in classes 
is necessary to accomplish the purposes indicated in the preceding 
paragraph. For example, two businesses of the same net worth 
may show widely different relationships between the assets and 
liabilities and between the assets and proprietorship. 

A B 

Assets $25,000.00 $125,000.00 

Liabilities 5,000.00 105,000.00 

Net Worth $20,000.00 $ 20,000 00 

The equity of the owner in business A is 83 per cent of the 
assets, while in business B it is only 16 per cent. In business B 
it is important to know if the $125,000.00 consists of $120,000.00 
fixed and $5,000.00 current assets, or any other combination. 
Fixed assets cannot be converted readily into cash for the purpose 
of paying the debts of the business. It is likewise important to 
know the composition of the $105,000.00 liabilities, whether they 
are long term (fixed) or short term (current), that the necessary 
arrangements may be made to satisfy them at maturity. 

Form 

Two forms of presenting the balance sheet have been developed, 
each of which is an elaboration of the fundamental equation. 



20 ACCOUNTING FUNDAMENTALS [Ch. II 

a. Report Form for a Sole Proprietorship 

DAVID MULFORD 
BALANCE SHEET, DECEMBER 31, 19 

Assets 
Current Assets: 

Cash $ 2,800.00 

Accounts Receivable 8,600.00 

Notes Receivable 1 ,000 00 

Accrued Interest Receivable 8.00 

Inventory of Merchandise 12,600.00 

Total Current Assets $25,008.00 

Deferred Charges: 

Prepaid Insurance 8 50.00 

Inventory of Supplies 30 . 00 

Total Deferred Charges 80.00 

Fixed Assets: 

Land $ 4,000.00 

Buildings 10,000 00 

Furniture and Fixtures 3,500.00 

Total Fixed Assets 17, 00. 00 

Total Assets $42,588.00 

Liabilities 
Current Liabilities: 

Accounts Payable . . $ 5,500.00 

Accrued Wages Payable 88.00 

Notes Payable 3,000.00 

Total Current Liabilities $ 8,588.00 

Fixed Liabilities: 

Mortgage Payable 5,000 00 

Total Liabilities 13,588.00 

Proprietorship 
David Mulford, Capital $29,000.00 



Ch. II] 



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22 ACCOUNTING FUNDAMENTALS [Ch. II 

Both forms contain exactly the same information but differ in 
arrangement and appearance. The report form is an adaptation 
of the first equation appearing in this chapter (assets liabilities 
= proprietorship), while the account form is based on the second 
equation (assets = liabilities + proprietorship). The date of 
preparation is highly important, regardless of the form, and 
should be indicated always at the top of the statement together 
with the name of the business and the title Balance Sheet. 

The balance sheet in account form is the more popular for 
obvious reasons. The mere length of a balance sheet in report 
form, in itself, favors the account form. In the account form, 
an easier comparison of comparable sections of the statement is 
possible. Whenever two pages are used in the account form, 
invariably they are opposite ones so as to present the complete 
statement before the eyes of the reader. 

QUESTIONS 

1. How is the fundamental accounting equation expressed in the ac- 
count form of balance sheet? In the report form of balance sheet? 

2. Distinguish between a note receivable and an account receivable. 

3. Inventory of merchandise usually is valued at what price? Suppose 
market price is higher than cost price, which price is used usually 
for inventory purposes? Would you say it is desirable or undesirable 
to value inventory of merchandise at market price, if market price is 
higher than cost price? Why? 

4. Do you believe fixed assets when acquired should be listed at cost 
price or at the amount they might be expected to bring if sold in the 
secondhand market? Why? 

6. If you wanted to classify all the assets of a large manufacturing 
business under two headings, what headings would you use? Why? 

6. Can you give the point of view of those persons who list prepaid 
expenses under the heading current assets? Under the heading 
deferred charges? 

7. Is the accrued interest on a mortgage owned by an enterprise a 
current or a fixed asset? Is the mortgage a current or a fixed asset? 
What is a mortgage? 

8. Is interest accrued but not yet due on a note payable an accrued 
liability? Is it a current liability? Is it a deferred credit? What 
is a deferred credit? 

9. Distinguish between a prepaid expense and an accrual payable. 

10. Express liabilities in terms of the fundamental accounting equation. 

11. If the liabilities exceed the assets, what is the status of proprietor- 
ship? 



Ch. H] THE BALANCE SHEET 23 

12. How may a proprietor increase his equity in an enterprise? Is there 
any other way in which the net worth of an enterprise may be 
increased over a period of time? 

13. If the liabilities of an enterprise increase, does the equity of the 
owner decrease necessarily? Give an illustration to prove your 
answer. 

14. Would it be possible for an enterprise to have earned a net profit 
during a year, if the assets on the balance sheet at the end of the 
year were less than they were at the beginning of the year? Explain. 

15. Would it be possible for an enterprise to have operated at a net loss 
for a year, if the liabilities at the end of the year were less than at the 
beginning of the year? Explain. 

16. Suppose the four items listed below were either omitted or treated 
improperly in the preparation of a balance sheet. Indicate in each 
case the possible effect on the equity of the owner. 

a. A note receivable was listed as an account receivable. 
&. The inventory of merchandise was overvalued. 

c. Accrued interest on notes payable was ignored. 

d. A mortgage payable on the real estate was subtracted from the 
total value of the land and buildings. 

17. Indicate for each of the four cases cited in question 16 whether the 
total assets of the balance sheet were understated, overstated, or 
correctly stated. 

18. Indicate for each of the following items whether it is a fixed asset, 
a current asset, a deferred charge, u fixed liability, a current lia- 
bility, or a deferred credit: 

a. Patents. 

6. Unpaid taxes on business property. 

c. Customer accounts owed to the enterprise. 

d. Accrued interest not due on a bank loan. 

e. Amounts owed to a bank on signed notes. 
/. Amounts owed to trade creditors. 

g. Interest collected in advance on customer notes. 
h. Advertising paid in advance. 

f . Inventory of office stationery. 

j. Mortgage on the business property. 

k. Store supplies on hand. 

I. Money in the safe and bank. 

19. What accounting title should be given for balance sheet purposes 
to each item listed in question 18? 

20. Should notes owed by customers be considered cash? Should any 
of the following items be considered cash : United States government 
bonds? Checks received from customers? Postal money orders? 

21. Give two synonyms for proprietorship. 



CHAPTER III 
ANALYSIS OF PROPRIETORSHIP 

The proprietorship or net worth of an enterprise varies over a 
period of time, as a result of: 

1. Operating the enterprise at a profit or loss. 

2. Additional investments by the owner. 

3. Withdrawals of capital by the owner. 

4. Combinations of above three factors. 

The previous chapter considered the balance sheet an 
exhibit of the assets, liabilities, and proprietorship of an enter- 
prise at a given time. This chapter is concerned with the 
analysis of changes in proprietorship during a period of time. 

Fiscal Period 

A fiscal period is the uniform interval between the preparation 
of the financial statements of a business. It may be a year, 
six months, three months, one month, or any other uniform 
period. Most concerns have their fiscal year end with the 
calendar year, but many, as a matter of economy and conven- 
ience, have it end some time other than December 31. It seems 
advisable to arrange the fiscal year to close when business is 
regularly dull and inventories are low. The financial statements 
are prepared after all business transactions of that period have 
been considered. 

Comparison of Proprietorship 

In the preceding chapter the balance sheet prepared for David 
Mulford revealed that he had a net worth of $29,000.00 at the 
close of business on December 31. Twelve months before a 
similar statement showed the equity of the proprietor to be 
$25,000.00, his original investment. A comparison of these 
two figures shows that proprietorship had a net increase of 
$4,000.00 during the fiscal period. If an investigation reveals 
that Mr. Mulford did not invest any more of his personal funds 

24 



Ch. Ill] ANALYSIS OF PROPRIETORSHIP 25 

in the business or withdraw any of its assets during the year, 
this net increase is the result of operating the business at a net 
profit. 

The difference between the net worth of a business at the 
beginning and at the end of a fiscal period is the net increase or 
decrease in proprietorship, and, if there have been no added 
investments or withdrawals, it will represent the net profit or 
loss for the period. 

Balance Sheet Changes 

As already stated a balance sheet may be expressed algebrai- 
cally as 

Assets = Liabilities + Proprietorship 
A = L + P 

If thus viewed, it will be apparent that the proprietorship 
figure on a balance sheet at the end of a period will be different 
from the net worth figure at the beginning of the period, if asset 
and liability totals have changed in any one of the following ways : 

Proprietorship will increase if 

1. Assets increased while 

a. Liabilities remained the same. 

b. Liabilities decreased. 

c. Liabilities increased a lesser amount. 

2. Assets decreased while liabilities decreased a greater 
amount. 

3. Assets remained the same while liabilities decreased. 
Proprietorship will decrease if 

4. Assets decreased while 

a. Liabilities remained the same. 

6. Liabilities increased. 

c. Liabilities decreased a lesser amount. 

5. Assets increased while liabilities increased a greater amount. 

6. Assets remained the same while liabilities increased. 

In order to determine whether a net increase or decrease in 
proprietorship is due to a net profit or loss, or whether it is due in 
whole or in part to added investments or withdrawals by the 
owner, it is necessary to investigate the reasons for the variation. 



28 ACCOUNTING FUNDAMENTALS [Ch. JU 

Factors That Increase Proprietorship 
Proprietorship increases as a result of 

1. Added Investments, a term used to describe additional 
financial contributions to a business by the owner, and 

2. Net Profit, a term used to describe the increase in proprietor- 
ship resulting from the operation of a business in a given 
period. 

Net profit resembles added investments in that it increases the 
equity of the owner in the business. It differs in that it arises 
from sources within the business, while added investments 
originate outside. 

The balance sheet prepared at the close of a period includes the 
net profit and added investments made during the period. If 
an asset was sold at a profit, assets and proprietorship increased 
by the amount of the profit, with no change in the liabilities. 
If the owner made an additional investment in the business, say 
$3,000.00 cash, the assets and proprietorship increased $3,000.00, 
with no change in liabilities. 

Factors That Decrease Proprietorship 

Proprietorship decreases as a result of 

to 

1. Withdrawals, a term used to describe the removal of assets 
from the business by the owner, and 

2. Net Loss, a term used to describe the decrease in proprietor- 
ship resulting from the operation of a business in a given 
period. 

Net loss resembles withdrawals in that it reduces the equity 
of the owner in the business. 

The balance sheet prepared at the close of a period reflects the 
net loss and any withdrawals made during the period. If an 
asset was sold at a loss, assets and proprietorship decreased by 
the amount of the loss, with no change in liabilities. If the 
owner withdrew from the business for his personal use, say 
$3,000.00 cash, the assets and proprietorship decreased $3,000.00, 
with no change in liabilities. 



Ch. IIIJ ANALYSIS OF PROPRIETORSHIP 27 

Net Increase or Decrease in Proprietorship Analyzed 

With either a net increase or decrease in proprietorship there 
may be a net profit or loss for the period depending on the rela- 
tionship existing between withdrawals and added investments. 
As previously stated, the net increase agrees with the net profit, 
and the net decrease with the net loss, if there have been neither 
added investments nor withdrawals. The following will 
illustrate : 

1. A Net Increase in Proprietorship as the result of Added 

Investments and the Net Profit. 

Assume that Mr. Mulford had an equity of $25,000.00 on 
January 1, 19A, that he had an equity of $29,000.00 on 
December 31, 19A, and that he had invested $1,000.00 of 
additional assets in the business during the year. 

Proprietorship, December 31, 10A $29,000.00 

Proprietorship, January 1, 19 A 25,000 00 

Net Increase in Proprietorship $ 4 ,000 00 

Added Investments 1,000.00 

Net Profit for the Year $ 3,000.00 

The above analysis indicates that $1,000.00 of the increase 
was caused by added investments and $3,000.00 by oper- 
ating the business at a net profit. 

2. A Net Increase in Proprietorship as the result of Added 

Investments in excess of the Net Loss. 
Assume that Mr. Mulford had an equity of $25,000.00 on 
January 1, 19 A, that he had an equity of $29,000.00 on 
December 31, 19A, and that he invested $13,000.00 of 
additional assets in the business during the year. 

Proprietorship, December 31, 19A $29,000.00 

Proprietorship, January 1, 19 A 25,000.00 

Net Increase in Proprietorship $ 4,000.00 

Added Investments 13,000.00 

Net Loss for the Year $ 9,000.00 

This analysis indicates that although the proprietor made 
added investments of $13,000.00, his equity in the business 
was only $4,000.00 more than it was a year ago; therefore, 
the business must have operated at a net loss of $9,000.00 
for the year. 



28 ACCOUNTING FUNDAMENTALS [Ch. Ill 

3. A Net Increase in Proprietorship as the result cf Net Profit 

in excess of Withdrawals. 

Assume that Mr. Mulford had an equity cf $25,000.00 on 
January 1, 19A, that he had an equity of $29,000.00 on 
December 31, 19A, and that he had withdrawn $3,000.00 
of cash during the year. 

Proprietorship, December 31, 19A $29,000.00 

Proprietorship, January 1, 19 A 25,000 00 

Net Increase in Proprietorship $ 4 ,000 00 

Withdrawals 3,000.00 

Net Profit for the Year $ 7,000.00 

The above analysis indicates that tho equity of the owner 
increased $4,000.00 in spite cf the $3,000.00 he withdrew; 
therefore, the business made a net profit of $7,000.00 
during the year. Interpreting the analysis in reverse, 
Mr. Mulford made a net profit of $7,000.00 for the period, 
he withdrew $3,000.00 of it during the year, and $4,000.00 
of it remained in the business at the end of the year. 

4. A Net Increase in Proprietorship as the result of Added 

Investments and Net Profit in excess of Withdrawals. 

Proprietorship, December 31, 19 A $29,000.00 

Proprietorship, January 1, 19A 25,000.00 

Net Increase in Proprietorship $ 4,000.00 

Withdrawals 2,000.00 

Total '. $ 6,000.00 

Added Investments 5,000.00 

Net Profit for the Year $ 1,000 00 

The above analysis indicates that in spite of withdrawals 
of $2,000.00, the equity of the owner went up $4,000.00; 
therefore, the total increase must have been $6,000.00, of 
which $5,000.00 was caused by added investments and the 
remaining $1,000.00 by operating at a net profit for the 
year. 

5. A Net Increase in Proprietorship as the result of Added 

Investments in excess of the Withdrawals and the Not 
Loss. 



Ch. Ill] ANALYSIS OF PROPRIETORSHIP 29 

Proprietorship, December 31, 19A $29,000.00 

Proprietorship, January 1, 19A 25,000.00 

Net Increase in Proprietorship $ 4,000.00 

Withdrawals 2,000.00 

Total $ 6,000.00 

Added Investments 7,000.00 

Net Loss for the Year $ 1,000.00 

The above analysis is similar to No. 4 except that the 
added investments exceeded the total $6,000.00. Because 
the owner made added investments of $7,000.00, it would 
be expected that the total increase would be at least 
$7,000.00; since it was only $6,000.00, it is evident that the 
business operated at a net loss of $1,000.00 for the year. 

6. A Net Decrease in Proprietorship as the result of With- 

drawals and a Net Loss. 

Assume that Mr. Mulford had an equity of $29,000.00 on 
January 1, 19A, that he had an equity of $25,000.00 on 
December 31, 19A, and that he had withdrawn $3,000.00 
of assets from the business during the year. 

Proprietorship, December 31, 19A $25,000.00 

Proprietorship, January 1, 19 A 29,000.00 

Net Decrease in Proprietorship $ 4,000.00 

Withdrawals 3,000.00 

Net Loss for the Year $ 1,000.00 

The above analysis indicates that $3,000.00 of the net 
decrease was attributable to withdrawals by the owner and 
$1,000.00 to operating the business at a net loss. 

7. A Net Decrease in Proprietorship as the result of Net Loss 

in excess of Added Investments. 

Assume that Mr. Mulford had an equity of $29,000.00 on 
January 1, 19A, that he had an equity of $25,000.00 on 
December 31, 19A, and that he had invested $3,000.00 of 
additional cash during the year. 

Proprietorship, December 31, 19 A $25,000.00 

Proprietorship, January 1, 19 A 29 ,000 . 00 

Net Decrease in Proprietorship 8 4 , 000 . 00 

Added Investmsnts 3,000.00 

Net Loss for the Year fc 7,000.00 



30 ACCOUNTING FUNDAMENTALS [Ch. HI 

A net decrease in proprietorship in a period when the owner 
increased his investment indicates that the operation of 
the business resulted in a loss which is the sum of the 
decrease in proprietorship and the additional investments. 
The above analysis indicates that in spite of added invest- 
ments of $3,000.00, the equity of the owner at the end of 
the year was $4,000.00 less than at the beginning of the 
year; therefore, the business lost during the year not only 
the $3,000.00 of added investments but $4,000.00 more. 

8. A Net Decrease in Proprietorship as the result of With- 

drawals in excess of Net Profit. 

Assume that Mr. Mulford had an equity of $29,000.00 on 
January 1, 19A, that he had an equity of $25,000.00 on 
December 31, 19A, and that he had withdrawn $5,000.00 
of assets from the business during the year. 

Proprietorship, December 31, 19 A $25,000.00 

Proprietorship, January 1, 19A 29,000.00 

Net Decrease in Proprietorship $ 4,000.00 

Withdrawals 5,000.00 

Net Profit for the Year $ 1,000.00 

This analysis indicates that although the proprietor with- 
drew $5,000.00, his equity went down only $4,000.00; there- 
fore, the business must have operated at a net profit of 
$1,000.00 for the year. 

9. A Net Decrease in Proprietorship as the result of With- 

drawals in excess of the Added Investments and the Net 
Profit. 

Proprietorship, December 31, 19 A $25,000.00 

Proprietorship, January 1, 19 A 29,000.00 

Net Decrease in Proprietorship $ 4,000.00 

Added Investments 3,000.00 

Total $ 7,000.00 

Withdrawals 9,000.00 

Net Profit for the Year $ 2,000.00 

The above analysis indicates that the net decrease in 
proprietorship of $4,000.00 was caused by the owner's 
withdrawal of $4,000.00 more than the total of his added 
investments and his net profit for the year. 



Ch. Ill] ANALYSIS OF PROPRIETORSHIP 31 

10. A Net Decrease in Proprietorship as the result of With- 
drawals and Net Loss in excess of Added Investments. 

DAVID MULFORD 

ANALYSIS OF PROPRIETORSHIP 

For the Year Ended December 31, 19A 

Proprietorship, December 31, 19 A $25,000.00 

Proprietorship, January 1, 19 A 29,000.00 

Net Decrease in Proprietorship $ 4,000.00 

Added Investments 3,000.00 

Total $ 7,000.00 

Withdrawals 2,000.00 

Net Loss for the Year $ 5,000.00 

The above analysis indicates that the net decrease in pro- 
prietorship of $4,000.00 was caused by added investments of 
$3,000.00 being $4,000.00 less than the total of the $2,000.00 
withdrawals and the $5,000.00 net loss for the year. 

Analysis of Proprietorship 

The purpose of this statement is to explain the difference 
between proprietorship at the beginning and at the end of a 
fiscal period, in terms of added investments, withdrawals, and 
net profit or net loss. 

The form of the statement is that followed in the ten illustra- 
tions, more particularly in the tenth, where the necessary heading 
is included. 

Solution by Equations 

NOTE: It may be a help to sonic students to summarize the calculations of this chapter 
algebraically. 

1. Final proprietorship initial proprietorship = net increase 
in proprietorship. 

2. Final proprietorship initial proprietorship added 
investments + withdrawals = net profit for the period. 

In solving equation 1, if the difference results in a figure less 
than zero, there is a net decrease in proprietorship. In solving 
equation 2, if the final answer is less than zero, the business has 
sustained a net loss. 

Since added investments and net profit each increase proprie- 
torship while withdrawals and net loss each decrease it, a group- 
ing of like items leads to the following equations: 



32 ACCOUNTING FUNDAMENTALS (Ch. Ill 

If a net profit: 

Initial proprietorship + added investments + net profit = 

withdrawals + final proprietorship. 
If a net loss: 

Initial proprietorship + added investments = withdrawals 

loss + final proprietorship. 



Significance of the Chapter 

In addition to the main purpose of this chapter, as explained 
previously, it has an auxiliary purpose of considerable impor- 
tance to present some fundamental proprietorship concepts 
which are essential to an understanding of accounting techniques 
and results. The method employed in this chapter to explain 
the difference between the proprietorship at the beginning and 
at the end of a fiscal period is one which may be followed by a 
business that has no records, or totally inadequate ones. The 
Analysis of Proprietorship will be used in this text, as it is used 
in practice, as a check on another and better method of explaining 
the change in proprietorship resulting from net profit or loss, 
which is presented in the next chapter. 

QUESTIONS 

1. What is meant by a fiscal period? 

2. In what month and on what day do you think the fiscal year ends 
for the United States government? For your state? 

3. What circumstances might influence an enterprise to have its fiscal 
year end at a date other than the end of the calendar year? 

4. What factors increase net worth? 

5. What factors decrease net worth? 

6. Under what circumstances is the net increase in proprietorship the 
same as the net profit for a period? 

7. Prove or disprove with figures that a business may have a greater 
net worth at the end than it had at the beginning of a period although 
it sustained a net loss for the period. 

8. Assume a business was operated at a net profit for a fiscal period 
and that the owner made both additional investments and with- 
drawals. Express the equation to solve for the added investments, 
if all the other items are known. 

9. Assume the owner made additional investments and withdrawals 
and that the business was operated at a net loss during a fiscal 
period. Set up the equation to solve for the withdrawals, if all 
other items are known. 



Ch. Ill] ANALYSIS OF PROPRIETORSHIP 33 

10. What is the amount of increase or decrease in proprietorship, if 
during a fiscal period 

a. Assets are decreased $5,000.00 and liabilities are decreased 

$7,000.00? 
6. Assets are increased $2,000.00 and liabilities are decreased 

$3,000.00? 

c. Assets are decreased $3,000.00 and liabilities are increased 
$2,000.00? 

d. Assets are increased $4,000.00 and liabilities are increased 
$6,000.00? 

e. Assets are decreased $6,000.00 and liabilities are decreased 
$5,000.00? 

/. Assets are increased $1,500.00 and liabilities are increased 

$1,200.00? 
g. Assets remain the same and liabilities are decreased $1,700.00? 

11. Under what conditions will 

a. Net profit exceed the net increase in proprietorship? 

b. Net loss exceed the net decrease in proprietorship? 

c. Net increase in proprietorship exceed the net profit? 

d. Net decrease in proprietorship exceed the net loss? 

12. The business of A had a net worth a year ago of $25,000.00. Today 
it has a net worth of $30,000.00. During the year A inherited and 
placed in the business $9,000.00 of cash. He made no withdrawals 
during the year. 

a. Was the business operated at a net profit or net loss for the year 
and in what amount? 

b. From the facts stated above do you think A had any net income 
(net profit) for the year? 

13. The business of B has a net worth of $20,000.00. A year ago it 
had a net worth of $18,000.00. During the year B made no addi- 
tional investments but he gave out of the funds of the business 
$1,000.00 cash to his university endowment fund and $100.00 to 
the welfare fund of his community. What was the amount of the 
net profit or net loss of the business for the year? 

14. On January 1, 19 the business of Thomas Lloyd had assets of 

$30,000.00 and liabilities of $10,000.00. Six months later it had 
assets of $28,000.00 and liabilities of $6,000.00. During the six 
months Lloyd withdrew $3,000.00 and gave it to his mother to 
help her purchase a home. In the same period he placed in the 
business a note receivable for $1,000.00 which he had inherited 
from the estate of his father. The note had not matured by 
June 30, 19 

a. Would the note be included in the $28,000.00 total of business 
assets on June 30. 19 ? 



34 ACCOUNTING FUNDAMENTALS [Ch. Ill 

b. Would the total of the business assets be the same if the note had 
matured and had been paid by the maker? Explain. 

c. What is the net increase or decrease in proprietorship for the six 
months? 

d. Determine the amount of the net profit or loss for the period. 

e. What would have been the net worth of the business on June 30, 
if Lloyd had not made an added investment and a withdrawal of 
assets? 

16. What would be the effect on the capital of an enterprise if it earned 
$50,000,000.00 in a year and $60,000,000.00 of its cash were dis- 
tributed to its owners? 

16. The business of C has a net worth of $40,000.00. During the past 
year C withdrew $7,000.00 cash and operated the business at a 
net profit of $5,000.00. What was the net worth of the business a 
year ago? 

17. The business of D had a net worth of $1 6,000.00 a year ago. Today 
it has a net worth of $20,000.00. The business was operated at a 
profit of $5,000.00 during the year. D made no added investments 
during the year. What did D do during the year? 



CHAPTER IV 
THE STATEMENT OF PROFIT AND LOSS 

The prime purpose of the analysis of proprietorship in the 
previous chapter is to explain the difference between the net 
worth of a business at the beginning and at the end of a fiscal 
period in terms of added investments, withdraAvals, and net 
profit or loss. Such a statement shows the amount of the net 
profit or loss for a fiscal period but it does not disclose the sources 
and amounts of the income and expenses which resulted in the 
net profit or loss. This information is essential to the successful 
management and direction of an enterprise. It is presented in a 
statement variously known as the statement of profit and loss; 
the statement of income, profit and loss; the statement of income 
and expense; the operating statement; and by other titles. 

Purposes of the Statement of Profit and Loss 

A statement of profit and loss is prepared at the end of each 
fiscal period to present a summary of the various items of income 
and expense which have arisen during the period. It should be 
emphasized that this statement covers the operations of the 
entire period, in contrast to the balance sheet which pictures the 
financial condition on a given date. A business is conducted to 
make a profit, and the final figure of the statement of profit and 
loss shows whether that object has been realized. In addition, 
and equally important, statements of profit and loss furnish the 
owner with operating facts and figures, a study of which may 
indicate ways of increasing income, reducing expenses, or effect- 
ing changes which may result in greater net profits in subsequent 
periods. 

The owner of a business is not the only one interested in 
the statement of profit and loss. Estimates with respect to the 
future possibilities of an enterprise are based in part on the 
results of the past. The owners and, in large-scale enterprises, 
the directors, the executives, oftentimes even the humblest 

35 



36 ACCOUNTING FUNDAMENTALS [Ch. IV 

employees have an interest in the results shown by such a state- 
ment and in the choice of proper policies resulting in part from 
an analysis of it. Trade and long-term creditors are interested 
also in the results of the operations of any enterprise to which 
they have extended credit or loaned funds. Similarly prospec- 
tive buyers of a business or prospective purchasers of business 
securities are interested in the trend of the earnings as shown by 
the statements of profit and loss over a series of fiscal periods. 
_Itjluiuld_be_borne in mind that each year the information shown 
in thisjJtatfiment must be considered in the preparation of the 
federal and, where required, state Income-tax returns. 

Income and Expenses 

Before explaining the content of the statement of profit and 
loss, it is necessary to make clear the use of the terms income and 
expenses. 

Income includes compensation for personal or professional 
services rendered; gains from sales of and dealings in land/ 
property, business, or other investments; interest earned; rent 
earned; dividends received; and gains, profits, and earnings from 
any source whatever. In general it is "the gain derived from 
capital, from labor, or from both combined."* It is not income 
if it represents a return of capital or in vestment, f 

Many interpretations of income are made by accountants, 
economists, jurists, and members of other professions. The 
definition used here is based on the definition of the Treasury 
Department in governmental regulations issued to aid in the 
interpretation of the federal income-tax law. 

Gross income in a manufacturing, merchandising, or mining 
business means the net sales less the cost of goods sold, plus any 
income from investments (including profits derived from the 
sale of fixed assets) and from incidental or outside sources. 

Income of nonprofit enterprises such as charitable, religious, 
educational, or social institutions would include gifts available 
for current use within the period in addition to any or all of 
those indicated for profit enterprises. 

* As defined by the United States Supreme Court in several decisions. 

t Many accounting writers consider the actual amount of sales as income. 
As the figure for sales includes a return of capital it seems better to view as 
income only the profit arising from sales. 



Ch. IV] THE STATEMENT OF PROFIT AND LOSS 37 

Expenses are all costs incurred to obtain gross income whether 
payment has been made or not. Ordinary expenses include 
such items as wages, taxes, supplies, insurance, and depreciation. 

Net income (net profit) is the excess of the gross income over 
the expenses and losses. 

Net loss is the excess of the expenses and losses over gross 
income. 

Cash and Accrual Methods cf Accounting 

There is no necessary relationship between cash receipts and 
disbursements and income and expenses. The net change in 
cash may be ascertained by comparing the cash item shown in 
the balance sheet at the end of the last period with the cash item 
shown in the balance sheet at the end of the current period. 
The detailed changes in cash may be determined only from 
separate records wherein all receipts and disbursements are 
recorded. 

A cash basis of accounting is a system wherein income is not 
recognized unless it has been received in cash, and expenses are 
ignored until paid in cash. The accrual basis of accounting 
is a system wherein income is recognized when earned, whether 
or not received in cash, and expenses are recognized when incurred, 
whether or not paid in cash. In any business with opening and 
closing inventories of merchandise the accrual basis is practically 
essential. 

The mere receipt of cash does not indicate income, nor does 
every disbursement of cash represent expenses. Money may be 
received from the sale of an asset at a loss. Cash may come into 
the business because of the added cash investment of the owner. 
In these two cases the business income does not increase. Money 
may be paid out for machinery or be withdrawn by the proprietor 
without the expenses of the business being affected. 

If some merchandise has been sold to customers and cash has 
not been collected, or if some merchandise has been purchased 
and has not been paid for in cash, it is obvious that the balance 
between the cash which has been received for merchandise and 
the amount which has been paid for merchandise in that particular 
period is a meaningless figure. To determine the correct income 
from sales it is necessary to consider all purchases and sales 
whether for cash or for credit. As most businesses engaged in 



38 ACCOUNTING FUNDAMENTALS [Ch. IV 

selling merchandise have inventories of unsold merchandise, 
have accounts receivable, and have accounts payable, they are 
forced to use the accrual basis to determine the net earnings with 
any degree of accuracy. In this text the accrual basis will be 
used exclusively. 

Illustration of Simple Statement of Profit and Loss 

Suppose the following facts pertained to the business of Allan 

Walton for the year ended December 31, 19 : Merchandise 

sold amounted to $50,000.00; merchandise on hand at the begin- 
ning of the year had cost $2,000.00; merchandise purchased 
during the year had cost $34,000.00; merchandise on hand at 
the end of the year had cost $3,000.00. Expenses had been as 
follows: For salaries $11,000.00; for delivery expenses $1,600.00; 
for advertising $500.00; for rent $1,500.00; for insurance $300.00; 
for store expenses $400.00. 

ALLAN WALTON 

STATEMENT OF PROFIT AND Loss 
For the Year Ended December 31, 19 

Sales (Gross) . , . $50,000.00 

Cost of Goods Sold: 

Inventory of Merchandise, January 1, 19 $ 2,000.00 

Purchases 34,000 00 

$36,000.00 
Less: 

Inventory of Merchandise, December 31, 19 3,000.00 33,000.00 

Gross Profit on Sales $17,000.00 

Less Operating Expenses: 

Salaries $11 ,000.00 

Delivery Expenses 1 ,600 00 

Advertising 00.00 

Rent 1 ,500 00 

Insurance 300.00 

Store Expenses 400.00 

Total Expenses 15,300.00 

Net Profit for the Year $ 1,700.00 

In presenting the sources of income and the expenses of an 
enterprise for a period, it is desirable to use the accepted account- 
ing titles which are both brief and descriptive, i.e., the merchan- 
dise sold during the year is called Sales, the merchandise on hand 



Ch. IV) THE STATEMENT OF PROFIT AND LOSS 89 

at the beginning of the year is referred to as Merchandise Inven- 
tory, January 1, 19 , merchandise bought during the year is 

listed as Purchases, and the merchandise on hand at the end of 
the year is indicated as Merchandise Inventory, December 31, 

19 The various expenses are listed by titles such as Salaries, 

Delivery Expenses, Advertising, Rent, Insurance, and Store 
Expenses. 

The statement of profit and loss as shown on page 38 presents 
the facts just considered. 

This illustrative statement furnishes Allan Walton, the 
owner of the business, with concise information about the opera- 
tions of his business for the past year. He may compare these 
figures with those of other years; he shouJ4 study them as he 
plans for the year which is ahead. 

The statement of facts about the Allan Walton business was 
limited to certain fundamental items. It is possible for a busi- 
ness to have sources of income other than Sales, to have many 
more expenses than those illustrated, and to have other signifi- 
cant operating facts which were not mentioned. In addition, 
the expenses of the business should be classified in the statement 
of profit and loss, if a more exact picture of the results of opera- 
tions is to be presented. In order to include the other possible 
items in the statement of profit and loss and to classify the 
expenses, it is necessary that the profit and loss statement 
terminology be studied in more detail. 

Profit and Loss Statement Terminology 

The first item to be shown in a statement of profit and loss is 
the principal source of income. In a manufacturing, mining, 
or mercantile business the main source of income is sales of com- 
modities; in a bank it is interest, discount, collection and 
exchange fees; with brokers or agents it is commissions; with 
professional people, such''as doctors, lawyers, and accountants, 
who are selling services, it is fees. 

The outstanding points to be noted on a statement of profit and 
loss prepared for a merchant are net sales, cost of goods sold, 
gross profit on sales, net profit on sales, and net profit for the 
period. 

Net sales is the term applied to the difference between gross 



40 ACCOUNTING FUNDAMENTALS [Ch. IV 

sales and the returns and allowances on sales. The amount of 
the net sales is the real index of the volume of business transacted. 

1. Gross Sales signifies the total contract price of all merchan- 
dise sold during the fiscal period. 

2. Sales Returns shows the value (ordinarily at original con- 
tract price) at which merchandise sold has been returned to 
an enterprise. 

3. Sales Allowances is the title used by the seller to cover 
reductions subsequently made in the contract price of 
merchandise sold. 

Sales Returns and Sales Allowances are combined frequently 
in one title since both are reductions of the gross sales. 

Cost of goods sold is the phrase used to describe the cost of the 
merchandise which was marketed during the period. This 
term must not be confused with the costs of selling goods, such 
as salaries and commissions paid to salesmen, delivery expenses, 
store supplies, and advertising. 

In the first period of operation, if all the merchandise purchased 
was marketed, the cost of goods sold would be the cost of the 
merchandise bought. 

If any merchandise was on hand at the end of the period then 
the value of this inventory would be subtracted from purchases 
to determine the cost of goods sold. 

In a period when the business both opens and closes with an 
inventory, the cost of goods sold would be determined by adding 
the value of the initial inventory to the value of purchases and 
from this total subtracting the value of the closing inventory. 

Other items under this heading must be considered sometimes, 
such as transportation costs on merchandise purchased, and 
merchandise returned to or allowances obtained from the seller. 

The cost of the initial inventory plus the cost of the merchan- 
dise acquired in a period, including transportation costs, repre- 
sents the value of the merchandise to be accounted for. If the 
total of the value of the merchandise returned and the amount of 
allowances obtained on merchandise plus the value of unsold 
merchandise is subtracted from the value of the merchandise 
to be accounted for, the balance will be the cost of the merchan- 
dise sold (cost of goods sold). 



Ch. IV] THE STATEMENT OF PROFIT AND LOSS 41 

These items may be shown as follows: 

Cost of Goods Sold: 

Initial Inventory Sxxxxxxx 

Purchases xxxxxxx 

Transportation In xxxxxxx Sxxxxxxx 

Less: 

Purchase Returns and Allowances Sxxxxxxx 

Closing Inventory xxxxxxx xxxxxxx 

Cost of Goods Sold Sxxxxxxx 

An explanation of these terms follows : 

1. Purchases is the title applied to the total contract price of 
all merchandise acquired for the purpose of selling. 

2. Transportation In is the title which covers the freight, 
express, parcel post, cartage, or other costs necessary to 
get the merchandise purchased to the place where the busi- 
ness wants it. It is an additional cost of the merchandise 
bought. Another title commonly used is Freight and 
Cartage In, although it is not so inclusive as the one 
suggested. The term is never used to cover transportation 
costs on fixed assets such as machinery and office equip- 
ment. To determine the total cost of fixed assets at the 
time of acquisition, transportation costs are added to the 
contract price. 

3. Purchase Returns and Allowances is the title which repre- 
sents the value of all merchandise returned by and the 
amount of price concessions and rebates subsequently 
obtained by the business on purchases. 

Gross profit on sales is the excess of the net sales over the cost 
of goods sold. It is the total amount of profit before the deduc- 
tion of any of the expenses of operating the business. 

Selling expenses are the costs of marketing or distributing the 
product. A few typical examples follow: 

1. Advertising is the cost to obtain publicity through the 
agencies of newspapers, magazines, and the radio; the 
expense of printing and distributing handbills and cata- 
logues; and like expenditures that have as their purpose 
the ultimate increase of the sales volume. 



12 ACCOUNT/NO FUNDAMENTALS [ Ch< jy 

2. Transportation Out is the title that covers the freight, 
express, parcel post, cartage, or other costs necessary to 
send the merchandise to the place indicated by the customer. 
This item is not treated as a reduction from sales but as an 
item of selling expense. 

3. Delivery Expenses is the title applied to the cost of operat- 
ing a truck used to deliver merchandise locally. Typical 
costs are wages of the driver, gasoline, oil, repairs, auto 
licenses, and depreciation. Transportation Out is used to 
cover the cost of sending merchandise to a destination not 
reached by the business truck. 

4. Sales Salaries (or Sales Commissions) represent amounts 
paid or accrued to employees or agents who assist in the 
direct marketing of the product. 

5. Store Expenses include cleaning, wrapping paper, twine, 
pasteboard cartons, boxes, and other materials needed and 
used to prepare the goods sold for delivery. Not all the 
value of supplies purchased in a period is placed in the profit 
and loss statement; only the amount used is an expense of 
the period. The balance on hand at the end of the period 
is indicated in the balance sheet as inventory of supplies. 

6. Depreciation of Store Furniture and Fixtures is the term 
used to describe the estimated decline in the value of store 
furniture and fixtures caused chiefly by wear and tear. 

General and administrative expenses are the costs of those general 
expenses necessary to the conduct of the business as a unit but 
which have not been applied directly to departments of the 
enterprise, as well as the expenses of the executive offices. A 
few of the customary titles follow: 

1. Office Expenses include cleaning, carfare, and supplies such 
as postage, stationery, carbon paper, billheads, envelopes, 
and other materials needed in the administration of the 
business. 

2. Office Salaries. 

3. Telephone and Telegraph. 

4. Property Taxes represent amounts levied by a governmental 
unit on property, especially land and buildings. There 
are other forms of taxes, such as federal income tax, inherit- 



Ch. IVJ THE STATEMENT OF PROFIT AND LOSS 43 

ance taxes, estate taxes, and special assessment taxes which 

are not considered as expenses. 

6. Bad Debts are uncollectible accounts and notes receivable. 
6. Depreciation of Office Furniture and Fixtures. 

Net profit on sales is the excess of the gross profit on sales over 
the selling, and general and administrative expenses. 

Net loss on sales is the excess of the selling, and general and 
administrative expenses over the gross profit on sales. , 

O.her income includes all income other than that obtained from 
the major purpose for which the business was organized. Some 
common examples follow: 

1. Interest Earned represents income of the business resulting 
from the loan of its money or credit to others. 

2. Purchase Discounts are additional income of the business 
resulting from reductions obtained from creditors by the 
payment for merchandise purchases within stated periods. 

3. Cash Dividends Received represent receipts of money aris- 
ing from the distribution of profits by corporations in which 
shares of stock are owned. 

4. Profit arising from the sale, exchange, or conversion of 
assets other than merchandise, such as stocks or bonds, 
for more than their book values. 

5. Rental Income represents income of the business arising 
out of property not used in operations but leased to tenants. 

6. Commissions Earned represents income earned when the 
business acts as an agent in the sale of property owned by 
another. 

Other expenses and losses are costs which arise from other than 
the major operating causes. Some common examples follow: 

1. Interest Expense is the cost of borrowing money. 

2. Sales Discounts represent reductions made to customers 
for the payment of bills within stated periods. 

3. Extraordinary Losses represent losses such as fire losses and 
losses arising from the sale, exchange, disappearance, or 
abandonment of any asset not regularly bought and sold. 

. s Net profit for the period is found by adding other income to the 
net profit on sales and subtracting other expenses and losses. 



44 ACCOUNTING FUNDAMENTALS [Ch. IV 

If there has been a net loss on sales, there may still be a net profit 
for the period if other income exceeds the net loss on sales and 
the other expenses and losses. 

Net loss for the period is found by subtracting the other income 
from the net loss on sales and the other expenses and losses. 
If the business had a net profit on sales there may still be a net 
loss for the period if other expenses and losses exceed the net 
profit on sales and the other income. 

The difference between other income and other expenses and 
losses frequently is/idded to or subtracted from the net profit or 
loss on sales. 

Form 

To illustrate the form of a statement of profit &nd loss there 
follows the one prepared for David Mulford. 



Ch. IV] THE STATEMENT OF PROFIT AND LOSS 45 

DAVID MULFORD 

STATEMENT OP PROFIT AND Loss 

For the Year Ended December 31, 19_ 

Sales (Gross) $168,000.00 

Less: Sales Returns and Allowances 800.00 

Net Sales $167,200.00 

Cost of Goods Sold: 

Inventory of Merchandise, January 1, 19 $ 10,500.00 

Purchases 117,600.00 

Transportation In 1 ,500.00 

Cost of Goods to Be Accounted For $129,600.00 

Less: 

Purchase Returns and Allowances 8 C9 . CO 
Inventory of Merchandise, De- 
cember 31, 19 12,600.00 13,100.00 116,500.00 

Gross Profit on Salos $ 50,700.00 

Less Operating Expenses: 

Selling Expenses: 

Advertising $ 8,000.00 

Sales Salaries 17,000.00 

Store Expenses 950.00 

Transportation Out 430.00 

Depreciation of Store Furniture and Fixtures 00.00 

Total Selling Expenses $ 26,900.00 

General and Administrative Expenses: 

Office Expenses $ 850 00 

Office Salaries 14,000.00 

Insurance 1 ,200 00 

Property Taxes 250.00 

Bad Debts 450.00 

Depreciation of Building 400 . 00 

Depreciation of Office Furniture 

and Fixtures 100.00 

Total General and Adminis- 
trative Expenses 17,2^0.00 44,150.00 

Net Profit on Sales $ 6,550.00 

Other Expenses and Losses: 

Interest Expense $ 550 . 00 

Sales Discounts 3,200.00 

Loss Sale of Ideal Radio Stock 2,800.00 

$ 6,550.00 
Other Income: 

Interest Earned $ 100.00 

Purchase Discounts 2 , 700 . 00 

Cash Dividends Received 200.00 3,000.00 3,550.00 

Net Profit for the Year $ 3,000.00 



46 ACCOUNTING FUNDAMENTALS [Ch. IV 

This statement shows the sources of the income and expenses 
which resulted in a net profit of $3,000.00 for the twelve months 
ended December 31, 19 

A detailed statement such as the illustration just given is 
essential to the proper management of a business, but the above 
data may be condensed into the following summarized statement: 

DAVID MULFORD 

CONDENSED STATEMENT OF PROFIT AND Loss 
For the Year Ended December 31, 19_ 

Net Sales $167,200.00 

Less Cost of Goods Sold 116,500.00 

Gross Profit on Sales $ 50,700.00 

Less Selling, and General and Administrative 

Expenses 44,150.00 

Net Profit on Sales $ 6,550.00 

Less Excess of Other Expenses and Losses over 

Other Income 3,550.00 

Net Profit for the Year. . . ... . . $ 3,000.00 

The student should realize that the forms illustrated, while 
typical, are not to be considered a standard of practice for all 
types of business as to either terminology or detailed arrangement. 
The illustrations are for the business of a merchant. Other 
lines of endeavor would require captions and arrangements 
better suited to their needs. Even the size of the enterprise 
may influence arrangement and the extent to which detailed 
items should be shown in the statement. In a very large estab- 
lishment the statement may be in the form of a condensed sum- 
mary with practically all of the summary figures supported by 
appended schedules of detailed figures. 

An absolute standard of captions and form for all businesses is 
impossible because of the diversifications of business itself. 
Within given fields of business, however, progress has been and 
is being made toward standardization. The Interstate Com- 
merce Commission requires railroads to report on a prescribed 
form, the Federal Reserve Board has suggested a form for 
manufacturers and merchants and, in some instances, by agree- 
ment among themselves, establishments in the same field of 
endeavor are using standard forms. The increasing publicity 



Ch. IV] THE STATEMENT OF PROFIT AND LOSS 47 

given to the profit and loss statements of the leading companies 
in itself should help to standardize the statements of like 
enterprises. 

Dual Procedure to Compute Net Profit or Loss 

The final result of the statement of profit and loss must agree 
with the amount of the net profit or loss shown in the analysis of 
proprietorship. Since the net profit or loss of the analysis 
of proprietorship is ascertained by comparing the initial and final 
proprietorship with due regard for additional investments and 
withdrawals, while the statement of profit and loss results in the 
same figure after the comparison of income and expense items, 
it will be realized that in accounting there are two ways to deter- 
mine the net profit or loss, each of which acts as a check on the 
other. 

Complements the Balance Sheet 

The statement of profit and loss and the balance sheet comple- 
ment each other. The balance sheet shows financial condition 
at a particular date, usually the last day of the period, while the 
statement of profit and loss shows the results of operation during 
the entire fiscal period. In any careful analysis of the financial 
condition of an enterprise, one must make use of the information 
shown in both statements. 

QUESTIONS 

1. What is income? Gross income? An expense? Net income? 

2. Name a principal source of income for each of the following: doctors, 
brokers, lawyers, teachers, salesmen, department stores, banks, 
insurance companies. 

3. a. Could a person who did not work have any income? How? 
6. Could a person who had no capital have any income? How? 

4. a. Income derived from real estate is referred to as ? 

6. Income derived from the ownership of bonds is referred to 
as ? 

c. Income derived from the ownership of shares of stock in corpora- 
tions is referred to as ? 

d. Income derived from the ownership of mortgages is referred to 
as ? 



48 ACCOUNTING FUNDAMENTALS [Ch. IV 

5. If a person inherited $10,000.00 cash, would the inheritance be 
income? If he invested the $10,000.00, would the return on the 
investment for a given period be income? 

6. What is a statement of profit and loss? Give some other titles by 
which it is known. 

7. Which statement is the more informative to the management of an 
enterprise, the statement of profit and loss or the analysis of pro- 
prietorship ? Explain. 

8. In the last year A received a salary of $1,000.00 in cash, a cash 
bequest of $1,000.00, a $1,000.00 present from his mother in cash 
and $500.00 cash as rent for a property he owned. lie gave $200.00 
cash to his community welfare fund. 

a. How much cash did he receive? 
6. What was his income for the year? 

9. A year ago D purchased a property for $10,000.00 cash. During 
the year he paid for taxes on the property $300.00, for repaira 
$200.00, and for insurance $100.00. In the same period he received 
as rent for the property $1,000.00 cash. 

a. What was the gross income from the property? 
6. What were the expenses for the property? 
c. Was there any net income or net loss because of the ownership of 
the property during the period? 

10. a. What is meant by the expression cash basis of accounting? 

6. What is meant by the expression accrual basis of accounting? 

11. Are returned sales and allowances considered expenses of an enter- 
prise? Justify your answer. 

12. At the beginning of a fiscal period the business of C had on hand 
merchandise which cost $1,000.00. During the year $10,000.00 
worth of merchandise was bought. At the end of the year, the 
merchandise on hand at cost was worth $2,000.00. 

a. What was the cost of the goods purchased? 

6. What was the cost of the goods sold? 

c. What was the cost of the goods which were not sold? 

13. Distinguish between selling expenses and general and administrative 
expenses. 

14. Is there any method of checking the net profit or the net loss figure 
as shown by a statement of profit and loss? Explain. 

15. If the inventory of merchandise at the end of a fiscal period is 
understated, what is the effect on the Cost of Goods Sold? On the 
Net Profit for the period? On the Net Worth of the enterprise? 

16. What words would describe x in each of the following equations? 
a. Gross Profit on Sales + Cost of Goods Sold = x 

6. Gross Profit on Sales Net Profit on Sales = x 

c. Value of Goods to Be Accounted For Cost of Goods Sold =* x 



Oh. IV] THE STATEMENT OF PROFIT AND LOSS 49 

17. What part of the statement of profit and loss is affected by 

a. Freight In? /. Purchase Returns and Allow- 

6. Sales Returns and Allow- ances? 

ances? g. Advertising? 

c. Freight Out? h. Purchase Discounts? 

d. Sales Discounts? i. Office Expenses? 

e. Interest Earned? j. Store Expenses? 

18. In the preparation of a statement of profit and loss for the retail 
business of Mr. Edward Andrew, you learn that the following items 
were omitted or not considered: 

a. Wages paid in advance $ 30 . 00 

6. Unpaid sales expenses of 180 . 00 

c. Inventory of Merchandise at the end of the period. . 2,850 00 

d. Interest accrued but not due on bonds owned 300 . 00 

What was the effect of each of these errors on the net profit for the 
period? What was the effect of all of these errors on the net profit 
for the period? 

19. a. Do you believe the following facts indicate favorable or unfavora- 
ble changes? Explain. 

Last Year This Year Increase 

Net Sales $23,000.00 $30,000.00 $5,000.00 

Net Profit 7,500.00 8,100.00 600.00 

Assume the owner had invested $75,000.00 in the business and that 
the net profit at the end of last year had been withdrawn. 
6. Would your answer be different if it is assumed that the net profit 
of last year had been left in the business all of this year? 

20. Would it be possible for a business to have a net profit for a period, 
if it had a net loss on sales? How? 

21. What is the income of David Mulford in the statement of profit and 
loss on page 45? 

22. Distinguish between the total of cash paid for merchandise and the 
cost of goods sold. 

23. Why isn't the net profit for the period equal to the excess of the cash 
receipts over the cash disbursements? 



CHAPTER V 
ACCOUNTS THEIR CONSTRUCTION 

The balance sheet, the analysis of proprietorship, and the state- 
ment of profit and loss were considered in the three preceding 
chapters, to make clear the process of determining the net worth 
of a business at the close of a fiscal period, and the method of 
presenting the causes for the variation in net worth throughout 
the period. The question logically arises, from what sources are 
the data for these statements obtained? 

Definition of an Account 

An account, in a broad sense, is a record of the financial trans- 
actions relating to a person, enterprise, property, or other item 
subject to review. In an accounting system, an account is a 
systematic record of the financial facts pertaining to a particular 
asset, a particular liability, an income item, an expense item, or 
a proprietorship item. 

Purpose of Accounts 

Accounts supply the recorded data for the preparation of 
accounting statements. 

Except for accounts receivable and accounts payable, the 
numerous changes in the amounts of which make it impossible to 
remember them and require, therefore, detailed records, it is 
possible to prepare a statement of assets and liabilities for an 
enterprise without the use of accounts. The cash in the bank and 
in the drawer can be determined easily, the inventory of mer- 
chandise can be taken and valued, the notes receivable will be 
found in the safe, the furniture and fixtures, delivery equipment, 
and other assets can be listed and their values estimated. 

Such a method of determining the assets, liabilities, and 
proprietorship is the plan followed when adequate records are not 
available. It has certain important disadvantages. 

1. There is no assurance that all assets and liabilities have been 
included. The amount of cash can be determined but 

50 



Ch. V] ACCOUNTS THEIR CONSTRUCTION 51 

there is no evidence to show that all of the cash received 
was accounted for or that money paid out during the period 
was used to benefit the business. In valuing furniture and 
fixtures and other tangible assets, it is easy to overlook cer- 
tain small pieces of equipment and to understate the assets 
to that extent. In order, therefore, to prevent fraud and 
carelessness, to avoid overlooking or possibly duplicating 
assets and liabilities, the keeping of a complete set of 
accounts becomes a necessity to a business enterprise. 

2. The impossibility of remembering the history of each asset 
and liability also necessitates the keeping of adequate 
records. For example, all the items representing furniture 
and fixtures may be known, but how shall they be valued? 
The office safe will have an efficient life span which differs 
from the typewriter, adding machine, or filing cabinet. 
Each item may have been bought at a different time and for 
a different price. These details cannot be remembered 
and some formal history of each should be kept. 

3. From a comparison of balance sheets and a knowledge of 
additional investments and withdrawals during a period, 
the amount of the net profit or loss can be determined but 
not the sources thereof. Complete data for the statement of 
profit and loss require detailed accounts for both income 
and expense items. 

The Ledger 

A ledger is a bound or loose-leaf book or card file of accounts. 
Since these accounts are the source of information for the state- 
ments, they should be arranged in a way to facilitate statement 
preparation. All accounts which will appear later in the balance 
sheet should be grouped together, while those that will be found 
subsequently in the profit and loss statement should be associated 
in another part of the ledger. 

Basic Classes of Accounts 

Fundamentally, accounts may be divided into two major 
classes, real and nominal accounts. 

Real accounts are asset, liability, and proprietorship accounts. 
They are the accounts which make possible the determination of 
financial condition by means of a balance sheet. 



52 ACCOUNTING FUNDAMENTALS [Oh. V 

Nominal accounts are those which explain the sources of 
income and expenses. They constitute the basis for the prepara- 
tion of the statement of profit and loss. If they were not used, 
every variation in net worth caused by income or expense would 
have to be made directly in the account of the owner. 

Real accounts which are partly nominal, and nominal accounts 
which are partly real, may be referred to as mixed accounts, but 
this title does not indicate a third class of accounts. For exam- 
ple, the Prepaid Insurance account may show that $1,000.00 has 
been paid for insurance premiums. If one-fifth of the insurance 
has expired then $200.00 of the total of $1,000.00 is nominal in 
character and represents an expense, while $800.00 is still pre- 
paid, is real in character, and is an asset. 

Captions or Account Titles 

The title of each account must be descriptive of the class of 
items that is placed under it; for instance, the asset title Office 
Furniture and Fixtures would represent all kinds of office equip- 
ment such as typewriters, adding machines, desks, and filing 
cabinets. 

Proper captions for specific nominal accounts depend to a 
great extent on the amount of detail necessary for an adequate < 
control of the business. For example, the title Delivery Expenses 
may be sufficient for the owner of one truck, while a department 
store with a fleet of delivery trucks may wish separate accounts 
for oil and gas, tires, repairs, automobile insurance, drivers' 
wages, and other expenses incident to the delivery of goods. 
While the caption of a nominal account should be broad enough to 
include related expenses or income items, there is danger in select-' 
ing one that is too inclusive and not specific enough. Adminis- 
trative Expenses as a caption would include stationery and 
printing, office salaries, postage, telephone and telegraph, and 
depreciation of office furniture and fixtures. Separate accounts 
for each of these items would make for greater internal control of 
expenses and therefore are recommended. 

Form and Content 

There is a variety of forms for accounts, but the most common 
is the T account, so called becau^each account in the rough 



Ch. V) 



ACCOUNTS THEIR CONSTRUCTION 



53 



resembles a capital letter T. At the center of the horizontal line a 
perpendicular is drawn downward to separate the account into 
two distinct parts. The space to the left of the perpendicular is 
termed the debit side, while that to the right is called the credit 
side. 

To enter an* amount on the left side of an account is known as 
debiting or charging the account. To enter an amount on the 
right side of an account is known as crediting the account. 

That facts and figures may be entered uniformly, all accounts 
may be ruled as follows : 



Account Caption 



Date 


Explanation 


F 


Amount 


Date 


Explanation 


F 


Amount 


Year 
Month 



Q 






Dollars 


2 

3 


Year 
Month 


1 






Dollars 


5 


o; 








Debit Side 












Credit Side 









The headings of the columns may not be written in an account, 
but are placed in the illustration so that the student may know 
the type of information which is found in the several subdivisions. 

A caption is placed above and in the center of each account. 
The year is written only at the top of the date column on each 
side of the account. The name of a month appears only once on 
each side, opposite the first item. The day appears opposite 
the first item on each day. It may appear opposite each item. 
The explanation column is used to further explain certain items. 
For the present the F (folio) column will not be used. Its pur- 
pose, however, is to provide a space in which to indicate the 
source of the information which appears opposite it. The 
amount columns are self-explanatory. 

The first item on the left side of the Cash account on page 54, 
$1,800.00, represents the cash balance on October 1. All the 
increases in cash which took place during October are debited to 
the account. The decreases in cash are credited to the account 
shown on the right side. The $3,397.00 excess of the debit over 
the credit side of the account on October 31 is known as the bal- 
ance of cash. This balance is ascertained, not by subtracting 



54 



ACCOUNTING FUNDAMENTALS 
Cash 



[Ch. V 



Oct. 


1 


Balance 




1,800 


00 


,0ct. 


1 


Rent 




150 


00 




4 


Sales 




600 


00 




4 


Purchases 




450 


00 




16 


J. R. Reed 




700 


00 




15 


Salaries 




200 


00 




25 


Notes Receiv- 










28 


Notes Payable 




500 


00 






able 




400 


00 




28 


Interest Ex- 










25 


Interest 












pense 




5 


00 






Earned 




2 


00 




*31 


Balance 




*3,397 


00 




30 


Sales 




1,200 


00 






















4,702 


00 










4,702 


00 


Nov. 


1 


Balance 




3,397 


00 















*This record is sometimes written in red ink to emphasize that it is the difference 
between the two sides of the account. 

" the total of the smaller from the total of the larger side, but by 
^ increasing the smaller side to the equal of the larger side. The 
October 31 cash balance of $3,397.00 is then brought down below 
the double rulings on the debit side to indicate the balance on 
November 1. It will be noticed that both sides of the account are 
ruled on the same line so that the transactions of the next month 
will start opposite each other. 

Accounts that have balances are referred to as open accounts, 
while those that total the same on both sides are termed closed 
accounts. An open account, the debit side of which exceeds the 
credit side, is said to have a debit balance. An open account, 
the credit side of which exceeds the debit side, is said to have a 
credit balance. 

The treatment of the Cash account is characteristic of the 
method of keeping, ruling, and balancing other open asset 
accounts with several debits and credits. An asset account is 
debited for increases and credited for decreases in its balance. 

A closed account is ruled and totaled as follows: 

United Engineering Corporation 



June 


10 
24 


Sales 
Sales 




1,551 

882 


15 
22 

37 


June 


30 


Cash 




2,433 


37 


2,433 


2,433 


37 























Ch. V] 



ACCOUNTS THEIR CONSTRUCTION 



55 



Many customers make but one purchase a month and later 
pay the full amount. If any such account has a debit equal to 
the credit, it need not be totaled. It is sufficient to draw a single 
line across the amount columns only: 

J. H, Ross 



19_ 
May 


27 


Sales 






1,691 


|19_ 
55 June 


C 


Cash 




1,691 


55 




1 




1 



If an account has a single debit and no credits, or a single 
credit and no debits, no rulings or totals are necessary. 

Notes Payable 



Oct. 


28 


G. L. Owens 




500 


00 


Oct. 


1 


Balance 




3,500 


00 




31 


Balance 




5,000 


00 




20 


F. T. Kelly 




1,200 


00 
















28 


First National 
























Bank 




800 


00 










5,500 


00 










5,500 


00 














Nov. 


1 


Balance 




5,000 


00 



The method of keeping, ruling, arid balancing the Notes Pay- 
able account illustrates the treatment of other open liability 
accounts which have several debits and credits. As a liability 
account has a credit balance, the opening balance is found on the 
right side. Items which increase the balance arc credited to 
the account added to the right side. Items which reduce the 
account are debited to it entered on the left side. 

The first item on the right side of the Notes Payable account, 
the credit balance of $3,500,00, represents the amount of notes 
owed by the enterprise at the close of business on September 30. 
That balance is increased by the credit items of October 20 and 
28 which represent, respectively, the issuance of a $1,200.00 note 
to F. T. Kelly and an $800.00 note to the First National Bank. 
The account is reduced debited on October 28 by the payment 
of a $500.00 note which was given originally to G. L. Owens. 
On October 31 the $5,000.00 balance of the account is added to 
the smaller side the left side to indicate there are $5,000.00 of 
unmatured notes payable outstanding. As of November 1, the 



56 



ACCOUNTING FUNDAMENTALS 



[Ch. V 



$5,000.00 balance is brought down below the double ruling on the 
right or credit side. 

David Mulford, Capital 



Mar. 


1 


Withdrawal 








Jan. 


1 


Balance Ini- 












Cash 




900 


00 






tial Proprie- 








July 


1 


Withdrawal 












torship 




25,000 


00 






Cash 




1,100 


00 


May 


1 


Added Cash 








Dec. 


31 


Balance Final 












Investment* 




3,000 


00 






Proprietor- 








Dec. 


31 


Net Profit 




3,000 


00 






ship 




29,000 


00 






















31,000 


00 










31,000 


00 














Jan. 


T 


Balance Ini- 








i 
j 
















tial Proprie- 








i 
















torship 




29,000 


00 



As an Owner's Capital account has a credit balance, if the 
enterprise has any net worth, the opening balance of $25,000.00 
in David Mulford, Capital account is found on the right side. 
That balance represents Mulf ord's capital at the beginning of the 

fiscal period, January 1, 19 Items which increase that 

balance are credited to the account; items which reduce the 
account are debited to it. The $3,000.00 credit to the account 
on May 1 represents an additional investment in the business by 
Mulford. The $3,000.00 credit of December 31 represents an 
addition to the owner's capital account because of the transfer 
to it of the $3,000.00 net profit for the year. The $900.00 debit 
of March 1 and the $1,100.00 debit of July 1 represent reductions 
in the account because of withdrawals of cash from the business 
by Mulford. The $29,000.00 balance of the account on Decem- 
ber 31 is added to the smaller side the debit side to make it 
equal the total of the credit side. The balance is brought down 
below the double ruling to indicate that the equity of the owner in 
the business, at the beginning of the new year, is $29,000.00. 

Relationship between the Balance Sheet and Real Accounts 

The balances of the real accounts shown in a ledger correspond 
to the items in the balance sheet arranged in account form, and to 
the fundamental accounting equation assets equal liabilities 
plus proprietorship. 



Ch. V] 



ACCOUNTS THEIR CONSTRUCTION 



57 



Balance Sheet in Account Form 


Ledger Balances, Real Accounts 


Left 


Right 


Left 


Right 


Assets 


Liabilities 
Proprietorship 


Assets are real 
accounts with 
debit balances 


Liabilities and 
Proprietorship 
are real accounts 
with credit bal- 
ances. 



Debit and Credit Schedule for Real Accounts 

f 
As the method of debiting and crediting the Cash account 

applies to all asset accounts, the method of debiting and crediting 
Notes Payable applies to all liability accounts, and the method of 
debiting and crediting David Mulford, Capital applies to any 
owner's capital account, it is possible to summarize the procedure 
of debiting and crediting assets, liabilities, and proprietorship 
accounts as follows: 



DEBIT 

1. Each increase in an asset 

2. Each decrease in a liability 

3. Each decrease in proprietorship 



CREDIT 

1. Each decrease in an asset 

2. Each increase in a liability 

3. Each increase in proprietorship 



The Construction of Nominal Accounts 

It has been shown that the nominal accounts are necessary to 
explain the sources of income and expense. Expenses result in a 
decrease in proprietorship ; therefore they are debited when they 
increase and credited when they decrease. For example, if a 
telephone bill is paid, the account Telephone and Telegraph is 
debited as that expense increased. If an employee pays for a 
personal long-distance call which was charged to the business, the 
Telephone and Telegraph account is credited as the expense of 
that account is decreased. Income items result in an increase in 
proprietorship, hence they are credited when they increase and 
are debited when they decrease. 

Office Expenses 



Jan. 


4 


Stationery 




25 


00 


Jan. 


30 


Supplies re- 










14 


Cleaning 




4 


00 






turned 




3 


00 




28 


Supplies 




13 


00 















58 



ACCOUNTING FUNDAMENTALS 



[Ch. V 



Office Expenses is a typical expense account. It is debited 
with each item which causes it to increase; it is credited with each 
item which reduces the account. The $25.00 debit on January 4 
represents the purchase of stationery, the $4.00 debit on January 
14 the cost of cleaning the office and the $13.00 debit of January 
28 the cost of supply items for the office. The $3.00 credit of 
January 30 represents a reduction in the account because of the 
return of that amount of the supplies purchased on January 28. 

Interest Earned 















Jan. 


15 


On a note 




9 


00 
















22 


On a note 




7 


00 
















31 


On a note 




5 


00 



Interest Earned is a typical income account. It is credited 
with each item which increases the account; it is debited with 
items which reduce the account. 

Debit and Credit Schedule for Real and Nominal Accounts 

The debit and credit schedule for real accounts must be 
expanded to include nominal accounts. 



DEBIT 

1. Each increase in an asset 

2. Each decrease in a liability 

3. Each decrease in proprietorship 
because of: 

a. A withdrawal 

6. An expense 

c. A decrease in income 



CREDIT 

1. Each decrease in an asset 

2. Each increase in a liability 

3. Each increase in proprietorship 
because of: 

a. An additional investment 
6. A decrease in an expense 
c. An increase in income 



This schedule of debit and credit will be applied to specific 
transactions in later chapters, and the student may find it easier 
to follow, if it is restated as: 



DEBIT 

1. Each increase in an asset 

2. Each decrease in a liability 

3. Each withdrawal of capital 

4. Each increase in an expense 

5. Each decrease in income 



CREDIT 

1. Each decrease in an asset 

2. Each increase in a liability 

3. Each addition to investment 

4. Each decrease in an expense 

5. Each increase in income 



Ch. V] 



ACCOUNTS THEIR CONSTRUCTION 



59 



SUMMARY OF DEBIT AND CREDIT SCHEDULE 

KINDS OF ACCOUNT BALANCES 
DEBIT CREDIT 

1. Assets 1. Liabilities 

2. Expenses 2. Proprietor's Capital 

3. Decreases in Income 3. Income 

4. Decreases in Expenses 

To increase the balance of any accr ant add to the larger side; 
to decrease the balance of any account add to the smaller side. 
Therefore, to increase an account with a debit balance it must be 
debited and to decrease it, it must be credited. Conversely, to 
increase an account with a credit balance it must be credited and 
to decrease it, it must be debited. 

Forwarding Account Totals 

Whenever the debit or the credit side of an account page is 
filled, a new page is opened and either the balance of the account 
or the totals of both the debit and credit sides are carried forward 
to it. In such cases the old page should be balanced and the 
balance carried forward to the new page, with reference on each 
page to the number of the other page, or if the totals are carried 
forward, such totals should be shown in ink at the bottom of the 
old page thus : 

Edmund Parke (Page 3) 



Dec. 


1 


Balance 




300 


00 


Dec. 


2 


Cash 




300 


00 




3 


Sales 




200 


00 
















4 


Sales 




80 


00 














xxxxxvx 


NXV-i 

*^ 


Os>^XXXX^VX>*X>^XXXXNX>s 


XN^ 


.xvxvxxxxy 


~ 


NXXXXX- 


^XN^ 


NXXX> k XXXX^XX 1 VXVXXX^Xw 


>^xx 


xxxv>^>^x> 


^s^- 




19 


ISaleT 




~450 


00 




Ts 


Notes Receiv- 










20 


Sales 




268 


00 






able 




500 


00 


= 


20 


F'wd to page 8 


*- 


2,869 


00 




20 


F'wd to page 8 


-=. 


J^,o70 


00 





* Irregular lines indicate that not all the items in this account are shown. 
The new page would appear: 

Edmund Parke (Pago 8) 



Dec. 


20 


F'wd from page 
3 




2,869 


00 


Dec. 


20 


F'wd from page 
3 




1,570 


00 



60 ACCOUNTING FUNDAMENTALS [Ch. V 

QUESTIONS 

1. What is meant by an account? Where are accounts kept? If all 
accounts were classified into two groups, what would be the names 
of those groups? What accounts enter into each group? 

2. What is meant by a mixed account? 

3. Suppose it were desired to classify all accounts into five groups, can 
you suggest the five group titles? 

4. What is the purpose of accounts? 

5. What is a ledger? Is a ledger always a book? 

6. Are accounts arranged in a ledger according to any predetermined 
plan? 

7. Would there be an account in the ledger with the title Assets? 
Liabilities? Proprietorship? Expense? Income? 

8. Would you have a ledger account headed Accounts Receivable? 
Explain. Notes Receivable? Explain. 

9. An account is divided into how many main parts? How are these 
parts referred to? 

10. An account with equal amounts on both sides is referred to as what 
kind of account? 

11. An account one side of which is greater in amount than the other is 
referred to as what kind of account? 

12. What do you mean by the word balance as used in connection with 
accounts? 

13. An account the left side of which is greater than the right side is said 
to have what kind of balance? 

14. a. When is an asset account debited? Credited? 
6. When is a liability account debited? Credited? 

c. When is a proprietor's account debited? Credited? 

d. When is an expense account debited? Credited? 

e. When is an income account debited? Credited? 

15. Under what account title in the ledger should each of the following 
items appear? 

a. An adding machine. 

6. Insurance paid in advance. 

c. An automobile used for delivery purposes. 

d. A note owed by the enterprise. 

e. Money in the safe and in bank. 
/. An office safe. 

g. A note owed to the enterprise. 
h. Ground owned by the enterprise. 
i. Buildings owned by the enterprise. 

j. Showcases, counters, and other equipment used for the display 
or the selling of goods. 



Ch. V] ACCOUNTS THEIR CONSTRUCTION 61 

16. The study of what chapter, previous to the present one, helped you 
to answer Question 15? 

17. Complete the following sentences: 

a. An account with a debit balance represents 

6, An account with a credit balance represents 

18. How would you know when an account with a credit balance repre- 
sented a liability? An income? The proprietor? 

19. How would you know when an account with a debit balance repre- 
sented an asset? An expense? 

20. Sfate a transaction which would cause an increase in 
a. The debit side of the Notes Payable account. 

6. The credit side of the Owner's Capital account. 

c. The credit side of the Notes Payable account. 

d. The debit side of the Notes Receivable account. 

e. The debit side of the Office Furniture and Fixtures account. 

21. State a transaction which would illustrate 

a. An increase in one asset and a decrease in another. 
6. An increase in one liability and a decrease in another. 

c. An increase in a liability and an increase in an asset. 

d. A decrease in an asset and a decrease in a liability. 

e. A decrease in an asset and a decrease in proprietorship. 

22. Is it possible in the same transaction to have 

a. An increase in an asset and an increase in an expense? 
6. An increase in a liability and an increase in an expense? 

c. An increase in an asset and a decrease in an expense? 

d. A decrease in an asset and a decrease in income? 

e. A decrease in an asset and a decrease in the owner's capital? 

23. Are all real accounts with credit balances liabilities? Explain. 



CHAPTER VI 

ACCOUNTS THEIR OPERATION 

The last chapter was devoted to an explanation of the composi- 
tion of accounts. The purpose of this chapter is to show how the 
accounts may be used to record the transactions of an enterprise 
and to supply data for the financial statements. 

Transaction 

A transaction is an occurrence in an enterprise which requires 
recognition in the accounts. It may be a purchase, a sale, a 
receipt of cash, or a payment of cash. It may be a more involved 
occurrence, such as the recognition of the decline in value of an 
asset over a period of time, because of depreciation, or it may be 
the very simple decision that a particular item would be better 
shown under another title, thus requiring a mere transfer of an 
amount between two accounts. 

Transactions Classified 

Practically all transactions may be classified into four main 
groups. 

1. Exchange transactions. Those which involve changes in 
assets, liabilities, or both, but leave proprietorship undis- 
turbed, such as exchanges of 

a. An asset for an asset. The acquisition of one asset for 
another, as the purchase of an automobile truck for cash, 
or the receipt of cash in payment of a note receivable. 
6. A liability for a liability. The creation of a new liability 
for an old one, as the giving of a note payable to a credi- 
tor, the note payable taking the place of the previously 
existing account payable. 

c. An asset for a liability. The acquisition of an asset in 
exchange for a liability of the same amount, as the pur- 
chase of office equipment on credit. 

62 



Ch. VIJ ACCOUNTS THEIR OPERATION 63 

d. A liability for an asset. The reduction of a liability by 
the reduction of an asset in similar amount, as the can- 
cellation of a note payable when it is paid in cash. 

2. Additional investment and withdrawal transactions. Those 
which involve changes in assets or liabilities, and proprietor- 
ship, as a result of additional investments or withdrawals by 
the owner. 

a. Increases in assets and proprietorship because of addi- 
tional asset investments by the owner. 

j b. Decreases in liabilities and increases in proprietorship 
by the owner paying some of the debts of the enterprise 
from his purely personal funds thus increasing his 
investment in the business. 

c. Decreases in assets and proprietorship because of asset 
withdrawals by the owner. 

d. Increases in liabilities and decreases in proprietorship 
from the transfer to the enterprise of a personal liability 
of the owner. 

3. Profit or loss transactions. Those which involve changes in 
assets or liabilities as a result of income or expense items. 
This class involves not only the asset and liability accounts 
but the nominal accounts as well. 

a. Increases in assets and increases in income, resulting 
from income items such as the receipt of cash for interest, 
rent, or commission. 

6. Decreases in liabilities and increases in income, such as 
the cancellation of an account payable because of com- 
missions earned from a creditor. 

c. Decreases in assets and increases of expenses, such as the 
payment of cash for wages, salaries, or rents. 

d. Increases in liabilities and increases of expenses, such as 
the purchase of advertising space on credit. 

4. Transfer transactions. Those which arise out of mere book 
transfers, such as the transfer of an income amount to 
another title; the transfer of an expense amount to another 
caption ; the transfer of the amount of one asset to another 
title; or the transfer of the amount of a liability to another 
caption. 

Some transactions involve more than one subheading within a 
group, i.e., the purchase of an automobile truck partly for cash 



64 ACCOUNTING FUNDAMENTALS [Ch. VI 

and partly on credit is a transaction which involves subheadings 
a and c of Group 1. Other transactions involve more than one 
group, i.e., every sale of merchandise at other than exact cost 
figures represents a gain or a loss element, hence such a sale is an 
exchange transaction in part, Group 1, and a profit or loss trans- 
action in part, Group 3. 

Double -entry Bookkeeping. 

The systematic recording of the facts of the financial transac- 
tions of a person or enterprise is known as bookkeeping or account 
keeping. But not all account keeping is in accord with sound 
accounting practice, as was pointed out in Chapter I. Some 
individuals are satisfied with an incomplete system of accounts. 
It is the purpose of accounts to show the financial condition of 
an enterprise, the changes therein, and the causes thereof. The 
only system which will do this is known as double-entry 
bookkeeping. 

Double-entry bookkeeping is a system of account keeping 
wherein all the financial transactions of a person or an enterprise 
are recorded in a manner to show the effect of each, on the assets, 
the liabilities, the owner's capital, the income items, and the 
expense elements. Each transaction is supported by an entry or 
entries. 

Entry 

The record of a transaction is spoken of as an entry. Each 
entry in the double-entry system is in two parts to show both the 
debit and credit elements involved in the transaction. These 
two parts, the debit and the credit amounts of each entry, must 
exactly equal each other. This does not mean that in a given 
entry there will be but one debit and one credit of equal value. 
Rather it means that in each entry the sum of the debit amounts 
must be equal to the sum of the credit amounts regardless of the 
number of each. This equalization of debits and credits in each 
entry is referred to as the fundamental basis of the double-entry 
system. The double feature of each entry with the equalization 
of the two parts makes possible a complete system of accounts and 
one the mathematical accuracy of which can be proved. 



Ch. VI] ACCOUNTS THEIR OPERATION 65 

Application of the Debit and Credit Schedule 
For every transaction it is necessary to 

1. Analyze the occurrence to determine whether asset, lia- 
bility, income, expense, or owner's capital accounts are 
increased or decreased. 

2. Apply to each element of the transaction a descriptive 
accounting caption. If possible, use a ledger account 
already set up. 

3. Apply the debit and credit schedule, keeping in mind that 
each increase in an account in the case of a new one means 
increasing it from zero in other words, opening it. 

4. Maintain an equality of debits and credits. 

The following seven typical transactions pertaining to the 
business of S. F. Turner will be used to illustrate the proper 
method of analysis and procedure: 

1. October 1, 19 Mr. S. F. Turner began a small retail 

business investing cash $5,000.00, land valued at $3,000.00, 
a building valued at $10,000.00, and showcases and other 
equipment for the store valued at $500.00. Mr. Turner 
made the business assume a liability to A. L. Lloyd in the 
amount of $500.00. 

a. Business assets, liabilities, and proprietorship increased. 

b. Descriptive titles for the assets are Cash, Land, Building, 
and Store Furniture and Fixtures. A. L. Lloyd is the 
account caption for the liability. S. F. Turner, Capital 
is the appropriate account heading to describe the equity 
of the owner. 

c. Debit Cash with $5,000.00 because that asset increased. 
Debit Land with $3,000.00 because that asset increased. 
Debit Building with $10,000.00 because that asset 
increased. 

Debit Store Furniture and Fixtures with $500.00 

because that asset increased. 

Credit A. L. Lloyd with $500.00 because that liability 

increased. 

Credit S. F. Turner, Capital with $18,000.00 as capital 

increased. 



66 



ACCOUNTING FUNDAMENTALS 



[Ch. VI 



d. The four debit items are offset by the two credit items 
so the equality of debits and credits is established. 

The actual entry for this transaction, as it would appear in the 
accounts, is as follows: 

Cash 



Oct. 1 


Investment 




5,000 


H 













Land 



|ia_ 

Oct. 


1 


Investment 




3,000 


00 















Building 



Oct. 


1 


Investment 




10,000 


00 















Store Furniture and Fixtures 



! 19 - 
Oct. 


1 


Investment 




500 


00 












A. L. Lloyd 














Oct. 


1 


Liability As- 
























sumed 




500 


00 



S. F. Turner, Capital 













|19__ 
Oct. 


1 


Investment 




18,000 


00 



2. October 1, 19. Mr. Turner bought stationery and 
miscellaneous office supplies from the Pennsylvania Sta- 
tionery Store for $25.00 cash. 
a. These supply items will shortly be consumed and should 

be considered an expense rather than an asset, hence 

expenses have increased and assets decreased. 
6. Office Expenses and Cash are descriptive captions. 
c. Debit Office Expenses $25.00 because that expense 

account increased. 

Credit Cash $25.00 as that asset account decreased. 



Ch. VI) ACCOUNTS THEIR OPERATION 67 

d. The equality of debits and credits is apparent in a simple 
transaction such as this which involves but one debit 
and one credit. 

The actual entry for this transaction requires the opening of a 
new account, Office Expenses, which is debited for $25.00. The 
credit of $25.00 to Cash is made in the Cash account which was 
opened in the entry for the first transaction. A debit or a credit 
to an account which is on the ledger is entered in that account. 
A debit or a credit to an account which is not in the ledger 
requires the opening of such new account. 

3. October 1, 19 A typewriter and desk were purchased for 

$180.00 cash from the Excelsior Office Equipment Company, 
a. This is an exchange of one asset for another. It is not 

necessary to set up an account with the Excelsior Office 

Equipment Company since payment was made at once. x 
6. Office Furniture and Fixtures and Cash accounts are 

affected. 
c. Debit Office Furniture and Fixtures with $180.00 

because of the increase in that asset account. 

Credit Cash with $180.00 because of the decrease in that 

asset account. 

4. October 1, 19 Merchandise was purchased from T. F. 

Gordon for $1,500.00; $500.00 in cash was paid and a 60-day 
6 per cent interest-bearing note for the balance was given, 
a. The asset Merchandise Inventory increased $1,500.00, 

another asset, Cash, decreased $500.00, and liabilities 
increased $1,000.00. 

6. As records are not kept in a small retail business to show 
each item in the inventory of merchandise, the only debit 
account affected by the acquisition of the merchandise is 
the account, Purchases, which is charged with the price 
of all merchandise acquired by the business for the 
purpose of selling. The asset Cash decreased and the 
liability Notes Payable, increased. 

c. Debit Purchases with $1,500.00 as that account increased. 
Credit Cash with $500.00 as that asset decreased. 
Credit Notes Payable with $1,000.00 as that liability 
increased. 



68 ACCOUNTING FUNDAMENTALS [Ch. VI 

d. The one debit item is the equal of the two credit items, 
so equality is maintained. 

5. October 2, 19 Mr. Turner sold merchandise that had 

been bought for $70.00, to P. R. Dunn for $100.00 on 
account. Terms 2/10, n/30. On account is the expression 
which indicates that the transaction is a credit one. 

a. The asset claims against customers increased $100.00. 
The merchandise inventory decreased $70.00 and the 
business made a gross profit of $30.00. 

6. The account P. R. Dunn will designate the particular 
account receivable. 

To record the sale of the merchandise the total sales 
price is placed in the account, Sales. No attempt is 
made at this point to separate the sales into cost and 
profit. 

c. Debit P. R. Dunn with $100.00 because an increase took 
place in that asset account for that amount. The terms 
2/10, n/30 mean that P. R. Dunn is offered a discount 
of 2 per cent if he pays this bill within 10 days, otherwise 
he has 30 days in which to pay. At this time there 
is no certainty that he will pay within the discount 
period, so he must be charged the full amount. 
Credit Sales with $100.00 because an increase took place 
in that income account. 

6. October 8, 19 A $500.00 check was sent to A. L. Lloyd, 

a creditor, in full of account. The expression in full of 
account signifies the complete satisfaction of a debt. 

a. The liability to Lloyd and the asset Cash are decreased. 
6. This transaction affects the accounts of A. L. Lloyd and 

Cash. 
c. Debit A. L. Lloyd for $500.00 because that liability 

account decreased. 

Credit Cash for $500.00 because that asset decreased. 

7. October 12, 19 A check was received from P. R. Dunn 

for $98.00, in full of account, /or his purchase of ten days 
ago. 

a. The asset Cash increased, the asset claim against a 
customer decreased, and an expense account increased. 

6. The assets Cash and P. R. Dunn are involved as is an 
expense account. As P. R. Dunn was debited when he 



Ch. VI] 



ACCOUNTS THEIR OPERATION 



69 



purchased the goods, he must be credited now. Sales 
Discounts is a descriptive caption to indicate the expense 
of discounts taken by customers for payments made 
within the discount period. 
c. Debit Cash $98.00 as that asset increased. 

Debit Sales Discounts with $2.00 as that expense item 

increased. 

Credit P. R. Dunn with $100.00 as that asset account 

decreased that amount. 

The following ledger accounts are arranged to facilitate state- 
ment preparation as suggested in Chapter V; they show the 
debits and credits of the above transactions : 



Cash 



Store Furniture and Fixtures 



(Page 1) 



19 












19 












Oct. 


1 


Investment 




5,000 


00 


Oct. 


1 


Office Expenses 




25 


00 




12 


P. R. Dunn 




98 


00 




1 


Office Equip- 
























ment 




180 


00 
















1 


Purchases 




500 


00 
















8 


A. L. Lloyd 




500 


00 


P, R. 


Dunn (Page 2) 


19 
Oct. 


2 


Sales 




100 


II 19 - 
OOOct. 


12 


Cash 




100 


00 


Land (Page 3) 


19 
























Oct. 


1 


Investment 




3,000 


00 














1! 

Building (Page 4) 


Oct. 


1 


Investment 




10,000 


00 













(Page 5) 



19 
Oct. 


1 


Investment 




500 


00 






' 







Office Furniture and Fixtures (Page 6) 


19 
























Oct. 


1 


Desk and 
























Typewriter 




180 


00 















70 ACCOUNTING FUNDAMENTALS [Ch. VI 


A. L. Lloyd (Page 7) 


19 
Oct. 


8 


Cash 




500 


00 


Oct. 


1 


Liability As- 
sumed 




500 


00 


Notes Payable (Page 8) 














19 
Oct. 


1 


T. F. Gordon 




1,000 


00 


S. F. Turner, Capital (Page 9) 














19 
Oct. 


1 


Investment 




18,000 


00 


Sales (Page 10) 












II 19 
Oct. 


2 


P. R. Dunn 




100 


00 


Purchases (Page 11) 


t. 


1 


T. F. Gordon 




1,500 


00 













Sales Discounts 



(Page 12) 



19 










1 












Oct. 


12 


P. R. Dunn 




2 


00 














Office Expenses 




(Page 


13) 


19 
























Oct. 


1 


Books, 
























Stationery 




25 


00 






' 









Since the debits and credits of each transaction are equal, the 
sum of the debits and the sum of the credits should equal. It 
follows, therefore, that the sum of the debit totals and the sum 
of the credit totals of the accounts in a ledger should equal. 
It is also true that the sum of the accounts with debit balances 
, and the sum of the accounts with credit balances should equal. 

The following table summarizes the figures shown by the above 
ledger both by totals and by balances; 



Ch. VI] 



ACCOUNTS THEIR OPERATION 



71 



Ledger Accounts 


Totals 


Balances 

A. 


Debit 


Credit 


Debit 


Credit 


Cash 


$ 5,098.00 
100.00 
3,000.00 
10,000.00 

500.00 

180.00 
500.00 

1,500.00 
2.00 
25 00 


$ 1,205.00 
100.00 

500.00 
1,000.00 
18,000.00 
100.00 


$ 3,893.00 

3,000.00 
10,000.00 

500.00 
180.00 

1,500.00 
2.00 
25.00 


$ 1,000 00 
18,000.00 
100.00 


P. R. Dunn 


Land 


Building 


Store Furniture and Fix- 
tures 


Office Furniture and Fix- 
tures 


A.L.Lloyd 
Notes Payable 


S. F. Turner, Capital 


Sales 


Purchases 


Sales Discounts 


Office Kxpenscs 




$20,905 00 


$20,905.00 


$19,100.00 


$19,100.00 



Proprietor's Personal or Drawing Account 

If the owner of an enterprise withdraws business assets for his 
personal use, the amounts may be debited to his Capital account 
as shown in Chapter V. At the time of such withdrawals, 
unless they are exceptionally large amounts, the owner does not 
Consider that he is reducing his investment in the business, nor 
is he, if the accumulated current profits are in excess of his with- 
drawals. In order to show his personal transactions with his 
business more clearly, and not to disturb his Capital or Invest- 
ment account during a period, it is general practice to place all 
such proprietor's personal items in a separate account known as 
the Proprietor's Personal or Drawing account. This plan merely 
divides into two accounts the Owner's Capital account as it has 
been considered heretofore. Where a Personal or Drawing 
account is used, the Owner's Capital account seldom receives a 
debit or credit during a period. The Capital account is credited 
for the amount of the original investment, thereafter it is debited 
or credited for such items as a decrease of capital by the with- 
drawal of a large sum, or a deliberate increase of capital by the 
investment of an additional substantial sum. 



72 ACCOUNTING FUNDAMENTALS [Ch. VI 

When merchandise and ordinary amounts of cash are with- 
drawn by the owner, the debits are to the Personal account. If 
merchandise is withdrawn at cost price, as is usual, the credit 
record should be made to Purchases because the transaction 
is not a sale within the usual meaning of that word; it is a non- 
profit transaction equivalent to the withdrawal of any other 
asset by the owner. In practice, merchandise withdrawals at 
cost price often are credited to the Sales account, a minor error 
since such withdrawals constitute a relatively insignificant part 
of total sales. Merchandise withdrawn at any figure in excess of 
cost should be credited to Sales. 

QUESTIONS 

1. What is the purpose of accounts? 

2. Into what two classes may accounts be divided? 

3. Accounts may be divided into five classes. Name them. 

4. What is the accounting meaning of a transaction? 

6. Do all business transactions involve expense or income elements? 
Explain. 

6. The nominal accounts may be called explanation accounts. What 
do they explain? 

7. Is it possible for an enterprise to earn an income without its assets 
increasing? 

8. Is it possible for an enterprise to have an expense without its assets 
decreasing? 

9. The recording of the facts of the financial transactions of an enter- 
prise is known by what title? 

10. The accounting record of a transaction is known as an ? 

11. The accounting record of a transaction may be divided into how 
many parts? By what titles are these parts known? 

12. Does an entry consist of just one debit and one credit? Explain. 

13. What is the fundamental basis of the double-entry bookkeeping 
system? 

14. Give the rule for debiting Assets. Liabilities. Income accounts. 
Expense accounts. The Proprietor's account. 

16. Give the rule for crediting accounts. 

16. Cite a business transaction to illustrate each of the following com- 
binations of the debit and credit schedule: 
a. Increase in an asset and an increase in income. 
6. Increase in an expense and an increase in a liability. 

c. Decrease in a liability and a decrease in an asset. 

d. Decrease in the Owner's Capital and an increase in a liability. 

e. Increase in an asset and an increase in a liability. 



Oh. VI) ACCOUNTS THEIR OPERATION 73 

/. Increase in an expense and a decrease in an asset. 
g. Increase in an asset and a decrease in an expense. 

17. Without using figures give the entries for the following transactions : 

a. Investment by the owner of cash, merchandise, and notes 
receivable. 

b. Assumption by the business of the personal liability of the owner 
on a note. 

c. Receipt of a note from a customer. 

d. Receipt of a bill from the Clinton Carting Company for delivering 
merchandise to customers. The bill is to be paid at the end of 
the month. 

e. The sending of a check to a creditor for a purchase of ten days 
ago less the discount. 

/. The withdrawal of merchandise at cost by the proprietor. 

g. The withdrawal of merchandise at sales price by the proprietor. 

18. Give the entries for the following transactions : 

a. The sale to Ralph Clements for $1,000.00 of merchandise which 

had cost $800.00. The 60-day 6 per cent interest-bearing note 

of Clements is received in payment. 
6. The receipt, at the maturity of the note mentioned in part a 

above, of a check from Ralph Clements in full payment of the 

note and interest. 

c. The receipt of a check from a customer, within the discount 
period, for a $500.00 sale which was subject to 2 per cent discount. 

d. The cash payment to a customer for goods returned today. The 
returned goods had cost the enterprise $16.00 and had been sold 
to the customer for $30.00. 

e. The granting of a $25.00 credit to a customer for goods returned 
today. 

19. Give the entries for the following transactions: 

a. H. Appleton began business investing cash $5,000.00. 
6. Appleton purchased merchandise from J. Murta for $1,000.00 
cash. 

c. Appleton purchased merchandise from S. Supplee on account 
$1,000.00. 

d. Appleton purchased an office desk, a chair, and a filing cabinet 
from H. Blair for $120.00 and gave his 30-day note in payment 

e. Appleton sold merchandise to J. Proctor for cash $200.00. 

/. Appleton sold merchandise to R. Gamble on account $300.00. 
g. Appleton sold merchandise to L. Smith $400.00 and accepted 
Smith's 30-day note in payment. 

20. Give the entries for the following transactions: 

a. Paid one month's rent in cash $150.00 to W. Quick and Brothers, 
real-estate agents. 



74 ACCOUNTING FUNDAMENTALS [Ch. VI 

6. Paid R. Wilson, one of the salesmen, a commission of $75.00 in 
cash. 

c. Purchased various supply items for the office from Hopkins and 
Company, for cash $20.00. 

d. Received a check for $90.00, six months' interest on the $3,000.00, 
6 per cent A. B. C. Company bonds owned by the enterprise. 

e. Paid salaries as follows: Office force $100.00; sales force $150.00. 
/. Purchased an automobile truck for delivery purposes from 

B. Earnshaw and Company, for cash $800.00. 
g. Paid B. Earnshaw and Company, for gas and oil for the truck 

$3.30 cash. 
h. Sent a check for $12.00 to the state department of motor vehicles 

for license plates for the automobile truck. 

21. Could proprietorship be represented on the ledger in just one 
account? If two accounts are used for this purpose, what are they 
called? Assuming the use of two accounts to be good practice, as 
is the case, how do you justify it? 

22. Assuming two accounts with the owner on a ledger, which one would 
you designate as the main account? What kind of balance should 
that account have, ordinarily? Why? 

23. If the personal account of the owner is charged for withdrawals and 
credited with the net profit for the period, what would its balance 
represent, if it is assumed there were no additional investments? 
Explain. 

24. If no drawing account is kept for the proprietor, under what condi- 
tions will the balance of his capital account agree with the net worth 
of the business at the beginning of the year? 

25. If no drawing account is kept for the proprietor, will the balance of 
his capital account agree with the net worth of the business at the 
end of the year? Why or why not? 

26. In a retail business why is it customary to have one account for 
notes receivable and an individual account for each account 
receivable? 



CHAPTER VII 

JOURNALIZING AND POSTING 

Although it is possible to analyze business transactions into 
their respective debits and credits and to insert the results 
directly into the ledger accounts, as was done in the preceding 
chapter, this procedure is not advisable ordinarily for the follow- 
ing reasons : 

1. There will be no one place where a complete entry may be 
viewed. If a transaction involves several debits and credits 
it will be extremely difficult to trace it through the ledger. 

2. A chronological record of the entries will be lacking. It 
should be possible to find a complete history of the trans- 
actions arranged in the order of their happening. 

3. It is not possible for more than one person to work on a 
ledger at a time. Large establishments are forced to use a 
number of ledgers and many people to care for their thou- 
sands of accounts. Entering transactions directly in the 
ledger presumes one person will make the complete entry. 

4. The space in the ledger is too limited to permit adequate 
explanations to be made. 

5. Direct entries in the ledger make it extremely difficult to 
locate errors, such as 

a. Omitting a debit or a credit item. 

&. Posting a debit or credit item to the wrong side of an 

account. 
c. Dropping or adding a cipher, or ciphers, or reversing 

figures in entering the debit and credit items. 

It is desirable, therefore, that an accounting system provide a 
place where each complete entry with adequate explanation may 
be made in the order of its happening. The journal is such a 
place. 

The Journal 

A journal, in a broad sense, is a chronological record of trans- 
actions. In a double-entry system of accounts the journal is a 

75 



76 



ACCOUNTING FUNDAMENTALS 



[Ch. VII 



book of original record in which is set forth for each transaction, 
the date, the debit and credit items and amounts involved, as well 
as an adequate explanation. 

The journal does not replace, it precedes the ledger. The 
journal is the original book in which the entries are recorded as 
they happen. The ledger is the final book to which the debits 
and credits of the journal are transferred so that they may be 
assembled under their respective account titles. 

The Journal Form 

. With occasional, minor variations, the form of the journal 
illustrated below is the one in common use. 

JOURNAL 



Date 


Accounts and Explanation 


F 


Debit 
Amounts 


Credit 
Amounts 


Yr 
















rd 


C? 






Dollars 


rt 


Dollars 


"? 


g 


Q 








0? 

O 




d 



The headings of the columns indicated in the above illustration 
may not be written in the journal, but are placed here so that the 
student may know the type of information which is found custom- 
arily in the several columns. The F (folio) column is for refer- 
ence purposes; its use is explained later in this chapter. 

The Journal Entry Its Composition 

The process of making the original entries for transactions is 
called journalizing. 

Each journal entry is composed of four parts: 

1. The date. The date on which the transaction occurred 
is placed in the columns at the left of the page, 

2. The debit and credit accounts involved. The debits are 
placed close to the left margin of the account and explana- 
tion section. The credits are indented uniformly directly 
under the debits. 

3. The debit and credit amounts involved. Each debit 
amount is entered in the left and each credit amount in the 
right amount column. 



Oh. VII] 



JOURNALIZING AND POSTING 



77 



4. An explanation. The explanation is started on the line 
under the last credit item. It is a supplementary state- 
ment about the transaction which, with the debit and credit 
parts of the entry, should describe adequately the -circum- 
stances of the transaction to' one who understands book- 
keeping. The chief purpose of the explanation is to help 
make clear the entire entry whenever reference may be 
made to it. 

The Journal Illustration 

The form in which an entry is recorded is important as a means 
of sharply distinguishing debit from credit items that errors may 
be avoided in transcribing these items to the ledger. In order 
that each entry may stand out distinctly it is common practice 
to skip a line between entries. 

The journal entries which follow are those for the transactions 
which were used to illustrate the application of the debit and 
credit schedule in the preceding chapter. 

JOURNAL (Page 1) 



Date 


Accounts and Explanation 


F 


Debit 
Amounts 


Credit 
Amounts 


Oct. 


1 


Cash 


1 


5,000 


00 










Land 


3 


3,000 


00 










Buildings 


4 


10,000 


00 










Store Furniture and Fixtures 


5 


500 


00 










A. L. Lloyd 


7 






500 


00 






S. F. Turner, Capital 


9 






18,000 


00 






Mr. Turner began business today investing 
















assets and a liability as indicated above. 
















Office Expenses 


13 


25 


00 










Cash 


1 






25 


00 






Stationery and miscellaneous office sup- 
















plies bought for cash at the Pennsylvania 
















Stationery Store. 
















Office Furniture and Fixtures 


6 


180 


00 










Cash 


1 






180 


00 






Purchased typewriter and desk for cash 
















from the Excelsior Office Equipment 
















Company. 













78 



ACCOUNTING FUNDAMENTALS 



[Ch. VII 







Purchases 


11 


1,500 


00 










Cash 


1 






500 


00 






Notes Payable 


8 






1,000 


00 






Purchased merchandise from T. F. Gordon 
















giving cash $500.00 and a 60-day 6 per 
















cent interest-bearing note for the balance. 














2 


P. R. Dunn 


2 


100 


00 










Sales 


10 






100 


00 






Sold merchandise to P. R. Dunn. 












.^>X>WN 


,^XX~ 


Terms 2/10, n/30. 

XN^rvXXy-N^^XXXXN-f'XXN^'XX^N^'^.y'XXV^^ 


"s^-V 


^vXX^N>^VX> 


^XNX 









8 


A. L. Lloyd 
Cash 


7 
1 


500 


00 


t(Page 
500 


5) 
00 






Sent check to A. L. Lloyd to settle in- 












VXNXNX 


.XN> 


debtedness in full. 


^^ 


^vxxxxxx. 


XXX 


'Xx-VyXx-XXN 


XNx~ 


.->xxx>*/' 


-^xy 

12 


Cash 


w^y 

1 


sx^-^XNy-X, 

98 


"XXV, 

' 

oc 


'XXVXVXXXN 

[(Page : 


.xxx- 

13) 






Sales Discounts 


12 


2 


00 










P. R. Dunn 


2 






100 


00 






Received check from P. R. Dunn for sale 
















of October 2 less discount. 












* Irregular lines indicate page breaks. 
t Indicate journal page number. 



Posting 

Transferring the debit and credit items from a journal to their 
respective accounts in a ledger is known as posting. The exact 
names of the accounts used in the journal should be carried to 
the ledger. For example, it would not be correct to debit 
Expenses in the journal and later transfer that debit to the Office 
Expenses account in the ledger even though it has been indicated 
clearly in the explanation that it is an item of office expense. 
In this case, Office Expenses should have been debited in the 
journal. 

Posting may be done at any time but it must be completed 
before the financial statements can be prepared. It is advisable 
to keep the more active accounts posted to date. For example, 
the bookkeeper should be able to tell at any time the cash balance, 
what a customer owes, and the amount owed to each creditor. 

Considerable freedom is permitted in the order in which 
accounts are posted. Some bookkeepers prefer to post all of the 



Ch. VII] 



JOURNALIZING AND POSTING 



79 



.debits first and avoid shifting from one side of the accounts to the 
other. Others will select and post first all of the debits and credits 
on one page that affect a particular account. Still others prefer 
to make complete postings of each entry before proceeding to the 
next entry. This last method is the one recommended to the 
student; post each debit and credit item as it appears in the 
journal. 

The F (folio) column in the journal is used at the time the 
debits and credits are posted to the ledger, to indicate the pages 
of the ledger on which the accounts are located. The folio 
column in the ledger is used to indicate the page numbers of the 
journal from which the entries are posted. Thus there are cross 
references in both the journal and the ledger. 

An index of the accounts should be made in the front of the 
ledger. 

The Ledger 

The ledger accounts for the transactions which were journalized 
in this chapter appear below. Since each ledger record includes 
a reference to the page of the journal on which the complete 
entry is shown, it is not necessary to place anything in the 
explanation columns of the accounts. The reader will notice 
that in order to illustrate better the use of the folio columns in the 
ledger, it has been assumed that the next to the last journal entry 
was made on journal page 5, and that the last entry was on page 
13 of the journal. 

Cash (Page 1) 



Oct. 


1 




1 


5,000 


00 


Oct. 


1 




1 


25 


T- ~ 

00 




12 




13 


98 


00 




1 




1 


180 


00 
















1 




1 


500 


00 
















8 




5 


500 


00 



P. R. Dunn 



(Page 2) 



Il9_ 
Oct. 


2 




1 


100 


|19__ 


12 




13 


100 


00 



Land 



(Page 3) 



|19_ 
Oct. 


1 




1 


3,000 


00 















80 ACCOUNTING FUNDAMENTALS [Ch. VII 


Buildings (Page 4) 


Oct. 


1 




1 


10,000 


00 


i 












Store Furniture and Fixtures (Page 5) 


Oct. 


1 




1 


500 


00 


i 












Office Furniture and Fixtures (Page 6) 


Oct. 


1 




1 


180 


00 


i 












A. L. 


Lloyd (Page 7) 


Oct. 


8 




5 


500 


00 


Oct. 


1 




1 


500 


00 


Notes Payable (Page 8) 














Oct. 


1 




1 


1,000 


00 


S. F. Turner Capital (Page 9) 














Oct. 


1 




1 


18,000 


00 


Sales (Page 10) 














Oct. 


2 




1 


100 


00 


Purchases (Page 11) 


19 
Oct. 


1 




1 


1,500 


00 


i 












Sales Discounts (Page 12) 


Oct. 


12 




13 


2 H 














Office Expenses (Page 13) 


llftJ 








H 












Oct. 1 




1 


25 













Ch. VII] JOURNALIZING AND POSTING 81 

The ledger summarizes under the respective account titles all 
the debits and credits which appear in the journal for each title. 
It thus facilitates the determination of account balances (see 
Chap. V). 

QUESTIONS 

1. What is a journal? 

2. In practice, does the journal entry precede or follow the ledger entry 
of a transaction? 

3. If all journal entries are posted to a ledger, why have a journal? 
Why have a ledger? 

4. What are the various parts of a journal entry? 

5. What is meant by journalizing? Posting? 

6. In an entry, which accounts are expressed first, the debits or the 
credits? Which are shown on the left side? Which amounts are 
shown in the right money column? 

7. Give the various parts of the rule for debiting accounts. For 
crediting accounts. 

8. May items posted from the journal be placed under different account 
titles in the ledger? Why? 

9. Is there any cross reference between the journal and the ledger? 
Explain. 

10. Is it desirable to keep ledger postings up to date? Why? 

11. If you desired to ascertain how much a customer owed, where would 
you look? Why? 

12. If you wanted to use book figures for balance sheet or statement of 
profit and loss purposes, what book would you use? Why? 

13. Is a journal a chronological or an alphabetical record of transactions? 

14. Are accounts in a ledger arranged according to any predetermined 
plan? Explain. 

15. Does a journal entry consist necessarily of only one debit and only 
one credit? Explain. 

16. Are the following statements true or false? If necessary, qualify 
your answer. 

a. In a given journal entry there may be ten debits and only one 

credit. 
6. When an expense account is debited some asset account must be 

credited. 

c. The journal and the ledger contain the same information. 

d. The ledger gives more details about a transaction than the journal 
does. 

e. The object of accounting is to prepare a systematic record of the 
transactions of a business. 



82 ACCOUNTING FUNDAMENTALS [Ch. VII 

/. Debiting an account increases its balance. 
g. An increase in an income account is credited. 
h. A decrease in a liability account is debited. 

17. Omitting dates and explanations, give the entries for the following 
transactions: 

a. Mr. X began business investing cash $1,000.00, a note signed by 
Mr. C for $200.00, and a claim on Mr. D for $50.00. 

b. Mr. X purchased merchandise on account $1,000.00 from Mr. E. 

c. Mr. X purchased merchandise for cash $300.00 from Mr. F. 

d. Mr. X purchased merchandise from Mr. G for $400.00 and gave 
his 30-day note in payment. 

e. Mr. X sold merchandise on account $300.00 to Mr. H. 
/. Mr. X sold merchandise for cash $250.00 to Mr. I. 

g. Mr. X sold merchandise to Mr. L for $200.00 and accepted Mr. 

L's 30-day note in payment. 
h. Mr. X paid $500.00 cash on account to Mr. E. 
i. Mr. X paid $400.00 to Mr. G in payment of a 30-day note. 
j. Mr. X received $300.00 cash from Mr. H in full of account. 
k. Mr. X received $200.00 cash in payment of the note of Mr. L. 
18 What business transaction occurred in each of the following 
instances? 

a. Notes Receivable was debited and J. Jones was credited. 

b. Proprietor's Capital account was debited and Notes Payable was 
credited. 

c. R. Croft was debited and Notes Payable was credited. 

d. Cash was debited and Notes Payable was credited. 

e. Notes Receivable was debited and Proprietor's Capital was 
credited. 

