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McGRAW-HILL ACCOUNTING SERIES
F, H. EL WELL, CONSULTING EDITOR
ELEMENTS OP ACCOUNTING
The quality of the materials used in the manufacture
of this book is governed by continued postwar shortages.
McGRAW-HILL ACCOUNTING SERIES
F. H. ELWELL, Consulting Editor
Blacker Cost Accounting
Blacker Essentials of Cost Accounting
Coleman Elements of Accounting
Foulke Practical Financial Statement Analysis
Greer and Wilcox Problems in Cost Accounting
MacFarland and A yars-r- Accounting Fundamen-
tals
Taylor and Miller C.P.A. Problems and Ques-
tions in Theory and Auditing
Taylor and Miller Solutions to C.P.A. Problems
Taylor and Miller Intermediate Accounting
ELEMENTS OF
ACCOUNTING
BY
RAYMOND W. COLEMAN, PH.D.
Associate Professor of Accounting
Carnegie Institute of Technology
FIRST EDITION
THIRD IMPRESSION
McGRAW-HILL BOOK COMPANY, INC.
NEW YOKK AND LONDON
1941
ELEMENTS OF ACCOUNTING
COPYRIGHT, 1941, BY THE
McGRAw-HiLL BOOK COMPANY, INC.
PRINTED IN THB XTNITED STATES OF AMERICA
All rights reserved. This book, or
parts thereof, may not be reproduced
in any form without permission of
the publishers.
COMPOSITION BY THE MAPLE PRESS COMPANY, YORK, PA.
PRINTED AND BOUND BY COMAC PRESS, INC., BROOKLYN, K. Y,
To
E. B. G.
PREFACE
This book is designed for a short course in accounting at
college level. Emphasis has been placed on the uses and inter-
pretation of accounting data, but attention has also been given
to the procedures whereby these data are entered on the records.
A general understanding of the methods of recording accounting
values but not a proficiency in the mechanics of accounting
is an essential background for the analysis of statements. A
failure to understand the sources of these values often results in
distorted impressions of their significance.
The text, problems, and questions have been correlated to
stress fundamental ideas in accounting. These ideas, if thor-
oughly understood, will assist the student to reason accurately
with the economic facts of a business.
An attempt has been made to treat the subject matter so that
it will possess greater flexibility than does a more complete text
not designed for the time limitations imposed by a short course.
If necessary, certain chapters (after Chap. VI) may be omitted
without seriously disturbing the continuity of the course. For
example, if instruction is being given to a group interested in
accounting because of its importance to investment analysis, it
might be desirable to stress the text and problem material in
Chaps. XIV and XV and to omit Chaps. VII, XII, and XIII.
It is impossible to make specific acknowledgments of indebted-
ness to the numerous authors of textbooks and articles which
have influenced the preparation of thi* book. I am especially
indebted to Prof. W. A. Paton for his encouragement in the
past and for the influence of his writings.
RAYMOND W. COLEMAN.
PITTSBURGH, PA.,
January, 1941.
vu
CONTENTS
PAQH
PREFACE vii
CHAPTER I
INTRODUCTION 1
Evolution of accounting. Branches of accounting. A definition
of accounting. Accounting and related subjects. Questions.
Suggested supplementary readings.
CHAPTER II
BASIC STATEMENTS 8
The accounting equation. The balance sheet as an expression
of the basic equation. Principal asset groupings. Reserves (or
allowances) against assets. Principal liability groupings. Prin-
cipal net worth groupings. Determination of profit or loss by
balance sheet comparisons. The profit and loss statement.
Principal groupings in the profit and loss statement. Statement
of change in net worth. Relation between the statements.
The accounting period. Questions. Suggested supplementary
readings.
CHAPTER III
BASIC BOOKS 27
Development of the account. Structure and operation of the
account. Debiting and crediting accounts. Classification of
accounts in the ledger. Account numbering systems. The
journal. Relation between basic books and statements. Ques-
tions. Suggested supplementary readings.
CHAPTER IV
THE ACCOUNTING CYCLE 38
Underlying documents. Transactions. Journalizing ordinary
business transactions. Posting journal entries. Footing the
accounts. Taking the trial balance. Questions. Suggested
supplementary readings.
CHAPTER V
THE ACCOUNTING CYCLE. (Continued) 53
Adjusting entries. Inventory adjustment. Assets requiring valu-
ation accounts. The cash basis and the accrual basis of account-
ing. Accrued expenses. Accrued income. Prepaid expenses.
Deferred income. Closing entries. Readjusting entries. Ques-
tions. Suggested supplementary readings.
X CONTENTS
PAGB
CHAPTER VI
THE ACCOUNTING CYCLE. (Concluded) 70
The work sheet. Preparation of the profit and loss statement.
Preparing the statement of change in net worth. Preparation of
the balance sheet. Closing the books. Summary of the steps in
the accounting cycle. Questions. Suggested supplementary
readings.
CHAPTER VII
JOURNAL AND LEDGER SUBDIVISIONS 85
Columnar journals. Operation of the special-column general
journal. Special journals. Purchase journal. The sales journal.
Cash receipts journal. Cash disbursements journal. Imprest
cash fund. The general journal when special journals are used.
Controlling accounts and subsidiary ledgers. Advantages of con-
trolling accounts and subsidiary ledgers. Operation of controlling
accounts and subsidiary ledgers. Voucher register. Operation
of the voucher system. Relation between specialized journals, con-
trolling accounts, and subsidiary ledgers. Questions. Suggested
supplementary readings.
CHAPTER VIII
PROBLEMS OF VALUATION 109
Effect of valuation on financial status and operations. Con-
servatism in valuation. Accounting assumptions influencing
problems of valuation. Valuation and functional uses of assets.
Cash. Bank reconciliation statement. Marketable securities.
Accounts receivable. Notes receivable. Merchandise inventory.
Determining cost of merchandise. Cost or market, whichever is
lower. Supplies and prepaid expenses. Questions.
CHAPTER IX
PROBLEMS OF VALUATION. (Concluded) 125
The relation of depreciation to the fixed asset. Capital and
revenue expenditures. Methods of computing depreciation.
Buildings, equipment, and machinery. Recording depreciation.
Appreciation. Land. Depletion. Intangibles. Liabilities.
Net worth. Questions. Suggested supplementary readings.
CHAPTER X
INDIVIDUAL PROPRIETORSHIP AND PARTNERSHIP 136
Individual proprietorship. The partnership as a desirable form
of business organization. Articles of partnership. A share in the
profits and a share in the business. Organization entries. The
partner's accounts. Distribution of profits and losses. Dissolu-
tion. Liquidation. Liquidation by installments. Questions.
Suggested supplementary readings.
CONTENTS xi
PAGE
CHAPTER XI
CORPORATIONS 156
Corporate proprietorship. Definition. When desirable as a form
of organization. Steps in the formation of a corporation. Dis-
tinctive corporate records. Sale of stock for cash. Premium and
discount. Subscriptions. Installment subscriptions. Defaulted
subscriptions. Treasury stock. No-par stock. Common and
preferred stock. Bonds. Bond interest. Profit distribution.
Surplus. Reserves. Funds. Change from a partnership to a
corporation. Questions. Suggested supplementary readings.
CHAPTER XII
COST ACCOUNTING 179
Definition of cost accounting. Cost accounting and management.
Finance and cost accounting. Production and cost accounting.
Cost accounting and sales. Classification of expenses. Elements
of cost to manufacture. Departments. Methods of cost accumu-
lation. Process cost system. Specific order system. Questions.
CHAPTER XIII
COST ACCOUNTING. (Concluded) 191
General ledger controlling accounts for costs. Material. Pur-
chasing. Receiving. Storing. Entries to record material cost.
Labor. Entries to record direct labor transactions. Manu-
facturing overhead. Direct labor-hour rate. Labor cost rate.
Machine-hour rate. Recording manufacturing overhead. Dis-
tribution costs. Statements in cost accounting. Summary.
Questions. Suggested supplementary readings.
CHAPTER XIV
<ATEMENT ANALYSIS 220
Techniques of analysis. Standards of comparison. Purpose and
limitations of ratio analysis. Balance sheet ratios. Profit and loss
ratios. Interstatemcnt ratios. Questions.
CHAPTER XV
STATEMENT ANALYSIS. (Concluded) 231
Ratios and trends. Balance sheet comparisons. Favorable and
unfavorable financial trends. Profit and loss comparisons.
Summary. Questions. Suggested supplementary readings.
PROBLEMS 243
INDEX 289
ELEMENTS OF ACCOUNTING
CHAPTER I
INTRODUCTION
Evolution of Accounting. Accounting is concerned with
recording and analyzing the transactions of a business. Its
development has been a process of evolution a growth in
response to the demands of an increasingly complex economic
organization. Records, in some form, however crude, became
necessary shortly after man had progressed to a stage of civiliza-
tion where he exchanged his goods and services for those of others. 1
Not until 1494, however, when Luca Pacioli published his treatise,
was there a book which offered a technique for keeping accounts. 2
Historically, Pacioli's treatise marks an important step in the
keeping of records by double-entry bookkeeping. Another
important step occurred in the latter part of the nineteenth
century, when bookkeeping was expanded into what is now
1 There is ample evidence of early bookkeeping records: in Babylon clay
tablets, as early as 2600 B.C., and later papyrus records disclosed
commercial transactions; in Rome the elaborate system of taxation
and the governmental budgetary system necessitated records, and the
"Adversaria," a book frequently kept by the head of the household, recorded
the household receipts and expenditures; in Great Britain the English Pipe
Roll of 1130 was compiled by the Treasurer and entered on the Exchequer,
and showed debts due the Crown; as early as 1340 accounts of the Steward
of the Local Authority of Genoa were kept by a system of double entry; in
both Venice and Florence double-entry bookkeeping was used in the early
part of the fifteenth century.
2 Pacioli's text, "Suma de arithmetica geometria proportion! et propor-
tionalita" ("Everything about Arithmetic, Geometry, and Proportion "),
contained also the first printed treatise on algebra. The bookkeeping
section of the text is entitled "De computes et scripturis." Pacioli was a
mathematician of recognized standing. Sometime after the publication
of his text Da Vinci collaborated with him in "The Divine Proportione,"
Pacioli writing the text and Da Vinci furnishing the illustrations.
1
2 ELEMENTS OF ACCOUNTING [Chap. I
known as accounting. This change followed closely the rise in
importance of the corporate form of organization after the Civil
War. Larger capital investments with more complex business
structures necessitated the development of better methods of
keeping and analyzing business records.
More recently the reports prescribed by various governmental
agencies in this country have had a marked effect on the growth
of accounting. The Federal income-tax law, for example, \as
meant much to the development of systematic accounting.
Many enterprises, which prior to its enactment possessed ina 'e-
quate records, were forced to keep records sufficiently adequ vte
for the computation of the tax. It is not to be inferred from this,
however, that the accounting principles advocated by the Bureau
of Internal Revenue are necessarily the most desirable for use by
the enterprises submitting reports. In many cases these regula-
tions have not, in the opinion of management, been suitable for
the requirements of enterprises.
The regulations of the Interstate Commerce Commission have
exerted a marked effect upon railway accounting; the reports to
the Comptroller of the Currency prescribe information which
must be furnished by reporting banks ; and the regulations of the
Securities Exchange Commission prescribe the data which must
be submitted to the commission for approval before corporate
securities can be sold. While most of these measures were
designed to regulate or control certain aspects of economic
activity, they have invariably influenced the development of
accounting.
At the present time the uses to which accounting may be
applied are numerous. It may be employed not only by business
enterprises but by nonprofit organizations (lodges, churches, etc.)
for the direction of their activities; by national, state, or other
governmental units to record the receipt and expenditure of
funds; and, in fact, by any individual or group for the protection
of its interests or the administration of its affairs.
The predominant use of accounting, however, is to control the
finances and operations of an enterprise. Therefore, unless
otherwise noted, the subject will be considered from the point of
view of the owner or the management of a business.
Branches of Accounting. Some conception of the degree to
which the evolution of accounting has progressed in profit enter-
Chap. I] INTRODUCTION 3
prises may be acquired by examining its principal branches. For
immediate purposes the term " accounting" will be provisionally
defined as the technique of controlling and interpreting business
records.
The first division, in order of logical sequence, is system installa-
tion. This special branch is concerned with the most desirable
plan for keeping the records of a business. The nature of the
individual enterprise is studied; then that plan of keeping records
which best suits the peculiar requirements of the enterprise is
devised. It follows, therefore, that the degree to which account-
ing systems may be standardized is strictly limited. The
accounting requirements ideal for one business may be inade-
quate for another and cumbersome for still another. It is as
unreasonable to expect a standardized accounting system to meet
the needs of all businesses as it is to argue for identical capital or
machinery requirements for all enterprises. The best accounting
system is that which gives the most desirable information with
the least amount of effort and expense. To approach this ideal
as closely as possible, the accountant usually checks and, if neces-
sary, revises the system after it has been in operation.
Bookkeeping, another important division of accounting, is con-
cerned for the most part with the clerical aspects of analyzing
and recording business transactions. The relation between book-
keeping and accounting is solely a question of inclusiveness ;
accounting comprises bookkeeping as well as other divisions of
the subject.
A third phase consists of the preparation of accounting state-
ments. This includes taking the results of bookkeeping, revising
the values of properties and other things owned by the business,
and, after all necessary adjustments have been made, presenting
significant facts of the enterprise in statement form.
A fourth division is the analysis and interpretation of accounting
statements for the purpose of indicating how changes may be made
in order to strengthen finances and improve earnings.
A fifth field, cost accounting, may be defined as the analytical
study of the costs of a business. Cost accounting has developed
in response to a growing complexity of manufactured products,
and the necessity of knowing costs not only of products but of the
various processes in manufacturing arid marketing commodities
and in rendering services.
4 ELEMENTS OF ACCOUNTING [Chap. I
Quite properly auditing is the division to be considered last. 1
It deals with the verification of accounting records. Usually the
purpose of an audit is twofold: to determine the true financial
condition and the earnings of a business, and to detect errors or
fraud.
A Definition of Accounting. From this brief survey of the
branches of accounting the following features should be noted:
1. A plan wherein records relating to the business are kept
2. The analysis and recording of all business transactions
relating to the enterprise
3. The preparation and analysis of statements drawn from the
records
4. The verification and criticism of the records and statements
These points may be incorporated into a somewhat more
comprehensive definition than the provisional one given earlier
in the chapter (page 3). From the point of view of manage-
ment, accounting may be defined as a method of classifying,
recording, summarizing, and interpreting those values of an
enterprise which are measurable in monetary units.
Accounting and Related Subjects. A still clearer conception
of the nature of accounting may be gained by briefly discussing
its relation to allied fields.
Foremost among related subjects is economics. Economics
has been commonly defined as the social science of wealth. The
term " wealth" refers to those things appropriated by man to
serve his needs, goods that are scarce and that satisfy some want.
Since these commodities are limited in quantity and since there
are almost universal cravings for them in some form, the indi-
vidual's conduct is largely shaped by a desire to obtain them.
Fortunately, there is no uniformity of desire for an unlimited
stock of one type of wealth. Those having an excess of one kind
exchange it for a more desired form. Before this exchange can be
made, however, some measurement of the relative worth or
1 Other divisions of accounting, not an integral part of the records of
profit enterprises, include governmental accounting, which is concerned
with the records of national, state, municipal, or other governmental units;
income-tax accounting, which relates to the preparation of tax returns for
the Bureau of Internal Revenue or state authorities; and budgets, which
pertain to predetermined plans of operation which serve as standards of
comparison with actual operating results.
Chap. I] INTRODUCTION 5
desirability must be placed on the commodities to be transferred.
Price is the monetary expression of value placed on these articles
of wealth. Accounting records, in monetary measurement, all
the wealth (and in addition certain rights and privileges not
classifiable as economic wealth) of the business enterprise.
Accounting in its relation to economics fulfills a very specific
function. It records and presents the values of an enterprise in
such a way that the entrepreneur can most prudently direct the
wealth under his control into the most productive channels.
The point of view of the economist differs from that of the
accountant. The economist's point of view is a social one. He
is interested in the particular enterprise only as it influences the
economic structure. Business occurrences of an enterprise are
of no special consequence except as they relate to wealth and
hence acquire social significance. In contrast, the accountant
ordinarily takes the point of view of the management, or of the
owners, which considers the business transaction in relation to its
effect upon the individual enterprise.
This difference in points of view necessitates caution in the
application of economic terms to the field of accounting. A
consideration of the term "profit" will illustrate this point. To
the economist, profit refers to the return accorded the entre-
preneur for the peculiar function which he performs and which
cannot be delegated to land, labor, or capital. Essentially it is
a return resulting from the assumption of final responsibility for
bringing together the factors or agents of production. The
accountant uses the term as it applies to the owner of the busi-
ness; it refers to the increase in proprietorship resulting from
operations over a period of time. Profit to the accountant is the
excess of the revenue received during a specified period of time
over the costs incurred in obtaining that revenue. This differ-
ence may contain wages to the proprietor, interest on his invested
capital, or rent on land held by the company. The accountant's
profit may contain what the economist would consider a mixture
of rent, interest, wages, and true economic profit; or it may
contain only the economic concept of rent, interest, or wages,
with economic profit entirely lacking.
Like economics the relation of law to accounting is in many
cases a close one. The law of contract, of principal and agent, of
sales, of negotiable instruments, of real and personal property, of
6 ELEMENTS OF ACCOUNTING [Chap. I
partnerships, of corporations, and of bankruptcy greatly influ-
ences, and in not a few cases governs, the accounting procedure
to be followed. In fact some legal consideration is involved
whenever a business transaction involving a relationship between
the enterprise and an outside entity occurs.
Again accounting procedure is often closely related to engineer-
ing practice. The valuation of business property, the selection
of the most efficient mechanical equipment for the control of
materials, the determination of standards of performance through
time and motion studies, and the establishment of wage-payment
plans are illustrations of problems, part engineering and part
accounting.
The relation of accounting to management is somewhat differ-
ent from the fields discussed so far. Modern management is
dependent upon the aid furnished by accounting. The phrase
" accounting is a tool of management" is omitted from few text-
books discussing this relationship. Accounting renders a service
by placing in the hands of management analyzed business data
relating to the financial structure of the enterprise. With this
information, wise decisions and intelligent policies are possible;
without it, decisions and policies are made in the absence of facts.
It should be noted, however, that all problems of management
cannot receive aid from accounting. Only those data with which
accounting is concerned, economic values of an enterprise that
can be quantitatively measured in dollars and cents, provide
significant assistance in the formulation of management policies.
Only to a limited degree can management look to accounting for
aid in the difficulties of plant layout; of personnel relationships;
of advertising procedure and similar problems.
Questions
Review.
1. When and by whom was the first published treatise on double-entry
bookkeeping written?
2. Why does accounting closely follow the development of business
enterprises?
3. How do you explain the fact that accounting for business has developed
faster than accounting for other purposes?
4. Enumerate and discuss briefly six different fields or branches of
accounting.
5t Define accounting from the standpoint of management.
Chap. I] INTRODUCTION 7
6. Explain the relation of accounting to economics; law; engineering;
management.
7. Contrast the point of view of the accountant and of the economist,
Discussion.
8. Of what benefit would the study of accounting be to a lawyer? A
businessman? An investor? A banker?
9. How may accounting assist the businessman to control his enterprise
in respect to the business cycle?
10. Taken from an advertisement of an accounting system: "Our system
permits the user to draw from the records all the essential data necessary
for the preparation of the federal income tax report and to prepare a
balance sheet and profit and loss statement of his business." Is there
any limit to the flexibility of a single ready-made accounting system?
Explain.
11. Discuss the relative merits of studying accounting from the point of
view of learning thoroughly a particular system, as against learning
the underlying principles of accounting applicable to a variety of
enterprises.
12. (Jlivc reasons why the following should or should not possess an account-
ing system:
a. A hospital d. A fraternity
b. A university e. A very small business
c. A city government /. A very large business
13. How do you account for the frequent conflict of viewpoints of accoun-
tants and economists? Of accountants and engineers?
14. What is the relation between the presence of a good accounting system
and management? To what extent can it aid management, and
wherein is it of limited use?
JLO. Discuss the role of accounting in a plan of economic control.
Suggested Supplementary Readings
On the history of accounting:
LITTLETON, A. C.: "Accounting Evolution to 1900," American Institute
Publishing Company, New York, 1933.
PERAGALLO, EDWAHIX "Origin and Evolution of Double Entry Bookkeep-
ing/' American Institute Publishing Company, New York, 1936.
On the general nature of accounting:
GREEK, II. C.: "How to Understand Accounting," Chap. 1, The Ronald
Press Company, New York, 1928.
KOHLER, E. C., and P. L. MORRISON: "Principles of Accounting," Chap. 1,
McGraw-Hill Book Company, Inc., New York, 1931.
PATON, W. A.: "Essentials of Accounting," Chap. 1, The Macmillan Com-
pany, New York, 1938.
ROREM, C. R.: "Accounting Method," Chaps. 1 and 2, University of Chicago
Press, Chicago, 1930.
CHAPTER II
BASIC STATEMENTS
While the historical approach describes the growth and impor-
tance of accounting in business, it does not offer an explanation
of the subject itself. To explain better several fundamental
principles and to offer a background for the study of the account-
ing cycle considered in later chapters, the present chapter and the
succeeding one will survey the most important statements and
books.
The Accounting Equation. Important among the principles
in accounting is the concept that someone either the owner or
someone else has a claim to all property rights or other things
of value to the enterprise. The technical name given to the
things of value owned by the business is assets; the technical name
given to rights to assets is equities. Expressed algebraically the
basic equation in accounting is as follows:
Assets = Equities
Even though the business may have legal title to all the assets,
some obligations to others are usually outstanding. Thus
equities are of two types: the rights of outsiders to the assets of
the business, and the rights of the owners. Equities of outsiders
are called liabilities; equities of the owners, proprietorship. The
customary form in which the basic equation is expressed includes
both types as follows :
Assets = Liabilities + Proprietorship
The Balance Sheet as an Expression of the Basic Equation.
The balance sheet 1 is a direct expression of this basic equation.
*The "Accountants' Handbook" lists the following other statement
titles sometimes used instead of the term "balance sheet": "general balance
sheet; financial statement; statement of resources and liabilities; statement
of assets and liabilities; statement of assets; liabilities and capital; state-
ment of financial condition; statement of worth." Paton, W. A., ed.,
"Accountants' Handbook," p. 5, The Ronald Press Company. New York'
1933.
Chap. II] BASIC STATEMENTS 9
It may be defined as the accounting statement which shows, at a
given date, the financial structure of the enterprise by exhibiting
the assets, liabilities, and net worth or proprietorship.
Assume, for example, that the assets and equities of John Ade
were as follows:
Cash $ 750
Accounts receivable 1 , 000
Merchandise inventory 3 , 000
Land 2,000
Buildings 5,000
Delivery equipment 500
Accounts payable 450
Notes payable 300
John Ade, proprietorship 11 , 500
These data expressed in the form of the basic equation would be
Cash, $750 + accounts receivable, $1,000 + merchandise
inventory, $3,000 + land, $2,000 + buildings, $5,000 -+-
delivery equipment, $500 = accounts payable, $450 +
notes payable, $300 + John Ade, proprietorship, $11,500
This cumbersome arrangement may be overcome by exhibiting
the same data in balance sheet form.
JOHN ADE
BALANCE SHEET, DECEMBER 31, 19
Assets Liabilities
Current : Current :
Cash $ 750 Accounts payable . . $450
Accounts Notes payable 300
receivable. . . . 1,000 Total current
Merchandise liabilities $ 750
inventory... 3,000
Total current
assets $ 4,750
Proprietorship
Fixed:
Land $2,000 John Ade, capital. . . . 11,500
Buildings 5,000
Delivery
equipment . . 500
Total fixed
assets 7,500
Total assets , $12,250 Total equities . $12,250
10 ELEMENTS OF ACCOUNTING [Chap. II
Principal Asset Groupings. The statement given on page 9,
exhibiting the financial structure of a comparatively simple
business, may be contrasted with the more complex balance
sheet on pages 12 and 13, which also better serves as a reference
for a discussion of the principal sections within the statement.
On the asset side of the usual balance sheet the principal group-
ings are current assets, investments, sinking funds, deferred
charges, fixed assets, and intangible assets.
Current assets are those which will be converted into cash in
the normal course of business within a comparatively short time,
usually within a year. Customary titles listed under current
assets are cash, accounts receivable, notes receivable, merchandise
inventory, and other current assets.
1. Cash includes currency on hand, bank drafts or deposits
available for use, money orders, and checks. Any deposit,
fund, check, or other item which is not readily converted into
cash should be excluded from the current asset group and
shown in a separate classification in the balance sheet.
2. Accounts receivable arc claims on customers for the payment
for goods or services sold on account. Frequently accounts
receivable arising from causes other than those in the normal
course of trade are listed under separate captions (amounts
due from common carriers for lost or damaged goods, for
example).
3. Notes receivable include all written promises from debtors
to pay the amounts due to the business. Like accounts
receivable, if the notes arise from causes other than those
found in the normal course of trade, they are frequently
listed under separate headings.
4. Merchandise inventory is the term applied to the value of
the stock-in-trade on hand on a given date. Other inven-
tories may be similarly shown supplies, for example.
5. When the title other current assets is used, suitable explana-
tory information should accompany the items included.
Marketable securities of other companies, which are
intended to be quickly turned into cash, are frequently
listed under a separate caption among the current assets
when the amount justifies this treatment.
Chap. II] BASIC STATEMENTS 11
Under investments appear assets represented by shares of stock,
bonds, mortgages, negotiable instruments, and the purchase of
interests which are not readily marketable or which the business
has no intention of placing on the market. Temporary or short-
term investments are not included under this caption.
Under funds are included sums of money, or other assets,
periodically accumulated for some specific purpose. Usually
the fund is created to retire some obligation or to purchase an
asset.
Prepaid expenses are frequently combined with deferred
charges. Both groups contain items the benefits of which are
to be received sometime in the future. No cash outlay or new
liability will be incurred to secure these benefits. Prepaid
expenses refer to recurrent items paid in advance: interest, rent,
taxes, and like expenses. Since they are usually prepaid for a
short period with the life span of the assets limited accordingly,
they are sometimes considered current assets. Deferred charges,
however, usually last much longer and for the most part are non-
recurrent items such as organization expense and bond discount.
Normally the service has already been partially received and will
continue to bo received over a number of future fiscal periods;
thus, strictly speaking, these deferred charges cannot be con-
sidered current assets. This distinction, although recognized by
good authority, is not generally accepted as desirable practice.
Those opposing the distinction point out that it is difficult to
separate the two groups sharply. Moreover, the amount of
prepaid items is usually small, and it is convenient as well as
conservative to group prepaid expenses and deferred charges
together. When this is done, they are, of course, excluded from
current assets.
Fixed assets, in contrast to current assets, ordinarily last longer
than one fiscal period (i.e., the time elapsing between opening and
closing the books) and are kept so long as they continue to serve
the needs of the business in carrying on its operations. The
distinction between current and fixed assets is based largely on
time and intended use. The fiscal period usually serves as the
interval of time differentiating between the two. The intended
use of each is quite different. Current assets are sold, exchanged,
pr collected but eventually are converted into cash. Fixed assets
12 ELEMENTS OF ACCOUNTING [Chap. II
SWIFT &
(An Illinois
CONSOLIDATED BALANCE
(Consolidating All Wholly-owned
Assets
Current Assets:
Cash . .$34,761,429.66
Marketable securities at cost or less (market value, $10,842,120.29) . . 10,641,665.58
Accounts and notes receivable
Trade $35,896,082.68
Other 7 5, 913. 54
$ 36,652,996.22
Less: Reserve for doubtful accounts and notes. . 514,063 71
36,138,932.51
Inventories Products where cost was not ascertain-
able were valued at approximate market prices,
allowing for estimated selling expenses; other prod-
ucts and ingredients and supplies at the lower of
cost or market
Product $78,166,366.63
Ingredients arid supplies , 5 , 740 , 854 . 67
83,907,221.30
Due from domestic subsidiaries not consolidated, current 350,025. 17
Total current assets $165 , 799 , 274 . 22
Investments :
Securities of subsidiaries not consolidated
Domestic:
Libby, McNeil & Libby, at cost, less reserve of
$1,395,19384 ... , $23,870,759.66
96,684 Preferred 6 "7, cumulative shares
1,858,431 Common shares
A. C. Lawrence Leather Company, at cost, less
reserve of $1,813,000 52 8,634,859.58
955,672 Common shares
Others ^SSOJJl 1 . 06
$" 3370867431) ."30
Wholly-owned foreign subsidiaries excluding
Canada: (see notes)
Great Britain $1,798,200.00
Continental Eu-
rope . $277,407.20
Less: Wholly re-
served for .. 277,407.20
1,798,200.00
$ 34,884,630^30
Miscellaneous securities, at cost 1,231,939. 11
Due from domestic subsidiaries not consolidated
not current 210,869.21
36,327,438.62
Other Assets:
Equity in mutual casualty company. ..., $ 2,681,729.86
(Equity based on market value of its investments
$3,692,431.67)
Long term receivables, less reserve 2,238,982.75
4,920,712.61
Fixed Assets:
Property, plant and equipment, at appraised value
January 1, 1914, plus subsequent additions at cost $197,772,385.17
Less: Reserve for depreciation and depletion. . . 96,042,644 99
101,729,740.18
Prepaid Expenses and Deferred Charges :
Prepaid insurance and taxes $ 1,282, 164.60
Expense on first mortgage bond issue (being amor-
tized) 222,507.29
Miscellaneous deferred charges 313,660.16
1,818,332.05
Treasury Stock, 79,465 shares (at market value,
October 31, 1936, $23^ per share, which is less than
cost) : . 1.857,494.38
Total assets $312,452.992.06
* From, the Swift & Company annual report to stockholders.
Chap. II] BASIC STATEMENTS 13
COMPANY*
Corporation)
SHEET, OCTOBER 28, 1939
Domestic and Canadian Subsidiaries)
Liabilities
Current Liabilities:
Notes payable $ 671,250.00
Accounts payable
Trade $ 4,375,567.23
Other 744.925.63
6,120,492.86
Accrued liabilities
Interest $ 635 , 937 . 50
Payrolls 823,861.67
General taxes 3,248,821.15
Income taxes for this and prior yoars (subject to
final determination) 4,622,215.75
Other 148.281.95
9,479,118.02
Reserve representing balance of processing taxes as
of October 26, 1935, carried in suspense pending
final determination as to disposition 8, 397,049. 14
Other cm rent liabilities
Due to domestic subsidiaries not consolidated. . $ 61 ,584.88
Due to foreign subsidiaries not consolidated . . 1 ,61 1 ,088.98
Sinking f und payment on first mortgage bonds, due
May 15, 1940 1 , OOP , OOP . 00
2.672.673.80
Total current liabilities $ 26 , 340 , 583 . 88
Long Term Debt:
First mortgage sinking fund 3% % bonds, due May
15, 1950
Authorized $50 , OOP , 000^ 00
Issued $43,000,000.00
Less: Retired through sinking
fund and by call $6 , 000 , 000 . 00
inking fund payment,
due May 15, 1940, pro-
Siriking fund payment,
due May 15, 1940, pro-
vided above 1,000,000.00
7.000.000.00
36,000,000.00
Reserves :
General reserve for fire and other contingencies. ... $ 12,555,767.33
Reserve for inventory price decline 6,767,000.00
18,322,767.33
Capital Stock and Surplus:
Capital stock, par value $25
Authorized and issued 6,000,000 shares ... . $ 1 50 , 000 , 000 . 00
Earned surplus (of which $1,857,494.38 is appropri-
ated by purchase of treasury stock) 81,789,640.85
Total shareholders' investment ". 231 , 789 , 640 . 85
Total liabilities, capital stock and surplus $312,452,992.06
Contingent liabilities: -.-.
Foreign drafts discounted, etc $15,994.86
Possible liability arising out of sundry lawsuits
14 ELEMENTS OF ACCOUNTING [Chap. II
are not ordinarily for sale or readily converted into cash. Instead
they are consumed or worn out while rendering the service for
which they were purchased. The more common titles included
in this group are land, buildings, machinery, delivery equipment,
and furniture and fixtures.
1. Land consists of the ground owned and used by the business.
2. Buildings include the edifices owned and used by the
business.
3. Machinery comprises mechanical equipment used in the
manufacture of products for sale.
4. Delivery equipment consists of motor trucks, horses and
wagons, and any other means of transporting merchandise
to the business or to customers.
5. Furniture and fixtures include such items as showcases,
counters, desks, chairs, filing cabinets, and other equipment
needed by the office force, by the selling department for
display, or for the storing of merchandise.
Intangibles include organization expenses, 1 goodwill, patents,
trade-marks, copyrights, franchises, and similar items in contrast
to assets thought to have values of a more de term in able nature,
like machinery and buildings. The use of this caption is largely
a convention all assets excluded cannot be considered tangible,
e.g., accounts receivable.
Reserves (or Allowances) against Assets. Reserves, or allow-
ances, against current assets are deductions from the value of the
asset to which they refer and are used to determine the book
value of the asset. The title reserve for doubtful accounts, for
example, contains the estimated amount of uncollectible accounts.
This is deducted from the total of outstanding accounts receivable
to determine their estimated cash realizable value.
Reserves against fixed assets operate in a similar manner. For
example, the decline in the value of an asset due to wear while in
operation is accumulated in the account reserve for depreciation.
The book value of the fixed asset therefore is the difference
1 Organization expense is sometimes listed as a deferred expense. This
implies that it is being written off against c,urrent operations. Under the
regulations of the Bureau of Internal Revenue most intangible assets may
not be written off as allowable deductions.
Chap. II] BASIC STATEMENTS 15
between the balance in the asset account and that in the reserve
account. The reserve account can in no sense be considered as
containing an amount of assets or a fund set aside for a specific
purpose; it merely represents deductions from the value of the
asset to which it refers.
Principal Liability Groupings. The distinction between cur-
rent and fixed items is made not only for assets but also for
liabilities. The principal liability groupings are current, long-
term, and unearned income. Current liabilities are those obliga-
tions to outside parties for which no special funds have been
established and which have to be paid within a comparatively
short time, usually one year. The following list comprises the
more common titles.
1. Accounts payable arc amounts owed for credit purchases.
If the respective amounts are appreciable, a distinction
should be made between accounts payable arising from
normal business purchases of goods or services and those
arising from other sources.
2. Notes payable include all written unconditional promises
made by the business to pay a sum of money at a definite
future time, either to order or to the bearer and signed by a
properly authorized person in the organization. Usually
only those maturing within one year are included. Notes
payable arising from causes other than transactions dealing
with the purchase of merchandise are frequently classified
separately (a short-term note payable to the bank, for
example).
3. Accrued liabilities are the current obligations existing at the
close of the fiscal period, not yet due, but which neverthe-
less are owed by the enterprise. They usually include
such recurring items as wages, rent, and interest. For
example, an item of accrued wages arises when at the close
of the fiscal period there is an amount of wages owed to the
workers but riot yet due and payable to them.
Three criteria are used to distinguish a long-term liability from
a current liability: the purpose, the manner of payment, and the
maturity of the debt.
Current liabilities are incurred to finance short-term operations
and must be paid within a reasonably short time. In contrast
16 ELEMENTS OF ACCOUNTING [Chap. II
the funds provided from long-term obligations are ordinarily
used for investments of a comparatively permanent character, to
finance expansions or fixed assets, for example.
Long-term obligations may be settled by refunding, by pay-
ment from a special fund, or from current assets. If they are
refunded, new securities are sold and the proceeds received from
their sale are used to pay off the maturing debt. If a special
fund has been established to accumulate the means of discharging
the obligation, then payment is made from this source. If a
liability is settled by either method, it should be classified as a
long-term obligation.
If, however, no special provision has been made for its payment
and it is paid from current assets, then it differs from a current
liability solely on the basis of maturity, and it should be classified
as a current liability, if due within the fiscal period.
Typical long-term liabilities are notes payable (with a maturity
date of more than one year), bonds, and mortgages.
1. Notes payable (defined on page 15) are listed under long-
term liabilities only when they mature more than one year
from the date of the balance sheet.
2. Bonds are written promises, under seal, to pay a definite
amount, with interest, at some determinable future date.
Frequently they are secured by pledges of specific properties.
3. Mortgages payable consist of long-term promissory notes
secured by a transfer of property as security, with the
provision that such transfer will be voided if the conditions
of the mortgage are fully satisfied.
Unearned income is revenue for which cash, receivables, or
other assets have been obtained but which belongs to a subse-
quent fiscal period. Interest income or rent income collected in
advance are examples. Unearned income must be considered a
liability because the business has an obligation to render a
service to those who have paid in advance. Since the obligation
is to be paid in service, not in cash, it can scarcely be considered
either a current or long-term liability; instead, it is accorded a
separate section in the balance sheet.
Principal Net Worth Groupings. The net worth section of the
balance sheet contains the equity or rights of the proprietors in
the assets of the business. The manner in which proprietorship
Chap. Ill BASIC STATEMENTS 17
is expressed depends on the type of business organization. If the
enterprise is owned by one man, his capital contributions that
are relatively permanent are recorded under the heading capital
preceded by the name of the proprietor (e.g., J. Jones, capital).
Current changes in the proprietor's investment arising from
transactions between the owner and the business are usually
recorded in an account with the title personal or drawing preceded
by the name of the owner (J. Jones, personal, for example).
If the business is in the form of a partnership, the same arrange-
ment is followed as for a sole proprietorship, except that instead
of considering the proprietorship of one owner, the equities of
two or more appear in the net worth section.
If the company is incorporated, the equity capital stock repre-
sents the transferable shares of the corporation. Individual
shares of capital stock are not shown in the balance sheet. The
authorized capital stock is the total amount that the state in
which the corporation is organized permits it to issue. The
value of each interest or share specified in the charter is known as
the par value. If the stock is sold for less than its par value, it is
sold at a discount; if for more than its par value, it is sold at a
premium. Many states permit corporations to issue stock with-
out a par value. When this is done, the issuing corporation is
authorized to sell a specified number of shares and the capital
stock equity of the stockholders is equal to the amount paid for
the stock.
For the most part, current additions or deductions to the stock-
holder's equity are made in surplus, which contains the accumu-
lated earnings of the corporation and, together with capital stock,
constitutes the equity of the owners (see page 172 for a distinction
between types of surplus).
Determination of Profit or Loss by Balance Sheet Comparisons.
From the point of view of the owner there are two sets of facts,
above all others, which he expects to be able to obtain from his
books: first, the value of his equity; second, whether this value is
increasing or decreasing. The function of the balance sheet is to
exhibit the first fact; it is even possible for the second fact to be
furnished by a comparison of balance sheets. Thus, if the value
of John Ade's proprietorship on January 1, 19 , was $11,500
and at the end of the year, December 31, 19 , it had increased
to $13,250 and, further, if he invested $500 additional cash and
18 ELEMENTS OF ACCOUNTING [Chap. II
withdrew $250 from his equity during the year, the profit from
business operations would be $1,500. *
The Profit and Loss Statement. 2 The determination of profit
or loss by a comparison of balance sheets is, after all, a most
unsatisfactory method. A mere statement of the amount of the
increase or decrease in proprietorship due to business operations
is of limited use. To control operations, it is essential to know
the manner in which the increase or decrease in proprietorship
occurred. This is the function of the profit and loss statement.
It explains the change in proprietorship due to business opera-
tions. It may be defined as the statement which shows in detail
the sources of revenue or income earned 3 (the flow of goods or
services during a given period of time in exchange for funds or
other assets received from customers) during a fiscal period, the
1 Withdrawals or investments must be eliminated from the owner's
account in order to determine profit by a comparison of proprietorship
accounts. If in the case under consideration Ade invested $500 and with-
drew $250 during the year, the capital account of December 31, 19 , would
be adjusted by deducting the investments and adding the withdrawals to
determine what it would have been if affected only by business operations.
The resultant capital account balance of $13,000 when compared with the
$11,500 balance in Ade's proprietorship account of December 31, 19 ,
would show a profit of $1,500.
2 Throughout the text, terms in general use rather than those which the
writer believes are preferable have been used. The title profit and loss
statement, for example, although widely used, is not as descriptive of its
contents as is the title statement of expense and revenue. From the stand-
point of management a classified statement of expense and revenue is more
important than the amount of profit or loss (which has been previously
determined in the profit and loss account). Moreover, the statement usually
does not contain both a profit and a loss even if the generic use of the terms
is accepted.
The " Accountants' Handbook" gives preference to the title income
sheet to that of profit and loss statement. Other titles which it cites are
"profit and loss account; income account; statement of income, profit, and
loss; statement of operating results; statement of earnings; statement of
expense and revenue; revenue statement; summary of income and expense;
statement of income and capital account; statement of loss and gain; trad-
ing, profit and loss statement." Paton, op. cit., p. 6.
3 The terms "revenue" and "income" are commonly used interchange-
ably. When a distinction is made, revenue is measured by (but must not
be confused with) the cash and other assets given by customers in exchange
for the sales of commodities or services. Income emerges after all costs
applicable to the revenue of the fiscal period are deducted.
Chap. IIJ BASIC STATEMENTS 19
cost of obtaining the revenue, and the resultant profit or loss.
An explanation of the fact that John Ade's profit for the fiscal
year ending December 31, 19 , was $1,500 assumes more signifi-
cance when shown in the following form than when obtained by
comparing the proprietorship sections in two successive balance
sheets.
JOHN ADE
PROFIT AND Loss STATEMENT
For the Period January 1, 19 , to December 31, 19
Net sales $25,230
Merchandise inventory, January 1, 19 $ 2,225
Merchandise purchases 18,000
Goods available for sale $20 , 225
Merchandise inventory, December 31, 19 3,000
Cost of goods sold 17,225
Gross profit 1 8,005
Selling expenses 3 , 372
General administrative expenses 3 , 108
Total operating expenses 6 , 480
Net operating profit 1 , 525
Nonoperatirig expenses:
Interest 25
Net profit $ 1,500
Another illustration of the profit and loss statement, in greater
detail and hence of more benefit for the purpose of discussing
content, is the statement on page 20.
Regardless of the form assumed by the statement, some
attempt is usually made to distinguish between the principal
activities of the business and those incidental to the performance
of the main function. Revenues and expenses concerned with
the most important activities are grouped under an " operating"
section; revenues and expenses concerned with incidental activ-
ities are grouped under a " nonoperating " section. It is fre-
1 Some writers believe that the term "gross margin" should be substituted
for that of "gross profit." These writers believe that profit can be deter-
mined only after all expenses are deducted from the revenue of a period.
Therefore any intermediate profit such as gross profit is misleading and
tends to confuse the reader. For a more complete presentation see W. A.
Paton, "Essentials of Accounting," pp. 756-757, The Macmillan Company,
New York, 1938.
20 ELEMENTS OF ACCOUNTING [Chap. II
SWIFT & COMPANY
(An Illinois Corporation)
CONSOLIDATED INCOME STATEMENT AND SURPLUS ACCOUNT FOB THE
PERIOD FROM OCTOBER 29, 1938 TO OCTOBER 28, 1939
(Consolidating All Wholly-owned Domestic and Canadian Subsidiaries)
Sales (including service revenues) ................................. $756 , 73 1 , 53G . 99
Cost of sales and service, including transportation, but excluding the
charges deducted below ......................................... 678.748,063.03
$ 77,983,473.96
Selling (including expense of the distributing houses),
advertising, general and administrative expenses. . . . $48,740,368.16
Depreciation and depletion (see notes) ......... 6,818,751.27
Taxes (other than federal income taxes) ........... 7,844,665.83
Contribution to Pension Trust (see notes) ........ 2, 170, 138.07
Provision for doubtful accounts .................... 653 , 694 93
66.227,618.26
Operating income .............................................. $ 11,755,855.70
Other income:
Dividends received
From subsidiaries not consolidated:
Domestic ................................ $ 656,031.22
Foreign, to extent earned in current
year (see notes) ......... $734,350.27
Less: Losses of foreign subsidiaries
for year taken up (see notes) . . . 8,014 40
726,335.78
From miscellaneous securities ................. 96,984.82
$ 1,479,351.82
Interest from miscellaneous securities, etc .......... 240 ,517.16
Miscellaneous net .............................. 17 , 552 . 76
^ 737, 421 74
$ 13,493,277.44
Interest charges:
On funded debt, including amortization of expense on
first mortgage bond issue ....................... $ 1 , 436 , 664 . 86
Other interest ................................... 21 ,016.48
*' 457 681.34
$ 12,035,596.10
Special credits:
Special distribution by mutual casualty company ... $ 763,094.20
Profit on sale of securities net .............. 156,325.01
Realized gain on foreign exchange ................ 284 , 730 . 37
$ 13,239,745.68
Loss on sale, dismantling and retirement of fixed property net ....... 837 , 035 80
$ 12,402,709.88
Provision for Federal income taxes .................................. 2 , 081 , 187 . 23
Balance for year carried to earned surplus account .................... $ 10 , 321 , 522 . 65
NOTE: The treatment accorded profits or losses of foreign subsidiaries is defined in the
accompanying notes. As to the Canadian subsidiary consolidated, its profit earned for the
year included above of $143,666.20 is before providing for the unrealized loss of $736,701.89
in converting to U. S. Dollars its net current assets spread in the consolidated balance sheet
herewith, which is included in the charge of $742,403.05 against the consolidated earned
Chap. II] BASIC STATEMENTS 21
EARNED SURPLUS ACCOUNT*
Surplus, October 29, 1938 $ 78,318,310.50
Deduct:
Earned surpluses of foreign subsidiaries not consolidated, heretofore
taken up m consolidated surplus to October 29, 1938 now eliminated . . 1 , 823 , 293 . 87
Surplus as adjusted, October 29, 1938 $ 76,495,016.69
Balance of net income for year as above 10,321 ,522.65
$ 86,816,539 34
Dividends paid:
January 1, 1939, 30jf; April 1, 1939, 30f<; July 1, 1939, 30^; October 1,
1939, ZQt 7.104,131.10
$ 79,712,408.24
Add:
Restoration of certain depreciation provisions in prior
years not allowable as deductions for income taxes . $ 3,753,732.68
Dividends received from foreign subsidiaries not con-
solidated, in excess of their profits for current year
(see notes) 520,204.73
4,273,937.41
$ 83,986,345.65
Deduct:
Additional provision for federal income taxes for prior
years $ 700 , 000 . 00
Investments in subsidiaries in Continental Europe now
wholly reserved for 277,407.20
Miscellaneous investments and other accounts in Con-
tinental Europe now writttn off 476,894.55
Unrealized loss in converting net current assets of the
Canadian subsidiary and foreign accounts of Swift &
Company into U. S. Dollars at year end rate of ex-
change, net 742 , 403 . 05
2 ' 196 ' 704 ' 80
Surplus, October 28, 1939 . . . $ 81.789.640 85
* From the Swift & Company annual report to stockholders.
quently difficult to allocate certain items to a particular section,
but the separation of activities into these two groups has been
accorded wide acceptance in practice.
Aside from this distinction, which is usually made, several
main captions are ordinarily found which may well serve as the
basis for a brief discussion of the principal groupings in the
statement. These are as follows: gross sales; deductions from
sales; cost of goods sold; gross profit; operating expenses; oper-
ating profit or loss; nonoperating expenses; nonoperating income;
net profit or loss.
surplus account. As to the foreign subsidiaries not consolidated, the part of the dividends
received taken up above represents their current year's profits before considering the
unrealized loss of $600,106.77 in converting their net current assets, which has been charged
against their surplus accounts. These surplus accounts have been eliminated this year from
t-he consolidated surplus account herewith, by the charge thereto of $1,823,293.87.
22 ELEMENTS OF ACCOUNTING [Chap. II
Principal Groupings in the Profit and Loss Statement. The
term gross sales includes all sales made or services rendered,
without deductions, during the fiscal period. From gross sales
various items are subtracted to determine net sales. The princi-
pal deductions are sales returns (goods returned to the company
making the sale) and sales allowances (goods not returned but the
amount of the original billing reduced). These two items are
usually combined under a single caption.
Because of its importance as a comparison with net sales, cost
of goods sold is usually separated from other expenses, and the
method of its computation is indicated in the profit arid loss
statement. The cost of goods sold figure may be obtained by
keeping records of the goods sold at their cost price. Another
method consists of first determining all the goods available for
sale during the period covered by the statement. This is done
by adding to the merchandise on hand at the beginning of the
fiscal period the net purchases made during the period (net
purchases are determined by adding to gross purchases all
freight-in or transportation costs, and deducting from this total
all purchase returns and allowances). 1 Normally two things
happen to the goods available for sale: some arc sold, in which
case they become the cost of goods sold, and some remain on hand
in the form of an inventory. 2 Hence, if the final inventory
(which must be counted and priced) is deducted from the goods
available for sale, the remainder will be the cost of goods sold.
When the cost of goods sold is deducted from the net sales, the
result is gross profit.
Operating expenses are thg^costs incurred which are essentiaj
to^jgbtoin the^jQiiUTi_so]irce of revenue. Expenses should be
grouped in such a manner as to correspond to the structure or
organization of the business, so that responsibility by depart-
ments or some other functional division may be determined.
Operating expenses are frequently divided into two sections:
selling expenses and general administrative expenses. Selling
expenses include all costs of marketing. Typical selling expenses
are salaries or commissions paid to those directly concerned with
1 This is the usual computation. There may, however, be other additions
or deductions.
2 This precludes, of course, the possibility of the merchandise deteriorating,
of its theft, or of losses, due to changed methods of valuation or other factors.
Chap. II] BASIC STATEMENTS 23
marketing the product; advertising, which consists of publicity
costs incurred to increase sales; delivery expense, which includes
the cost of transporting goods sold to the customer; depreciation
on furniture and fixtures used by the sales department; and any
other expense the cost of which might be attributed directly to
the function of selling. General administrative expenses cannot
be allocated to any department performing a specific function,
hence they are classified under a general heading. The following
are examples: office expense, which includes postage, stationery,
envelopes, and other office supplies used during the fiscal period;
depreciation on office equipment; general insurance; and mis-
cellaneous taxes. The excess of gross profit over operating
expenses is called operating profit and indicates the profitableness
of the main operations of the business.
In contrast to the operating section of the profit and loss
statement, the nonoperating section includes income and expense
items not directly related to the main activity of the business.
Interest received from temporary investments held by a small
retail establishment would ordinarily be classified as nonoperating
income. If the securities were sold below cost, the loss suffered
would usually be treated as a nonoperating expense. 1 Non-
operating expenses are deducted from operating profit, and
nonoperating income is added (or subtracted, if a loss) to it to
determine net profit (or net loss) for the period.
Statement of Change in Net Worth. To supplement the profit
and loss statement as a device to explain the variations in pro-
prietorship, the statement of change in net worth is used. This
statement shows not only the change in net worth due to business
operations, as disclosed by the profit and loss statement, but also
the other major causes for changes in proprietorship.
Data in the illustration on page 17, when arranged in
the form of a statement of change in net worth, will appear as
shown on page 24.
There is no essential difference in the form of the statement
prepared for a partnership from that of one prepared for a sole
1 There is widespread agreement among accountants that the non-
operating section should include items incidental to the main activity of the
business. There is no such agreement as to what should be included.
Discounts on purchases, discounts on sales, interest expense, and interest
income are at times treated as operating and at times as nonoperating items.
24 ELEMENTS OF ACCOUNTING [Chap. II
JOHN ADE
STATEMENT OF CHANGE IN NET WORTH
January 1, 19 , to December 31, 19
John Ade, capital, January 1, 19 $11 ,500
Net profit for the year 1 , 500
Add additional investments 500
$13,500
Deduct withdrawals 250
John Ade, capital, December 31, 19 $13,250
proprietorship. Instead of the equity of a single proprietor, the
equities of two or more partners are considered. For a corpora-
tion, however, the changes in net worth are presented for the
most part in the capital stock and surplus accounts. The
principal additions to surplus are the earnings of the corporation,
and the principal deductions are the distribution of earnings to
the stockholders in the form of dividend payments. The net
worth structure of the corporation is so different from that of the
individual proprietorship or partnership that the title statement
of change in net worth is usually altered to statement of surplus
(see page 21).
Relations between the Statements. An objective of funda-
mental importance in accounting is the distinction between the
capital and income of a business. Capital may be defined as a
stock of wealth; income as a flow of goods or services which
increases that wealth. The basic statements in accounting are
designed to recognize this distinction.
The balance sheet is a statement of financial position; it shows
the wealth or resources of a business at a particular time together
with the equities or rights in those resources.
The profit and loss statement shows the origin of the income,
the cost of securing it, and the increase (net profit) or decrease
(net loss) in proprietorship due to the activities of the business.
The statement of change in net worth shows significant changes
in the proprietorship equity, due not only to regular business
operations in terms of net profit or loss but also to other causes
which increase or decrease the net worth of a business.
The Accounting Period. The concept of an accounting or
fiscal period is of prime importance since it affects all elements
appearing in the statements. The figures in the statements must
be interpreted in terms of the length of the accounting period.
Chap. II]
BASIC STATEMENTS
25
Clearly, the amount of sales for a six-month period is not com-
parable with the amount of sales in the same business for one
year.
The length of the accounting period varies according to the
requirements of the industry and the needs of management.
Probably the length of time most often used is the fiscal year,
which may or may not coincide with the calendar year. Semi-
annual, quarterly, and monthly periods, however, are commonly
used.
Questions
Review.
1. Explain the following terms:
(1) Balance sheet
(2) Current assets
(3) Cash
(4) Accounts receivable
(5) Notes receivable
(6) Merchandise inventory
(7) Investments
(8) Sinking fund
(9) Prepaid expenses
(10) Deferred charges
(11) Fixed assets
(12) Land
(13) Buildings
(14) Machinery
(15) Delivery equipment
(16) Furniture and fixtures
(17) Intangibles
(18) Reserve for doubtful
accounts
(19) Reserve for depreciation of
machinery
(20) Current liabilities
(21) Accounts payable
(22) Notes payable
(23) Accrued liabilities
(24) Long-term liabilities
(25) Bonds
(26) Mortgages payable
(27) Unearned income
(28) Capital stock
(29) Surplus
(30) Profit and loss statement
(31) Gross sales
(32) Net sales
(33) Sales returns
(34) Sales allowances
(35) Cost of goods sold
(36) Gross margin
(37) Operating profit
(38) Operating expenses
(39) Selling expenses
(40) General administrative
expenses
(41) Net profit
(42) Statement of change in net
worth
2. What is the accounting equation? Explain how the balance sheet is
an expression of this equation.
3. In what respect is the profit and loss statement an expression of the
accounting equation?
4. Give three criteria for distinguishing between a current liability and a
long-term liability.
5. Explain how profit or loss can be determined by a comparison of bal-
ance sheets. What are the shortcomings of such a procedure? How
does the profit and loss statement overcome these defects?
26 ELEMENTS OF ACCOUNTING [Chap. II
6. Distinguish between a selling expense and a general administrative
expense.
7. What is the relation between the balance sheet and the profit and loss
statement? Between the statement of net worth and the balance sheet?
8. Why is the concept of a fiscal period so important in accounting?
Discussion.
9. With which items or sections of the balance sheet would you be most
concerned if you intended to buy an interest in the enterprise? If you
intended to extend a long-term loan? If you intended to extend a
short-term loan?
10. From the standpoint of management, which statement is more impor-
tant, the balance sheet or the profit and loss statement?
11. "The balance sheet is a statement of position; the profit and loss state-
ment a statement of progress." Explain.
12. Is there any relation between cash receipts and revenue? Between cash
expenditures and expenses? Is the net profit for a period equal to the
excess of cash receipts over cash disbursements for the same length of
time?
13. Should prepaid expenses be listed under current assets or under deferred
charges?
14. Should investments appear among the current assets in a balance sheet?
Discuss.
15. What are the principal additions and deductions to be found in a
statement of net worth if the enterprise is
a. A single proprietorship
6. A partnership
c. A corporation
Suggested Supplementary Readings
KESTER, R. B.: "Principles of Accounting," 4th ed., Chaps. 2 and 3, The
Ronald Press Company, New York, 1939.
MACFARLAND, G. A. 7 and R. D. AYARS: "Accounting Fundamentals/ 1
Chaps. 2, 3, and 4, McGraw-Hill Book Company, Inc., New York, 1936.
PORTER, G. H., and W. P. FISKE: "Accounting," Chap. 3, Henry Holt &
Company, Inc., New York, 1935.
PRICKETT, A. L., and R. M. MIKESELL: "Principles of Accounting," Chaps.
1 and 2, The Macmillan Company, New York, 1937.
SANDERS, T. H., H. R. HATFIELD, and U. MOORE: "A Statement of Account-
ing Principles," pp. 25-97, American Institute of Accountants, New
York, 1938.
CHAPTER III
BASIC BOOKS
The statements discussed in the previous chapter are prepared
at the close of an accounting period. During the period, how-
ever, changes are occurring in the various asset and equity
elements. The device used to record these changes is known as
the account. It may be defined as a systematic arrangement
whereby changes in asset and equity elements are recorded.
Development of the Account. The relation between the state-
ments and the basic equation, discussed in the previous chapter,
is a close one. The necessity for using accounts and the manner
in which they are employed may also be demonstrated by expand-
ing the basic equation.
Assume that on February 1 William Moore invested the follow-
ing asset and equities in a small retail business: cash, $1,000;
furniture and fixtures, $450; equipment, $1,250; accounts pay-
able, $750; notes payable, $250. When this information is
recorded in the form of the basic equation (Assets = Liabilities
+ Proprietorship), it appears as follows:
Cash, $1,000 + furniture and fixtures, $450 + equipment,
$1,250 = accounts payable, $750 + notes payable, $250
+ W. Moore, capital, $1,700
In balance sheet form this is shown as follows :
W. MOORE
BALANCE SHEET, FEBRUARY 1, 19*.
Assets Liabilities
Cash $1 ,000 Accounts payable $ 750
Furniture and fixtures 450 Notes payable 250
Equipment 1 ,250
Proprietorship
W. Moore, capital 1,700
$2,700 $2,700
Assume further that the following transactions or business
occurrences took place during February:
27
28 ELEMENTS OF ACCOUNTING [Chap. Ill
February 3. Moore invested additional cash, $250.
