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Public Accounting 
and Auditing 



Volume n 



y By 

J. F. ^lERWOOD 

Certified Public Accountant and Auditor 



Published by 

SOUTH-WESTERN PUBLISHING CO. 

Cincinnati, Ohio 



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Copyright 192 1 

SOUTH-WESTERN PUBLISHING CO. 

Cincinnati, Ohio 






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PREFACE 

This is the second volume of a two-volume series. A 
knowledge of the subject-matter discussed in Volume One is 
necessary in order to comprehend the discussion in Volume 
Two. 

This volume relates to various phases of accountancy 
dealing principally with problems encountered by the practic- 
ing public accountant and auditor. As each topic is taken 
up, it is discussed as to accounting principles and practice. 

Chapters One to Three relate to partnership accounting 
problems, the discussion covering transactions incident to organi- 
zation, operation and dissolution. 

Chapters Four to Seven relate to corporation accounting 
problems, the discussion covering transactions incident to organ- 
ization; transactions incident to the handling of various classes 
of capital stock; transactions relating to dividends, and the 
accounting for mergers and consolidations. 

Chapters Eight to Eleven relate to systematization in 
which appear a discussion of Mercantile Accounting, Depart- 
mentalization, Flour Mill Accounting and Cost Accounting. 
This discussion is, of necessity, of an elementary nature. No 
attempt has been made to exhaust the subject. It is felt that 
it is better to discuss the fundamental principles incident to 
systematization and apply them to a few particular concerns, 
thereby creating an interest on the part of the student to con- 
tinue the study of this important phase of accounting by further 
investigation and research work. 

Chapters Twelve to Fifteen relate to the Federal Income 
and Surtaxes on Individuals and to the Federal Income and 
Excess Profits Taxes on Corporations. Two chapters are 
devoted to individuals and two to corporations. 

The questions for class discussion and the problems for 
practice work are selected from the C. P. A. and Institute exam- 
inations. The author has attempted to select and grade the 
problems so that they apply to the topics under discussion in 
each chapter and that the student may be led from the known to 
the unknown. In other words, it is believed that the student 
with the proper preliminary training, who has mastered the 
principles of accounting and auditing as presented in Volume 
One, should be able to take up Volume Two and complete the 
work without difficulty, provided he masters the additional 
principles and phases of accounting as they are developed in 
the discussion. 



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In conclusion, the author desires to thank those teach- 
ers and practicing accountants who have offered many helpful 
suggestions in connection with the preparation of the manu- 
script., He is especially indebted to E. R. Thoma, Instructor 
of Accounting, University of Washington; W. O. Winkler, 
C. P. A., Dean, School of Commerce, Valparaiso University, 
and George E. Bennett, C. P. A., Professor of Accounting, 
Syracuse University, for the material assistance rendered in 
the preparation of the manuscript for this volume. He also 
feels indebted to Paul F. Fusselman, attorney at law, income 
tax inspector, U. S. Treasury Department, for the assistance 
rendered in connection with the preparation of the manuscript 
relating to the Federal Income and Excess Profits Taxes. 

The author realizes that there may be many imperfections 
in the present volume, and he shall gratefully receive any con- 
structive criticisms and suggestions with which he may be 
favored by those teachers who, because of their experience in 
presenting the subject to students, are in a position to make 
such suggestions as may be worthy of consideration and which 
it may te found advisable to incorporate in another edition of 
this volume which it is hoped will appear in the course of time. 

J. F. SHERWOOD, C. P. A. 
Cincinnati, Ohio. 
July I, 192 1. 



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CONTENTS 



Pages 
CHAPTER I I-I6 

Partnership Accounting 

Partnership Organization 

Equal Investments 

Overvaluation of Inventories 

Capital Proportional to Investments 

Investing G<x>d Will 

Reserve for Depreciation of Assets Invested 
Distribution of Profits and Losses 

Interest on Capital 

Distribution of Profits as Salary 

Distribution of Profits in Proportion 
to Investments 
Partnership Law 

Articles of Copartnership 

Essential Elements 

Classes of Partnerships 
Auditing Practice 

CHAPTER II 17-32 

Partnership Accounting (Continued) 
Partnership Dissolution 

Distribution of Profits and Losses 

Distribution of Assets 

Liquidating Dividends 
Partnership Law 

Dissolution 

Liability of Partners 

Divisions of Profits and Losses 

Division of Assets 

Loans of Partners 
Accounting Practice 

CHAPTER III 33-48 

Partnership Accounting (Concluded) 
Financial Embarrassment 
Bankruptcy 
Trustee in Bankruptcy 
Statement of Affairs 
The Deficiency Account 
Realization and Liquidation Statement 
Receivership Accounting 
• Commercial Law 

Bankruptcy 

Assi^ment 

Receivership 
Accounting Practice 

I 



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II CONTENTS 

Pages 

CHAPTER IV 49-64 

Corporation Accounting 
Corporate Transactions 
Corporate Records 
Corporation Law 

Advantages of Incorporation 
Disadvantages of Incorporation 
Application for Charter 
Accounting Practice 

CHAPTER V 65-80 

Corporation Accounting (Continued) 
Treasury Stock 
Donation Stock 
Forfeited Stock 
Premium on Treasury Stock 
Discount on Treasury Stock 
Corporation Law 

Liability to Subscribers 

Conditional Subscriptions 

Liability on Stock Purchased at a 
Discount 

Liability on Sub. to Bank Stock 
Accounting Practice 

CHAPTER VI 81-^ 

Corporation Accounting (Continued) 
Dividends 

Cash Dividend 

Stock Dividend 

Scrip Dividend 

Property Dividend 

Liquidating Dividend 
Corporation Law 

Dividends Declared Out of Profits 

Dividends on Stock Not Fully Paid 

Dividends on Pref. and Com. Stock 

Stock Dividends 
Accounting for Dividends 

CHAPTER VII 97-112 

Corporation Accounting (Concluded) 
Combinations 
Merger 

Holding Companies 
Consolidated Statements 
Income Tax Procedure 

Consolidated Returns 

When Corporations are Affiliated 

Filing Consolidated Returns 
Accounting Practice 



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CONTENTS III 

Pages 

CHAPTER VIII 113-128 

Systematization 

Accounting Systems 

Preliminary Information 
Fundamental Principles 
Mercantile Accounting 
Accounting System 
Books of Account 
Outline of Accounts 
Manufacturing the Books of Account 
Accountant's Report 
Pro Forma Statements 

CHAPTER IX. •. 129-144 

Systematization (Continued) 
Departmental Accounting 
Loose-Leaf Records 
Voucher System 
Books of Account 
Branch Store Accounting 

CHAPTER X 145-160 

Systematization (Continued) 
Flour Mill Accounting 
Outline of Accounts 
Record of Purchases 
Record of Cash Receipts and 

Disbursements 
Record of Sales 
Journal 
Stock Record 

Material Consumption Report 
Production Report 
Ledgers 

CHAPTER XI 161-176 

Systematization (Concluded) 
Cost Accounting 

Object of Cost Accounting 

Advantages of Uniform Systems 

Cost Accounting as an Aid to Management 

Devising a Cost Accounting System 

Cost Systems 

Job Cost or Production Order System 
Continuous Production or Process System 
Predetermined Estimate System 

Elements of Cost 

Accounting for Material 

Accounting for Labor 

Accounting for Overhead Expenses 

Controlling Accounts 



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IV CONTENTS 

Pages 
CHAPTER XII 177-192 

Federal Income Taxes 

The Income Tax on Individuals 
Income to be Reported 
Reporting on Cash or Accrual Basis 
Gross Income 

Income Exempt from Taxation 
Taxable Interest on Liberty Bonds 

CHAPTER XIII 193-208 

Federal Income Taxes (Continued) 
Income Tax on Individuals 

Deductions from Gross Income 
Items not Deductible 
Credits Allowed 
Making of Returns 
Rates of Tax 
Computation of Tax 
Payment of Tax 
Penalties 

CHAPTER XIV 209-224 

Federal Income Taxes (Concluded) 
The Income Tax on Corporations 
Corporations Subject to Tax 
Net Income 
Gross Income ^ 
Corporations Exempt from Tax 
Personal Service Corporations 
Deductions from Income 
Items not Deductible 
Credits Allowed 
The Rate of the Tax 
Calculation of the Tax 
Place for Filing Returns 
Returns and Payment of Tax 

CHAPTER XV 225-240 

Federal Excess Profits Taxes 

Net Income for the Taxable Year 
Invested Capital 
Computation of Invested Capital 
Credits Allowed 
Determination of the Tax 
Computing the Taxes of Corporations 
Corporation Tax Table 
Information and Payment at Source 



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Chapter One 

PARTNERSHIP ACCOUNTING 

1. ACCOUNTING THEORY 

In most particulars there is no essential difference between 
the records and accounts of a partnership and those of a sole 
proprietorship or a corporation. With the exception of the 
proprietorship accounts, no new or different accounts are neces- 
sary and no new principles are introduced. Certain problems 
may arise, however, in the conduct of a partnership which 
do not arise in the conduct of a sole proprietorship or a corpo- 
ration. 

The essential problems of partnership accounting are those 
which bear upon the character of the partnership relation and 
refer to the proper division tto be made of profits and losses, 
and of the assets and liabilities at time of dissolution of the part- 
nership. If it is clearly understood in each case just what con- 
tract has been made there is ordinarily little difficulty in formu- 
lating the accounts. But, unfortunately, the terms of partner- 
ship agreements are at times vague, and even the courts have 
not always agreed on their interpretation. Some of the cases 
in which difficulties arise are, therefore, of importance to the 
accountant even though there may be no really vital accounting 
principles involved. 

The principal difficulties in partnership accounting arise 
in connection with: 

1. Partnership organization. 

2. Distribution of profits and losses. 

3. Partnership dissolution. 

Partnership Organization. With reference to the ques- 
tions arising in connection with the organization of partnerships, 
only a few can be mentioned here: 

Equal Investments. If A. M. Reichard and J. E. Nobis 
agree to form a partnership, the former investing $25,000.00 in 
cash and the latter $25,000.00 in merchandise, their financial 
condition may be expressed as follows: 



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PUBLIC ACCOUNTING AND AUDITING 

Balance Sheet 



Assets 

Cash $25,000.00 

Merchandise 25,000.00 


Liabilities 

Net Worth: 
A. M. Reichard, 

Capital $25,000.00 

J. E. Nobis, 

Capital 25,000.00 


$50,000.00 


$50,000.00 



Overvaluation of Inventories. In this case the only 
question involved is the value of the merchandise. If it is 
correctly valued there is no difficulty. It is important that 
its value be correct for if it later develops that it was overvalued 
and ^orth only $20,000.00, the $5,000.00 loss will not fall 
entirely on Nobis, but must be equally shared by Reichard. 

Capital Proportional to Investments. If Nobis invests 
$30,000.00 of merchandise instead of $25,000.00, with the un- 
derstanding that his interest in the firm is to be proportional 
to his investment, no difficulty arises, as his Capital account will 
be increased to $30,000.00 and Reichard's will remain as before. 

Investing Good Will. If, however, Reichard is already 
engaged in business with an investment of $25,000.00 in mis- 
cellaneous assets and Nobis agrees to invest $30,000.00 in cash 
in order to be admitted as owner of a half interest in the new 
firm, a new element enters. Since Nobis is willing to invest 
$30,000.00 in order to be an equal partner with Reichard who 
is investing only $25,000.00 in tangible assets, he must believe 
that the good will of Reichard's business is worth $5,000.00. 
Upon this basis the condition of the new firm may be expressed 
as follows: 

Balance Sheet 



Assets 

Misc. Assets $25,000.00 

Cash 30,000.00 

Good Will 5,000.00 



$60,000.00 



LlABIUTIES 

Net Worth: 
A. M. Reichard, 

Capital $30,000.00 

J. E. Nobis, 

Capital 30,000.00 

$60,000.00 



It will be seen from the above illustration that the value 
of the good will has been credited to Reichard's account since 
he is the one who has contributed the good will. 

If one firm purchases the business of another for a price 
greater than the net tangible assets of the former, the difference 
between the purchase price and the net assets must be debited 
to Good Will. 



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PARTNERSHIP ACCOUNTING 3 

Reserve for Depreciation of Assets Invested. If, on the 

other hand, the business is purchased for less than the book 
value of the net assets, the question arises as to how the dif- 
ference is to be shown. Some argue that each asset should be 
scaled down proportionately so that the book value of the net 
assets will -be equal to the purchase price. This would seem to 
lead to unsatisfactory results, since all of the assets are prob- 
ably not equally overstated. Some may be worth their book 
value while others may be entirely worthless. It would seem 
better to credit the difference between the two amounts to a 
reserve account and to charge to this account any assets regarded 
as worthless or any losses arising from their liquidation. 

If, when all the assets purchased from the old firm have 
been liquidated or the value of those still on hand has been 
accurately verified by means of an appraisal, the reserve ac- 
count shows a credit balance, this amount may be shared 
equally by the partners and should be credited to their capital 
accounts. It should not be treated as a profit arising from 
the purchase of the business because a profit is realized only 
through a sale and not through a purchase. It simply rep- 
resents an adjustment of the partners' capital accounts. If, 
on the other hand, the account shows a debit balance, this 
should also be shared equally and charged to the partners* 
capital accounts. Some accountants might charge this to Good 
Will, but the policy would certainly be a poor one. It is un- 
doubtedly better practice to make the adjustment through 
the partners* capital accounts. 

To illustrate the above points, we may assume that Reichard 
and Nobis purchase the business of John Brown, whose financial 
condition is shown by the following: 

Balance Sheet 



Assets 

Cash $ 4,000.00 

Accounts Rec 6,000.00 

Merchandise 5,000.00 

Notes Receivable . . 1,000.00 

Furniture and Fix. . 500.00 

Mach. and Tools . . 1,500.00 

Land 1,000.00 

Buildings 2,000.00 



$21,000.00 



Liabilities 

Accounts Payable. $ 3,000.00 

Notes Payable 1,950.00 

Accrued Wages 750.00 

Accrued Taxes 250.00 

Accrued Interest. . . 50.00 

Net Worth: 
John Brown, 

Capital 15,000.00 

$21,000.00 



If Reichard and Nobis agree to assume Brown's liabilities 
and to pay him $9,000.00 for his assets exclusive of cash and 
to invest $1,000.00 each in cash, their financial condition may be 
represented by. the following: 



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PUBLIC ACCOUNTING AND AUDITING 

Balance Sheet 



Assets 

Cash $ 2,000.00 

Accounts Rec 6,000.00 

Merchandise 5,000.00 

Notes Receivable... 1,000.00 

Furniture and Fix. . 500.00 

Mach. and Tools. . . 1,500.00 

Land 1,000.00 

Buildings 2,000.00 



$19,000.00 



Liabilities 
Accounts Payable. $ 3,000.00 

Notes Payable i ,950.00 

Accrued Wages 750.00 

Accrued Taxes 250.00 

Accrued Interest. . . 50.00 

Res. for Depr. of 

Assets 2,000.00 

Net Worth: 
A. M. Reichard, 

Capital 5,500.00 

J. E. Nobis, 

Capital 5,500.00 

$19,000.00 



If an appraisal of the land places its value at $800.00, the 
following adjustment would be made: 

Res. for Depr. of Assets $200.00 

Land $200.00 

If $600.00 due from customers finally proves uncollectible, 
there would be another adjustment: 



Res. for Depr. of Assets $600.00 



Due from Customers. 



$600.00 



If the merchandise is liquidated without loss, the reserve 
for depreciation of assets would show a credit balance of $1 ,200.00 
which would be divided equally between Reichard and Nobis and 
credited to their capital accounts. 

If, on the other hand, the merchandise should prove to be 
grossly overstated, entailing a loss of $1,600.00 in liquidation, 
thereby causing an additional debit of this amount to the reserve 
for depreciation of assets, this account will show a debit balance 
of $400.00. Since this results in a loss greater than was provided 
for by a reserve, the excess ($400.00) must be shared equally 
by the partners. Some might charge this to good will but this 
would be n questionable policy. There is simply an extraordinary 
loss and it is better practice to adjust the partners' capital 
accounts. 

Distribution of Profits and Losses. The second class of 
difficulties involved in partnership accounting as mentioned 
above are those which arise in connection with the distribution 
of profits and losses. Legally, in the absence of an agreement 
to the contrary, profits and losses are divided equally among 
the partners regardless of the amount of their investments In 
case of unequal investments, therefore, it is customary for the 
partners to stipulate in the partnership agreement that profits 
and losses are to be divided in proportion to the capital invested 
or on some other basis. 



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PARTNERSHIP ACCOUNTING S 

Int^est on Capital. In some cases, it is desired to make 
the division of profits correspond to the ability and influence 
of the different members or to the amount of time which they 
devote in the conduct of the business rather than to the capital 
invested. In such cases, interest at an agreed rate is allowed 
on the capital invested or sometimes only on the amount invested 
above a certain sum in order to compensate the members 
in proportion to the amount invested. Sometimes, in stating 
how this interest shall be treated on the records, grievous ac- 
counting errors are made. For instance, it is sometimes stip- 
ulated in the case of two partners that interest shall be figured 
on the excess investment of the larger investor and credited to 
his account and debited to the account of the smaller investor. 

If Reichard and Nobis are partners, with an investment 
of $10,000.00 and $5,000.00 respectively, and it is agreed that 
Reichard is to receive credit at 6% for his excess investment, 
according to this plan Nobis will be charged $300.00 for the 
use of the $5,000.00 which is used in the conduct of the joint 
business of which Reichard will receive the benefit the same 
as Nobis if profits are shared equally. It is only necessary 
to assume that Da vies, an outsider, instead of Reichard, loaned 
the money to the firm to see the correct procedure. In that 
case, the amount of the interest paid Davies would be charged 
to the Interest account, and be treated as a charge against 
profits of the firm, and the same procedure should be followed 
in case the $5,000.00 is contributed by Reichard, as an addi- 
tional investment. If all of the partners are credited with 
interest on their investments, it should be considered as a 
distribution of profits and should be charged to Profit and Loss 
instead of Interest. Interest credited to a partner on his excess 
investment is in the nature of interest on borrowed capital 
and is a proper charge to the Interest account. In case the 
profit-sharing ratio is proportional to the capital investment, it 
is useless to provide for the allowance of interest on capital, as 
it would not affect the results in any way. 

Distribution of Profits as Salary. Sometimes the part- 
nership agreement provides for the payment of a certain per cent, 
of the net profits to one of the partners as a salary for his ser- 
vices. In this case, it is important to know whether by **net 
profits" is meant the profits after the salary is deducted or before 
it is deducted ; that is, whether the salary is to be regarded as 
an expense of the business or a division of the profits. It makes 
considerable difference in the final results as to which interpre- 
tation is accepted. To illustrate: If Reichard and Nobis are 
engaged in a partnership business managed by Reichard with 
the agreement that Reichard is to receive 25% of the net profits 
as a salary, the remainder to be divided equally among the two 
partners and the profits before deducting Reichard 's salary are 
$30,000.00, the following solutions would illustrate the results 
under the different interpretations. 



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6 PUBLIC ACCOUNTING AND AUDITING 

If the 25% allowance for salary is regarded as a distribution 
of the profits, the result would be as follows: 

A. M. Reichard, for salary, 25% $ 7,500.00 

50% of $22,500.00 11,250.00 $18,750.00 

J. E. Nobis, 50% of $22,500.00 11,250.00 

$30,000.00 

If, on the other hand, Reichard 's salary is to be regarded 
as an operating expense, the $30,000.00 profits are not net but 
include his salary in addition to net profits. Since his salary 
is 25% of net profits, the $30,000.00 must be 125% of net pro- 
fits and the latter would equal to $24,000.00. The division 
would now be: 

A. M. Reichard, for salary $ 6,000.00 

50% of $24,000.00 12.000.00 $18,000.00 

J. E. Nobis, 50% of $24,000.00 12,000.00 

$30,000.00 

It will be seen, therefore, that it is important that the agree- 
ment should specify clearly which method is to be followed. 

Distribution of Profits in Proportion to Inyestments. 

If the partnership agreement states that profits are to be divided 
in proportion to the investment and the investment does not re- 
main the same throughout the year, the question may arise 
as to whether in the figuring of profits the basis used should be : 

1. The capital at the beginning of the period. 

2. The capital at the end of the period. 

3. The average capital during the period. 

The last would seem to be the most equitable. It is found 
by multiplying the capital invested by each partner by the 
number of days it remains unchanged, adding the totals which 
will be equal to his total investment for one day. When all are 
reduced to this basis, the profits can be distributed on the basis 
of the proportion of the different totals. 