/. Notes Payable was debited and Cash was credited. 

g. Notes Payable was debited and Proprietor's Capital account was 

credited. 

h. H. Leidy was debited and Sales was credited. 
i. Purchases was debited and K. Mead was credited. 
j. Office Expenses was debited and II. Hess was credited. 
k. Office Furniture and Fixtures was debited and Cash was credited. 
19. What entry is necessary to record each of the following transactions? 
You are to assume that any necessary entries on prior dates were 
made properly. All of these transactions are not for the same 
enterprise, 
a. Sent a check for $1,470.00 to the Elite Manufacturing Company, 

in payment for our merchandise purchase of eight days ago, 

which purchase was subject to a 2 per cent discount if paid within 

ten days. 



Ch. VII] JOURNALIZING AND POSTING 83 

b. Received a check for $1,407.00 from T. H. Eddy in payment for 
principal and interest on his $1,400.00, 30-day, 6 per cent interest- 
bearing note which matured today. 

c. Gave a credit of $100.00 to W. E. Fulton, a customer, for 
defective merchandise returned by him. 

d. The merchandise returned by W. E. Fulton was resold for $60.00 
cash to A. S. Buhl. 

e. The proprietor took home postage stamps worth $5.00 and 
envelopes worth $2.00. 

/. Sold the A. B. C. Company stock for $1,600.00 cash. This stock 
had been purchased some months ago for $1,500.00. 

g. A $10.00 credit memorandum was sent to T. M. Poolc, a cus- 
tomer, because of an error in addition on an invoice sent to him 
several days ago. 

h. A check was sent to the Pennsylvania Coal Company for coke 
purchased to heat the store. The $80.00 bill had been left last 
week by the driver of the coke truck and had been recorded by 
our bookkeeper. 

i. In payment for merchandise sold R. B. Edgar today, he gave us a 
United States government bond at par $100.00, a noninterest- 
bearing note for $400.00 signed by G. I. Pitt, a customer of his, 
and $100.00 cash. 

j. Clipped and cashed United States government bond interest 
coupons amounting to $40.00. 

k. The proprietor did not take his $75.00 weekly salary. 

I. Purchased for $15,000.00 the land and building we were renting. 
The land was valued at $5,000.00 and the building at $10,000.00. 
We were allowed $150.00 for unexpired rent. We gave in pay- 
ment a first mortgage for $10,000.00 and a check for the balance. 
m. In part payment of his salary, a store clerk took merchandise at 
cost $10.00. 



CHAPTER VIII 
BOOKS OF ORIGINAL ENTRY 

The journal and the ledger which were explained in the preced- 
ing chapters constitute the fundamental accounting books. The 
recording of debits and credits for transactions, first in an original 
entry record and later in a ledger, constitutes the fundamental 
method of making records in accounting books, 

The Need for Additional Journals 

i It is possible to keep complete records for a small enterprise 
with one journal and one ledger. Such a system is limited, 
however, to the ability of one or two persons to record the debits 
and credits for all transactions in the journal and to post every 
debit and credit to the ledger. Such a system is inelastic. It 
makes no provision for dividing and specializing the office labor 
and does not take advantage of simplifications in methods of 
recording and posting which are possible without disturbing the 
fundamental principles of debit and credit. 

A bookkeeping system should be designed and operated to 

\avoid waste of effort and should be sufficiently elastic to expand 
and cover any reasonable growth in the volume of transactions of 
the business. 

The ledger, since it is a book of final entry which includes very 
much briefer records of transactions than the journal, does 
not require expansion or division with the same degree of neces- 
sity as the journal does. If one ledger is not adequate for an 
enterprise, it is a simple matter to add another. The expansion 
of the ledger in accord with modern practice will be considered, 
however, in a later chapter. 

Although it is possible to record all the financial transactions 
of a small enterprise in one journal and one ledger, even the 
smallest enterprises may find it economical, hence advisable, to 
divide the journal into a number of special journals. 

84 



Ch. VIII] BOOKS OF ORIGINAL ENTRY 86 

Various Books of Original Entry 

The journal is divided on the basis of the various types of 
transactions which occur frequently, i.e., sales of merchandise, 
purchases of merchandise, receipts of cash, and disbursements of 
cash. A special journal for transactions of the same character is 
possible for the reason that all such transactions result in a debit 
or a credit to the same account. Every sale of merchandise, 
regardless of whether it is made for cash, for a note, or on account 
to a customer, represents an increase in sales income. In this 
respect, every sale of merchandise is just like every other sale of 
merchandise; hence it is possible to have a special original entry 
book for sales of merchandise alone. The credit postings of this 
book are made always to the Sales account. Similarly every 
disbursement of cash, no matter to whom or why paid out, repre- 
sents a decrease in the asset Cash. All cash disbursements are 
alike to that extent (credits to Cash), hence they may be placed 
in a special cash disbursements journal. 

Whenever transactions of a similar nature happen with suffi- 
cient frequency to warrant it, a special journal is provided for that 
class of transactions. In view of the diversity of business itself, 
it is not to be expected that all enterprises will use the same 
special books of original entry. There are certain types of 
transactions that are so common to all business, i.e., cash receipts 
and cash disbursements, that the special journals for the record- 
ing of them (cash receipt book and cash disbursements book) are 
in popular use. There are other types of transactions that are so 
frequent with mercantile and manufacturing establishments, 
i.e., sales of merchandise and purchases of merchandise, that the 
special journals for them (sales journal and purchase journal) are 
common within those fields. 

The books of original entry so far indicated sales journal, 
purchase journal, cash receipts book, and the cash disbursements 
book, together with the journal itself are the ones in most 
popular use. When special journals are provided, the journal is 
named the general journal and is used for the recording of those 
transactions for which special journals have not been provided. 

Form and Content 

A journal sheet, ruled as already illustrated, suffices, when 
properly captioned, for any one of the special journals, in its 



86 



ACCOUNTING FUNDAMENTALS 



[Ch. VIII 



simplest form. The first column is used for the date, month and 
day, with the year indicated at the top on each page. The 
account and explanation column is used to record the accounts 
involved by the transactions of the particular book. This wide 
column has other uses which vary somewhat between the several 
journals as will be noticed in the illustrations. The third 
column is used for folio numbers to indicate the pages of the 
ledger to which the items are posted. The use of the two money 
columns similarly varies in the different journals. 

Each journal book may be a separate book with its own cover, 
or it may be just a section of one large book in which all the 
journals are kept. 

Sales Journal Illustrated and Explained 

SALES JOURNAL 



Date 


Account, Terms, and Detail 


F 


Items 


( 'ustomer 
Debit 


19_ 
Jan. 


2 

13 

24 

29 
30 

31 
31 


A. R. Douglas, 2/10, n/30 
10 tons Egg coal @ $11 
5 tons Pea coal @ $7 
\V. B. Harris, n/30 
20 bags Lime @ .60 
R. S. Hamilton, 2/10, n/30 
8 tons Buckwheat coal @ $5 
4 tons Pea coal @ $7 
3 tons Egg coal @ $11 
II. A. Dawson, 2/10, n/30 
5 tons Egg coal @ $11 
2 tons Pea coal @ $7 
W. B. Harris, 2/10, n/30 
10 tons Egg coal @ $11 
6 tons Buckwheat coal @ $5 
O. Boyd Wilson 
15 bags Lime @ .60 
Sales credit 


* 
2 

r> 



4 

r 
ij 

r> 
c 

6 

28 


110 
35 


00 
00 


145 
12 

101 
69 

140 
9 


00 
00 

00 
00 

o 

00 


40 
28 
33 


00 
00 
00 

00 
00 


55 
14 


110 
30 


00 
00 


^_-X J-, 


-= 


476 


00 







* The figures in any folio column are not inserted until the transactions are posted to the 
ledger. 



In view of the fact that it is customary for a vendor to send a 
sales invoice or bill to each customer for each charge sale and to 



Ch. VIII] 



BOOKS OF ORIGINAL ENTRY 



87 



retain a carbon duplicate which is numbered and filed, it is not 
necessary to record the details of sales in the sales journal. A 
reference in the sales journal to the invoice number indicates 
where the details may be found. The sales journal illustrated 
on page 86 is abbreviated, therefore, to the following : 

SALES JOURNAL 



Date 


Accounts m 
-o . , , Terms 
Receivable 


F 


Sales 
Invoice 
Number 


Customer 
Debit 


Jan. 


2 


A. R. Douglas, 2/10, n/30 


2 


1 




145 


00 




13 


W. B. Harris, n/30 


3 


2 




12 


00 




24 


R. S. Hamilton, 2/10, n/30 


4 


3 




101 


00 




29 


II. A. Dawson, 2/10, n/30 


5 


4 




69 


00 




30 


W. B. Harris, 2/10, n/30 


3 


5 




140 


00 




31 


O. Boyd Wilson 


6 


6 




9 


00 





31 


Sales credit 


28 


__ 





476 


00 



The use of the sales book, as illustrated, is limited to the 
recording of sales of merchandise on credit the terms of sale 
being other than 100 per cent cash. Each entry represents, 
therefore, a debit to a customer and a credit to Sales for the total 
of the sales invoice. In posting, the customer accounts are 
debited daily but Sales is credited only at the end of the month, 
for the total. In the illustration, the Sales account is credited on 
January 31 Avith $476.00 which is the total of the charge sales for 
the month. 

The crediting of the total of this book to Sales is the factor 
which limits it to the records of sales of merchandise alone. If 
any fixed asset, such as furniture and fixtures, is sold, the credit 
must be to the account representing that particular asset and 
not to Sales which represents only merchandise sales. 



Advantages of the Use of the Sales Journal 

The use of the special journal for sales has certain decided 
advantages over the method of recording charge sales in a general 
journal. 



88 



ACCOUNTING FUNDAMENTALS 



[Ch. VIII 



1. It is easier to find the entry of a particular charge sale. 

2. The total charge sales for any period are obtained readily. 

3. The recording of charge sales is facilitated. It is easier 
to make entries as illustrated in the sales book than to 
record debits, credits, and explanations in a general journal. 

4. Posting charge-sale entries is facilitated. The postings 
are reduced practically one-half. Instead of a credit 
posting to Sales for each entry, one credit posting is made 
at the end of a month for the total. 

5. Specialization in office labor is provided in part, with its 
attendant localization of responsibility and speedier and 
more accurate work. The person assigned the duty of 
recording charge sales becomes very familiar with the work, 
fast and accurate in doing it, and careful about it. 

Purchase Journal Explained 

PURCHASE JOURNAL 



Date 


Accounts rp, 
n LI Terms 
Payable 


F 


Invoice 
Number 


Creditor 
Credit 



















The form of the purchase journal is the same as that for a 
sales journal. The wide column is headed Accounts Payable 
instead of Accounts Receivable. The next to the last column is 
headed Invoice Number in contrast to a similar sales journal 
column headed Sales Invoice Number. The last column is 
headed Creditor Credit in contrast to the sales journal's Customer 
Debit column. 

Merchandise or raw material purchases on credit are entered in 
the same way entries are recorded in the sales journal. If 
invoices or bills received from creditors are given consecutive 
numbers, as they very often are, then the number of the invoice 
is entered in the column provided for that purpose. Where 
invoices are not so numbered and are filed under the name of the 
vendor, then the invoice number column is unnecessary. An 
entry is not made in the purchase book until the invoice has been 
checked as to quantity, price, and extension, and the receipt of 



Ch. VIII] BOOKS OF ORIGINAL ENTRY 8 



the goods in satisfactory condition has been verified. The entry 
when made is of the date of the invoice and not the date of the 
receipt of the goods. 

The illustrated purchase journal is limited to the recording of 
purchases of merchandise or raw materials on credit the terms of 
purchase being other than 100 per cent cash. Each entry repre- 
sents, therefore, a debit to Purchases and a credit to a creditor 
for the total of the purchase invoice. In posting, the creditors' 
accounts are credited daily, but Purchases is debited only at the 
end of the month, for the total. 

Debiting the total of this book to the Purchases account is the 
factor which limits it to the records of merchandise or raw mate- 
rial purchases. If any other asset, such as machinery, is pur- 
chased, the debit must go to the account representing that asset 
and not to Purchases. All purchases on credit other than mer- 
chandise or raw materials are entered in the general journal. 

Advantages comparable to those enumerated for the sales 
journal apply to the use of the purchase journal. 

Cashbook Illustrated and Explained 

The cashbook, which is the most common of all the special 
books of original entry, consists of two special journals, the cash 
receipts journal and the cash disbursements journal. Sometimes 
these tAvo books are kept in separate bindings, more often they 
are in the same binding, usually on opposite pages, the cash 
receipts journal always on the left page, the cash disbursements 
journal on the right page. This is the form in which they are 
illustrated on pages 90 and 91. 

It will be noticed that the two cash pages are ruled parallel 
although there are not so many items on the left or debit side 
as on the credit side. When one of the two pages of a cashbook 
is filled and it is necessary to carry the totals forward to another 
page, the totals of both pages are forwarded. To this extent 
entries for current receipts and disbursements are kept opposite 
each other. 

The cash balance on February 1 is placed in the second money 
column so that it will not be considered with new receipts and be 
posted again to the Cash account in the ledger. Only the 
receipts during February will be included in the cash debit at 



90 



ACCOUNTING FUNDAMENTALS 



[Ch. VIII 



the end of that month. Each side of the illustrated cashbook 
is a journal separate unto itself. The left side cash receipts 
journal shows records of transactions which brought cash into 
the business. The asset Cash is increased and is debited at the 
end of the month for the total, while the various accounts listed 
in the account column are credited daily. The total debited to 
Cash offsets exactly the credits to the various accounts listed. 
. The right side the cash disbursements journal shows 
records of transactions which caused payments of cash by the 

CASH RECEIPTS JOURNAL 



Date 


Accounts Credited Explanation 


F 


Amount 




Jan. 


2 


J. B. Harr, Capital Investment 


26 


5,000 


00 








12 


A. II. Douglas Invoice of 2d less dis- 
















count 


2 


142 


10 








19 


Sales* Cash sales 


28 


250 


00 








31 


\V. B. Harris On account 


3 


12 


00 








31 


Sales Cash sales 


28 


125 


00 








31 


Cash debit 


1 






5,529 


10 






Balance 









5,529 


10 
10 


Feb. 


1 






2,624 



* This credit is the total cash sales of tho day. It is obtained from the cash register or 
from the cash sales slips. 

business. The total of this journal represents a decrease in the 
asset Cash, which is credited for the total at the end of a month. 
The various accounts listed in the account column are the off- 
setting debits and are posted daily. - 

}A11 receipts and disbursements of cash should be entered in the 
cashbook. \ Each figure placed in the amount column should 
agree with the face of the check or the actual cash received or 
given. 

Transactions which involve discounts may be entered in one of 
several ways. In the illustration a check was received from 
A. R. Douglas on January 12, for $142.10 in payment of a sales 
invoice of January 2 for $145.00 but on which a 2 per cent dis- 
count had been offered for payment within 10 days. The illus- 



Ch. VIII) 



BOOKS OF ORIGINAL ENTRY 



91 



tration shows Cash debited and A. R. Douglas credited for the 
actual amount of cash received. It is also necessary, however, 
to give credit to Mr. Douglas for $2.90, the amount of the dis- 
count deduction to which he is entitled for prompt payment. 
This same amount of discount must be shown as an expense in 
the Sales Discounts account. The method recommended for the 
present is to make the entry for the discount portion of a trans- 
action in the journal. The general journal entry necessary in 
the case just cited is 

CASH DISBURSEMENTS JOURNAL 



Date 


Accounts Debited Explanation 


F 


Amount 




Jan. 


2 


Rent Expense Month in advance 


41 


200 


00 








2 


Office Expenses Stationery 


39 


50 


00 








2 


Purchases Cash purchases 


30 


800 


00 








3 


Furniture and Fixtures Desks and chairs 


16 


150 


00 








17 


IT. Ware Invoice of 3d 


17 


700 


00 








31 


Notes Payable To B. Jones 


25 


1,000 


00 








31 


Interest Expense On above note 


46 


5 


00 








31 


Cash credit 


1 






2,905 


00 




31 


Balance 








2,624 


10 












_ 


5,529 


10 















GENERAL JOURNAL 



Date 


Accounts and Explanation 


F 


Debit 
Amounts 


Credit 
Amounts 


Jan. 


12 


Sales Discounts 


47 


2 


90 










A. R. Douglas 


2 






2 


90 






To record discount allowed on payment of 
















sales invoice of 2d. 













Another method of handling transactions involving discount, 
but not recommended, is to enter the full amount involved on 
one side of the cashbook and the amount of the discount on the 
other side of the cashbook. For the case cited, the entries under 
this plan follow: 



92 



ACCOUNTING FUNDAMENTALS 
CASH RECEIPTS JOURNAL 



[Ch. VIII 



Date 


Account Explanation 


F 


Amount 




Jan. 


12 


A. R. Douglas Invoice of 2d 


145 


00 







CASH DISBURSEMENTS JOURNAL 



Date 


Account Explanation 


F 


Amount 




Jan. 


12 


Sales Discounts A. R. Douglas 




2 


90 







This method gives the same results as the first plan, but it 
records incorrect statements of fact on both sides of the cashbook. 
In the illustrated case $145.00 cash was not received nor was 
$2.90 disbursed. It is a convenient method, however, since the 
complete record can be made in the cashbook without resort to 
the journal and this undoubtedly accounts for its frequent 
use. 

Advantages comparable to those cited for the sales journal 
apply to the use of cash journals. In addition, the use of a cash- 
book permits the quick determination of the cash balance, thus 
facilitating frequent and regular testing of the balance with the 
actual count of cash as revealed by cash on hand and in bank. 

General Journal Explained 

The general journal is the same as developed in Chapter VII, 
but it is no longer used for transactions for which special journals 
are provided. 

All items invested by the proprietor, except cash, are recorded 
in the general journal. Suppose J. B. Harr whose cash invest- 
ment was recorded in the cash receipts journal, had invested, 
in addition to the cash, notes owed to him in the amount of 
$1,800.00, furniture and fixtures of a value of $100.00, and 
claims on L. S. Harris for $600.00 and R. Walker for $800.00. 
At the same time the business assumed obligations he owed on 
notes payable for $500.00 and to Lloyd Smith for $250.00. The 
general journal entry to record these facts is 



Ch. VIII] 



BOOKS OF ORIGINAL ENTRY 
GENERAL JOURNAL 



93 



Date 


Accounts and Explanation 


F 


Debit 
Amounts 


Credit 
Amounts 


Jan. 


2 


Notes Receivable 




1,800 


00 










Furniture and Fixtures 




100 


00 










L. S. Harris 




600 


00 










R. Walker 




800 


00 










Notes Payable 








500 


00 






Lloyd Smith 








250 


00 






J. B. Harr, Capital 








2,550 


00 






To record the assets other than cash con- 
















tributed, and the liabilities transferred, 
















to the business by J. B. Harr. 













Cross-checking 

When a transaction may be placed in either of two journals it 
may be recorded in both. The reason for the double recording is 
the desire to have each journal show all entries which pertain to 
it. To prevent double posting it is necessary to cross-check the 
appropriate items in both journals. To cross-check means to 
place a check mark ( V] in the folio column of both journals. 

To show the owner's complete investment including the cash in 
the general journal, and the cash element in the cash receipts 
journal, the investment may be recorded as follows: 

GENERAL JOURNAL 



Date 


Accounts and Explanation 


F 


Debit 
Amounts 


Credit 
Amounts 


Jan. 


2 


Cash 


V 


5,000 


00 










Notes Receivable 




1,800 


00 










Furniture and Fixtures 




100 


00 










L. S. Harris 




600 


00 










R. Walker 




800 


00 










Notes Payable 








500 


00 






Lloyd Smith 








250 


00 






J. B. Harr, Capital 








7,550 


00 






To record the complete investment by 
















J. B. Harr. 













94 



ACCOUNTING FUNDAMENTALS 



[Ch. VIII 



The $5,000.00 cash item must be recorded also in the cash 
receipts journal, thus: 

CASH RECEIPTS JOURNAL 



Date 


Account Explanation 


F 


Amount 




Jan. 


2 


J. B. Harr, Capital Investment 


" 


5,000 


00 







The check mark in the folio column of the general journal indi- 
cates that the debit to Cash is not to be posted from that book. 
As a result the debit postings for this general journal entry are 
$5,000.00 short of the amount of the credit postings. The check 
mark in the folio column of the cash receipts journal indicates 
that the credit to J. B. Harr, Capital is not to be posted from that 
book. Since the $5,000.00 cash item will be included in the cash 
receipts total to be debited to the Cash account, the credit post- 
ings from the cash receipts journal will be $5,000.00 short of the 
debit amount. The shortage of credit postings from the cash 
receipts journal offsets exactly the debit shortage from the general 
journal. 

The total amount credited to J. B. Harr, Capital is the same 
under both methods of recording. By the first method illus- 
trated, the Capital account will have credits of $5,000.00 from 
the cash receipts journal and $2,550.00 from the general journal. 
Under the second method it will have just one credit for $7,550.00 
from the general journal. 

This method of cross-checking makes possible the recording of 
items such as cash sales in both the cash receipts journal and the 
sales journal, and cash purchases in both the cash disbursements 
and purchase journals so that the total sales and total purchases 
for each month will be shown in their respective journals. 

When cash sales are entered in the cash receipts journal and 
checked thus : 

CASH RECEIPTS JOURNAL 



Date 


Account Explanation 


F 


Amount 




Jan. 


19 


Sales Cash sales 


v 


250 


00 





Ch. VIII] BOOKS OF ORIGINAL ENTRY 

and in the sales journal, as follows: 

SALES JOURNAL 



95 



Date 


Account Terms 


F 


Sales 
Invoice 
Number 


Customer 
Debit 


Jan. 


19 


Cash Cash sales 


V 






250 


00 



the debit to Cash is from the cash receipts journal with no off- 
setting credit from that bocik, and the credit to Sales is from the 
sales journal with no offsetting debit from that book. 

Other Journals Sometimes Used 

1. Sales Returns Journal. A special journal for returned sales 
is provided when such transactions are of sufficient frequency to 
warrant it. Its general form is the same as that illustrated for 
the sales journal but the column headed Customer Debit is 
changed to Customer Credit. The postings are credits to the 
customers affected and the debit is to Sales Returns for the total. 
Sometimes this book is a journal for both returned sales and 
allowances, in which case it is called the sales returns and allow- 
ances journal, and the total of the book is debited to the account, 
Sales Returns and Allowances. A separate journal for sales 
returns and another for sales allowances are provided in a busi-,, 
ness where the number of transactions of both types warrants 
their use. 

2. Purchase Returns Journal. This separate journal is based 
on the same principles as the others. Here again there may be 
one journal for purchase returns and another for purchase allow- 
ances, or the two may be combined in a purchase returns and 
allowances journal. In either case the debits are to the creditor 
accounts involved. The credits are to the accounts Purchase 
Returns and Purchase Allowances, if two books are used, and 
Purchase Returns and Allowances, if one book is provided. 

3. Notes Receivable Journal. This special journal is used to 
record the receipt of notes from customers. The debit is to 
Notes Receivable, the credits to the customers involved. 

4. Notes Payable Journal. This book is used to record the 



96 



ACCOUNTING FUNDAMENTALS 



[Ch. VIII 



issuance of notes to creditors. The debits are to creditors' 
accounts and the credit is to Notes Payable. 

Compound Transactions 

Not every transaction may be recorded completely in one 
journal. Sometimes there are several elements involved which 
require records in two or more journals. An instance is the 
investment by the owner illustrated previously in this chapter. 

If more than one business paper is involved in a transaction it 
is desirable to record each paper separately. For example, sup- 
pose the sale on April 5, 19 of $1,500.00 worth of merchandise to 

Walter Miller, who pays $500.00 cash at the time of the sale, 
gives the business a 30-day promissory note for $600.00, and asks 
that the $400.00 balance be carried on open account for 60 days. 
Each of the business papers involved in this transaction is 
recorded separately. The $1,500.00 sales invoice is charged to 
Miller in the sales journal. The check for $500.00 is credited to 
Miller in the cash receipts journal, and the $600.00 note is 
credited to Miller in the general journal. The ledger account 
with Walter Miller appears as follows : 

Walter Miller 



Apr. 


5 


Sales Journal 


S 


1,500 


00 


Apr. 


5 
5 


Cash Receipts 
Journal 


CR 
J 


500 
600 


00 
00 



The $400.00 debit balance is the amount owing on open 
account. 

Ledger References to Various Books 

When more than one journal is used, it is not sufficient to enter 
in the folio column of the ledger a page number to refer to the 
original entry. A symbolic letter or letters must precede each 
page number to indicate the original entry journal to which the 
number refers. Suggested symbols are: 

S for sales journal. 

P for purchase journal. 

J for general journal. 

CR for cash receipts journal. 

CD for cash disbursements journal. 

SR for sales returns and allowances journal. 

PR for purchase returns and allowances journal. 



Ch. VIII] BOOKS OF ORIGINAL ENTRY 97 

Correcting Entries 

A correcting entry is one made to correct an error existing in 
the accounts as the results of an an incorrect journal entry. 

Errors are inevitable now and then and some of them can be 
corrected satisfactorily without making entries. If the incorrect 
entry has been posted, the method by which mistakes are cor- 
rected by means of entries is recommended. It is a clear, neat, 
and complete way to correct misstatements in the accounts. An 
error should never be erased or blotted out, so that it is impossible 
to tell what record was there. Such a method may cast doubt on 
the validity of the record and on the integrity of the person who 
did it. 

In cases where an incorrect amount or a wrong account caption 
has been journalized and the mistake is noticed before any 
posting of the incorrect item has been made, the plan of ruling 
out the Avrong amount or item and inserting the correct one 
above it is as satisfactory as any method. 

If the mistake on the books results from an omitted entry 
then such entry should be recorded, but it is not what is known 
as a correcting entry. It is an entry which should have been 
made. It is entered under the date of the discovery of its 
omission, with a reference in the explanation section of the entry 
to the date it should have been made. If a $100.00 check for 
rent was mailed on the first of a month and on the sixth it was 
discovered that it was not recorded in the cash disbursements 
journal, it is entered on the sixth with comment that it was 
omitted on the first. 

Suppose on the second of the month B. B. Smith, a customer, 
paid $150.00 to be applied to his credit. In the cash receipts 
journal B. W. Smith, another customer, was credited. On the 
twelfth the error was discovered. If not posted, it may be cor- 
rected by the ruling out and inserting plan, otherwise by a cor- 
recting entry. If the latter method is followed, an entry is made 
on the twelfth in the general journal, as follows: 

B. W. Smith 150.00 

B. B. Smith 150.00 

To correct credit on the 2d in cash receipts 
journal to B. W. Smith, which should have 
been to B. B. Smith. 



98 ACCOUNTING FUNDAMENTALS [Ch. VIII 

A reference to the entry on the twelfth should be added to the 
incorrect entry on the second. 

In the above illustration the cash item was recorded correctly, 
consequently it does not appear in the correcting entry. Cor- 
recting entries are to correct the accounts which are stated 
incorrectly. 

Correcting entries in cases where cash is misstated should be 
recorded in the cashbook. Suppose $50.00 were spent for office 
expense items on the third of the month. A clerk entered the 
item as Office Expenses $50.00 in the cash receipts journal. 
To correct this error by the entry method, an entry debiting 
Office Expenses $100.00 should be made in the cash disburse- 
ments journal on the day the error is discovered. $50.00 of 
the $100.00 entry offsets the incorrect entry, the other $50.00 
records the correct entry on the books. 

Suppose a $100.00 sale on account to R. Hall was entered 
incorrectly in the purchase journal and posted before the error 
was discovered. This incorrect entry resulted in a debit to 
Purchases and a credit to R. Hall for $100.00 each. To correct 
this situation by one entry it is necessary to make the following 
general journal record: 

R. Hall 200.00 

Purchases 100.00 

Sales 100.00 

To correct errors resulting from the recording 

of a sale to R. Hall on credit, in the purchase 

journal. 

These few illustrations of errors and how to correct them 
are merely suggestive. Errors are possible in any part of the 
system of accounts and considerable thought and care arc often 
necessary to correct them. 

QUESTIONS 

1. Why would a small enterprise find it advisable to use a number of 
special journals rather than one journal? 

2. From a bookkeeping standpoint, why is it possible to have a special 
journal for sales? For purchases? For cash receipts? For cash 
disbursements? 

3. Would it be advisable to have one special journal for both Sales 
Returns and Allowances and Purchase Returns and Allowances? 
Explain. 



Ch. VIII] BOOKS OF ORIGINAL ENTRY 99 

4. Is a cashbook, in which both cash receipts and disbursements are 
recorded, one or two special journals? Explain. 

5. a. Name nine journals a wholesale enterprise might use. 

6. Suppose the enterprise referred to in a above used only five 
journals. Name them. 

6. What accounts are posted as debits and credits from 
a. The sales journal? 

6. The cash receipts journal? 

c. The purchase journal? 

d. The cash disbursements journal? 

e. The purchase returns journal? 
/. The notes payable journal? 

g. The sales returns journal? 
h. The notes receivable journal? 

7. Explain the several methods of recording and posting cash sales 
when special journals for sales and cash receipts are used. 

8. When you examine a ledger account, how do you know from what 
special journal an item was posted? 

9. Assuming the use of the five journals emphasized in this chapter, 
a. Name the journal or journals in which each of the following 

transactions should be recorded: 

(1) A merchandise sale on account. 

(2) The receipt of a note from a customer. 

(3) A merchandise purchase for cash. 

(4) The receipt of a check from a customer. 

(5) The return of defective merchandise to a creditor. 

(6) The granting of an allowance to a customer for defective 
merchandise sold to him. 

(7) A cash payment to a creditor. 

(8) The issuance of a note to a creditor. 

(9) A sale of merchandise for cash. 

(10) A sale of merchandise to a customer who gave his note in 
payment. 

(11) The cash purchase of various small supply items for the 
office. 

(12) The receipt of a check in payment for the note of a customer. 

(13) The payment of interest on a note payable. 

(14) The payment of a note originally given to a creditor. 

(15) The sale of merchandise to a customer who made a down 
payment in cash, gave his note for part of the balance, and 

requested the remainder be carried on open account. 

(16) The sale of an old office desk for cash. 

(17) The sale of an old office typewriter, on account. 

(18) The purchase of oil for heating purposes, on account. 



100 ACCOUNTING FUNDAMENTALS [Ch. VIII 

6. Indicate the accounts you would debit and credit in each of the 
transactions enumerated in a above. 

10. What do you mean by cross-checking in journals? Explain by an 
example. 

11. Assume a business used only one journal and in a month it had 163 
charge sales. How many postings would it have saved, if it had 
used a sales journal? 

'12. Would it be correct or incorrect to enter in the purchase journal the 
purchase of a fixed asset on account? Explain. 

13. How is the equality of debits and credits in the ledger maintained, 
if the total of the right side of a cashbook is less than the total of 
the left side? Explain. 

14. Name the journal or journals in which the necessary entry or entries 
would be made to correct each of the following errors : 

a. A sale of merchandise to a customer, 5 days ago, was overlooked 
and not recorded. Would it make any difference in your answer 
if the error was discovered in the month in which it was made or 
discovered in a subsequent month? 

6. The purchase of merchandise, 10 days ago, from Harrison Morris 
was incorrectly credited in the purchase journal, to Harrison 
Morrison. 

c. A rent payment, early in the month, was incorrectly charged to 
Real Estate in the cash disbursements journal. 

d. The receipt of a note from a customer, last month, was entered 
in the sales journal as a charge to the customer and a credit to 
Sales. 

e. A $5.00 payment made for the purchase of office supplies was 
entered, some days ago, as a credit to Office Expenses on the left 
side of the cashbook. 

/. A $125.00 purchase of merchandise, from Robert Nyce on 
account, was entered, some days ago, in the sales journal. 

g. A $150.00 purchase of merchandise from Harold Stone was 
entered as a $15.00 item, a week ago, in the purchase journal. 

15. Give the debits and credits, and the amounts if necessary, for each 
of the items enumerated in question 14. 

16. Do special journals require the same number of accounts in the 
ledger, more accounts, or fewer accounts than a single journal 
requires? 

17. If special journals are used, is it impractical to take a daily trial 
balance? 



CHAPTER IX 

THE TRIAL BALANCE 

It is desirable periodically, usually once a month in the average 
business, to test the mathematical accuracy of the books. This 
is accomplished by means of a trial balance which tests the 
ledger equilibrium. 

It has been shown in Chapter VI that the fundamental princi- 
ple of double-entry bookkeeping requires that the sum of the 
debits and the sum of the credits in each entry must be equal. If 
all debits and credits arc transferred correctly from the original 
entry books to the ledger, it follows that the ledger must balance, 
i.e., that the sum of the debits will equal the sum of the credits. 
A corollary to this is that the sum of the debit totals of all the 
accounts will agree with the sum of the credit totals of all the 
accounts. Similarly it follows that the sum of the accounts 
with debit balances will equal the sum of the accounts with 
credit balances. 

Definition 

A trial balance is a list of the accounts on a ledger at a given 
date with the debit and credit totals of each account, or it is a list 
of the accounts on a ledger at a given date with the debit or 
credit balance of each account. 

Purpose 

There are two reasons for the preparation of a trial balance : 

1. It proves or disproves the equality of the debits and credits 
in the ledger. 

2. It is a convenient summary or abstract of the ledger 
accounts and is, therefore, the basis for the preparation 
of the balance sheet and the statement of profit and loss. 

A trial balance may be prepared at any time if all entries have 
been posted. It is common practice to prepare one monthly, 

101 



102 



ACCOUNTING FUNDAMENTALS 



[Ch. IX 



thereby limiting the period of possible errors and facilitating their 
discovery. 

Summarizing the Ledger 

After journalizing and posting it is necessary to do some 
preliminary work on a ledger before taking a trial balance. 

Accounts, the totals of which arc not obvious, must be added 
and the totals placed in small lead-pencil figures under the last 
items. As these figures remain permanently in the accounts to 
facilitate subsequent additions, they should be so small that 
they will not fill posting spaces and will not interfere with the 
placement of other figures in the spaces where they are located. 

The account with R. F. Davis, a customer, is reproduced below 
to illustrate the method of totaling, ruling, and balancing an 
account. 

R. F. Davis 



jNov. 


1 


Balance 




450 


00 


Nov. 


10 




Jll 


300 


00 




6 




S8 


80 


00 




15 




CR18 


100 


00 




9 




S12 


30 


00 




20 




CR24 


100 


00 




16 




S19 


60 


00 










500 


00* 




28 


240.00* 


S32 


120 


00 


Dec. 


8 




CR34 


100 


00 










740 


00* 




16 




CR40 


100 


00 


Dec. 


14 




S38 


150 


00 










7CO 


00* 




21 


300.00* 


S43 


110 


00 




31 


Balance 




300 


00 










1,000 


00* 






















1,000 


00 










1,000 


00 


Jan. 


1 


Balance 




300 


00 















* Small pencil figures. In the amount columns these figures should be small enough not 
to interfere with the next item being entered on the following line. 

The pencil figures 240.00 and 300.00 shown in the explanation 
column of the debit side on November 28 and December 21 
respectively indicate the balances existing in the account on 
those dates. It is customary to indicate an account balance by 
pencil figures placed on the larger side of the account. 

The balance 300.00, entered on the credit side of the account on 
December 31, indicates the account is to be restated as a single 
balance. The difference is indicated by adding an amount to the 
smaller side to make it equal the larger side. This balance is 
brought over to the larger side and entered immediately below 



Ch. IX] 



THE TRIAL BALANCE 



103 



the double rulings. On January 1, as a result of all previous 
transactions, R. F. Davis has a debit balance of $300.00, in other 
words he owes this business $300.00. Balancing an account and 
ruling it in this way may be done at any time. Special effort 
is often made to balance accounts at the end of fiscal periods. 

Offsetting debit and credit items in an account may be indi- 
cated at the time of posting by single rulings placed under them 
provided the account is in balance to the point of the rulings, 
thus: 

O. L. White 



Dec. 



Balance 



S21 
S45 



50000 



20000 
"40000 



Dec. 



CR11 
CR27 
CR29 
CR31 



50000 



12500 
7500 



40000 



Another method of cancelling offsetting debit and credit items 
in an account at the time of posting is to mark both the debit 
and credit items by the same letter placed in the explanation 
columns, as follows: 



Notes Receivable 



19__ 












19 












Dec. 


1 


(30 day note) d 


J 6 


150 


00 


Dec. 


23 


a 


CR 23 


125 


00 




3 


(20 day note) a 


J 9 


125 


00 




24 


b 


CR 25 


175 


00 




4 


(20 day note) b 


J 12 


175 


00 




28 


c 


CR 31 


150 


00 




7 


(30 day note) 


J 13 


200 


00 




31 


d 


CR 35 


150 


00 




8 


(20 day note) c 


J 14 


150 


00 















The unlettered items are the ones which have not been satisfied 
and are still open, in this case the $200.00 debit on December 7. 

Form 

A trial balance may be prepared on journal paper. The title 
and date should appear at the top, with the accounts listed in 
the same order as they appear in the ledger, with their respective 
totals or balances in the proper money columns. The debit 
totals or debit balances appear in the left money column and the 
credit totals or credit balances in the right. It is helpful for 
reference purposes, if the ledger page number of each account is 
indicated in the narrow column to the left of the account titles. 



104 



ACCOUNTING FUNDAMENTALS 



[Ch. IX 



Illustrations 

A trial balance of totals for the business of G. W. Adams on 
December 31, 19 , follows: 



G. W. 

TRIAL BALANCE, 



ADAMS 
DECEMBER 31, 19 









Dr. 


Cr. 




1 


Cash 


$37,400 


00 


$28,600 


00 




2 


R. F. Davis 


1,000 


00 


700 


00 




3 


O. L. White 


1,100 


00 


1,100 


00 




4 


A. R. Blake 


2,300 


00 


2,300 


00 




5 


Notes Receivable 


800 


00 


600 


00 




6 


Furniture and Fixtures 


1,200 


00 








7 


M. O. Nunn 






300 


00 




8 


G. W. Adams, Capital 






9,100 


00 




9 


Sales 






30,000 


00 




10 


Purchases 


25,000 


00 








11 


Store Expenses 


100 


00 








12 


Rent 


1,200 


00 








13 


Office Expenses 


200 


00 








14 


Salaries 


2,400 


00 












$72,700 


00 


$72,700 


00 









The trial balance of totals just presented is comparable to 
an equation, the debit items of which exactly equal the credit 
items. The accounts with totals which balance, such as those 

G. W. ADAMS 
TRIAL BALANCE, DECEMBER 31, 19 









Dr. 


Cr. 






1 


Cash 


$ 8,800 


00 








2 


R. F. Davis 


300 


00 








5 


Notes Receivable 


200 


00 








6 


Furniture and Fixtures 


1,200 


00 








7 


M. O. Nunn 






$ 300 


00 




8 


G. W. Adams, Capital 






9,100 


00 




9 


Sales 






30,000 


00 




10 


Purchases 


25,000 


00 








11 


Store Expenses 


100 


00 








12 


Rent 


1,200 


00 








13 


Office Expenses 


200 


00 








14 


Salaries 


2,400 


00 












$39,400 


00 


$39,400 


00 









Ch. IX] THE TRIAL BALANCE 105 

of 0. L. White and A. R. Blake in the above illustration, may 
or may not be included in a trial balance of totals. Unless they 
are needed to give evidence of the volume of business with 
them, it is useless to include them. 

If a new list with account differences is presented, it too will 
balance, since the smaller side of each account will be deducted 
from both sides, and accounts with the same debit and credit 
totals will be omitted altogether, thus equally affecting both 
sides. A trial balance of balances from the same ledger of G. W. 
Adams, December 31, 19 is shown at the bottom of page 104.' 

The equality of the debit and credit items in either trial 
balance indicates the equality of the debits and credits in the 
ledger. If a trial balance of differences is desired, it is prepared 
directly from the ledger and a trial balance of totals is not 
prepared as a preliminary to it. 

Since a trial balance of balances does not include closed 
accounts and shows the exact balances of the open accounts, it is 
a briefer statement and is more significant, which probably 
accounts for its popularity. It is the form which will be used 
throughout this text, and which should be used by the student in 
all assigned problems. 

The trial balance taken at the end of the first month of the 
existence of a business is the only one which summarizes the 
records of a single month. All others summarize the accumu- 
lated records in the accounts. If a business is eleven months 
old and a trial balance is taken monthly, a trial balance for the 
records of the eleventh month alone would be meaningless. 
For example, if the Cash account at the end of the tenth month 
had a debit balance of $10,800.00 and during the eleventh month 
had debits of $3,000.00 and credits of $5,000.00, a trial balance 
for the eleventh month alone would show Cash with a credit 
balance of $2,000.00 which is_ an incorrect statement of fact. 
The Cash account has an actual balance of $8,800.00 at the end 
of the eleventh month. 

Trial Balance Does Not Indicate All Errors 

A balanced trial balance proves a ledger to be in balance but 
it does not prove that the journalizing and posting have been 
absolutely correct. It proves that the equality of debit and 
credit has been maintained and nothing more than that. 



106 ACCOUNTING FUNDAMENTALS [Ch. IX 

Some errors it does not reveal are 

1. The omission of an entire entry. 

If a transaction such as a sale on account is omitted, the 
records are short a debit to an account receivable and a 
credit to Sales for the same amount. 

2. Recording the wrong amount .although the entry is correct 
otherwise. 

If a sales slip is overadded the customer is charged an 
excess amount and the Sales account is overcredited a like 
amount. * 

3. A debit or a credit to the wrong account. 

a. If a debit is made to John L. Williams instead of J. K. 
Williams the records balance, although one customer is 
overdebited and another underdebited. An error of this 
character will be discovered and reported probably by 
the overcharged customer. This error would not 
affect the total of claims on customers,- consequently it 
would not affect the calculation of correct net worth 
and net profit or loss. 

fe. If not located certain debits or credits to the wrong 
account result in the ultimate determination of an 
incorrect net profit or loss and net worth of the business. 
For example, if repairs to the delivery truck are charged 
to Delivery Equipment instead of Delivery Expenses, 
an asset will be overvalued and an expense will be 
understated, by the same amount. Such errors are 
referred to as errors of principle as they affect both 
nominal and real accounts. 
4. Compensating or offsetting errors. 

If the debit side of Cash is overadded $100.00 and the 
credit side of Notes Payable is overadded a similar amount, 
the trial balance will balance. One erfor offsets the other. 
If the debit side of Cash is overadded $100.00 and the 
debit side of Notes Receivable is underadded $100.00, 
the trial balance will balance although two accounts are 
wrong. Such errors, especially those which involve cash 
should be discovered quickly as a result of accounting 
routine. A well-ordered system requires the book balance 
of cash to be compared frequently with the actual count of 



Ch. IX] THE TRIAL BALANCE 107 

cash; very often it is done daily. At such times errors in 
cash, such as those illustrated, are discovered. 

Errors of this nature, which do not affect the equilibrium 
of the ledger, indicate the need for careful and accurate book- 
keeping, if the statements prepared at the end of fiscal periods 
are to reflect the true condition of the enterprise. 

It is one of the functions of auditing, which is a subject outside 
the scope of this book, to check the accuracy of the accounts with 
respect to errors of principle, referred to under point 3 above. 

If a trial balance balances, it is customary from the book- 
keeping standpoint to assume the correctness of the accounts. 

Procedure If Trial Balance Does Not Balance 

When a trial balance does not balance the error or errors 
may have occurred in the trial balance, the ledger, or the journals. 
The fact that a difference is small is no index of the amount of 
the errors. A difference of $8.30 may be the net difference of 
errors involving thousands of dollars. 

One plan for locating the trouble is to examine the trial 
balance first and from it go backward to the ledger and then 
to the journals. 

1. Determine the difference between the trial balance totals. 
It frequently happens that if only one item is omitted or 
duplicated the figure is familiar or easily traceable. 

2. Examine the trial balance to see if any balances are placed 
on the wrong side. 

3. Add the trial balance columns again. 

4. Check with the ledger to see if all balances are taken 
correctly. 

5. Rcadd the ledger and redetermine the account balances. 

6. Check postings from the original entry books to the ledger, 
to see if 

a. The wrong amount has been entered. 

b. A debit or credit has been omitted or duplicated. 

c. A debit has been posted as a credit or vice versa, 

As checking is done, a distinguishing check mark such as ( is ) 
should be placed beside each debit and credit in both the original 



108 ACCOUNTING FUNDAMENTALS [Ch. IX 

entry books and the ledger, so that later both books may be 
scrutinized for missing or duplicated check marks. 

Some Special Tests for One Error 

If a trial balance is out of balance as a result of just one mis- 
take, considerable labor and time may be saved by applying the 
special tests for one error. Since it is frequently the case that 
only one error has been made, it is advisable after ascertaining 
the trial balance difference, to apply these special tests, before 
following the procedure just outlined. 

1. If the difference is $ .01, $ .10, $1.00, $10.00, $100.00, etc., 
the mistake is likely to be the result of incorrect addition or 
subtraction but there is no clue as to the location of the 
error. 

2. If the difference is divisible by 2, perhaps a debit balance 
has been placed in the trial balance as a credit, or vice 
versa, or a debit item has been entered in the ledger as a 
credit, or vice versa. For example, if the $300.00 debit 
balance of the R. F. Davis account in the G. W. Adams 
trial balance of balances had been placed in the credit 
column, the total of the debit side of the trial balance would 
have been $39,100.00 and that of the credit side $39,700.00. 
The credit total would have been larger than the debit total 
by $600.00. This difference is divisible by 2. The quotient 
$300.00 indicates the figure which caused the difference. 

3. If the difference is divisible by 9, perhaps 

a. A transposition of figures has taken place. 

For example, if the Purchases account had been listed in 
the G. W. Adams trial balance as $52,000.00 instead of 
$25,000.00, the trial balance difference would have been 
$27,000.00. This difference is divisible by 9 with a 
resulting quotient of 3,000. The digit 3 in this quotient 
indicates that the difference between the digits which 
have been transposed is 3, in this case 5 and 2. The 
ciphers indicate that the transposition has taken place 
to the left of the third digit. If 47 is written as 74, or 
vice versa, the difference will be 27. If this difference of 
27 is divided by 9 the quotient will be 3, indicating that 
the difference between the transposed figures was 3, in 



Ch. IX] THE TRIAL BALANCE 109 



this case 4 and 7. The transposition of any two figures 
the difference between which is 3, as 36 for 63, or 85 for 
58, will result in a difference of 27. 
The transposition of any two figures gives a difference 
which is a multiple of 9. If the difference is divided by 
9 the quotient indicates the difference between the digits 
which have been transposed. 
6. A one-place slide has taken place. 

For instance, if the Rent account with a debit balance of 
$1,200.00 had been placed in the trial balance as 
$120.00 in other words the decimal point moved over 
one place the debit total of the trial balance would be 
$1,080.00 smaller than the credit total. This difference 
is divisible by 9 with a resulting quotient of 120 which 
indicates the amount where the slide occurred. 
4. If the difference is divisible by 99 perhaps a two-place slide 
has taken place. 

For example, if the Salaries account had been placed in the 
trial balance as a debit balance of $24.00 instead of 
$2,400.00, the difference of $2,376.00 is divisible by 99 with 
a resulting quotient of 24 which indicates the amount 
involved in the slide. 

If the error is not discovered through the help of these special 
tests, resort must be had to the procedure previously outlined, 
which as a last measure provides for a complete checking of all 
postings to the ledger. 

QUESTIONS 

1. a. Distinguish between a trial balance and a balance sheet. 

b. Is there any difference in the form of a trial balance and a balance 
sheet? 

c. Is there any difference in the purposes for which a trial balance 
and a balance sheet are prepared? 

2. Distinguish between a trial balance and a statement of profit and loss, 
emphasizing the purposes for which they are prepared, their form, 
and content. 

3. Name 

a. An account title which will appear in the trial 'balance and the 

balance sheet. 
6. An account title which will appear in the trial balance and will 

not appear in the balance sheet. 



110 ACCOUNTING FUNDAMENTALS (Ch. IX 



c. An account title which will appear in the trial balance and in the 
statement of profit and loss. 

d. An account title which will appear in the trial balance and will 
not appear in the statement of profit and loss. 

4. Is it possible for any facts shown by a trial balance at the end of a 
fiscal period to agree with the facts which appeared in the balance 
sheet at the close of the preceding fiscal period? Name some and 
state the conditions which make the agreement possible. 
' 5. What kind of balance, if any, should each of the following accounts 
have in a trial balance? Why? 

a. Cash. 

b. A creditor's account. 

c. Office Salaries. 

d. Notes Receivable. 

e. Proprietor's Capital. 
/. A customer's account. 
g. Notes Payable. 

h. Sales. 

i. Interest Income. 

j. Purchase Returns and Allowances. 

6. Does a trial balance in balance prove that a set of books is absolutely 
correct? Explain. 

7. How much will a trial balance be out of balance, if at all, as a result of 
each of the following errors? 

a. A debit of $75.16 to Frank Anderson was posted as a debit to 

Frank Andrews. 
6. A credit of $35.00 to Roy Wood was posted as a debit to that 

account. 

c. A debit of $17.89 to J. Torrey was not posted at all. 

d. A credit of $85.00 to L. Brown was posted as a credit of $58.00. 

e. A debit of $1 7.00 to Office Expenses was posted as a credit to that 
account. 

/. A credit of $10.00 to Interest Income was credited to Purchase 

Discounts. 

g. A debit of $100.00 to Rent was posted as a debit of $10.00. 
h. A credit of $17.22 to Office Furniture and Fixtures was posted as 

a credit of $17.02. 
i. A debit of $5,500.00 to the Building account was posted as a 

debit of $55.00. 

8. What test, if any, would help to indicate the kind of error illustrated 
in 

a. Question 76? 

b. Question 7d? 

c. Question 7e? 



Ch. IX] THE TRIAL BALANCE 111 

d. Question 7g? 

e. Question 7i? 

9. Why is a check mark, such as (i/), made in both the journals and 
the ledger when figures are compared in order to find errors? 

10. Which, if any, of the following prevent a trial balance from balancing 
and why? 

a. A bill for repairs to the delivery truck was not recorded nor had it 
been paid when the trial balance was taken. 

b. The invoice for some office supply items purchased and received 
ten days ago was not recorded, but an entry was made in the 
same month at the time the check was mailed. 

c. The Purchases account was debited with a tire bought for the 
delivery truck. 

d. A customer was debited in the cash disbursements journal with 
the amount of the check received from him. 

11. What would be the effect, if any, of each of the mistakes referred to 
in question 10, on the net profit for the period, if it were calculated 
immediately after the trial balance was taken? 

12. The debit side of a trial balance totals $78,857.85, the credit side 
$81,976.35. List three possible errors which may have resulted in 
the difference between these two totals, assuming in each case that 
only one mistake was made. 

13. What classes of account balances are found in the debit trial 
balance column? Credit column? 

14. We owed the X Company $500.00 on open account. We pur- 
chased $300.00 of merchandise on account. The bookkeeper 
debited the X Company with $3.00. Prior to discovering the 
mistake, would the debit or credit total of the trial balance be too 
high or too low and by what amount? If the first sentence were 
omitted, what would your answer be? (The answer is not the 
same.) 



CHAPTER X 
CAPITAL AND REVENUE EXPENDITURES 

In Chapter VI, in connection with the application of the debit 
and credit schedule, it was stated that it is necessary to apply a 
jcte^riptive accounting^ caption to each element in a transaction. 
The account titles chosen for the debit and credit items of an 
entry are important since they determine largely the subsequent 
treatment of the items on the books and in the statements. The 
selection of account titles is particularly important in distinguish- 
ing between capital and revenue expenditures. 

Expenditure 

An expenditure is a payment or the incurring of a debt for an 
asset or an expense. If an asset is acquired or an expense 
incurred, an expenditure is made, whether or not the cash is paid 
immediately. 

Capital Expenditure 

A capital expenditure is one that results in an increase in the 
relatively permanent value of an asset. If an asset has a service 
life of more than a year, its cost should be capitalized debited to 
an asset title; if less than a year, its cost should be charged to 
revenue debited to an expense title. 

Each capital expenditure is debited to an asset account. 
Some common capital expenditures are for 

1. The original purchase or construction of fixed assets. 

2. Additions and Extensions. An expenditure for an addition 
or an extension increases the serviceable value of a fixed 
asset because it provides structures, facilities, or equipment 
that are not replacements of existing assets. Expenditures 
to add a wing to a building, to supply safety gates for eleva- 
tors, or to provide additional shelves and counters in a store 
are illustrations. 

112 



Ch. X] CAPITAL AND REVENUE EXPENDITURES 113 

3. Replacements. An expenditure for a replacement results in 
a new asset to take the place of another which is worn out, 
inadequate, or obsolete. The new asset may or may not be 
identical with the unit replaced. A delivery truck may be 
replaced with a new one of like kind or with a new one of 
greater capacity. In either case the cost of the new asset is 
capitalized (charged to the fixed asset account involved), 
but the value on the books of the superseded asset is can- 
celed (written off). 

4. Improvements and Betterments. An expenditure for an 
improvement or a betterment increases the efficient life of an 
asset or its capacity or serviceability. Examples are 
expenditures to substitute a special body for the one on a 
motor truck, to modernize existing structures, facilities, or 
equipment, to improve the ventilating system with air con- 
ditioning, to substitute a slate roof for a wooden shingle one, 
or to substitute steel stairs for the existing wooden ones. In 
the case of the replacement of an asset, the betterment is the 
amount by which the cost of the new item exceeds the value 
on the books of the item superseded. To illustrate, if an 
automobile body which is considered to have a value on the 
books of $500.00 but has no exchange value is discarded and 
replaced by a special body which cost $750.00, the actual 
betterment is $250.00. To register this $250.00 in the 
accounts, that amount may be capitalized and the remaining 
$500.00 charged to an expense account. Another and better 
method to record the replacement of an asset is to relieve 
the books of the value of the discarded asset and to capitalize 
the entire expenditure for the new asset. In the illustra- 
tion, the $500.00 value of the body discarded would be 
charged to an expense caption and the entire expenditure 
of $750.00 would be capitalized (charged to the Motor 
Truck or Delivery Equipment account). 

5. Renewals. An expenditure for a renewal renews the life of 
an intangible asset. In a sense, renewals are replacements. 

/The terms differ in that replacements affect tangible assets 

/and renewals affect intangible assets. Expenditures that 

renew or extend the life of original agreements should be 

capitalized. Examples of renewals are the costs of renew- 



114 ACCOUNTING FUNDAMENTALS [Ch. X 

ing leaseholds, franchises, copyrights, and royalty, license, 
and formula contracts. 

6. Deferred Charges. An expenditure for a deferred asset 
should be capitalized and written off during subsequent 
fiscal periods. Examples of capital expenditures in this 
group are organization expenses for corporations, the dis- 
count and expenses of floating a bond issue, improvements 
to a lessor's property by a lessee under a lease with more 
than a year to run, experimental and research costs, pack- 
ing and transportation of machinery to a new location, and 
rearrangement of assembly lines to facilitate the flow of 
production. 

7. Stocks and Bonds. The commission paid for the purchase 
of securities and the cost of stamps or tax required by the 
government in connection therewith are expenditures that 
increase the cost of the securities and that should be 
capitalized. 

Revenue Expenditure 

Revenue is a synonym for income. A revenue expenditure is 
an expense, a cost incurred to obtain gross income. Such 
expenditures do not increase the book value of any asset; they 
are sources of debits to expense accounts. 

Revenue expenditures in connection with fixed assets arise as 
the result of repairing, maintaining, and operating them. 

Each revenue expenditure is debited to an expense account. 
Examples of revenue expenditures are 

1. Repairs. An expenditure for ordinary repairs docs not 
increase the book value of any asset but is made to maintain 
its normal operating efficiency. Such repairs do not extend 
the normal service life of any asset. Replacing spark plugs 
in an automobile, straightening a bent axle, replacing a 
broken glass window, and replacing a broken cog in a 
machine are illustrations of ordinary repairs. 
Extraordinary repairs, which appreciably prolong the life of 
an asset, are sometimes made. They constitute replace- 
ments of major parts of an asset. An illustration is the 
substitution of a new motor in an airplane or a delivery 
truck. Extraordinary repairs are usually capitalized. 



Ch. X] CAPITAL AND REVENUE EXPENDITURES 115 

2. Maintenance. An expenditure for maintenance is one made 
to keep the plant and equipment operating efficiently. 
Examples of such expenditures are cleaning, oiling, and 
inspecting fixed assets. 

3. Operating Expenses. An expenditure to carry on activities 
incident to current operations is a revenue expenditure. 
Examples are expenditures for wages, light and heat, 
interest, property insurance, group insurance, rent, supplies, 
and property taxes, where the benefits do not extend to 
future fiscal periods. 

Necessity of Proper Distinction 

Capital expenditures and revenue expenditures are more easily 
distinguished in theory than in practice. Value and time are the 
two important elements to be considered in determining whether 
an expenditure is properly chargeable to capital or to revenue. 
If relatively permanent value is added to any asset and the 
benefit extends substantially and measurably beyond the year 
when it is added, it should be treated as a capital expenditure, 
otherwise as a revenue expenditure. 

An incorrect charge of a capital or revenue expenditure results 
at the end of a period in an incorrect balance sheet and profit and 
loss statement. If a revenue expenditure is charged to an asset, 
assets and net worth will be overstated, expenses understated, 
and net profit overstated or net loss understated. To charge to 
revenue an expenditure which should be capitalized has the 
opposite effect, assets and net worth will be understated, expenses 
overstated and net profit understated or net loss overstated. 

It will be seen that the proper distinction between capital 
and revenue expenditures is a matter of indicating clearly assets 
apart from expenses, and vice versa. The particular account 
titles chosen for this purpose are relatively unimportant as long 
as they indicate clearly the major distinction between assets and 
expenses. If $300.00 cash is spent for desks for an office, it is 
not vitally important whether the expenditure is charged to 
Office Furniture and Fixtures, Furniture, Furniture and Fixtures, 
Office Equipment or some similar asset title, but it is important 
that it should not be charged to Office Expenses or any other 
expense account. 



116 ACCOUNTING FUNDAMENTALS [Ch. X 

Guiding Principles 

The following principles are helpful in determining whether 
a particular expenditure should be capitalized or charged to 
revenue: 

1. Expenditures incident to the acquisition of a fixed asset, 
ready to use, should be capitalized. These would include 
such items as the contract price for an asset, transportation, 
cost of installation, repairs at the time of purchase to a 
property acquired in a run-down condition, and in the case 
of property under construction, taxes, insurance, and 
interest. 

2. Expenditures which add relatively permanent value to a 
fixed asset should be capitalized. This may result from 
additions or betterments. 

3. Expenditures which merely maintain asset values should be 
charged to revenue. 

4. Expenditures which benefit only one fiscal period should be 
charged to revenue, otherwise to capital. 

Illustration of Application of Principles 

1. A manufacturer in New York City purchased an automobile 
truck which was nationally advertised at $2,000.00 f.o.b. 
Detroit. When he paid for his truck he paid $2,000.00, the 
Detroit price, plus $40.00 for freight to New York City, 
plus $200.00 extra for a special body. At the same time 
he paid his insurance agent $80.00 for a one-year insurance 
policy covering fire, theft, and liability on the truck. 

The cost of the special body and the freight should be 
capitalized along with the base price of $2,000.00. In other 
words $2,240.00 should be charged to the Automobile 
Truck or Delivery Equipment account representing the 
expenditure necessary to acquire this particular truck ready 
to use. The $80.00 paid for insurance protection is not a 
part of the truck cost. It is an expense incident to oper- 
ations and should be charged to Prepaid Insurance, Insur- 
ance, Automobile Truck Expenses, or Delivery Expenses, 
whichever title is used by the business. 

2. A manufacturer purchased, as the site for a new factory, a 



Ch. X] CAPITAL AND REVENUE EXPENDITURES 117 

plot of ground on which stood ten old dwellings. The 
ground cost him $50,000.00, the old dwellings $20,000.00. 
The houses were razed at a cost of $3,000.00 and had no 
scrap value. The excavation for the cellar and the founda- 
tion of the new building cost $10,000.00 and the building 
itself $90,000.00. The manufacturer paid $200.00 for 
special insurance to protect him during the period of con- 
struction, $4,000.00 as interest on money borrowed for 
building purposes up to the date the factory was ready 
for use, $100.00 for an insurance policy guaranteeing title 
to the property, and $1,500.00 to the real-estate agent who 
negotiated the purchase for him. 

Every expenditure here mentioned should be capitalized 
since each is a part of the cost of acquiring the new factory 
ready for use. 

3. An investor purchased an old and dilapidated dwelling and 
the lot on which it stood. He had immediate expenditures 
for painting, plumbing, roofing, paperlianging, and car- 
pentry work to put it in good condition that it might be 
leased to a tenant. 

Such repair work should be capitalized as costs incident to 
placing the property in good condition ready to use. These 
repair expenditures are part of the cost of the dwelling to 
the new owner. If the property had been in good condition 
when purchased, a higher price would have been asked for it. 

4. An office had ten typewriters which cost $150.00 each, were 
carried in the Office Furniture and Fixtures account, and- 
were expected to last five years. At the end of three years 
one of these machines was discarded and was replaced by a 
new one which cost $125.00. 

Should any part or all of the $125.00 expenditure have been 
capitalized? The entire $125.00 expenditure should be 
capitalized, but the value on the books of the discarded 
typewriter should be canceled. 

5. An oil company added a new section cf an oil tank thereby 
increasing its capacity and usefulness. This expenditure 
may be considered either an addition or a betterment and 
should be capitalized. 

6. The new factory referred to in 2 was painted at a cost of 
$800.00 six years after it was built. This expenditure was 



118 ACCOUNTING FUNDAMENTALS [Ch. X 

made in an endeavor to maintain the value of the property. 
It was an operating expense and a proper charge to revenue. 
7. A corporation had expenditures incident to organization in 
the amount of $5,000.00. The charter obtained from the 
state permitted it to operate for a period of 50 years. 
Should the $5,000.00 Organization Expense, the title by 
which these expenditures are referred to in the accounts, be 
considered an asset or an expense? The expenditures 
should be capitalized at the time of occurrence and treated 
as an asset because they benefit more than one period. 
Theoretically they benefit each of the 50 years. In view of 
the questionable value of this item to the company in later 
years, it is customary in practice to eliminate it from the 
assets in the course of a few years. 

When the facts about an expenditure are known and there is 
still real doubt whether it should be capitalized or charged to 
revenue, conservative practice favors charging it to revenue. 
Articles of small value but with a life longer than a year maybe 
charged to revenue. Spades, hoes, and rakes bought by a farmer 
are illustrative. Many businessmen make a practice of charging 
all items to revenue that cost less than a set figure, say $10.00 in a 
small concern, or $100.00 in a large concern. This plan pre- 
vents the inflation of assets and the overstatement of net 
profits and net worth by the amount of doubtful or relatively 
small expenditures. 

QUESTIONS 

1. What is an expense? A cash disbursement? An expenditure? 

2. If a promissory note is paid off in cash, does the payment represent 
an expenditure? An expense? A disbursement? 

3. What is meant by the expression, to capitalize an expenditure? By 
the expression, to charge an expenditure to revenue? 

4. To capitalize an expenditure which should have been charged to 
revenue has what effect on net worth? On total assets? On the net 
profit for the period? On the net income shown by the enterprise 
on its income-tax return? 

5. Tell, with reasons, whether each of the following expenditures 
should be capitalized or charged to revenue: 

a. Purchased a machine in Germany. 

6. Paid import duty, freight, and cartage on the machine. 

c. Paid for the installation of the machine in our factory. 



Ch. X] CAPITAL AND REVENUE EXPENDITURES 119 

d. Two months later paid a mechanic for repairs to the machine 
referred to above. 

e. Replaced worn-out gutters and spouts on the factory building. 
/. Replaced a hand-operated freight elevator which had cost 

$350.00 with an electric elevator which cost $1,500.00. 

g. Had the badly worn and dangerous slate treads on the main 
stairway replaced with steel treads at a cost of $300.00. 

h. Had a fire escape and fire doors installed on the warehouse at a 
cost of $750.00. 

i. Had a 500-gallon container placed underground and an electric 
gasoline pump erected at the private garage of the company, cost 
$325.00. 

j. Spent $500.00 for painting the factory building; it had not been 
painted for six years. 

k. Sent a check for $60.00 to the state department of motor vehicles 
for licence plates for the trucks. 

I. Paid the Motor Repair Co. $125.00 for repairing one of the auto- 
mobile trucks which had been damaged in an accident. The 
damage was not covered by insurance. 

m. In order to obtain a tenant for the vacant warehouse, the follow- 
ing bills were incurred: cleaning the inside of the property $60.00; 
painting inside and outside of the building $400.00; partitioning 
the south end of the second floor for office purposes, laying special 
floor, etc. $600.00. 

6. Is an expenditure involved in either or both of the following trans- 
actions? 

a. Had a private garage erected on the grounds of the company at a 
cost of $5,000.00. Payment was made by a 30-day note given 
to the contractor. 

6. Paid the $5,000.00 note referred to in a above. 

7. The Machinery account on the books of an enterprise was charged 
with the following items: 

a. The cost of new parts to replace other parts which were worn out. 

b. The cost of labor and materials to set up additional new machinery. 

c. The expense of moving old machinery from one part of the factory 
to another. 

d. The contract price of new machines purchased. 

e. Freight paid on new machines. 

/. The cost of repairs made to recently purchased secondhand 

machines. 
g. The cost of new attachments for old machines, to increase their 

efficiency. 
h. The cost of safety devices installed around moving machinery, 

on order of the state inspectors. 



120 ACCOUNTING FUNDAMENTALS [Ch. X 

i. The cost of new belts for some old machines. 

Which of the above charges, if any, should have been made to 

revenue accounts? 

If the Machinery account was credited with a cash discount taken 

for the prompt payment of an invoice for new machinery, would you 

agree that the credit was correct? 

8. The Delivery Equipment account is found to contain the following 
items : 

a. The cost of spark plugs purchased to replace worn-out ones. 

b. The cost of license plates for the year. 

c. The cost of drivers' license fees. 

d. The premium on a one-year automobile-insurance policy covering 
fire, theft, and property damage. 

e. The damage fees paid to a person injured by one of our trucks. 
These fees were over and above the amount paid by the insurance 
company for the same accident. 

/. The cost of repairing an auto-truck fender which was damaged in 

a collision. 
g. The cost of a special body placed on a truck chassis in order to 

handle bulky merchandise. 

h. The cost of painting the firm name on all trucks. 
i. The purchase of gasoline to fill a large tank located under ground 

in the rear of the plant. 

j. The purchase of a trailer for use in long-distance hauling. 
Are all of the above charges correct? If not, under what account 
should each incorrect one have been placed? 

9. The Land account of a bus company reveals that it has been charged 
with the following items: 

a. Fee paid an appraisal company for services at the time the land 
was purchased. 

b. Commission paid a real-estate company for representing the bus 
company in the purchase of the land. 

c. Amount paid for searching title. 

d. Lawyer's fees and court costs to cover expenses of litigation 
arising out of a disagreement as to title to the property. 

e. Cost of leveling the tract. 

/. Property taxes during the period the bus terminal was under con- 
struction. 

g. All costs of landscaping. 

h. Cost of roadways leading in from the main road. 

i. Assessment levied by the city council to cover proportion of the 
cost of improvements made in the highway on which the terminal 
is located. 

Criticize the treatment of each of the above items. 



Ch. X] CAPITAL AND REVENUE EXPENDITURES 121 

10. A manufacturing enterprise purchased several other properties in 
the immediate neighborhood of its main plant. These properties 
were converted into buildings suitable for the needs of the business. 
Only one ledger account was kept for Buildings and it was charged 
with the following expenditures : 

a. Cost of moving one of the newly acquired buildings to a more de- 
sirable location. 

6. Amounts paid to carpenters, masons, roofers, and painters for 
reconditioning the newly acquired buildings. 

c. The cost of building an additional floor on one of the buildings. 

d. The cost of replacing drain pipes and gutters on the old-plant 
building. 

e. The cost of repainting the fire escape on the old-plant building. . 
/. The cost of replacing broken glass windows in one of the newly 

acquired buildings. 
g. The cost of a sprinkler system for the old plant installed to 

reduce insurance premiums. 
h. The cost of replacing a wooden floor in one of the newly acquired 

buildings with a concrete floor. 
Discuss the propriety of each of the above charges. 



CHAPTER XI 
ADJUSTING THE BOOKS 

Emphasis in the preceding chapters was placed on 

1. Journalizing, which is the procedure of recording business 
transactions in books of original entry. 

2. Posting, which is the process of transferring the debits and 
credits of original entry records to their respective ledger 
accounts. 

3. Taking a trial balance, which is the preparation of a list of 
the accounts in a ledger on a given date, with their debit and 
credit totals, or their debit or credit balances. 

Incompleteness of the Records 

The books of a business do not show all the essential facts for 
the preparation of the statement of profit and loss and the 
balance sheet. This is true, though every transaction may have 
been recorded correctly, every debit and credit posted properly, 
and a trial balance prepared accurately. 

At the end of any fiscal period a trial balance does not disclose 
the amount of 

1. The closing inventory of merchandise.* 

2. The closing inventories of supplies.* 

3. The unrecorded accrued items 
a. Accruals payable. 

6. Accruals receivable. 

4. Deferred items 

a. Deferred charges to subsequent periods. 
6. Deferred credits to subsequent periods. 

5. The depreciation of fixed assets. 

6. The estimated bad debts. 

7. Other matters for which provision should be made. 

* In the absence of a perpetual inventory system under which quantities 
of goods as well as values are recorded. 

122 



Ch. XI] ADJUSTING THE BOOKS 123 

Definition and Purpose 

Because of the incompleteness of the records, by reason of the 
facts above cited, it is necessary to record these facts in the 
accounts at the end of a fiscal period. 

Adjusting the books is the process of modifying accounts at the 
end of a fiscal period, that they may show the correct condition of 
the business at that particular date. Modification is accom- 
plished by means of journal entries which are referred to as 
adjusting entries or adjustments. 

Inventory of Merchandise 

The trial balance shows the value of the inventory of merchan- 
dise at the beginning of the period only. Subsequent changes in 
inventory are recorded in other accounts. For that reason, it is 
not possible to determine from the ledger the value of the inven- 
tory of merchandise on hand at the end of the period. To ascer- 
tain the value of the merchandise on hand at a given time, it is 
necessary to prepare a list which will show the detailed items and 
their value. 

Assume the following facts : 

Inventory of Merchandise, January 1, 19 , as 

per trial balance $ 2,000.00 

Purchases as shown by trial balance 40,000.00 

Inventory of Merchandise, December 31, 19 , 

as shown by the inventory sheets 2,500.00 

To record the new inventory of merchandise as a separate item 
on the books, the following entry is necessary : 

DECEMBER 31, 19 

inventory of Merchandise, 12/31/19_ 2,500.00 

Cost of Goods Sold 2 , 500 . 00 

To place the new inventory on the books 
in its own account. 

A debit is made to the Inventory of Merchandise, December 31, 

19 account in order to show this asset on the books. Confusion 

is avoided if each inventory account is dated. This account will 
remain unchanged on the books until the close of the next fiscal 
period, at which time it will be the opening inventory of that 
period. 

* The adjusting entries marked with an asterisk (*) affect the Coordinating 
Illustration and the Adjusted Trial Balance at the end of this chapter. 



124 



ACCOUNTING FUNDAMENTALS 



[Ch. XI 



The credit is made to a new account, Cost of Goods Sold. At 
the end of a period it is necessary to compare the cost of goods sold 
with net sales in order to determine the gross profit on sales, as 
was explained in Chapter IV. This credit is difficult to under- 
stand until it is realized that by means of debits to this Cost of 
Goods Sold account the total cost of all merchandise held for sale 
during the period is assembled. The credit for the unsold portion 
(the final inventory) causes the balance of the Cost of Goods Sold 
account to reveal the cost of the merchandise which was sold. 

To complete the adjusting entries necessary to build up the 
Cost of Goods Sold account for this illustration, the following 
entry is made: 

DECEMBER 31, 19 

"Cost of Goods Sold 42 , 000 . 00 

Inventory of Merchandise, 

1/1/19 2,000.00 

Purchases 40 , 000 . 00 

To consolidate the initial inventory 
and the Purchases accounts into 
Cost of Goods Sold account. 

The effect of these adjusting entries on the ledger accounts 
involved may be shown as follows : 

Inventory of Merchandise, January 1, 19 



19._ 
Jan. 


1 


Balance 




2,000 


00 


19_ 
Dec. 


31 


(b) 


J 


2,000 


00 





Purchases 



19_ 
Dec. 


31 


Total 




40,000 


I 19 
00 Dec. 


31 


(b) 


J 


40,000 


00 





Inventory of Merchandise, December 31, 19_ 



19_ 
Dec. 


31 


(a) 


J 


2,500 


H 










1 



Cost of Goods Sold 



19 
Dec. 


31 


(b) 


J 


42,000 


^19_ 
Dec. 


31 


(a) 


J 


2,500 


00 



The postings of the first adjusting entry items are indicated by 
the letter (a), the second by the letter (b). 



Ch, XI] ADJUSTING THE BOOKS 125 

The balance of the Cost of Goods Sold account resulting from 
the two illustrated entries is $39,500.00, which is the cost of the 
merchandise marketed during the period. 

It is possible to use only one account for inventory of merchan- 
dise and omit the date from its caption. 

The assumed business for which these adjusting entries are 
made does not have accounts on its books with Transportation In, 
and Purchase Returns and Allowances. If it had, it would bo 
necessary to transfer the balances of both of these accounts to 
Cost of Goods Sold, by the entries 

Cost of Goods Sold xxx 

Transportation In xxx 

To transfer Transportation In costs to the Cost of 
Goods Sold account. 

Purchase Returns and Allowances xxx 

Cost of Goods Sold xxx 

To reduce the Cost of Goods Sold account by the 
amount of the Purchase Returns and Allowances. 

The first entry above might be combined with the one on 
page 124, thus consolidating the debits to Cost of Goods Sold. 

Transportation In is an additional element of cost, while 
Purchase Returns and Allowances account reduces cost. 

Inventories of Supplies 

In the same manner as for inventory of merchandise, an 
enumeration is made of unused supplies. When supplies are 
purchased a charge is made to a nominal account such as Sta- 
tionery and Printing, Coal, Postage, Office Expenses, Store 
Expenses, or Gasoline. At the end of a period each of these 
accounts which appears on a set of books is reduced by the value 
of unconsumed portions. The figure shown in the trial balance 
is partly real and partly nominal. The unused supplies are 
assets and are placed in the balance sheet usually under deferred 
charges. The used portion is one of the operating expenses of the 
period. 

Assume: 

Store Expenses in the trial balance $800.00 (Trial Balance) 
Inventory of Store Expenses, 

12/31/19_ 50.00 (Balance Sheet) 

Cost of store supplies consumed. . . $750.00 (Profit and Loss) 



126 ACCOUNTING FUNDAMENTALS [Ch. XI 

To record this inventory of store expenses the following entry 
is necessary: 

DECEMBER 31, 19 

"Inventory of Store Expenses 50.00 

Store Expenses 50,00 

To record the value of unconsumed store supplies 
and to modify the Store Expenses account to 
show the true expense for the period. 

Accrued Items 

Under the accrual basis of accounting it is necessary to recog- 
nize any item of expense or income whether or not paid or 
received. The ledger accounts do not show the steadily increas- 
ing obligations of the business that will not be paid until a subse- 
quent period, nor the steadily increasing claims of the business 
on other individuals or enterprises which will not be collected 
until a later period. 

Accruals payable is the term applied to the accumulating debts 
which arise out of services rendered to the business over a period 
of time but which debts are not due. Accrued Wages Payable, 
Accrued Interest Payable, and Accrued Taxes Payable are 
illustrative titles. The amount of each accrual is added to the 
figure shown in the trial balance, if any, to determine the amount 
of the true expense arising from this source. The accrued pay- 
able item is shown in the balance sheet as a liability. 

Assume : 

Salaries as shown by the trial 

balance $5,500.00 (Trial Balance) 

Unrecorded salaries owing to em- 
ployees but not due 300.00 (Balance Sheet) 

Cost of salaries for the period. . . $3 ,800 .00 (Profit and Loss) 



To record these accrued salaries the folio wing en try is necessary : 

DECEMBER 31, 19 

*Salaries 300.00 

Accrued Salaries Payable 300.00 

To record unpaid salaries on Dec. 31, 19 



Ch. XI] 



ADJUSTING THE BOOKS 



127 



These facts in ledger form are as follows: 

Salaries 



Deo. 


31 
31 


Total paid 


J 


5,500 
300 


00 
00 















Accrued Salaries Payable 

loll 



Dec. 



31 




Accruals receivable is the term applied to accumulating claims 
which arise out of services rendered by the business over a period 
of time but which claims are not due. Examples are accrued 
interest receivable and accrued rent receivable. The amount of 
each accrual receivable is added to the figure shown in the trial 
balance, if any, to determine the true income arising from this 
source. The accrual receivable item is shown in the balance sheet 
as an asset. 

Assume : 



Interest Earned as shown by the 



trial balance 



. . $110.00 (Trial Balance) 



8.00 (Balance Sheet) 



Accumulated interest on unma- 

turcd notes receivable 

Correct interest earned this period $1 18 00 (Profit and Loss) 

To incorporate this supplementary fact in the records the fol- 
lowing adjusting entry is necessary: 

DECEMBER 31, 19 

* Accrued Interest Receivable 8.00 

Interest Earned 8 00 

To add to the Interest Earned account the interest 
income which has not been received, and to set up 
an additional asset. 

Deferred Items 

Deferred items represent those portions of the receipts and 
receivables, and the expenditures of a period which are applicable 
to a subsequent fiscal period or periods. 

Deferred charges are expenditures that are to be charged off as 
expenses to a subsequent period or periods. They include such 



128 ACCOUNTING FUNDAMENTALS [Ch. XI 

items as prepaid insurance, prepaid rent, and prepaid interest. 
The term deferred debits or deferred charges is descriptive since it 
represents expenditures for which the expense charges are 
deferred or postponed until the fiscal period to which they are 
applicable. The amount of such prepayment is subtracted from 
the trial balance figure to determine the correct amount applicable 
to the current period. Each prepayment appears in the balance 
sheet as an asset which will benefit the enterprise in a subsequent 
period or periods. (See Chapter II.) 
Assume: 

Prepaid Insurance in the trial bal- 
ance $500.00 (Trial Balance) 

Unexpired insurance, December 31, 

19_ 300.00 (Balance Sheet) 

Cost of expired insurance for the 

period $200.00 (Profit and Loss) 

The following adjusting entry is necessary: 

DECEMBER 31, 19 

"Insurance 200.00 

Prepaid Insurance 200.00 

To reduce the Prepaid Insurance account by 
the portion which expired this fiscal period. 

Some deferred charges arise out of items debited to expense 
accounts at the time the cash was paid or the liability incurred. 
Assume: 

Interest Expense in the trial bal- 
ance $280.00 (Trial Balance) 

Prepaid Interest, December 31, 

19_ 30.00 (Balance Sheet) 

Cost of interest for the period .... $250.00 (Profit and Loss) 

The following adjusting entry is necessary: 

DECEMBER 31, 19 

Prepaid Interest 30 . 00 

Interest Expense 30.00 

To reduce the Interest Expense account by the 
amount paid in advance. 

Deferred credits represent receipts or receivables of one period 
:hat are earnings of a subsequent period or periods. Deferred 



Ch. XI] ADJUSTING THE BOOKS 129 

credits is a descriptive, term since it represents items received or 
receivable which will not be included in income until the period 
or periods in which earned. Examples are interest collected in 
advance, subscriptions collected in advance, and rent collected in 
advance. In each case the amount of the deferred credit is 
subtracted from the trial balance figure to determine the correct 
income of the current period. Each deferred credit appears in 
the balance sheet as a liability to be satisfied by services or 
product. (See Chapter II.) 
Assume : 

Rent Earned account in the trial 

balance $390.00 (Trial Balance) 

Rent collected but unearned in the 

period 30.00 (Balance Sheet) 

Rent income for the period . $360 . 00 (Profit and Loss) 

The following adjusting entry is necessary: 

DECEMBER 31, 19 

*Rent Earned 30.00 

Rent Collected in Advance 30.00 

To reduce the Rent Earned account by the 
amount collected in advance. 

Some deferred credits arise out of items credited to deferred 
liability accounts at the time the cash was received or the receiva- 
ble recorded. 

Assume : 

Rent Collected in Advance in 

the trial balance $6,500.00 (Trial Balance) 

Rent Collected in Advance, De- 
cember 31, 19_ 300 00 (Balance Sheet) 

Rent income for the period . . . $6,200.00 (Profit and Loss) 

The following adjusting entry is necessary: 

DECEMBER 31, 19 

Rent Collected in Advance 6 , 200 . 00 

Rent Earned 6 , 200 . 00 

To reduce the Rent Collected in Advance 
account by the amount earned this fiscal 
period. 



130 



ACCOUNTING FUNDAMENTALS 



[Ch. XI 



The Depreciation of Fixed Assets 

Most fixed assets depreciate because of wear and tear, climatic 
conditions, lapse of time, incapacity, and inadequacy. At the 
end of each fiscal period the estimated amount of this decline is 
recorded in the accounts. The practice of charging a part of 
the original cost of fixed assets to operation is based on the 
fact that the investment in depreciable fixed assets should 
be recovered during the life of the asset. If the decline in 
value is ignored, operating costs are understated and the fixed 
assets appear in the balance sheet at overvalued figures. 

The most common method to determine the amount of the 
periodic depreciation of an asset is to estimate the number of 
years or months during which the asset may be expected to 
function efficiently under the maintenance policy and method of 
use of the enterprise owning it. The net cost cost minus scrap 
value of the asset is divided by this estimate and the quotient 
is the amount of depreciation to be charged to each period, year or 
month. The periodic charge expressed as a fixed percentage of 
cost may be determined by dividing the periodic depreciation by 
the cost price of the asset. 

Assume : 

Furniture and fixtures acquired at a cost of $4,000.00 

Estimated life 10 years, with an assumed scrap 
value of 400.00 



Net cost to be written off $3 ,600 .00 



Each year $360.00 should be charged as an expense. 
9 per cent of the $4,000.00 cost price. 

The following adjusting entry is necessary: 



This is 



DECEMBER 31, 19 

*Depreciation of Furniture and Fixtures 360.00 

Reserve for Depreciation of Furniture 

and Fixtures 360.00 

To record the 9 per cent depreciation of furni- 
ture and fixtures for the period. 

These facts in ledger form are as follows: 
Furniture and Fixtures 



|19_ 
Dec. 


31 






4,000 


H 










| 



Ch. XI] ADJUSTING THE BOOKS 

Reserve for Depreciation of Furniture and Fixtures 



131 















19_ 
Dec. 


31 




J 


360 


00 



Depreciation of Furniture and Fixtures 



19_| 
Dec.31 




J 


360 


00 













As there are many depreciable fixed assets it is best to qualify 
the debit by the name of the asset. The reserve account which is 
kept for each group of depreciable fixed assets is credited instead 
of the asset account as it is preferable to keep the asset account 
on the books at the cost price. The purpose of the reserve 
account is to modify the value of an asset, hence it is termed a 
valuation reserve. 

Valuation reserve accounts have credit balances. They are not, 
however, either liability, proprietorship, or income accounts. 
They exist in lieu of credits to assets and for account classification 
purposes should be considered as parts of the assets they offset. 
It is good practice and follows sound theory to present these 
valuation accounts on a balance sheet as deductions from the 
assets to which they refer, thus: 

Furniture and Fixtures $4,000.00 

Less: Reserve for Depreciation 360.00 $3,640 00 

Assume : 

Buildings which cost $8,000.00 are considered to be depreciat- 
ing each year at the rate of 5 per cent of cost. 
The following adjusting entry is necessary: 

DECEMBER 31, 19 

*Deprcciation of Buildings 400.00 

Reserve for Depreciation of Buildings 400.00 

To record the expense for the period of the 
depreciation of buildings at the rate of 5 per 
cent. 

After the first fiscal period the trial balance will have a figure 
for each reserve for depreciation of assets purchased in previous 
periods and still in use. The adjusting entry increases the 
balance of each such account. 



132 ACCOUNTING FUNDAMENTALS [Ch. XI 

Assume : 

Buildings cost $8,000.00 

Reserve for Depreciation of 

Buildings in the trial balance. $ 800.00 (Trial Balance) 

Depreciation of buildings for the 
year 400.00 (Profit and Loss) 

Reserve for Depreciation, De- 
cember 31, 19_ $1,200.00 (Balance Sheet) 

The subject of depreciation is of such importance that further 
consideration will be given to it in Chapter XV. 

Estimated Bad Debts 

A business that extends credit can estimate with a fair degree of 
accuracy from past experience the amount of its claims on other 
individuals and enterprises which may be expected to be uncol- 
lectible, i Some attempt should be made, therefore, at the end of a 
period to reduce the value of such claims to a fair appraisal of 
their realizability and also to adjust the income by the amount of 
the anticipated loss. Expected losses from receivables are con- 
sidered expenses of the periods in which the credits are extended 
and not of the periods in which the claims prove uncollectible. 

Since it is impossible to point out the particular accounts and 
notes receivable which will not be collected, no credit can be made 
directly to these accounts. A new ledger account is opened, 
therefore, and is known as Reserve for Bad Debts. It is another 
valuation reserve account and its balance is subtracted from 
Accounts Receivable in the balance sheet. u~ 

If the experience of a number of years shows that claims on 
others to an amount which is approximately 1 per cent of the net 
sales have been uncollectible periodically, an entry is made at the 
end of a period debiting Bad Debts and crediting Reserve for Bad 
Debts for such an amount. w 

Assume net sales for a period $50,000.00, and estimated loss by 
bad debts to be 1 per cent of net sales. 

To record the adjustment for bad debts the following entry is 
necessary : 

DECEMBER 31, 19 

*Bad Debts 500.00 

Reserve for Bad Debts 500.00 

To adjust the books by the amount of esti- 
mated uncollectible claims, 1 per cent of net 
sales of $50,000.00. 



Ch. XI] ADJUSTING THE BOOKS 133 

After the first fiscal period in which a Reserve for Bad Debts 
account is created, there will be a figure in the trial balance for 
that account. As Reserve for Bad Debts is credited with esti- 
mated bad debts and is debited in subsequent periods with the 
actual losses arising out of claims on customers, the Reserve for 
Bad Debts in the trial balance will have a credit balance if actual 
losses are less than estimated, and a debit balance if the contrary 
is true. 

The balance sheet figure for Reserve for Bad Debts is the 
amount which the businessman has learned from past experience 
to be reasonable. The figure used in the adjusting entry agrees 
with the amount used in the statement of profit and loss for the 
period. It is the amount necessary to bring the trial balance 
figure up to the point where it is a reasonable reserve. 

Assume: 

Accounts Receivable in the trial 

balance $10,000.00 

Reserve for Bad Debts in the 

trial balance, credit balance $ 30.00 (Trial Balance) 
Reserve for Bad Debts in the 

balance sheet, December 31, 

19_ 300.00 (Balance Sheet) 

Bad debts expense for the year $ 270 . CO (Profit and Loss) 

Assume : 

Accounts Receivable in the trial 

balance $10,000.00 

Reserve for Bad Debts in the 

trial balance, debit balance . . $ 30.00 (Trial Balance) 
Reserve for Bad Debts in the 

balance sheet, December 31, 

19_ 300.00 (Balance Sheet) 

Bad debts expense for the year $ 330.00 (Profit and Loss) 

Miscellaneous Adjustments 

Such miscellaneous adjustments as develop will be considered in 
later chapters. 

Guiding Principles on Adjustments 

As the subject of adjusting the books is a difficult one for 
beginning students in accounting, the following statement of 
principles reemphasizes some salient features : 



134 ACCOUNTING FUNDAMENTALS [Ch. XI 

1. Adjustments are necessary to make the books agree with 
the figures in the balance sheet and statement of profit and 
loss. 

2. With respect to accruals and deferred items 

a. The trial balance figures should be viewed as represent- 
ing the cash paid or received for the items, whether they 
bear real or nominal account captions. 

b. Accruals are always added to trial balance figures to 
determine income or expense figures. 

c. Deferred items are always deducted from trial balance 
figures to determine income or expense figures. 

d. The figures used in the adjusting entries for accruals are 
the amounts to be shown in the balance sheet. 

e. The figures used in the adjusting entries for deferred 
items are 

(1) The apiounts to be shown in the balance sheet if the 
trial balance captions are those of nominal accounts. 

(2) The amounts to be shown in the statement of profit 
and loss if the trial balance captions are those of real 
accounts. 

3. Adjustments for reserves for depreciation and reserve for 
bad debts always increase the reserve account balances. 
The figures used in the adjusting entries are always the 
amounts that appear in the statement of profit and loss 
for the period. 

Coordinating Illustration 

The adjusting entries marked with an asterisk in this chapter 
pertained to the books of Robert R. Clifton, whose trial balance, 
December 31, 19 , before adjustments, follows: 



Ch. XI) ADJUSTING THE BOOKS 135 

ROBERT R. CLIFTON 
TRIAL BALANCE, DECEMBER 31, 19 

Debit Credit 

Cash $ 3,200.00 

Accounts Receivable 8,000.00 

Notes Receivable 1 ,000.00 

Inventory of Merchandise, January 1, 19 . . . 2,000.00 

Prepaid Insurance . 500.00 

Land ... 2,000.00 

Buildings . . 8,000.00 

Furniture and Fixtures . . . . .. 4,000.00 

Accounts Payable . . $ 2,500.00 

Mortgage Payable 3,000.00 

Robert R. Clifton, Capital. . . 20,000.00 

Sales 50,000.00 

Purchases 40,000.00 

Store Expenses 800.00 

Salaries 5,500.00 

Property Taxes 220.00 

Office Expenses 600.00 

Interest on Mortgage 180.00 

Rent Earned 390.00 

Interest Earned 110.00 

$76,000.00 $76,000.00 

Adjusted Trial Balance 

A trial balance taken immediately after the posting of adjust- ' 
ing entries is termed an adjusted trial balance. Such a trial 
balance contains no mixed accounts. Each account is distinctly 
real or nominal and represents an asset, an expense, a liability, 
income, or proprietorship. This is natural since the purpose of 
adjusting entries is to so modify the accounts that they will 
reveal the true condition of the business at a particular date. 



136 ACCOUNTING FUNDAMENTALS [Ch. XI 

The following is the adjusted trial balance of the books of 
Mr. Clifton, after the adjusting entries marked with an asterisk 
in this chapter have been posted to the ledger: 

ROBERT R. CLIFTON 

ADJUSTED TRIAL BALANCE, DECEMBER 31, 19 

Debit Credit 

Cash . $ 3,200.00 

Accounts Receivable ... 8 , 000 . 00 

Reserve for Bad Debts. .. $ 500.00 

Notes Receivable 1 ,000 . 00 

Accrued Interest Receivable ... 8.00 

Inventory of Merchandise, December 31, 19 . 2,500.00 

Inventory of Store Expenses . 50 . 00 

Prepaid Insurance .... . 300 . 00 

Land . 2,000.00 

Buildings 8,000.00 

Reserve for Depreciation of Buildings 400.00 

Furniture and Fixtures 4,000.00 

Reserve for Depreciation of Furniture and Fixtures 360 . 00 

Accounts Payable 2 , 500 . 00 

Accrued Salaries Payable 300.00 

Rent Collected in Advance 30.00 

Mortgage Payable . 3 , 000 . 00 

Robert R. Clifton, Capit al 20 , 000 . 00 

Sales 50,000.00 

Cost of Goods Sold . 39 , 500 . 00 

Store Expenses . 750.00 

Salaries . 5,800.00 

Property Taxes ... 220 . 00 

Office Expenses . 600 . 00 

Insurance .. 200.00 

Depreciation of Furniture and Fixtures 360.00 

Depreciation of Buildings . . 400.00 

Bad Debts 500.00 

Interest on Mortgage .. . . . 180.00 

Interest Earned . . . . 1 18 . 00 

Rent Earned . . 360.00 

$77,568.00 $77,568.00 

QUESTIONS 

1. a. What is meant by the expression, adjusting the books? 

b. What do you mean by adjustments? 

c. When, why, and where are adjustments made? 

2. Name several of the items because of which a set of books may have 
to be adjusted. 



Ch. XI] ADJUSTING THE BOOKS 137 

3. Why is it not possible to determine from the trial balance the value 
of the inventory of merchandise at the end of a period? 

4. Assume the following facts: 

Inventory of merchandise at the beginning of the period, $10,000.00. 
Inventory of merchandise at the end of the period, $15,000.00. 
Purchases during the period, $60,000.00. 

a. What was the cost of all merchandise available for sale during 
the period? 

b. What was the cost of the merchandise which was not sold during 
the period? 

c. What was the cost of the merchandise sold? 

d. Give the adjusting entries necessary for these facts. 

6. Suppose the Postage account on a set of books has a debit balance 
of $600.00 at the end of a period and the postage on hand amounts 
to $50.00. 

a. What amount of expense for the period is indicated by the above 
facts? 

6. Do these facts indicate any item which should appear on the 
balance sheet? If so, under what main heading, and under what 
account title? 

c. Give the adjusting entry necessary for these facts. 

6. a. What is meant by an accrued item? 

b. Give an illustration of an accrual payable. 

c. Give an illustration of an accrual receivable. 

7. Suppose the property taxes of an enterprise in the amount of 
$600.00 had not been paid at the end of a fiscal year. 

a. Did the enterprise have any tax expense that year? 

b. Give the adjusting entry, if any such entry is necessary for this 
fact. 

8. Suppose an enterprise purchased $200,000.00 of 6 per cent bonds 
at par on the date they were issued April 1. Six months' interest 
was received on the bonds October 1. The enterprise kept its books 
on the accrual basis and its fiscal year ended December 31. 

a. What amount of interest was earned that period? 

b. What amount of interest was collected that period? 

c. What amount of interest was accrued at the end of the period? 

d. How much for interest would be entered in the statement of 
profit and loss for the period? 

e. How much for interest accrued would be entered on the balance 
sheet at the end of the period? In which section of the balance 
sheet? 

9. a. What do you mean by a deferred item? 
b. What do you mean by a deferred charge? 



138 ACCOUNTING FUNDAMENTALS [Ch. XI 

c. What do you mean by a deferred credit? 

d. Give an illustration of a deferred charge. 

e. Give an illustration of a deferred credit. 

10. Suppose an enterprise paid, in the month of January, $1,200.00 for 
property taxes for the current year. Assume also that the fiscal 
year of this enterprise is the calendar year. 

a. Did the enterprise have any deferred charge or deferred credit; 
if so, how much on January 31? On March 31? 

b. What would be the tax expense of this enterprise for the month 
of August? 

c. If this enterprise adjusts its books monthly, give any necessary 
adjusting entry on January 31. On October 31. 

11. What would be the effect on the net profit for a period and the net 
worth of an enterprise, if depreciation was overlooked? If the 
estimate for depreciation was overstated? 

12. a. What do 3 r ou mean by the expression a valuation reserve account? 

b. Give an illustration of a valuation reserve account. 

c. Does a valuation reserve account appear on the statement of profit 
and loss, the balance sheet, or both? Under what section or 
sections? 

13. Assume a business has owned a delivery truck for one year. The 
truck cost 81,150.00; the owner of the business expects to use it four 
years and thinks it will have a trade-in value of SI 50.00 at the end 
of that time. 

a. Give the adjusting entry necessary for the above facts at the end 

of the first year of the life of the truck. 
6. Give the adjusting entry at the end of the second year, 
c. How would the value of this truck be shown on the balance sheet 

at the end of the third year? 

14. Assume the estimated bad debts of an enterprise at the end of its 
first year in business amount to $240.00. 

a. Give the necessary adjusting entry. 

b. Why, in your answer to a above, did you credit Reserve for Bad 
Debts? 

15. a. What do you mean by an adjusted trial balance? 

b. Are there any mixed accounts in an adjusted trial balance? Why? 

16. a. Suppose insurance premiums are charged to the account Prepaid 

Insurance which account has a debit balance of $600.00. Sup- 
pose also that the amount of insurance which has expired at the 
end of the period is $200.00. Give the adjusting entry. 
b. Suppose insurance premiums are charged to the account Insur- 
ance, which account has a debit balance of $600.00. Suppose 
also that $400.00 of the above $600.00 is unexpired at the end of 
the period. Give the adjusting entry. 



Ch. XI] ADJUSTING THE BOOKS 139 

17. Would the net profit be overstated or understated and by what 
amount if 

a. Prepaid wages of $50.00 and unearned rent of $200.00 were 
ignored? 

6. Accruals receivable of $120.00 were omitted and the final inven- 
tory of merchandise were overvalued by $100.00? 

18. If a trial balance figure is affected by both an accrual and a deferred 
item, will the amount in the statement of profit and loss be more 
or less than the trial balance figure? Explain. 



CHAPTER XII 
CLOSING THE BOOKS 

Adjusting the books, which was the subject of the preceding 
chapter, should be done at least once every twelve months. 
A year is the usual period of time for the measurement of results. 
A person thinks of his age in terms of years, of his income on an 
annual basis, and is accustomed to paying taxes which are 
usually assessed or determined yearly. It is not unusual to 
hear expressions such as, "We made a profit last year," or 
"We made a profit this year in contrast to a loss last year/' 
Seldom, if ever, are heard expressions such as, "Our company 
made a profit in the first seventeen years of its existence," or 
"My business suffered a loss in its second nineteen-months 
period." The year is the popular period of time for business 
comparisons. 

The records of the income and expense items throughout 
a fiscal period are accumulated in the nominal accounts. If 
these accounts are to show their facts plainly, period by period, 
it is necessary that they be cleared of their figures at the end of 
each period. This clearing of the nominal accounts is known as 
closing the ledger, closing the accounts, or closing the books. 

Definition and Purposes of Closing the Books 

Closing the books is the process wherein, by journal entries, 
the balances of the nominal accounts are transferred to the 
summary account Profit and Loss, and the balance of the Profit 
and Loss account, in turn, is transferred to the personal or 
capital account of the owner. It is the usual practice to transfer 
the balance of Profit and Loss to tho owner's personal account 
and then to transfer the balance of the personal to the owner's 
capital account. 

Books are closed at the end of a fiscal period for the following 
reasons : 

1. To transfer to proprietorship the amount of the net profit 
or loss of the period so that the account or accounts of the 
owner will show the same net worth as the balance sheet. 

140 



Ch. XII] CLOSING THE BOOKS 141 

2. To clear each nominal account so that its results may be 
indicated plainly, period by period. 

3. To collect and preserve in the Profit and Loss account a 
summary of the nominal account balances of each period. 

Closing Procedure 

Closing the books is the process of journalizing and posting 

1. A set of entries by means of which the balances of the 
nominal accounts are transferred to the Profit and Loss 
account. 

2. An entry to transfer the balance of the Profit and Loss 
account to the personal account of the owner, if any, 
otherwise to the capital account. 

3. An entry to transfer the balance of the personal account 
of the owner, if any, to his capital account, if the owner so 

. desires. 

In addition to journalizing and posting the transfer entries 
it is customary and desirable in the closing process to 

1. Total and rule the nominal accounts to indicate clearly that 
they have no balances and are ready for a new period. 

2. Total, balance, and rule the real accounts where necessary 
to indicate clearly that their balances agree with the figures 
shown in the balance sheet. 

3. Prepare a postclosing trial balance as a check on the 
accuracy of the clerical work incident to the closing process. 

The Profit and Loss Account 

The Profit and Loss account is a temporary, summary account 
created and then closed in the closing process. Prior to the 
consideration of this topic, reference Avas not made to it. It was 
not necessary since it is not used in the recording of other than 
closing entries. The student should not be confused by a 
popular expression which is often heard when a person has 
suffered a loss, "Oh, I shall charge it to Profit and Loss." Cur- 
rent items of income or expense should never be credited or 
charged directly to the Profit and Loss account. To do so 
would hide the source of the particular income or expense item. 



142 ACCOUNTING FUNDAMENTALS [Ch. XII 

Similarly the Profit and Loss account should not be confused 
with the profit and loss statement. The latter is outside the 
books, the former is an account placed on the books when they 
are closed. 

The Profit and Loss account has the same characteristics as 
any other nominal account since it is a summary of them. It 
is created as the result of closing journal entries which 

1. Debit Profit and Loss and credit each nominal account 
which has a debit balance. 

ROBERT R. CLIFTON 
ADJUSTED TRIAL BALANCE, DECEMBER 31, 19 

Debit Credit 

Cash $3,200.00 

Accounts Receivable 8,000 .00 

Reserve for Bad Debts $ 500.00 

Notes Receivable 1 ,000.00 

Accrued Interest Receivable . 8.00 

Inventory of Merchandise, December 31, 19 2,500.00 

Inventory of Store Expenses 50 . 00 

Prepaid Insurance 30000 

Land 2,000.00 

Buildings . . . 8,000.00 

Reserve for Depreciation of Buildings 400.00 

Furniture and Fixtures 4,000.00 

Reserve for Depreciation of Furniture and Fixtures 360 . 00 

Accounts Payable . . 2,500.00 

Accrued Salaries Payable 300.00 

Rent Collected in Advance. ... 30.00 

Mortgage Payable . . 3,000.00 

Robert R. Clifton, Capital.. 20,000.00 

Sales . 50,000.00 

Cost of Goods Sold . 39 ,500 . 00 

Store Expenses 750.00 

Salaries 5,800.00 

Property Taxes 220 .00 

Office Expenses 600.00 

Insurance . 200.00 

Depreciation of Furniture and Fixtures 360.00 

Depreciation of Buildings 400.00 

Bad Debts 500.00 

Interest on Mortgage 180 . 00 

Interest Earned 1 18 . 00 

Rent Earned 360.00 

$77,568.00 $77,568.00 



Ch. XII] CLOSING THE BOOKS 143 

2. Credit Profit and Loss and debit each nominal account 
which has a credit balance. 

The Profit and Loss account is closed by a journal entry 
which 

1. Debits Profit and Loss and credits the personal or capital 
account of the owner, if there is a net profit, or 

2. Credits Profit and Loss and debits the personal or capital 
account of the owner, if there is a net loss. 

Illustration 

To illustrate the closing process, the entries to close the books 
of Robert R. Clifton are given. 

The trial balance on page 142 is an abstract of the ledger of 
Robert R. Clifton after his books were adjusted at the end of the 
period. It is a copy of the adjusted trial balance developed in 
the preceding chapter. There are no mixed accounts in it. 
Each account is either real or nominal. 

The nominal accounts are to be closed. They are to be trans- 
ferred to the summary account Profit and Loss. Since nominal 
accounts with debit balances are to be transferred to the debit 
side of Profit and Loss, the following compound entry closes all 
of them. 

Profit and Loss 48,510.00 

Cost of Goods Sold 39 , 500 . 00 
Store Expenses 750 . 00 
Salaries 5,800.00 
Property Taxes 220 00 
Office Expenses GOO . 00 
Insurance 200 00 
Depreciation of Furniture and Fix- 
tures 360.00 
Depreciation of Buildings 400.00 
Bad Debts 500.00 
Interest on Mortgage 180.00 

To transfer the debit nominal account 

balances to Profit and Loss. 

The posting of the above entry closes the debit nominal 
accounts and places the aggregate of their balances, $48,510.00, 
on the debit side of the Profit and Loss account. 



144 



ACCOUNTING FUNDAMENTALS 



[Ch. XII 



Since the credit nominal accounts are to be transferred to the 
credit of the Profit and Loss account, the following compound 
entry closes all of them. 

Sales 50,000.00 

Interest Earned 1 18 . 00 

Rent Earned 360.00 

Profit and Loss 50 , 478 . 00 

To transfer the credit nominal account 
balances to Profit and Loss. 

The posting of the above entry closes the credit nominal 
accounts and places the aggregate of their balances, $50,478.00, 
on the credit side of the Profit and Loss account. 

Since the balance in the Profit and Loss account is a credit, it 
is the net profit for the period. This net profit is to be trans- 
ferred to the capital account of Mr. Clifton, since he has no 
personal account, and is accomplished by the following entry: 



Profit and Loss 

Robert R. Clifton, Capital 
To transfer the net profit for the year 

ended December 31, 19 to Robert II. 

Clifton, Capital. 



1,968.00 



1,908.00 



The Profit and Loss account of Robert R. Clifton, as it appears 
in the ledger ruled and closed, is as follo\vs: 

Profit and Loss 



ig 












19 










1 


Dec. 


31 




J 


48,510 


00, 


Dec. 