10. Additional equipment was purchased for cash, $125.
12. Furniture was purchased on credit, $75.
15. Cash was disbursed in payment of an account, $150.
16. A note of $250 was given in payment of an account.
17. A note payable was paid, $100.
20. Moore withdrew cash, $50.
Expressed in the form of the basic equation, these data (includ-
ing the item of February 1) are recorded as follows:
(1) Cash, $1,000 -h furniture and fixtures, $450 -f equipment, $1,250 =
accounts payable, $750 + notes payable, $250 + W. Moore, capital,
$1,700.
(3) Cash, $1,250 -f furniture and fixtures, $450 -f equipment, $1,250 =
accounts payable, $750 -j- notes payable, $250 -j- W. Moore, capital,
$1,950.
(10) Cash, $1,125 + furniture and fixtures, $450 + equipment, $1,375 =
accounts payable, $750 + notes payable, $250 + W. Moore, capital,
$1,950.
(12) Cash, $1,125 -f furniture and fixtures, $525 + equipment, $1,375 =
accounts payable, $825 + notes payable, $250 -\- W. Moore, capital,
$1,950.
(15) Cash, $975 -f furniture and fixtures, $525 + equipment, $1,375 =
accounts payable, $675 + notes payable, $250 + W. Moore, capital,
$1,950.
(16) Cash, $975 + furniture and fixtures, $525 + equipment, $1,375 =
accounts payable, $425 + notes payable, $500 + W. Moore, capital,
$1,950.
(17) Cash, $875 -f furniture and fixtures, $525 + equipment, $1,375 =
accounts payable, $425 + notes payable, $400 -f- W. Moore, capital,
$1,950.
(20) Cash, $825 + furniture and fixtures, $525 + equipment, $1,375 =
accounts payable, $425 + notes payable, $400 -j- W. Moore, capital,
$1,900.
If there were -no further transactions during February, the
balance sheet on February 28 will appear as follows:
Assets - Liabilities
Cash $ 825 Accounts payable $ 425
Furniture and fixtures 525 Notes payable 400
Equipment 1 , 375
Proprietorship
W. Moore, capital 1,900
$2,725 $2,725
Chap. Ill] BASIC BOOK& 29
Conceivably, in a business with very few transactions, changes
in asset and equity elements might be recorded by direct balance
sheet adjustments. Even in a small business, however, the
presence of any considerable number of transactions would make
this method cumbersome. It becomes clerically impracticable
in a business of any appreciable size where a multiplicity of
transactions occur during the course of a business day.
Moreover, certain transactions are of such a nature as to
preclude the possibility of direct balance sheet adjustments. It
would be difficult, for example, to know the immediate effect of
a sale upon the financial condition of a business; proprietorship
is not increased by the total amount of the sale, for the cost of it
must first be deducted. Such a computation of costs, by each
sale, would be highly impractical, if not impossible, in ordinary
cases. Furthermore, some changes occur in such a manner as to
make them impossible of continuous measurement; depreciation,
for example.
Structure and Operation of the Account. The account over-
comes these difficulties. In order to fulfill its function of record-
ing changes in asset and equity elements, the account should
provide for three things: a balance; increases to the balance; and
decreases to the balance. These requirements are provided by
the so-called T account illustrated below.
Cash
Balance
Increases
Decreases
Operation of the account follows the same general principles as
does that of the basic equation or the balance sheet. Asset
balances are placed on the left-hand or debit side of accounts;
liability and proprietorship balances on the right-hand or credit
side. When, for example, the owner invests an additional
amount of cash (see item under date of February 3 in the illus-
tration of page 28), it increases the asset account cash and is
placed on the debit side. The owner's account is likewise
increased, and, since it is an equity, the amount is placed on the
credit side. If we record the transactions of Moore's business
for the month of February, these data will appear as shown in the
following accounts:
30
ELEMENTS OF ACCOUNTING
CASH (Asset)
(Chap. Ill
(Debit)
Feb. 1 Balance 1,000
3 250
(Credit)
Feb. 10
FURNITURE AND FIXTURES (Assets)
125
(Debit)
Feb. 1 Balance
(Credit)
450
EQUIPMENT (Asset)
(Debit)
Feb. 1 Balance 1,250
10 125
(Credit)
ACCOUNTS PAYABLE (Liability)
(Debit)
Feb. 15
150
(Credit)
Feb. 1 Balance
NOTES PAYABLE (Liability)
750
Feb. 17
(Debit)
100
(Credit)
Feb. 1 Balance
16
250
250
W.
MOORE, CAPITAL (Net Worth)
Feb. 20
(Debit)
50
(Credit)
Feb. 1 Balance
3
1,700
250
Debiting and Crediting Accounts. Thus, from an examination
of these typical transactions and the manner in which they are
recorded in the T accounts, it is apparent that all increases in
assets are recorded on the debit side; all increases in liabilities
and proprietorship on the credit side; all decreases in assets on
the credit side; all decreases in liabilities and proprietorship on
the debit side. In summarized form the rule for debiting and
crediting accounts is as follows:
Debit to
1. Increase an asset
2. Decrease a liability
3. Decrease an item of proprietorship
Chap. Ill] BASIC BOOKS 31
Credit to
1. Decrease an asset
2. Increase a liability
3. Increase an item of proprietorship
In applying the rule of debit and credit to the expense and
revenue accounts, the relationship between net worth and these
accounts should be borne in mind. Expense and revenue
accounts explain the change in proprietorship due to business
operations. Temporarily expense reduces and revenue increases
proprietorship. What the ultimate effect upon net worth will
be can be ascertained only when all expenses belonging to a
fiscal period are compared with all revenue earned during the same
period. If revenue exceeds expenses, the result is a profit; if
expenses exceed revenue, the result is a loss.
It is impractical to record these transactions directly under
proprietorship because the large volume of such transactions
would render the net worth account too cumbersome. The
various revenue and expense items would be so intermingled in
the proprietorship account as to make it difficult to know the
amount of any specific element; hence much significant informa-
tion would be lost to management.
To illustrate the operation of these accounts, assume that
during the month of March, the following summarized transac-
tions 1 occurred in Mr. Moore's business:
March 1. Paid rent for March, $80.
31. Purchased merchandise on account, $420; for cash, $265 (of the
purchases made $175 worth of merchandise was on hand at the
end of the month and $510 worth of merchandise was sold). 2
Sold merchandise on account, $525; for cash, $325.
Paid clerk's salary, $75.
Received cash from customers, $275.
Paid cash to creditors, $450.
The February and March data would be recorded in the
accounts as follows:
1 Summarized transactions are given here in order to provide a simple
illustration. Such summaries are not, however, typical of recommended
accounting procedures.
2 Current purchases of merchandise are entered in the expense account
purchases. At the close of the fiscal period the value of goods on hand is
transferred from the purchases account to the asset account inventory.
32
ELEMENTS OF ACCOUNTING
[Chap. Ill
CASH (Asset)
(Debit)
(Credit)
Feb. 1
Balance 1,000
Feb. 10
125
3
250
15
150
Mar. 31
325
17
100
31
275
20
50
Mar. 1
80
31
265
31
75
31
450
ACCOUNTS RECEIVABLE (Asset)
(Debit)
(Credit)
Mar. 31
525
Mar. 31
275
MERCHANDISE INVENTORY (Asset)
(Debit)
(Credit)
Mar. 31
175
FURNITURE AND FIXTURES (Asset)
(Debit)
(Credit)
Feb. 1
450
12
75
EQUIPMENT (Asset)
(Debit)
(Credit)
Feb. 1
1,250
10
125
ACCOUNTS PAYABLE (Liability)
(Debit)
(Credit)
Feb. 15
150
Feb. 1
750
16
250
12
75
Mar. 31
450
Mar. 31
420
NOTES PAYABLE (Liability)
(Debit)
(Credit)
Feb. 17
100
Feb. 1
250
16
250
Chap. Ill] BASIC BOOKS
W. MOORE, CAPITAL (Net Worth)
33
Feb. 20
(Debit)
50
(Credit)
Feb. 1
3
1,700
250
SALES (Revenue)
(Debit)
Mar. 31 To profit and loss
850
(Credit)
Mar. 31
850
PURCHASES (Expense)
Mar. 31
31
(Debit)
420
265
Mar. 31
31
(Credit)
To profit and loss
175
510
RENT (Expense)
Mar. 1
(Debit)
80
(Credit)
Mar. 31 To profit and loss
SALARY (Expense)
(Debit)
Mar. 31
75
(Credit)
Mar. 31 To profit and loss
75
PROFIT AND Loss ACCOUNT
(Credit)
Mar. 31 Sales balance
850
(Debit)
Mar. 31 Purchase balance 510
31 Rent 80
31 Salary 75
To W. Moore, capital 185
Items of revenue are credited to the account sales because the
effect is to increase proprietorship ; items of expense are debited
to the accounts salary and rent because the effect is to reduce
proprietorship. In order to summarize the net effect of opera-
tions on proprietorship, all the expense and revenue accounts are
transferred to a summary account called " profit and loss"
which, in this case, shows a profit for the month. This
balance is then transferred to the proprietorship account to
show an increase in the capital account by the amount of the
profit.
If there were no other transactions during the month, the
balance sheet of March 31 will appear as follows:
34 ELEMENTS OF ACCOUNTING [Chap. Ill
Assets Liabilities
Cash $ 555 Accounts payable $ 395
Accounts receivable 250 Notes payable 400
Merchandise inventory 175
Furniture and fixtures 525 Proprietorship
Equipment 1,375 W. Moore, capital 2,085
$2,880 $2,880
The profit and loss statement for the two months of February
and March would be:
Sales $850
Less cost of goods sold 510
Gross profit 340
Less Rent $80
Salary _75 155
Net profit $185
Classification of Accounts in the Ledger. The book or file
wherein the accounts are kept is known as a ledger. Accounts
are arranged in the ledger to facilitate the preparation of the
important statements the accounts in the balance sheet appear
first, then those in the profit and loss statement. This arrange-
ment results, of course, in the following five classifications:
Balance sheet
1. Assets
2. Liabilities
3. Net worth
Profit and loss statement
4. Revenue
5. Expenses
While all account classifications follow this arrangement, at
least in general outline, amplifications and refinements are usually
necessary.
Account Numbering Systems. In addition to titles which
should clearly explain the contents, numbers or other means of
identification are frequently given to the accounts. In large
corporations particularly this may save time and expense in
referring to the accounts. The following numbering system,
based on the accounts discussed in Chapter II, offers an illustra-
Chap. Ill) BASIC BOOKS 35
tion of a flexible method which can be used to advantage in a
moderately sized enterprise. 1
1 Assets
11 Current assets
111 Cash
112 Accounts receivable
113 Reserve for doubtful accounts
114 Notes receivable
115 Merchandise inventory
116 Prepaid expenses
12 Long-term investments
13 Fixed assets
131 Land
132 Buildings
133 Reserve for depreciation on buildings
134 Machinery
135 Reserve for depreciation on machinery
136 Delivery equipment
137 Reserve for depreciation on delivery equipment
138 Furniture and fixtures
139 Reserve for depreciation on furniture and fixtures
14 Intangible assets
15 Other assets
2 Liabilities
21 Current liabilities
211 Accounts payable
212 Notes payable
213 Accrued expenses
22 Long-term liabilities
221 Long-term notes
222 Mortgages payable
223 Bonds payable
23 Other liabilities
3 Net worth
31 Capital stock
32 Surplus
1 For numerous illustrative classifications and numbering systems see the
" Accountants' Handbook," p. 165ff. For a more detailed discussion of
classification and numbering of accounts than is afforded in the text, see
R. B. Kester, " Principles of Accounting," pp. 659-669, The Ronald Press
Company, New York, 1939.
36
ELEMENTS OF ACCOUNTING
[Chap. Ill
The Journal. Thus far the discussion has proceeded as though
business occurrences were recorded directly to the accounts a
method which, in fact, is not followed. Clerically such a process
would be tedious. Furthermore the account is not designed to
receive detailed information about transactions, but to record
changes in single asset or equity elements. It is the function of
the journal to tell the story of the transaction; to show the date
on which it occurred; its effect on the accounts involved; and
the amounts by which the accounts are changed; and finally to
supply any further explanation which may be required.
In appearance the simple journal frequently assumes the
following form:
GENERAL JOURNAL FORM
a
b
c
d
e
f
Columns a and b are used for the date of the transaction
month and day, respectively; in column c the names of the
accounts debited and credited are written and also the explana-
tion of the transaction; column d is the folio column, in which is
placed the page number of the ledger account to which a given
amount is carried; column e is the debit amount column; column
/ the credit amount column.
Relation between Basic Books and Statements. The relation
between basic books and statements in accounting is a coherent
one, and an appreciation of this relationship is essential to an
understanding of the accounting cycle. As business occurrences
alter the status of asset and equity elements in the statements,
the increases or decreases are recorded in the accounts. It is the
function of the accounts appearing in the ledger to show the
changes in asset and equity elements. The story of the business
occurrence, or transaction, cannot, however, be conveniently told
in the ledger. Instead it is recorded in the journal, after which
increases or decreases in particular asset or equity elements are
carried to their respective accounts in the ledger.
Details of these relationships are elaborated in the three
succeeding chapters on the accounting cycle.
Chap. Ill] BASIC BOOKS 37
Questions
Review.
1. What is the relation between the statements and the accounts?
2. What are the essential requirements of an account?
3. Give reasons for the development of the account.
4. Give a summarized rule for debiting and crediting accounts.
6. Discuss the relation between net worth and the expense and revenue
accounts.
6. In what order should accounts appear in the ledger?
7. Give a classification of accounts.
8. Explain the purpose of a system of numbering accounts.
9. Definfe:
a. Debit
&. Credit
c. Account
d. Ledger
e. Journal
/. Profit and loss account
10. Explain the relation between the journal and the ledger.
11. What is the function of the journal? Of the ledger?
12. Discuss the relationship between the basic books and statements in
accounting.
Discussion.
13. What determines the account titles used in the ledger?
14. Why is it important to select the account titles with considerable care?
15. Is it possible to show all important facts of the business in the accounts?
Explain.
16. When should explanations be given to journal entries?
17. The courts give preference to journal records instead of ledger records
when the books are presented as evidence. Why?
Suggested Supplementary Readings
BOLON, D. S.: " Introduction to Accounting," Chaps. 5 and 6, John Wiley &
Sons, Inc., New York, 1938.
HUSBAND, G. R., and O. E. THOMAS: "Principles of Accounting," Chaps. 4,
5, and 6, Houghton Mifflin Company, Boston, 1935.
KESTER, R. B.: "Principles of Accounting," 4th ed., Chap. 4, The Ronald
Press Company, New York, 1939.
MACFARLAND, G. A., and R. D. AYARS: "Accounting Fundamentals,"
Chaps. 5, 6, and 7, McGraw-Hill Book Company, Inc., New York, 1936.
ROREM, C. R.: "Accounting Method," Chaps, 4 and 6, University of
Chicago Press, Chicago, 1930.
CHAPTER IV
THE ACCOUNTING CYCLE
- "The balance sheet may be considered as the groundwork of
all accountancy, the origin and the terminus of every account" 1
is a statement frequently cited when discussing the continuity of
accounting operations. It means, of course, that the balance
sheet, which shows the financial structure of a business, is the
point of departure in the cycle of accounting operations. Sub-
sequent transactions alter the financial structure of the enterprise.
The goal to which all operations in the accounting cycle lead is a
new balance sheet.
Underlying Documents. Before beginning a discussion of the
various steps in the accounting cycle, it should be noted that a
business occurrence or transaction is usually marked by some
form of document. These documents or memoranda are the
sources of records to be described in the first step in the account-
ing cycle, the journalization of ordinary business transactions.
In the usual enterprise, cash receipts, cash disbursements,
purchases, and sales comprise the bulk of business transactions.
The underlying document for a cash receipt transaction may be a
cash sales slip giving the description and amount of goods sold;
it may be a duplicate receipt (the original being given to the
person making the payment), either for a cash sale or a payment
on account; or it may be a duplicate deposit ticket issued by the
bank at the time of making a deposit. Cash disbursements may
have as originating documents accounts payable vouchers, which
certify a given transaction, or duplicate checks or check stubs,
indicating payments made. Purchase transactions may be
recorded from several originating documents: from accounts-
payable vouchers, previously mentioned; from receiving depart-
ment reports; or from purchase orders prepared by the purchasing
department. Sales transactions may have as their source either
l Sprague, C. E., "The Philosophy of Accounts," p. 26, The Ronald
Press Company, New York, 1920.
38
Chap. IV] THE ACCOUNTING CYCLE 39
sales orders prepared by the salesman, duplicate invoices (which
show particulars of goods sold date, quantity, description, price,
total amount, terms of sale), delivery slips, or credit memoranda.
Transactions. The records of most ordinary business occur-
rences or transactions are based on business documents. The
transaction, which has heretofore been considered as synonymous
with a business occurrence, may be defined as any circumstance
or set of circumstances causing a change in the status of any
asset or equity. On the basis of this definition transactions may
be classified in three types:
1. Those involving a relationship between the business and
some outside person or entity. Cash receipts, cash dis-
bursements, purchases, and sales are examples.
2. Those involving a change in some asset or equity due to the
operation of the business or the passage of time. Deprecia-
tion, and the conversion of material, labor, and other manu-
facturing costs into finished goods are illustrations.
3. Those involving the transfer of some account balance to
another account. They are not represented by a real busi-
ness event. The transfer of individual expense and revenue
accounts into the summary profit and loss account, and in
turn the transfer of this balance to the net worth account or
accounts are examples.
Again, transactions may be classified according to their effect
on assets, liabilities, and proprietorship, the elements in the basic
equation. The nine types of changes which may result from
transactions are shown in the illustration on page 41. 1
This classification is particularly significant when related to
the rule for debiting and crediting accounts. It indicates the
distinct combinations of transactions affecting the elements of
the basic accounting equation. Furthermore it emphasizes the
dual nature of the transaction: for every debit total in a given
transaction there must be a corresponding credit total of like
amount.
Journalizing Ordinary Business Transactions. The first type
of transaction to be considered in the accounting cycle involves
a relationship between the enterprise and some outside party or
1 To avoid confusion, it should be noted that this classification could be
extended to include eighteen transactions. The following might be added
40 ELEMENTS OF ACCOUNTING [Chap. IV
entity. With these transactions, as with any other type, there
are three steps in the analysis for purposes of journalization:
1. Determining the accounts affected
2. Determining how the accounts are affected
3. Applying the rule for debiting and crediting accounts
To illustrate this analysis consider the investment of cash,
$3,000, and merchandise, $6,000, by F. W. Baker. The accounts
affected are as follows: cash, an asset; merchandise inventory, an
asset; and F. W. Baker, capital, an item of proprietorship.
Cash is increased, merchandise inventory is increased, and
proprietorship is increased. The rule for debiting and crediting
accounts is applied at this stage, with the result that cash is
debited, merchandise inventory is debited, and F. W. Baker,
capital, is credited. In general journal form the transaction is
recorded as follows:
F. W. BAKER
GENERAL JOURNAL, JANUARY, 19
Jan. 2 Cash 3,000
Merchandise inventory 6 , 000
F. W. Baker, capital 9,000
To record the initial investment of F. W.
Baker
to the illustration on p. 41 :
Assets may be decreased by
1. A decrease in proprietorship
2. A decrease in liabilities
3. An increase in other assets
Liabilities may be increased by
4. A decrease in proprietorship
5. A decrease in other liabilities
6. An increase in assets
Proprietorship may be increased by
7. An increase in other items of proprietorship
8. An increase in liabilities
9. A decrease in assets
All of the last set, however, duplicate the nine in the illustration. For
example, to say that assets may be increased by an increase in proprietorship
(in the illustration) is the same as saying that proprietorship may be
increased by an increase of assets (in this footnote). Although only one set
should be used, either, of course, may be used equally well.
Chap. IV]
THE ACCOUNTING CYCLE
41
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42
ELEMENTS OF ACCOUNTING
[Chap. IV
In the general journal the account to be debited is always
written first. Accounts to be credited follow and are indented
to the right. In a given transaction all accounts to be debited
are written first and all accounts to be credited, second. The
explanation of the transaction is written directly beneath the
last account credited, and the full width of the column is used.
Posting Journal Entries. As explained in Chapter III, the
journal contains the record of the transaction, the ledger the
record of the account. The process of transferring entries from
the journal to the proper accounts in the ledger is known as
posting. The ledger account, where information from the journal
is posted, appears (in skeleton form) as follows :
NAME OF ACCOUNT
(page number)
(a)
(6)
(0
^x^x-x/x/xy
The month date is placed in column a, the day date in column
6, explanations or notations in column c, and the amount to be
debited or credited in column c. Column d is the folio column.
In the ledger a figure here serves a double purpose: it indicates
that the posting has been made, and it shows the page number in
the journal where further information concerning the transaction
may be obtained. In the journal a number in th^ folio column
indicates that the posting has been effected, and it shows the
page in the ledger to which the amount has been carried.
In the example used in the previous step, the posting process
would be completed as follows :
CASH
Page 1
Jan. 2
1 3,000
MERCHANDISE INVENTORY
Page 2
Jan. 2 1 6,000
F. W. BAKI
GR, CAPITAL Page 3
Jan. 2 1 9,000
The cash account is debited $3,000; the merchandise inven-
tory is debited $6,000; and F. W. Baker, capital, is credited
Chap. IV]
THE ACCOUNTING CYCLE
43
$9,000, with proper accompanying notations for dates and folio
numbers. In the journal the page number of the respective
accounts is written in the folio column on the same line as the
account titles.
Footing the Accounts. The next step in the accounting cycle
consists of footing the accounts, a process whereby the balance
of each account is determined. This step is important, mainly
as preliminary to the succeeding one, that of taking a trial
balance. The technique may be illustrated by the following cash
account used in the example given later in this chapter (page 48).
CASH
Page 1
Jan.
2
j
3,000
00
Jan.
2
1
100
00
8
2
900
00
2
1
450
00
17
2
1,200
00
3
1
75
00
20
1,866.00*
2
450
00
4
1
2,000
00
5,550
00*
5
1
240
00
10
2
50
00
13
2
300
00
22
2
300
00
26
3
50
00
31
3
120
00
8,685
00*
* Small pencil figures.
Two steps are necessary in footing accounts:
1. Total the column figures on each side of the account in
small, legible pencil marks, written directly beneath the
last figure in the respective column.
2. Write the difference between the two totals in the explana-
tion column on the side having the greater total.
Taking the Trial Balance. After the accounts are footed,
those having balances are placed in a trial balance. This may be
defined as a list of open accounts (accounts having balances)
appearing in the ledger and arranged either according to total
debits and total credits in each account (trial balance, page 50) or
according to the balance of each account (trial balance, page 51).
The first form has the advantage of indicating the volume of
transactions affecting specific accounts, but the second is cus-
tomarily used because the balance sheet and the profit and loss
44 ELEMENTS OF ACCOUNTING [Chap. IV
statement may be prepared without the clerical computation
required to determine the account balance. The purpose of the
trial balance is twofold: to offer presumptive evidence of the
clerical accuracy of the ledger, and to arrange the accounts in a
convenient form for the preparation of the statements.
Once the accounts have been footed, the steps required. to
prepare a trial balance (by account balance) are as follows:
1. Write the open accounts on ordinary two-column journal
paper in the order of their appearance in the ledger, placing
each account balance in its appropriate column on the same
line as the account title.
2. Draw an addition line under the last figure in the trial
balance. Draw another addition line under the other
column directly opposite.
3. Add both columns and write in the amounts, placing double-
ruled lines beneath the totals.
In order to check the accuracy of the ledger, the trial balance
is usually taken monthly, even though the statements are not
prepared so often. When it is taken monthly, totals of previous
months are included in the balances until the end of the fiscal
period.
Sometimes the column totals of the trial balance fail to balance.
The following procedure 1 is recommended for discovering errors:
1. If there is a difference of 1 cent, 10 cents, $1, etc., it is
reasonable to assume first that there is an error in addition.
2. If the difference between the totals is divisible by 2, make
the division and look through the trial balance for a debit
account balance of this amount improperly classified as a
credit amount, or vice versa.
1 Recommended procedures for locating errors sometimes include sug-
gestions for locating transpositions and slides in figures; these may be
helpful if there is only one error. For an explanation of these special tests
see MacFarland and Ayars, "Accounting Fundamentals," pp. 102-103,
McGraw-Hill Book Company, Inc., New York, 1936. For an extended
discussion of methods of locating errors see H. A. Finney, "Introduction to
Principles of Accounting," pp. 469-476, Prentice-Hall, Inc., New York,
1938.
Chap. IV] THE ACCOUNTING CYCLE 45
3. Check the amounts in the trial balance against the ledger
account balances. Be sure that the closed accounts equate
and that all accounts with balances have been included.
4. Check account additions and subtractions.
5. Verify the postings, working from the ledger to the journal.
Place a small check mark opposite the figures compared in
both the ledger and the journal. Examine these closely
for figures with two marks or with none.
It should be noted that even though the trial balance totals
are equal, this is only presumptive evidence of accuracy in the
ledger important errors may still be present. Errors either of
omission or of commission may be made without any effect on
the equilibrium of the trial balance. Errors of omission may
include the failure to journalize an entire transaction, or, if
journalized, to post it. Errors of commission may include
mistakes made in analyzing a transaction; either wrong accounts
or wrong amounts may be journalized, postings may be made to
wrong accounts, or the wrong amounts may be posted. But if
compensating errors are made if the total debits in a given
transaction, or a series of transactions, equal the total credits
such errors will not be disclosed by the trial balance.
To illustrate better the first three steps in the accounting
cycle the process of journalizing, posting, and taking a trial
balance a somewhat extended example is offered.
ILLUSTRATIVE PROBLEM
Assume that on January 2, 19 , F. W. Baker started business with an
investment of $3,000 in cash and $6,000 in inventory. Assume further
that the following transactions occur during the month:
January 2. Paid rent for January, $100.
2. Bought furniture and fixtures from W. R. Simmons, $750; paid
cash, $450 and gave a 60-day 6 per cent note dated January 2
for the balance.
3. Bought office supplies for cash, $75.
4. Bought merchandise for cash, $2,000; from J. W. Wilson on
account, $1,500.
6. Paid cash for insurance for the calendar year, $240.
8. Sold merchandise for cash, $900; to J. C. Steele on account,
$750.
10. Paid cash for advertising space in Herald Tribune, $50.
13. F. W. Baker withdrew cash, $300.
46 ELEMENTS OF ACCOUNTING [Chap. IV
January 14. J. C. Steele returned goods sold to him January 8 amounting to
$150.
15. F. W. Baker sold one-half of his equity in the business to C. J.
Ford for $4,350 cash. It was agreed that Ford would share in
no portion of the profits made during the current month.
17. Sold merchandise for cash, $1,200; to V. B. Jones on account,
$200.
18. Returned merchandise purchased from J. W. Wilson, $200.
20. Received cash on account from J. C. Steele, $450.
22. Paid J. W. Wilson $300 on account and gave him a 90-day
6 per cent note for $400.
26. Paid miscellaneous expenses, $50.
29. F. W. Baker reduced his equity by accepting a note of the firm
of $1,500 for 1 year bearing interest at 6 per cent.
31. Paid clerical salaries, $120.
F. W. BAKER
GENERAL JOURNAL, JANUARY, 19
Page 1
Jan. 2 Cash 1 3,000
Merchandise inventory 4 6 , 000
F. W. Baker, capital 9 9,000
To record the initial investment of
F. W. Baker
2 Rent 18 100
Cash 1 100
2 Furniture and fixtures 6 750
Cash 1 450
Notes payable 8 300
To record the purchase of furniture
and fixtures from W. R. Simmons
The note is for 60 days, is dated
Jan. 2, and bears 6 per cent
. interest
3 Office supplies 16 75
Cash 1 75
To record the purchase of office
supplies from Weldon Brothers
4 Purchases 13 3,500
Cash 1 2,000
J. W. Wilson 7 1,500
To record the purchase of merchan-
dise from J. W. Wilson
5 Insurance premiums 5 240
Cash 1 240
To record the purchase of insurance
for the calender year
Chap. IV] THE ACCOUNTING CYCLE 47
Page 2
Jan. 8 Cash 1 900
J. C. Steele 3 750
Sales 11 1,650
To record the sale of merchandise to
J. C. Steele
10 Advertising 15 50
Cash 1 50
To record the purchase of adver-
tising space in the Herald Tribune
13 F. W. Baker, capital 9 300
Cash 1 300
To record the withdrawal of cash
14 Sales returns 12 150
J. C. Steele 1 150
To record goods returned from sale
of Jan. 8
Jan. 15 F. W. Baker, capital 9 4,350
J. C. Ford, capital 10 4,350
To record the sale of one-half Mr.
Baker's equity to Mr. Ford. It
was agreed that Mr. Ford would
share in no portion of the profits
made during the current month
17 Cash 1 1,200
V. B. Jones 2 200
Sales 11 1,400
To record the sale of merchandise
to V. B. Jones
18 J. W. Wilson 7 200
Purchase returns 14 200
To record goods returned purchased
Jan. 4 from J. W. Wilson
20 Cash 1 450
J. C. Steele 3 450
To record payment on account
22 J. W. Wilson 7 700
Cash 1 300
Notes payable 8 400
The note is for 90 days, bears in-
terest at 6 per cent, and is dated
Jan. 22.
48 ELEMENTS OF ACCOUNTING
26 Miscellaneous expenses 20 50
Cash 1
Paid sundry expenses
29 F, W. Baker, capital 9 1 ,500
Notes payable 8
The note given to Mr. Baker is
dated Jan. 29, is for one year, and
bears interest at 6 per cent
Jan. 31 Office salary 17 120
Cash 1
Paid clerical salaries for January
F. W. BAKER
GENERAL LEDGER
CASH
V. B. JONES
J. B. STEELS
MERCHANDISE INVENTORY
[Chap. IV
Page 3
50
1,500
120
Page 1
Jan.
2
1
3,000
00
Jan.
2
1
100
00
8
2
900
00
2
1
450
00
17
2
1,200
00
3
1
75
00
20
1,866.00*
2
450
00
4
1
2,000
00
6,660
00*
5
1
240
00
10
2
50
00
13
2
300
00
22
2
300
00
26
3
50
00
31
3
120
00
3,685
00*
Page 2
Jan.
17
2
200
00
Page 3
Jan.
8
150.00*
2
750
00
Jan.
14
2
150
00
20
2
450
00
600
00*
Page 4
(Jan.
2
1
6,000
00
* Small pencil figures.
Chap. IV] THE ACCOUNTING CYCLE 49
INSURANCE PREMIUMS Page 5
JanT
5
1
240
00
FURNITURE AND FIXTURES Page 6
F
2
1
750
00
J. W. WILSON Page 7
Jan.
18
2
200
00
Jan.
4
600.00*
1
1,500
00
22
2
700
00
900
00*
NOTES PAYABLE Page 8
Jan.
2
1
300
00
22
2
400
00
29
3
1,500
00
2,200
00*
F. W. BAKER, CAPITAL
Page 9
19_
19_
Jan.
13
2
300
00
Jan.
2
2,850.00*
1
9,000
00
15
2
4,350
00
29
3
1,500
00
6,150
00*
C. F. FORD, CAPITAL
Page 10
I 19 -
r
15
2
4,350
00
SALES Page 11
Jan.
8
2
1,650
00
17
2
1,400
00
3,050
00*
SALES
RETURNS AND ALLOWANCES
Page 12
19_J
Jan. 14
2
150
00
*Sxnall pencil figures.
50 ELEMENTS OF ACCOUNTING (Chap. IV
PURCHASES Page 13
EC
Jan.
4
1
3,500
00
PURCHASE RETURNS AND ALLOWANCES
ADVERTISING
OFFICE SUPPLIES
MISCELLANEOUS EXPENSES
Page 14
II 19 -
Jan.
18
o
200
00
Page 15
19_
Jan.
10
2
50
00
Page 16
Jan.
3
1
75
00
OFFICE SALARIES
Page 17
Jan.
31
3
120
00
RENT
Page 18
Jan.
2
1
100
00
Page 19
19__
Jan.
,
26
3
50
00
BAKER AND FORD
TRIAL BALANCE BY TOTAL DEBITS AND CREDITS
January 31, 19
Cash $ 5,550 $ 3,685
Accounts receivable:
V. B. Jones 200
J. C. Steele 750 600
Merchandise inventory January 2, 19 . . 6,000
Insurance premiums 240
Furniture and fixtures 750
J. W. Wilson 900 1,500
Notes payable 2,200
F. W. Baker, capital 6, 150 9,000
Chap. IV] THE ACCOUNTING CYCLE 51
Baker and Ford (Continued)
C. J. Ford, capital 4,350
Sales 3,050
Sales returns and allowances 150
Purchases 3,500
Purchase returns and allowances 200
Advertising 50
Office supplies 75
Office salaries 120
Rent 100
Miscellaneous expense 50
$24,585 $24,585
BAKER AND FORD
TRIAL BALANCE BY ACCOUNT BALANCES
January 31, 19
Cash $ 1 ,865
Accounts receivable:
V. B.Jones 200
J. C. Steele 150
Merchandise inventory January 2, 19 . . 6,000
Insurance premiums 240
Furniture and fixtures 750
J. W. Wilson $ 600
Notes payable 2,200
F. W. Baker, capital 2,850
C. J. Ford, capital 4,350
Sales 3,050
Sales returns and allowances 150
Purchases 3,500
Purchase returns and allowances 200
Advertising 50
Office supplies 75
Office salaries 120
Rent 100
Miscellaneous expense 50
$13,250 $13,250
Questions
Review.
1. What is meant by the accounting cycle?
2. Explain the importance of underlying documents in the journalization
process.
3. Give a classification of transactions.
4. What three steps are necessary in the analysis of a transaction?
5. Explain the use of the folio column in the journal and in the accounts.
6. What two steps are necessary in footing accounts?
52 ELEMENTS OF ACCOUNTING [Chap. IV
7. Outline the necessary steps in taking a trial balance.
8. Give a procedure for locating errors in the trial balance.
9. Enumerate some of the errors which the trial balance will not disclose.
Discussion.
10. Distinguish between the function of the trial balance and the function
of the balance sheet.
11. What is the relation between the trial balance and
a. The balance sheet
6. The profit and loss statement
c. The ledger
12. Under what conditions should a trial balance by totals of debits and
credits in each account be used? Under what conditions should a trial
balance by account balances be used?
Suggested Supplementary Readings
COLE, W. M.: "The Fundamentals of Accounting," Chaps. 9 and 10,
Hough ton Mifflin Company, Boston, 1921.
KOHLER, E. L., and P. L. MORRISON: " Principles of Accounting," Chaps. 5
and 6, McGraw-Hill Book Company, Inc., New York, 1931.
MACFARLAND, G. A., and R. D. AYARS: "Accounting Fundamentals,"
Chaps. 7 and 9, McGraw-Hill Book Company, Inc., New York, 1936.
McKiNSEY, J. O., and H. S. NOBLE: "Accounting Principles," Chap. 6,
South- Western Publishing Company, Cincinnati, 1939.
PATON, W. A.: "Essentials of Accounting," Chap. 4, The Macmillan Com-
pany, New York, 1938.
POWELSON, J. A.: "Introductory Accounting," Chaps. 2, 3, and 4, Prentice-
Hall, Inc., New York, 1926.
CHAPTER V
THE ACCOUNTING CYCLE. (Continued)
In the last chapter transactions were divided into three groups.
First, were those (already considered) which express a relation-
ship between the business and some outside party or entity.
Second, were those which involve a change in the value of some
asset or equity due to the operation of the business or to the
passage of time (the diminished value of a machine due to wear
and tear, for example). Third, were those in which the balance
of one account is transferred to another. For the most part
transactions of the second group are recorded by means of
adjusting entries, those of the third group by means of closing
entries.
Adjusting Entries. The entries required to correct the
accounts to their proper values are commonly known as adjusting
entries. On the completion of the trial balance and before the
profit and loss statement and the balance sheet can be prepared,
certain adjustments must be made to the ledger accounts before
they will disclose financial and operating results as accurately as
it is possible to state them.
For convenience of discussion, these adjustments may be classi-
fied as follows:
1. Inventories
2. Assets requiring valuation accounts
3. Accrued expenses
4. Accrued income
5. Prepaid expenses
6. Deferred income
Inventory Adjustment. Before discussing 'the inventory
adjustment, the distinction between the terms " merchandise
inventory," " purchases," and "cost of goods sold" should be
made clear. The merchandise inventory account contains the
value of the asset (merchandise stock-in-trade) at the end of the
53
54 ELEMENTS OF ACCOUNTING [Chap. V
fiscal period. The purchases account is treated as an expense
and includes the amount of merchandise acquired during the
fiscal period. The balance of the cost of goods sold account is
the cost price of the sales for the fiscal period. The relationship
of the purchases and the merchandise inventory account to the
cost of goods sold account is a close one. If the inventory figure
has increased, it means, ordinarily, that not all the purchases
made during the period were sold. Therefore, of the total
amount of purchases made, part goes to the increase in the
inventory, the remainder to the cost of goods sold. If, however,
the cost of goods sold is greater than the purchases made during
the period, this means that the cost of goods sold is made up not
only of all the purchases but also of an amount equal to the
decrease in inventory value.
Such is the case in the present illustration. The decrease in
the inventory of $1,100 (January 1, $6,000; June 30, $4,900)
means that an amount of goods equal to all purchases made
during the fiscal period has entered into the cost of goods sold
together with an inventory value amounting to $1,100. This
may be shown as follows: 1
June 30, 19__
Cost of goods sold 6,000
Merchandise inventory, Jan. 1, 19 6,000
To close the inventory of Jan. 1, 19
Merchandise inventory, June 30, 19 4,900
Cost of goods sold 4,900
To record the inventory of June 30, 19
If the merchandise purchases made during the period amount
to $18,950, purchase returns and allowances total $420, and
transportation in is $120, these balances may be transferred to
cost of goods sold by the following entries on June 30:
Cost of goods sold 18,950
Purchases 18,950
To transfer purchases into the cost of goods
sold account
1 An alternative procedure for recording inventory adjustments is to place
the values of both inventories in a single account in which case the balance
te the last inventory value,
Chap. V]
THE ACCOUNTING CYCLE
55
Purchase returns and allowances 420
Cost of goods sold 420
To transfer purchase returns and allowances to
the cost of goods sold account
Cost of goods sold 120
Transportation in 120
To transfer transportation in to the cost of
goods sold account
When these adjusting entries are posted, the accounts involved
will appear as follows:
MERCHANDISE INVENTORY, JANUARY 1, 19
19
Jan. 1 Balance
6,000
19
June 30
MERCHANDISE INVENTORY, JUNE 30, 19
6,000
19
June 30 Balance
4,900
PURCHASES
19
June 30 Total
18,830
19
June 30
PURCHASE RETURNS AND ALLOWANCES
18,830
19
June 30
420
19
June 30 Total
TRANSPORTATION IN
420
19
June 30
120
19
June 30
120
COST OF GOODS SOLD
19,
June 30
6,000
18,830
120
19
June 30
4,900
420
As in the case of merchandise, the important consideration of
supplies inventory is to distinguish between the expense and the
56 ELEMENTS OF ACCOUNTING [Chap. V
asset elements. If, for example, the supplies account balance is
$125 and the amount remaining is $40, then the latter amount is
the asset portion and the supplies expense for the period is $85.
The entry to adjust these values is as follows:
June 30, 19
Supplies expense 85
Supplies 85
Assets Requiring Valuation Accounts. Although inventories
do occasionally have valuation accounts, these are used for the
most part with accounts receivable and fixed assets. The pur-
pose of an asset valuation account is to show the decline in the
value of the asset to which the valuation account refers. The
decrease, instead of being recorded directly in the asset account,
is placed in a special account. To determine the book value of
an asset having a valuation account, the amount appearing in
the asset account proper must be considered jointly with the
valuation account balance.
It is most unlikely that all accounts outstanding at the close
of the fiscal period will be collected. Recognition of the probable
loss from doubtful accounts must, of course, be taken before the
loss actually occurs; to do otherwise would result in a later
fiscal period being burdened with an expense which does not
properly belong to it. The period in which the sale originated
should bear the cost incurred in securing the revenue for that
period. Hence an estimate is made of the doubtful accounts and
recorded as follows:
June 30, 19
Bad debts 95
Reserve for doubtful accounts 95
To record the estimated losses on outstanding accounts
receivable
The balance of accounts receivable (assumed) and the effect
of the adjusting entry on the accounts involved may be shown as
follows:
ACCOUNTS RECEIVABLE
-_ |
June 30 Balance 3,200 I
Chap. V] THE ACCOUNTING CYCLE 57
RESERVE FOR DOUBTFUL ACCOUNTS
I- , ^_-
June 30 95
BAD DEBTS
June 30 95
In general, the same principle is applied in making the adjust-
ment for depreciation. In the illustration used, the depreciation
on furniture and fixtures for the six -month period is $125. This
is recorded in the journal as follows:
June 30, 19
Depreciation 125
Reserve for depreciation on furniture and fixtures 125
The balance of furniture and fixtures (assumed) and the data
contained in the adjusting entry will appear in ledger form as
follows :
FURNITURE AND FIXTURES
__, -
June 30 1,500 J
RESERVE FOR DEPRECIATION OF FURNITURE AND FIXTURES
June 30 125
DEPRECIATION OF FURNITURE AND FIXTURES
June 30 125
The depreciation charge is an expense; the reserve for deprecia-
tion is a valuation account to be deducted from the asset to which
it refers before the book value of the asset can be determined.
The Cash Basis and the Accrual Basis of Accounting. Books
are kept either on the cash or on the accrual basis. While the
distinction between the two cannot be sharply defined in view
of the current usage of the term " cash basis/' revenue on the cash
basis is usually considered as realized only when cash has been
received, and expenses are considered applicable to the period in
58 ELEMENTS OF ACCOUNTING [Chap. V
question only when they have been paid. The accrual basis has
been explained as consisting of "the effort to recognize in a given
period all revenues which can fairly be said on the basis of valid
business and legal rules to have been earned in the period, and
to charge thereto as expenses all the costs attaching to such
revenues." 1 While a strict observation of the cash basis would
undoubtedly simplify the accounting process, for practical busi-
ness purposes it is wholly inadequate. 2
Accrued Expenses. An accrued expense item is an addition to
the expenses of the accounting period about to be closed and a
liability owing, but not yet due. If, for example, unpaid salaries
at the close of the fiscal period amounted to $50, the adjusting
entry to record it would be
June 30, 19_
Salaries 50
Accrued salaries payable 50
When the entry is posted, the ledger accounts will appear as
follows:
SALARIES
June 30 Balance 850
30 50
ACCRUED SALARIES PAYABLE
June 30 50
iPaton, W. A., ed., "Accountants' Handbook," p. 1083, The Ronald
Press Company, New York, 1933.
2 DR Scott explains the inadequacy of the cash basis as follows: "If
incomes are received in a period earlier than corresponding expenses are paid
the effect of handling them on a cash basis will be to increase the net income
of the earlier period and to decrease that of the later period. One period
might show a net gain and the other a net loss when as a matter of fact the
operations of the two periods were the same except for the dates of cash
receipts and payments. The inadequacy and impropriety of such a method
is particularly evident in corporate business where directors as well as stock-
holders are so largely dependent upon accounting records for their judgment
of the profitableness or unprofitableness of periodic operations." Ibid fJ p.
1083.
Chap. V] THE ACCOUNTING CYCLE 59
Accrued Income. Accrued income is an addition to revenue
since the income has been earned within the period about to be
closed. At the same time it is an asset, a receivable not yet due
or collectible. For example, if the interest accrued, but not due,
on the notes receivable held by Baker and Ford amounts to $5,
this information will be journalized as follows:
June 30, 19
Accrued interest receivable 5
Interest earned 5
When this entry is posted, the ledger accounts will appear as
follows:
INTEREST EARNED
June 30 Balance 20
30 (adjustment) 5
ACCRUED INTEREST KEOEJVABLE
June 30 (adjustment) 5 I
* Prepaid Expenses. Prepaid expenses, the fifth type of adjust-
ment under consideration, offers an illustration of the relation
between assets and expenses. A prepaid expense is a claim of
the business for services to be rendered and, as such, is an asset.
As the services are rendered, the claim for future benefits is
correspondingly reduced and the asset becomes an expense. An
expense may be defined, in terms of an asset, as an expired asset
value.
If, for example, advertising expense amounts to $250 and of
this $35 represents the value of the unexpired portion, 1 the
adjusting entry necessary to record this will be as follows:
June 30, 19_
Prepaid advertising 35
Advertising 35
1 The process of adjusting accounts at the close of the fiscal period is
largely a question of resolving mixed accounts into their respective elements.
A mixed account contains two or more distinct elements of asset, liability,
net worth, revenue, or expense items. In the present example, the adver-
tising account is predominately an expense. Prior to adjusting the account,
however, it is mixed because it contains both expense and asset elements.
60 ELEMENTS OF ACCOUNTING [Chap. V
When this entry is posted, the respective ledger accounts
affected will appear as follows :
ADVERTISING
19
June 30 Balance 250
19
June 30 (adjustment) 35
PREPAID ADVERTISING
19
June 30 (adjustment) 35
Deferred Income. The last adjustment to be discussed is
deferred income, which refers to revenue recorded on the books
which has not yet been earned and hence must be passed on to
the period which can properly claim it. This adjustment is at
once a liability and a deduction from revenue. The liability is
not to be construed as one to be settled by a payment in
money but rather as an obligation to be satisfied by rendering
a service. For example, the rent paid in advance by the tenant
for the use of a garage is a liability of the enterprise in the sense
that the business owes a service (specifically, the use of the
garage for the ensuing month). The entry necessary to show
this is
June 30, 19
Rent income 15
Deferred rent payable 15
When the entry is posted, the ledger accounts will appear as
follows :
RENT INCOME
June 30 (adjustment) 15
19
June 30 Balance 75
DEFERRED RENT PAYABLE
19
June 30 (adjustment) 15
Closing Entries. With very few exceptions all adjustments
are recorded before closing entries are made. 1 Closing entries
1 Taxes and bonuses based on net income are exceptions.
Chap. V]
THE ACCOUNTING CYCLE
61
deal with individual expense and revenue accounts, the profit
and loss account, and accounts of the owners. The temporary
proprietorship accounts (expense and revenue) have two impor-
tant characteristics. First, their life span is temporary; it is
limited to a fiscal period. Second, the accounts are closely
related to the proprietor's equity; they explain the changes due
to business operations. The function of the closing entries is
to summarize the expense and revenue accounts and to show the
net effect of operations upon proprietorship.
To facilitate this process, a summary account called profit and
loss is opened. Into this all expense and all revenue account
balances are transferred. The balance of the profit and loss
account, in turn, is carried to proprietorship. These facts may
be summarized as follows:
PROFIT AND Loss ACCOUNT
(Debit)
Individual expense account balances
are closed into profit and loss by
debiting the summary account and
by crediting the respective expense
accounts
If the business has operated at a
profit, this amount is transferred
to proprietorship by debiting
profit and loss and crediting the
proprietorship account
(Credit)
Individual revenue account balances
are closed into profit and loss by
crediting the summary account
and by debiting the respective
revenue accounts
If the business has operated at a loss,
this amount is transferred to
proprietorship by crediting profit
and loss and debiting the proprie-
torship account
Readjusting Entries. The closing entries clear the balances
of all profit and loss accounts. Asset and liability accounts,
however, which were placed in the ledger because of the various
adjustments still remain on the books. Since these balances are
significant only at the close of the fiscal period, they are removed
on the first day of the new accounting period. This is accom-
plished by reversing the adjusting entry. A readjusting (or
reversing) entry transfers an item, which has been adjusted, from
an asset or liability account to an expense or revenue account.
For example, since the account accrued salaries payable (page
58) is significant only because it appears in the balance sheet at
the close of the fiscal period, the amount is removed when it is
62
ELEMENTS OF ACCOUNTING
[Chap. V
no longer of any use. Hence on July 1 the following readjusting
entry is made :
Accrued salaries payable 50
Salaries 50
As a result of this entry the liability account is cleared and the
expense account reduced. Thus, when salaries ""are paid on
lJuly 3, the recording entry will be
Salaries 100
Cash 100
After the reversing entry has been made and the payroll
recorded, the salary account shows the amount of expense
applicable to the fiscal period beginning July 1. The accounts
appear as follows:
SALARIES
19__
June 30
30
Balance 850
(adjustment) 50
19_
June 30 To profit and loss
900
900
900
July 3
100
July 1
50
ACCRUED SALARIES PAYABLE
19
July 1 (readjusting entry)
50
June 30 (adjustment)
50
The asset, accrued interest receivable, is removed from the
books by the following entry:
Interest earned 5
Accrued interest receivable 5
When the entry is posted, the accounts appear as follows:
INTEREST EARNED
June 30 To profit and loss
July 1 (readjusting entry)
15
15
5
June 30 (adjustment)
30 Balance
5
10
15
Chap. V]
THE ACCOUNTING CYCLE
ACCRUED INTEREST RECEIVABLE
63
June 30 (adjustment)
July 1 (readjusting entry)
Similarly, the prepaid advertising account will be closed by
the following readjusting entry:
Advertising 35
Prepaid advertising 35
After the readjusting entry has been posted, the accounts
affected appear as follows :
ADVERTISING
June 30 Balance
250
250
30 To profit and loss
July 1 (readjusting entry) 35
PREPAID ADVERTISING
June 30 (adjustment)
35
215
250
July 1 (adjustment)
35
June 30 (readjusting entry) 35
Deferred rent payable, the last of the adjustments considered
in this chapter, is closed by the following entry:
Deferred rent payable 15
Rent income 15
After posting, the accounts will appear as follows:
RENT INCOME
June 30 (adjustment)
To profit and loss
15
60
75
June 30 Balance
July 1 (readjusting entry)
DEFERRED RENT PAYABLE
75
15
July 1 (readjusting entry)
15
June, 30 (adjustment)
15
64 ELEMENTS OF ACCOUNTING [Chap. V
To better summarize the content of this chapter the trial
balance and a list of adjustments of Baker and Ford are given as
of June 30, 19 From these data the adjusting, closing, and
readjusting entries are recorded as they appear in the general
journal.
BAKER AND FORD
TRIAL BALANCE, JUNE 30, 19
Cash $ 2,250
Accounts receivable 3 , 200
Notes receivable 400
Merchandise inventory, January 1, 19 . 6,000
Insurance premiums 240
Furniture and fixtures . . 1,500
Office supplies ... 125
Accounts payable ... . $ 1,450
Notes payable ... 2,000
F. W. Baker, capital 3,000
C. J. Ford, capital 4,500
Sales 23,385
Sales returns and allowances 225
Interest earned. ... 10
Rent income 75
Purchases 18,830
Purchase returns and allowances 420
Transportation in 120
Advertising 250
Salesman's salaries 550
Office salaries 300
Rent 700
Interest expense 25
Miscellaneous expense 125
$34,840 $34,840
Additional data:
(1) Merchandise inventory, June 30, 19 $4,900
(2) Office supplies on hand 40
(3) Estimated loss on outstanding accounts receiva-
ble 95
(4) Depreciation on furniture and fixtures 125
(5) Office salaries accrued 50
(6) Accrued interest on notes receivable 5
(7) Prepaid advertising 35
(8) Rent income deferred 15
(9) Unexpired insurance 120
(10) Prepaid interest on notes payable 10
(11) Rent paid in advance 100
Chap. V] THE ACCOUNTING CYCLE 65
BAKER AND FORD
ADJUSTING AND CLOSING ENTRIES
June 30, 19
(1)
June 30 Cost of goods sold, January 1, 19_ 6,000.00
Merchandise inventory 6 , 000 . 00
To close the merchandise inventory of
January 1, 19 into the cost of goods sold
to
Merchandise inventory, June 30, 19 4,900.00
Cost of goods sold 4,900.00
To record the inventory of June 30, 19
(3)
Cost of goods sold 18,830.00
Purchases 18,830.00
To transfer purchases to the cost of goods
sold account
(4)
Purchase returns and allowances 420 . 00
Cost of goods sold 420 .00
To transfer purchase returns and allowances
to the cost of goods sold account
(5)
Cost of goods sold 120.00
Transportation in 120.00
To transfer transportation in to the cost of
goods sold account
(6)
Office supplies expense 85 . 00
Office supplies 85.00
To record the supplies on hand and to cor-
rectly state the supplies expense for the
fiscal period
(7)
Bad debts 95.00
Reserve for doubtful accounts 95 . 00
To record the estimated losses on outstand-
ing accounts receivable
(8)
Depreciation on furniture and fixtures 125.00
Reserve for depreciation on furniture and
fixtures 125.00
To record the depreciation on furniture and
fixtures from January 1 to June 30, 19
(9)
Salaries 50.00
Accrued salaries payable 50 . 00
To record unpaid salaries
66 ELEMENTS OF ACCOUNTING [Chap. V
(10)
June 30 Accrued interest receivable 5 . 00
Interest earned 5 . 00
To record the interest earned but not due
on notes receivable
(ID
Prepaid advertising 35 . 00
Advertising 35 . 00
To record advertising expense deferred to
the next fiscal period
(12)
Rent income 15 . 00
Deferred rent payable 15.00
To adjust the rent income paid in advance
for the use of the garage
(13)
Insurance 120 . 00
Insurance premiums 120.00
To record the insurance expense for the
period
(14)
Prepaid interest 10.00
Interest 10.00
To record prepaid interest on notes payable
(15)
Prepaid rent 100.00
Rent 100.00
To record rent paid in advance
(16)
Sales 23,385.00
Interest earned 15 . 00
Rent income 60 . 00
Profit and loss 23,460.00
To close the income accounts into the profit
and loss account
(17)
Profit and loss 22,135.00
Sales returns and allowances 225 . 00
Cost of goods sold 19,630.00
Advertising 215 . 00
Sales salaries 600.00
Office salaries 300.00
Rent 600.00
Interest expense 15 . 00
Miscellaneous expense 125 . 00
Bad debts 95.00
Insurance 120.00
Office supplies expense 85 . 00
Depreciation 125.00
Chap. V] THE ACCOUNTING CYCLE 67
June 30 To close the expense accounts and the
deduction from income accounts into
profit and loss
(18)
Profit and loss 1 ,325.00
F. W. Baker, drawing 662.50
C. J. Ford, drawing 662.50
To distribute the profits from operations for
the 6 mouths ending June 30, 19 , into
the drawing accounts of the partners
(19)
F. W. Baker, drawing 662. 50
C. J. Ford, drawing 662 . 50
F. W. Baker, capital 662.50
C. J. Ford, capital 662.50
To close the balances of the partners' draw-
ing accounts into their capital accounts
BAKER AND FORD
READJUSTING ENTRIES, JULY 1, 19
(1)
Accrued salaries payable 50 . 00
Salaries 50.00
To reverse the adjusting entry of June 30
(2)
Interest earned 5 . 00
Accrued interest receivable 5 . 00
To reverse the adjusting entry of June 30
(3)
Advertising 35 . 00
Prepaid advertising 35.00
To reverse the adjusting entry of June 30
(4)
Deferred rent payable 15.00
Rent income 15 . 00
To reverse the adjusting entry of June 30
(5)
Interest expense 10 . 00
Prepaid interest 10 . 00
To reverse the adjusting entry of June 30
(6)
Rent 100.00
Prepaid rent 100.00
To reverse the adjusting entry of June 30
Questions
Review.
1. Why are ad justing entries necessary? Distinguish between the function
of adjusting and closing entries.
68 ELEMENTS OF ACCOUNTING [Chap. V
2. Give a classification of adjustments.
3. Explain the relationship between merchandise inventory, purchases,
and cost of goods sold.
4. What is the purpose of a valuation account? Explain the relation
between the valuation account and the asset account to which it refers.
6. Distinguish between the cash and the accrual basis of keeping books.
6. Identify each of the following as asset, liability, expense, or revenue
items :
a. Accrued expense
b. Accrued income
c. Prepaid expense
d. Deferred income
7. Discuss the relation between assets and expenses.
8. Distinguish between the function of the profit and loss account and the
profit and loss statement.
9. What is the purpose of readjusting entries?
10. Explain how one can determine the asset or liability element when
expense or revenue accounts are used as mixed accounts.
11. Explain the effect of a failure to include the following adjustments on
the financial status, as shown by the balance sheet, and on operations,
as shown by the profit and loss statement:
a. Wages owed workers but not yet payable to them
b. Interest earned on notes receivable but not yet due for payment
c. Prepaid advertising which has not been used in the present period
but which will be used in the succeeding period
d. Interest on notes receivable which has been paid in advance but
which will be earned in the next fiscal period
e. An increase in the value of merchandise inventory
/. Depreciation on machinery
g. Estimated bad debts on outstanding accounts receivable
Discussion.
12. On October 1 an annual premium of $240 was paid on a 1-year property
insurance policy. Should this amount be charged to the asset account
insurance premiums or to the expense account insurance expense? If
the amount is charged to the asset account, what would be the adjust-
ing entry at the close of the fiscal period? If charged to the expense
account?
13. "Why bother with adjustments anyway? Year in and year out they
are about the same in my business. Any error caused through a failure
to consider them at the close of a given fiscal period will be just about
offset by the failure to include them in the succeeding period." Evalu-
ate this statement.
Suggested Supplementary Readings
BOLON, D. S.: "Introduction to Accounting," Chaps. 13, 14, and 15, John
Wiley & Sons, Inc., New York, 1938.
Chap. VI THE ACCOUNTING CYCLE 69
FINNEY, H. A,: "Introduction to Principles of Accounting," Chaps. 10 and
11, Prentice-Hall, Inc., New York, 1938.
HUSBAND, G. R., and 0. E. THOMAS: "Principles of Accounting," Chaps. 9
and 11, Houghton Mifflin Company, Boston, 1935.