Interest on Investment a Fixed Charge. In case the 
partnership agreement provides for the payment of interest 
on the investments of the partners, this interest should be recorded 
regardless of whether profits are made. This is treated as a 
fixed charge and must be debited to the Profit and Loss account. 

The Profit and Loss account is usually closed into the 
partners' accounts at the end of the fiscal period. If there is a 
net gain, the amount is credited to the partners, and if there is 
a net Joss the amount is charged to the partners. The gain or loss 
may be recorded in the partners* capital or drawing accounts. 
Since it is supposed that drawings have been made against an- 
ticipated profits, the latter method is often employed. In either 
case, the balance of the drawing account is usually transferred 
to the capital accounts at the dose of the fiscal period. 



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PARTNERSHIP ACCOUNTING 7 

2. AUDITING THEORY 

Partnership Agreements. A partnership agreement in 
writing corresponds to the minute book of a corporation. As 
a corporation is bound by its by-laws, so are partners bound by 
their partnership agreement. 

The auditor should insist upon the partnership agreement 
being produced. It should be carefully read and notes taken 
with regard to any important matters relating to the finances, 
accounts, rights and liabilities of the individual partners. 

In the event there is no partnership agreement in writing 
or the agreement is lacking in matters of importance, the follow- 
ing general information should be secured if possible. 

1. The nature and scope of the business. 

2. The amount of the original capital. 

3. The agreement as to contribution of original capital. 

4. Are partners permitted to make withdrawals from their 
investment? If so, to what extent? 

5. Upon what basis are profits to be distributed or losses 
shared? 

6. Are partners allowed a specified salary? If so, is such 
salary to be charged to expense before or after determining the 
profit or loss for the period? 

7. Are partners entitled to interest on the capital invested? 
If so, at what rate and on what basis is it to be calculated? 

8. In case of dissolution, how are profits or losses incident 
to realization and liquidation of assets and liabilities to be dis- 
tributed? 

9. Is there an agreement that a scientific system of accounts 
should be kept, and is it provided that the accounts should be 
audited periodically by a professional accountant? 

10. Are there any special agreements with regard to any 
matters of importance not outlined above? 

After ascertaining all the important phases of the partnership 
agreement, the auditor should be able to detect any violation 
of the agreement, and should call each partner's attention to the 
matter at once. Even though the auditor is employed by one of 
the partners, he must remain unbiased and neutral. Otherwise, 
in case of litigation, or in a suit for an accounting, the auditor 
may find himself in an embarrassing position. 



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8 PUBLIC ACCOUNTING AND AUDITING 

3. PARTNERSHIP LAW 

Dr. Jackson, of England, in a paper read some years ago 
before the Chartered Accountants Students* Societies of King- 
ston-upon-HuU, England, said: 

"Next to the contract of marriage, the contract of part- 
nership is perhaps the most far-reaching legal contract; it 
requires the utmost good faith between the parties. It deals 
not only with the status of the firm created by the partnership 
agreement; it treats not only of the relationship of the parties 
among themselves and with the firm, but it introduces the 
various combmations of rights and obligations which may arise 
between the firm or its respective partners and the world at 
large." 

Partnership is the relation between two or more persons in 
which they have united their capital, labor, skill, or experience 
in the prosecution of a business, as principals, for their mutual 
benefit. 

A partnership may be formed by any of three methods: 

(a) Oral contract. 

(b) Written contract. 

(c) Implication, or implied contract. 

A partnership which is to be terminated within a year may 
be formed by an oral contract, but if it is to run longer than a 
year, the Statute of Frauds requires that the contract be in 
writing or that there be written evidence of a contract. Un- 
doubtedly, there should be a written contract in all cases of 
partnership agreement. It will avoid possible misiilnderstanding 
aiid will enable the partners to know at any time just what their 
rights are as against each other. In case of death of one of the 
partners, there can be no doubt as to the understanding between 
partners. 

Articles of Copartnership. Written agreements that 
form a partnership are known as Articles of Copartnership and 
should include among other things the following: 

(a) Name of the firm. 

(b) Nature of the business. 

(c) Location of the business. 

(d) Names of the partners. 

(e) Investment of each partner. 

(f) Duties of the partners. 

(g) Division of profits and losses, 
(h) Division of assets in dissolution. 

Essential Elements. From the preceding definition, 
we may deduce certain essential elements of every partnership 
agreement. 



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PARTNERSHIP ACCOUNTING 9 

(a) There must be an evident intent to enter into a 
partnership agreement. This may be manifested by a 
contract or agreement, either expressed or implied, written or 
oral, which establishes a legal relationship between partners. 

(b) Only persons competent to contract may enter 
into a partnership agreement. 

(c) The partners must agree to contribute a common 
fund, property, skill, or services for a business to be owned 
in common. 

(d) There must be a community of control in which 
each partner is authorized to act for the other or others. 

(e) The business for which the partnership is or- 
ganized must be a lawful enterprise, otherwise the agree- 
ment would be unenforceable. 

(0 The partners must agree to divide the profits 
and share the losses. This is sometimes implied. In the 
absence of an agreement, it is understood that the profits 
and losses are to be divided equally. 

Classes of Partnerships. Partnership organizations may 
be classified as general, implied, or limited. 

Implied Partnership. When the acts and language of 
two or more parties establish the presumption of a partnership 
regardless of the relations between the parties, they are liable 
to third parties as partners. 

Limited Partnership. While the law regulating limited 
partnership varies in the different states, the following are the 
principal features: 

(a) One or more of the partners are known as special 
partners. These special partners contribute to the capital, 
but are not liable for debts of the firm beyond the amount 
contributed. 

(b) Limited partnerships are required to publish the 
names of all partners, length and nature of the partnership, 
and the amount investal by both general and special 
partners. 

(c) Special partners have no voice in the conduct of the 
business. They may examine the condition of the business 
from time to time, but if they interfere in the management 
or enter into firm transactions, they become liable as general 
partners. 

(d) Special partners are prohibited from withdrawing 
their capital in the form of dividends, profits, loans, or 
salaries, but they may assign their interest without the 
consent of the general partners. 



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10 PUBLIC ACCOUNTING AND AUDITING 

General Partnership. In a general partnership, the mem- 
bers associate together in conducting the business. They are liable 
in common for firm debts. General partners can not assign 
their interests without the consent of the other members. Every 
partner is an agent of the partnership in carrying on the ordi- 
nary affairs of the business. 

Secret Partner. A secret partner (sometimes called a 
dormant or sleeping partner) is one who contributes in the 
general management and shares in the profits. He is liable 
equally with the other partners, but as he is not known to the 
public he often escapes liability. 

Silent Partner. A silent partner takes no active part in 
the business and he usually does not announce his connection 
with the firm. He may share in the profits and is liable for the 
firm debts just as are the general partners. 

Nominal Partner. A nominal partner is one who allows 
his name to be used or to appear as that of a partner. He has 
no share in the profits, but is liable with the other partners 
for firm debts. 

Ostensible Partner. An ostensible partner is one who 
appears to the public, or is held forth as a partner, though, in 
reality he has not contributed to the capital nor does not share 
in the profits. He may be held liable for firm debts. 

4. AUDITING PRACTICE 

J. M. Patterson and J. L. Terbush, Certified Public Ac- 
countants, are engaged to make an audit of the accounts of the 
firm of McMahan, Olds & Company for the fiscal period ending 
June 30, 1920, and are to make a report showing the results 
of the year's operation, including the proper adjustment of 
the accounts at the time of the partnership organization, and 
a Balance Sheet after final adjustments are made. 

Preliminary information shows that McMahan, Olds & 
Company is a partnership organized one year previous, on 
July I, 1919. At that time the partnership, which had been 
conducted by R. G. McMahan and L. B. Olds, decided to admit 
M. S. Cole as a partner. The partnership agreement showed 
the following facts : 

Cole was to contribute $30,000.00 and was to be entitled 
to one-third of the profits for one year. 

Before making the contribution, the following changes were 
to be made on the books of McMahan and Olds: 

(a) Book value of the store to be written down 5%. 

(b) Allowance for doubtful accounts to be set up, 
amounting to 2%. 

(c) Merchandise to be revalued at $35,000.00. 

(d) Furniture and Fixtures to be revalued at $2,500.00. 



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PARTNERSHIP ACCOUNTING 



II 



At the end of the year, the amount of good will is to be 
fixed at three times the net profits in excess of $20,000.00, this 
good will to be set up on the books, the corresponding credit 
being to McMahan and Olds equally. 

After the good will is determined at the end of the year, 
Cole was to contribute enough cash so that his capital account 
would equal just one-third of the total capital. 

McMahan, Olds and Cole are each entitled to draw $3,000.00 
in cash, the remaining profits to be carried to their capital 
accounts. 

On June 30, 1919, the Balance Sheet* of McMahan and Olds 
exhibited the following financial condition : 

McMAHAN & OLDS 
Balance Sheet, June 30, 1919 



Assets 

Store $15,000.00 

Accts. Receivable. . 12,000.00 

Cash 9,000.00 

Fur. and Fix 2,800.00 

Merchandise 37,000.00 

Misc. Equipment . . 4,200.00 



$80,000.00 



LlABIUTlES 

Accounts Payable. $10,000.00 
Bills Payable 5,000.00 

Net Worth: 
R. G. McMahan, 

Capital 30,000.00 

L. B. Olds, 

Capital 35.000.00 

$80,000.00 



The audit showed that the following transactions were 
consummated during the course of the year: 

Merchandise bought on credit $240,000.00 

Cash purchases 25,000.00 

Cash sales 125,000.00 

Credit sales 175,000.00 

Accounts payable paid (face $245,000.00, 

discount 2 per cent.) 240,100.00 

Accounts receivable collected (face $170, 
000.00, all net except $50,000.00 on 
which 2 per cent, discount was allowed) 169,000.00 

Buying expenses, paid cash 1,500.00 

Selling expenses, paid cash 21,000.00 

Delivery expenses, paid cash 9,000.00 

Management expenses, paid cash 4,500.00 

Miscellaneous expense, paid cash 3,000.00 

Interest on notes payable, paid cash 250.00 

Partners each withdrew cash per agreement 3,000.00 



^This engaeefnent does not comprehend an audit of the Balance Sheet 
of McMahan and Olds as of June 30, 1919. It covers the period beginning 
July I, 191^, and ending June 30, 1920. Therefore, the accounts as shown 
are as submitted by the clients. 



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12 PUBLIC ACCOUNTING AND AUDITING 

The following additional information was secured and agreed 
upon: 

Inventory of merchandise, June 30, 1920.. . $60,000.00 

Depreciation on store 285.00 

Allowance for doubtful accounts 165.00 

Furniture and jfixtures to be written down.. . . 200.00 
You may assume that you are employed by Patterson and 
Terbush, Certified Public Accountants. The preceding infor- 
mation is taken from the working papers prepared by the account- 
ants at the office of the client. You are instructed to prepare 
a report from the information given, your report to consist of 
the following: 

(i) Correcting entries necessary to correctly state 
the accounts at the beginning of the period, July i, 1919. 

(2) Adjusting entries incident to the preparation of a 
financial statement, at June 30, 1920. 

(3) A Statement of Profit and Loss as at June 30, 1920. 

(4) A Balance Sheet as at June 30, 1920. 

(5) Closing journal entries. 

(6) An auditor's certificate to be qualified on account 
of the fact that the inventory was not taken under your 
supervision but stating that you tested it and found it to 
be correct as tested. 

(7) Comments, with suggestions as to improving the 
system of accounts in use. You may assume that the books 
of account are poorly planned and improperly kept. A 
satisfactory internal check is not maintained. 

A. THEORY QUESTIONS 

1. Wherein do the books of a copartnership differ from 
those of a corporation in the same line of business? 

C. P. A. Ex. 

2. What distinction, if any, would you make as to sal- 
aries and drawings of the partners in a partnership concern, 
as affecting profit and loss? C. P. A. Ex. 

3. In case you were consulted by prospective partners 
regarding the terms of a partnership agreement, what points 
would you recommend for incorporating in such agreement? 

C. P. A. Ex. 

4. In an equal partnership with three partners, one was 
unable to meet his share of the investment with cash and gave 
his note drawing interest for part. When he paid the interest, 
the bookkeeper credited each of the other partners for one-half 
of the same. He objected and the matter is referred to you at 



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QUESTIONS AND PROBLEMS 13 

the time of the audit. He claims it should have been credited 
to Interest account and thus have been divided betwieen all 
three. Write your decision and reasons therefor. 

C. P. A. Ex. 

5. A and B are in partnership, A receiving two-thirds 
and B one-third of the profits. On November 30, 1919, the 
Profit and Loss account (after charging interest on net capital 
as of end of fiscal period at 5 per cent.) showed a profit of 
$6,000.00. On the first of December, 1918, the start of the yeir 
under audit, A had a capital of $10,000.00 in his business and 
during the year drew out $4,500.00. B on the same date had a 
capital of $8,000.00 and during the year drew out $1,000.00. 

Make up the two capital accounts as they should appear 
on November 30, 1919. C. P. A. Ex. 

B. LEGAL QUESTIONS 

1. Define partnership. State five essential elements of 
partnership. C. P. A. Ejc. 

2. What is the difference between an ordinary partnership 
and a limited partnership? C. P. A. Ex. 

3. Who is a nominal, a secret, a dormant, or an ostensible 
partner? C. P. A. Ex. 

4. To what extent may the acts of one partner bind the 
other partner? C. P. A. Ex. 

5. Is the individual property of a copartner liable for 
a copartner's debts? C. P. A. Ex. 

6. Is contribution to the capital of a business necessary 
to constitute one a partner in same? Explain. C. P. A. Ex. 

7. A, who is engaged in carrying on a mercantile business, 
borrows money of B and promises the latter a compensation 
for its use equal to 10% of the cinterprise. Is B liable as A's 
partner for the debts of the business? C. P. A. Ejc. 

8. A, B and C respectively contribute ten, eight and six 
thousand dollars to the capital of a partnership. How should 
the resulting losses and gains be distributed in the absence of 
any agreement as to their distribution? 

Inst. Ex. 

C. ACCOUNTING PROBLEMS 

I. Smith, Hill and Davis form a partnership under an 
agreement that Smith is to have a salary of $200.00, Hill $150.00, 
and Davis $100.00 a month respectively. The profits are to be 
divided in proportion to the amount of business secured by each 
partner. The partners are to be individually responsible for 
any direct losses arising from their own business. 

They are in business nine months, at the end of which 
their books show the following: 



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14 PUBLIC ACCOUNTING AND AUDITING 

Smith's sales $5,310.00 

Hill's sales 3,100.00 

Davis' sales 3,200.00 

Net profits 2,468.50 

They then decide to rescind the salary agreement, treating 
any salary drawn as an advance, but otherwise to divide the 
profits according to the original arrangement. 

You find errors during the nine months' period, namely: 

Office furniture, charged to operation $ 65.00 

Fund lent by Davis, credited to his salary 

account 400.00 

and open items not entered on the books as follows: 

Smith's salary (ninth month) $200.00 

Hill's salary (ninth month) 150.00 

Advertising 27.50 

Clerk hire 130.00 

Telephone 6.00 

Rent 50.00 

Stationery 15.00 

Accounts Receivable, Smith's business, un- 
collectible 210.00 

and that the sales represent a gross profit of 100% over cost 

of merchandise. 

Set up the journal entries necessary to readjust the accounts. 
Prepare a correct Profit and Loss statement and a statement 
showing the distribution of the profits. Inst. Ex. 

(Note. The salaries paid to partners should have been charged, accord- 
ing to the original agreement, to Profit and Loss. It is evident, however, 
from the information given, that the salaries have not been charged to Profit 
and Loss. The net profits of $2,468.50 must have resulted from the following: 

Gross Profit on Sales $5,805 .00 

Deduct: 

Expenses of Operation $3t27i .50 

Furniture charged to Operation 65 . 00 3,336 . 50 

Net Profits $2,468.50 

Since the salary agreement has been rescinded, and all salaries drawn 
are to be considered advances, it is not necessary to make an adjusting entry. 
The fact that Davis' salary for the ninth month has been set up while the 
others partners' salaries have not been set up, indicates that the entries were 
made when the salaries were drawn; hence the salary accounts can be con- 
sidered as drawing accounts. Since Smith and Hill have made no drawings 
during the ninth month no entry is necessary.) 

2. A and B, each carrying on a similar business, agree to 
form a partnership, the new firm to take over the assets and 
assume the liabilities of each. The following Trial Balances 
representing the book accounts were presented: 



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ACCOUNTING PROBLEMS 15 

A 

Capital $40,000.00 

Machinery and Fixtures $30,000.00 

Cash 2,000.00 

Bills Receivable 5,000.00 

Accounts Receivable 30,000.00 • 

Inventory Merchandise 25,000.00 

Wages 7,000.00 

Wages Due 250.00 

Expense 10,000.00 

Bills Payable 10,000.00 

Merchandise Account 40,000.00 

Accounts Payable 20,000.00 

Repairs 1,250.00 

$110,250.00 $110,250.00 

B 

Capital $50,000.00 

Machinery and Fixtures $30,000.00 

Cash 4,000.00 

Bills Receivable 8,000.00 

Accounts Receivable 40,000.00 

Wages 9,000.00 

Wages Due 500.00 

General Expense 15,000.00 

Bills Payable 15,000.00 

Merchandise Account 50,000.00 

Inventory 32,000.00 

Repair Account 2,500.00 

Accounts Payable 25,000.00 

$140,500.00 $140,500.00 

Formulate opening entry for the new firm. Each partner 
is to draw half the profits. A profit of $30,000.00 is made dur- 
ing the first year. Set up journal entry to divide the profit be- 
tween the partners. C. P. A. Ex. 

3. A. Wells, a manufacturer of novelties, is joined by I. 
M. Anxious in partnership upon the following terms: 

A. Wells is to receive a monthly salary of $100.00 for the 
first year, which shall be a first charge upon the profit after 
providing for the usual business expenses and before reckoning 
3% upon the partner's capital. In the event of such profit 
during the first year, or any subsequent year, not exceeding 
6% of the total capital (after payment of the salary), this 
salary shall be reduced to $75.00 per month the following year, 
and remain so until the yearly profit advances to more than 6%, 
when such salary shall return to $100.00, commencing the year 
succeeding the one showing the required increase of profit. 



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i6 PUBLIC ACCOUNTING AND AUDITING 

Should the profit in any one year amount to more than io% 
upon capital, A. Wells shall be entitled (in addition to the salary 
he has received for that year) to a bonus of 33H% upon any 
sum in excess up to $1,500.00 and 25% upon any further excess, 
and this bonus shall be a chaise against profit, before allotting 
the interest at 3% upon capital. Any profit then remaining 
shall be divided equally. From the following particulars, con- 
struct separate capital accounts for partners for five years, 
starting capital : 

A. Wells, $6,000.00, I. M. Anxious, $5,000.00. 
Profit before deducting salary, interest or bonus: 

1st year $1,750.00 

2d year 1,800.00 

3d year 4,250.00 

4th year 5,000.00 

5th year 5»500.oo 

No drawing on account. Distribution of profits when as- 
certained. C. P. A. Ex. 

(Note. To solve this problem, use a sheet of ledger paper. Open 
accounts allowing a full pSL«e for each partner. Close the accounts at the 
end of each year and bring down the partners' present capital. The problem 
stat^ that the salary is paid monthly. At the end of the year, under the 
conditions stated, the partners may also receive a bonus. You may assume 
that both the salary and bonus were paid in cash. The interest on the invest- 
ment and the net profits should be credited to the partners' capital accounts.) 

4. In making an audit of the books of the partnership of 
A and B, you find that the agreed division of profits was to 
be on the basis of the capitals and of the time they were left 
in the business. 

The books show as follows: A*s account, paid in January i, 
$6,000.00; March i, $2,000.00; June i, $4,000.00; November i, 
$1,000.00; withdrew, April i, $3,000.00; October i, $2,000.00. 

B's account, paid in January i, $4,000.00; February i, 
$1,000.00; August I, $3,000.00; withdrew. May i, $2,000.00; 
December i, $1,000.00. 

Prepare statements showing method of arriving at correct 
profit distribution. C. P. A. Ex. 



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Chapter Two 

PARTNERSHIP ACCOUNTING 

1. ACCOUNTING THEORY 

Partnership Dissolution. As was shown in the preceding 
discussion of partnership accounting, the principal work of the 
public accountant is in connection with the organization, the 
distribution of the profits and losses, and the dissolution of 
the partnership. 