31 




J 


50,478 


00 




31 




J 


1,968 oo; 












! 





_ 







50,478 


00 













50,478 


oo, 1 



Ruling and Balancing the Accounts 

It is customary to total and rule the nominal accounts after 
the closing entries are posted. The method of ruling is the 
same as shown in Chapter V for the real accounts, except that 
there is no balance shown either above or below the rulings. 

Real accounts may be balanced and ruled at any time without 
disturbing the equality of debit and credit. The personal 
accounts with customers and creditors may be balanced and ruled 
frequently. All real accounts should be balanced and ruled at 
the end of the fiscal year, where necessary. 



Ch. XII) CLOSING THE BOOKS 145 

The Postclosing Trial Balance 

It is quite easy to make clerical errors in the process of jour- 
nalizing and posting the closing entries, and especially in the 
ruling and balancing of the real accounts. After closing, the 
books should be in balance, and at the end of the first month of a 
new period it will be presumed that they were in balance at the 
end of the past period. An error in closing, or ruling and 
balancing, at the end of a period may cause much inconvenience 
when the next regular trial balance is prepared, because the 
error may not be discovered in the course of the new month's 
work. It is desirable, therefore, after posting the closing entries 
and balancing and ruling the accounts to make a test of the 
equality of debits and credits. Such a test, if presented as a 
trial balance, is known as a postclosing or proof trial balance. 

ROBERT R. CLIFTON 

POSTCLOSING TUIAL BALANCE, DECEMBER 31, 19 

Debit Credit 

Cash $ 3,200.00 

Accounts Receivable 8 ,000 . 00 

Reserve for Bad Debts $ 500.00 

Notes Receivable 1 ,000.00 

Accrued Interest Receivable 8.00 

Inventory of Merchandise, 12/31/19 2,500.00 

Inventory of Store Expenses . . . . : 50.00 

Prepaid Insurance 300 . 00 

Land 2,000.00 

Buildings 8,000.00 

Reserve for Depreciation of Buildings 400.00 

Furniture and Fixtures . . 4,000.00 

Reserve for Depreciation of Furniture and Fix- 
tures 360.00 

Accounts Payable 2,500.00 

Accrued Salaries Payable 300.00 

Rent Collected in Advance 30.00 

Mortgage Payable 3,000.00 

Robert R. Clifton, Capital 21,968.00 

$29,058.00 829,058.00 

A trial balance taken after closing contains only real accounts, 
as the nominal accounts have been closed. The same items as 
appear in the balance sheet appear in the postclosing trial balance, 
but the balance sheet differs from it in form and arrangement. 



146 ACCOUNTING FUNDAMENTALS [Oh. XII 

Since there is no use for a postclosing trial balance other than as 
a test of equilibrium, this test is often reduced to mere lists of 
debit and credit balances without account titles. 

The postclosing trial balance of the books of Robert R. Clifton, 
which appears on page 145, is similar in appearance to any other 
trial balance. It contains the same figures as the adjusted trial 
balance used in the illustration of this chapter, except that the 
nominal accounts are missing and Robert R. Clifton's Capital 
account shows a credit balance of $21,968.00. 

After the completion of the closing process the detailed items 
on the ledger again may be represented by the fundamental 
accounting equation 

Assets = Liabilities + Proprietorship 

QUESTIONS 

1. a. What is meant by the expression the process of closing the books? 

b. When is it customary to close the books? Why? 

c. Are all the accounts on a ledger closed in the closing process? 
What accounts are closed? Why aren't all the accounts closed? 

d. Why are books closed? 

2. a. Are journal entries used in the process of closing the books? 

Why? 

b. Could books be closed without the use of the Profit and Loss 
account? Explain. 

3. a. What account balances are transferred to the debit of Profit and 

Loss? To the credit of Profit and Loss? 

b. A debit balance in Profit and Loss indicates a net gain or a net 
loss for the period? 

c. What should be done with the balance of Profit and Loss? 

4. a. Should current items of income and expense ever be credited or 

charged to Profit and Loss? Why? 

b. Is there any difference between the Profit and Loss account and 
the profit and loss statement? 

5. Indicate whether the following statements are true or false: 

a. Ruling and balancing the real accounts is the most important 
feature of the process of closing the books. 

b. The real accounts are closed when they are balanced. 

c. Closing the books is accomplished by means of journal entries. 

d. Income account balances are transferred to the credit of Profit 
and Loss. 

e. Nominal accounts with debit balances are transferred to the 
credit of Profit and Loss. 



Ch. XII] CLOSING THE BOOKS 147 

/. There are open accounts on a set of books after closing. 

g. The Profit and Loss account is both opened and closed in the 

closing process. 
h. The items on a postclosing trial balance are the same as the items 

which appear in the statement of profit and loss. 
i. A postclosing trial balance contains only real accounts. 

6. a. What is a trial balance? 

b. What is an adjusted trial balance? 

c. What is a postclosing trial balance? 

d. Why is a postclosing trial balance taken? 

7. a. Distinguish between a balance sheet and a postclosing trial 

balance. 

6. Will the total of the formal balance sheet agree with the total of 
the postclosing trial balance? Explain. 

8. Name at least three important facts which are disclosed by a state- 
ment of profit and loss but not by the Profit and Loss account. 

9. Give at least two accounts which are exceptions to the following 
statement: "All credit accounts in a postclosing trial balance are 
liabilities." 

10. Are all debit accounts in a postclosing trial balance assets? 

11. a. Would there be any harm done, if a bookkeeper ruled and bal- 

anced a nominal account during a period? 

b. What do you mean by ruling and balancing an account? 

12. Indicate whether the following statements are true or false. Qualify 
your answer, if necessary. 

a. An adjusted trial balance contains no mixed accounts. 

6. There are no nominal accounts in a postclosing trial balance. 

c. In order to close an expense account, it is debited. 

d. The balance of a Reserve for Depreciation account is larger in the 
postclosing trial balance than it was in the trial balance. 

e. The balance of a Reserve for Depreciation account is larger in 
the postclosing trial balance than it was in the adjusted trial 
balance. 

13. a. If monthly statements are prepared for an enterprise, are its 

books closed monthly? 

b. How can monthly statements of profit and loss be prepared, if 
the books are not closed monthly? 

c. If monthly statements are prepared, are the books adjusted 
monthly? 

d. Would it be an advantage or a disadvantage to an enterprise to 
close its books monthly? 

14. Suppose a complete set of books had been kept for an enterprise for a 
period of four years but had never been closed and statements had 
never been prepared. 



148 ACCOUNTING FUNDAMENTALS [Ch. XII 

a. Could a balance sheet be prepared for this enterprise at the end 

of the four years? 
6. What would be the heading on the statement of profit and loss 

of this enterprise, if such a statement were prepared? 

15. Why is it the custom to close the books once a year? 

16. After the postclosing trial balance is prepared it is discovered that 
the 

a. Inventory of merchandise was overstated $100.00. 

b. Reserve for depreciation of buildings was understated $80.00. 
What entries would be necessary to correct the books? 



CHAPTER XIII 

THE WORK SHEET ITS CONSTRUCTION AND USE 

In Chapter XI, "Adjusting the Books/' there was considered 
the process of modifying the accounts so that they would show the 
true condition of the business. In the last chapter, " Closing 
the Books," there was considered the process of closing the 
nominal accounts and consolidating the net result with the 
proprietor's account at the end of a fiscal period. 

The topics of Chapters XI and XII are extremely important 
and difficult parts of accounting, and require very careful atten- 
tion to numerous and significant factors. No matter how 
skilled in accounting, a person usually does not proceed to make 
a set of difficult adjusting entries directly in the journal of an 
enterprise, to post them to the ledger, to take an adjusted trial 
balance, to prepare the statements, and to make and post the 
closing entries, without first preparing a preliminary draft of his 
solution. Such a preliminary draft is the subject matter of this 
chapter. It is made in a rather definite form and is known as a 
work sheet. 

Definition 

A work sheet is a columnar sheet on which, in addition to the 
trial balance, are collected, classified, and summarized the data 
essential to the adjusting entries, the closing entries, and the 
preparation of the statements balance sheet, profit and loss, 
and analysis of proprietorship. 

The Work Sheet Its Objects and Advantages 

A work sheet is desirable for the following reasons: 

1. It brings together the trial balance and the adjusting data. 

2. It classifies and summarizes the information shown by the 
trial balance and the adjusting data, thus facilitating 

a. The preparation of the formal statements. 
6. The preparation of the closing entries. 

149 



150 



ACCOUNTING FUNDAMENTALS 



[Ch. XIII 



3. It reveals the net results of the period much more quickly 
than is true when the results are not known until the formal 
statements are prepared. 

4. It assists in the location of any errors which may be made in 
adjusting, closing, and balancing the accounts. 

5. It makes possible the preparation of statements during the 
fiscal period without the necessity of formal adjusting, and 
closing entries. 

Since the purpose of accounts is to aid management in its 
control of an enterprise, the work sheet is extremely important 
because it furnishes a quick means of determining results. The 
use of a work sheet makes it possible for an enterprise to ascer- 
tain results and have statements prepared from time to time 
during the year (monthly results are quite common), and to 
postpone formal adjusting, and closing entries to the end of the 
fiscal year. 

The Work Sheet Its Structure 

Work sheets have six, eight, ten, or more columns depending 
on the amount of the data which must be considered as a supple- 
ment to the trial balance and on the use to which the information 
is to be put. The form to be followed in this text provides 
ten columns. There are columns for the balances of the ledger 
accounts, the adjusting data, the balances of the ledger accounts 
as they would appear after the posting of adjusting entries, 
and other columns to show the ultimate disposition of these 
balances to the profit and loss statement or the balance sheet. 

The Work Sheet Its Form 

TEN-COLUMN WORK SHEET 



F 


Account Titles 


Trial 
] balance 


Adjust- 
ments 


Adjusted 
Trial 
Balance 


Profit 
and Loss 
Items 


Balance 
Sheet 
Items 


Dr. 
"T" 


Cr. 


Dr. 
3 


Cr. 


Dr. 


Cr. 


Dr. 


Cr. 


Dr. 


Cr. 

"To" 






2 


4 


5 


6 


7 


8 


9 



The F column to the extreme left is used to indicate the number 
of the ledger page on which each account is found. 



Ch. XIII] THE WORK SHEET 151 

Under Account Titles are entered the titles of the open 
accounts in the ledger and such supplementary account captions 
as arc necessitated by the adjusting data. 

In Columns 1 and 2 are placed the balances of the open 
accounts in the ledger. 

In Columns 3 and 4 the debit and credit amounts of the adjust- 
ing data are introduced. To each adjustment is assigned a 
distinguishing letter. It is placed beside the several debits and 
credits of a particular adjustment to facilitate the preparation 
of the adjusting entries in the journal. The sum of all the 
debits in these columns is equal to the sum of all the credits. 

Columns 5 and 6 represent an adjusted trial balance. In the 
illustration which follows, the figures in those columns are the 
same as those shown for the adjusted trial balance in Chapter XI 
since the same data were considered. The totals of both columns 
should be in agreement. 

To Columns 7 and 8 are extended the figures for all the nominal 
accounts for the amounts which appear in the adjusted trial 
balance columns. These columns, 7 and 8, supply all the infor- 
mation necessary for the preparation of the statement of profit 
and loss, except the details needed for the cost of goods sold sec- 
tion, and the closing entries. The difference between the totals 
of these two columns is the net profit or loss for the period. 

In Columns 9 and 10 are carried all the real accounts for the 
amounts which appear in the adjusted trial balance columns. 
These two columns, 9 and 10, serve as a basis for the preparation 
of the formal balance sheet and the statement of proprietorship. 
The difference between the totals of these two columns is in 
agreement with the difference between Columns 7 and 8. 

Throughout the work sheet it is important to place each 
amount opposite its descriptive title if the purpose of this helpful 
device is to be achieved. 

Adjustments on the Work Sheet 

The debit and credit items used in the adjustment columns 
of a work sheet are the same as those used in adjusting journal 
entries. In posting entries to a ledger each new debit or credit 
item is placed beneath the last entry on its side of the account. 
In a work sheet each new debit or credit item is placed in the next 
debit or credit column to the right of the descriptive title. It 



152 ACCOUNTING FUNDAMENTALS [Ch. XIII 

might be said that in the ledger work moves vertically downward, 
while in the work sheet it proceeds horizontally from left to 
right. 

Each adjustment debit or credit to an account which does not 
appear in the trial balance requires that a new account be listed. 
These new account titles are placed below the original trial 
balance titles. 

Adjusted Trial Balance of the Work Sheet 

The figures placed in the adjusted trial balance columns of a 
work sheet are the result of considering amounts in the trial 
balance and the adjustment columns. If there is a debit balance 
in the trial balance columns and a debit adjustment the figure 
in the adjusted trial balance debit column is the sum of these 
two items. If both items are credits the sum is placed in the 
credit column of the adjusted trial balance section. If the 
items appear in unlike columns (trial balance debit and adjust- 
ments credit or vice versa), the debit or credit difference is 
extended to its proper column of the adjusted trial balance 
section. 

Profit and Loss and Balance Sheet Columns 

No mixed accounts remain after the ledger balances have been 
modified by the adjustments. The entire amount of each 
account with a balance in the adjusted trial balance columns is 
extended, therefore, to the proper column under profit and loss 
or balance sheet. If it appears in the debit adjusted trial balance 
column, it must be extended to a debit column in order to main- 
tain the equality of debit and credit.' Conversely, if a credit, 
it must be extended to a credit column. 

The form shown on page 153 illustrates the method of distribu- 
tion and the location of the net profit or loss for the period. 

Two classes of items need special comment. The drawing or 
personal account of the owner is not an asset or a liability. 
If a debit, it is extended to the debit balance sheet column as an 
offset in part to the owner's capital; if a credit, to the credit 
balance sheet column as an addition to the owner's capital. 
It is needed in the statement of proprietorship. The Reserves 
for Depreciation and Bad Debts have credit balances and are 
placed in the credit balance sheet column &s offsets in part to 
the assets whose values they reduce. In the formal balance 



Ch. XIII] 



THE WORK SHEET 



153 



sheet each valuation reserve is shown as a subtraction from its 
related asset. 



Adjusted Tri 


al Balance 


Profit a 


nd Loss 


Balanc 


e Sheet 


Debit 
Balances 


Credit 
Balances 


Nominal 
Dr. Items 


Nominal 
Cr. Items 


Real 
Dr. Items 


Real 
Cr. Items 


If assets 








Assets 




If expenses 




Expenses 








If owner's pc 


rsonal 






Owner's 




If decrease in 


income .... 
If liabilitie 


Decrease 
in Income 

s. . . . 




Personal 


Liabilities 




If income 




Income 








If owner's 


capital .... 






Owner's 




If reserves. 








Capital 
Reserves 






Net Profit 


Net Loss 


Net Loss 


Net Profit 



Equalizing the Profit and Loss and Balance Sheet Columns 

After the extension of each item in the adjusted trial balance 
columns of the work sheet to the profit and loss or balance sheet 
sections, the next step is the placement of the totals in small 
lead-pencil figures at the bottom of the last four columns. 

In accordance with the usual accounting procedure, the 
difference between the profit and loss columns is added to the 
column with the smaller total. If the difference is placed in 
the debit profit and loss column, it represents the net profit 
and is extended to the credit balance sheet column as an item 
to be considered an addition to the owner's capital. Conversely, 
if the difference is entered in the credit profit and loss column, 
it represents the not loss and is extended to the debit balance 
sheet column as an offset in part to the owner's capital. The 
work-sheet illustration shows the method of ruling and totaling 
the columns. 

The total of the debit balance sheet column of the work sheet 
will not agree with the total of the assets in a formal balance 
sheet, if there is an item such as a net loss, a drawing account for 
the owner, or a valuation reserve account. Similarly, the total 
of the credit balance sheet column will not agree with the total 
of the liabilities and proprietorship in the balance sheet. It 



154 ACCOUNTING FUNDAMENTALS [Ch. XIII 

must be borne in mind that the work sheet is merely an aid to 
the accountant. It is not exhibited as a statement of business 
condition, even to the owner. From it are prepared the state- 
ments which are exhibited to the owner, creditors, and other 
interested parties. These statements, as has been shown previ- 
ously, are designed to be as nontechnical as possible, that they 
may be clear to a person untrained in accounts. 

If the work sheet balances, it is not positive proof that the 
results are correct. It indicates merely that the equality of 
debit and credit has been maintained. For example, if a debit 
item in the adjusted trial balance columns were placed by error 
in the debit balance sheet column instead of the debit profit 
and loss column, the work sheet would still balance, but the 
statements prepared from the work sheet would not exhibit the 
true condition of the enterprise. 

The Work Sheet Illustration 

A complete work sheet based on the facts set forth in Chapter 
XI appears on page 155. 

To avoid constant reference to Chapter XI, the adjustment 
facts on which this work sheet is based are here restated. 

The supplementary data consist of 

Inventory of merchandise, December 31, 19 $2,500.00 

Inventory of store expenses, December 31, 19 50.00 

Unrecorded salaries owing to employees but not due 300 . 00 
Accumulated interest on unmatured notes receiv- 
able 8.00 

Unexpired insurance, December 31, 19 300.00 

Rent collected in advance (unearned rent), Decem- 
ber 31, 19_ 30.00 

Depreciation of furniture and fixtures 360 . 00 

Depreciation of buildings 400 00 

Estimated bad debts 500.00 

In Columns 3 and 4 are found a debit and a credit for each item 
of the supplementary data. Offsetting debits and credits are 
related by means of the identifying letters used. It should be 
noted that the debits and credits identified by the letter (b) 
do not represent an item of the supplementary data. That 
particular adjustment is necessary to accumulate the total 
debit to Cost of Goods Sold account. It will be noticed also 
that the balance of the Cost of Goods Sold account shown in 



Ch. XIIIJ 



THE WORK SHEET 



155 



ROBERT R. CLIFTON 
WORK SHEET, DECEMBER 31, 19 


I 

o> 

i 

"3 





888 


8 8888 




8 


8 


cicocT 


0000 
CO O O O 
CO CO <* O 







o 

a 


P 


888 8888 


88 8 






81 


lii iiii 


oo 






1 


(woe-. NOO 


c 

i 


O 


8 88 


81 


O 000 

o 

10 


8 


(5 


88888 


O OOOO 
O OOOO 




8 


8 
8*1 


OOOOO 
O O <N O 00 

t 00 <N O -i 


0000 
OOOO 
O W CO ** O 

8 




00 

Oi 


Adjusted Trial Balance 


6 


OOOO OO 


0000 
OOOO 


81 


OOOO OOO 

go o o o H 
OOO COrH 

c^cooo 


O CO O O 
CO CO ^ O 


1 


& 


OOO OOOO OOOOO 
OOO OOOO OOOOO 


O OO OO OOO 
OO 00 OOO 


8 
S 

O 
fe 


1 




OOO OOOO OOOOO 
OOO OOOO OOCJOOO 


O OO OOO OOO 
CO 




COOOrH <NOOf 


Adjustments 


o 


88 88 8 


O O OOOO 
O OOOO 


8 

00 

CO 

o" 






OO 00 00 

o oo 
c^ o 

3 


8 88888 

if) CO CO ^ O 

3 S S 3 3 3 




5 


8 8 


88 88 8 8 8 


811 



co 

CO 

g 3 


OO 00 O O O O 
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00 

CO 

o' 




& -5-S ^S <l 3 3 


III Trial Balance 
Account Titles 





8888 88181! 


OOOO O O 
OOOO C5 - 
OOOO CO ^ 

CJ iO 


P 


. 1 

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Sooooooo oooooo 
ooooooo oooooo 


ii 








00000000 000<NOOO < 
(NOOOOOOO OOOOCJO^H C 


1; 


1 
1 

2 

0, 

I 


COOO'-^MWOO^ OO O j 

o co 

\ ' -N ' % 



156 ACCOUNTING FUNDAMENTALS [Ch. XIII 

the debit adjusted trial balance column ($39,500.00) is a profit 
and loss item, representing the actual cost of goods sold. 

The Work Sheet Its Use 

After the work sheet is completed it does not matter to what 
use it is placed first. Any of the formal statements may be pre- 

ROBERT R. CLIFTON 

STATEMENT OF PROFIT AND Loss 
For the Your landed December 31, 19 

Sales $50,000.00 

Cost of Goods Sold: 

Inventory of Merchandise, January 1, 19 $ 2,000.00 

Purchases 40,000.00 

$42,000.00 
Less: Inventory of Merchandise, December 31, 

19_ 2,500.00 

Cost of Goods Sold 39,500.00 

Gross Profit on Sales. . . . $10,500.00 

Less Operating Expenses: 

Salaries $5,800.00 

Store Expenses . ... . 750 . 00 

Office Expenses .... ... 600 . 00 

Depreciation of Buildings .... .... 400 . 00 

Depreciation of Furniture and Fixtures 360 00 

Insurance . . . 200 . 00 

Property Taxes 220 . 00 

Bad Debts . 500 00 

Total Operating Expenses. . 8,830.00 

Net Profit on Sales $ 1,670.00 

Other Income: 

Interest Earned .. $ 118.00 

Rent Earned 360.00 

$ 478.00 

Other Expenses: 

Interest on Mortgage .. . . 180.00 298.00 

Net Profit for the Period $ 1.968 00 

ROBERT R. CLIFTON 

ANALYSIS OF PROPRIETORSHIP 
For the Year p]nded December 31, 19 

Net Worth as shown by the Balance Sheet, December 31, 19 $21,968.00 

Net Worth, January 1, 19 . . . 20,000.00 

Net Profit as shown by the Statement of Profit and Loss $ 1 ,968.00 



Ch. XIII] 



THE WORK SHEET 



157 



88 




158 



ACCOUNTING FUNDAMENTALS 



[Ch. XIII 



pared first or the adjusting and closing entries may be made. At 
this point the student should realize that once a work sheet has 
been completed, the recording of the adjusting entries in the jour- 
nal is a mere matter of copying the entries indicated by Columns 
3 and 4. The entries suggested here are identical with those 
marked with an asterisk in Chapter XT. The entries necessary 
to close the books are indicated by the profit and loss columns, 
7 and 8. It is advisable to compare these columns with the 
closing entries for the same problem given in Chapter XT I. The 
data for the profit and loss statement are in Columns 7 and 8 
although reference may have to be made to other columns for 
details such as are needed to present the cost of goods sold section 
of the statement. The data for the balance sheet are in Columns 
9 and 10, as is the information necessary for the analysis of pro- 
prietorship statement. 

The several statements prepared from this work sheet are 
shown on pages 156 and 157. 

REVIEW OF ACCOUNTING PROCEDURE 

Inasmuch as the major operations in the construction and 
presentation of the accounts of an enterprise have been covered, 
it seems desirable to restate them in the order in which they 
occur, and to emphasize them by a brief review. 

The major operations in the order of their occurrence may be 
listed : 



TITLE OF OPERATION 

1. Journalizing 

2. Posting 

3. Taking a Trial Balance 

4. Recording Adjustments (on the 
books, on a work sheet, or on 
both, but always on the books at 
the end of each fiscal year). 

5. Preparing a Statement of Profit 
and Loss 

6. Preparing a Balance Sheet 

7. Closing the Books 



WHEN PERFORMED 

Daily 

Daily for items for which it is 

necessary to know daily balances 

Monthly 

Whenever a statement of profit 
and loss and a balance sheet are 
desired. This is usually monthly, 
quarterly, semiannually, or 
annually. 

Usually this operation is per- 
formed only once every twelve 
months, at the end of the fiscal 
year. 



Ch. XIII] THE WORK SHEET 159 

Steps 5, 6, and 7 are listed in an arbitrary order. Which of 
these three operations is done first, second, and third is a matter 
of personal preference. 

It will be noticed that the work sheet, an important piece of 
accounting work, is not listed as a separate major operation. 
It develops in connection with steps 4, 5, 6, and 7 and is purely 
an aid to an accountant. It is not a part of the book records. 

An operation in which accounting plays a very important part 
is not included as one of the distinctly major accounting steps. 
This is the process of gathering the supplementary data essential 
to recording adjustments. Taking the inventories of mer- 
chandise and supplies; determining the amount of accrued 
and deferred items; ascertaining the amount of depreciation 
applicable to various fixed assets; estimating the amount of 
bad debts; and gathering other data requiring adjustments 
represent a tremendous task in the usual business of any con- 
siderable size. 

Operations, such as totaling, balancing and ruling accounts, 
correcting errors, posting adjusting entries, and taking an 
adjusted or a postclosing trial balance, while important, are not 
considered major operations. 

QUESTIONS 

1. What is a work sheet? When and why is it prepared? 

2. Is a work sheet prepared before or after the adjusting journal entries? 
The statements? The closing entries?. 

3. Is a work sheet ever prepared without formal adjusting entries being 
made; if so when and why? 

4. Is a work sheet ever prepared without formal statements being 
made? Explain. 

5. Is a work sheet ever prepared without formal closing entries being 
made? Explain. 

6. Think of a ten-column work sheet and answer the following ques- 
tions by numbers. 

a. What columns supply the information for the adjusting entries? 
6. What columns supply the information for the balance sheet? 

c. What columns supply the information for the statement of profit 
and loss? 

d. What columns supply the information for the closing entries? 

e. What columns supply the information for the analysis of pro- 
prietorship? 

/. What columns are equivalent to an adjusted trial balance? 



160 ACCOUNTING FUNDAMENTALS [Ch. XIII 

g. What columns supply the information taken from the ledger 
before adjustments are made? 

7. Why are letters used alongside the amounts in Columns 3 and 4? 

8. a. Do any mixed accounts appear in Columns 1 and 2? 

b. Do any mixed accounts appear in Columns 5 and 6? In 7 and 
8? In 9 and 10? 

9. a. An item in Column 5 is always extended to one of what other 

two columns? Why? 

6. An item in Column 6 is always extended to one of what other two 
columns? Why? 

10. Is the net worth of an enterprise shown in one figure in the work 
sheet? Explain. 

11. What items, other than assets, may appear in the debit balance sheet 
column? 

12. What items, other than liabilities, may appear in Column 10? 

13. To which two columns is the net profit added? The net loss? 

14. The proprietor's personal account appears in which balance sheet 
column? 

15. Indicate any differences between the balance sheet columns of the 
work sheet and the postclosing trial balance. 

16. Will the totals of the balance sheet columns of the work sheet agree 
with those of the formal balance sheet? Explain. 

17. a. Would the work sheet balance, if the amount of Notes Payable 

were placed in Column 8 instead of Column 10? If the debit 
balance of the proprietor's personal account were placed in 
Column 7 instead of Column 9? 

6. If a work sheet balances, is it positive proof that the results 
shown are correct? 

18. Suppose the following items appear in Column 5. Give, by number, 
the column to which each is extended. 

a. Insurance. /. Furniture and Fixtures. 

6. Store Expenses. g. Depreciation of Buildings. 

c. Notes Receivable. h. Cost of Goods Sold. 

d. Inventory of Store Expenses. i. Prepaid Insurance. 

e. Salaries. j. Bad Debts. 

19. Suppose the following items appear in Column 6. Give, by number, 
the column to which each is extended. 

a. Sales. e. Rent Earned. 

6. Reserve for Depreciation. /. Interest Collected in Advance. 

c. Notes Payable. g. Reserve for Bad Debts. 

d. Accrued Salaries Payable. h. Interest Earned. 

20. List the steps in the accounting cycle of operations, in the order in 
which you think they occur. 

21. Must the formal statements be prepared before the books are closed? 
Explain. 



CHAPTER XIV 
INVENTORIES, ACCRUALS, AND DEFERRED ITEMS 

In Chapter XI it was shown that it is necessary to adjust a 
set of books at the end of a period, because of 

1. The closing inventory of merchandise. 

2. The closing inventories of supplies. 

3. The unrecorded accrued items: 

a. Accruals payable. 

b. Accruals receivable. 

4. Deferred items: 

a. Deferred charges to subsequent periods. 
6. Deferred credits to subsequent periods. 

5. The depreciation of fixed assets. 

6. The estimated bad debts. 

7. Other matters for which provision should be made. 

In order to have more complete information about and to 
decide the ultimate disposition of the adjustment items, each 
of those marked with an asterisk in Chapter XI will be recon- 
sidered in this or the following chapter. 

The adjusting entries require the opening of a number of 
new accounts. The new nominal accounts are cleared in 
the closing process. The new real accounts are open on the books 
after closing. Some of these real accounts will become nominal 
in character, in part or entirely, during the new fiscal period. 
Because some of these accounts will represent expenses or income 
in whole or in part in the new period, it is considered desirable to 
transfer their balances to nominal account titles. This transfer 
is accomplished by entries which are known as readjusting, 
reversing, postclosing, or reopening entries. 

The process of readjusting the books is desirable but is not 
imperative, as will be shown in the illustrations which follow. 

161 



162 ACCOUNTING FUNDAMENTALS [Ch. XIV 

Readjusting Entry Defined 

A readjusting entry is an entry made as of the first day of a new 
period to transfer an adjustment item from a real to a nominal 
account title. It is the reverse of an adjusting entry. 

Inventory of Merchandise 

Inventory of merchandise as defined in Chapter II is the 
merchandise on hand at a given time. The inventory list 
should show the composition and value of each class of unsold 
goods on a given date. It should include all merchandise on 
hand which was acquired or produced for the purpose of selling 
even though it is obsolete, shopworn or otherwise damaged. 
Proper allowance should be made in valuing the substandard 
goods. 

In Chapter XI it was shown that it is necessary at the end of a 
fiscal period to determine the value of the merchandise on hand. 
The bases for valuing inventories of merchandise used most 
commonly by business concerns are 

1. Cost. 

2. Cost or market whichever is lower. 

Cost value means the total of all expenditures made to acquire 
and put the goods in a salable condition. It includes the invoice 
price, transportation, handling and storage expenditures. 

Market value means* "the current bid price prevailing at the 
date of the inventory for the particular merchandise in the 
volume in which usually purchased. . . . " The method of 
valuing according to cost or market whichever is the lower is 
approved by the Federal Reserve Board and the United States 
income-tax authorities and is used generally. It is important 
to understand that this method applies to each itom in the 
inventory list and not to the total, as is indicated in the brief 
illustration which appears on page 163. 

The amount extended for each item to the last column is 
obtained by using the lower of its cost or market values. The 
total of the last column is the cost or market whichever is lower 
value of the inventory, a figure which conservative practice 
approves. The cost or market method of valuing inventory 
avoids the anticipation of profits by valuing at cost in cases 
where the market price is higher. It also avoids the postpone- 
ment of a loss by valuing at market price when it is lower than 

* United States Treasury Department Regulations. 



Ch. XIV] INVENTORIES, ACCRUALS, DEFERRED ITEMS 163 



cost. To value unsold goods at a price higher than cost is to 
anticipate profits. Profits are not made until goods are sold. 
To value unsold goods at cost when they could be replaced at a 
lower price is postponing a loss from the period in which the 
decline in value occurred to the period in which the goods may 
be sold. 

COMPUTATION OF INVENTORY VALUE 
Cost or Market Whichever Ts the Lower 



Item 


Count 

20 
15 
10 
10 


Cost 


Markol 


Cost or Market 
Whichever Is 
Lower 


Unit 


Total 


Unit 


Total 


Unit 

$35.00 
40 00 
12.00 
2 50 


Total 


Beds -Single . ... 
Heels Double .... 
Dressing Tables .... 
Chairs . . 
Total 


$35 00 
45 00 
15 00 
3.00 


$ 700 00 
675 00 
150 00 
30 00 


$38.00 
40.00 
12 00 
2.50 


$ 700.00 
600 00 
120 00 
25 00 


$ 700 00 
600 00 
120 00 
25 00 


$1,555.00 


$1,505 00 


$1,445 00 



The same method of valuing inventory must be used con- 
sistently. If it is not, the results of different periods are not 
determined on the same basis and the possibility of making 
valuable comparisons between periods is destroyed. 

Inventorying merchandise at cost or market whichever is the 
lower value may result in incorrect figures for cost of goods sold 
and gross profit on sales in the profit and loss statement. For 
example, if the inventory of merchandise on hand at the end 
of a period cost $2,500.00 but on the cost or market whichever 
is the lower basis is worth only $2,000.00, the incorrect profit and 
loss statement appears as follows: 

Sales. $50,000.00 

Cost of Goods Sold: 

Inventory of Merchandise, January 

1, 19_ $ 2,000.00 

Rirchases 40,000.00 $42,000.00 

Less: Inventory of Merchandise, December 31, 

19_ 2,000.00 

Cost of Goods Sold 40,000.00 

Gross Profit on Sales $10,000.00 

The cost of goods sold and the gross profit on sales figures are 
incorrect because $2,000.00 is not the cost of the inventory on 



164 ACCOUNTING FUNDAMENTALS [Ch. XIV 

hand at the end of the period. It is the cost or market whichever 
is the lower value; $2,500.00 is the cost value of the inventory. 
A better way to present this statement is 

Sales $50,000.00 

Cost of Goods Sold: 

Inventory of Merchandise, January 

1, 19_ .. . $ 2,000.00 

Purchases . 40,000.00 $42 , 000 . 00 

Less: Inventory of Merchandise, December 31, 

19_ . 2,500.00 

Cost of Goods Sold 39,500.00 

Gross Profit on Sales . $ 10 , 500 . 00 

The $500.00 decline in inventory value would be deducted as a 
separate item in the Other Expenses and Losses section of the 
profit and loss statement. (See Chapter XXVI.) 

In Chapter XI $2,500.00 was the value of the inventory of 
merchandise assumed to be on hand at the end of the period. 
The following entry was given as the means of registering this 
inventory value as a separate account on the books: 

DECEMBER 31, 19 

Inventory of Merchandise, 12/31/19_ 2,500.00 

Cost of Goods Sold 2 , 500 . 00 

To place the new inventory on the books 
in its own account. 

The Cost of Goods Sold account was cleared in the closing 

process but the Inventory of Merchandise, December 31, 19 

account is still open. The question now arises, is it desirable 
to readjust this account or to leave it as it is? 

A readjusting entry is not necessary for two reasons 

1. The Inventory of Merchandise, December 31, 19 account 

will be needed in the preparation of the next statement of 
profit and loss, as the final inventory of merchandise of a 
given period becomes the initial inventory of merchandise 
of the next period. 

2. The Inventory of Merchandise, December 31, 19 account 

on the books is a constant reminder of the value of the 
merchandise carried over from the previous period. Unless 
some error is found, the inventory of merchandise figure 
should remain unchanged on the books during the following 
fiscal period. 



Ch. XIV] INVENTORIES, ACCRUALS, DEFERRED ITEMS 165 

Inventories of Supplies 

Inventories of supplies as defined in Chapter II are supply 
items such as stationery, twine, wrapping paper, packing boxes, 
etc., on hand at a given date. A separate inventory record is 
made of each class of consumable assets. 

Since supply items are consumed in a relatively short period 
of time, it is the usual practice to charge expenditures for them 
to nominal account titles, such as Office Expenses, Store Expenses, 
and Postage. At the end of a period each of these accounts is 
reduced by the value of unconsumed portions. 

As was indicated in Chapter XI it is necessary at the end of a 
fiscal period to make adjusting entries for the supply items on 
hand. The entry given for the $50.00 assumed inventory of 
store supplies in that chapter, was 

DECEMBER 31, 19 

Inventory of Store Expenses 50.00 

Store Expenses 50.00 

To record the value of unconsumed store supplies 
and to modify the Store Expenses account to 
show the true expense. 

The Store Expenses account was cleared in the closing process 
but the Inventory of Store Expenses account is still open. 

Since all supply items at the time of their purchase are con- 
sidered to be expense transactions and are charged to nominal 
account titles, it is desirable from the standpoint of consistency 
to transfer the inventories of such items to their respective 
nominal account captions at the beginning of a new period. 

In the case just cited this is accomplished by the following 
readjustment entry: 

JANUARY 1, 19 

Stores Expenses 50.00 

Inventory of Store Expenses 50.00 

To transfer the balance in the Inventory of Store 
Expenses account to Store Expenses 

The above entry has another advantage. As expenditures 
are made for Store Expenses in the new period they are charged 
to that title. The Store Expenses account will show, therefore, 
at all times during the period, the aggregate of the amount 



166 



ACCOUNTING FUNDAMENTALS 



[Ch. XIV 



carried forward and the new expenditures made under that 
heading. 

In case the above entry is not made as a readjustment, it must 
be made as an adjustment at the end of the period. The read- 
justment entry at the beginning of a new period is recommended 
and is required throughout this text. 

Accrued Items 

Accruals payable as defined in Chapter II are accumulating 
debts which arise out of services rendered to the business over 
a period of time but which debts are not due. No business 
paper, such as a purchase invoice, a check, or a note exists for the 
amount of an accrual. 

In Chapter XI it was shown that the amount of each accrual 
payable existing at the end of a period has to be recognized and 
recorded on the books. The case used for an illustration in that 
chapter assumed unrecorded salaries owing to employees but 
not due at the end of the period, in the amount of $300.00, 

The adjusting entry given for this fact was 



DECEMBER 31, 19 

Salaries 

Accrued Salaries Payable 
To record unpaid salaries. 



300.00 



300.00 



The Salary account was cleared in the closing process but the 
Accrued Salaries Payable account is still open. These accounts 
appear on the ledger as follows : 

Salaries 



19_ 












19 _ 












Dec. 


31 


(Total paid) 




5,500 


00 


Dec. 


31 


(Closing entry) 


J 


5,800 


00 




31 


(Adjusting 
























entry) 


J 


300 


00 














- . 










5,800 


00 









, 


5,800 


00 







Accrued Salaries Payable 















19 __ 










==_= 














Dec. 


31 


(Adjusting 
























entry) 


J 


300 


00 



Ch. XIV] INVENTORIES, ACCRUALS, DEFERRED ITEMS 167 

The purpose of the Accrued Salaries Payable account is to 
record the liability under this heading at the end of the period. 
This liability will be satisfied on the first payday of the new 
period when salaries are paid. Since salaries paid are charged 
to the nominal account Salaries, it is desirable that a readjust- 
ment entry be made to transfer the balance of Accrued Salaries 
Payable account to Salaries. This is accomplished by the 
following entry: 



JANUARY 1, 19 

Accrued Salaries Payable 

Salaries 

To transfer the balance of Accrued Salaries 
Payable account to Salaries. 



300.00 



300.00 



Let it be assumed that the first payday of the new period is on 

January 3, 19 , and that the amount of the salaries paid is 

$375.00. 

After the readjusting entry shown above and the cash dis- 
bursements entry for the salaries paid on January 3, 19 are 

posted to the accounts in the ledger, the nominal and accrued 
accounts for salaries appear as follows: 

Salaries 



Dec. 


31 


(Total paid) 




5,500 


00 


Dec. 


31 


(Closing entry) 


J 


5,800 


00 




31 


(Adjusting 
























entry) 


J 


300 


00 






















5,800 


00 










5,800 


00 


Jan. 


3 


(Total paid) 


CD 


375 


00 


Jan. 


1 


(Readjusting 
























entry) 


J 


300 


oof 



Accrued Salaries Payable 



19 












19._ 












Jan. 


1 


(Readjusting 








Dec. 


31 


(Adjusting 












entry) 


J 


300 


00 






entry) 


J 


300 


00 











The readjustment entry on January 1, 19 transferred the 

$300.00 liability from Accrued Salaries Payable to Salaries. 
The showing of the liability in the nominal account made it 
possible for the regular salary entry on January 3, 19 to 
offset the record of the liability and to register the $75.00 salary 
expense of the new period. 



168 ACCOUNTING FUNDAMENTALS [Ch. XIV 

As all accruals payable are comparable in character to the one 
used in the illustration, readjusting entries should be made for 
them. 

Accruals receivable are accumulating claims which arise out 
of services rendered by the business over a period of time but 
which claims are not due. A particular accrual receivable may 
be made up of a number of relatively small items which come 
due at varying times. A good example is Accrued Interest 
Receivable. This account shows the aggregate of accrued 
interest on all notes receivable. 

As in the case of accruals payable it is desirable to make read- 
justment entries for accruals receivable. The purpose of an 
accrual receivable account is to record an asset at the end of the 
period. That asset will most likely be collected, in whole or in 
part, during the new period but not as a separate item. It will 
probably be collected as a part of a receipt from an income item. 
It is desirable, therefore, that the accrual receivable be shown 
as of the first day of the new period under a nominal rather than 
an asset title. 

The illustration in Chapter XI of an accrual receivable at the 
end of a period was accumulated interest on unmaturcd notes 
receivable $8.00. 

The adjusting entry for it was 

DECEMBER 31, 19 

Accrued Interest Receivable 8.00 

Interest Earned 8.00 

To add to the Interest Earned account the interest 
income which has not been received, and to set up 
an additional asset 

The Interest Earned account was cleared in the closing process 
but the Accrued Interest Receivable account is still open. Since 
this asset Accrued Interest Receivable will be collected along 
with interest earned in the new period, the balance of the asset 
account should be transferred to the Interest Earned title. This 
is accomplished by the readjusting entry 

JANUARY 1, 19 

Interest Earned 8.00 

Accrued Interest Receivable 8.00 

To transfer the balance of the Accrued Interest 
Receivable account to Interest Earned. 



Ch. XIV] INVENTORIES, ACCRUALS, DEFERRED ITEMS 169 

Suppose $48.00 as interest on notes is collected on June 1, 19 

and that this collection includes the $8.00 which was accrued 
at the end of the previous period. 

After the readjusting entry given above and the cash receipts 

entry on June 1, 19 are posted to the ledger, the nominal and 

accrued accounts for interest appear as follows: 

Interest Earned 



Dec. 


31 


(Closing entry) 


J 


118 


00 


Dec. 


31 


(Total 
























received) 




110 


00 
















31 


(Adjusting 
























entry) 


J 


8 


00 










118 


00 










118 


00 


Jan. 


1 


(Readjusting 








June 


1 


(Total 












entry) 


J 


8 


00 






received) 


CR 


48 


00 



Accrued Interest Receivable 



Dec 


31 


(Adjusting 
entry) 


J 


8 


00 


Jan. 


1 


(Readjusting 
entry) 


J 


8 


00 











The $48.00 credit to the Interest Earned account offsets the 
$8.00 claim for accrued interest carried over from the previous 
period and registers the receipt of $40.00 for current interest 
earned. 

Deferred Items 

Deferred charges are expenditures of one period that are to be 
charged as expenses to a subsequent period or periods. Illus- 
trations are inventory of store expenses, prepaid insurance, 
prepaid rent, and prepaid interest. 

Inventory of store expenses which was considered earlier ia 
this chapter is an illustration of a deferred charge. In that 
case the amount of the deferred charge which benefits a sub- 
sequent period is represented by the actual inventory of store 
supply items. With accounts such as Prepaid Insurance and 
Prepaid Rent, the deferred charge is represented by unexpired 
services the benefits of which will be received in a subsequent 
period or periods. 



170 ACCOUNTING FUNDAMENTALS [Ch. XIV 

The method of treatment given for inventory of store expenses 
applies to all deferred charges if the original expenditures are 
charged to expense account captions. In all such cases it is 
necessary to adjust the expense account at the end of the period 
for unconsumed or unexpired amounts. The balance of the 
inventory or other unexpired deferred charge accounts opened 
by the adjustment entries should be transferred by readjustment 
entries to expense account captions as of the first day of the new 
period. 

Not all deferred charge accounts are treated the same as 
Inventory of Store Pkpensrs. For example, in Chapter XI an 
illustration of a deferred charge was developed from the following 
facts : 

Prepaid Insurance in the trial balance $500.00 

Unexpired insurance, December 31, 19 300.00 

Cost of expired insurance for the period $200.00 

The following adjusting entry was made: 

DECEMBER 31, 19 

Insurance 200.00 

Prepaid Insurance 200.00 

To reduce the Prepaid Insurance account by 
the portion which expired this fiscal period. 

The Insurance account was closed in the process of closing 
the books but the Prepaid Insurance account is still open with a 
debit balance of $300.00. It is not necessary to make any 
readjusting entry for this account. All new expenditures for 
insurance are charged to Prepaid Insurance. At the close of the 
next period an adjusting entry similar to the one just given is 
made for the amount of insurance expired. 

Adjusting entries may be more frequent than closing entries. 
Books are closed ordinarily only once a year, but they may be 
adjusted semi-annually, quarterly, or monthly, depending on 
the number of times financial statements are prepared in a 
fiscal year. Sometimes the adjustments are not made on the 
books but are made on work sheets from which the statements 
are prepared. 

Suppose monthly statements are prepared for this business 
where the expired insurance was $200.00 for the year. The 
monthly adjusting entry under this situation is 



Ch. XIV) INVENTORIES, ACCRUALS, DEFERRED ITEMS 171 

JANUAKY 31, 19 
Insurance 16 . 67 

Prepaid Insurance 16.67 

To reduce the Prepaid Insurance account by 
the portion expired in the month of January. 

In the illustration the original expenditure was charged to 
Prepaid Insurance, an asset title. It might have been charged to 
Insurance, an expense account. Both are mixed accounts. 
Ordinarily if the expenditure benefits the current fiscal period to a 
greater extent than a subsequent period or periods, an account 
with a nominal title is selected. In such cases the books are 
adjusted for the unexpired part of the account. Conversely, 
a real account title is used if the greater part of the expenditure 
benefits a subsequent period or periods. In a case of this kind, 
which is the one presented by the figures given above, the books 
are adjusted for the amount which has expired. 

Deferred credits, as defined in Chapter II, represent receipts or 
receivables of one period that will be earnings of a subsequent 
period or periods. They represent items received or receivable 
which are not included in income until the period or periods in 
which earned. They are liabilities which are satisfied usually in 
services or products. 

In Chapter XI the facts used to illustrate this type of adjust- 
ment were 

Rent Earned account in the trial balance $390 . 00 

Rent collected but unearned in the period 30 . 00 

Rent income for the period $360 . 00 

In this illustration rent collections were credited to the income 
title Rent Earned. It was necessary at the end of the fiscal 
period to adjust the Rent Earned account for the amount of the 
rent collected but unearned in the period. This adjustment was 
accomplished by the entry 

DECEMBER 31, 19 

Rent Earned 30.00 

Rent Collected in Advance 30 . 00 

To reduce the Rent Earned account by the 
amount collected in advance. 

The Rent Earned account was cleared by the closing of the 
books, but the Rent Collected in Advance account is still open. 



172 



ACCOUNTING FUNDAMENTALS 



[Ch. XIV 



Since the amount of the rent collected in advance will be 
income in the new period, it is desirable to transfer it to the 
Rent Earned account. This is accomplished by the readjusting 
entry 



JANUARY 1, 19 

Rent Collected in Advance 

Rent Earned 

To transfer the balance of Rent Collected in 
Advance account to Rent Earned. 



30.00 



30.00 



The rent accounts in the ledger now appear as follows : 

Rent Earned 



Dec. 


31 


(Adjusting 








Dec. 


31 


(Total 












entry) 


J 


30 


00 






collected) 




390 


00 




31 


(Closing entry) 


J 


360 


00 






















390 


00 










390 


00 














Jan. 


1 


(Readjusting 
























entry) 


J 


30 


00 



Rent Collected in Advance 



Jan. 


1 


(Readjusting 
entry) 


J 



30 


00 


Dec. 


31 


(Adjusting 
entry) 


J 



3000 



The $30.00 rent collected in advance in the past period is an 
income item in the new period. It is proper, therefore, that it 
appears as of the first day of the new period under the income 
account title Rent Earned. 

Readjusting entries should be made for all deferred credits if 
the original collections are credited to an income account title. 
They are comparable in character to the rent illustration just 
given. 

If the original collections for rent are not credited to the 
nominal account title Rent Earned but to the liability title 
Rent Collected in Advance, then the adjusting entry at the end 
of the period is different and a readjusting entry is not necessary. 
For example, suppose the rent collected in the past period was 
credited to the account Rent Collected in Advance. The facts 
would then be stated 



Ch. XIV] INVENTORIES, ACCRUALS, DEFERRED ITEMS 173 



Rent Collected in Advance as shown in the trial 
balance ...................................... $390.00 

Unearned rent collected in the period .............. 30 . 00 

Rent earned in the period ........................ $360 . 00 

In this case it is necessary to adjust the books at the end of the 
period for the amount of rent earned by the following adjusting 
entry: 

DECEMBER 31, 19 _ 
Rent Collected in Advance 360.00 

Rent Earned 360.00 

To reduce the Rent Collected in Advance 
account by, and to set up the Rent Earned 
account for, the amount earned in the period. 

After closing, the accounts involved appear as follows : 
Rent Collected in Advance 



19_ 
Dec. 


31 
31 


(Adjusting 
entry) 
Balance 


J 


360 
30 


00 
00 


19_ 
Dec. 


31 

31 
d 


(Total 
collected) 

Balance 


_ 


390 


00 


390 
Rer 


00 


390 


00 
00 






it I 


19_ 
Dec. 

2arne 


30 


19__ 
Dcc. 


31 


(Closing entry) 


J 


360 


00 


19_ 
Dec. 


31 


(Adjustment 
entry) 


J 


360 


00 







The Rent Earned account was closed in the closing process but 
the Rent Collected in Advance account is still open with a credit 
balance of $30.00 which is the amount collected in advance. 
Since, under this plan, new collections are credited to the Rent 
Collected in Advance account, a readjustment entry is not 
necessary. 

Generalizing from this last illustration it can be stated 
readjusting entries are not necessary if the original receipts or 
receivables are credited to liability titles. 

It is correct to credit receipts or receivables for income items 
not yet earned, either to purely income titles or to deferred 
credit titles. Thus, in the illustrations just 'used, the $390.00 



174 ACCOUNTING FUNDAMENTALS (Ch. XIV 

rent collected was credited correctly either to Rent Earned or to 
Rent Collected in Advance. Since the amount of a particular 
deferred credit at the end of a period is usually smaller than the 
amount earned by the account out of which it arises, it seems 
desirable to credit to nominal account titles income items col- 
lected in advance. This treatment requires adjustments at the 
end of the period for the amount of the deferred credits and 
readjustment entries as of the first day of the new period. 

Guiding Principles on Readjustments 

1. No readjustments are necessary with respect to 

a. The inventory of merchandise. 

b. Reserves for depreciation. 

c. Reserve for bad debts. 

2. So that the customary debits and credits to nominal 
accounts may be made throughout the period, readjust- 
ments arc desirable with respect to accruals receivable and 
accruals payable. 

3. Deferred items may or may not need to be readjusted. 

a. If the bookkeeper customarily debits or credits nominal 
accounts when deferred-item transactions occur, readjust- 
ing entries should be made. 

6. If the bookkeeper customarily debits or credits real 
accounts when deferred-item transactions occur, readjust- 
ing entries should not be made. 

4. Readjusting entries are made as of the beginning of the 
period. 

The following chronological order of ledger operations must 
be kept in mind: 

a. Recording readjusting entries. 

b. Recording the cash paid or liability incurred, or the cash 
received or receivable. 

c. Taking a trial balance. 

d. Recording adjusting entries. 

e. Recording closing entries. 

/. Ruling, totaling, and balancing ledger accounts where 

necessary. 
g. Taking a postclosing trial balance. 



Oh. XIV] INVENTORIES, ACCRUALS, DEFERRED ITEMS 175 

QUESTIONS 

1. What is a readjusting entry? When is it usually made? Where is 
it made? Why is it made? 

2. a. Is a readjusting entry desirable for Inventory of Merchandise? 

Explain. If desirable, give it. 

b. Is a readjusting entry desirable for Inventory of Store Expenses? 
Explain. If desirable, give it. 

3. a. Give the adjusting entry necessary at the end of a period for store 

salaries accrued in the amount of $120.00. 

6. Give the readjusting entry, as of the first day of the new period, 
for the fact in a. 

4. a. Give the adjusting entry necessary at the end of a period for 

$600.00 of mterest accrued on bonds owned. 

b. Give the readjusting entry for the fact in a. 

c. Suppose the readjusting entry requested in 6 was not made, what 
entry or entries should be made when $3,600.00 cash is received as 
interest on bonds? The $3,600.00 includes the $600.00 accrued. 

5. Suppose most of the insurance policies of a business cover more than 
a one-year period. 

a. When insurance is purchased should it be charged to Insurance 
or Prepaid Insurance? Why? 

b. If the answer given to a is Insurance, what adjusting entry is 
required at the end of a period? What readjusting entry, if any, 
as of the beginning of the next period? 

c. If the answer given to a is Prepaid Insurance, what adjusting 
entry is required at the end of a period? What readjusting entry, 
if any, as of the beginning of the next period? 

6. a. What are the most common bases for valuing inventory of mer- 

chandise? 

b. Does cost value include transportation, handling, and storage costs? 

c. What do you mean by cost or market value whichever is lowerf 
Does this method apply to the total inventory or to each item in 
the inventory? 

7. How can you justify writing down the value of inventory of merchan- 
dise items to market values in a declining market and not justify 
writing them up to market values in a rising market? 

8. If inventory of merchandise is valued at cost or market whichever is 
lower, is the figure obtained for cost of goods sold the real cost figure? 
Is the gross profit on sales figure the real gross profit on sales amount? 
Explain. 

9. If the facts are known, is it possible to value inventory of merchandise 
at cost or market whichever is lower and yet have the cost of goods 
sold and the gross profit on sales figures correct? How? 



CHAPTER XV 

BAD DEBTS, DEPRECIATION, OBSOLESCENCE, 
DEPLETION 

In Chapter XI it was stated that the books of an enterprise 
should be adjusted at the end of a period because of the estimated 
bad debts and the depreciation of fixed assets. %The adjusting 
entries for these items debited the nominal accounts Bad Debts 
and Depreciation of Furniture and Fixtures, and credited the 
real accounts Reserve for Bad Debts and Reserve for Depreci- 
ation of Furniture and Fixtures. ^ 

The nominal accounts opened by these adjustments are closed 
in the process of closing the books. The real account titles are 
open after closing. These valuation reserve accounts opened 
at the end of a period are created to offset in part the asset 
accounts they represent. They exist in lieu of credits to the 
asset accounts and their balances should not be disturbed, 
therefore, as of the first day of the new period. Readjustment 
entries are not necessary since reserve accounts do not become 
income or expense items of subsequent periods. 

BAD DEBTS 

^ The accrual basis of accounting makes necessary the adjust- 
ment of the records to include all items that affect income and 
expenses whether or not cash has been received or paid. Busi- 
nessmen who sell on a credit basis learn that it is almost impossible 
to collect all of their receivables because certain claims on 
customers prove to be worthless in whole or in part. ^*~ 

Purposes of the Reserve for Bad Debts 

In Chapter II current assets were defined as cash and other 
assets that will be converted into cash through the normal 
operation of the business, usually in less than a year. The 
current asset section of the balance sheet will not be correct unless 

176 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 177 

the accounts and notes receivable are reduced by the anticipated 
amount of uncollectible items. 

The Reserve for Bad Debts account is a valuation account 
set up for the purpose of modifying the value shown in Accounts 
and Notes Receivable. It normally has a credit balance but 
it is not a liability. Since it is impossible to forecast the par- 
ticular receivable which will prove to be the source of a loss, 
the Reserve for Bad Debts account is credited in the adjusting 
entry. 

In Chapter XI the estimated bad debts was considered to be 
equal to 1 per cent of the $50,000.00 of net sales for the period. 
The adjusting entry was 

DECEMBER 31, 19 

Bad Debts 500.00 

Reserve for Bad Debts 500 . 00 

To adjust the books by the amount of esti- 
mated uncollectible claims, 1 per cent of net 
sales of $50,000.00. 

What constitutes a reasonable estimate for uncollectible 
claims varies between classes of businesses and with changes in 
the general condition of business prosperity. Establishments in 
the same line of business may not have the same relative losses 
from bad debts because credit investigations and collection 
policies differ. The length of the period for which credit is 
extended is another factor causing differences between businesses. 
Long credit periods are apt to result in greater bad debt losses 
than shorter credit periods. For example, installment houses 
may have greater losses from bad debts than enterprises which 
sell the same kind of goods on shorter term credit. 

Process of Estimating the Amount of Bad Debts 

The chief difficulty in providing for uncollectible claims is the 
determination of a reasonable estimate. 

Four methods of estimating are of sufficient importance to 
warrant consideration: 

1. Percentage of Net Sales. The percentage of net sales 
method estimates bad debts as a percentage of the net sales for 
the period. The percentage figure is obtained by comparing the 
actual bad debts of past periods with the net sales of the same 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 179 



Time 


Net Sales 


Net Credit 
Sales 


Accounts 
Receivable 
(Trade 
Debtors) 


Accounts 
Determined 
Worthless 


Bad Debts 
Recovered 


Five years ago 


$ 150,000.00 


$120,000.00 


$13,000 00 


$ 750.00 


-0- 


Four years ago 


170,000.00 


140,000 00 


12,000 00 


850 00 


$ 50 00 


Three years ago 


200,000.00 


160,000.00 


10,000.00 


850.00 


60 00 


Two years ago 


240,000 00 


190,000.00 


20,000 00 


950.00 


50 00 


Last year 


270,000 00 


210,000.00 


21,000 00 


900 00 


40 00 


Totals 


$1,030,000.00 


$820,000 00 


$82,000 00 


$4,300 00 


$200.00 



The history of the last five years shows that approximately 
four-tenths of 1 per cent of net sales, one-half of 1 per cent of 
net credit sales and 5 per cent of accounts receivable proved to be 
bad. The computation of these percentages follows : 



Bad Debts to Net Sales 


Bad Debts to Net Credit 
Sales 


Bad Debts to Accounts 
Receivable 


$4.300.00 - $200.00 


$4,300.00 - $200.00 


$4,300.00 - $200 00 


$1,030,000.00 - 00398 


$820,000.00 ~ * UU5 


$82,000.00 " ' C 



Unless the general condition of business prosperity in the 
current period differs materially from that of the previous five 
years, it is reasonable to expect that the past experience with 
respect to bad debts will continue. These percentages when 
applied to the current figures show the following results : 

Net Sales $250,000.00 X .004 = $1,000.00 

Net Credit Sales 200,000.00 X .005 = 1,000.00 

Accounts Receivable 20,000.00 X .05 = 1,000.00 

These calculations are approximately as they should be. 
As only a certain proportion of the uncollected customers' 
accounts go bad, the amount to be credited to the Reserve for 
Bad Debts should be approximately the same, regardless of the 
method used. 

The application of rates determined by practical experience 
has to be modified sometimes because of external or internal 
factors, or both. The particular level of general business con- 
ditions, a change in sales, credit or collection policies by the 
enterprise or a change in its personnel or internal organization 



1 80 ACCOUNTING FUNDAMENTALS [Ch. XV 

may be sufficient cause to justify the alteration of a rate based 
on past experience. For example, the percentage used at the 
end of a particular year may be less than the past history indi- 
cates to be necessary, if 

1. A period of prosperity is starting after a long period of 
depression. 

2. An efficient credit department is installed and the extension 
of credit is guarded carefully. 

3. A collection department is provided and is efficiently 
managed. 

Writing Off Bad Accounts 

After all ordinary means have been exhausted and further 
attempts to collect a balance due would entail an expense in 
excess of the amount involved, the receivable should be written 
off the books. There is no excuse for continuing such an account 
as an asset. 

If a set of books is kept on a cash basis no deduction may be 
made from income for bad debts since income is not recorded 
on the books until collected. For example, if a doctor does not 
place his fees on his books as income until they are collected, 
he cannot show any deduction from his income for the amount he 
estimates he will be unable to collect. 

In an enterprise where provision for future losses of existing 
accounts and notes receivable has not been made, the Reserve for 
Bad Debts account does not exist. In such a case if a particular 
loss is recognized the amount of the account or note is charged 
to Bad Debts. This method treats bad debts as a loss of the 
year in which it is determined that there is no probability of 
collection, regardless of the year of the sale. On the books of 
such an enterprise the Bad Debts account will show the amount 
of losses actually sustained during that period. 

If a Reserve for Bad Debts account is provided for doubtful 
claims on customers, it should be debited with all or any part 
of an uncollected account as soon as the attending circumstances 
indicate that it is worthless. The purpose of the reserve for bad 
debts is to charge the period in which the credit arose rather than 
the period in which the account proves to be uncollectible. 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 181 



Assume the following facts: 

1. On December 24 last year $600.00 worth of merchandise 
was sold to Frank Driscoll on credit. 

2. On December 31 the trial balance showed 

a. Sales (including DriscolPs) $50,000.00 

6. Accounts Receivable 8,000.00 

3. On October 12 of the current year a check for $240.00 was 
received for the Driscoll account. It represented a settle- 
ment on the basis of forty cents on the dollar. As Driscoll 
was insolvent this was all that could be collected. 

The entries for these facts, if there is no Reserve for Bad Debts 
account, and if there is such an account, are as follows : 



Date 



If No Reserve 



If Reserve Had Been Created Equal to 
1 Per Cent of Sales 



Dec. 31 
last year 



No Entry 



Oct. 12 
this year 



Cash 
Bad Debts 

Frank Driscoll 
Account settled on 
basis of $.40 on the 
$1.00. Driscoll in- 
solvent. 



240 00 
360 . 00 



600.00 



Bad Debts 500 00 

Reserve for Bad 

Debts 500,00 

To adjust books by 1 
per cent of Sales esti- 
mated to be uncollect- 
ible. 
Profit and Loss 500 . 00 

Bad Debts 500.00 

To close the Bad Debts 
account to Profit and 
LOBS. 

Cash 240.00 

Reserve for Bad Debts 360 . 00 

Frank Driscolt 600 00 

Account settled on 
basis of $.40 on the 
$1.00. Driscoli in- 
solvent. 



The following forms summarize the debits and credits to the 
accounts Bad Debts and Reserve for Bad Debts in an enterprise 
which uses the reserve account. 

Bad Debts 



Is debited in the adjusting entry 
with the amount of bad debts ex- 
pense of the current fiscal period. 



Is credited in the closing entry 
with an amount equal to the 
debit. 



182 



ACCOUNTING FUNDAMENTALS 
Reserve for Bad Debts 



[Ch. XV 



Is debited with all losses arising 
from bad debts. 



Is credited in the adjusting entry 
with the amount of bad debts ex- 
pense of the current fiscal period. 



In a fiscal period of twelve months the losses of accounts and 
notes tend to close the Reserve for Bad Debts account. If it has 
a debit balance at the end of a period, it represents an excess of 
actual over estimated losses; if a credit balance, it represents an 
excess of estimated over actual losses. 

Recovery of Former Bad Debts 

It sometimes happens that an account or note which was 
written off as bad proves to be collectible. In order to have 
the customer's account show a complete history of all the trans- 
actions with him, it is recommended that the collection of the 
debt be handled through his account. To illustrate, assume that 
Driscoll paid the balance of his account two years after it was 
charged off. The following entries are necessary whether a 
reserve account was or was not used at the time Driscoll's 
unpaid balance was considered lost : 

Frank Driscoll 360.00 

Bad Debts Recovered 360.00 

To charge Driscoll with amount previously 

charged off as bad. 

Cash 360.00 

Frank Driscoll 360 . 00 

To credit Frank Driscoll with check to cover 

balance charged off, October 12, 19 

At the end of the period the Bad Debts Recovered account 
may be treated as any other credit nominal account and closed 
as a gain of the period to the Profit and Loss account, and this 
treatment is recommended. It may be credited, however, 
directly to the capital account of the owner without going 
through the intermediate Profit and Loss account. This latter 
treatment arises out of the viewpoint that the item is a very 
special gain which increases net worth because of excessive 
charges to Bad Debts in prior periods. Under this plan, the 
Bad Debts Recovered account is not shown as a part of the net 
profit for the period. 



Ch. XVJ BAD DEBTS, DEPRECIATION, OBSOLESCENCE 183 

DEPRECIATION 

In preceding chapters it was demonstrated that expenditures 
for items consumed had to be considered expenses of the period 
or periods in which used. Supplies were charged to the period 
in which they were consumed. Insurance which expired in a 
period was considered an operating expense of the period. In 
the same way expenditures for most fixed assets must be appor- 
tioned over the periods which receive the benefits from those 
assets. The expenditure for delivery equipment, for example, 
is not a complete loss in the period when it is disposed of. A 
portion of its value is consumed and is an expense to each period 
of its useful life. The same is true of the cost of buildings, 
furniture and fixtures and other fixed assets. Because fixed 
assets are usually long lived the periodic decline in value should 
not be ignored. 

Definition 

Depreciation may be defined as a cost or expense arising out of 
the continuous lessening in the value of fixed assets caused 
chiefly by wear and tear, the effect of the elements, and gradual 
obsolescence. 

Several parts of this definition need special emphasis: 

1. Continuous Lessening. Depreciation begins as soon as the 
asset is ready for use and continues until it is disposed of. It 
will not depreciate so rapidly if kept in good repair but repairs 
will not arrest the continuous lessening of its worth. Sudden 
declines in value are not chargeable to depreciation. These 
would include losses by fire, storm, theft, floods, earthquakes, 
and other losses that come suddenly and unexpectedly. The 
gradual and continuous lessening in value is the very essence of 
depreciation. 

2. Value. Value means cost value and must not be confused 
with exchange or replacement values. If an asset has rendered 
service to the business equal to one-tenth of the possible service 
that it is capable of rendering, it has depreciated regardless of 
the fact that its exchange value may have increased. Fluctua- 
tions in the market value of fixed assets usually are ignored. 

3. Fixed Assets. Depreciation is limited to fixed assets. It 
does not apply to current assets, i.e., merchandise on hand is 
inventoried and valued as explained previously. 



184 ACCOUNTING FUNDAMENTALS [Ch. XV 

Not all fixed assets are subject to depreciation. For example, 
it does not apply to land used or held for building or storage 
purposes, nor to goodwill, as they are not affected by the chief 
causes of depreciation. Some fixed assets like dishes in a 
restaurant, electric insulators, and certain small tools are usually 
100 per cent useful until broken. The decline in the value of 
assets of this kind is measured ordinarily by subtracting an 
appraised inventory value at the end of the period from the 
balance of the ledger account. The difference represents the 
cost of the asset chargeable to the current period. 

4. Wear and Tear, Effect of the Elements, and Gradual Obsoles- 
cence. The most important causes of depreciation are wear and 
tear, effect of the elements, and gradual obsolescence although 
they are not the only ones. Wear and tear refers to the shrinkage 
in value caused by the use of an asset. The effect of the elements 
refers to the influence of climatic conditions. Climatic condi- 
tions cause certain assets to decay or corrode and therefore 
contribute to the lessening in their values. 

Gradual obsolescence refers to the lessened value of fixed assets 
due to successive improvements in the arts which make it 
unprofitable to use some assets until exhausted. For example, 
the experience of an enterprise may show that certain assets 
which have physical lives of thirty years are discarded in eighteen 
years because it is no longer profitable to use them. In the course 
of eighteen years so many improvements and changes are avail- 
able in asset models and productive methods that the assets 
owned are discarded twelve years before the end of their physical 
lives. (See section on Obsolescence.) 

Some intangible assets such as patents, copyrights, licenses, 
and leaseholds decline in value because of the passage of time. 
Their efficient lives are limited by law or contract. 

The Problem of Depreciation 

It is recognized generally that any tangible fixed asset, except 
land used or held for building or storage purposes, depreciates 
and that the amount of the periodic depreciation should be 
charged to operations. The amount to be charged and the 
method to be used present problems on which there is disagree- 
ment. To determine the periodic amount of depreciation on an 
asset, certain fundamental factors should be considered. 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 185 

Factors Influencing the Amount of Periodic Depreciation 

To determine the amount of depreciation which should be 
written off each fiscal period, three fundamental factors must be 
considered: 

1. Cost. Cost includes the purchase price or construction 
cost of the asset, transportation, cost of installation, repairs at 
the time of purchase to a property acquired in a partially worn- 
out condition, and in the case of property under construction, 
taxes, insurance, and interest. 

2. Estimated Useful Life. The estimated useful life of an 
asset is the number of fiscal periods it is expected to be used 
economically. The useful life does not start until the asset is 
in position ready for use and continues until it is traded in, 
scrapped, sold, exchanged, stolen, or wrecked. 

To forecast this useful life it is necessary to learn about the 
conditions under which the asset will be used, the effect of the 
climate on it, and the policy of the owner with respect to repairs 
and maintenance. It is difficult to forecast variations in use 
caused by sudden obsolescence, inadequacy, and periods of 
depression and prosperity. 

Inadequacy refers to the inability of an asset to satisfy the 
increasing requirements which arise out of changed market con- 
ditions. For instance, the demand for the product of a machine 
may increase to an extent that it is economically necessary to 
discard the machine and replace it with a model of greater capacity. 

In the case of improvements made to leased property the 
estimated useful life is the number of years remaining in the lease 
provided the useful life of the improvements exceeds that of the 
lease. 

Two assets which are exactly alike may not have the same 
useful life, particularly if used under different conditions. Metal 
is affected sooner if near salt water; delivery trucks wear out 
faster in hilly than in flat country; buildings used as stores do 
not depreciate so rapidly as those of similar construction which 
house machinery; assets not in use often deteriorate more rapidly 
than if used, because of the action of the elements; assets in use 
in a plant operating many hours each day have shorter lives than 
those in a plant which works fewer hours each day; and those 
operated by careless employees do not have so long a useful life 
as those run by careful operators. 



186 ACCOUNTING FUNDAMENTALS [Ch. XV 

3. Estimated Salvage Value. The estimated salvage value is 
the amount expected to be realized at the time the asset is junked 
or traded in. Salvage values are so low, usually, that this factor 
frequently is not considered. 

The difference between the cost and the estimated salvage 
value is the amount of depreciation to be recovered during the 
useful life of the asset. 

Computation of the Depreciation Charge 

The amount of depreciation is calculated usually on a time 
basis. There are other bases only one of which the per- 
formance basis will be illustrated. 

The following facts are used to determine the amount of 
depreciation under each method: 

1. Cost of machine on January 1, 19 , $10,000.00. 

2. Estimated useful life, ten years. 

3. Estimated salvage value, $500.00. 

4. Estimated units of output, 100,000. 

5. Units of output first twelve months, 12,000. 

Straight-line Method 

The straight-line method charges depreciation to operations in 
equal periodic amounts over the estimated useful life of the 
property without regard to its performance. It is the method 
in most common use because it does not involve extensive 
mathematical computations and it effectively accomplishes its 
purpose. Time is an important element in the straight-line 
method. There are other methods in which time is an essential 
factor but relatively their use is so infrequent that they will not 
be explained. 

Over a period of ten years, the depreciation charged off on 
the machine in the illustration should equal $10,000.00 minus 
$500.00 or $9,500.00. If the books are adjusted annually then 
$950.00 or 9)^ per cent of cost will depreciate this asset during 
its estimated useful life. 

The following formulae indicate the method in summary form : 

r> . ,. T. . .. Cost Salvage 

Periodic Depredation = Estimated Useful Life 

~ . j. ^ A Periodic Depreciation 

Periodic Rate = ??- 

Cost 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 187 



The following table shows how the straight-line method affects 
the operating costs and the asset values: 



Period 


Periodic 
Depreciation 


Accumulated 
Reserve 


Book Value 


1 


$ 950.00 


$ 950.00 


$9,050.00 


2 


950.00 


1,900.00 


8,100.00 


3 


950.00 


2,850.00 


7,150.00 


4 


950.00 


3,800.00 


6,200.00 


5 


950.00 


4,750.00 


5,250.00 


6 


950.00 


5,700.00 


4,300.00 


7 


950.00 


6,650.00 


3,350.00 


8 


950.00 


7,600.00 


2,400.00 


9 


950.00 


8,550.00 


1,450.00 


10 


950.00 


9,500.00 


500.00 




$9,500.00 







As indicated in the table the periodic charge to Depreciation 
is $950.00. The Reserve for Depreciation account increases by 
the same amount each period. At the end of the estimated life 
of the asset the difference between the cost of the asset as shown 
in the asset account and the allowance for depreciation as shown 
in the Reserve for Depreciation account is the estimated salvage 
value of the asset. 

The book value of an asset is the value at which it is shown on 
the books. In the illustration above it is the excess of the amount 
shown in the asset account over its related valuation reserve 
account. 

The straight-line method is also called the fixed percentage of 
cost method as it is a plan under which a constant percentage of 
the cost of an asset is written off each period. 

Unit of Performance Method 

The unit of performance method writes off the cost of an asset 
in periodic amounts which vary according to performance. The 
time element is not considered. Depreciation is charged to 
periods in proportion to the use which has been made of the asset. 

In the case of a machine each unit which is produced by the 
asset is charged with its proportionate share of the estimated 
depreciation of the asset. If, in the illustration, the machine 
is capable of producing 100,000 units then each unit is charged 



188 



ACCOUNTING FUNDAMENTALS 



fCLXV 



with .095. In the first year if the machine has an output of 
12,000 units the depreciation charge is $1,140.00; in the second 
year if the output is 15,000 units, the depreciation charge is 
$1,425.00. 

Under this method 

r> - ,. T^ ... Cost - Salvage Value TT 

Periodic Depreciation = ^ n =5 ? TT .. X Units 

^ Possible Performance Units 

of Performance per Period 
Periodic Treatment on the Books 

At the end of a fiscal period the values of the depreciable assets 
on the books should be adjusted for depreciation by one of the 
following two methods: 

1, Write Down the Assets. To write down an asset the adjust- 
ing entry debits a depreciation or other expense account and 
credits the asset account, thus: Assume tools owned at a cost 
of $2,000.00. At the end of the first yearly period the inventory 
of tools is appraised at $1,600.00. Some of the original tools 
have been broken, stolen, or discarded; others are badly worn. 
These facts would be shown in the accounts as follows: 

Tools 



19 

Jan. 



(Total owned) 



! 2,000,00 



DECEMBER 31, 19 

Depreciation of Tools) 

or > 400.00 

Tool Expense J 

Tools 400 00 

To adjust the books for the amount of depre- 
ciation of tools. 

DECEMBER 31, 19 

Profit and Loss 400 . 00 

Depreciation of Tools) 

or > 400.00 

Tool Expense ) 

Depreciation of Tools 



Dec. 


31 


(Adjusting 
entry) 


J 


400 


00 


Dec. 


31 


(Closing 
entry) 


J 


400 


00 











Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 189 

The Tools account appears as follows: 

Tools 



Jan. 


1 


(Total owned) 




2,000 


00 


Dec. 


31 


(Adjusting 
entry) 


J 


400 


00 



The account Tools shows a debit balance of $1,600.00 which 
is the estimated value of the tools owned at the end of the period 
and the figure which appears in the balance sheet. 

The method of writing down the value of the asset directly 
may be followed for all depreciable assets but its use is limited 
usually to depreciable assets with comparatively short lives 
such as patterns and small tools. 

2. Create Specific Reserve Accounts. The method of creating 
specific reserve accounts provides a special reserve account for 
each class of fixed assets subject to depreciation. In the case 
of long-lived assets, it is desirable to show the investment in 
each class of assets in separate asset accounts and the accumu- 
lated shrinkage in their values caused by depreciation in sepa- 
rate reserve accounts appropriately titled. In this way a more 
complete history of the assets is available readily. 

The entry necessary to adjust the books at the end of each 
fiscal period debits the proper depreciation account and credits 
a specific reserve account for each class of fixed assets. 

The accounts for the figures shown in the table on page 187 
appear as follows : 



190 



ACCOUNTING FUNDAMENTALS 
Machinery 



[Ch. XV 



I19_ 
Jan. 


1 


(Original Cost) 




10,00000 












Depreciation of Machinery 






De7 


31 


(Adjusting entry 1st yr.) 


J 


950 


00 


Dec. 


31 


(Closing entry 1st yr.) 




J 


950 


00 


Dec. 


31 


( " " 2dyr.) 


J 


950 


00 


Dec. 


31 


( " " 2dyr.) 




J 


950 


00 


Dec. 


31 


( " " 3dyr.) 


J 


950 


00 


Dec. 


31 


( " " 3dyr.) 




J 


950 


00 


Dec. 


31 


( " " 4th yr.) 


J 


950 


00 


Dec. 


31 


( " H 4th yr.) 




J 


950 


00 


Dec. 


31 


( " " 5th yr.) 


j 


950 


00 


Dec. 


31 


( " " 5th yr.) 




J 


950 


00 


Dec. 


31 


( " " 6th yr.) 


j 


950 


00 


Dec. 


31 


( " " 6th yr.) 




J 


950 


00 


Dec. 


31 


( " " 7th yr.) 


J 


950 


00 


Dec. 


31 


( " " 7th yr.) 




J 


950 


00 


Dec. 


31 


( " " 8th yr.) 


j 




00 


Dec. 


31 


( " " 8th yr.) 




J 


950 


00 


Dec. 


31 


( " " 9th yr.) 


j 


950 


00 


Dec. 


31 


( " " 9th yr.) 




J 


950 


00 


Dec^ 


31 


( " " 10th yr.) 


j 


950 


00 


Dec. 


31 


( " " 10th yr.) 




J 


950 


00 






Reserve fc 


>r 


Depr 


ec 


iatio 


n o 


f Machinery 






















Dec. 


31 


(Adjusting entry 1st yr.) 




J 


9,50 


00 














Dec. 


31 


( " " 2dyr.) 




J 


950 


00 














Doc. 


31 


( " " 3dyr.) 




J 


950 


00 














Dec. 


31 


( " " 4th yr) 




J 


950 


00 














Dec. 


31 


( " " 5th yr.) 




J 


950 


00 














Dec. 


31 


( " " 6th yr.) 




J 


950 


00 














Dec. 


31 


( " " 7th yr.) 




J 


950 


00 














Dec. 


31 


( " " 8th yr.) 




J 


950 


00 














Dec. 


31 


( " " 9th yr.) 




J 


950 


00 














Dec. 


31 


( " " 10th yr.) 




J 


950 


00 



The Depreciation of Machinery account is closed each year. 
At the end of the estimated .useful life of the machine, the differ- 
ence between the asset account and its reserve account is the 
estimated scrap value of the machine, $500.00. 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 191 

Reserve for Depreciation Account 

A depreciation reserve account is a valuation account which 
shows the amount by which an asset has been revalued because 
of depreciation. It has a credit balance and exists in lieu of 
credits to its related asset. It does not represent a fund which 
will provide the cash with which to acquire another asset at the 
time the existing one is replaced. A fund account is an asset 
account; it represents cash, securities, or other assets set aside 
for a specific purpose. (See Chapter XXVI.) 

Disposal of a Fixed Asset 

A depreciable fixed asset although kept in ordinary repair 
must be discarded eventually. Regardless of the cause of the 
disposal, certain adjustments should be made in the records: 

1. Depreciation should be provided for the current period to 
the date of disposal. 

2. The asset account should be relieved of the cost value of the 
discarded asset. 

3. The reserve account should be relieved of that part of its 
balance which applies to the discarded asset. 

4. If the asset is sold, traded, or discarded because no longer 
serviceable and the amount realized differs from the book 
value, the difference should be recorded in an account 
which may be titled Profit through Disposal of Fixed 
Assets, or Loss through Disposal 'of Fixed Assets. 

5. If the asset is abandoned because of an accident the unin- 
sured loss, if any, should be transferred to an account 
descriptive of the loss, such as Fire Loss, or Loss from 
Collision. 

For purposes of illustration the example stated under Com- 
putation of the Depreciation Charge on page 186 is continued 
and appropriate journal entries are given: 

1. After ten years of serviceable life the machine is sold for 
cash on January 1, 19 for its book value, $500.00. 

JANUARY 1, 19 

Cash 500.00 

Reserve for Depreciation of Machinery 9,500.00 

Machinery 10,000.00 

To record the sale at its book value of 
machinery purchased, January 1, 19 . 



192 ACCOUNTING FUNDAMENTALS [Ch. XV 

2. Suppose the machine is sold for $2,500.00 cash after eight 
years of serviceable life. 

JANUARY 1, 19 

Cash 2,500.00 

Reserve for Depreciation of Machinery 7,600.00 

Machinery 10 , 000 . 00 

Profit through Disposal of Fixed 

Assets 100.00 

To record the sale for $100.00 more than 
its book value, of machinery purchased, 
January 1, 19 

3. Suppose the machine is sold for $2,000.00 cash at the end 
of eight years of serviceable life. 

JANUARY 1, 19 

Cash 2,000.00 

Reserve for Depreciation of Machinery 7,600.00 
Loss through Disposal of Fixed Assets 400.00 

Machinery 10,000.00 

To record the sale for $400.00 less than 
its book value, of machinery purchased, 
January 1, 19_j-. 

4. Suppose the machine is traded in at the end of eight years 
of serviceable life for another machine priced at $14,000.00. 
The allowance on the old machine is $2,500.00; the balance 
is paid in cash. 

JANUARY 1, 19 

Machinery 14 ,000 . 00 

Accounts Payable 14,000.00 

To record the purchase of the new 
machine. 

Accounts Payable 2,500.00 

Reserve for Depreciation of Machinery 7,600.00 

Machinery 10,000.00 

Profit through Disposal of Fixed 

Assets 100.00 

To record the transfer of the old 
machine in part payment of the new 
machine. 
Accounts Payable . 11, 500 . 00 

Cash 11,500.00 

To record the check given in full of 
account. 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 193 

A profit or a loss account which arises out of the disposal of a 
fixed asset may be treated as any other nominal account and 
closed to the Profit and Loss account. This treatment is recom- 
mended. It may be closed, however, directly to the account of 
the owner on the theory that this special profit or loss arises from 
excessive or insufficient depreciation charges in prior periods. In 
either case, it must be considered for income-tax purposes. 

The Effect of Capital Expenditures on Fixed Assets 

The cost of fixed assets is increased by subsequent capital 
expenditures, which may necessitate a change in the estimated 
scrap value or a change in the estimated life of the asset. When 
the cost, the estimated scrap value, or the estimated life of an 
asset is changed, the periodic depreciation charge must be 
changed. 

The following procedure may be used to determine the new 
figure for depreciation : 

1. Compute the book value of the asset to the effective date of 
the change. 

2. Add any capital expenditure. 

3. Deduct the newly estimated scrap value. 

4. Divide by the newly estimated life. 

Assume that: 

January 1, 19A, a building was purchased for $35,000.00. 
January 1, 19F, an addition that cost $4,000.00 was made to 

the building, but it did not change the estimated useful life 

of 25 years nor the estimated scrap value of $1,000.00. 
The annual depreciation from January 1, 19 A to December 31, 

19E was 31,300.00. 

January 1, 19A cost $35,000.00 

Depreciation from January 1, 19A to December 

31, 19E 6,800.00 

Book value December 31, 19E $28,200.00 

January 1, 19F capital expenditure 4,000 .00 

Book value January 1, 19F $32,200.00 

Estimated scrap value as redetermined January 1, 

19F 1,000.00 

Depreciation to be recovered after January 1, 

19F $31,200.00 

Annual depreciation on an estimated life of 20 

years $ 1 ,560.00 



194 ACCOUNTING FUNDAMENTALS [Ch. XV 

OBSOLESCENCE 

Some assets are discarded before they are worn out because of 
changed conditions, the most important cause of which is 
obsolescence. 

Definition 

Obsolescence may be defined as the gradual or the sudden 
reduction in the value of a fixed asset prior to the end of its 
normal useful physical life caused by improvements in the arts, 
changed economic conditions, or legislation. 

Provision for Gradual Obsolescence 

The gradual reduction in the value of a fixed asset caused 
by obsolescence should be included in the depreciation charge, 
if experience makes it possible to forecast this factor with a 
reasonable degree of certainty. 

Provision for Sudden Obsolescence 

In the case of a machine, sudden obsolescence may result from 
the development of a new machine which makes the continued use 
of the old machine economically unprofitable. Sudden obsoles- 
cence results not only from inventions and other improvements in 
the arts, but from changed economic conditions and legislation. 
A change in public demand may stop the orders for the merchan- 
dise produced by certain equipment. An example of legislative 
obsolescence was the effect of prohibition laws on the value of 
brewery equipment. Sudden obsolescence ends the useful life 
of an asset and causes its value to decline completely or to a 
scrap value. 

Provision may be made for a future possible loss from sudden 
obsolescence but, if it is, such provision is not considered to be 
one of the operating expenses of a business unless the loss is 
rather definitely predictable. An amount is not included in 
the periodic depreciation charge for sudden obsolescence. If 
provision is made, it is accomplished by keeping in the business 
a share of the periodic profits with an appropriate record of the 
particular purpose for which such provision is made. Further 
consideration is given the subject of contingency losses in Chap- 
ters XXV and XXVI. 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 195 

If an asset is discarded because it is obsolete, the difference 
between the realized value, if any, and the book value of the 
asset is charged to an account which may be titled Loss through 
Obsolescence or Loss through Disposal of Fixed Assets. The 
Loss through Obsolescence or Loss through Disposal of Fixed 
Assets account is closed to the Profit and Loss account, or directly 
to the account of the owner as a very special loss which has no 
relation to the regular profit and loss items, preferably to Profit 
and Loss. 

DEPLETION 

The provision for depreciation is an attempt to safeguard the 
capital of an enterprise. If depreciation is ignored the costs of 
operation are understated and net profits and net worth are 
overstated. If profits are withdrawn in a case where deprecia- 
tion is inadequately provided for, such withdrawals may include 
some capital. 

A further attempt to safeguard the capital of an enterprise is 
necessary if the fixed assets include any natural resources which 
are being exhausted as the result of operations. 

Depletion Defined 

Depletion is the lessening in the value of a natural resource 
caused by the extraction or use of its product. 

Fixed assets subject to depletion are known as wasting assets. 
Examples are lands which contain natural deposits of metals, 
coal, oil, gas, clay, asbestos, cement rock, salt, sand, and slate. 
In each case the removal of a part of the asset results in a reduc- 
tion in its value. This lessening in the value of the wasting 
asset should be charged to the cost of production. 

The discussion in the following paragraphs is limited to 
minerals. 

Factors Influencing the Amount of Periodic Depletion 

To determine the amount of the periodic depletion charge, 
four factors must be considered : 

1. Cost. If the property is acquired by purchase the amount 
to be absorbed through depletion charges is the price paid for 
the entire property less the value of any machinery, equipment, 
or surface rights acquired. 



196 ACCOUNTING FUNDAMENTALS [Ch. XV 

2. Residual Value. The surface of many natural-resource 
properties may be used for other than extractive purposes even 
after all of the recoverable units are removed. If the property 
has a residual value it should be subtracted from the cost to 
determine the total amount of depletion to be recovered. 

3. Estimated Units Recoverable. Not all of a wasting asset 
may be removed economically. Certain coal deposits are not 
large enough to make it worth while to continue to mine them. 
By estimated units recoverable is meant the number of units of 
the product which it is expected may be removed profitably. 
The units may be expressed as tons, pounds, barrels, cubic feet, 
or other measure. 

4. Units Recovered. The total number of units recovered 
refers to those extracted in any given length of time. 

Computation of the Depletion Charge 

The amount to be charged in any one period because of deple- 
tion is found by determining first the proportionate amount of the 
investment which should be recovered for each unit and multiply- 
ing this figure by the number of units removed in the period. 

The following formulae indicate the procedure : 

TT . _ . . _,. Cost Residual Value 

Unit Depletion Charge = Estimated Units Recoverable 

Periodic Depletion Charge = Unit Depletion Charge X Units 

Recovered in the Period 

Assume the f ollowing facts : 

1. Cost of ore land, $1,000,000.00. 

2. 250,000 tons estimated to be recoverable. 

3. 30,000 tons removed in the first year. 

4. No additional capital expenditures. 

5. No estimated residual value. 

$1 000 000 00 

'050*000 == $4-00, the depletion charge on each ton removed. 

$4.00 X 30,000 = $120,000.00, the depletion charge for the 
twelve months' period, 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 197 

Treatment on the Books 

Each fiscal period an adjusting entry is made which charges 
Depletion with the amount applicable to the period and credits 
either the property account or a Reserve for Depletion account. 
The latter is preferred for the same reasons given for the use of 
depreciation reserve accounts. 

If the Reserve for Depletion account is used and the origi- 
nal estimates have been correct, by the time the property is 
exhausted the aggregate of the periodic credits to the reserve 
account should equal cost minus residual value. The Reserve 
for Depletion is another valuation reserve account. It should 
be shown on a balance sheet as a subtraction from the property 
account. 

QUESTIONS 

1. What kind of account is Reserve for Bad Debts? What is its 
purpose? What kind of balance does it have normally? What 
items are charged to it? 

2. Name some factors which would cause the relative losses from bad 
debts to vary between different enterprises. 

3. The amount of estimated bad debts may be determined as a per- 
centage of net sales or a percentage of net credit sales. As between 
these two plans, which would you favor and why? 

4. Can you give any plans other than those mentioned in question 3 
for determining the amount of estimated bad debts? 

6. If the books are adjusted monthly, which plans for estimating bad 
debts are the most satisfactory and why? 

6. Should the amounts of estimated bad debts, under the various 
plans referred to above, approximate each other? Why? 

7. When should a particular account receivable be written off against 
the Reserve for Bad Debts account? 

8. In what period is a bad debt considered an expense, if a Reserve for 
Bad Debts account is provided? If a Reserve for Bad Debts 
account is not provided? 

9. If an attorney at law does not count his fees as income until they are 
collected in cash, can he claim any expense for bad debts? Explain. 

10. Suppose the account of John Smith, a customer with a debit balance 
of $100.00 carried over from last year, is written off to the Reserve 
for Bad Debts account. 

a. What effect would that write-off have on the net profit or loss 
of the current year? Explain. 



198 ACCOUNTING FUNDAMENTALS [Ch. XV 

6. Suppose that two years later John Smith pays the debt. What 
entry or entries should be made? 

11. a. What is depreciation? 

b. What are the causes of depreciation? 

, c. Give some illustrations of depreciation caused by wear and tear. 

d. Give some illustrations of depreciation caused by the elements. 

e. Give some illustrations of depreciation caused by gradual 
obsolescence. 

/. May depreciation be prevented by adequate repairs? 

12. a. Why is depreciation limited to fixed assets? 

6. Can you give an illustration of a fixed asset which does not 
depreciate? 

c. Can you name some assets which decline in value because of the 
mere passage of time? 

13. a. Name the three factors which must be considered in determining 

the periodic amount of depreciation for an asset. 
6. What do you mean by the cost of an asset? Would cost include 
freight, customs duty if imported, and installation expenses? 

c. In determining the estimated useful life of an asset, what factors 
must be considered? 

d. What is meant by estimated salvage value? 

14. Would it be fair to state that all identical automobile trucks in the 
United States were depreciating at the same rate? Explain. 

15. a. Explain the plan of depreciating an automobile truck on the 

straight-line method. 

b. Explain the method of depreciating an automobile truck on a 
performance basis. 

16. "A factory which is closed down for a year suffers no depreciation. " 
Do you agree with that statement? Explain. 

17. a. Would there be any error of principle involved in a depreciation 

entry which debited depreciation of the asset and credited tho 
asset? 

6. Is the method of a sometimes used for certain assets? For 
example? 

c. Is the method suggested by a the customary plan for recording- 
depreciation? What is the customary entry? 

18. a. What is a reserve for depreciation account? 
6. What kind of balance does it have? 

c. Is it a liability? An income? 

d. How and where is it shown on a balance sheet? 

e. When is it debited? 

19. Suppose an asset appeared on the books with a debit balance of 
$1,000.00, its particular reserve for depreciation account with a 
credit balance of $800.00. 



Ch. XV] BAD DEBTS, DEPRECIATION, OBSOLESCENCE 199 

a. What was the cost of the asset? 
6. What is the book value of the asset? 

c. What entry should be made, if the asset is discarded as of no 
value? 

d. What entry should be made, if the asset were sold for $125.00 
cash? 

e. What entry should be made, if the asset were sold for $250.00 
cash? 

20. If any of the following assets decline in value, should the decline be 
charged to depreciation? Explain in each case. 

a. Land used for storage space by a business. 
6. Secondhand automobiles held by a dealer. 

c. Stocks owned and listed on the New York Stock Exchange. 

d. Salable goods on the shelves of a merchant's store. 

e. Delivery equipment used by a business. 

21. Does the creation of a reserve for depreciation account reduce the 
amount of cash available for the current needs of the business? 
Explain. 

22. The owner of a business failed to depreciate his assets because he 
felt the value of his business land was increasing fast enough to 
offset depreciation on his other assets. Discuss the merits of this 
contention. 

23. Is there any difference between a reserve account and a fund? 
Explain. 

24. Discuss the proposition, whether the account Loss through Dis- 
posal of Fixed Assets should be closed to Profit and Loss or to the 
account of the owner of the enterprise. 

25. What kind of obsolescence may be treated as one of the causes of 
depreciation? What kind may not? Give examples of both kinds. 

26. What is the effect on the net profit for a period and the net worth 
of an enterprise: 

a. If depreciation is overlooked? 

6. If excess depreciation is provided? 

c. If depreciation is undercalculated? 

27. a. What is depletion? 

6. Fixed assets subject to depletion are known as what kind of 
assets? 

c. What are the factors which influence the periodic amount of 
depletion? 

d. Give the debit and the credit accounts of a periodic adjustment 
for depletion. 



CHAPTER XVI 
BUSINESS PAPERS AND PRACTICES 

Practically all business transactions are represented by business 
papers. These papers are evidences of the transactions and 
facilitate their recording. It is desirable, therefore, that con- 
sideration be given to those papers in most general use. 

PROMISSORY NOTES 
Definition 

As defined by the Uniform Negotiable Instrument Act, "A 
negotiable promissory note, within the meaning of this act, is an 
unconditional promise, in writing, made by one person to another, 
signed by the maker, engaging to pay on demand or at a fixed 
or determinable future time, a sum certain in money, to order or 
bearer." 

Negotiable means that legal title to the instrument can be 
transferred from one party to another by delivery in the case 
of an instrument payable to bearer, and by indorsement and 
delivery in the case of an instrument payable to order. Negoti- 
ability is indicated by such words as to the order of or to bearer. 

Unconditional promise signifies that the promissory note con- 
tains an unqualified promise to pay. 

In writing indicates that the promise is not an oral one and 
includes printing, typing, and handwriting. 

A person includes a body of persons or a corporation. 

Sum certain means that the amount to be paid must be definite. 

The face value of a promissory note is the amount specified 
in the instrument. Maturity value is the amount payable when 
the note is due; it agrees with the face value if the note is non- 
interest bearing; it exceeds the face value if the note bears 
interest. A note does not bear interest unless so stated. 

All notes must be dated and, if not payable on demand, the 
maturity date must be fixed or determinable. If the note is 
payable on demand, it must be paid upon presentation to the 

maker; if fixed, the due date is specified as April 6, 19 ; if 

200 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 201 

determinable it is payable a given number of days, months, or 
years after the date of the note. 

The place of payment should be stated if it is other than the 
place of business of the person engaging to pay. 

Purpose and Use of Notes 

The main purpose of a promissory note is to act as an evidence 
of indebtedness. As an evidence of indebtedness a negotiable 
note is particularly serviceable because 

1. It specifies a definite sum of money. 

2. It is payable on demand or at a specified or determinable 
date. 

3. It is easily transferred. 

4. It is accepted in court as prima-facie evidence of the 
correctness of the original claim. 

Notes are in very general use in business but they are particu- 
larly serviceable to banks when extending loans to borrowers, 
and to creditors in making definite the amount and date of pay- 
ment of customer obligations. 

Illustrations of Notes 



$470.27 Philadelphia, Pa., July 17, 19 

Thirty days after date I promise to pay to 
the order of Arnold C. Blake 

Four hundred seventy and 27/100 Dollars 

Payable at The Second Street National Dank 

Value received. 

No. 14 Due August 16, 19 Harry B. Davis 



Noninterest-bearing promissory noto. 



$290.80 Philadelphia, Pa., July 17, 19_ 

Thirty days after date I promise to pay to 
the order of Harrison B. Adams 

Two hundred ninety and 80/100 Dollars 

Payable at The Second Street National Bank 



Value received, with interest at 6%, per annum. 

No. 15 Duo. August 16, 19 George P. Roth 



Interest-bearing promissory note. 



202 ACCOUNTING FUNDAMENTALS [Ch. XVI 

Parties to a Note 

There are two original parties to a note 

1. The maker who promises to pay. 

2. The payee to whose order the note is made payable. 

If a payee indorses a note and transfers it, he is known also 
as an indorser. The person to whom title to the note is trans- 
ferred is known as the indorsee. The indorsee may become, in 
turn, an indorser. 

Indorsements 

A promissory note or other negotiable instrument may be 
indorsed on the back in one of a number of forms to meet the 
needs of the situation. 

1. Unqualified indorsements 

a. If indorsed in blank the indorser merely signs his name 
on the back of the instrument, thereby making it payable 
to any holder without further indorsements. 

b. If indorsed in full or special the indorser writes on 

the back of the instrument "Pay to the order of 

(a named party) " and signs his name. Such an indorse- 
ment requires an indorsement by the indorsee for further 
transfer of the instrument. 

2. Restricted indorsement 

If to a blank or full indorsement are added restrictive words 
such as, "For Collection Only" or "For Deposit Only," 
the instrument can be used solely for such restricted pur- 
pose. In such a case the party to whom the instrument is 
transferred (usually a bank) is merely the agent of the 
indorser. 

3. Qualified indorsement 

If to a blank or full indorsement are added the words 
"Without Recourse," the indorser indicates that he trans- 
fers title to the instrument but is not to be held liable for 
it if the maker does not pay at maturity. 

4. Accommodation indorsement 

An accommodation indorsement is usually a blank indorse- 
ment by an indorser who is accommodating the maker 
of the instrument without any consideration being given. 
An accommodation indorsement is a means whereby the 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 203 

accommodation indorser lends credit to the maker in a 
case where the payee desires the written promise of the 
maker supplemented by another name. 

Note Accounts 

A promissory note to the maker is an instrument to be paid; 
hence it is recorded in the account Notes Payable. To the 
holder of a note (the payee or indorsee) it is an instrument the 
value of which is to be received and is recorded in the account 
Notes Receivable. 

If the holder of a note indorses it to a creditor, without quali- 
fication, or discounts it at the bank, he is liable to subsequent 
holders for the amount of the note, if it is not paid by the maker 
at maturity. Between the date of indorsement and the maturity 
date of the note such a liability is known as a contingent liability. 
In order that the contingent liability of an indorser may be shown 
on his books, the credit entry at the time a note is indorsed is 
not made to Notes Receivable but to the account Notes Receiv- 
able Discounted. In determining the status of notes receivable 
for an enterprise, at a particular time, both Notes Receivable and 
Notes Receivable Discounted accounts are considered. In 
presenting the facts of these two accounts on a balance sheet the 
amount of the Notes Receivable Discounted account is shown 
as a subtraction from the amount of Notes Receivable and the 
difference is extended among the current asset amounts. 

The fundamental character of a particular note never changes 
to the business which issues or receive it. If a note is a notes 
payable to an enterprise it never becomes a notes receivable to 
that enterprise; a note which is a notes receivable to an enter- 
prise never becomes a notes payable to that enterprise although 
it may become by indorsement and transfer a notes receivable 
discounted. Since the Notes Payable account is credited when 
a note is issued and is debited when a note is paid, it follows that 
the Notes Payable account cannot have a debit balance; if it 
has any balance it must be a credit. Since the Notes Receivable 
account is debited when a note is received and is credited when 
a note is paid, and Notes Receivable Discounted is credited 
when a note receivable is transferred, it follows that the Notes 
Receivable account cannot have a credit balance; if it has any 
balance it must be a debit one. In view of the fact the Notes 



204 ACCOUNTING FUNDAMENTALS [Ch. XVI 

Receivable Discounted account is credited to show the contingent 
liability on a note receivable indorsed and is debited when the 
contingent liability is ended, it follows that if this account has a 
balance it must be a credit one. It also follows that if the Notes 
Receivable Discounted account has a balance, the Notes Receiv- 
able account must have a balance of at least the same amount. 

* 

Renewing Notes 

If the payee of a note permits the maker to renew it, a new 
note is made out. In such a case the payee in order to show the 
complete history of the transactions should charge the old note 
to the account of the maker and credit the maker with the new 
note. The maker should record the transaction by crediting 
the old note to the account of the payee and charging the payee 
with the new note. 

Dishonored and Protested Notes 

When a note or other negotiable instrument is not paid at 
maturity after being properly presented to the maker, it is said 
to be dishonored. 

If payment for a negotiable instrument is not obtained at 
maturity, the holder should serve notice of dishonor on any 
indorsers in order to avoid the discharge of liability by them. 
This notice usually is in the form of a Certificate of Protest 
issued by a notary public or other officer authorized by law to 
administer oaths. 

Since note transactions so frequently involve interest or dis- 
count, the illustrative entries for note transactions are deferred 
until interest and discount are considered. 

INTEREST AND DISCOUNT 

If an enterprise borrows or lends capital, whether the loan is 
evidenced by notes, bonds, mortgages, or other forms of indebted- 
ness, interest or discount is likely to be a factor. 

Definition of Terms 

Interest is a charge made for the use of capital. From the 
standpoint of the lender, interest is a source of income; to the 
borrower it is an expense. 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 205 

Discount is a reduction from a principal sum made usually in 
consideration of the payment of an obligation prior to maturity 
or as the interest charge on a loan which is due at a future date. 
It differs from interest in that it is deducted from the principal 
sum rather than added to it. 

Ordinarily, interest is ,paid by the borrower after the use of 
the capital, while discount is paid before the use of the capital. 

Classes of Interest 

The more common classes of interest are interest on long-term 
indebtedness, such as interest on bonds or mortgages payable, 
interest on short-time loans, interest on securities owned; and 
interest income arising out of the usual business transactions, 
such as account, note, and bank-deposit transactions. Interest 
on long-term and short-term indebtedness should be kept 
separate as should interest earned on investment securities and 
interest earned from all other sources. 

Account titles used for interest on long-term indebtedness are 
Interest on Bonds and Interest on Mortgages. Interest on 
short-term debt is recorded in Interest Expense account. Inter- 
est on securities owned is recorded usually in the account Interest 
on Investments, while all other interest earnings are recorded 
in the account Interest Income. 

Classes of Discount 

The more common classes of discount are cash, trade, commer- 
cial or bank, stock, and bond. 

1. Cash discount is the allowance which is deductible by the 
buyer from the contract price of merchandise if full payment 
is made within a specified period. A cash discount is 
offered customers to encourage prompt payment of bills. 
The account titles used to record cash discounts are 

a. Sales Discounts on the books of the vendor. 

b. Purchase Discounts on the books of the vendee. 

2. Trade discount is the allowance which is deductible by a 
customer from the published list price of merchandise to 
determine the contract price. Trade discount is used 

a. To care for fluctuations in the selling price of mer- 
chandise without reprinting the catalogue. 



206 ACCOUNTING FUNDAMENTALS [Ch. XVI 

6. To conceal from competitors the actual selling price. 
c. To quote different prices to quantity buyers and buyers 

of smaller amounts of merchandise. 

In businesses where trade discounts are used the prices 
listed in catalogues purposely are made higher than the 
real selling prices are expected to be. By means of dis- 
count sheets the trade is kept informed of the trade dis- 
counts currently offered. The actual selling price at any 
time is the list price less the quoted trade discounts. 
A trade discount is stated usually as a series of discounts 
such as 10 per cent, 10 per cent, and 5 per cent. When a 
series of discounts is stated the first rate applies to the list 
price and each succeeding rate applies to the diminishing 
base. For example: 



List price $1 ,000 00 

Less 10 per cent 100.00 



Less 10 per cent. . . 


$ 900.00 
90 00 






Less 5 per cent . . 


$ 810 00 
40 50 






Selling price. . 


$ 769 50 







As customers are billed at actual selling prices (list prices 
less quoted trade discounts) it is riot necessary to record 
trade discounts on the books of either the buyer or seller. 

3. Commercial or bank discount is intqrest paid in advance. 
It arises out of the practice of discounting notes, under 
which practice a bank in making a loan to a borrower 
on a note may calculate the interest on the loan, deduct the 
amount as discount from the face amount of the note, and 
give the borrower the proceeds. The ledger accounts used 
to record commercial discounts are 

a. Interest Expense on the books of the borrower. 
fe. Interest Income on the books of a business which earns 
such discounts. 

4. Discount on stock and discount on bonds are allowances 
made to buyers when securities of an enterprise are sold 
at less than the par value. They will be explained more 
fully in later chapters. 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 



207 



The Time Factor in Interest and Discount 

Interest and discount are expressed at an annual rate, but 
allowance is made for the length of time the capital is used. 

Time Stated in Months. If the term of a note is stated in 
months, as one month or three months after date, the 
maturity date falls on the same day of some future month. 
If a note is dated the 31st, it will fall due the last day of the month 
in which it matures. 