MACFABLAND, G. A. and R. D. AYABS: "Accounting Fundamentals," Chaps.
11 and 12, McGraw-Hill Book Company, Inc., New York, 1936.
STBEIGHTOFF, F. H.: "Elementary Accounting," Chaps. 7 and 8, Harper &
Brothers, New York, 1928.
CHAPTER VI
THE ACCOUNTING CYCLE. (Concluded)
The various operations in the accounting cycle described in the
two preceding chapters are of secondary importance to manage-
ment in comparison with the summarization of records in the
form of statements. The greatest service accounting can render
to management is to present significant, timely information
relating to operations and finances in a clearly understandable
manner.
The Work Sheet. At the close of the fiscal period it is impor-
tant to management that the profit and loss statement, the
balance sheet, and the statement of change in net worth be
prepared as quickly as possible. This can be greatly facilitated
through the use of the work sheet. The work sheet is a sum-
marizing device designed to facilitate the adjusting and closing
process. It contains the trial balance and data essential to the
adjusting and closing entries and to the preparation of the
statements.
It permits the rapid compilation of reports since proper analysis
and classification can be made and the statements prepared
directly from the work sheet. It is prepared before the adjust-
ments are made and the books are closed. Journalization and
posting can await the completion of the statements. The work
sheet is not a part of the regular accounting records or statements
but rather a device which may be used whenever it is necessary
to summarize quickly the adjusting and closing process and
obtain classified data for the preparation of statements.
Furthermore the work sheet is an effective device for the pre-
vention and detection of clerical errors in the adjusting and
closing process because, when completed, it provides a check on
clerical accuracy and on the classification of all adjustments.
The accompanying 10-column work sheet (see page 72) is fre-
quently used because of its completeness and because of the ease
it affords in avoiding or checking clerical errors. Other forms,
however, having both more and less columns are used as circum-
stances warrant.
70
Chap. VI] THE ACCOUNTING CYCLE 71
The steps required in the preparation of the 10-column work
sheet may be outlined as follows:
1. The first section contains the unadjusted trial balance.
Even if the trial balance is copied, the addition of each
column should be checked so that no errors of transcribing
are present.
2. In the second section, headed "adjustments," the adjusting
entries are entered on the appropriate line opposite the
account affected. At the upper left of the amount a
circled letter or number is written to identify the entry.
Thus in the first entry the number appears at the upper left
of the debit amount, and the same number appears at the
upper left of the credit amount. As in the general journal,
each entry is self-balancing. If, when added, the totals of
the adjustment columns fail to equate, the error may be due
to the fact that the debit part of an entry is not equal to
the credit part, or it may be due to an error in addition.
By numbering each entry it is a simple matter to trace its
failure to balance. Furthermore, when the entries are
journalized, it is easier to trace debit and credit amounts
than it would be without this means of identification.
3. In the third section, headed "adjusted trial balance,"
original balances in the unadjusted trial balance are com-
bined with the adjustments and extended in the appropriate
columns of the adjusted trial balance. If, for example, a
given account in the unadjusted trial balance has a debit
balance and an amount appears opposite the debit column
of the adjustment section, the figures are added and
extended into the adjusted trial balance debit column. If,
however, the amount in the adjustment column is a credit
balance, it will, of course, be deducted from the balance in
the unadjusted trial balance and the difference extended in
the adjusted trial balance. This naturally assumes that
the amount in the adjustment column is less than that in the
unadjusted trial balance. A failure of the two columns to
balance may be attributable to two causes: an error in the
process of extension, combining data in the unadjusted
trial balance and the adjustments; or an error in the addition
of columns.
72
ELEMENTS OF ACCOUNTING [Chap. VI
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Chap. VI]
THE ACCOUNTING CYCLE
73
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74 ELEMENTS OF ACCOUNTING [Chap. VI
4. The fourth and fifth sections contain extensions of balances
in the adjusted trial balance into the appropriate profit and
loss or balance sheet columns. Expense and deductions
from revenue accounts appear on the debit side of the
column headed "profit and loss"; revenue and deductions
from expense accounts appear in the credit column of the
same section. Assets and deductions from liability or net
worth accounts are extended to the debit column of the
balance sheet section; liability, net worth, and deductions
from asset accounts are extended to the credit column of the
balance sheet section.
5. Write the balancing figure in the profit and loss columns
and in the balance sheet columns. If extensions and addi-
tions have been made correctly, these two figures will be
the same. If a profit has been made, the excess of revenue
over expenses will require a balancing figure in the expense
column and the increase in proprietorship (due to the profit)
will appear in the credit column in the balance sheet
section. 1
Preparation of the Profit and Loss Statement. Two forms of
the profit and loss statement are frequently used, the report
(page 75) and the account (page 76).
In general the statement should be condensed sufficiently to
appear on a single sheet. Whether a detailed form or a con-
densed form is used depends upon the purpose it is to serve. In
either case the important facts should be disclosed to the reader.
It should be noted that it is as easy to obstruct the presentation
of essential data or relationships by showing too much detail as
1 The reason for the difference in totals in the profit and loss columns is
because the changes in proprietorship, due to business operations, are
recorded in temporary proprietorship accounts, and the excess of the
revenue accounts over the expense accounts is the profit for the fiscal period.
At first glance the reason for this difference in the balance sheet columns
may not be so clear. Changes in financial structure due to business oper-
ations are always recorded directly in the asset and liability accounts
affected. These transactions, however, are not recorded directly in the
capital accounts. Instead, they are entered in expense and revenue
accounts, and through the closing process the profit or loss is transferred to
the capital accounts. Hence in the balance sheet section, if a profit has
been made (the same as an increase in capital hi this case), the figure is
added to the credit column.
Chap. VI) THE ACCOUNTING CYCLE 75
it is by condensing the statement to the point of showing too
little. In either event the statement that fails to disclose
essential information or relationships can scarcely be considered
satisfactory.
Certain details should be carefully observed. The heading
should state clearly the name of the business, the title, and the
BAKER AND FORD
REPORT FORM OF THE PROFIT AND Loss STATEMENT
For the 6 Months Ending June 30, 19
Gross sales $23,385
Less sales returns and allowances 225
Net sales $23,160
Cost of goods sold:
Merchandise inventory, January 1, 19 $ 6,000
Purchases $18,830
Plus transportation in 120
$18,950
Less purchase returns and allowances 420 18,530
Goods available for sale $24 , 530
Less merchandise inventory, June 30, 19 4,900
Cost of goods sold 19 , 630
Gross profit on sales $ 3 , 530
Less selling expenses:
Advertising $ 215
Sales salaries 600
Total selling expenses $ 815
Less general administrative expenses:
Office salaries $ 300
Rent 600
Insurance expense 120
Office supplies expense 85
Depreciation 125
Bad debts 95
Miscellaneous expense 125
Total general administrative expense 1 ,450 2,265
Net profit from operations $ 1 , 265
Nonoperating income:
Interest earned $ 15
Rent income 60
Total $ 75
Nonoperating expenses:
Interest expense 15 60
Net profit for the period $ 1 , 325
76 ELEMENTS OF ACCOUNTING [Chap. VI
period of time covered. The use of the amount columns, sub-
totals, totals, and marginal indentations should be carefully
noted.
The manner in which revenue and expenses are arranged in the
operating statements depends to a large degree upon the internal
organization of the enterprise. Classification should follow a
pattern which will permit allocation of responsibility within the
organization. While the arrangement to be followed depends
upon the individual business requirements, the following features
are usually emphasized :
1. Gross sales
2. Net sales
3. Cost of goods sold
4. Gross margin or gross profit
5. Selling and administrative expenses
6. Net profit from operations
7. Nonoperating income and nonopcrating expenses
8. Net profit
BAKER AND FORD
ACCOUNT FORM OF THE PROFIT AND Loss STATEMENT
For the 6 Months Ending June 30, 19
Expense Revenue
Cost of goods sold $19,630 Net sales $23, 160
Advertising 215 Interest income 15
Salaries 900 Rent income 60
Rent 600
Miscellaneous expense 125
Insurance expense 120
Office supplies expense .... 85
Depreciation 125
Bad debts 95
Interest expense 15
Total expense $21 ,910
Net profit 1,325
$23,235 $23,235
Preparing the Statement of Change in Net Worth. The state-
ment of change in net worth should include the following items :
1. A suitable title including the name of the enterprise, the
of the statement, and the period
Chap. VI]
THE ACCOUNTING CYCLE
77
2. The balance of net worth at the beginning of the period
3. Profits earned
4. Additional investments
5. Withdrawals of capital
6. Net worth at the end of the period
If the business is a sole proprietorship, the single capital
account balance is shown in the statement; if it is a partnership,
the capital accounts of the owners may be arranged as shown in
statement of change in net worth on this page ; if it is a corporation,
the proprietorship equity is represented by capital stock and
surplus, due consideration being given to stock discount and
stock premium (see Chapter XI).
BAKER AND FORD
STATEMENT OF CHANGE IN NET WORTH
For the 6 Months Ending June 30, 19
Baker
Ford
Total
Net worth balar
Additional inves
Profit
r,fi ? January 1, 19
$9,000.00
662.50
$4,500.00
662.50
$ 9,000.00
4,500.00
1,325.00
tments
Total
$9,662.50
6,000.00
$5,162.50
$14,825 00
6,000 00
Withdrawals
Net worth balan
ice, June 30, 19
$3,662.50
$5,162.50
$8,825.00
Preparation of the Balance Sheet. Like the profit and loss
statements, balance sheets are prepared in either the report or
the account form (pages 79 and 80). In general the same prin-
ciples of construction apply to the balance sheet as apply to the
profit and loss statement. The statement should be condensed
sufficiently to appear on a single sheet if necessary, considerable
detail can be relegated to supporting schedules (page 81). The
heading should state clearly the name of the business, the title,
and the date on which the statement is drawn. Care should be
taken that the proper forms for group headings, columns, sub-
totals, and marginal indentations are used.
While the manner of grouping the items in the balance sheet
depends on the nature of the business and the purpose of the
statement, the following suggestions are general enough to apply
in most cases:
78 ELEMENTS OF ACCOUNTING [Chap. VI
1. Assets should be arranged in logical sequence. What con-
stitutes logical sequence depends upon the intended use.
If the balance sheet is being prepared for an investor
interested primarily in the fixed assets, the sequence should
be from fixed to current assets. If, however, the statement
is being prepared for a banker interested in the current
condition of a business, current assets should ordinarily be
listed first on the asset side and current liabilities first on
the liability side. This arrangement enables the reader to
quickly contrast the two groups and to form an opinion of
the solvency of the enterprise. If this sequence is followed,
the usual order of asset groupings is as follows :
a. Current assets
6. Fixed assets
c. Deferred charges
Frequently, a fourth group is added. Special funds in
hands of trustee, and investments may be cited as examples
which belong to this group and which do not fit into the
threefold classification given.
2. Liabilities should be arranged in a sequence to conform with
the arrangement of assets. If current assets appear first on
the asset side, current liabilities should appear first on the
liability side.
3. Proprietorship items should appear as a group under an
appropriate caption.
4. Asset, liability, and proprietorship items should be stated
at their gross amounts, with deductions shown. Examples
of such deductions are reserve for doubtful accounts, reserve
for outstanding purchase discounts, and discount on capital
stock.
Chap. VI] THE ACCOUNTING CYCLE 79
BAKER AND FORD
REPORT FORM OF THE BALANCE SHEET
June 30, 19
Assets
Current Assets:
Cash $ 2,250.00
Accounts receivable $3 , 200 . 00
Less reserve for doubtful
accounts 95 00 3,105.00
Notes receivable 400 00
Accrued interest receivable 5 . 00
Merchandise inventory, June 30,
19_ 4,900.00
Prepaid expenses:
Prepaid insurance .... $ 120.00
Office supplies 40 . 00
Prepaid interest 10 00
Prepaid rent 100 00
Prepaid advertising. . . 35.00
Total prepaid expenses 305 . 00
Total current assets $10 , 965 . 00
Fixed Assets:
Furniture and fixtures $1 ,500 00
Less reserve for depreciation 125 00 1 ,375 00
Total assets $12,340.00
Liabilities
Current Liabilities:
Accounts payable $ 1 ,450 00
Accrued salaries payable 50 00
Notes payable 2,000 00
Total current liabilities $3,500.00
Deferred Credits:
Deferred rent income 15 00
Total liabilities - 3,515.00
Net Worth
F. W. Baker, capital $3,662.50
C. J. Ford, capital 5,162.50
Total net worth $ 8,825 .00
80
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ELEMENTS OF ACCOUNTING [Chap. VI
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Chap. VI]
THE ACCOUNTING CYCLE
81
BAKER AND FORD
SCHEDULE 1, PREPAID EXPENSES
June 30, 19__
Insurance $120
Office supplies 40
Interest 10
Rent 100
Advertising 35
Total $305
Closing the Books. After the profit and loss statement, the
statement of change in net worth, and the balance sheet are
prepared, entries are made in the journal and in the ledger to
bring the books into conformity with the statements. The steps
necessary to accomplish this are as follows :
1. Journalize and post the closing entries (see Chapter V).
2. Rule and balance the expense and revenue accounts.
3. Prepare a post-closing trial balance.
As already mentioned, closing entries are concerned with the
transfer of expense and revenue accounts to the summary
account profit and loss. The balance of this, in turn, is trans-
ferred to proprietorship.
At the close of the fiscal period the temporary proprietorship
accounts must be ruled and balanced, and accounts appearing in
the balance sheet usually are ruled and balanced. The following
example illustrates how an account is closed and its balance
carried forward.
CASH
Jan.
2
1
3,000
00
Jan.
2
1
100
00
8
2
900
00
2
1
450
00
17
2
1,200
00
3
1
75
00
20
2
450
00
4
1
2,000
00
5
1
240
00
10
2
50
00
13
2
300
00
22
2
300
00
26
3
50
00
31
3
120
00
31
Balance
1,865
00
5,550
00
5,550
00
Jan.
31
Balance
1,865
00
82 ELEMENTS OF ACCOUNTING [Chap. VI
The steps required to close an account are as follows:
1. Add both amount columns.
2. Add to the column having the smaller total an amount
which will make it equal to the other column.
3. Draw a single line under the last figure in the column having
the greatest number of figures. This line separates the
individual items from the column totals.
4. Draw another single line under the account column having
the lesser number of figures and directly opposite the first
single line drawn.
5. Write the totals directly beneath the single lines drawn.
' 6. Draw double lines beneath the totals.
7. If the balance of the account is carried forward, it appears
directly beneath the double-ruled lines.
After the accounts are ruled and balanced, a final test of the
equality of debits and credits in the ledger is made. This is the
function of the post-closing trial balance.
BAKER AND FORD
POST-CLOSING TRIAL BALANCE
June 30, 19
Cash $ 2,250.00
Accounts receivable 3 , 200 . 00
Reserve for doubtful accounts $ 95 . 00
Notes receivable 400.00
Accrued interest receivable 5 . 00
Merchandise inventory 4 , 900 . 00
Prepaid insurance 120 . 00
Office supplies 40.00
Deferred interest payable 10 . 00
Deferred rent expense 100 . 00
Deferred advertising expense 35 . 00
Furniture and fixtures 1 , 500 . 00
Reserve for depreciation of furniture
and fixtures 125 . 00
Accounts payable 1 , 450 . 00
Accrued salaries payable 50 . 00
Notes payable 2,000.00
Deferred rent income 15 . 00
F. W. Baker, capital 3,662.50
C. J. Ford, capital 5,162.50
$12,560.00 $12,560.00
Chap. VI] THE ACCOUNTING CYCLE 83
Since all the temporary proprietorship accounts have been closed,
only the balance sheet accounts will appear in the final ledger
summary. Thus the distinction between the balance sheet and
the post-closing trial balance is one of form, not of content.
The post-closing trial balance appears in the accompanying form.
Summary of the Steps in the Accounting Cycle. An outline
of the operations discussed in the last three chapters may be
made as follows:
1. Journalization of ordinary business transactions
2. Posting journal entries
3. Footing the accounts
4. Taking a trial balance
5. Determining the adjusting transactions
6. Preparing a work sheet
7. Preparing a profit and loss statement
8. Preparing a statement of change in net worth
9. Preparing a balance sheet
10. Journalizing the adjusting entries
11. Journalizing the closing entries
12. Posting the adjusting entries
13. Posting the closing entries
14. Ruling and balancing the accounts
15. Taking a post-closing trial balance
16. Journalizing the readjusting entries
17. Posting the readjusting entries
18. Ruling and balancing asset and liability accounts dealing
with accrued and deferred items
A few comments on this list are in order. First, the exact
number of steps in the outline is debatable. The list given is
somewhat detailed, and it is quite possible to combine several
operations. Again, it may not be desirable to follow this
sequence. Steps 5 to 14, inclusive, are made at the close of the
fiscal period. Exactly when a particular operation is done is
largely a matter of necessity and convenience. It should be
noted that these steps vary considerably in importance. Step 3,
for example, requires but slight skill and time to perform, while
step 5 requires considerable skill and time. Finally, it was found
convenient in explaining some of the steps in the accounting
cycle to depart from the order followed in this summary since
84 ELEMENTS OF ACCOUNTING [Chap. VI
some relationships can be more easily explained by following a
sequence other than this one.
Questions
Review.
1. Explain the function of the work sheet. What are its advantages?
2. Enumerate the steps in the preparation of a 10-column work sheet.
3. Discuss the preparation of the profit and loss statement and the balance
sheet considering the following aspects:
a. The detail to be shown
b. The use of supporting schedules
c. The heading of the statement
d. The manner in which the various important items are to be shown
4. Distinguish between the report and the account form of the profit and
loss statement.
6. What items should appear in the statement of change of net worth?
6. Distinguish between ruling and closing an account.
7. What steps are essential to close an account?
8. Should all accounts be closed? Explain.
9. Distinguish between the appearance and function of the final ledger
summary and the balance sheet.
10. Enumerate the steps in the accounting cycle.
Discussion.
11. What should be the criterion for the addition of columns in the work
sheet?
12. To what extent should an effort be made to standardize statement forms
within the same industry? Should differences in capitalization and
geographical location be given any weight?
Suggested Supplementary Readings
BOLON, D. S.: "Introduction to Accounting," Chaps. 16, 17, 18, and 19,
John Wiley & Sons, Inc., New York, 1938.
JOHNSON, A. A.: " Principles of Accounting," Chap. 15, Farrar & Rinehart,
Inc., New York, 1937.
MACFABLAND, G. A., and R. D. AYARS: "Accounting Fundamentals,"
Chap. 13, McGraw-Hill Book Company, Inc., New York, 1936.
PATON, W. A.: "Essentials of Accounting," Chap. 27, The Macmillan
Company, New York, 1938.
PRICKETT, A. L., and R. M. MIKESELL: "Principles of Accounting," Chaps.
11 and 12, The Macmillan Company, New York, 1937.
ROREM, C. R.: "Accounting Method," Chaps. 11, 12, and 13, University
of Chicago Press, Chicago, 1930.
CHAPTER VII
JOURNAL AND LEDGER SUBDIVISIONS
The operation of a general journal and a general ledger, as
discussed in the last three chapters, are minimum requirements
for any business keeping complete records. With the exceptions
of small enterprises, however, most concerns use special adapta-
tions of the journal and the ledger to economize in clerical costs
and to present data in a more convenient form than the simple
journal and the general ledger permit.
Columnar Journals. As the transactions of a small enterprise
increase in volume, the first change in journalization is likely to
be the addition of special columns to the general journal. The
selection of headings for the columnar journal depends on the
frequency of transactions of a like nature. In the illustration on
page 87 the column headings used are those which represent
transactions occurring most often in a small or moderately sized
business. One advantage resulting from this change is a saving
in the posting process. One hundred sales recorded in a general
journal in a given week would require 100 postings to the sales
account. The same number entered in a columnar journal
would necessitate only one posting, by total, to the sales account.
A second advantage, which naturally follows, is the reduction of
errors in posting. With the number of postings reduced, the
possibility of error is decreased. A third advantage of the
special column in the general journal is that certain classified
data are available to management prior to their appearance in
the ledger. This may be highly important when quick decisions
based on these data must be made. Special columns should be
added, however, only when the clerical economies in posting or
the advantages to management warrant their extension.
Operation of the Special-column General Journal. The prin-
cipal considerations to be observed in operating a special-column
general journal are as follows:
1. When a special column is used for each simple journal entry,
only one of the two accounts affected is entered on a line
85
86 ELEMENTS OF ACCOUNTING [Chap. VII
in the journal. The other half of the transaction is entered
in the special column under which all similar items are
recorded. For example, the purchase of merchandise on
account from J. W. Wilson is recorded by entering the name
of Mr. Wilson in the account column with whatever explana-
tion is necessary. The debit amount is placed in the pur-
chase column where it will be included in the total and
posted to the debit of the purchase account; the credit
amount is carried to the sundry credit column and posted
immediately to Wilson's account and the page number placed
in the ledger folio.
2. When both debit and credit amounts are carried to the
sundry column, two lines are used for journalizing; and
each account is posted individually with the page number
of the account appearing in the folio column opposite the
respective account title. The purchase return of J. W.
Wilson of March 5 and the sale return of J. C. Steele of
March 6 are examples of this type.
3. The same procedure is followed for compound entries.
Each account title is given a separate line with the page
number of the account appearing in the folio column. The
journal entry recording the purchase of the delivery truck
under date of March 4 illustrates the method of recording
- these entries.
4. When it is necessary for purposes of clarity to enter in the
account column an account title which has a special column,
the posting is made by total and the individual account
title is checked in the folio column to prevent duplicate
posting. For example, the cash sales and cash purchases
under date of March 6 receive their postings to their
respective accounts by totals only.
5. Each page is proved as it is completed. If no error has been
made, the total of all debit columns will be equal to the
total of all credit columns. Thus, errors in the equality of
debits and credits can be localized to a given page.
6. If more than one page is used during a fiscal period, the
totals of a given page are carried forward to their respective
columns on the succeeding page.
7. When the column totals are posted, this should be indicated
by placing the page number of the account, to which the
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS
87
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o
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o
J. W. Wilson On account
Office expense Postage
J. C. Steele On account
O. E. Martin On account
Advertising
A. L. Morrison On account
J. W. Wilson On account
D. C. Stewart On account
Delivery Truck Purchased from Allison
Cash Auto Co. Note is for 60 days at 6%
Notes Payable
J. C. Steele On account
J. W. Wilson Merchandise returned from invoice
Purchase returns of Nov. 2
V. B. Jones On account
O. E. Martin On account
Sales returns Sales returned from invoice of Nov. 2
J. C. Steele
D. C. Stewart On account
Cash sales
J. C. Harris On account
Cash purchases
IN CO ^ O O
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88 ELEMENTS OF ACCOUNTING [Chap. VII
totals are posted, directly beneath the respective total.
Since items in the sundry columns have been posted indi-
vidually, a check mark is placed beneath the total of this
column to indicate that it has been considered.
Despite the advantages of special columns in the general jour-
nal, there are some undesirable features. A serious objection is
that, as the business increases in size, division of bookkeeping
work is most difficult if all the journalization is made in one book.
Furthermore, with the increase in the volume of transactions,
the extension of special columns in the general journal, although
justified, may nevertheless cause it to be unwieldy and cumber-
some and, as a consequence, may afford little or no reduction in
the work of journalization.
Special Journals. These difficulties may be avoided through
the use of special journals. A special journal contains only
transactions of a like nature. Through the establishment of
several such journals, it is possible to divide the labor of journal-
izing among several bookkeepers. Moreover, the disadvantages
of unwieldiness and cumbersomeness of large columnar general
journals are not characteristics of special journals.
The basis for the installation of special journals is the same as
that governing the establishment of special columns in the
general journal whenever a sufficiently large number of like
transactions occurs, it becomes desirable to establish special
journals because of the clerical economies afforded and the con-
venience of classified data for the management. Ordinarily
most activity is shown in transactions affecting purchases, sales,
cash receipts, and cash disbursements, and accordingly these
four special journals are used more than any others. 1
Purchase Journal. The purchase journal contains all transac-
tions relating to the purchase of merchandise stock in trade. 2
The same principle for the extension of columns is applied as has
been before noted: Whenever the activity of certain types of
1 Other special journals are frequently used for expense, capital stock, sales
returns and allowances, and purchase returns and allowances.
2 Often this journal is limited to purchases on account with all others
being recorded elsewhere. While this method simplifies the operations in
the purchase journal, it should be noted that it does not supply management
with the total purchases or offer it all the information which may be given
about them from a single source.
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS
89
transactions warrant segregating them, either for reasons of
clerical economy or because of the convenience of the data for
managerial purposes, special columns should be installed. The
form of the journal depends on the nature of the enterprise, its
size, its operations, and the departments to be emphasized. In
the illustration which follows, two departments are noted.
The most important points to be observed in the operation of
this journal are the following:
1. All accounts appearing in the account column are indi-
vidually credited and the page number of each account is
entered in the folio column (except cash purchases discussed
in step 2). The terms of purchase and any other significant
data arc rioted in the explanation section.
2. When cash purchases are journalized, a check mark is
placed in the folio column to indicate that the posting has
been made elsewhere. For example, the cash purchase of
$500 under date of August 1 appears in both the cash dis-
bursements journal and the purchase journal. To avoid
duplicate posting, a check mark is placed in the ledger folio
column in both journals. The debit to the purchase
WALTER STETSON AND COMPANY
PURCHASE JOURNAL, AUGUST , 19
Pur-
Pur-
Date
Account Explanation
F
chases
Depart-
chases
Depart-
Accounts
payable
Sundry
ment A
ment B
Dr.
Dr.
Cr.
Cr.
Aug.
1
B. A. Hart 2/10, n/30
P10
100
00
50
00
150
00
Notes payable 60 day, 6%,
J. V. Blackburn
21
200
00
100
00
300
00
Cash
V
200
00
300
00
500
00
2
A. S. Reed 2/10, n/30
P18
150
00
150
00
3
T. C. Wilcox 2/10, n/30
P40
125
00
150
00
275
00
C. H. Wardell 7/30
P37
100
00
100
00
Notes payable 60 day, 6%,
B. O. Fields
21
200
00
300
00
500
00
4
W. C. Clark 2/10, n/30
P4
100
00
300
00
400
00
Cash
V
200
00
200
00
5
B. A. Hart 2/10, n/30
P10
50
00
50
00
6
T. C. Wilcox 2/10, n/30
P40
150
00
150
00
1,225
00
1,550
00
1,275
00
1,500
00
(40A)
(40B)
(20)
V
90 ELEMENTS OF ACCOUNTING [Chap. VII
account is made by a total posting from the purchase jour-
nal; the credit to the cash account is made by a total posting
from the cash disbursements journal.
3. Purchases are segregated by departments and the column
totals carried to the debit of their respective accounts. The
posting is noted by placing the ledger page number directly
beneath the double-ruled line of the total.
4. All purchases made on account are entered in the accounts
payable column. The creditor's accounts are posted indi-
vidually. The total of the accounts payable column is
carried to the credit of the account of that name.
5. All amounts not appearing in the accounts payable column
are entered in the sundry column. These are posted indi-
vidually to the respective accounts affected. The total of
the column is checked to indicate that no total posting is to
be made.
6. Sometime prior to posting the column totals, the journal is
proved by adding the totals of all debit columns and com-
paring the amount with the totals of credit columns to be
sure that the two are equal.
The Sales Journal. In principle the operation of the sales
journal is the same as that of the purchase journal. It contains
transactions relating to the sales of merchandise or services.
Although it is not necessarily so, it usually follows that the same
departments appear in the sales journal as in the purchase journal.
The operation of the sales journal requires a consideration of
the following points:
1. All accounts appearing in the account column are indi-
vidually debited and the page number noted in the folio
column (except, of course, items appearing in other jour-
nals). The terms of sale, description of notes taken, and
any other information considered noteworthy, appears in
the explanation section.
2. Sales are segregated by departments and postings are made
by totals with the page number of the respective accounts
written beneath the column totals.
3. All sales on account are entered in the accounts receivable
column and the column total is posted to the account bear-
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS
91
ing that name (see page 99 for further discussion). The
page number is placed beneath the total.
4. The sundry column operates in the same manner as before
noted all postings are made individually and the column
total is checked.
5. Cash sales are entered in both the cash receipts journal and
the sales journal, and the folios are checked, as previously
described, to prevent duplicate posting.
6. The totals of the debit columns are checked against the
totals of the credit columns to prove the journal.
WALTER STETSON AND COMPANY
SALES JOURNAL, AUGUST, 19
Q Q 1 -_
Qoloa
Accounts
Date
Account Explanation
oaies
Dept. A
oaies
Dept. B
Receiv-
able
Sundry
Cr.
Cr.
Dr.
Dr.
Aug.
1
H. W. Cox 2/10, n/30
R4
200
00
50
00
250
00
Cash
V
75
00
200
00
275
00
2
R. P. Stewart 2/10, n/30
R32
50
00
100
00
150
00
Notes receivable 60 day, 6 %
J. A. Harris
4
200
00
300
00
500
00
Cash
V
100
00
225
00
325
00
3
O. A. Meany 2/10, n/30
R16
250
00
150
00
400
00
V. C. McEvoy 4/10, n/30
R15
2,000
00
500
00
2,500
00
Cash
V
100
00
35
00
135
00
4
Cash
V
120
00
65
00
185
00
5
C. H. Webster 2/10, n/30
R43
200
00
400
00
600
00
6
R. D. Stewart 2/10, n/30
R32
150
00
250
00
400
00
Cash
V
65
00
100
00
165
00
3,510
00
2,375
00
4,300
00
1,585
00
(30A)
(305)
(3)
V
Cash Receipts Journal. The cash receipts journal contains a
record of all transactions relating to the receipt of cash. The
principal considerations to be observed in its operation are as
follows :
1. All items listed under the account column are posted indi-
vidually to the credit of their respective accounts and the
page number entered in the folio (except as noted in step 6).
2. The actual amount of all cash received is written in the
cash column, and the total of the cash column is posted to
92
ELEMENTS OF ACCOUNTING
[Chap. VII
the debit of the cash account. The ledger page number is
placed beneath the total.
3. Deductions from accounts receivable are entered in the
sales discount column. This total is posted to the debit
of the sales discount and the page number placed beneath
the total.
4. The gross amount of accounts receivable is entered in the
accounts receivable column. This total is posted to a single
account in the general ledger (explained further on page
99). The page number is then written beneath the total.
It should be noted that for any given entry appearing in the
accounts receivable column, the total of the cash received
plus the discounts taken is equal to the account receivable.
WALTER STETSON AND COMPANY
CASH RECEIPTS JOURNAL,* AUGUST, 19
Date
Account Explanation
Cash
Dr.
Sales
Discount
Dr.
Accounts
Receiv-
able
Cr.
Sundry
Cr.
Aug.
1
O. A. Meany payment on account
R16
490
00
10
00
500
00
Walter Stetaon investment
25
500
00
500
00
Sales slips 178-191
V
275
00
275
00
2
Notes payable 60 day, 6 per cent,
First National
21
600
00
600
00
Sales slips 192-203
V
325
00
325
00
3
C. H. Webster payment on ac-
count
R43
245
00
5
00
250
00
Notes receivable Note of J. B.
Smith
4
200
00
200
00
Interest income
36
3
00
3
00
Sales slips 204-211
V
135
00
135
00
4
Sales slips 212-223
V
185
00
185
00
5
R. P. Stewart payment on ac-
count
R32
392
00
8
00
400
00
H. W. Cox payment on account
R4
194
00
6
00
200
00
6
Sales slips 224-247
V
265
00
265
00
3 , 809
00
29
00
1,350
00
2,488
00
(1)
(32)
(3)
V
* A feature frequently included in the cash receipts journal is a bank column. Each
time funds are deposited, the proper amount is placed in this column. The total is posted
twice, to the debit of the account bearing the name of the bank and to the credit of the cash
account.
5. All amounts which cannot be classified in special columns
are placed in the sundry column. These amounts are
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS 93
posted individually, and the page number of the respective
account is placed in the ledger folio. Since postings have
been made individually, a check mark is placed beneath the
total to indicate that it is not to be posted.
6. When a cash sale is entered in the journal, a check mark is
placed in the folio column to indicate that the posting has
been made elsewhere. For example, the cash sale of $275
on August 1 is entered in the cash column. The specific
sale is included in the total of that column and is carried
to the debit of the cash account. A check mark is placed
in the folio column to indicate that the sale is not to be
posted individually to the sales account. The sale in
question is included in the total of sales carried to the credit
of that account (page 91).
7. Sometime prior to posting, the journal is proved by adding
all debit columns to be certain that they are equal to the
sum of the credit columns.
Cash Disbursements Journal. All cash expenditures are
recorded in the cash disbursements journal. The principal points
to be observed in its operation are as follows:
1. All items appearing in the account column are debited
individually to their respective accounts and the page
number is placed in the folio column. The corresponding
credit to cash is made by a total posting. Any explanation
is placed in the column bearing that title. Regardless of
whatever other explanation is noted, the number of the
check issued in payment of the item should be given.
2. The cash column contains the actual amount disbursed.
The total is credited to the cash account, and the posting is
noted by writing the page number beneath it.
3. The total of the purchase discount column is posted to the
credit of that account, and the fact is noted by placing the
ledger page number beneath the total.
4. The total amount of a particular payable is entered in the
accounts payable column, and the amount is posted indi-
vidually to the account in question. It should be noted that
for a given account subject to discount, the final payment is
less than the full amount by the discount offered.
OF
[Chap. Vtt
5. The sundry column operates in the same manner as explained
in the other journals. The individual amounts appearing
in this column are debited to the accounts affected, and the
column total is checked.
6. As before described, items recorded in more than one jour-
nal are checked to prevent duplicate postings.
WALTER STETSON AND COMPANY
CASH DISBURSEMENTS JOURNAL, AUGUST, 19
Date
Account Explanation
F
Cash
Purchase
Discount
Accounts
Payable
Sundry
Cr.
Cr.
Dr.
Dr.
Aug.
1
B. A. Hart check No. 207
P10
727
50
22
50
750
00
Advertising check No. 208
44
75
00
75
00
Purchases check No. 209
V
500
00
500
00
2
Delivery expenses check No. 210
(gas & oil)
45
15
00
15
00
T. C. Wilcox check No. 211
P40
386
50
13
50
400
00
3
Office equipment check No. 212
13
115
00
115
00
Postage \ Check No.
52
7
00
Office supplies f 213 to re-
51
12
50
Telegraph fimburse
53
2
00
Miscellaneous expense ; petty cash
59
26
00
4
50
4
W. C. Clark check No. 214
P4
485
00
15
00
500
00
Purchases check No. 215
V
200
00
200
00
J. V. Blackburn check No. 216
P3
291
00
9
00
300
00
B. D. Fields check No. 217
P6
582
00
18
00
600
00
5
A. S. Reed check No. 218
P18
388
00
12
00
400
00
Office supplies check No. 219
51
20
00
20
00
6
Payroll check No. 220
62
200
00
200
00
4,011
00
90
00
2,950
00
1,151
00
(D
(42)
(20)
V
Imprest Cash Fund. The imprest cash fund is a supplementary
device frequently used with the cash disbursements journal.
Cash expenditures made by check provide a receipt and surround
the disbursements with important safeguards. There are occa-
sions, however, when it is not expedient to write a check for
every item. The imprest petty cash fund is established to
provide for small disbursements or cash demands at unusual
times.
When the fund is established, an entry is made in the cash
disbursements journal debiting petty cash and crediting the
general cash account. Under the imprest system the petty cash
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS 95
account is inactive; it remains the same unless the amount for
which it was established is increased or decreased.
Payments are made from the fund as necessary, and, for each
payment made, the keeper of the fund retains some type of
receipt. This may be in the form of a petty cash voucher, an
invoice, a sales ticket, or other form. A check upon the accuracy
of the operation of the fund can be made at any time by adding
the cash remaining in the fund to the total of the receipted bills.
The sum should be equal to the amount for which the fund was
established.
The petty cash fund is replenished at either of two times
when the amount remaining in the fund becomes low, or at the
end of the fiscal period when adjustments must be made when
all expenses and liabilities must be included in the statements.
In both cases the procedure is the same. The keeper of the
petty cash fund is reimbursed for the expenditures made, and he
gives the proper person all the receipted bills or petty cash
vouchers he has accumulated in exchange for a check of like
amount. An entry is then made in the cash disbursements
journal for the expenses paid (or in a voucher and check
register as shown on pages 105 and 106 under date of
November 30). The keeper of the petty cash fund, after cashing
the check, has on hand the amount for which the fund was
established.
The General Journal When Special Journals Are Used. Even
though most of the transactions are removed from the general
journal when special journals are used, it is in no sense useless.
It fulfills two important functions. First, all transactions which
cannot be recorded in some special journal are entered in the
general journal. For example, the admission of a partner
through the contribution of assets other than cash would be
entered in the general journal, since there would be no other
journal in which to record it. Again, unless special journals are
established for returned sales and purchases, all such transactions
would be entered in the general journal. A second function is
that it provides space for detailed explanations which special
journals do not offer. If, for example, the partner admitted (in
the case just cited) made his contribution in cash instead of other
assets, even though the entry would be recorded in the cash
receipts journal, it might be desirable to place it in the general
96 ELEMENTS OF ACCOUNTING [Chap. VII
journal, to check the folio to prevent duplicate posting, and to
write a complete explanation of the transaction.
Controlling Accounts and Subsidiary Ledgers. So far the
discussion of special journals has proceeded without reference to
subdivisions of the ledger. The use of special journals, however,
usually accompanies the two principal devices used in the sub-
division of the ledger the controlling account and the subsidiary
ledger. Specialized journals facilitate the use of controlling
accounts by making possible postings by totals. A controlling
account shows in summary, or by totals, the sum of balances in
itg supporting subsidiary ledger. A subsidiary ledger contains
accounts of a like nature removed from the general ledger and
placed in a special ledger. Subsidiary ledgers and controlling
accounts must be considered jointly since the use of one neces-
sitates the use of the other. No change can properly be made in
one without that change being reflected in the other. Usually
accounts receivable and accounts payable are the two most
active groups, and, accordingly, controlling accounts and sub-
sidiary ledgers are established for these two more often than for
others. 1
Advantages of Controlling Accounts and Subsidiary Ledgers.
There are two important reasons for the extension of the principle
of controlling accounts and subsidiary ledgers : it may be advisa-
ble for clerical reasons, and it may be desirable for managerial
purposes.
As more accounts are added to the general ledger, the increased
length of the trial balance may present an unsatisfactory situa-
tion. The time required to prepare it is, of course, extended.
Further, errors may be most difficult to locate.
The use of controlling accounts and subsidiary ledgers largely
overcomes these drawbacks. Assume, for example, that the
general ledger contains 75 customers 7 accounts. The steps in
the establishment of the account receivable controlling account
would be to remove the 75 customers' accounts from the general
ledger, to place them in a special ledger, and to substitute a
controlling account having a balance equal to the sum of all the
accounts removed. Thus the trial balance would be reduced by
1 In addition to these, however, controlling accounts and subsidiary
ledgers are frequently established for notes receivable, materials, plant and
equipment, bondholders, stockholders, and expenses.
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS
97
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&8 ELEMENTS W ACCOUNTING [Chap. VII
74 accounts since only those in the general ledger appear in the
trial balance. When other controlling accounts are introduced,
the trial balance is similarly reduced in size. With the reduction
of the number of accounts appearing in the trial balance, the
time required to prepare it is, of course, correspondingly reduced.
Furthermore errors are localized. An essential characteristic
of the controlling account is that its balance is equal to the sum
of all balances in its supporting ledger. If a given controlling
account fails to agree with its subsidiary ledger, the error is
localized it is either in the controlling account or in the sub-
sidiary ledger. No such localization is possible in the general
ledger if controlling accounts are not used.
Operation of Controlling Accounts and Subsidiary Ledgers.
As before mentioned, accounts receivable and accounts payable
are the two groups for which controlling accounts and subsidiary
ledgers are most often established. The illustration on page 97
shows the sources of postings for these two controlling accounts
and their supporting ledgers.
The first step in establishing a controlling account and a sub-
sidiary ledger is to remove all accounts to be placed in the
subsidiary ledger and for them to substitute a controlling account.
Assume, for example, that the individual customer accounts
appearing in the general ledger of Walter Stetson on August 1
were as follows :
H. W. Cox $ 420
V. C. McEvoy 350
O. A. Meany 670
R. P. Stewart 560
C. H. Webster 480
$2,480
These accounts are removed from the general ledger and a con-
trolling account substituted by the following general journal
entry:
Accounts receivable 2 ,480
H. W. Cox 420
V. C. McEvoy 350
O. A. Meany 670
R. P. Stewart 560
C.H.Webster 480
Chap. VII) JOURNAL AND LEDGER SUBDIVISIONS 69
No definite number of accounts can be cited as the proper
number before it becomes worth while to use a controlling account
and a subsidiary ledger. A common rule of thumb, however, is
to set the total at 50.
As credit sales are made, the transactions are recorded in the
sales journal, and the amount of each sale is posted immediately
to the debit of the customer's account affected. The particular
debit is included in the total of accounts receivable and is posted
from the sales journal to the debit of the accounts receivable
controlling account.
Credits to customer's accounts are posted individually from
the cash receipts journal. The total of the accounts receivable
column in the cash receipts journal is posted to the credit of the
accounts receivable controlling account.
It is possible that debits or credits may be made from other
sources. If, for example, there is no special journal for sales
returns and allowances and H. W. Cox returns $35 worth of goods
sold to him, the required entry in the general journal would be
Sales returns 35
H. W. Cox 35
The debit item would be posted as usual. The credit item,
however, must be posted twice, once to the accounts receivable
controlling account and once to the customer's account in the
subsidiary ledger. This does not disturb the equilibrium of
debits and credits, since only the controlling account appears in
the general ledger and only accounts appearing in the general
ledger are included in the trial balance.
A check is made, nevertheless, between the controlling account
and its supporting ledger to be certain that they are in agreement.
A list of the account balances in the subsidiary ledger should be
compared with the balance of the controlling account. This
reconciliation should be made at least as often as the trial balance
is taken.
Voucher Register. The voucher system combines features of
both the special journal and the special ledger. Although the
voucher register is primarily a purchase journal, it is extended to
include the journalization of all costs incurred. Under the
voucher system the unpaid file of vouchers takes the place of
the accounts payable ledger.
100
ELEMENTS OF ACCOUNTING
[Chap. VII
In order to understand the operation of the voucher register as
a journal, a description of several features is essential. Out-
standing among these is the recognition of all payables at the
time they are incurred. This provides an important means of
internal check 1 for the control of expenses. Ordinarily, without
the voucher system, there is no record of expenses until they have
(Front)
Nfl.nriA Vftiio.hftr N<V
Aram's Dfttp. (of vniir-Vmr^
Date
(Of Purchase)
Description
Amount
Prepared I
Entered B:
\y
Payment
y Approved for 1
(Reverse)
Distribution
Purchases :
Dppn.rt.TYipnt. A
Nn.mp.
Voiinhpr TSfo
AHoVpss
Dp.partmpnt, D
Selling Expenses
Date of Vou
Date of Pur
p.hp.r
Tp.rms
General Expenses
Amount,
Check No.
Other Expenses
Total
Voucher form (front and reverse) .
1 For a discussion of internal check, see p. 192.
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS 101
been paid. It may easily happen that an expense is incurred
and no recognition of its existence made for as long as 60 days.
The voucher register not only recognizes the liability but also
shows how it was paid. A realization of this fact is essential if
one is to understand how cash purchases are recorded. Cash
purchases of all kinds are recorded in the voucher register only
after first recognizing the liability for the purchases. The recog-
nition of the liability is part of the routine of operating the
voucher system, the object being to divide authority among
officials and thus secure a better system of internal check than
would otherwise be possible. Thus all current liabilities and all
costs thereby incurred are distributed in the voucher register,
either in special columns or in the sundry column.
As a ledger the voucher system eliminates the formal accounts
payable ledger and for it substitutes a file of unpaid vouchers.
This substitution can be made to good advantage if each specific
purchase can be considered as a unit for which a payment will be
made. This arrangement may be most undesirable, however, if
it is often necessary to know the amount purchased from each
creditor. Again, if the specific obligation is not settled as a
single item, but instead purchase returns, partial payments, or
other adjustments are made, the required entries to effect these
changes may make the system so cumbersome as to render it
worthless.
Operation of the Voucher System. The operation of the
voucher system usually follows this procedure:
1. At the time materials or services are purchased, a voucher
is prepared (page 100). This form contains space for a
description of the goods or services purchased, the date, the
amount, the name of the person or firm from whom the
purchase has been made, and the terms of purchase. Each
voucher is numbered. The voucher should be prepared
with considerable care, for from it the transaction is recorded
in the register. It serves to recognize the liability and to
authorize its payment at the proper time.
2. The transaction is recorded in the voucher register (page
105) from the data on the voucher. Each line in the
voucher register contains one item. The total amount of
the voucher is entered in the payable (credit) column, and
102 ELEMENTS OF ACCOUNTING [Chap. VII
the corresponding debit is entered in the appropriate
column.
3. After the entry has been made, the voucher is filed according
to the date when the discount should be accepted or, if no
discount is offered, when the bill should be paid. This file
of unpaid vouchers takes the place of the accounts payable
ledger; it indicates .the amount outstanding owing to
creditors.
4. Postings are made by column totals, with the page number
noted beneath the total, except in the case of the sundry
column. Items appearing in this column arc posted indi-
vidually, with suitable notations in the ledger folio column.
The total, of course, is checked.
5. As specific vouchers arc paid, a check is drawn for the proper
amount and a record is made in the check register. This
register (page 106) operates in principle the same as does
the cash disbursements journal. In the voucher register
the number of the check and the date of payment are
entered opposite the number of the voucher in question.
When a voucher is paid, it is removed from the unpaid
voucher file. The number of the check issued in payment
is written on the face of the voucher. After all notations
have been made, it is filed either in alphabetical or numerical
order in the paid voucher file.
6. Partial payments, purchase returns, and notes present
special problems. When a check is drawn for the partial
payment of a voucher, it is recorded as usual in the check
register and the voucher register. The amount of the pay-
ment is noted on the face of the voucher, and it is returned
to the unpaid voucher file to await final settlement. The
same type of notation is made on the voucher when purchases
are returned. The transaction, however, is recorded in the
general journal f arid this fact is noted in the paid column
of the voucher register. When a note is given in settlement
of an account, the voucher is removed from the unpaid file,
marked "paid," and filed among the paid vouchers. The
transaction is recorded in the general journal, and proper
notation is made in the paid column of the voucher register.
An alternative method for recording returns, allowances, or
partial payments consists of preparing a credit memoranda.
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS
163
In appearance it is the same as or similar to a voucher.
Essential data on the form should include a description of
the deduction and the amount to be credited, the latter
being written in red ink. The memoranda is then recorded
in the voucher register in the usual manner, except that the
amount is written in red ink. This amount will, of course,
be deducted when the column is added.
ILLUSTRATIVE PROBLEM
On November 1, 19 , Walter Stetson and Company decided to install a
voucher system. The creditors' balances on that date were as follows:
Creditor
Goods Purchased for
Total
Department A
Department B
A S Reed
$ 125
200
400
800
$100
175
200
500
$ 125
300
175
600
1,300
B A Hart
T C Wilcox
W C Clark
C. H Wardell
$1,525
$975
$2,500
The purchases, other expenses incurred, and cash disbursements
for the month of November were as follows:
November 1. Paid $125 to Hazelwood Realty Company for November rent.
2. Increased the amount carried in the petty cash fund by $35.
3. Paid A. S. Reed $125, less a 2 per cent discount.
6. Returned merchandise with a value of $200 to C. H. Wardell
(purchased for Department A).
9. Purchased merchandise on account from T. C. Wilcox for
$450 ($200 for Department A; $250 for Department B).
10. Paid B. A. Hart $300, less a 2 per cent discount.
13. Paid United Trust and Savings Bank $2,000 in settlement of
a matured note (assume that the discount charge has been
recorded and that no adjustment is necessary).
15. Purchased merchandise on account from B. A. Hart for $150
(Department B).
16. Purchased merchandise on account from A. S. Reed for $850
($550 for Department A] $300 for Department B).
17. Received an invoice for gasoline and oil from Penn Oil
Company for $35 (used by delivery truck).
104 ELEMENTS OF ACCOUNTING [Chap. VII
November 20. Paid W. C. Clark $600, less a 2 per cent discount.
23. Gave T. C. Wilcox a 60-day 6 per cent note for $175 in
payment of the amount due November 1.
24. Purchased merchandise on account from A. S. Reed for $750
(Department B).
27. Purchased merchandise for cash from J. B. Wilson amounting
to $850 ($600 for Department A\ $250 for Department B).
30. Paid the payroll for November:
To Ruth Wilson $ 75
John Cole 90
Frank Ritter 225
Fred Rivers 80
Total $470
30. Paid the invoice received from Outdoor Advertising Com-
pany on November 21.
The petty cash fund was replenished for the following dis-
bursements made during the month:
Telegraph $ 3
Postage 22
Community Fund 15
Stationery 8
$48
The first step in recording the data of this problem is to transfer
the various amounts from the subsidiary accounts payable ledger
to the voucher register. For example, a voucher is prepared for
the purchase from A. S. Reed, and from it an entry is made in the
voucher register. Similarly for each unpaid purchase a num-
bered voucher is prepared and recorded in the voucher register
under the name of the person to whom the amount is owed. The
voucher register illustration (page 105) has fewer columns for the
distribution of charges to various accounts than is ordinarily
found.
Returned purchases are recorded in the general journal and
proper reference is made to the entry in the paid column of the
voucher register (see entry of November 6, page 106). The
same procedure is followed when a note is given in payment of an
account (see entry of November 23).
When a cash purchase is made, a voucher is prepared for the
purchase (see entry under date of November 27 on pages 105 and
106), and a check is issued in payment of it.
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS 105
CM oo t^ o o
O D O O
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o o
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CO CO
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106
ELEMENTS OF ACCOUNTING
[Chap. VII
CHECK REGISTER
Dal
:e
Creditor
Check
Num-
ber
Vou-
cher
Num-
ber
Vouchers
Payable
Purchase
Discount
Cash
19_
Nov
1
Hazel wood Realty
1
6
125 00
125 00
9
Petty cash
2
7
35 00
35 00
3
A. S. Reed
3
1
125 00
2 50
122 50
10
B. A. Hart
4
2
300 00
6 00
294 00
13
*>0
United Trust and Savings Bank ....
W C Clark
5
6
10
4
2,000.00
600 00
12 00
2,000.00
588 00
07
J B Wilson
7
16
850 00
850 00
SO
Payroll
8
17
470 00
470 00
Petty cash (reimbursement)
9
18
48 00
48 00
4,553 00
20 . 50
4,532 50
(25)
(73)
(1)
WALTER STETSON AND COMPANY
GENERAL JOURNAL
19__
Nov. 6 Voucher payable 200
Purchase returns (department A) 200
Goods purchased Oct. 17 from C. II. Wardell
23 T. C. Wilcox 175
Notes payable (60 days 6 per cent) 175
For goods purchased Oct. 12
Relation between Specialized Journals, Controlling Accounts,
and Subsidiary Ledgers. Specialized journals, controlling
accounts, and subsidiary ledgers are closely related. Special
journals facilitate the use of controlling accounts by providing
special columns which, in turn, make possible postings by total
an essential feature in the operation of controlling accounts. The
use of a subsidiary ledger containing accounts of a 'like nature
necessitates a controlling account in the general ledger to show,
in summary form, the increases, decreases, and balances of all
accounts in the supporting ledger over which it exercises control.
These three devices are the principal ones used in the sub-
division of the journal and ledger. The occasion giving rise to
the subdivision is the same in the journal as in the ledger. When-
ever a large number of transactions in the journal or accounts in
the ledger occur, if they are of the same general type, cumbersome
records can be avoided, clerical economies can be effected, and
data can be classified and presented to management in a more
Chap. VII] JOURNAL AND LEDGER SUBDIVISIONS 107
usable manner through the subdivision of the journal and the
ledger.
The voucher system is an application of the principle of journal
and ledger subdivision. The voucher register is a highly special-
ized purchase journal. The file of unpaid vouchers is a substitute
for the accounts payable ledger. Other subdivisions may be
made according to the requirements of the individual business
whenever the activity of transactions or accounts justifies their
use.
Questions
Review.
1. What are the advantages of using special-column general journals?
When should they be installed?
2. In what respects are special journals more desirable than special columns
in the general journal?
3. What is the determining factor as to whether special journals should be
used? Subsidiary ledgers? Controlling accounts?
4. Name the principal special journals commonly used?
5. Explain how a cash sale would be recorded if all cash receipts are entered
in the cash journal and all cash disbursements are placed in the sales
journal.
6. Is the general journal of any significance when specialized journals are
used?
7. Discuss the procedure for operating an imprest petty cash fund when:
a. The fund is established,
b. Payments are made from the fund.
c. The fund is replenished.
8. What advantages result from the use of controlling accounts and sub-
sidiary ledgers?
9. What are the sources of debits and credits to the following controlling
accounts :
a. Accounts receivable
6. Accounts payable
c. Expense
10. In what respects does the voucher system contain features of the special
journal? Of the special ledger?
11. When is the installation of a voucher system advisable? Inadvisable?
12. How is the record of cash disbursements changed when a voucher system
is used?
Discussion.
13. Explain how specialized journals, subsidiary ledgers, and controlling
accounts are related.
108 ELEMENTS OF ACCOUNTING [Chap. VII
14. Is a cash account which receives postings from a cash journal a con-
trolling account? Why?
15. Assuming the existence of proper specialized journals, subsidiary ledgers,
and controlling accounts, explain how a purchase made from a customer
(who has no account in the accounts payable ledger) would be recorded.
Do not propose to open an account in the accounts payable ledger.
Suggested Supplementary Readings
BOLON, D. S.: "Introduction to Accounting," Chaps. 11 and 12, John
Wiley & Sons, Inc., New York, 1938.
COLE, W. M.: "The Fundamentals of Accounting," Chaps. 11-13, Houghton
Mifflin Company, Boston, 1921.
McKiNSBY, J. 0., and H. S. NOBLE: " Accounting Principles," Chaps. 8 and 9,
South- Western Publishing Company, Cincinnati, 1939.
NEWLOVE, G. H., L. C. HAYNES, and J. A. WHITE: "Elementary Account-
ing," Chaps. 9-11, D. C. Heath & Company, Boston, 1938.
PATON, W. A.: "Essentials of Accounting," Chaps. 9, 11, and 12, The
Macmillan Company, New York, 1938.
PORTER, C. H., and W. P. FISKE: "Accounting," Chap. 6, Henry Holt &
Company, Inc., New York, 1935.
ROREM, C. R.: "Accounting Method," Chaps. 14-16, University of Chicago
Press, Chicago, 1930.
CHAPTER VIII
PROBLEMS OF VALUATION
A study of procedures and statements is apt to leave one with
the impression that accounting possesses the logical coherence
and consistency of an exact science. Orderly columns of figures
in the books and statements imply an exactness and a finality to
accounting values which, in fact, do not exist. While the state-
ments are most useful as a guide to management, investors, and
others, the scope of their usefulness can be appreciated only
when something is known of the methods of valuation and the
limitations imposed upon the apparent exactness of values
appearing in them.
Effect of Valuation on Financial Status and Operations. This
knowledge is important because both the balance sheet and the
profit and loss statement are affected by current valuations. To
illustrate this, consider the case of a machine with a purchase
price of $1,000. Whether the machine is valued at its cost of
$1,000 or possibly at $850 at the end of the fiscal period clearly has
a direct bearing upon the financial status of the business. If
the machine is valued at $850 instead of $1,000, both the asset
and proprietorship are decreased by $150. If this decrease was
due to the wear and tear occasioned by use, the $150 would be
treated as an expense and thereby decrease the profit for the
period by this amount.
Conservatism in Valuation. To consider the statements as
reflecting the financial status or the results of operation with
mathematical accuracy is to overlook the effect of economic and
political forces upon the enterprise. While it may be most
difficult, if not impossible, to evaluate these forces, to ignore their
presence limits the usefulness of the accountant's judgment.
Since problems of valuation are so frequently matters of
judgment and since absolute accuracy cannot be obtained, there
has developed among accountants the attitude that the state-
ments should reflect conservative judgment or, specifically, that
109
110 ELEMENTS OF ACCOUNTING [Chap. VIII
assets or profits should never be overstated. The result of such
a practice, it is believed, will induce conservative management,
and the financial strength of the enterprise will be less damaged
than from alternative policies.
This doctrine is commonly expressed by the following state-
ment: "Anticipate no unrealized income and provide for all
possible losses." So impressed have many accountants become
with the necessity of conservatism that the rule of "cost or
market, whichever is the lower" is widely accepted as the prin-
ciple for the valuation of most current assets (by cost is meant the
purchase price; by market, the replacement price).
The length to which conservatism should be carried is undoubt-
edly a matter of judgment. Proper provision should be made
for losses which may reasonably be expected. On the other hand,
the application of this principle to the extent that legitimate
estimates of revenue or profits are understated cannot be accepted
as a proper application of the doctrine.
Accounting Assumptions Influencing Problems of Valuation.
Other factors influencing problems of valuation are the assump-
tions made in accounting theory. One of these is that the enter-
prise is a going concern that it will continue to operate and to
perform the functions which the management intends. Conse-
quently any thought of business failure, with the resultant
lowered values placed upon the assets, does not normally influence
their valuation.
A second assumption is that only assets and equities measur-
able in dollars and cents are within the scope of accounting
treatment. The probable effect of political, economic, or social
changes and the loyalty or efficiency of a company's personnel
may be of extreme importance but are not considered in the
statements.
Still another assumption is that the value of money is constant.
As yet accounting practice does not reflect changes in the value
of the dollar in the statements. 1
A fourth assumption is that, initially (i.e., at the time it is
purchased), the cost of an asset determines its value. This does
not mean, of course, that the asset remains on the books at the
cost price. As it is used in the business, its value changes. It
1 For the discussion of an accounting technique which considers changing
price levels, see Henry W. Sweeney, "Stabilized Accounting," Harpers &
Brothers, New York, 1936.