At the time of dissolution, profits and losses must be prop- 
erly divided between partners. The remaining assets, after all 
outstanding obligations or liabilities have been liquidated, must 
also be properly divided between the partners. 

Distribution of Profits and Losses. The profits and 
losses may be of two classes — those resulting from operations 
and those resulting from dissolution. However, there is no 
difference in the basis of the distribution. All profits and 
losses are to be shared in accordance with the partnership 
agreement. In the absence of any agreement, either oral or 
written, they must be shared equally. 

Distribution of Assets. After the operating profits or 
losses have been properly distributed, the usual procedure is 
to convert the assets into cash (this is known as realization of 
assets) and to pay all obligations to outside creditors. (This 
is known as liquidatmg liabilities.) After liabilities to outside 
creditors have been liquidated, any liabilities to individual 
partners should be liquidated. For instance, if a partner has 
loaned a sum of money to the firm and accepted the firm's 
note, he is entitled to a settlement after outside creditors are 
satisfied and before distribution of the remaining assets to part- 
ners. 

The net assets, usually in the form of cash, must be dis- 
tributed to partners on the basis of their net investments at 
time of distribution. In other words, the partners are entitled 
to withdraw the net capital as shown by their respective capital 
accounts after all adjustments have been made provided there 
are sufficient assets. Of course, if an agreement exists as to 
the distribution of profits, the distribution must be made in 
accordance with the agreement. 

Liquidating Dividends. Usually the process of real- 
ization of assets and liquidation of dividends extends over a 
long period of time, and it is not infrequent that the partners 
may desire to make a partial distribution of assets before all 
have been realized upon. Such a partial distribution is known 
as a liquidating dividend. 

17 



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i8 



PUBLIC ACCOUNTING AND AUDITING 



The difficulty in distributing a part of the assets before 
realization of assets and liquidation of liabilities have been 
entirely completed, lies in the danger of overpaying certain 
partners. If the one in charge of the liquidation should over- 
pay a partner, and the overpayment cannot be recovered, he 
may be held liable to the other partners for the amount of the 
loss incurred. Such an overpayment may easily occur when the 
profit and loss sharing ratio is different from the capital sharing 
ratio and large and unexpected losses occur in the process of 
realization and liquidation. 

To illustrate: Assume that the following represents the 
Balance Sheet of the A, B, C Company, which is being liqui- 
dated by H: 

Balance Sheet 



Assets 

Cash 

Accounts Rec 

Merchandise 


.$1,000.00 
.15,000.00 
.29,000.00 


LlABIUTIES 

Creditors $20,000.00 

Net Worth: 

A Capital 5,000.00 

B Capital 10,000.00 

C Capital 10,000.00 




$45,000.00 




$45,000.00 



A has been in active charge of the business and, as a con- 
sequence, the partnership agreement provides that profits and 
losses are to be shared equally. H receives $34,000.00 from 
the sale of merchandise and collects $5,000.00 of the accounts 
receivable. It will be seen that he realized a profit of $5,000.00 
on the sale of merchandise. The cash balance is increased to 
$40,000.00. The profit is distributed equally among the part- 
ners and the liabilities are liquidated. The remainder, $15,000.00, 
is distributed to the partners on the ratio of their investment. 
(This is known as a liquidating dividend.) The condition of the 
firm would then be as follows: 

Balance Sheet 



Assets 
Accounts Rec $10,000 . 00 


Liabilities 
Net Worth: 

A Capital $ 2,000.00 

B Capital 4,000.00 

C Capital 4,000.00 


$10,000.00 




$10,000.00 



If it should now be determined that $9,000.00 of the ac- 
counts receivable amounting to $10,000.00 are uncollectible and 
worthless, the loss must be shared equally in accordance with 
the agreement, therefore, J^ or $3,000.00 of this loss would be 
chargeable to A. His account would then show a debit of 
$1,000.00. H must collect this sum from A before he can return 



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PARTNERSHIP ACCOUNTING 



19 



the investment of B and C. If this amount is later found to 
be uncollectible, H would be liable to B and C for the loss 
sustained. 

In order to avoid such a result as the above, Hatfield and 
Walton suggest that the first liquidating dividends be paid 
not on the basis of the investment of the different partners, 
but so as to reduce their investment accounts to the same 
ratio as their profit or loss sharing ratio. After this equilibrium 
is once attained, future losses and liquidating dividends will 
be shared on the same basis, therefore, tJiere would be no danger 
of an overpayment. As to whether the court would uphold 
such a plan if any of the partners objected to it is very doubtful. 

If objection to this method of distribution is made, the 
liquidator could either refuse to make any partial payments 
at all until all assets have been converted into cash and all 
liabilities liquidated, when a final settlement could be made 
and each partner could then be permitted to withdraw his net 
capital, provided there were sufficient assets. The liquidator, 
in some instances, can make a partial dividend of the cash on 
hand on the basis of the proportionate capital provided he 
reserves enough cash to secure himself from any contingency 
arising from an unexpected loss in the realization of remaining 
assets. 

2. PARTNERSHIP LAW 

Contractual Agreement 



Partnership 
Dissolution 



I. By Acts of Partners 



Mutual Agreement 

Withdrawal 

Sale or Assignment 



2. By Operation of Law ] Bankruptcy \ ^l ^"V 

[War •" [of a partner 



3. By Decree of Court 



Misconduct 

Fraud 
' Breach of Contract 

Insanity 

Imprisonment 
Dissolution. A partnership is formed by contract. It 
may be terminated in a similar manner. If in the original, or 
in a subsequent agreement, it was agreed that the partnership 
be dissolved at a certain time, the dissolution is said to be "by 
agreement," or "by acts of the partners." There is nothing 
to prevent a dissolution of a partnership at any time previous 
to time of agreed dissolution. One cannot be compelled to 
remain a partner against his wishes. A court may decree dis- 
solution of a partnership. Misconduct, fraud, bad faith, breach 
of partnership contract, incapacity of a partner due to insanity, 
imprisonment, etc., are all common causes for dissolution "by 
decree of court." 



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20 PUBLIC ACCOUNTING AND AUDITING 

Liability of Withdrawing Partner. If a partner with- 
draws before termination of the partnership in accordance with 
the agreement and without the mutual consent of all the part- 
ners, he may be held liable to them for any losses they may 
sustain due to his withdrawal. If the partnership was not 
formed for a specific length of time, or was not limited to the 
accomplishment of a certain purpose for which it was formed, 
the withdrawing partner cannot be held liable for damages 
sustained by other partners on account of his withdrawal. 

Liability to Creditors. Notice of withdrawal or retire- 
ment should be given to all persons who have had dealings with 
the firm, and to the public at large, by the partner who is with- 
drawing. This will enable him to avoid liability to creditors 
who may extend credit to the partnership thinking he is still a 
partner. He cannot escape liability for obligations contracted 
while he was a partner, but by properly announcing his with- 
drawal, he may escape liability for the future obligations of 
the firm. 

In case creditors secure a judgment against the firm, exe- 
cutions may be levied either on the firm property or on the 
separate property of any one of the partners. In other words, 
the creditors may take judgment against any or all the partners 
and may collect claims out of the firm's assets or from the prop- 
erty owned by any one or more of the partners. The partners 
will have to adjust the matter between themselves afterward 
as best they can. This indicates the importance of the use of 
proper care in associating one's self in a partnership with others. 
A partner's personal estate though not invested in the partner- 
ship is subject to assessment in case the firm assets are not 
sufficient to pay the obligation. A partner is also liable for 
any damages that may result from fraud, torts, or other acts 
of his partners. However, a partner usually will not be held 
criminally liable for the acts of his partners. 

Division of Profits and Losses. Profits and losses from 
operations previous to dissolution are shared in accordance 
with the partnership agreement. In the absence of an agreement, 
they are shared equally. Profits and losses incident to dissolution 
are shared on the same basis, unless otherwise specified. 

Division of Assets. In the absence of any agreement, the 
amount of each partner's investment is returned to him in full 
upon dissolution of the partnership, provided there are sufficient 
assets. If there are not sufficient assets to return the invest- 
ments of the partners, there is said to be a capital loss. 

In the event there is no agreement to the contrary, profits and 
losses are shared equally, while the proceeds of the liquidation are 
distributed on the basis of the investment. 

Loan of Partner. If a partner has made a loan to the 
firm, it is important that this be shown so that it can be easily 



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PARTNERSHIP ACCOUNTING 21 

proven in case of liquidation. According to law, the outside 
creditors are first paid from the proceeds of the liquidation, 
then the loans to partners, and finally the remainder is dis- 
tributed among the partners. It will be seen, therefore, that 
in case of a loan, the partner will be recompensed before 
the other partners receive any of their investment. It may 
make considerable difference, therefore, as to whether addi- 
tional money put into the business is to be an investment or 
a loan. 



3. ACCOUNTING PRACTICE 

The problems appearing in the various state C. P. A. 
examinations and in the examinations held by the American 
Institute of Accountants are a fair indication of the kind of 
problems encountered by an accountant in public practice. 
Many of these problems relate to partnership dissolution. 



Proposition A. 

The following problem taken from a recent C. P. A. exam- 
ination is an example of one of the most common classes of prob- 
lems relating to partnership dissolution. 

"The following Trial Balance is taken from the books of a 
partnership in which profits and losses are shared equally: 

Building and Equipment $10,000.00 

Merchandise Inventory 8,000.00 

Accounts Receivable 5,000.00 

Profit and Loss 7f700 . 00 

A Drawing 3,000.00 

B Drawing 1,500.00 

C Drawing 2,800.00 

A Capital $15,000.00 

B Capital 10,000.00 

C Capital 6,000.00 

Accounts Payable 7,000.00 

$38,000.00 $38,000.00 



The firm decided to sell the business and dissolve the 
partnership, and procured a purchaser who offered the sum of 
$12,000.00 for the business, including the good will. The offer 
was ultimately accepted on the understanding that the purchaser 
would assume all existing liabilities, which he agreed to do, 
and the sale was forthwith consummated. 

Draft journal entries incident to the sale of the business 
and dissolution of the partnership and construct ledger accounts 
showing the settlement of the partnership." 



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22 PUBLIC ACCOUNTING AND AUDITING 

Solution 

It will be noted that the partnership agreement provides for 
equal distribution of profits and losses. Nothing is said about 
distribution of the cash received from the sale of the entire 
business, hence, this must be distributed on the basis of the 
partners' investments. 

The transaction incident to the sale of the business may be 
set up in journal form, it simply being necessary to debit the 
proper accounts for the liabilities assumed by the purchaser, 
the cash received, the loss sustained, and to credit Uie proper 
accounts for the assets parted with. 

Accounts Payable $ 7,000.00 

Cash 12,000.00 

Profit and Loss 4,000.00 

Buildings and Equipment, $10,000.00 

Merchandise Inventory — 8,000 . 00 

Accounts Receivable 5,000.00 

Sold the entire business, in- 
cluding good will. It is agreed 
that the purchaser will assume 
all existing liabilities. 

Analysis of the Profit and Loss account now shows an 
operating loss of $7,700.00 and a liquidating loss of $4,000.00. 
Operating losses are to be shared equally, but nothing is said 
about liquidating losses, hence they must be shared on the 
same basis as operating losses. 

A Drawing $ 3,900.00 

B Drawing 3,900.00 

C Drawing 3,900.00 

Profit and Loss $11,700.00 

To charge the net loss into 
the partners* drawing accounts, 
each partner sharing the profits 
or losses equally, as per partner- 
ship agreement. 

It is now necessary to close each partner's drawing account 
into his capital account. 

A Capital $ 6,900.00 

B Capital 5,400.00 

C Capital 6,700.00 

A Drawing $6,900.00 

B Drawing 5400.00 

C Drawing 6,700.00 

To close partners' drawing 

accounts into their respective 

capital accounts. 



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PARTNERSHIP ACCOUNTING 23 

After posting the above entries, the capital accounts of 
the partners will appear as follows: 

A Capital B Capital C Capital 



$6,900.00 



$15,000.00 $5,400.00 



$10,000.00 $6,700,00 



$6,000.00 



Analysis of the partners' capital accounts now reveals 
that C's withdrawals plus his share of the losses amount to more 
than his investment, consequently he is indebted to A and B 
for the excess amounting to $700.00. If C is solvent, he must 
pay back this sum in cash. 

Cash $700.00 

C Capital $700.00 

In dissolving the partnership 
it was found that C had over- 
drawn his account, and it was 
necessary that he pay back the 
sum of $700.00, which he did. 

C's capital account is now in balance. The cash balance 
amounts to $12,700.00. This sum must be divided between 
A and B in accordance with their net investments at this time. 

A Capital $8,100.00 

B Capital 4,600.00 

Cash $12,700.00 

A and B withdrew an 

amount equal to the balance of 

their capital accounts, thereby 

completing the dissolution of the 

business. 

If C had been insolvent, and it was found impossible to 
collect from him the excess withdrawal of $700.00, the loss 
should be shared by A and B equally as per partnership agree- 
ment. 

Profit and Loss $700.00 

C Capital $700.00 

To set up loss resulting from 
insolvency of C. 

A Capital $350.00 

B Capital 350.00 

Profit and Loss $700.00 

To distribute loss resulting 
from C's insolvency, A and B 
sharing equally. 

After adjusting the loss of $700.00, A's net investment 
will be found to be $7,750.00 and B's $4,250.00. The net cash 
amounting to $12,000.00 would have to be distributed to A 
and B on the basis of their net investments. 



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24 PUBLIC ACCOUNTING AND AUDITING 

A Capital $7,750. oo 

B Capital 4,250.00 

Cash $12,000.00 

To distribute the remaining 
cash balance of $12,000.00 be- 
tween A and B on the basis of 
their present investments; A's 
present investment being 31/48 
and B's 17 748 of the total invest- 
ment. 

The one in charge of the dissolution could not be held 
responsible for the loss due to C's overdrawing his account, 
because it was not in the form of an overpayment of a liqui- 
dating dividend. The loss was due to the fact that C was per- 
mitted to withdraw a sum out of proportion to his investment, 
and^ when the operating loss and loss incident to the sale of the 
business was charged to his drawing account, the total was 
greater than his investment. 

Proposition B. 

The following problem, taken from a recent examination 
held by the American Institute of Accountants, is given to 
demonstrate the accounting in connection with a series of 
liquidating dividends. 

'The capital of a partnership is contributed as follows: 

A $90,000.00 

B 45,000.00 

C i5,ooo..oo 

A*s salary is $5,000.00, B's, $3,000.00, and C's, $2,000.00 
per year. 

At the end of the first year's business, C dies, automatic- 
ally bringing about dissolution. The books are closed and the 
net assets of the business are shown to be $152,500.00. A and 
B liquidate the affairs of the partnership and distribute the 
remaining assets as follows: 

First liquidating dividend $42,410.20 

Second liquidating dividend 74f622 . 30 

Final liquidating dividend 31,967.50 

The partnership agreement provided for profit sharing on 
a basis of 50% to A, 30% to B, and 20% to C. 

Set up journal entries showing distribution of profits and 
losses and distribution of liquidating dividends. Show partners' 
accounts after liquidation has been completed and accounts 
closed." 

Solution 

Operating Lrosses. The book value of assets is shown 
to be $152,500.00, while the partners' capital accounts show 
that capital amounting to $150,000.00 has been contributed. 
Salaries due partners amount to $10,000.00. It is evident, 



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PARTNERSHIP ACCOUNTING 25 

therefore, that there has been an operating loss of $7,500.00 
sustained during the year. This must be divided among the 
partners according to agreement. (It is assumed that each 
partner's salary has been credited to his capital account.) 

A Capital $3,750. 00 

B Capital 2,250.00 

C Capital 1,500.00 

Profit and Loss $7,500.00 

Net loss amounting to $7, 

500.00 distributed as per agree- 
ment; A, 50%; B, 30%; and 

C, 20%. 

First Liquidating Dividend. While the problem gives 
sufficient information to enable the liquidator to determine the 
total result from realization of assets, it is assumed that at the 
time of the first liquidating dividend^ this total result was not 
known, hence it could not be proportioned among the partners. 
It is customary to charge off all losses before distributing the 
net assets, but there is no way by which the amount of the 
loss sustained at the time of the first liquidating dividend can 
be determined, hence no adjustments can be made. ^ 

The liquidator desiring to protect himself from risk of over- 
paying any of the partners desires to distribute this dividend in 
such a manner as to reduce the capital sharing ratio of the 
partners to the same basis of the profit and loss sharing ratio. 

Reference to the Working Sheet, illustrated on page 27, 
will show that th^ approximate ratio of the partners' net 
investment to the total net capital is A, 60%; B, 30%; and C, 
10%; while the partners* agreement was that profits and losses 
were to be shared on a basis of A, 50%; B, 30%; and C, 20%. 

After this first liquidating dividend of $42,410.20 is dis- 
tributed, the remaining net capital will be $110,089.80. A's 
capital can safely be paid down to $55,044.90, which is 50% of 
the remaining assets. It will readily be seen that if all the 
remaining assets proved worthless, A's share of the loss would 
be 50%, or $55,044.90, which would be just equal to the amount 
of his net investment after the first dividend is distributed. 
In other words, it will be seen that it will be safe to pay A the sum 
of $36,205.10. 

B's capital can safely be paid down to $33,026.94, which 
is 30% of die remaining assets. In other words, he can be paid 
the sum of $12,723.06. 

C's capital, which amounts to $15,500.00, is already less 
than 20% of the remaining assets, which is $22,017.96. Since 
this exceeds his net investment by $6,517.96, if all remaining 
assets proved worthless, it will be seen that C would be indebted 
to A and B for $6,517.96. If C should be insolvent, A and B 
would be compelled to share the loss on a ratio of 50% and 
30%. In other words, A would lose ^ and B %. This con- 
tingent loss should be charged to A and B before distribution 
of Sie first dividend. A should be charged with ^ of $6,517.96 



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26 PUBLIC ACCOUNTING AND AUDITING 

or $4,073.73. B should be charged with % of $6,517.96, or 
$2,444.23. A's balance would be $32,131.37; B's balance 
would be $10,278.83; hence the first liquidating dividend may 
be journalized as follows: 

A Capital $32,131.37 

B Capital 10,278. 83 

Cash $42,410.20 

A liquidating dividend 
amounting to $42,401.20 dis- 
tributed to A and B on a basis de- 
signed to reduce the capital shar- 
ing ratio of partners to the same 
ratio as their profit or loss sharing 
basis. 

Second Liquidating Dividend. This dividend amounts 
to $74,622.30. Deducting this sum from the total remaining 
capital leaves $35,467.50, which would be the amount of the loss 
in case the remaining assets proved worthless. Distributing 
this contingent loss to each of the partners on the basis of 50% 
30% and 20%, will result in each partner's account showing 
the following balance: 

A. $41,384. 88 

B 24,830.92 

C 8,406.50 

Consequently, it will be safe to distribute this dividend 
to the partners on the basis of the above balances, for it will 
readily be seen that if all remaining assets prove worthless 
the loss would simply be equal to the balance of each partner's 
account after this dividend is distributed. 

A Capital $41,384.88 

B Capital 24,830.92 

C Capital 8,406.50 

Cash $74,622 . 30 

To distribute a dividend of 

$74,622.30. This dividend estab- 
lishes a capital sharing ratio 

between partners equivalent to 

their profit or loss sharing ratio; 

hence all future dividends may 

be distributed on a basis of A, 

50%; B, 30%; C, 20%. 

Final Liquidating Dividend. This dividend amounts to 
$31,967.50. Since the partners' capital accounts have already 
been reduced to a ratio of 50%, 30% and 20%, this ratio being 
the same as the profit or loss sharing ratio, it will be seen that 
this dividend may be distributed on the same basis, as follows: 

A, 50% $15,983.75 

B, 30% 9*590.25 

C, 20% 6,393.50 



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PARTNERSHIP ACCOUNTING 



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28 



PUBLIC ACCOUNTING AND AUDITING 



A Capital $15.983. 75 

B Capital 9.590.25 

C Capital 6,393.50 

Cash $31,967.50 

To distribute to partners the 
remainder of cash after all assets 
have been realized upon and all 
liabilities liquidated. 

While this dividend is distributed in accordance with the 
profit or loss sharing ratio of the partners, it is only because 
the partners' capital sharing ratio has been reduced to the same 
basis; hence, the rule that distribution of capital must be on 
the basis of tJie partners' investments has not been violated. 