The following four illustrations show the variations in the 
actual life of notes dated the last day of the month: 



Date of Note 
January 31 
February 28 
June 30 
November 30 



Term 
of Note 
3 months 
3 months 
3 months 
3 months 



Maturity Date 
April 30 
May 28 
September 30 
February 28 (Leap year, February 29) 



Time Stated in Days. If the term of a note is stated in days, 
it is customary to count the actual number of days. To compute 
the number of days between two dates for interest or discount 
purposes omit either the first or the last day briefly, count the 
midnights. 

For example: 



Date of Note 
January 31 
February 28 
June 30 
November 30 



Term 
of Note 
90 days 
90 days 
90 days 
90 days 



Maturity Date 
May 1 (Leap year, April 30) 
May 29 (Leap year, May 28) 
September 28 
February 28 



Banks usually count the actual number of days which elapse 
regardless of the method of expressing the term of a note. Bank 
practice also may vary slightly as to the computation of the 
time, since some banks count both the first and the last day. 
If the maturity date falls on a Sunday or a holiday, the note is 
due and payable on the next business day. 

Computation of Interest and Discount 

Simple interest and discount are computed in the same manner 
and usually on the basis of a 360-day year. On the 360-day 
year basis, the computation for 30 days is the same as for one 



208 ACCOUNTING FUNDAMENTALS [Ch. XVI 

month, and for 90 days it is the same as for three months. 
The United States Government uses exact time or 365 days 
(other than leap years). 
Interest and discount are computed alike, by the formula 

Principal X Rate X Time == Interest 

Assume a principal sum of $1,500.00, an annual rate of 6 per 
cent, and a period of 48 days. 

P X R X T = Interest 
$1,500.00 X .06 X 4 %co = $12.00 

The time factor is expressed as a fraction, the numerator of 
which is the number of days for which the interest is desired, 
the denominator is 360. 

Several shorter methods of calculating interest, especially for 
short periods of time, are based on the 360-day year and a 
6 per cent per annum rate. 

6 Per Cent 60-Day Method 

Since 60 days is one-sixth of a 360-day interest year, if the 
annual rate is 6 per cent then the interest for 60 days at 6 per cent 
is 1 per cent of the principal. On any sum the interest for 60 
days at 6 per cent is determined by pointing off two places to the 
left of the decimal point in the principal sum. If the time is other 
than 60 days, the interest for 60 days at 6 per cent is multiplied 
by a fraction, the numerator of which is the given number of 
days, the denominator of which is 60. For example: 

$15.00 is the interest for 60 days at 6 per cent on $1,500.00 

For 48 days at 6 per cent the interest is 

4 %o or % of $15.00 or $12.00 

The 6 per cent 60-day method may be used to advantage when 
the number of days is evenly divisible by 6, which makes possible 
reducing the fraction to lower terms. 

6 Per Cent 6-Day Method 

Another of the shorter methods determines first the interest 
at 6 per cent for 6 days. If the interest for 60 days at 6 per cent 
is determined by pointing off two places to the left of the decimal 
point in the principal sum, since 6 days is one-tenth of 60 days, 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 209 

the interest for 6 days at 6 per cent is determined by pointing 
off three places to the left of the decimal point in the principal. 
After the interest at 6 per cent for 6 days is determined, the 
interest at 6 per cent for one day is obtained by dividing by 6. 
The quotient is then multiplied by the given number of days to 
find the desired interest at 6 per cent. For example: 

$1.50 is the interest on $1,500.00 for 6 days at 6 per cent 
$1.50 -*- 6 equals $.25, the interest for 1 day at 6 per cent 
$ .25 X 48 equals $12.00, the interest for 48 days at 6 per cent 

The 6 per cent 6-day method may be used to advantage when 
the principal sum is evenly divisible by 6. If the principal sum 
is not evenly divisible by 6, there is frequently a temptation to 
drop a fractional part of a cent when the division by 6 is made. 
To overcome this objection, the rule may be restated as follows: 

1. Determine the interest for 6 days at 6 per cent by pointing 
off three places to the left of the decimal point. 

2. Multiply the result by the given number of days. The 
product is the interest for six times the number of days. 

3. Divide the result by 6. 

$1.50 is the interest on $1,500.00 for 6 days at 6 per cent 

$1.50 X 48 equals $72.00, the interest for 288 days at 6 per cent 

$72.00 -f- 6 equals $12.00, the interest for 48 days at 6 per cent 

Students will find this alternative method to be easier than 
most other procedures as it does not matter whether the principal 
sum or the number of days is evenly divisible by 6. 

Either of the shorter methods may be used if the given rate 
is other than 6 per cent. The interest at 6 per cent is deter- 
mined and is then multiplied by a fraction, the numerator of 
which is the given rate and the denominator of which is 6. If 
the given rate is 7 per cent, the interest is % of the answer at 
6 per cent; if the given rate is 5 per cent, the interest is % of 
the answer at 6 per cent. 

Computation of Discount on an Interest-bearing Note 

If an interest-bearing note is discounted prior to maturity the 
discount is computed as follows: 

1. The maturity value of the note is determined by adding 
to the face value the interest for the life of the note. 



210 ACCOUNTING FUNDAMENTALS [Ch. XVI 

2. The unexpired time of the note is calculated by ascertaining 
the total number of days between the date of discount and 
the date of maturity. 

3. The discount on the maturity value of the note for the 
unexpired time at the given rate of discount is computed. 

Assume: A $2,500.00, 90-day 6 per cent interest-bearing note, 
dated March 4, is discounted on May 9 at a 6 per cent discount 
rate. 

$2,500.00 is the face value of the note 

37.50 is the interest for 90 days at 6% 
$2,537.50 is the maturity value of the note 

10.15 is the discount for 24 days at 6% on $2,537.50 
$2,527.35 is the discounted value of the note on May 9 

Since the above note is carried on the books of the holder 
at its face value $2,500.00 and produces $2,527.35, the $27.35 is 
interest earned. In the case of an interest-bearing note which 
is converted into cash for a larger amount than the figure at 
which it is carried on the books, it is not necessary to record the 
discount charged, but it is necessary to record the interest actu- 
ally earned and received by the holder of the note. Similarly, 
if an interest-bearing note is discounted and produces less than 
the face value of the note, it is not necessary to record the interest 
earned on the note, but it is necessary to record as Interest 
Expense the difference between the face value and the discounted 
value. 

ENTRIES FOR NOTES AND INTEREST AND DISCOUNT 

Notes, whether interest-bearing or noninterest-bearing, are 
recorded always at their face value. 

Some of the most common entries for both noninterest-bearing 
and interest-bearing note transactions follow. In order to 
simplify the presentation of these entries they are all shown as 
entries in a general journal. In practice, the entries which 
involve cash are entered in the cash journals and in businesses 
where sufficient notes are received or given to warrant the use of a 
notes receivable or a notes payable journal, or both, the appro- 
priate entries are recorded therein. The date and the explana- 
tion parts of each illustrative entry are omitted. 



Ch. XVI) BUSINESS PAPERS AND PRACTICES 211 

Entries for Noninterest-bearing Notes 

1. Assume: Gene Stuart gives a $1,500.00, 60-day note to 
Robert Todd to apply on account and Todd takes it at 
face value. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Robert Todd 1 , 500 . 00 Notes Receivable 1 , 500 . 00 

Notes Payable 1 , 500 . 00 Gene Stuart 1 , 500 . 00 

2. Assume : At the maturity of the note it is paid by the maker 
to the payee. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Cash 1 , 500 . 00 

Gash 1 , 500 . 00 Notes Receivable 1 , 500 . 00 

3. Assume: At maturity the note is still held by the payee 
and is not paid by the maker. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Gene Stuart 1 , 500 . 00 

Robert Todd 1 , 500 . 00 Notes Receivable 1 , 500 . 00 

The maker's entry shows that the note matured, was not paid, 
and that there is a liability to Robert Todd for the amount of the 
note. 

The payee's entry transfers the amount due on the* unpaid 
matured note to the account of Gene Stuart, the maker. It is 
important that this transfer be made in order to show in the 
maker's account a complete history of the dealings with him. 
The transfer of the unpaid matured note from the Notes Receiv- 
able account to an open account receivable in no way prevents 
the payee suing the maker on the note. 

4. Assume : At the maturity of the note it is renewed by mutual 
consent, the maker giving the payee a new note with the 
same face value as the old note. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Gene Stuart 1 , 500 . 00 

Robert Todd 1 , 500 . 00 Notes Receivable 1 , 500 . 00 

Robert Todd 1 , 500 . 00 Notes Receiv- 

Notes Payable 1 , 500 . 00 able 1 , 500 . 00 

Gene Stuart 1,500.00 



212 ACCOUNTING FUNDAMENTALS [Ch. XVI 

These entries (with adequate explanation for each) on the 
journals of the maker and the payee show that the old note was 
disposed of by renewal. 

5. Assume: At the maturity of the note $750.00 is paid and a 
new note for $750.00 is accepted by the payee from the 
maker. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Gene Stuart 1 , 500 . 00 

Robert Todd 1 , 500 . 00 Notes Receivable 1 , 500 . 00 

Robert Todd 1,500.00 Cash 750.00 

Cash 750.00 Notes Receiv- 

Notes Payable 750 . 00 able 750 . 00 

Gene Stuart 1,500.00 

6. Assume: That the note is held 15 days by the payee and is 
then discounted at the bank at a 6 per cent rate. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Cash 1,488.75 

No entry Interest Ex- 

pense 1 1 . 25 

Notes Receivable 

Discounted 1 , 500 . 00 

The maker of a note does not know immediately what a payee 
does with it; furthermore, the transfer of the note by the payee in 
no way changes its character to the maker. 

The payee's credit to the account Notes Receivable Dis- 
counted records the contingent liability assumed by the payee 
at the time of indorsement. Although the note is no longer 
in the possession of the payee the $1,500.00 debit which appears 
for it in the Notes Receivable account is offset by the credit 
for the same amount in the Notes Receivable Discounted account. 

7. Assume: That the note is held 15 days by the payee and 
is then transferred by indorsement and delivery to Ralph 
Dawes, a creditor, who agrees to take it at its discounted 
value on a 6 per cent basis. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Ralph Dawes 1 , 488 . 75 

No entry Interest Ex- 

pense 11.25 

Notes Receivable 

Discounted 1 , 500 . 00 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 213 

The facts of this assumption, with respect to the maker of the 
note, are comparable to those of the preceding assumption. 

From the standpoint of the payee, the facts of this assumption 
are not identical with those of the preceding assumption, but 
they are quite similar. In illustration 6 the note was discounted 
and transferred to the bank for cash; in this instance the note 
was transferred at a discounted value to a creditor. 

8. Assume : That the note had been discounted sometime in the 
past by the payee. At maturity the note is presented by 
the holder to the maker and is paid. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Notes Receivable 

Cash 1,500.00 Discounted 1,500.00 

Notes Receivable 1 , 500 . 00 

The payment of the note by the maker relieves the payee 
(and any other indorsers) of the contingent liability on the note. 
The payee and other indorsers of a note are not notified at the 
maturity of the note if it is paid by the maker but they should 
be notified promptly if it is not paid, otherwise they may assume 
it is paid and may be relieved of their contingent liability on it. 

9. Assume : That the payee had discounted the note sometime 
in the past, that the maker does not pay the note at matu- 
rity, and that the payee pays the bank which discounted 
it the amount of the note plus fees incurred for protesting it. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Notes Receivable 

Protest Fees 2 . 00 Discounted 1 , 500 . 00 

Robert Todd 1 , 502 . 00 Notes Receivable 1 , 500 . 00 

Gene Stuart 1,502.00 

Cash 1,502.00 

It is necessary for the maker of the note to record the fact that 
his liability on the note is increased by $2.00, the amount of the 
protest fees. Robert Todd, the payee, who reimbursed the 
bank for the full amount of the note and the protest fees, has 
a claim on Gene Stuart, the maker, for $1,502.00. The entry 
given above for the maker's journal records this full claim of 
Robert Todd. 



214 ACCOUNTING FUNDAMENTALS [Ch. XVI 

The first entry on the payee's journal clears the records of the 
contingent liability. The contingent liability became a real 
liability, the payment of which is recorded by the second entry. 

Entries for Interest-bearing Notes 

1. Assume: Gene Stuart gives a $1,500.00, 60-day 6 per cent 
interest-bearing note to Robert Todd to apply on account, 
and Todd takes it at face value. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Robert Todd 1 , 500 . 00 Notes Receiv- 

Notes Payable 1 , 500 . 00 able 1 , 500 . 00 

Gene Stuart 1 , 500 . 00 

2. Assume : At the maturity of the note it is paid by the maker 
to the payee. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Cash 1 , 5 1 5 . 00 

Interest Ex- Notes Receivable 1 , 500 . 00 

pense 15.00 Interest Income 15.00 
Cash 1,515.00 

3. Assume: At maturity the note is still held by the payee 
and is not paid by the maker. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Gene Stuart 1 , 515 . 00 

Interest Ex- Notes Receivable 1,500.00 

pense 15.00 Interest Income 15.00 
Robert Todd 1,515.00 

The maker's entry records the facts that the note matured and 
was not paid, that the interest expense was incurred, and that 
Robert Todd has a claim for the face value of the note plus the 
interest thereon. 

The payee's entry records the facts that the maker of the 
note, Gene Stuart, owes the face value of the matured and 
unpaid note plus the interest accrued thereon. 

4. Assume: At the maturity of the note the interest is paid 
but the note is renewed by mutual consent, the maker 



Ch. XVI) BUSINESS PAPERS AND PRACTICES 215 

giving the payee a new 6 per cent interest-bearing note 
with the same face value as the old note. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 ,500.00 Gene Stuart 1 ,515 .00 
Interest Ex- Notes Receivable 1 , 500 . 00 

pense 15 . 00 Interest Income 15 . 00 

Robert Todd 1,515.00 

Robert Todd 1,515.00 Cash 15.00 

Notes Payable 1 , 500 . 00 Notes Receiv- 

Cash 15.00 able 1,500.00 

Gene Stuart 1,515.00 

5. Assume: At the maturity of the note the interest is paid 
as is $750.00 on account of the principal and a new 6 per 
cent interest-bearing note for $750.00 is accepted by the 
payee from the maker. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 ,500.00 Gene Stuart 1 ,515.00 

Interest Ex- Notes Receivable 1 , 500 . 00 

pense 15.00 Interest Income 15.00 
Robert Todd 1,515.00 

Robert Todd 1,515.00 Cash 765.00 

Cash 765 . 00 Notes Receiv- 

Notes Payable 750.00 able 750.00 

Gene Stuart 1,515.00 

6. Assume: That the note is held 15 days by the payee and 
is then discounted at the bank at a 6 per cent rate. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Cash 1,503.64 

No entry Interest Income 3 . 64 

Notes Receivable 

Discounted 1 , 500 . 00 

7. Assume: That the note is held 15 days by the payee and 
is then transferred by indorsement and delivery to Ralph 
Dawes, a creditor, who agrees to take it at its discounted 
value on a 6 per cent basis. 



216 ACCOUNTING FUNDAMENTALS [Ch. XVI 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Ralph Dawes 1 , 503 . 64 

No entry Interest Income 3.64 

Notes Receivable 

Discounted 1 , 500 . 00 

8. Assume: That the note had been discounted sometime 
in the past by the payee. At maturity the note is pre- 
sented by the holder to the maker and is paid. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1,500.00 Notes Receivable 

Interest Ex- Discounted 1 , 500 . 00 

pense 15 . 00 Notes Receivable 1 , 500 . 00 
Cash 1,515.00 

9. Assume: That the payee had discounted the note sometime 
in the past, that the maker does not pay the note at 
maturity, and that the payee pays the bank which dis- 
counted it the maturity value of the note plus protest 
fees. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Notes Payable 1 , 500 . 00 Notes Receivable 

Interest Ex- Discounted 1 , 500 . 00 

pense 15.00 Notes Receivable 1,500.00 

Protest Fees 2 . 00 Gene Stuart 1 , 517 . 00 

Robert Todd 1,517,00 Cash 1,517.00 

10. Assume: Gene Stuart owes Robert Todd $1,500.00 due 
this day. He cannot pay in cash so he gives, and Todd 
accepts, a 60-day note which includes in its face value 
interest on $1,500.00 at 6 per cent for 60 days as well as 
the full amount of the debt. 

MAKER'S JOURNAL PAYEE'S JOURNAL 

Robert Todd 1 , 500 . 00 Notes Receiv- 

Interest Ex- able 1 , 515 . 00 

pense 15 . 00 Gene Stuart 1 , 500 . 00 

Notes Payable 1 , 515 . 00 Interest Income 15 . 00 

The above example illustrates note transactions when the 
interest is included in the face value of the note. 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 217 

DRAFTS 

Definition 

A negotiable draft is an unconditional written order of one 
party to another, signed by the drawer, directing the payment 
of a specified sum of money on demand or at a fixed or deter- 
minable future time, to bearer or to the order of a named party. 
Drafts are also known as bills of exchange, particularly when 
used in international transactions. 

A draft differs from a note in that it is an order to pay while the 
note is a promise to pay. A note originates with a debtor while 
a draft originates with a creditor or a vendor. 

Parties to a Draft 

There are three parties to a draft, the drawer, the drawee, 
and the payee. The drawer is the maker of the draft, the one 
who draws it and whose signature is at the lower right corner 
of the draft. The drawee is the party on whom the draft is 
drawn, the one who is directed to pay and whose name appears 
at the lower left corner of the draft. The payee is the party 
in whose favor the instrument is drawn. The drawer may name 
a separate third party as the payee, he may make the draft 
payable to bearer, or he may name himself as the payee by 
making the draft payable to his own order. 

Kinds of Drafts 

Drafts may be classified as follows: 

1. According to the time of payment as 

a. Sight or demand. A sight draft is one which is payable 

immediately on presentation to the drawee, 
fe. Time. A time draft is one which is payable after a period 
of time has elapsed from the date it is drawn or is 
presented to the drawee for acceptance. A time draft 
is usually worded 
(1) On (a definite future date), pay to the order of 

In this instance the draft is payable 

at the fixed future date. 



218 ACCOUNTING FUNDAMENTALS [Ch. XVI 

(2) Sixty days (or other definite period of time) after 
date, pay to the order of 

The words after date make the draft due and payable 
the given number of days after the date the draft 
is drawn. 

(3) Sixty days (or other definite period of time) after 
sight, pay to the order of 

The words after sight indicate that the draft is 
payable the given number of days after it is pre- 
sented to the drawee and is accepted by him. 

2. According to the number of original parties as 

a. Three-party drafts. A three-party draft is one in which 
the drawer, the drawee and the payee are different 
persons. 

6. Two-party drafts. A two-party draft is one in which the 
drawer and the payee are the same person. 

3. According to the drawer and drawee as 

a. Commercial. A commercial draft is one the drawer 

and drawee of which are not banks. 
6. Bank. A bank draft is one the drawer and drawee of 

which are banks. 

Bank drafts are invariably three-party sight or demand drafts. 
Commercial drafts vary; they may be three-party time or sight, 
or two-party time or sight drafts. 

Acceptance 

The drawee of a draft does not have to accept it. If he 
accepts a sight or demand draft he does so by paying it. If 
he accepts a time draft he should write the word accepted and 
sign his name across the face of the instrument. It is customary 
also to write the date of the acceptance; if the draft is drawn 
payable a certain period of time after sight, the date of acceptance 
is necessary to determine the maturity date of the draft. 

A time draft which has been accepted by the drawee is known 
as an acceptance. Since an acceptance represents the written 
acknowledgment of the drawee that he will honor the instrument 
at maturity, it is equivalent to a promissory note and is con- 
sidered a notes payable by the drawee and a notes receivable 
by the payee. 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 219 

Purpose and Use of Drafts 

Drafts are used 

1. As an aid in the collection of past due accounts. Drafts are 
used sometimes by creditors in an endeavor to collect over- 
due claims on customers. The creditor draws a two-party 
sight draft on the customer, indorses it, and gives it to 
his bank for collection. The creditor's bank tries to 
collect the draft through a bank near the customer. Since 
the customer may be fearful that refusal to honor the draft 
may reflect unfavorably on his credit with the home bank, 
he is more likely to honor the draft than to respond to 
collection letters. 

2. As an aid in collecting some C.O.D. sales. C.O.D. sales 
shipped by freight are consigned on an " order bill of lading" 
to the shipper with the request that the transportation 
company notify the buyer of the merchandise on its arrival 
at destination. A two-party sight draft is drawn by 
the shipper on the buyer and is indorsed by the shipper 
as is also the bill of lading. The draft with bill of lading 
attached is then given by the shipper to his bank for collec- 
tion or is mailed to a bank in the buyer's city. On receipt 
of the draft and bill of lading the bank in the buyer's city 
notifies the buyer that it has these two instruments. If 
the buyer pays the draft he receives the bill of lading with 
which he can procure the merchandise from the transporta- 
tion company. Bills of lading are considered in Chapter 
XVII. 

3. As a convenience in the collection and settlement of accounts. 
Suppose B in Pittsburgh owes $500.00 to A in Philadelphia 
and that A owes $590.00 to C in Pittsburgh. A could 
draw a draft on B payable to C; if the draft is paid by B 
the indebtedness of B to A and A to C is settled. Whether 
the draft would be a sight or a time one would depend 
on the terms of settlement which applied to the accounts. 
This type of draft is used less than formerly and should 
not be used ordinarily without the consent of the drawee. 

4. As a means of converting open account balances into 
negotiable time paper. At the time of a charge sale of 
merchandise, the vendor may arrange with the customer 



220 ACCOUNTING FUNDAMENTALS [Ch. XVI 

for the privilege of drawing a time draft on the customer, 
either immediately or subsequently. If the vendor finds 
that he needs negotiable time paper for discount purposes 
he may then draw a time draft on the customer. The 
draft, of course, must not advance the date of payment 
over the terms agreed upon at the time of the sale. 

Illustrations of Drafts 



$300.70 


Philadelphia, Pa. 


, July 17, 19_ 


At sight 




Pay to 


The order of Harlan Schnader 


Three hundred and 70/100 




Dollars 


Value received 
To Brakely Woll 


and charge the same to account of 
Murray A. Brown 


No. 29 Pittsburgh, Pa. 





Three-party sight diaft. 



$760.43 


Philadelphia, Pa., July 17, 19_ 


On demand 


Pay to 


The order of Murray A. Brown 


Seven hundred sixty and 43/100 


Dollars 


Value received 
To Paul A. Denny 


and charge the same to account of 
Murray A. Brown 


No. 30 Pittsburgh, Pa. 





Two-party sight draft. 



$420.90 
Sixty days after date 




Philadelphia, Pa. 


, July 17, 19_ 




Pay to 


The order of Wallace L. 


Bacon 






Four hundred twenty and 


90/100 




Dollars 


Value 
To L. P. Lowry, Jr. 


received 


and charge the same to account of 
Murray A. Brown 


No. 31 Chicago, 111. 









Three-party time draft. 



Ch. XVIJ BUSINESS PAPERS AND PRACTICES 221 



$1000.00 


Philadelphia, Pa. 


, July 17, 19_ 


Sixty days after sight 




Pay to 


The order of Murray A. Brown 


One thousand and no/100 




Dollars 


Value received 
To Henry L. Davis 


and charge the same to account of 
Murray A. Brown 


No. 32 Middletown, N. Y. 





Two-party time draft. 

The above two-party time draft will be due 60 days after it is 
presented and accepted by Henry L. Davis, the drawee. Drafts 
drawn " after sight " should be presented to the drawee for 
acceptance as promptly as possible. 



The Second Street National Bank 
No. 415 Philadelphia, Pa., July 17, 19 

Pay to the order of Murray A. Brown $600.00 

Six hundred and no/100 Dollars 

To Tenth Street National Bank, 

New York, N. Y. Walton H. Easby 



Cashier. 



Bank draft. 

A bank draft specifies no particular time for payment; there- 
fore, like a check, it is due at sight or on demand. A bank 
draft is a check of one bank on a correspondent bank. 

Other Forms of Demand Drafts 

In addition to the bank draft there are many other forms of 
demand drafts in such common use that they are not referred 
to as drafts but by their own titles, such as checks, cashiers 9 
checks, postal money orders, and travelers 9 checks. These forms 
of drafts will be considered in Chapter XVII. 

Entries for Drafts 

Since an accepted time draft is a notes receivable to the 
payee and a notes payable to the drawee, the entries for it at the 
time of payment, discount, or dishonor are the same as those 



222 



ACCOUNTING FUNDAMENTALS 



[Ch. XVI 



illustrated previously in this chapter for notes. The entries 
for both sight and time drafts at the time of their acceptance 
may be summarized as follows: 

SUMMARY OF DRAFT ENTRIES AT TIME OF ACCEPTANCE 



Conditions 


Drawer 


Drawee 


Payee 


Two-party Sight 


Cash . . xxxx 


Drawer, *. xxx 


The Payee Is the Drawer 




Drawee xxxx 


Cash xxx 






Notes Receiv- 


Drawer xxx 




Two-party Time 


able xxxx 


Notes Payable xxx 


The Payee is the Drawer 




Drawee xxxx 








Payee . . . xxxx 


Drawer xxx 


Cash . ... xxxx 


Three-party Sight 


Drawee xxxx 


Cash xxx 


Drawer xxxx 




Payee xxxx 


Drawer. xxx 


Notes Receiv- 


Three-party Time 


Drawee xxxx 


Notes Payable . ... xxx 


able ...... xxxx 








Drawer xxxx 




Notes Receiv- 
able xxxx 








Notes Receiv- 
able Dis- 
counted xxxx 















The second entry illustrated for the drawer of a three-party 
time draft records his contingent liability. In the event the 
drawee of a three-party time draft does not honor it at maturity, 
the drawer is liable to the holder of the draft. Until the draft 
is paid, therefore, the drawer is contingently liable. The 
drawer's contingent liability is recorded by the same entry 
used to record the contingent liability of the indorser of a note. 
When the contingent liability of the drawer of a draft is ended 
the fact is recorded by the same entry used by the indorser of a 
note to record the fact he is no longer contingently liable. 

Trade Acceptance 

A trade acceptance is a time draft drawn by the seller on the 
purchaser of merchandise and accepted by the latter. A trade 
acceptance contains on its face a statement that it arose out of 
the sale of merchandise, by words such as: "The obligation of 
the acceptor hereof arises out of the purchase of goods from the 
drawer." 

Trade acceptances are usually two-party time drafts. Since 
trade acceptances are drawn usually at the time merchandise is 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 



223 



sold, they are considered more desirable than ordinary notes 
and time drafts which may have arisen out of standing or even 
past due accounts. 




Philadelphia, Pa. 



'7, 



( City of Drawer ) ( Date ) 
September 15, 19. 



."4-J 



( Date of Maturity) 
hundred and no/ioo 



obligation of the acceptor he; 



from the drawer, the drawee ma 



or trust company in the United S 



V 



^m 



e B. Cameron 



(Name of Drawee) u 

10 New Market St. fe ^ 

( Street Address ) U * 
Massi/on, Ohio. O 



cof 



j. 



wl|_ 
IsCQ 



(City of Draweer 3 
D 



.3 




88 



No. 

to the Order of Ourselves 

Dollars ( fe 00 - 00 ) 
the purchase of goods 
F ayable at any bank, banker 
i he n ay designate. 



Hall and Hants 



C Signature of Drawer) 



Trade acceptance. 

Trade acceptances like other time drafts are considered notes 
receivable to the payee and notes payable to the drawee. The 
entries for them are the same as the entries already illustrated 
for notes and time drafts. Because trade acceptances are a 
particularly desirable class of notes, holders record them some- 
times in the separate account Trade Acceptances Receivable. 



QUESTIONS 

1. What is a promissory note? Who are the original parties to a note 
and by what titles are they known? May any other persons 
become parties to a note and by what title are they known? 

2. What is meant by negotiability and what words in a note indicate it? 

3. What do you mean by the face value of a note? Maturity value? 
When are face and maturity values not the same? Does a note bear 
interest unless it definitely so states? 

4. If you are willing to extend credit to a person or to lend him money, 
you are trusting him, so why bother to have him give you a promis- 
sory note? 

5. Would you prefer to have money owed to you on a promissory note 
or on an open book account? Why? 

6. If you borrow money at your own bank, would your bank require 
you to give it a note? Might the note be your own note, if so who 
are the parties? Might the note be one of your customer's notes, 
if so who are the parties? 



224 ACCOUNTING FUNDAMENTALS [Ch. XVI 

7. a. Draw a 60-day noninterest-bearing note for $400.00 in which 

Arnold Beck is the payee and George Monroe is the maker. 

b. Draw a 30-day 6 per cent, $500.00 note in which Henry Hopkins 
is the maker and Howard Ickes is the payee. 

8. Explain how an indorser might make 

a. An unqualified or blank indorsement. 
6. A full or special indorsement. 

c. A restricted indorsement. 

d. A qualified indorsement. 

9. What is an accommodation indorsement? How and why is it made 
usually? 

10. In what accounts are promissory notes recorded? 

11. a. If a note is a note receivable, may it ever become a notes payable 

to the payee? 

b. If a note is a note payable, may it ever become a notes receivable 
to the maker? 

12. a. What is meant by a contingent liability? 

b. Which original party to a note may acquire a contingent liability 
on the note? . How? 

c. May there be a number of persons who are contingently liable 
on a particular note? Explain. 

13. Without the use of figures, give the entries for the following trans- 
actions: 

a. Received a note from D. Gordon on account. 

b. Gave a note to H. Harr on account. 

c. Discounted at bank the Gordon note received in a above. 

d. Paid the note given to H. Harr in b above. 

e. The Gordon note received in a above and discounted in c above 
was not paid by the maker at maturity, so we paid it plus protest 
fee to the bank. 

/. Received a note on account from E. Williams. 
g. Discounted the E. Williams note received in / above. 
h. The E. Williams note matured and we did not receive a notice of 
protest. 

14. Suppose the following account balances appear on our ledger: 

Notes Receivable Notes Payable Notes Receivable Discounted 



18,000.001 



10,000.00 7,000.00 



a. What amount of customer notes would you expect to find in the 
safe? 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 225 

b. What amount of customer notes with our name on the back are 
in banks? 

c. What is our direct or primary liability on notes? 

d. What is our contingent liability on notes? 

e. What is the greatest loss we may suffer on notes? 

/. Assume we suffered the greatest possible loss on notes, would 
we be expected to pay out any money on them? How much? 

g. How and where would the facts at the beginning of this question 
be shown on a balance sheet? 

15. a. How is a note renewed? 

fc. What entry or entries should a payee make, if a note is renewed? 
c. What entry or entries should a maker make, if a note is renewed? 

16. a. What is interest? Discount? 

b. What do you mean by a cash discount? 

c. What do you mean by a trade discount? 

'd. What do you mean by commercial or bank discount? 

17. In what account, if any, are recorded 
a. Cash discounts received? 

6. Cash discounts allowed? 

c. Trade discounts received? 

d. Trade discounts allowed? 

e. Commercial discounts on a borrower's books? 
/. Commercial discounts on a lender's books? 

g. Interest received on ordinary notes receivable? 
h. Interest paid on ordinary notes payable? 
i. Interest received on bonds owned? 
j. Interest paid on a mortgage payable? 

18. How would you calculate a trade discount of 10 per cent, 10 per 
cent, and 5 per cent? 

19. What is the maturity date of each of the following notes: 
a. One drawn January 27 for 10 days? 

ft. One drawn March 15 for 30 days? 

c. One which is payable one month from April 30? 

d. One which is payable one month from January 31? 

20. a. Is there any difference in the method of computing ordinary 

interest and discount? 

6. Why is the interest at 6 per cent for 60 days, the same as 1 per 
cent on the principal sum for one year? 

c. Why is the interest at 6 per cent for 6 days, the same as one- 
tenth of 1 per cent on the principal sum for one year? 

d. What is the interest on $1,200.00 at 6 per cent for 30 days? 

e. What is the interest on $2,400.00 at 6 per cent for 6 days? 
/. What is the interest on $3,600.00 at 6 per cent for 1 day? 



226 ACCOUNTING FUNDAMENTALS [Ch. XVI 

21. For what number of days was a note discounted, if it was drawn 
for 30 days on May 1 and was discounted on May 4? If it was 
discounted on May 12? 

22. a. Give the journal entry for Arnold Beck in question 7 a. 

b. Give the journal entry for George Monroe in question 7a. 

c. Give, in general journal form, the entry for Arnold Beck at the 
maturity of the note referred to in 7a. 

d. Give, in general journal form, the entry for George Monroe at 
the maturity of the note referred to in 7a. 

e. Give the journal entry for Henry Hopkins in question 76. 
/. Give the journal entry for Howard Ickes in question 76. 

g. Give, in general journal form, the entry of Henry Hopkins at the 

maturity of the note referred to in 76. 
h. Give, in general journal form, the entry for Howard Ickes at the 

maturity of the 'notes referred to in 76. 

23. Suppose A. Hill owed B. Davis $1,000.00 due today. Suppose also 
that Hill deferred payment by giving Davis a 60-day note which 
included, in its face, interest at 6 per cent for the 60 days. 

a. Give Hill's entry. 
6. Give Davis' entry. 

c. Give Hill's entry when the note matures and is paid. 

d. Give Davis' entry when the note matures and is paid. 

24. What do you mean by a draft? Distinguish a draft from a note. 
By what titles are the parties to a draft known? What party may 
become an indorser of a draft? 

25. a. What do you mean by a sight or demand draft? 

b. What do you mean by a time draft? 

c. What do you mean by a three-party draft? 

d. What do you mean by a two-party draft? 

e. What do you mean by a bank draft? 

26. a. What do you mean by an acceptance? 
6. What party accepts a time draft? 

c. How is a sight draft accepted? 

d. A payee records an acceptance in what account? 

e. A drawee records an acceptance in what account? 

27. Give some reasons why drafts are used. 

28. Assume Smith owes Black $500.00 and Black owes Green $500.00. 
a. Draw a 30-day, three-party draft for these facts. 

6. Draw a three-party sight draft for these facts. 
Assume the draft referred to in a was accepted. 

c. Give Smith's entry. 

d. Give Green's entry. 

e. Give Black's entry. 



Ch. XVI] BUSINESS PAPERS AND PRACTICES 227 

Assume the draft referred to in 6 above was drawn and honored. 
/. Give the payee's entry. 
g. Give the drawer's entry. 
h. Give the drawee's entry. 

29. What do you mean by a trade acceptance? In what respect is it 
different from an ordinary draft? Would you prefer to hold the 
trade acceptance or the ordinary acceptance of a customer? Why? 



CHAPTER XVII 
BUSINESS PAPERS AND PRACTICES (Continued) 

Business papers are not all negotiable instruments such as 
those considered in Chapter XVI. Some papers in very general 
business use are merely reminders and evidences of transactions, 
without which it would be extremely difficult, if not impossible, 
to conduct many businesses, especially if credit sales and pur- 
chases are made. From an accounting standpoint many of these 
papers are necessary as bases for entries. 

It is the purpose of this chapter to continue the study of 
business papers and practices and to exhibit and explain the 
use of some business forms which were not considered in Chapter 
XVI. Some of the papers considered are negotiable, others are 
not. 

In order to include some of the papers and practices considered 
in this chapter, it is necessary to think in terms of at least a 
fair-sized and well-organized business, a business where the 
proprietor has delegated some of the responsibility to others. 

PAPERS AND PRACTICES FOR PURCHASES 

Before any item is purchased by a business someone with 
authority has to observe that it is needed and request the pur- 
chasing agent, or other person charged with the responsibility 
of buying, to procure it. The request is made 'on a purchase 
requisition. 

Purchase Requisition 

A purchase requisition is a written request from one depart- 
ment of a business to the purchasing department to purchase 
goods or services. An example is the request of the office 
department through its manager to the purchasing agent to 
purchase an article needed by the office. A purchase requisition 
usually is made out at least in duplicate. The original is sent 
to the purchasing agent, the duplicate is retained by the issuing 
department. 

228 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 229 

Purchase Order 

On receipt of a purchase requisition the purchasing department 
issues a purchase order to the business from which the purchase 
is to be made. This purchase order usually is made with extra 
copies. The original is sent to the vendor, a copy is kept by 
the purchasing department, a copy is sent to the department 
requesting the purchase as an acknowledgment of the receipt 
of the requisition and notice of compliance, and another copy 
may be sent to the receiving department, if the business has 
such a department, as advice to expect and prepare for the 
receipt of the material. 

Purchase Invoice 

Prior to the receipt of the purchase, or at least accompanying 
it, a purchase invoice is received. A purchase invoice is an 
invoice considered from the standpoint of the purchaser of 
goods. An invoice is a document sent by the seller of goods 
to the purchaser which shows at least the date; quantity, descrip- 
tion and unit prices of the items purchased; the total amount; 
and the terms of payment. 

The invoice number, the purchaser's order number, and other 
information are shown frequently on the invoice. The purchase 
invoice is also called a bill. 

The form shown on page 230 is a purchase invoice to the Buyer 
Company and a sales invoice to the Seller Company. It contains 
the essential features of a satisfactory invoice but it should be 
noted that a simplified invoice form is used sometimes. The 
simplified form which is endorsed by the United States Depart- 
ment of Commerce contains more supplementary information 
than the form illustrated and has a section reserved for the 
customer's use only. 

The purchase invoice is the first of the business papers referred 
to in this chapter which is the basis of an accounting entry. 
Usually an entry is not made for the purchase invoice until the 
goods are received, checked for quantity and quality, and the 
invoice checked for unit price, extensions, total amount, and 
terms. When the goods and invoice are checked and proper 
notation to that effect is made on the invoice, then it is used 
as the basis of an entry in the purchase records. The simplified 



230 



ACCOUNTING FUNDAMENTALS 



[Ch. XVII 



form of invoice provides space for proper checking by the 
customer. When the simplified form is not used the purchaser 
frequently provides a reminder of the items to be checked and a 
place for the checking by the use of a rubber stamp designed 
for that purpose. 



THE SELLER COMPANY 
Pittsburgh, Pa. 

Invoice No. 763 

SOLD TO The Buyer Company 
27 Harrison Ave., 
Detroit, Mich. 
Purchaser's Order No. 96 
Terms 2/10, nl 30. Shipped P. R. R. 



Date July 19, 19 



Date July 19, 19 



Quantity 



Description 



Unit Price 



Amount 



15 
25 



Cases X X Material 
Bbls. XXX Material 



10.00 
15.00 



150.00 
375.00 



525 00 



An invoice. 

Credit Memorandum 

A credit memorandum or credit memo, as it is called, is a 
document issued by the seller of goods to the purchaser as 
notice that a credit on the books of the seller is given to the 
purchaser for reasons shown on the document. In form the 
credit memorandum is similar to an invoice but it is prepared on 
different-colored paper and is marked Credit Memorandum. 

A credit memorandum is prepared in duplicate. The original 
is sent to the purchaser, the duplicate is retained by the vendor. 
Credit memos arise as the result of the delivery of defective 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 231 

goods, of goods damaged in transit, of a quantity in excess of an 
order, of goods of a different quality or kind from those ordered, 
or for other reasons such as arithmetical mistakes on the invoice 
or the use of incorrect unit prices. 

If the purchaser of goods has recorded the original invoice, the 
credit memorandum is the basis of an entry which debits the 
vendor and credits the appropriate account. If the original 
invoice has not been recorded, the credit memorandum is attached 
to it and an entry for the modified original invoice is recorded. 

Debit Memorandum 

A debit memorandum or debit memo, as it is called, is a docu- 
ment issued by the seller of goods to the purchaser as notice 
that a debit or charge is made on the books of the seller for reasons 
shown on the document. If the seller of goods prepaid freight 
for the convenience of the purchaser and the amount of the freight 
was unknown at the time the invoice was prepared, a debit 
memorandum would be issued by the seller for the amount of the 
freight. A debit memorandum also is used in cases where an 
error in the original invoice resulted in an undercharge to the 
purchaser. In form a debit memorandum is similar to a credit 
memorandum but it is prepared on different-colored paper and 
is marked Debit Memorandum. 

A debit memorandum is prepared in duplicate. The original 
is sent to the purchaser, the duplicate is retained by the vendor. 
To the purchaser the debit memorandum is the basis of an entry 
which credits the vendor and charges the appropriate account. 

A debit memo is the title given also to a document which 
originates with a buyer. It is a form used by some purchasers 
to notify a seller that the account of the latter is charged for 
an item such as goods returned or delivery charges paid by the 
purchaser on goods which were to be delivered at the expense 
of the shipper. 

Bill 

A bill is a document which shows the amount charged for 
goods sold or services rendered. The word bill is used as a 
synonym for invoice but its meaning is not limited to a document 
which shows charges for goods sold. The word bill also means 
a document which shows charges for services sold. Common 



232 ACCOUNTING FUNDAMENTALS [Ch. XVII 

usage approves an expression such as, "Has the bill for the 
merchandise purchased been received?" but it does not approve 
"Has the invoice from the doctor been received?" or "Has 
the rent invoice been paid?" 

Bills are received for services purchased, such as telephone, 
telegrams, repairs to plant and equipment, electricity, gas, 
water, freight, cartage, express, rent, and professional services. 

A bill is the basis of an entry to the purchaser of a service, 
the same as an invoice is the basis of an entry to the purchaser 
of goods. It is quite common practice to postpone book record 
of bills until they are paid, at which time they are recorded as 
expenses in the cash disbursements journal. In order to keep a 
complete record of all liabilities it is recommended that bills 
received and not paid immediately should be recorded to show 
the expenses incurred and the liabilities created. 

PAPERS AND PRACTICES FOR SALES 

Sales originate in an order received from a customer or in 
orders obtained by salesmen. In sales of substantial amounts, 
it is desirable always to have the customer's signature on the 
order. If the sale is a charge one a sales invoice is prepared 
and sent to the customer at the same time as the merchandise. 

Retail sales, both charge and cash, are recorded usually on 
the sales pads of the salesmen who take the orders. Each 
salesman's sales pad provides for at least a duplicate record to 
be kept and is numbered consecutively throughout in order that 
all sales tickets may be accounted for. The salesman must 
indicate for each sale whether it is a cash, a C. 0. D., or a charge 
sale. If the sale is a charge one the original sales slip is the 
sales invoice; the duplicate is the basis of a charge to the customer 
in the sales journal. If the sale is a cash one the money and the 
slip are sent to the cashier. The cash received by the cashier 
from cash sales is verified by the amount of the cash sales slips 
and the duplicate sales-pad records kept by the salesmen. 
The method of recording charge and cash sales was explained 
in Chapter VIII. 

Sales Invoice 

The sales invoice is an invoice considered from the standpoint 
of the seller of the goods. Sales invoices may be made with a 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 



233 



number of extra copies. The original is sent to the purchaser 
of the goods; a copy is sent to the bookkeeper as the basis for 
an entry in the sales journal; another copy is sent to the shipping 
department as notice to ship the goods to the customer; other 
copies are used as needed. The sales invoice copies sent to the 
bookkeeper are used in some businesses as the sales journal. 
They are placed in a binder and postings are made directly from 
the bound duplicate sales invoices to the customers' accounts 
in the ledger. At the end of a period, say one month, the total 
of the duplicate invoices is obtained and is posted to the credit 
of the Sales account. The posted duplicate invoices are then 
placed in a more permanent binder and filed as the original 
records of that period's sales postings. 

A credit memorandum, a debit memorandum, and a bill, 
all of which may be used by a vendor, were explained previously 
in this chapter. 

A Statement 

The word statement when used in connection with a personal 
account refers to a statement of the account. It is a periodic 
summary of the account which shows the balance at the beginning 
of the period, the amounts charged and credited to the account 



STATEMENT 


THE SELLER COMPANY 


Pittsburgh, Pa. 


To The Buyer Company 


27 Harrison Ave., 


Detroit, Mich. July 31, 19 


19_ 




Dr. 










July 


1 


Balance 


400 


00 








13 


Mdse. per invoice 


600 


00 








19 


Mdse. per invoice 


525 


00 








27 


Mdse. per invoice 


915 


00 


2,440 


00 






Cr. 












8 


Cash 


400 


00 








15 


Allowance, per credit memo 


40 


00 








22 


Cash 


560 


00 


1,000 


00 




31 


Balance 






1,440 


00 



A statement. 



234 ACCOUNTING FUNDAMENTALS [Ch. XVII 

during the period, and the balance. It is customary in many 
businesses to send monthly statements to customers. These 
statements serve to remind customers of amounts due and 
provide opportunity for customers to compare their accounts 
with the records kept by the creditor. A statement usually 
does not reproduce all the details shown by the sales invoices 
sent to a customer during the period; it simply restates the 
items shown in the customer's ledger account in any form which 
will be understood clearly by the customer. 

PAPERS AND PRACTICES FOR SHIPMENTS 

The papers and practices for the delivery of merchandise over 
the counter or by the regular delivery service of the business 
need no special explanation. The same is true for deliveries 
made by parcel post and express, which agencies may be used 
also for C. 0. D. shipments. Merchandise shipped by freight 
requires the preparation of a special business paper called the 
bill of lading. 

Bill of Lading 

A bill of lading is an instrument given by a transportation 
company to a shipper as a receipt for the goods to be carried 
and a contract to convey them. It is a written acknowledgment 
of the quantity and kind of goods received, and a contract 
. in which the carrier agrees to convey the goods as stated on the 
face of the bill of lading but subject to the conditions printed 
on the back of the instrument. 

There are two kinds of bills of lading straight and order bills. 
Both straight and order bills are prepared in triplicate. The 
first copy is called the original, the second copy the shipping 
order, and the third copy the memorandum. The original is 
signed by the shipper and the carrier and is the shipper's receipt 
from the carrier and evidence of the contract to transport the 
goods. The shipping order is signed by the shipper and is 
retained by the carrier as evidence of its instructions. The 
memorandum is an exact copy of the original, is signed by both 
the carrier and the shipper and is retained by the shipper. 
Distinguishing differences between straight and order bills 
follow : 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 



235 



Differences 


Straight 


Order 


Color of Paper 


All copies white 


Original on yellow paper. 
Shipping Order and 
Memorandum on blue 
paper 


Negotiability 


Nonnegotiable 


Negotiable 


In form of Consignment 


Direct to Consignee 


To the order of the 
shipper with request 
that purchaser be noti- 
fied 



A straight bill of lading is used in shipping goods which have 
been sold on credit. When a straight bill is used the customer 
may obtain the merchandise from the carrier without presenting 
the bill of lading. 

An order bill of lading is used when the shipper desires to 
collect the amount of the sale before the carrier delivers the 
merchandise to the customer. This is done by attaching a 
sight draft to the order bill of lading (see Chapter XVI) and 
forwarding it for collection through a local bank or through a 
bank at the destination point. When the customer pays the 
agent bank the amount of the draft, the bank surrenders the 
bill of lading to the customer, who may then obtain the mer- 
chandise from the carrier. Under this plan the shipper controls 
the merchandise until collection is made. Goods shipped on 
order bill are not delivered until the original order bill of lading, 
properly indorsed to the holder, is presented. 



236 



ACCOUNTING FUNDAMENTALS 



[Ch. XVII 



UNIFORM STRAIGHT BILL OF LADING 
ORIGINAL-NOT NEGOTIABLE 



THE PENNSYLVANIA RAILROAD COMPANY 



RECEIVED, subject to the ela 



mod Unfit in offcn on th date of the IHOO of this BiU of Ladw. 



At 

From- 



193 




Nor* Where the rate depeadent on value, ahippen are required to etate epeeJicaUy in writing the 
wd or deelared value of the property 
The ecreed or declared nhM of the property to hereby epeaflcaUy etated by the ahipper to be oet . 



Jfc 



Chargre advanced. 




(2) 

THIS SHIPPING ORDER 



285 



THE PENNSYLVANIA RAILROAD COMPANY 



RECEIVE, object to 



n* and Unfit m *ffct oa tbo d*U of tb IMUO of thu Bbippiog Order, 



At 

Front- 



d ordrr, eieept u eoted (mnteoU and eoaditioa of eontraU of 



.. _____________ . a pparrot rood 

._ ___ . _f dMtuted M lodiotUKi lilow. which 

penon or corporation in poMcwwn nf tbe property under the contract) 
owa road or it* own water line, otherwise to deliver to another carrier 

rtion of Mid route to deituwtioo, and at to CM* 



u&koown), marked, coa- 



, , , 

Mid company (ib word company bcini iindVratood throubout th contract at BMantag aoy 
rty under the contract) apee* to carry to lU uauat place of delivery at Mid destination, if on tU 
water line, otherwise to deliver to another carrier on tbe route to Mid destination )t w mutually ard, M to each earner 



, 

of afl or any of Mid property over aU or any portion of Mid route to deituwtioo, and at to CM* p 
property, that every MrvTee to b performed Emuoder aball betubpet to aU tb* coodttion* not p 
^^ - --- -id, ueludinc tbe eo^it.o M on bj^ereof, wbich arTbereby crd to by the 



, 

v at any tune tatrnftod to U o 
d by law. whether p ;i 
' -------- * 



I k rr IM ~. .4. k .... .^~- ^.-~ 

( 3 ) VatfM> !>< 9^*, U> W LMU A^W ., (M^feTeMr.! ^.11^ ^ MT. CtaMtaiM TMV..M. -~ II 

THIS MEMORANDUM Jy^S 

Af%.f. Ne^. 



THE PENNSYLVANIA RAILROAD COMPANY 



287 



^t<"Kl"Vfcb. aub;rct K>T 
the OrMpna) Bill of I 

At _ 



rroifi 



ioa ad"tarTrTi in effo.r 



103 



of all or My of Mid property owr all or My portion of Mi 
property, that every wrvice to be perforated hereuader ha 
bereio oonUiMoViKludmK the oonditioM OB back hereof, 



of Mid route to dwtinntion. and ae lo each party at in> 
hall be eubject to all the condittooi not prohibited 



which arc henby agrwd to by the shipper and accerl 



t in> time mtrmtcd in all or any of M 
ited by law. nhrihcr printed or writte 
and accerlrd for hioWlf and hi* amiD 



Bill of lading. 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 237 

PAPERS WHICH CIRCULATE AS CASH 
Check 

A check is a written order of a depositor on his bank to pay 
a specified sum of money to the order of a named person, or to 
bearer. Unless postdated a check is payable on presentation. 





Pittsburgh, Pa. My 20, 19 No. "6 


Pay to the 
Order of 


FORBES NATIONAL BANK 8-139 
Fifth and Oakland 

Harris Towson $ 90-20 


Ninety and 2c 


j 




^^^ JL/Qt'flTS 




Ralph B. Lonsdale 







A check. 

Cashier's Check. 

A cashier's check is a bank's check drawn by its cashier on 
itself. Cashiers 7 checks are used in the payment of the expenses 
and liabilities of a bank and are issued to depositors who may 
wish to purchase them. When a person wishes to make a 
payment where his own check may not be acceptable, he may 
purchase a cashier's check and use it. As a rule, a cashier's 
check is accepted in payment more readily than an individual's 
check because the bank is better known. 

Certified Check 

A certified check is a depositor's check on which a bank officer 
has certified that the depositor has sufficient funds on deposit 
to meet the check. The bank officer certifies for the bank 
that the check is good by stamping a word such as certified and 
the name of the bank across the face of the check and by adding 
his signature. The amount of the check is deducted at once 
from the depositor's account in the bank and thereafter the certi- 
fied check is a liability of the bank to the holder. 



238 ACCOUNTING FUNDAMENTALS [Ch. XVII 

Travelers' Checks 

Travelers 1 checks are checks issued by a bank, bankers' 
association, or by an express company, all in even denominations, 
for the convenience of a traveler who is the payee. Each check 
carries a specimen of the signature of the payee. When the 
payee desires to cash one of the checks he identifies himself by 
countersigning the check to match the specimen of his signature. 
Travelers' checks arc accepted generally by hotels and banks. 

Express Money Order 

An express money order is a sight draft of an express company 
payable at any one of its branches, which is used for the same 
purpose as a check. One important use is to remit cash for a 
C. O. D. shipment sent by express. 

Postal Money Order 

A postal money order is a sight draft issued by one postmaster 
on another but payable on identification at any postoffice. 

Bank Draft 

A bank draft is a check drawn by a bank on a depository 
bank (see Chapter XVI). Bank drafts are used in the payment 
of the expenses and liabilities of banks. Like cashiers' checks, 
bank drafts may be purchased by persons who desire to use them 
in making payments. 

As all of the seven forms of commercial paper defined above 
are orders to pay cash on presentation they are considered cash 
items and are recorded in the cash journals. 

PAPERS AND PRACTICES RELATING TO A BANK ACCOUNT 

Almost every businessman has a deposit account with a com- 
mercial bank. Such an account offers manj' advantages in that 
it provides a safe place in which to keep money; is a means of 
collecting notes, drafts, checks, and other cash items; and 
permits the use of checks for payments by the business. Pay- 
ment by check is not only a great convenience to the drawer 
but the indorsement by the payee is an acknowledgment of its 
receipt. A businessman's bank is also the source of his bank 
loans and the place where the discount of commercial paper may 
be made. 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 



239 



Opening the Account 

After a prospective depositor has selected a bank on the basis 
of safety, convenience of location, and possible services to him, 
it is necessary that he be introduced to the bank by a responsible 
person. The introduction is required because the reputation 
of the bank depends in large part on the reliability of its deposi- 
tors. A record is kept by the bank of the depositor's sponsor. 

It is necessary for a depositor who has been accepted by a 
bank to sign a " signature card" to indicate to the bank the 
signature he will use in signing checks. 

Deposit Ticket or Slip 

A deposit ticket or slip is a form provided by the bank on 
which the depositor lists the items of a deposit. Toward tho 





Deposited at 
GIRARD TRUST COMPANY 




To Credit of 




Raymond B. Evans 


431 New Market St. 


July 21, 19__ 


Subject to the rules and conditions of the Philadelphia Clearing House 
Association of which the depositor admits receiving notice. 


Notes 


(Please Omit Dollar Mark) 


Dollars 


Cents 


100 
19 
4 


00 
00 
25 


do 1's and 2' 
Coin 


s 








123 


25 


Checks and Coupons, as follows 
(enter singly) 
(If in City, name of Bank; if out of City, name of place 
where payable) 
1st National 


17 


23 


4th National 




101 


19 


New York, N. 


Y. 


202 


43 


Chicago, 111. 
TOTAL 




27 


04 


471 


14 




(Please Omit Dollar Mark) 







Deposit ticket or slip. 



240 



ACCOUNTING FUNDAMENTALS 



[Ch. XVII 



top of the ticket are spaces for the name and address of the 
depositor, and the date. Then follows spaces for listing notes, 
coin, and checks. Checks are listed separately. The deposit 
ticket is handed to the teller at the bank along with the deposit 
and is kept by the bank. 

Passbook 

The passbook is a small book provided by the bank in which the 
total amount of a deposit is entered by the bank at the time a 
deposit is made. It acts as a receipt to the depositor for deposits 
made. 

Checkbook 

A checkbook is a book of detachable blank checks and stubs 
which is provided for the depositor by the bank. Its form varies ; 

BACK OF PREVIOUS STUB STUB CHECKS 



Brought Forward 1,619.22 
July 20, Deposit 46 19 
July 21, Deposit 201 09 
July 22, Deposit 634 26 

Carried forward 2,500 76 


Brought Forward 
No. 241 
July 20, 19_ 


300 
10 

78 
294 


06 
No. 241 
Pittsburgh, Pa. 
FORBES NATIONAL BA 
00 Pay to the 
order of Business Week 


Business Week 


3 yr. Subscription 






Ten and no/100 






No. 242 
July 21, 19__ 


No. 242 
Pittsburgh, Pa. 
FORBES NATIONAL BA 
Pay to the 
40 order of A. 11. Harris ( 


A. R. Han is 


Invoice of 


July 12, leps 


2% 


Seventy eiht and 40/100 






No. 243 
July 22, 19Z 


No. 243 
Pittsburgh, Pa. 
FORBES NATIONAL BA 
Pay to the 
00 order of B. F. Dawson 


B. F. Dawson 


Invoice of 


July 13, lees 


2<* 


Two hundred ninety four. . . 




I 


Carried forward 


682 


46 C 



Checkbook with three checks to the page. 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 241 

some checkbooks are single-check size with stub, others include 
several checks and stubs to the page. 

Deposits as made are entered by the depositor on either the 
front or the back of a stub in the checkbook. As a check is 
drawn its stub is filled out to agree with the check as to number, 
date, name of payee, and amount. The reason for the payment 
should also be shown on the stub. In single-check-size check- 
books it is customary to deduct the first check from the deposits 
as shown on the stub, to carry the balance forward, to add to the 
balance each deposit as made and to deduct from the balance 
each check drawn. In checkbooks with several checks to the 
page, between periodic balances it is customary to carry forward 
the balance and deposits as an accumulating total, and to carry 
forward separately the accumulating total of check stubs. The 
checkbook balance naturally is the excess of the total of the 
preceding balance and deposits over the total of checks drawn. 
The procedure of keeping the checkbook may be changed to 
suit the wishes of the depositor provided all essential information 
about deposits and checks is shown. 

Drawing a Check 

A check should be drawn carefully to insure that it is payable 
to the proper person and for the correct amount. The amount 
of the check stated in figures should be entered close to the 
dollar mark and should agree with the written amount. The 
amount stated in writing should begin at the extreme left of 
the amount space and any unused portion of the space should 
be voided by an irregular line. 

The Bank Statement 

The bank statement is a report submitted periodically (very 
often monthly) by a bank to a depositor to show the bank's 
record of the depositor's account for the period. It shows the 
bank's balance of the account at the beginning of the period, 
deposits made and other credits, a list of the checks paid and 
other debits, and the balance at the end of the period. The 
checks paid and canceled by the bank and other debit and credit 
memoranda are returned to the depositor with the statement. 



242 ACCOUNTING FUNDAMENTALS [Ch. XVII 

On the back of the statement there is printed very often a 
form to assist the depositor in reconciling the balance shown by 
his checkbook with the balance shown by the bank. 

On receipt of the bank statement and canceled checks a 
depositor should prepare a reconciliation statement at once, 
in order that any errors by the bank may be reported immediately 
and any checkbook errors may be corrected at once. 

Outstanding Checks 

Outstanding checks are checks drawn on a depository bank 
but not presented for payment prior to the close of the period 
covered by the bank statement. In a current list of outstanding 
checks should be included any checks which were outstanding 
at the last reconcilement and which are still outstanding. A 
certified check which has not been presented for payment is 
not considered outstanding on the books of the drawer. The 
amount of such a check is deducted by the bank from the balance 
of the drawer's account at the time of certification by means of a 
debit memorandum which is charged to the depositor's account. 

The Statement of Reconciliation 

A statement or record prepared by a depositor to determine 
and account for the difference between the balance shown by the 
bank and the balance shown by his checkbook is known as a 
reconciliation statement. The average depositor prepares a 
reconciliation statement on the back of the stubs of his checkbook. 
If the statement cannot be shown there conveniently it should 
be prepared on a form to be kept permanently. 

The balance shown on the bank statement and the checkbook 
balance may agree. This is seldom the case with active accounts, 
for the reason that the bank deducts from the depositor's account 
only those checks which are presented to it for payment, while 
all checks drawn are deducted in the checkbook. The two 
balances will differ by at least the amount of the outstanding 
checks. 

Other items may contribute to the difference between the two 
balances. The depositor may not know that the bank has 
charged his account with collection and exchange fees or service 
fees. Deposits mailed and charged to the bank by the depositor 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 243 

may not have been received by the bank in the period and may 
not have been credited. In addition to the above the difference 
between the two balances may arise in part from errors by the 
bank or the depositor. 

The Reconciliation Process 

1. Arrange canceled checks in numerical sequence. 

2. Compare canceled checks with the list of outstanding 
checks at the previous reconciliation and with the current 
checkbook stubs, and make a memorandum of any errors. 

3. In connection with 2 prepare a list to show the numbers 
and amounts of checks which are outstanding. 

4. Compare deposits as shown by the bank statement with 
deposits as shown on the checkbook and make a memoran- 
dum of any errors and any items which appear on the bank 
statement or the checkbook, but not on both. 

Very often the difference between the bank and the checkbook 
balances is the amount of the outstanding checks. If it is not, the 
errors and adjustments discovered in carrying out the four steps 
enumerated above, together with the outstanding checks, may 
explain the difference. If there is still an unexplained difference 
it may be the result of errors in addition or subtraction in the 
checkbook, and these should be verified. The unexplained 
difference may be due to an error by the bank. 

If errors are found in the checkbook, instead of changing all 
subsequent totals and balances, the balance as of the date of 
reconciliation is corrected. The place of correction is noted on 
the stub on which the error took place. 

It is possible to reconcile by bringing the checkbook figures 
into agreement with the bank balance, but the method which is 
recommended is to bring the bank's figures into agreement with 
the adjusted checkbook balance. The adjusted checkbook 
figure is the amount against which checks may be drawn, and is 
an important figure, therefore, from the standpoint of subsequent 
transactions with the bank. 

Illustrations of Reconciliation Statements 

If the difference between the two balances is simply outstand- 
ing checks, reconciliation is made by subtracting the total of the 



244 ACCOUNTING FUNDAMENTALS [Ch. XVII 

outstanding checks, which are listed individually, from the bank 
balance, and the remainder agrees with the checkbook balance. 

BANK RECONCILIATION STATEMENT, JULY 31, 19 

Checkbook balance $640.29 

Balance per bank statement $702.91 

Deduct: 

Outstanding checks 

No. 403 $18.70 

407 15.20 

412 20.87 

413 7.85 62.62 

Balance as per checkbook $640. 29 

The reconciliation data may indicate that the incorrect check- 
book balance has to be adjusted. If so, the adjustments are 
made, then the bank balance is brought into agreement with the 
adjusted checkbook balance. 

BANK RECONCILIATION STATEMENT, AUGUST 31, 19 

Checkbook balance $ 813.09 

Deduct: 

Collection and Exchange charged by bank .5Q 

Adjusted checkbook balance $ 812.59 

Balance per bank statement $ 750 . 26 

Add: 

Deposit of August 31 not credited by bank . 278.44 

$1,028.70 
Deduct: 

Outstanding checks 

No. 413. $ 7.85 

449 .... 102.00 

461. . . . .... 18.90 

462 ... 54.37 

463. . . . 32.99 216. U 

Adjusted balance as per checkbook . . . $ 812.59 

Entries after Reconciliation 

Many depositors keep no other book record of cash items than 
a checkbook, and very often they make extreme errors in keeping 
it. Sometimes deposits are made and not entered in the check- 
book or are entered in the wrong amount, checks are cashed and 
not recorded, and errors in addition and subtraction are made. 
After such persons have prepared reconciliation statements there 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 245 

are no entries or adjustments to be made since there are no other 
records to adjust. 

A depositor who keeps a complete record of cash transactions 
in cash journals is far less likely to make serious errors in keeping 
his checkbook. The balance shown by the cash journals should 
always equal the balance shown by the checkbook plus the 
amount of cash on hand. It is a general business practice to 
reconcile daily the balance of the cash journals with the check- 
book and undeposited cash. When a depositor who keeps 
complete records discovers at the time of reconciling his bank 
account that there are errors or that there are items not recorded 
by him, it is necessary to correct all his records to conform to the 
facts shown in the bank reconciliation statement. 

Errors discovered in reconciling may require entries to correct 
on the books of the depositor. For example, if the cash dis- 
bursements journal and the checkbook stub show a payment 
on account to a creditor during the month in the amount of 
$60.00 but the canceled check is in the amount of $66.00, an 
entry for the extra $6.00 payment is necessary. 

Charges made and credits allowed by the bank during a 
period, but discovered by the depositor for the first time in 
reconciling, require entries in the cash journals. For example, 
the August 31 bank reconciliation statement showed that the 
bank had charged $.50 for collection and exchange items. The 
collection and exchange items are entered in the cash disburse- 
ments journal as a charge to Collection and Exchange. 

THE TREATMENT OF SOME SPECIAL CASH ITEMS 

Voided Check 

If a check is spoiled at the time of preparation or subsequently, 
it should be marked void as should the stub. Such a check 
should be pinned or glued to the stub so that all checks may be 
accounted for. 

Check Cashed for a Customer 

If a check is cashed for a customer it is not necessary to make 
an entry on the books. The check which is received takes the 
place of an equivalent amount of cash in the daily deposit. If 
the check is not honored it will be charged back to the account 



246 ACCOUNTING FUNDAMENTALS [Ch. XVII 

of the depositor by his bank. In that event the depositor would 
charge the customer in the cash disbursements journal for the 
amount of the dishonored check and would proceed to collect 
it at once. 

Check Exchanged for Money 

A person without a banking connection who wishes to make a 
payment through the mail may ask a depositor to make out a 
check payable to the order of a named party in exchange for an 
equal amount of money. If the depositor agrees, the cash 
received is credited in the cash receipts journal to the account 
of the individual for whose convenience the check is issued. The 
check is charged to the account of the same person in the cash 
disbursements journal. By cross-checking or writing contra 
in the folio columns, the personal account need not be posted. 

Stopping Payment on a Check 

The payment of a check may be stopped if, prior to present- 
ment, a stop-payment slip is filled out at the bank and signed by 
the drawer. 

Bank Overdraft 

An overdraft exists in the account of a depositor if the bank 
honors checks which exceed in amount the balance in the deposi- 
tor's account. Banks sometimes permit an overdraft in a small 
amount as a convenience to the depositor, but they are not 
required to do it. National banks are prohibited from doing it 
by statute. A depositor should be careful to avoid overdrawing 
his account. If he does and the bank refuses payment of a 
check it may be not only embarrassing but harmful to his 
credit. 

Cash Over and Short 

Cash Over and Short is the title of an account to which is 
charged any unexplained shortage in cash on hand and to which 
is credited any unexplained excess of cash on hand. Previously 
in this chapter it was explained that it is general practice to 
reconcile daily the book balance of cash with the checkbook and 
undeposited cash. When there is an unexplained difference, 
since the balance of cash on hand cannot be changed, it is 



Ch. XVII] BUSINESS PAPERS AND PRACTICES 247 

necessary to change the balance shown by the books. This is 
accomplished in the case of a shortage by an entry in the cash 
disbursements journal which debits Cash Over and Short account 
and credits Cash for the difference. In the case of an excess 
of cash on hand, the entry is made in the cash receipts journal 
as a debit to Cash and a credit to Cash Over and Short. 

Some unexplained differences in cash are never found, as 
they are the result of mistakes in making change. Over a 
period of time such short or ovcrchanging mistakes should 
about equalize each other. The amounts of other mistakes as 
they are discovered are transferred by journal entries from the 
Cash Over and Short account to the appropriate account titles. 

Cash over and short items should be investigated very care- 
fully. If at the end of a fiscal period there is a balance in the 
Cash Over and Short account, it is considered usually, if a debit 
balance, an expense; if a credit balance, an income. 

OTHER PAPERS AND PRACTICES 

It will be appreciated that not all the business papers and 
practices with which the accounting student should be familiar 
have been covered in this chapter and the preceding one. There 
are many other forms and practices, some in use entirely within 
an enterprise, such as the forms and practices connected with 
the accounting for labor and materials in a factory, and some in 
use between enterprises, such as the forms and practices in 
leasing, insuring or selling real estate, or investing funds. Some 
of these other papers and practices will be considered in connec- 
tion with the topics of the remaining chapters, but yet others 
must be left for consideration by more specialized accounting 
texts or by books in other fields of business. 

QUESTIONS 

1. Do you think a professor of accounting has the right to purchase a 
portable blackboard for a university classroom and to charge it to 
his university? Do you think the dean of the school of business has 
that right? Explain. Who, in your university, has the right to 
purchase needed articles? How does he know the articles are 
needed? 

2. What is a purchase requisition? Why is it customary to make it in 
duplicate? 



248 ACCOUNTING FUNDAMENTALS [Ch. XVII 

3. What is a purchase order? How many copies are made of it and 
why? 

4. a. What is a purchase invoice? What does it show, usually? 

b. Is a purchase invoice a sales invoice to anyone else? Who? 

c. Are invoices often referred to as bills? 

d. What is a bill? 

e. Would you say you received a bill or an invoice from your dentist? 
From your grocer? From your physician? 

5. May the receipt of a purchase invoice precede the receipt of the 
goods? How may that happen? When is an entry made for a 
purchase invoice? 

6. a. What is a credit memorandum? Who issues it? How may it be 

distinguished from an invoice? How many copies are made of 
it? Why? What occurrences usually prompt the issuance of 
credit memos? 

b. A credit memo arising out of the purchase and sale of merchandise 
is the basis for what entry on the books of the seller? The buyer? 

7. a. What is a debit memorandum? 

b. A debit memorandum is the basis for what entry on the books 
of the buyer? The seller? 

8. Give your views on the following statement: "It is not necessary 
for an enterprise to record, until they are paid, bills for telephone, 
telegraph, rent, gas, and electric services." 

9. a. Suppose a sales invoice is made in triplicate. What is the disposi- 

tion of each of the three parts? 

b. Distinguish between a sales invoice and a monthly statement. 

c. Is it customary for a department store to send a sales invoice for 
each charge sale? To send out monthly statements? 

10. a. What is a bill of lading? 

b. Who are the parties to a bill of lading? 

c. How many copies are made of a bill of lading? 

d. What is each part called and what is the disposition of each part? 

e. How many kinds of bills of lading are there? What are they 
called? 

11. a. How can you tell quickly whether a bill of lading is a straight or 

an order bill of lading? 

b. Give another important distinction between the two kinds of 
bills of lading. 

c. When is it customary to use the straight bill? 

d. When is it necessary to use the order bill? 

12. Explain the procedure, when an order bill is used to make a C.O.D. 
sale on merchandise which is shipped by freight. 

13. Can you name any article which is shipped frequently on order 
bills by manufacturers to dealers? 



Ch. XVII) BUSINESS PAPERS AND PRACTICES 249 

14. What is a check? Who may draw a check? Who are the parties 
to a check and by what titles are they known? When is a check 
payable? Is a check a draft? 

16. a. What is a cashier* 's check? For what purpose is it used? 

6. What is a certified check? For what purpose do you think it is 
used? 

c. What are travelers! checks? Why are they used? How is the 
payee of a travelers' check identified? 

d. What is an express money order? A postal money order? Why 
are these instruments used? 

e. What is a bank draft? 

f. If you received any one of the instruments mentioned in this 
question, in what journal would you enter it? Why? 

g. If you lived in Texas and wanted to make a payment in New 
York City, in funds payable in New York City, how could you 
do it? 

16. A bank account offers what advantages to a businessman? 

17. What are the advantages of paying bills and invoices by checks? 

18. What factors should influence a businessman in the choice of his 
bank? 

19. Who makes out a deposit slip? Why? How is it made out? 

20. What is a passbook? 

21. After you have placed money in a bank, how do you get any of it 
out of the bank? 

22. In drawing a check, care should be exercised on what particulars? 
Explain why in each instance. 

23. A bank statement to a depositor gives what information? What 
does a bank send with the statement? 

24. If your checkbook balance and the balance shown on the bank state- 
ment do not agree, which should be the larger amount, ordinarily? 

25. What do you mean by a reconciliation statement? 

26. In addition to checks outstanding, can you mention any other 
factors to explain a variance between your checkbook and the bank 
statement balances? 

27. Indicate whether your checkbook balance would be under or over- 
stated, and how much, as the result of each of the following errors: 
a. You listed a deposit of $10.00 as $100.00. 

6. You forgot to enter a $15.00 deposit. 

c. You draw a check for $10.00 but listed it on the stub as $1.00. 

d. You draw a check for $8.00 but forgot to list it at all. 

e. You drew a check for $6.72 but listed it on the stub as $7.62. 
/. In adding your check stubs you overadded by $100.00. 

28. a. What entry would you make and where, if, in reconciling, you 

discovered that a $75.00 check drawn to the order of a creditor 



250 ACCOUNTING FUNDAMENTALS [Ch. XVII 

during the month had been listed as $57.00 on the checkbook 
stub and the general books? 
b. What proof is there of the error in a? 

29. a. If you cashed a check for a customer, what entry would you 

make, if any? 

b. Can you prevent the payment of a check, once you have issued it? 

c. What is meant by a bank overdraft? Are banks likely to permit 
it? 

30. a. How frequently should the Cash account and cash be reconciled? 

How is this done? 

6. When is the Cash Over and Short account charged? In what 
journal? 

c. When is the Cash Over and Short account credited? In what 
journal? 

d. If you discovered that a $10.00 excess of cash three weeks ago 
was due to an unrecorded payment on account by a customer, 
what entry would you make and where? 



CHAPTER XVIII 

THE GENERAL AND SUBSIDIARY LEDGERS- 
CONTROLLING ACCOUNTS 

Inadequacy of One Ledger 

In the development of this text it has been considered that 
all the ledger accounts of a business are kept in one ledger. 
Such a point of view is fair for probably most small businesses, 
but it is not correct for any business where the number of accounts 
exceeds the ability of one person to record them. Obviously 
where there are too many accounts for one person to post, it is 
necessary to use more than one ledger. 

In a business where there are so many accounts that more than 
one ledger is required for them or more than one person is neces- 
sary to post them, it is customary to divide the ledger into a 
number of very definite parts. From the ledger as it has been 
considered heretofore, there are taken certain account groups the 
accounts of which are sufficiently numerous to warrant their 
own separate ledgers. In the average business the personal 
accounts with customers constitute the largest single group 
and the personal accounts with creditors are likely to be the 
next largest group. These two groups of accounts are removed 
from the ledger as it has been known thus far, and are replaced 
therein by accounts which are known as controlling accounts, 
one controlling account for each separate group ledger. The 
separate new ledgers are known as subsidiary ledgers ; the original 
ledger is known thereafter as the general ledger. 

The General Ledger 

The general or main ledger is the ledger in which all the 
accounts of an enterprise are kept in detail or through con- 
trolling accounts. In an accounting system where separate 
ledgers are provided for customers' and creditors' accounts 
respectively, the general ledger contains all accounts except the 

251 



252 ACCOUNTING FUNDAMENTALS [Ch. XVIII 

personal ones, and for them it has two controlling accounts, 
one called Accounts Receivable, the other Accounts Payable. 

Subsidiary Ledger 

A subsidiary ledger is a ledger which contains accounts of 
like nature which are summarized and controlled on the general 
ledger by a controlling account. 

All accounts with customers are of like character; they nor- 
mally have debit balances, if any balance at all, and they repre- 
sent amounts owed to the enterprise by its customers. Similarly, 
accounts with creditors have credit balances normally, if any 
balance at all, and indicate amounts owed by the enterprise to its 
creditors. 

The subsidiary ledger for customers' accounts is known as 
the accounts receivable ledger, the customers ledger, the trade 
debtors ledger, and the sales ledger; the subsidiary ledger for 
creditors' accounts is known as the accounts payable ledger, the 
creditors ledger, the trade creditors ledger, and the purchase 
ledger. The accounts in a subsidiary ledger may be arranged 
alphabetically, alphabetically within certain geographical groups, 
alphabetically within wholesale and retail groups, or on other 
bases. The first plan mentioned is the usual one. 

Controlling Account 

A controlling or control account is an account in the general 
ledger which summarizes the accounts in a subsidiary ledger. 
The balance of the controlling account should equal the aggregate 
balances of the accounts in the subsidiary ledger which it controls. 

The controlling account, Accounts Receivable, is known also 
as the Customers Controlling account, Trade Debtors account, 
and by other titles. The controlling account, Accounts Payable, 
is known also as the Creditors Controlling account, Trade 
Creditors account, and by other titles. 

Advantages of Subsidiary Ledgers and Controlling Accounts 

Many advantages result from the use of subsidiary ledgers 
and controlling accounts: 

1. The trial balance is shortened. Each subsidiary ledger 
reduces the number of accounts which appear in the trial 



Ch. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 253 

balance of the general ledger by the number of open accounts 
in the subsidiary ledger less one. 

2. The preparation of the statements is simplified by the 
shorter trial balance. 

3. Certain responsibilities are fixed and accuracy encouraged. 
A well-organized accounting system usually provides that 
the work of one person checks with that done by another. 
Since the controlling account balance should equal the 
sum of its controlled account balances, it is possible to 
check the accuracy of the clerk operating a subsidiary 
ledger. Constant checking makes for accuracy. 

4. The accounting system is made more elastic. The use of 
subsidiary ledgers makes it possible for more persons to 
be engaged in posting the entries of the business. 

5. Specialization in the work of posting is provided and leads 
to more effective use of ledger accounts. For example, 
the person assigned the duty of posting the customers 
subsidiary ledger not only becomes fast and accurate in 
doing the work, but develops facility in interpreting the 
records on which he works. A customers ledger clerk 
should notice quickly such matters as the accounts which 
are past due, those which are becoming inactive, and those 
which include old and disputed claims which may become 
the cause of the estrangement of the customers. An 
effective customers ledger clerk is an able assistant to the 
credit and collection manager. 

6. Errors are localized. Imagine the discouraging task of 
trying to locate errors in a general ledger which contains 
thousands of accounts. If subsidiary ledgers and control- 
ling accounts are used and the trial balance does not 
balance, the total of the list of the balances of each sub- 
sidiary ledger is compared with its controlling account 
balance. Differences, if any, are reconciled. If the total 
of each subsidiary ledger list agrees with its controlling 
account, then the difference is caused most likely by errors 
in the remaining general ledger accounts. On the other 
hand, if the trial balance of the general ledger balances, 
but the total of a subsidiary ledger schedule does not agree 
with the balance shown by its controlling account, it may 
be assumed safely that the error is in the subsidiary ledger. 



254 



ACCOUNTING FUNDAMENTALS 



[Ch. XVIII 



7. Posting delays are minimized. When reference is made to 
ledger accounts for certain information, it is advantageous 
to have like accounts grouped together. Where they are 
so grouped in subsidiary ledgers, work on all the accounts 
is not interrupted by the periodic examination of particular 
groups. 

THE OPERATION OP SUBSIDIARY LEDGERS AND CONTROLLING 

ACCOUNTS 

The form of a subsidiary ledger account is exactly the same 
as the account form heretofore considered. 

The form of a controlling account is similarly the same as the 
account form previously considered. The controlling account 
receives its postings from the original entry books, usually 
however from column totals. Controlling account posting is 
done periodically, usually at the end of a month. 

Debits to Customers for Sales 

The initial items in customers' accounts are debits which 
originate in sales as recorded in the sales journal. 

Assume the following sales journal transactions are to be 
posted: 

SALES JOURNAL 









Sales 




Date 


Account Terms 


F 


Invoice 


Customer 








Number 




Jan. 


3 


Richard Ewing 2/10, n/60 


15 


100 


1,800 


00 




8 


William Jackson n/30 


19 


101 


600 


00 




21 


David Charles 1/10, n/30 


7 


102 


720 


00 




24 


Variety Dep't. Store 60-day note 


96 


103 


4,500 


00 




29 


H. T. Adams n/30 


2 


104 


3,000 


00 




31 


Accounts Receivable debit Sales credit 


| 30 




10,620 


00 











Each customer listed in the above sales journal is debited 
in the accounts receivable subsidiary ledger and the page number 
of the account is inserted in the F (folio) column at the time of 
posting. If a loose-leaf subsidiary ledger is used, check marks, 



Ch. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 255 



instead of page numbers, are placed in the F column opposite the 
names of customers, as the accounts are arranged alphabetically. 

By the end of the month, debits totaling $10,620.00 are 
entered in the accounts receivable subsidiary ledger, so it is 
necessary that this same amount be posted as a debit to the 
controlling account. The debit to the Accounts Receivable 
account and the credit to the Sales account are indicated on the 
last line of the sales journal. It is necessary to insert two page 
numbers in the F (folio) column on the last line, one for the debit 
and one for the credit. 

Without the use of a subsidiary ledger and a controlling 
account, the posting of the illustrated sales journal would require 
in the general ledger five personal accounts with debit postings 
and one account (Sales) with a credit posting. With the use 
of the subsidiary ledger and the controlling account, the five 
personal accounts are opened in the subsidiary ledger and the 
only postings in the general ledger are as follows: 

Accounts Receivable 



II 19 - 

Jan. 


31 




S41 


10,620 


00 















Sales 











19_ 
Jan. 


31 




S41 


10,620 


00 



The one debit to the controlling account at the end of the 
month controls completely the debits (regardless of number) 
made to the subsidiary ledger during the month. The con- 
trolling account debit in the general ledger is offset by the credit 
to Sales for the same amount. 

Credits to Creditors for Purchases 

The initial items in creditors' accounts are credits which 
originate in purchases as recorded in the purchase journal. 

Assume the purchase journal transactions, as shown at the top 
of page 256, are to be posted. 

Each creditor listed in the following purchase journal is credited 
in the accounts payable subsidiary ledger. If a bound ledger is 
used the page number of the account is inserted in the F (folio) 
column at the time of posting; otherwise a check mark is inserted. 



256 



ACCOUNTING FUNDAMENTALS 
PURCHASE JOURNAL 



[Ch. XVIII 









Pur- 




Date 


Account Terms 


F 


chase 
Invoice 


Creditor 
Credit 








Number 




19 














Jan. 


4 


Futuristic Furniture Co. 2/10, n/30 


12 


50 


3,000 


00 




10 


Elite Wholesalers n/30 


10 


51 


1,500 


00 




19 


Kates and Robbins 1/10, n/60 


20 


52 


1,200 


00 




24 


Moore Mfg. Co. 1/2 cash, bal. 60 


32 


53 


1,600 


00 




30 


Eastern Radio Sales Co. n/60 


9 


54 


500 


00 




31 


Purchases debit Accounts Payable credit 


<33 
{20 




7,800 


00 















By the end of the month, credits totaling $7,800.00 are entered 
in the accounts payable subsidiary ledger, so it is necessary 
that the same amount be credited to the controlling account. 
The credit to the Accounts Payable account and the debit to the 
Purchases account are indicated on the last line of the purchase 
journal. It is necessary to insert two page numbers in the 
F (folio) column on the last lina, one for the debit and one for 
the credit. 

The five personal accounts with creditors are opened in the 
accounts payable subsidiary ledger. The general ledger postings 
from the purchase journal are 

Purchases 



|19_ 
Jan. 


31 




P 19 


7,800 


00 















Accounts Payable 













I 19 - 

JJan. 


31 




P 19 


7,800 


00 



The credit to the controlling account at the end of the month 
completely controls the credits (regardless of number) made 
to the subsidiary ledger during the month. The equality of the 
debits and credits in the general ledger is maintained because 
the controlling account credit is offset by the debit to Purchases 
for the same amount. 



Ch, XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 257 



Credits to Customers for Cash Receipts 

Cash receipts from customers are credited to them by entries 
in the cash receipts journal. Since cash receipts arise from 
general ledger sources, as well as from customer ledger sources, 
in order to obtain easily the total credits to customers in a 
period, for credit to the controlling account, it is necessary to add 
an extra column to the two already provided in the cash receipts 
journal. 

It will simplify the recording of cash receipts transactions where 
discount is involved if an additional column is included and 
headed Sales Discounts. 

Assume the following cash receipts journal for the business 
used to illustrate this chapter: 

CASH RECEIPTS JOURNAL 



Date 


Accounts vi * 
Credited Explanation 


F 

30 
19 
3 

53 
15 

7 
V 

2 
51 

1 


Credit 


Debit 


General 
Ledger 


Accounts 
Receiv- 
able 


Sales 
Dis- 
counts 


Cash 


19 
Jan. 


2 
2 
9 
12 

13 
31 

31 
31 
31 


Balance 12,200.00 
Sales Cash sale 
William Jackson On acc't. 
Notes Receivable F. Beldcn 
Interest Income On above note 
Richard Ewing Inv. 1/3 less 2 % 
David Charles Inv. 1/21 less 1 % 

Accounts Receivable credit 
Sales Discounts debit 
Cash debit 
Balance 7,798.80 


200 

1,000 
10 


00 

00 
00 


100 

1,800 
720 


00 

00 
00 


36 
7 


00 
20 


200 
100 

1,010 
1,764 
712 


00 
00 

00 
00 
80 


1,210 


00 


2,620 


00 


43 


20 


3,786 


80 








Feb. 


1 







The sum of the debit columns of any original entry book should 
equal the sum of the credit columns, otherwise there is a mistake. 
The sum of the Credit columns of the above cash receipts journal 
is $3,830.00. The Debit columns total the same figure. 

The daily postings from the illustrated cash receipts book are 
credits to the six account titles listed in the Accounts Credited 
column. Three of these credits are made in the general ledger, 
as is evidenced by the three sets of figures which appear in the 
General Ledger column. The other three credits are made in 
the accounts receivable subsidiary ledger, as is evidenced by the 
three sets of figures which appear in the column for that ledger. 



258 ACCOUNTING FUNDAMENTALS [Ch. XVIII 

The credits to the individual accounts of customers are made 
in the accounts receivable subsidiary ledger, since that is the 
ledger in which the customers' accounts were opened. 

At the end of the month, the total of the Accounts Receivable 
column is posted to the credit of Accounts Receivable in the 
general ledger, in order to summarize or control the credits 
made during the month from the cash receipts journal to the 
accounts receivable subsidiary ledger. The end of the month 
debit postings are as indicated debits to Sales Discounts $43.20 
and to Cash $3,786.80. 

The postings made to the general ledger from the illustrated 
cash receipts journal, expressed as a general journal entry, are: 

Sales Discounts 43 20 

Cash 3,786.80 

Accounts Receivable 2 , 620 . 00 

Credits posted during the month 1,210.00 

The above general journal entry is not made actually; it is 
used here simply to summarize in familiar form the debits and 
credits which are posted from the cash receipts journal to the 
general ledger at the end of the posting period. 

The use of a General Ledger column and an Accounts Receiv- 
able column in the cash receipts book serves two purposes. 
First, to indicate to the posting clerk the ledger in which the 
account to be credited is found. The particular account to 
be credited is an account in the ledger indicated by the heading 
of the column in which the amount is entered. The second 
purpose of these two columns is to show clearly at the end of the 
month the amount of credit postings made during the month 
in the general ledger and for which no control posting is necessary, 
and the amount of credit postings made during the month to the 
accounts receivable subsidiary ledger and for which an end of the 
month credit to the controlling account is necessary. 

The use of the Sales Discounts column makes it possible to 
record on one line of the cash receipts journal the debit to Cash 
for the amount received from a customer, the debit to Sales 
Discounts for the discount allowed the customer, and the credit 
to the customer for the full amount of the invoice. The Sales 
Discounts column eliminates the necessity for a general journal 
entry to record the discount, as was illustrated and recommended 
in Chapter VIII. 



Ch. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 259 



When the person who makes the end of the month postings 
from the cash receipts journal is familiar with the accounts to be 
debited and credited, it is unusual to rule the book at the end 
of the month, column by column, as in the illustration on page 
257. The column totals are shown on the same line, and their 
ledger folios are shown in parentheses immediately below the 
totals, thus: 

CASH RECEIPTS JOURNAL 



Date 


Account Explanation 


F 


Credit 


Debit 


General 
Ledger 


Accounts 
Receiv- 
able 


Sales 
Discounts 


Cash 


19 
Jan. 


1 
31 


Balance 12,200.00 
Balance 7,798.80 


^ > 


















1,210 


00 


2,620 


00 


43 
(51) 


20 


3,786 
(1) 


80 


Feb. 


1 


(Y) 




(2) 







The cash balances on January 1 and February 1 are shown in the 
Explanation column as memoranda. In cash journals of this 
kind formal balancing of the two cash journals is not necessary. 
The cash balance may be obtained formally in the Cash account 
in the ledger. 

The Accounts Receivable account in the general ledger, as the 
result of the sales journal and the cash receipts journal postings, 
appears as follows: 

Accounts Receivable 



|19_ 
Jan. 


31 




S41 


10,620 


II 19 - 
OOJan. 


31 




CR17 


2,62000 



The above account has a debit balance of $8,000.00, which 
means that customers owe the business that amount. If the 
various customer accounts in the subsidiary ledger are balanced 
and a list of the balances prepared, the total should be $8,000.00. 



260 



ACCOUNTING FUNDAMENTALS 



[Ch. XVIII 



Debits to Creditors for Cash Disbursements 

Cash payments to creditors are debited to them by entries 
in the cash disbursements journal. Since cash disbursements 
arise from general ledger causes, as well as from creditors ledger 
causes, in order to obtain easily the total cash payments to 
creditors in a period, for debit to the controlling account, it is 
necessary to add an extra column in the cash disbursements 
journal. 

It will simplify the recording of cash disbursement transactions 
where discount is involved if an additional column is included 
and headed Purchase Discounts. 

Assume the following cash disbursements journal for the 
business used to illustrate this chapter: 

CASH DISBURSEMENTS JOURNAL 









Debit 


Credit 


Date 


Accounts Debited Explanation 


F 


General 


Accounts 


Purchase 










Ledger 


Payable 


Discounts 


Cash 


19 
Jan. 


2 


Rent Expense Jan. in adv. 


43 


200 


00 










200 


00 




6 


Office Expenses Stationery 


44 


50 


00 










50 


00 




10 


Purchases Cash purchase 


33 


800 


00 










800 


00 




14 


Futuristic Fur. Co. Inv. 1/4, less 2 % 


12 






3,000 


00 


60 


00 


2,940 


00 




15 


Salaries Payroll 


45 


600 


00 










600 


00 




19 


Notes Payable Haynes 60 days 


21 


1,000 


00 


















Interest Expense 6 % on note 


30 


10 


00 










1,010 


00 




24 


Moore Mfg Co. Acc't. Inv. 1/24 


32 






800 


00 






800 


00 




29 


Kates and Robbins Inv. 1/19 less 1 % 


20 






1,200 


00 


12 


00 


1,188 


00 




31 


Salaries Payroll 


45 


600 


00 










600 


00 








l/ 


3,260 


00 
















31 


Accounts Payable debit 


20 






5,000 


00 












31 


Purchase Discounts credit 


54 










72 


00 








31 


Cash credit 


1 














8,188 


00 





The sum of the Debit columns of the above cash disbursements 
journal equals the sum of the Credit columns hence the debits 
and credits as originally recorded in this book balance. 

The daily postings from this cash disbursements journal are 
debits to the ten accounts listed in the Accounts Debited column. 
Seven of these debits are made in the general ledger, as is evi- 
denced by the seven sets of figures which appear in the General 
Ledger column. The other three debits are made in the accounts 



Ch. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 261 

payable subsidiary ledger, as is evidenced by the three sets of 
figures which appear in the Accounts Payable column. The 
debits to the individual accounts of creditors are made in the 
accounts payable subsidiary ledger, since that is the ledger in 
which the creditors' accounts were opened. 

At the end of the month the total of the Accounts Payable 
column is posted to the debit of the Accounts Payable account, 
in order to control the debits made during the month from the 
cash disbursements journal to the accounts payable subsidiary 
ledger. The end of the month credit postings are as indicated 
credits to Purchase Discounts, $72.00 and to Cash, $8,188.00. 

In order to present, in a familiar form, the debits and credits 
posted at the end of the posting period to the general ledger 
from the cash disbursements journal, they are illustrated in the 
form of a general journal entry, as follows: 

Debits posted during the month 3 , 260 . 00 

Accounts Payable 5 , 000 . 00 

Purchase Discounts 72 . 00 

Cash 8,188.00 

The advantages which result from the use of the General 
Ledger, Accounts Payable, and Purchase Discounts columns in 
the cash disbursements journal are comparable to those con- 
sidered in connection with the use of the special columns in 
the cash receipts journal. The comments made about the end 
of the month ruling of the cash receipts journal by a person 
thoroughly familiar with the postings to be made apply equally 
to the cash disbursements journal. 

The Accounts Payable account, after the cash disbursements 
journal is posted at the end of the month, appears as follows: 

Accounts Payable 



|19_ 
'Jan. 


31 




CD 20 


5,000 


|19_ 
00 Jan. 


31 




P 19 


7,800 


00 



The above controlling account has a credit balance of $2,800.00, 
which indicates the amount owing to creditors on open account. 
The sum of the credit balances in the accounts payable ledger 
should be $2,800.00, 



262 



ACCOUNTING FUNDAMENTALS 



[Ch. XVIII 



Other Credits to Customers Other Debits to Creditors 

Credits to customers for cash receipts have been considered, 
but credits from other sources have not. Customers are credited 
for notes received, for merchandise returned, and for allowances 
granted to them. The entries for such transactions, in the 
absence of a notes receivable journal and a sales returns and 
allowances journal, are made in the general journal. 

It is evident from the past discussion that two Credit columns 
should be used in the general journal instead of one as heretofore. 
One of the Credit columns will show credits to be made in the 
general ledger, the other will show credits to be made in the 
accounts receivable subsidiary ledger and will provide readily 
the total of such credits for posting a credit to the Accounts 
Receivable account at the end of the month. 

Debits to creditors for cash payments made to them have been 
considered, but debits from other sources have not. Creditors 
are debited for notes given, for merchandise returned, and for 
allowances obtained from them. The entries for such transac- 
tions, in the absence of a notes payable journal and a purchase 
returns and allowances journal, are made in the general journal. 

It is evident again from the past discussion that two Debit 
columns should replace the one used heretofore in the general 
journal. One of the Debit columns will show debits to be made 
in the general ledger, the other will show debits to be made in the 
accounts payable subsidiary ledger and will provide readily the 
total of such debits for posting a debit to the Accounts Payable 
account at the end of the month. 

When subsidiary ledgers for both customers and creditors are 
used, the general journal requires a minimum of four amount 
columns, two Debit and two Credit, as follows: 

GENERAL JOURNAL 
JANUARY. 19 



Debit 


F 


Date 

Debit and Credit Accounts 
Explanation 


F 


Credit 


Accounts 
Payable 


General 
Ledger 


General 
Ledger 


Accounts 
Receiv- 
able 

























Oh. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 263 



Other Debits to Customers Other Credits to Creditors 

Various other transactions with customers and creditors make 
necessary entries which sometimes include debits to customers 
and sometimes include credits to creditors. Such entries, if 
cash is not involved, are made in the general journal. They 
may be made in the four-column journal, as pictured above, but 
not so easily as in a six-column journal, which has an Accounts 
Receivable Debit column and an Accounts Payable Credit 
column, in addition to the four columns illustrated. Since 
the average general journal page accommodates six columns 
satisfactorily, their use is recommended. 

GENERAL JOURNAL 
JANUARY, 19 



Debit 




Tif *> 




Credit 










A^aie 

Debit and Credit Accounts 










Accounts 
Payable 


Accounts 
Receiv- 
able 


General 
Ledger 


F 


Explanation 


F 


General 
Ledger 


Accounts 
Receiv- 
able 


Accounts 
Payable 


1,500 


00 










10 


12 
Elite Wholesalers 






























Elite Furniture Company 


11 










1,500 


00 
















To correct improper credit, purchase 






























journal 1/10 






























13 
















150 


00 










11 


Elite Furniture Company 






























Purchase Returns and Allowances 


35 


150 


00 
























Return of detective merchandise 






























24 
























4,500 


00 


3 


Notes Receivable 






























Variety Department Store 


96 






4,500 


00 




















60-day note dated 1/24 






























25 
















1,350 


00 










11 


Elite Furniture Company 






























Notes Payable 


21 


1,350 


00 
























15-day note dated 1/25 






























26 
















100 


00 










32 


Moore Manufacturing Company 






























Purchase Returns and Allowances 


35 


100 


00 
























Allowance for damage in shipping 






























30 




















3,000 


00 






3 


H. T. and C. B. Adams 






























H. T. Adams 


2 






3,000 


00 




















Debts of H. T. Adams 






























assumed by II. T. and C. D. Adams 
























4,500 


00 


V 




V 


1.600 


22 














3,000 


00 






2 


Dr. Accounts Receivable Cr. 


2 






7,600 


00 






3,100 


00 










20 


Dr. Accounts Payable Cr. 


20 










1,500 


00 



264 



ACCOUNTING FUNDAMENTALS 



[Ch. XVIH 



Assume the general journal, shown on page 263, is the journal 
of the business used to illustrate this chapter. 

It will be noticed that the end of the month postings from the 
illustrated general journal include both debits and credits to 
each of the controlling accounts. 

If a transaction involves a debit to a customer and a credit to 
Cash, or a debit to Cash and a credit to a creditor, the entry is 
recorded in one of the cash journals. Entries of this character 
arise as the result of transactions, such as the return of an over- 
payment to a customer, checks of customers returned by the 
bank because of insufficient funds, or the receipt of cash from a 
creditor for the amount of an allowance obtained and recorded 
after the purchase invoice was paid in full. 

To illustrate, assume an example which is not connected with 
the accounts used to illustrate this chapter. John Marks, a 
customer, overpaid his account $100.00. His account in the 
customers ledger shows a credit balance of that amount, so a 
check for $100.00 is sent to him. The entry in the cash disburse- 
ments journal is as follows: 

CASH DISBURSEMENTS JOURNAL 









Debit 


Credit 


Date 


Account Explanation 


F 


General 


Accounts 


Purchase 










Ledger 


Payable 


Discounts 


Cash 


19 
May 


8 


Accounts Receivable ) return of 




10000 










10000 






John Marks / overpayment 

















Both of the above debits are posted and two page numbers 
are inserted in the F (folio) column alongside the one amount of 
$100.00. The debit to John Marks is made in the accounts 
receivable subsidiary ledger. The debit to the Accounts Receiv- 
able account controls the posting to the subsidiary ledger. The 
entry for this transaction would be an easier one and would be 
made in the usual way if an Accounts Receivable column was 
included in the cash disbursements journal. Entries of this 
character are so exceptional they do not justify the inclusion of 



Ch. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 265 

an Accounts Receivable column in the cash disbursements 
journal and an Accounts Payable column in the cash receipts 
journal. 

In order that a controlling account may control completely 
the subsidiary ledger it represents, it is necessary that every 
amount which is posted, as either a debit or a credit in the sub- 
sidiary ledger, be included in the summary postings or be posted 
separately to the controlling account. 

The two controlling accounts used in the illustrations of this 
chapter appear now, as follows: 

Accounts Receivable 



19 












19_ 












Jan. 


31 




S41 


10,620 


00 


Jan. 


31 




CR17 


2,620 


00 




31 




J 6 


3,000 


00 




31 




J 6 


7,500 


00 



Accounts Payable 



Jan. 


31 
31 




CD 20 
J 6 


5,000 
3,100 


00 
00 


Jan. 


31 
31 




P 19 
J 6 


7,800 
1,500 


00 
00 



Procedure If Note Journals Are Used 

If notes received from customers are recorded in a notes receiva- 
ble journal, then such entries are not included in the general 
journal. From the notes receivable journal the customers are 
credited in the subsidiary ledger and at the end of the month the 
daily postings are summarized for general ledger and controlling 
account purposes by posting a debit to Notes Receivable and a 
credit to Accounts Receivable for the total. If any notes received 
during the month had interest included in their face, the end of 
the month summary postings are a debit to Notes Receivable and 
credits to Accounts Receivable and Interest Income. 

If a notes payable journal is used, all entries for notes issued to 
creditors are recorded therein and not in the general journal as 
illustrated. From the notes payable journal creditors are 
debited in the creditors subsidiary ledger, and at the end of the 
posting period the daily postings are summarized for general 
ledger and controlling account purposes by debiting Accounts 
Payable and crediting Notes Payable. If any notes were given 



266 ACCOUNTING FUNDAMENTALS [Ch. XVIII 

during the period with interest included in their face, the sum- 
mary postings are debits to Accounts Payable and Interest 
Expense and a credit to Notes Payable. 

Procedure If Returns and Allowances Journals Are Used 

If a sales returns and allowances journal is used, the accounts 
of customers whose names appear therein are credited in the 
accounts receivable subsidiary ledger. The monthly summary 
debits Sales Returns and Allowances and credits Accounts 
Receivable. 

If a purchase returns and allowances journal is used, the 
accounts of creditors whose names appear therein are debited 
in the subsidiary ledger for creditors. The monthly summary 
debits Accounts Payable and credits Purchase Returns and 
Allowances. 

Control Procedure for Sales to Proprietor 

If the practice in a business is to consider proprietor's with- 
drawals of merchandise as sales and to record them in the sales 
journal, a proprietor's personal account is opened in the accounts 
receivable subsidiary ledger. The proprietor may settle this 
account by payment with his personal check. If he does not 
settle with cash a general journal entry is made at the end of 
the fiscal period to debit the proprietor's personal account in the 
general ledger with the amount of his personal account in the 
customers subsidiary ledger. The debit amount of this entry 
is made in the General Ledger Debit column of the general 
journal; the credit entry is made in the Credit Accounts Receiv- 
able Ledger column. The effect of this entry is to prevent 
Accounts Receivable being overstated by the amount charged 
to the proprietor. 

If merchandise withdrawn by the proprietor is recorded 
originally by general journal entry as a debit to the proprietor's 
personal account and a credit to either Purchases or Sales, 
the customers controlling account and subsidiary ledger are not 
affected. 

Procedure to Record Sales to a Creditor and Purchases from a 
Customer 

It sometimes happens that a charge sale is made to a creditor 
or a credit purchase is made from a customer. In such a situation 



Ch. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 267 

it is desirable to have accounts in both the customers and the 
creditors subsidiary ledgers with the person who has the dual 
relationship to the business. The accounts may be settled 
separately, in which case they offer no new problem. If both 
accounts are settled by a single payment, an entry is made of the 
cash item in the proper cash journal and the remaining balances 
of the accounts are adjusted by a general journal entry. 

Procedure If a Controlled Account Shows an Opposite Balance 

Sometimes an account in a subsidiary ledger shows a balance 
which is the opposite of its controlling account and of the balances 
of the other accounts in the same ledger. For example, a 
customer's account in the accounts receivable subsidiary ledger 
may show a credit balance, or a creditor's account in the accounts 
payable ledger may show a debit balance. Such a condition is 
caused usually by a credit memorandum issued or received 
after the account is settled in full, by an overpayment, or a 
deposit made to hold goods. When the subsidiary ledger total 
of balances is prepared for comparison with its controlling 
account, it is necessary to subtract the amount of such an 
opposite balance from the sum of the balances of the other 
accounts. 

The sum of the opposite balances of a subsidiary ledger should 
be added to the amount of both controlling accounts for balance 
sheet purposes. For example, if a customer's account in the 
customers subsidiary ledger has a credit balance of $5,000.00, 
Accounts Receivable and Accounts Payable should be shown in 
the balance sheet for $5,000.00 more than the amount of the book 
balances of these controlling accounts. The balances of the 
controlling accounts are not changed. 

References to Other Controlling Accounts 

The principle of control which governs the use of subsidiary 
ledgers and controlling accounts has been fundamental in the 
development of modern accounting systems for large-scale 
enterprises. In addition to Accounts Receivable and Accounts 
Payable many other controlling accounts are in general use, such 
as Capital Stock, Stores, Work in Process, Finished Goods, 
Delivery Equipment, and Buildings. Some of these and other 
controlling accounts will be considered in later chapters. 



268 ACCOUNTING FUNDAMENTALS [Ch. XVIII 

QUESTIONS 

1. What do you mean by a subsidiary ledger? A general ledger? 

2. Suppose a business had a general and two subsidiary ledgers. How 
many ledgers would be used to take a trial balance? How is this 
possible? 

3. What is a control account? What is the evidence of its control? 

4. In what respect are all customer accounts alike in character? All 
creditor accounts? 

6. What condition must exist to warrant the establishment of a sub- 
sidiary ledger for customers? 

6. What is the most popular title of the controlling account for 
customers? For creditors? 

7. Name a subsidiary ledger which you believe would be used by a 
bank. A department store. An electric-light company. A 
telephone company. A gas company. 

8. Give at least four advantages resulting from the use of a subsidiary 
ledger and a controlling account. 

9. Would it be possible for a business with 5,000 accounts to have a 
shorter trial balance than another business with 162 accounts? 
How? 

10. Suppose a business has the following open accounts : 

Assets (exclusive of customers) . . 50 

Customers .. . . 22,000 

Liabilities (exclusive of creditor accounts) .... 2 

Creditor accounts 100 

Expenses 20 

Income 5 

Proprietor 2 

a. If all accounts are kept in one ledger, how many items would be 

in the trial balance? 
6. If customer and creditor subsidiary ledgers are used, how many 

items would be in the trial balance? 

11. In what way are responsibility and accuracy encouraged by the use 
of subsidiary ledgers? 

12. How is an accounting system made more elastic by the use of 
subsidiary ledgers? 

13. Do you believe a customer ledger clerk can become, in that position, 
more than a clerk who posts debits and credits to customer accounts? 
If so, how? 

14. In a given month, who is the more likely to make clerical errors in 
posting, a customer ledger clerk or the general ledger bookkeeper? 
Why? 



Ch. XVIII] THE GENERAL AND SUBSIDIARY LEDGERS 269 

15. a. From what journal or journals do customer accounts receive 

debits? Credits? 