Chap. VIII] PROBLEMS OF VALUATION 111
does mean, however, that the accountant considers the asset
worth what has been paid to acquire it. 1
Valuation and Functional Uses of Assets. Still another influ-
ence affecting the valuation of assets is the function which they
perform. From the management point of view, fixed assets as
a group are used in the conduct of the business, in the manu-
facture or sale of commodities or services. Ordinarily they will
not be disposed of so long as they can be used for the purpose for
which they were purchased. In terms of function performed,
therefore, the ideal basis of valuation for fixed assets is the cost
of securing the services rendered by the asset.
In contrast, current assets are consumed within a short time in
business operations. They will be used, primarily, for the pur-
chase of merchandise or services and for payments for expenses
or for obligations of the firm. Current assets, not already in the
form of cash, will be shortly converted into cash. Hence the
ideal basis of valuation for this group, in terms of function per-
formed, is their cash realizable value.
Cash. No difficulty is experienced in applying this rule to
cash. It is not always apparent, however, what should be
included in the category of cash. Cash on hand and in banks
(not, of course, deposits in closed banks), bank notes, bank
drafts, postal and express money orders, individual checks, in
fact, everything that serves the purpose of cash should be
included. Foreign currency should be excluded unless it may
readily be converted into domestic currency, and, even so, suit-
able reserves should be established for fluctuations.
Cash to be used for a specific purpose should also be excluded.
If it is being accumulated for the payment of a bond issue, for
example, it is not ordinarily available for the payment of current
liabilities and therefore should be excluded from the current
assets.
Bank Reconciliation Statement. The exact amount of cash
which should appear in the balance sheet, however, may not be
obtained solely from data in the cash account. Seldom does the
amount of cash in the ledger account agree with the balance of
the bank statement as of the same day. Hence a reconciliation
of the two must be made and suitable adjustments entered on the
1 For an extended discussion of accounting postulates, see W. A. Paton,
"Accounting Theory," Chap. 20, The Ronald Press Company, New York,
1922.
112 ELEMENTS OF ACCOUNTING [Chap. VIII
books before the proper amount of cash can be included in the
statement. Assume, for example, that the checkbook balance on
December 31, 19 , was $1,318.62 and that the balance of the
bank's statement was $1,248.12 and that upon investigation, the
following discrepancies were discovered:
1. Checks outstanding consisted of the following:
No. 762 $ 25.00
No. 764 17.50
No. 765 150.00
No. 767 132.00
No. 768 37.50
$362.00
2. A deposit of $419 was made on December 31, but the amount was not
included in the bank statement.
3. The bank statement included protest fees of $2, a collection charge of
fifty cents, and interest credited by the bank amounting to $4.50.
4. The following errors were made in writing checks:
Check No. 712 was written for $250; on the check stub it was recorded
as $252.50.
Check No. 757 was written for $153; on the check stub it was recorded
as $135.
When placed in statement form the reconciliation between the
checkbook balance and the bank statement will appear as follows :
BANK RECONCILIATION STATEMENT
December 31, 19
Balance per bank statement $1 ,248 . 12
Add:
Protest fee $ 2.00
Collection charge .50
Deposits 419.00
Error in check No. 757 18.00
Total additions $439.50
Deduct:
Interest credited by bank $ 4 . 60
Checks outstanding:
No. 762 $ 25.00
No. 764 17.50
No. 765 150.00
No. 767 132.00
No. 768 37.50 362.00
Error in check No. 712 2.50
Total deductions 369.00
Net additions .' 70. 50
per checking account $1,318.62
Chap. VIII] PROBLEMS OF VALUATION 113
It should be noted that the discrepancy between the checking
account balance and the bank statement may be due to items not
considered by the bank or by the company. In the latter event,
adjustments must be made on the books of the company to
include these items. Specifically, in the illustration under discus-
sion, the required adjusting entry is as follows:
Cash 2.00
Protest-fees 2.00
Collection charges . 50
Interest income 4 . 50
To include the adjustments of interest income, pro-
test fees, and collection charges
In the event that differences cannot be located, these dis-
crepancies are entered in an account for cash short and over. If
this account has a debit balance, it is treated as an item of mis-
cellaneous expense; if a credit balance, an item of miscellaneous
income.
Marketable Securities. The valuation of marketable secu-
rities is closely related to cash. In this classification are included
securities of unquestioned liquidity which the enterprise would
not hesitate to sell if additional funds are necessary. While the
weight of logic would seem to favor market value as the basis of
valuation, in practice, cost or market, whichever is the lower, is
commonly used. The reason for this, of course, is the desire
for conservatism. Whatever method is adopted, it should be
indicated in the balance sheet. 1
Accounts Receivable. Like cash, realizable value is the basis
for the valuation of accounts receivable. Under accounts receiv-
able are included amounts due from trade debtors, claims of a
readily collectible nature arising in the ordinary course of trade.
Amounts due from other debtors (from employees, officers, or
others, for example) should be shown under other titles.
It is most unlikely that the total amount of receivables out-
standing at the end of the fiscal period will be collected. The
past experience of the enterprise is the best criterion for deter-
mining probable losses. Accordingly a reserve for doubtful
accounts is provided to care for the estimated losses. The most
1 Securities are sometimes valued at cost, with their market value noted
in the balance sheet. Still another method consists of valuing the securities
at cost and setting up a reserve for market fluctuations to care for any
disparities between cost and market price.
114 ELEMENTS OF ACCOUNTING [Chap. VIII
common method of estimating the amount of doubtful accounts
is to base the losses on the sales for the fiscal period or on the
outstanding accounts receivable. Assuming that the outstand-
ing accounts amount to $150,000 and that estimated losses from
doubtful accounts amount to 2 per cent, the entry to record this
at the close of the fiscal period would be as follows :
Bad debts 3,000
Reserve for doubtful accounts 3,000
The bad debt account is an operating expense, 1 a cost of securing
the revenue sales. To fail to recognize it before the loss actually
occurred would mean that the fiscal period in which the loss
materialized would bear a cost properly chargeable to a previous
period. 2
The reserve for doubtful accounts is a valuation account which
when considered in conjunction with the account to which it
refers (accounts receivable) shows the estimated cash realizable
value of that asset. In the balance sheet the reserve account is
deducted from the asset to show the net amount.
If the amount of bad debts has been overestimated, the excess
credit balance in the reserve account should be treated as a non-
1 Two other methods of classifying bad debts are sometimes used. One
considers the expense as a deduction from gross sales on the basis that
revenue from sales is overstated by the amount of uncollectible accounts
receivable. Another method treats bad debts as a loss chargeable to net
income, if originating in the current period, and chargeable to surplus, if
originating in an earlier period. This is based on the assumption that the
values shown in accounts receivable are correct until proved otherwise.
2 When an account written off as worthless is later collected, the account-
ing treatment to be followed depends on the conditions of sale, write-off,
and collection.
If the sale, write-off, and collection are all made in the same fiscal period,
the account receivable in question would be debited to place the asset on
the books, and bad debts would be credited to remove the charge previously
made. Cash would then be debited and accounts receivable credited.
If the account was collected in the same period in which it was written
off but the sale was made in a previous fiscal period, then the same procedure
would be followed as in the first case except that the reserve for doubtful
accounts would be credited instead of bad debts.
If the collection was made in a period later than the one in which the
sale and write-off occurred, then the amount should be placed in surplus
or some other account which does not affect the determination of profit
for the current period.
Chap. VIII] PROBLEMS OF VALUATION 115
operating item of income. If the balance remaining is very
small, it is frequently left in the reserve account.
The same type of an adjustment is made for outstanding sales
discounts. 1 Assume that at the close of the fiscal period there
are outstanding sales discounts amounting to $600. On the
basis of past experience it is estimated that 75 per cent of these
will be accepted. During the following fiscal period the actual
discounts accepted totaled $500. At the close of the fiscal period
the estimated sales discounts (75 per cent of $600) which probably
will be accepted are shown as follows:
Sales discounts 450
Reserve for outstanding sales discounts 450
In the succeeding period cash is debited as accounts are paid
and discounts are accepted; the reserve for outstanding sales
discounts is debited, and accounts receivable are credited. This
continues until there are no longer any remaining accounts which
were outstanding at the close of the past fiscal period and which
are still subject to discount. Any amount remaining in the
reserve for outstanding sales discounts should be treated as a
nonoperating item chargeable against the net income from opera-
tions of the period. If the balance is small, it is often left in the
reserve account, and the sales discounts of a subsequent period
charged against it.
Notes Receivable. In general, estimated cash realizable value
should be used for the valuation of notes receivable as well as for
accounts receivable. In practice, however, notes receivable are
usually listed at face value and any of doubtful collectibility are
taken from the account and shown under a separate caption.
Notes other than those obtained from trade debtors should also
be shown separately.
1 Two methods are commonly used in classifying sales discounts. Accord-
ing to one point of view they should be treated as financial expense because
the discount is offered as an incentive. When receivables are paid promptly,
there are, of course, fewer losses from bad debts. Hence sales discounts
should be considered as a collection expense.
According to the other point of view, sales discounts are a deduction
from gross sales since the net income from sales is reduced by the amount
of the discounts accepted. Hence they should be classified the same as
sales returns and allowances as a deduction from the gross revenue received
from sales.
116 ELEMENTS OP ACCOUNTING [Chap. VIII
When a note receivable has been discounted, a special problem
of valuation arises. The party discounting the note and endors-
ing it is liable for payment upon maturity if the maker fails to
pay it.
To illustrate the procedure of discounting a note, assume that,
on February 2, A gave to B a 90-day 6 per cent note for $500 in
settlement of an account. Thirty days later the note was dis-
counted at the bank at a 6 per cent rate. When the note
matured, A defaulted in his payment. The protest fee amounted
to $1.25. Subsequently A was declared bankrupt, and his credi-
tors received a final payment equal to 60 per cent of their claims.
B will record the note as follows:
Notes receivable 500
A (accounts receivable) 500
When the note is discounted, the entry will be
Cash 502.42
Interest income 2 . 42
Notes receivable discounted 500 .00
The contingent liability of B is shown by the account notes
receivable discounted. In the balance sheet it is deducted from
notes receivable to show the net amount held.
The following procedure is used to compute the discount:
1. Ascertain the maturity value of the note. In the example
used it is found by determining the interest on $500 for 90
days at 6 per cent. This amount is added to the face value
of the note resulting in a maturity value of $507.50.
2. Find the amount of the discount charge by multiplying the
maturity value of the note by the rate of discount for the
discount period. The maturity value, $507.50, multiplied
by the rate of 6 per cent, for the period of 60 days, results in
a discount of $5.08.
3. Determine the amount received by the person discounting
the note. This is done by deducting the discount charge
from the maturity value. The maturity value is $507.50;
the discount charge is $5.08; hence the amount received is
$502.42.
When the maker of the note refuses payment, B is liable for the
face value of the note, the interest, and the protest fee. This is
recorded on B'a books as follows:
Chap. VIII] PROBLEMS OF VALUATION 117
Notes receivable dishonored 600 . 00
Protest fee 1 .25
Interest expense 7 . 50
Cash 508.75
At the same time the note is removed from the notes receivable
account because of its doubtful collectibility, and the contingent
liability is removed from the books because of its changed status.
This is shown by the following entry:
Notes receivable discounted 500
Notes receivable 500
This entry is made whenever the contingent liability no longer
exists (either through payment of the note by the maker or by
conversion to a real liability through the maker's failure to pay
upon maturity). If, within a reasonable time, the dishonored
note together with the other charges are not paid, they are
placed in an open account by the following entry:
A (special account receivable) 508. 75
Notes receivable dishonored 500 . 00
Protest fee 1 .25
Interest expense 7 . 50
The journal entry to record the final amount (60 per cent of
$508.75) received from A would be as follows:
Cash 305.25
Loss on dishonored notes 203 . 50
A (special account receivable) 508 . 75
As soon as the loss is evident, it is charged against operations if
originating during the current fiscal period; if originating in a
previous fiscal period, it is charged to a suitable reserve account
(if one has been established), to proprietorship or to some non-
operating expense.
Merchandise Inventory. The problems of valuation discussed
previously in this chapter are relatively simple compared to those
presented by merchandise inventory. The fact that this asset,
unlike the others discussed, appears in both the balance sheet and
the profit and loss statement has an important bearing upon these
difficulties. Ideally, goods on hand, ready for sale, should be
valued in the balance sheet the same as other current assets, at
118 ELEMENTS OF ACCOUNTING [Chap. VIII
cash realizable value. Ideally, inventory in the profit and loss
statement should be valued at cost, since profits or losses can be
determined accurately only by ascertaining the difference
between revenue and expenses.
In practice neither basis is used consistently by most enter-
prises. The commonly accepted rule for the valuation of inven-
tory is cost or market, whichever is the lower. 1 This rule is
prompted by a desire for conservatism so that no inventory will
appear in the balance sheet at more than its realizable price and
no profit will be anticipated in the profit and loss statement.
The inventory account should include all merchandise, regard-
less of whether it is held in the possession of the firm or elsewhere.
It should exclude all stocks not owned by the company. The
account contains all costs necessary in order to bring the mer-
chandise to the form in which it is ready to be sold. Included
among these are the original purchase price, incoming freight
and drayage, and insurance. Items incurred after the goods are
ready for sale and located at the place of sale are usually distri-
bution costs.
There are three types of merchandise inventory accounts
ordinarily used, raw material, goods in process, and finished
goods. The raw material account contains the value of goods
bought and before processing. The goods in process account
contains the value of material, plus other assignable costs which,
have entered into the manufacture of partially completed prod-
ucts. The finished goods account contains the value of those
goods which have completed the final stage of the manufacturing
process.
Determining Cost of Merchandise. The cost of merchandise
inventory depends on the method used to obtain it. In order to
illustrate this, three methods of determining inventory value will
be briefly described and compared.
First, in terms of simplicity, is the basis of actual cost for each
unit. When it is possible to ascertain without difficulty the costs
of particular quantities on hand, this method may prove to be
desirable. Especially is this true in wholesale and retail concerns.
In these enterprises (in contrast to those engaged primarily in
the production of goods) profits are measured by comparing the
1 For a description of other methods of valuation, see "Accountants'
Handbook/' pp, 381jf,
Chap. VIII]
PROBLEMS OF VALUATION
119
revenue received from sales with the actual cost of obtaining the
revenue.
Often, however, it is not practicable to value each item of
merchandise but instead to use some method of estimating it.
One of the simplest methods is to compute the average price.
This is done by adding the various prices per unit and dividing by
their number. The units in the inventory multiplied by the
average price per unit results in the value of the inventory (see
illustration on page 120). The simple average fails to consider,
however,- the difference between purchases of large and small
amounts.
The weighted-average cost method overcomes this objection.
This method gives due weight to the prices at which given
quantities are purchased. If, however, the inventory turnover
is rapid, it may easily happen that no portion of merchandise
purchased during the earlier part of the fiscal period is left in the
final inventory. When this condition prevails, the computation
of inventory by the weighted-average method may present an
unrealistic value, for in most merchandising fields the old stock
is sold first and the stock on hand is kept as fresh as possible.
The recent purchase (first-in-first-out) method is in- accord
with this practice. It is based on the assumption that the oldest
stock is sold first and that the inventory consists of those units
most recently purchased. Furthermore, since the prices are
taken of the last quantities purchased, they at least approximate
replacement or market price.
To better explain these three methods 1 of estimating cost,
assume that the physical inventory is 5,000 units and that the
other significant data are as follows:
Date
Quantity
Price per Unit
Amount
Dec. 3
5,000
$1.35
$ 6,750
7
2,500
1.30
3,250
12
1,000
1.25
1,250
20
1,500
1.25
1,875
30
2,000
1.20
2,400
Total
12,000
$6.35
$15,525
1 Other methods of determining merchandise inventory cost are to be
found in the cost accounting texts listed at the end of Chapter XIII.
120
ELEMENTS OF ACCOUNTING
[Chap. VIII
A COMPARISON OF THE SIMPLE AVERAGE, WEIGHTED-AVERAGE, AND RECENT-
PURCHASE METHODS OF COMPUTING INVENTORY COST
Method of Valuation
Computations
Inventory
Value
Simple average
Weighted average ....
Recent purchase
5,000 units X $1.27(86.35 -5- 5)
5,000 units X $1.29375($15,525-^ 12,000)
Dec. 30. 2,000 units X $1.20 $2,400
20. 1,500 units X 1.25= 1,875
12. 1,000 units X 1.25 1,250
7. 500 units X 1.30 = 650
$6,350.00
6,468.75
6,175.00
Cost or Market, Whichever Is Lower. According to the basis
of valuation, cost or market, whichever is the lower, market
value or replacement value must be used if it is less than cost.
The market price may be obtained from newspapers, trade
publications, or from direct correspondence with those selling the
commodities.
The application of the market or cost price requires that each
group of items be individually valued and that cost or market,
whichever is the lower for the particular group, be selected. The
effect of this is shown by the following example:
Cost
Market
Lower of Cost
or Market
Product A
$ 5,000
$ 5,350
$ 5,000
Product B
1,250
1,250
1,250
Product C
8,500
8,250
8,250
Total
$14,750
$14,850
$14,500
Thus in the balance sheet the valuation of inventory at cost
or market, whichever is the lower, is indeed a most conservative
basis. It places in this statement an amount lower than either
the total purchase cost or the estimated replacement cost of
inventory.
In the profit and loss statement the application of this rule
raises difficulties. Assume, for example, that the inventory at
the end of a fiscal period, valued at cost, amounted to $15,000,
and that the other items in the trading section are as follows:
Chap. VIII] PROBLEMS OF VALUATION 121
Sales $100,000
Cost of goods sold:
Inventory beginning $10,000
Purchases 60,000
Goods available for sale $70, 000
Inventory ending 15,000
Cost of goods sold 55,000
Gross profit $ 45,000
If the same conditions of the illustration prevail, except that
the final inventory amounts to $13,000 and is valued at cost or
market, whichever is the lower, then the gross profit for the
period would be reduced by $2,000, 1 as shown by the following
statement:
Sales $100,000
Cost of goods sold:
Inventory beginning $10,000
Purchases 60,000
Goods available for sale $70,000
Inventory ending 13 ,000
Cost of goods sold 57,000
Gross profit $ 43,000
In the succeeding fiscal period when the inventory of $13,000
becomes the beginning inventory, the effect is to increase profits
by $2,000 over what they would have been had the purchase cost
of $15,000 been used. When the two fiscal periods are con-
sidered, the effect of using the lower replacement cost figure is nil.
Despite the widespread acceptance of the rule of cost or market,
whichever is the lower, this basis has not met with unqualified
approval. 2 A compromise measure designed to overcome these
1 This assumes that the $2,000 is included in the inventory. If the amount
in question is carried to the nonoperating section of the profit and loss
statement, neither gross profit nor profit from operations will be affected.
2 "The traditional view has been that merchandise should normally be
valued at its cost, but that, when the market price is less than the cost, the
latter should be substituted. Confessedly illogical, this practice became
rather general in the United States, being approved of by most accountants
as having the merit of conservatism. . . . But one can easily see that in
many cases the crude rule, cost or market whichever is lower, is in no sense
truly conservative/' Hatfield, H. R., "Accounting," p. 99, D. Appleton-
Century Company, Inc., New York, 1927.
"The vogue of 'cost or market, whichever is the lower,' has been brought
about in considerable measure by the preoccupation of accountants with
122 ELEMENTS OF ACCOUNTING [Chap. VIII
objections is sometimes followed by setting up a reserve for
inventory fluctuation. Under this system the inventory is
valued at cost and a reserve for inventory fluctuation is estab-
lished. To establish the reserve the following entry would be
made:
Surplus 2,000
Reserve for market fluctuations in inventory . . 2 , 000
An alternative treatment would be to establish the reserve by
charging a nonoperating expense item as follows:
Inventory adjustment 2,000
Reserve for market fluctuation in inventory ... 2 , 000
The reserve would be deducted from inventory in the balance
sheet in the same manner as the allowance for doubtful accounts
is deducted from accounts receivable. After the reserve has
served its purpose, it may be closed into net income or surplus or
readjusted to the requirement of the inventory of the new fiscal
period.
Supplies and Prepaid Expenses. The supplies inventory is
taken in a manner similar to the merchandise inventory. The
first step consists of counting all items on hand. Postage,
stationery, and all other current expenses which have unused
quantities remaining are counted and valued at cost.
the statement of financial condition, as opposed to the income sheet, and
with the somewhat unintelligent attitude of commercial bankers toward
such statement. From the standpoint of the presentation of reports which
shall be useful to the operating management the rule is a nuisance rather
than a bit of business wisdom. That it is bad reporting to overstate the
asset values in the balance sheet may be taken for granted, but it may be
insisted that the adoption of the 'cost or market ' policy throughout the
preparation of the statements is a very clumsy and ineffective way of
attempting to avoid such overstatement. If instead of accepting 'cost or
market' as an almost sacred tenet of the profession, beyond criticism, public
accountants would take time off to examine the effects of the policy on
comparative income reports, it is safe to assume that there would be a rapid
waning of the enthusiasm for this approach to inventory valuation/'
Paton, W. A., "Essentials of Accounting," p. 486 (New York, 1938). By
permission of The Macmillan Company, publishers.
"The old rule, 'cost or market, whichever is lower/ in some cases permits
true conditions to be ignored and it may inject into the balance sheet a false
and misleading element." Montgomery, R. H., "Auditing Theory and
Practice," p. 182, The Ronald Press Company, New York, 1927.
Chap. VIII] PROBLEMS OF VALUATION 123
Prepaid expenses are treated in a like manner. Rent, adver-
tising, insurance, taxes, and other current operating expenses
paid in advance are usually valued on the cost basis.
Supplies and prepaid expenses furnish good examples of the
relation between assets and expenses. With few exceptions an
expense is an expired asset value. As the asset portions of
supplies and prepaid items are used, the expired portions become
expenses. The problem of valuing items in this category consists
of determining what portion of the amount in an account is
unused and hence an asset, and what portion is used and therefore
an expense.
Questions
Review.
1. Explain how the balance sheet and the profit and loss statement are
affected by the valuation of assets.
2. Defend the policy of conservatism in valuation.
3. Give four assumptions in accounting which influence the valuation of
assets.
4. Explain how the function performed by an asset affects its method of
valuation.
6. On what basis should the following be valued:
a. Cash
b. Marketable securities
c. Accounts receivable
d. Notes receivable
e. Merchandise inventory
/. Supplies and prepaid expenses
6. What is the purpose of the bank reconciliation statement?
7. Why is a reserve for doubtful accounts established?
8. What is the purpose of the notes receivable discounted account?
9. When should a loss arising from an uncollectible account be charged to
a. The current fiscal period
6. The reserve for doubtful accounts
c. Proprietorship
10. Should any record be kept of unpaid accounts receivable even after they
have been written off?
11. What adjustment should be made if the amount placed in the reserve
for doubtful accounts proves to be more than is needed?
12. Explain the following methods of pricing inventories;
a. Average price
b. Weighted average
c. Kecent purchase
124 ELEMENTS OF ACCOUNTING [Chap. VIII
Discussion.
13. "The balance sheet and the profit and loss statement are expressions
of opinion and not of fact." Evaluate.
14. "A bad debt is a legitimate business item. It is quite conceivable that
a credit manager should be criticized adversely for attempting to keep
this expense too low." Defend this statement.
15. The following objections, among others, have been offered to the inven-
tory basis of valuation cost or market, whichever is the lower:
a. It greatly increases the work of pricing the inventory.
b. Decreases in values are recognized, increases are not; hence the rule
is inconsistent.
Discuss these objections.
CHAPTER IX
PROBLEMS OF VALUATION. (Concluded)
In terms of function, fixed assets are sharply distinguished
from current assets. They are decidedly of secondary impor-
tance to the credit status of the enterprise, since it is not the
purpose of fixed assets to be converted into cash. Instead they
are used in the production or sale of commodities and are kept in
the business so long as they continue to perform the function for
which they were acquired.
The Relation of Depreciation to the Fixed Asset. In eco-
nomics fixed assets have been termed " installment service
goods/' 1 a form of capital which for the most part is held in
reserve but which gives off services by installments. If, for
example, a machine costing $1,000, lasting 10 years and having no
residual worth, declines in value at a constant rate, the cost of
acquiring this service is $100 per year. This decline hi the value
of the asset is termed ''depreciation" and is one of the costs of
securing revenue for the period. 2 Depreciation, in accounting,
includes not only those causes contributing to the lessened value
of an asset due to use but also those causes due to the passage of
time. 3
Baylor, F. W., " Principles of Economics," p. 63, The Ronald Press
Company, New York, 1922.
2 Here again is an illustration of the relation between an asset and an
expense. The expense, depreciation, is the expired fixed asset value charge-
able to the operations of a given accounting period.
8 " Accountants' Handbook," p. 579, lists the following as the principal
causes:
1. Ordinary wear and tear in use
2. Unusual damage or deterioration
3. Exhaustion
4. Limited possibility of use
5. Inadequacy
6. Obsolescence
7. Cessation of demand for product
125
126 ELEMENTS OF ACCOUNTING [Chap. IX
Capital and Revenue Expenditures. The problem of account-
ing for asset values, in contrast to that of determining the cost
of securing its service, or depreciation, finds expression in the
distinction between capital and revenue expenditures. Care
should be taken not to associate the term " expenditures" solely
with cash. An expenditure, as the term is used here, may also be
made by incurring a debt.
Capital expenditures increase the value of a fixed asset. The
acquisition of a new asset, additions in value to those already
owned (as, for example, the construction of a new wing on the
factory) and expenditures commonly termed " betterments "
result in the assets being increased in usefulness or possessing
greater capacity than before. These three types are the most
common forms of capital expenditure.
Revenue expenditures are made for the purpose of securing
income. They apply exclusively to the current period. Repairs
and maintenance charges, for example, are made in order to
enable operations to continue at a desirable standard of per-
formance. Presumably they do not increase the life of the asset
beyond the point at which it was originally calculated.
A clear distinction between a capital and a revenue expendi-
ture is of extreme practical significance in determining financial
status and the earnings of a period. Confusion in the classifica-
tion of expenditures results in a misstatement of assets and earn-
ings. If a revenue expenditure is erroneously classified as a
capital expenditure, both asset values and profits are inflated; if
a capital expenditure is erroneously classified as a revenue
expenditure, the asset values and profits are deflated by the same
amount.
Despite the importance of this distinction, it is not always easy
to discriminate between capital and revenue expenditures. 1
Expediency is sometimes the deciding factor. A large railroad
1 Dewing cites such a case with the following example: "Thus it may cost
a railroad $500,000 to eliminate a grade crossing in a populous suburb of a
large city. Clearly the need for the change has been increasing as the
suburb grew, and its advantage will be felt for years to come, yet the railroad
will collect no more fares after the grade crossing is gone, nor will its cost
of operation be appreciably less; its property is no more valuable, as a
railroad, than it was before the money was spent." Dewing, A. S., "The
Financial Policy of Corporations," p. 530, The Ronald Press Company,
New York, 1926.
Chap. IX] PROBLEMS OF VALUATION 127
might find it cumbersome and costly to attempt a fine distinction
between capital and revenue expenditures for transactions involv-
ing small amounts. From the standpoint of comparing the
results of one fiscal period with the results of another, it is not as
important to insist upon a border-line distinction as it is to
follow a consistent policy. In order to assure uniformity in this
and other points, many companies have found it advisable to
define their policy and to include a statement of it in a manual
prepared for the guidance of those working on their records.
Methods of Computing Depreciation. The problem of
accounting for depreciation is, in one important respect at least,
similar to that of discriminating between a capital and revenue
expenditure; it involves a distinction between capital and
revenue. The failure of the life span of the asset to coincide
with the fiscal period raises the question as to how much of the
total cost shall be retained on the books as capital (fixed asset)
and how much shall be treated as a charge against revenue
(depreciation). '
There are various methods of determining the amount of
depreciation to be charged off at the end of a fiscal period. In
this country the straight-line method 1 is most commonly used.
It apportions depreciation at a uniform rate over the useful life
of the asset. For example,, assume that a machine costing $970
has an estimated life of nine years and a residual value of $70.
The residual value subtracted from the cost leaves $900 to be
apportioned over a period of nine years. If the fiscal period is one
year, the annual depreciation charge will be $100. Simplicity of
computation is the greatest advantage offered by this method.
To some, however, it is an oversimplification of the whole problem
of apportioning depreciation. One criticism often cited is that
it fails to distinguish in its periodic charges between operating
periods of great and of slight activity.
The production method of apportioning depreciation meets
this objection. The important difference between the two is
that the straight-line method is computed on a time basis, while
the production method is computed on a performance basis.
According to the production method, the total number of units
1 It is called the straight-line method because, when the successive book
values of the diminishing asset are plotted on a diagram, a straight line is
formed.
128 ELEMENTS OF ACCOUNTING [Chap. IX
the machine will produce, or the total service it will render in its
useful life, is first estimated. The assignable cost is then deter-
mined by deducting the scrap value from the cost recorded in the
account. The total output in terms of production, or service, is
divided into the assignable cost. The result is the depreciation
charge per unit. If we make the further assumption, in the
illustration just cited, that the machine will produce an estimated
200,000 units during its useful life, then its assignable service
cost ($900) divided by the output (200,000 units) results in a per
unit depreciation charge of $0.0045. Thus, if the output of the
first fiscal period is 25,000 units, the depreciation charge would
be $112.50. Despite the merit possessed by this method, it is
often difficult to make an accurate estimate of the total output
during the life of an asset with the result that its usefulness is
limited accordingly.
There are numerous other methods of apportioning deprecia-
tion. 1 It may be charged off at increasing, decreasing, or fluc-
tuating amounts over the life span of the asset. The lack of
agreement as to the proper method to use is not so important as
it is to recognize that depreciation is a definite expense, the cost
of securing the service of a fixed asset. The amount, regardless
of how it is determined, must be definite; it cannot be varied
according to whim without failing to protect adequately capital
investment and to state profits with reasonable accuracy.
Buildings, Equipment, and Machinery. In general the usual
assets subject to depreciation are buildings, equipment, and
machinery. The same basis applies to all: cost less depreciation.
The term "cost" is usually more inclusive thaji the initial outlay
for the asset. For example, the account buildings may include
the demolition charges necessary to remove an old building and
clear the site. Such an item is a proper charge to the building (if
the land is owned by the business prior to incurring the cost) since
it is an essential cost of conditioning the ground before erecting
the building. Interest on borrowed money which has been used
to finance the erection is likewise considered a proper construction
cost. The interest cost ceases, of course, upon the completion
of the building. The distinction between capital and revenue
charges is particularly important in valuing buildings. All
1 For an explanation of other methods see the " Accountants' Handbook,"
p. 626.
Chap. IXJ PROBLEMS OF VALUATION 129
necessary repairs are treated as revenue charges; all improve-
ments are considered capital expenditures.
The same principles apply to machinery and equipment. The
cost of these assets include full installation expenses plus any
additions or betterments.
Recording Depreciation. Inasmuch as the manner of record-
ing depreciation is similar for buildings, equipment, and machin-
ery, a single illustration will be used to discuss the journal entries
required. Assume that machine 1 is purchased at the beginning
of a fiscal period (one year) with an invoice cost of $900; express
charges paid by the enterprise amount to $25; installation costs
incurred amount to $45. Assume further, that the machine is
estimated to have a life of nine years, a residual value of $80, and
a removal cost of $10. In the middle of the third year it is sold
for $750.
The journal entry required to record the purchase of the
machine would be as follows:
Machinery 970
Cash (or accounts payable) 970
To record the purchase of machine 1 invoice cost, $900;
express charges, $25; installation costs, $45
Depreciation for the first year, 1 computed on a straight-line
basis, would be recorded by the following entry:
Depreciation of machinery 100
Reserve for depreciation of machinery 100
Depreciation for the second year and the first six months of the
third year would be journalized as follows:
Depreciation of machinery 100
Reserve for depreciation of machinery 100
Depreciation of machinery 50
Reserve for depreciation of machinery 50
1 The net amount expected to be realized from the sale of the asset, $70
(the residual value of $80, less the removal cost of $10), is subtracted from
the total cost of the machine, $970, to obtain an amount of $900. If this
cost is apportioned over the nine-year life span of the asset on a straight-line
basis, the result will be an annual depreciation charge of $100. The profit
of $30 from the sale of the asset is obtained by subtracting the book value
of the machine, $720 (the cost of $970 less the depreciation written off for
2H years, $250), from the $750 realized from its sale.
130 ELEMENTS OF ACCOUNTING [Chap. IX
The accumulated depreciation on the machine sold is removed
from the reserve account and carried to the machinery account
by the following entry:
Reserve for depreciation of machinery 250
Machinery 250 .
The cash received and the profit made on the sale of the machine
is recorded as follows:
Cash 750
Machinery 720
Profit on sale of fixed asset 30
Appreciation. The recognition of appreciation is subject to
much less general approval by accountants than is that of depre-
ciation. If appreciation has been realized, accounting practice
substantiated by court decisions approves its recognition.
There is no such general agreement, however, on the matter of
estimated or unrealized appreciation. The more conservative
accountants feel that it should not appear on the books because
it anticipates profits. The objection to this position can be
overcome, for the most part, if estimated appreciation is kept
out of the earnings for the period and out of surplus available
for the declaration of dividends. Assuming that land held for
sale by the company has, according to conservative estimate,
appreciated $5,000, this may be shown on the books by the
following entry:
Land 5,000
Reserve for land appreciation 5 , 000
The valuation account, reserve for land appreciation, is sub-
tracted from the land account in the balance sheet. This
method, which may be used with any asset, draws attention to
the fact that in the opinion of the management appreciation
should be noted. Nevertheless it avoids the danger of declaring
dividends out of a surplus which has not been realized.
Land. The valuation of land is similar to the other fixed
assets discussed, since it is valued at cost. It differs markedly,
however, in that, if the company intends to hold the land for use,
neither appreciation nor depreciation is usually recognized.
This practice is based on the assumption that land held for use
will continue to serve in the future as well as in the present and
Chap. IX] PROBLEMS OF VALUATION 131
that, since market value has no effect upon this use, neither
appreciation nor depreciation is significant in its valuation. All
capital expenditures such as attorneys' fees, guarantee of title,
recording of fees, grading, filling, leveling (in general, those costs
necesvsary to prepare the land for its intended use) are proper
additions to the cost of land.
Depletion. When land holdings are in the form of timber
tracts, oil wells, mines, or other forms which are consumed in the
operation of the business, a charge is made to operations for the
expired value of the resources. This expense is termed depletion.
Provision for depletion must be made, otherwise the capital of
the busineSvS will have disappeared with the removal of the last
unit of timber, oil, or other product. To compute depletion the
total yield of the natural resource is first estimated. Then an
amount is apportioned to each fiscal period on the basis of
physical output. The resulting depletion cost is chargeable
against the revenue of the period. The corresponding credit is
either to the property account or to an allowance for depletion
account. Although the determination of depletion is a most
difficult problem, a failure to recognize it, with the subsequent
declaration and payment of dividends, results in the return of the
capital investment to the stockholders a legitimate procedure
only if the management and the stockholders clearly understand
that the business is being liquidated.
Intangibles. The valuation of intangibles is subject to greater
uncertainty than are any of the assets previously discussed.
There may be slight relation between the recorded value of an
intangible and its real worth. A highly successful invention, for
example, is usually worth much more to the business than the
cost price of the patent would indicate. It is not cases such as
this, however, that have aroused skepticism but rather those
which result in the overvaluation of intangibles. Goodwill,
particularly, has in the past proved a most adaptable device for
manipulation.
The fact that conservative accounting practice requires that
intangibles be excluded from the accounts unless a definite price
has been paid for them makes for even further uncertainty.
It is quite common for a firm having considerable goodwill to
have no recorded amount on its books, because there has been
no act which occasioned its purchase. In contrast, a firm having
132 ELEMENTS OF ACCOUNTINO [Chap. IX
much less goodwill may show a substantial amount because of
circumstances which led to its purchase.
The doubt surrounding the valuation of intangibles begins with
the selection of items to be included under this classification.
Accounts receivable, for example, are never included under the
intangible caption, but logically it would be most difficult to
prove that they are more tangible than either trade-marks or
franchises.
The separation between tangible and intangible items is based
on custom. The principal items included under intangibles are
goodwill, patents, copyrights, trade-marks, leaseholds, franchises,
organization expenses, and formulas. These are frequently
divided into two distinct types: those which have a more or less
definite term of life, and those which do not. In the first group
are patents, copyrights, and leaseholds. Here the legal life span
is definite, even though the economic life span may not be. A
patent is a government grant entitling the owner to the sole
right, usually for 17 years, to make or sell an invention or process.
Its full cost should be written off over the economic life of the
asset which in no case should exceed its legal life.
The copyright is similarly valued. It is a legal right given to
an author which permits him to publish, exclusively, certain
written material. Usually the copyright affords this protection
for 28 years.
Likewise, the leasehold should be valued at cost and amortized
over a period not longer than that covered by the contract.
* The second group of intangibles (those which have an indefi-
nite life span) include goodwill, trade-marks, formulas, and organ-
ization expenses. Foremost among the items in this group is
goodwill. Its value is determined by capitalizing the earnings
in excess of those of a representative business. The causes for
the excess earnings are numerous. Goodwill may come into
existence through an established reputation for fair dealing, a
favorable business location, an efficient well-managed organiza-
tion, a personnel with profitable social or business connections, a
special advantage in purchasing or marketing goods; a judicious
use of a trade-mark or trade name; or the use of a patent with
monopolistic results.
The computation of the goodwill of a business requires a
knowledge of the following:
Chap. IX] PROBLEMS OF VALUATION 133
1. The value of tangible assets
2. The normal rate of return on capital invested in the industry
as a whole
3. The rate of capitalization of excess earnings
Suppose, for example, that a given business had net tangible
assets valued at $50,000 and for a number of years had realized
an average of 12 per cent on its investment. Assume further
that the normal return on the capital invested in the industry is
10 per cent. The excess return of $1,000 per year earned by the
enterprise would be computed as follows :
$50,000 at 12 per cent $6,000
$50,000 at 10 per cent 5,000
Excess return $1 , 000
If it is agreed that the excess profits can be expected to last five
years (or that the rate of capitalization of excess earnings is 20
per cent), the resultant goodwill is $5,000.
Goodwill, like other items in the second group, should be
valued at cost. The fact that excess earnings exist does not
warrant placing goodwill on the books unless it has been pur-
chased. To do otherwise would result in an item of a most
questionable nature. The procedure would be comparable to
appreciating any asset without its value first being realized by a
sale.
There is no complete agreement as to whether the intangibles
of this second group should be kept on the books or be written off.
According to one point of view, unless the value of the particular
items has been impaired, they should be retained on the books,
at cost, so long as they contribute toward earnings. Hence they
are not subject to amortization in the same manner as those
intangibles which have a definite legal life span.
According to another point of view, cost is an unsatisfactory
index of what the patent, franchise, or other intangible having an
indefinite life span is really worth, and further, because of the
general discredit and skepticism accorded the valuation of intan-
gibles, it is preferable to write off the assets as quickly as possible.
Liabilities. Considerably less difficulty is usually experienced
in the valuation of liabilities than of assets. This is particularly
true when the liability is known and the claim is definite. Here
the face value of the obligation is the basis of valuation.
134 ELEMENTS OF ACCOUNTING [Chap. IX
A more serious problem lies in the certainty that all liabilities
are shown. This may present difficulties in those cases of con-
tingent liabilities where the ultimate liability is unknown, such
as notes receivable which have been discounted, merchandise in
transit, guarantees given on services rendered or articles sold, or
contracts given when the service to be performed has not yet
been rendered. Often the best that can be done in these cases
is to estimate the probable liability. Frequently no amount is
shown in the balance sheet, but, instead, a footnote or a
parenthetical notation is included, drawing attention to the
contingency.
Net Worth. The correct valuation of net worth is to a large
extent dependent on an accurate valuation of assets and lia-
bilities, since this equity is the difference between these two.
One important requirement is to show clearly the equities of the
different groups of proprietorship. Specific problems in the
valuation of net worth are considered in the two succeeding
chapters.
Questions
Review.
1. What is the difference between current and fixed assets?
2. Explain how depreciation may be used to illustrate the relation between
an asset and an expense.
3. Distinguish between a capital and a revenue expenditure. Why is this
distinction important? What is the result of a failure to properly
distinguish between the two?
4. Explain the straight-line method of computing depreciation. What are
its advantages? Its disadvantages?
6. Discuss the advantages and the disadvantages of the production method
of computing depreciation.
6. What is the basis of valuation for
a. Buildings, machinery, equipment
b. Land held for use
c. Land held for sale
d. Patents, copyrights, and leaseholds
e. Goodwill, trade-marks, and formulas
7. Discuss the principal problems in recording appreciation.
8. What is the result of a failure to recognize and record depletion?
9. Discuss the difficulties in the valuation of liabilities.
10, What is the important requirement in the valuation of net worth items?
Chap. IX] PROBLEMS OF VALUATION 135
Discussion.
11. " When a reserve for depreciation is properly kept, there will be enough
money set aside to buy a new asset when the old one wears out/' Refute
this statement.
12. "Why bother with depreciation anyway? We use an asset as long as
we can operate it, then throw it away and buy another." Is this prac-
tice defensible?
13. " Depreciation should be related to the capacity of the business to
absorb the expense. In years of profitable operations the depreciation
charge should be greater than in years when the business has operated
at a loss." Discuss.
Suggested Supplementary Readings
HATFIELD, H. R.: " Accounting," Chaps. 2-6, D. Appleton- Century Com-
pany, Inc., New York, 1927.
KESTER, R. B.: "Principles of Accounting," 4th ed., Chaps. 24 and 25,
The Ronald Press Company, New York, 1939.
PORTER, C. H., and W. P. FISKE: " Accounting," Chap. 14, Henry Holt
Company, Inc., New York, 1935.
ROREM, C. R.: " Accounting Method," Chaps. 21-30, University of Chicago
Press, Chicago, 1930.
SANDERS, T. H., H. R. HATFIELD, and U. MOORE: "A Statement of Account-
ing Principles," Part III, American Institute of Accountants, New
York, 1938.
CHAPTER X
INDIVIDUAL PROPRIETORSHIP AND PARTNERSHIP
The two preceding chapters on problems of valuation dealt
primarily with assets and to a less extent with liabilities, while the
problems of net worth were postponed to this chapter and the
succeeding one for consideration. The valuation of net worth
depends largely upon the form of the business organization.
The three most important of these forms are the individual
proprietorship, the partnership, and the corporation.
Individual Proprietorship. In the individual proprietorship a
single person owns the business. Its greatest advantage is the
independence afforded the owner. In this respect it is noticeably
superior to the partnership or the corporation. The ease and
economy of organization, the lack of restrictions on the initiative
of the owner, and the comparatively slight interference in the
affairs of management may be advantages of sufficient importance
to warrant using the sole proprietorship in preference to other
forms of organization.
The principal types of accounting entries dealing with the
valuation of the net worth of an individual proprietorship are
those of organization, distribution of profit or loss, and dissolu-
tion of the business. No separate consideration is given to these
transactions, since their treatment would be duplicated largely
in the discussion of partnership problems, which will be presented
in the order indicated.
The Partnership as a Desirable Form of Business Organiza-
tion. In general the partnership is preferable to the sole pro-
prietorship when more capital is required than can be furnished
by an individual or when a combination of abilities is needed.
Two definitions of the partnership have found wide acceptance.
Chancellor Kent has described it as " a contract of two or more
competent persons, to place their money, effects, commerce or
business, or some or all of them in lawful commerce or business,
and to provide the profit and bear the loss, in certain propor-
136
Chap. X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 137
tions." The Uniform Partnership Act provides the following
definition: "A partnership is an association of two or more
persons to carry on as co-owners a business for profit."
In at least two important respects the partnership offers advan-
tages over the incorporated organization. First, it is superior to
the corporation in definiteness of legal status. The widespread
acceptance of the Uniform Partnership Act has made it possible
to know what to expect when legal difficulties arise within those
states operating under the act. In contrast, some state corpora-
tion statutes have been loosely drawn and no court interpreta-
tions have been given; consequently their legal status is unknown.
This fact has influenced many corporations to incorporate in
those states where adequate legal interpretation has been given
to the statutes. Moreover, the corporation is subject to blue-sky
legislation restrictions on the issue of securities. There is no
comparable interference with the sale of partnership shares.
The second advantage of the partnership is that usually no
more restrictions are placed on its movements than if it were an
individual. It can operate with a freedom and secrecy wholly
lacking in a corporation. It is not ordinarily required to submit
numerous reports to state authorities, is not subject to special
taxes, and in general does not have its activities as rigidly
restricted as a corporation does. Like the individual proprietor-
ship, the partnership is easy to organize. The necessary for-
malities and costs of organization are considerably less than they
are when the business is incorporated.
Articles of Partnership. The partnership 1 is so lacking in the
formalities of organization that it is not even essential to have
written partnership agreements. The law will infer relation-
ships from the acts of the partners. It is desirable, however,
that articles of partnership be drawn in order to anticipate causes
for disagreement and to forestall friction among partners by
clarifying all possible causes for misunderstanding. Important
points to be included in the articles of partnership are
1 Unless otherwise specified, the term "partnership" applies to a general
partnership, "one wherein the members carry on all their trade and business
for their joint benefit and profit." Similarly, the term "partner" used
without qualification refers to a member of a general partnership. For a
detailed classification of partnerships and of partners, see Corpus Juris
(47 C. J., pp. 463#)-
138 ELEMENTS OF ACCOUNTING [Chap. X
1. The name of the partnership.
2. The names of the partners.
3. The date on which the partnership begins.
4. The location of the business.
5. The scope of the business.
6. The amount of each partner's investment.
If the capital contribution is made in property, it is
important that the valuation be accurate. Once
invested, the partners become joint owners.
7. Duties of the partners.
Duties and obligations of the partners to each other are
governed by the articles of partnership. In the absence
of any agreement, each partner has the right to partici-
pate generally in the affairs of the partnership.
8. Restrictions to be imposed on the partners.
All members of the partnership are bound by the acts
of any partner committed within the scope of the busi-
ness. Any restrictions imposed on the members which
might involve the partnership (for example, endorsing
notes of others, becoming sureties, etc.) should be
included in the partnership agreement.
9. The amount of withdrawals to be allowed.
10. Provisions for keeping partnership records.
The length of the accounting period, the statements to
be prepared, and any accounting procedures likely to
cause controversy should be fully covered.
11. Sharing of profits and losses.
In the absence of provisions to the contrary, both
profits and losses are shared equally, regardless of
capital investments. Furthermore, unless otherwise
specified, losses of the partnership are borne in the same
proportion that profits are shared.
Another factor affecting the sharing of profit or loss is
whether interest should be credited on capital. If there
is no agreement among the partners, interest is neither
credited for capital balances nor charged for withdrawals.
Salaries similarly affect the amount of profit or loss to
be distributed among the members. In the absence of
provisions to the contrary, no salaries are payable to
Chap. X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 139
partners regardless of capital contributions, abilities, or
time spent in the business.
12. Duration of the partnership.
Although the life of the partnership may be terminated
by several causes (see page 147), it is indefinite unless
otherwise specified. Partnership interests cannot be
transferred except with the consent of the remaining
partners. The withdrawal of any partner without the
assent of his copartners renders him liable to a suit for
damages for any injuries suffered. Because of the diffi-
culties of terminating a partnership, it may be desirable
to limit its life to a relatively short time. Then, if con-
ditions are satisfactory, the partnership may be renewed
for a longer period.
13. Provisions for the admission of new partners.
An outstanding characteristic of the partnership is that
of unlimited liability of the partners. Since all members
are jointly liable for all debts of the firm and further
since each partner can incur obligations of the firm, it is
especially important that considerable care surround the
selection of new members.
14. Provisions for dissolution.
15. Special provisions.
Typical considerations which might be included under
this section are the selection of arbitrators in the event
of dispute, basis for the valuation of goodwill upon the
retirement or death of a partner, procedure in the event
of liquidation, and the amount of insurance to be
carried on the partners' lives.
A Share in the Profits and a Share in the Business. A funda-
mental distinction which must be grasped before provisions in
the partnership agreement or accounting problems of partnership
can be understood is the difference between a share in the profits
and a share in the business. If, for example, a partner has a one-
third share in the profits, he will receive one-third of them and
bear one-third of the losses (unless his loss-sharing ratio differs
from his profit-sharing ratio). If, however, he possesses a third
interest in the business, he owns one-third of all the net assets
(total assets less total liabilities). This does not imply that he
140 ELEMENTS OF ACCOUNTING [Chap. X
receives the same amount of profits. Unless specifically stated
in the articles of partnership or by oral agreement, there is no
relation between capital invested and profits shared. In the
absence of any agreement among the partners, profits or losses
will be shared equally, regardless of their respective investments.
The distinction between a share in the profits and a share in the
business is important, for the first is a question of profit distribu-
tion, the second a problem of capitalization the subject now
under discussion.
Organization Entries.
Case One. When the amount paid by the incoming partner
is equal to the book value of the share acquired.
Probably the simplest case of capitalization is the investment
of the incoming partner of an amount equal to the book value of
the share acquired. Assume, for example, that A has property
valued at $20,000. B invests sufficient cash to acquire a one-
third share in the business. His investment will be recorded
by a single entry:
Cash 10,000
B capital 10,000
Case Two. When a revaluation of assets is required before a
new partner is admitted.
Assume that A's balance sheet is as follows:
Cash $ 1,000 A capital $20,000
Accounts receivable 3 , 000
Merchandise 7,000
Buildings 7,000
Land 2,000
$20,000 $2p JL 000
Assume further that, prior to the admission of 5, it is agreed
that accounts receivable are overvalued $100, merchandise $240,
and buildings $400. B is admitted to a one-third interest in the
partnership after these valuations have been taken into considera-
tion. The following entry is necessary in order to adjust the
assets to their new values:
A capital 740
Accounts receivable 100
Merchandise 240
Buildings 400
Chap.X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 141
After this entry is made, A' a net worth will be $19,260. This
amount is equal to two-thirds of the proposed partnership
capitalization ($28,890). J3's investment will be equal to one-
third of the total capitalization and will be journalized as follows:
Cash 9,630
B capital 9,630
Case Three. When the incoming partner pays more than the
book value of the share acquired.
Assume that A's investment amounts to $20,000 and that B
acquired a one-third interest by investing $12,000. If B has not
overpaid for his share, he will expect to hold a one-third interest
in a business having a total net worth of $36,000 (three times
$12,000, the amount paid for his interest). But the sum of A's
investment ($20,000) plus B's ($12,000) results in a total of
$32,000, or $4,000 less than the recorded values. This difference
is goodwill, which in this case has resulted from conditions
within the business prior to B's entrance. It is treated as a
profit to A and is recorded by the following entry:
Goodwill 4,000
A capital 4,000
B's cash payment is recorded as follows:
Cash 12,000
B capita] 12,000
If A had other partners aiding him in the development of good-
will, the various partner's capital accounts would receive credits
in proportion to their profit-sharing ratio. If a complete state-
ment of the new partnership assets is shown, goodwill must be
recorded.
It may not be desirable, however, to place goodwill on the
books. Its valuation has been subjected to so much abuse that
investors and others have become skeptical of its significance.
Consequently many believe that it should be omitted from the
balance sheet. Conservative accounting practice sanctions this
omission and favors the adjustment of capital accounts.
In the illustration under discussion, if goodwill is not to be
recorded and the capital accounts are to be adjusted, the total
capitalization will be $32,000 (A's capital of $20,000 plus 5's
capital of $12,000). The entry to record B's investment would
be the same as before:
142 ELEMENTS OF ACCOUNTING [Chap. X
Cash 12,000
B capital 12,000
Since the total capitalization is limited to $32,000 and A has
a two-thirds interest, his capital account should have a balance
of $21,333.33. B's capital account should have a balance
of $10,666.67 (one-third of $32,000). To adjust the capital
accounts, the following entry would be necessary:
B capital 1,333.33
A capital 1 ,333 33
If the incoming partner pays more than the book value of the
share acquired because he is anxious to be associated with the
firm and not because the share is worth what has been paid for
it, this difference must be considered as a bonus to those who
were members of the firm prior to the admission of the new
partner.
Case Four. When the incoming partner pays less than the
recorded book value of the share acquired.
Again, assume that A's investment is $20,000 and that B
acquires a one-third interest by the payment of $7, V 500. The
reason for making the offer to B may determine whether goodwill
should be placed on the books. If B brings with him connections
or abilities which will increase the earnings of the business and
for which A is willing to pay, then an intangible asset may be
placed on the books. The title of this intangible should describe
the circumstances responsible for admitting B to the enterprise
for an amount less than the book value of the share acquired.
Since A has a capital investment of $20,000 and a two-thirds
interest in the business, the total partnership capitalization is
$30,000. If B's share is one-third, he expects the book value of
his share to be $10,000, or $2,500 more than the amount he pays.
This difference may be recorded by the following entry:
(An account title which describes the nature of
the intangible asset contributed by the in-
coming partner) 1 2 , 500
B capital 2,500
1 The title goodwill cannot be properly used to describe this asset. Good-
will arises because a given enterprise has an earning capacity greater than
that enjoyed by a representative concern in the same industry. It is
quite possible that the intangible asset used in this entry would arise for
Chap. X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 143
The cash investment would, of course, be recorded as follows:
Cash 7,500
B capital 7, 500
If through a desire to be conservative or if an urgent need for
new capital prompted the offer to 5, the $2,500 in question should
be treated as a bonus. The total capitalization would be the
sum of A' a capital ($20,000) and B's investment ($7,500). A's
capital account would show a balance equal to two-thirds of this
total ($18,333.33), and B's capital account would show a balance
equal to one-third of the total ($9,166.67). The entry necessary
to adjust the partnership capital accounts would be as follows:
A capital 1,666.67
B capital 1,666.67
Case Five. When the incoming partner purchases an interest
from a retiring partner.
Assume that A's interest (valued at $20,000) is purchased by C
for $22,500. If the purchase is made without revaluations of
goodwill or other assets, the transaction concerns only C and A.
The entry necessary to effect the change is as follows:
A capital 20,000
C capital 20,000
The fact that C pays more than the book value of the share
acquired does not affect the capitalization of the partnership,
since in this case, the transaction is a personal one between the
incoming and the retiring partner.
The Partner's Accounts. A second major problem in partner-
ship accounting is that of distributing profits or losses to the
partners. Their equities are usually shown by the capital
account and the personal account. The capital account contains
the original investment, substantial additions and reductions to
capital, and the balance of the personal account at the close of the
fiscal period. The personal account contains transactions involv-
ing a relationship between the proprietor and the business,
except decreases in capital or additional investments of consider-
the opposite reason because the business has an unsatisfactory record of
earnings and hence the incoming partner refuses to join the enterprise
except by paying less than the recorded book value of the share acquired.
The exact title used here should be indicative of the reason why the amount
of $2,500 came into being.
144 ELEMENTS OF ACCOUNTING [Chap. X
able amounts. If necessary, more than one personal account
may be set up to record special relationships. For example, a
drawing account may be established to record the cash with-
drawn by a partner. Essentially then the capital account shows
the vested proprietorship of the partner, while the personal
accounts indicate the current changes in proprietary interest.
For example, if A and B share profits in the ratio of 75 per cent
and 25 per cent, respectively, and the profit for the period
amounts to $4,000, it would be transferred to the personal
accounts by the following entry:
Profit and loss 4,000
A personal 1,000
B personal 3, 000
Balances of the personal accounts are then closed into the
respective capital accounts.
Distribution of Profits or Losses. The distribution of profits
or losses is frequently complicated by the fact that partners do
not make equal contributions of services or capital. To adjust
these inequalities it may be desirable to use different methods
for distributing profits or losses.
Assume, for example, that X makes a small capital contribu-
tion but spends most of his time conducting the affairs of the
business. Y contributes most of the capital but spends little
time in the business. Assume further that X receives a salary
of $2,500 per year and Y receives none. Under these conditions
X's salary would be considered a distribution of profits to be
made to X because of his service contribution. The entry neces-
sary to record the salary would be as follows:
Salaries 2,500
X salary 2,500
The expense account salaries is closed into the summary profit
and loss account. In the profit and loss statement it should be
shown as a disposition of profit. 1 If the salary is paid, it is
1 There may be conditions under which it seems advisable to treat salaries
as an operating expense. When a partnership contains numerous partners
and when an active member has a small investment and receives a salary,
his position may be comparable to that of an employee. Under these con-
ditions his salary should be treated as an operating expense. For a more
extended treatment see W. A. Paton, "Essentials of Accounting," pp.
622-623, The Macmillan Company, New York, 1938.
Chap.X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 145
settled in the same way as is any other liability; if it is not paid,
it is transferred to X's capital account.
Similarly interest allowed on capital is a method of adjusting
unequal capital contributions. The interest may be computed
on capital balances at the beginning of the fiscal period, at the end
of the fiscal period, or on the average amount. The last method,
of course, is the most accurate since it considers changes of both
amount and time. The principal steps required to compute the
average capital investment of a partner are as follows:
1. The investment balance at the beginning of the period is
multiplied by the number of months it has remained
unchanged.
2. When a change in the investment occurs, the new balance is
multiplied by the number of months it remains unchanged.
3. This procedure is repeated for each change in capital
throughout the entire fiscal period.
4. The amounts, in month-dollars, 1 are totaled and divided by
the number of months covered by the averaging process.
The result is the average capital balance.
Assume, for example, that the accounts of the two partners,
X and F, appear as follows:
X CAPITAL
I Mar. 1 Balance 2,000
X PERSONAL
May 1 500 I Aug. 1 500
Y CAPITAL
I Mar. 1 Balance 20,000
Y PERSONAL
June 1 1,000 I Oct. 1 5,000
Dec. 1 500 I
1 This computation may also be made in day-dollars. When this is done,
the respective capital balances are multiplied by the number of days the
balance remains unchanged. The total, in day-dollars, is divided by the
total days covered by the averaging process.