Loss on Realization. Reference to the Working Sheet 
will now show a total loss on realization of $3,500.00. This 
must be distributed to tha partners on the basis of their agree- 
ment. 

A Capital $1,750.00 

B Capital 1,050.00 

C Capital 700.00 

Profit and Loss $3,500.00 

To distribute loss on reali- 
zation to partners. A, 50%; B, 

30%; C,20%. 

It is now possible to set up the capital accounts of the 
partners. 



Operating Loss $ 3,750.00 

First Liquidating 

Dividend.. 32,131.37 

Second Liquidating 

Dividend.... 41,384.88 

Final Liquidating 

Dividend 15.983 • 75 

Loss on Realization i ,750 . 00 

$95,000.00 



Contributed 

Capital $90,000.00 

Salaries 5,000.00 



$95,000.00 



B 



Operating Loss $ 2,250.00 

First Liquidating 

Dividend 10,278. 83 

Second Liquidating 

Dividend 24,830.92 

Final Liquidating 

Dividend 9,590. 25 

Loss on Realization 1,050.00 
$48,000.00 



Contributed 

Capital $45,000.00 

Salaries 3,000.00 



$48 ,000.00 



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THEORY QUESTIONS 

c 



29 



Operating Loss $ 1,500.00 

Second Liquidating 

Dividend 8,406 . 50 

Final Liquidating 

Dividend 6,393 • 50 

Loss on Realization 700.00 


Contributed 

Capital 

Salaries 


$15,000.00 

2,000.00 


$17,000.00 


$17,000.00 



A. THEORY QUESTIONS 

1. On learning of the death of a partner, what woulc^be 
your duty in case you were bookkeeper for a firm of partners 
that has no articles of partnership? C. P. A. Ex. 

2. In case of dissolution of a partnership, in what order 
should the assets be distributed when there are creditors of 
the firm and also loans by partners of the firm, besides their 
stipulated capital in the business, and assuming tl\at the re- 
maining assets after liquidation of the liabilities are insufficient 
to repay the capital in full, profits being divided in a different 
ratio from capital? C. P. A. Ex. 

3. A partnership is dissolved as at January i, both part- 
ners being in debt to the firm. Subsequently, the assets are sold 
at less than the book value and the liabilities are partly liqui- 
dated. The partners pay their indebtedness as of January i. 

How must the liquidating loss be adjusted as between the 
partners? Why? C. P. A. Ex. 

4. AB and CD form a partnership known as Middale 
Steel Company. AB puts in $100,000.00 towards forming 
capital for the company, and CD, who has been a practical 
worker and is to devote his whole time to the business, puts 
in $35,000.00, and it is agreed that CD's experience be put 
up as substitute for his deficiency of capital. Business was 
conducted for five years when they agreed to dissolve. AB 
made claim to the $100,000.00 which he put in originally, but 
CD objects, claiming an equal division as partner of the whole 
capital. 

Discuss the rights of the two parties. Can AB legally 
withdraw his $100,000.00? C. P. A. Ex. 

5. A and B formed a partnership for the manufacture of 
automobile accessories, A putting in $30,000.00 and B putting 
in $20,000.00, all the latter had, the object being to organize 
a company on a basis of $50,000.00. B was considerably more 
experienced than A, and it was agreed that he be the real manager 
of the affairs of the company, although A was nominally die 
head of the concern. B was to share equally in the profits with 



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30 



PUBLIC ACCOUNTING AND AUDITING 



A. Later A made advances to the firm of $5,200.00. After a 
number of years, A and B mutually agreed to dissolve partner- 
ship. In settling, B contended his own share should be $22, 
600.00. The advances had to be aid out of the capital account, 
there not being enough over the capital account of the company 
to pay the same. 

(a) Is B's contention correct? Discuss fully. 

(b) What is the rule as to — 

(i) Debts? (3) Capital? 

(2) Advances? (4) Profits? C. P. A. Ex. 

B. LEGAL QUESTIONS 

1. (a) In what various ways may a partnership be termi- 
nated? 

(b) For what firm contracts is an outgoing partner liable? 

C. P. A. Ex. 

2. What precautions should be taken by a partner upon 
retiring from the firm? Why? C. P. A. Ex. 

3. What are the rules which must be observed in adjusting 
the accounts of partners in liquidation: 

(i) As to payment of losses? 

(2) As to application of assets? Inst. Ex. 

4. Does the agreement between partners at the time of 
a dissolution, that the remaining partner assumes all the lia- 
bilities to partnership creditors, free the withdrawing partner 
from such liability to such creditors? State reason for your 
answer. C. P. A. Ex. 

5. A and B are partners, A dies. The assets are found to 
be worth only 75% of the liabilities in liquidation. A's estate 
is solvent, while B's is insolvent. What are the rights of the 
firm's creditors against A's assets not invested in the partnership, 
and what are the rights of B's personal creditors as to the part- 
nership assets? State the rule governing in such cases. 

C. P. A. Ex. 
C. ACCOUNTING PROBLEMS 
I. A and B, partners in a commercial enterprise, share 
profits and losses equally. At the end of five years, the part- 
nership terminates and the Balance Sheet appears as follows: 
Balance Sheet 



Assets 

Cash $ 5,600.00 

Accounts Rec 28,000.00 

Mdse., Inventory . . 36,000 . 00 
Plant and Mach — 15,400.00 



$85,000.00 



Liabilities 
Accounts Payable . $30,000 . 00 

Bills Payable 10,000.00 

Net Worth: 

A Capital 30,000.00 

B Capital 15,000.00 

$85,000.00 



After studying the Balance Sheet, an offer to buy at $30, 
000.00 (except cash) is accepted. Make final adjustments and 
closing entries and show amount each partner receives. 

C'. P. A. hjx.» 



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ACCOUNTING PROBLEMS 31 

2. The firm of A & B began business on January i, 1912, 
the terms of the partnership contract specifying that no interest 
was to be credited on investments or charged on withdrawals, 
and all profits or losses were to be shared equally. A invested 
$24,000.00 and B $15,000.00. 

On November 30, 1914, the partnership was dissolved, and 
as the books had not been properly kept, the following state- 
ment was submitted to the partners as a basis for settlement 
and agreed to by them: Cash, $14,200.00; net debit of A, 
$6,300; expenses, $15,300.00; net credit of B, $10,500.00; 
profit and loss, debit, $9,000.00, credit, $1,500.00; real estate 
having an estimated market value of $3,390.00; the bank holds 
firm's six months' 6% note for $10,000.00, due January 31, 1915, 
on which interest is unpaid. B liquidated the assets and 
liabilities and in due course sold the real estate for $4,000.00 
and paid off the note when due. 

Prepare the partners' accounts as of November 30, 1914, 
and as of the close of liquidation, and a Balance Sheet as of 
November 30, 1914. 

C. P. A. Ex. 

(Note. The problem does not indicate definitely whether the balances 
of^ A's and B's accounts represent their capital or drawing accounts. It 
might be solved on a basis of either assumption. However, it b best to assume 
that reference is to the partners' capital accounts. The date of the close of 
liquidation is not given, but January 31, 19 15, may be assumed as the proper 
date. 

An analysis of the application of the resources of the partnership 
from January i, 191 2, to November 30, 191 4, indicates an excess application 
of $2,900.00. This would seem to indicate that the Cash account had been 
overdrawn by this amount. In reality, however, the problem shows a cash 
balance of $14,200.00. Accepting this as true, it is evident that resources of 
$17,100.00 ($14,200.00 -f $2,900.00) were received from profits on sales. 
On these assumptions, the net loss to be distributed to the partners' accounts 
at the date of dissolution, November 30, 19 14, is $5,900.00. 

Between November 30, 19 14, and January 31, 191 5 (assumed to be 
the date at close of liquidation) there was a gain on Real Estate of $700.00. 
Interest on the note at the bank amounted to $100.00; hence there was a 
net gain of $600.00.) 

3. A, B and C are in partnership, A's capital being $90, 
000,00; B's, $50,000.00; and C's, $50,000.00, Their agree- 
ment IS to shareprofits or losses in the following ratio: A, 60%; 
B, 15%; C, 25%. During the year C withdrew $10,000.00. 

Net losses during the year were $15,000.00 and it is decided 
to close out the business. 

It is uncertain how much the assets will ultimately yield, 
although none of them are known to be bad. 

The partners, therefore, mutually agree that as the assets 
are liquidated, distribution of cash on hand shall be made month- 
ly in such manner as to avoid, so far as feasible, the possibility 
of paying to one partner cash which he might later have to repay 
to another. 



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32 PUBLIC ACCOUNTING AND AUDITING 

Collections are made as follows: May, $15,000.00; June, 
$13,000.00; July, $52,000.00. After this no more was collected. 

Show the partners' accounts, indicating how the cash is 
distributed in each installment based on the above agreement. 

C. P. A. Ex. 

4. A, B, and C formed a partnership. A agreed to furnish 
$10,000.00, and B and C each $7,000.00. A was to manage the 
business and receive one-half of the profits; B and C were each to 
receive one-fourth. A supplied merchandise worth $8,500.00, 
but no additional cash. B turned over to A, as managing 
partner, $9,000.00 cash, and C turned over $5,500.00. 

The business was conducted by A for some time, but with- 
out keeping exact books. While managing the business, A 
purchased additional merchandise amounting altogether to 
$75,000.00 and made sales of $100,000.00. The cash received 
and paid out for the partnership was not kept separate from A's 
personal cash. 

In order to straighten out matters, B took over the manage- 
ment. He found receivables amounting to $20,000.00, and of 
these he collected $4,500.00. The merchandise still on hand 
he sold for $500.00. These receipts he deposited in a bank to 
the credit of the firm. The remaining accounts proved worth- 
less. The outstanding accounts payable amounted to $2,000.00 
of which $1,500.00 had been incurred in purchasing merchandise 
and $500.00 for expenses. These accounts he paid. A presented 
vouchers showing that during his management he had paid 
other expenses of $2,400.00. By mutual agreement B was held 
to be entitled to $100.00 on account of interest on excess capital 
contributed, and A and C were to be charged $75.00 each for 
shortage in contribution of capital. 

(a) Draft adjusting and closing journal entries; set up 
Profit and Loss account and accounts of each of the partners. 

(b) Show how the above final adjustment would be modi- 
fied if A proved to have no assets or liabilities outside the part- 
nership. Inst. Ex. ' 



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Chapter Three 

PARTNERSHIP ACCOUNTING 
1. ACCOUNTING THEORY 

Financial Embarrassment. It not infrequently occurs 
that a partnership* will become financially embarrassed. This 
does not necessarily mean that the partnership is insolvent. It 
may mean that the assets are in some manner tied up, that it 
cannot meet current obligations, such as taxes, pay rolls, notes, 
etc., maturing at the present time. 

If a firm is unable to meet its current obligations, yet is 
solvent and wishes to avoid bankruptcy proceedings, there are 
two possible courses of procedure open. 

First: It may make an assignment with the consent of 
creditors. It must be remembered that an assignment is always 
made in favor of the creditors and with their consent. If a firm 
attempts to make an assignment without the consent of cred- 
itors, they may immediately bring bankruptcy proceedings. 
The assignee is appointed by the concern itself for the benefit 
of creditors. 

Second: It may appear in a court of equity and seek the 
appointment of a receiver known as a "receiver in equity." 

Regardless of whether the firm desires to make an assign- 
ment or whether they seek the appointment of a receiver in 
equity, creditors are entitled to a statement showing the finan- 
cial condition of the debtor. Likewise, the court will require 
a report showing the financial condition. In this country, no 
standard form^ of statement is specified by the courts. How- 
ever, the appointment of a receiver is looked upon by the courts 
of equity as an extreme measure to be resorted to only after 
the courts are convinced that such action is essential to a proper 
readjustment of finances and eventual liquidation. The court 
will not appoint a receiver unless the referee in the case finds 
one or more of the followinjg^ conditions existing: 

First: If the firm claims to be solvent, it must be apparent 
that insolvency' is so evident that there may not be a proper 
realization of assets for the benefit of the creditors. 

Second: If the firm is insolvent and creditors bring bank- 
ruptcy proceedings, (a) that they have some right or lien upon 
the property of the debtor; (b) that they have a legal right to 
consider the property of die debtor as a fund which may be 
used to satisfy their claims: or (c) that the debtor has fraudu- 
lently secured title or their possession to the property in liti- 
gation. 

Bankruptcy. As has already been shown, a firm is in- 
solvent when the value of the assets is less than the amount 
of the gro ss liabilities. When such a condition exists, the concern 

*While this discussion of bankruptcy is included under the head of part- 
nership accounting, the principles set forth are, in most instances, applicable 
to individuals and corporations as well as partnerships. 

33 



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34 PUBLIC ACCOUNTING AND AUDITING 

may seek voluntary bankruptcy proceedings, or the creditors 
may seek involuntary bankruptcy proceedings. In either event, 
the procedure is practically the same. The court appoints a 
receiver in bankruptcy. The receiver is charged with the 
protection and care of the property of the debtor until such 
time as the creditors can meet and appoint a trustee. It will 
be noted that the duties of the receiver in bankruptcy are, in this 
respect, different from the receiver in equity. The receiver in 
bankruptcy does not continue business operations nor does he 
proceed to realize upon the assets and to liquidate the liabilities. 
He simply cares for the property. With the consent of the 
court, a receiver in bankruptcy may realize on perishable as- 
sets to prevent loss thereon. He is not permitted, however, 
to dispose of any of the assets without the consent of the court. 
In fact, the work of the receiver is entirely dependent upon his 
instructions from the court. 

As soon as a trustee has been appointed by the creditors, 
he will immediately proceed to dispose of the assets and to liq- 
uidate the liabilities. When such realization and liquidation 
has been completed, or probably at intervals during the process 
of realization and liquidation, the trustee may be required to 
render a statement of operations to the court. Such a state- 
ment has generally become known as a Realization and Liqui- 
dation Statement. 

Trustee In Bankruptcy. H. C. Bentley, C. P. A., in his 
Science of Accounts, has described so well the appointment 
and duties of the trustee in bankruptcy that we can do no 
better than to quote from him. 

"When an individual, partnership, or business corporation 
has been adjudged a bankrupt, the creditors at their first meet- 
ing after the adjudication should appoint one or more trustees, 
as may be required. In case they do not exercise this privilege, 
the court will appoint the trustee. The first meeting referred 
to above must be held not less than ten nor more than thirty 
days after the adjudication, at the county seat of the county in 
which the bankrupt had his principal place of business. 

"The trustee in bankruptcy must account for all moneys 
belonging to the bankrupt concern which may be received by 
him; collect and reduce to money the property of the bankrupt; 
deposit all moneys received by him as such trustee in a bank 
designated by the court; disburse the funds only by check; lay 
before the final meeting of the creditors detailed statements of 
the administration of the estate; make final reports and file 
final accounts with the referee fifteen days before the day fixed 
for the final meeting of the creditors, and pay dividends within 
ten days after they are declared by the referee. He must also 
report to the court, in writing, the condition of the estate and 
the amount of money on hand, together with such other details 
as may be required by the court, within the first two months 
after his appointment and every two months thereafter, unless 
otherwise oniered by the court. 



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PARTNERSHIP ACCOUNTING 35 

"It is customary for the trustee to compile, or have com- 
piled, a Statement o f Affairs and a Deficiwcy Statement as 
soon as possible after his appointment. From these two state- 
ments the court, the trustee, and any other persons at interest, 
may gain a fair idea of the probable results from liquidation. 
It is not compulsory on the part of the trustee to have such 
statements compiled, but it is usually done as a matter of good 
practice. 

"The only statement actually required by the court must 
be furnished by the bankrupt himself within ten days after the 
adjudication if an involuntary bankrupt, and with the petition 
if a voluntary bankrupt, and consists of a schedule of his prop- 
erty, showing the amount and kind of property, the location 
thereof, and its money value in detail; a list of creditors with 
their addresses, the amount due each of them, the consideration 
thereof, the security held by them, if any; and a claim for such 
exemptions as the bankrupt may be entitled to. This report 
must be rendered in triplicate." 

Statement of Affairs. In C. P. A. examinations, the 
Statement of Affairs has been playing quite a^ prominent part. 
It can readily be seen that such a statement is of great value 
to creditors at the time of assignment or of the appointment 
of a receiver. The receiver is uLsu^Hy given expressed or implied 
authority to employ an accountant to prepare a statement of 
the busmess, and in some cases a Balance Sheet audit is made. 
Appraisers are often employed to determine the realizable value 
of assets. Creditors may then ascertain not only the book value 
of assets and the gross liabilities, but may learn the expected 
realization. The statement shows the assets and liabilities as 
they appear on the books of the debtor. In addition to this in- 
formation, it also shows the estimated or appraised value of 
asse ts, the amount of the preferred claims, and the amount of 
secured and unsecured liabilities. Naturally, preferred claims 
and secured liabilities must be liquidated first, consequently un- 
secured creditors must depend upon the remaining balance for 
settlement of their claims. 

A Statement of Affairs, properly prepared, will give all of 
this information, and will show the amount of the insolvency 
or deficiency. A firm is insolvent only when the realizable value 
of assets is less than the gross liabilities. 

It must be remembered that in a partnership, the personal 
property of each partner is, in reality, assessable for the satis- 
faction of firm creditors. Therefore, in preparing a Statement 
of Affairs for a partnership it may be advisable to include a list 
of thepersonal assets^pf the partners. 

The DeBciency Account. This account is similar to 
the Profit and Loss account of a going concern. It is prepared 
in order to explain the causes and reasons for the estimated 
deficiency as shown in the Statement of Affairs. It begins with 
the balance of surplus as shown on the books of the concern, and 
to this is added all sources of profit that increase the amount 



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36 PUBLIC ACCOUNTING AND AUDITING 

to be accounted for. All expenditures of the firm are charged 
to the account as are all losses incurred by it. The balance of 
the account shows the same amount of deficiency as is shown 
by the Statement of Affairs. In other words, the Deficiency 
account might be said to be a schedule designed to explain the 
amount of deficiency shown in the Statement of Affairs. 

Realization and Liquidation Statement. This is a 
statement designed to show the operations of the trustee. It 
may be subdivided into: 

(i) A Balance Sheet showing the book values as appear- 
ing on the books of account of the bankrupt concern. 

(2) A statement showing liabilities liquidated and assets 
realized upon. • 

(3) An operating statement showing losses and gains from 
realization. 

(4) Assets not realized upon and liabilities not liquidated. 

The only difference between such a statement prepared 
by a trustee and one prepared by a receiver in equity is that the 
receiver in equity continues to operate the business, conse- 
quently he acquires new assets and incurs additional liabilities. 
These, of course, must be added to the original assets and 
liabilities, for they must be accounted for. 

Receivership Accounting. The accounting for receivers 
in bankruptcy is very simple, as the receiver is appointed only 
temporarily and does not operate the business, neither does 
he proceed with the liquidation. He simply holds the assets 
until a trustee is appointed by creditors. 

Accounting for a trust<ee in bankruptcy, while somewhat 
more complex 5ian the accounting for a receiver in bankruptcy, 
is less complex than accounting for a receiver in equity. The 
trustee proceeds at once to realize on the assets and to liquidate 
the liabilities. Often the trustee keeps account of receipts and 
disbursements only. 

Accounting for the receiver in equity depends entirely upon 
the extent and nature of the business in the hands of the 
receiver. However, it is no more complex than the accounting 
for the same concern under normal operation. The account- 
ing for receiverships may be considered from the following stand- 
points: 

(i) Opening the receiver's books of account. 

(2) Accounting for administration of properties by the 
receiver. 

(3 Statements to be rendered to the court. 

(4) Closing the receiver's books of account. 

(5) Accounting for the concern in the hands of the re- 
ceiver. 



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PARTNERSHIP ACCOUNTING 37 

Opening the Receiver's Books of Account. Since 
a iffpivf^r in i*qnity I'g appointed by the court, and must render 
a full account of his operations to the court, he must, of neces- 
sity, keep his accounts in such form as to enable him to render 
proper statements showing the results of his operations. 