6. From what journal or journals do creditor accounts receive 
credits? Debits? 

16. Suppose a sales journal contained 379 charge sale records in a 
month. How many debits would be posted from that journal to 
a. The general ledger? 

6. The subsidiary ledger for creditors? 

c. The subsidiary ledger for customers? 

How many credits would be posted from that journal to 

d. The subsidiary ledger for creditors? 

e. The general ledger? 

/. The subsidiary ledger for customers? 

17. From the purchase journal which account in the general ledger is 
debited? Credited? 

18. How is it possible to distinguish, in the cash receipts journal, cash 
received from customers from cash received from all other sources? 

19. Suppose a cash receipts journal has money columns headed Cash, 
Sales Discounts, General Ledger, and Accounts Receivable, name 
two debits postings to the General Ledger each month. Name one 
credit posting. 

20. Is there any advantage in having a Purchase Discounts column in 
the cash disbursements journal? What? 

21. What end of the month column total postings are made from a cash 
disbursements journal with columns headed Cash, Purchase Dis- 
counts, General Ledger, and Accounts Payable? 

22. From the cash disbursements journal illustrated on page 260, 
a. How many debit postings were made to 

(1) The subsidiary ledger for creditors? 

(2) The subsidiary ledger for customers? 

(3) The general ledger? 

&. How many credit postings were made to 

(1) The general ledger? 

(2) The subsidiary ledger for customers? 

(3) The subsidiary ledger for creditors? 

c. What was the total amount (dollars and cents) of postings to the 
general ledger as debits? As credits? 

23. How many money columns are desirable in the general journal, if 
the business uses a general ledger and a subsidiary ledger for 
customers? If it uses a general ledger and subsidiary ledgers for 
customers and creditors? 

24. How would the following entries in the six-column general journal 
illustrated on page 263 be made in the four-column general journal 
illustrated on page 262? 



270 ACCOUNTING FUNDAMENTALS [Ch. XVIII 

a. The first entry the one on January 12. 
6. The sixth entry the one on January 30. 

25. Can you justify the inclusion of a proprietor's personal account in 
the customers ledger? What would you do with such an account, 
if it were open at the end of a fiscal period? Why? 

26. May accounts with the same person appear in both the customer 
and creditor subsidiary ledgers? Why? 

27. Suppose the Accounts Receivable account has a balance of $50,- 
000.00, the Accounts Payable account a balance of $25,000.00. 
Suppose also there is one account in the creditor subsidiary ledger 
with an opposite balance of $10,000.00. 

a. What do you mean by an opposite balance? 
6. What could have caused the opposite balance here referred to? 
c. What amounts should appear in the balance sheet, for the facts 
of this question? 



CHAPTER XIX 

COLUMNAR JOURNALS AND PETTY CASH SYSTEMS 
COLUMNAR JOURNALS 

In Chapter VIII the journal was divided into a number of 
journals on the basis of the types of transactions which occur 
frequently. The sales journal was provided for sales of mer- 
chandise transactions/ the purchase journal for purchases 
of merchandise transactions, and the cash receipts and cash 
disbursements journals for receipts and payments of cash 
respectively. 

In the preceding chapter when it was desired to classify further 
certain types of transactions this result was accomplished by the 
addition and use of extra columns in the special journals. For 
example, when the use of the general and subsidiary ledgers 
made it desirable that cash receipts be classified to distinguish 
those receipts which came from general ledger sources from those 
which came from customer ledger sources, this result was obtained 
by the use of a General Ledger column and an Accounts Receiv- 
able Ledger column in the cash receipts journal. The classifica- 
tion of cash payment transactions and of general journal trans- 
actions was accomplished similarly by the use of extra columns 
in the cash disbursements journal and the general journal. 
The cash receipts journal, the cash disbursements journal, 
and the general journal, which were developed in the preceding 
chapter as an incident to the study of the use and operation of 
subsidiary ledgers and controlling accounts, are columnar 
journals. 

Definition and Purpose 

A columnar journal is a journal with more than one debit 
column or more than one credit column. 

Sometimes two money columns are sufficient to classify a 
journal as columnar. For example, if to the one-money-column 
sales journal, as developed in Chapter VIII, is added one extra 

271 



272 ACCOUNTING FUNDAMENTALS [Ch. XIX 

column to classify or analyze either the debits or the credits, 
the book is a columnar sales journal. There is no limit to the 
number of money columns which may be used in a journal except 
the limit which develops from the inconvenience of a book with 
too many columns. 

Each journal of Chapter VIII provided the place to record 
the debits and the credits for transactions of a certain type. 
Each columnar journal similarly provides the place to record the 
debits and the credits for transactions of a certain type as well 
as the opportunity to classify or analyze the debits, the credits, or 
both, by means of extra money columns. 

Form of Columnar Journals 

There is no standard form for columnar journals. The form 
varies with the different journals and it may differ for the 
same journal as between two businesses. Sometimes one journal 
page is not wide enough to accommodate the necessary columns 
so the opposite page is used also, the two pages representing one 
page of that particular journal. Each journal should be designed 
so that the transactions entered in it may be recorded adequately 
and conveniently. 

THE USE AND OPERATION OF COLUMNAR JOURNALS 

As mentioned previously, the cash receipts, the cash disburse- 
ments, and the general journals which were developed in the 
preceding chapter are illustrations of columnar journals. 

Columnar Sales Journal 

Suppose a business desires to keep its merchandise purchases 
and sales classified by departments, of which it has three. 
Instead of one Purchases and one Sales account in the gen- 
eral ledger there will be three Purchases and three Sales accounts, 
a separate Purchases and a separate Sales account for each 
department. 

Each customer named in the sales journal on page 273 is 
debited in the accounts receivable subsidiary ledger for the 
amount which appears in the Debit Accounts Receivable column 
opposite his name. At the end of the month the Accounts 
Receivable account in the general ledger is debited for the total 



Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 273 



of the Debit Accounts Receivable column and each sales account 
is credited for the total of its column, as indicated. 

SALES JOURNAL 









fial AO 


Debit 


Credit 


Date 


Account Terms 


F 


OHiCS 

Invoice 
Number 


Accounts 


Sales 


Sales 


Sales 










Receiv- 


Depart- 


Depart- 


Depart- 










able 


ment A 


ment B 


ment C 


19_ 
Jan. 


2 


W. S. Smith, 2/10, n/30 


22 


1 


225 


00 


100 


00 


50 


00 


75 


00 




5 


J. B. Jordan, n/30 


11 


2 


48 


00 


48 


00 












8 


T. B. Wallace, 1/10, n/30 


30 


3 


160 


00 


90 


00 


70 


00 








14 


It. Jones, 2/10, n/30 


10 


4 


165 


00 


80 


00 


60 


00 


25 


00 




22 


B. L. Hess, 1/10, n/30 


9 


5 


220 


00 


105 


00 


75 


00 


40 


00 




29 


S. O. Pcet, 1/10, n/30 


17 


6 


205 


00 


115 


00 


45 


00 


45 


00 




31 


Accounts Re- 


























ceivable Dr. 


2 




1,023 


00 
















31 


Sales Dcpt. A Cr. 


40 








538 


00 












31 


Sales Dept. B Cr. 


41 












300 


00 








31 


Sales Dept. C Cr. 


42 
















185 


00 







The postings to the general ledger at the end of the month 
expressed in the familiar two-column general journal form are: 



Accounts Receivable 

Sales Department A 
Sales Department B 
Sales Department C 



1,023.00 



538.00 
300.00 
185.00 



It is not customary to rule the sales journal at the end of the 
month as in the illustration. The column totals are all shown 
on the same line; and the ledger pages of the accounts, to which 
the end of the month postings are made, are not shown in the 
F (folio) column but in parentheses immediately below the totals 
as illustrated for the cash receipts journal on page 259. The 
practice of showing all column totals on the same line and the 
posting folios in parentheses below the totals is true not only for 
the sales and cash receipts journals but for all columnar journals. 

The analytical sales journal as illustrated furnishes all the 
information that a single money column sales journal supplies 
plus an analysis of sales by departments. A business which 
uses a columnar sales journal as illustrated and a columnar 
purchase journal which provides an analysis of purchases by 



274 



ACCOUNTING FUNDAMENTALS 



[Ch. XIX 



departments is supplied with many of the data necessary for 
the preparation of departmental statements to show the gross 
profit or loss on sales. In order that such statements may be 
prepared it is also necessary to classify and record, by depart- 
ments, the opening and closing inventories, transportation 
inbound charges, and returns and allowance transactions for 
both purchases and sales. 

Recording Cash Sales 

Cash sales are recorded by one of several plans. 

1. By a charge to the customer in the sales journal and an 
immediate credit to the customer in the cash receipts journal. 
Since this method involves the opening of unnecessary customer 
accounts in the ledger it is too burdensome a plan to be followed 
where cash sales are frequent. 

2. By an entry in the cash receipts journal. This entry is 
not made for each sale but for the total cash sales of a day. The 
cash receipts journal is chosen as the book of original entry 
rather than the sales journal because the cash receipts journal 
should show all receipts of cash. To record a cash sale in 
both the cash receipts and sales journals and to post in the usual 
way would result in two entries for each cash sale. If the cash 
sales include merchandise from each of the three departments, 
three lines of the cash receipts journal are required for the entry, 
thus: 



CASH RECEIPTS JOURNAL 









Credit 


Debit 


Date 


Account Explanation 


Jb' 


General 
Ledger 


Accounts 
Receiv- 
able 


Sales 
Discounts 


Cash 


19 
























Jan 


5 


Sales Dept. A^ 
Sales Dept. B >Cash sales for day 
Sales Dept. Cj 




20 
15 
12 


00 
00 
00 










20 
15 
12 


00 
00 
00 



Each departmental sales account is credited in the general 
ledger for the amount indicated. The debit to Cash in the 
general ledger is included as a part of the total posted to that 
account at the end of the month. 



Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 275 



In a business where cash sales are recorded completely in the 
cash receipts journal, all sales slips including those for cash sales 
should be accounted for and carefully audited. A dishonest 
employee may attempt to cover a shortage in cash by destroying 
or underadding some cash sales slips. 

If there are daily cash sales from each department, there is a 
daily three-line cash receipts journal record. In order to reduce 
the required daily cash sales entries and the resulting postings, 
and to provide a recording method whereby cash sales are 
checked and recorded by two different persons, cash sales are 
sometimes recorded by plan 3. 

3. Cash sales are recorded in the cash receipts journal and the 
sales journal and their entry is facilitated by the use of a special 
cash sales column in each of these books. The Cash Sales col- 
umns are used only for sales of merchandise made solely for cash. 

SALES JOURNAL 











Debit 


Credit 


Date 


Account Terms 


F 


Invoice 


















Number 


Accounts 
Receiv- 


Cash 
Sales 


Sales 
Dept. A 


Sales 
Dept. B 


Sales 
Dept. C 










able 










Jan. 


2 


W. S. Smith, 2/10, n/30 


22 


1 


225 


00 






100 


00 


60 


00 


75 


00 




5 


J. B. Jordan, n/30 


11 


2 


48 


00 






48 


00 












5 


Cash sales for day 


" 








47 


00 


20 


00 


15 


00 


12 


00 



CASH RECEIPTS JOURNAL 



Date 


Account Explanation 


F 

\s 


Credit 


Debit 


General 
Ledger 


Accounts 
Receiv- 
able 


Cash 
Sales 


Sales 
Discounts 


Cash 


Jan. 


o 
5 


Balance 9,800.04 
Cash sales for day 










47 


00 






4700 



Cash sales are entered in both journals individually or by 
daily totals as illustrated. The check mark in the F column 
of the sales journal is made at the time the entry is recorded to 
indicate that the debit item of $47.00 is not to be posted from 
that journal. The check mark in the F column of the cash 



276 ACCOUNTING FUNDAMENTALS [Ch. XEK 

receipts journal is made also at the time the entry is recorded 
to indicate that the credit item of $47.00 is not to be posted from 
that journal. The debit to Cash in the ledger for the amount 
of cash sales is made as a part of the debit which is posted at the 
end of the month to that account from the cash receipts journal. 
The credits for cash sales are made to the departmental sales 
accounts in the ledger as parts of the end of the month credits 
from the sales journal. By this plan cash sales result in a debit 
to Cash through the cash receipts journal and credits to the 
departmental sales accounts through the sales journal. The 
totals of the Cash Sales columns in the two journals are not 
posted. 

When cash sales are recorded by plan 3, an owner is able to 
determine at any time during a period, from the departmental 
sales columns in the sales journal, the total volume of sales 
both charge and cash. 

4. Another method of recording cash sales uses a sales journal 
and a cash receipts journal ruled as illustrated in plan 3. The 
operation of this plan differs from method 3 in that complete 
postings are made for cash sales from both books. From the 
sales journal at the end of the month the total of the Cash Sales 
column is debited to a Cash Sales account in the general ledger. 
The credits from the sales journal are the same as in plan 3. 
From the cash receipts journal the total of the Cash Sales column 
is credited at the end of the month to the new account Cash 
Sales. The debit postings from the cash receipts journal are the 
same as in plan 3. The Cash Sales account should balance 
after both the sales and cash receipts journals are posted. 

The check marks in the F columns of both journals are as 
necessary under this plan as in plan 3. The various debits to 
Cash Sales in the sales journal and the various credits to Cash 
Sales in the cash receipts journal are not posted individually 
but by totals from the Cash Sales columns of the two journals. 
The use of plan 4 discloses through the Cash Sales account the 
volume of cash sales business, period by period. 

5. In businesses where departmental sales accounts are not 
used it is quite common to find cash sales recorded exclusively 
in the cash receipts journal by means of a special Cash Sales 
column in that book. The special Cash Sales column facilitates 
the posting of cash sale items. At the time of recording a check 



Ch.XIX) COLUMNAR JOURNALS, PETTY CASH SYSTEMS 277 

mark is placed in the F column for each cash sale entry. The 
total of the Cash Sales column is credited to Sales at the end of a 
posting period and the offsetting debit is included in the debit to 
Cash for the total of the Cash column. This plan may be used 
if departmental sales accounts are kept, provided a special Cash 
Sales column for each department is included in the cash receipts 
journal. 

In addition to the five plans which were described, there are 
other methods of recording cash sales. If a cash sale is made to a 
customer who is usually a charge customer, the cash sale should 
be recorded always in the sales journal as a charge to the cus- 
tomer. Credit should be given to the customer immediately 
in the cash receipts journal for the amount of the sale. This 
method preserves a record in the customer's account of all sales 
to him. Such a record is important in that it causes the cus- 
tomer's account to show both the total volume of business and a 
full history of the transactions with the customer. 

Recording Sales for a Note 

A merchandise sale for which a note is accepted immediately 
is recorded as two transactions. The sale is charged to the 
customer in the sales journal and the note is credited to the 
customer in the notes receivable journal, if one is used, otherwise 
in the general journal. A compound transaction of this kind 
is entered as though its parts occurred at different times. 

Recording C.O.D. Sales 

A local C.O.D. (cash on delivery) sale, where payment is 
received by the business the same day the sale is made, may be 
treated as a cash sale. Entry of the C.O.D. sales ticket is delayed 
until the goods are delivered, paid for and the cash is received 
at the business. 

An out of town or other C.O.D. sale where payment is not 
received the day the sale is made, requires different treatment. 
Such a sale is recorded in the sales journal as a C.O.D. charge 
to the customer. The letters C.O.D. are written after the 
customer's name in the sales journal. The usual account in the 
accounts receivable subsidiary ledger is not opened for each 
C.O.D. customer because the charge is a temporary one which 
is to be satisfied on delivery of the merchandise. The debit is 



278 



ACCOUNTING FUNDAMENTALS 



[Ch. XIX 



posted to a section of the ledger headed C.O.D. Customers 
and the name of the customer is written in the explanation section 
of the line on which the debit is made. When payment is 
received at the business the C.O.D. customer is credited in 
the accounts receivable column of the cash receipts journal. 
The credit posting is made to the C.O.D. Customers account 
on the line opposite the debit. 

A C.O.D. page in the accounts receivable ledger appears as 
follows : 

C.O.D. Customers 



Jan. 


4 


R. S. Davis 


S- 


76 


40 


Jan. 


5 




CR- 


76 


40 




10 


B. L. Jones 


S- 


89 


26 




12 




CR- 


89 


26 




14 


Sam L. Wilson 


s- 


14 


80 
















16 


Oscar S.Norton 


8- 


29 


76 




17 




CR- 


29 


76 



The illustration shows that all C.O.D. sales have been collected 
up to January 17, except the one made to Sam L. Wilson for 
$14.80 on the 14th of the month. 

Columnar Sales Journal with Sundries Section 

The sales journal illustrated previously was for a business 
with sales classified by departments. The same kind of columnar 
journal may be used by a business which does not have a depart- 
mental system but desires an analysis of sales by any other 
system of classification. Sales may be analyzed by names of 
salesmen, by geographical districts, by commodities or by other 
classification. Sometimes the sales journal is provided with a 
sundries section in which to record an exceptional sales item, 
i.e., one which occurs so infrequently that a special sales column 
is not provided for it. When a sundries section is included, 
the sales journal may be used to record the sale of any item 
whether merchandise or not. The sale on account of a fixed asset 
or an investment may be recorded in a sales journal with a 
sundries section. 

Suppose it is desired to classify the sales of a business by com- 
modities and the sales journal shown on page 279 is provided. 

The Sundries columns of the illustrated sales journal provide 
a place to record the sale of any item not represented by one 
of the special sales columns. The sale on the ninth of the month 



Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 279 









.a 










O 


*i & 










2 4! 


fa ^ 










c 


i & 










02 


O OQ 










fa 


2 !$ 










cj 


' 8 S 


8 








3 


*o ^^ 


O5 






+j 





<N 


s ! 


X s. 




1 


1 






X 






00 


8 888 


8 








If 


Q O O 
C> C^ iO 

rH C^ rH rH 





I 








88 88 8 


8 








J 8> 


S S C 


8 




3 







rH rH ^f rH C"! 


rH 


CO 


ftf 




f 


8 888 


8 




p 






J'g 


8 HI 


rH 


9 


r/? 












W 




, 


8888888 


8 




GO 


s 


o'3 


S S S | 8 ^ g 


O 


^^ 




o 


O y5 




<N' 


s - x 






r/ O CJ 


rH Cl CO Tfl O CO !> 

O O O O O O O 








G 


* rS 5 












fa 


~t* CO C^l CJi CO O O 

r^H rH OQ C 1 ^ I s * rH ^H 










QQ 


CO CO CO CO 










g 


c c e 












O" O CD O" O" O o" 

rH CO O rH rH rH rH 










8 


lillljl 
^ Q 1w^^i 












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rH rH C^ C^l 










"S 


1 










Q 


1 ti 







280 



ACCOUNTING FUNDAMENTALS 



[Ch. XIX 



to Harris and Smith represents not the sale of merchandise 
but the sale of an extra newly purchased desk from the office of 
this business. The sale on the twenty-third to James Bern was 
the sale of a load of old crates, packing boxes, and wood in which 
goods had been delivered to the business. 

Each customer named in the sales journal is debited in the 
accounts receivable ledger for the amount which appears in the 
Debit Accounts Receivable column opposite his name. 

The figure 2 in parentheses below the double rulings in the 
Debit Accounts Receivable column indicates that the Accounts 
Receivable account on page 2 of the general ledger has been 
debited for the total of that column. The figures in parentheses 
under the totals of the three special sales columns indicate that 
the totals of those columns have been credited to their respective 
accounts on the pages mentioned. Each account in the sundries 
section is credited separately as is evidenced by the ledger page 
numbers in the F column of that section. The total of the 
Sundries Amount column is not posted. 

Columnar Purchase Journal for Merchandise Only 

The columnar purchase journal may be designed to record only 
purchases of merchandise. It may be ruled to classify mer- 
chandise purchases by departments, commodities or other classi- 
fication. Such a purchase journal resembles in general form the 
sales journal illustrated on page 273. 

PURCHASE JOURNAL 



Date 


Account Terms 


F 


Pur- 
chase 
Invoice 
Num- 
ber 


Credit 


Debit 


Acounts 
Payable 


Pur- 
chases 
Dcpt. A 


Pur- 
chases 
Dcpt. B 


Pur 
chas 
Dcpt 


P,S 

. C 



























Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 281 

The creditors named in the purchase journal are credited in 
the accounts payable ledger. The end of the month postings 
include a debit in the general ledger to each of the purchase 
accounts represented by a special column and a credit to Accounts 
Payable. 

Recording Merchandise Purchases for Cash, for C.O.D., and 
for Notes 

Cash purchases of merchandise, in the sense that a cash pur- 
chase means payment before delivery, practically never occur 
in some businesses. In the average business cash purchases 
are far less frequent than cash sales. Cash purchases of mer- 
chandise are recorded by plans similar to those described for 
recording cash sales. 

A C.O.D. purchase is a cash purchase. 

It sometimes happens that merchandise is paid for before it is 
delivered. When this situation occurs the payment is charged 
to the account of the vendor in the Accounts Payable column of 
the cash disbursements journal. On receipt of the merchandise 
the vendor is credited in the purchase journal. 

A merchandise purchase for which a note is given immediately 
is recorded as two transactions the purchase in the purchase 
journal as a credit to the vendor; and the note in the notes 
payable journal, if one is used, otherwise in the general journal 
as a charge to the vendor. 

Columnar Purchase Journal with Sundries Section 

Usually the purchase journal is designed as the book of original 
entry not only for merchandise purchases but for the purchase 
on account of any other asset or service for which a purchase 
invoice or a bill is received. Such a purchase journal is provided 
with special columns and a sundries section for the classification 
of commodities and services purchased. Economy of space in 
the purchase journal, as in the sales journal, limits the provision 
of special columns to those purchases which occur with sufficient 
frequency to warrant the use of special columns. The infrequent 
purchase for which a special column is not provided is recorded 
in the sundries section. 

Bills for services such as telephone, gas, and water if paid 
promptly are recorded in the cash disbursements journal. If 



282 



ACCOUNTING FUNDAMENTALS 



[Ch. XIX 







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d 




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8 8 3 




c 




g 




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III 


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lrj LQ jtj 
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Account 1 


N C^ W CM C^l O* 

1 

o, 

8 
3 a 
^ co 8 

% -8" 11^ 

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5g S 3 

^ ^j ^^ ^i^ ^g c^ 

















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Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 283 

not paid promptly they are recorded in the purchase journal 
in order that the amount of all expenses and liabilities may be 
shown on the books. 

Each creditor named in the purchase journal is credited in the 
accounts payable ledger for the amount which appears in the 
Credit Accounts Payable column opposite his name. At the end 
of the posting period the total of the Credit Accounts Payable 
column is credited to Accounts Payable. The total of each 
debit column and each item listed in the sundries section are 
debited to their respective accounts in the general ledger. The 
folios for column-total postings are indicated by numbers in 
parentheses placed below the totals. The folios for items 
posted from the sundries section are placed in the F column of 
that section. 

If the purchase and cash disbursements journals include Cash 
Purchases columns, such columns are used only for purchases of 
merchandise made solely for cash. 

Columnar General Journal 

The general journal which was developed in the preceding 
chapter, as an incident to the study of the use and operation of 
subsidiary ledgers and controlling accounts, is a columnar 
journal. The columnar general journal is the book of original 
entry for all transactions for which special journals are not 
provided. In a business which uses only purchase, sales, cash 
receipts, and cash disbursements journals, whether in columnar 
form or not, the general journal is the book of original entry for 
such transactions as: 

1. Notes when received and issued. 

2. Returns and allowances on purchases and sales when made 
or received for credit and not for cash. 

3. Investments, other than cash, made by the owner in the 
business. 

4. Adjustments. 

5. Closing entries. 

6. Correcting entries in which cash is not involved. 

Columnar Cash Receipts and Disbursements Journals 

The cash receipts and the cash disbursements journals illus- 
trated and explained in the preceding chapter are columnar 
journals. 



284 



ACCOUNTING FUNDAMENTALS 



ICh.XIX 



Other Columnar Journals 

If a special journal is used for any one of the following: notes 
receivable, notes payable, sales returns, sales allowances, sales 
returns and allowances, purchase returns, purchase allowances, 
purchase returns and allowances or any other definite class of 
transactions and is provided with more than one debit column 
or more than one credit column, such a journal is a columnar 
journal. For example, if a business receives many customer 
notes, the use of a notes receivable journal to record their receipt 
is warranted. If some notes have interest included in their 
faces and other notes are accepted from indorsers at face values 
plus accrued interest, or at discounted values, special columns 
are needed to care for such variations from face values. A 
columnar notes receivable journal provides not only for the 
debit to Notes Receivable and the credit to the customer but 
for the debits and credits to Interest Income. It may be ruled 
as follows: 

NOTES RECEIVABLE JOURNAL 









Credit 


Debit 


Date 


















Re- 
ceived 


Account 


F 


Accounts 
Receiv- 
able 


Interest 
Income 


Notes 
Receiv- 
able 


Interest 
Income 


Jan. 


5 


Walter Ronald 




1,000 


00 






1,000 


00 








12 


George Watson 




505 


00 






500 


00 


5 


00 




19 


Harry Ross 




400 


00 






400 


00 








26 


Wm. Hopkins 




606 


00 






6QO 


00 


6 


00 




28 


A. B. Zem Company 




995 


00 


5 


00 


1,000 


00 








30 


T. S. Scull 




796 


00 


4 


oc 


800 


00 














4,302 


00 


9 


00 


4,300 


00 


11 


00 










(2) 




(49) 




(5) 




(49) 





In practice,the illustrative notes receivable journal is ruled with 
additional explanatory columns and becomes not only a journal 
but a notes receivable register. An illustration of a notes 
receivable register is given in the next chapter. In this chapter 
the subject matter is limited to the use and operation of debit 
and credit columns in the various journals. 



Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 285 

The entry on January 12 records the receipt from Qeorge 
Watson of a $500.00, 6 per cent interest-bearing note which 
has run for 60 days, and which George Watson indorsed to the 
business. Watson was allowed credit for the face of the note 
plus accrued interest. The $5.00 interest allowed Watson 
on this note and interest from the date received to the maturity 
date of the note will be collected from the maker. The entry 
on January 26 is similar to the one on January 12. 

The entry on January 28 records the receipt from the A. B. 
Zern Company of a $1,000.00 note due in 30 days, which the 
Zern Company indorsed. The note was accepted at its dis- 
counted value, hence the credit of $995.00 to the Zern Company 
and the $5.00 credit to Interest Income. The debit was to 
Notes Receivable for $1,000.00. The entry on January 30 is 
similar to the one on January 28. 

The name of each customer listed in the Account column 
appears on the instrument for which he is credited, as the maker 
or indorser, if a note, or as the drawee or indorser, if a time draft. 
Each customer is credited in the accounts receivable subsidiary 
ledger for the amount shown in the Accounts Receivable column 
opposite his name. At the end of the month the controlling 
account Accounts Receivable is credited for the total of the 
Accounts Receivable column as is Interest Income for the total 
of its column. Notes Receivable and Interest Income are 
debited each for the total of its column. The sum of the two 
Credit columns equals the sum of the two Debit columns. 

Summary of the Posting Process 

In the set of columnar journals illustrated in this and the 
preceding chapter, the posting process may be summarized as 
follows : 

1. The total of a column headed General Ledger or Sundries 
is never posted. The individual items represented therein 
are posted to the general ledger. 

2. The items represented in a column the heading of which is 
the name of a controlling account are posted individually 
to the subsidiary ledger and in total to the controlling 
account. 

3. All other columns are posted by totals only, never by items. 



286 ACCOUNTING FUNDAMENTALS [Ch. XIX 

Advantages of Columnar Journals 

A number of important advantages result from the use of 
columnar journals: 

1. Journalizing is facilitated. Time is saved and the process 
of journalizing is simplified when some debits and credits 
may be made by merely inserting amounts in appropriately 
headed account columns. 

2. Posting is facilitated. 

a. Columns are used to indicate to the posting clerk the 
ledger in which particular postings are to be made, as 
in the cash and general journals. 

6. When subsidiary ledgers are used, column totals reveal 
the amounts to be posted to the controlling accounts. 

c. The totals of columns which represent accounts are 
posted to the accounts instead of the individual items 
in the columns. If the purchase journal includes a 
column which represents the account Purchases Depart- 
ment A and there are twenty-five items in the column 
in a given month, only the total is posted to the account. 
In every case where it is possible to post by column 
totals, postings are reduced by the number of items in 
the column less one. 

3. The use of subsidiary ledgers and controlling accounts is 
facilitated. This advantage was explained under 2&. 

4. Errors are localized. The sum of the debit columns of a 
columnar journal must equal always the sum of the credit 
columns. Since it is customary to test the equality of the 
debit and credit columns every time a page 'is filled and 
the totals are carried forward, as well as at the end of the 
month when summary postings are made, many mistakes 
are discovered and corrected prior to the preparation of 
the trial balance. 

5. The analyses of purchases and sales are facilitated. The 
ease with which entries are recorded in columnar journals 
and posted therefrom to the ledgers encourages managers 
of businesses to obtain analyses of purchases and sales by 
departments, commodities, or other classification. A 
manager who has analyses of purchases and sales is in a 
better position to control the operations of a business than 



Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 287 

is a manager who does not have such data. In addition, 
the manager who obtains his analyses of purchases and 
sales directly from the original entry records receives the 
information regularly and promptly. 

PETTY CASH SYSTEMS 

It has been assumed heretofore in this chapter that all cash 
items were recorded in the cash receipts or the cash disbursements 
journals. This assumption is correct with respect to cash items 
received; they are recorded in the cash receipts journal. It 
may not be entirely correct with respect to cash disbursements. 

Cash is the most current asset of a business; it is the one with 
a most general use and is the asset most likely to be misappro- 
priated. Its receipt and disbursement require, therefore, 
particular safeguards against misappropriations and against 
errors. 

All cash received should be recorded in the cash receipts journal 
and deposited daily. The daily deposit feature minimizes the 
opportunity for cash on hand to be misappropriated by prevent- 
ing an unnecessary accumulation of cash in the safe or money 
drawer of the business. It also makes possible a more complete 
audit of cash receipts. 

Cash payments should be made by check, if possible, and 
recorded in the cash disbursements journal. Payments made 
by check furnish a permanent record, thereby reducing the 
opportunity for error or misappropriation and provide the 
means of a more complete audit of cash disbursements. An 
indorsed canceled check is also an acknowledgment of the 
receipt of the payment by the payee. Disbursements which 
it is impossible or inconvenient to pay by check, for such items 
as train fare, carfare, postage, telegrams, and expressage, should 
be paid in coin or currency from a special petty cash fund created 
for that purpose. The record of such petty cash disbursements 
depends on the particular petty cash system in use. 

Petty Cash Fund 

A petty cash fund is cash in the form of coin or currency which 
is set apart to pay for very small items. The fund is created 
by a check which is drawn for that specific purpose and the 



288 ACCOUNTING FUNDAMENTALS [Ch. XDC 

money when the check is cashed is given to a petty cashier who 
thereafter is custodian of the fund and responsible for it. 

The notion sometimes prevails that a petty cash fund arises 
as the result of trifling cash receipts. Such is not the case. 
Cash receipts, no matter how small, are entered in the cash 
receipts journal and are deposited in the bank. The petty cash 
fund is established by a check drawn for an amount sufficient 
usually to take care of petty cash needs for one month. 

When the check for petty cash is drawn a charge to Petty 
Cash is made in the cash disbursements journal. Thus two 
ledger accounts are used to control cash the regular Cash 
account to control the cash in bank and undeposited and the 
Petty Cash account to represent the cash in the petty cash fund. 

Disbursements from the petty cash fund are recorded and 
posted to the ledgers by various methods of which three will 
be described, the petty cash book as a journal, the imprest 
system, and the voucher system. 

Petty Cash Book as a Journal 

The petty cash book is a book in which are recorded all dis- 
bursements from the petty cash fund. 

Since petty cash receives its funds from only one source 
cash, and the entry for a check drawn for petty cash is recorded 
in the cash disbursements journal and posted therefrom, it is 
not necessary to post any debits and credits from the receipts 
section of the petty cash book. The receipts section is simply 
a memorandum part of the book, in fact since the amount of 
money allotted for petty cash purposes is usually well known 
within a business, the receipts section is very often omitted. 

The remaining parts of the book are provided to record dis- 
bursements from petty cash and are operated in a manner similar 
to that described earlier in this chapter for the columnar purchase 
journal. As an invoice or bill is paid the amount is entered in 
the Credit Petty Cash column and in one of the Debit columns 
or in the Sundry Debits section. All postings are by column 
totals except for the items in the Sundry Debits section, which 
items are posted individually. The figure 2 in parentheses 
opposite the total of 31.00 in the Credit Petty Cash column 
indicates that the Petty Cash account in the general ledger 
has been credited for that amount on page 2. The figures 



Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 289 



PETTY CASH BOOK 


Sundry Debits 


*3 

4! 


8 
I 

^ 
O 

5 5 
* 1 

d * 

i i 
1 1 

3 

.2 
H <g 


* 1 3 $ 1 


Amount 


8 8 


8 i 


rH CO 


^ 




43 

1 

Q 


& W) 

> .3 
-5 .22 

<< * 


8 8 


8 1 


CO CJ rf< 




x s 

s 




03 23 

o 

s & 

w 


888 8 


8 i 


i-H 1-1 0* CS 


O 

1 




CO 

o> 

8 2 

rrt <D 

33 Q. 
O K 
W 


8 888 88 


8 g 


w w c^ co e* ^H 


C4 

1 




+3 

I 


^1 
(8^ 


8S88S88888S 


88 8H 


iOT-tOO^CO<Nr-i^COC<ICQ 


rH O i ( 

CO iO 00 






Explanation 


>> c* 

0> O Q? ^ 

afla.S.S |S|J 
1 S.8H "Sg-.a^ 1 1: I 

OX-iiOaaXCO^-3 03 

d< W U PH c8 * W CW H o M PQ 


03 
3 
O 


^^SSSSSSSSS 3 1 


J i 

rH >-3 




Receipts 


g 


88 1818 


1 


SrH T 1 
CO 00 


o 
o 


1 
fl 


*53 r 


J 

f-i >-a 


1 

fe 



290 



ACCOUNTING FUNDAMENTALS 



[Ch. XIX 



in parentheses at the bottom of the Debit columns indicate 
that the totals of these columns have been debited to their 
respective general ledger accounts on the pages mentioned. 
The figures in the F column of the Sundry Debits section indicate 
the general ledger page numbers of the two accounts which were 
debited from that section of the book. 

The summary postings at the end of the month may be illus- 
trated in two-column general journal entry form, as follows: 



Office Expenses 
Store Expenses 
Advertising 
Transportation Out 
Sales Returns and Allowances 
Petty Cash 



12.00 
6.00 
9.00 
1.00 
3.00 



31.00 



The system just described uses the petty cash book as a journal 
in which petty cash disbursements are recorded and from which 
they are posted to the general ledger. The Petty Cash account 
in the general ledger after reimbursement appears as follows: 

Petty Cash 



Jan. 


2 




OD- 


50 


00 


Jan. 


31 




PCB- 


31 


00 




31 




CD- 


31 


00 







































When the balance in the fund is quite low another check is 
drawn for, or approximately for, the amount spent and is charged 
to Petty Cash in the cash disbursements journal. 

Under any petty cash system the petty cashier should be 
required to obtain a receipt for each disbursement, if possible. 
The cash in the drawer plus the receipts should at all times equal 
the balance of the Petty Cash account. 

Imprest System 

Imprest system of petty cash is any method of keeping petty 
cash records by which petty cash is reimbursed for the exact 
amount disbursed. When the imprest system is used the petty 
cash fund is often called the imprest fund. 

The petty cash fund is established by exactly the same method 
as was just explained, by drawing a check for petty cash pur- 



Ch. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 291 



poses for the amount deemed necessary and by a charge to Petty 
Cash in the cash disbursements journal. Record of disburse- 
ments may or may not be kept in a petty cash book. If a petty 
cash book is used, it is identical in appearance with the one 
previously illustrated but it is only a memorandum book and 
not a source of postings. If a petty cash book is not used, the 
receipts for disbursements obtained by the petty cashier con- 
stitute the memoranda of disbursements. 

Reimbursement is accomplished by drawing a check to Petty 
Cash for the exact amount spent and by charging the same 
amount in the cash disbursements journal to the accounts for 
which the disbursements were made. 

The cash disbursements journal entries for petty cash, assum- 
ing the facts and figures used in the previous illustration are as 
follows : 

CASH DISBURSEMENTS JOURNAL 









Debit 


Credit 


Date 


Account Explanation 


F 


General 
Ledger 


Ac- 
counts 
Pay- 


Pur- 
chase 
Dis- 


Cash 










able 


counts 




Jan. 


2 

vXVX 


Petty Cash to start fund 

l S^.>^>^ ; ^^ : ^ ; ^^^^^x^X>ky-> k XVXNXNX' 




50 

"^s^^^s^s 


00 

> ^_ 


^X/VX>>-XVJ 


"VXN. 


"VXN_y>.XV, 


xvx% 


50 

.XVXNXN^-V 


00 

S\S" 


Jan. 


31 


Office Expenses 






12 


00 


















Store Expenses 
Advertising 
Transportation 
Out 
Sales Ret. and 


to reim- 
burse 
petty 
cash 




6 
9 

1 


00 
00 

00 


















Allow. 






3 


00 










31 


00 



The Petty Cash account under the imprest system is never 
debited after the initial charge unless the fund proves inadequate 
for the needs of a period and is increased. Similarly Petty Cash 



292 ACCOUNTING FUNDAMENTALS [Ch. XIX 

is never credited unless the fund proves too large and is reduced. 
Since it is desirable to include in the ledger account balances 
at the end of a month the disbursements from petty cash during 
the month, it is customary to reimburse petty cash monthly. 
The balance of petty cash at the beginning of each monthly 
period represents, therefore, the amount allotted for petty cash 
purposes. 

Voucher System 

The voucher system of petty cash is any method of keeping 
petty cash records which requires that each disbursement by the 
petty cashier be evidenced by a voucher signed by a person 
empowered to authorize petty cash disbursements. Under this 
system the petty cashier is simply the custodian of the fund. 
Disbursements are not made without the authority of signed 
vouchers. Responsibility for the safekeeping and disbursement 
of the fund is thus placed in the hands of two persons, so that 
misappropriation requires collusion. Very often the heads of 
departments or their assistants are authorized to sign vouchers. 

Since the voucher system of petty cash requires a signed 
voucher and, if possible, a receipt for each disbursement, it is 
not necessary to keep a petty cash book. When the fund is 
started the check which is drawn is charged to Petty Cash 
in the cash disbursements journal. Periodically the vouchers 
are entered in the cash disbursements journal as charges to the 
accounts for which the disbursements were made and a reim- 
bursing check is drawn to the order of Petty Cash, exactly as 
illustrated under the imprest system. 

QUESTIONS 

1. What is a journal? A columnar journal? 

2. What do you mean by an analytical sales journal? An analytical 
purchase journal? 

3. Can you suggest different bases for the analysis and classification 
of sales by the use of a columnar sales journal? Make similar 
suggestions for the analysis and classification of purchases by the 
use of a columnar purchase journal. 

4. Suppose the sales of an enterprise are classified by departments of 
which there are five. 



Oh. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 293 

a. The sales journal of this enterprise would have to include how 
many money columns as a minimum? 

6. Why might it contain more money columns than the number 
given in your answer to a? 

c. Suppose it contained the number of columns given in your 
answer to a. Give the general ledger debits and credits at the 
end of any month. 

d. What would be the main advantage of a sales journal, such as 
the one considered in this question? 

6. a. Give a plan for recording cash sales. 

b. Give another plan for recording cash sales. 

c. Give yet another plan for recording cash sales. 

d. Which of these plans do you favor? Why? 

e. If cash sales columns are used in both the sales and cash receipts 
journals, may the totals be posted? Where? Would the ledger 
balance, if they were not posted? Why? 

6. a. How should a sale for a note be recorded? Why? 

6. How should a C.O.D. sale be recorded, if cash is not received for 
several days? 

7. a. For what purpose is a sundries section added to a sales journal? 

To a purchase journal? 
6. Is the total of the sundries section posted? Why? 

8. Look at the sales journal illustrated on page 279, then answer the 
following questions about it : 

a. What number of debit postings are made to the subsidiary ledger 

for customers? 
6. What number of debit postings are made to the general ledger? 

c. What number of credit postings are made to the general ledger? 

d. What amount (dollars and cents) is posted to the general ledger 
as debits? As credits? 

e. What amount of debit postings is made to the subsidiary ledger 
for customers? 

9. May a purchase journal be designed to record the purchase of any 
commodity or service needed by the business? Would not such a 
journal necessarily contain so many columns that it would be 
inconvenient to use? 

10. What factor would cause you to decide in favor of providing a 
column for a commodity or service in the purchase journal? 

11. Look at the purchase journal illustrated on page 282, then answer 
the following questions: 

a. Give the accounts, without amounts, which are debited and 
credited in the general ledger at the end of the month. 

6. Would any other debits or credits be posted from this journal to 
any ledger? 



294 ACCOUNTING FUNDAMENTALS [Ch. XIX 

12. If subsidiary ledgers and controlling accounts for customers and 
creditors are not used, may an analytical sales journal be used? 
A columnar purchase journal? 

13. What classes of entries are recorded in a general journal? 

14. Could controlling accounts and subsidiary ledgers for customers and 
creditors be used conveniently without 

a. A columnar sales journal? 

6. A columnar cash receipts journal? 

c. A columnar purchase journal? 

d. A columnar cash disbursements journal? 

e. A columnar general journal? 

/. A columnar notes receivable journal? 
g. A columnar notes payable journal? 

15. Look at the notes receivable journal on page 284, then tell 

a. The debits to be posted and where. 

b. The credits to be posted and where. 

16. Tell where, if at all, the total of each of the following columns is 
posted and whether debited or credited: 

a. The accounts receivable column in the cash receipts journal. 
6. The purchase discounts column in the cash disbursements journal. 

c. The general ledger column in the cash receipts journal. 

d. The sales discounts column in the cash receipts journal. 

e. The accounts payable column in the cash disbursements journal. 
/. The accounts payable column in the purchase journal. 

g. The accounts receivable column in the sales journal. 

h. The general ledger column in the cash disbursements journal. 

17. Give the advantages arising out of the use of 
a. Columnar journals. 

6. Controlling accounts and subsidiary ledgers. 

18. Why is it desirable to make payments by check? 

19. a. If a business operates a petty cash fund, is that fund created by 

the accumulation of a lot of small receipts? 
6. How is the fund created? For what purpose? 

c. What entry is made when the fund is created? Where? 

d. If a business operates a petty cash fund, 

(1) May it use a petty cash book? 

(2) May it not use a petty cash book? Why? 

20. Look at the petty cash book on page 289, then give 

a. The end of the month entry, if the book is used as an original 
entry book. 

b. The end of the month entry, if the book is not used for posting 
purposes. 

c. The end of the month entry, if a petty cash book is not kept and 
the record of petty cash disbursements is made on vouchers. 



Oh. XIX] COLUMNAR JOURNALS, PETTY CASH SYSTEMS 295 

21. Which method of recording disbursements from petty cash would 
you recommend, the use of a petty cash journal or the voucher 
system? Why? 

22. Under the voucher system of petty cash, if the petty cash drawer is 
audited at any time during a month, what should be found there? 

23. Under the imprest system of posting petty cash 

a. How much cash is in the petty cash drawer the first of each 

month? Why? 
ft. When might the Petty Cash account receive a debit after the 

fund is started? A credit? 

24. Suppose the petty cash fund is larger than necessary, so the fund is 
reduced $50.00. What entry or entries should be made and where, 
if the voucher system is used? 



CHAPTER XX 
OTHER RECORDS 

In earlier chapters, particularly those on business papers and 
practices, it was noticed that there are many records of transac- 
tions other than those made in the journals and ledgers. For 
example, the book entries for purchases are supplemented by 
purchase orders and purchase invoices; sales entries are sup- 
ported by sales invoices; and cash entries for disbursements 
are represented by checkbook stubs or petty cash book entries, 
petty cash receipts, or vouchers. Such records and any others 
which are provided to supplement the regular entries in order 
that complete and detailed information about the accounts of 
an enterprise may be available are known as auxiliary records. 

Auxiliary Record Defined 

An auxiliary record is one which supplements the journals 
and ledgers of an enterprise. 

The title auxiliary record implies that such a record is primarily 
supplementary in character; oftentimes, however, it is not only 
supplementary but actually subsidiary in the sense that it supplies 
detailed explanations of the balance of a ledger account. Aux- 
iliary records are many and varied, so just a few which are 
common to many enterprises are explained in this chapter as 
illustrations of the usefulness of this kind of record. 

Inventory Sheet * 

Previous discussions have emphasized the necessity for periodic 
inventories. Since inventories disclose not only the value of 
goods on hand but are necessary to determine the cost of goods 
sold, they are of great importance in accounting and should be 
taken and recorded in a manner and on forms which will insure 
accuracy. Inventory sheets should be designed to indicate for 

296 



Ch. XX] 



OTHER RECORDS 



297 



each department, style or brand, the items on hand, their 
quantity, the unit cost price and the total amount. The sheets 
should also provide space for signatures so that responsibility 
for each step in the inventory process may be localized. 

The following illustration of an inventory sheet is designed to 
make it serviceable in many kinds of enterprise. 



Dopartrnnnt. 








D* 


Sheet No. 








Description 


Quantity 


Unit 
Cost 


Total 


xy^<><>c<>c<xxxx><><^^ 


KXXXXXXX 


xxxx> 


;x> 


COCXX) 


<x 


Called Entered Priced 
Ry Ry Ry 


Ext OIK 
Hy._ 


led 









Inventory sheet. 

If the inventories of an enterprise are not valued on a cost 
basis but on a cost or market whichever is lower basis and it is 
doKired to show for each item in the inventory the values on 
both bases, the additional facts may be provided for by a few 
extra columns on the inventory sheets, as shown at the top of 
page 298. 

An illustration of the computation of inventory value 
on the cost or market whichever is lower basis is given on 
page 163. 

The inventory sheets constitute a permanent and valuable 
auxiliary record to the inventory entries set up on the 
books. 



298 



ACCOUNTING FUNDAMENTALS 



[Ch. XX 



Departmcr 

Tjnr.atinn 


t. 


a 


. Date 
Shee 


t I 


sTo. 








Description 


Quan- 
tity 


Cost 


Market 


Lower of Cost 
or Market 


Un 

Pric 

-u-a .-= 

-, . ^s^ - 
- N_>^.' -^ 


Lt 

e 

X>s 


Total 


Unit 
Price 


Total 


Unit 
Price 


Total 


>OO<XXXX>O<KX>C< 


xxxx; ' 


>o-rx. 




>OC<0 


<X. 


KXX> 


oc 


OOQ 


oc 


<XX> 


yc 


Called Entered 
% Hv 


Prieed for Cos 
for Market. 


;t, 


Extc 
B 


nded 

y 













Inventory sheet. 

Insurance Register 

In thinking of the Prepaid Insurance and the Insurance 
accounts which appear on the books the student is reminded 
that an enterprise of any size, because of the variety and amount 
of its insurance needs, purchases its insurance protection from 
many different insurance companies, for different amounts, and 
for different periods. The rates and premiums on the various 
kinds of policies also vary. An enterprise may insure its build- 
ings against fire loss in the amount of $100,000.00. The insur- 
ance may be given to one insurance company, to five companies 
in the amount of $20,000.00 each qr it may be distributed among 
any number of companies for varying amounts with a total of 
$100,000.00. This insurance protection may have been procured 
for one year or for a term of two, three, five, or any other number 



Ch. XXJ 



RECORDS 



299 



rt 

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o 



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cd *-* 
S c3 



w 



8 

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a 



PH 



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88 



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= 8 

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g % 
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oo Tfi o 

rH O ^ 

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O 



o 



Remarks 




Adjusting Data 


g rH 

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1 S H ,8 
5 Q ^ 


sss 


00 <M 

CO TJH r- 


S TJ 

2 -2 "P 

3 -3 - c3 
C G< L.J <D 

3 b * 


88 
2^ 


| Monthly Insurance Charge 


8 
P 


CO O O 


co ^ ^ 


i 
fc 


888 

CO rH rt* 


-4^ 

o 



888 

CO rH Tt< 


-4-> 

D. 
$ 


888 


CO rH Tj< 


fcb 

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300 ACCOUNTING FUNDAMENTALS [Ch. XX 

of years. It is quite possible that this insurance was not all 
taken on the same date. Tlie buildings may have been built or 
acquired on different dates and the insurance placed accordingly. 
It is possible some of the policies were taken on one-year terms, 
others for three years, others for five years, and so on. The 
enterprise may have built up, similarly, $10,000.00 of fire- 
insurance protection on its furnishings, $5,000.00 of burglary 
and theft protection, and $30,000.00 on its stock of merchandise. 
It may carry tornado, plate-glass, fidelity, employers' liability, 
boiler-explosion, automobile, and other forms of insurance 
protection. 

In order to keep a record of the pertinent facts of each policy, 
its date, amount, premium, term, risk covered, date of expiration, 
and so on, and to have a comprehensive picture of the insurance 
in force from which analyses may be made and adjusting data 
gathered, it is customary to keep an insurance register as an 
auxiliary record. 

The first policy entered in the insurance register (Eastern 
Insurance Company policy 6183) had been in force for two years 
when it was listed in the register on January 1, of the current 
year. The total premium had been $200.00 of which $80.00 
had been charged off in the two preceding years and $120.00 
remained to be charged to the current and the two following 
years. For purposes of adjusting the books the register fur- 
nishes insurance costs on a monthly as well as an annual basis. 

The register here illustrated is intended for use as an auxiliary 
record, nevertheless the total of the last column must agree on 
December 31 of any year with the balance shown in the Prepaid 
Insurance account on the ledger after the insurance adjusting 
entry is recorded and posted. To that extent the register is 
not only a supplementary but a subsidiary record to the Prepaid 
Insurance account; it supplies an explanation of the balance of 
that account. 

It would be a simple matter to convert this auxiliary record 
into a book of original entry from which postings to the ledger 
are made. Since the policies of the company are probably 
placed through insurance brokers to whom the premiums are 
owed at the time the policies are received and listed in the 
register, it would be necessary to add a column to show the 
names of the brokers. If so used the entries at the time insurance 



Oh. XX] OTHER RECORDS 301 

is purchased would not be made in the journal or purchase book 
and the register would be the source of postings. Debits would 
be made from the_regLster_io_Preiiaid .Insurance for the total of 
the column which is titled 'Paid This Yaar' under the Premium 
section. Credits would be made to the brokers' accounts in the 
accounts payable ledger for the amounts in the ' Paid This Year ' 
column, and the total of that column would be credited to the 
Accounts Payable control account in the general ledger.^ If used 
as a book of original entry it would be possible to post the adjust- 
ing entry which debits Insurance and credits Prepaid Insurance 
from the register. It is more desirable, however, to include the 
insurance adjusting entry with the others in the general journal; 
then it is not so apt to be overlooked. 

Notes Receivable Register 

If the receipt of notes and time drafts is an infrequent occur- 
rence in an enterprise there is little need to supplement the 
record kept by the usual entries. Memoranda on a desk calendar 
pad will serve as sufficient additional records especially as 
reminders of due dates. If the receipt of such instruments is a 
common occurrence, the use of a notes receivable register is 
advisable. The register will provide a complete history of each 
paper, will indicate whether it is on hand or has been discounted, 
and will serve as a reminder of its maturity date. 

In the average enterprise the use of the notes receivable register 
as an auxiliary record is satisfactory but in an enterprise which 
receives a great many notes it is desirable to use the register as a 
notes receivable journal. To do so saves time in that the 
entry for a note is made at the same time and in the same place 
as the complete memorandum of it. The " illustration which 
follows is that of a notes receivable register used as a book of 
original entry, hence called a notes receivable journal. If only 
an auxiliary record is required the Debit, Credit, and F (folio) 
columns of the illustrated book are omitted and a column for 
amount is added. 

The customers who send in notes or drafts are listed in the 
third column; the page numbers in the F column indicate that the 
credits have been posted to the ledger. Whether the instrument 
is a note or a draft is shown in the column headed N or D. In 
the column titled Maker or Drawee is placed the name of the 



302 



ACCOUNTING FUNDAMENTALS 



[Ch. XX 



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person who is obligated to pay the instrument at maturity because 
he had signed it as the maker in the case of a note or had accepted 
it in writing as the drawee in the case of a draft. In the Indorser 
or Drawer column is shown the name of the person, if any, 
who is contingently liable as the indorser, if a note, or as the 
drawer or indorser, if a draft. 

The first transaction illustrated represents the receipt by the 
enterprise of a $400.00 note to be applied to the account of 
H. Blair. The note was drawn by G. Bacon in favor of H. Blair 
but was indorsed by Blair to the order of the business. 

The second transaction is similar. W. Harris indorsed and 
sent in for credit a $500.00 note drawn in his favor by O. Denny. 

The third transaction is the record of the receipt of a note 
for $1,000.00 from W. Ronald. It will be noticed that the Dis- 
position section of the notes receivable journal indicates that 
this note was discounted on February 18, while the two preceding 
notes were held to maturity when they were paid in full. 

The fourth illustration is the record of the receipt from G. 
Watson of a $500.00, 6 per cent interest-bearing draft drawn by 
Watson in his own favor on R. F. Edwards. The draft was 
accepted by Edwards on January 22 from which date interest 
accrued on it. It was necessary, therefore, when the acceptance 
was indorsed to the order of the business on February 21 by 
Watson, to allow him credit not only for its face amount, but 
for the accrued interest as well. Since the $2.50 credit allowed 
Watson because of the accrued interest will be returned to 
the business at the maturity of the note, it was charged to 
Interest Income. The debits and credits made for this transac- 
tion presented in the form of a two-column general journal entry 
are as follows : 

Notes Receivable 500 . 00 

Interest Income 2.50 

G.Watson 502.50 

The last transaction illustrated represents the following facts: 
R. Edel owed the business $891.00 and the amount was due. 
He could not pay in cash and offered his 60-day $900.00 note 
which was accepted at its discounted value. Notes Receivable 
was debited for $900.00, the face value of the note, but R. Edel 
was credited for only $891.00. The necessary $9.00 balancing 
credit was made to Interest Income. 



304 ACCOUNTING FUNDAMENTALS [Ch. XX 

The figures in parentheses below the double rulings of the 
Debit and Credit columns indicate the general ledger page 
numbers of the accounts to which these column totals were 
posted. The summary postings to the general ledger at the 
end of the month may be pictured as follows: 

Notes Receivable 3 , 300 . 00 

Interest Income 2 . 50 

Accounts Receivable 3 , 293 . 50 

Interest Income 9 . 00 

The notes receivable journal as illustrated is a book of original 
entry solely for notes and time drafts received. Entries for 
the disposal of these instruments are made in the other journals 
such as the cash receipts and general journals. The Disposition 
section of the notes receivable journal, in fact all columns 
except the ones for Date Received, Debit, Credit, F, and Received 
From, are for explanatory or auxiliary information. 

If an enterprise issues sufficient notes and accepts enough time 
drafts that a complete record of them in convenient form is 
desirable, a notes payable book either as a register or as a journal 
may be provided. Such a book is ruled in the same general 
form as the notes receivable book with suitable changes in 
column headings. 

Payroll 

It is necessary in most businesses to keep some formal record of 
the compensation paid to each employee and a payroll record of 
the employees in each department. The necessary information 
may be recorded on forms similar to those on pages 306 and 307. 
Both of these forms are auxiliary records rather than books of 
original entry. In most businesses payroll deductions are neces- 
sary for social security taxes (federal old-age benefits), for federal 
income tax required to be withheld by the employer, for bond 
purchases, for various insurance commitments, and for other 
reasons. Some form of payroll earnings record is necessary for 
each employee to determine the make-up of each check given; the 
annual summary of gross earnings and amount of taxes withheld, 
which the federal act requires the employer to furnish each 
employee; the liability of the business to the federal government 
for amounts withheld; the amounts voluntarily deducted for 



Ch. XX] OTHER RECORDS 305 

the purchase of savings bonds; the purchases made from such 
deductions; and miscellaneous deductions for advances, group 
insurance, and hospital insurance. The Payroll Earnings 
Record of Charles A. Price appears on page 306. It will be 
noted that he is also an employee of the department illustrated 
in the Payroll record on page 307. 

The Payroll record shows information similar to the Payroll 
Earnings Record for each employee of a given department. 
Where employees have authorized deductions such as for insur- 
ance, many businesses make such deductions only in the last 
payroll of a given month. 

When payment is made by check it is desirable to open a 
special bank account for payroll purposes. The check drawn 
and charged in the cash disbursements journal to Payroll is 
deposited in a special payroll bank account. Checks against 
this special account are drawn to the order of the employees and 
are listed by number and name of employee in the Payroll 
record. This procedure relieves the person who usually signs 
checks from the necessity of signing the many pay checks since 
that task can be delegated to another who is responsible for 
the payroll bank account. 

Whether wages and salaries are paid by check or in currency 
and coin, it is customary on paydays to make only one entry in 
the cash disbursements journal, a charge to Payroll. Record 
of the payments by individuals and by departments is kept in 
the Payroll record. 

In order that the Payroll account be charged with gross earn- 
ings, the following entry would be made for each payroll to 
supplement the charge to Payroll from the cash disbursements 
journal: 

Payroll xxxx 

Old-age Pension Taxes Payable xxxx 

Employees' Income Tax Withholding xxxx 

Group Insurance Payable xxxx 

Hospital Insurance Payable xxxx 

Savings Bonds Withholding xxxx 

To record the liabilities arising out of deductions 

for the payroll period ended (date). 

At the end of each month the gross payroll figures as shown 
: ~ the Payroll record are summarized and distributed to the 



306 



ACCOUNTING FUNDAMENTALS 



(Ch. XX 




Ch. XX] 



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308 ACCOUNTING FUNDAMENTALS [Ch. XX 

general ledger accounts, which should be charged by an entry 
such as 

Sales Salaries xxxx 

Delivery Salaries xxxx 

Office Salaries xxxx 

Factory Wages xxxx 

Payroll xxxx 

To record the payroll distribution (gross earnings) 
for the month of 

If the Payroll record is an auxiliary record, the above two 
entries would be made in the general journal. If the Payroll 
record is used as a source of postings, they would be posted 
directly from the Payroll record to the ledger. 

To prevent padding of the payroll, the Payroll record of each 
department should be inspected and signed by the foreman or 
manager. 

The federal old-age pension tax is imposed on both the employer 
and the employee; the employer is responsible for withholding 
the tax from the employee and remitting such amounts with the 
tax payable by himself. The employer is required to pay the 
tax so computed to the Collector of Internal Revenue every 
calendar quarter. The rate used in these forms and entries is 
1 per cent, but it may be changed by Congress at any time. On 
a payroll of $20,000.00 for the month of May, the following 
entry would be necessary to record the liability of the employer 
for his share of the old-age pension tax : 

Social Security Taxes 200 . 00 

Old-age Pension Taxes Payable 200.00 

To record the employer's liability for the 
month of May. 

Although both state and federal laws must be considered, 
unemployment funds are administered by the states. The 
federal rate is 3 per cent on employee earnings up to $3,000.00 
during the 12-month period. State and federal unemployment 
taxes are paid by the employer, who can take credit against the 
federal tax for payments made to the state up to 90 per cent of 
the total tax liability. On a payroll of $20,000.00 the following 
entry is typical to record the liability arising out of unemploy- 
ment taxes: 



Ch. XX] OTHER RECORDS 309 

Social Security Taxes 600 . 00 

Unemployment Taxes Payable State 540.00 

Unemployment Taxes Payable Federal 60 . 00 

To record the liability for the month of May 

of 0.3 per cent to the Collector of Internal 

Revenue and 2.7 per cent to the state. 

Social security taxes may be treated as a general expense in a 
relatively small business but should be apportioned among the 
departments in a business of any size. The debits may be to 
Social Security Taxes Sales, Social Security Taxes Office, and 
Social Security Taxes Factory. 

The payroll deductions have been ignored in the problems in 
this text because the authors did not wish to complicate each 
payroll when state and federal laws may change with frequency, 
particularly with respect to rates of withholding. 

Plant Ledgers 

In a business of any size the general ledger accounts for fixed 
assets, particularly those for buildings and the various classes of 
equipment such as store furniture and fixtures, office furniture 
and fixtures, delivery equipment, and machinery should be 
supported by additional records. These records may be auxiliary 
ones, but it is desirable that they take the form of subsidiary 
ledgers which supply detailed information about the balances 
of the general ledger accounts which control them. The Store 
Furniture and Fixtures account in the general ledger, for example, 
includes in its balance the figures for such items as showcases, 
counters, scales, bins, and other equipment used for the display 
or the selling of goods. Such items may have been acquired 
on different dates for different amounts and may have varying 
lives. If a complete history of each piece of property is desired, 
as it most certainly should be, it is obvious that the formal 
entries for plant asset items must be supplemented by additional 
records. 

The detailed record of a physical property should show the 
kind of item, the date acquired, its cost, from whom acquired, 
its location, its book value, any significant occurrences which 
have affected it, and how it was disposed of. Such a record 
is exceedingly valuable in the settlement of an insurance claim, 
in supplying details to support periodic adjustments, and in 



310 



ACCOUNTING FUNDAMENTALS 



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Ch. XX] OTHER RECORDS 311 

furnishing information for the federal income-tax return when 
the asset is disposed of. 

The illustration, as shown on page 310, is that of a card or sheet 
in a delivery equipment subsidiary ledger. It indicates the kind 
of information which should be kept in any of the subsidiary 
plant ledgers. 

Other Auxiliary Records 

Without further illustration mention may be made of other 
auxiliary records which meet particular needs. 

An enterprise which owns considerable real estate as an invest- 
ment needs an additional record to supplement its real estate 
account. This record should take the form of a subsidiary 
ledger comparable to the plant ledgers previously described. 
Each different piece of real estate should be represented by a 
card or sheet which shows its description, location, date acquired, 
cost divided between land and buildings, book value, and so on. 

If real estate is rented to different people the enterprise needs 
another record to keep the names of the tenants, description 
of properties rented and vacant, dates of leases, terms of leases, 
and monthly rentals. This auxiliary record may be operated 
as a tickler to serve as a reminder of the dates when the various 
rents are due. The tickler feature may be provided, if the 
record is in book form, by twelve columns similar to those used 
in the notes receivable journal to show maturity dates; if . the 
record is kept on cards, they may be filed under the days of the 
month when the rents are due. 

If an enterprise or an individual owns a number of different 
stocks and bonds the general ledger account Investments should 
be supplemented with a record to show the details of each differ- 
ent investment owned. Still another record is necessary as a 
memorandum of the dates when the different dividends and 
interest items are due and the amounts in each case, also to 
serve as a place to register the date of payment of each particular 
dividend or interest amount received. 

Auxiliary records in connection with sales are very common. 
In addition to the formal entries and sales invoices, there are 
records to obtain an analysis of sales by products, territories, 
and salesmen. Similarly Purchases, the various expense, and 
other accounts are supplemented by auxiliary records which 



312 ACCOUNTING FUNDAMENTALS [Ch. XX 

are necessary in a well-organized accounting system. Without 
adequate auxiliary and subsidiary records the management 
of an enterprise is not obtaining the full measure of information 
it may expect and require of its accounting departments. 

QUESTIONS 

1. a. Distinguish an auxiliary record from a journal entry. 

b. Name some auxiliary records. 

c. What useful purpose is served by auxiliary records? 

2. Look at the inventory sheet illustrated on page 298 and explain the 
purpose of the provisions for signatures or initials at the bottom. 

3. Inventory sheets are auxiliary records to what entries? 

4. a. Does the Prepaid Insurance or the Insurance account on a ledger 

supply all the information needed by an enterprise with respect 
to its insurance? Why? 

b. Name some facts which an insurance register would show. 

c. Are all policies taken at the same time? Why not? 

d. Is an insurance register serviceable in connection with 

(1) Expirations? How? 

(2) End of the period adjustments? How? 

(3) Decisions to increase or decrease the amount of insurance in 
force? How? 

5. What purposes are served by a notes receivable register? 

6. a. Why is it important to know the exact date a note matures? 

b. Why is it important to know if there are any indorsers on a note? 

7. a. In what respect does the maker of a note bear the same relation- 

ship to the holder as the draivee of a draft? 

b. In what respect does the drawer of a time draft bear the same 
relationship to the holder as the indorser of a note? 

8. Under what condition is the use of a notes payable register desirable? 

9. Who do you think has greater need for a notes receivable register 
a manufacturer of heavy machinery or a retailer who operates a 
dry-goods store? Why? 

10. Can you see any advantages arising from the use of a payroll register 
and payroll earnings records? 

11. If the cash disbursements journal entry on paydays is a charge to 
Payroll and a credit to Cash, how and when are the various salary 
and wage accounts charged? 

12. Suppose your university owns 1,000 office desks which are dis- 
tributed throughout its various buildings. 

a. Can you see any advantage which would come from an auxiliary 
record for each desk which would show the date of purchase, the 
cost price, and the present location? 



Ch. XX] OTHER RECORDS 313 

6. If the desks referred to in a are owned by a profit-seeking enter- 
prise, is such an auxiliary record equally desirable? Should it 
show more information than is suggested by a? Why? 

13. Explain the plant ledger card illustrated on page 310. 

14. Suppose an individual owned a number of dwellings for investment 
purposes. 

a. In what account is his income from the properties shown? 
6. Would he need an auxiliary record to the account given in answer 
to a? Why? 

c. In what account are the property cost values shown? 

d. Would he need an auxiliary record to the account given in answer 
to c? Why? 

15. Suppose an individual owns shares of stock in 40 different corpora- 
tions and bonds of 25 other corporations. 

a. In what account or accounts would these securities be recorded? 
6. Should he have an auxiliary record for the account or accounts 

given in answer to a? Why? 
c. How would the individual know if he received all dividends and 

interest to which he is entitled? Suggest a form of auxiliary 

record for this purpose. 



CHAPTER XXI 

PARTNERSHIPS 

The discussion thus far in this book has been limited to a 
consideration of the accounting requirements of an enterprise 
owned by one person a sole proprietorship. The rules and 
methods which have been developed are general in character 
and apply to any type of ownership organization. An organiza- 
tion with more than one owner presents some new problems, 
however, to the consideration of which this and the following 
four chapters are devoted. Problems peculiar to the partnership 
type of organization will be covered in this and the next chapter, 
while those peculiar to the corporate form of organization will 
be considered in the following three chapters. 

The additional accounting problems of an enterprise with 
more than one owner relate solely to the proper treatment of the 
accounts with the owners of the enterprise. 

Definition 

A partnership is defined by the Uniform Partnership Act as 
"an association of two or more persons to carry on, as co-owners, 
a business for profit." 

The above brief legal definition needs explanation to supply 
an adequate conception of a partnership. A partnership is a 
contract relationship entered into by two or more persons who 
agree to combine their effects, labor, and skill, or some or all 
of these, in a lawful business, trade, occupation, or profession 
and to divide the profits, as such, between them. 

The partners need not contribute equal amounts, in fact 
some may not contribute any property. The experience and 
skill of a partner may be his contribution and may be as impor- 
tant to the success of the partnership as a large property invest- 
ment of another partner. The property of a partner is no 
longer his after it is invested; it belongs to the partnership and 
is held by the partners as co-owners. The liability of a partner 

314 



Ch. XXI] PARTNERSHIPS 315 

for the debts of the partnership is not limited to the amount of 
his investment; usually it is unlimited, so that the personal 
private wealth of each partner is back of the debts of the partner- 
ship. The partners, in the absence of an agreement to the 
contrary, share equally the net profits or losses. The death or 
withdrawal of a partner terminates the partnership. 

It is not always an easy matter to determine whether or not a 
partnership exists. A partner is at once a principal and an 
agent for his partners in matters which come within the range of 
the partnership business. Each partner has an equal right to 
assist in the management of the partnership, unless limited by 
definite agreement of the partners, and each is entitled to an 
equal share of the profits, unless otherwise arranged. Co-owner- 
ship, mutual agency, voice in management, and profit sharing 
as owners are very important features in determining whether 
or not the relationship constitutes a partnership, although any 
one of these features in itself may not be conclusive proof. 

A partnership is known as a firm and is the type of organization 
chosen by the owners of many small enterprises with limited 
capital needs. It is also the form of organization selected by 
the owners of many professional enterprises, such as engineering, 
legal, and accounting offices which are service organizations 
whose relations to their clients carry very personal responsibilities. 

Advantages of a Partnership 

Compared with a sole proprietorship there are certain advan- 
tages inherent in the partnership. 

1. A greater amount of capital is possible. 

2. The service, as owners, of persons of marked abilities, vary- 
ing experience, and different degrees of wealth may be 
obtained. 

Disadvantages of a Partnership 

There are some features of a partnership which prove a dis- 
advantage to this form of organization. 

1. The unlimited liability for the debts of the firm makes some 
persons reluctant to become a partner. 

2. The mutual-agency feature, whereby the acts of a partner 
which come within the scope of the partnership business 



316 ACCOUNTING FUNDAMENTALS [Ch. XXI 

are binding on his associates, makes some persons reluctant 
to enter into a contract under which they will be so bound. 

3. A partnership interest is not transferable readily. Without 
the consent of the remaining partners an interest in a 
partnership cannot be sold to another person. 

4. Misunderstandings and disputes may arise among the 
partners especially with regard to the management policy 
and the distribution of profit or loss. 

5. The life of a partnership is limited. It is terminated 
with the legal incapacity, the withdrawal, or the death 
of a partner. 

6. A partnership cannot obtain as much capital as a corpora- 
tion. (Corporations are discussed in later chapters.) 

Articles of Partnership 

It should be evident from the limited discussion thus far 
given that a partnership is an association which should not be 
entered into lightly but only after due deliberation and investiga- 
tion of the other proposed partners. A partnership contract 
may be oral or written. In view of the very great possibility of 
misunderstanding and consequent disagreement among the 
partners, the partnership agreement should not be an oral one. 
The contract, which is called the articles of partnership, should be 
prepared in writing. This agreement if carefully drawn will 
indicate the intentions of the partners with respect to many 
points, which, if not decided in advance, may be the cause of 
friction. Some of the points to be covered by the articles are 

1. Date. 

2. Names of partners 

3. Name of the firm. 

4. Location. 

5. Nature of the business. 

6. Date of commencement and term of contract, unless 
indefinite. 

7. Statement of the contribution to be made by each partner 
and the date on which it is to be made. If property 
other than cash is to be contributed, the value at which 
it is to be placed in the records should be approved in 



Ch. XXI] PARTNERSHIPS 317 

advance by all partners; subsequent losses or gains arising 
from such property are shared by all. Similarly, liabilities 
assumed by the partnership should be approved by all 
partners. 

8. Method 'of sharing profits and losses. On this point the 
following questions should be considered: 

a. Is interest to be allowed on capital? If so, on what 

basis? 
6. Are salaries to be allowed partners? If so, how much 

and when are they to be paid? 

c. What basis is to be used to distribute profits or losses 
whether or not interest and salaries are factors? 

d. What is the status of profits left in the business? 

9. Statement of limitation on withdrawals. If merchandise 
is withdrawn for personal use is it to be taken at cost? 
Are cash or other asset withdrawals to be considered as 
impairing capital, or as withdrawals of a portion of the 
accruing profits? 

10. A statement of the division of duties among partners, the 
amount of time to be given to the firm by the partners, 
the delegation of the right to sign contracts, checks, and 
other business papers. 

11. A statement of the method of accounting to be employed 
and the length of the fiscal period. A statement which 
provides for a periodic review of the records by a certified 
public accountant is a very desirable feature. 

12. A statement of the procedure to be followed in case of 
voluntary or involuntary dissolution. 

13. A statement with respect to the arbitration of disputes. 

14. A statement of the amount of insurance to be carried by 
the firm on the lives of the several partners, if any. 

15. A provision to prohibit any partner from acting as surety, 
accommodation indorser, or bondsman for an outsider 
without the written consent of all members. 

Each partner should sign the articles and obtain a copy of 
them. The accountant for the firm will be guided by the 
agreement in opening the books, distributing the profits or 
losses, and in recording other matters which affect the partners' 
accounts. 



318 ACCOUNTING FUNDAMENTALS [Ch. XXI 

Bonds of Partnerships 

From the standpoint of liability of partners there are two 
kinds of partnerships : 

1. The general partnership, which is sometimes spoken of 
as the common law, old-fashioned, or ordinary partnership, 
in which each partner has unlimited liability for the debts 
of the firm. 

2. The special or statutory partnership which must be organ- 
ized under the authority of the statute of a state and under 
which the liability of some but not all of the partners may 
be limited to the amount of their investments. 

Kinds of Partners 

It will be noticed that there are at least two kinds of partners, 
general and limited. The general partner is one with the right 
to share in the management of the firm and with full liability 
for its debts. The limited partner, who is also known as a 
special partner, is one with limited liability for the debts of the 
firm. There are other kinds of partners silent, secret, and 
nominal; but for a definition of these classes as well as for a 
more complete discussion of the legal aspects of partnerships the 
student is referred to books on business law. 

General Partnership Rules 

Unless provision is made to the contrary in the articles of 
partnership, partners are bound by the following general rules: 

1. Each partner has an equal right to assist in the management 
of the enterprise. 

2. Profits an4 losses are shared equally. 

3. Losses are divided on the same basis as profits. 

4. Interest 

a. Is not allowed on capital, whether investments of the 

partners are equal or unequal. 
6. Is not to be charged on withdrawals, although it may be 

allowed on capital at the beginning of the period. 

5. Salaries are not allowed, regardless of any inequality in time 
spent by the partners for the benefit of the firm and without 
regard to the varying abilities of the several partners. 



Ch. XXI] PARTNERSHIPS 319 

Partnership Balance Sheet 

The balance sheet of a partnership differs from that of a sole 
proprietorship in the net worth section only. It is essential 
that the equity of each owner be stated clearly and the total 
equity of the several partners be extended as the net worth of 
the firm. 

Partnership Profit and Loss Statement 

A partnership profit and loss statement is exactly the same 
as the profit and loss statement of a sole proprietorship except 
for a supplementary section at the bottom of the statement in 
which is shown the distribution of the net profit or loss among the 
partners. 

In the following illustration of the supplementary section 
which appears at the bottom of a partnership statement of 
profit and loss, it is assumed that the articles of partnership 
provide that 

1. Each partner is to be allowed 6 per cent interest on his 
investment at the beginning of the year. 

2. That partner East is to be allowed a salary of $200.00 a 
month and partner West a salary of $300.00 a month. 

3. That any profit remaining or loss resulting after the interest 
ancf salary allowances is to be divided equally between the 
partners. 

At the beginning of the year partner West's investment was 
$24,000.00 and partner East's was $12,000.00. The net profit 
for the year was $8,000.00. 

Net Profit $8,000.00 

Distribution : 

Interest on Capital: 

N. 0. West.... . $1,440.00 

S. O. East .. 720.00 $2,160 00 

Partners' Salaries: 

N. 0. West.... . $3,600.00 

S. 0. East 2,400.00 6,000 00 8,160.00 

Excess of Interest and Salaries over Net Profit $ 160.00 

Charged to: 

N. O. West $ *80.00 

S. O. East 80.00 160.00 



320 ACCOUNTING FUNDAMENTALS [Ch. XXI 

The statement of profit and loss which includes the above 
supplementary section is in accord with the provisions of the 
federal income-tax law which do not permit either interest on 
invested capital or salaries of partners to be deducted as expenses 
of operation. The statement shows that the net profit of the 
firm is $8,000.00. The supplementary section indicates how 
that amount is distributed between the partners by means of 
interest allowance, salary, and an equal distribution of the 
resulting figure. 

Distribution of the Net Profit or Loss 

The articles of partnership may provide for any method of 
distributing the net profit or loss which the partners feel to be 
equitable. In the absence of a special plan for distributing a 
loss, any special plan provided for the distribution of profits 
applies. Among the more general plans for profit distribution 
are the following: 

1. Equal distribution. 

2. Fixed percentages other than equal. 

3. On the basis of net investments at the end of the period. 

4. On the basis of average capital investments for the period. 

5. Partly as interest and partly by fixed percentage* 

6. Partly as salaries and partly by fixed percentages. 

7. Any combination of the above plans. 

To illustrate these different plans it is assumed that N. O. West 
and S. 0. East formed a partnership on January 1 of the current 
year, investing $24,000.00 and $12,000.00 respectively. During 
the year Mr. West withdrew $300.00 cash on May 1, and $500.00 
of merchandise of which $100.00 was on March 1 and $400.00 
was on September 1. Mr. East withdrew $500.00 cash on 
July 1. The net profit for the year is $8,000.00. 

1. Equal Distribution. If the articles of partnership of West 
and East made no reference to a plan of distributing profits 
they are to be divided equally. Suppose that is the case or 
that the agreement provides for an equal distribution. 

The closing journal entry to distribute the balance of the 
Profit and Loss account is 



Ch. XXI] PARTNERSHIPS 321 

Profit and Loss 8,000.00 

N. O. West, Drawing 4,000.00 

S. O. East, Drawing 4,000.00 

To distribute the net profit for the year 

equally. 

2. Fixed Percentages Other than Equal. The articles of 
partnership may provide for an unequal distribution of the 
net profit expressed in terms of fixed percentages to be applied 
each fiscal period. Assume that Mr. West and Mr. East have 
agreed to a 60/40 distribution respectively. Under this plan 
Mr. West is entitled to $4,800.00 and Mr. East to $3,200.00. 

The equivalent of this plan is found if the agreement provides 
that profits are to be distributed according to the original 
contributions of the partners, if they happen to be unequal. As 
Mr. West contributed $24,000.00 out of the $36,000.00 of invested 
capital, under this plan his share of the profits would be % or 
$5,333.33 and Mr. East who contributed $12,000.00 would be 
entitled to % or $2,666.67. If profits are not withdrawn by all 
partners, if added investments and withdrawals are not made in 
proportion to the original investment and at the same time by 
the several partners, this method is not an equitable basis for 
distributing profits. 

3. On the Basis of Net Investments at the End of the Period. 
In order to make some allowance for changes in the equities of 
the partners during the period, the profit distribution percent- 
ages are sometimes computed on the relationship that exists 
between the net investments of the several owners on the date 
of distribution. 

The net investments of Mr. West and Mr. East in the illustra- 
tion are determined as follows: - 

Mr. West Mr. East 
Investment, January 1 ......................... $24,000.00 $12,000.00 

Withdrawals ................................. 800.00 500.00 

Net Investment, December 31 .................. $23,200.00 $11,500.00 

Under this plan Mr. West is entitled to 23 %47 of the net 
profit of $8,000.00 or $5,348.70 and Mr. East is credited with 
of $8,000.00 or $2,651.30. 



This plan affects the profit distribution figures to the partners 
by reason of changes in their equities, but it is a weak plan in 



322 



ACCOUNTING FUNDAMENTALS 



[Ch. XXI 



that the time element is not provided for. No consideration 
is given to the length of time that capital is employed in or has 
been out of the enterprise. 

4. On the Basis of Average Capital Investments for the Period. 
This plan provides for the distribution of profits on the basis 
of the average capital investment of each partner. If Mr. West 
and Mr. East had agreed on this plan the computation would 
be made as follows: 

N. O. West 



Date 


Withdrawals 


Investments 


Net 
Investment 


Months 
Unchanged 


Equivalent 
for 1 month 


Jan. 1 
Mar. 1 
May 1 
Sept. 1 


$100.00 
300.00 
400.00 


$24,000.00 


$24,000.00 
23,900.00 
23,600.00 
23,200.00 


2 
2 
4 
4 


$ 48,000.00 
47,800.00 
94,400.00 
92,800.00 


$283,000.00 





S. O. East 



Date 


Withdrawals 


Investments 


Net 
Investment 


Months 
Unchanged 


Equivalent 
for 1 month 


Jan. 1 
July 1 


$500.00 


$12,000.00 


$12,000.00 
11,500.00 


6 
6 


$ 72,000.00 
69,000 00 


$141,000 00 





Mr. West had the equivalent of $283,000.00 invested for one month. 
Mr. East had the equivalent of $141,000.00 invested for one month. 
The firm had the equivalent of $424,000.00 invested for one month. 
Mr. West is entitled to 283/424 of $8,000.00 net profit or $5,339.62. 
Mr. East is entitled to 141/424 of $8,000.00 net profit or $2,660.38. 
Net profit for the year $8,000.00 

If the withdrawals are not made on the first of the month 
the partners may agree to ignore fractional parts of a month. 
Changes in the investment between the first and the middle of 
the month are considered to have taken place on the first and 
those between the middle and the end of the month are con- 
sidered as of the end of the month. If exactness is desired the 
computation may be made in terms of number of days unchanged 
instead of months unchanged and the final column may be 



Ch. XXI] PARTNERSHIPS 323 

headed "Equivalent for 1 Day." Otherwise the procedure 
is the same as that just indicated. 

5. Partly as Interest and Partly by Fixed Percentages. It is 
assumed in the following illustration that 6 per cent interest is 
allowed on the capital invested at the beginning of the year, but 
no interest is charged on withdrawals as they are considered 
withdrawals of accruing profits. The remaining profit is to be 
distributed equally, 

Mr. West is entitled to a credit for interest of $1,440.00 and 
Mr. East to $720.00. 

Net Profit $8,000.00 

Distributed as interest: 

N. O. West $1,440.00 

S. O. East 720.00 2,160.00 

Balance distributed equally : $5 , 840 . 00 

N. 0. West $2,920.00 

S. 0. East 2,920.00 5,840.00 

The entries to record the distribution of the $8,000.00 and the 
closing of the drawing accounts are as follows: 

Interest on Partners' Capital 2 , 160 . 00 

N. 0. West, Drawing 1,440.00 

S. 0. East, Drawing 720.00 

To record interest at 6 per cent on the 

capital invested by each partner at the 

beginning of the year. 

Profit and Loss 2 , 160 . 00 

Interest on Partners' Capital 2 , 160 . 00 

To close the Interest on Partners' Capital 
account to Profit and Loss. 

Profit and Loss 5 , 840 . 00 

N. O. West, Drawing 2,920.00 

S. O. East, Drawing 2,920.00 

To close the Profit and Loss account to 

the drawing accounts. 

N. O. West, Drawing 3,560 00 

N. O. West, Capital 3,560.00 

To transfer the net balance of the draw- 
ing account to the capital account. 

S. 0. East, Drawing 3 , 140 . 00 

S. 0. East, Capital 3 , 140 . 00 

To transfer the net balance of the drawing 
account to the capital account. 



324 ACCOUNTING FUNDAMENTALS [Ch. XXI 

If interest is allowed on invested capital, the articles of part- 
nership should make clear whether it is to be computed on the 
original investment, on the net investment at the time of dis- 
tribution, on the average amount of capital invested for the 
fiscal period, or whether it is to be computed only on the excess 
above a stated minimum. Obviously each of these plans results 
in a different amount to be credited to each partner. 

Interest allowed on the capital investment of the partners is a 
method of adjusting equitably the differences in the amount of 
the capital contributions to the firm. As such, it is a method 
of distributing profits and appears in the statement of profit 
and loss after the net profit or loss for the year is determined. 
If provided for in the agreement, it is allowed whether the enter- 
prise operates at a net profit or loss. 

If interest on loans of partners to the enterprise is a factor, 
the amount involved should be debited to Interest Expense the 
same as if the money had been borrowed from an outsider and 
credited either to Cash or to the drawing account of the partner 
depending on whether or not it was paid in cash. 

6. Partly as Salaries and Partly by Fixed Percentages. While 
most partners give of their time as well as of their capital, 
some partners spend considerably more time than others in the 
interest of the firm and some have special skill, ability, or con- 
nections that enable them to bring considerable income to the 
firm. In order to provide for these personal service inequalities, 
salary may be allowed to some or all of the partners and at 
varying amounts. The agreement should state when the 
salaries are due and if not withdrawn whether or not interest 
is to be allowed on such amounts. 

Cash payments to partners for salaries are recorded when paid 
in the cash disbursements journal as debits to the account 
Partners' Salaries. If the salaries when due are not taken in 
cash the entries are made in the general journal as debits to 
Partners' Salaries and credits to the drawing accounts of the 
partners concerned. At the end of the fiscal period the Partners' 
Salaries account is closed to Profit and Loss. 

In the statement of profit and loss partners' salaries like 
interest on partners 1 capital should be treated as a method of 
distributing profits. If provided for in the agreement, salaries 
are allowed whether the enterprise operates at a net profit or loss. 



Ch. XXI] PARTNERSHIPS 325 

7. Any Combination of the Above Plans. A plan in very com- 
mon use which combines features of two of the methods pre- 
viously described is one which provides that profits are to be 
divided partly as interest on capital, partly as salaries, and the 
balance equally. 

Statement of Partners' Capitals 

To explain changes in partners' equities, without burdening the 
balance sheet, a statement of partners' capitals is usually pre- 
pared. The following statement is for the partnership of West 
and East, assuming the facts of plan 5 of the illustrations pre- 
sented earlier in this chapter for Distribution of the Net Profit 
and Loss. 

WEST AND EAST 

STATEMENT OP PARTNERS' CAPITALS 

For the Year Ended December 31, 19_ 

West East Together 

Capital, January 1, 19_ $24,000.00 $12,000.00 $36,000.00 

Plus: Net Profit for the Year 4,360.00 3,640.00 8,000.00 

Total $28,360.00 $15,640.00 $44,000.00 

Less: Withdrawals 800.00 500.00 1,300.00 

Capital, December 31, 19 $27,560.00 $15,140.00 $42,700.00 

The above statement exhibits the amount of equity of each 
partner that should appear in the balance sheet. 

Drawing or Personal Accounts of Partners 

Unless withdrawals or added investments are for substantial 
amounts and arc intended to be permanent they are not debited 
or credited usually to the capital accounts of the partners. 
Minor debits and credits to the partners during a period are 
made to their drawing or personal accounts. 

In an illustration in this chapter the drawing account balances 
were arbitrarily closed to the capital accounts. This may or 
may not be the proper procedure in a particular case. If it is 
the intention of the partners to increase or decrease their invest- 
ments by the periodic balances of their drawing accounts, the 
illustrated entries are correct. In such cases the ratios of capital 
investments may change from period to period, in which case 
the profit distribution plan may need frequent revision. Very 



326 



ACCOUNTING FUNDAMENTALS 



[Ch. XXI 



often the partners of a firm do not wish their capital accounts 
to be disturbed by drawing account balances. If a drawing 
account shows a debit balance at the end of a period after the 
books are closed, the partner concerned may intend to pay cash 
to the firm for the amount of the balance, or he may desire the 
debit balance to remain open on the books to be satisfied by 
salary or other credits of the new period. The equity of a 
partner who has a drawing account with a debit balance is the 
excess of his capital account credit balance over the drawing 
account debit balance. 

A partner with a credit drawing account balance after the books 
are closed may desire his account to be undisturbed as evidence 
of a balance subject to withdrawal by him and in the nature of a 
temporary loan to the partnership. Such an account, in the 
event of the dissolution of the firm, may take precedence over the 
investment claims of partners against the firm. 

The kind of transactions entered usually in a partner's drawing 
account are illustrated by the following pro-forma outline of 
such an account. 

Partner's Drawing 



Withdrawals (temporary) xxx 

Share of resulting loss, if any., xxx 



Added Investments (temuorary) xxx 

Salary not taken xxx 

Interest allowed on loans if not 

taken in cash xxx 

Interest allowed on capital in- 
vested xxx 

Share of remaining profit xxx 



Some partners never take their salaries in cash, as such. They 
desire their drawing accounts to be credited for salaries due them. 
Cash or merchandise taken by them or personal bills paid for 
them are charged to their drawing accounts. 

QUESTIONS 

1. Do you believe a partnership business might need all the accounting 
records so far considered in this text? 

2. Would you say that problems peculiar to partnerships relate more 
particularly to the showing of the assets, the liabilities, or the net 
worth accounts? 



Ch. XXI] PARTNERSHIPS 327 

3. a. What is a partnership? 

6. Must partners contribute equal amounts of property? 
c. Must each partner contribute property? If not, what may he 
contribute in lieu thereof? 

4. Suppose partner A contributes $10,000.00, partner B $1,000.00. 
Neither partner withdraws capital or contributes additional 
capital during the year. Suppose, also, no agreement exists with 
respect to the division of net profit or loss and at the end of the year 
the firm is worth $20,000.00. 

a. What is the net profit or loss of the firm? 
6. What is B's share of the net profit or loss? 

c. What is B's net worth at the end of the year? 

Suppose further that A is worth $30,000.00 in addition to his 
interest in the business, that B has no additional wealth, and that 
these extra facts are known generally. 

d. Do you believe this firm would enjoy a favorable credit rating? 
Why? 

Suppose the business was ruined suddenly by a flood and its debts 
far exceeded its remaining assets. 

e. What is the limit of B's losses? 
/. What is the limit of A's losses? 

5. Why do you believe the partnership type of organization is so popu- 
lar with professional offices such as accounting finurf? 

6. Can you name any advantages of the partnership when com- 
pared with the sole proprietorship type of organization? Any 
disadvantages? 

7. a. What do you mean by the expression "the unlimited liability 

of a partner for the debts of the firm"? 

6. What is meant by the expression "the mutual agency feature" 
of a partnership? 

c. May a partner sell his interest to anyone he chooses? 

d. Must the partnership agreement be in writing? 

e. Should the partnership agreement be in writing? Why? 

/. Name some of the points which should be covered by the articles 
of partnership, giving the reasons why in each instance. 

8. a. How are profits divided among partners in the absence of agree- 

ment? 

6. How are losses divided among partners in the absence of agree- 
ment? 

c. Is interest on capital invested allowed in the absence of agree- 
ment? 

d. Are partners entitled to salaries in the absence of agreement? 

e. If interest is allowed on capital investment and salaries are 



328 ACCOUNTING FUNDAMENTALS [Ch. XXI 

granted to the partners, are these allowances considered to be 
part of the profit distribution plan? 

/. If provision is made for interest on capital investment and for 
salaries to the partners, may they be effective in a year in which 
the firm suffers a net loss? 

9. a. How may an attempt be made to make profit distributions equi- 
table when the capital investment of the several partners varies? 

6. How may an attempt be made to make profit distributions equi- 
table when the ability of the partners and the time devoted to the 
business vary? 

10. If interest is allowed on capital investment, is it always on the 
amount of the original investment? If not, what other plans are 
there? 

11. How could you determine the amount of the average capital invest- 
ment of a partner for a year? 

12. a. Should salaries to partners be listed as an expense of the enter- 

prise or be shown at the bottom of the statement of profit and 
loss as part of the distribution to partners? 

6. In what part of the statement of profit and loss is shown the 
interest allowance to partners on 

(1) Loans? 

(2) Capital investments? 

13. If a partner withdraws in excess of his current credits, is such excevss 
withdrawal an expense to the business? Explain. 

14. What items are debited and credited to the personal account of a 
partner? To the capital account? 

16. Is a drawing account more important in a partnership than in a 
sole proprietorship? Why or why not? 

16. Should a partner be charged with merchandise withdrawals at cost 
or sales price? Explain. 

17. Is a complete and accurate accounting system more important in a 
partnership than in a sole proprietorship? Why? 



CHAPTER XXII 
PARTNERSHIPS (Continued) 
A partnership may be formed in several different ways: 

1. Two or more individuals may form a partnership enterprise. 

2. An organized partnership with the consent of all partners 
may 

a. Admit a partner who purchases an interest from one 

or more of the old partners. 
6. Admit a partner who purchases an interest from the 

old firm by increasing the total capital by the amount 

of his investment. 

An existing partnership contract is terminated, among other 
reasons, with the death, insanity, bankruptcy, or withdrawal 
of a partner, by the expiration of the contract, or by the admission 
of a new partner. The termination of a partnership contract 
does not mean, however, that the enterprise necessarily ceases; 
a new partnership agreement may be entered into and the 
enterprise continued. The termination of an old partnership 
agreement and the drawing of a new one is very common practice 
in connection with the withdrawal of a partner or the admission 
of a new one. 

Recording Each Partner's Original Investment 

The investment by each partner in a new enterprise is recorded 
in exactly the same way as an investment by a sole proprietor. 
In the partnership there are several owners instead of one. Such 
opening partnership records may be indicated by the following 
pro-forma journal entry: 

Assets (itemized) xxx 

Liabilities and Reserves (itemized) xxx 

Partner's Capital xxx 

To record the original investment of Mr 

at values agreed upon in the articles of partnership* 

829 



330 ACCOUNTING FUNDAMENTALS [Ch. XXII 

If assets other than cash are invested by a partner it is impor- 
tant that all partners agree to the values at which they are 
accepted, since subsequent profits or losses on them are shared 
by all partners. Before the first entry to record a partner's 
investment is made, a summary of the articles of partnership 
should be entered in the journal as a memorandum. 

Entries to Record the Admission of a New Partner 

As a new partner shares in all profits and losses arising after his 
admission, it is important that the book values of the exist- 
ing partnership be questioned and, if necessary, that they be 
adjusted. Reserves for bad debts and depreciation may be 
excessive or inadequate, the current value of land or other 
assets owned by the partnership may be considerably higher 
or lower than at the time they were acquired, and the old enter- 
prise may have developed goodwill which is not reflected in the 
records. These references are suggestive of the type of valuation 
problems to be considered and adjusted by journal entries prior 
to the admission of a new partner, if the rights of all partners 
are to be safeguarded. 

To record the admission of a partner to an existing firm 
properly, it is necessary to determine 

1. The equity of the old partners as shown by a balance sheet 
adjusted if necessary to the agreed-upon values. 

2. The initial net worth of the new partnership. 

3. The proportionate interest in the capital of the new enter- 
prise which the new partner is to have. 

1. If Payment Is Not Made to the Firm. A new partner may 
be admitted as the result of the purchase by him of an interest 
from one or more of the old partners. 

Assume for illustration that Mr. F. L. Flynn has an equity in 
the firm of Flynn and Hemm of $8,000.00, Mr. G. M. Hemm 
has an equity of $4,000.00, and that profits and losses are shared 
equally, also that Mr. H. N. Ross wishes to obtain a one-fourth 
equity in the partnership and a one-third interest in the profits. 

Among other things it is agreed that the values shown for the 
assets and liabilities in the current balance sheet of Flynn and 
Hemm are approved by all parties and that the same set of books 



Ch. XXII] PARTNERSHIPS 331 

is to be continued with an explanatory statement of the new 
agreement shown in the journal. 

a. Assume further that Mr. Ross purchases his interest 
from Mr. Flynn and that the nfet worth of the partnership 
is to remain unchanged at $12,000.00. In a case of this 
kind where a new partner makes payment to an old 
partner, the entry to record the admission of the new 
partner is the same regardless of the amount of the 
payment. Since Mr. Ross is to have a one-fourth interest 
in the initial capital of the new enterprise, his account 
is credited and Mr. Flynn's account is debited with 
$3,000.00, as follows: 

F. L. Flynn, Capital 3 , 000 . 00 

H. N. Ross, Capital 3,000.00 

To record the transfer of a one-fourth 
interest in the partnership. 

6. If Mr. Ross purchases a one-fourth interest in the 
firm for $4,000.00, with payments to the old partners 
as individuals; and if it is agreed that the proportionate 
interests of the old partners arc to remain the same, the 
entry to record the transfer is as follows : 

F. L. Flynn, Capital 2,000.00 

G. M. Hemm, Capital 1,000.00 

H. N. Ross, Capital 3,000.00 

To record the transfer of a one-fourth 
equity in the partnership. 

As Mr. Flynn had an equity equal to two-thirds of the net 
worth of the firm at the time Mr. Ross was admitted, his capital 
account is reduced by an amount which is equal to two-thirds 
of the figure for which Mr. Ross is credited. 

This transaction, under which a $3,000.00 capital account 
credit on the books of the new partnership was sold by the 
old partners as individuals for $4,000.00, involves a $1,000.00 
profit item to the partners personally. Since profits and losses 
of the old firm were divided equally, this $1,000.00 must be so 
distributed. Mr. Flynn's share of the $4,000.00 purchase 
price is, therefore, $2,500.00 and Mr. Hemm's share is $1,500.00. 



332 ACCOUNTING FUNDAMENTALS [Ch. XXII 

2. If Payment Is Made to the Firm. A partner may be admitted 
by the purchase of an interest the payment for which is to go to 
the partnership and not to the individual partners. 

Assume: That the accounts on the books reflect the agreed- 
upon values and that the books of the old firm are to be used by 
the new firm with an explanatory record in the journal of the 
new partnership agreement. 

a. Assume further that Mr. Ross pays the new firm $4,- 
000.00 cash for a one-fourth interest. The entry to 
record the investment of Mr. Ross as a new partner in 
the firm is as follows: 

Cash 4,000.00 

H. N. Ross, Capital 4,000.00 

To record the investment necessary to 
give Mr. Ross a one-fourth interest. 

The initial net worth of the new partnership is $16,000.00, 
divided as follows: Mr. Flynn $8,000.00, Mr. Hemm 
$4,000.00, and Mr. Ross $4,000.00. 

b. Suppose Mr. Ross pays $3,000.00 cash for a one-fourth 
interest in an initial net worth of $15,000.00. Since the 
investment of $3,000.00 by Mr. Ross is to give him a 
one-fourth interest in $15,000.00 or $3,750.00, it is 
necessary for the other two partners to transfer $750.00 
from their capital accounts to that of Mr. Ross. The 
entries to record the investment and the establishment 
of the new partner's equity are as follows : 

Cash 3,000.00 

H. N. Ross, Capital 3,000.00 

To record the cash investment by H. N. 
Ross. 

F. L. Flynn, Capital 375.00 

G. M. Hemm, Capital 375.00 

H. N. Ross, Capital 750.00 

To record the transfer agreed upon to give 
H. N. Ross a one-quarter equity in the 
initial capital of the new partnership. 

In this particular illustration it was necessary for the old 
partners to induce Mr. Ross to join the firm. The old firm 



Ch. XXII] PARTNERSHIPS 333 

may have needed his cash investment or his services so badly it 
was willing to grant him a capital credit in excess of his actual 
investment. The excess credit to the new partner is a loss to the 
two old partners who divide it equally according to their profit 
and loss distribution plan. 

It is possible for an additional credit to be allowed Mr. Ross 
in recognition of the personal business reputation he had devel- 
oped. Assume: On the investment of $3,250.00 cash Mr. Ross 
is to be allowed a capital credit of $4,000.00 in a total initial 
net worth of $16,000.00. The entries to record his investment 
and the establishment of his interest are 

Cash 3,250.00 

H. N. Ross, Capital 3,250.00 

To record the cash investment by H. N. 
Ross. 

Goodwill 750.00 

H. N. Ross, Capital 750.00 

To record the goodwill allowance granted 
H. N. Ross. 

c. Suppose Mr. Ross pays $4,500.00 cash for a one-fourth 
interest in an initial net worth of $18,000.00. 

If the initial net worth of the partnership is greater than the 
capital of the old partners and the investment of the new partner, 
the excess is the value allowed for the favorable reputation 
Goodwill developed by the old partnership. In this case the 
computation is 

Initial net worth of the partnership $18,000.00 

Less: 

Capital of old partners: 

Flynn $ 8,000.00 

Hemm 4,000.00 

Total $12,000.00 

Investment of new partner . . 4 . 500 . 00 16 . 500 . 00 
Goodwill allowed old partnership $ 1 , 500 . 00 

Two entries are necessary to adjust the partnership records 
one to record the goodwill of the old partnership and another to 
record the investment of the new partner. 



334 ACCOUNTINO FUNDAMENTALS [Ch. XXII 

Goodwill 1,600.00 

F. L. Flynn, Capital 760 . 00 

G. M. Hemm, Capital 760.00 
To distribute equally the goodwill devel- 
oped by the partnership prior to the 

admission of Mr. Ross. 

Cash 4,500.00 

H. N. Ross, Capital 4,500.00 

To record the investment of Mr. Ross 
equal to a one-fourth interest. 

The $1,500.00 debit to Goodwill represents a profit to the 
old partners, hence its distribution to them according to the 
profit and loss sharing ratio. 

Before discussing the asset goodwill, \vhich was used in the last 
two illustrations, mention should be made again that a partner 
may be taken into a firm without making any property invest- 
ment. The services of a person may be so valuable to a partner- 
ship that he is admitted to membership in the firm with the right 
to a specified share in the profits but without any share in the 
equity. The admission of a partner on such a basis does not 
require any formal entry but an explanatory memorandum should 
be made in the journal as a summary of the new partnership 
agreement. Such a partner with the approval of the other 
members of the firm may establish an equity by allowing salary 
and other credits to accumulate or by making a property invest- 
ment at a later date. 

GOODWILL 
Definition 

Goodwill is the value of the established reputation of an enter- 
prise. 

An established reputation is developed by many factors such 
as excellent management, high quality of products and services, 
favorable prices, convenient location, and courteous and fair 
actions in all matters. Such influences, in themselves, build 
up consumer demand for the products or services of the enter- 
prise, which, if reflected in net profit returns above those of 
normal business, indicates that the reputation has a value. A 
reputation value goodwill should not be set up on the books of 
an enterprise which creates it unless the value is established by the 



Ch. XXII] PARTNERSHIPS 335 

sale of an interest in it. If the reputation of one enterprise is pur- 
chased by another, the purchasing enterprise should show good- 
will as an asset for the amount paid for the reputation acquired. 

The reason why goodwill should not appear on the books of 
the enterprise which creates it, unless its value is established 
by the sale of an interest in it, should be apparent. If the 
owners of an enterprise could fix arbitrarily a value on goodwill 
and set it up as an asset, there would be no limit to the figure 
they might use and the result might be ridiculous. 

In the last illustration of the entries to record the admission 
of a new partner, the asset goodwill was involved. The old 
partners Flynn and Hernm had a capital of $12,000.00. Ross 
was admitted as a partner with a one-fourth interest upon the 
payment of $4,500.00. The purchase by partner Ross of a 
one-fourth interest in profits and equity for $4,500.00 established 
the net worth figure of $18,000.00 for the new partnership, 
which in turn fixed the value of the goodwill of the old partnership 
at $1,500.00. The Ross investment included the purchase by 
him and the sale by the old firm of an interest in the goodwill 
it had developed and justified the charge to the Goodwill account. 

Determining the Value of Goodwill 

The ability of an enterprise to earn better than normal profits 
for one year is not adequate evidence of goodwill. The evidence 
should cover a number of years, the net profits of which should 
be averaged. In determining the average annual net profit 
for a given period of years exceptional and nonrecurring expenses 
or income of any particular year should be excluded. The 
profit trend for the period considered should be noted, since an 
enterprise with a decreasing profit trend may have the same 
average as one with an upward trend. The trend should be 
considered in connection with the state of general business 
prosperity for the period covered. 

The value of established reputation depends in part on the 
estimate of its permanency. An outsider who is contemplating 
the purchase of an enterprise or an interest therein is very much 
interested in the number of years that special benefits may be 
expected to flow from such reputation. If net earnings are 
erratic or declining, the value of the reputation is highly question- 
able in spite of an excess of average annual net profit. 



336 ACCOUNTING FUNDAMENTALS [Ch. XXIT 

In professional partnerships goodwill is questionable if the 
death or withdrawal of a key man is apt to destroy it. In 
business establishments goodwill may be estimated by capitaliz- 
ing the excess earnings. 

For purposes of illustration the following facts are assumed : 

1. The average net income of an enterprise for the last five 
years is $20,000.00. 

2. The average capital investment for the same period is 
$175,000.00. 

3. A normal rate of return is considered to be 10 per cent. 

At 10 per cent a capitalization of the excess earnings results 
in goodwill of $25,000.00 computed as follows: 

Average net income for the last five years ....... $20 , 000 . 00 

Less 10 per cent of the average capital investment 17 , 500 . 00 
Excess of the average over normal net income ... $ 2 , 500 . 00 

$2,500.00 






Goodwill 



The above illustration is correct theoretically, but it is modified 
commonly in practice. Suppose the outsider who contemplates 
the purchase of this business or an interest therein, estimates 
that eight years is the future period in which better than normal 
profits may be expected. On the basis of such an estimate he 
would not be willing to value goodwill at more than eight times 
the average annual excess of $2,500.00 or $20,000.00, and of 
course he would try to acquire it at a figure lower than that. 
The final goodwill figure is usually, therefore, a matter of 
bargaining. 

Recording Goodwill 

Goodwill, if purchased outright, is recorded at cost price. 
If only an interest in goodwill is sold, it is recorded at the figure 
established by the price paid for the portion sold. 

Goodwill should be charged to the Goodwill account and should 
not be concealed in some other asset account. The journal 
entry to record goodwill in a partnership was illustrated earlier 
in this chapter. Other goodwill entries will follow in later 
chapters as occasion demands. 