146 ELEMENTS OF ACCOUNTING [Chap. X
The computations necessary to obtain the average capital
balance of each partner 1 for the period from March 1 to December
31 are as follows:
X
From March 1 to May 1 $2,000 X 2 = 4,000 month-dollars
From May 1 to August 1 1 , 500 X 3 = 4 , 500 month-dollars
From August 1 to December 31 2,000 X 5 = 10,000 month-dollars
Total 18,500
18 500
Average investment of X = j~ = $1,850
Y
From March 1 to June 1 $20,000 X 3 = 60,000 month-dollars
From June 1 to October 1 19,000 X 4 = 76,000 month-dollars
From October 1 to December 1 24,000 X 2 = 48,000 month-dollars
From December 1 to December 31 23,500 X 1 = 23,500 month-dollars
207,500
Average investment of Y - jg = $20,750
Interest on $1,850 at 6 per cent for 10 months $ 92 . 50
Interest on $20,750 at 6 per cent for 10 months 1 , 037 . 50
Total $1,130~00
Assuming that the profit for the period amounts to $3,500 and
that all profits or losses are to be distributed equally between the
partners after salary and interest allowances are considered, then
the following entries would be made:
To distribute X's salary
Administrative salaries 2 , 500
X personal 2,500
To distribute the interest on capital
Interest on partners' capital 1 , 130 . 00
X personal 92.50
Y personal 1 ,037. 50
To complete the distribution between the partners
X personal 65
Y personal 65
Profit and loss 130
1 If partnership profits are distributed in proportion to average capital
investments, this method may be used for determining the average of each
capital account. For example, in the illustration used, -X" ; s total month-
dollars amount to 18,500, B's to 207,500, the total to 226,500. A'B profit-
sharing ratio would be 18,500/226,500 and B's would be 207,500/226,500.
Chap. X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 147
Thus, when a combination of methods is used, the final distri-
bution of a profit may require a charge to the partners' accounts
to adjust them properly.
Dissolution. The third phase of partnership accounting to be
considered is dissolution. It has been defined as "the change in
the relation of the partners caused by any partner ceasing to be
associated in the carrying on as distinguished from the winding
up of the business. On dissolution the partnership is not termi-
nated, but continues until the winding up of partnership affairs
is completed. " l
The Uniform Partnership Act lists the following causes for
dissolution:
1. Without violation of the agreement between the partners.
(A) By the termination of the definite term or particular under-
taking specified in the agreement,
(B) By the express will of any partner when no definite term or
particular undertaking is specified,
(C) By the express will of all the partners who have not assigned
their interests or suffered them to be charged for their separate
debts, either before or after the termination of any specified
term or particular undertaking,
(D) By the expulsion of any partner from the business bona fide
in accordance with such a power conferred by the agreement
between the partners,
2. In contravention of the agreement between the partners, where
the circumstances do not permit a dissolution under any other
provision of this section, by the express will of any partner at any
time;
3. By any event which makes it unlawful for the business of the
partnership to be carried on or for the members to carry it on in
partnership;
4. By the death of any partner;
5. By the bankruptcy of any partner or the partnership;
6. By decree of the court. On application by or for a partner the
court shall decree a dissolution whenever:
(A) A partner has been declared a lunatic in any judicial proceed-
ing or is shown to be of unsound mind,
(B) A partner becomes in any other way incapable of performing
his part of the partnership contract,
1 Uniform Partnership Act, Part VI, Sees. 29, 30.
148 ELEMENTS OF ACCOUNTING [Chap. X
(C) A partner has been guilty of such conduct as tends to affect
prejudicially the carrying on of the business,
(D) A partner wilfully or persistently commits a breach of the
partnership agreement, or otherwise so conducts himself in
matters relating to the partnership business that it is not
reasonably practicable to carry on the business in partnership
with him,
(E) The business of the partnership can only be carried on at a
loss,
(F) Other circumstances render a dissolution equitable.
Dissolution is to be distinguished from the termination of a
partnership. When a partner ceases to be associated with the
organization but the firm continues to function with a changed
membership, the problem of dissolution is to determine the equity
of the retiring partner. This may involve a revaluation of assets
and usually requires a distribution of the profit or loss for the
time elapsing from the close of the last fiscal period to the date
of the partner's retirement.
When a partnership interest is withdrawn at its book value,
the accounting treatment is simple. Assume that the partner-
ship equities of R, S, and T are correctly shown by the following
statement:
Sundry assets 127,500 R capital $15,000
S capital : 7,500
T capital 5,000
$27,500 $27,500
Assume further that T upon retiring from the firm is paid
$5,000 for his equity and that R and S continue the partnership.
The retirement is recorded by the following entry:
T capital 5,000
Cash 5,000
If, however, T receives $6,000 for his interest and if goodwill
exists, his withdrawal from the firm may be recorded as follows:
Goodwill 1,000
T capital 5,000
Cash 6,000
In this case goodwill is an asset turned over by the old partner-
ship to the new.
Chap. X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 149
If it is undesirable to place it on the books, the payment to T
may be first recorded as follows:
T capital 6,000
Cash 6,000
Then the $1,000 debit balance in !T's capital account would be
treated as a bonus to T to be borne by R and S in proportion to
their profit-and-loss-sharing ratios. If profits and losses are
shared equally, the entry would be recorded as follows:
R capital 500
S capital 500
T capital 1,000
If conditions within the partnership are such that T is willing
to accept $4,000 for his equity, the cash payment to him would
be recorded by the following entry:
T capital 4,000
Cash 4,000
The remaining balance in T's account would then be apportioned
to R and S, if they share profits equally, in the following manner:
T capital 1 ,000
R capital 500
S capital 500
Liquidation. When dissoluton is accompanied by liquidation,
the affairs of the partnership are terminated and the books are
closed. After the firm's debts are paid and the partnership
assets are converted into cash, the procedure for the distribution
of assets is as follows:
1. Distribute all profits or losses arising from operations or
from liquidation
2. Distribute cash to each partner for the amount of his equity
as shown by his capital account
The proceeds from liquidation may be distributed among the
partners by a single payment, or the payments may be distrib-
uted by installments. To better explain the procedure followed
when liquidation has been effected by a single payment, assume
the conditions of the following illustration.
150
ELEMENTS OF ACCOUNTING
[Chap. X
BALANCE SHEET OF A, J5, AND C
Cash $ 500 A capital $15,000
Sundry assets 24,500 B capital 7,000
C capital 3,000
$25,000
$25,000
Assume further, that the partners share profits and losses in the
following ratios: A, 50 per cent; 5, 25 per cent; and C, 25 per
cent. Assets other than cash are liquidated for $11,500. This,
when added to the $500 in the balance sheet, amounts to $12,000
available for payment to the partners. Hence the loss from
liquidation is $13,000.
This loss together with the distribution of assets may be shown
as follows:
Capital
Share of
Loss
Payment
4
$15,000
$ 6,500
$ 8,500
B
7,000
3,250
3,750
C
3,000
3,250
-250
Total
$25 , 000
$13,000
$12,000
If C pays the $250 owed to the firm, A and B will receive the
amounts indicated in the table. If, however, C is unable or
unwilling to pay this amount, the $250 will be treated as a loss
and divided between A and B in proportion to their adjusted
profit-and-loss ratios. In this event C no longer shares profits or
losses, and the adjusted ratio for A is 66% (50 per cent of the
changed total, 75 per cent, instead of 100 per cent), and for B is
33)^ (25 per cent of the changed total, 75 per cent). The dis-
tribution of C's deficiency may be shown in the following tabular
form:
Capital
Loss
Assets
C"s Deficiency
Payment
A
$15,000.00
7,000.00
3,000.00
$ 6,500.00
3,250.00
3,250.00
$ 8,500.00
3,750.00
-250.00
$166.67
83.33
$ 8,333.33
3,666.67
B
C
Total...
$25,000.00
$13,000.00
$12,000.00
$250.00
$12,000.00
The journal entry necessary to show the realization of cash
from the assets sold is
Chap. XI INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 151
Cash 11,500
Sundry assets 11 ,500
To distribute the loss from liquidation
A capital 6,500
B capital 3,250
C capital 3,250
Sundry assets 13,000
If C pays his capital deficiency,
Cash 250
C capital 250
Cash would then be distributed between the partners as
follows :
A capital 8,500
B capital 3,750
Cash 12,250
If C did not pay his capital deficiency of $250, this amount
would be distributed between A and B as follows:
A capital 166.67
B capital 83.33
C capital 250. 00
The final payment of cash available for distribution (if C did
not make the payment of $250) would be
A capital 8,333.33
B capital 3,666.67
Cash 12,000.00
Liquidation by Installments. Distribution of partnership
assets by installments presents a difficulty not found when
liquidation is accomplished by a single payment. Distribution
of installment proceeds should be made in such a manner as to
avoid overpaying a partner at any time. This difficulty arises
when the profit-and-loss-sharing ratio differs from the ratio of the
partners' capital contributions.
Suppose, for example, that the balance sheet of X, F, and Z
is as follows:
Assets $30,000 X capital $ 5,000
7 capital 8,000
Z capital 17,000
$30,000 $30,000
152
ELEMENTS OF ACCOUNTING
[Chap. X
Profits and losses are shared equally. Assets are realized in the
following order:
Installment 1 $ 6,000
Installment 2 9,000
Installment 3 (final) 12,000
$27,000
In order to avoid overpaying a partner, the distribution of
installment proceeds is made on the assumption that all assets
may be lost. Thus, the possible loss after realizing the first
installment of $6,000 is $24,000 ($30,000 - $6,000).
The distribution of the first installment may be shown as
follows:
Capital
Possible
Loss
Share of
Installment
Distribution
of Capital
Deficiencies
Payment
x
$ 5,000
$ 8,000
-$3,000
Y
8,000
8,000
z
17,000
8,000
9,000
$3,000
$6,000
Total
$30,000
$24,000
$6,000
$3,000
$6,000
Since X's capital investment is exceeded by his share of the
possible loss, he receives no portion of the installment otherwise
he would be overpaid. His capital deficiency (the excess of the
possible loss over his capital) cannot be distributed between Y
and Z, since Y'a possible loss is equal to his capital investment.
Therefore, the total amount of the installment is paid to Z, and
X's deficiency is set against the excess of Z's capital over his
possible loss.
The second installment would be distributed as follows:
Capital
Possible
Loss
Share of
Installment
Payment
X
$ 5,000
$ 5,000
o
Y
8,000
5,000
$3,000
$3,000
Z
11,000
5,000
6 000
6 000
Total
$24,000
$15,000
$9 000
$9 000
Chap. X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 153
The final payment would be apportioned in the following
manner:
Capital
Loss
Payment
X $5,000 $1,000 $4,000
Y 5,000 1,000 4,000
Z 5,000 1,000 4,000
Total $15,000 $3,000 $12,000
In journal form, the distribution of the three installments
would be recorded as follows:
Cash 6,000
Sundry assets 6,000
To record the receipt of cash available for the
payment of installment 1
Z capital 6,000
Cash 6,000
To record the distribution of installment 1
Cash 9,000
Sundry assets 9,000
To record the receipt of cash available for the
payment of installment 2
Y capital 3,000
Z capital 6,000
Cash 9,000
To record the distribution of installment 2
Cash 12,000
Sundry assets 12,000
To record the receipt of cash available for the
payment of installment 3
Loss from liquidation 3 , 000
Sundry assets 3,000
To record the loss from liquidation
X capital 1 ,000
Y capital 1 ,000
Z capital 1,000
Loss from liquidation 3 , 000
To distribute the loss from liquidation
X capital 4,000
Y capital 4,000
Z capital 4,000
Cash 12,000
To record the payment of the final i
154 ELEMENTS OF ACCOUNTING [Chap. X
Questions
Review.
1. In what respects is the individual proprietorship superior to the partner-
ship or the corporation?
2. Wherein is the partnership form of organization preferable to the sole
proprietorship? To the corporation?
3. Are articles of partnership essential to the operation of a partnership?
Are they advisable? Why?
4. Enumerate important points to be included in the articles of partnership.
6. Distinguish between a share in the profits and a share in the business
of a partnership. Why is this distinction important?
6. Distinguish between the function of the partners' capital accounts and
of their personal accounts.
7. Argue in defense of treating salaries and interest on capital balances of
the partners as a distribution of profit.
8. In the absence of any agreement among the partners, how are profits
and losses distributed among them?
9. Distinguish between dissolution and liquidation.
10. Enumerate the principal causes for dissolution.
11. In what order should claims to the assets of the partnership be paid in
the event of liquidation?
12. What is the basis for the distribution of assets among the partners upon
liquidation?
Discussion.
13. What type of a record is made on the books of a partnership when the
equity of a partner is bought
a. By a new partner
6. By an existing member of the firm
c. From firm funds
14. A and B are partners sharing profits and losses equally, with capital
account balances of $10,000 and $7,500, respectively. C is admitted to
a one-third interest in the partnership by a payment of $5,000. What
entry should be made if
a. A and B are willing to admit C for this amount because they feel that
his presence in the business is worth the difference between what he
pays and the book value of the share acquired.
b. C is admitted at this figure solely because the firm needs cash.
If C paid $12,000 for a one-third interest, what entry would be made
a. If goodwill is recorded
b. If goodwill is not recorded
Suggested Supplementary Readings
FINNEY, H. A.: "Introduction to Principles of Accounting," Chaps. 10
and 17, Prentice-Hall, Inc., New York, 1938,
Chap.X] INDIVIDUAL PROPRIETORSHIP, PARTNERSHIP 155
HATFIELD, H. R., "Accounting," Chaps. 19 and 20, D. Appleton-Century
Company, Inc., New York, 1927.
HUSBAND, G. R., and O. E. THOMAS: "Principles of Accounting," Chaps.
19-21, Houghton Mifflin Company, Boston, 1935.
MACFARLAND, G. A., and R. D. AYARS: "Accounting Fundamentals,"
Chaps. 21 and 22, McGraw-Hill Book Company, Inc., New York, 1936.
McKiNSEY, J. O., and H. S. NOBLE: "Accounting Principles," Chaps. 16
and 17, South- Western Publishing Company, Cincinnati, 1939.
PATON, W. A. : " Essentials of Accounting," Chaps. 31 and 32, The Macmillan
Company, New York, 1938.
CHAPTER XI
CORPORATIONS
Many of the accounting problems of corporations, like those
of individual proprietorship and partnerships, are directly con-
cerned with the proper valuation of net worth. There is
considerable difference, however, between the net worth of a sole
proprietorship or a partnership and that of a corporation. This
distinction lies in the fact that the corporation, unlike the other
two organizations, is a legal entity, a being quite apart from those
who own or manage it. The corporation entity owns the assets
of the business, and the stockholders in turn own the corporation.
Corporate Proprietorship. The proprietorship of the corpora-
tion consists of the outstanding capital stock and surplus. The
former represents the investment of the stockholder, an interest
which cannot be withdrawn at will. It may properly be con-
sidered as a protection to the creditors, for in the event of liquida-
tion all creditors' claims are settled before any portion of the
stockholder's investment is returned to him.
Surplus, the other portion of corporate proprietorship, is
measured by the excess of assets over the sum of liabilities and
capital stock of the corporation. Unlike capital stock the invest-
ment in surplus may, under conditions to be discussed later, be
withdrawn from the corporation and distributed among the
stockholders.
Definition. Among the many definitions of corporations, that
of Chief Justice Marshall 1 is frequently cited.
A corporation is an artificial being, invisible, intangible, and existing
only in contemplation of law. Being the mere creature of law, it pos-
sesses only those properties which the charter of its creation confers upon
it, either expressly or as incidental to its very existence. These are such
as are supposed best calculated to effect the object for which it was
created. Among the most important are immortality, and, if the
expression may be allowed, individuality; properties, by which a per-
1 Dartmouth College v. Woodward, 4 Wheat. (U. S.) 518, 636, 4L. ed. 620,
156
Chap. XI) CORPORATIONS 157
petual succession of many persons are considered as the same, and may
act as a single individual. They enable a corporation to manage its
own affairs, and to hold property, without the perplexing intricacies,
the hazardous and endless necessity, of perpetual conveyances for the
purpose of transmitting it from hand to hand. It is chiefly for the
purpose of clothing bodies of men, in succession, with these qualities
and capacities, that corporations were invented, and are in use. By
these means, a perpetual succession of individuals are capable of acting
for the promotion of the particular object, like one immortal being.
Important characteristics to be noted in the corporation are
its limited liability, its continuity of organization, and its adapta-
bility to the requirements of large-scale operations.
When Desirable as a Form of Organization. Probably the
greatest advantage of the corporate organization over the sole
proprietorship or partnership is that of limited liability. In both
the individual proprietorship and the partnership the personal
property of the owners can be used for the satisfaction of business
debts. Ordinarily, in the event of failure, the stockholder of a
corporation does not lose more than the par, or nominal, value
of his stock. Stockholders in bank, insurance, or other fiduciary
concerns are frequently liable for twice this amount, and in some
cases this liability has been placed at three times the par value of
the stock. The purpose of this extra precaution is to afford
additional protection to creditors when the enterprise occupies a
position of public trust.
Another important feature of the corporation is its continuity
of existence. The individual proprietorship and the partnership
terminate upon the death or retirement of a member, but the
life of the corporation is not affected by the incapacity of a stock-
holder. For certain types of enterprises (banks, railroads,
and insurance companies, for example) this may be of great
significance.
The fact that the interests of stockholders can be transferred
with greater ease than in either a sole proprietorship or partner-
ship makes the corporation especially adaptable to large-sized
enterprises. Furthermore the lack of restrictions upon the num-
ber of stockholders facilitates raising large amounts of capital.
In still another respect the corporation is well suited to large-
scale industry: it is especially adapted to functionalized manage-
ment. Ownership in the corporation is vested in the stockholders,
BLEMMfs OF ACCOUNTING (chap, xi
who elect a board of directors charged with the responsibility of
management. The directors elect officers, who in turn employ
others. The general policies formulated by the board are
executed under the direction of the corporate executives. Under
this form of control it is possible to secure the services of men
best fitted for the required tasks.
Steps in the Formation of a Corporation. The scope of the
functions that may be exercised by the management depends
largely upon the statutory law of the state in which the enter-
prise is incorporated. Since these laws vary considerably, it is
quite common for an enterprise to incorporate in a state which
grants liberal rights and powers and to carry on most of its busi-
ness in other states. After selecting the state in which the enter-
prise is to be incorporated, the principal steps to be taken in its
formation are as follows:
1. The incorporators draft a charter in accordance with the
state regulations. In this, such data as the name of the
business, its location, its purpose, the nature of its capitaliza-
tion, the names and addresses of subscribers, and the names
and addresses of directors chosen previous to the first annual
meeting of the stockholders are included. This applica-
tion, accompanied by the necessary f ees ; is sent to the proper
state officer, usually the Secretary of State.
2. If the application is approved, the official charter or articles
of incorporation are returned to the incorporators. Copies
are filed in the proper state offices.
3. The stockholders hold a meeting for the acceptance of
the charter and the formulation and adoption of the
bylaws (regulations governing internal management of the
corporation).
4. A directors' meeting is held, at which time a president,
vice-president, secretary, and treasurer are chosen, and
arrangements are made for initiating the affairs of the
enterprise.
Distinctive Corporate Records. If the corporation is of suffi-
cient size, the ordinary accounting books used by the sole pro-
prietorship or partnership may be inadequate. The corporation
may need special records to care for its requirements. 1
1 This section conveys only a general impression of distinctive corporate
Chap. XI] CORPORATIONS 159
Among these distinctive records is the minute book. It is a
memoranda record of stockholders' and directors' meetings,
particularly valuable for accounting purposes because it presents
a history of the corporation, resolutions passed and actions taken.
Frequently it furnishes the authority for journal entries relating
to the declaration and payment of dividends, the issue of stocks
or bonds, and other matters requiring action of the board of
directors. Furthermore, from the data in the minute book, one
is able to determine the legality of actions taken by the directors,
i.e., whether they are in accordance with the corporate charter
and the bylaws.
For the most part other books peculiar to the corporation con-
sist of those required for keeping suitable records of stockholders 7
interests. If the stock is sold widely by subscription, a subscrip-
tion journal is often used. This is a special journal in which data
relating to the stock subscriptions are recorded. Appropriate
rulings include provisions for the date of subscription, the name
of the subscriber, the amount subscribed, and the terms of pur-
chase. Summary postings are made to the control account
subscribers in the general ledger, and daily postings are made to
the accounts of the individual subscribers.
The subscribers controlling account in the general ledger is
supported by the subscription ledger which contains an account
for each subscriber to the capital stock of the corporation. The
individual subscribers' accounts are ruled much the same as is
the ordinary ledger account. Space is provided for the date of the
transaction, the number of shares subscribed, the purchase price
and par value of the stock, and the date and amount of payments.
When the subscriptions are paid and the stock is issued, if the
volume of such transactions warrant r a stock certificate book may
be used. This special journal contains pertinent data relating
to the issue of the stock; essentially it records the receipt of cash
and the issue of the stock. Postings, by totals, are made from
this journal to the controlling account capital stock, and daily
postings are made to the individual stockholder's account.
These accounts appear in the capital stock ledger as subsidiary to
the controlling account capital stock. Each account shows the
records. Discussion in greater detail may be found in the accounting texts
listed at the end of this chapter.
160 ELEMENTS OF ACCOUNTING [Chap. XI
date of issue, the number of shares owned, the par value, and the
purchase price of the stock.
Among the other special books frequently used, the stock
transfer book shows data relating to the transfer of shares, the
date of transfer, the serial number of the stock exchanged, and
the date of exchange.
Sale of Stock for Cash. Ordinarily, the first transaction to be
recorded is the sale of capital stock. If we assume that the
corporation is organized with a capitalization of 1,000 shares of
stock, par value $100, and that each of the three organizers, A, B,
and C buys 250 shares for cash, this would be journalized as
follows:
Cash 75,000
Capital stock 75,000
If it is desired to show the amount and nature of the capitaliza-
tion, this may be accomplished by a dated memoranda in the
journal similar to the following:
The Corporation, organized under the laws of Pennsylvania,
received its charter dated as of The authorized capital stock consists
of 1,000 shares of common stock, par value $100.
Or, if a memoranda in the journal is not considered sufficient, the
data may be entered in the ledger with this entry:
Capital stock unissued 100,000
Capital stock authorized 100,000
Despite the fact that this entry appears in the ledger, it has little
more significance than a memoranda item. The account capi-
tal stock unissued merely indicates that the corporation has
the right to issue stock to the amount shown in the account.
Unissued capital stock can never be properly considered an
asset. The account capital stock authorized is likewise a mem-
oranda account and cannot be considered part of proprietorship
since no investment has been made.
When the stock is sold and certificates are issued, the following
entry is made:
Cash 75,000
Capital stock unissued 75,000
After this entry has been posted, these account balances will
appear in the net worth section of the balance sheet as follows;
Chap. XI) CORPORATIONS 161
Capital stock:
Authorized $100,000
Less unissued 25,000
Issued and outstanding $75,000
Premium and Discount. When the stock is sold at more or
less than its par value, this fact must be noted in the accounts,
since the law specifies that if the capital stock has a par value, it
must be shown in the account figures. The usual procedure is to
record any excess over par to an account premium on stock and
to record any amount less than par in an account discount on
stock. If, for example, D bought 10 shares of stock at 103 and
E bought 10 shares at 98, D's purchase would be recorded as
follows:
Cash 1,030
Premium on stock 30
Capital stock 1 ,000
E's purchase would be recorded:
Cash 980
Discount on stock 20
Capital stock 1 ,000
In the balance sheet, premium on stock is an addition to, and
discount on stock a deduction from, the par value of capital
stock outstanding.
Subscriptions. If subscriptions to capital stock are taken and
payments are made later, a record is made of the claims against
the subscribers. In order to illustrate this, assume that F
subscribes for 20 shares of stock at 90 and pays for the subscrip-
tion one month later. This will be recorded as follows :
Subscribers (F) 1 ,800
Discount on stock 200
Capital stock subscriptions 2 , 000
The subscriber's account is an asset, a claim for the amount
he has agreed to pay. This claim should, of course, be stated at
the amount collectible from him if the stock is sold at a price
other than par. In the event of bankruptcy the subscriber is
liable for an amount equal to the par value of the stock if it has
been sold at a discount.
The capital stock subscription account is an item of proprietor-
ship, of temporary status, pending the payment of the subscrip-
162 ELEMENTS OF ACCOUNTING [Chap. XI
tion, at which time the proprietorship is changed to one of a more
permanent character. The following entry shows the payment
of the subscription:
Cash 1 ,800
Subscribers (F) 1 ,800
The entry to show the issue of stock is
Capital stock subscriptions 2 , 000
Capital stock 2,000
Installment Subscriptions. The subscription agreement may
permit the subscriber to pay for stock by installments. Assume
that G subscribes for 50 shares of stock at par on March 1 and
that half is to be paid when the subscription is taken, the balance
to be paid in two equal monthly installments due April 1 and
May 1. On March 1 the initial payment and the balance to be
paid will be recorded by the following entry:
Cash 2,500
Subscribers (G) 2,500
Capital stock subscriptions 5,000
When the notice of the first installment is given, the following
entry will be made:
Installment 1 1 ,250
Subscribers 1 ,250
When the first installment is paid, it is recorded as follows:
Cash 1 , 250
Installment 1 1,250
The notice of the second installment and its subsequent pay-
ment w.ould be similarly recorded.
The installment account has the same status as that of the
subscriber's account, i.e., it is an asset, a claim against individuals
for amounts due the corporation. When the subscriptions are
fully paid and the stock certificates are issued, the following entry
is made:
Capital stock subscriptions 5 , 000
Capital stock 5,000
Defaulted Subscriptions. When a subscriber fails to sustain
the terms of his subscription agreement and defaults in his pay-
Chap. XI] CORPORATIONS 163
ments, the corporation still has a claim. Some states permit it
to retain all that has been paid in; others require that the stock
be sold and that any amount realized in excess of the corporation's
equity be returned to the defaulting stockholder. To illustrate
the necessary entries, assume that / subscribed for two shares of
stock at par to be paid in two equal installments. The first
payment was made but the second was defaulted. The entry to
record the subscription would be as follows:
Subscribers (J) 200
Capital stock subscriptions 200
The initial payment would be recorded as follows:
Cash 100
Subscribers (/) 100
If the corporation retained all that had been paid in, the entry
would be as follows:
Capital stock subscriptions 200
Subscribers (/) 100
Surplus from forfeited subscriptions 100
By this entry the capital stock subscription and the subscriber's
account are cleared. The account surplus from forfeited sub-
scriptions is an item of capital surplus (see page 172), to be con-
sidered as a permanent investment comparable to capital stock.
It should not be treated in the same manner as earned surplus
available for distribution among stockholders.
If the stock is sold on the market at 95 and the amount realized
in excess of the corporation's equity is returned to the defaulting
subscriber, the entry will be
Cash 190
Subscribers (/) 10
Capital stock 200
The discount is, of course, an item chargeable to J. In order to
show the settlement by cash of the defaulted subscription, the
following entry should be made:
Capital stock subscriptions 200
Subscribers (./) 110
Cash 90
Within the limits permitted by law, the corporation may deter-
mine its own policy. It might, for example, issue stock equal in
164 ELEMENTS OF ACCOUNTING [Chap. XI
value to the payments received. In the case under discussion, J
would then receive one share of stock and the balance of his
subscription would be canceled. Again, it might be the policy of
the corporation, as a matter of maintaining good public relations,
to return all the payments that had been made.
Treasury Stock. In one respect the accounting treatment of
defaulted stock is similar to that of stock acquired by the corpora-
tion either through purchase or donation. Ordinarily any sur-
plus arising from either transaction is an item of capital surplus
(see page 172). 1
Treasury stock may be defined as those shares of the corporation
which after issue have been reacquired through purchase or
donation and which are held in the company's treasury. It is
similar to unissued stock in that both are shown in the balance
sheet as a deduction from capital stock authorized. Outstanding
capital stock is the amount in the hands of stockholders; hence
any stock reacquired constitutes a retirement of the outstanding
stock. Like unissued stock, treasury stock is a means of raising
capital, not an asset.
If unissued stock is sold at a discount, the purchaser may, in
the event of failure, lose not only what he has paid in but he may
also be required to pay the amount of the discount. If treasury
stock is sold below par, however, it is generally considered to be
fully paid and nonassessable and the purchaser incurs no subse-
quent liability for the discount. 2
In order to illustrate the accounting procedure for treasury
stock, suppose that a corporation with outstanding capital stock
of $100,000 received a donation of 100 shares (par 100) from its
stockholders for the purpose of raising working capital.
1 In some states the accounting treatment of treasury stock is influenced
by legal restrictions. For example, in California a corporation which pur-
chases its own stock is required by law to charge the purchase price of the
stock to earned surplus.
2 This is the common interpretation. Hatfield questions its accuracy.
His argument is as follows: "This, however, is probably incorrect except
where the stock has been donated to the corporation. Thus, if stock issued
at par was reacquired by the corporation at 90, to sell it at less than 90 would
work an actual reduction of the contributed capital. If sold at 90 or above
the protection which the creditors of the company have a right to assume
will be fully maintained." Hatfield, H. R., "Accounting," p. 183, D.
Appleton-Century Company, Inc., New York, 1927.
Chap. XI] CORPORATIONS 165
This transaction is journalized by the following entry:
Treasury stock 10,000
Donated surplus 10,000
The net worth section of the balance sheet would then appear
as follows:
Capital stock authorized $100,000
Less treasury stock 10,000
Capital stock outstanding $ 90 , 000
Donated surplus 10,000
$100,000
If, now, the treasury stock cannot be sold at par but instead is
sold at 95, this will be recorded as follows:
Cash 9,500
Donated surplus 500
Treasury stock 10,000
In a somewhat similar manner, capital surplus may arise if
the corporation purchases its own stock. Assume that a corpora-
tion buys 25 shares of its own stock at 95. This is journalized as
follows:
Treasury stock 2,500
Surplus from the purchase of treasury stock. . . . 125
Cash 2,375
If the stock is later sold at 105, the following entry will be made:
Cash 2,625
Surplus from the sale of treasury stock 125
Treasury stock 2,500
In each case the surplus in question is capital surplus, and it
arises because of the difference between the par value of the stock
and the price paid or received for it.
No-par Stock. So far the discussion has been limited to stock
having a par value. Beginning with New York in 1912, most
states have enacted laws which now permit corporations to issue
stock without par value.
It was thought by those proposing the change that the removal
of nominal valuations on corporate shares would better reflect
true values than par value stock, because it would remove any
implication, in the minds of investors, that a share of stock was
166 ELEMENTS OF ACCOUNTING [Chap. XI
worth its par value. This expectation has not been realized
for the devise of no-par stock has failed to curb the ingenuity of
promoters and managers in issuing " watered stock." 1
In general, when no-par stock is sold, whatever amount is
received from the stockholder is usually carried directly to the
capital stock account. This simplifies the accounting procedure
in that it eliminates the necessity for stock discount and premium
accounts. For example, if a corporation sells 1,000 shares of
no-par stock at 45, the entry to record this will be
Cash 45,000
Capital stock common, no par 45,000
The laws of some states permit or require the board of directors
to specify a stated value for no par stock. This introduces slight
difficulty since the accounting procedure is similar to that of par
value stock. If, for example, the stated value on the stock in the
previous illustration amounted to $40, the entry to record the
sale of the stock would be
Cash 45,000
Paid-in surplus 5 , 000
Capital stock 40,000
Common and Preferred Stock. The discussion so far has been
concerned only with common stock. There are, of course,
numerous types of storks classified in various ways. The most
usual as well as the most important divisions are common and
preferred. Common stock is the ordinary stock of the corporation.
Its holders assume the greatest risk in the event of failure; their
income return is a residual one in that the claims of creditors and
stockholders having prior rights must first be satisfied; and,
finally, it is ordinarily only the common stockholders who have
the right to vote.
Preferred stock usually carries a prior claim on the assets of the
corporation in the event of failure; it generally carries a prior
right to dividends before distribution is made to common stock-
holders; and only in unusual cases do the holders of preferred
l The term "watered stock" is frequently used in financial parlance.
Its meaning is not always clear. The evil in its use, however, lies in the
fact that asset values are overstated. For example, if capital stock is
issued to the amount of $500,000 in payment of factory property actually
worth only $400,000, the stock has been "watered," or falsely stated, to
the Amount of $100,000,
Chap. XI] CORPORATIONS 167
stock vote. In general the differences between common and
preferred stocks are specified by law or in the certificate of the
preferred stock. 1
The accounting procedure for different types of stock does not
vary greatly. The primary consideration is to identify each
type of stock by means of proper account titles and to separate
carefully all entries relating to each class of stock from those of
others.
Bonds. Despite the fact that legally, preferred stock is an
equity of ownership, practically it is similar to bonds as an instru-
ment of borrowing. As previously defined (see page 16), a
bond is a formal written promise, under seal, to pay a definite
amount, with interest, at some determinable future date. Bonds
are often used in preference to preferred stock because the issuing
corporation is able to secure funds at a lower rate of interest,
since the investors believe they are accepting a correspondingly
lower risk.
No attempt will be made to enumerate the multiplicity of
types. The general accounting procedure for bonds is the same,
regardless of type. Care should be taken, however, to keep all
entries relating to a given issue distinct from those of other issues.
One frequently used method of classifying bonds is to place
them into two groups according to the type of security and
according to the method of paying interest. They may be
secured by specific physical properties, as a general first-mortgage
bond; they may be secured by pledging other securities as a
collateral trust bond; and, finally, they may have no specific
security other than the promise of the issuing corporation as,
for example, debenture bonds.
1 Among the different typos of preferred stock, the following are especially
important: cumulative before dividends can be paid to the common stock-
holders not only the current dividend must be paid to the preferred stock-
holders but also all dividends in arrears; noncumulative if dividends are
not paid for the current year, the corporation is under no obligation to
ever pay them; participating if the stock is participating preferred, it
shares with common stock in any extra amount of dividends paid after the
common stock has received a dividend equal to that paid the preferred
stockholder; convertible preferred stockholders may, under the terms of the
agreement with the corporation, convert their preferred stock, if they wish,
into common stock of the corporation, or, in rarer cases, into corporate
bonds.
16$ ELEMENTS OF ACCOUNTING [Chap. XI
On the basis of the method of paying, bonds are usually classi-
fied as registered and coupon. A registered bond is recorded in
the name of the owner, and the interest and principal is paid to
the owner of record. In contrast the interest and principal on
coupon bonds are paid to whoever presents the properly dated
coupons. 1
The principal accounting entries for bonds may be illustrated
by assuming an issue authorized for $100,000, with arrangements
made to market them through an investment banker. The
authorization of the bonds may be recorded by the following
entry:
Unissued general first mortgage 5 per cent
bonds 100,000
General first mortgage 5 per cent bonds
authorized 100,000
If the entire issue was sold outright to an investment banker
and his firm assumed the responsibility for marketing the obliga-
tions, the following entry would be made upon delivery of the
bonds to the investment house:
Investment bank 100,000
Unissued general first mortgage 5 per cent
bonds 100,000
If the bonds are sold to the banker at par, the following entry
will be made upon receipt of cash:
Cash 100,000
Investment bank 100,000
Following this an entry will then be made to recognize the
bonds outstanding:
General first mortgage 5 per cent bonds
authorized 100,000
General first mortgage 5 per cent bonds
outstanding 100,000
Instead of handling the securities through an investment
banker, the issuing corporation may sell its bonds directly to
1 For an extended discussion of the many types of bonds, see A. S. Dewing,
"Financial Policy of Corporations," Chaps. 4r-8, The Ronald Press Com-
pany, New York, 1926.
Chap. XI] CORPORATIONS 169
the public. If, in this event, A subscribed to $20,000 worth of
bonds at 95, this would be recorded as follows:
Bond subscriber (A) 19,000
Discount of general first mortgage 5 per cent bonds 1,000
General first mortgage 5 per cent bond subscriptions 20,000
When the bonds are fully paid by A, the following entry will
be made:
Cash 19,000
Bond subscriber (A) 19, 000
Delivery of the bonds to A will be designated by the following
entry:
General first mortgage 5 per cent bond subscriptions 20,000
General first mortgage 5 per cent bonds outstanding .... 20 , 000
To illustrate the sale of bonds at a premium, assume that
$10,000 worth are sold to B at 105. The entry to record the
cash sale will be
Cash 10,500
Premium on general first mortgage 5 per cent bonds .... 500
General first mortgage 5 per cent bonds outstanding .... 10 , 000
Bond Interest. The discount and premium on bonds must
be considered in computing the interest cost. Bond premium or
discount arises because the nominal or stated rate of interest
in the bond does not agree with the market rate which investors
place on the risk. If an issue of $100,000, 20-year 4 per cent
bonds brings only $80,000 when sold, the investors have evaluated
the risk at 5 per cent. 1
Despite the fact that the corporation received only $80,000,
it will have to pay $100,000 to the bondholders at the end of 20
years. The $20,000 difference between the par value of the issue
and the amount realized may properly be considered part of the
interest cost, incurred because the rate stated in the bond was too
low. It should be apportioned or amortized over the life of the
issue to determine the annual addition to the amount of interest
1 An annual yield of $4,000 (4 per cent of $100,000) divided by $80,000,
the amount actually invested, results in a return of 5 per cent.
170 ELEMENTS OF ACCOUNTING [Chap. XI
paid to the bondholders. 1 The entry to record the issue of bonds
in the illustration under discussion would be
Cash 80,000
Discount on bonds outstanding 20, 000
Bonds outstanding 100,000
If interest is paid semiannually, the current interest payment
and the proper amount (one-fortieth, on a semiannual basis) of
bond discount may be apportioned to the period by the following
entry:
Bond interest 2,500
Discount on bonds outstanding 500
Cash 2,000
Similar entries will be made every six months until the end of
the 20-year period. When the bonds mature, if they are retired
at par, the following entry will be made :
Bonds outstanding 100,000
Cash 100,000
Similarly, if the bonds are sold at a premium, the premium is
amortized over the life span of the bond and subtracted from the
current interest charge. If, for example, the bonds under
discussion sold for 110, the sale would be recorded as follows:
Cash 110,000
Bond premium 10 , 000
Bonds outstanding 100,000
The semiannual interest charge may be journalized in the
following manner:
Bond interest 1 , 750
Bond premium 250
Cash 2,000
In the balance sheet, bond premium or discount is an addition
to or a deduction from the maturity value of the bonds. The
liability for the bonds, while shown at the maturity or legal
value, carries an adjustment to this amount equal to the premium
or discount.
Profit Distribution. Corporate earnings are distributed to
stockholders by the declaration and payment of dividends. The
1 In order to simplify the explanation, compound interest has been ignored.
Chap. XI] CORPORATIONS 171
term " dividends' 7 is used in various ways. It may refer to the
rate at which the distribution of profit is made to stockholders,
to the payment received by the stockholders, or to the amount
owed by the corporation to the stockholders.
Once declared, dividends become a liability of the corporation.
If, for example, the directors declared dividends at the rate of 5
per cent on 1,500 shares (par $100) of common stock, this would
be journalized as follows:
Surplus 7, 500
Dividends payable (common) 7 , 500
While the charge for dividends is ordinarily made to surplus,
it is sometimes made to profit and loss.
Upon payment of the liability in cash, the following entry
would be made:
Dividends payable (common) 7,500
Cash 7,500
It should be noted that there are two distinct problems pre-
sented by dividends. One is a problem of the proper administra-
tion of income. Even though the profits are adequate for the
declaration of extra dividends, it may be prudent to withhold
them from distribution it may be desirable to retain profits
in the business in order to provide for a margin of safety in
maintaining a regular dividend rate a precaution particularly
important in enterprises subject to fluctuating earnings. Again,
accumulated profits may be earmarked for particular purposes
(see page 173) or to provide for possible future losses.
The second problem of dividends is that of deciding the wisdom
of incurring a liability which will subsequently decrease cash.
Although dividends are usually paid in cash, other methods are
used. Script (written promises of the corporation to pay the
dividend at a later date) is sometimes used to postpone the cash
settlement of the liability.
From the standpoint of conserving cash, stock dividends are
even more effective than script as a means of settling dividend
liabilities. For example, in the illustration just used, if a stock
dividend was given in settlement of the liability, the following
entry would be made:
Dividend payable (common) 7 , 500
Capital stock (common) 7,500
172 ELEMENTS OF ACCOUNTING [Chap. XI
From the stockholder's point of view his proportionate share
in the total assets of the corporation remains the same. He holds
more shares of stock, but each share has a book value less than
before the dividend was paid. From the standpoint of the
corporation there has been no change in the total net worth
of the business, although surplus has been decreased and capital
stock increased by an equal amount.
Still another method, rarely employed, is the payment of
dividends in property of the corporation.
Surplus. As previously mentioned, the prudent administra-
tion of income may lead the directors to retain earnings within
the corporation. Records of these earnings appear, for the most
part, in some type of an earned surplus account. There are
two principal types of surplus : earned and capital.
Earned surplus has been defined as "the balance of the net
profits, net income, and gains of a corporation after deducting
losses and after deducting distributions to stockholders and
transfers to capital-stock accounts." 1 In general then this
surplus consists of accumulated profits either from ordinary
business operations or from unusual gains such as the sale of
fixed assets. It is the surplus into which the profit or the loss
for the period is closed.
Capital surplus "comprises paid-in surplus, donated surplus
and revaluation surplus that is, surplus other than earned
surplus; surplus not arising from profits of operation but from
such sources as sale of capital stock at premium, profit on dealings
in a corporation's own stock, donated stock, appraisal valuations
and surplus shown by the accounts at organization." 2
Ordinarily a distinguishing feature between earned and capital
surplus is the permanency of the net worth item. Earned
surplus is subject to numerous changes; dividends, operating
deficits, and adjustments for losses not applicable to the current
fiscal period are examples of deductions from the accumulated
earnings recorded in this account. In contrast, an item of
1 Committee on Definition of Earned Surplus of the American Institute of
Accountants.
a Preliminary Report of a Special Committee on Terminology of the
American Institute of Accountants, p. 118, D. Appleton-Century Company,
Inc., New York, 1931.
Chap. XI] CORPORATIONS 173
capital surplus once recorded is usually a relatively permanent
form of proprietorship.
Reserves. One of the problems of accounting for the adminis-
tration of income consists of the establishment and operation of
surplus reserves. The term " reserve" is commonly applied
to three distinct types:
1. Surplus (or proprietorship)
2. Valuation
3. Liability
A surplus reserve is a portion of earned surplus earmarked
for a specific purpose. Common examples of this type are
reserves for plant extensions, obsolescence, and contingencies.
The reserve is created by action of the board of directors and
may be transferred back to the general surplus account when the
board so desires. The journal entry to establish a reserve for
contingencies for $10,000 would be
Surplus 10,000
Reserve for contingencies 10,000
A valuation reserve shows the decline in the asset to which it
refers. The account reserve for depreciation, for example, shows
the recorded decline which, when deducted from the cost of the
asset, shows its book value.
The term liability reserve is commonly used to signify the
account of an estimated accrued liability. The federal income
tax is the example usually cited in explaining this type. If the
accounting period closes with the calendar year, the tax cannot
ordinarily be computed in sufficient time to know the amount.
Hence an estimate is made and an entry debiting surplus (the
tax is charged against profits, not operations) and crediting
reserve for Federal income tax is recorded in the journal The
reserve account is closed upon payment of the tax.
Sometimes a reserve account is set up for wages or other
accrued liabilities (with the corresponding charge to an expense
account, not surplus). When these liabilities are clearly deter-
minable, there is no reason why they should not be classified as
accrued liabilities. If the liability must be estimated, less con-
fusion results by classifying it as an estimated liability instead
of a so-called reserve.
174 ELEMENTS OF ACCOUNTING [Chap. XI
The expression secret reserve cannot properly be classified as
any type of an account since it refers to the absence of recorded
financial data. It results from the accounting practice of deliber-
ately understating the value of net assets of an enterprise with,
of course, an equivalent understatement of proprietorship.
Despite the fact that the practice of creating secret reserves is
widely used, it is to be condemned on the grounds that this device
fails to disclose the financial facts of an enterprise as accurately
as it is possible to show them.
Funds. A common error in popular usage of the term reserve
is to confuse it with a fund. A fund is a sum of money, or other
assets, set aside for a specific purpose. The use of a surplus
reserve may or may not be accompanied by the use of a fund.
The general procedure for using a fund with a surplus reserve
may be illustrated by a corporation having a contract with its
bondholders which provides for the payment of $15,000 annually,
on December 31, to trustees who then invest the funds. The
annual payment to the trustees would be recorded as follows :
Sinking fund 15, 000
Cash 15,000
Expenses incurred in operating the fund are deducted from any
income earned from the securities. Net earnings are shown as
income applicable to the current fiscal period. Disposition of the
net proceeds from the operation of the fund depends upon the
trust agreement the proceeds may be turned over to the fund
or retained by the company.
If the company wished to set up a surplus reserve at the same
time, the annual entry would be
Surplus 15,000
Reserve for sinking fund 15,000
When the bonds are paid, the reserve for sinking fund is closed
into surplus.
Change from a Partnership to a Corporation. Accounting
problems relating to corporate reorganization and consolidation
are often intricate; complicated transactions arise involving the
change in stockholders' equities when one class of stock is
exchanged for another. A problem commonly encountered in
shifting from one form of an organization to another is that
Chap. XI] CORPORATIONS 175
presented by the change from a partnership to a corporation.
The technique of closing the books of the partnership and
transferring all asset, liability, and proprietorship accounts to
the books of the corporation may best be shown by an illustration.
Assume that A and B, equal partners, decide to change their
partnership to a corporation with a capitalization of $100,000.
All assets and liabilities of the partnership are taken over by the
corporation. A and B are to receive $90,000 par value in com-
mon stock for their business, it being agreed that their proprie-
torship is worth this amount. C, the third incorporator, buys
20 shares at par for cash. Assume further that the balance
sheet of A and B appears as follows:
Assets Liabilities and Proprietorship
Cash $ 5,000 Accounts payable $ 15,000
Accounts receivable 25,000 Notes payable 5,000
Merchandise 50,000 A capital 40,000
Building 15,000 B capital 40,000
Land 5,000
Total $100,000 Total $100,000
Since A and B receive $90,000 for a recorded equity of $80,000,
the difference may be considered goodwill. This asset is recorded
as follows :
Goodwill 10,000
A capital 5 , 000
B capital 5,000
The appropriate entries to transfer the assets of the partnership
to the corporation will be
A, B, and C Corporation 110,000
Cash 5,000
Accounts receivable 25 , 000
Merchandise 50,000
Building 15,000
Land 5 , 000
Goodwill 10,000
Liability and proprietorship accounts are closed by the fol-
lowing entry:
Accounts payable 15 , 000
Notes payable 5,000
A capital 45 ,000
B capital 45,000
A, , and C Corporation 110,000
176 ELEMENTS OF ACCOUNTING [Chap. XI
On the books of the A, 5, and C Corporation, the following
entry will be made to record the transfer of the assets of the
partnership:
Cash 5 , 000
Accounts receivable 25,000
Merchandise 50,000
Building 15,000
Land 5,000
Goodwill 10,000
A and B partnership 110,000
The entry to record the assumption of the partnership lia-
bilities and the issue of common stock to A and B will be
A and B partnership 110,000
Accounts payable 15,000
Notes payable 5,000
Capital stock common 90 , 000
The cash sale of stock to C will be recorded by the following
entry:
Cash 2,000
Capital stock 2,000
The balance sheet of the corporation will then appear as
follows:
Assets Liabilities and Proprietorship
Cash $ 7,000 Accounts payable $ 15,000
Accounts receivable 25 , 000 Notes payable 5 , 000
Merchandise 50 , 000 Capital stock common ... 92 , 000
Building 15,000
Land 5,000
Goodwill 10,000
Total $112,000 Total $112,000
Questions
Review.
1. Distinguish between the proprietorship of a partnership and the pro-
prietorship of a corporation.
2. Enumerate three important characteristics of the corporation.
3. Under what conditions is the corporation preferable to the individual
proprietorship and the partnership form of organization?
4. What are the steps hi the formation of a corporation?
$ Enumerate five distinctive corporate records,
Chap. XII CORPORATIONS 177
6. Is unissued capital stock an asset? Explain.
7. Where should stock discount or stock premium appear in the balance
sheet?
8. Discuss the status of the capital stock subscription account. Where
does it appear in the balance sheet?
9. Compare unissued stock with treasury stock.
10. How are dividends expressed for no-par stock?
11. Explain the following:
a. Authorized capital stock
6. Capital stock outstanding
c. Capital stock subscribed
d. Treasury stock
e. Unissued stock
/. No-par stock
g. Donated capital stock
12. Distinguish between common and preferred stock.
13. Classify bonds according to security and method of paying interest.
14. Discuss the relation of discount and premium on bonds to bond interest.
16. How is bond premium and bond discount shown in the balance sheet?
16. Distinguish between earned and capital surplus. Why is this distinc-
tion important?
17. What is a " secret reserve"?
18. Distinguish between a surplus reserve and a fund.
19. Enumerate three types of reserves. Explain each.
Discussion.
20. "A stock dividend is not income from the standpoint of the recipient."
Evaluate.
21. " Stock discounts are deferred charges to operations." Refute this.
22. "The declaration of a dividend is a problem of earnings; the payment of
a dividend is a financial problem. The two are quite distinct." Discuss
this distinction.
Suggested Supplementary Readings
On corporation accounting:
FINNBY, H. A. "Introduction to Principles of Accounting," Chaps. 18 and
19, Prentice-Hall, Inc., New York, 1938.
HATFIELD, H. R.: "Accounting," Chaps. 7, 8, 10, 12, and 15, D. Appleton-
Century Company, Inc., New York, 1927.
, T. H. SANDERS, and N. L. BURTON: "Accounting Principles and
Practices," Chaps. 16 and 17, Ginn and Company, Boston, 1940.
HUSBAND, G. R., and O. E. THOMAS: "Principles of Accounting," Chaps.
22-26, Houghton Mifflin Company, New York, 1935.
KESTER, R. B.: "Principles of Accounting," Chaps. 18-20, The Ronald
Press Company, New York, 1939.
178 ELEMENTS OF ACCOUNTING (Chap. XI
KREBS, W. S.: "Outlines of Accounting," Chaps. 33-36, Henry Holt &
Company, Inc., New York, 1923.
MACFARLAND, G. A,, and R. D. AYARS: "Accounting Fundamentals,"
Chaps. 23-27, McGraw-Hill Book Company, Inc., New York, 1936.
McKiNSEY, J. 0., and H. S. NOBLE: " Accounting Principles," Chaps. 18-21,
South- Western Publishing Company, Cincinnati, 1939.
PATON, W. A.: "Essentials of Accounting," Chaps. 33-36, The Macmillan
Company, New York, 1938.
On corporation procedure and finance:
CONYNGTON, T., R. J. BENNETT: rev. by II. R. CONYNGTON, "Corporation
Procedure," The Ronald Press Company, New York, 1927.
DEWING, A. S.: "Financial Policy of Corporations," The Ronald Press
Company, New York, 1934.
FIELD, K.: "Corporation Finance," The Ronald Press Company, New York,
1938.
GERSTENBERG, C. W.: "Financial Organization and Management," Pren-
tice-Hall, Inc., New York, 1932.
HOAGLAND, H. E.: "Corporation Finance," McGraw-Hill Book Company,
Inc., New York, 1933.
CHAPTER XII
COST ACCOUNTING
General accounting records compiled by methods described
in the preceding chapters have furnished management with its
principal means of financial guidance. Shortly after the turn
of the present century, however, the subject of cost accounting
had developed sufficiently to become an important supple-
mentary device for managerial control.
Definition of Cost Accounting. Cost accounting may be
defined as an analytical study of the expenses of a business.
It includes the systematic accumulation and accurate recording
of detailed cost information, its summarization and presentation
in cost statements, and finally as a means of analysis, a com-
parison of the costs recorded with predetermined standards.
Cost accounting is an expansion of general accounting no
new principles are introduced but the same ones are applied to
expenses with greater detail than in general accounting.
Cost Accounting and Management. The function of a cost
accounting system is to furnish management with expense data
which afford it an opportunity to exercise a satisfactory control
over operations. This control is extended into three divisions of
management: finance, production, and sales. Within each
group cost accounting can render valuable contributions.
Finance and Cost Accounting. The relation between finance
and cost accounting may be explained in terms of the primary
function of management, that of preserving the capital entrusted
to it. This can be done only through operating the business at a
profit. Financial or general accounting is a useful guide in
accomplishing this objective, but it frequently fails to offer an
analysis sufficiently detailed to enable management to act as
quickly as highly competitive conditions require. A general
accounting system offers only totals of expenses and summary
statements at the close of fiscal periods, but a cost accounting
system permits a better control of costs through detailed analyti-
179
180 ELEMENTS OP ACCOUNTING (Chap. XII
cal studies summarized in monthly reports, or even more fre-
quently, if necessary.
Production and Cost Accounting. In no aspect of manage-
ment is a knowledge of costs more essential than in production.
Here the importance of physical operations is usually stressed.
When this emphasis is made to the neglect of costs, it may lead
to unfortunate consequences. If new machinery is installed,
idle time reduced, defective work decreased, or waste material
reclaimed at a cost in excess of the resulting economies, they
cannot be considered profitable. The profitableness of changes
in production methods must be judged in terms of the effect of
these changes on the unit costs of the articles produced.
Adequate production control requires not only a knowledge of
what the product costs but also a knowledge of the costs in every
department and process in its manufacture. To provide this
control, predetermined, or standard, costs are used as a basis
for comparing the actual costs incurred. An analysis of the
causes for variations between these figures is a most effective
means of production cost control.
Cost Accounting and Sales. Once the goods have been pro-
duced, the sales policies of the management determine largely
whether the goods can be disposed at a profit. A cost account-
ing system offers considerable aid in controlling the selling and
general administrative expenses. Particularly is this true when
these costs are compared with standard costs and responsibility
is fixed for the disparities resulting.
Attempts to increase revenue by reducing the selling price,
planning campaigns, etc., are usually not considered within the
province of cost accounting. It may be noted, however, that
changes in the selling price can affect costs as well as revenue.
A reduction in the selling price may increase the volume of sales
and result in a lower unit cost of the product. Certain types of
expenses (depreciation, insurance, and taxes, for example)
change slightly regardless of the capacity at which the plant
operates. Hence an increase in the revenue from sales would
not be accompanied by a corresponding increase in these costs.
It does not always follow that a reduction in selling price will
produce this effect. The reduced price might bring forth a
greater volume of sales but still not enough revenue to offset the
added cost of the extra units sold. This would result in a
Chap. XII] COST ACCOUNTING 181
smaller profit than before. Whatever sales policy may be
followed, a knowledge of the costs of distribution is essential
before intelligent decisions can be made.
Classification of Expenses. In terms of the functions of
management, expenses are classified as follows :
1. Material
2. Labor
3. Manufacturing overhead
4. Distribution (selling and general administrative)
Elements of Cost to Manufacture. Whatever benefits cost
accounting may render in other fields, it is in manufacturing
that it holds a predominant position. The three elements in
the total cost to manufacture are material, labor, and manufac-
turing overhead.
The first element includes all the material used in the manu-
facture of a product that can be identified with, and charged to,
it. In the manufacture of a radio, for example, the wood used
in the cabinet would be considered direct material cost.
The second element includes all labor that can be identified
with the article and charged to it. The wages of a worker who
assembles the individual cabinet are an example. The term
" prime cost" is frequently used to describe the sum of direct
material and labor costs.
The third element consists of all items that cannot be directly
applied to the product but are nevertheless incurred in its
manufacture. Indirect material, indirect labor, and miscel-
laneous expenses entering into the manufacturing process all
the costs other than the direct ones are thus classified as
manufacturing overhead.
The glue used in the radio cabinet work would be an example
of indirect material because its value cannot easily or accurately
be allocated to each unit produced.
Salaries paid to superintendents and foremen and wages
paid to janitors, watchmen, and storekeepers are examples of
indirect labor. These costs are classified as items of manu-
facturing overhead since they cannot be easily distributed to
each unit produced, or because it is not worthwhile to do so.
In addition to these two groups there are numerous other
items. Heat, light, water, spoilage of goods in production,
182 ELEMENTS OF ACCOUNTING [Chap. XII
depreciation of factory buildings and machinery, taxes on factory
property and machinery, compensation insurance of factory
employees, and insurance of the factory buildings and machinery
are items of manufacturing overhead. In each case it would
be inexpedient or impossible to prorate an amount of expense
to the job or product produced.
Departments. For ordinary purposes in factory cost account-
ing this threefold classification is inadequate because it does
not divide the expenses so that responsibility for them can be
easily delegated. Consequently expenses are frequently classi-
fied by departments which correspond, as far as possible, to
production centers, or to sections of the factory using similar
machines or engaged in similar operations which will permit
the accumulation of expenses distinct from other such divisions or
sections of the factory. Manufacturing departments are of two
types, producing and service. A producing department is
directly concerned with manufacturing the product. A service
department, however, in some way assists the producing depart-
ments to better perform their functions (maintenance and cost
accounting departments, for example) and only indirectly
assists in manufacturing the product. The service department
costs are apportioned to the producing departments on the basis
of the benefits received.
Methods of Cost Accumulation. The manner in which these
costs are accumulated depends on the complexity of the busi-
ness organization and the manner in which the product is
manufactured.
In a small enterprise, operating under simple conditions, a
complete cost accounting system is undesirable, for usually the
organization does not require detailed information to control
costs; neither can it afford the expense of compiling such informa-
tion. Some control can be exercised by establishing depart-
ments and ascertaining costs for each. Assume, for example,
that a business is started on a moderate scale to manufacture two
articles. Information relative to the costs of each could be
obtained by establishing two departments. The costs compiled
by departments, when compared with the sales for each product,
would give definite information about the profitableness of the
two products,
Chap. XII]
COST ACCOUNTING
183
When a more complete control is required, costs may be col-
lected in one of two ways: either by a process system or by a
specific order system.