The extent of the accounts of the receiver will depend very 
largely upon the specific instructions of the court. The receiver is 
frequently given control of only a part of the property; possibly 
only the current assets. It is not often that he is instructed^ to 
take possession of the fixed assets nor to assume the liabilities, 
though he may be instructed to pay a part or all of the liabilities 
incurred prior to his appointment. The assets taken over and 
the liabilities assumed may be journalized by debiting the assets, 
crediting the valuation reserves and liabilities, and crediting 
the concern for the balance. To illustrate: Assume that A is 
appoint ed receiver for B and C and the instructions of the court 
order him to take over the following assets: 

Accounts Receivable $1,000.00 

Less Res. for Doubt. Accts 200 . 00 $ 800 . 00 

Merchandise 2,000.00 

Notes Receivable 2,000.00 

The receiver opens accounts with each of the assets taken 

over, credits the reserve account with the amount of the reserve 

set up on the books of the partnership, and credits B and C* 

Partnership/* for the diffe rence. 

The following will serve to illustrate the proper journal 

entry on the bool^ of "A, Receiver," for the facts given above: 

Accounts Receivable $1,000.00 

Merchandise 2,000.00 

Notes Receivable 2,000.00 

Res. for Doubtful Accounts. . . $ 200.00 

B and C, Partnership 4,800.00 

Accounting for Administration of Properties by 
Receivers. After the books of the receiver have been properly 
opened, the accounting for the administration of properties is 
very similar to the accounting for the partnership under nor- 
mal operation. He must account for all transactions. The 
assets acquired and liabilities created through his operations 
must be carefully recorded in such a way that they may not 
be confused with assets and liabilities with which the receiver 
is not charged nor concerned. In some cases, the receiver keeps 
only a record of the cash receipts and disbursements. Usually, 
however, this is not sufficient. A complete set of books should 
be kept, showing all transactions in detail. 

The accounts kept by the receiver should be uniform as 
nearly as possible with those previously kept by the partner- 
ship. Even in cases where systems of accounts previously in 
operation have been found to be defective, it is advisable to 



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38 PUBLIC ACCOUNTING AND AUDITING 

arrive at the results in such a manner that old and new figures 
can be expressed, broadly speaking, in the same terms. The 
failure to do this, or the failure to provide for exhibiting as 
great a degree of detail in the accounts as has been done before, 
may prove embarrassing at a time when it is desired to submit 
the accounts for a number of years to prospective purchasers 
or to bankers for preliminary consideration before investigation 
with view of extending credit. 

The accounts of the receiver should be closed at regular 
intervals and upon the same dates as the accounts of the part- 
nership were closed previously. The object of this is to enable 
the receiver to render statements on the same dates as hereto- 
fore. 

Statements to be Rendered to the Court. The first 
report required by .the court will be a statement supported by 
schedules showing the properties taken over and the liabilities 
assumed, the liabilities being properly classified as to preferred 
claims, secured, unsecured and contingent liabilities. The court 
will require subsequent reports from time to time or, at least, 
annually. A StatMJent q£ Affairs is usually the first report to 
be submitted. It is prepared at the beginning of the receiver- 
ship. Realization and Liquidation Statements are submitted to 
show results^ of the^ receiver's operations. These statements 
will be found illustrated hereinafter." 

Closing the Receiver's Books of Account. The books 
of the receiver should be closed at the end of each fiscal period, 
closing all realization losses and profits into a Receiver's Profit 
and Loss account. When the receivership is brought to a close, 
and the business is returned to the owners, the receiver will 
close the remaining asset and liability accounts on his books 
by means of a journal entry, debiting the liabilities to be assumed 
by the owners and crediting the assets being returned to the 
owners. The difference will constitute a debit to the concern. 
This entry is practically the reverse of the opening entry at the 
time the receiver is appointed. 

Accounting for the Concern in the Hands of the 
Receiver. As soon as the receiver is appointed and takes charge 
of the business, an account with him should be opened in the 
general ledger, and he should be charged for the assets taken 
over and the liabilities assumed. 

The customary plan is to charge the. receiver with assets 
at book value less the valuation, xesficves. set up, and to credit 
him with th^liabilities.at book value. Another plan is to charge 
the receiver with the assets at expected-to-realize values, and 
credit him with the liabilities at expected-to-rank values. If 
the latter plan is followed, the difference between the book 
values and the realization and liquidation values should be 
closed into the Profit and Loss account. This is faulty because 
it anticipates a profit or loss that may vary widely from the actual 
results of the receiver's operations. 



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PARTNERSHIP ACCOUNTING 39 

The method used by the receiver in opening his books 
should be followed by the bookkeeper of the concern. Using 
the same illustration as that shown in explaining the opening 
entry of the receiver, the journal entry on the books of the 
concern would be as follows: 

Reserve for Doubtful Accounts — $ 200.00 

A, Receiver 4,800.00 

Accounts Receivable $1,000.00 

Merchandise 2,000.00 

Notes Receivable 2,000.00 

It will be seen that this entry closes those accounts on the 
books of the partnership that are taken over by the receiver. 

2. COMMERCIAL LAW 

"The Congress shall have power to establish uniform laws 

on the subject of bankruptcy throughout ^he United States." 

— U. S. Constitution, Article i, Section 8, Paragraph 4. 

Congress was given the constitutional right to pass uni- 
form laws covering bankruptcy. Under this authority, the 
Congress of the United States has passed several different laws. 
The law in force at the present time was approved July i, 1898. 
Since that time there have been several amendments. 

This does not prohibit the states from enacting legislation 
concerning bankruptcy, but any state insolvency or bankruptcy 
law must not be in conflict with the Federal law. 

Bankruptcy Courts. Original jurisdiction in bankruptcy 
proceedings rests with the district courts of the several states, 
in the Supreme Court of the District of Columbia or the U. S. 
Court in the District of Alaska. These Courts have the author- 
ity to — 

adjudge persons bankrupt; 

allow or disallow claims; 

appoint receivers; 

take charge of the bankrupfs property after the filing 

of the petition; 
punish bankrupts and other persons, including officers 

and agents of corporations for any violation of the 

bankruptcy act; 
authorise the continuation of a bankrupfs business for 

a limited time by receivers or trustees, if such will be 

for the benefit of the estate; 
close estates by approznng fituU accounts and discharg- 
ing the trustees; 
reopen them when it appears they were closed before 

being fully administered; 
discharge or refuse to discharge bankrupts as the facts 

may warrant. 



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40 PUBLIC ACCOUNTING AND AUDITING 

Acts of Bankruptcy. The bankruptcy law under Section 
Three indicates that a person has committed an act of bank- 
ruptcy when he has: 

"i. Conveyed, transferred, concealed, or removed, or 
permitted to be concealed or removed, any part of his property 
with intent to hinder, delay, or defraud his creditors, or any 
of them; or 

**2. Transferred, while insolvent, any portion of his prop- 
erty to one or more of his creditors with intent to prefer such 
creditors over his other creditors; or 

"3. Suffered or permitted, while insolvent, any creditor 
to obtain a preference through legal proceeding^, and not hav- 
ing at least five days before sale or final disposition of any prop- 
erty affected by such preference vacated or discharged such 
preference; or 

''4. Made a general assignment for the benefit of his cred- 
itors, or being solvent, applied for a receiver or trustee for his 
property, or, because of insolvency, a receiver or trustee has been 
put in charge of his property under the laws of a State, of a 
Territory, or of the United States; or 

"5. Admitted in writing his inability to pay his debts, 
and his willingness to be adjudged a bankrupt on that ground." 

Partnerships May Become Bankrupts. A partner- 
ship may be adjudged a bankrupt either while in operation or 
after dissolution before final settlement has been made. When 
the bankrupt is a partnership, the trustee of the partnership 
property must keep separate accounts of the property belong- 
ing to the individual partners. The expenses of administration 
is paid from both classes of property (firm and individual) in 
such proportions as the court may determine. The bankruptcy 
act provides the following: 

"The net proceeds of the partnership property shall be 
appropriated to the payment of the partnership debts, and the 
net proceeds of the individual estate of each partner to the pay- 
ment of his individual debts. Should any surplus remain of 
the property of any partner after paying his individual debts, 
such surplus shall be added to the partnership assets and be 
applied to the payment of the partnership debts. Should any 
surplus of the partnership property remain after paying the 
partnership debts, such surplus shall be added to the assets of 
the individual partners in the proportion of their respective 
interests in the partnership." 

Bankruptcy Proceedings. Bankruptcy may be volun- 
tary or involuntary. It is voluntary when proceedings are 
instituted by a person or firm in its own behalf. It is involun- 
tary when the proceedings are instituted by an outside party. 

Proceedings may be instituted by any one or more of the 
creditors to whom the alleged bankrupt is indebted not less 
than $500.00 in case the total number of creditors is less than 



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PARTNERSHIP ACCOUNTING 41 

twelve. If there are twelve or more creditors, the proceedings 
must be instituted by three or more creditors, and their claims 
must aggregate hiore than $500.00. 

Involuntary bankruptcy proceedings may be instituted by 
creditors filing petition asking that the debtor be declared a 
bankrupt. This petition must set forth the following facts: 

" I . That the debtor owes at least $1 ,000 . 00. 

"2. That the debtor is insolvent. 

"3. That the debtor has committed an act of bankruptcy. 

"4. That the act of bankruptcy was committed within 
four months of the filing of the petition, except in the case of 
fraud, where there is no fixed time limit." 

To go into voluntary bankruptcy, the debtor files the peti- 
tion, indicating that he is unable to pay his debts and asking 
that he be adjudged a bankrupt. He also files schedules giving 
the names and addresses of all creditors and the amounts due 
them, as well as a description of his assets and their value. Cred- 
itors are then notified and served with copies of the debtor's 
petition. Further proceedings are the same as in cases of invol- 
untary bankruptcy. 

Assignment. A debtor who is insolvent may assign all 
his property to a person for the benefit of his creditors. 
The proceedings in making an assignment are prescribed by 
the state laws, consequently they vary in the different states. 
An assignment is not often made, because it does not enable 
the debtor to get a discharge from his debts. Any of his 
creditors may institute proceedings in bankruptcy, after which 
the settlement must be made in the bankruptcy court. 

Receivership. After proceedings have been instituted in the 
Federal court located in the judicial district where the bank- 
rupt resides or has his principal place of business, or where any 
property belonging to the bankrupt is located, it is customary 
for the court to appoint a receiver, who is given charge of the 
bankrupt's property until the first meeting of creditors is called. 

Of course, the bankrupt may defend himself, in which case 
he is entitled to a jury trial before the court can pronounce him 
a bankrupt. 

After the receiver has been appointed, the bankrupt is 
required to file a list of claims against him. Creditors are re- 
quired to file proof of their claims. This consists of an affidavit 
by the creditor stating the nature and amount of the claim that 
is due and owing, and indicating the security, if any, he holds 
for him. 

The receiver is appointed temporarily to preserve the prop- 
erty until a trustee can be elected. He does not conduct the 
business, but merely takes care of the goods, pays the taxes and 
other dues, and is permitted to employ a caretaJcer to look after 
the premises between the commencement of the action and the 
election of the trustees. He must give bond, and is entitled to 



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42 PUBLIC ACCOUNTING AND AUDITING 

fees based on a percentage of the amount of property handled. 
He may, with the court's permission, dispose of goods of a per- 
ishable nature or goods subject to changes in style and likely 
to become unsalable, and deposit the money realized in a bank 
until such time as the trustee is elected. 

3. ACCOUNTING PRACTICE 
Proposition A 

D. C. Brown, of the firm of Brown & Coleman, endorsed 
notes of P. E. Curry to the amount of $12,000.00. Through 
the failure of Mr. Curry to pay the same when due, D. C. 
Brown was called upon to meet the notes and was unable to 
do so. A meeting of the creditors was called to determine wheth- 
er further credit should be extended, or the business liquidated. 
They requested that a Statement of Affairs be prepar^, show- 
ing the status of the business as a liquidating concern. 

The following accounts appear on the books of Brown & 
Coleman, as of April 30, 1920: Delivery Equipment, $3,500.00; 
Warehouse and Office Fixtures, $2,900.00; Inventories — ^Mer- 
chandise, $78,180.00; Miscellaneous Supplies, $600.00; Ad- 
vances on Consignments — Inward, $2,200.00; Customers* 
Accounts, $71,084.00; Notes Receivable, $20,200.00; Cash 
in Bank, $7,353.68; Petty Cash Fund, $200.00; Unexpired 
Insurance, $100.00; Rent Paid in Advance, $400.00; Notes 
Payable, $20,000.00; Accounts Payable, $72,160.00; Notes 
Receivable Discounted, $20,000.00; Bank Loan, $6,000.00; 
Taxes Accrued, $400.00; J. M. Coleman — Capital, $35,250.46; 
D. C. Brown— Capital, $32,835.22; Interest Accrued on Notes 
Payable, $72.00. 

In going over these accoimts, the partners decided that 
the Delivery Equipment would bring $2,400.00 and the Fix- 
tures $1,250.00; that the Inventory of Merchandise, while 
in good condition, would realize but $50,000.00 on forced sale, 
and Miscellaneous Supplies, $200.00. Of the Customers' ac- 
counts $35,000.00 were good; $23,600.00 were doubtful, but 
would realize 50%; $12,484.00 were bad. Of the Notes Re- 
ceivable $20,000.00 were good; $200.00 were bad; Advances 
on Consignments — Inward, $2,000.00; $346.00 was due for 
wages. 

From the above information, prepare a Statement of Affairs 
and a Deficiency account. 

Solution 

The statement appearing on the following page indicates 
that the net free assets amoimt to $109457 . 68, while the amount 
of unsecured liabilities amount to $110,232.00; consequently if 
the net free assets were to be disposed of at their estimated 
value, there would be a shortage of $774 . 32. There is also found 



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PARTNERSHIP ACCOUNTING 



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44 



PUBLIC ACCOUNTING AND AUDITING 



to be a deficiency to partners of $68,860.00. This consists of 
the partners' individual investments plus the amount of the 
deficiency to creditors. 

The deficiency to creditors may be collected from either 
or both of the partners. If one of the partners is insolvent 
the entire amount might be collected from the other partner. 
Even though both partners have personal assets that are asses- 
sable, the creditors may collect the entire deficiency from one 
of the partners, leaving the partners to settle the matter be- 
tween themselves. 

If desired, the personal assets of the partners might be 
listed among the assets in the Statement of Affairs. This is 
often done, though it is not called for in this particular propo- 
sition. 



Deficiency Account 



Estimated Loss on 

Realization of Assets: 

*^Notes Receivable $ 200. 00 

M Customers' Accounts 24,2B4, 00 

t^Advances 200.00 

>\ Mdse., Inventory 28,180. 00 

'^isc. Suppl. Inventory 400.00 

^ Unexpired insurance 100.00 

^Rent Prepaid 400.00 

"^ Delivery Equip 1,100.00 

♦^ Fixtures 1,650.00 

<^Accommodation Paper £n- 

dorsed by D. C. Brown . . . 12,000. 00 
^^ages Accrued 346.00 



Deficiency to Creditors 
per Statement of Af- 
fairs t 



$68,860.00 



774.32 



of 



Deficiencv to Partners 
Capital Investments: 

M. Coleman 35,250.46 

C. Brown 32,835 . 22 



J! 



168,860.00 



This account shows the causes as well as the amount of 
the deficiency. Note that this correlates with the deficiency 
shown on the Statement of Affairs. 

Proposition B 

After due consideration of the Statement of Affairs prepared 
April 30, 1920, the firm of Brown & Coleman decided to liqui- 
date, and J. M. Coleman was appointed receiver for that pur- 
pose. On July 2, 1920, he reported as follows: 

COLLECTIONS 

Customers* Accounts $46,000. 84 

Merchandise Inventory ^ 53,001 .00 

Miscellaneous Supplies 200.00 

Delivery Ex)uipment 2,680.00 

Fixtures 1,570.00 

Advances 2,000.00 



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PARTNERSHIP ACCOUNTING 



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46 PUBLIC ACCOUNTING AND AUDITING 

DISBURSEMENTS 

Taxes Accrued $ 400.00 

Notes Payable 20,000.00 

Accounts Payable 72,160.00 

Accommodation Paper 10,000.00 

Bank Loan 6,000.00 

Interest Accrued on Notes Payable 72 .00 

Expenses (including Wages) 3*089.40 

$2,000.00 accommodation paper was renewed. The ac- 
commodation paper which D. C. Brown had endorsed was 
charged to his capital account. 

You are asked to prepare a Statement of Realization and 
Liquidation. 

Solution 

On the preceding page appears the Realization and Liqui- 
dation Statement of the receiver. This shows the complete 
result of the receiver's operations in statement form. 

Note that the exact loss on the realization and liquidation 
is $56,801.56, while the Deficiency account, prepared just be- 
fore the receiver was appointed, showed an estimated loss on 
the realization of assets of $68,860 . 00. The Statement of Affairs 
shows that on the basis of the estimated loss, there would have 
been a deficiency to creditors of $774.32; consequently it is 
evident that, under the direction of the receiver, the realization 
and liquidation has been more satisfactory to the creditors 
than anticipated. 

It will be noted that the accommodation paper amounting 
to $2,000.00 has been renewed. This is the only liability not 
liquidated, and since it is only a contingent liability it will be 
seen that it may not result in an actual liability Even though 
it should prove to be a loss, the total loss would be increased 
to only $58,801 . 56, which is less than the amount of the invest- 
ments of the partners, the sum of which is $68,085.68; hence, 
under the direction of the receiver, the deficiency to creditors 
was eliminated and the assets realized not only enough to liq- 
uidate all liabilities, but there is a balance left to be divided 
between the partners of $9,284.12 after allowing for possible 
loss due to the contingent liability of $2,000.00 on accommo- 
dation paper. 

A. THEORY QUESTIONS 

1. Explain the difference between a Trial Balance, State- 
ment of Affairs and Balance Sheet. C. P. A. Ex- 

2. Explain the differences between a Trading account, 
Loss and Gain account, Manufacturing account. Deficiency 
account. C. P. A. Ex. 



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QUESTIONS AND PROBLEMS 47 

3. Define: Account Current, Account Stated, Amorti- 
zation, Revenue, Working Capital, Betterment, Accrual, Hid- 
den Reserve, Internal Check, Administration Expense. 

C*. A . A. hjx., 

4. Set up a Deficiency account, explaining the points 
involved. C. P. A. Ex. 

5. With what accounts of a bankrupt concern would you 
open the books of the receiver? 

State your reasons for so doing. Inst. Ex. 

B. LEGAL QUESTIONS 

1. Explain what is meant by "receiver in bankruptcy" 
and "trustee in bankruptcy," and state how and by whom 
each may be appointed. Inst. Ex. 

2. What are the duties of a receiver of an insolvent part- 
nership? C. P. A. Ex. 

3. What is the general nature and object of the Bank- 
ruptcy Law? What is the effect of a discharge in bankruptcy? 
By what law is the subject of bankruptcy regulated in this 
country? C. P. A. Ex. 

4. Mention the principal acts which constitute acts of 
bankruptcy. 

5. (a) Is the bankruptcy act a state law or a federal 
law? 

(b) In what year was it adopted? 

(c) What are the respective functions of a Receiver, a 
Referee and a Trustee in Bankruptcy? C. P. A. Ex. 

C. ACCOUNTING PROBLEMS 

I. Adam Smith and Thomas Gray have been in business 
as contractors for the last six years. Each invested $63,000.00 
cash, and was to receive one-half of the gain and bear half of 
the losses, which were as follows for the entire period: 

Year 1899, Gain $15,000.00 

1900, Gain 18,000.00 

1901, Gain 21,852.00 

1902, Gain 1,500.00 

1903, Loss 1,300.00 

1904, Loss , 3,000.00 

Each withdrew from the business for private use $6,000.00 
per year. On December 31, 1904, an assignment was made, 
and the assignee obtained the following information in addition 
to that already given, from which he proceeded to make a State- 
ment of Affairs and a Deficiency account to be placed before 
the creditors: 

Unsecured creditors on open account $ 27,000.00 

Fully secured creditors 6,900.00 

Securities held by above consist of pat- 
ents, valued at 9,000.00 

Partly secured creditors 105,000.00 



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48 PUBLIC ACCOUNTING AND AUDITING 

Securities held by above consist of rail- 
way shares, valued at $ 60,000.00 

Wages due 2,000.00 

Rent due 400.00 

Bills Payable 60,000.00 

Book Debts (good) 3,000.00 

Book Debts (doubtful) (est. worth 

$225.00) 800.00 

Book Debts (bad), of no value 900.00 

Stock-in-trade 112,500.00 

Above is estimated worth 66,600.00 

Plant and Machinery cost 120,000.00 

Above estimated to produce 60,000.00 

Office Furniture, $900.00, estimated worth 600.00 

Bills Receivable under discount 10,000.00 

Estimated liability of estate on above 4,000 . 00 

Cash in bank 252 .00 

From the facts given above, prepare: 

(a) A Statement of Affairs. 