Ch. XXII] PARTNERSHIPS 337 

The asset goodwill is not subject to depreciation a&d once the 
account for it is set up on a set of books it need not be written 
off. Its value may be preserved, even increased, as time goes 
on. Because of its intangible character, however, some enter- 
prises do write it down. In some cases it is reduced to the purely 
nominal figure $1.00. When this is done goodwill is charged 
directly to capital it should not be treated as an expense and 
charged to an account which finds its way into the profit and 
loss account. 

DISSOLUTION 
Definition and Causes 

The word dissolution as applied to a partnership refers to the 
cancellation of a partnership contract. As stated in the forepart 
of this chapter a partnership contract is dissolved, among other 
causes, by the expiration of the contract, the death, insanity, 
bankruptcy, or withdrawal of a partner, or by the admission of a 
new one. The contract also may be dissolved if the partners 
agree to liquidate for any reason or if they convert the enterprise 
into a corporate form of organization. The word dissolution 
does not imply that the business is to be terminated. If a 
new partnership is formed to carry on the business of the old 
one, the old contract is canceled and a new one immediately 
takes its place. 

The Accounting Problems of Dissolution 

Illustrations previously shown in this chapter indicated the 
entries necessary on the books of a partnership if there was a 
dissolution caused by the admission of a new partner. The 
old agreement was canceled, a new one was drawn immediately 
and the books of the dissolved partnership were used for the 
records of the new partnership. 

If a partner withdraws or dies it is necessary to determine his 
equity on the date of withdrawal or death. The problem is 
complicated by the necessity of estimating the net profit or 
loss of the period immediately preceding death or withdrawal 
when the date differs from the close of the regular fiscal period. 

If the partnership not only is dissolved but is also liquidated, 
the accounting records must be completely closed. The process 
of liquidation involves 



338 ACCOUNTING FUNDAMENTALS [Ch. XXII 

1. Distribution of the net operating profit or loss for the last 
period to the date of dissolution. 

2. Conversion of the assets into cash. 

3. Liquidation of the liabilities. 

4. Division of the net profit or loss resulting from realization of 
the assets and liquidation of the debts. 

5. Distribution of the assets to the partners according to their 
respective equities on the date of distribution. 

Withdrawal or Death of a Partner 

For purposes of illustration it is assumed that the following 
condensed balance sheet shows the condition of the partnership 
of Holt, Hirt, and Hyde on December 31, 19 

HOLT, HIRT, HYDE 

BALANCE SHEET, DECEMBER 31, 19 

Assets (Various) $50 , 000 . 00 Liabilities (Various) .... $20 , 000 . 00 

Holt, 

Capital.. $15,000.00 
Hirt, 

Capital.. 10,000.00 
Hyde, 

Capital.. 5,000 00 30,000 00 

$50,000.00 $5Q,0()07(JO 

Assume further that the partners share net profit or loss, 
Holt 50 per cent, Hirt 30 per cent, and Hyde 20 per cent, also 
that Mr. Holt desires to withdraw as of December 31, 19 

If the partners agree that the balance sheet figures need further 
adjustment prior to the withdrawal, suitable entries are made. 
For example, if it is agreed that the Reserve for Bad Debts 
account should be increased $500.00, this increase in a valuation 
reserve account reduces the equities of the partners and is charged 
to their capital accounts according to the profit and loss sharing 
ratio, as follows: 

Holt, Capital 250.00 

Hirt, Capital 150.00 

Hyde, Capital 100.00 

Reserve for Bad Debts 500 . 00 

To increase the reserve for bad debts to further 
care for possible losses after the withdrawal of 
Mr. Holt. 



Ch. XXII] PARTNERSHIPS 339 

Entries to illustrate the type of journal record which is neces- 
sary when a partner withdraws were presented in connection 
with the entries to record the admission of a new partner and 
will not be illustrated further. 

The accountant should examine the articles of partnership 
carefully to note any special provisions covering the procedure 
to be followed in case of the withdrawal or death of a partner. 
The entries to close the account of a deceased partner are similar 
to those for withdrawals. They vary according to whether a 
new partner takes the place of the deceased or whether the equity 
is purchased by the remaining partners. 

Realization Conversion of Assets into Cash 

If Messrs. Holt, Hirt, and Hyde agree to go out of business 
and Mr. Haiice buys the partnership assets for cash at their book 
values plus $6,000.00 for goodwill, the following entry records the 
sale: 

Hance, Vendee 56,000.00 

Assets (various) 50,000.00 

Profit Sale of Partnership 

Assets 6,000.00 

To charge Mr. Hance with the purchase 

price of the partnership assets including 

goodwill, to close out all asset accounts 

and to record the profit arising from the 

sale of goodwill. 

When Mr. Hance, the purchaser of the business, satisfies the 
charge against him by payment in cash, record is made in the 
cash receipts journal. The old firm is then in position to liquidate 
its debts and make distribution to the partners. 

Division of the Net Profit or Loss of Dissolution 

The net profit or loss arising out of the sale of a business or 
any of its assets is distributed among the several partners in the 
same ratio as operating net profit or loss. It is highly important 
that such profit or loss of dissolution be divided among the 
partners prior to the payment of cash to them. 

To continue the illustration, the profit from the sale of the 
partnership assets is distributed by the following entry: 



340 ACCOUNTING FUNDAMENTALS [Ch. XXII 

Profit Sale of Partnership Assets 6 , 000 . 00 

Holt, Capital 3,000.00 

Hirt, Capital 1,800.00 

Hyde, Capital 1,200.00 

To distribute the profit resulting from the 

sale of the partnership. 

It sometimes happens that the distribution of a loss from either 
operation or dissolution results in a debit balance in the capital 
account of a partner. If such partner is able to make good the 
deficiency his account is credited and the asset contributed 
usually Cash is debited. If the partner cannot make up the 
deficiency the debit balance is apportioned between the remaining 
partners on the basis of the profit and loss sharing ratio. If a 
loss should cause Mr. Hyde to have a debit balance in his capital 
account and he is not able to pay it off, his account is considered 
an additional loss to be divided five-eighths to Mr. Holt and three- 
eighths to Mr. Hirt. This particular distribution is based on the 
fact that the partnership agreement provided that net profit 
or loss was to be divided 50 per cent to Holt, 30 per cent to Hirt, 
and 20 per cent to Hyde. Any loss to be borne by Holt arid 
Hirt alone is, therefore, on the basis of five-eighths and three- 
eighths respectively. 

Liquidation Distribution of the Cash 

After the assets are converted into cash the claims of creditors 
are satisfied before the equities of the partners. For each 
liability satisfied an entry is made in the cash disbursements 
journal debiting the liability account and crediting Cash. 

In the Holt, Hirt, Hyde illustration when $56,000.00 is collected 
from Mr. Hance there are $20,000.00 of creditor claims to be 
satisfied. After they are paid there is $36,000.00 available for 
the partners. It is distributed according to the credit balances 
remaining in the capital accounts of the partners by the following 
entry: 

Holt, Capital 18 , 000 . 00 

Hirt, Capital 11,800.00 

Hyde, Capital 6,200.00 

Cash 36,000.00 

To charge each partner with the 
amount paid him in complete liqui- 
dation of his equity in the partnership. 



Ch. XXII] PARTNERSHIPS 341 

If any partner has made loans to the partnership his loan 
account is satisfied before distribution is made to the partners 
for their capital accounts. 

Each partnership dissolution presents its own peculiar problems 
and some become highly involved. The discussion of this 
subject in this text has been limited to the liquidation of solvent 
concerns where the claims of partners are satisfied by one final 
distribution of assets. The problems arising out of the liquida- 
tion of insolvent concerns and installment distributions to 
partners are left to texts which cover the more advanced prin- 
ciples of accounting. 

QUESTIONS 

1. Suppose Rogers owns a business, the net worth of which is $8,000.00. 
a. Give the entry on the books of the business, if Rogers sold a 

half interest to Smith for $8,000.00 and the money went into the 
business. 
6. Give the entry if the cash was kept by Rogers personally. 

c. Give the entries if Rogers sold a one-half interest to Smith 
for $10,000.00 cash and the money went to the credit of the firm. 

d. Give the entries if Rogers sold a one-half interest to Smith for 
$7,000.00 cash and the money went to the firm, the initial worth 
of which is to be $16,000.00. 

e. Suppose the same facts as in d except that the initial net worth 
of the firm is to be $15,000.00. 

2. Why would an owner be willing to sell an interest in his business 
for a consideration which is less than the proportionate share of 
his equity in the business? 

3. Suppose there are four partners in an enterprise, each has an equal 
interest in the equity and net profits, and the net worth is $20,000.00. 

a. If X is admitted to the partnership on a basis equal to the others 
how much would he invest? (Assume pay mentis to be made 
to the firm solely on the basis of the facts and figures given 
above). 

6. Is it possible X might pay more than the figure you gave in 
answer to a? Why? 

4. a. What is goodwill*! 

b. Name some factors which develop goodwill. 

6. A and B are partners. They invested $10,000.00 each, their net 
worth is still $20,000.00 but they have earned and withdrawn from 
the business $12,000.00 apiece for each of the last 10 years. 
a. Do you think they would sell the business for $20,000.00? For 
$50,000.00? Why? 



342 ACCOUNTING FUNDAMENTALS ' [Ch. XXII 

6. Would it be in accord with sound accounting principles for them 
to set up a Goodwill account on their books say for $10,000.00? 
For $30,000.00? For what amount? 

c. Suppose they sell a one-third interest in the equity and the net 
profits to C for $40,000.00 and payment is made to the firm. May 
the account Goodwill now appear on the books? If so, for how 
much? 

6. Where may goodwill be classified on the balance sheet? 

7. On what basis may the value of goodwill be determined? 

8. Is goodwill subject to depreciation? Why? 

9. Why do you think some enterprises write down the value of good- 
will to $1.00? 

10. Can you mention any enterprises which show goodwill on their 
balance sheets? 

11. Can you name any local enterprises which you believe have good- 
will whether they show it on their statements or not? Why? 

12. a. What factors may cause a partnership to dissolve? 

6. If a partnership is dissolved, is the business terminated, neces- 
sarily? Explain. 

13. Suppose a partner dies at the end of the second month of a fiscal 
year. What accounting work is necessary? 

14. a. A loss in dissolution would be divided among the partners on 

what basis? 
6. Assets in dissolution are distributed to the partners on what 

basis? 
c. In dissolution are liabilities or partners' equities satisfied first? 

Why? 

16. In dissolution one of three partners has a debit balance in his 
capital account and his personal assets are insufficient to meet it. 
How should it be charged to the other partners A and B who have 
shared profit or loss five-eighths and two-eighths respectively? 



CHAPTER XXIII 

CORPORATIONS 

The last two chapters dealt with problems peculiar to the 
partnership type of organization. It is the purpose of this and 
the succeeding two chapters to consider problems inherent in the 
corporate form of organization. 

A corporate enterprise, the same as a partnership, needs all 
the accounting books and other records described in connection 
with an enterprise owned by a sole proprietor and needs to follow 
all the steps outlined in the accounting cycle. Because of its 
type of organization, a corporation needs additional books 
and accounts to keep records of its members and their equity. 

Definition 

A corporation is an entity created by law to conduct an enter- 
prise. 

A corporation, commonly referred to as a company, is primarily 
an association of persons who have been authorized by legal 
action to conduct an enterprise. Although made up of mem- 
bers, the corporation is a separate legal entity in itself. It is 
empowered to transact business under its own name; to purchase, 
hold, and convey title to both real and personal property; to 
institute and defend litigation and, unless previously dissolved, 
to continue its existence to the end of its legal life, regardless of 
changes in the personnel of its membership. 

The corporation is a creature of the law, hence its rights, 
privileges, powers, and existence are limited by the specific 
provisions of its charter and the general law. 

The enterprise, for the conduct of which a corporation is 
organized, need not be a private business undertaking. The 
enterprise may be the government of a city, town, or school 
district. A corporation created for such a purpose is known as a 
public corporation. The enterprise may be primarily a religious, 
charitable, educational, or social undertaking, in which case the 

343 



344 ACCOUNTING FUNDAMENTALS [Ch. XXIII 

corporation formed is usually a nonprofit corporation, member- 
ship in which is not evidenced commonly by shares of stock. 

The vast majority of corporations are those organized to 
carry on business undertakings with the profit motive. Mem- 
bership in such corporations is evidenced by shares of stock, 
and it is to the consideration of this class of corporations that 
the following discussion is devoted. 

Formation 

Except for a few cases, such as national banks which obtain 
their charters under the authority of federal laws, the charters 
for corporations are obtained from the various states under 
authority of state statutes. The requirements for incorporation 
vary as between the several states as do the privileges, rights, 
and powers granted. Since certain states have more liberal 
incorporation laws than others, it is common practice to obtain 
a charter in a state other than the one where the corporation 
will conduct its principal business. For this same reason and 
further because the procedure of incorporation is a legal matter 
and not an accounting one, no attempt will be made here to 
discuss completely the formation of a corporation. A few main 
features which are required quite generally are as follows : 

1. A required number of incorporators must sign and file with 
the proper state official an application for a charter. On 
the application there must be stated: the name of the 
proposed corporation; the nature of its business; the place 
of the business; the names and addresses of its subscribers 
and the number of shares subscribed by each; the names 
and addresses of the directors chosen for the first year; 
the amount and number of shares of par value stock or the 
number of shares of no par stock; and the amount paid in. 

2. Necessary fees must be paid to the state. 

3. Public advertisements of the application for a charter must 
appear, if and as required. 

4. If the application is approved, the charter or certificate of 
incorporation is signed by the authorized state officer, 
recorded in the proper state office, and returned to the 
incorporators. 

5. A meeting of the stockholders is held to accept the charter 
and adopt bylaws. 



Ch. XXIH] CORPORATIONS 345 

6. The charter is recorded usually in the office of the recorder 
of deeds for the county where the corporation has its main 
office. 

Management 

The members of the corporation adopt bylaws which ordinarily 
can be amended only by the same body. These rules specify 
the time and place for meetings of the official corporate body, 
delegate powers to the directors and officers, and otherwise 
provide for the conduct of the internal affairs of the corporation. 

The directors are elected by the members and it is the usual 
practice for the directors in turn to choose the officers such as the 
president, vice-president, treasurer, and secretary. 

Comparison with Partnerships Advantages 

When compared with partnerships, the corporate form of 
organization has certain very decided advantages, among which 
are 

1. The stockholders who are the owners of a corporation do 
not have unlimited liability for the debts of their enterprise 
as do the partners in a general partnership enterprise. This is 
true because a corporation is a distinct legal entity apart from 
its members. Ordinarily the losses of a stockholder are limited 
to the amount of his investment, if his stock has been paid for 
in full. 

2. If there is a purchaser, the transfer of a stockholder's 
interest in a corporation is relatively easy compared to the 
transfer of a partner's interest in a firm. The latter requires 
the unanimous consent of all partners, the dissolution of the 
old partnership, and the establishment of a new one. The 
former involves simply the transfer of a stock certificate. 

A stockholder may dispose of his stock as and when he pleases 
without disturbing the corporate existence. If the stock of a 
company is popular and there is an active market for it, a 
person may purchase or dispose of an interest in the enterprise 
at will. 

3. The life of a successful corporation is practically continuous, 
while that of a partnership is uncertain. The death or with- 
drawal of a partner, among many other causes, dissolves a 
partnership; but the death or withdrawal of a stockholder, even 



346 ACCOUNTING FUNDAMENTALS (Ch. XXIII 

a stockholder with a controlling interest in the company, does not 
disturb its existence. This feature of permanence lends stability 
to the corporate form of organization, attracts investors and 
makes it possible for the corporation to undertake long-term 
contracts. 

4. There is practically no limit to the number of stockholders 
a corporation may have or to the maximum amount of capital 
which may be invested. On the other hand, the partners in a 
firm are not likely to go on adding associates whose partnership 
actions bind them all. The capital investment of a partnership 
is limited to the financial ability of the few partners to contribute 
to it. The charter of a corporation limits the number of shares 
and the amount of its capital stock, but if such figures 
prove inadequate an application may be made to amend the 
charter. 

The number of stockholders in some corporations runs into the 
hundreds of thousands and the amount of capital into the 
hundreds of millions. The corporate form of organization may 
be said to have every advantage that goes with large-scale 
enterprise. 

5. A corporate form of organization is likely to give an enter- 
prise a more unified form of control than does a partnership. 
In a partnership each member has an equal share in management. 
In a corporation the members elect a board of directors who 
choose officers to carry out their policies. The board of directors 
is responsible to the members who vote according to the extent 
of their interests, on the basis of the number of shares owned. 

6. The representative form of corporate control makes it 
possible for the enterprise to enlist the services, not as employees 
but as directors, of men of wide experience and influence whose 
major interests may be in other lines of endeavor. This is not 
possible in a partnership. 

Comparison with Partnerships Disadvantages 

There are certain disadvantages connected with corporations 
which do not apply to partnerships. 

1. Every member of a partnership has the proprietary urge. 
This is not true in the same degree in a large corporation which 
may suffer from absentee ownership lack of active interest in its 
affairs by its members. 



Ch. XXIII] CORPORATIONS 347 

2. There is a greater possibility of the misuse of power in a 
corporation than in a partnership. Because of absentee owner- 
ship, it is possible oftentimes for directors and officers to violate 
the power entrusted to them and to divert to their personal gain 
opportunities which belong to the corporation. 

3. Corporations are burdened with a greater number of reports 
and taxes than are partnerships. 

4. It is more expensive to organize a corporation than a 
partnership. 

5. Since the activities of a corporation are limited by its 
charter, it may not be so free to extend its field of action as is a 
partnership. 

6. Since a corporation is created by the state it is subject to 
greater governmental control than is the partnership. 

7. Because of the limited liability feature of the corporation, 
a small corporate enterprise with wealthy ^stockholders does not 
have so high a credit rating as would a partnership with the same 
members. 

All things considered the advantages of the corporate over 
the partnership form of organization far outweigh the 
disadvantages. 

Although a corporation is a legal entity, the fact must not be 
overlooked that it is managed and operated by humans. The 
choice of directors and officers determines its policies and results. 
A change in personnel of those in control or the death of an 
important stockholder, director, or officer does not disturb its 
legal existence but may have a profound effect on its economic 
existence. 

Capital Stock Terms Defined 

The capital of an enterprise whether it be a sole proprietorship, 
a partnership, or a corporation is the excess of the assets over the 
liabilities. It is the proprietary or ownership interest (equity) 
in the total assets of the enterprise. The capital of a corporation 
must not be confused with its capital stock. At the time a 
corporation is organized and the members invest in it, the amount 
of its capital and its capital stock may be the same. 

Earlier in this chapter it was stated that the application for a 
charter for a corporation must state the amount and the number 
of shares of par value stock or the number of shares of no par 



348 ACCOUNTING FUNDAMENTALS [Ch. XXIII 

value stock. The charter when issued authorizes the corporation, 
among other powers, to issue a certain amount of capital stock 
divided into a given number of shares of par value stock or a 
certain number of shares of no par stock, or both. Since it is 
common practice for a corporation not to issue all the stock 
authorized by its charter, it is customary to refer to authorized 
capital stock and capital stock, the latter indicating usually 
capital stock authorized and issued. 

Authorized capital stock is the amount of ownership interest a 
corporation is authorized by its charter to issue on a share basis. 

Capital stock is authorized capital stock or, as very commonly 
used, it is the amount of ownership interest actually issued by a 
corporation on a share basis. 

Outstanding capital stock is the amount of capital stock issued 
by a corporation which is in the hands of stockholders. 

Unissued capital stock is the amount of capital stock authorized 
by charter but not issued. 

Subscribed capital stock is the amount of authorized capital 
stock for which contracts of sale have been made but for which 
full payment has not been received. 

Unsubscribed capital stock is the amount of authorized capital 
stock for which contracts of sale have not been made. 

Stock Terms Defined 

An ownership interest in a corporation is evidenced by a 
certificate of stock, which indicates the number of shares of the 
capital stock owned. 

A share of capital stock is a unit of ownership participation in 
the affairs of a corporation. 

A corporation may have more than one class of stock. If so, 
each class has certain rights and privileges. The usual classes of 
stock are common and preferred, with a number of varieties of 
each. 

Preferred stock is any class of ownership participation in the 
affairs of a corporation which has any special rights over the 
common stock. Usually the preference is a first but limited 
claim on dividends ahead of the common stock. Another com- 
mon preference, among many which may be specified, is that 
the preferred stock shall rank ahead of common stock in the 
distribution of the assets of a corporation in case of dissolution. 



Ch. XXIII] CORPORATIONS 349 

There may be a number of classes of preferred stock, such as 
6 per cent first preferred and 7 per cent second preferred, and 
there are 9, number of varieties such as: participating preferred; 
nonparticipating preferred; cumulative preferred; redeemable 
preferred ; convertible preferred ; and non voting preferred. Unless 
otherwise specified a preferred stock with preference over the 
common stock as to dividends is cumulative. If a 6 per cent 
cumulative preference stock receives no dividends for two years 
it is entitled to 12 per cent before any dividends are paid on the 
common stock. A noncumulative preferred stock carries the 
dividend preference for each year separately and the unpaid 
dividends of one year do not accumulate for the next year. 

Common stock is the class of ownership participation in the 
affairs of a corporation to which no preferences over any other 
class of stock are granted. It participates usually in earnings and 
in assets in dissolution after the rights of preferred stockholders, 
if any, are satisfied. The common stock is the ordinary stock 
which is the first to feel the effects of losses and which benefits 
most by profits in excess of the amount necessary to satisfy 
preferred dividend claims. If only one class of stock is issued it is 
all common stock. The common stock usually carries the voting 
privilege. 

Under the laws of some states common stock may be divided 
into a number of classes, such as non voting and voting, which are 
designated usually Class A and Class B, respectively. When this 
privilege is used, it is customary to issue a relatively small 
amount of Class B voting stock, the control of which by the 
organizers of the corporation gives them control of the enterprise. 

Treasury stock is full -paid capital stock reacquired by the 
issuing corporation as the result of purchase, donation, or the 
payment of a debt. 

Par value stock is any authorized capital stock, the certificates 
for which state a nominal or uniform figure for each share in the 
particular class of stock; $10.00, $50.00, and $100.00 are very 
common par value figures. Par value stocks are shown in the 
Capital Stock account of the issuing company at par value 
figures regardless of the amounts at which disposed. 

No par value stock is any authorized capital stock, the certifi- 
cates for which do not state any nominal or par value for each 
share. 



350 ACCOUNTING FUNDAMENTALS [Ch. XXIII 

Rights of a Stockholder 

Unless restricted by a limitation of privilege placed on the 
entire class of stock of which it is a part, each share of stock 
entitles its owner, among other rights, to 

1. A vote at the annual or special meetings of the stock- 
holders. 

2. A proportionate share in any profit distribution. 

3. A proportionate share in any assets of the corporation which 
remain after the payment of debts, in case of dissolution. 

4. A proportionate share of the rights to subscribe to any 
new stock which may be issued by the corporation. 

Capital Stock Accounts 

A separate account should be kept on the books for each class of 
capital stock and each class should be presented clearly on the 
balance sheet of the corporation. 

Unissued capital stock and treasury stock are not assets. 
They are deducted from the authorized capital stock to deter- 
mine the outstanding capital stock in the proprietorship section 
of the balance sheet. The proper form is indicated on page 358. 

Other Proprietorship Accounts 

After a corporate enterprise starts operations its capital as the 
result of operating profits and losses alone is not the same as the 
amount shown by the Capital Stock account which, in the case 
of par value stocks, is kept at par value figures. Increases and 
decreases in capital which do not affect the amount of capital 
stock are shown at the end of a period in Surplus or Deficit 
accounts. 

Surplus is the excess of the assets over the liabilities and capital 
stock of an enterprise. In other words it is the amount to be 
added to capital stock to indicate the equity of the stockholders 
in a corporation. 

Deficit is the excess of the liabilities and the capital stock 
over the assets of an enterprise. It is the amount to be deducted 
from capital stock to indicate the equity of the stockholders in a 
corporation. 



Ch. XXIII] CORPORATIONS 351 

The proprietorship equation adjusted to corporate needs is 

Assets Liabilities = Capital Stock + Surplus 

or 
Assets Liabilities = Capital Stock Deficit 

A more complete consideration of surplus and deficit is reserved 
for Chapter XXV. 

SPECIAL BOOKS AND RECORDS OF CORPORATIONS 

Because of its type of organization, a corporation needs 
certain special books and records which are not necessary in 
other forms of organization. Unlike a partnership, a corporation 
does not show proprietorship accounts with its various members 
on its general ledger. The reasons are: there may be many 
thousands of members or stockholders; the stockholder list may 
be changing constantly as the result of transfers of stock; and 
corporations must keep records of their par value capital stock 
at par value figures. The shares of par value stock issued by a 
corporation to its stockholders are represented on the general 
books by the account Capital Stock, the balance of which equals 
the number of shares issued multiplied by the par value of 
the stock. If there are several classes of stock, there is a separate 
account for each, as Preferred Stock and Common Stock. Each 
of such accounts controls a subsidiary ledger wherein the accounts 
with the various stockholders are shown. 

Minute Book 

The minute book is the official record of the meetings of 
incorporators, stockholders, and directors of a corporation. 
It is kept by the secretary of the corporation with the advice 
of the legal counsel of the company. In it are recorded all 
resolutions offered and the actions thereon. 

Many corporate actions need to be supported by evidence 
that they have been authorized by proper resolution of the stock- 
holders or the board of directors. This evidence takes the form 
of a certified copy of the appropriate minute of a meeting of 
stockholders or the board. For example, the bank in which a 
corporation deposits its cash items would require a certified 
minute of the board as evidence of who was authorized to sign 
checks. 



352 ACCOUNTING FUNDAMENTALS [Ch, XXIII 

If well kept, the minute book contains a copy of the charter 
and bylaws and record of actions pertaining to such matters 
as the nomination and election of directors and officers, the 
salaries of officers, the declaration of dividends, and the issuance 
of stocks and bonds. 

The minute book is not an accounting book but it is of particu- 
lar importance to the accountant as authority for many entries. 

Subscription Records 

If the capital stock of a corporation is sold to a number of 
persons with payment to be made at a later date, it is desirable 
to have a special form on which a subscriber may agree to pur- 
chase the stock. This special record shows for each subscription, 
the signature of the subscriber, the date, the number of shares for 
which he subscribed and the amount. It is the basis for a 
charge to the account Subscribers to Capital Stock and serves 
as a subsidiary record to that account. Sometimes this record 
is obtained on subscription sheets with a number of subscribers 
to the page, other times it is obtained by the use of a separate 
card or sheet for each subscription. 

If the subscriptions arc to be paid by installments, a subscribers' 
subsidiary ledger with an account for each subscriber is opened 
usually so that a complete record of each subscriber's payments 
may be kept. In appearance and operation this ledger is similar 
to the subsidiary ledger for accounts receivable. 

If subscriptions are obtained for more than one class of stock, 
a separate subscription record is used for each and a separate 
controlling account represents each on the general books. Thus 
in the ledger of a company may be found the accounts Subscribers 
to Common Stock and Subscribers to Preferred Stock. 

When a board of directors issues a call on subscribers for the 
payment of an installment on their subscriptions, the call 
should be recorded on the general books of the company by a 
charge to an installment account and a credit to the proper 
subscribers' controlling account. The installment account on the 
books indicates that a definite date has been set by the board for 
the payment of a definite amount of subscriptions. The install- 
ment account is a more current asset than the subscribers' con- 
trolling account. The subscribers' ledger is a sufficient subsidiary 
record ordinarily to care for subscriptions paid by installments. 



Ch. XXIII] CORPORATIONS 353 

Installment Scrip Book 

As stockholders ordinarily receive their stock certificates 
only after all installment payments have been made, receipts 
are issued as evidence of partial payments on stock subscriptions. 
These receipts are known as installment scrip. When all install- 
ment payments have been made the installment receipts are 
exchanged for stock certificates. 

The book containing the installment scrip is in two parts a 
stub and receipts sections, separated by perforations. On the 
stub appears the date, the number of the scrip, the name of 
the subscriber, the number of shares subscribed, the amount of 
the subscription, the number of the call, and the amount paid 
by the installment. The receipt portion is signed by the proper 
officers of the corporation and contains all of the information 
shown on the stub in addition to the certification of payment 
and a statement of the agreement to exchange the scrip for a 
stock certificate when the contractual conditions are fulfilled. 

Sometimes installment receipts after the first one are recorded 
on the original receipt and sometimes receipts are in loose form 
and not in a scrip book as described. Whether an installment 
scrip book is or is not used, detailed records of installment 
receipts are entered in the subscribers' ledger. 

Stock Certificate Book 

A stock certificate book is divided, like an installment scrip 
book, into two parts a stub and the formal certificate sections. 
The stub is used to record the number of the certificate, the date, 
name of party to whom issued, the number of shares, and if not 
an original issue, the name of the party from whom transferred, 
the number of his certificate, and its number of shares. When 
a certificate is canceled it is pasted to its stub. 

The stock certificate certifies that the party named is the 
owner of the stated number of shares of the capital stock of the 
corporation. In addition the certificate usually. states the name 
of the corporation, the certificate number, the date, the class of 
stock to which the certificate refers, the par or stated value, if 
any, the state in which incorporated, and the number of author- 
ized shares of capital stock. Stocks which are listed on the 
New York Stock Exchange must carry all this information and 



354 



ACCOUNTING FUNDAMENTALS 



[Ch. XXIII 




J4 



GO 



^6T '81 



ANVJJMOO xsnnx 

UT 



*s 



Ch. XXIII] CORPORATIONS 355 

meet additional requirements. Each certificate is signed usually 
by two officers authorized by the bylaws to sign certificates 
and is stamped with the corporate seal. 

On the reverse side of a stock certificate is a blank power of 
attorney for use if the certificate is to be transferred. 



"For Valim "Rpnfiivfirl _,., hereby pell, assign 


Notice: The signature to this assign- 
ment must correspond with the name 
as written upon the face of the Cer- 
tificate in every particular without 
alteration or enlargement or any 
changes whatever. 


and transfer unto 


sharps 


of the Capital Stock represented by the within 
Certificate and do hereby irrevocably constitute 
and appoint 
Attorney, 


to transfer the said stock on the books of the 
within named Company with full powers of sub- 
stitution in the premises. 

Dn.toH 




In Presence of 





Transfer form on back of stock certificate. 

Capital Stock Ledger 

If a corporation has but a few stockholders the stock certificate 
book may furnish sufficient information about the holdings of 
each. If it has many stockholders a subsidiary stockholders' 
ledger capital stock ledger is necessary. 

Each stockholder has an account in the stockholders' ledger. 
This ledger is operated on the same general principles as any 
other ledger but it is peculiar in one respect, it is kept usually 
in terms of shares of stock and not in dollars and cents. A 
stockholder is credited for the number of shares acquired by 
him directly from the corporation or by transfer from another 
stockholder. He is debited with the number of shares he 
transfers. 

The capital stock ledger is subsidiary to the Capital Stock 
account. If the, stock is par value stock, to check the sub- 
sidiary ledger with its control account, it is necessary to multiply 
the sum of the credit balances of the subsidiary ledger by the 
par value of a share. The subsidiary ledger should check also 



356 



ACCOUNTING FUNDAMENTALS 



[Ch. XXIII 



with the sum of the balances shown by the stock certificate book. 
Postings are made to the stockholders ledger from the stock 
certificate book or from the stock transfer journal when one is 
used. If there are several classes of stock, there is a separate 
subsidiary ledger for each class. 

CAPITAL STOCK LEDGER 
R. A. DAVIS 205 GREENTREE ROAD, SYLVANDALE, PA. 









Certificates 








Certificates 








Surrendered 








Issued 


Date 


Name of 
Transferee 


F 




Date 


Name of 
Transferor 


F 




Number 


Number 


Number 


Number 








of Cer- 


of 








of Cer- 


of 








tificate 


Shares 








tificate 


Shares 


19_ 










19 










July 12 


T. B. Reed 


T52 


804 


300 


Jan. 8 


Original Issue 


SCB 


CIO 


200 


July 12 


R. A. Davis 


T62 


804 


200 


Feb. 11 


Walter Brown 


T 5 


782 


350 












Feb. 25 


Chas. Benson 


T17 


804 


500 












May 20 


Jas. Rhoada 


T40 


1105 


250 












July 12 


R. A. Davb 


T52 


1277 


200 



&&&&&&&&&&&&&^^ 

The suggested form of capital stock ledger account of the 
Sylvan Furniture Company illustrated above, reveals that 

R. A. Davis owns 1,000 shares of stock on July 12, 19 His 

first stock in the company, 200 shares, was acquired on January 

8, 19 , as part of an original issue. Certificate 610 was issued to 

him and he was credited for the 200 shares directly from the 
stock certificate book. Additional stock was acquired by him 
on transfer from other stockholders on February 11 and 25, 
and on May 20, On July 12, Davis sold 300 shares to T. B. 
Reed. The debits and credits on that date show the method 
of treating the sale of a part of a block of stock. Instead of 
debiting Davis for the 300 shares he sold to T. B. Reed, he is 
charged with 500 shares and credited for 200 shares. Certif- 
icate 804 for 500 shares was canceled and two new certificates 
issued. One for 300 shares went to T. B. Reed, the other for 
200 shares went to Davis. All debits and credits after the 
first one were posted from the stock transfer journal. This is 
indicated in the folio column by the letter T with page numbers. 

Stock Transfer Journal 

To facilitate the recording of shares transferred from one stock- 
holder to another some companies use a stock transfer journal. 



Ch. XXIII] 



CORPORATIONS 



357 



When used, this journal is the source of all postings to the capital 
stock subsidiary ledger except for the original issue of shares. 
It is operated the same as any other journal but its debits and 
credits are always to stockholders' accounts. A stockholder 
transferring stock is charged and the one to whom transferred 
is credited. The debits and credits are made in number of 
shares and not in dollars and cents. 

The following is a suggested form for such a journal: 

STOCK TRANSFER JOURNAL (Page 52^ 



Canceled Certificates 


New Certificates 


Num- 
ber 


Shares 


Owner Debited 


F 


Date 


Num- 
ber 


Shares 


Owner Credited 


F 


804 


600 


11. A. Davis 


/ 


July 12 


12/G 


300 


T. B. Heed 


V 










July 12 


1277 


200 


R. A. Davis 


V 


143 


200 


W. W. Moore 


y 


July 13 


1278 


350 


F. B. Short 


\s 










July 13 


1279 


50 


M. 8. Jones 


\s 



In the illustration above R. A. Davis surrendered certificate 
804 as he had sold 300 shares of the 500 which were represented 
by this certificate. Two new certificates were issued by the 
corporation, 1276 for 300 shares to T. B. Reed and 1277 for 
200 shares to R. A. Davis. Certificate 804 was canceled and 
attached to its stub in the stock certificate book. 

Corporations with stocks listed on the New York Stock 
Exchange are required to employ a transfer agency and a registrar 
who are not identical. Usually they are different trust com- 
panies. The corporation also cannot act as registrar of its 
own stock. This requirement is to prevent the false issue of 
stock by company officers. 

Transfers of stock do not alter the number of outstanding 
shares as the debits and credits to the stockholders' accounts 
are equal. For this reason a summary posting of the trans- 
fer journal to the controlling account Capital Stock is never 
necessary. 

Proprietorship in the Corporate Balance Sheet 

The following treatment of proprietorship accounts on the 
balance sheet is recommended: 



358 ACCOUNTING FUNDAMENTALS [Ch. XXIII 

X. Y. Z. COMPANY 
BALANCE SHEET, DECEMBER 31, 19A 

Assets (Various) $700,000.00 

Liabilities (Various) 200,000.00 

Proprietorship $500,000,00 

Capital Stock: 

6 Per Cent Preferred Stock Authorized $200,000.00 (a) 

Less: Treasury Stock 20,000.00 (6) 

Outstanding $180,000.00 (d) 

Common Stock Authorized $400,000.00 (a) 

Less: Unissued 150,000.00 (c) 

Outstanding '. 250,000.00 (d) 

Surplus 70,000.00 

Total Proprietorship 500,000.00 

The information needed in the proprietorship section of a bal- 
ance sheet may be obtained as follows : 

a. The amount of capital stock authorized is constant; it 
appears in the corporate charter, and usually on each stock 
certificate and on each balance sheet. In this text no 
account is kept for it. 

6. The amount of treasury stock may be obtained from a 
general ledger account captioned Treasury Stock and 
recorded at par value. 

c. The amount of unissued capital stock may be obtained by 
subtracting the issued capital stock from the authorized 
capital stock. The balance of the Capital Stock controlling 
account is the issued stock. 

d. The amount of the outstanding capital stock may be 
obtained from the Capital Stock controlling account in the 
general ledger if there is no treasury stock. If treasury 
stock is a factor, the outstanding capital stock should agree 
with the excess of the Capital Stock controlling account over 
the Treasury Stock account. The balance of the controlling 
account Capital Stock Preferred in the above balance sheet 
is $200,000.00 as all the preferred stock is issued. The 
balance of the controlling account Capital Stock Common 
in the above balance sheet is $250,000.00, the amount of 
the issued common stock. 

Sometimes the proprietorship section of a balance sheet indi- 
cates only the amount of stock issued. In such a case a footnote 



Ch. XXIII] CORPORATIONS 359 

to the balance sheet should refer to the amount of stock author- 
ized but unissued. 

QUESTIONS 

1. a. Would you say that a corporation might need to use all the 

accounting books and records previously described for a sole 
proprietorship? 

6. The problems peculiar to corporation accounting relate more 
particularly to the treatment and showing of the assets, the 
liabilities, or the net worth of the company? 

2. a. What is a corporation? 

b. May a particular corporation have as few members as a particular 
partnership? 

c. Which is more likely to have many members a partnership or 
a corporation? 

d. Do you know how many stockholders the American Telephone 
and Telegraph Company has? The Pennsylvania Railroad? 

e. Does a member of a corporation have anything to show for his 
membership ? What ? 

3. a. Under what authority does a corporation exist? 
b. Explain how a corporation is formed. 

4. Can you give any advantages of the corporate over the partnership 
type of organization? Any disadvantages? 

5. a. A stockholder's participation in a corporation is evidenced by 

a ? 

b. A stockholder's interest in a corporation is represented by the 
ownership of so many of ? 

6. May the amounts of the capital and the capital stock of a corporation 
be different? Explain. 

7. What is meant by authorized capital stock? Unissued capital 
stock? Subscribed capital stock? Outstanding capital stock? 

8. a. What do you mean by a share of stock? 

b. What rights, ordinarily, accompany the ownership of a share 
of stock? 

9. What do you mean by common stock? Preferred stock? Treasury 
stock? Par value stock? No par value stock? 

10. Assume A is worth $50,000.00. What is the limit of his possible 
losses, ordinarily, if he starts his own business and invests $10,000.00 
in it? If he invests $10,000.00 in the stock of a corporation by pur- 
chasing 200 shares at $50.00 a share? Explain in both instances. 

11. If a corporation uses par value stock and has not distributed all of 
its profits, in what account are the profits shown? Would it be 
satisfactory to show them in the Capital Stock account? Explain. 



360 ACCOUNTING FUNDAMENTALS [Ch. XXIII 

12. What do you mean by surplus? Deficit? 

13. In what two ways may the net worth of a corporation be determined? 

14. Would it be possible to have a deficit and still have a balance of 
cash? Explain. 

15. If a corporation has a Surplus account of $80,000.00 must it have 
a cash balance of at least $80,000.00? Explain. 

16. The records of the Rex Novelty Company show a substantial profit 
at the end of the year. No profits were distributed during the year 
and there is no cash available with which to distribute them. 
Account for this condition. 

17. a. How may treasury stock be shown on the balance sheet? Unis- 

sued stock? 

6. Should preferred stock and common stock be consolidated or 
shown separately on a balance sheet? Why? 

18. Why does not a corporation show accounts with its various stock- 
holders on its general ledger? Where does it show them? 

19. a. What is the title of the general ledger controlling account for 

common stock? For preferred stock? 

b. In what respect is a subsidiary ledger for stockholders peculiar? 

c. What records would a corporation keep of the fact that it sold 200 
shares of common stock to Harvey Adams at par $50.00 a share? 

d. What records would the corporation referred to in c keep, if 
Harvey Adams sold 50 of his shares to Wilson Campbell at $80.00 
a share? 

e. What effect, if any, would the facts of d have on the general 
ledger controlling account for common stock? 

/. What is the evidence of control between the general ledger con- 
trolling account for common stock and its subsidiary ledger? 

20. a. What do you mean by a minute book? 

b. What do you mean by a subscription record? 

21. What is a stock certificate book? What does it show? 

22. a. What happens to a partnership, if a partner withdraws? 

6. What happens to a corporation, if a stockholder sells his interest 
to another person? 

c. How do you think you could sell some stock you owned, if the 
stock is listed on the New York Stock Exchange? 

d. Do you have to do anything to and with your stock certificate 
when you sell some shares? What? 



CHAPTER XXIV 

CORPORATIONS (Continued) 

Unless otherwise noted, all references to capital stock and 
illustrations of capital stock accounts in this chapter pertain 
to par value stock. 

After the corporation is created by the issuance of its charter 
and there has been a meeting of the incorporators and stock- 
holders to elect directors, adopt bylaws, and complete the internal 
organization of the corporate body, it is possible to open the 
account books. 

ENTRIES TO OPEN THE CORPORATE RECORDS 

The first record to be made on the books of a corporation, 
like the first one to be made on the books of a partnership, is 
not a formal entry but a statement in the general journal about 
the opening of the enterprise. For the corporation it should 
indicate the date the books were opened, the date the charter 
was granted, the nature of the business, the amount of capital 
stock authorized, and the par value, if any, of the shares. This 
statement may be quite brief since its purpose is merely to 
mention some of the most important facts, the complete details 
of which are shown in the charter and the minute book. 

The charter of a corporation states the amount of capital 
stock which the corporation is authorized to issue. Some 
accountants prefer to show that amount immediately in the 
accounts and make an entry for it. If the amount of the author- 
ized capital stock is $150,000.00 the following entry is made: 

Unissued Capital Stock 150 , 000 . 00 

Capital Stock Authorized 150,000.00 

To record the amount of the author- 
ized capital stock. 

The entry above seems quite unnecessary. Unissued capital 
stock is not an asset of the corporation; it is a potential asset, 
but potential assets are not shown on the books. The capital 

361 



362 



ACCOUNTING FUNDAMENTALS 



[Ch. XXIV 



stock authorized need not be shown in an account; it is referred 
to in the opening explanatory record in the general journal and 
is stated in the charter. 

It is quite a common practice for corporations to be authorized 
by charter to issue an amount of capital stock in excess of 
immediate needs. The amount of authorized capital stock over 
the amount required at the time of organization provides for 
capital stock expansion at a later date, without the necessity 
of having the charter amended. 

If the authorized capital stock exceeds the amount issued, 
the stockholders should regularly be informed of that fact. 
Methods of giving them this information were discussed in the 
last chapter in connection with the balance sheet of a corporation. 

Stock Issued for Cash 

Assume the figures of the previous illustration. A corporation 
is authorized to issue $150,000.00 of capital stock, 1,500 shares 
with a par value of $100.00 each. Suppose $100,000.00 of that 
amount is issued to stockholders for cash. The remaining 
$50,000.00 of capital stock is not to be issued at this time. The 
only entries necessary are 



CASH RECEIPTS JOURNAL 



e 1) 



Date 


Account Explanation 


F 


Credit 


Debit 


General 
Ledger 


Accounts 
Receiv- 
able 


Sales 
Discounts 


Cash 


19 






















Jan. 


2 


Capital Stock Mr. A for 120 shares 




12,000 


00 










12,000 


00 




2 


Capital Stock Mr. B for 180 shares 




18,000 


00 










18,000 


00 




3 
3 


Capjtal Stock Mr. C for GO shares 
Capital Stock Mr. D for 240 shares 




6,000 
24,000 


00 
00 










G , 000 
24 , 000 


on 

00 




4 


Capital Stock Mr. E for 300 shares 




30,000 


00 










30,000 


00 




4 


Capital Stock Mr. F for 100 shares 




10,000 


00 










10,000 


00 



It should be noticed that each credit was made to the Capital 
Stock account. A stockholder does not have an account in the 
general ledger. Each stockholder receives a credit in the capital 
stock subsidiary ledger for the number of shares issued to him. 
The capital stock subsidiary ledger credit postings are made 
from the capital stock certificate book. 



Gh. XXIV] 



CORPORATIONS 



363 



The above facts when posted to the general ledger involve 
only two accounts, as follows: 

Cash 



19_ 
Jan. 






CR 


100,000 


00 















Capital Stock 















Jan. 


2 




CR1 


12,000 


00 
















2 




CR1 


18,000 


00 
















3 




CR1 


6,000 


00 
















3 




CR1 


24,000 


00 
















4 




CR1 


30,000 


00 
















4 




CR1 


10,000 


00 



The debit to Cash would not be made until the end of the 
month when the $100,000.00 would be included as part of a 
larger figure. 

The Capital Stock account is a controlling account which 
controls the subsidiary capital stock ledger. In the capital 
stock ledger each stockholder's interest is indicated by the 
number of shares credited to him. The total share credits 
of the capital stock ledger multiplied by $100.00, the par value 
of a share, gives $100,000.00, which is the same amount as the 
balance shown by the Capital Stock account. 

Stock Issued for Physical Property Other Than Cash 

Assume the same figures as before, authorized capital stock 
$150,000.00, par value of a share $100.00, amount of stock to be 
issued at this time $100,000.00. Assume further that Messrs. 
A, B, C, D, and F pay cash for their stock, but that the board of 
directors of the corporation has agreed to accept certain other 
assets from Mr. E. 

The entries to record the receipt of cash from A, B, C, D, and F 
are exactly the same as illustrated previously. 

In order to acquire the assets, other than cash, of the business 
owned by Mr. E, the directors agreed to issue $30,000.00 of 
stock to him and to assume the liabilities of the enterprise. 
The balance sheet of the business acquired from Mr. E is as 
follows: 



364 ACCOUNTING FUNDAMENTALS 

888 



[Ch. XXIV 




Ch. XXIV] 



CORPORATIONS 



365 



The schedules of Accounts Receivable and Accounts Payable 
attached to the balance sheet are 



SCHEDULE A 
ACCOUNTS RECEIVABLE 

S.Powell 81,600.00 

B. Ash 1,400.00 

L. Leidy 3,000.00 

J. Torrey 2,000.00 

G. Neff 1,000.00 

$9,000.00 



SCHEDULE B 
ACCOUNTS PAYABLE 

B. Gleason $2,500.00 

H. Schriver 3,760.00 

T. Lowry 3,400.00 

$9,650.00 



It is assumed further that the directors of the corporation had 
the assets of the business of Mr. E appraised and that the 
appraisement figures showed the balance sheet figures to be 

GENERAL JOURNAL 
JANUARY, 19 



Debit 


F 


Date 
Debit and Credit Accounts 
Explanation 


F 


Credit 


Accounts 
Payable 


Accounts 
Receiv- 
able 


General 
Ledger 


General 
Ledger 


Accounts 
Receiv- 
able 


Accounts 
Payable 
















2 




















1,600 


00 








S. Powell 




















1,400 


00 








B. Ash 




















3,000 


00 








L. Leidy 




















2,000 


00 








J. Torrey 




















1,000 


00 








G. Neff 
























10,000 


00 




Inventory of Merchandise 
























350 


00 




Prepaid Insurance 
























4,000 


00 




Land 
























13,500 


00 




Buildings 
























3,000 


00 




Office Furniture and Fixtures 
























11.25Q 


00 




Machinery 






























Reserve for Bad Debts 




450 


00 
























Mr. E.Vendor 




50,650 


00 
























To record the assets obtained from 






























Mr.E. 
























20,050 


00 




Mr. E. Vendor 






























B. Gleason 












2,500 


00 
















H. Schriver 












3,750 


00 
















T. Lowry 












3,400 


00 
















Mortgage Payable 




11,000 


00 
























To record the liabilities of Mr. E 






























assumed by the company. 
























30,000 


00 




Mr. E. Vendor 






























Capital Stock 




30,000 


00 
























To record the stock issued to Mr. E. 

















366 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

correct. To record the acquisition of the assets and the assump- 
tion of the liabilities of the business of Mr. E, as well as the 
issuance of stock to him, the entries shown on page 365 are 
made in the general journal of the corporation. 

The first of the previous entries records the assets on the 
books of the corporation at the values at which acquired. In 
this illustration the values at which acquired are identical with 
the book values shown on the books of Mr. E. It is not neces- 
sary, however, for the corporation to set up -on its books the 
reserve for depreciation accounts which appear on Mr. E's 
books. Very often, the values at which assets are acquired 
differ considerably from the book values at which they appear 
on the books of the vendor. 

In the case of accounts receivable, the corporation receives from 
Mr. E claims on customers in the amount of $9,000.00 but which 
claims are valued by the corporation at $8,550.00, the same 
figure at which Mr. E valued them. In order to show on its 
books the $9,000.00 total amount of accounts receivable it 
will endeavor to collect, as well as its estimate of their value, 
it is necessary for the corporation to debit the various customers 
for the full amount of the claims on them, a total of $9,000.00, 
and to credit Reserve for Bad Debts for $450.00. 

Stock Issued for Intangible Properly 

Assume the same general facts as in the last illustration. 
A, B, C, D, and F pay cash for their stock but E pays by trans- 
ferring to the corporation the assets of his going enterprise. 
Suppose the asset and liability figures of the business of Mr. E 
are the same except for inventory of merchandise which is 
$4,000.00 instead of $10,000.00 as before. If the inventory of 
merchandise is only $4,000.00 then the net worth of the business 
of Mr. E, according to his books, is only $24,000.00. 

The business of Mr. E may have an established business repu- 
tation which reflects itself in his net profits and the directors of 
the corporation may be willing to pay for that reputation. If 
so they are paying for the asset goodwill. 

If an appraisement of the assets of Mr. E's business shows 
them to be stated on the books at fair values and the corporation 
gives Mr. E $30,000.00 in stock for his equity in his enterprise, 
it is paying for $6,000.00 of goodwill. 



Ch. XXIV] CORPORATIONS 367 

The entry to record these facts is the same as before except 
that Inventory of Merchandise is debited for $4,000.00 and the 
asset Goodwill is debited for $6,000.00. 

There are other forms of intangible property besides goodwill, 
as explained under the heading fixed assets in Chapter II. Such 
intangible property may constitute very productive assets to 
the enterprise which purchases them. 

Stock Issued for Services 

There are quite a few expenses incident to the organization 
of a corporation, among which are: charter fees to be paid to the 
state in which the enterprise is incorporated, costs of preparing 
the stock certificates, legal fees, and sometimes accounting and 
engineering fees. Very often one or more of the incorporators 
pay these fees personally and take stock in the corporation in 
satisfaction of their claims. Whether these expenses are finally 
paid by the corporation in cash or capital stock, the debit is to 
the same account Organization Expense. This account repre- 
sents an expense which benefits the corporation throughout its 
entire life and, theoretically, might be prorated over that period 
of time. Practically, Organization Expense, since it has no 
realizable value, is written off as rapidly as possible by charging 
it to Surplus, preferably within a period of four or five years. 
For federal income-tax purposes such a write-off is not a deduct- 
ible item from gross income. As long as the Organization 
Expense account is open on the books it is in the nature of a 
prepaid expense and usually is included in the balance sheet in 
the deferred charge section. 

Stock Issued at a Discount 

State laws may prohibit the issuance of par value stock at 
less than par value. Where allowed, the owners of such stock 
may be liable to creditors for the amount of the difference. 
Par value stock, regardless of the price at which issued, must 
be recorded in the Capital Stock account at par value. Assume 
that $100,000.00 of par value stock is issued for cash at 95 per cent 
of par. The entry to record these facts, presented, for the sake 
of simplicity in general journal form, is 



368 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

. Cash 95,000.00 

Discount on Capital Stock 5 , 000 . 00 

Capital Stock 100 , 000 . 00 

To record the issue at 95 per cent of 
par value, of $100,000.00 of stock to 
Messrs H, I, and J. 

The Discount on Capital Stock account is not an expense to 
be written off against Profit and Loss. Sometimes it is shown 
on the asset side of a balance sheet and although not an asset 
no harm may result if readers of the balance sheet examine it 
thoroughly. A better method of showing discount on capital 
stock on the balance sheet is to deduct it from capital stock as 
follows: 

PROPRIETORSHIP 

Capital Stock Authorized $150,000.00 

Less: Unissued 50,000 00 

Outstanding $100,000.00 

Less: Discount on Capital Stock 5,000.00 

Paid-in Capital $95,000.00 

If a corporation with Discount on Capital Stock account on 
its books accumulates a surplus in excess of the discount, it 
may charge the Discount on Capital Stock to Surplus. In 
so doing it is denying the stockholders the right to dividends 
out of accumulated profits to the extent that they have been used 
to make the stock full paid. 

Stock Issued at a Premium 

If stockholders pay in excess of par value for their stock, the 
stock is said to have been issued at a premium. The premium 
contributed by the stockholders is no I a profit to the corporation, 
it is a part of its invested capital. Assume that $100,000.00 
of capital stock is issued for cash at a premium of 5 per cent. 
The debits and credits involved are shown by the following 
entry : 

Cash 105,000.00 

Capital Stock 100,000.00 

Premium on Capital Stock 5 , 000 . 00 

To record the issue at 105 per cent of 

par value, of $100,000.00 of stock to 

Messrs. O, P, and Q. 



Ch. XXIV] CORPORATIONS 369 

On the balance sheet, premium on capital stock belongs in the 
proprietorship section. It may be shown as premium on capital 
stock or as paid-in or capital surplus. 

Stock Subscriptions 

All the illustrations of this chapter, thus far, have assumed 
immediate payment for stock. Very often stock is sold well 
in advance of payment for it. The sale of the stock is evidenced 
by signed subscriptions through which the subscribers agree to 
pay for the stock. These subscriptions are an asset to the 
corporation. They indicate also the obligation of the corporation 
to issue its stock to the subscribers upon payment of their 
subscriptions. Both sets of facts are recorded on the books. 

Assume a corporation obtained subscriptions for 1,000 shares 
of its stock, par value $100.00. Both the asset of the corporation 
and its obligation to issue stock upon the payment of subscrip- 
tions are recorded by the following general journal entry: 

Subscribers to Capital Stock 100 , 000 . 00 

Capital Stock Subscribed 100 , 000 . 00 

To record the receipt of subscrip- 
tions, as shown by the subscription 
lists. 

When payment is received by the corporation for subscriptions, 
the entry is made 

Cash 100,000.00 

Subscribers to Capital Stock 100,000.00 

To record the receipt of cash from 
subscribers to capital stock. 

After subscriptions are paid in full, stock certificates are issued. 
An entry is necessary to indicate that the corporation has met 
its obligation to issue stock to the subscribers. This entry is 

Capital Stock Subscribed 100 , 000 . 00 

Capi tal Stock 100 , 000 . 00 

To record the issue of stock certifi- 
cates to full-paid subscribers. 

If approved by the board of directors of the corporation, 
subscriptions may be paid for in services or any form of property, 
tangible or intangible, as well as by cash. 

A corporation may not have immediate need for all the cash 
represented by subscriptions to capital stock and may call for 



370 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

payments by installments. As an installment is called, the 
date for its payment is fixed and the amount of the installment 
becomes due in the nearer future than the uncalled balance of the 
Subscribers to Capital Stock account. This change in the 
status of the Subscribers to Capital Stock account is represented 
on the books by the entry 

Installment No. 1 40 , 000 . 00 

Subscribers to Capital Stock 40,000.00 

To record the call for a payment on 
January 15, of 40 per cent of subscrip- 
tions. 

Each call on subscribers is represented by its own installment 
account in the general ledger. 

On January 15, when payment is received, the entry is 

Cash 40,000.00 

Installment No. 1 40 , 000 . 00 

To record the receipt of cash for in- 
stallment No. 1. 

Suppose a corporation with an authorized capital stock of 
$150,000.00 sold $100,000.00 by subscription. Suppose also 
that a call of 40 per cent was made on subscribers and paid and 
that a second call of 20 per cent was made but is not due. These 
facts would be presented in the balance sheet of the corporation 
as follows: 

ASSETS 

Current Assets LIABILITIES 

Cash $40,000 00 None 

Installment No. 2 . 20.000.00 PROPRIETORSHIP 

Subscribers to Capital Stock 40,00000* Capital Stock 

Authorized. . $150,000 00 
Less: Unissued.. 50,000 00 

Subscribed but Unissued . $100,000.00 
* To be be called within a year. 

Ordinarily capital stock is not issued until subscriptions are 
paid in full. Sometimes a corporation has no need for the 
payment of subscriptions beyond a certain percentage and 
issues its stock appropriately marked as to the amount paid 
thereon. Suppose a corporation with an authorized capital 
stock of $150,000.00 obtained subscriptions for $100,000.00. 
After $60,000.00 was called and collected, the company found 
it did not need the remaining 40 per cent and issued stock marked 



Ch. XXIV] CORPORATIONS 371 

60 per cent paid to its subscribers. Since there is no intention of 
calling the remaining $40,000.00 of subscriptions, a balance sheet 
presentation of the unpaid subscriptions may be shown better 
as a deduction in the proprietorship section than as an asset. 
If included as an asset, the uncalled subscriptions should not 
be classed as a current asset but should be listed at the bottom of 
the assets as a special asset under a heading such as Other Assets. 
The better treatment is 

PROPRIETORSHIP 

Capital Stock Authorized . $ 1 50 , 000 . 00 

Less : Unissued . 50,000 . 00 

Subscribed '$100,000.00 

Uncalled Subscriptions. 40,000.00 

Capital Paid In . $60,000.00 

If the charter of a corporation provides for more than one class 
of stock it is necessary to keep separate records for each class. 
On the books of a company there may appear accounts with 
debit balances, such as Subscribers to Common Stock, Subscribers 
to First Preferred Stock, Subscribers to Second Preferred Stock, 
Installment No. 1 First Preferred Stock, and so on. There may 
be accounts with credit balances, such as Common Stock Sub- 
scribed, First Preferred Stock Subscribed, arid Second Preferred 
Stock Subscribed. After subscriptions are paid in full and 
the various classes of stock are issued, there are credit balance 
accounts, such as Common Stock, First Preferred Stock, and 
Second Preferred Stock. 

Subscriptions in Default 

It may happen that a subscriber does not complete payments 
on his subscription. The action to be taken by the corporation 
depends in part on the laws of the state in which the company 
is incorporated. The stock of the defaulting subscriber some- 
times may be considered forfeited to the corporation and may be 
resold by it. Sometimes the stock is resold and the defaulting 
subscriber charged with any resulting loss. The entries depend 
on the legal action taken, but any gain to the corporation 
does not represent a current Profit and Loss item. It is an 
amount to be transferred to proprietorship as an additional 
capital contribution. 



372 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

TREASURY STOCK 

Treasury stock should not be confused with unissued stock. 
The latter has never been issued but the former has been out- 
standing. If unissued stock is issued at a discount, it may 
carry a liability to creditors for the amount of the discount, 
in case the corporation is not able to meet its debts. On the 
other hand, treasury stock ordinarily carries no such liability. 
Treasury stock is full-paid, nonassessable stock reacquired but 
not canceled by the issuing company. 

Although a debit balance account on the books, Treasury 
Stock is not an asset. It is a partial offset to the Capital 
Stock account. The amount by which the credit balance of 
Capital Stock exceeds the debit balance of Treasury Stock 
represents the stock outstanding in the hands of stockholders. 
It is hardly sound reasoning to consider that some of its own 
reacquired stock is an asset with which to meet claims of the 
corporation's creditors. Nevertheless* it sometimes is shown as 
an asset. 

Treasury stock should not be included in the account Invest- 
ments along with the stocks and bonds of other companies which 
may be owned. It should be shown on the books in the separate 
account Treasury Stock and on the balance sheet as a deduction 
from capital stock authorized. 

A company sometimes reacquires its own stock in order to 
cancel it. Cancellation requires certain legal procedure on the 
completion of which treasury stock ceases to be treasury stock. 
Cancellation definitely reduces the capital stock of the company. 
If the laws of the incorporating state permit, its own stock may 
be reacquired by purchase in order to sustain the market for 
it or to have stock available for sale to employees. Treasury 
stock may be the result of a gift to the company by its stock- 
holders. The company may need funds and its stock may not 
command par in the market. In order to provide a stock which 
may be sold at the prevailing market price and which is free 
from liability to creditors, the stockholders may donate some 
of their shares to the company. This is more likely to occur in 
companies whose stock has been issued originally for property 
or services on a rather excessive value basis. Treasury stock 
may be acquired for other reasons, i.e., by gift of stockholders 



Ch. XXIV] CORPORATIONS 373 

to eliminate an accumulated loss or by acceptance from a stock- 
holder in payment of a debt. 

When treasury stock is acquired by a company the accounts 
of the former owners in the capital stock subsidiary ledger are 
charged and an account captioned Treasury Stock or headed 
with the name of the company is credited. The issued shares 
are still in existence and the subsidiary ledger must account for 
them. 

Entries for Par Value Treasury Stock If Donated 

Since treasury stock is considered a partial offset to capital 
stock, it should be recorded at par value. In the entries which 
follow it is assumed that $100.00 par value stock in the amount 
of $20,000.00, out of a total of $200,000.00 issued, is donated 
and later sold for $15,000.00. The donation is recorded by the 
entry 

Treasury Stock 20 , 000 . 00 

Surplus from Donated Stock 20,000.00 

To record the gift from stockholders of 
200 shares of capital stock (10 per cent 
of their holdings.) 

The sale is recorded by the entry 

Cash 15,000.00 

Surplus from Donated Stock 5 , 000 . 00 

Treasury Stock 20 , 000 . 00 

To record the sale of 200 shares of 
treasury stock. 

The balance of $15,000.00 in the account Surplus from Donated 
Stock represents, in effect, an additional contribution from 
stockholders. The use of this special surplus account preserves 
an independent record of the source of this contribution to the 
company. 

Entries for Par Value Treasury Stock If Purchased 

Purchased treasury stock, the same as donated treasury 
stock, is recorded at par value. Some of the entries for the 
purchase and sale of treasury stock are illustrated by the follow- 
ing transactions : 

Assume a company purchases one of its own $100.00 par value 
shares at par. The entry is 



374 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

Treasury Stock 100 . 00 

Cash 100.00 

To record the purchase of a share of the com- 
pany's own stock at par. 

If the share is resold at $110.00, the entry without explanation 
is 

Cash 110.00 

Treasury Stock 100 . 00 

Surplus from Sale of Treasury Stock 10 . 00 

The account Surplus from Sale of Treasury Stock indicates 
an increase in capital contributions of stockholders and the 
source thereof. 

Suppose a company purchased a $100.00 par share at $120.00. 
Presumably the company must have a surplus to a proportionate 
part of which the purchased share is entitled. The entry 
without explanation is 

Treasury Stock 100 . 00 

Surplus Used for Treasury Stock 20.00 

Cash 120.00 

If the company resells the share at $125.00 the entry without 
explanation is 

Cash 125.00 

Treasury Stock 100 . 00 

Surplus Used for Treasury Stock 20 . 00 

Surplus from Sale of Treasury Stock 5 . 00 

Suppose a company purchased a $100.00 par share at $90.00. 
The entry without explanation is 

Treasury Stock 100.00 

Cash 90.00 

Surplus from Treasury Stock Purchased 10 . 00 

If the purchased stock is held and not resold, the account 
Surplus from Treasury Stock Purchased indicates the source of 
this addition to the surplus of the company, 

If this share is sold for $96.00 the debits and credits are 

Cash 96.00 

Surplus from Treasury Stock Purchased 10.00 

Treasury Stock 100.00 

Surplus from Sale of Treasury Stock 6.00 



Ch. XXIVJ CORPORATIONS 375 

Attention is called again to the fact that not all states permit 
the purchase of its own stock by a corporation. The propriety 
of such purchases, unless for retirement, is a debatable question. 
The theory on which the foregoing illustrations are based is 
that the acquisition of its own stock by a company, from an 
accounting standpoint, may be viewed in much the same manner 
as though the stock were canceled. Hence its entry at par value 
figures and the treatment of any profit arising from its resale as 
an increase in the capital contributions of stockholders. There 
is another theory which distinguishes between donated stock 
and purchased stock. Under this theory any profit arising 
out of the purchase and sale of its own stock is considered no 
different from a profit on other stocks, hence it is treated as 
income and not an additional capital contribution. This 
latter theory seems to fit cases where corporations deliberately 
deal in their own stock. 

Classes of Treasury Stock 

If a company has more than one class of stock it may have 
treasury stock for each class. It is important that each class 
of treasury stock, such as treasury stock common or treasury 
stock first preferred, be recorded in separate accounts since 
each is deducted on the balance sheet from its respective stock 
account. 

A more exhaustive consideration of treasury stock is out of 
place in an elementary text and is left for intermediate and 
advanced books. 

NO PAR VALUE STOCK 

At the time a corporation starts business the par value of a 
share of its stock may not agree with the value of a share as 
shown on its books because the stock may have been issued at a 
discount or a premium. The par value may not be the same 
as the very first market price of a share. Certainly after a 
corporation is in existence for some time, the par or nominal 
value of a share may have little relation to its value as expressed 
either on the books of the enterprise or in the market place. 

The use of par value stock provides certain temptations, such 
as the temptation to incorporators to overvalue the assets and 



376 ACCOUNTING FUNDAMENTALS (Ch. XXI? 



services for which stock is to be issued to them. It also furnishes 
the unscrupulous security salesman with a marked par value 
on the face of a stock certificate with which to take advantage 
of a prospective stockholder who may be uninformed in financial 

matters. 



The idea that a share of stock is simply a unit of ownership 
participation in the affairs of a corporation, regardless of its 
nominal value, was emphasized in 1912 when New York State 
enacted a law to permit corporations to issue stock without any 
par or nominal value. Since then practically all states have 
enacted similar laws and no par value stock has been used 
extensively. 

The use of no par value stock has not eliminated all the 
possible abuses to creditors, stockholders, and investors which 
may arise from the corporate form of organization. In fact 
its use brought new abuses which in the opinion of some writers 
are greater problems than the old ones. No par stock and the 
use of various classes of common stock, such as voting and 
nonvoting classes, have provided greater opportunity for the 
manipulation of corporations by insiders. 

No par stock may be used for cither or both common and 
preferred classes of stock and, when issued, is considered full 
paid and nonassessable. All stock in a given class need not be 
issued at the same price. It may be issued when necessary at 
such prices as it will command. 

Entries to Record No Par Stock Issues 

The same account titles are used to record the issue of no 
par stock as were used for par value stock, except that Discount 
on Capital Stock and Premium on Capital Stock are not necessary 
and the account titles for no par stock accounts are qualified to 
indicate that the stock is of no par value. Discount on Capital 
Stock and Premium on Capital Stock are not necessary since no 
par stock is never sold at a discount or a premium. 

Assume a corporation is authorized to issue, in addition to 
par value preferred stock, 1,000 shares of no par common. 
Assume also that 500 shares of common are issued at $30.00 a 
share and later the remaining shares are issued at $35.00 a share. 
If issued for cash the entries are 



Ch. XXIV] CORPORATIONS 377 

Cash 15,000.00 

Common Capital Stock No Par 15 , 000 . 00 

To record the issue of 500 shares of no 
par common at $30.00 a share to 
Messrs. A, B, C, and D. 

Cash 17,500.00 

Common Capital Stock No Par 17 , 500 . 00 

To record the issue of 500 shares of no 
par common at $35.00 a share to 
Messrs. M, N, O, and P. 

If no par stock is issued for property other than cash, the 
various items of property both tangible and intangible are 
debited and the appropriate no par stock account is credited. The 
values at which the property is accepted by the corporation must 
be approved by the board of directors. No par stock may be 
issued also for services rendered to the corporation, particularly 
in connection with its organization. The number of shares 
to be issued and the value of the services must be approved by 
the board. 

No par stock may be sold by subscription and paid by install- 
ments as called by the board. If so, account titles similar to 
those illustrated for par value stocks, are used. The capital 
stock subsidiary ledger is operated exactly the same for no par 
as for par value stock. 

The entries just illustrated and the values used to indicate 
no par stock are in accord with all the principles previously 
developed and are recommended. They are not followed always 
in practice. Unless prohibited by law, a corporation may 
show no par stock at a value other than that at which it is 
issued. Such other value, if used, is determined by the stock- 
holders or the board of directors of the corporation and is known 
as a stated value. A stated value is usually lower than the 
figure at which the stock is sold. In the illustration for which the 
last two entries were given, suppose the figure $10.00 was set 
as the stated value. In that case the two entries are as follows: 

Cash 15,000.00 

Common CapitalStock No Par 5 , 000 . 00 

Paid-in Surplus 10 , 000 . 00 

To record the issue of 500 shares of no 

par common at $30.00 a share to 

Messrs. A, B, C, and D. 



378 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

Cash 17,600.00 

Common Capital Stock No Par 5 , 000 . 00 

Paid-in Surplus 12 , 600 . 00 

To record the issue of 500 shares of no 

par common at $35.00 a share to 

Messrs. M, N, O, and P. 

The amount received for the stock in excess of the stated value 
should be credited to the account Paid-in Surplus. The use of 
the account Paid-in Surplus indicates that the amount involved 
has been contributed to the corporation by its stockholders 
and has not been earned. Unfortunately there is often no legal 
compulsion to require the use of an account such as Paid-in 
Surplus for the amount paid in by stockholders in excess of the 
stated value. 

Treasury Stock No Par 

No par stock, like par value stock, may be donated to a cor- 
poration by its stockholders. If so, the entry to record it is 

Treasury Stock No Par 3,000 00 

Surplus from Donated Stock 3,000.00 

To record the donation of 100 shares of 
stock at the value at which it was issued. 

The explanation of the above entry indicates that the value 
placed on the treasury stock is the value at which it was issued. 
Sometimes the donated treasury stock cannot be identified 
with a particular issue and its original value is not known. 
The stock may have been issued at different times and for 
varying amounts. In such a case the treasury stock may be 
valued at the average price at \yhich all the stock was issued. If 
so, the entry to record the facts of the last illustration is 

Treasury Stock No Par 3,250 00 

Surplus from Donated Stock 3,250.00 

To record the donation of 100 shares of 
stock at the average value at which it 
was issued. 

If the treasury stock is sold, the account Surplus from Donated 
Stock is increased, if the price exceeds the value at which Treas- 
ury Stock was debited; it is decreased, if the price is lower. 

Some accountants advocate that no par treasury stock should 
not be recorded on the books by a formal entry, when it is 



Ch. XXIV] CORPORATIONS 379 

donated. Record of it is kept by a memorandum in the Treasury 
Stock account in the capital stock subsidiary ledger. The 
memorandum merely states the date received and the number of 
shares. Journal entry record is not made until the stock is 
sold. This method is not consistent with the orthodox plan 
of recording par value treasury stock. There are still other 
plans for recording donated no par treasury stock which are not 
considered here. 

If no par treasury stock is purchased, it is recorded by entries 
similar to those recommended for par value treasury stock. 
It should be recorded in the treasury stock no par accounts 
at the value at which it was issued. If the issuing figure cannot 
be determined, it is entered at the average price at which stock 
was issued. It is quite possible that treasury stock no par 
may have to be entered in the treasury stock no par accounts 
at the stated value and the difference between the stated value 
and the price paid may have to be shown in a surplus account. 

No Par Stock on the Balance Sheet 

Since no par stock is authorized by charter as a number of 
shares rather than an amount of stock and may be sold at 
varying prices, it is necessary to indicate authorized and unissued 
stock on the balance sheet by shares and not amounts. 

PROPRIETORSHIP 

Preferred Stock Authorized $100,000.00 

Less: Unissued 40,000.00 $ 60,000.00 

Common Capital Stock No Par 

5,000 Shares authorized 

1 ,000 Shares unissued 

4,000 Shares issued $100,000.00 

200 Shares in treasury 5,000.00 

3,800 Shares outstanding 95,000.00 

Paid-in Capital $155,000.00 

For the sake of brevity in presentation, the number of shares 
authorized, unissued, and in the treasury are often referred to 
as in the illustration which follows. In this illustration assume 
the same facts but consider that the common stock issued is 
shown in the Common Capital Stock No Par account at a 
stated value of $10.00 per share. 



380 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

PROPRIETORSHIP 

Preferred Stock Authorized $100,000.00 

Less: Unissued 40,000.00 $ 60,000 .00 

Common Capital Stock No Par 

authorized 5,000 shares; unissued 1,000 shares; 

in treasury 200 shares; outstanding 3,800 

shares at stated value $10.00 . 38,000.00 

Capital Surplus .... . 57,000.00 

Paid-in Capital. . . $155,000.00 



QUESTIONS 

1. a. Give the general ledger accounts which are debited and credited 

if a corporation sells a total of 1,000 shares of its $50.00 par value 
common stock for cash to 171 different people. 

b. How does the corporation know who owns its stock and how 
much is owned by each person? 

c. What entry is made, if the 1,000 shares referred to in a are sold 
to the 171 different people but payment is not to be made until 
called by the directors of the company? 

d. Assume the facts in c. What entry is made when a call is issued 
for 50 per cent of the amount due, payment to be made one 
month later? What entry when payment is made? 

2. May stock be issued for cash? For physical property other than 
cash? For intangible property, if so what? For anything else? 

3. a. Name several items which are chargeable to Organization 

Expense. 

b. Does Organization Expense ever appear on a balance sheet; if 
so in which section and how can you justify its appearance 
there? 

4. Does Organization Expense remain on the books permanently? If 
not, approximately how long? If ever eliminated, that result is 
accomplished by a charge to what account? 

6. a. Is Discount on Stock an expense, asset, income, proprietorship, 

or liability account? 

6. Does Discount on Stock appear on the balance sheet or state- 
ment of profit and loss? In which section? 

c. If the company is very successful, what is likely to happen to the 
Discount on Stock account? 

6. a. On the books of a company the account Premium on Stock 
appears with a credit balance of $10,000.00. Tell the story 
which is indicated by that account. 

6. Would you consider Premium on Stock a part of Surplus? If 
so what kind of surplus would you label it? 



Ch. XXIV] CORPORATIONS 381 

7. On a balance sheet you notice among the assets the following two 
accounts: Installment No. 3, $10,000.00 and Subscribers to Capital 
Stock, $30,000.00. What story comes to your mind as the result 
of seeing these two accounts? 

8. On a balance sheet you notice the following items: 

Capital Stock Authorized $200,000.00 

Less: Unissued 75 ,000 .00 

Subscribed but Unissued $125,000.00 

Tell everything you can about this company. 

9. a. What is treasury stock? 

6. Should the Treasury Stock account have a debit or credit % 
balance? 

c. Is treasury stock an asset? Explain. 

d. How is treasury stock shown on the balance sheet? 

e. What happens to the Treasury Stock account, if the treasury 
stock is canceled? 

/. How may treasury stock be acquired? 

g. Suppose treasury stock is acquired from stockholder -Y. What 
debit and credit are made in the subsidiary ledger for stock- 
holders? 

10. a. Give the entry if one share of treasury stock is acquired for cash 

at par $50.00. 
6. Give the entry if acquired for cash at $45.00. 

c. Give the entry if acquired for cash at $55.00. 

d. Give the entry if the share in a is sold for $59.00 cash. 

e. Give the entry if the share in 6 is sold for $63.00 cash. 
/. Give the entry if the share in c is sold for $47. (X) cash. 

11. What entry may be made if a corporation sells 

a. 100 shares of no par common stock for cash at $15.00 a share? 

6. Another 100 shares for cash at $17.00 a share? 

c. Suppose a company uses a stated value of $5.00 for each share of 
no par common stock. Suppose also it sold 100 shares to the 
public at $10.00 a share. What entry is made? 

12. How could a company show the following facts on its balance 
sheet? Common stock no par authorized 2,500 shares; unissued 
1,500 shares; in the treasury 100 shares at stated value of $5.00 a 
share; outstanding 900 shares at the stated value of $5.00 a 
share. 

13. A corporation with common stock of $200,000.00 and a deficit of 
$80,000.00 exchanges all of its $100.00 par value stock for no par 
value stock on the basis of one share of no par value for two shares 
of the old par value stock. The no par stock has a stated value of 
$10.00 a share. 



382 ACCOUNTING FUNDAMENTALS [Ch. XXIV 

a. What is the effect on the balance sheet? 

6. What entry would record this exchange? What other entry 
would be made, most likely? 

c. Would the above occurrence completely transform the picture 
of the financial condition of this company? 

d. Is the company in any better financial condition after the exchange 
of stock than before? 



CHAPTER XXV 

CORPORATIONS (Concluded) 

Every entry and every account illustrated in the two preceding 
chapters on corporations had some connection with the issuance, 
reacquisition, or resale of its capital stock by a corporation. 
Very little reference was made to any other entries and accounts 
peculiar to a corporate enterprise. There is no difference 
between a corporation and a partnership or a sole proprietorship 
with respect to the methods used to record and post cash, sale, 
purchase, note, and all other transactions which involve business 
contacts of the enterprise with its customers and creditors. 
There is no difference in the method of taking a trial balance 
or adjusting the books, but a minor variation in procedure is 
necessary in the process of closing the books. 

Closing the Books of a Corporation 

The process of closing the books is exactly the same for a 
corpgratioii as for a partnership or a sole proprietorship with 
respect to the transfer of the nominal account balances to the 
summary account Profit and Loss, at the end of a fiscal period. 
The balance of the Profit and Loss account is transferred in sole 
proprietorships and in partnerships to the owners' accounts. 
In a corporation with par value stock, the balance of Profit 
and Loss is transferred to the Surplus account; it is not trans- 
ferred to the Capital Stock account. The latter account reflects 
the par value of issued stock and is not increased or decreased 
by the amount of any net profit or loss. 

The balance of Profit and Loss may be transferred to Capital 
Stock where no par value stock is used, but it should not be. 
A no par value capital stock account is not regulated by any 
par value, so that the balance of Profit and Loss may be combined 
with it. This practice is not approved because a Capital Stock 
account should preserve a record of the original contributions 
of the owners at par value figures or in the case of no par stock 
at stated or at issuing values, preferably the latter. Further- 

383 



384 ACCOUNTING FUNDAMENTALS [Ch. XXV 

more, any increase or decrease in net worth from the amounts 
represented by the original contributions of the stockholders 
should be shown under separate account titles. In any cor- 
poration whether par or no par stock is used the balance of 
Profit and Loss should be transferred to the account Surplus. 

Surplus 

Surplus was defined in Chapter XXIII as the excess of the 
assets over the liabilities and capital stock of an enterprise. 
It does not represent cash or any other specific asset. It is 
simply an excess of the book value of all assets over the book 
value of the liabilities and the amounts shown in the capital 
stock accounts. 

Undivided Profits 



Undistributed profits are accumulated sometimes in the 
account Undivided Profits. If so, that account is really an 
addition to the Surplus account. Bank statements frequently 
distinguish surplus from undivided profits to indicate by the 
former the amount of surplus the bank intends to retain and by 
the latter the amount which the board of directors desires to be 
free for the payment of dividends or appropriation by the board. 

Classification of Surplus 

There are two main classes of surplus earned and capital. 

Earned surplus arises from the successful operation of the 
business. Profits not distributed are accumulated in the Surplus 
account, which account, unless otherwise qualified, represents 
earned and free surplus. Earned surplus is sometimes appro- 
priated earmarked by action of the board of directors for a 
particular purpose, in. which case it is known as appropriated 
surplus. The appropriation of surplus is an action taken by a 
board of directors to retain profits in the enterprise for a particular 
purpose and to indicate that the amount earmarked is not avail- 
able for a dividend distribution. A board may appropriate 
surplus for such purposes as the extension of plant facilities, for 
the retirement of a particular long-term liability, or as a margin 
of safety against possible unforeseen losses. 

Surplus appropriated for particular purposes is shown under 
special account titles, such as Surplus Reserve for Sinking Fund 



Cb. XXV] CORPORATIONS 385 

and Surplus Reserve for Plant Extension, usually abbreviated, 
however, to Reserve for Sinking Fund and Reserve for Plant 
Extension. Unappropriated, earned surplus is known as/ree sur- 
plus. Free surplus is available for dividends. The balance of 
the Surplus account usually represents earned and free surplus. 
Capital surplus is unearned surplus which arises from other 
than operating sources. Under this heading are included any 
surplus items which result from transactions, such as the original 
sale of capital stock at a premium, donations of stock or assets, 
or assessments on full-paid stock. If a corporation for any 
reason appreciates the value of its assets as the result of an 
impartial appraisal, the offsetting credit may be made to Capital 
Surplus but a better treatment is to credit a special surplus 
account. A suggested title is Surplus Arising from Revaluation 
of Assets or simply Revaluation Surplus. 

Appropriated Surplus Accounts 

Appropriated surplus accounts such as Reserve for Sinking 
Fund, Reserve for Plant Extension, and Reserve for Contin- 
gencies are created by debits to Surplus and credits to the particu- 
lar appropriated surplus accounts. When the purpose for 
which an appropriated surplus account is established no longer 
exists, its balance is transferred back to Surplus and becomes 
available for dividend declarations. A more complete discussion 
of appropriated surplus accounts is withheld for the next chapter. 

Surplus Adjustments 

1. For Errors of Past Periods. The process of adjusting the 
books at the end of a period is exactly the same for a corporation 
as for a partnership or a sole proprietorship. Occasionally, 
during a period or at the time periodic adjustments are being 
made, errors of prior periods are discovered. These errors 
should be handled in such a manner that the operating results 
of the current period are not disturbed by them. They represent 
debits and credits to Surplus rather than Profit and Loss. 

Assume several errors made at the end of the last period are 
discovered in the current period, namely: a $1,000.00 under- 
valuation of inventory of merchandise and clerical mistakes 
which understated the depreciation of buildings by $500.00 
and the estimated bad-debt provision by $300.00. 



386 ACCOUNTING FUNDAMENTALS [Ch. XXV 

All these errors affect net worth as shown at the end of the 
last period and are adjusted through the Surplus account. 
The understatement of inventory of merchandise resulted in an 
undervaluation of assets and net worth. The understatement 
of the two reserve accounts overvalued assets and net worth. 
These errors are corrected by the following entries made at the 
time of discovery: 

Inventory of Merchandise, Dec. 31, 19 1,000.00 

Surplus 1,000.00 

To correct an undervaluation of inven- 
tory of merchandise at the end of the 
previous period. 

Surplus 800.00 

Reserve for Depreciation of Build- 
ings 600.00 
Reserve for Bad Debts 300.00 
To correct errors in listing amounts pro- 
vided for the above two reserve accounts 
at the end of the last period. 

2. For Nonoperating and Unusual Profits or Losses. Any 
unusual profit or loss item which is not expected to recur regularly 
may be closed to Surplus rather than Profit and Loss. A loss 
from such occurrences as a fire or a robbery which was much more 
than a minor theft is an unusual item. A profit from the sale 
of land or buildings which had enhanced in value from neighbor- 
hood changes is an exceptional item. Some accountants feel 
that the Profit and Loss account of a current period should not 
be affected by such unusual items and that they are absorbed 
better in Surplus. 

Changes in net worth which result from over- or underconserva- 
tive actions of the past are absorbed in the Surplus account rather 
than Profit and Loss. Thus a revaluation of fixed assets down- 
ward because of failure to provide adequate depreciation in the 
past is not a profit and loss item from current operations. 

The practice of closing unusual profit and loss items to Surplus 
and the usual operating nominal account balances to Profit and 
Loss causes the latter account to reflect the results of current 
operations only. The figures of Profit and Loss may be com- 
pared, therefore, period by period to determine the trend of 
operating results. 



Ch. XXV] 



CORPORATIONS 



387 



Illustrations of Surplus and Capital Surplus Accounts 

The following illustrations indicate the usual type of debits and 
credits to the two main, surplus accounts. 

Surplus (earned surplus) 



CREDITED FOR 

A credit balance of Profit and 

Loss xxx 

Nonopcrating and unusual 

profits xxx 

Errors of past periods which 

increase net worth xxx 

Elimination or decrease of an 
appropriated surplus account, xxx 



DEBITED FOR 

1. A debit balance of Profit and 1. 
Loss xxx 

2. Nonoperating and unusual 2. 
losses, such as thefts, fire loss, 

and revaluation of fixed as- 3. 
sets downward due to inade- 
quate allowance for depreci- |4. 
ation in the past xxx 

3. Dividends declared xxx 

4. Errors of past periods which , 
decrease net worth xxx 

5. Creation or increase of an 
appropriated surplus account, xxx 



The third item on the debit syle dividends declared is 
considered later in this chapter. 

Capital Surplus 



DEBITED FOR 

1. Discount on Capital Stock. . . xxx 

2. Revaluation downward of 
fixed assets previously written 

up xxx 



CREDITED FOR 

1. Premium on Capital Stock ... xxx 

2. Revaluation of fixed assets 
upwards ... . . ... xxx 

3. Donations ... xxx 

4. Assessments on full-paid 
stock xxx 



Each of the items in Capital Surplus should be a separate 
ledger account. The second item on the credit side is shown 
better in a separate account which is not closed to Capital Sur- 
plus, such as Surplus from Revaluation of Assets or Revalu- 
ation Surplus. 

Surplus on the Balance Sheet 

In order that the net worth of the corporation may be shown 
in one section of the balance sheet, surplus should follow capital 
stock in the proprietorship section. 



388 ACCOUNTING FUNDAMENTALS [Ch, XXV 

PROPRIETORSHIP 
Capital Stock Authorized. . . . $150,000.00 

Less: Unissued 50,000.00 

Outstanding $100,000.00 

Surplus: 
Earned: 

Free: $ 35,000.00 

Appropriated: 
Reserve for 
Plant Exten- 
sion $10,000.00 

Reserve for 
Contingen- 
cies 10.000 00 20,000.00 

$ 55,000.00 

Capital Surplus 25.000.00 80,000.00 

Net Worth $180,000.00 



Statement of Surplus 

To explain changes in surplus during a fiscal period, without 
burdening the formal balance sheet, a supplementary statement 
is usually prepared. 

STATEMENT OF FREE SURPLUS 

Initial balance, January 1, 19___ $40,000.00 

Adjustments for errors of past periods: 
Increasing net worth: 

Understatement, Inventory, January 1, 19 $ 1,000.00 

Decreasing net worth: 

Understatement, Reserve for Depre- 
ciation of Buildings $500.00 

Understatement, Reserve for Bad 

Debts 300.00 800.00 200.00 

Adjusted surplus, January 1, 19_ $40,200.00 

Add: 

Net profit, January 1 to December 31, 19 $27,300.00 

Damages from Breach of Contract 500.00 27 , 800 . 00 

Total $68,000.00 

Less: 

Addition to Reserve for Plant Extension $ 5,000.00 

Appropriated as Reserve for Contingencies 10 ,000 .00 

10 per cent cash dividend declared and paid 10,000.00 

Fire loss not covered by insurance 8.000.00 33 . OOP . 00 

Final balance as shown by the balance sheet $35,000.00 



Ch. XXV] CORPORATIONS 389 

The above statement of free surplus is prepared on the same 
general principles as the statement of the analysis of proprietor- 
ship in Chapter III. A similar statement for Capital Surplus is 
not necessary usually, since a change in the balance of that 
account is infrequent. 

If there are changes in the Capital Stock account during a 
period, too numerous to show conveniently in the formal balance 
sheet, a separate statement is prepared for it. 

Deficit 

A deficit is the amount by which the liabilities and capital 
stock of an enterprise exceed the assets. It is the exact opposite 
of a surplus and indicates that the equity of the stockholders 
is less than the amounts shown in the capital stock accounts. 
If only one Surplus account is kept, a debit balance therein is a 
deficit. In such a situation the debit balance of Surplus may 
be transferred to a Deficit account. 

A deficit should not be shown on a balance sheet as an asset. 
It should be shown as a subtraction in the proprietorship section. 
It may be eliminated from the records by charging it against 
subsequent additions to either Surplus or Capital Surplus 
accounts. 

DIVIDENDS 

The profits of a corporation arc distributed to the stockholders 
by means of dividends declared by the board of directors. 

Definition 

A dividend is an amount to be distributed proportionately. 
The word also means the portion received or to be received by a 
person as well as the rate used to indicate the amount to be 
divided. From the viewpoint of a corporation the word refers 
usually to a proportionate distribution of profits to stockholders, 
of assets to creditors of an insolvent enterprise, and of assets to 
stockholders of a company in liquidation. At this time the 
discussion is limited to consideration of dividends as a means 
of distributing to stockholders all or part of the balance shown 
in the Surplus account. 



390 ACCOUNTING FUNDAMENTALS (Ch. XXV 

Declared by Formal Action of the Board 

Although a corporation may have accumulated sufficient 
profits to make a distribution among its stockholders, such an 
action is not taken except by formal resolution of the board of 
directors. The directors constitute the body to which authority 
to manage the enterprise is delegated by the stockholders and 
dividends are not declared until, in the judgment of the board, 
it is deemed wise to make a profit distribution. If the board 
feels that the assets of the corporation should be conserved for 
such purposes as the expansion of the enterprise, to prevent a 
decrease in the amount of current assets, or to entrench the 
company for an expected period of depression, it may reduce 
the amount of the dividend ordinarily paid or omit it altogether. 
Stockholders do not know whether they are to receive a share 
of the profits of their company until the board takes positive 
action thereon. Without the approval of a definite dividend 
resolution by the board, dividends are not paid. 

Large corporations with many stockholders are not likely to 
distribute all accumulated profits. The boards of such com- 
panies prefer to maintain a regular dividend, usually paid 
quarterly, and to build up a substantial amount of surplus 
so that dividends may be continued during periods of poor 
business. The dividends paid in a particular period need not 
be earned in that period. 

Dividends Paid from Earnings 

It is a sound principle of accounting that dividends are payable 
only out of surplus earnings. In fact it is generally unlawful 
to distribute dividends which impair invested capital. Creditors 
view the amount shown in a Capital Stock account as a pro- 
prietary investment over which their claims take precedence. 
Any impairment of investment because of dividends reduces 
the protection afforded their claims. In a sole proprietorship 
or a partnership, withdrawals in excess of earnings are com- 
pensated by the fact that the private wealth of the owners is 
back of the debts of the enterprise. In a corporation this is 
not true; therefore, the law protects creditors by forbidding 
dividends which impair capital. Stockholders also, unless 
definitely advised to the contrary, view a dividend received 



Ch. XXV) CORPORATIONS 391 

as a share of corporate profits and not as the return of a part of 
their investment. 

As a matter of practice, the decision as to what amount of 
surplus is available for dividends is not an easy one, especially 
in cases of no par stock shown on the books at stated values. 
A complete discussion of the subject, surplus available for 
dividends, is a more appropriate topic for intermediate and 
advanced texts. 

Declaration and Notice of a Dividend 

The resolution of a board of directors to authorize a distribution 
of corporate profits to stockholders indicates the amount to be 
paid on each share. With par value stock the dividend is 
stated commonly as a percentage of par; with no par shares the 
declaration states the amount per share. The resolution states 
also the date declared, the date stockholders' names must be 
on record to receive the dividend, and the date of payment. A 
dividend notice is worded somewhat as follows: 

THE A. B. C. COMPANY 

March 1, 19_ 

The directors of the A. B. C. Company have this day declared a 
dividend of two per cent on the Common Capital Stock of the company, 

payable April 1, 19 to stockholders of record at the close of business 

March 15, 19 

Signed 



Secretary 

If the par value of a share is $50.00, the above notice indicates 
that the dividend is to be $1.00 a share, that it was declared on 
March 1 and is to be paid on April 1 to stockholders of record 
at the close of business March 15. If an investor purchases 
stock of this company prior to March 15 but the stock is not 
transferred to his name by that date, he does not receive the 
dividend from the company. He would have to obtain it from 
the person who sold him the stock. A purchaser of stock after 
March 15 does not receive the dividend since he purchased the 
stock, ex-dividend without the right to receive the dividend. 

Between March 15 and April 1 the company has opportunity 
to prepare the list of stockholders at the close of business on 
March 15 and to draw the dividend checks. Where there are 



392 ACCOUNTING FUNDAMENTALS [Ch. XXV 

many stockholders it is customary to pay each dividend with 
checks drawn on a special dividend bank account opened for 
that purpose. 

The declaration and notification of a dividend action estab- 
lish a liability on the part of the company to its stockholders. 
Between the date declared and the date paid, the dividend, if 
not payable in stock of the company, is a current liability. 

If a company has both preferred and common stocks, a 
dividend may be declared on the preferred even though not 
declared on the common. 

Classification of Dividends 

Dividends to stockholders may be classified as distributions 
of earnings and distributions of capital. 

1. Distributions of Earnings. 

a. By Distributing Assets to Stockholders. To distribute 
profits as a dividend, free surplus must be available 
at least in the amount of the dividend. Most dividends 
are paid in cash but they may be paid in other assets 
of the company, such as government securities owned, 
stocks and bonds of other corporations, or merchandise. 
A dividend paid in cash or other assets decreases the 
net worth of the corporation. 

6. By Creating a Liability to Stockholders. If surplus is 
sufficient but cash is inadequate to pay a dividend, 
cash may be borrowed for the purpose. On the other 
hand, in such a situation the dividend may be made 
payable in bonds, promissory notes, or scrip of the 
corporation. Dividend scrip is a certificate of a com- 
pany issued to a stockholder promising to pay the 
amount of a dividend at a later date. Any dividend 
which increases the liabilities of a company decreases 
its net worth. 

c. By Distributing Stock to Stockholders. In order to 
conserve cash, the board of directors of a corporation 
may declare a dividend out of surplus payable in the 
stock of the company. Such a dividend neither decreases 
assets nor increases liabilities, hence it does not decrease 
the net worth of the company. It reduces surplus by 



Ch.XXV] CORPORATIONS 393 

the same amount it increases capital stock. To declare 
a stock dividend a sufficient amount of treasury stock, 
unissued stock, or both must be available. 
2. Distributions of Capital. 

a. By Liquidating Dividends. If a corporation goes out 
of business, its assets are converted into cash, creditors 
are paid off, and cash when available is distributed 
proportionately to stockholders. Such capital dis- 
tributing dividends are known as liquidating dividends. 
6. By Distributing Capital with Profits. The dividends 
to distribute earnings of some companies sometimes 
include a distribution of capital. It may be legal in 
some states, particularly for companies with wasting 
assets, such as oil, mining, and timber companies, to 
declare and pay dividends which represent, in part at 
least, a return of investment. When so used the 
announcement which accompanies "the dividend to 
the stockholder should indicate clearly the extent of the 
capital return. 

Any dividend which impairs the amount of capital originally 
contributed by the stockholders is a return of capital to the 
extent of the impairment. 

Recording Dividends out of Earnings 

Assume the following proprietorship section of a balance sheet: 

PROPRIETORSHIP 

Capital Stock Authorized (par $100.00) $150,000.00 

Less: Unissued 50,000.00 

Outstanding $100,000.00 

Surplus free 80,000.00 

Net Worth $180,000^00 

Assume also that the directors of the company represented 
by the above section of a balance sheet declared a dividend of 
10 per cent on the outstanding capital stock. 

1. Entries When a Dividend Is Declared. If the dividend is 
payable in an asset or liability of the company, to record the 
declaration the entry is 



394 ACCOUNTING FUNDAMENTALS [Oh. XXV 

Surplus 10,000.00 

Dividends Payable 10 , 000 . 00 

To record the declaration on May 15, 

19 by the board of directors of a 

dividend of 10 per cent payable in cash 

on July 1, 19 to stockholders of 

record on June 1, 19 

The Dividends Payable account is a current liability to 
be paid out of current assets or exchanged for another current 
liability. Since a dividend to be paid in the stock of the com- 
pany does not represent a current liability a different account 
is credited for it when declared. If the dividend is a stock 
dividend, the entry without explanation is 

Surplus 10,000.00 

Stock Dividend Payable 10 , 000 . 00 

2. Entries When a Dividend Is Paid. On the date the liability 
on dividends payable is satisfied, the entry varies according 
to the kind of distribution made. The entry without explana- 
tion for the payment of the dividend recorded in the first entry 
in 1 above, is 

Dividends Payable 10 , 000 . 00 

Cash 10,000.00 

If any asset other than cash is distributed, the credit is to 
such other asset account. If the dividend is satisfied by the 
issuance of notes, scrip, or other liability of the company, the 
credit is to the appropriate liability account, such as Notes 
Payable or Dividend Scrip Payable. If scrip is used, when 
finally taken up by the company, Dividend Scrip Payable is 
debited and Cash is credited. 

If the dividend is payable in the company's own stock, when 
the stock is issued, the entry without explanation is 

Stock Dividend Payable 10 , 000 . 00 

Capital Stock 10 , 000 . 00 

If treasury stock rather than previously unissued stock is 
used for the dividend, the credit is t Treasury Stock and not 
to Capital Stock. 

The entries for dividends on no par stock, for which assets are 
distributed or liabilities are created to stockholders, are the 
same as those illustrated for par value stock. The amount to 



Ch. XXV] CORPORATIONS 395 

record for no par stock dividends varies because of the different 
values at which no par stock is recorded in the Capital Stock 
account when issued originally. A conservative plan to record 
a stock dividend which is declared out of accumulated earnings 
is to charge Surplus and credit Stock Dividend Payable with the 
amount obtained by multiplying the number of shares to be 
issued as the dividend by the average paid-in value of the old 
outstanding shares. There are other plans for valuing no par 
stock dividends, among them one which values the dividend 
at the stated value of the shares distributed. A company 
issuing a no par stock dividend should indicate clearly the amount 
charged to Surplus because of the dividend. An inadequate 
charge makes possible the repeated use of the same surplus 
for no par stock dividend purposes. 

No par treasury stock distributed as a dividend is charged to 
Surplus at the price at which it is carried in the accounts. 

Recording Dividends out of Capital 

Since this subject, recording dividends out of capital, includes 
complete liquidating dividends and involves the larger subject of 
realization on the assets and the liquidation of the liabilities and 
stock of a corporation, with perhaps a special realization and 
liquidation loss, it is left to more advanced texts. 

Dividends on the Balance Sheet 

If a dividend is payable in current assets or is to be satisfied 
by the issuance of liability paper, as previously stated, it is 
shown on the balance sheet of the declaring company, from the 
date declared until the date paid, in the current liability section. 
If a dividend is payable in stock, it is shown in the proprietorship 
section of the balance sheet, between the date declared and the 
date satisfied, as it is a credit in suspense to the Capital Stock 
account. 

Cumulative Dividends in Arrears 

If a dividend on cumulative preferred stock is not declared, 
there is no liability for it on the part of the company. The 
undeclared dividend simply accumulates as a preferential claim 
against profits, to be paid before common stockholders receive a 
dividend. On the balance sheet the extent of cumulative 
dividends in arrears is indicated usually by a footnote. Inf orma- 



396 ACCOUNTING FUNDAMENTALS [Ch. XXV 

tion about cumulative preferred dividends in arrears is important 
to both the preferred and common stockholders. 

SHARE OF STOCK VALUES 

A number of different kinds of value are attributed to a 
share of stock. Par value and no par value were explained on 
page 349 and stated value on page 377. Other values commonly 
referred to are market, liquidating, and book. 

Market Value 

The market value of a share of stock is the current price 
commanded by a share in the market place. Market value is 
seldom the same as the par, stated, liquidating, or even the 
book value of stock. Market price is influenced by many 
factors including the general state of business prosperity; the 
condition and outlook for the industry of which the company 
is a part, as well as for the company itself; the personnel of the 
company; the record of the company with respect to earnings 
and dividends; and the book value of the stock. 

Liquidating Value 

Liquidating value is the amount to which a share is entitled 
and the amount realized by a share, if a corporation sells its 
assets, pays its liabilities and retires its stock. A share of 
preferred stock may be entitled to a certain figure, say, $100.00 
in liquidation before common stockholders receive anything. 
The preferred shaie is said to have a liquidating value of $100.00. 
A share of common stock with a par value of, say, $50.00 may 
receive $2.17 in liquidation, which latter amount is its liquidating 
value. 

Book Value 

The book value of a share of stock is its worth as evidenced 
by the figures shown on the books of the company. The book 
value of a share is determined by dividing the net worth of the 
corporation by the number of outstanding shares. If there 
is more than one class of stock, the book value of a share in a 
particular class is determined by dividing the portion of the net 
worth applicable to the class of stock of which the share is a 
part by the number of outstanding shares in the class. The 



Ch. XXV) 



CORPORATIONS 



397 



net worth of a corporation is represented by the total of the 
proprietorship section of its balance sheet, which amount is also 
the excess of its assets over its liabilities. 

THE EFFECT OF DIVIDENDS ON THE BOOK VALUE OF STOCK 

Dividends paid in assets or liabilities of a company decrease its 
net worth and the book value of each of its shares. Since stock 
dividends represent transfers from Surplus to Capital Stock, 
both of which are proprietorship accounts, they do not decrease 
net worth. Stock dividends do increase, however, the number of* 
outstanding shares and consequently reduce the book value 
of each share. 

The figures used to illustrate the recording of dividends out of 
earnings are used again in the following illustration, to demon- 
strate the effect of dividends on the book value of a share of stock. 



Items 


Before 


After 


Dividend 
Declaration 


10 Per Cent 
Asset 
Dividend 


10 Per Cent 
Liability 
Dividend 


10 Per Cent 
Stock 
Dividend 


Capital Stock 


$100,000.00 
80,000.00 


$100,000.00 
70,000.00 


$100,000.00 
70,000.00 


$110,000.00 
70,000.00 


Surplus 


Net Worth 


$180,000.00 


$170,000.00 


$170,000.00 


$180,000.00 


Number of Shares 
Outstanding 


1,000 


1,000 


1,000 


1,100 


Book Value of Each 
Share 


$180.00 


$170.00 


$170.00 


$163.63 





QUESTIONS 

1. a. In a corporation to which account should the balance of Profit 

and Loss be closed? 

6. May Profit and Loss ever be closed to the Capital Stock account? 
How is this possible ? Is it desirable ? Is it undesirable ? Why ? 

2. a. What is surplus? 

b. Does surplus represent cash or any other specific asset? 

c. What is undivided profit? What kind of companies frequently 
use this title? 

3. a. Distinguish earned from capital surplus. 

6. Why should earned and capital surplus be distinguished in the 
accounts and statements? 



398 ACCOUNTING FUNDAMENTALS [Ch. XXV 

c. Name several sources of capital surplus. 

d. What is meant by appropriated surplus? 

e. Name several appropriated surplus account titles. 
/. What is the real purpose of appropriating surplus? 

4. Suppose it is discovered that the inventory of merchandise at the 
end of the previous fiscal period was overvalued $5,000.00 because 
of a clerical error. 

a. Give the entry to correct this error. 
6. If Surplus is either debited or credited in your answer to , give 

the reason for such debit or credit. 

*5. Can you give any profit or loss items which are closed at the end 
of a period to Surplus rather than Profit and Loss? Cite the reason 
in each case. 

6. Do the following items constitute earned or capital surplus? Why? 

a. Premium on capital stock. 

6. Credit balance of Profit and Loss at the end of a period. 

c. Errors of past periods which increase net worth. 

d. Assessments on full-paid stock. 

e. Bad debt recovered. 

/. Profit from the sale of land which was used for storage space for 
the last fifteen years but was needed no longer. 

7. a. In order to ascertain the true change in the net worth of an 

enterprise between periods arid the causes thereof, may it be 
necessary to study both the statement of profit and loss and the 
statement of surplus? Explain. 

b. What is a statement of surplus? 

8. a. May a deficit be shown in any account other than deficit? Which 

account? 

b. What is the net worth of a company which shows on its balance 
sheet: Common Stock, $50,000.00; Preferred Stock, $50,000.00; 
Deficit, $20,000.00? 

9. a. Is it possible for a company to distribute in a year more profits 

than were earned that year? Explain. 

6. When does a stockholder know if he is to receive a 
dividend? 

c. If a company is earning a substantial profit must dividends be 
paid? Explain. 

10. Suppose a corporation has assets, $25,000.00; liabilities, $14,000.00; 
common stock, $10,000.00; and surplus, $1,000.00. Would the 
creditors of the corporation have any right to object, if a dividend 
of $5,000 was paid to the stockholders in cash? Why? If paid in 
stock of the company? Why? 

11. a. Assume a corporation has common stock $50,000.00 and earned 

surplus $30,000.00. 



Ch. XXV] CORPORATIONS 399 

(1) Give the entry if a dividend of 10 per cent is declared payable 
one month later in cash. 

(2) Give the entry when the dividend is paid. 

(3) Why make the entry for a above? Why not wait and record 
the dividend only when it is paid? 