Process Cost System. The process cost system can be used
successfully only when the product manufactured is the result
of a sequence of operations and consists of like articles. The unit
cost is determined by dividing the total cost for a period by the
output. Therefore it is highly important that the articles be
alike; otherwise the average unit cost would be misleading and
inaccurate.
A vital feature of the process system is the cumulation of
costs by departments. The unit cost is computed for the depart-
ment, for the final product, and for any other classification of
cost that seems desirable. This requires, of course, two sets of
data: costs and units of output. To better explain the operation
of a process system, assume that the following departmental costs
were incurred for a given month:
Department A
Department B
Department C
Material
$5,000
$2,016
$1,020
Labor.
2,500
1,056
1 445
Manufacturing overhead .
1,500
1,488
935
Total
$9,000
$4,560
$3,400
Assume further, that the following operating data, in units
produced, for the same month, were as follows:
Department A
Department B
Department C
Units started in process . .
Units completed and
transferred to the suc-
ceeding department. . . .
Units completed but re-
maining in the depart-
ment
5,000
5,000
5,000
4,500
200
4,500
4,000
Units still in process
300*
500*
* Assume that the units in process in department B are one-third completed and that the
units in process in department C are half completed.
184
ELEMENTS OF ACCOUNTING
[Chap. XII
SUMMARY COST STATEMENT FOR A PROCESS SYSTEM
For the Month of , 19
Depart-
ment A
Depart-
ment B
Depart-
ment C
Total
Cost
Per
Unit
Cost
Cost
Per
Unit
Cost
Cost
Per
Unit
Cost
Cost
Per
Unit
Cost
Material
$5,000
2,500
1,500
$1,00
0.50
0.30
$2,016
1,056
1,488
$0.42
0.22
31
$1,020
1 , 445
935
$0 24
34
0.22
$8,036
5,001
3,923
$1.66
1.06
0.83
Labor
Manufacturing overhead
Cost incurred in each depart-
ment
$9,000
$1.80
$4,560
9,000
$0.95
1 80
$3,400
12,375
$0.80
2.75
$16,960*
$3.55
Cost transferred from preceding
department
Total cumulated cost
$9,000
$9,000
$1 80
$13.560
$12,375
635
550
$2.75
$15.775
$14,200
1,575
$3.55
The cost incurred in each de-
partment is accounted for
as follows:
Cost transferred to succeed-
ing department
Cost of work in process
Cost of units completed and
remaining in the depart-
Total cost charged to each
department
$9,000
$13,560
$15,775
* The total cost of all the departments may be accounted for as follows:
Total cost of finished goods $14 ,200
Inventory of work in process:
Work still in process in Department B $ 635
Work completed in Department B and awaiting transfer
to Department C 550
Work still in process in Department C 1 , 575 2 ,760
$16,960
The compilation of a process cost summary may be prepared
in a form similar to the illustration on this page. The computa-
tions in the summary are as follows:
1. The per unit cost of $1.80 for Department A is obtained by
dividing the total cost of the department ($9,000) by the
number of units produced (5,000). The per unit cost of
each element of cost to manufacture is determined in the
same manner.
2. Department B is charged with the $9,000 of costs transferred
from Department A plus the material, labor, and manu-
Chap. XII] COST ACCOUNTING 185
factoring overhead expenses of $4,560 charged directly
to Department 5, resulting in a total of $13,560 charged to
Department B. In this department there was the equival-
ent of 4,800 units completed 4,500 units completed and
transferred to Department C, 200 units completed but
still remaining in the department, and 300 units one-third
completed (or the equivalent of 100 completed units).
The unit cost of $0.95 in Department B is obtained by divid-
ing the cost incurred in the department ($4,560) by the num-
ber of units produced in the department (4,800). The
cumulative total unit cost to this point is $1.80 (Department
A) plus $0.95 (Department 5) or a total of $2.75. The
total cumulative cost of $13,560 charged to Department B
may be accounted for as follows:
4,500 units at $2.75 per unit completed and
transferred to Department C $12,375
200 units at $2.75 per unit completed and
retained in Department B 550
300 units of work in process, one-third
completed.
300 units X $1.80 (unit cost in Depart-
ment A) = $540
300 units, one-third completed in De-
partment B is the equivalent of 100
completed units. 100 units X $0.95
(unit cost in Department B) = 95 635
$13,560
3. Department C is charged with the $12,375 of costs trans-
ferred from Department B plus the material, labor, and
manufacturing overhead costs of $3,400 charged directly
to Department (7, making a total of $15,775 charged to
Department C. In this department there was the equiva-
lent of 4,250 units completed 4,000 units completed and
transferred to the finished goods inventory and 500 units
only one-half completed (or the equivalent of 250 units
fully completed). The unit cost of $0.80 in Department
C is obtained by dividing the cost incurred in the depart-
ment ($3,400) by the number of units produced in the
department (4,250). The cumulative total unit cost to
186 ELEMENTS OF ACCOUNTING [Chap. XII
this point is $1.80 (Department A) plus $0.95 (Department
B) plus $0.80 (Department C) or a total of $3.55. The
total cumulative cost of $15,775 charged to Department C
may be accounted for as follows:
4,000 units at $3.55 per unit completed
and transferred to the finished goods
inventory $14,200
500 units of work in process, one-half
completed.
500 units X $2.75 (unit costs in Depart-
ments A and B) = $1,375
500 units, one-half completed in Depart-
ment C is the equivalent of 250 com-
pleted units. 250 units X $0.80
(unit cost in Department C) = 200 1,575
$15,775
The summary cost statement for the month (see page 184)
shows this information in tabular form.
Each month (or a shorter interval, if necessary), a process
cost summary is prepared similar to the illustration shown.
The data appearing in the cost statement are, of course, entered
in the journal. To show the amount of direct material applied
to each department, the following entry is made:
Department A 5,000
Department B 2,016
Department C 1 ,020
Material stores 8,036
Direct labor cost is apportioned by the following entry:
Department A 2,500
Department B 1 , 056
Department C 1 ,445
Labor 5,001
Manufacturing overhead is distributed as follows :
Department A 1 , 500
Department B 1,488
Department C 935
Manufacturing overhead 3,923
Chap. XII]
COST ACCOUNTING
187
The transfer of costs from one department to another is accom-
plished by the following entries:
Department B 9,000
Department A 9,000
Department C 12,375
Department B 12,375
The finished goods (if valued as an actual, not a predetermined
cost) are recorded as follows:
Finished goods 14,200
Department C 14,200
The various work in process inventories may be closed into a
single account by the following entry:
Work in process inventory 2,760
Department B 1 , 185
Department C 1 , 575
When the above journal entries are posted, the departmental
accounts will appear as follows:
DEPARTMENT A
Material
Labor
Manufacturing overhead
5,000
2,500
1,500
Transferred to Department B 9,000
9,000
9,000
DEPARTMENT B
Material
2,016
Transferred to Department C 12,375
Labor
1,056
To work in process inventory 1 , 185
Manufacturing overhead
1,488
Transferred from
Department A
9,000
13,560
13,560
DEPARTMENT C
Material
Labor
Manufacturing overhead
Transferred from
Department B
1,020
1,445
935
12,375
15,775
To finished goods 14,200
To work in process inventory 1 , 575
15,775
188 ELEMENTS OF ACCOUNTING [Chap. XII
FINISHED GOODS
From Department C 14,200 1
WORK IN PROCESS INVENTORY
From Departments B and C 2,760
The cost of the lost units may be transferred to a special
account as follows:
Goods lost in production xxx
Department B xxx
Department C xxx
The account goods lost in production is included in the manu-
facturing overhead expense before it is prorated to the various
departments.
In brief, by using a process cost system, it is possible to deter-
mine the unit cost of the completed product, the department, or
the process. For products which follow a sequence of operations
in their manufacture and which are identical, this system is the
only method of cumulating costs that can be used. Refined
sugar, cement, and chemicals are illustrations.
The system does, however, have distinct limitations. It is
restricted in its application, and the actual costs cannot be found
until the end of the accounting period.
Specific Order System. The last objection can be overcome
to a considerable degree by the use of a specific order cost account-
ing system. Under this system costs are accumulated for each
product or lot, and the cost of the particular article or group
of articles can be determined when they are manufactured.
It is not necessary to wait until the end of the month.
The difference between process and specific order cost account-
ing, while distinct, is in a sense one of degree, not of type. The
specific order system, like the process system, accumulates costs
by departments, thus enabling a departmental control of costs.
In addition, however, costs are allocated to the particular prod-
uct. Each order or product has its costs cumulated on a sum-
mary similar to the illustration on page 189. Thus a more
complete control over costs is obtained by a specific order system
than by a process system. It is also more expensive to operate.
If it is possible to use the process system and obtain an average
Chap. XII]
COST ACCOUNTING
189
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190 ELEMENTS OF ACCOUNTING [Chap. XII
cost with satisfactory results, such a procedure will be more
economical.
In a majority of cases, however, this alternative is not possible.
When the products are not manufactured as a result of sequence
but are combined with other articles to complete them, any
method of averaging the cost of such dissimilar items would
result in a useless set of figures. Costs must be compiled in
these cases by individual orders or individual products. Clothes
tailored to suit the requirements of the individual, heavy machin-
ery, and construction work are examples of products which must
be manufactured to individual specifications and which must
have their costs cumulated in a manner similar to the illustra-
tion on page 189.
It should be noted that the use of one method of cumulating
costs does not imply that the other is excluded. It is quite
possible for both systems to be employed a process cost system
in which operations are in sequence and the products are of a
simple nature and of one kind, and a specific order system in
which these products are assembled with other parts to make a
finished product which varies considerably in the final form.
For example, a construction company making its own cement
would cumulate the cost of this product on a process basis,
although the cost of the entire project would be cumulated on a
specific order basis.
Questions
Review.
1. Why is the control of costs especially important to management?
2. What is the relation between finance and cost accounting? Production
and cost accounting? Sales and cost accounting?
3. Give a functional classification of expenses.
4. Enumerate and explain briefly the elements of cost to manufacture.
5. Why are expenses classified by departments?
6. Distinguish between a producing and a service department.
7. Distinguish between a process cost system and a specific order cost
system. Under what conditions should each be used?
8. Does the use of one method of compiling costs mean tnat any other
method is excluded? Explain.
CHAPTER XIII
COST ACCOUNTING. (Concluded)
In order to render the service of which it is capable, cost
accounting should enable management to control not only
products, processes, and departments, but also different types
of costs: principally, manufacturing (material, labor, and
manufacturing overhead) and distribution (selling and general
administrative) .
General Ledger Controlling Accounts for Costs. For the
most part, the detail in factory cost accounting is controlled
by several accounts in the general ledger. Under the least
complicated cost accounting systems these controlling accounts
are as follows:
1. Materials
2. Labor
3. Manufacturing overhead
4. Work in process
5. Finished goods
The materials account shows, in summary form, the total raw
material received and issued during the month and the amount
remaining on hand at the end of the month. The labor account
shows the total wages incurred. The manufacturing overhead
account receives only the indirect expenses of manufacturing or
those which cannot be applied directly to the product. The work
in process account receives all costs entering into production.
As the partially finished goods are completed, their costs are
transferred to the finished goods account.
Material. The control of costs should begin before they have
been incurred. If it is to be effective, a plan must be devised
to reduce the possibility of error and to make theft, fraud, and
other losses difficult. The expression "internal check" is
used to describe a plan designed to accomplish these objectives,
191
192
ELEMENTS OF ACCOUNTING
[Chap. XIII
The following statement affords a terse definition of internal
check:
Such a system consists in the accounting records, methods, and details
generally of an establishment being laid out in such a way that no part
of the accounts will be under the absolute and independent control of
any one person; that on the contrary, the work of one employee will be
complementary to that of another; and that a continuous audit will be
made of the details of the business. 1
The first step in the establishment of a system of internal
check is to determine the various operations and the agents
PURCHASE REQUISITION
Purchase Order No
Date Ord(
>rpd Da,t,p Dpsirpd Datfi Rpp.pivpH
Quantity
Description
Account No. Charged
Requisitic
mpfl "Ry Apprnvpd Ry
responsible for them. The principal operations in the control
of materials are as follows:
1. Purchasing
2. Receiving
3. Storing
4. Accounting
Purchasing. The responsibility for prudently buying goods is
delegated to the purchasing agent. Briefly stated, the functions
ordinarily performed by his department are as follows:
1 Montgomery, R. H., and W. A. Staub, "Auditing Principles," p. 39,
The Ronald Press Company, New York, 1923,
Chap. XIII]
COST ACCOUNTING
193
1. To receive and judge requests for purchases
2. To order the goods
3. To verify the fact that goods received are as ordered
His office will have on hand quotations (or they will be secured
when requests for purchases are made) which enable him to
know the most favorable prices, the most desirable method of
transportation, and any other factors that affect the cost of
securing materials. The request to purchase can come from the
storekeeper or from other authoritative sources. This request
is formally made on a purchase requisition prepared in duplicate
(illustration, page 192). One copy is sent to the purchasing
office and constitutes the request for goods to be ordered. The
second copy is retained by the storekeeper as a memoranda.
Both copies bear a number in order to facilitate identification.
PURCHASE ORDER
Purchase Order No Purchase Requisition No Date_
Vendor
Address-
Shipping Instructions-
Catalogue
Number
Quantity
Description of Material
Unit
Price
Total
Price
By-
Purchasing Agent
When the purchasing agent sends for the goods, he prepares
several copies of a purchase order (see above). One copy is sent
to the company from whom the goods are ordered. This serves
as authority for shipping the goods. A second is retained by
the purchasing department as a memoranda. A third copy may
be sent to the department requesting the goods in order to
194
ELEMENTS OF ACCOUNTING
[Chap. XIII
indicate that the purchase order has been sent to the vendor.
A fourth may be sent to the receiving department. 1
When the vendor's invoice (see below) is received by the
company, it is sent to the purchasing agent's office where it is
compared with the purchase order and finally with the receiving
records. Quoted prices, computations, - and extensions are
checked, and, if these are found to be correct, the invoice is sent
to the accounting department.
INVOICE
To:
Name
Address-
Invoice No._
Date
Terms_
Description
Unit
Price
Amount
Receiving. When a copy of the purchase order is sent to the
receiving department, it is filed to await delivery of the goods.
The functions of this department may be listed briefly as follows :
1. To receive incoming materials
2. To check the quantity and quality of goods received
3. To send goods to the stores department
When materials are received from the vendor, the receiving
clerk signs what papers may be necessary to release the shipment
1 Sometimes, particularly in small receiving departments, an objection is
raised against sending a statement of the expected quantity and quality of
goods to the receiving clerk. It is felt that this encourages careless check-
ing. It should be noted, however, that, when a copy of the purchase order
is not sent, some report must be prepared and a check against the quantity
and quality ordered must be made elsewhere. In the meantime the goods
await final storage pending approval. This complicates storage problems.
Chap. XIII]
COST ACCOUNTING
195
from truckmen or other carriers. He then inspects the goods
and reports quantity, quality, breakage, or other important
data on the receiving report (see below). The receiving report is
prepared in triplicate. One copy is sent to the purchasing
department, where it is compared with the invoice. Another
is retained by the receiving clerk for reference. A third is sent
to the storekeeper, who checks it when he stores the goods.
Received fror
Date Shippec
Purchase He
RECEIVING RECORD
Receiving Record No.
n Data
1 Rniitp. Tnpnmin
ig Charges
. Account No
quisition No Purchase Order No
Quantity
Weight
Material Received
Unit
Cost
Total
Cost
By By
Inspector Receiving Clerk
Storing. The successful organization and operation of the
storeroom is a most important part of the effective control of
merchandise. Not only is the storeroom a vulnerable place for
theft, but losses of equal seriousness can occur through spoilage
and by not having the proper amount on hand when needed.
An experienced man delegated with the responsibility of main-
taining the proper stock of goods and of receiving and issuing the
material should be in charge of the storeroom. His work will be
196
ELEMENTS OF ACCOUNTING
[Chap. XIII
tf
w
o
Q
W
I
s
II
I!
o 6
'8 S5
Chap. XIII]
COST ACCOUNTING
197
greatly facilitated if attention is given to the proper location
of the storeroom, if it is situated conveniently to receive materials,
and if they can be issued close to the point of use. A study of the
most suitable methods of storing will usually result in greater
ease and economy in handling materials.
In general the storekeeper is charged with the following
responsibilities in handling materials:
1. Receiving
2. Storing
3. Issuing
4. Keeping records
When the storekeeper receives the report from the receiving
department, it is checked carefully and, if found correct, serves
as the basis for an entry on the stores ledger sheet (page 196).
The receiving report is then filed and the goods are stored.
Charge :
Productic
Standing
Deliver To
MATERIAL REQUISITION
Credit:
m OrnW No Stores Ar.noiint, No.
OrHp.r No T Rprpisition No.
Quantity
Description
Unit Cost
Total
Dn.tp ReceivH By
Material is issued by the storekeeper only upon presentation
of appropriate requisitions by foremen or others with the proper
authority (see above). These requisitions serve as a basis for
entries in the issued section of the stores ledger. The difference
198 ELEMENTS OF ACCOUNTING [Chap. XIII
between the received and issued section represents the amount
of material which, if there has been no error, will be found in the
storeroom and will be equal to the balance of the controlling
account materials in the general ledger. Periodically the amount
of goods in the storeroom as shown by the store ledger card is
checked by physical count. Any shortage or excess quantity as
disclosed by the stores record is adjusted to conform to the
actual count.
Entries to Record Material Cost. The controlling account
materials in the general ledger and the subsidiary cost accounting-
records are affected by all transactions 1 relating to direct and
indirect materials received or issued from the storeroom. The
principal transactions are as follows:
1. Material received
2. Direct material issued
3. Direct material returned from production
4. Indirect material issued
5. Indirect material returned from production
When goods are purchased, the following entry is made on
the general accounting records:
(Dr.) Materials
(Cr.) Accounts payable (or vouchers payable)
This entry is made in the voucher register. The same amount,
compiled from the receiving reports, is carried to the material
received section of the stores ledger.
When direct material is issued to production, the following
entry is made:
(Dr.) Work in process
(Cr.) Materials
This is a summary entry made at the end of the month and
compiled from the total of material requisitions received by the
storekeeper. These requisitions are used as the basis for an
1 Not all of the possible cost accounting forms and entries are included in
this chapter. To describe these would confuse rather than assist the
student to obtain a general impression of cost accounting. For a detailed
treatment of material, labor, and manufacturing overhead, see C. L. Van
Sickle, "Cost Accounting," Harper & Brothers, New York, 1938, or other,
texts, listed at the end of this chapter.
Chap. XIII] COST ACCOUNTING 199
entry made in the material issued section of the stores ledger
sheet. At the same time an entry is made in the materials
section of the cost sheet.
When direct materials are returned from production in a
usable state, the entry on the general accounting records to
record the total is
(Dr.) Materials
(Cr.) Work in process
This entry is compiled from the monthly summary obtained from
the storekeeper. As these returned items appear in the store-
room, a memoranda is prepared by the storekeeper. This is
used as the supporting document for an entry on the stores
ledger. It may be handled in the material received section of
the ledger similar to the receipt of additional material, or it may
appear in the material issued section in red ink as a deduction.
Similarly an entry to denote a deduction is made in red ink in the
materials section of the cost sheet.
Labor. In general the same technique is used for the control of
direct labor cost as for raw material. Care is taken that each
important operation involves two or more people and that the
work of one checks, without duplicating, the work of another.
Forms (which vary widely depending on individual business
requirements) are an essential part of a system of internal check
for labor.
The usual operations to be controlled are the following:
1. Hiring
2. Recording time
3. Supervision
4. Computing labor cost
5. Paying
If the business is large enough, a personnel director or an
employment manager examines the prospective employee and
obtains essential information about him. If the worker is
hired, his name is added to the list of active workers.
Once employed, the worker's daily entrance and exit to the
plant or building should be carefully checked. Numerous
arrangements have been devised to obtain these data. One of
the most widely accepted is the time clock card (page 200).
200
ELEMENTS OP ACCOUNTING
[Chap. XIII
CLOCK CAIi
Nfl-ITH**-
ID
N<
i
W**k TCnHing
Morning
Afternoon
Overtime
Total
Hours
In
Out
In
Out
In
Out
Sunday
Monday
Tuesday
Wednesday
Thursday
Friday
Saturday
"Rpgillar Tim P. Ratft
ft
$
Ovfirt.imfi Rjitft
Totfl.1 wagfis
How the time of the worker is spent in the factory is shown by
the daily time report (page 201). The total amount of time on
the time clock record should, of course, check with the total time
spent by the worker, as shown by the daily time report. This
report is likewise a check upon the supervisory duties of the
foreman in that his signature indicates his belief that the report
is accurate.
The labor cost is computed from the daily time report by the
cost clerk. He checks the computations and extensions and
distributes the costs to departments or to particular jobs.
Finally the paymaster's department prepares the payroll.
This information is drawn from the payroll sheet (page 202).
The chief duty of the paymaster is to pay the worker and to have
evidence of having done so. The check is the most convenient
as well as the most usual form of payment. If employees are paid
by currency, the pay envelopes are prepared for each worker as
Chap. XIII]
COST ACCOUNTING
201
DAILY TIM!
Mam ft
3 REPOI
Date
IT
Job
No.
Depart-
ment
Descrip-
tion
Time
Started
Time
Stopped
Total
Hours
Rate
Amount
Totals
FOREMAN
shown by the amount on the payroll summary. A statement of
earnings and deductions is sometimes included. If a payroll is
used, it should be signed by all those who have had anything to do
with its preparation as well as by those who have received pay-
ment. It should also be signed by the auditor who compared
the payroll with the list of active workers in the employment
manager's office.
Thus the most common sources of defalcation would be made
difficult under a system of internal check. An inflation of the
payroll, for example, would require the collusion of someone in
the employment manager's office, a timekeeper or cost clerk,
and possibly a foreman and a worker. Similarly other types of
collusion would require the combined efforts of two or more per-
sons in order to be perpetrated without being quickly discovered.
Entries to Record Direct Labor Transactions. The principal
transactions involving direct labor cost are as follows:
1. Its incurrence
2. Its payment
" 3. Its application to production
The following entry is required to record labor cost incurred:
(Dr.) Labor
(Cr.) Accounts payable (or vouchers payable)
202
ELEMENTS OF ACCOUNTING
[Chap. XIII
DIRECT LABOR PAYROLL
Shftfit Nn. fnr WPPV TCndi'ncr
3s
60
H
32
s
o o
H W
Saturday
&
%
fe
Thursday
Wednesday
Tuesday
!
O
a
1?
nd
OQ
O
$s
I
Chap. XIII] COST ACCOUNTING 203
In the general accounting records this appears in the voucher
register.
When the payroll is paid, the following entry is made:
(Dr.) Accounts payable (or vouchers payable)
(Cr.) Cash
This entry is recorded in the cash disbursements journal and
in the voucher register. No cost accounting record is necessary.
When direct labor costs are applied to production, the neces-
sary entry is
(Dr.) Work in process
(Cr.) Labor
If a process cost system is in use, the total direct labor cost is
allocated at the end of the month to the departments or processes
in which the cost was incurred. If, however, a specific order
system is in use, the cost sheet of each order (illustration, page
189) is charged for the proper amount.
Manufacturing Overhead. Unlike material and labor costs, a
system of internal check is not organized to control manufacturing
overhead because it consists of so many diverse elements. It
should be noted, however, that some of these elements are subject
to control by internal check. Indirect material and indirect
labor, important portions of manufacturing overhead, ordinarily
come under the same system of control as direct material and
direct labor. For the remainder (miscellaneous items incurred
in the factory such as insurance, power, and repairs), control is
exercised by comparing actual costs with a predetermined
standard and by explaining any difference.
For a process cost system the diverse elements of manu-
facturing overhead cause no special difficulty because all costs are
averaged and there is no reason why a fine distinction between
direct and indirect costs should be made. For a specific order
system, however, it is quite a different matter. Because of the
indirect nature of manufacturing overhead, it is impossible to
measure exactly the proper amount which should be distributed
to a particular unit.
For this reason no attempt is made to distribute manufacturing
overhead to production as it is incurred. Instead the amount
applied is predetermined, A normal distribution rate IS used
204 ELEMENTS OF ACCOUNTING [Chap. XIII
which apportions all manufacturing overhead to production over
the course of a fiscal period. For any one month, however, there
may be considerable disparity between the manufacturing over-
head incurred and the amount applied to production. The cost
of heating the factory, for example, may be great during the
winter and negligible during the summer. For the unit cost of
an article to be representative, seasonal factors should be elimi-
nated and a period of time selected long enough to cover such
cost variations.
Again, in seasonal industries, production does not bear a close
relation to manufacturing overhead; for the most part these costs
increase as time elapses, regardless of the output. Machines
continue to depreciate, and taxes must be paid despite volume
of the goods manufactured. 1 By using a normal distribution
rate, seasonal factors can be eliminated and manufacturing over-
head costs can be rendered comparable from month to month.
There is still another reason why predetermined costs are
necessary to distribute manufacturing overhead: as soon as a job
is completed, it should be possible to know its cost. No difficulty
is encountered in the case of material and direct labor costs, since
they are known. Manufacturing overhead, however, must be
estimated and apportioned by a normal distribution rate.
There are two important considerations in determining the
selection of rates: past experience and an estimate of probable
changes.
Of the numerous rates for the distribution of manufacturing
overhead, the direct labor-hour, the direct labor cost, and the
machine-hour rates are probably used to a greater extent than
others.
Direct Labor-hour Rate. The direct labor-hour rate is
obtained by dividing the estimated total departmental manu-
facturing overhead for the coming year by the estimated labor-
hours to be worked in that department in the next year. Assume,
for example, that in a given department the workers engaged in
direct labor are employed 10,000 labor-hours (obtained by multi-
1 The distinction between different types of manufacturing overhead
should be noted. Certain elements such as depreciation, taxes, and insur-
ance are known as fixed costs and accumulate regardless of output. Other
elements such as repairs, power, and light are known as variable costs and
fluctuate with output (although not proportionately).
Chap. XIII] COST ACCOUNTING 205
plying the number of hours spent by each worker by the total
number of workers). Assume, further, that the yearly amount of
manufacturing expense incurred in the department averages
about $5,000. Reduced to a labor-hour rate, this means that,
for every hour of direct labor applied to a product, a manufac-
turing overhead cost of 50 cents is incurred ($5,000 manufac-
turing cost -T- 10,000 labor-hours). Hence for any job within
the department the number of direct labor-hours multiplied by
the rate of 50 cents will result in the amount of manufacturing
overhead applicable to the job in question.
Labor Cost Rate. The labor cost rate for a department is
similarly computed. Assume that the direct labor cost in the
department under discussion amounts to $20,000 a year. In this
instance manufacturing expense is 25 per cent of direct labor cost
($5,000 manufacturing expense -f- $20,000 direct labor cost).
Thus 25 per cent of the direct labor cost will be the amount of
manufacturing overhead applicable to any job in this department.
Machine-hour Rate. If the total number of hours for the
operation of machines in a department amounts to 2,000 per
year, the cost per hour of manufacturing overhead, expressed in
terms of a machine-hour rate, would be $2.50 ($5,000, the manu-
facturing overhead -r- 2,000 machine-hours). A particular job
requiring 3 hours therefore would bear a manufacturing overhead
cost of $7.50.
The rate to be used, of course, is that one which most accurately
distributes the total manufacturing overhead to production. If
machines set the pace and direct labor enters only slightly into
production, it is unusual for either direct labor cost or hours to
be used as a rate base.
Usually a distribution rate based on time will be found prefer-
able to one based on cost, because manufacturing overhead
increases as time elapses. A machine-hour, labor-hour, or a
similar time basis will ordinarily be preferable to a rate based on
cost.
Recording Manufacturing Overhead. The principal transac-
tions involved in accounting for manufacturing overhead are as
follows:
1. Determining the amount of manufacturing overhead by
types of expenses
206 ELEMENTS OF ACCOUNTING [Chap. XIII
2. Classifying expenses incurred by the departments affected
3. Distributing service department expenses to producing
departments
4. Applying manufacturing overhead to the product
5. Accounting for the difference between the manufacturing
overhead incurred and the amount applied to production
Assume that the estimated manufacturing overhead expenses
for the coming year are as follows:
Indirect material $1 , 200
Indirect labor 800
Insurance 600
Repairs 300
Heat, light, and power 1 , 100
Depreciation of machinery 1 , 000
$5,000
Assume further that this estimated overhead expense is based on
a production of 10,000 units. Under these conditions the pre-
determined overhead rate to be applied to production would be
50 cents for every unit produced.
The actual overhead expenses incurred during the year, how-
ever, amounted to $5,100 and were recorded by the following
entries:
Indirect material 1 , 150
Materials 1 , 150
Indirect labor 825
Vouchers payable 825
Insurance 650
Vouchers payable 650
Repairs 325
Vouchers payable 325
Heat, light, and power 1 , 150
Vouchers payable 1 , 150
Depreciation of machinery 1 , 000
Reserve for depreciation of machinery 1 ,000
Chap. XIII)
COST ACCOUNTING
207
Manufacturing overhead (actual) 6, 100
Indirect material 1 , 150
Indirect labor 825
Insurance 650
Repairs 325
Heat, light, and power 1 , 150
Depreciation of machinery 1 , 000
These expenses are entered on a manufacturing overhead
distribution sheet (see below), where they are classified and dis-
tributed to the proper departments.
MANUFACTURING OVERHEAD DISTRIBUTION SHEET
Expenses
Total
Depart-
ment
A
Depart-
ment
B
Depart-
ment
C
Depart-
ment
D
Indirect material
$1,150
$ 400
$ 500
$150
$100
Indirect labor
825
300
200
125
200
Insurance
650
300
250
25
75
Repairs
325
125
100
50
50
Heat, light, and power. . . .
Depreciation of machinery
1,150
1,000
375
500
550
500
50
175
Total cost
$5,100
$2,000
$2 , 100
$400
$600
These items are distributed to the various departments on the
basis which seems most equitable. The underlying conditions
in the factory must be considered before deciding upon the most
accurate method. It is common practice, however, to distribute
indirect material on the basis of the departments indicated on
the material requisitions ; indirect labor according to labor-hours ;
depreciation, taxes, and insurance on machinery in proportion
to the investment in machinery; rent, light, heat, and deprecia-
tion of the building on the basis of floor space; and superin-
tendence according to the number of laborers in each department.
When manufacturing overhead is classified by departments,
an entry similar to the following (this is a summary entry for the
month) is made in the general journal at the end of the month:
Department A 2,000
Department B 2, 100
Department C 400
Department D 600
Manufacturing overhead 5 , 100
208 ELEMENTS OF ACCOUNTING [Chap. XIII
These departments are of two types: those immediately con-
cerned with production of the product and those which render a
service to the producing departments. In order to learn the cost
of a producing department, service department costs must first
be distributed. Assuming that C and D are service departments
and that an equal distribution of services is made to the producing
departments A and B, this distribution will be made as follows:
Department A 500
Department B 500
Department C 400
Department D 600
These service departmental accounts show the actual manufac-
turing overhead in each department.
When a process cost accounting system is used, manufacturing
overhead is usually distributed no further. When a specific
order cost accounting system is used, however, an additional
step is taken : manufacturing overhead is distributed on the basis
of a normal rate to the particular job.
If 9,600 units were produced during the year and if the pre-
determined rate for the application of manufacturing overhead
was 50 cents per unit, the amount applicable to production for
the year would be $4,800. The 12 monthly entries to show the
amount of manufacturing overhead applied to production may be
summarized for convenience as follows:
Work in process 4 , 800
Applied manufacturing overhead, Depart-
ment 4 2,550
Applied manufacturing overhead, Depart-
ment B 2,250
If the distribution rate has been wisely selected, at the end of
the year, differences between the balances of the departmental
manufacturing overhead accounts will be slight. Month by
month, however, there will be disparities. Since statements are
prepared from costs incurred, an adjustment must be made to
take care of these differences. Any discrepancy between the
two balances is closed into the account over- and underapplied
manufacturing overhead. In Department A, for example, the
actual manufacturing overhead is $2,500, the applied manufac-
turing overhead is $2,550 and, therefore, the amount overapplied
is $50.
Chap. XIH] COST ACCOUNTING 209
The journal entry to record this is as follows:
Applied manufacturing overhead Department A . 2 , 550
Department A manufacturing overhead 2,500
Over- and underapplied manufacturing over-
head 50
The journal entry to record the underapplied manufacturing
overhead of Department B (determined in the same manner as
for Department A) is as follows:
Department J5, applied manufacturing overhead . 2 , 250
Over- and underapplied manufacturing overhead . 350
Department J5, manufacturing overhead 2 , 600
The balance of the over- and underapplied manufacturing
overhead account is carried forward month by month. At the
end of the year it is analyzed and is apportioned to the proper
elements of manufacturing costs for the period. Usually the
amount is divided between the cost of goods sold and the inven-
tories (finished goods and work in process). Frequently, how-
ever, if the balance is not large it is closed into the cost of goods
sold account. The resultant error is not important if the
inventory values are small.
If, however, the balance in the over- and underapplied manu-
facturing overhead account arose because of abnormal conditions
(an unusually large amount of idle time, for example) then the
resulting excessive overhead cost should be considered a loss
rather than an addition to the cost of manufacturing the product
and should be shown as a nonoperating expense item in the
profit and loss statement (this is the assumption made in the
illustrative problem, page 215).
The various accounts affected by this illustration are as
follows:
MANUFACTURING OVERHEAD (Actual)
5,100 I 5,100
DEPARTMENT A, MANUFACTURING OVERHEAD (Actual)
2,000
500
2,500
2,500
2,500
210 ELEMENTS OF ACCOUNTING [Chap. XIII
DEPARTMENT B, MANUFACTURING OVERHEAD (Actual)
2,100 2,600
500
2,600 2,600
DEPARTMENT C, MANUFACTURING OVERHEAD (Actual)
4QQ i - - 4QQ
DEPARTMENT D, MANUFACTURING OVERHEAD (Actual)
60 I " 22
DEPARTMENT A, APPLIED MANUFACTURING OVERHEAD
2 ^ 55Q i - 2,550
DEPARTMENT B, APPLIED MANUFACTURING OVERHEAD
2,250 [I ' """""""'"""
OVER- AND UNDERAPPLIED MANUFACTURING OVERHEAD
350 I =_=___ 50
Distribution Costs. Until recent years costs to manufacture
have received attention to the neglect of selling and adminis-
trative costs. This situation has existed despite the fact that
profits depend, among other things, not only upon the economical
production of goods but also upon their distribution to the con-
sumer at a suitably low cost.
The general technique of control over distribution costs 1
(which include all the activities of selling, delivery, and collecting
for the goods sold) is similar to that of manufacturing overhead.
The budget, or a system of standard costs, is prepared to indicate
what the marketing activities should cost. The difference
between these predetermined costs and the costs incurred dis-
closes how well the performance conforms with the expectations.
Much of the analysis of selling and administrative costs is of a
statistical nature and is made quite apart from the books of
1 Traditionally, costs have been divided into production, selling (dis-
tribution), and general administration groups. With increasing study
in the analysis of costs, there is the tendency to allocate those of the general
and administrative groups to production and distribution.
Chap. XIII] COST ACCOUNTING 211
account. Although the exact procedure to be followed in this
analysis depends on the type of business and the features to be
stressed, the following steps are essential:
First, the costs are recorded by types of expenditures, such as
salesmen's salaries, advertising, freight-out, etc.
Second, the distribution process is divided according to market-
ing activities. Despite the variations found in different enter-
prises, a convenient fourfold classification has been made as
follows: 1
1. Creating demand that is, arousing effective desire on the part
of the customer for the product which the enterprise has to sell,
through advertising, promotion, solicitation, etc.
2. Obtaining orders that is, converting this demand into a specific
agreement for the purchase of the product, through contact by
salesmen or otherwise.
3. Handling and delivery that is, conducting the physical operations
incident to storing, sorting, grading, packing, loading, shipping,
transporting, and delivering the product.
4. Realizing on the sale that is, arranging credit terms, billing, post-
ing, preparing statements, collecting, handling and depositing cash,
with work in connection with sales record-keeping generally.
Third, costs classified on the basis of expenditures are reclassi-
fied according to functions. Some of these costs can be allocated
directly to particular functions, but many others will have to be
distributed on the most equitable basis possible.
Fourth, costs are classified according to salesmen, customers,
territories, products, or other groups. Again this proration is
made on what seems to be the most equitable base.
Fifth, when the cost per unit classified according to salesmen,
customers, territories, products, or other bases is made and is
compared with corresponding analyses of the revenue received
from sales (classified by the same groups as the costs), manage-
ment should be able to derive an opinion of the profitableness of
each unit. In order to do this it should, of course, have some idea
of what the costs and profits of the various classifications should
be; hence an adequate control over distribution costs presupposes
that budgets or standard costs have been established.
Statements in Cost Accounting. The control afforded by a
cost accounting system over the various costs in making and
1 "Accountants' Handbook," p. 1333.
212 ELEMENTS OF ACCOUNTING [Chap. XIII
selling the product is incomplete without statements which
present significant data to management. In this respect cost
accounting offers an outstanding service to management it
permits the preparation of monthly statements instead of waiting
until the close of the fiscal period. When statements are pre-
sented with greater frequency, it is possible, of course, to dis-
cover defects just that much quicker and to take immediate steps
to overcome them.
The balance sheet of a manufacturing concern differs slightly
from that of a trading concern. The principal distinction lies in
the fact that there are three inventories : raw materials, goods in
process, and finished goods, whereas in the ordinary trading con-
cern there is only the finished goods inventory. Furthermore
in most manufacturing concerns perpetual inventories are kept
which greatly facilitate the preparation of statements.
Again, the profit and loss statement differs but slightly in
form except in the cost of goods sold section. Here the manu-
facturing section may be expanded, or better still, may appear as
a separate schedule.
If the manufacturing section appears as a separate statement,
there are three principal sections: material, labor, and manufac-
turing overhead. In each case the amount which entered into
production is shown.
The following illustrations are examples of the principal cost
statements referred to in this chapter.
BLACKWELL MANUFACTURING COMPANY
TRIAL BALANCE, DECEMBER 31, 19
Cash $ 3,550.00
Accounts receivable 19 , 872 . 50
Inventories, December 1, 19_^:
Finished goods 5,500.00
Goods in process 9,633.50
Materials (direct and indirect). . . 14,835.25
Machinery and factory equipment 42 , 600 . 00
Reserve for depreciation of ma-
chinery and equipment $ 6,300.00
Office equipment 5,500.00
Reserve for depreciation of office
equipment 600 .00
Buildings 35,975.00
Reserve for depreciation of build-
ings 3,575.00
Chap. XIII] COST ACCOUNTING 213
Land 11,000.00
Unexpired insurance 700 . 00
Accounts payable 8,500.00
Factory payroll 320.00
Notes payable 2,600.00
Common stock 100,000.00
Surplus 21 ,933.25
Sales 31,500.00
Sales returns and allowances 375 . 00
Purchase discount 160.00
Purchase of materials 8 , 275 . 00
Factory labor 13,350.00
Factory light, heat, and power . . . 785 . 00
Repairs to equipment 125 . 00
Sundry factory expense 635 . 00
Salesmen's salaries 1 , 500 00
Salesmen's traveling expenses. ... 410.00
Advertising 250 . 00
Office salaries 440.00
Office supplies expense 25 . 00
Telephone and telegraph 32 . 00
Taxes 80.00
Interest expense 22 . 50
Bad debts 17 50
$175,488.25 $175,488.25
Additional Data:
(1) Inventories, December 31, 19 :
Finished goods $ 6,200
Goods in process 7 , 630
Materials 13,570
Of the materials issued from the storeroom during the month, $1,000
worth consisted of indirect materials.
(2) One-sixth of the factory labor is indirect labor.
(3) One4ialf of the telephone and telegraph expense is apportioned to
selling expenses, the balance to general administrative expenses.
(4) The interest expense accrued amounts to $7.50.
(5) Depreciation on machinery and factory equipment is 10 per cent
annually.
(6) Depreciation on office equipment is 5 per cent annually.
(7) The estimated losses from bad debts amount to 1 per cent of the
gross sales.
(8) The insurance expired amounts to $100. Three-fourths of this is to
be distributed to factory expense, and the balance to general adminis-
trative expense.
214 ELEMENTS OF ACCOUNTING [Chap. XIII
(9) The underapplied manufacturing expense amounts to $65.
(10) The depreciation on the building is 3 per cent annually. Two- thirds
of the cost is to be distributed to factory expense and one-third to
general administrative expense.
(11) Three-fourths of the taxes expense is to be distributed to factory cost
and one-fourth to general administrative expenses.
. BLACKWELL MANUFACTURING COMPANY
BALANCE SHEET, DECEMBER 31, 19
Assets
Current Assets:
Cash $ 3,550.00
Accounts receivable $19,872.50
Less reserve for doubtful accounts 3 1 5 . 00 19, 557 . 50
Finished goods 6,200.00
Goods in process 7 , 630 . 00
Materials 13,570.00
Total current assets $ 50,507.50
Fixed Assets:
Office equipment $ 5 , 500 . 00
Less reserve for depreciation for
office equipment 622.92 $ 4,877.08
Machinery and equipment $42 , 600 . 00
Less reserve for depreciation for
machinery and equipment .... 6 , 655 .00 35 , 945 . 00
Buildings $35,975.00
Less reserve for depreciation for
buildings 3,664.92 32,310 08
Land 11,000.00
Total fixed assets 84, 132. 16
Deferred Charges:
Unexpired insurance 600 . 00
Total assets $135,239.66
Equities
Current Liabilities:
Accounts payable $ 8 , 500 . 00
Notes payable 2,600.00
Factory payroll 320.00
Interest expense accrued 7.50
Total current liabilities $ 11 ,427. 50
Net Worth:
Common stock $100,000.00
Surplus 23,812.16 123,812.16
Total liabilities and net worth $135 , 239 . 66
Chap. XIII] COST ACCOUNTING 215
BLACKWELL MANUFACTURING COMPANY
CONDENSED PROFIT AND Loss STATEMENT
For the Month Ending December 31, 19
Sales $31,500.00
Less sales returns and allowances 375 . 00
Net sales $31 ,125.00
Less cost of goods sold (see statement of cost to
manufacture and cost of goods sold) 26 , 223 . 70
Gross profit on sales $ 4,901 .30
Selling expenses:
Salesmen's salaries $1 , 500 . 00
Salesmen's traveling expenses 410 . 00
Advertising 250.00
Telephone and telegraph 16. 00
Total selling expenses $ 2,176.00
General and administrative expenses:
Office salaries $ 440.00
Office supplies expense 25 . 00
Telephone and telegraph 16. 00
Insurance 25 . 00
Depreciation of building 29 . 97
Depreciation of office equipment. . . 22.92
Taxes 20.00
Bad debts 332.50
Total general and administrative expenses . . 91 1 . 39
Total operating expenses 3,087. 39
Net operating profit $ 1,813.91
Other expenses:
Interest expense 30 . 00
Underapplied manufacturing overhead 65 . 00
$ 95.00
Other Income:
Purchase discount 160.00 65.00
Net profit for the period $ 1,878.91
216 ELEMENTS OF ACCOUNTING [Chap. XIII
BLACKWELL MANUFACTURING COMPANY
STATEMENT OF COST TO MANUFACTURE AND COST OF GOODS SOLD
For the Month Ending December 31, 19
Direct material:
Materials inventory, December 1, 19 $14,835.25
Purchases of materials 8, 275 . 00
Total $23,110.25
Less materials inventory, December 31, 19 13 , 570 . 00
Materials placed in production $ 9 , 540 . 25
Indirect materials used 1 , 000 . 00
Cost of direct materials used $ 8,540.25
Direct labor applied to production 11,125.00
Manufacturing overhead applied to production
(See analysis of manufacturing overhead) 5 , 254 . 95
Total cost to manufacture 24,920.20
Add work in process, December 1, 19 $ 9,633.50
Deduct work in process, December 31, 19 7,630.00
Net addition 2,003.50
Cost of goods manufactured $26,923.70
Add finished goods, December 1, 19 $ 5,500.00
Deduct finished goods, December 31, 19 6,200.00
Net deduction 700 . 00
Cost of goods sold $26,223.70
BLACKWELL MANUFACTURING COMPANY
ANALYSIS OF MANUFACTUKING OVERHEAD
For the Month Ending December 31, 19
Manufacturing overhead incurred:
Indirect labor $2,225.00
Indirect material 1,000.00
Factory light, heat, and power 785 . 00
Repairs to equipment 125 . 00
Factory insurance 75 . 00
Depreciation of machinery and fac-
tory equipment 355 . 00
Depreciation of building 59. 95
Taxes 60.00
Sundry factory expense 635 . 00
Total manufacturing expense $5 , 319 . 95
Less applied manufacturing expense ... 5 , 254 . 95
Balance underapplied manufacturing
expense $ 65.00
Chap. XIII] COST ACCOUNTING 217
Summary. Cost accounting can render important services to
management in the fields of finance, production, and sales. In
finance it can supplement the general accounting records by
offering detailed analyses of expenses, and it permits the pre-
sentation of statements of operation at more frequent intervals
than is feasible in general accounting. In production detailed
costs when compared with standard or budgetary figures enable
management to know when specific costs are under control. In
sales an analysis of costs enables management to better control
the functions of selling, delivery, and collecting. Moreover,
unless costs are known, the management cannot act intelligently
in adjusting production to market price or in adjusting selling
price to the buyer's demand for the product. In all cases cost
accounting offers data which permits the management to make
decisions in terms of the effect upon unit costs and hence upon
profits.
Costs may be classified as follows:
1. Production costs, consisting of
a. Direct material
6. Direct labor
c. Manufacturing overhead
2. Distribution costs, consisting of
a. Selling
6. General and administrative
These five are assembled not only by their respective groups but
by departments. This enables management to control costs by
production and distribution centers and to delegate responsibility.
In general there are two methods of accumulating costs, the
process and the specific order systems. In both, expenses are
classified by departments. They differ, however, in the manner
of determining the product's unit cost. Under the process
system the unit cost is an average. This method is used when
the products are indistinguishable and are manufactured as a
result of successive operations. In contrast the specific order
system accumulates costs for each product and is used when the
products are different and are manufactured as a result of assem-
bling the various parts.
Control should be exercised not only over processes, depart-
ments, or products, but also over specific costs. This may be
218 ELEMENTS OF ACCOUNTING [Chap. XIII
made effective through a system of internal check and through
the analysis of cost statements.
Questions
Review.
1. Name and describe briefly five accounts in the general ledger which
control detailed costs in a factory cost accounting system.
2. What is the purpose of a system of internal check?
8. What are the principal operations involved in controlling materials?
Outline a system of internal check indicating how the following forms
assist in the control of material cost:
a. Purchase requisition
6. Purchase order
c. Invoice
d. Receiving record
e. Stores ledger sheet
/. Material requisition
4. What are the usual operations in controlling labor cost? Discuss a
system of internal check stating how the following forms aid in exercising
control over labor cost:
a. Clock card
6. Daily time report
c.* Direct labor payroll
6. Is a close distinction between direct and indirect costs important in a
process cost accounting system? In a specific order system?
6. Why is a normal distribution rate used for apportioning manufacturing
overhead?
7. Describe briefly the computation of the following distribution rates:
a. Direct labor-hour rate
6. Labor cost rate
c. Machine-hour rate
8. In general should a normal distribution rate based on cost or time be
used for the distribution of manufacturing overhead?
9. What do distribution expenses include?
10. Outline briefly the steps to be taken in controlling distribution costs.
11. Give two reasons why cost accounting statements are preferable to
statements ordinarily prepared from a financial accounting system.
Suggested Supplementary Readings
For a brief treatment of cost accounting:
BUBTON, N. L.: "Introduction to Cost Accounting," Longmans, Green #
Company, New York, 1936,
Chap. XIII] COST ACCOUNTING 219
SCHLATTBB, C. F. i " Elementary Cost Accounting," John Wiley & Sons,
Inc., New York, 1927.
For a detailed treatment of cost accounting:
BLOCKER, J. G.: "Cost Accounting," McGraw-Hill Book Company, Inc.,
New York, 1940.
DOHB, J. L., H. A. INGBAHAM, and A. L. LOVE: "Cost Accounting," The
Ronald Press Company, New York, 1935.
LAWBENCE, W. B.: "Cost Accounting," Prentice-Hall, Inc., New York,
1937.
NEUNEB, J. J. W.: "Cost Accounting," Business Publications, Inc., Chicago,
1938.
REITELL, C., and C. E. JOHNSTON: "Cost Accounting," International Text-
book Company, Scranton, Pa., 1937.
SANDEBS, T. H.: "Cost Accounting for Control," McGraw-Hill Book
Company, Inc., New York, 1934.
VAN SICKLE, C. L.: "Cost Accounting," Harper & Brothers, New York, 1938.
WILLCOX, R. S.: "Cost Accounting," Business Publications, Inc., Chicago,
1934.
CHAPTER XIV
STATEMENT ANALYSIS
In the preceding chapters emphasis has been placed on the
proper recording and presentation of business transactions.
This, of course, is an essential prerequisite to the analysis of
financial statements. Unless transactions have been accurately
recorded and the statements have been honestly and competently
prepared in such a way as to disclose the significant facts of the
enterprise, no technique of analysis, however refined, can be
relied upon to present results which either investors, creditors, or
management can accept with confidence. The interpretation of
financial statements, however, is of more immediate importance
to these three groups than either the recording or the presentation
of accounting data ; for it is upon the analysis of business records
that policies and activities are largely based.
In the analysis of statements the viewpoints of investors,
creditors, and management vary. The investor is primarily
interested in the safety of his investment and the profit he hopes
to realize. The creditor is chiefly concerned with the ability of
the enterprise to pay its obligations when they fall due. The
management, while interested in these two viewpoints, is con-
cerned with the broader outlook of strengthening finances and
increasing profits.
Techniques of Analysis. Techniques of analysis may be classi-
fied in two groups. First are those which compare items, or
groups of items, taken from statements of the same date. These
relationships, known as ratios, are usually stated in percentage
form, although sometimes as decimals or fractions.
Ratios 1 may be conveniently divided into those which are pre-
pared from data in .
1 No attempt is made to offer a comprehensive survey of ratios. For a
detailed discussion see Stephen Oilman, "Analyzing Financial Statements,"
The Ronald Press Company, New York, 1934.
220
Chap. XIV) STATEMENT ANALYSIS 221
1. The balance sheet
2. The profit and loss statement
3. Both statements
The second technique consists of comparing items, or groups of
items, with those of a preceding period in order to establish a
trend.
Standards of Comparison. The success of either technique
depends on the use of proper standards of comparison; lacking
these, ratios or trends are of limited significance. These stand-
ards may be based on data taken either from the records of the
business or from outside sources dealing with comparable
enterprises.
Ordinarily the most useful base of comparison is that of past
performance. This base is essential to the establishment of a
trend and will be the subject of discussion in the succeeding
chapter.
Standards drawn from outside sources 1 provide valuable means
for comparing enterprises. The bases must, however, be carefully
chosen in order to be certain that they are appropriate, that the
items are comparable, and that proper features are emphasized.
The capital structure of an insurance company, for example,
differs greatly from that of a railroad, and it is to be expected that
an analysis of each would stress different items in the respective
statements. Differences in enterprises due to size, to geo-
graphical location, and to seasonal or cyclical variations require
care in the selection of standards. These and other differences
prevent the interpretation of statements from being a routine
procedure.
Purpose and Limitations of Ratio Analysis. In the analysis of
financial statements ratios are valuable means of diagnosis,
1 Among the important sources of standards obtained from outside sources
the following should be mentioned: financial manuals, particularly Moody 's,
Poor's, and those of the Standard Statistics Company; financial magazines,
such as Barren's, the Commercial and Financial Chronicle, and the Magazine
of Wall Street; departments of the Federal government, especially the Bureau
of Foreign and Domestic Commerce; publications of trade associations and
data obtainable from correspondence with the associations' secretaries;
publications of credit agencies, notably Dun and Bradstreet (their special
studies contain valuable ratio standards); bureaus of business research; and
the files of public accountants.
222 ELEMENTS Of ACCOUNTING [Chap. XIV
although in themselves they are not significant. When, however,
they are compared with appropriate standards and the relation-
ship is explained, they can be used to indicate financial and
operating strength or weakness.
Two limitations in the use of ratios should be noted. First,
the ratio must be selected which will best express a comparison
between significant financial or operating elements. What these
elements are depends on the purpose to be served by the analysis.
Creditors, for example, might well be interested in the ratio of
current assets to current liabilities they would not ordinarily
be as interested in the ratio of advertising to sales.
Second, unless good judgment is exercised in the application
of the ratio, the conclusions of the analysis are of questionable
benefit. The blind acceptance of a 2 to 1 standard as the desira-
ble relationship between current assets and current liabilities
without considering the limitations of the ratio is misleading.
Balance Sheet Ratios. The ratio of current assets to current
liabilities is undoubtedly the most widely known balance sheet
ratio. Expressed algebraically, and substituting the figures in
the illustration on page 223, it is as follows:
Current assets $45,000
= 1.9 to 1
Current liabilities $23,250
The purpose of this ratio is to indicate the ability of the
enterprise to pay its obligations. The excess of the current
assets over the current liabilities, or working capital, 1 offers some
measure of the protection afforded creditors.
As a rough criterion of debt-paying ability, it is useful. It is
misleading, however, to accept an arbitrary rule-of -thumb stand-
ard such as the widely used 2 to 1 ratio as an inflexible basis for
passing judgment on the solvency of a business. The amount of
working capital needed in a business is just that amount which is
enough to pay all obligations as they fall due. If more than
the necessary amount is kept on hand, the capital is not being
1 The term "working capital" should be used with care. The definition
given here conforms with the tentative definition given by the Special
Committee on Terminology of the American Institute of Accountants, and
also with long usage. The term "working capital" is sometimes employed,
however, to refer to total current assets, and the term "net working capital"
to refer to the excess of current assets over current liabilities.
Chap. XIV]
STATEMENT ANALYSIS
223
employed to best advantage and the proprietors are not receiving
the return that they might on the capital invested. If less than
enough working capital is maintained, the enterprise is, of course,
risking bankruptcy.
THE MILLER CORPORATION
BALANCE SHEET WITH PERCENTAGE COMPUTATIONS
December 31, 19
Amount
Percentage
of Total
Assets
Current Assets:
Cash
$ 5,000
3 1
Accounts receivable
20,250
12 8
Notes receivable
2,000
1 2
Merchandise inventories, December 31, 19_. .
Prepaid expenses
17,250
500
10.9
3
Total current assets
$ 45,000
28 3
Fixed Assets:
Land
$ 6,000
3.8
Buildings (net) .
40 000
25 2
Machinery and equipment (net)
65 , 000
40.9
Furniture and fixtures (net)
2,750
1 7
Total fixed assets
$113,750
71.6
Total assets
$158,750
100.0
Liabilities and Net Worth
Current Liabilities:
Accounts payable
$ 15,000
9.4
Notes payable
7,500
4.7
Accrued expenses
750
0.5
Total current liabilities
$ 23,250
14.6
Long-term Liabilities:
First mortgage bonds payable
25,000
15.7
Total liabilities
$ 48,250
30.3
Net Worth:
Common stock
$100,000
63.0
Surplus
10,500
6.6
Total net worth
$110,500
69.6
Total liabilities and net worth
$158,750
100.0
The amount of working capital required varies not only
between enterprises but also in the same business according to
224 ELEMENTS OF ACCOUNTING [Chap. XIV
seasons and according to the business cycle. Furthermore this
ratio offers no test of the rapidity of turnover of current assets
and current liabilities. If current assets are converted into cash
slowly and current liabilities mature quickly, a 2 to 1 ratio may
prove inadequate. 1
The ratio of quick assets to current liabilities (the "acid-test"
ratio) is a variation of the ratio of current assets to current
liabilities. When essential data are secured from the illustra-
tion on page 223, this ratio appears as follows:
A . , .. Quick assets $27,250 1 , -
Acid ratio = ~ ^ r ,. r . = eoo ' A = 1.2 to 1
Current liabilities $23,250
Quick assets include all the current assets except inventories.
Only cash available for the payment of debts and notes and
1 This point has been discussed as follows :
" A merchant who is granted a 60-day credit on a bill of goods by whole-
salers, for example, may be able to turn his stock-in-trade into cash com-
pletely within a 30-day period. How much capital need such a merchant
have in his business? None, it is answered, because the returns from his
sales will always be sufficient to pay his debts. The merchandise stock
will turn twice before his bills fall due. A renewal of his stock at the end
of 30 days need cause him no worry, as it likewise can be turned into cash
before payment is due. An investment in working assets will be required
here only if the conditions change, either through slowing of the stock
turnover caused by seasonal variations, or through the shortening of the
credit terms extended to him by wholesalers.
"If, then the business is thus self-sustaining, what becomes of the
popular two-to-one liquidity ratio? Has it any meaning other than a desire
to compel the entrepreneur to insure his stock at least one-half of its value
for the benefit of creditors? But why 50%? Some merchandise shrinks
75 % and even more at forced sales.
"Turning now to the other extreme, take the case of a merchandise
stock turnover of twice yearly, coupled with a credit extension of 10 days
from wholesalers. If it requires six months to sell the entire original stock,
and if it is customarily renewed as sold, and if the merchandise must be
met in 10 days, the owner must invest an amount equal to far more than
one-half of the average inventory as a matter of financial necessity. The
liquidity ratio must be much greater than two-to-one. True, if the profits
are sufficiently great to pay back the entire cost within 10 days granted
by the wholesaler, a two-to-one ratio might suffice. But such gains are
inconsistent with current merchandising." Gregory, H. E., "Accounting
Reports in Business Management," p. 209, The Ronald Press Company,
York, 1928,
Chap. XIV] STATEMENT ANALYSIS 225
accounts receivable resulting from normal trading activities
should be included.
This ratio is particularly useful in indicating the debt-paying
ability of the enterprise when large inventories are carried and if
there is any doubt about its valuation or how rapidly it may be
converted into cash. Special attention should be given to the
amount of receivables since their collectibility is an important
consideration in determining whether the assets are in fact
"quick."