(b) A Deficiency account. C. P. A. Ex. 
2. The copartnership of George L. Brown & Company, 

composed of George L. Brown, L. J. Henry and Fred S. Martin, 
is unable to meet its current obligations, and arranges a com- 
position with creditors whereby the latter agree, to accept 80% 
of their claims without interest. A trustee, Henry S. Smith, 
is appointed January i, 1915, by mutual consent, to take charge 
of the business during liquidation. On that date the ledger 
of the partners showed the following balances: Cash, $105.00; 
Accounts Receivable, $10,000.00; Accounts Payable, $12,000.00; 
Notes Receivable, $5,000.00; Notes Payable, $5,000.00; Bonds, 
(owned), $5,000.00; Inventory, $13,000.00; Premium on 
bonds, $150.00; Real Estate, $3,000.00; George L. Brown, 
$5,000.00; L. J. Henry, $6,605.00; Fred S. Martin, $7,650.00. 

The trustee continued trading for six months, his trans- 
actions summarized being as follows: Purchases, $8,000.00; 
salaries, $2,000.00; general expenses, $1,000.00; all paid in 
cash. Sales, $24,000.00; cost of sales, $16,000.00; cash re- 
ceived on realization, $19,250.00; cash disbursed in liquidation, 
$14,100.00; cash received in trading (sales), $12,000.00; cash 
disbursed in trading as above, $11,000.00. 

The notes receivable realized face value; accounts receiv- 
able were assigned to a banker at 10% discount. The bonds 
were sold, at 105 flat. The notes payable were paid as agreed, 
and the accounts payable were liquidated with the exception 
of one claim of $2,000.00 unsettled pending an old adjustment 
for damaged goods. Inventory at end of six months, $5,000.00; 
expenses of trusteeship, $2 , 100 . 00. 

To show the results of the trustee's handling of the busi- 
ness, prepare Realization and Liquidation statement. Deficiency 
account, Cash account, and Balance Sheet at termination. 

C. P. A. Ex. 



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Chapter Four 

CORPORATION ACCOUNTING 

1. ACCOUNTING THEORY 

Corporate Transactions. Accounting for corporations 
differs from the accounting for individuals and partnerships 
only in connection with the strictly corporate transactions. 
Entries for the authorized capital stock, capital stock subscrip- 
tions, capital stock issued, capital stock transferred, organiza- 
tion expenses, bond issues, dividends, surplus, etc., are typical 
of the corporate form of organization. 

Corporate Records and Books of Account. There are 
certain records and books of account peculiar to the corporation 
and necessary in order to properly record the corporate trans- 
actions. In some states the law requires that certain records 
of stock outstanding shall be kept. Usually the only records 
actually required are those relating to stock transfers, such* 
as a stock certificate book, transfer journal and a stockholders' 
ledger. 

Subscription Register. If there are but a few subscribers 
to capital stock, a proper record may be made in the corporation 
journal in connection with the subscription entry, but where 
there are many subscribers and subscriptions to capital stock 
are made over a comparatively long period of time, it is best to 
provide a subscription register in which may be recorded the 
names and addresses of subscribers, the amount of their sub- 
scriptions, and terms of payment. 

Subscription or Installment Ledger. Where there 
are many subscribers and the stock is to be paid for on a pay- 
ment or installment plan, it is best to keep a subsidiary ledger 
for accounts with subscribers. If there are only a few subscribers, 
accounts with them may be opened in the general ledger. Wheth- 
er accounts with subscribers are opened in the general ledger 
or in a subsidiary ledger, they should be charged with subscrip- 
tions to capital stock asi. shown by the subscription register. Of 
course, the entiy is posted from the journal and not from the 
subscription register. The subscription register is not a posting 
medium, but is an auxiliary record. 

The controlling account in the general ledger for sub- 
scriptions to capital stock may be termed "Subscriptions to 
Capital Stock." This account controls the subscription or in- 
stallment ledger. The total of the debits of the controlling ac- 
count will be equal to the total subscriptions made and charged 
to the subscribers' accounts in the subscription or installment 
ledger. 



49 



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50 PUBLIC ACCOUNTING AND AUDITING 

Stockholders* or Stock Ledger.* This is a subsidiary 
ledger controlled by the Capital Stock account in the general 
ledger. Some bookkeepers confuse this ledger with the sub- 
scription or installment ledger. It must be remembered that 
the subscription or installment ledger contains personal ac- 
counts with the subscribers to the capital stock; these accounts 
being debited with the amount of the subscriptions and credited 
with payments thereon. The stockholders' ledger contains 
accounts with the stockholders (not subscribers), and it is in- 
tended as a record of outstanding or issued capital stock. 

Each stockholder's account in this ledger should show the 
amount of stock actually issued and held. The accounts are 
credited with the amount of stock issued and debited with stock 
transferred, so that the balance of the accounts represents the 
amount of stock owned by the stockholders. 

Stock Certificate Book. This is an auxiliary book made 
up of blank stock certificates and stubs. When a certificate is 
issued, the stub should be carefully filled in giving all the infor- 
mation desired. Subscribers may be required to acknowledge 
receipt of stock by signing the stub. When certificates are can- 
celed, it is not uncommon in practice to paste the canceled cer- 
tificate to the stub. 

Transfer Register. When a stockholder sells or transfers 
a part or all of his stock, the one who acquires title to the stock 
should have the stock transferred on the books of the issuing 
corporation. Usually only a memorandum entry for transfers 
is made in the corporation journal, although, if desired, a special 
transfer register may be kept. These transfers affect only the 
accounts with stockholders in the stockholders' ledger, and do 
not in any way affect the Capital Stock account or any other 
account in the general ledger unless the stock is being trans- 
ferred back to the issuing company as donated or treasury stock, 
or is being converted or canceled. As long as the transfer of 
stock does not affect the amount or class of stock outstanding, 
no accounts in the general ledger are affected. 

Minute Books. Minute books are usually kept for the 
purpose of recording minutes of the meetings of directors and 
stockholders. Any ordinary blank book may be used for this 
purpose, as the secretary simply records the proceedings in the 
usual way. Sometimes the minutes are recorded in the corpor- 
ation journal. 

Dividend Book. Sometimes a dividend book is kept. 
A complete record of the dividends declared and paid is entered 
therein. No special form is in use and seldom is a special book 
kept, the usual plan being to simply record dividend transac- 
tions in the corporation journal and cash book. 

♦Both terms are used. It would seem better practice to use the term 
"Stockholders' Ledger" as the term "Stock Ledger" may be confused 
with a subsidiary leager kept in connection with book inventories of finished 
stock, the record of finishecf stock sometimes being termed a "Stock Ledger." 



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CORPORATION ACCOUNTING 51 

Bond Register. When bonds are issued, a register may 
be used for recording the bonds issued. It is similar to a stock- 
holders' ledger, and is designed to keep a record of and to show 
the amount of bonds sold and outstanding and by whom they 
are held. 

A combination book, or corporate record, bound or loose- 
leaf, is used by most corporation officials, and may be purchased 
at the leading book and stationery stores. This book usually 
provides space for the Certificate of Incorporation, by-laws, 
minutes of the directors' and stockholders* meetings, subscrip- 
tions to capital stock, capital stock issued and transfers, and 
a record of the stockholders' accounts. 

For illustration of special ruled corporate books, see pages 
58 to 61. 

2. CORPORATION LAW 

Definition. In a Supreme Court Decision,* a corpora- 
tion has been defined as ''An association of individuals united 
for some common purpose, and permitted by the law to use a 
common name, and to change its members without dissolution 
of the association." 

A corporation is an artificial being composed of individuals 
known as stockholders, yet entirely separate and distinct from 
its stockholders. It is created under the laws of the state in 
which it is organized for an expressed purpose, combining the 
capital for the mutual benefit of the stockholders. 

Formation. Its formation is different from that of a part- 
nership. A partnership is formed by contract or agreement, 
either expressed or implied, between partners, but a corporation 
is created by the state in which it is organized and in accordance 
with the laws of that state. Persons desiring to incorporate 
must secure a charter from the state as provided by law. This 
charter bestows upon a corporation the powers specified in the 
application for a charter. It usually shows the name of the cor- 
poration, its object and purpose, amount and classes of capital 
stock authorized, place of business, and term of existence. In 
addition to these specified powers, certain general powers are 
conferred, whether specified or not. 

The general powers implied are: 

(a) To use a corporate seal. 

(b) To buy, hold, and sell real property. 

(c) To app>oint officers. 

(d) To make by-laws. 

(e) To dissolve itself before expiration of term of 

existence. 
(0 To sue and be sued, 
(g) To do all legal things necessary to carry out the 

expressed purpose for which it was organized. 

♦108 U. S., 317,330. 



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52 PUBLIC ACCOUNTING AND AUDITING 

Adyantages of Incorporation. There are certain well- 
defined advantages in the corporate form of organization which 
naturally account for the great popularity of this form of busi- 
ness organization. 

1. Sufficient Capital More Easily Secured. The sale 
of stock to outside investors offers an attractive investment 
for both the small as well as the large investor. Certain in- 
vestors would be willing to risk a definite sum, small or large, 
in a corporation, but would not be willing to assume the risk 
incident to an interest in a partnership. The rights and liabilities 
of officers and stockholders being fixed by law, shares may be 
purchased without an indefinite or uncertain liability and without 
the necessity of the stockholder becoming identified with the 
management in any way if undesirable. 

2. Permanence of Organization Insured. A partner- 
ship may be dissolved at any time by the death, insolvency, or in- 
capacity of a partner, or even by a partner desiring to withdraw, 
as one cannot be forced to remain a partner against his widhes. 
A corporation is said to possess a continuous life without regard 
to changes in the ownership of the capital stock. It continues 
to exist for the term of existence specified in the charter, regard- 
less of changes of the stockholders. 

3. An Improved Organization With Better Man- 
agement. The authority and duties of the officers and direct- 
ors of a corporation are clearly defined. A corporation is man- 
aged by a board of directors chosen by the stockholders who in 
turn appoint the officers. The directors meet periodically and 
outline the general policies of the company. Officers are given 
definite powers and authority, and are responsible to the board 
of directors. The board of directors is responsible to the stock- 
holders, who meet at least annually to review the results of opera- 
tion, success of the management, and elect new directors or re- 
elect old ones for another term. Thus, it is seen, that if an officer 
proves inefficient or unsuccessful, he may be dispensed with. If 
the work of the directors is not satisfactory to the stockholders, 
new directors will be selected. In a partnership there may be 
dissatisfaction over the conduct, services, or ability of a partner, 
yet it is not a simple matter to determine upon a remedy. In a 
corporation business may be conducted only with the duly qual- 
ified officers; persons who are simply stockholders do not pos- 
sess power to transact business with outsiders. A partner is an 
agent of the partnership and, as such, may transact business in 
the name of the firm, thus binding the other partners. 

4. Stockholders May Dispose of Stock at Wiir. While 
a partner cannot dispose of his interest without the consent of 
the other partners, a stockholder may sell his stock to whom 
and when he pleases. A partner cannot pledge his interest as 
security for his personal benefit. A stockholder may do so at 
will, the corporation having no voice in the matter, neither will 



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CORPORATION ACCOUNTING 53 

it be affected. This is an advantage of considerable magnitude, 
under certain circumstances, to the investor. 

5. Liability of Stockholders Limited. The liability 
of a stockholder, except in certain cases, is limited to the amount 
of his investment which is the par value of the stock he holds 
or has subscribed for. A partner's liability extends beyond his 
investment and includes his personal holdings or wealth. A sub- 
scriber or holder of the capital stock of a bank is liable for double 
the amount of the par value of his stock. However, a stock- 
holder's liability is always limited, while the liability of a part- 
ner is usually unlimited. 

Disadvantages of Incorporation. It is true there are 
many advantages in the corporate form of organization, but at 
the same time there are certain well-defined disadvantages. 

1. Powers Limited or Restricted. The powers of a 
corporation are limited to those specified in the charter. In 
some states (Illinois, for example), a corporation cannot deal 
in real estate, neither can it purchase or hold stock in another 
corporation. An individual or partnership possessess the power 
or right to do anything that is legal and not forbidden by law, 
but a corporation is given authority to do only those things 
expressly permitted under the law. 

2. Credit May be Limited. A corporation may be un- 
able to secure as much credit as a partnership. Since stockholders 
are not responsible financially beyond the par value of their 
stock, it can readily be seen that the credit rating of a corpora- 
tion may be much less than the credit rating of a similar concern 
organized as a partnership. Hence, if a corporation desires a 
certain amount of credit, it may be necessary for one or more 
of the officers to endorse company notes assuming personal lia- 
bility thereon. 

3. Taxation and Supervision. Many burdens have 
been and are being imposed on the corporation, such as govern- 
ment (state and federal) requirements as to reports, fees, taxes, 
etc. The Income Tax laws have been the cause of many cor- 
porations dissolving and reorganizing in the form of a partner- 
ship, due to the fact that in many instances the law seems to be 
unfair to the corporation as compared with the partnership. 
(This will become more evident in a later study to be made of 
the Income Tax laws and their application.) 

Incorporators. The parties who file application for a 
charter or certificate of incorporation are known as the incor- 
porators. Such parties must be competent to contract, a part 
or all must be citizens of the state in which application for char- 
ter is filed, and usually each incorporator is required to be a sub- 
scriber for one or more shares of the capital stock. The incor- 
porators must all sign the application for the charter. 

Application for Charter. The application for a Certifi- 
cate of Incorporation or charter must be signed by the incorpo- 



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54 PUBLIC ACCOUNTING AND AUDITING 

♦ ■ 

Certificate of i^ntiticrtptton 

Q(a tiff f^fttttaxts ^ f^Mt. (SaUttttbttB* <IPI(io: 

We, the undersigned incorporators of The 

Company, do hereby certify that on the day of 



192 . ., all the incorporators of said Company did order, in writing, that 
books be opened for subscriptions to the capital stock of said Company, 

at on the day of , 

(City) 

192 . . at o'clock, ... M. ; and, at the same time, waive, in 

writing, the notice by publication of the time and place of such opening 

of books of subscription, required by law; and, further, said books 

having been opened at the time and place ordered, that ten per cent, of 

the capital stock of said Company has been subscribed. 



Inoorponton. 
Note — ^Fee for filing Certificate of Subscription $2.00. 

■' ■■♦ 

■» , '■■■■ O 



^^tit ^ttitltsl of incorporation 

OF 
The Company 

WITNESSETH, That we, the undersigned* 

of whom are cititens of the State of Ohio, desiring to form a corporation, 
for ffrofU, under the general corporation laws of said State, do hereby 
certify: 

FIRST, The name of said corporation shall be The 

Company. 

SECOND, Said corporation is to be located at 

(City or Town) 

in County, Ohio, and its 

(Street Number) 
principal business there transacted. 
TBI" -^ 



HIRD, Said corporation is formed for the purpose of 



FOURTH, The capital stock of said corporation shall be 
Dollars {f ), divided into 



( ) shares of DoUars (f ) 

each, 

IN WITNESS WHEREOF, We have hereunto set our hands, this 



day of , A. D. ig. 



(N«me) (AddreM) 

•"aU" or "a majority." 



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CORPORATION ACCOUNTING 55 

rators and filed with the Secretary of State or other designated 
officer. The legal requirements vary in the different states. 

The Ohio law requires that the corporation must file Cer- 
tificate of Subscription and Articles of Incorporation. (See illus- 
trations on opposite page.) The Articles of Incorporation must 
be subscribed by at least five persons, the majority of whbm 
must be citizens of Ohio. They may be acknowledged before 
any officer who is authorized to take acknowledgments of deeds, 
and the official character of the officer taking such acknowledg- 
ment must be certified to by the Clerk of the Court of Common 
Pleas of the county in which the acknowledgment is made. 
Subscription books must be opened, and at least 10% of the 
capital stock must be subscribed at the date of filing the Articles 
of Incorporation. 

Stockholders. All parties holding stock of a corporation, 
or who have subscribed for stock and their subscription has been 
accepted, are known as stockholders. In order to possess all 
the rights of a stockholder of record, the party holding stock 
must have his ownership duly recorded on the books of the issu- 
ing company. If a party purchases stock from a stockholder, 
such stock must be transferred on the books of the issuing com- 
pany before he is entitled to a certificate of stock in his own name, 
to vote, or to be entitled to a share in the dividend. The rights, 
powers, and liabilities of the common stockholders, while de- 
pendent largely upon the laws of the state and the by-laws of 
the corporation, may be generally summarized as follows: 

(a) Rights— 

1 . To be notified of the annual or any special meet- 
ings and to participate in all meetings of the stockholders. 

2. To cast one vote for each share of stock held, 
either in person or by proxy. 

3. To share in the dividends declared on the 
common stock in proportion to the amount of common 
stock owned. 

4. To share in any assets remaining after liqui- 
dation of all liabilities, in case of dissolution, in propor- 
tion to amount of common stock owned. 

5. To examine the books and records of the cor- 
poration, though this right has practically become re- 
stricted to the right to examine the stockholders* ledger. 

6. To sell the assets or property of the company. 

(b) Powers — 

1. To adopt and amend the by-laws. 

2. To elect the board of directors. 

3. To amend the Articles of Incorporation as pro- 
vided by law. 

4. To dissolve the company. 

5. To exercise all special f)owers conferred by 
the Articles of Incorporation. 



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S6 PUBLIC ACCOUNTING AND AUDITING 

(c) Liabilities — 

1. For any installments remaining unpaid upon 
stock subscriptions, either to the issuing company or to 
its creditors. 

2. For the amount of the discount received on 
stock purchased, to the company's creditors. 

3. For an amount equal to their original subscrip- 
tion to the stock of a national bank, and usually of a 
state bank or trust company, in case of insolvency of 
the company. 

4. For dividends paid from capital instead of 
from earned profits, to creditors of the company. 

Directors. The stockholders elect a board of directors 
which is charged with the management and direction of corpor- 
ate affairs. It will readily be seen that it would be impracticable 
for all the stockholders of a large corporation to meet periodi- 
cally or at special times to decide upon questions in connection 
with the direction and management of affairs; hence, the stock- 
holders elect a board of directors, who are responsible to them 
for the proper management of the corporate affairs. The direct- 
ors are held to be the agents of the corporation. 

A board of directors usually consists of three or more stock- 
holders. Where the board is composed of a large number of 
persons, it is customary to app>oint an executive committee of 
from three to five members of the board, who are given authority to 
administer the affairs of the corporation. Of course, the executive 
committee is responsible to the board of directors for their actions. 

Rights of Directors. Directors possess the right — 

1. To manage the corporate affairs. 

2. To elect the corporate officers. 

3. To vote on all matters coming before the board 
in an official manner, each director casting one vote in- 
stead of casting a vote for each share of stock owned. 

4. To declare and fix the amount of dividends. 

5. To execute corporate contracts unless this right 
has been conferred upon the officers. 

6. To examine the books of account and all 
records of the corporation. 

7. To allot shares of stock to applicants. The board 
as a whole, and not a committee, possesse? this power. 

Liabilities of Directors. The liabilities of directors are 
fixed by the state statutes. They are generally held liable — 

I. For gross negligence in managing the corporate 
affairs. 

2." For selecting officers who are not qualified for 
the positions to which they are elected. 

3. For failure to use ordinary care and exercise 
diligence in supervising the acts of the officers after 
they are selected. 



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CORPORATION ACCOUNTING 57 

4. For issuing stock as fully paid when it is not 
in reality fully paid. 

5. For declaring dividends out of capital instead 
of from profits. 

Officers. The board of directors appoints the officers. 
Usually a president, vice-president, secretary and treasurer are 
appointed as executive officers. Often one man holds two 
positions. All the officers are responsible to the board of directors 
and receive their instruction from the board. They have no 
authority whatever other than to perform the duties imposed 
by the by-laws of the corporation and the statutes of the state. 
They are generally liable for fraud or misrepresentation, or for 
exceeding the rights and powers conferred by the by-laws of 
the company or the statutes of the state. 

Compensation of Officers and Directors. The general 
officers of a corporation, including the directors, are supposed 
to serve in their capacities as such without compensation. There- 
fore, if officers and directors do serve in this capacity only, with- 
out having received compensation, or without an agreement to 
the effect that they are to receive compensation, they cannot, 
without consent of the stockholders, be voted salaries as back 
pay. To do so would be to give away corporate funds. If 
an officer renders special service in addition to the ordinary 
functions of his office, there is an implied promise to pay for 
such service, and in cases of this kind the directors have the 
right to fix the amount of the compensation. As a rule, stock- 
holders reserve the right to themselves to fix the salaries of the 
general officers, and they leave to the directors the right to fix 
the salaries of all other employes. 