6. Suppose the 10 per cent dividend is a stock dividend. 

(1) Give the entry when declared. 

(2) Give the entry when paid. 

(3) How much richer would a stockholder be after the payment 
of the 10 per cent stock dividend? Explain. 

12. Why is a dividend payable in cash shown as a current liability on a 
balance sheet while one payable in the stock of the company is 
shown in the proprietorship section? 

13. Are cumulative dividends on preferred stock in arrears a liability, 
if not declared? How is information about such dividends shown 
on the balance sheet? 

14. a. What do you mean by the par value of a share? 

6. What do you mean by the liquidating value of a share? 

c. What do you mean by the market value of a share? 

d. What do you mean by the book value of a share? 

e. After a company has been operating for some time are 

(1) Par value and book value likely to be the same? Explain. 

(2) Book value and market value likely to be the same? 
Explain. 

15. Is the net worth of a company reduced by the declaration of a 
dividend to be paid 

a. In cash? 

6. In the scrip of the company? 

c. In the stock of the company? 

16. Do you believe a corporation might ever be justified in borrowing 
cash to pay a dividend? 

17. Assume a corporation has the following accounts, among others: 
Common Stock, $50,000.00; Surplus, $40,000.00; Undivided Profits, 
$10,000.00. Assume also that there are 1,000 shares of stock, all 
outstanding. 

a. What is the par value of a share? 

b. What is the book value of a share? 

18. a. The Surplus account at the beginning of the year showed a debit 

balance of $10,000.00. This year a net profit of $8,000.00 
was made. May a dividend be declared? If so, to what 
extent? 

b. During the current year a corporation ran at a loss. However, 
the Surplus account still shows a substantial credit balance. 
Is it possible to declare a dividend? 



400 ACCOUNTING FUNDAMENTALS [Ch. XXV 

19. The following three facts were taken from a corporate balance 
sheet: 

Cash $ 50,000.00 

Accounts Receivable 80,000.00 

Capital Stock (Outstanding) 200,000.00 

Would you advise the declaration of a dividend? If so, to what 

extent? State your reasons briefly. 

20. The net worth of a corporation today is $150,000.00. One year ago 
it was $155,000.00. 

a. Is it possible that this corporation earned a net profit for the 
period? Explain. 

b. Assume that $20,000.00 of capital stock was sold at par during 
the year and that cash dividends of $18,000.00 were paid. 
Determine the net loss for the year, it being assumed that there 
were no other changes in the corporate surplus. 

21. a. What would cause a difference between the balance of the Surplus 

account in the ledger and the total surplus in the balance sheet? 
6. Would the total surplus in the balance sheet agree with the 
amount of surplus in the proprietorship equation? 



CHAPTER XXVI 

RESERVES AND FUNDS 

In Chapter XI, in connection with the topic " Adjusting the 
Books/' reference was made to reserve accounts. In Chapter 
XV, when the subjects bad debts, depreciation, obsolescence, and 
depletion were considered, reference was made again to reserve 
accounts. 

The reserve accounts referred to in Chapters XI and XV are 
valuation accounts. In Chapter XXV, which dealt with cor- 
porations, it was necessary to refer to another kind of reserve 
account an appropriated surplus account. It is desirable, 
therefore, that special consideration be given to the subject of 
reserves, in order to distinguish properly between the two classes 
mentioned previously and to consider any additional classes. 
At the same time it is desirable to consider the subject of funds. 
The words reserve and fund are frequently but incorrectly used 
one for the other. A very brief mention was made in Chapter XV 
of the word fund. 

RESERVES 

The accounting use of the word reserve as part of an account 
title is mostly in a literal sense, to convey the idea of retaining, 
withholding, setting aside, or setting apart especially for a 
particular purpose. In the vocabulary of the accountant, 
the word reserve is an overly popular one, consequently its 
use as part of an account title is not defined easily. 

Definition of a Reserve Account 

1. When used as a valuation account. A reserve account is 
an account created with a credit balance to show the actual or 
estimated decline in the value of an asset from a cause such as 
depreciation, depletion, bad debts, fluctuation downward in 
the value of merchandise owned, or the expiration in part of a 
time-limited right or privilege. 

401 



402 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

2. When used as a proprietorship or appropriated surplus 
account. A reserve account is an account created with a credit 
balance to show the amount of net worth (usually surplus) 
which is appropriated earmarked for a particular purpose. 
- 3. When used as an estimated accrued liability account. A 
reserve account is an account created with a credit balance to 
show the amount of an estimated accrued liability. 

Classification of Reserve Accounts 

The definition of a reserve account indicated that all reserve 
accounts may be classified into three groups. These groups 
with illustrative subdivisions are 

1. Valuation Reserves. 

a. Reserve for Depreciation. 

b. Reserve for Depletion. 

c. Reserve for Bad Debts. 

d. Reserve for Sales Discounts and Allowances. 

e. Reserve for Decline in Inventory Value. 
/. Reserve for Amortization of Patents. 

2. Proprietorship or Surplus Reserves, 
a. Reserve for Working Capital. 
6. Reserve for Plant Extension. 

c. Reserve for Possible Inventory Shrinkage. 

d. Reserve for Obsolescence. 

e. Reserve for Contingencies. 
/. Reserve for Sinking Fund. 

3. Liability Reserves. 

a. Reserve for Income Taxes. 

b. Reserve for Compensation Insurance. 

Valuation Reserves 

As pointed out in the definition, a valuation reserve account 
is used to show the actual or estimated decline in the value of an 
asset usually from operating causes, A valuation reserve 
receives its original and regular subsequent credit postings from 
entries the debits of which are made to operating expense 
accounts. The reason for the use of a valuation reserve account 
was given on page 189. Valuation reserve accounts are some- 
times called allowance accounts. This variation from the usual 



Ch. XXVI] RESERVES AND FUNDS 403 

practice is commendable in the interest of clarity in the use of 
accounting expressions. When the word allowance is used 
instead of the word reserve the specific account titles become, 
for example, Allowance for Depreciation of Machinery rather 
than Reserve for Depreciation of Machinery, and Allowance for 
Bad Debts rather than Reserve for Bad Debts. 

On page 131, where a valuation reserve account was first 
mentioned, it was stated that such an account is not an income, 
a liability, or a proprietorship account although it has a credit 
balance. A valuation reserve account is considered a part of 
its related asset account. Each credit to a valuation reserve 
account is made in lieu of a credit to the related asset account. 
On a balance sheet, therefore, a valuation reserve should be 
shown as a deduction from its related asset and not as an item 
in the liability or proprietorship section. 

In Chapter XV the valuation reserve accounts for depreciation, 
depletion, and bad debts were considered, so they will not be 
considered further. Attention will be given, however, to the 
other valuation reserve accounts mentioned on page 402 in this 
chapter. 

Reserve for Sales Discounts and Allowances. To be entirely 
consistent the asset accounts receivable should be revalued at 
the end of a fiscal period not only for the anticipated loss through 
bad debts but for anticipated sales discounts and allowances. 
Charge sales for which the discount period has not expired at 
the end of the fiscal period are still subject to the discount 
privilege. The asset accounts receivable should be reduced in 
value by the creation of a special Reserve for Discounts account 
for the anticipated amount of such discounts. Similarly, 
accounts receivable should be reduced by the creation of a 
Reserve for Allowances account in the anticipated amount 
of such allowances. These two special reserve accounts may 
be combined into one account, Reserve for Discounts and 
Allowances. The offsetting debits in the entry which creates 
this reserve account are to the accounts Sales Discounts and 
Sales Returns and Allowances for their respective amounts. 

In determining the amount to be credited to Reserve for 
Discounts and Allowances at the end of a fiscal period, con- 
sideration is given to the past experience of the enterprise in this 
connection and to the current condition of business in the trade 



404 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

and in general. If this special reserve account is used, then 
discounts taken and allowances granted in the new period on 
goods sold in the previous period are charged to this Reserve for 
Discounts and Allowances account. 

Ordinarily, anticipated discounts and allowances are not 
comparable in importance to anticipated bad debts so most 
enterprises ignore making an allowance for them even though 
they may provide a Reserve for Bad Debts account. When 
the Reserve for Discounts and Allowances account is used, 
it is shown on the balance sheet as a deduction from accounts 
receivable. 

Reserve for Decline in Inventory Value. In Chapter XIV it 
was noted that conservative practice approves the valuation 
of an inventory at cost, or cost or market whichever is the lower 
figure. If an enterprise wants to show its inventory on the 
books and in the statement of profit and loss at the cost figure 
but to use the cost or market value if lower, for balance sheet 
and income-tax purposes, it may do so by making an adjusting 
entry 

Inventory Adjustment xxx 

Reserve for Decline in Inventory Value xxx 

To record the decline in the value of inventory on a 
cost or market-value basis from the amount shown on 
the books at a cost value basis. 

On the balance sheet the inventory is shown among the 
assets at the net of its cost over the amount of the Reserve for 
Decline in Inventory Value account. The actual subtraction 
may be shown on the balance sheet, but there is no special reason 
for so doing if the method of valuation is indicated by a footnote 
on the balance sheet. The account Inventory Adjustment is 
closed to Profit and Loss for the current period and not to Cost of 
Goods Sold. If the cost value of inventory at the end of the new 
period is lower than the cost or market value, the Reserve for 
Decline in Inventory Value account is closed as a credit to Inven- 
tory Adjustment. If the cost or market value of the inventory at 
the end of the new period is lower than the cost value, then the 
Reserve for Decline in Inventory Value account is modified ill 
amount to agree with such difference in value and Inventory 
Adjustment is debited or credited accordingly. After the first 
year, Inventory Adjustment account may have a credit balance; 



Ch. XXVI] RESERVES AND FUNDS 405 

whether a debit or credit balance it is closed to Profit and Loss. 
(See page 164.) 

The Reserve for Decline in Inventory Value is a valuation reserve 
account and must not be confused with a Reserve for Possible 
Inventory Shrinkage, which is a proprietorship or surplus 
reserve. The Reserve for Decline in Inventory Value account 
provides for an actual decline in the value of inventory; the 
Reserve for Possible Inventory Shrinkage provides for a possible 
decline in the future. The Reserve for Possible Inventory 
Shrinkage account is considered later in this chapter. 

Reserve for Amortization of Patents. Some intangible assets 
such as patents, copyrights, licenses, and leaseholds decline in 
value because of the passage of time. Their efficient lives are 
limited by law or contract. The cost value of such assets should 
be revalued downward periodically. In the case of an inventor 
of a patent, the patent should be written off within 17 years; the 
purchaser of a patent would write off its cost within the number 
of remaining periods. Such revaluation is accomplished by an 
adjusting entry which debits an expense account and credits 
either the asset directly or a reserve for amortization account. 
An illustrative entry for the periodic revaluation of an intangible 
asset which declines in value because of the mere passage of 
time is 

Amortization of Patents xxx 

Patents 
or 

Reserve for Amortization of Patents xxx 

To reduce the value of patents for the current 
period's share of their original cost. 

Proprietorship or Surplus Reserve Accounts 

A proprietorship or surplus reserve account is not a valuation 
account nor is it a liability. It is a part of proprietorship, in 
the case of a corporation, a part of earned surplus which is 
appropriated earmarked for a particular purpose. The full 
title of a corporate surplus reserve account includes both the 
words surplus and reserve, as Surplus Reserve for Working 
Capital or Surplus Reserve for Plant Extension. These titles 
are commonly shortened by the omission of the word surplus, 
thus Reserve for Working Capital or Reserve for Plant Extension. 



406 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

Proprietorship or surplus reserve accounts are primarily a 
feature of corporation accounting. This is true to such an 
extent that this class of reserve accounts is more frequently 
referred to as surplus reserve accounts than as proprietorship 
reserve accounts. They will be referred to hereafter in this 
book as surplus reserve accounts. 

As pointed out in the definition, a surplus reserve account 
is an account created with a credit balance usually by a transfer 
from the owners' accounts in the case of sole proprietorships or 
partnerships, or from the Earned Surplus account in the case pf 
corporations. The amount shown in a surplus reserve account is 
still a part of proprietorship. The use of a surplus reserve account 
indicates the intention of the enterprise to hold an equivalent 
amount of assets for the particular purpose evidenced by the title 
of the account. The equivalent amount of assets is not neces- 
sarily segregated as will be explained shortly. Since it reflects a 
part of the net worth of the enterprise, a surplus reserve account 
appears on the balance sheet in the proprietorship section. 

Classification of Surplus Reserve Accounts 

When a board of directors authorizes the appropriation of 
surplus, it expresses its intention with respect to the use of an 
amount of earnings earmarked in a surplus reserve account. On 
the basis of the objectives for which they are created, surplus 
reserve accounts may be classified into five classes. 

1. Surplus reserved for reinvestment. 

2. Surplus reserved to cover future losses. 

3. Surplus reserved because of contractual obligations. 

4. Surplus reserved for certain other financial objectives. 

5. Surplus reserved for repairs and maintenance. 

A consideration of each of the above classes of surplus reserve 
accounts together with some illustrative account captions in 
each class follows. 

1. Surplus Reserved for Reinvestment. The board of directors 
of a corporation may decide that additional working capital is 
desirable and that it should be provided by retaining some 
of the profits. Working capital is the excess of the amount of 
the current assets over the amount of the current liabilities 
of an enterprise. Such excess is the amount of the capital of 
an enterprise which is not invested in fixed assets, is not necessary 



Ch. XXVI] RESERVES AND FUNDS 407 

to meet current liabilities, and is available, therefore, for use 
in the current operation of the business. 

The resolution of a board of directors authorizing the appro- 
priation of surplus for additional working capital is the basis 
for the following entry: 

Surplus xxx 

Reserve for Working Capital xxx 

To transfer the amount authorized by resolution of 
the board from Surplus to this special reserve. 

The appropriation of a part of surplus to the account Reserve 
for Working Capital is notice to all interested parties that it is 
not the intention of the board of directors to distribute as a 
dividend that portion of surplus which has been reserved; it is 
notice that the board does not consider the amount reserved 
available for dividends. The board of directors may at any 
time authorize the transfer of the balance of the Reserve for 
Working Capital account back to Surplus. 

Another account which indicates surplus reserved for reinvest- 
ment is the account Reserve for Plant Extension. The use of 
this account indicates the intention of the board of directors to 
accumulate profits for the purpose of enlarging the plant. The 
entry to create this account is 

Surplus xxx 

Reserve for Plant Extension xxx 

To transfer the amount authorized by the board from 
Surplus to this special reserve. 

If the policy of the company with respect to expansion is 
continued the Reserve for Plant Extension account will receive 
additional periodic credits. When the actual expansion takes 
place, the additional facilities acquired are charged to an asset 
account and an asset or a liability account is credited. 

Assume a new building was purchased and paid for in cash 

Buildings xxx 

Cash xxx 

The Reserve for Plant Extension account may now be closed 
back into Surplus. It must be realized, however, that the 
assets which were accumulated in the business as an offset to 
the Reserve for Plant Extension account have been used in the 



408 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

acquisition of the building and the company is in no better 
position, in fact it is in a poorer position, to pay cash dividends 
than before the building was purchased. If the company has 
sufficient unissued or treasury stock, it may declare a stock 
dividend to the amount of the Reserve for Plant Extension 
account. 

2. Surplus Reserved to Cover Future Losses. Surplus reserved 
under this heading is not for actual losses but for losses which 
may materialize. An example is Reserve for Possible Inventory 
Shrinkage. In a period of falling prices, the board of directors 
of a company may anticipate a material reduction in the replace- 
ment value of the asset inventory as it appears on the balance 
sheet at the end of a fiscal period. The appropriation of surplus 
to a Reserve for Possible Inventory Shrinkage account expresses 
this anticipation and the provision made for it. 

Other examples of reserves under this heading are 

a. Reserve for Obsolescence. This account is set up to cover 
possible future losses from sudden obsolescence. (See 
page 194.) 

b. Reserve for Contingencies. This account is created as a 
blanket reserve to cover possible future losses without 
specifically captioning them. 

3. Surplus Reserved because of Contractual Obligations. For 
example, an enterprise is required sometimes to provide a reserve 
as the result of a contract made with bondholders or mortgagees. 
The contract for a long-term loan to an enterprise may have the 
stipulation included that the enterprise is required periodically 
to reserve out of profits amounts which, over the life of the 
loan, will equal its total value. Since the loan will not mature 
for a number of years the bondholders will have the additional 
protection of the reserve. The creation of the reserve out of 
earnings implies that the net worth of the company at the time 
of the loan will not only be maintained but will increase by the 
amount of the reserve. The creation of the reserve prevents 
the distribution in the form of dividends of the profits reserved. 

Assume a 20-year 6 per cent bonded indebtedness in the 
amount of $50,000.00 with the requirement of an annual reserva- 



Ch. XXVI] RESERVES AND FUNDS 409 

tion from earnings of a pro rata share of the total indebtedness. 
The entry to start such a reserve is as follows: 

Surplus 2,500.00 

Reserve for Sinking Fund 2 , 500 . 00 

To set aside out of profits one-twentieth 
of the amount of the total bonded debt. 

A similar entry is made at the end of each succeeding fiscal 
period until a total of 20 such entries have been made. 

The calculation of the amount for the above entry was made 
on the straight-line basis, one-twentieth of the total debt to be 
provided for. It may be determined on other bases. 

The establishment of a sinking fund reserve provides the 
protection necessary to conserve the net worth of an enterprise 
which is operating on a profitable basis but it does not guarantee 
that at the expiration of the debt the company will be in a 
position to liquidate it. Profits may be reserved periodically 
for many years but as so far considered in this book there is 
no requirement as to the form in which they must be kept. 
In the illustration just considered the assets representing the 
profits shown in the reserve account may be in the form of land, 
buildings, machinery, or other nonliquid assets, or they may 
have been used to pay off current debt. The additional protec- 
tion required by bondholders with respect to the segregation of 
assets will be explained later in this chapter under the heading 
Funds. 

When a Reserve for Sinking Fund account is used, its balance 
is transferred back to Surplus when the liability to the bond or 
mortgage holders has been satisfied. 

4. Surplus Reserved for Certain Other Financial Objectives. A 
board of directors in a period of prosperity may appropriate 
surplus for the purpose of continuing dividends in less pros- 
perous periods. Such an appropriation of Surplus is indicated 
by the account title Reserve for Dividends. An enterprise 
may have a policy with respect to the retirement of preferred 
stock and surplus may be appropriated periodically for that 
purpose. The appropriate account title in this instance is 
Reserve for the Retirement of Preferred Stock. These two 
accounts illustrate the kind of reserve accounts found under this 
heading. 



410 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

5. Surplus Reserved for Repairs and Maintenance. This 
account is created to reduce earned and free surplus to the extent 
of the estimated cost of repairs to be made in the future. Fre- 
quently the offsetting debit is to the Repairs and Maintenance 
Expense account so that each fiscal period will be charged with its 
proportionate share of maintaining the equipment. In many 
enterprises repairs are made to equipment when business is dull. 
For example, in the fall and winter, repairs are made to equip- 
ment used primarily during the spring and summer months. 
During the war railroad equipment needed repairs but it could 
not be removed from active service without curtailing the trans- 
fer of men and materiel. The Interstate Commerce Commission 
permitted the railroads to prorate the estimated cost of these 
repairs although no cash was paid or liability incurred. In 
some industries major repairs are necessary at irregular intervals. 
For example, the relining of furnaces may be done on the average 
of every two or three years. To apportion the cost over each 
year receiving the benefit, a debit may be made to Repairs and 
Maintenance Expense and a credit to the Reserve for Mainte- 
nance. When the repairs are made the debit is made to Reserve 
for Maintenance. 

Liability Reserves 

As pointed out in the definition of a reserve account, a liability 
reserve account is an account created with a credit balance to 
show the amount of an estimated accrued liability. For example, 
at the end of a fiscal period an enterprise may not be able to 
determine accurately the amount of its income tax. That a 
tax will have to be paid on its profits of the current year is 
certain but the definite amount may not be known until some 
time in the next period. In such a situation the following entry 
is made: 

Surplus xxx 

Reserve for Income Taxes xxx 

To record the estimated income taxes for the year 
19_. 

Income taxes are not a charge against operations; they repre- 
sent a sharing of profits with the government, hence the charge 
in the above entry to Surplus and not to an operating expense 
account. 



Ch. XXVI] RESERVES AND FUNDS 411 

Taxes the amount of which is definitely known but is unpaid 
should not be shown in a Reserve for Taxes account. Such an 
item is entered on the books by an adjusting entry such as the 
following one: 

Property Taxes xxx 

Property Taxes Accrued xxx 

To record the unpaid property taxes for the period. 

Another reserve account which is classified as a liability reserve 
is Reserve for Pensions if it results from a contractual agreement 
with employees or is morally so considered by the company. 
Reserve for Compensation Insurance is another illustration of a 
liability reserve account. The total amount of premiums due 
for a fiscal period on compensation insurance is not known until 
after the close of the period, hence the use of the reserve account 
rather than an insurance accrued account. The debit in this 
instance is to the Compensation Insurance account. 

The Word Reserve Used Incorrectly 

As pointed out previously in this chapter, the word reserve is 
a very popular one in the field of accounting and frequently is 
misused. It has been stated that it is sometimes incorrectly 
used for the word fund. Similarly the word reserve as part of 
an account title is misused. For example, if an enterprise 
revalues an asset upward and makes an entry which debits the 
asset and credits Reserve for Unrealized Appreciation, it is 
using a reserve account title incorrectly. The credit in this 
instance belongs in an account titled Surplus Arising from 
Revaluation, or some similar title. 

A Secret or Hidden Reserve 

The expression a secret reserve or a hidden reserve is a very 
common one in accounting but peculiarly it does not refer to a 
particular reserve account on the books. It refers to a con- 
dition on the books of an enterprise whereby its net worth is 
understated. 

A secret or hidden reserve is the amount of the understatement 
of the net worth of an enterprise. A secret reserve results from 
undervaluing an asset or overvaluing a liability, thus: 



412 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

Undervaluing an asset by 

1. Charging a capital expenditure to a revenue account, i.e., 
an addition charged to repairs. 

2. Writing off an asset against Surplus, i.e., 

a. Reducing prematurely Patents, Copyrights, or other 
intangible asset accounts to a nominal value or to zero, 
or writing off Goodwill. 

&. Placing a tangible asset such as buildings, land, or 
furniture and fixtures on the books at a nominal figure 
or by reducing the value of such an asset to a nominal 
figure as soon as Surplus is large enough to permit. 

3. Overstating a valuation reserve account, i.e., excessive 
depreciation, depletion, or bad-debt allowances. 

4. Charging a capital expenditure to an appropriated surplus 
account, i.e., debiting the cost of a new building to Reserve 
for Plant Extension. (See page 407 in this chapter.) 

Overvaluing a liability by 

1. Creating an excessive liability reserve account, i.e., over- 
stating the Reserve for Income Tax account. 

The purposeful creation of a secret reserve is not recommended 
in spite of the fact that the tendency to create such a reserve 
may be a characteristic of the conservative person. Anyone 
enjoys finding $2.00 in his pocket when he thought there was 
only $1.00. Similarly the owners and boards of directors of 
enterprises enjoy the consciousness that their enterprises are 
likely to be worth more than the figures exhibited on the books 
and statements. The amount of the secret reserve is considered 
a margin of safety in case an unforeseen loss develops. 

The creation of a hidden reserve causes incorrect statements 
of the enterprise to be issued and in the case of corporations such 
statements deny the stockholders a knowledge of the correct 
condition of their enterprise. The creation of the secret reserve 
may have an influence on dividends and on the market price 
of the stock of the company and may facilitate manipulation of 
the stock by those who are aware of the facts. The purpose 
of accounting is to show true condition; ultraconservativc action 
is discouraged as much as excessively liberal action. 



Ch. XXVI] RESERVES AND FUNDS 413 

FUNDS 
Definition 

A fund is an asset, usually cash or securities or both, set apart 
for a specific purpose. 

Definition of a Fund Account 

A fund account is an asset account; it represents cash, securi- 
ties, or other assets set aside for a specific purpose. (See page 
191.) 

Purposes for Which Funds Are Created 

Many individuals outside the field of accounting use the word 
funds and actually create them. A salaried person may open 
an account in a savings bank and weekly deposit cash therein 
to build up a vacation fund. Christmas funds, representing 
money accumulated weekly in banks to meet the expenses of the 
Christmas season, have been very common. Parents may 
accumulate money in a fund for the education of their children 
or to purchase a home. Individuals sometimes create funds by 
directly setting aside assets rather than accumulating them. 
Thus they may give during their lives or create by will funds 
for the use of religious, educational, or charitable institutions. 

A business enterprise creates a fund in exactly the same way 
an individual does and for the same general purpose to have a 
particular asset or assets with which to meet a future need. 
Some of the particular purposes for which funds are provided 
in a business enterprise are indicated in the following discussion. 

Working Funds for Current Operations. Funds under this 
heading are those which are created to facilitate the current 
operations of the enterprise. Such funds consist of cash and 
represent, therefore, amounts withdrawn from the regular bank 
account of the enterprise and set apart for a particular purpose. 

The Petty Cash or Imprest Fund explained on page 287 is the 
most common of the working funds. Branch Funds which 
represent cash sent to branches to facilitate their operation is 
another illustrative title. Working Funds are current assets 
and are so presented on the balance sheet usually as a part of 
the asset cash. 

Funds for the Acquisition of Fixed Assets. On page 407 in this 



414 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

chapter, the account Reserve for Plant Extension was considered. 
That discussion pointed out how an enterprise might appropriate 
surplus for the ultimate purpose of extending plant facilities. 
Such an appropriation of surplus does not in itself insure that 
the assets retained in the business for reinvestment purposes 
will be in a form to be utilized, when needed, for the purpose 
for which the reserve is created. They may be tied up in inven- 
tory, accounts or notes receivable, or in other assets, or they 
may have been used to liquidate debt. 

If a company desires to utilize profits for expansion purposes, 
it may actually segregate the assets necessary for that purpose 
by creating a Plant Extension Fund. Assume a board of 
directors believes an expansion will be desirable in five years 
and estimates it should have $80,000.00 available for that 
purpose at the end of that time. It is decided to set aside 
$16,000.00 cash immediately and to invest that sum in marketa- 
ble bonds. It is also decided that each year thereafter an addi- 
tional amount will be set aside and invested, the amount to equal 
$16,000.00 less the net earnings of the fund for the preceding 
year. This procedure is to be continued until the fund reaches 
$80,000.00. Suppose it is also agreed that $16,000.00 shall 
be appropriated immediately from Surplus to Reserve for Plant 
Extension and that a similar amount shall be appropriated 
annually until the total is $80,000.00. 

The entries necessary for these assumed facts are as follows: 

1. a. On the date of the original purchase of bonds, December 
31, 19 

Plant Extension Fund 16 , 000 . 00 

Cash 16,000.00 

To record the purchase of $16,000.00, 
6 per cent bonds at par for the plant 
extension fund. Interest payable 
June and December 30. 

b. On the date of the original appropriation of surplus, 
December 31, 19 

Surplus 16,000.00 

Reserve for Plant Extension 16,000.00 

To record the appropriation by the 
board of directors of surplus for plant 
extension. 



Ch. XXVI] RESERVES AND FUNDS 415 

2. On June 30 when the first interest is received 

Plant Extension Fund 480 . 00 

Interest Earned on Plant Ex- 
tension Fund 480.00 
To record semiannual interest received 
on $16,000.00 6 per cent bonds held 
in the plant extension fund. 

The last entry above assumes that a separate bank account and 
separate books have been opened for the fund. 

3. On December 30 one year after the fund was established 

Plant Extension Fund 480.00 

Interest Earned on Plant Ex- 
tension Fund 480.00 
To record semiannual interest received 
on $16,000.00 6 per cent bonds held 
in the plant extension fund. 

Plant Extension Fund 15 , 040 . 00 

Cash 15,040.00 

To record transfer to plant extension 
fund of $16,000.00 less the income 
earned by the fund during the year. 

Surplus 16,000.00 

Reserve for Plant Extension 16,000.00 

To record the appropriation by the 
board of directors of surplus for plant 
extension. 

The above entries are continued as interest is received, surplus 
appropriated, and cash transferred to the fund, until both the 
fund and the reserve total $80,000.00. 

4. When the securities in the fund are converted into cash 
and the fund is used for the acquisition of a new building 

Building 80,000.00 

Plant Extension Fund 80 , 000 . 00 

To record the acquisition of a building 
with the plant extension fund. 

Reserve for Plant Extension 80,000.00 

Surplus 80,000.00 

To return to Surplus the amounts 
appropriated for plant extension. 



416 ACCOUNTING FUNDAMENTALS [Ch. XXVt 

A fund, such as the one just illustrated, may be operated 
without its equivalent appropriated surplus reserve and, as was 
explained earlier in this chapter, an appropriated surplus reserve 
may be used without an equivalent fund. 

Funds for the Redemption of Fixed Liabilities. In the discussion 
of Surplus Reserved for Contractual Obligations which began 
on page 408 in this chapter, it was observed that the creation 
of such a reserve account did not guarantee the existence of 
particular assets with which to meet the obligation at maturity. 
If the contract between a borrower and the bondholders on a 
long-term debt requires the accumulation of assets with which to 
meet the obligation at maturity or if the borrower merely 
desires to have such an accumulation of assets for this purpose, 
it is accomplished by the creation of a sinking fund. If the 
creation of the sinking fund is optional, it may remain in the 
control of the borrowing enterprise. The entries in such a 
case follow the same general plan as illustrated on page 414 for a 
plant extension fund. 

If the fund is a requirement of the contract, it is usual for the 
sinking fund to be controlled by an impartial trustee. The 
trustee is responsible for the investment of the cash in the fund, 
for the collection of the interest or dividends on the securities 
in the fund, and the ultimate payment of the fund monies to the 
proper parties. Sometimes the fund may be used to purchase 
bonds of the particular issue for the payment of which the fund 
is provided. In such a case the purchased bonds may be retired 
or they may be held as securities in the fund and the interest 
on them paid to the trustee. 

The entries to record the operation of a sinking fund in the 
hands of a trustee are substantially the same as those illustrated 
previously for a fund operated and controlled by the enterprise. 
From the income on the securities in the fund and any profit 
resulting from the purchase and sale of securities are subtracted 
the expenses and commission of the trustee as well as any losses 
resulting from the handling of securities. The trust agreement 
may provide that the net earnings may be accumulated in the 
fund or turned over to the enterprise. In either case, the net 
earnings of the fund should be shown on the books of the enter- 
prise as income of the year in which earned. 

In this chapter the periodic contributions to a fund have been 



Ch. XXVI] RESERVES AND FUNDS 417 

illustrated on the basis of a simple arithmetical calculation. 
Actually the periodic contributions may be determined on a 
number of different bases according to the provisions of the 
trust agreement. Sometimes the periodic contribution is not 
calculated on a time basis. In an extractive industry, for 
example, a coal mine, the periodic contribution may be deter- 
mined on the basis of the tonnage mined in the period. 

A sinking fund may be shown on a balance sheet in a special 
grouping between current and fixed assets. Obviously it is 
not a current asset and it is not a fixed asset in the sense that a 
fixed asset is a relatively long-lived asset necessary in the opera- 
tion of the business. The classification of a sinking fund as a 
fixed asset may be justified on the grounds that it is a long-term 
investment held for the purpjose of meeting a fixed liability at 
maturity. Another method of showing a sinking fund on the 
balance sheet is to present it as a deduction from the amount 
of the bond issue for the payment of which it was set up. This 
plan is excellent if the securities in the fund are bonds for the 
payment of which the fund exists. If the investments of the 
fund are in outside securities then they are assets held for a 
special purpose and should be shown among the assets of the 
enterprise. These very brief arguments tend to confirm the 
judgment that a sinking fund may best be shown in a special 
section of the balance sheet between current and fixed assets. 

A sinking fund may be operated without its equivalent appro- 
priated surplus reserve; on the other hand a reserve for sinking 
fund may be operated without its equivalent sinking fund. 

Funds for Other Purposes. Funds for a number of purposes 
other than those illustrated in this chapter are common with 
business enterprises. Some of these fund account titles are 
Pension Fund, Preferred Stock Retirement Fund, Insurance 
Fund, Vessel Replacement Fund, Strike Fund, Accident Claims 
Fund, Restoration of Leased Property Fund, and Contingent 
Fire Loss Fund. 

QUESTIONS 

1. a. What is a valuation reserve account? 

6. What is a surplus reserve account? 

c. What is a liability reserve account? 

d. Name several valuation reserve account titles. 



418 ACCOUNTING FUNDAMENTALS [Ch. XXVI 

e. Name several surplus reserve account titles. 
/. Name one liability reserve account title. 

g. The Reserve for Depreciation account is known by what other 
title? 

2. What is the purpose of each of the following reserve accounts: 
a. Reserve for Federal Income Taxes? 

6. Reserve for Contingencies? 

c. Reserve for Plant Extension? 

d. Reserve for Bad Debts? 

e. Reserve for Decline in Inventory Value? 
/. Reserve for Possible Inventory Shrinkage? 

3. What entries are necessary to create the reserves listed in question 
2? 

4. Which class of reserve accounts is shown on the balance sheet in 

a. The proprietorship section? 

b. The asset section? 

c. The liability section? 

5. a. What adjusting entry is made at the end of a period, if property 

taxes in the amount of 480.00 are accrued, are not recorded, 
and are not paid? 

b. What entry is made at the end of a period, if the estimated 
federal income tax for the period is $500.00? 

c. Are income taxes an operating expense? Explain. 

6. a. Is it necessary to have a Reserve for Sinking Fund account, if a 

sinking fund is created? Why or why not? 

6. Is it necessary to have a sinking fund, if a Reserve for Sinking 
Fund account is created? Why or why not? 

c. If the corporate balance sheet shows both a Sinking Fund and a 
Reserve for Sinking Fund should the balances of both agree? 
Explain. 

d. As the holder of a bond which is not to be paid for 20 years, 
would you prefer that the issuing company keep both a sinking 
fund and a Reserve for Sinking Fund account? Why? 

e. As a stockholder would you oppose either or both? 

/. Does the creation of a sinking fund reduce the possibility of 
profit distributions to stockholders? Explain. 

7. If working capital is the excess of current assets over current 
liabilities, how does the creation of a Reserve for Working Capital 
accomplish its purpose? 

8. Assume that a $200,000.00 building is purchased with money 
realized from the sale of a bond issue at par. Assume further that 
the company anticipates making an allowance for depreciation each 
year equal to 2j^ per cent of the cost price of the building, and it 
intends to provide a sinking fund to retire the bonds when due. 



Ch. XXVI] RESERVES AND. FUNDS 419 

What is the effect on the balance sheet and the statement of profit 
and loss of the provision for depreciation and the creation of the fund? 
If a fund is created why is a depreciation allowance necessary? 
9. a. Do you believe a company could create a secret reserve by over- 
depreciating its physical assets? 
6. What do you mean by a secret reserve? 

c. Suggest other methods by which secret reserves are created. 

d. Is the creation of a secret reserve desirable? Explain. 

10. What is a fund? 

11. If your college class is accumulating a fund to give to your school 
on graduation, just what does the class have in the fund? 

12. Why would a business enterprise create a fund? 

13. Suppose your city issued $10,000,000.00 of 20-year bonds. Suppose 
also it has a Sinking Fund Committee consisting of the Mayor, the 
City Controller, and a banker. 

a. Would the city have to give the Sinking Fund Committee any 
money each year? If so, what would the committee do with it? 

fc. Do you think it would be satisfactory if the Sinking Fund Com- 
mittee bought some of the city bonds? 

c. What entry should be made on the books of the city, if cash was 
given to the committee? 

d. What entry should be made on the city books for interest col- 
lected by the committee? 

14. Suppose a corporation has the following accounts among others: 
Cash, $100,000.00; Sinking Fund, $100,000.00; Bonds Payable, 
$100,000.00; Reserve for Sinking Fund, $100,000.00; Capital Stock, 
$100,000.00; Surplus, $100,000.00. It has 1,000 shares of stock 
outstanding. 

a. What is the par value of a share? 
6. What is the book value of a share? 

c. Give the entry or entries if the bonds are paid off. 

d. Give any other entries which should be made after the bonds are 
paid off. 



CHAPTER XXVII 

BONDS 

Any discussion of corporation accounting is incomplete without 
a consideration of the subject, the accounting for bonds. Since 
such consideration was not included in the preceding chapters, 
this chapter is devoted to it. 

As a topic, bonds belong in the fields of finance and law. The 
use of bonds, however, results in financial transactions which 
must be recorded and presented according to sound accounting 
principles. As in many other instances, it is not possible to 
record and present properly the financial facts pertaining to 
bonds without an adequate understanding not only of the facts 
in the particular instance but of the subject of bonds in general. 

Definition 

A bond, from the standpoint of accounting, may be considered 
a promise, under seal, to pay a definite sum of money, at a 
definite future date, to another person or bearer. 

It will be noticed that a bond is much the same as a promissory 
note. It differs in one important respect; it is made under seal. 
Under seal means that the promisor has not only signed the 
bond but attached some mark to show that he has made the 
promise solemnly and intends it to be binding. In lieu of 
attaching or making a seal, the promisor may use a form with 
the seal indicated thereon. 

Most bonds are not only promises to pay principal sums of 
money at definite future dates but are also promises to pay 
interest thereon, usually on a semiannual basis. A bond is 
usually a definite part of a particular issue, thus a corporation 
may borrow $100,000.00 by means of bonds, and the various 
bonds of the issue may be in amounts of $1,000.00, $500.00, 
$100.00, or $50.00. Bonds of $50.00 or smaller denomination 
are known as baby bonds. 

The use of bonds differs from the use of notes in that the former 
are used for long-term financing, the latter usually for short- 

420 



Ch. XXVII] BONDS 421 

term. Bonds may not mature for years; issues of 10-year, 20- 
year and even longer-term bonds are common. Corporations 
have made such extensive use of bonds in connection with their 
borrowings that an accounting consideration of bonds is usually 
limited to corporate bonds; the treatment in this chapter will 
be so limited. 

Some Popular Classes of Bonds 

It should be noticed that the heading indicates that only 
some popular classes of bonds are to be considered in this section. 
A complete classification of bonds is too extensive a study to be 
attempted in an elementary text on accounting. The accounting 
student should be familiar, however, with the meaning of the 
popularly known classes of bonds. One classification of bonds 
divides them into government and private bonds. Government 
bonds include the various issues of federal, state, county, munici- 
pal, and school district bonds. Private bonds include all bonds 
not issued by a governmental body. 

Another classification of bonds is based on the security behind 
them. So-called unsecured bonds arc those for which particular 
assets have not been pledged as security. Secured bonds are 
those for which particular assets have been pledged as security. 
The expression secured bond does not imply that at a particular 
time the pledged security is a complete or adequate protection 
for the bond issue. 

Debenture Bonds. Debenture bonds are an illustration of 
unsecured bonds. The holders of debentures are merely long- 
term creditors of the corporation and have no prior claim over 
other creditors to any of the assets of the corporation. 

First Mortgage Bonds. First mortgage bonds are an illustra- 
tion of secured bonds. A bond so named indicates one of an 
issue secured by a first lien on certain specific real property of the 
issuing corporation. The lien may be exercised in the interest 
of the bondholders in the event of default in the payment of 
principal when due or interest during the term of the loan. 
There may be second, third, and other numbered mortgage 
bonds issued with certain specific real property as security. 
The numbers indicate the order in which the various issues 
rank with respect to claim on the pledged property. 

Other popular classes of bonds are 



422 ACCOUNTING FUNDAMENTALS [Ch. XXVII 

Collateral frust Bonds. An issue of collateral trust bonds is 
secured by stocks or bonds or both, which are owned by the 
debtor corporation but are deposited with a. trustee for the 
bondholders as collateral security for the issue. 

Sinking Fund Bonds. Sinking fund bonds require the debtor 
corporation to accumulate funds to meet the issue at maturity. 

Serial Bonds. Serial bonds are those which require the pay- 
ment of parts of the issue periodically. 

Income Bonds. Income bonds are bonds the interest payments 
on which are conditioned on net earnings. Such bonds may or 
may not be secured. 

Guaranteed Bonds. Guaranteed bonds are those the principal 
or interest on which or both are guaranteed by another company. 

Refunding Bonds. Refunding bonds are those issued in 
exchange for or to redeem a previous issue. 

Convertible Bonds. Convertible bonds may be exchanged for 
the stock of the issuing corporation. 

Callable Bonds. Callable bonds may be called for redemption 
by the debtor corporation prior to maturity. The call price is 
usually in excess of the par value of the bonds. 

Gold Bonds. Gold bonds are bonds which specify payment at 
maturity in gold, if demanded by the holders. 

Coupon Bonds. Coupon bonds are bonds the interest pay- 
ments on which are provided for by coupons attached to the 
bonds. Each interest payment to be due on a bond is represented 
by a coupon; each coupon is a promise of the debtor corporation 
to pay the particular amount of interest due on the date specified. 
The holder of a coupon bond clips the proper coupon at interest 
periods and deposits it as a cash item in his bank account. The 
coupons are payable usually at the bank of the issuing corpora- 
tion. Coupon bonds are payable usually to bearer and are 
transferable upon delivery. 

Registered Bonds. Registered bonds are those the ownership 
of which is registered with the debtor corporation or its transfer 
agent and are payable only to the registered owner at maturity. 
Transfer of ownership must be accompanied by transfer of 
registration. A bond may be registered as to principal or 
principal and interest. If principal alone is registered, the bond 
carries coupons for the payment of interest. If both principal 
and interest are registered, interest is paid by check. 



Ch. XXVII] BONDS 423 

Authority to Issue Corporate Bonds 

The approval of the stockholders is usually necessary before a 
board of directors may provide for a corporate bond issue. If 
the company has both common and preferred stock, the common 
stockholders may have to authorize the issue and the preferred 
stockholders give their consent. Bonds are evidences of debt; 
they are liabilities of the corporation. Since bonds are used for 
long-term borrowings, the lenders frequently require the pledge 
of specific property or collateral, as security for the loan. Such 
pledging of specific assets of the corporation is a matter which 
requires stockholder action since it places another group the 
bondholders ahead of them with respect to the pledged assets, 
in case the company meets financial reverses. 

Quotation of Bond Prices 

Bond values are shown invariably on the books of a cor- 
poration at par value figures. Par is the face value of a bond. 
As previously stated, bonds are issued usually in amounts of 
$1,000.00, $500.00, and $100.00; $50.00 bonds and bonds of 
even smaller denomination arc issued sometimes; $1,000.00 
is the usual par value of a corporate issue. 

The market price of bonds is expressed on a $100.00-value 
basis. A $1,000.00 bond which is sold for $1,140.00 is said to 
have sold at 114; a $1,000.00 bond offered for sale at $920.00 
is quoted at 92. Fractional dollar values for bonds are quoted 
on the New York Stock Exchange in eighths, thus 110 % means 
a price of $1,108.75 for a $1,000.00 bond. Fractional dollar 
values of the bonds of the United States are quoted on the 
New York Stock Exchange in thirty-seconds, thus 101-28 is 
101 28-32 or $101.875 or $1,018.75 for a $1,000.00 bond. 

Bond Expenses 

Typical expenses in connection with an issue of bonds are the 
Fees paid to lawyers and accountants for professional services 
and the cost of the bond paper and engraving. Such expenses 
should be prorated over the life of the bonds because they are a 
cost of obtaining the use of the money for the period represented 
by the life of the issue. The problem of the amortization of these 
costs is simplified, if they are charged to Unamortized Bond 



424 ACCOUNTING FUNDAMENTALS [Ch. XXVH 

Discount and Expense, if the bonds are sold at a discount, or to 
Unamortized Bond Premium, if sold at a premium. It is not 
strictly logical to charge these expenses to the Unamortized Bond 
Premium account when the bonds are sold at a premium but 
it is done in the interest of simplicity. 

Bonds Sold at a Discount 

If bonds are sold at less than par value, the difference between 
par and selling price is charged to Unamortized Bond Discount 
or Unamortized Bond Discount and Expense account. The 
discount is really interest paid in advance to investors as an 
inducement to purchase the bonds. The principle of discount 
as additional interest is illustrated by the following example. 
Suppose a borrower needs approximately $500.00 for a period 
of six months. In order to procure the money he wants to use 
the note of a customer which he holds, in the amount of $500.00. 
The note bears interest at 6 per cent per annum and is due in 
six months. The borrower offers that note to the lender for the 
sum of $490.00. In view of the nature of the risk involved, the 
borrower offered a $10.00 discount inducement, in addition to 
the 6 per cent interest, by offering to sell the note at $490.00. 

It is customary to carry Unamortized Bond Discount and 
Expense account on the books and to present it on the balance 
sheet as a deferred charge a prepaid expense. Each period a 
portion of Unamortized Bond Discount and Expense is written 
off (amortized) as an additional interest expense of the bonds. 
At the maturity of the bonds, the account Unamortized Bond 
Discount and Expense should not have any balance. 

The treatment of Unamortized Bond Discount and Expense 
account, with respect to the strictly discount item, is quite a 
contrast to the treatment recommended for the account, Discount 
on Capital Stock. Discount on Capital Stock is treated as an 
amount of capital not paid in to the corporation. Bond discount 
is treated as interest paid in advance. 

If the entire issue of bonds matures at a fixed future date the 
Unamortized Bond Discount and Expense account may be 
amortized on a straight-line basis so that each period is charged 
with an equal amount. 

If the bonds are to be redeemed serially the Unamortized 
Bond Discount and Expense account may be amortized on the 



Ch. XXVII] 



BONDS 



425 



basis of the amount of bonds outstanding. Under this plan a 
fractional part of the discount and expense is taken periodically. 
The numerator of the fraction is the amount of bonds outstanding 
in a period, the denominator is the total of the bonds outstanding 
for all periods. Assume: On January 1 of the current year a 
$300,000.00 bond issue due in ten years was sold at a discount of 
10 per cent, interest to be 5 per cent payable semiannually on 
January and July 1. One-tenth of the bonds are to be redeemed 
each January 1. Under the bonds outstanding method the 
amount of the discount to be amortized each interest period 
is determined as follows: 



Year 


Bonds Outstanding 


Fractional Part of 
Total 


It early Amount 
Amortized 


1 


$ 300,000.00 


3 ^C5 


$ 5,454.55 


2 


270,000.00 


2 K65 


4,909 09 


3 


240,000.00 


2 K65 


4,363.63 


4 


210,000.00 


2 K65 


3,818.18 


5 


180,000.00 


: Me5 


3,272.72 


6 


150,000 00 


^65 


2,727.27 


7 


120,000.00 


l *i*5 


2,181.82 


8 


90,000.00 


%65 


1,636 36 


9 


60,000.00 


%63 


1,093.91 


10 


30,000.00 


^65 


515 47 




$1,650,000.00 


16 5f65 


S30,000 00 



It will be noticed that the total discount to be amortized 
(10 per cent of $300,000.00) is $30,000.00, the total of the last 
column. The fractions in Column 3 are obtained by considering 
the number of bonds outstanding each period in relation to the 
total for all periods. The first fraction in Column 3 is a reduction 
from the fraction 300,000 over 1,650,000. The other fractions 
are derived similarly. 

The amortization each interest period is one-half of the 
appropriate amount shown in the column headed Yearly Amount 
Amortized. 

The amortization of the bond discount by either of the plans 
described above is not scientific, as neither allows for interest 
on interest. They are used in practice for the same reason that 
the straight-line method of depreciation is used, because of their 
simplicity. 



426 ACCOUNTING FUNDAMENTALS [Ch. XXVII 

If bonds are called prior to maturity the unamortized bond 
discount and expense applicable to the redeemed bonds should 
be charged to the Loss (or Profit) Retirement of Bonds account, 
which maj r be closed directly to Surplus. Assume: A cor- 
poration issued on January 1 of a given year $200,000.00 ten-year 
6 per cent bonds at a discount of 10 per cent. On January 1 
six years later one-half of these bonds was redeemed at par. 
Between the date of issue and the date when one-half the bond 
issue was redeemed, $12,000.00 of the total of $20,000.00 of 
bond discount had been amortized. One-half of the $8,000.00 
unamortized discount is applicable to the redeemed bonds, 
consequently $4,000.00 of the balance of the Unamortized Bond 
Discount and P]xpense account should be charged to Loss 
Retirement of Bonds. 

Bond Premium 

When bonds are sold at a price in excess of par the difference is 
credited to Unamortized Bond Premium account. The sale 
of an issue of bonds at a premium indicates the interest rate 
carried by the issue is higher than necessary under the circum- 
stances. The proper interest rate cannot always be determined 
in advance of the issue, hence the sale of the bonds at a premium 
or discount. As indicated previously the expenses connected 
with the issue are debited to the Unamortized Bond Premium 
account and the net figure is allocated over the life of the bonds 
in the same way as was indicated for Unamortized Bond Discount 
and Expense account. 

In the balance sheet unamortized bond premium is treated 
usually as a deferred credit. Most deferred credit items are 
absorbed as income in subsequent periods but in the case of 
Unamortized Bond Premium account a portion of the account 
is credited each period to Interest on Bonds, thereby reducing a 
periodic cost account rather than increasing an income account. 

Bond Interest 

Bonds, unlike stocks, are liabilities of the issuing corporation. 
Interest on bonds accrues to the holders. When bonds are sold 
by one owner to another, it is customary to charge not only the 



Ch. XXVII] BONDS 427 

bid and accepted price but accrued interest as well. The 
amount of accrued interest at the time of a sale represents 
income to the seller, if he owned the bonds since the last interest 
period; it represents an asset to the buyer, an amount to be 
returned at the next interest period. A buyer debits the account 
Interest on Investments for the amount of accrued interest paid; 
he credits Interest on Investments for the amount of interest 
received. At the end of the next interest period, the credit to 
Interest on Investments, for the amount of the full six-months 
interest received, will exceed the debit; and the excess will be 
the interest earned on the bonds within that interest period. 
The first interest to be paid on an issue of bonds runs from the 
date of issue regardless of the dates when the bonds were sold. 
The original sale of bonds by the issuing corporation, if made 
at a date later than the date on the bonds, includes a charge for 
accrued interest. 

Coupons often are not presented promptly. Until payment 
is made the corporate balance sheet should show the liability 
on such coupons in the Interest on Bonds Accrued account in the 
current liability section. 

The Computation of Interest on a Bond between Interest Periods 

When a bond is purchased or sold between interest periods, 
interest is calculated on the par value of the bond, at the rate of 
interest carried by the bond, for the time interval between the 
last interest period and the date of purchase or sale. The time 
element is expressed as so many months and so many days from 
the last interest date. 

Assume: A purchased from B on August 13, at 97, a $1,000.00, 
6 per cent bond, the interest on which was payable each April 
and October 1. In addition to a payment of $970.00 for the prin- 
cipal of the bond, it is necessary for A to pay B the interest on 
$1,000.00 at 6 per cent from the last interest date, April 1, to 
the date of purchase, August 13. From April 1 to August 1 
is considered four months and from August 1 to August 13 
elapsed time is taken, namely, twelve days. The interest on 
$1,000.00 at 6 per cent for four months and twelve days is 
$22.00 the amount A must pay B for accrued interest. 



428 ACCOUNTING FUNDAMENTALS [Ch. XXVIJ 

Entry Illustrations 

Assume: A corporation authorized an issue of $300,000.00 
First Mortgage Bonds due in ten years and to bear 5 per cent 
interest payable semiannually on January 1 and July 1. 

1. Suppose on January 1, the date the bonds were authorized, 
the entire issue was sold at par. The entry is 

Cash 300,000.00 

First Mortgage Bonds Payable 300 , 000 . 00 

To record the sale at par of the entire 
issue of 10-year 5 per cent First 
Mortgage Bonds. 

2. Suppose two-thirds of the issue were sold on January 1 
at par. The entry is 

Cash 200,000.00 

First Mortgage Bonds Payable 200 , 000 . 00 

To record the sale at par of $200,- 
000.00 of the First Mortgage Bonds. 

3. Suppose the remaining $100,000.00 of bonds in 2 were sold 
at par on April 1 of the same year. The entry is 

Cash 101,250.00 

First Mortgage Bonds Payable 100 , 000 . 00 

Interest on Bonds 1 , 250 . 00 

To record the sale at par and accrued 

interest for three months of $100,- 

000.00 of the 10-year 5 per cent First 

Mortgage Bonds. 

In the above entry the credit to the account Interest on Bonds 
will offset in part the debit to the same account at the end of the 
interest period. Since a full six months' interest will be paid 

on the bonds on July 1, 19 , it was necessary to charge for the 

three months' interest which had accrued on them at the date 
of sale, April 1, 19 

4. Suppose the entire issue was sold on January 1 to invest- 
ment bankers at a discount of 10 per cent. The entry is 

Cash 270,000.00 

Unamortized Bond Discount and 

Expense 30,000.00 

First Mortgage Bonds Payable 300 , 000 . 00 

To record the sale to investment 



Ch. XXVII] BONDS 429 

bankers of the entire issue of $300,- 
000.00 of 10-year 5 per cent First 
Mortgage Bonds at a discount of 10 
per cent. 

Assumption 4, the last one on page 428, illustrates a very com- 
mon happening the sale of an issue to or the underwriting of 
an issue by investment bankers. The bonds are not always sold 
at a discount. As previously explained the price depends en the 
rate of interest and the extent of the risk involved as well as 
on a number of other factors. The investment bankers make 
their profit by selling the bonds to their customers at a price 
higher than was paid for them or as commission for underwriting. 

5. Suppose the entire issue was sold on January 1 to investment 
bankers at a premium of 10 per cent. The entry is 

Cash 330,000.00 

First Mortgage Bonds Payable 300 , 000 . 00 

Unamortized Bond Premium 30 , 000 . 00 

To record the sale to investment 

bankers, of the entire issue of $300,- 

000.00 of 10-year 5 per cent First 

Mortgage Bonds at a premium of 

10 per cent. 

6. Suppose all bonds are outstanding, were issued at par, and 
interest is to be paid at the end of the first interest period. The 
entries, to record the accrual of the interest for the six months' 
period and its payment, may be made under one of two plans. 

Plan A. 

July 1, 19_ 
Interest on Bonds 7 , 500 . 00 

Interest on Bonds Accrued 7,500.00 

To record six months' interest due 
this day on the $300,000.00, 10-year 
5 per cent First Mortgage Bonds. 

On the date the coupons paid by the bank are given to the 
corporation, the entry is 

Interest on Bonds Accrued 7 , 500 . 00 

Cash 7,500.00 

To record the payment by the bank 
of the interest coupons due July 1, 
19_ on the $300,000.00, 10-year 5 
per cent First Mortgage Bonds. 



430 ACCOUNTING FUNDAMENTALS (Ch. XXVII 

If any bondholders are tardy in presenting their coupons or 
fail to present them, the liability of the corporation because of 
such coupons is shown as a credit balance in the Interest on 
Bonds Accrued account. 

Plan B. The following entry may be made for the facts of 
this assumption: 

July 1, 19 
Interest on Bonds 7 , 500 . 00 

Cash 7,600.00 

To record the total amount of inter- 
est coupons due this date on the 
$300,000.00, 10-year 5 per cent 
First Mortgage Bonds. 

If the above entry is made, a check for the full amount of the 
coupon interest is drawn on the regular checking account of 
the corporation and used to open a coupon checking account at 
the bank. As coupons reach the bank they are charged to the 
special deposit account for coupons. Any balance remaining in 
the coupon bank account at the end of a fiscal period is an asset 
equal to the liability on unpaid coupons. 

Interest entries hi the subsequent illustrations will follow 
plan B. 

7. Suppose all bonds are outstanding, were issued at the 
discount illustrated in 4, that a semiannual interest payment is 
made and the Unamortized Bond Discount and Expense account 
is amortized on the straight-line basis. The entries are 

Interest on Bonds 7 , 500 . 00 

Cash 7,500.00 

To record the semiannual interest 
payment. 

Interest on Bonds 1 ,500 00 

Unamortized Bond Discount 

and Expense 1 , 500 . 00 

To amortize one-twentieth of the 
Unamortized Bond Discount and 
Expense account. 

8. The entries at the time interest is paid according to the 
facts stated in 5 are 



Ch. XXVII] BONDS 431 

Interest on Bonds 7 , oOO . 00 

Cash 7,500.00 

To record the semiannual interest 
payment. 

Unamortized Bond Premium 1,500.00 

Interest on Bonds 1 ,500.00 

To amortize one-twentieth of the Un- 
amortized Bond Premium account. 

9. Suppose the bonds are redeemed at the end of the ten-year 
period by payment in cash. The entry is 

P'irst Mortgage Bonds Payable 300,000.00 

Cash 300,000.00 

To record the redemption in cash of 
the entire issue of $300,000.00, 10- 
year 5 per cent First Mortgage 
Bonds. 

If, prior to maturity, a corporation buys some of its out- 
standing bonds as treasury bonds at a discount or premium, the 
difference between par and the price paid is debited or credited to 
an account title which may become a surplus item. 

Some Bond Retirement Problems 

Many bond issues are retired during a fiscal period. Assume 
that bonds originally issued at a discount mature on May 1, 19 A 
and that they are sinking fund bonds that required a reserve for 
sinking fund to be maintained. Assume that the corporate 
books are adjusted each December 31. On May 1, 19A entries 
are necessary to record the 

a. Payment of the interest for the last six months. 

b. Amortization of any remaining discount on the bonds. 

c. Last contribution to the sinking fund. 

d. Net earnings in the sinking fund since the last report. 

e. Corporate check to cover any deficiency in the sinking fund. 
/. Last transfer of earned and free surplus to the Reserve for 

Sinking Fund account to bring it into agreement with the 



432 ACCOUNTING FUNDAMENTALS [Ch. XXVII 

sinking fund but not in excess of the face of the outstanding 

bonds. 

g. Retirement of the bonds out of sinking fund monies. 
h. Return to the checking account of the corporation any 

excess remaining in the sinking fund. 
i. Removal of the Reserve for Sinking Fund account from the 

books. 

Bonds in the Balance Sheet 

Authorized and unissued bonds are not an asset to a corpora- 
tion; neither are they a liability. The amount of any authorized 
and unissued bonds is indicated on the balance sheet- as a foot- 
note or as a subtraction from the total amount authorized as 
in the illustration below. 

Treasury bonds, a corporation's own bonds reacquired, are 
shown in the Treasury Bond account with a debit balance 
but they do not represent an asset. They are debts which 
have been paid; consequently, they could not be assets. If 
the treasury bonds are canceled, the Treasury Bond account is 
closed into the Bonds Payable account and the amount of that 
liability account is permanently reduced. If the treasury 
bonds are kept alive for the purpose of possible resale, the 
Treasury Bond account remains open on the books with a 
debit balance but it is shown in the balance sheet as a deduction 
from the amount of authorized bonds in order to show the true 
bond liability of the corporation. 

The following illustration shows a method of treating bond 
facts in a balance sheet: 

First Mortgage 6 per cent Bonds Authorized. . $2CO,000.00 

Less: 

Unissued Bonds. . $50,000.00 

Treasury Bonds 5,000.00 55,000.00 

Outstanding Bonds .. $145,000.00 

Another method of presenting the same facts is 

First Mortgage 6 per cent Bonds Issued $150,000.00 

Less: 

Treasury Bonds 5,000.00 

Outstanding Bonds . . . 7. $145,000.00 



.Oh. XXVII] BONDS 433 

In this case a footnote on the balance sheet indicates that 
$50,000.00 of First Mortgage, 6 per cent Bonds are authorized 
but unissued. 

Subscription to Bonds 

Bonds may be sold on the subscription plan the same as stock. 
When sold in this way the entries are similar in style to those 
illustrated in Chapter XXIV for sales of stock on the subscription 
plan. 

Auxiliary Records 

A corporation with bonds outstanding requires supplementary 
records to keep the necessaiy information about the bonds and 
the interest paid on them. Bonds registered as to principal 
and interest must be listed in a register to show such items as 
the number of the bond, date issued, maturity date, par value, 
name and address of owner and name of transferee in case the 
bond is transferred. Space must bo provided also for a record 
of the interest payments made. Bonds, registered as to prin- 
cipal only, require provision for all of these records except those 
for interest payments. 

Record must also be kept of all coupons to shoAv those paid 
and those due and unpaid. 

Recording Bonds from the Investor's Standpoint 

A corporation issuing bonds either above or below par should 
attempt to keep correctly its periodic interest expense on the 
bonds. It should amortize the amount of the premium or 
discount on the bonds over their life. An investor in bonds 
does not have the same kind of responsibility for determining 
the correct income earned on bonds purchased at a premium 
or a discount. He may not intend to hold the bonds to maturity. 
It is quite likely that most individual investors completely 
ignore the amortization of bond premium and discount as their 
records are kept on a cash basis. They record bonds purchased 
at cost price in an account called Bonds Owned, Securities Owned, 
Stocks and Bonds, Investments, or some similar title. 



434 ACCOUNTING FUNDAMENTALS [Ch. XXVII 

The responsibility to determine interest income on bonds 
correctly is greater in the case of institutions holding large 
amounts of bonds, and with trustees of estates especially where 
there are remaindermen. 

Assume: A purchased from B on August 13, 19A, at 97, a 
$1,000.00, 6 per cent bond on which interest was payable each 
April and October 1. B purchased the bond from the issuing 
corporation at 99. 

1. The entry on J3's books on August 13, 19A is 

Cash 092.00 

Loss Sale of Securities 20 . 00 

Bond Investment 990 . 00 

Interest on Investments 22 . 00 

To record the sale of bonds at 97 plus accrued 

interest for four months and twelve days. 

2. The entry on A's books on August 13, 19A is 

Bond Investment 970.00 

*Interest on Investments 22 . 00 

Cash 992.00 

To record the purchase of bonds at 97 and 
accrued interest for four months and twelve 
days. 

3. The entry on A's books on October 1, 19 A is 

Cash 30.00 

Interest on Investments 30 . 00 

To record the receipt of six months' interest 
on bonds. 

Comments on Some Methods of This Chapter 

In concluding this chapter, it is desirable to comment on 
several matters which have been explained in it. The amortiza- 

* The debit might have been to Accrued Bond Interest Receivable, as 
the bondholder will receive back all the cash given the seller for interest 
when interest is paid at the end of the 6-month period. In 3 above the 
$80.00 includes the $22.00 given the seller and $8.00 earned by A between 
August 13, 19A and October 1, 19A. 



Ch. XXVII] BONDS 435 

tion of bond discount and bond premium was explained on simple 
arithmetical bases. There are other plans more scientific and 
accurate than those given. For these other plans the student is 
referred to more advanced texts. The methods of handling 
bond discount and bond premium on the books and on the 
balance sheet are the usual orthodox plans followed in general 
practice. They are not the most scientific methods of handling 
and treating these items on the books and the balance sheet. 
Here again, the student is referred to more advanced texts. 

QUESTIONS 

1. a. What is a bond? 

6. What do you mean by under seal? 

c. Distinguish a bond from a note. 

d. Is a bond secured, necessarily? 

e. Does the United States have any outstanding bonds? Do you 
happen to know if they are selling in the market at par, above, 
or below par? 

2. What do you mean by a secured bond? An unsecured bond? A 
debenture bond? 

3. Do you think a corporation would need a sinking fund, if its out- 
standing bonds were serial bonds payable in equal annual amounts 
over their life? Explain. 

4. What is a first mortgage bond? A convertible bond? A callable 
bond? 

5. Does a corporation know who holds its bonds? Explain. 

6. How may interest on bonds be paid by the debtor corporation? 
Explain. 

7. Why is it desirable and customary that stockholders approve a 
bond issue before issuance? 

8. a. Suppose you purchase a $100.00 government bond at 102 2 % 2 , 

how much do you pay for it? 

6. How much would you have to pay for four $1,000.00 bonds, if 
you bought them at 90^ ? 

9. Why is it customary for the buyer to pay the seller for the accrued 
interest on a boncl, while the purchaser of stocks pays only the 
market price? 

10. Expenses connected with the issuance of bonds are charged to 
what account? Name a few of such expenses. 



436 ACCOUNTING FUNDAMENTALS [Ch. XXVII 

11. What accounts show whether bonds were issued at amounts above 
or below par? 

12. Can you see any fundamental difference between a discount allowed 
when stock is issued and a discount allowed when a bond is issued? 
Are both expenses? Is either an expense in whole or in part in the 
year of issue? 

13. In which section of a balance sheet should each of the following 
accounts be found? 

a. Unamortized Bond Discount and Expense. 
6. Accrued Bond Interest Payable. 

c. Treasury Bonds. 

d. Unamortized Bond Premium. 

e. Premium on Capital Stock. 
/. Reserve for Sinking Fund. 
g. Bonds Payable. 

A. Sinking Fund. 

14. a. If the account Unamortized Bond Discount and Expense is 

being amortized each year, what is the annual adjusting 
entry? 

b. If the account Unamortized Premium on Bonds is being amor- 
tized each year, what is the annual adjusting entry? 

15. Bonds may be retired by payment in cash, by refunding, or by 
conversion. Explain these three plans and give the type of entry 
needed to record a retirement under each. 

16. a. Are treasury bonds an asset? Why? 

b. How are treasury bonds shown on a balance sheet? 

17. Why do you think unissued first mortgage bonds may be acceptable 
as collateral security for a loan while unissued capital stock may not 
be acceptable even if the company has paid a high rate of dividend 
over a long period of time? 

18. In a given year during the lifetime of a bond issue, what is the 
effect on the statement of profit and loss of amortizing the premium 
realized at the time the bonds were sold? 

19. Two corporations each need cash to acquire fixed assets. Corpora- 
tion A sells $100,000.00 of capital stock at a 10 per cent premium 
and Corporation B sells $100,000.00 of bonds at a 10 per cent 
premium. What is the effect of issuing these securities on the 
net worth of each of these corporations? 

20. a. If you buy a share of stock at $120.00 and it pays a dividend of 

$6.00 a year, what rate of return are you receiving? 



Ch. XXVII] BONDS 437 

b. If the share of stock referred to in a has a par of $100.00, what 
dividend rate is being paid by the company? 

c. If you buy a $1,000.00 4 per cent bond at 80, what annual rate 
of return are you receiving on cost? 

d. If the bond matures in two years, will you have earned the 
same, a higher, or a lower rate of return than given in your 
answer to c? Explain. 



CHAPTER XXVIII 
MANUFACTURING ACCOUNTS AND STATEMENTS 

Up to this point, practically all the discussion and illustrations 
of this text have been limited to the accounts and statements 
needed by an enterprise doing a trading business. Consideration 
will now be given to the accounts and statements of an enterprise 
engaged in a manufacturing business. 

A trading business sells essentially the same product it buys. 
A manufacturer buys one product and by means of labor applied 
to it transforms or constructs it into another more valuable 
product or products which he sells. The raw product which 
one manufacturer buys may be the finished product of another 
manufacturer. In the woolen industry, for example, a scourer 
prepares the raw wool for the spinner; the finished product of 
the scourer is the raw material of the spinner who manufactures 
yarn from it. The yarn which is the finished product of the 
spinning mill is raw material to the weaving enterprise which in 
turn produces a cloth fabric. The finished product of the 
weaving mill is the raw material of other manufacturers such as 
tailors. This illustration from the woolen industry might be 
supplemented with illustrations from many other industries. 

All the accounts and statements considered heretofore may 
be essential to a manufacturer. Because of the character of a 
manufacturing business, however, certain additional accounts 
are needed. A consideration of these new accounts, and the 
treatment of them in the accounting processes already considered 
and in the statements, is the purpose of this chapter. 

Elements of Manufacturing Cost 

In manufacturing a product there are three basic costs 
material costs, labor costs, and manufacturing expenses. 

Material Costs. Material costs are the costs of all substances 
or things which enter into the finished product. These sub- 
stances are called raw materials because they are to be converted 

433 



Ch. XXVIII) MANUFACTURING ACCOUNTS 439 

into or become a part of the new product. Thus woolen cloth 
is raw material to a tailor who converts it into a suit of clothing. 
Similarly, a speedometer is raw material to an automobile 
manufacturer who is going to use it as a part of the automobile 
he is manufacturing or assembling. In the manufacture of 
office desks, wood, nails, screws, metal caps for legs, locks, 
glue, paint, and so on are materials entering into the new product. 

Some substances or things used in manufacturing do not 
enter into the product but are necessary in its creation. They 
are factory supplies and enter into manufacturing-cost deter- 
mination, not under the heading Raw Materials but under 
titles such as Factory Supplies or Factory Expenses. For 
example, in the manufacture of office desks, sandpaper, cleaning 
and polishing fluids, and rags do not become a part of the product 
but they are necessary in its manufacture. 

Labor Costs. Labor costs are the costs of the services of 
employees whose work is connected with manufacturing; they 
are divided into direct and indirect labor costs. Direct labor 
costs are the costs of the services of employees who work directly 
on the raw materials whether by hand labor or with the aid of 
machines. 

Indirect labor costs are the costs of the services of employees 
who labor indirectly in the creation of the product, such as 
superintendents, foremen, engineers, repairmen, firemen, watch- 
men, tool grinders, timekeepers and elevator men. 

Manufacturing Expenses. Manufacturing expenses are known 
also as Factory Overhead, Factory Burden, Indirect Factory 
Expenses, Indirect Manufacturing Expenses, and Manufacturing 
Overhead. In this classification are expenses such as: rent of 
factory; taxes, insurance, repairs, and depreciation of the 
factory building, if owned; light, heat, and power; depreciation 
of machinery; factory supplies; and repairs to machinery. 

Account Titles Peculiar to a Manufacturing Enterprise 

The liability, net worth, and income accounts of a manu- 
facturer are the same as those heretofore considered for a trading 
enterprise. 

A number of fixed asset titles used by manufacturing enter- 
prises, such as Land, Buildings, Machinery, and Patterns were 
considered in Chapter II. Additional and equally descriptive 



440 ACCOUNTING FUNDAMENTALS [Ch. XXVIII 

fixed asset titles, such as Factory Furniture and Fixtures, and 
Tools are used when necessary. 

Among the current assets of a manufacturer, the principal 
new titles are for inventories. Heretofore, the use of the unquali- 
fied word inventory in the accounts referred to the inventory of 
merchandise. A manufacturer cannot list inventory so simply; 
his inventory is in three parts raw materials, partly finished 
goods, and finished goods. 

Inventory of Raw Materials Account. The Inventory of Raw 
Materials account presents no new problems. The valuation 
of raw materials inventory is usually on a cost or a cost or market 
basis as explained in Chapter XIV for inventory of merchandise. 

Inventory of Work in Process Account. Sometimes the account 
title Inventory of Partly Finished Goods is used to designate 
partly manufactured products. The account title which is the 
heading of this paragraph will be the one used in this chapter. 
Some enterprises, especially those engaged in the production 
of a product where the process takes but a few hours, seldom 
have an inventory of work in process. 

An inventory of work in process should be valued to include 
the cost of the raw materials used and the labor applied in the 
creation of the partly finished goods as well as a proportionate 
share of the indirect factory expenses. In the absence of an 
adequate cost-accounting system, the valuation of an inventory 
of work in process is likely to be an arbitrary valuation, especially 
if the enterprise manufactures a number of products. 

Inventory of Finished Goods Account. Inventory of Finished 
Goods is the account title used to record the value of manu- 
factured goods on hand. If some finished goods were on hand 
at the end of the preceding period, in the absence of exact 
inventory records it may be assumed they were sold during the 
current period. The assumption just mentioned makes possible 
the valuation of all finished goods on hand at the end of a period 
at current cost price, if that basis of valuation is followed. 

The expense accounts of a manufacturer include a number of 
accounts not considered previously. 

Direct Labor Account. Direct Labor is the account title to 
which is charged the wages earned by workmen who labor 
directly, either by hand or with the aid of machines, in the 
creation of the finished product of an enterprise. 



Ch. XXVIII] MANUFACTURING ACCOUNTS 441 

Indirect Labor Account. Indirect Labor is the account to 
which is charged the wages or salaries earned by^workmen whose 
labor is not directly applied in the creation of the finished product, 
such as superintendents, foremen, and firemen. 

Wages and salaries earned by indirect labor are charged very 
often to accounts other than Indirect Labor. For example, 
the salary of the superintendent may be charged to Superin- 
tendent's Salary; the salaries and wages of engineers and firemen 
may be charged to Light, Heat, and Power; the wages of 
machine repairmen to Repairs to Machinery; and so on. 

Other expense account titles peculiar to a manufacturer 
include such accounts as: Rent of Factory Building; Property 
Taxes on Factory, Factory Building Insurance, Repairs to 
Factory Building, and Depreciation of Factory Building, if the 
factory is owned; Light, Heat, and Power; Depreciation of 
Machinery; Factory Supplies; Repairs to Machinery; and so on. 
Such accounts are manufacturing expenses. 

Cost of Goods Manufactured and Cost of Goods Sold 

Cost of goods manufactured means the cost of producing the 
finished products turned out by a factory during a fiscal period. 
Cost of goods sold means, in a manufacturing enterprise, the 
cost of producing the finished product which was marketed during 
the period, whether made in that period or a prior one. In 
its first period of operation, the cost of goods sold by a factory is 
the cost of the goods manufactured less the inventory value of 
any unsold finished products. In any period other than the 
first, the cost of goods sold is the cost of goods manufactured 
plus the value of the finished goods on hand at the beginning 
of the period, less the value of finished goods inventory at the 
end of the period. 

A schedule to show the detailed costs of manufacturing in a 
period and the manufacturing cost of the goods sold is shown 
on the next page. 

The schedule on page 442 is designed to bring out two important 
cost figures. First, the cost of goods manufactured, $86,800.00 
in the illustration, and secondly, the manufacturing cost of 
goods sold, $85,000.00 in the illustration. Suppose the Hall 
Machine Company manufactures only one kind of machine 
and only one size. If it manufactured 434 machines in the 



442 ACCOUNTING FUNDAMENTALS [Ch. XXVIII 

SCHEDULE A 
THE HALL MACHINE COMPANY 

STATEMENT OP THE COST OF GOODS MANUFACTURED AND COST OF GOODS 

SOLD 
January 1, 19 to December 31, 19 

Inventory of Work in Process, January 1, 19 $ 9,000.00 

Cost of Raw Materials: 

Inventory of Raw Materials, January 1, 19 . $ 1,790.00 

Purchases of Raw Materials 35,000.00 

Transportation In 700.00 

$37,490.00 

Less: 

Inventory of Raw Materials, 

December 31, 19_ $1,300.00 

Purchase Returns and Allowances . . . 600 .00 1 , 900 . 00 

Cost of Raw Materials Used 35,590.00 

Direct Labor 31,000.00 

Manufacturing Expenses: 

Light, Heat, and Power $ 2, 160.00 

Indirect Labor 9,000.00 

Factory Supplies 650.00 

Insurance 700 .00 

Property Taxes 480.00 

Depreciation of Machinery 500 00 

Depreciation of Building 320 00 

Total Manufacturing Expenses 13 ,810 00 

Total $89,400.00 

Less: Inventory of Work in Process, December 31, 19__ 2,600.00 

Cost of Goods Manufactured $86,800.00 

Inventory of Finished Goodj, January 1, 19 4,400.00 

Cost of Goods Available for Sale $91 ,200 .00 

Inventory of Finished Goods, December 31, 19_ 6,200.00 

Manufacturing Cost of Goods Sold $85,000.00 

period just ended then the average cost of manufacturing a 
machine was $200.00 ($86,800.00 ~ 434). The inventory 
of finished goods on hand at the end of the period is priced at the 
average cost. The $6,200.00 inventory of finished goods, 

December 31, 19 , is the value of 31 machines on hand at the 

end of the period. 

The inventory of finished goods at the beginning of the period 
was valued at that time at the average cost price of the period 
just ended, 20 machines at $220.00 each a total of $4,400.00. 
The average cost price of a machine sold in the period just 



Ch. XXVIII] MANUFACTURING ACCOUNTS 443 

closed will not agree with the average cost of producing a machine 
in the period because of the difference in the manufacturing 
cost of the machines on hand at the beginning of the period 
and those produced during the period. If 20 machines were 

on hand January 1, 19 and 434 were manufactured during 

the year, then 454 machines represent the total available for 
sale during the period. Since 31 machines are on hand December 

31, 19 , then 423 were sold. The cost of the 423 machines 

sold was $85,000.00, hence the average cost of a machine sold 
during the period was $200.945. 

The method just illustrated for determining the average cost 
of manufacturing a unit or the average cost price of a unit sold 
cannot be applied in the case of a factory which produces more 
than one product or more than one size of a product. 

The information shown in the Statement of the Cost of Goods 
Manufactured and Cost of Goods Sold is presented very often 
in two statements. One statement is headed the Cost of Goods 
Manufactured, and shows all the facts presented down to and 
including Cost of Goods Manufactured, $86,800.00. The other 
statement is headed Statement of the Cost of Goods Sold; 
it shows the opening and closing finished goods inventories and 
the cost of goods manufactured in the current period as disclosed 
by the Statement of the Cost of Goods Manufactured. 

Statements 

No change in principle is involved in the presentation of the 
balance sheet and the statement of profit and loss for a manu- 
facturing enterprise. 

Because of the increase in the number of items affecting 
the Cost of Goods Sold section of the profit and loss statement, 
it is customary to present that information in a supporting 
schedule. Cost of goods sold is then expressed on the statement 
of profit and loss merely as a summary, with proper reference 
to its supporting schedule. 

The practice of condensing the statement of profit and loss 
is not limited to the Cost of Goods Sold section. Summary 
figures are used frequently for any one or for all of the main 
sections of the statement. Thus the Sales section, the Cost of 
Goods Sold section, or the sections devoted to Selling Expenses, 
General and Administrative Expenses, Other Expenses and 



444 ACCOUNTING FUNDAMENTALS [Ch. XXVIII 

Losses, and Other Income may be expressed as summaries but 
with appropriate reference in each case to a supporting schedule. 
The practice of condensing some or all of the sections of the 
Statement of Profit and Loss avoids the expansion of the state- 
ment to a size where it becomes difficult to handle or understand. 
For use by the management of an enterprise, any summary on 
the statement of profit and loss should be supported by an 
itemized schedule. For use in published reports, supporting 
schedules need not always be shown. 

Balance sheets are also prepared in condensed form. When 
so prepared supporting schedules are set up for each class of 
items condensed in the statement. 

Illustrative Statements 

The balance sheet and a condensed statement of profit and 
loss with supporting schedules for the business of the Hall 
Machine Company are presented on pages 445, 446 and 447. 
Schedule A which shows the cost of goods sold is not repeated 
since it was presented on page 442. 

Adjustments 

The only variations in the procedure of adjusting the books 
of a manufacturing from those of a trading enterprise occur in 
connection with the recording of the inventories on hand at the 
end of the period. The three inventory accounts, Inventory of 
Raw Materials, Inventory of Work in Process, and Inventory of 
Finished Goods are debited for their respective amounts but the 
credits go to new accounts not considered previously; they do 
not go to the Cost of Goods Sold account. 

The determination of the cost of goods manufactured involves 
so many accounts, it is customary for manufacturers, in the 
process of closing their books, to collect all of these manufactur- 
ing-cost accounts in the summary account Manufacturing. 
Since the cost of manufacturing for a period is reduced by the 
amount of any raw materials or partly finished goods on hand 
at the end of a period, it is necessary to credit Manufacturing 
for their amounts. The credit to Manufacturing is offset by 
the debits to Inventory of Raw Materials and Inventory of Work 
in Process 



Ch. XXVIII] 



MANUFACTURING ACCOUNTS 



445 



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446 ACCOUNTING FUNDAMENTALS [Ch. XXVIH 

THE HALL MACHINE COMPANY 

STATEMENT OP SURPLUS 
For the Year JLiided December 31, 19 

Balance, January 1, 19 $5,000.00 

Add: Net Profit for the Period 3,360.00 

$8,360.00 

Less: Estimated Federal Taxes 400.00 

Balance, December 31, 19_ $7,960.00 

THE HALL MACHINE COMPANY 
CONDENSED STATEMENT OP PROFIT AND Loss 

For the Year JLndcd December 31, 19 

Sales $126,080.00 

Less: Sales Returns and Allowances 710.00 $125,370.00 

Less: Cost of Goods Sold (Schedule A) 85,000.00 

Gross Profit on Sales $ 40,370.00 

Less: 

Selling Expenses (Schedule B) $ 24,220.00 

General and Administrative Expenses (Sched- 
ule C) 11,070.00 35,290.00 

Net Profit on Sales $ 5,080.00 

Other Expenses and Losses: 

Sales Discounts $2,370.00 

Loss on Sale of Machinery 150.00 $ 2,520.00 

Other Income: 

Interest Earned $ 200.00 

Purchase Discounts 600.00 800.00 1,720.00 

Net Profit for the Period $ 3,360 00 

SCHEDULE A 

COST OP GOODS MANUFACTURED AND COST OF GOODS SOLD 
(See page 442) 

SCHEDULE B 
SELLING EXPENSES 

Light, Heat, and Power $ 120.00 

Sales Salaries 9,200.00 

Traveling and Entertainment 3 ,000 . 00 

Advertising 7,000.00 

Commissions 4 , 500 . 00 

Insurance 200 .00 

Property Taxes 60.00 

Depreciation of Buildings 40 . 00 

Depreciation of Sales Furniture and Fixtures 100 . 00 

$24,220 00 



Ch. XXVIII] MANUFACTURING ACCOUNTS 447 

SCHEDULE C 
GENERAL AND ADMINISTRATIVE EXPENSES 

Light, Heat, and Power $ 120.00 

Office Salaries 10,000.00 

Postage 110.00 

Office Expenses 140.00 

Insurance 100 . 00 

Property Taxes 60 . 00 

Depreciation of Buildings 40 . 00 

Depreciation of Office Furniture and Fixtures. . . 200.00 

Bad Debts 300.00 

$11,070.00 

The balance of the Manufacturing account is the cost of the 
goods manufactured; it is transferred in the closing process 
to the summary account Trading. Since Trading is also charged 
with all of the selling expense accounts, it must receive credit 
for any finished goods on hand at the end of the period. The 
entry to set up the inventory of finished goods in its own account 
at the end of a period is, therefore, a debit to the Inventory of 
Finished Goods account and a credit to Trading. 

Adjusting Entries Illustrated 

Assume the following supplementary data for the Hall Machine 
Company at the endof the fiscal period. These facts supplement 
the information shown on the books as revealed by a trial 
balance and represent items for which the books must be adjusted. 

1. Inventories, December 31, 19 : 

a. Inventory of raw materials $1 ,300 . 00 

b. Inventory of work in process 2 , 600 . 00 

c. Inventory of finished goods 6,200.00 

2. Insurance expired during the period 1 , 000 . 00 

3. Accruals: 

a. Accrued interest on notes receivable 20.00 

b. Accrued property taxes 600 . 00 

c. Accrued payroll : 

Direct labor $200.00 

Indirect labor 50.00 

Fireman (Light, Heat, and Power) . 6 . 00 

Sales salaries 95 . 00 

Office salaries 100.00 451 .00 

4. Reserves to be increased because of: 

a. Depreciation of buildings 400.00 

b. Depreciation of machinery 500.00 



448 ACCOUNTING FUNDAMENTALS [Ch. XXVD3 

c. Depreciation of sales furniture and fixtures $100 . 00 

d. Depreciation of office furniture and fixtures 200 . 00 

e. Anticipated bad debts 300.00 

5. Estimated federal taxes for the period 400.00 

The adjusting entries are 

Inventory of Raw Materials, December 

31, 19_ 1,300.00 

Inventory of Work in Process, December 

31, 19_ 2,600.00 

Manufacturing 3 , 900 . 00 

To set up the new inventories of raw 
materials and partly finished goods in 
their own accounts and to reduce manu- 
facturing costs thereby. 

Inventory of Finished Goods, December 
31, 19_ 6,200.00 

Trading 6,200.00 

To set up the new inventory of finished 
goods in its own account and to credit the 
Trading account. 

Insurance 1,000.00 

Prepaid Insurance 1 , 000 . 00 

To reduce the Prepaid Insurance account 
by the amount which expired this period. 

Accrued Interest Receivable 20.00 

Interest Earned 20 . 00 

To add to the Interest Earned account the 
interest earned but not collected and to 
set up the asset account. 

Property Taxes 600 . 00 

Property Taxes Accrued 600 . 00 

To record property tax expense for the 
period and the liability thereon. Tax bill 
not yet due. 

Direct Labor 200.00 

Indirect Labor 50 . 00 

Light, Heat, and Power 6 . 00 

Sales Salaries 95 . 00 

Office Salaries 100.00 

Payroll Accrued 451 . 00 

To record wages earned by employees but 
not yet due. 



Ch. XXVIII] MANUFACTURING ACCOUNTS 449 



Depreciation of Buildings 400.00 

Reserve for Depreciation of Build- 
ings 400.00 
To record depreciation for the period. 

Depreciation of Machinery 500.00 

Reserve for Depreciation of Ma- 
chinery 600.00 
To record depreciation for the period. 

Depreciation of Sales Furniture and Fix- 
tures ' 100.00 
Reserve for Depreciation of Sales 

Furniture and Fixtures 100.00 

To record depreciation for the period. 

Depreciation of Office Furniture and 

Fixtures 200.00 

Reserve for Depreciation of Office 

Furniture and Fixtures 200.00 

To record depreciation for the period. 

Bad Debts 300.00 

Reserve for Bad Debts 300.00 

To record the estimated loss through un- 
collectible accounts. 

Surplus 400.00 

Reserve for Federal Taxes 400 . 00 

To record the estimated federal taxes 
for the period. 

Closing the Books 

In closing the books of a manufacturing enterprise it is cus- 
tomary to close the balance of all nominal accounts which show 
manufacturing costs or reductions in such costs into the summary 
account Manufacturing rather than Profit and Loss. It should 
be recalled that Manufacturing receives a credit from the 
adjusting entries for the amount of the raw materials and work 
in process inventories. The balance of the Manufacturing 
account represents the cost of goods manufactured; it is closed 
by transfer to the summary account Trading. 

Trading is charged with the cost of goods manufactured, 
with the amount of the inventory of finished goods on hand at 



450 ACCOUNTING FUNDAMENTALS [Ch. XXVIII 

the beginning of the period, with the amount of any sales returns 
and allowances, and with all selling expense accounts. Trading 
is credited with the balance of the Sales account. It will be 
recalled that Trading is also credited, through the adjusting 
entries, with the amount of the inventory of finished goods on 
hand at the end of the period. The balance of Trading is 
transferred to the summary account Profit and Loss. The 
Trading account balance represents the profit or loss on sales 
before general and administrative expenses are deducted. 

Allocation of Certain Expense Accounts. The allocation of 
certain expense accounts to a particular summary account in 
closing the books, raises some interesting questions. If the 
manufactured product is wound on a spool or placed in a con- 
tainer such as a box or bottle, the question arises whether the 
cost of such holders and containers and the expenses of placing 
the product on or in them are manufacturing or trading expenses. 
If such additional expenses are necessary to prepare the product 
for the market, put it in a condition ready for sale, they may be 
considered expenses of production and the accounts representing 
them closed to Manufacturing. Any expenses such as boxing 
and crating in order to ship a product may be considered expenses 
of trading and the accounts representing them closed to Trading. 

In order that each of the three major departments of a manu- 
facturing business production, trading, and general administra- 
tion may be charged its proper share of certain expenses, some 
expense accounts are closed by transfer in part to each of the 
three summary accounts Manufacturing, Trading, and Profit 
and Loss. The distribution is on the basis of the benefit received 
from the particular expense account. Property taxes, deprecia- 
tion of building, and repairs may be distributed on the basis 
of the space occupied by each major department. If the property 
is rented and not owned, rent may be distributed on the same 
basis. Departmental electricity costs may be measured by 
meter readings, heating costs distributed on a space occupied 
basis, and so on. Some costs have to be distributed rather 
arbitrarily. 

Closing Entries Illustrated 

The schedule of distribution for certain of the expense accounts 
of the Hall Machine Company is as follows; 



Ch. XXVIII] MANUFACTURING ACCOUNTS 451 

To To To 

Manufacturing Trading Profit and Loss 

Insurance 70% 20% 10% 

Property Taxes 80% 10% 10% 

Light, Heat, and Power 90% 5% 5% 

Depreciation of Buildings .... 80% 10% 10% 

The closing entries are 

Manufacturing 91 , 300 . 00 
Inventory Work in Process, 

January 1, 19 9,000.00 

Inventory Raw Materials, Jan- 
uary 1, 19_ 1,790.00 
Purchases Raw Materials 35,000.00 
Transportation In 700.00 
Factory Supplies 650 . 00 
Direct Labor 31,000.00 
Light, Iloat, and Power 2,100.00 
Indirect Labor 9,000.00 
Insurance 700 00 
Property Taxes 480 . 00 
Depreciation of Buildings 320.00 
Depreciation of Machinery 500.00 

To charge Manufacturing with all 

expenses of production. 

Purchase Returns and Allowances 600.00 

Manufacturing 600 . 00 

To reduce manufacturing costs by the 
amount of the Purchase Returns and 
Allowances account. 

Trading 86,800.00 

Manufacturing 86 , 800 . 00 

To charge the trading department 
with the cost of goods manufactured. 

Trading 29,330.00 
Inventory Finished Goods, Jan- 
uary 1, 19_ 4,400.00 
Sales Returns and Allowances 710.00 
Light, Heat, and Power 120 00 
Sales Salaries 9,200.00 
Travel.ng and Entertainment 3 , 000 . 00 
Advertising 7,000.00 
Commissions 4 , 500 . 00 
Insurance 200 . 00 
Property Taxes 60 . 00 



452 ACCOUNTING FUNDAMENTALS [Ch. XXVIII 

Depreciation of Buildings 40 . 00 

Depreciation of Sales Furni- 
ture and Fixtures 100.00 
To charge Trading with the opening 
inventory of finished goods and with 
all expenses of selling. 

Sales 126,080.00 

Trading 126,080.00 

To credit Trading with the amount 
of gross sales. 

Trading 16,150.00 

Profit and Loss 16 , 150 . 00 

To transfer selling profit to Profit 
and Loss. 

Profit and Loss 1 1 , 070 . 00 

Light, Heat, and Power 120.00 
Office Salaries 10 , 000 . 00 
Postage 110 00 
Office Expenses 1 40 . 00 
Insurance 100.00 
Property Taxes 60 . 00 
Depreciation of Buildings 40.00 
Depreciation of Office Furni- 
ture and Fixtures 200 00 
Bad Debts 300.00 
To transfer the expenses of admin- 
istration to Profit and Loss. 

Profit and Loss 2 , 520 . 00 

Sales Discounts 2 , 370 . 00 

Loss on Sale of Machinery 150.00 

To close the financing and other 

expenses to Profit and Loss. 

Interest Earned 200 . 00 

Purchase Discounts 600.00 

Profit and Loss 800.00 

To transfer the other income 
accounts to Profit and Loss. 

Profit and Loss 3 , 360 . 00 

Surplus 3,360.00 

To transfer the net profit for the 
period to Surplus. 



Ch. XXVIII] MANUFACTURING ACCOUNTS 



453 



After the adjusting and closing entries are posted to the 
summary accounts, they appear on the ledger substantially as 
follows: 

Manufacturing 



Dec. 


31 


(Closing) 




91,300 


00 


Dec. 
iing 


31 
31 
31 


(Adjusting) 
(Closing) 
(Closing) 




3,900 
600 
86,800 


00 
00 
00 


91,300 


00 


91,300 


00 






1 


'ra< 








Dec. 


31 
31 
31 


(Closing) 
(Closing) 
(Closing) 




86,800 
29,330 
16,150 


00 
00 
00 


Dec. 
id Lc 


31 
31 

>ss 


(Adjusting) 
(Closing) 




6,200 
126,080 


00 
00 

66 


132,280 


00 
tai 


132,280 








Profi 




Dec. 


31 
31 
31 


(Closing) 
(Closing) 
(Closing) 




11,070 
2,520 
3,360 


00 
00 
00 


Dec. 


31 
31 


(Closing) 
(Closing) 




16,150 
800 


00 
00 


16,950 


29 


16,950 


00 



















The Surplus account shows the following figures: 

Surplus 



Dec. 


31 


(Adjusting) 




400 


00 


Jan. 


1 


Balance 




5,000 


00 




31 


Balance 




7,960 


00 


Dec. 


31 


(Closing) 




3,360 


00 










8,360 


00 










8,360 


00 














19 
























Jan. 


1 


Balance 




7,960 


00 



In the closing entries the account Loss on Sale of Machinery is 
closed as an expense to Profit and Loss; it might have been closed 
to Surplus as a loss resulting from insufficient depreciation 
charges in prior periods. 



454 



ACCOUNTING FUNDAMENTALS [Ch. XXVIII 



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ACCOUNTING FUNDAMENTALS [Ch. XXVIE Ch. XXVIII] MANUFACTURING ACCOUNTS 



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456 ACCOUNTING FUNDAMENTALS [Ch. XXVIII 

As of the first day of the new period, The Hall Machine Com- 
pany should make readjusting entries to transfer the Accrued 
Interest Receivable and the Payroll Accrued accounts to their 
respective operating accounts. Payroll Accrued would be 
transferred to the various labor and salary accounts. 

The Work Sheet 

The adjusting entries are indicated clearly in the Adjustment 
columns of the work sheet. The data for a Cost of Goods 
Manufactured statement are shown in the Manufacturing 
columns. The data for a Cost of Goods Manufactured and 
Cost of Goods Sold statement are shown in the Manufacturing 
and Trading columns. The detailed selling expense information 
for the statement of profit and loss is shown in the Trading 
Debit column and the general and administrative expense 
information in the Profit and Loss Debit column. The data 
for the Other Expenses and Lo^sos and Other Income sections 
of the profit and loss statement are also given in the Profit and 
Loss columns. The Balance Sheet columns supply the data 
for the preparation of that statement. 

Work Sheet Illustrated 

In the work sheet for The Hall Machine Company on pages 454 
and 455, it will be noticed that the Adjusted Trial Balance 
columns are omitted. A person familiar with the preparation 
of a columnar statement of this character does not need to have 
the first four columns summarized in Adjusted Trial Balance 
columns. 

Anyone studying this work sheet will find it profitable to 
compare 

1. The statement of profit and loss given on page 446 and its 
supporting schedules with the items shown in the Manu- 
facturing, Trading, and Profit and Loss columns. 

2. The adjusting entries given on pages 448 and 449 with the 
items in the Adjustments columns. 

3. The balance sheet given on page 445 with the items in the 
Balance Sheet columns. 

4. The closing entries given on pages 4- r l, 452, with the items 
in the Manufacturing, Trading, and Profit and Loss columns. 



Ch. XXVIII] MANUFACTURING ACCOUNTS 457 

Comparison with Cost Accounting 

The subject of manufacturing accounts and statements should 
not be confused with the subject of cost accounting. It is 
true, the methods explained in this chapter show how the cost of 
goods manufactured and the cost of goods sold may be deter- 
mined. If an enterprise makes just one product in one size, 
even the average cost of a unit manufactured and the average 
cost of a unit sold may be determined, but it should be pointed 
out that such cost determination is made at the end of a period 
after all transactions have occurred. Furthermore, the methods 
of this chapter determined the cost of materials consumed by 
deducting the value of materials on hand at the end of a period 
from the sum of the amount on hand at the beginning of the 
period plus the amount purchased. A cost-accounting system 
keeps record of the amount and value of materials consumed, 
how they are used, and indicates the amount and value of the 
inventory which should be on hand at the end of a period. 

Labor utilized in the methods just considered is the amount 
paid for labor plus the amount accrued. In a cost system, the 
utilization of labor is recorded as applied and the amount used 
should agree with the amount paid for and accrued. 

There are many other comparisons it would be possible to 
make with a cost-accounting system. The purpose of this 
very brief comparison on just a few points is to prevent anyone 
thinking that the methods just described constitute what is 
known as a cost-accounting system. 

Students interested in accounting invariably enjoy the work 
on manufacturing accounts and statements. It is valuable 
not only for itself but as a splendid background for the subsequent 
study of cost accounting. 

QUESTIONS 

1. a. What is the essential difference between a trading and a manu- 
facturing business? 

6. Name some assets a manufacturing enterprise might have which 
a trading business might not have. 

c. What kinds of inventories is a manufacturer likely to have? 
Explain each kind. 

d. Name and explain some of the expense accounts peculiar to a 
manufacturing enterprise. 



458 ACCOUNTING FUNDAMENTALS (Ch. XXVIH 

2. a. Name the three basic costs of producing a pair of shoes. 

b. Name and explain a few of the particular expense titles which 
are included in the group known as " manufacturing expenses.' 1 

3. a. Name some classes of labor the costs of which are considered as 

indirect labor costs. 
b. What do you mean by direct labor costs? 

4. a. What conditions would have to apply, if the Cost of Goods Manu- 

factured figure was the same as the Cost of Goods Sold? 

b. Does the inventory of work in process at the beginning of the 
year enter into the calculation of the current Cost of Goods 
Manufactured? Why or why not? 

c. Does the inventory of raw materials at the beginning of the year 
enter into the calculation of the current Cost of Goods Manu- 
factured? Why or why not? 

d. Does the inventory of finished goods at the beginning of the 
year enter into the calculation of the current Cost of Goods 
Manufactured? Why or why not? 

6. a. Must the Cost of Goods Manufactured be known before the 
inventory of finished goods at the end of the year is priced? 
Explain. 

6. Is the average cost of a unit sold necessarily the same as the 
average cost of manufacturing a unit during a given year? 
Explain. 

6. a. If the cost of the goods manufactured is $48,000.00 

If the manufacturing cost of the goods sold is. . . 50,000.00 
If the inventory of finished goods at the beginning 

of the year is 5,000.00 

The final inventory of finished goods is ? 

6. If the manufacturing cost of goods sold is 875,000 00 

If the opening inventory of finished goods is. ... 6,200.00 

If the final inventory of finished goods is 5,400.00 

The cost of the goods manufactured is ? 

c. Assume the following figures: 

The opening inventory of finished goods con- 
sisted of 1 ,250 units 

The final inventory of finished goods consisted of 1 , 800 units 

Units produced during the year 16,500 

Units sold during the year ? 

d. Combine the following facts with those of c and determine the 
average manufacturing cost of a unit produced during the year. 
Assume the goods in the opening inventory were all sold. 

Manufacturing cost of the goods sold $41 ,345 .00 

Opening inventory of finished goods 3, 125.00 

Final inventory of finished goods 4,680.00 



Ch. XXVIII] MANUFACTURING ACCOUNTS 459 

e. On the basis of the facts of c and d how does the average cost of 
manufacturing a unit this past year compare with the year before? 

7. The work sheet of a manufacturer contains what new columns from 
those used previously in this text? Why are these new columns 
used? 

8. In closing the books of a manufacturer, which accounts are closed to: 
a. The debit of Manufacturing? 

6. The credit of Manufacturing? 

c. The debit of Trading? 

d. The credit of Trading? 

e. The debit of Profit and Loss? 
/. The credit of Profit and Loss? 

9. Are the following items transferred in closing to the debit or credit 
side of Manufacturing, Trading, or Profit and Loss? If necessary 
qualify your answer. 

a. Advertising. 
6. Office Salaries. 

c. Traveling and Entertainment. 

d. Final Inventory of Finished Goods. 
c. Delivery Expenses. 

/. Wages of Factory Watchman. 
g. Insurance on Factory Buildings. 
h. Transportation In. 
i. Opening Inventory of Raw Materials. 
j. Depreciation of Store Building. 
k. Interest Earned. 

/. Depreciation of Office Furniture and Fixtures, 
m. Postage. 
n. Purchase Discounts. 
o. Bad Debts. 
p. Light, Heat and Power. 
q. Sales Discounts. 
r. Purchase Returns and Allowances. 

10. Indicate whether you believe manufacturers would consider each 
of the following items a manufacturing or a selling expense. 
Explain for each. 

a. Placing cigarettes in packages. Cost of the package paper. 
6. Placing cigarette packages in cellophane. Cost of the cellophane. 

c. Boxing a machine for overseas shipment. (An exceptional 
shipment.) 

d. Placing pen points in boxes of 100 each. Cost of the boxes. 

e. Cost of display cards for use in retail outlets. 
/. Bottling toilet water. Cost of the bottles. 

g. Placing packages of cigarettes in cartons. Cost of the cartons. 



460 ACCOUNTING FUNDAMENTALS [Ch. XXVIII 

11. Suppose the one building is used for the factory, sales rooms, and 
office. On what basis would you suggest the distribution of each 
of the following expenses to Manufacturing, Trading, and Profit 
and Loss? 

a. Depreciation of Building. 
6. Light, Heat, and Power. 

c. Insurance on Building. 

d. Property Taxes. 

e. Repairs to Building. 

12. a. Why does a manufacturer want to know his manufacturing costs 

as distinct from his selling, his general and administrative, and 

his financial expenses? 
6. Should the accounting system be designed and operated to give 

the manufacturer the information under the different headings 

suggested in a? Why? 
c. In a large corporate enterprise what title do you think is given 

to the executive in charge of 

(1) Finances? 

(2) Production? 

(3) Accounting? 

(4) Sales? 



CHAPTER XXIX 
THE VOUCHER SYSTEM 

In a small enterprise a few officers can supervise personally 
all important matters. In a large enterprise this is impossible; 
authority is delegated, therefore, by the chief executives to 
departmental executives, and greater reliance is placed on 
systems of internal check. For example, before the accounting 
department records or the treasurer's office pays a purchase 
invoice, the several departments concerned with the transaction 
represented by the invoice must indicate their approval of it. 
A plan of internal check for purchase invoices, in fact for all 
cash disbursement items, is known as the voucher system. 

Voucher System Defined 

The voucher system is a plan and method of procedure for the 
verification, recording, and payment of all items, other than 
items to be paid from petty cash, which require the disbursement 
of cash. 

Most cash disbursements result from transactions which 
originate in the purchase of raw materials, merchandise, other 
assets, or services. For such items the voucher system provides 
usually 

1. For the verification, by the departments concerned, of all 
invoices and bills before they are recorded by the accounting 
department and the disbursement authorized by the proper 
officer. 

2. For the approval by the departments concerned prior to 
recording and authorization for payment, of all cash 
disbursement items for which invoices or bills are not 
received, such as wage, salary, and traveling expense items. 

3. For the recording, at the time of incurrence, of all approved 
financial obligations as liabilities of the enterprise, whether 
they are to be paid immediately or at a later date. 

461 



462 ACCOUNTING FUNDAMENTALS [Ch. XXIX 

4. For the recording of all cash disbursements, other than 
those from petty cash, as decreases of liabilities. 

5. For the showing of liabilities- on open account as a file of 
approved unpaid vouchers and not as accounts in a sub- 
sidiary ledger for creditors. 

6. For the use of the control account Vouchers Payable and 
the elimination of the Accounts Payable control account. 

The Verification of an Invoice 

To illustrate the requirements of the voucher system for the 
approval of an invoice, bill, or other item for which cash is 
disbursed, the verification of a purchase invoice is considered. 
The section of Chapter XVII devoted to Papers and Practices for 
Purchases should be reread despite the fact that a brief restate- 
ment of that discussion follows. 

The request for the purchase of goods originates in one of the 
departments of the business in the form of a requisition on the 
purchasing agent. The purchasing agent, in turn, purchases 
the goods by issuing a purchase order to the vendor, with a dupli- 
cate of the purchase order going to the requisitioning department. 

When the purchase invoice is received it is not entered usually 
until the departments concerned with that invoice have approved 
it. A representative of the department which requisitioned the 
purchase or a representative of the receiving department, if 
there is such a department, must approve the invoice as to 
quantity, quality, and condition. A representative of the 
purchasing agent's department must also approve the invoice 
as to price and terms, after which a representative of the account- 
ing department must approve it as to calculations and addition. 
Such a procedure localizes responsibility for the various approvals 
of an invoice to the departments concerned with that invoice, 
even to the representatives of the several departments, since 
each employee who approves an invoice must sign his name or 
place his initials on it. 

Not all of the approvals may appear on the invoice itself. The 
department receiving the goods may indicate its approval on the 
duplicate purchase order which was sent to it by the purchasing 
agent, and to whom it is returned when the receipt of the goods 
is approved as to quantity, quality, and condition. If the 
approval of the goods by the receiving department is indicated 



Ch. XXIX] THE VOUCHER SYSTEM 463 

on the duplicate purchase order, that paper is then attached 
to the invoice in the purchasing agent's office. The approval 
of the purchasing agent's department may be made directly on 
the invoice and the invoice with duplicate purchase order 
attached is then sent to the accounting department for that 
department's approval of extensions and total. 