The arbitrary standard often used is the ratio of 1 to 1: for
every dollar of current liabilities there should be a dollar of quick
assets to pay for them. Both the ratio of current assets to cur-
rent liabilities and the ratio of quick assets to current liabilities
indicate a condition of short-run solvency.
In contrast the ratio of net worth to total assets is an index of
solvency from the long-run point of view.
From the essential data from the balance sheet on page 223,
this ratio is computed as follows:
Net worth $110,500 ^
rr, . , = ji go ,y g x = 70 per cent
Total assets $158,750 ^
In general the larger the percentage of total asset investment
furnished by the owners, the greater the protection afforded
creditors and the less likelihood of failure due to inadequate
working capital.
Another valuable ratio which may assist in determining long-
run solvency is that of net worth to fixed assets. This ratio is
computed as follows:
Net worth _ $110,500 _
Total assets ~~ $113,750 ~ y/ per Cent
An increase in the proportion of net worth invested in fixed assets
should be closely watched. Overinvestment in fixed assets is
more difficult to remedy than in current assets for, while items
within the current asset group can be liquidated within a com-
paratively short time and the error corrected, investment mis-
takes made within the fixed asset group cannot be remedied so
easily since the life span of the asset is so much longer. Conse-
quently the opportunity to amend these investment errors must
be postponed to a later date. The difficulty of overinvestment
in fixed assets lies not only in the unbalanced financial structure
226 ELEMENTS OF ACCOUNTING [Chap. XIV
but also in the increase of such fixed charges as depreciation,
insurance, and taxes all of which continue regardless of the
income earned during the period.
Other balance sheet ratios emphasizing special features of
solvency or the distribution of the investment among the various
assets may be worked out. These depend on the special rela-
tionships to be emphasized and the person for whom the analysis
is being made. 1
Significant relationships may be noted from an examination of
a balance sheet by means of percentage computations. These
computations may be helpful in determining whether the invest-
ment has been prudently distributed among receivables, inven-
tories, or fixed assets. A disproportionate investment in any of
these may indicate a serious business ailment.
Profit and Loss Ratios. In recent years there has been a shift
from the importance formerly accorded the balance sheet to a
greater emphasis on the accounting requirements and the analysis
of the profit and loss statement. 2
The operating ratio is one of the most widely used of those
prepared from data within the profit and loss statement. It is
expressed as follows:
1 Two ratios widely used and designed to show the proportion of invest-
ment supplied by the owners or creditors are those of net worth to total
liabilities and total liabilities to total assets.
2 The following excerpt from a letter is an expression of this viewpoint.
"It is probably true that the accounting principles should be determined
and an accounting system organized with a view to securing an accurate
profit and loss figure and that the balance sheet is only a by-product of an
accurate statement of profit and loss."
The shortcomings of the balance sheet audit and the unfortunate reliance
that investors have placed upon the balance sheet as an index of the sound-
ness of investments have led many to minimize the significance of the balance
sheet and to emphasize the importance of the profit and loss statement.
The accounting requirements of these two statements may be closely related.
Costs furnish an illustration. In the balance sheet they appear as a series
of charges deferred to future periods (fixed assets), in the profit and loss
statement as the portion applicable to the current fiscal period (deprecia-
tion). Both statements are essential if adequate information about the
financial structure and operations of the enterprise is to be given. More-
over the profit and loss statement is probably no less susceptible to manipu-
lation than is the balance sheet. For an account of vanous methods of
income manipulation see B. Graham and D. L. Dodd, "Security Analysis,"
Chaps. 31-34, McGraw-Hill Book Company, Inc., New York, 1940.
Chap. XIV]
STATEMENT ANALYSIS
227
Operating ratio = Cost of good8 8old + P eratip g expenses
Total net sales
THE MILLER CORPORATION
PROFIT AND Loss STATEMENT WITH PERCENTAGE COMPUTATIONS
For the Year Ending December 31, 19
Amount
Percentage
of Sales
Sales (net)
$275,000
100
Cost of goods sold ... . .
214,000
77 8
Gross profit
$ 61,000
22.2
Operating expenses:
Selling expenses:
Salesmen's salaries
$ 28,000
10.2
Advertising
8,300
3.0
Bad debts
2,820
1.0
Sundry selling expenses
1,280
0.5
Total selling expenses
$ 40,400
14.7
General administrative expenses:
Office salaries
$ 6,500
2.4
Depreciation of furniture and fixtures
600
0.2
Insurance
1,750
0.6
Taxes
1,150
0.4
Sundry general administrative expenses. . . .
750
0.3
Total general administrative expenses . . .
$ 10,750
3.9
Total operating expenses
$ 51,150
18.6
Net operating profit
$ 9,850
3.6
Nonoperating items:
Interest expense
$ 1,450
5
Less interest income
325
0.1
Net iioiioperating expenses . ...
$ 1 , 125
0.4
Net profit
$ 8,725
3.2
Disposition of net profit
Dividends .
$ 5,000
To surplus
$ 3 , 725
When essential information from the illustrative statement on
this page is interpolated, the ratio computed from these data is
as follows:
228 ELEMENTS OF ACCOUNTING [Chap. XIV
$265,150 _,
= 96 PCT Cent
This ratio shows the relation between cost and selling prices in
the company and indicates the adequacy of the revenue to cover
the operating costs incurred.
Closely related to the operating ratio as an index of efficiency
in operation is the ratio of net (or operating) profit to sales. This
indicates how much of every dollar of sales results in profit. It
is computed as follows:
Net profit $9,850 r
= $275^000 = 3 ' 5
A common method of showing relationships within the profit
and loss statement is to compute various expense and revenue
groups as a percentage of sales (see page 227). When compared
with corresponding figures of a preceding period, it is most useful
in disclosing expense trends.
Interstatement Ratios. The third group of ratios are those
prepared from data in the balance sheet and in the profit and loss
statement. These indicate the profitableness of the investment
in the business.
Outstanding among the interstatement ratios is the ratio of
earnings to total assets. This is expressed as follows:
Earnings
Total assets
After substituting the necessary figures from the two statements
in this chapter, the ratio would be
$8,725
= 5 ' 5 per Cent
This ratio is particularly important since it indicates the success
of management in terms of the rate of earnings on all assets.
Similar relationships may be computed to show the rate of
earnings on groups of equities. Typical of these is the ratio of
earnings to proprietorship expressed as follows:
Earnings _ $8,725 _ 7Q
Proprietorship ~ $110,500 " 7 * y P6r ent
Chap. XIV] STATEMENT ANALYSIS 229
This ratio is, of course, significant to the owner for it shows the
return received on his capital balance at the end of the fiscal
period. This ratio is frequently computed according to types of
stockholders. It is often considered more important, when
computing these ratios, that earnings from major operations be
used instead of net profit. The reason for this is to eliminate
exceptional elements such as nonoperating income and expenses
since by doing so the profitableness of the investment or any
portion of it can be judged in terms of recurring income and
expenses.
Turnover ratios are similar to those of earning power in that
they indicate the effectiveness with which the assets are being
utilized. If, for example, the investment in the inventory turns
over once during the fiscal period and a profit results, the profit
will be doubled if the inventory investment turns over twice and
the same rate of profit prevails. The more often such trans-
actions of turnovers can be profitably repeated within a fiscal
period, the more profitable is the investment in the asset in
question.
The turnover of all the capital invested in the business is
expressed by the ratio of saks to total assets. Again, using
appropriate data from the two statements in this chapter, this
would be computed as follows:
Net sales $275,000 ? .
Total assets ~ $158,750 S
This indicates how effectively all the capital of the enterprise has
been utilized.
Another ratio, used even more perhaps than the one just dis-
cussed, is the merchandise turnover ratio. If the inventory is
valued at cost, it is expressed as the proportion of cost of goods
sold to the average inventory; if valued at selling price, it is
shown as the proportion of sales to the average inventory. 1
1 Caution should be exercised in the comparison of inventory turnover
ratios. For example, there is a greater margin between cost and selling
price in the products of industries producing typewriters than there is in
the products of meat-packing industries. In order to realize the same
return on the capital invested, it is to be expected that the inventory turn-
over would be greater in the later instance than in the former.
230 ELEMENTS OF ACCOUNTING [Chap. XIV
The inventory turnover ratio for the illustration in this chapter
is computed as follows (assuming $20,000 for the January 1,
19 , inventory):
Cost of goods sold $214,000 , ,
A ' 1 ~ 'MQ gOK = 11-
Average inventory $18,625
Care should be taken to be certain that the inventory is represent-
ative of merchandise on hand throughout the year. If it is
abnormally high or low, the resulting ratio will not, of course,
typify conditions which usually prevail.
Turnover ratios for accounts receivable, current assets, and
fixed assets may be very significant. Like other turnover ratios,
they indicate the effectiveness of the investment in particular
groups of assets and, if prudently used, may be helpful in dis-
closing overinvestment in them.
Questions
Review.
1. Explain why the accurate recording, presentation, and summarization of
business data are important prerequisites to the analysis of statements.
2. What two techniques of analysis are widely used?
3. Why are standards of comparison important in statement analysis?
4. What is the purpose of statement analysis? What are its limitations?
6. What ratios may be used to indicate the following:
a. Short-run solvency
b. Long-run solvency
c. The adequacy of revenue received from major operations
d. Profitableness of sales
e. The earning power of
(1) Total assets
(2) Proprietorship
(3) Specific asset groups
/. The effectiveness of utilizing the investment in
(1) Total assets
(2) Merchandise
(3) Accounts receivable
6. Explain how statements with percentage computations can be used to
advantage in statement analysis.
CHAPTER XV
STATEMENT ANALYSIS (Concluded)
While the development of techniques to aid in determining
desirable or undesirable business conditions is important, it is
equally significant to know the trend of finances and operations.
It is quite possible for the condition of an enterprise to be satis-
factory as judged by a single, or several ratios, and at the same
time for the trend to be unsatisfactory.
Ratios and Trends. Significant trends may be disclosed from
an examination of the same ratios for successive years. Assume,
for example, that in a given enterprise the ratios of quick assets
to current liabilities for several years appear as follows:
1937 3 2 to 1
1938 3 3 to 1
1939 2.2 to 1
1940 2.4 to 1
1941 1 6 to 1
The last ratio of 1.6 to 1 may be quite adequate, but the manage-
ment might well consider whether the causes for the decline in
this ratio as disclosed by the trend are such as to continue.
While not conclusive in itself, this device does suggest a point of
departure for a more thorough investigation.
Balance-sheet Comparisons. The comparative balance sheet
(page 232), showing increases or decreases in asset, liability, or
proprietorship items, is invariably used as the basis for deter-
mining financial trends. The usual method of classifying and
presenting these changes is in the form of the statement of source
and application of funds (page 233). 1
1 This statement, or some variation of it, is known by several other titles.
Among these are "statement of funds," "analysis of changes in financial
position," "application of funds statement/' and the "statement of new
assets and their application." The term "funds" as used in the present
discussion refers to balance sheet changes that give rise to sources and
applications of values for a given fiscal period.
The principal difference between the statement of source and application
of funds illustrated in this chapter and more elaborate forms lies in the
adjustments made to eliminate transactions which do not represent a flow
231
232
ELEMENTS OF ACCOUNTING
(Chap. XV
THE MILLER CORPORATION
COMPARATIVE BALANCE SHEET
December
31, 19A
December
31, 19B
Increase
Current Assets:
Cash
$ 5,000
$ 6,200
$ 1,200
Accounts receivable
20,250
24,300
4,050
Notes receivable
2,000
3 000
1,000
Merchandise inventories . . .
17 250
26 000
8,750
Prepaid expenses
5 000
7 500
2 500
Total current assets
$ 49,500
$ 67,000
$17,500
Fixed Assets:
Land
$ 6,000
$ 6,000
Buildings (net)
40 000
38 000
$ 2,000*
Machinery and equipment (net) . . .
Furniture and fixtures (net)
65,000
2,750
72,400
2,150
7,400
600*
Total fixed assets
$113,750
$118,550
$ 4,800
Total assets
$163,250
$185,550
$22,300
Current Liabilities:
Accounts payable
$ 15,000
$ 22 000
$ 7,000
Notes payable
7 500
5 000
2,500*
Accrued expenses
750
1 250
500
Total current liabilities
$ 23,250
$ 28,250
$ 5,000
Long-term Liabilities:
First mortgage bonds payable ....
$ 25,000
$ 30 000
$ 5,000
Total liabilities
$ 48,250
$ 58,250
$10,000
Net Worth:
Common stock
$100,000
$100,000
Surplus
15,000
27,300
$12,300
Total net worth
$115,000
$127 300
$12 300
Total liabilities and net worth .
$163,250
$185,550
$22,300
* Decrease.
NOTB: In the comparative statements in this chapter 19 A refers to the earlier year and
19 B to the later year.
of funds. One of the major groups of these transactions consists of adjust-
ment to net profit for such items as bad debts, depreciation, and amortiza-
tion of intangibles. These items do not represent outlays of funds. Instead,
they are allotments of past expenditures to a particular fiscal period. Simi-
larly charges to surplus arising from asset revaluations result in no flow of
funds. For a detailed discussion of the subject see H. A. Finney, "Prin-
Chap. XV] STATEMENT ANALYSIS 233
THE MILLER CORPORATION
STATEMENT OF SOURCE AND APPLICATION OF FUNDS
DURING THE YEAR 19B
Sources of funds:
Decreased assets:
Buildings $ 2,000
Furniture and fixtures 600
$ 2,600
Increased liabilities:
Bonds payable 5,000
Increased proprietorship:
Surplus 12,300
$19,900
Application of funds:
Increased assets:
Net increase in working capital $10, 000
Prepaid expenses 2 , 500
Machinery and equipment 7, 400
$19,900
A statement of changes in working capital (see below) usually
accompanies the source and application of funds statement. The
net increase or decrease in working capital shown as one figure is
more significant in the source and application of funds statement
than is a list of the current assets and current liabilities shown in
full. The detailed items may be arranged in the following form:
STATEMENT OF CHANGES IN WORKING CAPITAL
Increase in working capital:
Increases in current assets:
Cash $1 ,200
Accounts receivable 4 , 050
Notes receivable 1 , 000
Inventories 8, 750
Decreases in current liabilities:
Notes payable 2,500
$17,500
Decreases in working capital:
Increases in current liabilities:
Accounts payable $7,000
Accrued expenses 500
7,500
Net increase in working capital $10,000
ciples of Accounting" (Intermediate), Chaps. 29 and 30, Prentice-Hall, Inc.,
New York, 1934.
234 ELEMENTS OF ACCOUNTING [Chap. XV
The statement of source and application of funds indicates the
movement of financial values in the enterprise. Sources of these
values are as follows:
1. A decrease of assets brought about by
a. The reduction of working capital
6. The sale of fixed or other assets
2. The increase of liabilities by
a. Using long-term liabilities
3. The increase of proprietorship resulting from
a. Earnings from operations or other sources
fe. Capital investments of the owners
c. Gifts to the organization
Values are applied as follows:
1. To the increase of assets by
a. Increasing working capital
b. Purchasing a fixed or other asset
2. To the decrease of liabilities by
a. Reducing long-term liabilities
3. To the decrease of proprietorship by
a. Losses from operations or for other reasons
6. Payments of dividends, retirement of capital stock, or
other decreases of the capital investment
c. Donations by the organization
Favorable and Unfavorable Financial Trends. The statement
of source and application of funds is designed to present financial
data in a form which permits the evaluation of methods of
financing used by the enterprise. The principal means of cor-
porate financing are as follows:
1. Reinvestment of profits
2. Short-term notes
3. Bonds
4. Stocks
Of these four the reinvestment of profits, the "New England "
method, is the most conservative, since no claims of either prin-
cipal or interest need be paid in the future.
When the earnings of the enterprise permit, this method can be
used equally well to finance current or fixed assets. The working
Chap. XV] STATEMENT ANALYSIS 235
capital position is strengthened when funds obtained from profit-
able operations are used to increase current assets or decrease
current liabilities. Similarly the investment of profits in fixed
assets is a most conservative method of financing, since there are
no future claims for repayment of the amounts invested.
Short-term notes, on the other hand, require that the funds
invested from this source be repaid within a brief period of time.
Herein lies the principal danger in their use. The criterion of
self -liquidation is the standard to be applied to investments from
the proceeds of notes. They can properly be used only when the
assets purchased are sold prior to the maturity of the note and the
proceeds realized are applied to its payment.
One of the most unfavorable of all financial trends is that of
using funds secured from short-term borrowing to purchase fixed
assets. The proceeds of such an investment are frozen in the
asset for a period longer than the maturity date of the note.
Consequently, if the note is paid, funds must be secured elsewhere.
A similar situation arises when short-term notes are used to
reduce or pay off mortgages or other long-term liabilities. The
proceeds, once paid out, are not recoverable for the payment of
the note when it matures.
Most of the difficulties inherent in the use of short-term notes
can be overcome through the use of bonds or other forms of long-
term indebtedness. The principal distinction between a note and
a bond, so far as the trend of funds is concerned, is a question of
maturity. The use of proceeds secured from bonds, however,
does not carry with it the same dangers when the amount is
placed in fixed assets as is the case with short-term notes, because
a return can ordinarily be forthcoming from the investment
before the bonds mature. The investment of funds secured
from bonds to increase current assets or decrease current lia-
bilities represents a favorable trend from the standpoint of
improving the working capital position.
When an alternative of stocks or bonds may be used, the
former may prove preferable to bonds in securing funds for invest-
ment in either current or fixed assets. Stocks carry no legally
enforceable promise to pay for the principal amount; bonds do.
Dividends may be passed on common stock and often in certain
types of preferred stock, whereas interest on bonds cannot
ordinarily be passed without serious consequences.
236
ELEMENTS OF ACCOUNTING
[Chap. XV
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Chap. XV] STATEMENT ANALYSIS 237
Funds secured from the sale of fixed assets and applied to the
increase of current assets or the decrease of current liabilities
improves the position of working capital. The wisdom of this
trend, however, depends upon whether the operations have in any
way been impaired from the disposition of the fixed asset.
Profit and Loss Comparisons. The comparative profit and
loss statement (page 236) usually furnishes the basis for an
analysis of the earnings trend. The fact that a profit or a loss
has been made during a fiscal period, while important, is probably
no more significant to management or investors than is a knowl-
edge of the trend of earnings for several years past. For this
reason supplementary information about the trend of earnings
might well accompany statements of profit and loss.
A technique for the analysis of variations in net profit may be
a useful aid in interpreting this trend. The variation in profit
may be explained as being due to three causes: changes in the
volume of sales, changes in the cost of the goods sold, and
changes in operating and other expenses. The principal sections
of the profit and loss statement, it will be recalled, are as follows:
Sales xxx
Less cost of goods sold xx
Gross profit xx
Less expenses xx
Net profit x
An increase in net profit, for example, may be due to one or
more of the following causes:
1. An increase in the revenue from sales
2. A decrease in the cost of goods sold
3. A decrease in expenses
The analysis of the variation in net profit in the illustration
under discussion may be made as shown on page 238.
In this type of analysis, when two years are being compared,
the earlier year is taken as the base. The change in gross profit
due to the increase in the volume of sales is determined by obtain-
ing the difference ($5,000) and multiplying this figure by the
percentage of gross profit earned in the base year (22.18 per cent),
to obtain the amount of $1,110.
The decrease in gross profit due to the increased cost of goods
sold is determined by comparing the current year's cost of goods
238 ELEMENTS OF ACCOUNTING [Chap. XV
THE MILLER CORPORATION
STATEMENT OF VARIATION IN PROFIT
Change in gross profit due to sales volume :
Sales in 19B $280,000
lin 19A 275,000
Increase in sales volume 5 , 000
Increase in gross profit due to increased sales volume $1 , 110
Change in gross profit due to variation in cost of goods sold:
Cost of goods sold for 19B $218,000
Cost of goods sold on 19A basis 217,890
Decrease in gross profit due to increased cost of goods
sold 110
Net increase in gross profit $1 ,000
Net increase in expenses 5 , 010
Decrease in net profit $4 ,010
sold ($218,000) with what it would have been had the same rela-
tion existed between the cost and selling prices in the last year
as in the former one. Had the same percentage prevailed, the
cost of goods sold in the last year would have been 77.8 per cent
of sales ($280,000), or $217,890.
Finally the increase in the operating and other expenses for
the two periods is determined and the net decrease in profit is
shown.
This technique, like the other described in this chapter, does
not offer a conclusive explanation. It does, however, disclose
significant trends and indicates to the management the direction
in which its attention should be applied.
Summary. The interpretation of accounting statements is of
more immediate significance to management than either the
recording or summarization of business transactions, since policies
and activities are based largely upon the analysis of business
transactions. Proper recording and summarization are impor-
tant prerequisites, however, for, unless the statements are
honestly and competently prepared, the results will be of ques-
tionable significance.
Techniques of analysis may be divided into those concerned
with the establishment of relationships between items or groups
of items and those concerned with the establishment of trends.
Chap. XV] STATEMENT ANALYSIS 239
The successful use of either technique depends upon proper
standards of comparison. These may be based upon the past
performance, or they may be drawn from outside sources. In
the latter case, particularly, care must be taken to be certain that
the standards are appropriate.
The first technique of analysis, the establishment of relation-
ships by using ratios, is a valuable means of diagnosis when
employed with proper standards of comparison. Two limitations
of ratios should be noted : first, the ratio must be selected which
will best express a comparison between significant elements;
second, its successful use requires sound judgment based on a
knowledge of the business.
Ratios may be conveniently divided into those computed from
data in the balance sheet, from data in the profit and loss state-
ment, and from data taken from both statements.
In the balance sheet two ratios are widely used to indicate a
condition of short-run solvency : that of current assets to current
liabilities and that of quick assets to current liabilities. The
relationship of net worth to total assets is a useful aid to indicate
the long-run solvency of the enterprise.
In the profit and loss statement the operating ratio is widely
accepted as a criterion of managerial efficiency and the ratio of
net profit to sales as an indicator of the profitableness of the
business.
Of the relationships computed from data taken from both
statements, the ratios of earning power and turnover are generally
most useful.
It is quite possible for the condition of a business to be adjudged
satisfactory according to ratios and at the same time for the
trend to be unsatisfactory. The usual method for determining
the financial trend of an enterprise is to employ the comparative
balance sheet in order to ascertain increases and decreases in
asset, liability, and proprietorship items and to classify these
changes in a statement of source and application of funds.
The comparative profit and loss statement furnishes a basis
for the analysis of the earnings trend. Another helpful technique
is the analysis of the variation in net profit due to changes in
sales volume, changes in the cost of the goods sold, and changes
in operating and other expenses.
240 ELEMENTS OF ACCOUNTING [Chap. XV
The use of ratios and analytical devices to determine trends
of financing and operations are essential techniques for the
analyst. Techniques, however, must be clearly distinguished
from the interpretation of statements. In order to interpret, the
analyst must not only be familiar with the various techniques
but must also have a knowledge of the business, be able to select
the most significant aspects of the enterprise for analysis, choose
appropriate standards for comparison, and, finally, use sound
judgment in the interpretation of the results.
Questions
Review.
1. How can ratios be used in establishing trends?
2. Explain how comparative statements can be used as a device in deter-
mining trends.
3. What is the statement of source and application of funds?
4. Give a classification of the sources and the means of applying funds.
6. Discuss the favorable and unfavorable financial trends when the following
methods of raising capital are used:
a. Reinvestment of profits
b. Short-term notes
c. Bonds
d. Stocks
Discussion.
6. "Financial and operating statements are historical. They reflect past
transactions; hence any analysis of them is of little significance."
Evaluate.
Suggested Supplementary Readings
BOLON, D. S.: "Introduction to Accounting," Chaps. 32 and 33, John
Wiley & Sons, Inc., New York, 1938.
COLE, W. M.: "The Fundamentals of Accounting," Chap. 20, Houghton
Mifflin Company, Boston, 1921.
HUSBAND, G. R., and O. E. THOMAS: "Principles of Accounting," Chaps. 31
and 32, Houghton Mifflin Company, Boston, 1935.
KESTBR, R. B.: "Principles of Accounting," 4th ed., Chap. 26, The Ronald
Press Company, New York, 1939.
PATON, W. A.: "Essentials of Accounting," Chap. 38, The Macmillan
Company, New York, 1938.
PORTER, C. H., and W. P. FISKE: "Accounting," Chap. 21, Henry Holt &
Company, Inc., New York, 1935.
EOREM, C. R.: "Accounting Method," Chaps. 38 and 39, University of
Press, Chicago, 1930,
Chap. XV] STATEMENT ANALYSIS 241
Special books on statement analysis:
BLISS, J. H.t "Management through Accounts," The Ronald Press Com-
t pany, New York, 1924.
GILMAN, S.: "Analyzing Financial Statements," The Ronald Press Com-
,/ pany, New York, 1934.
GREGORY, H. E,: "Accounting Reports in Business Management," The
Ronald Press Company, New York, 1928.
GUTHMANN, H. G.: "The Analysis of Financial Statements," Prentice-
Hall, Inc., New York, 1936.
WALL, A., and R. W. DUNING: "Ratio Analysis of Financial Statements,"
Harper & Brothers, New York, 1928.
PROBLEMS
CHAPTER II. Basic Statements
Problem 1
William Davis, the proprietor of a haberdashery, began business ori
January 1, 19 , with the following asset, liability, and proprietorship items:
Cash $ 525
Merchandise 3 , 250
Furniture and fixtures 675
Accounts payable 735
William Davis, capital 3, 715
Instructions: Show by means of the basic accounting equation the con-
dition of the business January 1.
Problem 2
Six months later, June 30, 19 , the account balances were
Cash $ 650
Merchandise 3 , 475
Furniture and fixtures 690
Accounts payable 680
William Davis, capital 4, 135
Instructions:
a. Prepare a balance sheet as of June 30, 19
b. Can the profit or loss made by Davis for the 6 months be determined
by comparing his capital account on June 30 with his account on January 1 ?
Why?
Problem 3
During the 6-month period from January 1 to June 30, 19 , the revenue
and expenses were
Sales $15,265
Cost of goods sold 13,330
Salesman's salary 660
Telephone 30
Rent 600
Miscellaneous expenses 25
Instructions: From the above data prepare a profit and loss statement for
Davis's business for the period from January 1 to June 30, 19 ,
243
244 ELEMENTS OF ACCOUNTING
Problem 4
On January 20, 19 , Davis placed an additional cash investment of
$500 in the business, but by April of the same year it was apparent that the
cash balance carried was more than necessary, so on April 7 he withdrew $700.
Required: A statement of change in net worth of Davis's business from
January 1, 19 , to June 30, 19 Refer to problems 1, 2, and 3 for addi-
tional information necessary to prepare this statement.
Problem 5
At the close of business December 31, 19 , the George Washington Bank
shows the following asset, liability, and proprietorship balances:
Cash in vault and due from banks $15,500,000
Bank building 1 ,350,000
United States Government bonds 15,750,000
State and municipal securities 2 , 250 , 000
Other securities 300,000
Loans and discounts 10,750,000
Capital stock 2,700,000
Deposits 42,000,000
Surplus 1,625,000
Furniture and fixtures 135,000
Real estate 200,000
Other assets 90,000
From these balances prepare a balance sheet.
Problem 6
The following revenue and expense data are taken from the adjusted trial
balance of John Ashley December 31, 19 From them and a closing
merchandise inventory of $10,000 prepare a profit and loss statement for
the year.
Merchandise inventory, January 1, 19 $ 13,000
Merchandise inventory, December 31, 19 10,000
Purchases 75,000
Store salaries 8,300
Telephone and telegraph 400
Sales discounts 150
Salesmen's commissions 3 , 000
Bad debts 500
Depreciation of office furniture and fixtures 300
Income from security investments 225
Sales 100,000
Transportation in 300
Sales returns and allowances 2 , 000
Purchase returns and allowances 1 , 300
Store supplies used 700
Office salaries 5,800
PROBLEMS 245
Advertising 1 ,000
Purchase discounts 175
Loss on sale of fixed asset 2 , 000
Problem 7
On June 30, 19 , the following balances were taken from the records of
Curtis and Bates:
Cash $1,500
Notes receivable 750
Accounts receivable 400
Merchandise inventory, June 30, 19 5,400
Furniture and fixtures 400
Notes payable 450
Accounts payable 650
B. A. Curtis, capital 3, 820
J. D. Bates, capital 2,470
Sales 6,200
Cost of goods sold 4,700
Salaries expense 450
Interest income 25
Interest expense 15
The profit for the period (shared equally) has not been distributed. On
April 7, 19 , Curtis made an additional investment of $400; on May 3,
19 , Bates withdrew $350. The fiscal period is for 6 months.
Required:
a. A balance sheet
6. A profit and loss statement
c. A statement of change in proprietorship
Problem 8
The following balances were taken from the records of the Elliott-Pem-
broke Corporation on December 31, 19 :
Cash $ 10,000
Accounts receivable 35 , 000
Merchandise inventory 50 , 000
Land 8,000
Buildings and equipment 80 , 000
Office equipment 5 , 000
Accounts payable 27 , 500
Notes payable 5,000
Mortgage payable 25 , 000
Capital stock 100,000
Surplus 18,000
Sales 250,000
Cost of goods sold 200,000
Selling expenses 17 , 500
General administrative expenses 15,000
246 ELEMENTS OF ACCOUNTING
At the end of the year the surplus account was increased by the profit
earned and decreased $5,000 by the dividends declared from it.
Required:
a. A balance sheet
b. A profit and loss statement for the year ending December 31, 19
c. A statement of change in surplus.
CHAPTER III. Basic Books
Problem 9
On January 1, 19 , William Scott started business with the following
assets, liabilities, and proprietorship:
Cash $21 ,000
Furniture 2,000
Equipment 3 , 500
Notes payable 2, 500
William Scott, capital 24,000
One month later the same asset and equity accounts showed the following
balances :
Cash $10,800
Furniture 2 , 500
Equipment 4 , 500
Buildings 10,000
Land 4,000
Notes payable 1 , 500
Mortgage payable 6 , 000
William Scott, capital 24,300
During the month, Scott withdrew $200 cash from the business and
turned over furniture worth $500 to the business as an added investment.
Required:
a. A balance sheet showing the condition of the business January 1, 19
b. A balance sheet showing the condition of the business January 31, 19
c. Show how changes in the asset and equity elements might occur.
Start your explanation by opening a T account for each item contained
in the list of accounts January 1. Assume changes that might have
taken place in these accounts during the month so that each account
balance will be equal to the amount shown in the balance sheet Janu-
ary 31.
Problem 10
To illustrate the desired procedure for this problem, the first transaction
is recorded in the following form. Analyze the remaining transactions in
the same manner,
PROBLEMS
247
Transaction
Number
Name of
Account
Asset
Liability or
Proprietorship
Increase
or
Decrease
Debit
or
Credit
Amount
of
Change
(1)
(1)
Cash
Wilson, capital
Asset
Proprietorship
Increase
Increase
Debit
Credit
$30,000
30,000
(1) Arthur Wilson invests $30,000 cash in a business.
(2) Land costing $2,000 is purchased for cash.
(3) A building costing $7,500 is erected and paid for in cash.
(4) Equipment to the amount of $2,500 is purchased for cash.
(5) The proprietor withdraws $1,500 cash for his personal use.
(6) Merchandise costing $5,000 is purchased from J. W. Bates, as follows:
cash, $2,500; notes payable, $500; balance on account.
(7) Sales are made to R. C. Walker on account, $2,000; for cash, $750.
(8) R. C. Walker, a customer, pays $500 on account.
(9) J. W. Bates, a creditor, is paid $750 on account.
(10) A 30-day 6 per cent note for $1,000 is given by R, C. Walker to apply
on his account.
Problem 11
Following the same instructions as in problem 10, analyze these
transactions:
(1) William Brown starts business with a cash investment of $5,000.
(2) Rent is paid in advance, $100.
(3) Merchandise is purchased for cash, $2,500; on account, $1,750.
(4) Furniture and fixtures amounting to $500 are purchased on account.
(5) A delivery truck is purchased for $1,250 cash.
(6) A carpenter is paid $35 to make the necessary alterations in the
truck body.
(7) A typewriter costing $120 is purchased for cash.
(8) Merchandise is sold for cash, $1,250; on account, $3,150.
(9) A loan of $500 (secured by a 30-day 6 per cent note) is obtained
from the bank.
(10) A note of $450 is received from a customer.
(11) Payments are made to creditors amounting to $850.
(12) Cash amounting to $1,250 is received from customers.
(13) Gasoline and oil amounting to $10 are purchased for cash for the
delivery truck.
(14) The delivery truck has proved unsatisfactory and is sold for $1,200
cash (ignore depreciation).
(15) Another truck is purchased for $1,500 cash.
(16) The store clerk's salary is paid, $80.
(17) The $500 note given to the bank (9) is paid by Mr. Brown from his
personal funds as distinguished from the funds of the business.
248 ELEMENTS OF ACCOUNTING
(18) A creditor, who had overcharged $5, refunds this amount.
(19) A customer is given credit for goods returned valued at $30.
(20) A $25 cash contribution is made to the Community Fund.
(21) The typewriter, valued at $120, is stolen from the office.
(22) It is estimated that furniture and fixtures have depreciated $15.
(23) Merchandise, valued at $150, has so badly deteriorated that it is
unfit for sale and is thrown away.
(24) Mr. Brown withdraws $75 cash.
(25) The merchandise remaining unsold is valued at $1,800.
CHAPTER IV. The Accounting Cycle
Problem 12
On January 31, 19 , the ledger account balances of William Edward's
business were as follows:
Cash $ 1,530
Accounts receivable 6 , 000
Notes receivable 500
Merchandise inventory, January 1 7 , 000
Buildings 20,000
Land 5,000
Accounts payable 1 , 000
Notes payable 750
William Edwards, capital 36 ,000
Sales 10,890
Sales returns 250
Purchases 8,000
Purchase returns 125
Selling expenses 325
General administrative expenses 175
Interest income 30
Interest expense 15
The transactions during February may be summarized as follows:
(1) Sales for cash, $3,250.
(2) Sales on account, $6,500.
(3) Sales returns, for cash, $125.
(4) Purchases for cash, $5,500.
(5) Purchases on account, $1,250.
(6) Purchase returns on account, $175.
(7) Cash disbursements for selling expenses, $375.
(8) Cash disbursements for general administrative expenses, $150.
(9) Cash disbursements for notes payable, $500.
(10) Cash disbursements for accounts payable, $750.
(11) Cash receipts from customers, $7,250.
(12) Cash receipts from interest on notes, $5.
(13) Borrowed $250 from the bank, giving them a 60-day 6 per cent note.
(14) Edwards withdrew cash, $2,500.
PROBLEMS 249
Required:
a. A trial balance as of January 31.
b. The journalization and posting of summary transactions for February.
Set up T ledger accounts with opening balances. Identify each trans-
action by the appropriate number.
c. A trial balance as of February 28.
Problem 13
On January 1, 19 , Emanuel Francisco invested $500 cash in a vegetable
stand business. He paid the monthly rental of $35 for the floor space
occupied. He also paid $250 for display stands and other equipment and
$15 to a carpenter to make necessary alterations and installations. On
January 3, a vegetable supply costing $150 was purchased on account from
the Globe Produce Company. During the month, additional supplies
were purchased on account from the Globe Produce Company amounting to
$300. Sales for cash totaled $650. The cost of vegetables spoiled and
unfit for sale amounted to $12. Cash disbursements were as follows:
clerk hire, $50; payments on account to the Globe Produce Company, $350.
Instructions:
a. Journalize, using only the following accounts: Cash; Equipment;
Globe Produce Company; Emanuel Francisco, capital; Purchases;
General expense; Sales.
b. Post to ledger accounts.
c. Foot the accounts.
d. Prepare a trial balance.
e. Submit a balance sheet and a profit and loss statement. (Vegetables
on hand February 1 were valued at $125.)
Problem 14
Journalize the transactions in problem 10, post to ledger accounts, and
submit a trial balance.
Problem 16
Journalize the transactions in problem 11, post to ledger accounts, and
submit a trial balance.
Problem 16
On June 1, 19 , C. A. Woods began business with the following assets:
Cash $2,500
Merchandise inventory 2 ,000
Furniture and fixtures 700
Buildings 1,500
Land 800
June 2. Purchased merchandise from B. A. Hoover amounting to $250;
paid $150 cash and gave a 60-day 6 per cent promissory note
for $100.
250 ELEMENTS OF ACCOUNTING
June 5. Purchased merchandise from A. C. William on account amounting
to $35.75. Sold merchandise to A. D. Bartlett on account
amounting to $75.50. Sales for cash, $1,040.
7. Purchased stationery and supplies for cash amounting to $5.25.
9. Sold merchandise for cash amounting to $500. Sold merchandise
to D. V. Gaines on account amounting to $42.25.
12. Purchased merchandise amounting to $650 from C. D. Baker.
Terms 2 per cent off for cash, net 30 days. Paid cash.
13. Received a check for $25 from A. B. Bartlett to apply on account.
14. Sold merchandise to H. C. Brittain on account amounting to $125.
15. Paid cash for postage, $1.75.
16. Purchased merchandise for cash amounting to $562.
19. Contributed merchandise (costing $15 and selling for $25) to the
church bazaar.
22. Received a $50, 90-day 6 per cent note from H. C. Brittain.
23. Returned purchases made on June 12 amounting to $35 to C. D.
Baker; purchased office fixtures for cash amounting to $12.50.
26. Sold merchandise on account to H. C. Brittain amounting to
$250. Paid freight on the Brittain sale amounting to $7.25.
28. Purchased merchandise on account from C. D. Baker amounting
to $125.50.
29. Received a check for $50 from A. D. Bartlett to apply on account.
30. Paid delivery expenses incurred amounting to $10.75. Paid
clerk's wages amounting to $50.
Instructions:
a. Journalize.
6. Post to ledger accounts.
c. Foot the accounts.
d. Prepare a profit and loss statement (the merchandise inventory
June 30 is $1,500).
e. Submit a balance sheet.
CHAPTER V. The Accounting Cycle. (Continued)
Problem 17
Journalize the following adjustments as of December 31, 19 :
(1) The merchandise inventory at the beginning of the fiscal period,
January 1, 19 , was $16,000. The goods on hand December 31,
19 , amount to $14,000.
(2) At the close of the fiscal period, wages amounting to $550 have been
earned by the workers but will not be paid to them until the next
fiscal period.
(3) Interest accrued on notes payable amounts to $23.
(4) Depreciation on furniture and fixtures amounts to $350.
(5) Cash advances have been made to workers amounting to $35.
(6) Estimated losses on bad debts amount to $345.
(7) On December 1, a noninterest bearing note receivable maturing
the following January 30 was discounted at the bank. An interest
PROBLEMS 251
expense item of $15 was recorded at the time the note was
discounted.
(8) On June 30, annual insurance premiums amounting to $180 were
charged to the account insurance premiums.
(9) The rent income account includes $50 rent received in advance.
(10) Prepaid advertising amounts to $15.
(11) Interest accrued on notes receivable amounts to $50.
(12) Depreciation on delivery equipment amounts to $37.50.
(13) The balance of the office supplies account, as shown by the trial
balance, is $325. An inventory of the supplies on hand discloses
that the proper amount is $315.
(14) Interest collected in advance on notes receivable amounts to $12.50.
(15) The ledger account balance of cash on hand is $225. A count of the
cash discloses an amount of $227.
Problem 18
Journalize the following adjustments as of December 31, 19 :
(1) The trial balance dated December 31, 19 , contains the beginning
inventory (January 1) of $25,000. The inventory on hand at the
close of the fiscal period, December 31, is $20,000.
(2) Estimated losses from bad debts are $200.
(3) On December 1 a 60-day noninterest bearing note maturing the
following January 30 was discounted at the bank. The discount
charge of $50 was recorded when the note was discounted.
(4) On December 15 rent expense amounting to $250 was paid for the
month of January.
(5) On June 30 annual insurance premiums amounting to $120 were
charged to the account insurance premiums.
(6) Interest accrued on notes receivable amounts to $25.
(7) Wages expense amounting to $750 has accrued, although the payroll
will not be paid until the first week in January.
(8) The balance of the office supplies account in the trial balance is $625.
An inventory of the supplies on hand shows that the value should
be $475.
(9) Interest accrued on notes payable amounts to $17.50.
(10) Depreciation oil machinery amounts to $350.
(11) On December 31, the rent income account includes $20 applicable
to the month of January.
(12) Advertising expense amounting to $12.50 is prepaid.
(13) The cost of coal fuel during the year has been $1,250. Of this
amount three-fourths has been consumed.
(14) Accrued interest payable on the mortgage is $125.
(15) The salary account includes $25 advanced to a stenographer on
her January salary.
(16) Accrued salesmen's salaries are $47.50.
(17) Outstanding purchase discounts are $36.50.
(18) Outstanding sales discounts are $23.50.
(19) Accrued property taxes payable are $57.50.
252 ELEMENTS OF ACCOUNTING
(20) The partners' salaries for the year are $2,250 for J. Burton and
$2,500 for A. Shaw. These salaries have neither been paid nor
recorded on the books.
Problem 19
JOHN B. WILTON
TRIAL BALANCE, JUNE 30, 19
Cash $ 5,000
Accounts receivable 2 , 750
Reserve for doubtful accounts $ 50
Notes receivable 1 , 200
Merchandise inventory, January 1 2 , 250
Furniture and fixtures 375
Reserve for depreciation furniture and
fixtures 275
Land 4,000
Buildings 17,500
Reserve for depreciation buildings 6 , 000
Accounts payable 1 , 600
Notes payable 500
John B. Wilton, capital 29,923
Sales 52,195
Purchases 48,000
Salaries 7,800
Delivery expenses 1 , 200
Miscellaneous expenses 650
Interest expense $
Interest income 15
Rent income 175
$90,733 $90,733
Supplementary Data:
(1) Merchandise inventory, June 30, 19 , is $2,750.
(2) Depreciation of furniture and fixtures is estimated to be 10 per cent
annually.
(3) Three per cent of outstanding accounts are estimated to be
uncollectible.
(4) The salaries account includes $25 advanced to a worker on his July
salary.
(5) Miscellaneous expenses not recorded amount to $15.
(6) Interest accrued on notes receivable amount to $10; on notes pay-
able, $7.
(7) The rent income account includes an amount of $25 received in
advance.
Required:
a. Adjusting entries
b. Appropriate accounts ruled and balanced
PROBLEMS 253
c. Closing entries journalized and posted to ledger accounts
d. Readjusting entries as of July 1, journalized and posted to ledger
accounts
Problem 20
CHARLES BATES
TRIAL BALANCE, JUNE 30, 19
Cash $ 3,250
Notes receivable 4 , 300
Accounts receivable 11, 950
Merchandise inventory, January 1 20 , 500
Insurance premiums 180
Furniture and fixtures 2 , 750
Accounts payable $ 7 , 500
Notes payable 10 , 000
C. Bates, capital 27, 100
Sales 30,600
Purchases 25 , 350
Advertising 800
Delivery expense 500
Salesmen's salaries 2 , 800
Rent expense 1 , 050
Office salaries 900
Office expense 700
Interest expense 300
Interest income 130
$75,330 $75,330
Supplementary Data:
(1) Merchandise inventory, June 30, $24,500.
(2) A count of cash reveals a shortage of $5.
(3) Cash advances to office employees, $15.
(4) The rent account includes an amount of $150 paid on June 30 and
applicable to the month of July.
(5) Unexpired insurance premiums, $60.
(6) Interest accrued on notes receivable, $25.
(7) Depreciation pn furniture and fixtures, $75.
(8) Estimated uncollectible accounts, $225.
(9) Advertising prepaid, $65.
(10) Delivery expenses accrued, $50.
(11) Salesmen's salaries accrued, $120.
(12) Office supplies on hand, $350.
(13) Interest received in advance on notes receivable, $15.
Required:
a. Adjusting entries
6. The proper accounts ruled and balanced
264 ELEMENTS OF ACCOUNTING
c. Closing entries journalized and posted to ledger accounts
d. Readjusting entries journalized and posted to ledger accounts
CHAPTER VI. The Accounting Cycle. (Concluded)
Problem 21
Set up a 10-column work sheet from the trial balance and supplementary
data given in problem 19. Make the necessary adjustments, extensions,
and rulings.
Problem 22
Follow the same directions given in problem 21 for the trial balance and
supplementary data in problem 20.
Problem 23
JOHN WILLIAMS
TRIAL BALANCE, DECEMBER 31, 19
Cash $ 5,225.00
Accounts receivable 8 , 102 . 50
Notes receivable 4,300.00
Merchandise inventory, January
1, 19_ 3,750.00
Insurance premiums 800 . 00
Stock of Pittsburgh Coal Company 5 , 000 . 00
Land 6,275.00
Building 23,500.00
Furniture and fixtures 1 , 125.00
Accounts payable $ 10,430.00
Notes payable 2,000.00
Mortgage payable 22,500.00
John A. Williams, capital 21 , 100.00
John A. Williams, drawing 1 , 002 . 50
Sales 118,230.00
Sales returns 2,225.00
Purchases 99,000.00
Freight in 1 ,380.00
Store salaries 5,000.00
Store expense 950.00
Salesman's salary 1 ,700.00
Delivery expense 1 ,400 . 00
Warehouse expense 450 . 00
Advertising 1 , 100 . 00
Office expense 900.00
Office salaries 1,300.00
Interest income 75 . 00
Cash dividend (stock of Pittsburgh
Coal Company) 150.00
$174,485.00 $174,485.00
PROBLEMS 255
Supplementary Data, December 31, 19 :
(1) Inventories:
Merchandise, $4,236
Store supplies, $105
Office supplies, $85
(2) Interest accrued on notes receivable, $75.
(3) Insurance expense deferred, $276.
(4) Interest accrued on notes payable, $21.
(5) Interest accrued on mortgage payable, $1,350.
(6) Salary expense accrued :
(a) Store, $140
(6) Salesman, $68
(c) Office, $152
(7) Advertising booklets undistributed, $115.
(8) Estimated property taxes, $350.
(9) Depreciation rates:
(a) Furniture and fixtures 10 per cent
(&) Buildings 3 per cent
(10) Of the outstanding accounts receivable, 2 per cent are estimated to
be uncollectible.
Required:
a. A 10-column work sheet
b. A profit and loss statement
c. A balance sheet
d. A statement of change in net worth
e. Adjusting entries in general journal form
/. Closing entries
g. A post-closing trial balance
ft. Readjusting entries
256 ELEMENTS OF ACCOUNTING
Problem 24
THE DUTCH KITCHEN, INC.
TRIAL, BALANCE, DECEMBER 31, 19
Cash on hand $ 2,000
Cash on deposit 9 , 000
Accounts receivable 54 , 000
Reserve for doubtful accounts $ 300
Merchandise inventory, January 1, 19 13,800
Investments 14 ,000
Land 20,000
Buildings 125,000
Reserve for depreciation of buildings. . . . 18,750
Store furniture and fixtures 8 , 000
Reserve for depreciation of store furni-
ture and fixtures 2 , 400
Office furniture and fixtures 6 , 000
Reserve for depreciation of oflioe furni-
ture and fixtures 1 , 800
Delivery equipment 5 , 000
Reserve for depreciation of delivery
equipment 2 , 000
Accounts payable 9 , 000
Notes payable 5 , 000
Capital stock 165,000
Surplus 27,250
Sales 601 ,000
Sales returns and allowances 6 , 000
Purchases 404 , 700
Purchase returns and allowances 3,500
Transportation in 2 , 800
Store salaries 58,000
Salesmen's commissions 33 , 000
Transportation out 1 , 100
Delivery truck expenses 2 , 900
Store supplies 1 , 800
Advertising 5 , 000
Office salaries 44 , 000
Heat, light, and water 8,000
Office supplies 1 , 700
Insurance expense 3 , 000
Property taxes 2 , 000
Telephone and telegraph 1 , 900
Interest and discount expense 1 , 600
Sales discounts 3,000
Loss on sale of fixed assets 2 , 200
Purchase discounts 2 , 900
Interest earned on investments 600
$839,500 $839,500
PROBLEMS
257
Supplementary data:
(1) Merchandise inventory, December 31, 19 , $15,000.
(2) A reserve for bad debts equal to 2 per cent of accounts receivable is
established.
(3) Depreciation is computed on the fixed assets for the past year at the
following rates:
(a) Buildings 5 per cent
(b) Store furniture and fixtures 10 per cent
(c) Office furniture and fixtures 10 per cent
(d) Delivery equipment 25 per cent
(4) Interest expense accrued, $50.
(5) Prepaid advertising, $100.
(6) The $3,000 item charged to the insurance expense account represents
the premium on a 2-year policy purchased on July 1 of this year.
(7) The following items are on hand December 31 :
(a) Store supplies, $200.
(6) Office supplies, $100.
(8) Accrued interest on outside investments owned by the company, $80.
(9) Accrued salaries at the end of the year:
(a) Store salaries, $200.
(b) Office salaries, $150.
Required:
a. A 10-column work sheet
b. A profit and loss statement
c. A classified balance sheet
CHAPTER VII. Journal and Ledger Subdivisions
Problem 25
David Weldon operates a small wholesale business. All transactions
are to be recorded in a general journal ruled as indicated below.
GENERAL JOURNAL
Accounts
Receiv-
able
Dr.
Accounts
Payable
Dr.
General
Ledger
Dr.
F
Accounts and
Explanations
F
General
Ledger
Cr.
Accounts
Receiv-
able
Cr.
Accounts
Payable
Cr.
SX U *V>*_/N U / > V.
258 ELEMENTS OF ACCOUNTING
- During the week of May 7 to 13, the following transactions occurred:
May 7. Purchased merchandise on account from J. V. Fisher, $300.
8. Sold merchandise qn account to F. A. Rader, $200; to R. W.
Foster, $150.
9. Purchased merchandise from W. S. Hart, $250 for which a 6 per
cent 60-day note was given.
10. Returned $25 worth of merchandise purchased from J. V. Fisher.
11. W. E. Beck's account of $50 was considered worthless and written
off.
12. Purchased merchandise from J. W. Reed for $500 and gave him a
6 per cent 60-day note for $250, the balance to be paid within
30 days.
13. Sold merchandise amounting to $750 to J. E. Walker who gave in
payment a 6 per cent 30-day note for $250 and paid the balance
in cash.
Problem 26
a. Prepare a purchase journal with the following columns : date, creditor,
ledger folio, accounts payable. Journalize the following purchases on
account and explain how postings should be made.
June 2. From J. B. Thorp $500
3. From D. A. Brady 375
4. From B. J. Hill 765
5. From A. W. Davis 225
6. From J. D. Sears 150
&. Set up a sales journal with the following columns: date, customers,
ledger folio, accounts receivable. Journalize the following data and discuss
briefly how postings should be made.
June 2. To D. B. Scott $ 250
3. To J. M. Hart 325
4. To R. J. Tate 1,250
5. To H. V. Lane 500
6. To O. D. Porter 800
c. Set up a cash receipts journal with the following columns: date, expla-
nation, ledger folio, accounts receivable, sales discounts, miscellaneous, net
cash. After journalizing the following cash receipts, explain how the
postings should be made.
June 2. From D. B. Scott in payment of an account of $150 less 2 per cent
discount.
3. From J. E. Fulton in payment of a note of $250 plus interest of $5.
4. From R. J. Tate in payment of an account of $750 less 2 per cent
discount.
5. From the rent of a garage, $10.
6. From cash sales, $1,575.
d. Prepare a cash disbursements journal with the following columns:
date, explanation, ledger folio, accounts payable, purchase discounts, mis-
PROBLEMS 259'
cellaneous, net cash. Journalize the following cash disbursements and
state how the postings should be made.
June 2. To B. J. Hill in payment of an account of $600 less 3 per cent
discount.
3. For a new typewriter costing $120 to be used in the office.
4. For wages, $225.
6. To D. A. Brady in payment of an account of $300 less 3 per cent
discount.
6. To J. D. Sears in payment of an account of $75.
Problem 27 -
On December 1, 19 , the trial balance of the Westbrook Corporation
and the balances in the subsidiary ledgers were as follows:
WESTBROOK CORPORATION
TRIAL BALANCE, DECEMBER 1, 19
Cash $ 5,000
Notes receivable 1 , 500
Accounts receivable 3 , 500
Reserve for doubtful accounts $ 25
Merchandise inventory, January 1, 19 21 ,000
Delivery equipment 2 , 500
Reserve for depreciation of delivery equip-
ment 250
Notes payable 500
Accounts payable 6 , 500
Capital stock 30,000
Surplus 3,815
Sales 48,750
Sales returns and allowances 255
Purchases 47,500
Purchase returns and allowances 125
Freight in : 135
Advertising 500
Rent expense 2 , 200
Salesmen's salaries 3 , 415
Delivery expense 1 , 250
Office salaries 700
Insurance 200
Telephone and telegraph 50
Miscellaneous general expense 280
Interest expense 20
Sales discount 835
Bad debts 15
Interest income . . . , 15
Purchase discount 875
$90,855 $90,855
260
ELEMENTS OF ACCOUNTING
CUSTOMERS' LEDGER
G. O. Brady $ 125
R. D. Burns 625
A. C. Hart 250
J. G. Hay 325
D. E. Pond 370
W. A. Rider 250
O. A. Scott 275
R. W. Sears 430
L. R. Swift 100
A. B. Temple 750
$3,500
CREDITORS* LEDGER
C. H. Allis $1 ,250
R. O. Hood 1 ,750
A. D. Jenkins 500
O. L. Spencer 1,500
H. V. Stone 1,500
$6,500
Transactions for December have been journalised but not posted.
GENERAL JOURNAL
Date
Dec.
Accounts and Explanations
R. O. Hood
Purchase returns and allowances
Memo 237
Notes Receivable
A. B. Temple
90 days, 6 per cent dated Dec. 10
Sales returns and allowances
R. D. Burns
Memo 167
H. V. Stone
Notes payable
General
Dr.
60000
7500
57500
Accounts
Payable
Dr.
15000
25000
40000
General
Cr.
15000
25000
40000
Accounts
Receiv-
able
Cr.
50000
7500
57500
PROBLEMS
PURCHASE JOURNAL
261
Date
Account
Terms
F
Accounts
Payable
Cash
Purchases
Purchases
Cr.
Cr.
Dr.
19
Dec.
2
A. D. Jenkins
2/10, n/30
1,250
00
1,250
00
5
Cash purchase
750
00
750
00
8
C. H. Allis
2/10, n/30
2,250
00
2,250
00
15
H. V. Stone
2/10, n/30
1,775
00
1,775
00
18
R. O. Hood
30 days
250
00
250
00
22
Cash purchase
500
00
500
00
26
A. D. Jenkins
2/10, n/30
3,200
00
3,200
00
30
R. O. Hood
30 days
1,150
00
1,150
00
9,875
00
1,250
00
11,125
00
SALES JOURNAL
Accounts
Date
Accounts
Terms
F
Receiv-
Sales
Sales
able
Dr.
Dr.
Cr.
Dec.
2
J. G. Hay
2/10, n/30
1,500
00
1,500
00
5
A. C. Hart
30 days
125
00
125
00
7
Cash sales
1,300
00
1,300
00
10
A. B. Temple
2/10, n/30
1,750
00
1,750
00
12
O. A. Scott
30 days
250
00
250
00
15
W. A. Rider
2/10, n/30
75
00
75
00
20
R. D. Burns
2/10, n/30
1,500
00
1,500
00
25
D. E. Pond
2/10, n/30
3,700
00
3,700
00
29
Cash salee
2,000
00
2,000
00
8,900
2?
3,300
00
12,200
00
262
ELEMENTS OF ACCOUNTING
CASH RECEIPTS JOURNAL
Accounts
Sol no
Date
Accounts
Explanation
F
General
Sales
Receiv-
able
Discount
Cash
Cr.
Cr.
Cr.
Dr.
Dr.
Dec.
3
G. 0. Brady
On account
50
00
5000
5
D. E. Pond
On account
250
00
25000
7
Cash sales
1,300
00
1,30000
10
R. W. Sears
On account
300
00
30000
12
J. G. Hay
On account
1,500
00
30
00
1,47000
15
L. H. Swift
On account
100
00
10000
18
A. B. Temple
On account
1,750
00
35
00
1,71500
23
A. C. Hart
On account
250
00
25000
25
Notes receivable
D. E. Pond
500
00
50000
25
Interest income
NoteofD.E.
5
00
500
Pond
29
R. D. Bums
On account
1,500
00
30
00
1,47000
29
Cash sales
2,000
00
2,00000
505
00
3,300
00
5,700
00
95
00
9,41000
CASH DISBURSEMENTS JOURNAL
Date
Account
Explanation
F
General
Cash
Purchases
Accounts
Payable
Purchase
Discount
Cash
Dr.
Cr.
Cr.
Dec.
1
Rent
200
00
20000
1
Notes payable
0. L. Spencer
500
00
50000
1
Interest expense
10
00
1000
3
R. 0. Hood
On account
1,750
00
35
00
1,71500
5
Cash purchases
750
00
75000
12
Advertising
50
00
5000
18
C. H. Allis
On account
2,250
00
45
00
2,20500
22
Cash purchases
500
00
50000
25
H. V. Stone
On account
1,775
00
35
50
1,73950
28
Delivery expense
50
00
5000
30
Salesmen's salaries
715
00
71500
30
Office salaries
150
00
15000
1,675
00
1,250
00
5,775
00
115
50
8,58450
Instructions: Submit a trial balance as of December 31, 19 , and lists of
balances in the customers' and creditors' ledgers.