3. ACCOUNTING PRACTICE 

Recording Corporate Transactions. Accountants are 
frequently asked to devise accounting systems and to open the 
books of the corporation at the time of its organization. While 
a combination corporate book, such as is described on page 
51, may often be used with satisfactory results, yet, in many 
instances, it is advisable to devise corporate records with special 
rulings. In order to illustrate certain corporate records and 
books of account, we will assume the following transactions. 

Proposition A 

Transaction One. The Central Manufacturing Com- 
pany was incorporated January i, 1920, under the laws of the 
state of Ohio, with an authorized capital stock of $250,000.00, 
consisting of 2500 shares of the par value of $100.00 each. A 
subscription book had been opened and subscriptions to capital 
stock received, as shown in the illustration on page 58. 

Transaction Two. January 2, 1920, following the filing 
of Articles of Incorporation, the subscribers to capital stock were 



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58 



PUBLIC ACCOUNTING AND AUDITING 



assessed one-half the amount of their subscriptions. Certificates 

of stock are not to be issued until stock is fully paid. 

Transaction Three, March i, 1920, the subscribers 

settle for the balance due from subscriptions to capital stock 

as follows: 

Chas. Pratt $25,000.00 

H. W. Henry 25,000.00 

J. F. Ward 15,000.00 

L. G. Tillotson 2,500.00 

By agreement, Henry L. Hunt gives a ninety day note, 

with interest at 6%, for the balance due on his subscription. 

Stock certificates are issued. 

Transaction Four. July i, 1920, J. F. Ward sells 50 
shares of his stock to J. E. O'Brien. The stock is transferred 
on the books of the company, and a new certificate issued to 
J. F. Ward for 250 shares. 

SUBSCRIPTION REGISTER 

THE CENTRAL MANUFACTURING COMPANY 
Cincinnati, Ohio 
To be incorporated under the laws of the State of Ohio with an author- 
ized capital stock of $250,000.00, divided into 2,500 shares with a par value 
of $100.00 each. 

We, the undersigned, hereby severally subscribe for and agree to take 
at par, at the terms indicated, the number of shares of the capital stock of 
The Central Manufacturing Company set opposite our respective signatures. 



Date 


Name 


Address 


No. 
Shares 


Am't. 
Sub'd. 


Terms 


1920 
Jan. I 

I 
I 
2 

2 


Charles Pratt 
H. W. Henry 
T. F. Ward 
Henry L. Hunt 
L. G. Tillotson 


Leavenworth, Kans. 
Canton, Ohio 
Akron, Ohio 
St. Louis, Mo. 
Cleveland, Ohio 


500 
500 
300 
150 
50 


$50,000 

50,000 

30,000 

15.000 

5,000 


On demand 
On demand 
On demand 
On demand 
On demand 



Corporation JoumaL The illustration on page 59 shows 
an especially ruled corporation journal. If the capital stock 
were partly common and partly preferred, additional columns 
should then be ruled for the preferred stockholders' ledger, with 
provision for showing the number of each certificate and number 
of shares issued or transferred. It is assumed that proper 
entries for cash receipts and payments are made in the cash 
book. However, a memorandum entry is made in the corpo- 
ration journal for all cash transactions when they constitute 
strictly corporate transactions. 

Stockholders* Ledger. In the illustration on page 61, 
there is shown three accounts with stockholders. Space did 
not permit illustrating the accounts^ with all the stockholders. 
However, the object of the illustrations is to show the proper 
heading and ruling of the stockholders* ledger rather than the 
entries affecting the accounts therein. 



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CORPORATION ACCOUNTING 



59 



CORPORATION JOURNAL 



Stock- 

boldm' 

Ledger, Dr. 



General 
Ledger 



General 



Stoek- 
holder^ 
Or. 



No. 
Cert 



No. 
Sharee 



Dr. 



Eiphmatinn 



Or. 



No 
Shares 



No. 
Cert. 



$250,000.00 



Jan. 1, 1920 

Unissued Capital Stock 

Authorized Capital Stock 
The Central Manufactur- 
ii^ Co. was incorporated 
this date under the laws of 
the State of Ohio, with an 
authorized capital stock of 
$350,000.00, divided into 
2SOO shares with a par value 
of $100.00 each. 



150,000.00 



7,500.00 



Subscriptions to Capital Stock 

Capital Stock Subscribed 

Subscriptions to capital 

stock as per subscription 

register. 

Jan. 2, 1920 
Subscribers to capital 
stock were assessed one-half 
the amount of their subscrip- 
tions. By agreement no cer- 
tificates of stock are to be 
issued until stock has been 
fully paid for. (See cash 
book for entries on account 
of oish received from sub- 
scribers.) 

March 1» 1920 

Note Receivable 

Subs, to Capital Stock. . . 
Henry L. Hunt settles for 
balance due on his subscrip- 
tion b>r giving a ninety day 
note with interest at 6%. 

(See cash book for receipts 
from capital stock subscrib- 
ers for balance due on their 
subscriptions.) 



300 



150,000.00 



Capital Stock Subscribed. . . 

Unissued Capital Stock . . 
Certificates issued £Ls follows: 

Charles Pratt 

H. W. Henry 

T. F. Ward 

Henry L. Hunt 

L. G. Tillotson 
July 1, 1920 
J F. Ward, Cert, canceled 

J. E. O'Brien, Cert, issued 

|. F. Ward, Cert, issued 

J. F. Ward sells 50 shares 
of his stock to J. E. O'Brien. 



$250,000.00 



150,000.00 



7,500.00 



150,000.00 



500 
500 
300 
150 
50 



50 
250 



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62 PUBLIC ACCOUNTING AND AUDITING 

A. THEORY QUESTIONS 

1. What are the distinguishing characteristics of the cor- 
poration as compared with other forms of business organization? 
What principles does it cover, and what, if any, are its disad- 
vantages? Inst. Ex. 

2. (a) What books of record are necessary in addition 
to the books of account for a corporation existing under the 
laws of your state? 

(b) Of what value would such records be for the purpose 
of an audit? Inst. Ex. 

3. Can surplus be created in any way other than through 
profits earned from operations? Explain. Inst. Ex. 

4. Explain fully and state how accounts should be carried 
upon the books with: 

(a) Authorized Capital Stock. 

(b) Unsubscribed Stock. 

(c) Treasury Stock. 

(d) Preferred Stock. 

(e) Common Stock. 

5. A company has acquired, by purchase in the open mar- 
ket at $85.00 per share, 100 shares of its own capital stock, par 
value $100.00 per share. Its Balance Sheet shows "Treasury 
Stock, $8,500.00." Is this correct? If so, why? If not, state 
how you would adjust. C. P. A. Ex. 

B. LEGAL QUESTIONS 

1. (a) Define a corporation, (b) What general power 
does every corporation possess? (c) Distinguish between 
capital and capital stock, and explain the nature of a share of 
stock, (d) What are by-laws and who are bound by them? 

C. P. A. Ex. 

2. Have directors of a corporation the right to rescind, 
alter or amend by-laws adopted by stockholders? If so, under 
what conditions? If not, why not? C. P. A. Ex. 

3. To what extent may directors delegate their powers to 
an executive committee? Give reasons for your answer. 

Inst. Ex. 

4. Have directors the power to vote or pay increased sal- 
aries to officers for past services rendered in the usual and ordi- 
nary course of business? Give reasons for your answer. Inst. Ex. 

5. (a) What right has a stockholder to a share of the 
profits of a corporate business? (b) Has a stockholder a right 
to examine the books of a corporation? If so, for what purpose? 

Inst. Ex. 



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CORPORATION ACCOUNTING 63 

C. ACCOUNTING PROBLEMS 

1. Frame any entries necessary to record the action of 
the directors as it appears in the minutes of the meeting of Au- 
gust 15, 1917, of which the following is a synopsis, and the ac- 
tion of the officers taken pursuant to authority conferred on 
them by such minutes: 

The treasurer reported that the profits for the year as au- 
dited amounted to $59,287.00. Voted that a dividend of $40, 
000.00 be paid on October i to the stockholders of record Sept- 
ember 15, and that $10,000.00 of the profits *be appropriated 
as a reserve for relief of employes disabled while in the service 
of the United States and invested in liberty bonds. 

The treasurer reported that he had an offer of $1,000.00 
in settlement of a debt of $3,000.00 of the A. B. C. Company, 
which had been written off as uncollectible in 1914. He was 
authorized to accept the offer in full settlement. 

The president reported that he had received tenders for 
new building planned in the amount of $185,000.00. He was 
authorized to execute a contact accordingly. 

The president reported that a firm of bankers had offered 
to purchase $200,000.00 of the company's twenty-year five per 
cent, bonds to be dated October i, 191 7, at 93^and accrued int- 
erest. He was authorized to accept the offer and deliver bonds 
on that date. Inst. Ex. 

2. As on January i, 1905, a corporation is formed for 
the purpose of acquiring and conducting a cemetery, and starts 
business on that date with a capital stock of $100,000.00 paid 
for in cash. The company first purchases forty acres of land 
within easy access of a large city, paying for same at the rate 
of $1,000 per acre. It proceeds to expend considerable sums of 
money in the purchase and planting of trees and shrubs, laying 
out drives, and pathways, sodding, building of glass houses, 
etc. The policy of the company is to withhold 5ie selling of 
burial lots until after January i, 1915, so as to allow the trees 
and shrubs to become more fully grown and in the expectation 
that with the growth of the city their property will become 
more valuable. 

In the year 191 5, the company commences selling burial 
lots, and all lots are sold under a special provision whereby the 
company agrees to apply fift>' per cent, of all cash received on 
sales in the purchase of four per cent, bonds until a total of 
$150,000.00 of such bonds shall have been so purchased. The 
agreement further provides that after all the lots have been 
sold, the company will wind up its affairs and the above bonds, 
amounting to $150,000.00, shall be given to the city, which 
shall use tiie income of such bonds for keeping up the cemetery. 
It is the custom of the company not to purchase bonds until 
after the close of each fiscal year and after the total sales of 
that year have been determined. 



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64 PUBLIC ACCOUNTING AND AUDITING 

March, 1920, the directors of the company find that, while 
they believe the books to be in balance, no proper entries have 
been recorded showing the total cost of their investment, and 
that no entries have been made with respect to the fund of 
$150,000.00 from which said bonds are to be purchased. While 
cash dividends have been declared and paid, the directors are 
in ignorance of what their profits actually have been, and how 
much of the dividends so received have been out of their profits 
and how much in the nature of liquidating dividends repre- 
senting a return of their original investment. They, therefore, 
employ a Certified Public Accountant to determine all these 
matters, and to make the necessary entries on their books, and 
render report to them. 

After determining the clerical accuracy of the books, the 
accountant draws off the two Trial Balances given below, and 
from them prepares the necessary entries and obtains the in- 
formation required by the directors. 



Trial Balances 

DEBITS: Jan. i, 1915 Jan. i, 1920 

Real Estate $ 40,000.00 $ 40,000.00 

Improvements 45,000.00 45,000.00 

Bonds 125,000.00 

Administration Expense 20,000.00 46,000.00 

Upkeep of Cemetery 45,000.00 

Dividends paid 130,000.00 

Cash 7,000.00 40,800.00 

$112,000.00 $471,800.00 

CREDITS: 

Interest account representing inter- 
est at 4% on unexpended cash 

during development period $ 12,000.00 $ 12,000.00 

Bond Interest account 9,800.00 

Sale of Lots 350,000.00 

Capital Stock 100,000.00 100,000.00 

$112,000.00 $471,800.00 

An inventory of their unsold lots as on January i, 1920, 
shows that they have ten acres left unsold of equally desirable 
character with that already sold. Draw up entries, prepare 
Profit and Loss account for period and Balance Sheet as on 
January i, 1920, in same manner as if you had been the ac- 
countant engaged. In any interest calculation, use four per cent, 
simple interest. C. P. A. Ex. 



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Chapter Five 

CORPORATION ACCOUNTING 

1. ACCOUNTING THEORY 

Treasury Stock. A corporation frequently comes into 
possession of its own capital stock. This may come about 
through purchase, donation or forfeiture. In some states a 
corporation is not allowed to purchase its own capital stock. 
For instance, in Missouri the law provides that a corporation 
may not purchase its own capital stock but may acquire it 
in consideration of the surrender of a past due note provided 
such action is clearly in the interest of the corporation. The 
stock thus acquired may then be sold at whatever price it will 
command. 

Stock may be purchased when not forbidden by law. The 
corporation may purchase its own capital stock with possibly 
either of two objects in view. The object may be to reduce 
the amount of capital stock outstanding, thereby reducing the 
capital liability. This may occur at a time when the stock 
may be purchased at a discount. It is not likely that a corpora- 
tion would purchase its own stock at par or at a premium with 
the object of reducing the capital liability. Another instance 
for acquiring its own capital stock is probably due to an arrange- 
ment with stockholders in the form of an agreement to purchase 
the capital stock under certain contingencies. For instance, 
the corporation may agree with employes to sell a certain amount 
of capital stock and may further agree to purchase the capital 
stock at an agreed valuation at any time when the holder leaves 
the employ of the company. In this case, the stock might be 
acquired at par or at a premium. 

Donation Stock. Stockholders may donate a part of 
their holdings back to the issuing company. In some cases, 
there is an agreement to this effect at the time of organization, 
or when property is purchased at an overvaluation. The cor- 
poration may acquire a plant and agree to give the owner 
$100,000.00 in capital stock, common, though in reality tfte 
plant is actually worth but $75,000.00. It is agreed, however, 
that the owner is to donate back to the company $25,000.00 of 
the stock to be placed in the treasury and sold at whatever it 
will command, and this sum is to be used as additional working 
capital. It will readily be seen that action of this kind is in- 
tended to evade the law. The stock having been issued as 
fully paid stock and donated back to the company as treasury 
stock may be sold at a discount, and^ the purchaser thereof 
will not be liable either to the corporation or to the corporate 
creditors for the difference between the price paid and the par 
value of the stock. It is true that donation stock does not neces- 
sarily represent stock issued in consideration of property that 



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66 PUBLIC ACCOUNTING AND AUDITING 

has been overvalued. It may represent stock that was actually 
paid in full, but the stockholders finding it advisable to raise 
additional working capital may agree to donate a certain part 
of their holdings back to the company for the purpose of raising 
working capital or for some other purpose. 

Forfeited Stock. Subscribers may forfeit stock that has 
been partially paid for. A stockholder may subscribe for 
$5,000.00 worth of stock at par, agreeing to pay for it on an 
installment plan. In case he fails to meet the installments as 
they fall due, he may forfeit his stock, or, rather, forfeit his 
title to stock, for, in reality, the* stock is usually not issued 
until it has been paid for in full. 

Thus, it will be seen that a corporation may acquire its 
own capital stock either through purchase, donation or for- 
feiture, and there are certain accounting principles to be com- 
prehended. There should be a distinction in the accounts of 
stock acquired through purchase, donation or forfeiture. Many 
accountants consider stock purchased and stock donated in the 
same light, classing it as treasury stock and charging it to the 
same account, thereby making no attempt to distinguish be- 
tween stock acquired by purchase and stock donated. It would 
seem to be better practice to keep separate accounts for these 
two classes of stock. Stock actually purchased might be termed 
true "treasury stock," while stock donated might be termed 
"donation stock." Stock that has been forfeited should not 
be classed as treasury stock. Having never been fully paid, 
it cannot be sold at less than par value in most states. Further- 
more, the purchaser of forfeited stock at a discount would be 
liable for the difference between the price paid and the par 
value. 

Accounting for Stock Acquired by the Issuing Com- 
pany Through Purchase. Authorities do not agree as to 
the proper method to be used in recording capital stock ac- 
quired through purchase. Some claim that such stock should 
be charged to Treasury Stock at cost. Some claim that it 
should be charged at its estimated market value. Others claim 
that it should be charged at par value. 

Walton claims that "Treasury stock is a reduction of capital 
stock for the time being. In the Balance Sheet it should always 
be shown as such by being deducted from the total capital, thus: 

Capital Stock $100,000.00 

Less Treasury Stock.. 15,000.00 $85,000.00 

**In this way the total capital is shown and at the same 
time the actual stock outstanding. If the treasury stock is 
carried in any other way than at par, this offset cannot be made, 
since offsetting items must be of the same character. 



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CORPORATION ACCOUNTING 67 

Premium on Treasury Stock. "If treasury stock is 
bought at a premium, the stockholder who sells it to the com- 
pany has really sold two things — a certain number of shares 
of stock and his undivided interest in the surplus of the company. 
If the company has paid him that portion of the surplus, the 
proper entries to make would be a charge to Treasury Stock of 
the par value of the stock bought and a charge to Surplus of 
the premium paid. 

Discount on Treasury Stock. "When its own stock is 
bought by a company at a discount and placed in the treasury 
at par, it might at first sight appear as if they had made a 
profit on the purchase and that Surplus should be credited with 
the amount of the discount. The case is not the exact opposite 
of the purchase of treasury stock at a premium. The premium 
having been paid in cash represents an actual loss to the com- 
pany of a certain portion of its surplus. The discount not having 
been received in cash does not represent a realized profit, and 
unless the stock can be shown to be unquestionably worth 
par, it does not represent any profit at all. The proper treat- 
ment of the discount is to credit it to 'Contingent Profit on 
Stock,' or to some other account which will clearly indicate 
that it is not a real profit. When the stock is sold, the difference 
between par and the price realized would, if a discount, be 
charged, and if a premium be credited to the Contingent Profit 
account and the balance of that account would then be an 
actual realized profit or loss as the case may be." 

While Walton's ideas seem to be the more sound and the 
more practical, it is only just to quote what Bennett, who is 
considered quite an authority on corporation accounting, has 
to say. "The Treasury Stock account should be debited with 
the capital stock issued by a corporation and subsequently 
acquired at cost of stock purchased. The account should be 
credited with the value at which the shares were charged to 
this account. The balance of the account is an asset and should 
represent the cost of treasury stock owned. Treasury stock 
differs in no wise from the other stock outstanding except 
that, while in the treasury, it has no vote and cannot draw divi- 
dends. The voting stock is represented by the outstanding 
shares less the treasury shares owned." 

It will be noted that Bennett admits that the voting stock 
represents the difference between the outstanding stock and 
the amount of stock held in the treasury. However, his plan 
seems to be to consider treasury stock an asset to be listed as 
such on the Balance Sheet, while Walton considers treasury 
stock a deduction from the outstanding capital stock on the lia- 
bility side of the Balance Sheet. While the results obtained are 
the same under both plans, yet it is more logical to record treasury 
stock at its par value. When the stock was originally issued 
it was recorded at par. At the time of its purchase it should. 



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68 PUBLIC ACCOUNTING AND AUDITING 

therefore, be recorded at par also, and the diflference between 
the purchase price and the par value should be reflected either 
in the Surplus account or in a Contingent Profit and Loss 
account. 

If the stock is purchased at a premium, such premium 
undoubtedly represents the stockholder's share in the surplus, 
hence he is really paid for his stock at par, and in addition is 
given his share in the surplus on such stock; therefore, the 
amount of the premium should be charged to the Surplus ac- 
count. If, on the other hand, the stock is purchased at a dis- 
count, it cannot be said that the company has acquired surplus 
and that the Surplus account should, therefore, be credited with 
the amount of the discount. Instead, the company has made 
a contingent profit realizable only in the event of resale of 
stock above its cost. Such discount should, therefore, be con- 
sidered as a contingent profit and should be credited to Dis- 
count on Treasury Stock. It does not represent an earned profit 
available for dividends. 

Accounting for Stock Donated to the Issuing Com- 
pany. While it is true that donation stock is similar to treasury 
stock and might be so classified in the accounts, it would seem 
to be better to make a distinction between stock purchased by 
the issuing company and termed '^treasury stock" in the above 
discussion. To accomplish this purpose, stock acquired by 
gift may be charged to a Donation Stock account. Since the 
stockholders usually specify the purpose for which the stock is 
being donated, this would be a consideration in determining the 
proper account to be credited. 

If the stock donated to the issuing company represents 
an overvaluation of property or good will paid for by issuing 
original stock, such donation stock should be credited to Property 
or Good Will accounts, thereby reducing them to their actual 
value. It would be very poor practice to credit Surplus for the 
proceeds from the sale of donation stock and permit good will 
or other assets to remain on the books at an inflated value. 