After a representative of the accounting department has 
approved the invoice and has noted that all other necessary 
approvals have been made, a voucher to summarize the transac- 
tion is then prepared in the accounting department and sent 
to the officer authorized to approve it for payment at the proper 
time. The voucher, with invoice attached, or with invoice and 
duplicate purchase order attached, is then placed in a tickler 
file (a file arranged by dates) so that it will be noticed at the 
proper time for payment. 

In practice, the procedure just outlined is modified to meet 
conditions peculiar to a particular enterprise. Bills for supplies 
and services are approved by the accounting department and 
the departments receiving the benefits, as well as by the pur- 
chasing agent's department, if the order was placed through that 
department. 

Cash disbursement items for which neither invoices nor bills 
are received, such as wage and salary items, are approved by the 
departments concerned and by the accounting department. 
For example, a payroll sheet is approved by a representative 
of the payroll department or by the managers of the departments 
in which the employees are engaged and then by the accounting 
department for extensions and total. 

Definition of a Voucher 

A voucher is a paper on which a transaction is summarized, 
its correctness is certified, and an entry for it is authorized. 
There are various kinds of vouchers; for example the petty cash 
voucher was considered in Chapter XIX, and the journal voucher 
will be considered later in this chapter. The voucher used in 
connection with the voucher system is a voucher payable. 

In the previous section it was stated that after an invoice is 
approved by the departments concerned with the transaction, 
a voucher (voucher payable) is prepared in the accounting 
department. That statement with respect to the preparation 



464 ACCOUNTING FUNDAMENTALS [Ch. XXIX 

of a voucher may be expanded to include not only invoices 
but any cash disbursement item which is approved by the 
departments concerned. A voucher is necessary for each cash 
disbursement or for a group of disbursement items payable to 
the same party. 

In order to take advantage of discounts, vouchers are prepared 
and paid sometimes before the goods are received and the varioun 
departmental verifications of the invoice are noted. Such 
exceptions to the usual procedure occur only for purchases 
made from reliable or regular creditors and even then a most 
explicit memorandum is made as a follow-up, to insure the 
receipt of the goods and proper approvals from the departments 
concerned with them. 

The voucher payable, generally called a voucher, is an account- 
ing form on which is given a summary of the transaction it 
represents and authorization to record immediately and to pay at 
the proper time. Each voucher is numbered and usually shows 
on its face the name and address of the payee, the date prepared, 
the date due, a place to indicate the date paid, the terms, a 
place for the number of the check used in payment, the date of 
the invoice, a brief description of the transaction, the amount, 
the discount if any, the net amount payable, and the signatures 
of the persons authorized to approve it for recording and pay- 
ment. Sometimes a voucher is prepared upon the receipt of an 
invoice and, with the invoice attached, is sent to the departments 
concerned for their approval of the invoice and voucher. Under 
such a procedure the initials or names of approving parties in 
the several departments are shown on the face of the voucher. 

On the back of the voucher is printed usually a list of the 
accounts most frequently charged for cash disbursement items. 
At the time the voucher is prepared a member of the accounting 
department indicates, on this account list, the account or accounts 
to be debited and writes his initials to indicate who is responsible 
for this accounting decision. Debits to accounts not included 
in the printed list may be indicated in the Other Debits section. 
It is not necessary to indicate the account to be credited; a 
voucher when issued is always a credit to Vouchers Payable. 

Vouchers may be prepared in a manner to permit folding as 
in the illustration on page 465. When a foldable voucher is used, 
the invoice and other memoranda pertaining to it are enclosed 
between the front and back. 



Ch. XXIXJ 

Voucher Payable Illustrated 

(Front) 



THE VOUCHER SYSTEM 



465 



(Back; 



Voucher No. 5-06 




Voucher No. 5-06 


Check No. 431 






WILSON WIRE WORKS 




Payee John R. Jones, 


PITTSBURGH, PA. 




27 Main Street, 


Payee John R. Jones, 




Eric, Pa. 


27 Main Street, 






Erie, Pa. 






Date Due 5/18/19 








Date Paid 5/17/19 




Accounts Debited 


Amount 


Date I 
Terms 


ssucd 5/9/19 













2/10, n'30 


Pure Lasts Raw Materials 
Direct Labor 








Indirect Labor 1 










Invoice 
Date 


Description 


Amount 




Factory Supplies 
Sales Salaries 


39 


50 










Store Supplies 






May 8 


Invoice #327 
Factory Supplies 


39 


50 




Office Salaries 
Office Expenses 
Other Debits: 














d 
















t* 
















3 
















S 
















3 

a 
















r/l 










Discount 




79 












Amount of check 


38 


71 










Approved R. Price 










For Accounting Department 
Approved Ed. Lewis 




Total 


39 


50 


For Treasurer 











466 ACCOUNTING FUNDAMENTALS [Ch. XXIX 

Vouchers Payable Replace Creditors' Accounts 

In the voucher system each individual voucher is the evidence 
of indebtedness so that it is not necessary to keep a subsidiary 
ledger for accounts with creditors. Approved invoices and bills 
may be accumulated for a short period, such as a week or two 
before vouchers are prepared for them. In this way a number of 
invoices from one creditor may be summarized on one voucher 
and approved for recording and payment. If the plan of 
accumulating invoices and bills before vouchcring is followed, 
care must be exercised to prevent the loss of discount on invoices 
bearing different dates. 

Vouchers Payable Control Account Replaces Accounts Payable 

Since approved vouchers replace the subsidiary ledger accounts 
with creditors, the controlling account Vouchers Payable replaces 
the controlling account Accounts Payable. The Vouchers 
Payable account controls and its balance should agree with the 
total amount of unpaid approved vouchers as shown in the 
unpaid voucher file. The Vouchers Payable account balance 
should agree also with the total amount of unpaid approved 
vouchers as shown in the voucher register. 

The Voucher Register 

When prepared and approved for recording vouchers are 
entered in the voucher register. The voucher register is a 
columnar journal similar in appearance to the columnar purchase 
journal with a sundries section illustrated in Chapter XIX. In 
addition to the columns shown by a columnar purchase journal 
with a sundries section, the voucher register contains columns to 
indicate the number of each voucher, the date it is paid, and the 
check number used in payment. It will be noticed also that the 
credit column is captioned Vouchers Payable rather than 
Accounts Payable as in the purchase journal. 

If the needs of the enterprise require them, columns other than 
those illustrated may be used. For example, some voucher 
registers are provided with columns to indicate the terms and 
the number of the invoice. If reference is made to the voucher 



Ch. XXIX] 



THE VOUCHER SYSTEM 



467 



number and the vouchers are filed properly and promptly, these 
columns are not necessary. 

The sundries columns of the illustrated voucher register provide 
a place to record any voucher to be charged to an account not 
represented by one of the special debit columns. 



(Left Page) 



VOUCHER REGISTER Month of May 19_ 









Paid 


Cretlit 


Debit 


Date 


Payee 


Voucher 
No. 


Date 


Check 
No. 


Vouchers 
Payable 


Purchases 
Raw 
Mat'ls 


Direct 
Labor 


Indirect 
Labor 


Factory 
Supplies 


May 


1 


Dudley Lumber Co. 


5-01 


5/9 


429 


2.50 


00 


250 


00 
















3 


Office Fur. Company 


5-02 






300 


00 




















5 


Bell Tel. Company 


5-03 


5/5 


427 


12 


00 




















6 


Neil Camp, Paymaster 


5-04 


5/6 


428 


4,800 


00 






2,800 


00 


500 


00 








8 


Nat'l Brass Company 


5-05 


5/17 


430 


1,300 


00 


1,300 


00 
















9 


John H. Jones 


5-06 


5/17 


431 


39 


50 














39 


50 




10 


Vcme Mchy. Company 


5-07 






600 


00 




















11 


B, L. Davn ^^ 


5-08 






470 


00 


470 


S 














*^ 


3? 


^A^^^^^i^ 


^^^ 


&& 


^&& 


fWV 


^ 




^ 




^ 


*?W 


^ 


t&W 


^ 


-. 


- 










36.500 


00 


7,000 


00 


12,500 


00 


2,500 


00 


150 


00 


(17) 


(23) 


(25) 


(26) 


(27) 



VOUCHER REGISTER 



(Right Page) 



Debit 



Sales 
Salaries 



1,00000 



7,000 00 



(28) 



Store 
Supplies 



(29) 



Office 
Salaries 



50000 



(30) 



Office 
Expenses 



1200 



Sundries 



Amount F 



333 00 



60000 



Account 



Office Furniture and Fixtures 



Machinery 




The figures in parentheses below the double rulings indicate 
that the totals of the columns were posted, i.e., the (17) below 
the Credit Vouchers Payable column shows that Vouchers 
Payable was credited in the general ledger for $36,500.00 and 



468 ACCOUNTING FUNDAMENTALS (Ch. XXIX 

the (23) below the Purchases Raw Materials column shows that 
the general ledger account with that title was debited with 
$7,000.00, Each item in the Debit Sundries section is posted 
individually and the folio shown in the F column of that section. 

In the Date column is entered the date the voucher is recorded, 
not the date of the invoice. It should be repeated here, that 
the payees indicated in the register are not credited in any 
ledger. The number of each voucher is entered in the Voucher 
No. column. Vouchers are numbered consecutively. Somo- 
times a new series of numbers is started each month with the 
first number indicating the month, thus voucher 5-01 was 
number one in the month of May. 

In the Paid columns are given botli the date and the number 
of the check used in payment. Vouchers with blank spaces 
in the Paid columns are unpaid. The sum of the unpaid vouchers 
should agree with the balance of the Vouchers Payable control 
account in the general ledger and with the sum of the unpaid 
vouchers in the file. The inclusion of the Paid section makes the 
register the equivalent of a subsidiary ledger to the Vouchers 
Payable account. The register is both an original entry book 
and a subsidiary record to the Vouchers Payable control 
account. 



Vouchering an Item to Be Paid Immediately 

An item requiring immediate payment is vouchered and 
recorded in exactly the same manner as an item to be paid at a 
later date. If the item is a cash purchase it is recorded as 
though it were a credit purchase but the date and check number 
shown in the Paid section will show that it was paid the same 
day it was drawn. Voucher 5-03 to the Bell Telephone Com- 
pany and voucher 5-04 prepared for payroll purposes were paid 
the same days they were drawn. 

Filing Vouchers Payable 

Approved vouchers pending payment are filed in a tickler 
file which is arranged by dates. This plan of filing tends to 
prevent a voucher being overlooked on the day it should be paid, 
hence tends to prevent the loss of purchase discounts. 



Ch. XXIX) 



THE VOUCHER SYSTEM 



469 



Paid vouchers are filed in a numerical or an alphabetical file. 
If the latter, they are filed according to the name of the 
payee. 

The Check Register 

From the standpoint of debit and credit and postings to 
general and subsidiary ledgers, the cash disbursements journal 
of the voucher system is a much more elementary book than the 
cash disbursements journal of Chapter XVIII. It is merely a 
cashbook record of the payment of vouchers by checks, hence 
it is known also as the check register. 

Since every cash disbursement, other than one for a petty 
cash item, is represented by a voucher payable, and the charges 
for each voucher are recorded in the voucher register, the check 
register is simply a cash record of voucher payments. It should 
show for each disbursement, the date, name of payee, voucher 
number, check number, and the debit and credit amounts. 
Although vouchers are numbered consecutively, they do not 
become due for payment in consecutive order, consequently the 
check numbers do not agree with the voucher numbers. 



The Check Register Illustrated 

CHECK REGISTER 



Month of May 19 



Date 


Payee 


Voucher 
No. 


Check 
No. 


Debit 


Credit 


Vouchers 
Payable 


Purchase 
Discount 


Cash 


May 


5 


Bell Telephone 






















Company 


5-03 


427 


12 


00 






12 


00 




6 


Neil Camp, Pay- 






















master 


5-04 


428 


4,800 


00 






4,800 


00 




9 


Dudley Lumber 






















Company 


5-01 


429 


250 


00 


5 


00 


245 


00 




17 


Nat'l Brass Com- 






















pany 


5-05 


430 


1,300 


00 


26 


00 


1,274 


00 




17 


John R. Jones 


5-06 


431 


39 


50 




79 


38 


71 














i 










~'VXNXs > XNXV>>w''\>'VXXXVXNX^ 


^XV^VXVXNXVXXX>^VXVXN^SVVXXXXXNX V. VXVXXXVXN'V 


X/N, 


VXNX"^/" 


*xvx 

31 


^NX^-XXNXVXNXXXNXN/VXXXVX'X 


XVXNXXXXXVX- 


VXXXNXVXN. 


NXNLXVXVXV 


XXX* 


./vxvx\^vx 


^-/NX 


vx-sx-xxxxv 


* 


28.500 


00 


300 


00 


28,200 


92J 






(17) 




(52) 




(1) 



470 



ACCOUNTING FUNDAMENTALS 



[Ch. XXIX 



The only postings from the illustrated check register are those for 
the column totals. The figures in parentheses below the column 
totals indicate the ledger pages to which the postings were made. 
The debit to the Vouchers Payable account is offset by the 
credits to Purchase Discounts and Cash. 



The Voucher Check 

The voucher system usually includes the use of voucher checks. 
A voucher check is a check on which, or on a detachable state- 
ment to which, is indicated the voucher number and the specific 
indebtedness covered by the check. 

When the reference to the invoice, invoices, or other specific 
items covered by the check is made on the check itself, the 
indorsement of the check by the payee constitutes a receipt 
for the payment of the particular items. Whether the reference 
to the specific items paid by the check is on the check or on a 
detachable statement, the voucher check serves as a notice 
to the payee of the items paid by the check. 

Illustrations of Voucher Checks 



FORBES NATIONAL BANK 8-139 
Fifth and Oakland No. 429 




Pittsburgh, Pa. May 9, 19_ 


Date 


Invoice 


Amount 


May 


1 


Total 
Discount 
Net 


250 


00 


Pay to the 
Order of Dudley Lumber Co. $245.00 


Two hundred forty five and 00/100. . Dollars 


Wilson Wire Works 
By 


250 
5 


00 
00 


245 


00 


Voucher No. 5-01 Treasurer 


If incorrect, please return. 



The voucher check illustrated above contains on its face 
the voucher number and a reference to the specific item covered 
by the check. Sometimes the reference to the item is made 
on the back of the check. 



Ch. XXIX] 



THE VOUCHER SYSTEM 



471 



Voucher 
No. 5-01 



FORBES NATIONAL BANK 8-139 
Fifth and Oakland 



No. 429 



Pittsburgh, Pa. May 9, 19_ 



Pay to the 
Order of Dudley Lumber Co. 



$245.00 



Two hundred forty five and 00/100 Dollars 



Wilson Wire Works 

By 



Treasurer 



Detach Before Depositing 

If incorrect, please return check and attached statement. 

Your indorsement of the above check will be considered an acceptance 

of full settlement for the following items. 

Wilson Wire Works 



Date 



Invoice 



Amount 



Date 



Invoice 



Amount 



May 



25000 



Total 

Discount 

Net 



25000 
500 



24500 



It will be noticed in the voucher check illustrated immediately 
above that the lower portion should be detached by the payee 
before the check itself is deposited. 

Creditors' Voucher Index 

Since a subsidiary ledger for creditors is not a part of the 
voucher system, there is no convenient current record to show 
the volume of business done with each creditor. If this infor- 
mation is desired, a creditors' voucher index-card system is 
maintained. A card for each creditor is kept in the file and on 



472 



ACCOUNTING FUNDAMENTALS 



[Cb.XXIX 



it are shown the number and the amount of each voucher prepared 
in his favor, as in the illustration below. The file is arranged 
alphabetically. 

Illustration of a Creditor's Voucher Index Card 



WILSON WIRE WORKS 

Name of Creditor Dudley Lumber Co. 


Voucher 
Number 


Amount 


Voucher 
Number 


Amount 


Voucher 
Number 


Amou 


nt 


5-01 


250 


00 












6-07 


350 


00 














6-59 


650 


00 














7-13 


400 


00 














8-04 


300 


00 








































































































Sometimes, in lieu of a voucher index by creditors, an alpha 
betical file of duplicate vouchers is maintained. 

Notes Payable under the Voucher System 

If it should happen that an enterprise purchases an asset and 
issues a note in payment, the entry is recorded in the general 
journal. A liability on a note is shown in the Notes Payable, 
not the Vouchers Payable, account. If a purchase on a note 
were entered in the voucher register, the liability would be 
classed as a voucher payable which would be an incorrect 
classification. When a note payable matures and is to be paid, 
a voucher is prepared and recorded in the voucher register as a 



Ch. XXIXJ THE VOUCHER SYSTEM 473 

debit to Notes Payable and a credit to Vouchers Payable. The 
payment of the voucher is then entered in the cash disbursements 
journal check register. 

After a voucher is prepared and recorded, if it is decided to 
issue a note for that particular liability in order to delay the 
date of payment or for other reason, an entry is made in the 
general journal as a charge to Vouchers Payable and a credit to 
Notes Payable. In addition to the general journal entry, a 
record is made in the Date and Check No. columns of the Paid 
section of the voucher register, to indicate that the particular 
voucher is canceled by the issuance of the note (sec illustration ou 
page 475). At the maturity of the note, a new voucher is pre- 
pared, approved, and entered in the voucher register as part of 
the procedure connected with its payment. 

The Procedure for the Partial Payment of a Voucher 

If a voucher cannot be paid in full and it is decided to pay 
part of it and to defer the balance to a later date, the original 
voucher is canceled and new vouchers are prepared. The entry 
to record this change in plan is entered in the voucher register 
as a debit to Vouchers Payable in the Sundries section and a 
credit to Vouchers Payable in the Credit Vouchers Payable 
column. A. record is made also on the line for the original 
voucher in the Paid section of the voucher register, to indicate 
that the voucher was canceled and new vouchers issued (see 
illustration on page 475). 

If an enterprise is unable, frequently, to meet its vouchers on 
due dates and must resort to partial payments, or the issuance 
of notes to defer the payment of vouchers, it is an indication 
that the current financial position of the enterprise is not in a 
sufficiently liquid condition. 

Recording Purchase Returns and Allowances 

If goods received are not up to standard, they are returned 
and a deduction is made on the invoice before it is vouchered. 
If an invoice as received is not fully approved for any reason 
and an allowance is obtained from the vendor, a deduction is 
made on the original invoice. The credit memorandum when 
received from the vendor is attached to the voucher and invoice 
but the entry in the voucher register is for the net amount. 



474 ACCOUNTING FUNDAMENTALS [Ch. XXIX 

If a credit memorandum is received after a voucher is recorded 
and in the same month, it is necessary to make a correction 
on the voucher and to draw a line through the debit and credit 
amounts as recorded in the voucher register and to insert the 
new correct amounts immediately above the canceled amounts. 
Another method of accomplishing the same result involves a 
correction on the voucher and another entry in the voucher 
register. Assume raw materials in the amount of $480.00 
were purchased and received, the invoice approved and voucher 
7-03 was issued. The debit and credit of the voucher register 
entry for this transaction are 

Purchases Raw Materials 480.00 

Vouchers Payable 480.00 

Subsequent to the above entry, but in the same month, an 
allowance of $50.00 is obtained from the vendor because the 
goods proved to be of a lower quality than was ordered. The 
entry for this credit is 

Vouchers Payable 50 . 00 

Purchases Raw Materials 50.00 

The above entry is the exact opposite of the original entry 
and it is customary to record it in the same columns immediately 
above the original entry but in red ink. The use of red ink 
indicates that the debit and credit shown in the red-ink figures 
are the reverse of the normal debit and credit of the columns. 
At the end of the month, when the column totals of the voucher 
register are obtained, the total of any column is the sum of its 
black-ink figures less the sum of any red-ink figures. Sometimes 
two totals, a black-ink total and a red-ink total, are shown for 
the same column. This is necessary, if it is desired to credit 
the amount of the credit memorandum to an account other 
than that indicated by the caption of the column, i.e.j if it is 
desired to credit a red-ink entry in the Purchases Raw Materials 
column to Purchase Returns and Allowances rather than to 
have the red-ink amount act as a reduction of the debit to 
Purchases Raw Materials. 

Of the two plans mentioned above, the first plan of drawing a 
line through the figures of the original entry and inserting the 
new figures immediately above the canceled ones is far simpler 
than the second. 



Ch.XXIX] 



THE VOUCHER SYSTEM 



475 



If a credit memorandum is received prior to the payment of a 
voucher but in a month subsequent to its issue, a general journal 
entry is made. For the facts of the credit memorandum used 
in the last situation, the general journal entry is 

Vouchers Payable 480 . 00 

Purchases Raw Materials 480.00 

To' record the cancellation of voucher 7-03 for 
which a credit memorandum has been received. 
See voucher 8-09. 

Voucher 7-03 is marked canceled on the voucher register 
sheet of the month in which it was issued and reference is made 
to voucher 8-09. 

The new voucher, number 8-09, for $430.00 referred to in the 
explanation of the above entry, is prepared and recorded in the 
usual way in the voucher register. 

If it is desired to show on the records the amount of Purchase 
Returns and Allowances, the only change in the procedure just 
outlined is a modification of the general journal entry to the 
following: 

Vouchers Payable 480 . 00 

Purchases Raw Materials 430.00 

Purchase Returns and Allowances t 50.00 

To record the cancellation of voucher 7-03 

because of the receipt of a $50.00 credit 

memorandum. See voucher 8-09. 

The method of recording exceptional items in the voucher 
register is indicated in the following illustration. Some of the 
debit columns of the voucher register which are not needed 
for the illustration are omitted. 

VOUCHER REGISTER Month of July, 19_ 









Paid 


Credit 


Debit 


Date 


Payee 


Voucher 
No. 


Date 


Check No. 


Vouchon 
Payable 


Purchases 
llaw 
Mat'lg 


Sundries 


\mount 


F 


Account 


July! 1 


Hill Mchy. Company 


7-01 


7/21 


Note Payable 


1,200 


o: 1 






1,200 


00 




Machinery 




2 


B. S. Wallace 


7-02 


7/12 


V7-04, 05 


900 


00 


900 


00 






















f50 


00 


) C)0 


00 


) 










3 


II. Lowry 


7-03 






430 


00 


480 


00 












12 


B. S. Wallace 


7-C4 






4>0 


00 












C Vouchers 




12 


B. S. Wallace 


7-05 






4iO 


00 






900 


00 




I Payable 





- 










3.430 


00 


1.330 


00 


2,100 


22 








476 



ACCOUNTING FUNDAMENTALS 



(Ch.XXIX 



The record on the first line of the illustration on page 475 
shows that on July 1, voucher 7-01 was issued in favor of tho 
Hill Machinery Company for $1,200.00 and that on July 21 
a note payable was issued to the Hill Machinery Company and 
the voucher was canceled. The insertion of the words Note 
Payable in the Check No. column indicates the issuance of the 
note. The entry for the note appears in the general journal. 

The record on the second line indicates that voucher 7-02 
was entered on July 2, that on July 12 it was canceled and 
vouchers 7-04 and 7-05 were issued in replacement of it. The 
last two mentioned vouchers are shown on lines 4 and 5 as debits 
and credits to Vouchers Payable for $900.00. 

The record on July 3 shows that voucher 7-03 was issued 
in favor of H. Lowry for $480.00. The two $50.00 amounts 
in parentheses inserted immediately above the debit and credit 
amounts indicate a red-ink entry the debit and credit of which 
are the reverse of the column headings. The credit memorandum 
for this $50.00 entry is attached to the voucher and the face 
of the voucher is corrected to show an indebtedness to the vendor 
of $430.00. 

The column totals are shown as an illustration of the fact 
that the correct total of a column with a red-ink insert is the 
sum of the black figures loss the sum of any red-ink items. 



The Vouchers Payable Account 

The control account Vouchers Payable takes the place of the 
Accounts Payable account. The debits and credits to this 
account and their sources are shown in the following illustration : 

VOUCHERS PAYABLE 



'May 


31 


Check Register 




XXX 




May 


1 


Balance 




XXX 








General Jour- 










31 


Voucher Regis- 












nal 




XXX 








ter 




XXX 








Voucher Regis- 
























ter 




XXX 




















Balance 




XXX 
























xxxxx 












xxxxx 
















June 


1 


Balance 




XXX 





Ch. XXIX] 



THE VOUCHER SYSTEM 



477 



The balance of the Vouchers Payable account should agree 
with the total of the vouchers in the unpaid voucher file and 
with the sum of the unpaid vouchers as shown in the voucher 
register. 

Other Forms of Voucher Register 

Now that the essential features of the voucher system have 
been outlined, some of the variations in its use, particularly with 
respect to the form of the voucher register, may be considered. 

Voucher Register to Classify Purchases by Departments 

If a business desires to keep record of its purchases by depart- 
ments, a column for each department is provided in the debit 
distribution section of the voucher register. In the following 
illustration only the Credit Vouchers Payable and a few of the 
Debit distribution columns are shown. The columns which are 
omitted are the same as or comparable to the columns shown 
in the voucher register illustrated on page 467. 

VOUCHER REGISTER 



Credit 


Debit 


Vouchers 
Payable 


Purchases 
Dept. A 


Purchases 
Dept. B 


Purchases 
Dept. C 

























Voucher Register with Purchase Discount Column 

Some enterprises follow the definite policy of paying all invoices 
and bills within the discount period. Some enterprises even 
draw the check, for the amount of the invoice or bill less the 
discount, at the time the voucher is prepared. Under either 
or both of these situations, the amount of the purchase discount 
may be shown in the voucher register rather than in the cash 
disbursements journal. 



478 



ACCOUNTING FUNDAMENTALS 
VOUCHER REGISTER 



(Ch. XXIX 



Credit 


Debit 


Vouchers 
Payable 


Purchase 
Discounts 


Purchases 
Raw 
Materiab 




490 


OC 


10 


OC 


500 


00 







The few columns of a voucher register shown in the above 
illustration are sufficient to indicate the use of the Purchase 
Discounts column. The figures indicate that $500.00 worth of 
raw materials was purchased, that the invoice was subject to a 
discount of $10.00, and that a voucher in the amount of $490.00 
was prepared. 

When a purchase discounts column is included in the voucher 
register, it is eliminated from the cash disbursements journal. 

Under this plan, failure to pay a voucher within the discount 
period requires the preparation of another voucher for the 
amount of the discount not taken, or the cancellation of the old 
voucher and the preparation of a new one for the full amount 
of the invoice. 

Under this plan also, liabilities on vouchers are shown at net 
amounts and purchase discount is shown as an earning at the 
time the liability is incurred rather than at the time the debt 
is paid. The discount on vouchers not due and not paid must 
be treated, at the end of a fiscal period, as income collected in 
advance, since purchase discount is not earned until payment is 
made. 



Voucher Register with Debit Distribution Control Account 
Columns 

If an enterprise has a great many expense accounts, it may be 
inadvisable to expand the voucher register to provide a column 
for each expense. A voucher register with a great many columns 
is unwieldy and wasteful of time in recording. In such a situa- 
tion the size of the voucher register may actually be reduced, 
if additional subsidiary ledgers are provided for raw materials 



Ch. XXIX] 



THE VOUCHER SYSTEM 



479 



and the several classes of expense accounts, such as manufactur- 
ing, selling, and general and administrative. 



(Left Page) 



VOUCHER REGISTER Month of 



Date 


Payee 


Voucher 
No. 


Paid 


Credit 


Debit 


Date 


Check 
No. 


Vouche 
Payab 


n 
e 


Raw 
Materia 


s 


Mfg. 
Expenses 

















VOUCHER REGISTER 



(Right Page) 



Debit 


Selling 
Expenses 


Gen'l. and 
A dm. 
Expenses 


Sundries 


Amount 


F 


Account 

















In the voucher register just illustrated, the debit distribution 
accounts Raw Materials, Manufacturing Expenses, Selling 
Expenses, and General and Administrative Expenses represent 
controlling accounts each of which is suppoited by a subsidiary 
ledger. The raw materials subsidiary ledger, for example, 
contains accounts with the different sizes and kinds of materials 
used by the enterprise; the manufacturing expense subsidiary 
ledger contains accounts such as Light, Heat and Power, Indirect 
Labor, Factory Supplies, and Insurance. 

Charges to Direct Labor account are made in the Sundries 
section as are charges to all other accounts not represented by a 
column heading. The debits to accounts in the subsidiary 
ledgers arc made from the vouchers. The controlling accounts 
Raw Materials, Manufacturing Expenses, Selling Expenses, and 
General and Administrative Expenses are debited for the totals 
of their respective columns at the end of the month, when 
Vouchers Payable is credited with the total of its column. 



480 



ACCOUNTING FUNDAMENTALS 



[Ch. XXIX 



Voucher Register with Sundry Debit and Credit Columns 

Some voucher registers are prepared with a credit as well 
as a debit column in the sundries section. The purpose of the 
new credit column is to provide a place in the voucher register 
to record a transaction such as a purchase return or an allowance 
on purchases, after the voucher is prepared and recorded. The 
new credit column makes possible the recording of a purchase 
return or allowance without resorting to the red-ink inserts 
previously illustrated. 

Sundry Debit and Credit Columns in Voucher Register Illustrated 

VOUCHER REGISTER Month of July, 19__ 





Paid 


Credit 


Debit 


Sundry Debits and Credits 


Vouch- 










er No. 


Date 


Check 

No. 


Vouchers 
Payable 


Purchases 
Raw 
Mat 'Is. 


Account 


F 


Amount 
Debit 


Account 


F 


Amount 
Credit 


7-03 


7-11 


V7-03 


480 


00 


480 


00 


















7-06 






430 


00 






Vouchers Pay. 




4SO 


00 


Pur. Ilaw Mat'ls 




50 


00 



Columns not needed to illustrate the use of the sundry debit 
and credit columns were omitted in the voucher register illus- 
trated above. The entries are for two of the transactions shown 
in the voucher register on page 475. The record on the first 
line above shows that voucher 7-03 was issued for the purchase 
of $480.00 worth of raw materials, but that the voucher was 
canceled and voucher 7-06 was issued. The second record, 
voucher 7-06, shows that purchases in the amount of $50.00 
were returned or an allowance was obtained in that amount. 
The credit memorandum is attached to voucher 7-06. For the 
purpose of illustration, the above voucher register records are 
expressed in the form of general journal entries as follows: 



Purchases Raw Materials 
Vouchers Payable 

Vouchers Payable 

Vouchers Payable 
Purchases Raw Materials 



480.00 



480.00 



480.00 

430.00 
50.00 



Ch. XXIXJ THE VOUCHER SYSTEM 481 

An enterprise which uses a voucher register with both debit 
and credit columns under sundries might record a purchase 
return or an allowance by the red-ink insert method, if the 
return or allowance came in the month the voucher was recorded 
and before it was paid. If the credit did not come until after 
the month in which the original voucher was recorded, the 
credit would be recorded as illustrated on page 480* An enter- 
prise which prepares its checks at the same time the voucher is 
prepared would also record the credit as illustrated on the pre- 
vious page. 

The several different illustrations which have been given of 
the voucher register are sufficient to indicate that such a record 
should be designed to meet the needs of a particular enterprise. 
The forms in use vary from business to business. 

Advantages of the Voucher System 

The voucher system is not suggested as an accounting plan 
for all business enterprises. Its use is not necessary in a small 
enterprise, particularly one with a high degree of proprietary 
supervision and control. It may be a cumbrous plan to a large 
enterprise, especially if the enterprise is not well organized nor 
in a financial condition to permit the operation of the system 
as planned. If an enterprise which uses the voucher system 
runs short of cash and cannot pay its approved vouchers accord- 
ing to schedule, it may develop an unwieldy file of approved, 
unpaid vouchers. In addition, an enterprise may find the 
system hinders rather than helps, if it has many returns and 
allowances or other corrections after purchase invoices are 
approved and recorded, if it has to issue many notes to 
defer payments, or if it has to make many partial payments 
on approved vouchers. 

To an enterprise equipped with the personnel and finances 
to operate the system successfully, it offers certain very decided 
advantages, some of which are 

1. It provides a systematic plan for the verification and 
approval of all invoices, bills, and other items requiring 
the disbursement of cash. Cash disbursements are safe- 
guarded thereby. 

2. It provides for the recording in one journal (voucher 
register), at the time of incurrence, of all approved items 



482 ACCOUNTING FUNDAMENTALS [Ch. XXIX 

which require the immediate disbursement of cash or the 
assumption of current liabilities except those for notes and 
accruals payable. 

3. It provides for the immediate recording of all current 
liabilities. It is a common practice for enterprises which 
do not use the voucher system to fail to record bills for 
such items as services and repairs until such time as they 
are paid. It is desirable to show all liabilities on the records 
from the time incurred. 

4. It indicates current liabilities to creditors, other than 
those on notes payable and accruals payable, as a file of 
approved vouchers for particular invoices or bills and not 
as accounts with credit balances in a creditors' subsidiary 
ledger. The system, therefore, facilitates the payment of 
specific invoices and bills, a plan which is much more 
satisfactory to both the debtor and the creditor than a 
plan under which frequent part payments on account 
may be made. 

5. Voucher checks may be provided in a form to act as receipts 
for specific payments. 

6. Bookkeeping is reduced by the elimination of the creditors' 
subsidiary ledger. 

7. The cash disbursements journal is reduced to a mere check 
register because the distribution of the charges for each 
disbursement are made in the voucher register. 

8. The placing of responsibility for verifications and approvals 
strengthens the system of internal check. 

9. The payment of invoices and bills within the discount 
period is facilitated. Approved vouchers are placed in a 
tickler file under the last date they may be paid to save 
the discount. Vouchers to be paid each day are noticed 
by a daily reference to the file for that purpose. 

The Journal Voucher 

In addition to the voucher system, many large enterprises 
use vouchers for general journal entries. 

Entries in the general journal record transactions such as the 
receipt of notes from customers and the issuance of notes to 
creditors when note journals are not used, corrections of other 
entries, and adjusting and closing entries. General j ournal entries 



Ch. XXIX] 



THE VOUCHER SYSTEM 



483 



should be approved by the proper accounting officer and should 
be explained adequately before they are entered in the general 
journal. The use of vouchers makes easier the approval and 
explanation of the entries. 

Journal Voucher Illustrated 



WILSON WIRE WORKS 
JOURNAL VOUCHER 



No. 349 
Date June 10, 19 



Vouchers Payable 



Notes Payable 



To cancel voucher 5-07 and to record the issuance of 
a 30-day 6 per cent note dated today to the Acme 
Machinery Co. 



00000 



60000 



L. Little 



R. Price 



E. Dudley 



Prepared By 



Approved By 



Entered By 



Since a journal voucher contains a full explanation of the entry, 
the explanation may be omitted from the journal. In the 
general journal only the date, journal voucher number, and the 
debit and credit accounts and amounts will be shown. 

Very often the postings are made directly from the voucher 
to the accounts debited and credited and the voucher is entered 
in the general journal only for summary control account posting 
purposes. 

Concluding Comments 

The voucher system is not usually an easy subject for students 
to understand. The use of the voucher register CLS a combined 
original entry book and ledger constitutes a very radical depar- 
ture from the accounting methods previously studied. The 
methods of recording exceptional transactions, such as the 
issuance of a note for a voucher, the purchase return or allowance, 



484 ACCOUNTING FUNDAMENTALS [Ch. XXIX 

or the partial payment of a voucher, make the system seem even 
more radical in its variation from the more generally known 
accounting procedure. It is suggested that the general plan of 
operating the system be studied and understood before an 
intensive examination is made of the methods of recording 
exceptional transactions. 

QUESTIONS 

1. a. Is the voucher system more than a system of recording? What 

is it? 
6. Under the voucher system when does the accounting department 

record a purchase invoice? A bill for services rendered to the 

enterprise? A payroll sheet? 
c. How does the treasurer know whether or not to pay such items 

as are referred to in 6? 

2. a. What is a voucher payable? Where is it prepared? When is 

it prepared? What is done with it after it is made out? 
6. Is a voucher prepared for a purchase which is to be paid 
immediately? 

3. What kind of account is Vouchers Payable? Where is it kept? 
What does it control? 

4. a. How does the clerk who enters a voucher in the voucher register 

know what accounts to debit for it? 
6. Why is not the credit on each voucher indicated clearly as such? 

5. a. Under the voucher system how does a business know whom it 

owes, if a subsidiary ledger for creditors is not kept? 
6. Suppose it desired to keep a record of the purchases from each 
creditor, could it be done? How? 

6. To what extent does a voucher system increase work? Decrease 
work? 

7. "All vouchers are recorded in the voucher register." Do you agree? 

8. What two checks are there on the balance of the Vouchers Payable 
controlling account? 

9. What differences have you noted between the voucher register and 
the columnar purchase journal, with reference particularly to the 
transactions recorded, additional information shown, and the 
postings to be made? 

10. The Morris Equipment Company operates a subsidiary ledger for 
creditors. A voucher system has been approved by the President 
but has not been installed. What changes are necessary? 

11. a. What are the debits and credits from the check register? 

b. Why is it not necessary to provide a column in the check register 
for the general ledger? 



Ch. XXIX] THE VOUCHER SYSTEM 485 

12. a. Describe a plan for filing unpaid vouchers. 
6. Describe a plan for filing paid vouchers. 

13. In what respect does a voucher check differ from any other check? 

14. a. Explain the method of recording a purchase invoice for which a 

note is given. Explain also the method of recording the payment 
of the note. 
6. Explain the method of recording the issuance of a note to a 

creditor to satisfy an open account. 

16. Suppose a voucher cannot be paid in full and a partial payment is 
made. Explain how this situation is handled and recorded. 

16. a. Suppose you ordered 15,000 shipping boxes. A purchase invoice 

for that number was received but only 14,000 boxes were 
delivered. 

(1) How would the accounting department know that only 
14,000 boxes were delivered? 

(2) Would the invoice be entered at its face or a corrected 
amount? 

(3) What kind of document would you expect to receive from the 
box manufacturer, if the additional 1,000 boxes are not to 
be shipped? 

6. Suppose the purchase invoice referred to above had been entered 
at its face amount, by error, before the credit memo from the 
manufacturer was received, 

(1) Give two methods of correcting. 

(2) Which method do you favor? Why? 

c. Suppose the credit memo was not received and the error in 
recording the purchase invoice was not noticed until the month 
following the preparation and recording of the voucher but 
prior to the payment of it. 

(1) How could this situation be handled? 

(2) Why must the method suggested for c(l) be different from 
the methods suggested for 6(1)? 

17. In examining a voucher register you notice two sets of red-ink 
figures for the same amount, one set in the credit vouchers payable 
column and the other set in one of the debit columns. 

a. What is the significance of the red-ink figures? 

b. Are the end of the month totals of the columns in which the red- 
ink figures appear the sum of all the figures which appear in 
those columns? Explain. 

18. Set up a Vouchers Payable account and show therein the sources of 
the debits and credits to it. 

19. a. Do you believe it possible to design a voucher register in which 

purchase returns and allowances might be entered without the 



486 ACCOUNTING FUNDAMENTALS [Ch. XXIX 

use of red-ink inserts or without the use of a general journal 
entry? Explain. 

20. a. Can you think of any enterprises in which the use of the voucher 

system would not be advantageous? 

6. May a business which uses the voucher system have any current 
liabilities other than vouchers payable? If so, what? 

c. Which is the better business practice for a debtor, to make 
partial payments on account of amounts owed or to pay specific 
invoices? Why? Which plan does the voucher system 
facilitate? 

d. What do you mean by a system of internal check? Illustrate 
from the operation of the voucher system. 

21. a. Why would a business use journal vouchers? 

6. May the debits and credits be posted from the journal vouchers 

to the ledgers? 
c. If your answer to 6 is yes, would the business have any need for 

a general journal? If so, why? 



CHAPTER XXX 

ANALYSIS AND INTERPRETATION OF FINANCIAL 
STATEMENTS 

The definition, of accounting given in Chapter I included 
three distinct functions to record, to present, and to interpret 
the financial facts of an enterprise. Until now this book has 
been concerned, primarily, with the first two functions. Finan- 
cial facts must be recorded and presented before they can be 
interpreted. 

The full significance of an accounting statement may not be 
apparent to those persons for whom it has been prepared; it 
may need to be explained. It is the responsibility of the chief 
accounting officer to explain the accounting statements to the 
general officers and departmental executives of the company. 

The controller of a company is the executive in charge of 
accounting; it is his responsibility to see that an adequate 
accounting system is provided and operated, that statements 
and reports are prepared promptly and that these statements 
and interpretations of them are presented to the other executives 
in a manner which will facilitate their maximum utilization. 
Decisions with respect to future sales, production, finance, 
and other departmental policies are made by the executives in 
charge of those departments and the general management, but 
these decisions should be made with a full knowledge of the 
financial facts of the past as accumulated, presented, and inter- 
preted by the accounting department. 

Objectives of Statement Analysis and Interpretation 

In general, statement analysis and interpretation are made to 
determine 

1. If the financial condition of the enterprise, as indicated 
by its balance sheet is sound and if the relationship between 
the various balance sheet groups is satisfactory, i.e., that 
the relationships of current assets to current liabilities, 

4S7 



488 ACCOUNTING FUNDAMENTALS [Ch. XXX 

fixed assets to fixed liabilities, fixed assets to proprietorship, 
fixed liabilities to proprietorship, and other such relation- 
ships, are in proper proportion and indicate a healthy 
condition. 

2. If the enterprise, as indicated by its statement of profit 
and loss is operating with satisfactory results and that 
the relationships between certain operating figures and 
certain balance sheet figures indicate satisfactory conditions. 

3. If the financial facts and operating figures, as indicated 
respectively by the balance sheets and profit and loss 
statements for a number of periods, indicate any directions 
in which the enterprise seems pointed any trends. 

The information disclosed by analysis and interpretation is 
desired by the management of an enterprise as a means of better 
control and direction; it is desired by outsiders usually for 
credit and investment purposes. 

Analysis and Interpretation by the Accounting Department 

As has been explained previously, the analysis and interpreta- 
tion of accounting statements for the use of the management 
of an enterprise are a definite responsibility of the accounting 
department. Naturally such an analysis and interpretation 
are much more detailed than an analysis and interpretation 
which may be published in the annual report of an enterprise. 
An internal analysis and interpretation are more exact and 
comprehensive than an analysis and interpretation made by an 
outsider, because all statements of prior years are available 
as well as the detailed facts shown in the accounts on the books. 
In addition, existing conditions may be compared with pre- 
determined standards, such as budget figures when used. Varia- 
tions from predetermined standards should not merely be 
pointed out but should be investigated as to their cause. 

Analysis and Interpretation by an Outsider 

An analysis and interpretation, made from the published 
statements of an enterprise by someone not employed or engaged 
by it, are usually for credit or investment purposes. Such an 
analysis and interpretation are limited because the published 
statements usually are in condensed form and there is no oppor- 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 489 

tunity to supplement them by reference to the ledger accounts. 
A considerable amount of valuable information may be obtained, 
however, by a careful examination of the balance sheet of an 
enterprise, more may be obtained by an examination of both the 
balance sheet and the profit and loss statement, and much 
additional information may be obtained by a study of both 
statements for a number of prior years. 

Persons Interested in Analysis and Interpretation of Financial 
Statements 

1. Managers. Accounting is an indispensable aid to manage- 
ment. Through the analysis and interpretation of the financial 
statements the financial facts of the past and present are revealed 
more clearly, the results of operations are disclosed in greater 
detail, and data supplied on which, in part, future policies may 
be determined. 

2. Owners. In a small business enterprise the owners may 
be the managers; in a large corporate enterprise that situation 
is not likely. Analysis and interpretation of the financial 
statements afford stockholders a better measure of the accom- 
plishment of the managers of the enterprise, particularly with 
respect to dividend possibilities and the enhancement in the 
value of their stock in the future. 

3. Creditors. The short-term creditor will not make a loan 
to or sell goods on credit to a business which may not be in a 
sufficiently liquid position to settle the claim at maturity. 
The credit departments of banks and business houses maintain 
files of the statements of their debtors and make their own 
analyses and interpretations. 

Long-term creditors may be protected by the pledge of particu- 
lar assets, nevertheless they are very much interested in the 
analyses and interpretations of the financial statements of the 
companies whose bonds they hold. If they see financial difficul- 
ties ahead for the debtor corporation they may wish to sell their 
bonds in the market. 

4. Prospective Investors. A person contemplating an invest- 
ment in a particular enterprise is very much interested in its 
past and present financial condition and the trend of its operating 
profit or loss as exhibited by its statements over a number of 
periods. 



490 ACCOUNTING FUNDAMENTALS [Ch. XXX 

5. Government Officials. Analysis and interpretation of the 
financial statements of an enterprise may have to be made in 
connection with the various city, county, state, and federal 
taxes to which the business may be subject, also for filing reports 
with various state and national commissions which require such 
data. 

6. Employees. Some employees are interested in their 
companies as stockholders. They are interested also from the 
standpoint of the future development of the companies, the possi- 
bilities for which may be indicated by the information disclosed 
by the analysis and interpretation of the statements. 

7. Citizens. The ordinary citizen is interested in an analysis 
and interpretation of the financial statements of some companies, 
such as his bank, telephone, water, gas, and electric companies. 
The analysis of his bank statements helps him to determine 
its solvency and safety, the analyses of the statements of the 
utility companies indicate the possibilities of rate reductions or 
increases. Similarly the ordinary citizen should be interested in 
analyses of the statements of his governmental units since he 
contributes to their support as a taxpayer. 

Analysis and Interpretation Methods 

Some of the fundamental methods of analyzing and inter- 
preting financial statements are 

1. To set up a balance sheet with per cent as well as dollar and 
cent columns. The per cent columns alongside the assets 
indicate the percentage relationship of each group of 
assets to the total assets, as well as the relationship of each 
asset to the total of its group. In the liability and proprie- 
torship sections the per cent columns indicate the relation- 
ship of each liability and each item of proprietorship to 
its group and of each group to the total liabilities and 
proprietorship. 

2. To set up a profit and loss statement with a per cent as 
well as dollar and cent columns. Net sales Ls considered 
100 per cent and each item and each group of items are 
expressed as a percentage of net sales. 

3. To indicate the relationship of any one asset or group of 
assets, of any one liability or group of liabilities, of any 



Oh. XXX] ANALYSIS OF FINANCIAL STATEMENTS 491 

one net worth item or group of items to any other item or 
group of items on the balance sheet. Thus the relationship 
of land and buildings to first mortgage bonds payable 
may be indicated or the relationship of the current assets 
to the current liabilities. 

4. To show the relationship of any item or group of items on 
the profit and loss statement to any other item or group of 
items on the same statement, i.e., the relationship of 
selling expenses to net sales or general and administrative 
expenses to net sales. 

5. To indicate the relationship of any item or group of items 
on the balance sheet to any item or group of items on the 
statement of profit and loss, i.e., the relationship of net 
profit for the period to capital stock. 

6. To prepare a comparative balance sheet to indicate the 
increases and decreases in individual items which have 
taken place over the period. 

7. To prepare a comparative statement of profit and loss to 
indicate the increases and decreases of the current year 
from the preceding year. 

8. To ascertain results and conditions over a period of years 
from a study of balance sheets and profit and loss statements 
and to develop therefrom indications of trends. 

Ratios 

The relationship of one item to another is usually expressed 
as a ratio. Thus, if current assets are $600,000.00 and current 
liabilities are $200,000.00, the relationship is expressed as 
3 to 1 (3 : 1). Sometimes a relationship is expressed as a per cent. 
The relation of the current assets to the current liabilities for 
the figures just given is stated as 300 per cent. 

Analysis and Interpretation of a Balance Sheet 

The inclusion of the per cent columns in the balance sheet on 
page 492 facilitates the comparison of items on the statement. 
For example, it might not be evident from looking at the amounts 
alone that the Reserve for Bad Debts is less than one per cent 
of the amount of Accounts Receivable or that the Reserve for 
Depreciation of Buildings is 8.33 per cent of the amount in the 
Buildings account. Both of these reserve accounts seem small. 



492 ACCOUNTING FUNDAMENTALS [Ch. XXX 

THE STAR STORES COMPANY. 
BALANCE SHEET, DECEMBER 31, 19A 

Asseta 

Per Per Per 

Cent Cent Cent 

Current Assets: 

Cash $ 50,000.00 8.33 

Accounts Receivable $202,000.00 100.00 
Less: Reserve for 

Bad Debts 2.000.00 .99 

99 -* 200,000.00 33.34 

Notes Receivable 60 , 000 .00 8 33 

Inventory of Merchandise 300.000 00 50.00 

Total Current Assets 100 00 $ 600,000.00 42.8 

Deferred Assets: 

Prepaid Insurance 1 , 000 .00 00 . 1 

Fixed Assets: 

Land $200,000.00 25.00 

Buildings $600,000.00 100.00 

Less: Reserve for 

Depreciation 50,000.00 8.33 

91 - 6 ? 550,000.00 68.75 
Store Furniture and 

Fixtures $ 50,000.00 100.00 

Less: Reserve for 

Depreciation... 15.000.00 30.00 

OQ S 5 ' 000 - 00 4 - 375 
Office Furniture and 

Fixtures $ 20,000.00 100.00 

Less: Reserve for 

Depreciation 5,000 00 25 00 

75 00 15.000 00 1.875 

Total Fixed Asset* "7777777777 100 00 800.000.00 57.1 

Total Assets $1.401.000.00 100 00 

Liabilities 
Current Liabilities: 

Accounts Payable $178,000.00 68.46 

Notes Payable 80,000.00 30.77 

Accrued Payroll 2,000.00 .77 

Total Current Liabilities 100 00 $ 260,000.00 18.56 

Fixed Liabilities: 

First Mortgage 6 per cent Bonds Payable 200,000.00 14,27 

Proprietorship 
Capital Stock (7,500 shares par $100.00) .... $750,000 00 

Surplus 191.000 00 

Total Proprietorship 941.000.00 67.17 

Total Liabilities and Proprietorship $1.401.000.00 100.00 

If the company is not providing reserves on conservative bases 
then the balance sheet represents an overstatement of values 
and the profit and loss statement represents overstated profits. 

It will be noticed from The Star Stores Company balance 
sheet that Cash represents 8.33 per cent of the current assets 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 493 

and that Inventory of Merchandise is 50 per cent. Current 
assets are 42.8 per cent of all assets, deferred assets only .1 per 
cent and fixed assets 57.1 per cent. The amount of Notes 
Receivable seems high. That item represents 8.33 per cent of 
the current assets, the same proportion as Cash. If Notes 
Receivable are high because notes have been taken from delin- 
quent customers, then it would seem the company has not valued 
this item conservatively. On the other hand, if it is the usual 
practice for this company to take notes from customers, then no 
particular significance attaches to the item. 

The asset Accounts Receivable may be analyzed and shown 
in a schedule to indicate the amount not yet due, the amount 
not over 30 days past due, the amount over 30 days past due 
but not over 60 days, and the amount more than 60 days past 
due. 

Notes Payable seem high; they represent 30.77 per cent of the 
current liabilities. If the issuance of notes by the company 
reflects a failure to pay bills within the discount period, it is a 
warning signal with respect to the company's liquid position. 

The fixed liability First Mortgage Bonds Payable is secured 
by a lien on the Land and Buildings. The bondholders have 
ample protection as long as the company maintains a strong 
liquid position so that it can pay interest as it falls due. Unfor- 
tunately the balance sheet docs not indicate, as it should, the 
due date of the bonds. It will be noticed that the company 
is making no provision for their retirement; there is no reserve 
for bond retirement account nor is there a sinking fund. If 
these bonds mature within a few years, the company evidently 
will have to refund them. 

Ratio of Fixed Assets to Fixed Liabilities. The relationship of 
fixed assets to fixed liabilities is $800,000.00 to $200,000.00 or 
4 to 1 (4:1), a satisfactory condition J^Funds obtained from 
fixed liabilities are used usually for the acquiiUoa^f fixed 
assets and in this instance it is evident tEat $600,000.00 of 
proprietary capital was used for fixed assets. 

Ratio of Proprietorship to Fixed Liabilities. The relationship 
of net worth to fixed liabilities is $941,000.00 to $200,000.00 
or 4.705 to 1. Fixed liabilities mean interest payments, a 
fixed charge even in bad yearsjlplnterest on fixed liabilities may 
cause a serious drain on a company's cash in periods of poor 



494 ACCOUNTING FUNDAMENTALS [Ch. XXX 

business. During bad times particularly dividends need not 
be paid on capital stock. 

Ratio of Proprietorship to Total Liabilities and Proprietorship. 
The relationship of Proprietorship to Total Liabilities and 
Proprietorship is brought out clearly by the per cent column 
in the statement. Proprietorship interest in the company 
represents 67.17 per cent of the Total Liabilities and Proprietor- 
ship^From the standpoint of a creditor this percentage means 
that in the event of liquidation losses in asset values to an 
amount of 67.17 per cent could take place before creditors would 
lose anything. In the case of The Star Stores Company, how- 
ever, not all creditors would rank alike, since the bondholders 
have first claim on the land and buildings. 

Ratio of Proprietorship to Fixed Assets. The ratio of pro- 
prietorship to fixed assets is $941,000.00 to $800,000.00 or 
1.18 to l.^This ratio indicates that the owners either by original 
investments or the retention of profits in the business, in this 
instance by both methods, have contributed more than enough 
to acquire all the fixed assets. 

Current Ratio. A current ratio is the expression of the rela- 
tionship between the current assets and the current liabilities 
of an enterpriser^ It is a test used to determine the ability of 
an enterprise to liquidate its current indebtedness and to finance 
operations in the immediate future. Because of its long- 
continued use by bankers and other creditors, the current ratio 
is the best known of all ratios used in statement analysis. It 
is stated, very often, that a current ratio should be! 2 to 1J This 
statement cannot be accepted as a general rule altliough it may 
serve as a general guide. The proper ratio in a particular 
case depends largely on the special circumstances which apply 
to the company at the time. 

The current ratio for The Star Stores Company is $600,000.00 
to $260,000.00 or 2.31 to 1 or just 2.31. Expressed as a per- 
centage the relationship is 231 per centp&The figures on which 
this ratio is based seem to indicate that current assets are suffi- 
cient to liquidate current debt and leave $340,000.00 as working 
capital for future needs. The ratio indicates there are $2.31 
of current assets available to meet every $1.00 of current indebt- 
edness. Actually the current condition of The Star Stores 
Company does not appear so satisfactory as the current ratio 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 495 

indicates. The company has but*$50,000.00 of Cash on hand. 
If the immediate future proves to be a period of slow collections 
and poor business, so that Accounts and Notes Receivable are 
not collected promptly and Inventory of Merchandise is not 
turned into cash quickly, the company might find itself embar- 
rassed by a shortage of cash. Before that condition developed, 
the company could endeavor to borrow at bank, either on its 
own note or by discounting customer notes. 

The illustration of the previous paragraph not only shows the 
significance of the current ratio but the importance of proper 
proportions within the current asset group. 

Working capital is the excess of the current assets over the 
current liabilities; it does not change if both current assets 
and current liabilities increase or decrease in like amount, but 
the current ratio changes. If The Star Stores Company paid off 
$40,000.00 of accounts payable, working capital would remain 
at the figure $340,000.00 but the current ratio would change to 
$560,000.00 to $220,000.00 or 2.55 to 1. The new current ratio 
is an improvement over the previous ratio of 2.31 but the actual 
financial condition of the company would probably be weakened 
by this payment. 

Acid Test Ratio. The acid test ratio is the expression of the 
relationship of cash, receivables, and marketable securities, if 
any, to the current liabilities. The title of this ratio comes, 
obviously, from the severity of the contrast. From the stand- 
point of creditors, the higher this ratio, the more secure they feel. 
Ordinarily a ratio of 1 to 1 is considered satisfactory. In the 
case of The Star Stores Company the ratio is $300,000.00 to 
$260,000.00 or 1.15 to 1. The ratio of 1.15 to 1 is satisfactory 
ordinarily but in this instance is subject to the same comments 
made about thc^ current ratio, the relatively small amount of 

, - > L ~*~ 

cash. ^ ;. r HI 

Ratio of Intangibles to Surplus. The Star Stores Company 
does not have any intangible assets such as goodwill, patents, 
and trade-marks; if it had, the amount of such assets should 
be compared with the amount of surplus. Because the intangible 
assets may include the cost of some item of doubtful value, the 
businessman is likely to look askance at this asset. In addition, 
many leading enterprises have followed the practice of reducing 
the amount of an intangible such as goodwill from time to time 



496 ACCOUNTING FUNDAMENTALS [Ch. XXX 

by charges to Surplus. In his endeavor to determine sound 
values and relationships, the analyst outside the company is 
likely to compare intangibles with surplus and to note especially 
if any surplus would remain, if all the intangibles were written 
off. 

It would be possible to prepare many more ratios from the 
balance sheet of The Star Stores Company. Those given are 
merely illustrative. The use of ratios is most helpful when 
those of a particular company can be compared with standard 
ratios prepared from the balance sheets of a number of com- 
panies in the same industry. Such standard ratios are available 
in some industries as the result of the investigations of trade 
associations and other organizations. When standard ratios are 
available and are used for comparative purposes, variations 
between them and those of a particular enterprise must be 
considered with a full knowledge of the special circumstances 
which apply to the particular enterprise. 

Analysis and Interpretation of a Statement of Profit and Loss 

The inclusion of per cent columns in the statement of profit 
and loss on page 407 facilitates comparison of items on the state- 
ment. All percentages are based on Net Sales as 100 per cent. 
It will be noticed that Cost of Goods Sold represents 75 per cent 
and Gross Profit on Sales 25 per cent of Net Sales. Stating 
these facts in another way 75 cents of the average sales dollar 
represents cost and 25 cents the gross profit out of which the 
various expenses are met. 

Net Profit on Sales $133,000.00 is 8.75 per cent of Net Sales. 
Reduced to terms of an average $1.00 sale, 8.75 cents is the net 
profit. From the net profit on sales percentage is deducted 
the percentage figure representing the excess of Other Expenses 
and Losses over Other Income to produce the figure 8.62, the 
percentage of Net Profit for the Period. 

The per cent columns bring out much more clearly than the 
amount columns the relationship of each of the various expense 
accounts and each of the several expense classifications to Net 
Sales. For example, Delivery Expenses represents 1.32 per cent, 
Advertising 2.3 per cent, Store Salaries 7.04 per cent, Selling 
Expenses 12.96 per cent, Office Salaries 2.37 per cent, General 



Ch. XXXI ANALYSIS OF FINANCIAL STATEMENTS 497 

THE STAR STORES COMPANY 

STATEMENT OF PROFIT AND Loss 

For the Year Ended December 31, 19A 

Per 
Cent 

Sales SI ,550,400.00 102.00 

Less: Sales Returns and Allowances 30.400 00 2.00 

Net Sales $1,520,000.00 100.00 

Cost of Goods Sold: 

Inv. of Mdse., Jan. 1, 10A S 270,000 00 

Purchases 1.170.000 00 

$1,440,000.00 

Inv. of Mdjc., Dec. 31, 19A 300,000.00 1.140,000.00 75.00 

Gross Prout on Sales *. S 380,000.00 25.00 

Less: Per 

Selling Expenses: Cent 

Advertising $ 35,000.00 2 30 

Store Saliuies 107,000.00 7.04 

Store Expenses 6 , 000 . 00 .39 

Delivery Expenses. 20,000.00 1 32 

Insurance 3,000.00 .20 

Property Taxes 12 , 000 00 .79 

Dep. of Building. .. 9,000.00 .59 Per 

Dep. of Store Fur. Cent 

and Fixt 5,000 00 .33 $ 197,000.00 12.96 

General and Adm. Exp.: 

Office Expenses $ 2,010.00 .13 

Office Salaries 36 , 000 00 2 . 37 

Insurance 1,000.00 .07 

Property Taxes. . . . 4,000 00 .26 

Bad Debts 1,99000 .13 

Dep. of Building. . . 3,000.00 .20 
Dep. of Office Fur. 

and Fixt 2.000 00 .13 50.000 00 3 29 247.000 00 _16_25 

Net Profit on Sales TTTT. 777T $~133,000 00 "s775 

Other Expenses and Losses: 

Interest Expense $ 13,600 00 .89 

Sales Discounts 10 , 000 . 00 .66 $ 23 , 600 .00 1 . 53 

Other Inrome: 

Interest Earned $ 1 , 000 .00 .07 

Purchase Discounts.. 20.600 00 1 35 21.600 00 1 42 2.000 00 .13 

Net Profit for the Period $ 131.000 00 8 62 

and Administrative Expenses 3.29 per cent, and Interest Expense 
.89 per cent of Net Sales. 

Merchandise Turnover. To determine the number of times the 
average inventory was converted into sales during the year, the 
Cost of Goods Sold figure is divided by the amount of the average 
inventory at cost. The average inventory is the average of the 
inventory at the beginning and the end of the year. 

The average inventory of The Star Stores Company is $270,- 
000.00 plus $300,000.00 divided by 2 or $285,000.00. The cost 
of goods sold is $1,140,000.00. 



498 ACCOUNTING FUNDAMENTALS [Ch. XXX 

$1,140,000.00 



$285,000.00 



= 4 the rate of merchandise turnover 



The Star Stores Company is a trading business. In a manu- 
facturing business the turnover of finished goods is determined 
in the same manner by dividing the average inventory of finished 
goods into the cost of goods sold. The turnover of raw materials 
in a manufacturing business is found by dividing the average 
inventory of raw materials into the amount of raw materials 
used during the period. 

The management of an enterprise aims to maintain the 
smallest inventory consistent with satisfactory sales volume. 
The higher the rate of turnover the lower the capital require- 
ments to produce a given amount of net earnings. 

The possibility of comparing many more items on the state- 
ment of profit and loss is apparent. The comparisons mentioned 
are illustrative. The interpretation of the percentages calculated 
for a particular statement of profit and loss is aided greatly 
when they can be compared with standard percentages cal- 
culated for a number of companies in the same industry. 

Interstatement Percentages and Ratios 

A number of significant percentages and ratios may be obtained 
by comparing items or groups of items on the balance sheet with 
items or groups of items on the statement of profit and loss. A 
few examples will be illustrated. 

Number of Times Bond Interest Earned. The balance sheet 
shows that The Star Stores Company has $200,000.00 of 6 per 
cent bonds outstanding. The interest on these bonds amounts 
to $12,000.00 per year. The profit and loss statement shows the 
net profit for the period is $131,000.00. Since interest on the 
bonds was deducted as one of the Other Expenses, the net profit 
for the period exclusive of bond interest must have been $143,- 
000.03; $12,000.00 divided into $143,000.00 gives 11.9, which 
is the number of times the company earned the amount of interest 
on its bonds during the past year. Knowledge of this very 
favorable fact is gratifying to the bondholders. 

Percentage of Net Profits to Proprietorship at the Beginning 
of the Period. The proprietorship or net worth of The Star 
Stores Company is $941,000.00. If it is known that no dividends 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 499 

were paid during the year, then the $941,000.00 proprietorship 
figure includes the $131,000.00 earned in the period. In the 
absence of any adjustments to surplus, proprietorship a year 
ago was $810,000.00; $131,000.00 is 16.17 per cent of $810,000.00. 
^Percentage of Net Profits to Capital Stock. . The $131,000.00 
net profit shown by the statement of profit and loss is 17.47 per 
cent of the $750,000.00 of capital stock shown in the balance 
sheet. Here again there is an assumption, that there were no 
changes in the Capital Stock account during the year. 
- Profit per Share of Capital Stock. The balance sheet shows 
The Star Stores Company has 7,500 shares of capital stock 
outstanding 7,500 divided into $131,000.00, the net profit 
for the period, gives $17.47 as the earnings of each share of capital 
stock in the last period. This same answer may be obtained 
by multiplying the par value of a share by the percentage of 
profit on capital stock. 

Comparative Balance Sheets 

The analysis and interpretation of the financial statements 
of an enterprise -are aided greatly when each statement appears 
in comparative form. The statement of a single amount may 
carry very little meaning; only when compared with other 
amounts does its true significance become apparent. Some 
companies issue their statements in comparative form by pre- 
senting, usually, the figures for the period just ended in the 
first column, and the figures for the preceding period in the second 
column with a third column to indicate the amount of the 
increase or decrease in each item. Since increases and decreases 
are given usually in the one column, increases are indicated 
by the use of the plus (+) sign and decreases by the minus 
sign (-). 

The comparative balance sheet of The Star Stores Company, 
particularly the column showing Increases or Decreases, indicates 
certain outstanding facts. A decrease of $150,000.00 in Cash 
is noticed immediately, as is a decrease of $100,000.00 in the 
Total Current Assets. The increases in each of the fixed assets, 
especially in the cases of Land and Buildings stand out because 
of the size of the amounts. The $312,000.00 increase in Total 
Fixed Assets and the $80,000.00 increase in Total Current 
Liabilities are other especially noticeable items. 



500 



ACCOUNTING FUNDAMENTALS 



[Ch.XXX 



THE STAR 
COMPARATIVE BALANCE 



Assets 


19A 


10B 


Inc. or Dec. 


Current Assets: 
Cash 


$ 50,000.00 


$ 200,000.00 


-$150,000.00 


Accounts Receivable (Net) 
Notes Receivable 


200,000.00 
50,000.00 


210,000.00 
20,000.00 


- 10,000.00 
+ 30,000.00 


Inventory of Merchandise 


300,000 00 


270,000.00 


+ 30,000.00 


Total Current Assets. . . 


$ 600,000.00 


$ 700,000 00 


-$100,000.00 


Deferred Assets: 
Prepaid Insurance 


$ 1,000.00 


$ 2,000.00 


-$ 1,000.00 


Fixed Assets: 
Land 


$ 200,000.00 


$ 100,000.00 


+$100,000.00 


Buildings 


$ 600,000.00 


$ 380,000.00 


+$220,000.00 


Less: Reserve for De- 
preciation 


50,000.00 


38,000.00 


+ 12,000.00 




$ 550,000.00 


$ 342,000.00 


+$208,000 00 


Store Furniture and Fix- 
tures 


$ 50,000.00 


$ 42,000.00 


+$ 8,000.00 


Less: Reserve for De- 
preciation 


15,000.00 


10,000.00 


+ 5,000.00 




$ 35,000.00 


% 32,000.00 


+$ 3,000.00 


Office Furniture and Fix- 
tures 


$ 20,000.00 


$ 17,000.00 


+$ 3,000.00 


Less: Reserve for De- 
preciation 


5,000.00 


3,000.00 


+ 2,000.00 




$ 15,000.00 


% 14,000 00 


+$ 1,000 00 


Total Fixed Assets 


$ 800,000.00 


$ 488,000.00 


+$312,000.00 


Total Assets 


$1,401,000.00 


$1,190,000.00 


+$211,000 00 











NOTE: The column headed 19 A presents the figures as at the end of the year just closed; 
the column headed 19B presents the figures for the preceding year. 

A balance sheet comparison, such as the one here illustrated, 
shows net changes in an item between the end of one year and 
the same date one year later. It does not show the detailed 
changes for the item which have occurred during the year. For 
example, Buildings show a net increase of $220,000.00 from a 
year ago. This may mean that an additional building which 
cost $220,000.00 was acquired during the year or it may mean 
that a building which cost $250,000.00 was acquired and a 
building which cost $30,000.00 was sold. The fact that an 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 



501 



STORES COMPANY 

SHEET, DECEMBER 31, 10A and 19B 



Liabilities 


19 A 


19B 


Inc. or Dec. 


Current Liabilities : 
Accounts Payable 


$ 178,000.00 


$ 169,000.00 


+$ 9,000.00 


Notes Payable 


80,000.00 


10,000.00 


+ 70,000.00 


Accrued Payroll 


2,000.00 


1,000.00 


+ 1,000.00 


Total Current Liabili- 
ties 


$ 260,000.00 


$ 180,000.00 


+$ 80,000.00 










Fixed Liabilities: 
First Mortgage 6 per cent 
Bonds Payable .... 


$ 200,000.00 


$ 200,000.00 












Total Liabilities 


$ 460,000 00 


$ 380,000.00 


+$ 80,000.00 










Proprietorship 
Capital Stock 


$ 750,000 00 


$ 750,000 00 




Surplus End of Previous 
Year 


$ 60,000.00 


$ 15,000.00 


+$ 45,000.00 


Net Profit for the Year. . 


131,000.00 


120,000.00 


+ 11,000.00 


Total 


8 191,000.00 


$ 135,000.00 


+$ 56,000.00 


Dividends Paid 




75,000.00 


- 75,000 00 










Surplus End of Year 


$ 191,000.00 


$ 60,000.00 


+$131,000.00 










Total Proprietorship. . . 


$ 941,000.00 


$ 810,000.00 


+$131,000.00 


Total Liabilities and 
Proprietorship 


$1,401,000.00 


$1,190,000 00 


+$211,000.00 











item has increased between statements shows that the increases 
have exceeded the decreases. 

A comparison of the current ratio fqr the two years is impor- 
tant. As previously determined, for the year just ended the 
ratio is 2.31 to 1. A year ago the current ratio was $700,000.00 
to $180,000.00 or 3.89 to 1. It is noticed that the change was 
brought about by a decrease in current assets and an increase in 
current liabilities. Of great importance is the fact that the 
greatest change in current assets and liabilities was a decrease 
of $150,000.00 in cash which left that item with the relatively 
small balance for this company of $50,000.00. 



502 ACCOUNTING FUNDAMENTALS [Ch. XXX 

As previously calculated, the ratio of fixed assets to fixed 
liabilities at the end of the year just ended is 4 to 1. A year 
before the ratio was $488,000.00 to $200,000.00 or 2.44 to 1. 
Similar comparisons may be made between the ratios at the 
end of the year just closed and the end of the previous year for 
all the balance sheet ratios considered previously in this chapter. 

The few facts just noted about the comparative balance sheet 
of The Star Stores Company are sufficient to indicate that 
working capital has been materially reduced ($180,000.00) 
in the course of the last year for the acquisition of additional 
fixed assets, a dangerous practice unless the current ratio is an 
extremely favorable one. Additional Land, Buildings, Store 
Furniture and Fixtures, and Office Furniture and Fixtures 
were acquired during the past year. The management of the 
company was aware apparently of the severe reduction in working 
capital because it will be noticed that 110 dividends were paid 
this past year in contrast to $75,000.00 paid the previous year. 

An examination of the changes in the items which constitute 
the current assets and the current liabilities reveals some addi- 
tional changes of an unsatisfactory character. The increase of 
$30,000.00 in Notes Receivable may indicate the conversion of 
slow Accounts Receivable into Notes Receivable. Accounts 
Payable show an increase of $9,000.00 but particularly noticeable 
is the $70,000.00 increase in Notes Payable. Evidently this 
latter increase is an evidence of difficulty in meeting obligations 
and the conversion of Accounts Payable into Notes Payable 
or it may mean that the company has been forced to borrow 
on its own notes. The increase of $30,000.00 in Inventory of 
Merchandise is not especially significant. It may represent 
additional stock needed for the new store or stores or it may 
indicate the preparation of the management for an upward 
movement in sales volume. 

Comparative Profit and Loss Statements 

All changes shown by the comparative statement of profit 
and loss (page 50S) are increases with one exception, Bad Debts. 
Increase and decrease columns indicate some very significant 
changes, i.e., Net Sales increased 46.15 per cent but Cost of 
Goods Sold increased at a higher rate 50.16 per cent. The 
proportionate increase in the relation of Cost of Goods Sold to 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 



503 



THE STAR STORES COMPANY 

COMPARATIVE STATEMENT OF PROFIT AND Loss 

For the Twelve Months Ended December 31, 19 A and 19B 





19A 


19B 


Increase or Decrease 


Amount 


Per Cen< 
cf Net 
Sales 

102 00 
2 00 


Amount 

$1,055,600 00 
15,600 00 


Per Cent 
of Net 
Sales 


Amount 

{-$494,800 00 
+ 14,800 00 


Per Cent 


Sales 
Less: Sales Ret. and Allow. . 

Net Sales 
Costs of Goods Sold: 
Inv. of Mdse., Jan. 1, 19 
Purchases 


$1,550,400 00 
30,400 00 


101 50 
1 50 


+ 46 87 
+ 94 87 


$1,520,000 00 


100 00 
75.00 


$1,040,000 00 


100 00 
73 00 


+$480,000 00 


+ 46 15 


$ 270,000 00 
1,170,000 00 


$ 250,000 00 
779,200 00 


+$ 20,000 00 
r- 390,800 00 


+ 8 00 
+ 50 15 


Inv. of Mdsc., Dec. 31,19_ . 
Cost of Goods Sold 
Gross Profit on Sales 


$1,440,000.00 
300,000.00 


$1,029,200.00 
270,003.00 


+$410,800.00 
+ 30,000.00 
-\ $380,800 00 


+ 39.91 
+ 11.11 


$1,140,000.00 


$ 759,200 00 


+ 50 16 


$ 380,000 00 


25 00 


$ 280,800 00 


27 00 


+$ 99,200 00 


1- 35 33 


Selling Expenses: 
Advertising 


$ 35,000 00 
107,000 00 
6,000 00 
20,000 00 
3,000 00 
12,000 00 
9 OOJ 00 
5,000 00 
$ -197,000 00 


2 30 
7 04 
39 
1 32 
20 
79 
.59 
.33 
12 96 


$ 12,000 00 
71,300 00 
3,000 00 
15,000 00 
2,100 00 
7,200 00 
5,700 00 
4,200 00 
f "120,500 00 


1 15 
6 86 
.29 
1 44 
.20 
69 
55 
-.40 
11 58 


-+$ 23,000 00 
f- 35,700 00 
+ 3,000 00 
+ 5,000 00 
I- 900 00 
+ 4,800 00 
+ 3,300 00 
+ 800 00 
-1$ 76,500 00 


+191 67 
+ 50 07 
+ 100 00 
+ 33 33 
+ 42 86 
4- 66 67 
f 57 89 
+ 19 05 
+ 63 49 


Store Salaries 


Store Expenses 


Delivery Expenses 


Insurance 


Property Taxes 


Dep. of Buildings. .. . 
Dep. of Store F. and F 
Total Selling Expenses 
General and Administrative 
Expenses: 
Office Expenses 


$ 2,010 00 
36,000 00 
1,000 00 
4,000 00 
1,9 JO 00 
3,000 00 
2,000 00 


13 
2 37 
.07 
.26 
13 
,20 
.13 


$ 1,300 00 
25,000 00 
700 00 
2,400 00 
2,100 00 
1,900 00 
1,700 00 


13 
2 40 
07 
.23 
20 
.18 
17 


f- $ 710 00 
+ 11,000 00 
+ 300 00 
f 1,600 00 
- 110 00 
+ 1,10000 
+ 300 00 


1- 54 62 
+ 44 00 
I- 42 86 
+ 66 67 
- 5 24 
+ 57 89 
+ 17 65 


Office Salaries 


Insurance 


Property Taxes 


Bad Debts 


Dep of Buildings 


Dep. of Office F. and F . . 
Total Gen'l. arid Adm. Exp. 
Net Profit on Sales 
Other Expenses and Losses: 
Interest Expense 


$ 50,000 00 


3 29 


$ 35,10000 


3 38 


+$ 14,900 00 


+ 42 46 


$ 133,000 00 


8 75 


$ 125,200 00 


12 04 


+$ 7,800 00 


+ 6 23 


$ 13,600.00 
10,000 00 


.89 
66 


$ 12,800 00 
8,400 00 


1 23 

.81 


f $ 800 00 
+ 1,600 00 


+ 6 25 
+ 19 06 


Sales Discounts 


Other Income: 
Interest Earned 


$ 1,000.00 
20,600.00 


.07 
1 35 


$ 400 00 

15,600 00 


.04 
1 50 
11 54 


+$ 600 00 
+ 5,000 00 


+ 150 00 
+ 32 05 


Purchase Discounts 


Net Profit for Period 


$131,000 00 


8 62 


$ 120,000 00 


+$ 11,000 00 


+ 917 











Note: The year 19A refers to the year just closed; the year 19B refers to the preceding 
year. 



504 ACCOUNTING FUNDAMENTALS [Ch. XXX 

Net Sales during the last year is somewhat surprising in view 
of the large increase in volume. Either purchases were not 
made at as low a cost as in the previous year or they were not 
marked up for sale purposes at the same rate. Another possible 
explanation is the possibility that the last Inventory of Merchan- 
dise includes merchandise valued at a low replacement cost. 
The probabilities are the merchandise sold in the new store or 
stores did not carry the same relative mark-up as goods sold 
in the previous year. 

Because of the relatively higher Cost of Goods Sold in the last 
year as compared with the year before, the Gross Profit on Sales 
percentage declined from 27 per cent to 25 per cent. The 
decline in the Gross Profit on Sales percentage for the two- 
year periods may be noted also in the increase and decrease 
percentage column when it is observed that Net Sales increased 
46.15 per cent but Gross Profit on Sales increased only 35.33 per 
cent. 

It will be noticed, also, that the Total Selling Expenses 
increased at a rate higher than the rate of increase in Net Sales. 
The rate of increase in the Total General and Administrative 
Expenses, on the other hand, was lower than the rate of increase 
in Net Sales. Evidently the general administrative and office 
force and the general office expenses needed less expansion by 
reason of the increased volume of business than did the sales 
staff and the sales expenses. Note the actual and relative 
increase ia Advertising, Store Salaries, and Store Expenses. 
Delivery Expenses and Insurance, it will be noticed, increased 
at rates lower than the rate of increase in Net Sales. 

The Net Profit on Sales last year was 6.23 per cent higher in 
amount than the year before, but it should be noticed that the 
rate of Net Profit on Sales to Net Sales declined from 12.04 per 
cent to 8.75 per cent. Similarly, it should be noted that while 
9.17 per cent more profit was earned last year than the year 
before, the actual relationship of Net Profit for the Period to 
Net Sales declined from 11.54 per cent to 8.62 per cent. 

As previously determined, the rate of merchandise turnover 
last year was 4, the rate for the previous year was 2.9. This is a 
very decided point in favor of the management. Merchandise 
has been converted into other assets more rapidly and the 
inventory has not been increased at nearly so high a rate as 
the increase in sales volume. 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 505 

Since there was no change in capital stock or the number of 
shares outstanding between the dates of the statements under 
consideration and there was an increase in the amount of Net 
Profit in the last year, the rates indicating the percentage earned 
on capital stock and the earning rate per share of capital stock 
will show an increase. The number of times interest on bonds 
was earned, for the same reasons, is more favorable for the last 
year than for the preceding one. The percentage earned on 
proprietorship at the beginning of the period was calculated, 
earlier in this chapter, as 16.17 per cent. That rate is better 
than the rate of 15.69 per cent earned in the previous year, 
assuming there were no changes in capital stock in the period 
preceding the last one. 

Summary of the Analysis and Interpretation of the Star Stores 
Company 

A very brief summary of the findings from the analysis and 
interpretation of the Star Stores Company seems desirable. 
The management is to be commended on the increase in the 
volume of business done, on the acceleration in the rate of mer- 
chandise turnover, for increasing the annual net profit, and for 
its desire to increase its fixed assets without increasing the 
additional fixed liabilities with their attendant increase in fixed 
charges. 

The management apparently is not making adequate provision 
for future bad debts and for the depreciation of its fixed assets. 
In trying to carry out its policies, the management of the com- 
pany has taken one action which may have quite serious results. 
It has drawn on cash too heavily and immediate attention will 
be necessary apparently to the formulation of a plan to increase 
the cash balance. Since there was no increase in the fixed 
liabilities during the past year, the land and buildings acquired 
were free of encumbrances. It may be possible, therefore, to 
mortgage the new properties in order to build up cash and the 
working capital. 

The Determination of Trends 

If the statements of an enterprise for a number of periods are 
analyzed, it is possible to prepare figures to indicate the direction 
in which the activities of the enterprise are leading. The 



506 ACCOUNTING FUNDAMENTALS [Ch. XXX 

possibility is enhanced, if statement analysis is supplemented 
by an account analysis. For example, if sales by products 
are listed for a period of years, the figures may indicate clearly 
the tendency of the volume of one product to decline and the 
tendency of the volume of another product to increase. The 
trend is not indicated, necessarily, by steady declines or increases 
but by a tendency to decline or increase over a period of years. 
Thus may be traced the tendency of a major product to become 
a lesser product or a by-product to become a major product. 
Similarly, figures for a number of years would indicate the 
trends with respect to sales in various geographical divisions, 
in various products and so on. Trends with respect to the rate 
of earnings on capital stock, the rate of earnings on total assets, 
trends with respect to the relative shares of manufacturing cost 
as among wages, materials, and indirect manufacturing expense, 
and so on, may be prepared and be very useful. A trend may 
be expressed by merely listing the figures for the number of 
periods considered. Because it is easier to follow a series of 
figures expressed as a line or curve on a chart or by means of a 
diagram or graph, the trend is much more likely to be appre- 
ciated, if the figures are so expressed. 

The Use of Accounting Analyses and Interpretations 

The question may be raised, what should be the policy of 
The Star Stores Company for the future? Should additional 
properties be acquired by purchase or lease? If purchased, 
should they be financed out of working capital? Do collections 
need immediate and special care? And so on. It is not the 
responsibility of the accountant to answer these questions. 
His advice, the same as that of other departmental executives, 
will be sought undoubtedly by the general management. Man- 
agement has other sources of information in addition to the 
accounting department. It may have studies made of its 
purchasing methods, its sales policies, its financing methods, 
and of its personnel. It must make its decisions with due 
consideration to all the information which it has. 

The general management of The Star Stores Company may 
or may not have been aware during the past two years of all 
the facts brought out by the analysis and interpretation just 
made. Under any circumstances it is desirable for the account- 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 507 

ing department to make analyses currently and at the end of 
periods. The responsibility of the accounting department 
is to disclose facts. The proper use of these facts requires 
information greater than that disclosed by accounting alone. 
The accounting facts with respect to a given enterprise must be % 
viewed in the light of the special circumstances applicable to 
that enterprise, with due consideration to the position of that 
enterprise in its industry, with adequate regard to the position 
of the industry as a whole, and with an appreciation of economic 
conditions generally and the prospects for the future. The 
profitable use of accounting data in formulating and carrying 
out policies requires a breadth of business experience, imagina- 
tion, and courage. 

Concluding Comments 

In concluding this chapter, it is desirable to mention that no 
bases other than dollars and cents, ratios, and percentages have 
been considered. Comparisons on the basis of tons, pounds, 
barrels, gallons, or other quantity measures of product may be 
necessary also. An analysis on this basis may disclose the fact 
that the sales of an enterprise in terms of quantities increased 
between periods although the sales in terms of dollars decreased, 
or vice versa. It should be mentioned also, that no consideration 
has been given to the changing value of the dollar arising out of 
changes in the price level between periods. 

QUESTIONS 

1. The analysis and interpretation of the financial facts of an enter- 
prise are desired for what general purposes by 

a. Outsiders? 

b. The executives of the enterprise? 

2. In wh'ich section or sections of a balance sheet would you have a 
special interest, if you were a stockholder? A bondholder? A 
holder of a short-term note of the corporation? Why, in each 
instance? 

3. a. Of what advantage is it to the executives of an enterprise to have 

per cent as well as dollar and cents columns in the balance sheet? 
In the statemeiit of profit and loss? 

6. What is the advantage of a comparative balance sheet to the 
executives? To an outsider? 



508 ACCOUNTING FUNDAMENTALS [Ch. XXX 

c. What is the advantage of a comparative statement of profit and 

loss to the executives? To an outsider? 
4. What do you mean by a ratio? How may it be expressed? 
8. As a credit officer in a bank from which a loan is being asked, in 
which ratios of the borrower's statements would you be interested 
especially? Explain why in each instance. 

6. Why do you think it is desirable to show the percentage of each 
current asset to the total current assets? Of total current assets to 
total assets? Of each current liability to the total current liabili- 
ties? Of the total current liabilities to total liabilities and 
proprietorship? 

7. a. What is working capital? 
6. What is a current ratio? 

c. What is meant by the expression "the acid test ratio"? 

8. The X Company has a current ratio of 2 to 1, the Y Company 1 to 2, 
and the Z Company 1.6 to 1. Before you decide which of these 
companies is the best credit risk, what additional facts would you 
want to know? 

9. The current ratio of a corporation is 2 to 1. Which of the following 
suggestions would improve, which would reduce, and which would 
not change the ratio? 

a. To borrow money on an interest-bearing note. 
6. To sell a fixed asset for cash at a slight loss. 

c. To give an interest-bearing note to a creditor to whom money 
was owed on open account. 

d. To pay a current liability. 

e. To purchase merchandise for cash. 

10. An enterprise had two customers with credit balances of $2,500.00 
each on its books. In presenting its balance sheet, the enterprise 
listed its accounts receivable as the amount due by all customers less 
the two $2,500.00 credit balances. 

a. Was the action correct? 

6. Did the action have any effect on the amount of the working 

capital? 
c. Did the action have any effect on the current ratio? ." 

11. What is each of the following ratios supposed to indicate? 
a. Current ratio. 

6. Fixed assets to fixed liabilities. 

c. Proprietorship to fixed assets. 

d. Intangibles to surplus. 

e. Gross profit on sales to net sales. 
/. Selling expenses to net sales. 

g. Net profit on sales to net sales. 



Ch. XXX] ANALYSIS OF FINANCIAL STATEMENTS 509 

12. a. What is meant by merchandise turnover? 

6. Which enterprise do you think should have the higher mer- 
chandise turnover, a retail grocery store or a retail furniture 
store? Why? Which then do you think should have the 
higher percentage of gross profit on sales? Why? 

13. a. What is meant by the word trend? 

6. To notice a trend must the increases or decreases be constant? 

c. Over a series of years do you believe a company could determine 
whether there is a tendency of its sales volume in one of its 
products to decline or increase? Of its sales volume in certain 
geographical districts to increase or decrease? Of its manu- 
facturing expenses or cost of materials or labor costs to increase 
or decrease? 

d. Why is it important that trends such as those suggested by c be 
indicated to the management? 

14. a. Is it the responsibility of the chief accounting officer to point out 

such changes and tendencies as may be observed by accounting 

analyses and interpretations? Explain. 
6. Is it the responsibility of the chief accounting officer to make 

decisions and to take actions for the enterprise, as the result of 

such changes and tendencies as the studies of his department may 

indicate? Explain. 

16. Suppose you studied the balance sheets and the statements of profit 
and loss of a company for a period of several years and noticed the 
following tendencies. Tell whether you would consider each one a 
favorable or an unfavorable tendency, with your reasons. 

a. An increase in the ratio of notes payable to accounts payable. 

b. An increase in the ratio of accounts and notes receivable to 
inventory of merchandise. 

c. A decrease in the ratio of fixed assets to total assets. 

d. A decrease in the ratio of current liabilities to total liabilities. 

e. An increase in the charges for interest on fixed liabilities. 
/. A decrease in the ratio of cost of goods sold to net sales. 

g. An increase in the percentage of sales returns and allowances to 

net sales. 

h. A decrease in the amount of sales. 
i. An increase in the ratio of net sales to net worth. 

16. Why do you believe the Surplus account should be analyzed? 

17. Do you believe it would be helpful to the management of an enter- 
prise, if it could compare the results of the analysis of its own 
financial statements with standard figures prepared from the state- 
ments of a number of companies in the same industry? Explain. 



PROBLEMS 

Page 

Chapter II The Balance Sheet 512 

Chapter III Analysis of Proprietorship 516 

Chapter IV The Statement of Profit and Loss .... 521 

Chapter V Accounts Their Construction . . . 526 

Chapter VI Accounts Their Operation. . . 530 

Chapter VII Journalizing and Posting 534 

Chapter VIII Books of Original Entry 539 

Chapter IX The Trial Balance 543 

Chapter X Capital and Revenue Expenditures . 547 

Chapter XI Adjusting the Books . . . 549 

Chapter XII Closing the Books 555 

Chapter XIII The Work Sheet Its Construction and Use . . . 561 

Practice Set 1-A William Wible Problem. . . . . . 567 

Practice Set l-B Ray D. Oles Problem . 575 

Chapter XIV Inventories, Accruals, and Deferred Items .... 584 

Chapter XV Bad Debts, Depreciation, Obsolescence, Depletion . 592 

Chapter XVI Business Papers and Practices 599 

Chapter XVII Business Papers and Practices (Continued) .... 602 

Chapter XVIII The General and Subsidiary Ledgers Controlling 

Accounts 606 

Chapter XIX Columnar Journals and Petty Cash Systems . .611 

Practice Set 2- A William Wible Problem in Columnar Books. . . . 619 

Practice Set 2-B Ray D. Oles Problem in Columnar Books. . . . 634 

Chapter XX Other Records .649 

Chapter XXI Partnerships .650 

Chapter XXII Partnerships (Continued) . . . . ... 653 

Chapter XXIII Corporations . 660 

Chapter XXIV Corporations (Continued) .... .662 

Chapter XXV Corporations (Concluded) . 665 

Chapter XXVI Reserves and Funds 674 

Chapter XXVII Bonds 679 

Chapter XXVIII Manufacturing Accounts and Statements 685 

Chapter XXIX The Voucher System 693 

Practice Set 3- A Steel City Foundry Problem with a Voucher System 700 

Practice Set 3-# Colgate Rubber Products Corporation Problem 

with a Voucher System 718 

Chapter XXX Analysis and Interpretation of Financial Statements 735 



511 



512 ACCOUNTING FUNDAMENTALS [Ch. II 

Chapter n. The Balance Sheet 

1. The following items pertain to the business of T. A. Barnum. You 
are asked to use proper accounting titles and to group them as to 
assets, liabilities, and proprietorship. You need not show the 
various classes of assets and liabilities. 

Notes owed by the business Wages paid in advance 

Claims on customers for merchan- Mortgage payable on the building 

disc sold Amounts owed to the business by 
B Company stock customers on notes 

Claims of creditors for merchandise Land 

purchased Building 

Currency, coins, checks, and money Stock of merchandise on hand 

orders Rent collected in advance 

Prepaid insurance premiums The capital of T. A. Barnum 

Salaries accrued to employees Interest accrued on bonds owned by 
Interest accrued on notes owed by the business 

the business 

2. From the following information, determine the total amount of the 
liabilities. You need not classify the items in this problem. 

Inventory of Merchan- Cash $450.00 

dise $1 ,250.00 Accounts Receivable. ... 700.00 

Inventory of Supplies ... 150 . 00 Accounts Payable 300 . 00 

Furniture and Fixtures 980.00 

The annual rent of $600.00 was paid in advance on May 1, the date 
the business started. The above facts pertain to December 31 of 
the same year. 
The net worth of the business is $1,265.00. 

3. Present the assets, liabilities, and the proprietorship of the first 
of the following transactions in the form of the fundamental account- 
ing equation Assets = Liabilities + Proprietorship. Show the effect 
of each succeeding transaction on the preceding equation by set- 
ting up a new equation. 

a. J. Black invested $6,500.00 of cash and $5,000.00 of merchandise 
in a business and had the enterprise assume $2,000.00 of notes he 
owed on personal obligations. 

6. Purchased store fixtures at a cost of $1,000.00, terms 30 days net. 

c. Paid a $500.00 note. 

d. Merchandise that cost $350.00 was sold for $600.00. 

e. J. Black withdrew $75.00 of merchandise for personal use. 
/. Merchandise that cost $1,250.00 was sold for $970.00. 

g. Paid the liability arising out of the purchase of the store fixtures. 



Ch. II] 



PROBLEMS 



513 



4. Prom the following list of items, which is complete except for 
Accounts Receivable, you are to determine the amount of accounts 
receivable and set up the balance sheet as of December 31, 19 A, in 
account form. The asset and liability items need not be classified. 



Inventory of Merchan- 
dise 2,600.00 

Net Worth of T. W. 

Brown 4,325.00 

Inventory of Supplies ... 45 . 00 

Furniture and Fixtures . . 880 . 00 

6. The following information pertains to the business of J. F. Beeley 
as of December 31, 19A. You are to prepare a classified balance 
sheet in account form as of that date, using proper accounting titles. 



Cash $1,200.00 

Accounts Payable 610.00 

Notes Payable 750 . 00 

Notes Receivable 550 . 00 

Accounts Receivable .... ? 



Investment in Pennsyl- 
vania Railroad Bonds $ 7,500.00 

Accrued interest on 

above bonds 175.00 

Claims of creditors for 
merchandise pur- 
chased 11,500.00 

Claims on customers for 
merchandise sold. . . . 18,500.00 

Accrued interest on 

mortgage payable . . . 300.00 

Accrued interest on 
notes owed by the 
business 25 . 00 

6. C. P. Mates is considering the purchase of an interest in the business 
of A. P. Jack and employs you to set up a classified balance sheet 
of Jack's business in report form as of December 31, 19 A, using 
proper accounting titles. 



Furniture and Fixtures. $ 3,000.00 

Prepaid Advertising ... 250 . 00 

Delivery Truck 1 , 200 . 00 

Cach 9,800.00 

Land 5,000.00 

Building 20,000.00 

M ortgage Payable 1 1 , 000 . 00 

Notes owed by the busi- 
ness 8,500.00 

Inventory of Merchan- 
dise: 

Cost 19,000.00 

Marked to sell at 38 , 000 . 00 



Inventory of Merchan- 
dise 2,000.00 

Land 1,400.00 

Building 5,500.00 

Rent received in advance 200 . 00 

Accrued Interest Payable CO . 00 

Postage stamps 16.00 

Mortgage Payable 2 , 000 . 00 

Cash in bank 753.00 

Unpaid taxes 335.00 

Furniture and Fixtures . . 600 . 00 
Claims of creditors for 
merchandise pur- 
chased 1,200.00 



Checks received but not 

deposited $ 253.00 

Note payable to R. Post 360.00 

Wrapping paper, bags, 

twine, etc 95.00 

Promissory notes re- 
ceived from customers 
and not yet due 1 ,300.00 

Promissory note payable 
toL. O. Light 1,165.00 

Claims on customers for 
goods sold them 550 . 00 



514 



ACCOUNTING FUNDAMENTALS 



(Ch. II 



7. From the following list of items, prepare a properly classified bal- 
ance sheet in account form for J. Allen as of December 31, 19A: 



Accounts Receivable . . . 

Land 

Building 

Unearned Interest 

Accrued Salaries Pay- 
able 

Government Bonds .... 

Accrued Interest on 
Notes Receivable 

Inventory of Merchan- 
dise 



$13,000.00 

8,000.00 

14,000.00 

30.00 

100.00 
1,500.00 

35.00 
19,000.00 



Notes Receivable $ 5 , 000 . 00 

Auto Equipment 1 ,800.00 

Furniture and Fixtures 3,800.00 

Cash 12,000.00 

Notes Payable 3,320.00 

Prepaid Office Expenses 80 . 00 

Accounts Payable 14 , 100 . 00 

Net Worth of J.Allen.. ? 



8. From the following data, you are asked to prepare a properly classi- 
fied balance sheet in report form for F. D. Ross as of December 31, 
19A: 



Delivery Equipment.. . $ 1,400.00 

Furniture and Fixtures 3,900.00 

Notes Receivable 1 , 650 . 00 

Land 4,000.00 

Buildings 12,850.00 

Inventory of Store Sup- 
plies 25.00 

Prepaid Insurance 144 . 00 

Accounts Payable 5 , 830 . 00 

Inventory of Merchan- 
dise 10,750.00 



Notes Payable $ 2,600.00 

Mortgage Payable 8 , 000 . 00 

Accrued Interest on 

Mortgage Payable ... 120 . 00 

Accrued Taxes Payable 150.00 

Cash 2,455.80 

Accounts Receivable ... 1 , 187 . 00 
Accrued Interest Re- 
ceivable 10.00 



From the following information taken from the books and records 
of Dale Chapman as of December 31, 19 A, prepare a classified bal- 
ance sheet in account form, using proper accounting titles. Do not 
combine the accrued interest items. 



Land $ 5,200.00 

Patent 1,200.00 

Goodwill 1,000.00 

Prepaid Insurance 500 . 00 

Furniture and Fixtures 3,000.00 

Unpaid property taxes . 700 . 00 

Bank Loan 4,000.00 

Unused advertising 

booklets 180.00 

Delivery Equipment.. 4,900.00 

Building 19,800.00 

Mortgage Payable ... . 12 , 000 . 00 



Interest accrued on B & 

O bonds $ 98.00 

Interest accrued on 

mortgage payable. . . 240.00 

Interest accrued on 

notes owed 39 .00 

Cash in safe and bank . 3 , 950 . 00 

Promissory notes re- 
ceived from custom- 
ers 5,800.00 

Promissory notes owed 
by the business 3,900.00 



Ch. II] 



PROBLEMS 



515 



Inventory of Merchan- 
dise: 

Cost 

Marked to sell at .... 

Creditors' accounts to- 
taling 

Customers' accounts to- 
taling 

Salary Advances to Em- 
ployees 

Unused store supplies . 

Dale Chapman, Capital 

Baltimore & Ohio Rail- 
road Bonds 



Interest accrued on 
notes owed to the 

$18,000.00 business $ 43.00 

26,500.00 Rent collected in ad- 
vance from tenant 
12 , 000 . 00 renting the third floor 230 . 00 

Unused stamps, sta- 
15,200.00 tionery, and other 

office supply items. . . 190.00 

75 . 00 Interest paid in advance 

275.00 on bank loan 35.00 

? Accrued wages owed to 

employees 150.00 

7,800.00 



10. The items listed below were taken from the records of Robert Parke 
on December 31, 19 A. You are requested to prepare a classified 
balance sheet in report form as of that date. The statement will 
require the use of three money columns. 



Office Furniture and 
Fixtures 

Accrued Property Taxes 

Accrued Interest Re- 
ceivable 

Accrued Rent Receiv- 
able 

Inventory of Merchan- 
dise 

Rent Collected in Ad- 
vance 

Accrued Interest Pay- 
able 

Inventory of Store Sup- 
plies 



Notes Receivable $ 3,000.00 

$ 1 , 200 . 00 Accounts Payable . . 7 , 000 . 00 

200.00 Prepaid Insurance . 200.00 

X YZ Corporation Stock 500 . 00 

10.00 Cash.. . 4,000.00 

Land... 3,000.00 

50 . 00 Patent ... . . 1 , 000 . 00 

Building .. 10,000.00 

8 , 000 . 00 Unearned Interest. . . 5 . 00 

Mortgage Payable. .. 7,000.00 

60 . 00 Notes Payable ... 2 , 000 . 00 

Accounts Receivable . . 6 , 000 . 00, 

5 . 00 Delivery Truck 1 , 000 . 00 

Goodwill 5,000.00 

50 . 00 Prepaid Interest 5 . 00 



11. The December 31, 19A balance sheet of the business of S. S. Dickson 
showed an excess of assets over liabilities of $43,860.00. An 
examination of the records showed that the following errors were 
made: 

a. Accrued interest on a note payable was ignored. Amount $24.00. 

b. Unearned Rent of $60.00 was treated as Prepaid Rent. 

c. Withdrawals of cash by the proprietor were treated as an asset. 
Amount $150.00. 

d. Prepaid Insurance of $152.00 was considered as $125.00. 

e. Henry Morgan, a customer, was charged with $501.00 when the 
sale of merchandise was made to Harvey Morgen. 



516 ACCOUNTING FUNDAMENTALS [Ch. Ill 

/. A typewriter was purchased on December 28 for $130.00 but the 
bookkeeper treated it as an expense of doing business instead of 
as an asset. 

Present the figures in an orderly fashion to show the correct equity 
of the proprietor as of December 31, 19 A. Begin your solution 
with the incorrect proprietorship and end it with the correct 
proprietorship. 

12. The December 31, 19 A balance sheet of the business of B. T. 
Atwood showed an excess of assets over liabilities of $39,520.00. 
An examination of the records showed that the following errors 
were made: 
a. A new garage was erected during the last half of December at a 

cost of $375.00 but the bookkeeper treated it as an expense of 

doing business instead of as an asset. 
6. Accrued property taxes of $255.00 were ignored. 

c. Prepaid Interest of $30.00 was treated' as Unearned Interest. 

d. When a check for $115.00 was sent to Walker and Company, a 
creditor, the bookkeeper reduced the liability to Walker and 
Company by $155.00. 

e. When a $202.00 check was received from the X Company in 
payment of a $200.00 note and $2.00 interest, the bookkeeper 
reduced Notes Receivable by $202.00. No accrued interest 
receivable had been recorded. 

Present the figures in an orderly fashion to show the correct equity of 
the proprietor as of December 31, 19 A. Begin your solution 
with the incorrect proprietorship and end it with the correct 
proprietorship. 

Chapter III. Analysis of Proprietorship 

1. You are requested to compute the net profit or net loss in each of 
the following cases. Submit your solutions in the form of an 
analysis of proprietorship, assuming you are the owner. 

A B C D 

Proprietorship, Decem- 
ber 31, 19A $15,000.00 $31,870.00 $21,250.00 $60,940.00 

Proprietorship, January 

1, 19A 16,000.00 24,393.00 25,030.00 59,750.00 

Added investments dur- 
ing the year 5,000.00 4,945.00 2,560.00 6,500.00 

Withdrawals during the 
year 1,600.00 2,600.00 8,900.00 4,760.00 



Ch. Ill] PROBLEMS 517 

2. You are requested to set up a statement for each of the following 
cases to show the value of x: 

ABC D 

Proprietorship, Decem- 
ber 31, 19A $15,290.00 $ x $12,500.00 $23,000.00 

Proprietorship, January 

1, 19A 19,400.00 32,000.00 8,675.00 x 

Added investments dur- 
ing the year x 2,150.00 5,340.00 4,900.00 

Withdrawals during the 
year 5,235.00 4,800.00 x 2,225.00 

Net Loss 1,100.00 900.00 

Net Profit 1,000.00 6,980.00 

3. The business of A. K. Johnson was worth $14,850.00 on January 1, 
19A. During the year, Johnson withdrew cash and merchandise 
totaling $500.00 and made added investments of $3,800.00 cash. 
The statement of profit and loss prepared for the year showed a net 
profit of $2,400.00. The balance sheet prepared as of December 31, 
19A revealed liabilities of $4,575.00. Prepare a statement to show 
the amount of the assets on December 31, 19 A. 

4. a. On January 1, 19A, assets were valued at $116,580.30 and liabil- 

ities amounted to $88,716.24. One year later the assets were 
valued at $85,692.75 and liabilities amounted to $55,824.98. 
During 19A the proprietor, E. F. Jordan, withdrew $680.00 of 
merchandise and made an added investment of $4,800.00. 
Determine the net profit or loss for the year by presenting an 
analysis of proprietorship. 

6. Rework the problem assuming the January 1, 19A, and Decem- 
ber 31, 19A, figures were reversed. 

6. The records of A. J. Thomas disclose the following information 
from which you are to present the balance sheets as of January 1, 
19 A, and June 30, 19 A, in report form, and the analysis of pro- 
prietorship for the six-month period. 

January 1, 19A June 30, 19A 

Cash $ 5,000.00 $ 4,200.00 

Rent Received in Advance 400 .00 375 .00 

Accounts Receivable 10,500.00 12,050.00 

Inventory of Merchandise 25,000.00 22,770.00 

Furniture and Fixtures 5,000.00 4,500 00 

Land 5,000.00 5,000.00 

Building 10,000.00 9,500.00 

Accounts Payable 5,000.00 6,000.00 



518 ACCOUNTING FUNDAMENTALS [Ch. Ill 

During the six-month period Thomas withdrew merchandise that 
cost $500.00 and purchased a car for personal use with $2,000.00 of 
business cash. When the cash balance was low, he deposited 
$1,500.00 of personal cash to the credit of the business. 

6. J. Winter began business January 1, 19A with assets consisting of 
$10,000.00 cash and merchandise on hand valued at $4,000.00. 
Within the following 12 -month period he paid off a personal note for 
$750.00 with business cash and invested $3,250.00 of additional cash. 
On December 31, 19A, the assets and liabilities consisted of the 
following: 

Cash 81,000.00 Accounts Receivable . . $7,700.00 

Accounts Payable . . . G , 000 . 00 Inventory of Supplies . 100 . 00 

Notes Payable 750.00 Unpaid Salaries 200.00 

Furniture and Fixtures 1 , 250 . 00 Delivery Truck 1 , 100 . 00 

Inventory of Merchan- Notes Receivable 990.00 

dise 10,345.00 

Required: 

a. The balance sheet as of December 31, 19 A in classified account 
form. 

b. The analysis of proprietorship for the year. 

7. V. B. Dugan wishes you to determine his net profit or loss for the 
past year. His books and records show the following facts as of 
December 31, 19 A: 

Land. . . $3,000.00 Accounts Payable $6,000.00 

Building 8,000.00 Cash 4,375.00 

Inventory of Merchan- Delivery Equipment . . 1,500.00 

dise 5,500.00 Inventory of Fuel Oil . 85.00 

Accounts Receivable 5 , 250 . 00 Furniture and Fixtures . . 1 , 000 . 00 

Notes Payable 1 , 220 . 00 

The balance sheet of V. B. Dugan prepared as of Ja