Problem 28
Thomas Black operates a men's clothing store. On August 1, 19 , the,
post-closing trial balance of his ledger appeared as follows:
PROBLEMS 263
Cash $ 3,000
Notes receivable 300
Accounts receivable:
J. H. Frederick $ 50
N. A. Bartlett 75
A. D. Gainer 25
F. D. Abbott 35
R. W. Taylor 50
W. E. Wallace 15 250
Inventory, August 1, 19 25 ,000
Furniture and fixtures 1 ,250
Accounts payable:
Elite Clothing $1 ,000
Block and Block 500
Seal Raincoat 750
Cord Shoe 250 2,500
Notes payable 500
Thomas Black, capital 26,800
$29,800 $29,800
The ledger accounts to be used with the line space allotted to each are
as follows:
Line Line
Account Space Account Space
Cash 17 Sales discounts 7
Accounts receivable (each) 7 Purchases 12
Notes receivable 10 Purchase returns 7
Inventory 7 Purchase discounts 7
Furniture and fixtures 7 Freight in 7
Accounts payable control 7 Clerk hire 7
Accounts payable (each) 7 Fire insurance 7
Notes payable 7 Rent expense 7
Black, capital 7 General expense 7
Sales 14 Interest expense 7
Sales returns 7 Interest income 7
During the month of August the following transactions occurred:
August 4. Paid $100 rent for the month. Paid $30 to cover insurance for
August, September, and October.
5. Sent a check of $750 to Elite Clothing Company in payment on
account, less the customary discount of 2 per cent.
6. Purchased men's suits costing $575 from Block and Block
Tailors. Freight paid on the shipment amounted to $5.
J. H. Frederick paid his account in full.
8. F. D. Abbott and R. W. Taylor paid their accounts in full.
9. Cash sales for the week amounted to $825. Cash purchases for
the week amounted to $500.
264 ELEMENTS OF ACCOUNTING
August 11. Paid the Seal Raincoat account in full, less a 3 per cent discount.
Frederick purchased $45 worth of merchandise on account.
12. Purchased shoes from the Cord Shoe Company amounting to
$325.
13. Frederick was given credit for $10 worth of returned
merchandise.
14. Wallace, a customer, sent a 60-day 6 per cent note for the bal-
ance of his account.
15. A note payable of $100 with interest of $5 was paid.
16. Cash sales for the week amounted to $1,025; cash purchases
for the week, $150.
17. Bartlett bought additional merchandise on account, $25.
19. Gainer paid $10 on account.
21. Abbott purchased $55 worth of merchandise on account.
23. Wallace bought $80 worth of merchandise on account.
30. Wages of $80 were paid to a clerk.
31. From August 16 to August 31 cash sales amounted to $2,500.
Cash purchases amounted to $1,250.
At the end of the month Mr. Black installed specialized journals for cash
receipts, cash disbursements, and purchases, all to be started as of September
1. A specialized ledger was installed for accounts payable. The practice
of granting credit to customers was discontinued and a discount of 4 per
cent was offered for cash or for a promissory note. Frederick paid his bill
in full; Bartlett paid $50 cash and gave a 60-day 6 per cent note dated Sep-
tember 1 for the balance; Gainer settled by a cash payment; Abbott gave
a 30-day 6 per cent note dated September 1 for the balance of his account;
Wallace paid $30 cash and gave a 60-day 6 per cent note dated September 1
for the balance of his account. (All these entries were made as of Sep-
tember 1, 19 )
Summary Entries for September:
Cash Receipts: Cash sales for September amounted to $4,000.
September 7. Black invested $2,000 additional cash in the business.
10. Abbott paid his note with interest.
Cash Disbursements: Cash purchases for September amounted to $750.
September 1. Paid $200 rent for 2 months in advance.
3. Paid note of $200 with interest of $6.
5. Paid balance of Elite Clothing Company, no discount.
6. Paid balance of Block & Block account, no discount.
7. Paid balance of Cord Shoe Company, no discount.
10. Paid invoice of Elite Clothing Company, dated September 2.
13. Paid invoice of Cord Shoe Company, dated September 4.
18. Paid invoice of Elite Clothing Company, dated September 9.
20. Paid invoice of Block <fe Block, dated September 12.
30. Paid miscellaneous office supplies, $25.
Paid clerk hire, $85.
PROBLEMS 265
Purchases:
September 2. From Elite Clothing Company, goods purchased costing
$250; terms, 3/10, n/30.
4. From Cord Shoe Company, goods costing $75; terms,
2/10, n/30.
9. From Elite Clothing Company, goods valued at $25; terms,
3/10, n/30.
12. From Block & Block Tailors, goods costing $350; terms,
2/10, n/30.
15. From Seal Raincoat Company, goods costing $250; terms,
2/10, n/30.
20. From Elite Clothing Company, goods costing $75; terms,
3/10, n/30.
30. From Elite Clothing Company, goods costing $125; terms,
3/10, n/30.
During September, purchase returns for cash amounted to $300; sales
returns for cash amounted to $250.
Instructions:
a. Arrange the ledger accounts in the manner indicated.
b. Record the transactions for August in an ordinary two-column journal.
c. Journalize the transactions of September in special journals of your
own design.
d. Post the journal entries for August and September to the ledger
accounts.
e. Submit a trial balance and a list of accounts payable.
Problem 29
On June 1, 19 , the Bentwood Furniture Company decided to install a
voucher system. This required the removal of all accounts payable from
the general ledger, the elimination of the purchase journal, and altering the
form of the cash disbursements journal. After these changes were made,
the books of original entry and the special columns used in each were as
follows:
Voucher Register: Date; Vendor; Voucher Number; Paid: Date, Check
Number; Vouchers Payable (Cr.); Purchases, Kitchen Furniture (Dr.);
Purchases, Dining-room Furniture (Dr.); Purchases, Living-room Furniture
(Dr.); Purchases, Bed-room Furniture (Dr.); Purchases, Porch and Summer
Furniture (Dr.); Purchases, Rugs and Carpets (Dr.); Selling Expense (Dr.);
Administrative Expense (Dr.); and Sundries (Dr.). The last column has
space for the title of the account, the ledger folio, and the amount.
Cash Receipts: Date; Account; Ledger Folio; Cash (Dr.); Sales, Kitchen
Furniture (Cr.); Sales, Dining-room Furniture (Cr.); Sales, Living-room
Furniture (Cr.); Sales, Bed-room Furniture (Cr.); Sales, Porch and Summer
Furniture (Cr.); Sales, Rugs and Carpets (Cr.); and Sundries (Cr.). This
266
ELEMENTS OF ACCOUNTING
last space is divided into the following sections: account, ledger folio, and
amount.
Check Register: Date, Account, Check Number, Voucher Number, Cash
(Cr.), Purchase Discount (Cr.), Vouchers Payable (Dr.).
General Journal: Two-column form.
All sales are made for cash. Customers desiring credit are assisted by the
management to make arrangements with a financing company.
The balance of the creditor's accounts on June 1, with a distribution of
the purchases by departments, is as follows:
Dining
Room
Living
Room
Porch
and
Summer
Rugs
and
Carpets
Standard Furniture Mills
$1,200
Wildwood Lumber Company
$ 750
Michigan Furniture Company
$ 620
Furniture Supply Company ....
830
Proctor Furniture Company
400
Brookside Antique Furniture
300
Eastern Carpet Company
$450
$1,500
$1,020
$1,580
$450
Each of these accounts is closed, given a voucher number and recorded
in the voucher register (assume that each balance will be settled in full by a
single payment).
Assume that the various purchase and sales accounts are in the ledger
prior to the installation of the voucher system.
Transactions for the month are as follows :
June 1. Paid salaries for the month of May, $700; ($400 to selling and
$300 to administrative expenses). Voucher 8, check No. 1. Paid
the balance owed to the Michigan Furniture Company less a dis-
count of $12.40. Voucher 3, check No. 2.
2. Purchased kitchen furniture from the Proctor Furniture Company
for $200; terms, 2/10, n/30. Voucher 9.
3. Paid the Standard Furniture Mills for the balance owed less a
discount of $24. Voucher 1, check No. 3. Paid the Press-Globe
for newspaper advertising, $60. Voucher 10, check No. 4.
4. Purchased porch and summer furniture from the Wildwood Lum-
ber Company for $550; terms, 2/10, n/30. Voucher 11. Paid
Wilson Brothers, Stationers, $85 for office supplies. Voucher 12,
check No. 5.
5. Sent a check to the Wildwood Lumber Company for $750.
Voucher 2, check No. 6. Gave a 60-day 6 per cent note (dated
June 5) for $300 to the Brookside Antique Furniture Company
in settlement of the balance due to them on June 1. Voucher 6,
PROBLEMS 267
June 6. Paid the Proctor Furniture Company $392 in full payment of
their account balance. Voucher 5, check No. 7. Paid the Furni-
ture Supply Company the balance of their account less a discount
of $16.60. Voucher 4, check No. 8.
7. Purchased bed-room furniture from the Michigan Furniture
Company for $750; terms, 2/10, n/30. Voucher 13. Paid the
Eastern Carpet Company $441 in full settlement of their account,
voucher 7, check No. 9.
8. Cash sales for the week amounted to $3,200 distributed as follows*,
kitchen furniture, $325; dining-room furniture, $175; living-room
furniture, $470; bed-room furniture $580; porch and summer
furniture, $1,400, rugs and carpets, $250.
10. Paid voucher 9, check No. 10.
11. Drew a check to replenish the petty cash fund. Distribution of
expenditures were as follows: miscellaneous selling expenses,
$12.50; office supplies, $5; office expenses, $7.50; delivery expense,
$5. Voucher 14, check No. 11.
12. Purchased porch rugs from the Eastern Rug Company for $175,
terms, 2/10, n/30. Voucher 15.
13. Purchased a delivery truck from the Parker Motor Company for
$1,200. Paid $700 cash and gave a 90-day 6 per cent note for
the balance. Voucher 16, check No. 12.
14. Returned defective merchandise received from the Eastern Rug
Company purchased on June 12 and received a credit of $35.
15. Cash sales for the week amounted to $2,880 distributed as follows:
kitchen furniture, $150; dining-room furniture, $200; living-room
furniture, $625; bed-room furniture, $350; porch and summer
furniture, $1,075; rugs and carpets, $480. Paid voucher 13,
check No. 13.
17. Purchased living-room furniture from the Michigan Furniture
Company for $750, terms 2/10, n/30. Voucher 17. Paid the
Wildwood Lumber Company $300 on the purchase of June 4,
check No. 14.
18. Purchased porch and summer furniture from the Standard Furni-
ture Company for $450, terms cash. Mailed them a check for the
amount. Voucher 20, check No. 15.
19. Purchased a typewriter for cash from Wilson Brothers, Stationers,
for $110. Voucher 21, check No. 16.
20. Purchased living-room furniture from the Brookside Antique
Furniture Company for $125, terms, 2/10, n/30. Voucher 22.
21. Paid voucher 15, check No. 17.
22. Cash sales for the week amounted to $4,800 and were distributed
as follows: kitchen furniture, $525; dining-room furniture, $425;
living-room furniture, $630; bed-room furniture, $620; porch and
summer furniture, $1,750; rugs and carpets, $850.
24. Returned defective merchandise received from the Brookside
Antique Furniture on June 20 to the amount of $17,
268 ELEMENTS OF ACCOUNTING
June 25. Purchased kitchen furniture from the Proctor Furniture Company
for $325, terms, 2/10, n/30. Voucher 23.
26. Purchased dining-room furniture from the Michigan Furniture
Company for $875, terms, 2/10, n/30. Voucher 24.
28. Paid voucher 22, check No. 18.
29. Drew a check to replenish the petty cash fund. Distribution of
expenditures were as follows: miscellaneous selling expenses,
$15.75; office supplies, $12.50; delivery expense, $7.50. Voucher
25, check No. 19. Cash sales for the week amounted to $3,700
and were distributed as follows: kitchen furniture, $275; dining-
room furniture, $380; living-room furniture, $580; bed-room
furniture, $475; porch and summer furniture, $1,600; rugs and
carpets, $390.
Instrtictions:
a. Journalize all transactions.
b. Indicate how postings are made from each journal.
c. Set up the vouchers payable controlling account.
d. Prepare a list of the unpaid vouchers in the voucher register.
e. Total and rule each journal.
CHAPTER Yin. Problems of Valuation
Problem 30
On December 31, 19 , the balance of the cash account in the ledger was
$8,248.77. Outstanding checks totaled $545. A service charge of $1.27
was included in the bank statement but was not included in the cash account
balance. A deposit of $342.50 made December 31 was included in the
ledger account balance but was not included in the bank statement. The
balance of the bank statement was $8,450. Prepare a bank reconciliation
statement.
Problem 31
The bank statement balance of December 31, 19 , was $1,248.12. This
balance included protest fees of $5. Deposits amounted to $419 for Decem-
ber 31, but this amount was not included in the bank statement. The
checks outstanding totaled $362. The following errors were made on the
check stubs: Check No. 757 was written for $250, on the check stub it was
recorded as $252.50; check No. 712 was written for $153, and it was recorded
on the check stub as $135. The balance of the cash account was $1,325.62.
Prepare a bank reconciliation statement.
Problem 32
On December 31, 19 , outstanding accounts receivable amounted to
$30,000. It was estimated that 2 per cent would be uncollectible. During
the next fiscal period, all accounts were paid except an account amounting
to $150. Submit necessary journal entries,
PROBLEMS 269
Problem 33
The Osborn Wholesale Company offers a discount of 2/10, n/30 to all
its customers. On December 31, 19 , the outstanding sales discounts
amounted to $800. Of this amount it was estimated that 75 per cent
would be accepted. Accordingly, an allowance was created to recognize
the outstanding discounts. During the next fiscal period, the discounts
accepted amounted to $750. Submit journal entries.
Problem 34
On December 31, 19 , the balance of accounts payable was $25,000.
All accounts were subject to a 2 per cent discount, and accordingly an
allowance account was created to recognize the outstanding discounts.
During the next fiscal period, accounts to the amount of $19,000 were
paid within the discount period. The remaining accounts were paid later.
Problem 35
On September 1, 19 , A sells goods to B for $1,000. On September 15,
B gives A a 60-day 6 per cent note (dated September 15) in settlement of the
account. Thirty days later A discounts the note at the bank at a 6 per
cent rate. Upon maturity, the note is paid. Journalize these data on the
books of A and B.
Problem 36
On February 20, Wilson purchased merchandise which cost $2,500 from
Williams. On March 1, Wilson gave Williams a 30-day 6 per cent note
(dated March 1) for the amount of his purchase. On March 15, Williams
discounted the note at the bank at a 7 per cent rate. Upon maturity, the
note is dishonored and is returned by the bank after being formally pro-
tested. Protest fees amount to $2. Give the necessary journal entries
on Williams' books.
Problem 37
On February 15, 19 , Black purchased from White merchandise costing
$3,000. On March 1, Black gave White a 30-day 6 per cent note (dated
March 1) for the purchase. On March 16, White discounted the note at a
5 per cent rate. On March 31, White received notice from the bank stating
that Black had refused payment. White then paid the face value of the
note, the interest, and a protest fee of $2.50. On May 15, shortly after
the court declared Black bankrupt, all creditors received a final payment
of 40 per cent in full settlement of their claims against Black. Submit
dated journal entries on White's books.
Problem 38
On June 30, 19 , the merchandise inventory consists of 3,000 units.
Data relating to purchases during the month are as follows:
270
ELEMENTS Of ACCOUNTING
Date
Quantity Purchased
Price per Unit
June 5
2,000
$2.25
8
1,250
2.25
13
700
2.30
18
1,500
2.35
24
800
2.40
28
1,000
2.40
From this information determine the inventory value based on the follow-
ing methods:
a. Simple average
6. Weighted average
c. Recent purchase
CHAPTER IX. Problems of Valuation. (Concluded)
Problem 39
On July 1, 19 A., a machine with an invoice cost of $2,500 was delivered
at an extra cost of $25. The installation charges were $75. The machine
was estimated to have a scrap value of $150 and to have a life of 10 years.
Subsequently, the machine proved to be unsatisfactory, and 1 year from the
date of purchase it was sold for $2,000. The books are closed June 30 and
December 31. Give all dated journal entries.
Problem 40
The Primrose Path Florist Shop purchased a delivery truck June 30, 19 A,
for $700. It had an estimated life of 4 years and a residual value of $100.
After 3 years the truck was turned in as partial payment on the purchase
of a new one. The price of the new truck was $800; the trade-in value of the
old one was $275. Assuming the fiscal period to be the calendar year, give
all necessary journal entries.
Problem 41
On January 1, 19A, 10 machines costing $5,000 each were purchased for
cash. Each unit had an estimated life of 10 years. On January 1, 19F,
it was decided to sell the 10 units and replace them with more efficient
machines. The machines were operated until sold. On February 1, 19F,
6 were sold at $25 per unit more than their book value. The remaining
machines were held until March 1, 19F, at which time they were sold as a
lot for $6,875. The books are closed annually on December 31. Give all
dated journal entries.
Problem 42
A machine which cost $11,000 has an estimated life of 5 years and a
residual value of $1,000. It is estimated that during its life span it will
produce 100,000 units.
PROBLEMS 271
Required:
a. Journal entries to show the annual depreciation charge (on a straight-
line basis) and the disposition of the asset for $1,000 at the end of the
5-year period.
b. If 7,000 units were produced in a year, what entry would be required
to record the annual depreciation on a production basis? Assume that
the machine was disposed of after it had produced 100,000 units.
What entries would be necessary?
c. Assume that the machine was sold for $1,500 at the end of the fourth
year of operation. Give journal entries to record its disposition when
depreciation is computed on a straight-line basis and when it is recorded
on a production basis. Assume that the machine produced 82,000
units during the 4 years.
Problem 43
The Penn Coal Company purchased a coal deposit for $50,000. The
deposit had an estimated recoverable output of 750,000 tons. During the
first year of operation, 25,000 tons were mined. In April of the second year
it became apparent that only 80 per cent of the estimated output could be
recovered. Thirty thousand tons were mined during the second year.
Required:
a. The journal entry to record the depletion charge at the end of the
first year of operations
6. The journal entry to revalue the coal deposit
c. The journal entry to record the depletion charge for the second year
Problem 44
On January 12, 19 A, the Carleton Manufacturing Company paid $30,000
to the inventor for a patent. The company made additional disbursements
of $6,500 in perfecting the patent up to December 31, 19A. In 19B it sued
a competitor for infringement of patent rights, involving a cost of $4,000,
but the jury disagreed 'and no verdict was rendered. In 19C the company
again brought suit and was victorious, $5,000 damages being awarded. The
cost of the second trial amounted to $3,500. The company was granted
royalties from the defendant in the amount of $7,000 for 19C and $12,000
for 19B.
The patent was granted to the original inventor on January 3, 19A. No
amortization of the patent, however, has been made up to December 31,
19C, due to the pending damage suits. The patent had a legal life of
17 years, but the Carleton Manufacturing Company decided to follow a
conservative practice by writing off its cost over a period of 9 years. Assume
that the fiscal period for the company coincides with the calendar year.
Instructions: Prepare journal entries for these transactions. What bal-
ance should the patent account finally show, assuming that no other patents
were owned?
272 ELEMENTS OF ACCOUNTING
Problem 45
At the end of the sixth year of operations, December 31, 19F, the Carter
Corporation had assets of $550,000, liabilities of $100,000, capital stock
(original investment sold at par) $400,000, and surplus of $50,000. Assume
that assets and liabilities were correctly stated, that the company was
manufacturing a staple commodity, and that it had a good business
reputation.
A fair rate of return for a company of this type was considered to be 10
per cent. The profits for the preceding 6 years were as follows:
19A $10,000 19D $70,000
19B 40,000 19E 75,000
19C 60,000 19F 75,000
When the Carter Corporation was sold to another company on December
31, 19F, the goodwill was computed by capitalizing the average excess profit
of the preceding 6 years (the normal profit and excess profit for any year
were computed in terms of the capital investment at the beginning of the
year).
During the 6 years there were no additional capital investments. With-
drawals consisted of an 8 per cent cash dividend during each of the last
5 years; each dividend was declared on December 31.
Instructions: Compute the goodwill.
CHAPTER X. Individual Proprietorship and Partnership
Problem 46
Hagan and Dodge form a partnership with a capitalization of $75,000.
Hagan invests $37,500 in cash. Dodge contributes the following assets:
land, $5,000, buildings, $10,000, and equipment, $22,500.
Sometime later Kirby invests sufficient cash to acquire a one-third interest
in the business. Prior to his entrance, however, the land account is
decreased by $1,000 and the equipment account by $2,000. Give the
necessary journal entries.
Problem 47
Reuben Bicken and Sylvester Complain are equal partners with capital
accounts of $10,000 and $5,000, respectively. On September 30, 19 ,
Angus Anxiety acquires a one-third interest in the partnership by the pay-
ment of $8,000. On December 24 of the same year, Wesley Whimper is
admitted to a one-fourth interest in the partnership by a payment of
$10,000.
Required:
a. The journal entries required to record the admission of Anxiety if
goodwill is placed on the books.
6. The journal entries to record the admission of Whimper if
(1) Goodwill is placed on the books.
(2) Goodwill ia not placed on the books.
PROBLEMS 273
Problem 48
The articles of partnership of Davis and Scott contain the following
provisions:
1. Davis is to receive an annual salary of $3,200, Scott a salary of $2,600.
Salaries are to be considered a distribution of profit.
2. Each partner is to receive interest at 6 per cent per annum on the
balance of his capital account at the close of the fiscal period.
3. After salaries and interest have been distributed, the remaining profit
or loss is shared between Davis and Scott in the proportion of 60 and
40 per cent, respectively.
The net profit for the year (before salaries and interest were computed)
amounted to $8,000.
Submit general journal entries to show the distribution of profit (or loss)
to the partners.
Problem 49
The partnership agreement between Bristol and Logan provides for an
equal division of profits or losses after interest at 6 per cent on the average
capital invested has been computed. The partners' accounts appear as
follows:
BRISTOL, CAPITAL
February 1
2,000
January 1 (balance)
.. . 30,000
July 1
1,000
March 1
... 1,000
August 1
1,500
September 1
... 4,000
October 15
1 600
December 1
... 2,500
LOGAN, CAPITAL
April 1
1,000
January 1 (balance) . . . .
.. . 50,000
June 15
3,500
March 1
... 5,000
July 1
1,500
October 1
... 4,000
Seotember 1
2,000
December 1
... 2,000
The net profit for the period (before allowing for interest on investments)
is $7,500.
Required:
a. The amount of interest credited to each partner.
6. The entries necessary to distribute the profit to the partners.
Problem 50
A and B, partners, decide to liquidate their business. A has a capital
account balance of $10,000; B of $20,000. Profits and losses are shared
equally. After the payment of all obligations and the realization of all
assets, the cash available for distribution between the partners is $10,000.
Give the necessary journal entries to show the liquidation of the business.
274 ELEMENTS OP ACCOUNTING
Problem 61
On June 30, 19 , Smith and Jones, who share profits and losses equally,
decided to liquidate their partnership. Their balance sheet, on this date,
appeared as follows:
Assets
Cash hi bank $ 7,500
Accounts receivable 23 , 000
Inventory 25,000
Plant and machinery 15 , 000
$70,500
Liabilities
Accounts payable $15,500
Notes payable 10,000
Smith, capital 30,000
Jones, capital 15,000
$70,500
The assets of the partnership (except cash) were sold to Johnson for a
cash payment of $45,000. The partners paid the firm's liabilities and closed
the partnership books. Give all journal entries.
Problem 62
A, By and C are partners with capital accounts (at the close of the fiscal
period) of $20,000, $40,000, and $60,000, respectively. For several years
the partnership had been operated at a loss, and the partners, fearing that
the business would continue to be unprofitable, decide to liquidate. There
are no outstanding liabilities when the partnership is liquidated. The
assets are realized in the following order:
Installment 1 $21,000
Installment 2 15,000
Installment 3 (final) 37,500
Give all necessary journal entries and show the capital accounts ruled
and balanced.
CHAPTER XI. Corporations
Problem 63
On March 1, 19 , the Forbes Corporation was organized with a capitali-
zation of $100,000 common stock. On March 15, 750 shares (par $100)
were sold for cash to A at 97 per share. On May 1, 150 shares were sold
for cash to B at 102. Give all necessary journal entries on the books of
the corporation.
Problem 64
The Marsh-Thomas Corporation was organized May 1, 19 , with an
authorized capitalization of 10,000 shares of common stock, par value $100.
PROBLEMS 275
On May 15 A. C. Lane subscribed to 20 shares at 05. The agreement
provided that 10 per cent was to be paid at the time the subscription was
taken, the balance to be paid in three equal monthly installments beginning
June 15. All subscriptions were paid and the stock certificates were issued.
Give the necessary journal entries.
Problem 55
The Grant Corporation has authorized common stock of 5,000 shares, par
value $100, of which 4,000 shares are outstanding. In order to provide
working capital, three stockholders agree to give 25 shares each to the
corporation. Subsequently, the 75 shares of treasury stock are sold for
$115 per share.
Submit journal entries.
Problem 56
The Craft-Ferber Corporation has an authorized issue of 10,000 shares
of no-par stock of which 6,000 shares are outstanding. The corporation
has a surplus of $50,000. On June 30, 19 , dividends amounting to $3
per share were declared. On July 15, the dividends were paid. On August
15, 10 additional shares of no-par stock were sold to C. W. Price for cash
at $50 per share. On December 20, 20 more shares were sold to N. R.
Barton for $30 per share.
Give dated journal entries.
Problem 57
On October 1, 19 , J. V. Kirk subscribed to 20 shares of common stock
par $100 of the Lane Corporation to be paid in two equal monthly install-
ments beginning November 1, 19 . Kirk paid the first installment but
defaulted on the second.
Give the necessary journal entries if
a. No portion of the amount paid by Kirk is returned to him.
b. The entire subscription is sold by the corporation at 98 and after
deducting $10 as selling expenses, the balance is returned to Kirk.
c. The corporation issues 10 shares of stock to Kirk and relieves him of
further responsibility.
Problem 58
The Walker- Wilson Corporation sells its entire issue of $150,000, 10-year
second-mortgage 5 per cent bonds for 97. Give entries to
a. Record the sale of the issue.
6. Record the interest on the bonds at the end of the first 6-month period.
Problem 59
The Rand-Baker Corporation sells its entire issue of $100,000, 15-year
5 per cent first-mortgage bonds at 102. Give entries to
a. Record the sale of the issue.
6. Record the interest on the bonds at the end of the first 6-month period.
276 ELEMENTS OF ACCOUNTING
Problem 60
The Warner Corporation authorizes an issue of $200,000 first mortgage,
4 per cent, 20-year bonds. Interest is payable semiannually on January 1
and July 1. The entire issue is sold at par to Johnson and Bates, investment
bankers. The bond indenture provides for the maintenance of a sinking
fund and a reserve for sinking fund.
Give journal entries to record:
a. The authorization of the bonds
6. The delivery of the bonds to the investment banker
c. The receipt of cash from the investment banker
d. The outstanding bonds
e. The payment of interest on the bonds for the first 6 months
/. The establishment of a sinking fund 6 months after the bonds are issued
g. The establishment of a reserve for sinking fund 6 months after the
bonds are issued
Problem 61
On January 1, 19 _ , the Premier Corporation was incorporated with an
authorized capital of 2,000 shares of common stock, par value $100 per
share. The business of A and Bj partners, was taken over by the corpora-
tion. Each partner was given stock equal to the balance of his capital
account. The partnership balance sheet appeared as follows on January 1,
Assets Liabilities and Proprietorship
Cash ................... $ 5,000 Notes payable ........... $ 5,000
Notes receivable ......... 7 , 500 Accounts payable ........ 20 , 000
Accounts receivable ...... 25,000 Mortgage ............... 15,000
Merchandise inventory. . . 40 , 000 A, capital ............... 32 , 500
Furniture and fixtures ____ 7,500 , capital ............... 32,500
Buildings ............... 12,000
Land ................... 8,000 _
$105,000 $105,000
February 1 Brown subscribed to 50 shares of stock at 99. Ten per cent
was paid at the time the subscription was taken. The balance
was paid in two. equal monthly installments after which the
stock was issued.
March 1 White subscribed to 50 shares of stock at par. It was payable
50 per cent on March 8 and 50 per cent on March 20. White
made the first payment but defaulted on the second. On
March 25 the 50 shares were sold at 98. The expenses incident
to the sale were $15. The amount realized in excess of the
corporation's equity was returned to White.
July 30 Earnings for the fiscal period were $5,000. A 2 per cent divi-
dend was declared to stockholders of record and paid 10 days
later.
PROBLEMS 277
Directions:
a. Give the entries on the corporation's books to record the acquisition
of the partnership.
b. Give all necessary dated journal entries on the books of the corporation
to record the other data given.
Problem 62
Jones and Smith, equal partners, decided to expand their business. They
succeeded in interesting Johnson, the local banker, to join them in organizing
the Jones and Smith Corporation. The proposed corporation was to have
an authorized capitalization of 3,000 shares, par value, $100. The partner-
ship balance sheet prior to incorporation was as follows:
Cash $ 10,000 Accounts payable $ 15,000
Accounts receivable 20 , 000 Notes payable 5 , 000
Merchandise 35,000 Mortgage 20,000
Equipment 25,000 Smith, capital 55,000
Buildings 50,000 Jones, capital 55,000
Land 10,000
$150,000 $150,000
The assets of the partnership were accepted at book value by the cor-
poration with the exception of the land account which was decreased $5,000.
Jones and Smith received $10,000 for the goodwill of their partnership.
They were paid in capital stock of the newly formed corporation.
Johnson subscribed to 1,000 shares at par. He was allowed $500 for
his services as a promoter (and paid in the stock of the corporation). The
balance he paid in cash.
Brown was given 100 shares (par $100) for patents which he turned over
to the corporation.
Wilson, a creditor, accepted 80 shares at par in settlement of his $8,000
account.
Williams bought 50 shares at 99 and paid cash for his purchase.
Submit:
a. Entries to close the partnership books
b. Entries to open the books of the corporation, and record all data given
c. The balance sheet of the corporation after all transactions have been
recorded
CHAPTER XII. Cost Accounting
Problem 63
The inventories of the Novelty Manufacturing Company, January 1, 19 ,
were as follows: materials, $6,000; work in process, $3,000; finished goods,
$4,500. From January 1 to January 31 materials purchased amounted
to $23,500; labor costs incurred totaled $25,000, consisting of $21,000 direct
labor and $4,000 indirect labor; and manufacturing overhead totaled $11,000,
278 ELEMENTS OF ACCOUNTING
including the indirect labor and $2,000 of indirect materials, the remaining
$5,000 being such items as heat, power, insurance, depreciation, and taxes.
All direct labor and manufacturing overhead costs were applied to
production.
On January 31, 19 , the inventories were materials, $5,000; work in
process, $2,500; and finished goods, $3,500.
Instructions: Enter the above data in the following accounts: materials
inventory, direct materials used, payroll, direct labor, manufacturing over-
head, work in process inventory, finished goods inventory, and cost of goods
sold. Transfer the items from one account to another as the various costs
are incurred, transferred to production, completed, and sold. Assume that
the materials inventory contains both direct and indirect materials and
that the payroll account is charged each pay period with both the direct
and indirect labor and then credited at the end of the month when the
labor costs are distributed.
Problem 64
On September 1, 19 , the ledger of the Kringle Toy Company contained
the following balances: materials inventory, $7,500, including both direct
and indirect materials; work in process, $2,500; finished goods, $5,000.
During September materials purchased for cash and charged to the materials
inventory account totaled $17,500. The payroll account was charged
with the weekly payrolls of $4,000, $3,800, $4,100, and $4,100, of which
$12,500 was for direct labor and $3,500 for indirect labor to be distributed
at the end of the month.
During September $10,000 of direct materials and $1,000 of indirect
materials were applied to production. Manufacturing overhead items, in
addition to indirect materials and indirect labor, totaled $4,000 and were
paid in cash. The total cost of goods completed during the month was
$29,000. Finished goods on hand September 30 amounted to $6,000.
Sales for cash during September totaled $50,000. All labor and manufac-
turing overhead incurred was applied to production.
Instructions:
a. Prepare journal entries for the month of September.
b. Post to the ledger accounts after inserting the opening balances.
c. Rule and balance the accounts.
Problem 65
The Enterprise Company manufactures a product which is the result of
three processes. After a prolonged shutdown, operations were resumed
April 1, 19 During the month of April, pertinent cost and operating
data are as follows:
First Process. Material which cost $2,890 was put in process, and labor
and manufacturing overhead costs to the amount of $800 and $600, respec-
tively, were expended. Four thousand units were started in process,
3,700 were completed and transferred to the second process, and 300, two-
thirds completed, remained in the department.
PROBLEMS 279
Second Process. To the units transferred from the preceding department,
labor cost totaling $1,000 and manufacturing overhead amounting to $800
were applied. Of the 3,700 units received, 3,500 were completed and trans-
ferred to the succeeding department, and 200 remained in the second process,
half finished.
Third Process. In the last process, material costs of $1,300, labor costs of
$460, and manufacturing overhead of $585 were applied to the units from
the preceding department. Completed units totaled 3,200, and 300 units
half finished remained in process.
Instructions: Prepare a summary cost statement (see page 184).
CHAPTER XIII. Cost Accounting. (Concluded]
Problem 66
Enter the following transactions in the form indicated:
Transaction
Number
Journal Entry on General
Accounting Books
Record on Cost
Accounting Forms
(1) Material purchased for stores $6 , 525
(2) Direct material issued 5 , 215
(3) Direct material returned to stores 250
(4) Direct labor cost incurred 8,200
(5) Wages paid 8,200
(6) Direct labor applied to production 8, 200
(7) Indirect material issued from stores 1 , 275
(8) Indirect material returned to stores 130
(9) Indirect labor cost incurred and paid 2,640
(10) Additional manufacturing overhead items, paid for in cash:
Repairs $ 500
Light, heat, and water 1 , 215
Taxes 600
Compensation insurance 400 2 , 715
(11) Transfer the individual manufacturing overhead items to the
summary manufacturing overhead ledger account.
(12) Manufacturing overhead distributed to:
Department A 2,300
Department B 1,800
Department C 1 , 100
Department D 1,300
(13) Service departments C and D apportioned equally to producing
departments A and B.
(14) Manufacturing overhead applied to production:
Department A 3,550
Department B 2,900
280 ELEMENTS OF ACCOUNTING
Problem 67
On October 1, 19 , the ledger account balances of the Weldon Manu-
facturing Company were as follows:
Cash $ 5,000
Accounts receivable 7,000
Materials 5,000
Work in process 1 , 750
Finished goods 3, 500
Machinery 27,000
Buildings 15,000
Land 3,250
Accounts payable $ 2 , 750
Reserve for doubtful accounts 175
Reserve for depreciation on machinery 1 , 645
Reserve for depreciation on buildings 765
Capital stock 50,000
Surplus 12,165
$67,500 $67,500
Summary transactions for the month of October are as follows:
(1) Material purchased on account for stores $2, 100
(2) Direct material issued from stores 2 , 800
(3) Indirect material issued from stores 1 , 600
(4) Payroll for the month:
Direct labor all entered to production 5 , 200
Indirect labor 1 , 700
(5) Additional manufacturing overhead items, paid for in cash:
Water and power $2,800
Repairs to machinery 1 , 000
Compensation insurance 700
Taxes 300
$4,800
(6) Transfer the individual manufacturing overhead items to the
summary manufacturing overhead ledger account.
(7) Manufacturing overhead applied to production 8 , 060
(8) Underapplied overhead expense 40
(9) Work in process, October 31, 19_ 4,250
(10) Finished goods, October 31, 19 2,200
Instructions:
a. Prepare general journal entries to record these summary transactions.
6. Submit a statement of cost to manufacture and cost of goods sold.
NOTE: In the direct material section of the statement of cost to manu-
facture, indirect materials used must be subtracted from the total materials
PROBLEMS 281
placed in production. This must be done because the materials inventory
contains both direct and indirect materials. Since indirect material is an
element of manufacturing overhead, it must be transferred to this cost
classification.
Problem 68
The trial balance of the Cord-Fisher Corporation, February 1, 19 , is
as follows:
Cash $ 13,900
Accounts receivable 34,750
Reserve for doubtful accounts $ 850
Inventories, February 1, 19 :
Finished goods 3,500
Work in process 3 ,000
Materials 5,800
Machinery and equipment 46 , 500
Reserve for depreciation of machinery
and equipment 25 , 350
Buildings 61 ,800
Reserve for depreciation of buildings. . . . 15,600
Land 17, 100
Accounts payable 19,350
Capital stock 100,000
Surplus 25,200
$186,350 $186,350
Summary transactions for February are as follows :
(1) Purchases of material on account $ 7,200
(2) Material withdrawn from stores and chargeable to:
Direct material 4 , 200
Manufacturing overhead (indirect material) 1 , 100
(3) Labor summarized from time tickets and charged to:
Direct labor 5 , 600
Manufacturing overhead (indirect labor) 1 , 750
(4) Sales on account 21 , 000
(5) Cash receipts from accounts receivable 27,250
(6) Cash disbursements:
Accounts payable (other than payroll) 6 , 200
Accounts payable (payroll) 7,350
Manufacturing overhead (items paid in cash other than
indirect material and indirect labor) :
Light, heat, and water $700
Repairs to machinery and equipment 500
Compensation insurance 250
Taxes 175 1,625
Selling expenses 1 ,750
General administrative expenses (J3
282 ELEMENTS OF ACCOUNTING
(7) Uncollectible accounts receivable charged against the reserve
for doubtful accounts 550
(8) Depreciation on machinery and equipment (manufacturing
overhead expense) 387
(9) Depreciation of buildings . 100
Prorated as follows:
Manufacturing overhead $ 50
Selling expenses 25
General administrative expense 25
Total $100
(10) Increase in the reserve for doubtful accounts (general admin-
istrative expense) 700
(11) Enter the direct material and direct labor costs into produc-
tion.
(12) Transfer the detailed manufacturing overhead items to the
summary manufacturing overhead account.
(13) The manufacturing overhead chargeable to production is 87
per cent of direct labor cost.
(14) Cost of goods completed during February 15,500
(15) Cost of goods sold 14,700
(16) Adjust for the underapplied manufacturing overhead expense.
(17) Close the revenue and expense items to the summary profit
and loss account, and the final profit or loss to surplus.
Required:
a. Journalize the transactions and post to ledger accounts. Set up the
ledger with the accounts in their proper order. Do not set up detailed
accounts for the selling and the general administrative expenses, but,
in order to shorten the problem, open only two accounts for all of those
departmental expenses a selling expense account and a general
administrative expense account. Keep the manufacturing items in
detailed accounts.
6. Prepare a balance sheet and a profit and loss statement, supported
by a statement of cost to manufacture and cost of goods sold (on this
statement take account of the Note in part b of the instructions in
problem 66).
PROBLEMS 283
CHAPTER XIV. Statement Analysis
Problem 69
THE WESTLAKE CORPORATION
BALANCE SHEET, DECEMBER 31, 19
Assets
Current:
Cash $ 12,650
Marketable securities 28, 425
Notes receivable due from officers 11 , 500
Notes receivable due from trade debtors 10,300
Accounts receivable $ 20 , 300
Less reserve for bad debts 406 19,894
Inventories 32, 176
Prepaid advertising 8, 200
Total current assets $123, 145
Fixed:
Equipment and machinery $448,500
Less reserve for depreciation 46,125 $402,375
Land and buildings $178,350
Less reserve for depreciation 53,350 $125,000
Total fixed assets 527,375
Total assets $650,520
Liabilities and Proprietorship
Current :
Accounts payable $ 13 , 200
Notes payable due to banks 17, 500
Notes payable due to creditors 14 , 300
Accrued expenses 8,250
Total current liabilities $ 53,250
Long Term:
Mortgage payable 100 , 000
Net Worth:
Capital stock $400,000
Surplus 97,270
Total net worth 497,270
Total liabilities and proprietorship $650,520
Discuss the condition of this company. Give reasons in support of
your opinion.
Problem 70
On December 31, 19A, 1 year after its formation, the balance sheet
of the Fairfax- Wilson Corporation appeared as, follows;
284 ELEMENTS OF ACCOUNTING
Assets
Cash $ 7,000
Notes and accounts receivable (less reserve) 23 , 000
Inventories 40,000
Buildings and equipment (less reserve) 110,000
Land 20,000
Total assets $200,000
Liabilities and Proprietorship
Notes and accounts payable $ 30 , 000
Mortgage payable 25 , 000
Preferred stock 25,000
Common stock 100,000
Surplus 20,000
Total liabilities and proprietorship $200 , 000
Compute the significant ratios in this statement.
Problem 71
One year later (see problem 70) the balance sheet of the Fairfax- Wilson
Corporation appeared as follows:
Assets
Cash $ 15,000
Notes and accounts receivable (less reserve) 20 , 000
Inventories 45,000
Buildings and equipment (less reserve) 140,000
Land 20,000
Total assets $240,000
Liabilities and Proprietorship
Notes and accounts payable $ 20,000
Mortgage payable 25 , 000
Preferred stock 50,000
Common stock 100 , 000
Surplus 45,000
Total liabilities and proprietorship $240 , OOP
Compute the significant ratios in this statement.
Problem 72
Three years after its formation, the balance sheet of the Fairfax- Wilson
Corporation was as follows:
Assets
Cash $ 20,000
Notes and accounts receivable (less reserve) 35 , 000
Inventories 60,000
Buildings and equipment (less reserve) 140 , 000
Land 20,000
Total assets $275,000
PROBLEMS 285
Liabilities and Proprietorship
Notes and accounts payable $ 25 , 000
Mortgage payable 35,000
Preferred stock 50 , 000
Common stock 100 , 000
Surplus 65,000
Total liabilities and proprietorship $275,000
Required:
a. The significant ratios for this statement.
6. Compare the ratios for problems 70, 71, and 72 to determine whether
the financial position has improved. Assume that a dividend of
$10,000 was paid January 20 of the third year.
Problem 73
The Chase-Borden Corporation shows the following results of operation
for the year ending December 31, 19 :
Net Sales $200,000
Cost of goods sold 150,000
Gross profit 50,000
Selling expenses 20,000
General expenses 16 , 000
Net profit from operations 14 , 000
Nonoperating expense 2 , 000
Net profit $ 12,000
Compute significant ratios from this statement.
Problem 74
One year later the Chase-Borden Corporation showed the following
results from operation for the calendar year:
Net sales $260,000
Cost of goods sold 182,000
Gross profit 78 , 000
Selling expenses 30,000
General expenses 19,000
Net profit from operations 29,000
Nonoperating expenses 5,000
Net profit $ 24,000
Compute significant ratios from, this statement. Compare the ratios
with those computed for problem 73.
286
ELEMENTS OP ACCOUNTING
CHAPTER XV. Statement Analysis. (Concluded)
Problem 75
Prepare statements of source and application of funds from the data
contained in problems 70, 71, and 72. Comment upon the method of
financing.
Problem 76
Prepare a statement of variation in profit from the data in problems
73 and 74.
Problem 77
Comparative Balance Sheet of the Rand-Wilcox Manufacturing Company
December 31,
19A
December 31,
19B
Assets
Land
$ 5,000
$ 5,000
Buildings
25,000
32,000
Machinery
45,000
57,800
Delivery equipment
5,000
6,500
Unexpired insurance
150
50
Interest income accrued
15
25
Advertising prepaid
45
Goodwill
7,500
2,500
Raw materials
9,350
11,300
Goods in process
2,100
3,200
Finished goods
12,500
15,500
Accounts receivable
8,400
10,500
Notes receivable
4,000
3,500
Cash
5,600
8,200
$129,615
$156,120
Liabilities, Reserves, and Proprietorship
Capital stock, common
$ 50,000
$ 50,000
Capital stock, preferred
25,000
50,000
Notes payable
6,000
2,500
Accounts payable
7,500
4,300
Reserve for depreciation on buildings
6,000
7,500
Reserve for depreciation on machinery
8,500
10,250
Reserve for depreciation on delivery
equipment
1,350
1,900
Reserve for doubtful accounts
420
525
First mortgage bonds
10,000
20,000
Surplus
14,845
9,145
$129,615
$156,120
*
PROBLEMS
287
RAND-WILCOX MANUFACTURING COMPANY
COMPARATIVE PROFIT AND Loss STATEMENT
For the Year Ending
December 31, 19A
For the Year Ending
December 31, 19B
Sales
$135,000
$200,000
Cost of goods sold
110,000
160,000
Gross profit
25,000
40,000
Operating expense
17,500
30,200
Operating profit
7,500
9,800
Nonoperating expenses
2,000
3,000
Net profit
$ 5,500
$ 6,800
-
* *^ maam *=
RAND-WILCOX MANUFACTURING COMPANY
STATEMENT OF SURPLUS
Year, 19B
Balance, January 1, 19B $14,84"5
Less:
Goodwill write down $5,000
Dividends 7,500 12,500
$ 2,345
6,800
Plus profit for 19B.
Surplus, December 31, 19B $ 9,145
Required:
a. A comparative balance sheet with suitable asset, liability, and pro-
prietorship groupings
b. A statement of source and application of funds
c. A statement of working capital
d. A statement of variation in profit
e. A narrative report giving your opinion of the business
Problem 78
I. Select a company having two balance sheets and two profit and loss
statements of recent date. The profit and loss statement should
contain a cost of goods sold figure separate from selling and general
administrative expenses. These statements may be obtained from
the company's report to stockholders or from the financial manuals
of Moody's, Poor's, or the Standard Statistics Company.
II. Prepare the following statements:
A. A comparative balance sheet
B. A comparative profit and loss statement. It may be necessary
to reclassify and change the sequence of items within the statements
to suit the requirements of your analysis
288 ELEMENTS OF ACCOUNTING
C. A statement of source and application of funds
D. A schedule of working capital
E. A statement of surplus
F. An analysis of the variations in net profit
III. Submit a narrative report of the company commenting on the following
aspects, if they are worthy of mention:
A. The prospects for a prosperous or an unprofitable future within
the industry
B. The financial trend of the company, noting the following, if they
are significant :
1. Changes in proprietorship equity
2. Changes in working capital
3. Refinancing program
4. Ratios of earning power for
a. Capital invested by owners
b. Current assets %
c. Fixed assets
d. Receivables
e. Inventories
5. Turnover ratios for
a. Current assets
b. Fixed assets
c. Receivables
d. Inventories
6. Check for the following danger signals in financing:
a. Too small an amount of cash
b. Overinvestment in:
(1) Receivables
(2) Inventories
(3) Fixed assets
c. Too large an amount of intangibles with too little surplus to
support them
d. Insufficient capitalization
C. An analysis of operations with attention to
1. Ratio of net profit to sales
2. Reason for the variation in net profit
3. Changes in operating expenses
4. Changes in the ratio of operating expenses to net sales
D. The future of the industry correlated with the financial pofiition
of the business from a common-sense viewpoint.
IV. Assemble the report as follows:
A. Narrative analysis
B. Statement of source and application of funds
C. Schedule of working capital
D. Statement of surplus
j. Statement of variation hi profit
F. Comparative balance sheet
Or, Comparative profit and loss statement
INDEX
Accounting, accrual basis, 57
assumptions influencing valuation,
110
branches, 2
cash basis, 57
cycle, meaning of, 38
steps in, 83
definition, 4
equation, 8
evolution, 1
nonprofit organizations, 2, 4n.
period, 24
relation, to bookkeeping, 3
to economics, 4
to engineering, 6
to law, 5
to management, 6
Accounts, allowance, 14
classification of, 34
closing of, 81
controlling, 96
definition, 27
footing, 43
manufacturing, 191
mixed, 59n.
numbering systems, 34
operation, 29
partner's, 143
profit and loss, 61
reserve, 14, 173
rule for debiting and crediting, 30
structure, 29
temporary proprietorship, 61
valuation, 56
Accounts payable, controlling, 97
definition, 15
subsidiary ledger, 97
Accounts receivable, controlling ac-
count, 96
Accounts receivable, definition, 10
subsidiary ledger, 96
r valuation of, 113
Adjustments, accrued expense, 68
accrued income, 59
bad debts, 114
classified, 53
deferred income, 60
depreciation, 57
merchandise inventory, 53
prepaid expenses, 59
supplies, 55
work sheet, 71
Allowances, against assets, 14
Appreciation, valuation of, 130
Articles of partnership, 137
Assets, current, 10
deferred charges, 11
definition, 8
fixed, 11
groupings, 10
intangibles, 14
investments, 11
prepaid expenses, 11
relation, to equities, 8
to expenses, 59, 123, 125n.
to revenue, 18n.
reserves defined, 14
Auditing, 4
B
Bad debts, adjustment, 56, 114
Balance sheet, account-form illus-
tration, 9, 12, 80
comparative, 232
definition, 9
expression of the basic equation, 8
other statement titles, 8n.
preparation, 77
report form illustration, 79
289
290
ELEMENTS OF ACCOUNTING
Bank reconciliation statement, 111
Bonds, accounting entries, 168
defined, 16
discount, 169
interest, 169
premium, 169
types, 167
uses of, 235
Bookkeeping, 3
Buildings, definition, 14
valuation, 128
Business organizations, corporation,
when desirable, 157
individual proprietorship, when
desirable, 136
partnership, when desirable, 136
Business papers, 38
Capital stock, common, 166
discount, 161
dividends, 171
no-par, 17, 165
par value, 17
preferred, 166
premium, 161
sale for cash, 160
subscriptions, 161
defaulted, 162
installments, 162
records, 159
treasury, 164
unissued, 160
watered, 166n.
Capital surplus, 172
Cash, basis of accounting, 57
definition, 10
petty, 94
valuation, 111
Cash disbursements journal, de-
scription of, 93
illustration, 94
operation, 93
Cash receipts journal, description, 91
illustration, 92
operation, 91
Check register, description, 102
illustration, 106
Closing the books, steps necessary,
81
Closing entries, 60
Contingent liability, 116
Controlling accounts, accounts pay-
able, sources of posting, 97
accounts receivable, sources of
posting, 97
advantages, 96
in cost accounting, 191
definition, 96
operation, 98
relation, to special journals, 106
to subsidiary ledgers, 106
and trial balance, 96
Copyrights, valuation, 132
Corporation, bylaws, 158
capital stock, 156
definition, 156
formation, 158
profit distribution, 170
records, 158
surplus, 172
Cost, and asset values, 110
classification, 217
departments, producing and serv-
ice, 182
distribution, 210
labor, 181, 199
manufacturing overhead, 181, 203
material, 181, 191
prime, 181
standard, 180
Cost accounting, definition, 179
methods of accumulation, 182
relation, to finance, 179
to management, 179
to production, 180
to sales, 180
statements, 211
of analysis of manufacturing
overhead, 216
of cost to manufacture and
cost of goods sold, 216
Cost of goods sold, 22
INDEX
291
Cost or market, basis of valuation,
120
Current assets, 10
Current liabilities, 15
D
Debit and credit, 30
Deferred charges in balance sheet, 11
Deferred income, adjustments, 60
definition, 60
readjustments, 63
Depletion, 131
Depreciation, adjustments, 57
description, 125
methods of computing, 127
recording, 129
reserve, 129
Distribution costs, 210
E
Earned surplus, 172
Economics and accounting, 4
Engineering and accounting, 6
Entries, adjusting (see Adjustments)
closing, 60, 65
readjusting, 61, 67
Equities, 8
Expenditures, capital, 126
revenue, 126
Expenses, accrued, 58
classification, 181
general administrative, 23
nonoperating, 22
operating, 22
prepaid, 11, 59
relation, to assets, 59, 123, 125n.
to net worth, 31
selling, 22
Finance and cost accounting, 179
Finished goods, 118, 191
Fiscal period (see Accounting period)
Fixed assets, balance sheet, 78
definition, 11
Fixed assets, depletion, 131
depreciation, 125, 129
valuation, 125
(See also Assets)
Formulas, valuation, 132
Franchises, valuation, 132
Funds, definition, 11
sinking, 174
General administrative expenses, 23
General journal, operation when
special journals are used, 95
special columns, 85
Goodwill, partnership, 141
valuation, 132
Gross margin, 19n.
Gross profit, 22
Gross sales, 22
Imprest system, 94
Income, accrued, 59
deferred, 60
(See also Revenue)
Installment service goods, 125
Installments (see Capital stock)
Intangible assets, items included, 14
valuation, 131
Internal check, 192
Inventory, adjustments, 54
"cost or market" basis of valua-
tion, 120
determining cost, 118
merchandise, defined, 10
relation to purchases and cost of
goods sold, 53
reserve for market fluctuations,
122
turnover, 229
Investments, 11
Journal, columns, basis for selection,
85
202
ELEMENTS OF ACCOUNTING
Journal, definition, 36
disbursements, 93
general, special column, 87
purchase, 88
relation to ledger, 36
sales, 90
special basis for installation, 88
voucher, 99, 105
Journalization, 39
Labor, clock card, 200
daily time report, 201
definition, 181
direct, 181
entries to record cost, 201
indirect, 181
internal check for, 199
payroll sheet, 202
Land, 14, 130
Leaseholds, 132
Ledger, accounts payable, 97
accounts receivable, 97
classification of accounts in, 34
definition, 34
posting to, 42
relation, to journal, 36
to statements, 36
subsidiary, 96
Liabilities, accrued, 15
current, 15
contingent, 116
definition, 8
principal groupings, 15
reserves, 173
valuation, 133
Long-term liabilities! 15
Loss, net, 23
M
Machinery, definition, 14
valuation, 128, 129
Management, 6, 179
Manufacturing overhead, applica-
tion of, by direct-labor-hour
rate, 204
Manufacturing overhead, applica-
tion of, by labor-cost rate,
205
by machine-hour rate, 205
definition, 181
distribution sheet, 207
normal distribution rate, 203
over- and underapplied, 209
under process system, 203
recording cost, 205
under specific order system, 203
Material, cost, definition, 181
entries to record cost, 198
internal check, 191
purchase of, 192
receipt of, 194
requisition, 197
storeroom, 195
stores ledger sheet, 196
Merchandise (see Inventory and
Materials)
Mortgages payable, 16
N
Net worth, corporation, 17
individual proprietorship, 17
partnership, 17
ratio, to total assets, 225
to total liabilities, 226
relation of expense and revenue
to, 31
statement of change, 23
valuation, 134
(See also Proprietorship)
No-par stock, 165
Notes, short term, use of, 235
Notes payable, defined, 15
in voucher system, 102
Notes receivable, definition, 10
discounted, 116
dishonored, 117
valuation, 115
Organization expenses, 132
INDEX
293
Pacioli, Luca, 1
Partnership, admission of new part-
ner, 141
agreements, 137
capital accounts, 143
change to a corporation, 174
definition, 136
dissolution, 147
goodwill, 141
installment distribution, 151
liquidation, 149
organization entries, 140
profits or losses, 144
share, in business, 139
in profits, 139
Patents, 132
Posting, 42
Preferred stock, types, 167n.
Prepaid expenses, adjustments, 59
definition, 11
valuation, 123
Process cost system, 183
Production, and cost accounting, 180
method of computing deprecia-
tion, 127
Profit and loss account, sources of
debits and credits, 61
Profit and loss statement, account
form illustration, 76
comparative, 236
defined, 18
nonoperating section, 19
operating section, 19
other statement titles, 18n.
preparation, 74
principal groupings, 22
report form illustration, 19, 75
Proprietorship, definition, 8
temporary, 31
(See also Net worth)
Purchase, adjustments, 55
discounts, in check register, 106
in disbursements journal, 93
invoice, 194
order, 193
requisition, 192
R
Ratios, balance sheet, 222
classification, 220
current assets to current liabilities,
222
earnings, to proprietorship, 228
to total assets, 228
interstatement, 228
limitations, 221
merchandise turnover, 229
net or operating profit to sales, 228
net worth, to fixed assets, 225
to total assets, 225
operating, 226
profit and loss, 226
purpose, 221
quick assets to current liabilities,
224
sales to total assets, 229
Readjusting entries, 61
Reinvestment of profits, 234
Reserves, depreciation, 57, 129
doubtful accounts, 56, 114
liability, 173
secret, 174
surplus, 173
valuation, 173
Revenue expenditures, 126
8
Sales, discounts, 92, 115
journal, 91
returns, 22
Secret reserves, 174
Special journals, advantages, 88
basis for installation, 88
relation to controlling accounts,
106
Specific order cost system, 188
Statement analysis, prerequisites,
220
standards of comparison, 221
techniques, 220
trends, 231
Statements, balance sheet with
percentage computations! 223
294
ELEMENTS OF ACCOUNTING
Statements, bank reconciliation, 111
change in net worth, 21, 24, 77
changes in working capital, 233
comparative balance sheet, 232
comparative profit and loss, 236
profit and loss statement with
percentage computations, 227
relation to basic books, 36
source and application of funds,
233
variation in profit, 238
Stocks, use of, 235
Subsidiary ledgers, advantages, 96
definition, 96
relation to controlling accounts,
106
sources, of postings to accounts in
payable ledger, 97
of postings to accounts in
receivable ledger, 97
Supplies, 55, 122
Supporting schedules, 77, 81
Surplus, capital, 172
donated, 165
earned, 172
measurement of, 156
reserves, 173
System installation, 3
Trade-marks, 132
Transactions, analysis, 40
classified, 39, 41
definition, 39
Treasury stock, 164
Trends, disclosed, by balance sheet
comparisons, 231
by profit and loss comparisons,
237
Trial balance, definition, 43
illustrations, 50, 51
limitations, 45
post-closing, function, 82
post-closing, illustration, 82
procedure for discovering errors,
44
purpose, 44
steps required to prepare, 44
U
Unearned income, 16
Unissued stock, 160
Valuation, accounts, 56
accounts receivable, 113
appreciation, 130
assumptions influencing, 110
buildings, 128
cash, 111
and conservatism, 109
copyrights, 132
depletion, 131
and effect, on financial status, 109
on operations, 109
equipment, 128
formulas, 132
franchises, 132
and functions of assets, 111, 125
goodwill, 132
land, 130
leaseholds, 132
liabilities, 133
machinery, 128
marketable securities, 113
merchandise inventory, 117
net worth, 134
notes receivable, 115
organization expenses, 132
patents, 132
prepaid expenses, 122
reserves, 173
supplies, 122
trade-marks, 132
Voucher, illustration, 100
register, description, 99
illustration, 105
system, application of journal
and ledger subdivision, 99, 107
illustrative problem, 103
operation, 101
W
Working capital, 222
Work sheet, description, 70
illustration, 72
preparation, 71
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