If, on the other hand, the assets are not inflated, and the 
true purpose of the donation of stock is to provide working 
capital, die customary procedure is to credit Donated Working 
Capital. Like treasury stock, donation stock should be recorded 
on the books at par value. At the time it is acquired, debit 
Donation Stock and credit Donated Working Capital. If it 
is subsequently sold at a discount, the Donation Stock account 
should be credited for the par value and the discount should 
be charged to the Donated Working Capital account. This 
can be done either directly at the time of the sale of the dona- 
tion stock, or if desired, a separate account may be set up with 
Discount on Donation Stock, and this account can be closed 
into the Donated Working Capital account at the end of the 
fiscal period. Donation stock nearly always sells at a discount — 
seldom at par. The account with Donated Working Capital 



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CORPORATION ACCOUNTING 69 

will show the actual amount of working capital raised after 
all donation stock has been disposed of. This is clearly indicated, 
because this account is credited with the par value of donation 
stock acquired and debited with the discount on donation stock 
sold, consequently, the cash received from the sale of donation 
stock is just equal to the balance of the Donated Working Capi- 
tal account after all donation stock has been sold. 

The amount realized from the sale of donation stock is in 
reality an addition to surplus. It would not be wise, however, 
to credit it direct to the Surplus account and to consider it 
available for dividends. If it were distributed in the form of 
dividends, the stockholders would lose the benefit expected to 
accrue from the donation at the time it was made. In other 
words, if the surplus acquired through the sale of donation 
stock is distributed in the form of a dividend, the stockholders 
have simply sold their holdings to others and the company 
has not benefited in the least. Since the stock was acquired by 
gift and cost nothing, it will readily be seen that whatever is 
realized upon the sale thereof is truly a profit, but it should 
be considered as a permanent surplus not available for divi- 
dends. It is not infrequent that stockholders in making a dona- 
tion of capital stock specify that the receipts from its sale are 
not to be available for dividends. Therefore, in the Balance 
Sheet the surplus would be shown in two divisions. Profits 
realized from the sale of donation stock would be stated as 
permanent surplus, while the earned profits from operations 
only would be available for dividends to be distributed subject 
to the action of the board of directors. 

Accounting for Stock Forfeited by Subscribers. In 

some states the law provides that whatever installments may 
have been paid by the subscriber must be returned to the pur- 
chaser in case of default. In other states the law provides 
that a part, whether that above the expenses incurred in the 
handling of the transactions or a specified proportion of the 
amount paid in, must be returned to the purchaser; while 
in other states the law provides that the subscriber, in case 
of default in payments due on stock, forfeits all payments pre- 
viously made thereon. 

The law of the State of New York provides that "If de- 
fault shall be made in the payment of any installment, the 
board may declare the stock and all previous payments thereon 
forfeited for the use of the corporation after the expiration 
of sixty days from the service on the defaulting stockholder, 
personally or by mail directed to him at his last-known post 
office address, of a written notice requiring him to make pay- 
ment within sixty days from the service of the notice at a place 
specified therein, and stating that, in case of failure to do so, 
his stock and all previous payments thereon will be forfeited 
for the use of the corporation. Such stock, if forfeited, may be 
reissued or subscriptions therefor may be received as in the case 



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70 PUBLIC ACCOUNTING AND AUDITING 

of stock not issued or subscribed for. If not sold for its par 
value or subscribed for within six months after such forfeiture, it 
shall be canceled and deducted from the amount of the capital 
stock." 

Forfeited stock should be charged to Unissued Capital 
Stock rather than to Treasury or Donation Stock. Payments 
forfeited by the subscriber constitute suiplus. Such payments 
are usually held to be a permanent addition to surplus and not 
available for dividends, though it is doubtful if there can be 
any legal objection to distributing such surplus in the form 
of dividends. 

Bonus Stock. To promote the sale of stock, bonds, or 
other securities, a corporation sometimes offers a bonus in the 
form of capital stock. For instance, one share of common 
stock may be given as a bonus with each share of preferred 
stock sold at par. Stock given as a bonus is usually taken from 
treasury stock or donation stock. An account with Bonus 
Stock should be opened and this would be charged with the 
par value of the stock given as a bonus, and Treasury Stock 
or Donation Stock would be credited, provided such stock was 
originally charged to the Treasury Stock or Donation Stock 
accounts at par. If such treasury stock or donation stock had 
been set up at cost, then the Bonus Stock account would be 
charged at the same price, and the difference between the cost 
price and the par value would be charged to Discount on Capital 
Stock or some other similar account. The value of the stock 
given as a bonus is usually considered an organization expense 
and as such is written off over a period of years; that is, it 
is treated as a deferred expense. 

It is not often that original capital stock is given as a 
bonus, for the reason that the holder thereof would be liable 
for the full par value of the stock. Instead of acting as an induce- 
ment to purchasers of stock, bonds, or other securities, it might 
have just the opposite effect. Regardless of whether bonus 
stock represents original capital stock, treasury stock, or dona- 
tion stock, it must appear on the books as outstanding capital 
stock at par value. 

Increase in Capital Stock. A corporation may increase 
the capital stock by complying with state regulations. Such 
stock is disposed of in the usual way, the same as stock issued 
at the time of the organization of the corporation. No difficult- 
ies are encountered in the accounting procedure. The stock 
is usually sold at par, though it may sell at a premium. Cash, 
or whatever is received in payment of the stock, is debited and 
Capital Stock credited. 

To illustrate: Assume that the Goodell Manufacturing Co. 
decides to increase its capital stock and an authorized increase 
of $100,000.00 par value is provided for. The stock is sub- 
scribed and paid in cash. 



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CORPORATION ACCOUNTING 71 

(a) Unis'd Capital Stock $100,000.00 

Auth'd Capital Stock $100,000.00 

Increase in capital 
stock authorized. 

(b) Cash 100,000.00 

Unis'd Capital Stock. 100,000.00 

Stock sold at par. 

A corporation may inciease its capital stock outstanding 
by declaring a stock dividend out of surplus instead of paying 
a cash dividend. This is commonly referred to as ^'cutting a 
melon." 

To illustrate, assume that the Goodell Manufacturing Co. 
has authorized capital stock outstanding amounting to $200, 
000.00 and a surplus of $100,000.00. The directors meet and 
pass a resolution declaring a stock dividend of 25% payable 
out of surplus, at the same time authorizing application for 
an increase in the authorized capital stock of $50,000.00, the 
increase to be used in paying the dividend declared. The entries 
in journal form follow: 

(a) Surplus $25,000.00 

Dividend $25,000.00 

Dividend declared. 

(b) Unis'd Capital Stock 25,000.00 

Auth'd Capital Stock 25,000.00 

Increase in capital 
stock authorized. 

(c) Dividend 25,000.00 

Unis'd Capital Stock... 25,000:00 

Stock issued in payment 
of dividend, 25%. 

Decrease in Capital Stock. A reduction in capital stock 
may be made after being authorized by the proper state official 
and by complying with state statutes. The object of a decrease, 
in the outstanding capital stock is to eliminate a deficit occasioned 
by losses. Such action does not aflfect each stockholder's interest 
in the business, as there is no change in the actual assets, but 
it results in a book profit equal to the amount of the decrease 
and this book profit is an offset to the amount of the deficit. 
If the reduction is greater than the deficit, the excess is a credit 
to Surplus, though it is doubtful if such surplus should be con- 
sidered available for dividends. 

Assume that the Goodell Manufacturing Co. had a deficit 
of $25,000.00 and it had been decided to decrease the out- 
standing capital stock $35,000.00. 

Capital Stock $35,000.00 

Deficit or Profit and Loss. . $25,000.00 

Surplus (permanent) 10,000.00 

Decrease in capital stock outstanding. 



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72 PUBLIC ACCOUNTING AND AUDITING 

2. CORPORATION LAW 

Liability to Subscribers. Subscriptions to capital stock 
of a corporation may be made before or after incorporation. 
A subscription made before incorporation is an agreement to 
subscribe for stock. It is a contract entered into between the 
subscriber and incorporator or promoter and not between the 
subscriber and corporation, because the corporation, as such, 
does not exist until after Articles of Incorporation have been 
filed with the secretary of state or the proper official. A sub- 
scription to capital stock after incorporation is a contract 
between the subscriber and the corporation. 

Conditional Subscriptions. A subscription may be con- 
ditional. The conditions may be expressed or implied. If the 
agreement is **to subscribe for stock when the books are opened," 
or ''to pay for stock subscribed when the whole amount of 
stock agreed upon is subscribed for," such agreement constitutes 
a conditional subscription, such conditions being expressed. If 
the statutes require that a part payment must be made on 
subscribed stock at time of subscription but the subscriber 
fails to make payment, such failure does not always make the 
agreement void. The courts, in some cases, have held that the 
corporation may waive the condition if it desires to do so. The 
theory of these decisions is that the provision is for the benefit 
of the corporation only. 

Liability for Breach of Subscription Agreement. If 

a subscriber who has agreed to subscribe for stock when the 
books are opened for subscription fails to do so, he cannot be 
held liable for the entire amount of his subscription but only 
for any damages the corporation may suffer as a result of his 
breach of subscription agreement. 



Misrepresentation and Fraud. A subscriber is supposed 
to have informed himself regarding the nature of the subscrip- 
tion paper which he signs. He is also supposed to have investi- 
gated the charter and by-laws of the corporation and to be 
familiar with the statutes governing corporation organization. 
He cannot claim misrepresentation as a ground for avoiding 
his subscription contract. Of course, if he can prove that 
he was fraudulently induced to become a subscriber to the capital 
stock or a member of the corporation, he can avoid his subscrip- 
tion or withdraw from the corporation. He must report such 
fraud immediately upon discovery, for he cannot remain a 
member of the corporation while business is good, knowing 
that fraud has been committed, and then use it as a means of 
withdrawing when the corporation becomes financially em- 
barrassed. 



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CORPORATION ACCOUNTING 73 

When a Subscription may be Withdrawn. A subscriber 
may withdraw his subscription any time before the company 
is organized. Death revokes a subscription unless it has become 
legally binding before the subscriber died. After the company 
has been organized, the subscriber cannot withdraw his sub- 
scription, neither is he released from his subscription by the 
fact that another subscriber, whose subscription induced him 
to subscribe, has since unlawfully withdrawn his subscription. 
A subscriber is released from all obligations if any alterations 
are made in the Articles of Incorporation or there is an attempt 
made to transfer the subscription to a new company without 
his consent. 

Liability on Steele Purchased at a Discount. If a 

subscriber purchases stock at a discount, he may be held liable 
for the difference between the purchase price and par value of 
the stock subscribed. Even if there has been an agreement be- 
tween the subscriber and corporation that the stock is not 
to be paid for in full, and the stock is issued as fully paid, such 
agreement may not prove to be valid as against the corporation's 
creditors. If the corporation is not able to meet its obligations, 
the subscriber may be forced by the creditors to pay full par 
value for all stock subscribed. 

Liability on Subscriptions to Bank Stock. In the 

case of a subscription to bank stock, the liability is for double 
the par value. To some extent, this accounts for the fact that 
bank stock frequently sells, originally, for more than par value, 
the premium being a credit to surplus. It is not infrequent 
that a bank will begin business with a paid-in surplus almost 
or as great as the amount of capital stock issued, even though not 
a cent of earned surplus has resulted from operations. 

Exchange of Property for Capital Stock. If stock is 
paid for by transferring title in property, it is generally held 
that as long as there is no actual fraud in determining the 
value of the property, whatever price it is taken at, shall be 
final, and the subscriber is released from further liability to the 
corporation or its creditors. This is true even though the prop- 
erty may be overvalued. In certain instances, however, it has 
been held that overvaluation of property transferred in payment 
of stock is prima facie evidence of fraud. In such cases, the 
discrepancy would have to be satisfactorily explained or made 
up by the subscriber. The term "property" may include good 
will, patents, franchises, copyrights, trade-marks, and other 
intangible assets. 



3. ACCOUNTING PRACTICE 

To illustrate the principles discussed herein, there follows a 
solution of a problem taken from a recent C. P. A. examination. 



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PUBLIC ACCOUNTING AND AUDITING 



Proposition A 

J. B. Brown and L. C. Smith are partners and, in order 
to raise more capital and to preserve the organization, they decide 
to incorporate. A company was duly incorporated under the 
name of The Eclipse Company, with an authorized capital 
of $800,000.00, divided into 8,000 shares of the par value of 
$100.00 each. 

The partners agreed to sell for the sum of $800,000.00, 
payable in capital stock of the corporation at par, all rights 
to and title in the net assets of the partnership, exclusive of the 
cash, which was divided between the partners in proportion 
to their several interests at the time of the sale of the property. 

According to the articles of partnership, Brown and Smith 
were equally interested in the assets, but the profits and losses 
were on a basis of 60% and 40% respectively. 

The partnership Balance Sheet at the time of sale was: 

Balance Sheet 



ASSETS 

Land and Buildings $200,000.00 

Cash 10,000.00 

Inventories 100,000.00 

Accounts Receivable 150,000.00 

Machinery and 

Equipment 100,000.00 

$560,000.00 



LIABILITIES 

Notes Payable $100,000.00 

Accounts Payable 40,000.00 

Net Worth: 

Brown's Capital 210,000.00 

Smith's Capital 210,000.00 



$560,000.00 



For the purpose of providing working capital, the partner- 
ship donated $300,000.00 of the capital stock to the corporation 
which was subsequently sold at $50.00 per share. 

You are required to: 

1. Close the partnership books, showing ledger 
accounts of partners only. 

2. Open corporation books. 

3. Prepare a Balance Sheet of the corporation 
before sale of donated stock. 

4. Prepare a Balance Sheet after sale of donated 
stock. 

Solution 

The only doubtful point in the problem is the basis for 
the valuation of the stock to be divided between Brown and 
Smith. The problem does not indicate that the good will of 
the firm was valued at $90,000.00, though this is undoubtedly 
the case. One might solve the problem on the basis of any one 
of three different assumptions, (i) The capital stock acquired 
by the partners might be considered as having been taken over 
at par. (2) It might be considered as worth what was paid for 
it, that is, $82.00 per share. (5,000 shares @ $82.oo-$4io,ooo.oo, 



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CORPORATION ACCOUNTING 75 

which IS equivalent to the net assets as shown by the Balance 
Sheet of the partnership.) (3) It might be considered as worth 
50 cents on the dollar. (The net worth of the partners, excluding 
cash, is $400,000.00, for which the partners received capital 
stock with a par value of $800,000.00.) 

The following solution is based on the assumption that there 
was an agreement between the partners and the corporation that 
they were to donate $300,ooaoo of the capital stock back to the 
issuing company for the purpose of providing working capital. 
This $300,000.00 represents an overvaluation of good will. The 
partners actually sell to the corporation a business with a net 
worth of $410,000.00 for $500,000.00 of capital stock; hence 
it is assumed that the difference between the net worth and the 
purchase price represents the value of good will acquired by 
the corporation. 

I. The following entries are designed to close the partners' 
books of account: 

Notes Payable $100,000.00 

Accounts Payable 40,000.00 

Capital Stock (Eclipse Co.) . . 500,000.00 

Land and Building $200,000.00 

Inventories 100,000.00 

Accounts Receivable. . . . 150,000.00 

Mach. and Equip 100,000.00 

Profit and Loss 90,000.00 

Sold the entire business to 

The Eclipse Co. for capital 

stock with a par value of $800,- 

000.00 with an agreement to 

the effect that there was to be 

donated back to The Eclipse 

Co. capital stock of a par value 

of $300,000.00, the transfer of 

donated stock being completed 

at the time of sale. 

It will be seen that there remains on hand $10,000.00 in 
cash and capital stock with a par value of $500,000.00. Since 
the valuation of the good will resulted in a realization of a 
profit of $90,000.00, this profit must, of course, be divided in 
accordance with the profit and loss sharing ratio, which is on 
the basis of 60% to J. B. Brown and 40% to L. C. Smith; hence. 
Brown would be entitled to $54,000.00 and Smith, $36,000.00. 

Profit and Loss $90,000.00 

J. B. Brown $54,000.00 

L. C. Smith 36,000.00 

To distribute profits to 
partners in accordance with 
their profit and loss sharing 
basis : Brown, 60%, Smith, 40%. 



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76 



PUBLIC ACCOUNTING AND AUDITING 



This increases Brown's capital to $264,000.00 and Smith's 
capital to $246,000.00. 

The problem further states that the net assets are to be' 
divided between the partners in proportion to their several 
interests at the time of sale of the property. At first, it would 
seem that Brown and Smith, whose capital is given as $210,000.00 
each, should share in the net assets equally. However, the 
Balance Sheet of the partnership as given did not take into 
consideration the value of good will subsequently found to be 
$90,000.00. This good will representing a profit must, of course, 
be divided in accordance with the profit sharing ratio. After 
such division of the profits, the partners* proportionate capital 
is thereby affected. Their proportionate holdings are now 
found to be 44/85 (Brown) and 41 /85 (Smith). 

The following entry shows the proper distribution of the 
net assets between the partners: 

J. B. Brown $263,999.97 

L. C. Smith 246,000.03 

Cash $ 10,000.00 

Cap. Stock (Eclipse Co.) 500,000.00 

To distribute the net as- 
sets to partners in proportion 

to their several interests at the 

time of sale: Brown, 44/85, 

Smith, 41 /85. 

The ledger accounts of the partners now appear as follows: 
J. B. Brown 



Cash $ 5.176.47 

Cap. Stock (Eclipse Co.) 258,823.53 

$264,000.00 



Original Capital $210,000.00 

Profit, 60% 54,000.00 

$264,000.00 



L. C. Smith 



Cash $ 4,823.53 

Cap. Stock (Eclipse Co.) 241,176.47 

$246,000.00 



Original Capital $210,000.00 

Frofit,*40% 36,000.00 

$246,000.00 



2. The following entries are designed to open the cor- 
poration books: 

Unissued Capital Stock $800,000.00 

Capital Stock Authorized $800,000.00 

The Eclipse Co. was duly 
incorporated this date with an 
authorized capital stock of 
$800,000.00, divided into 
8,000 shares of the par value 
of $100.00 each. 



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CORPORATION ACCOUNTING >7 

Land and Buildings $200,000.00 

Inventories 100,000.00 

Accounts Receivable 150,000.00 

Machinery and Equipment. . . 100,000.00 

Good Will 390,000.00 

Notes Payable $100,000.00 

Accounts Payable 40,000.00 

Unissued Capital Stock. . 800,000.00 

To record the purchase of 
the business conducted by J. 
B. Brown and L. C. Smith, 
partners, acquiring title to all 
assets and good will, excepting 
cash, and assuming all liabili- 
ties. 

By agreement, Brown and Smith donate $300,000.00, par 
value, of the capital stock back to the issuing company for 
the purpose of providing working capital. 

Donation Stock $300,000.00 

Donated Working Capital $300,000.00 

To record the donation of 
capital stock by Brown and 
Smith. 

The donation stock was subsequently sold at $50.00 per 
share, hence a working capital of $150,000.00 was acquired. 
Since the donation stock d id no t command a price equivalent 
tojts jjtar value* it is certain that the Good Will account has 
6een inflated, and the discount on the donation stock should 
be credited to the Good Will account. 

Cash $150,000.00 

Donated Working Capital .... 150,000.00 

Donation Stock $300,000.00 

Sold donation stock, par 
value, $300,000.00, at $50.00 
per share. 

Donated Working Capital — $150,000.00 

Good Will $150,000.00 

To close Donated Work- 
ing Capital account into Good 
Will. 

If donated working capital were credited to Surplus instead 
of to Good Will, the concern would, in fact, be overcapitalized, 
and the Good Will account would be inflated. 



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78 



PUBLIC ACCOUNTING AND AUDITING 



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THEORY AND LEGAL QUESTIONS 79 

A. THEORY QUESTIONS 

1. How is treasury stock created on the books of a 
company? C. P. A. Ex. 

2. Mention and explain two common views concerning 
the treatment of donated capital stock. Inst. Ex. 

3. A company with an authorized capital of $500,000.00, 
par value $100.00, issues 4,000 shares in payment of various 
properties. In order to secure working capital, the stockholders 
return to the company three-eighths of their holdings to be 
sold at 50 and on the same day 500 shares are sold and paid 
for. 

How would you treat the matter? Draft entries and show 
ledger accounts and balances. C. P. A. Ex. 

4. What would be your procedure in regard to the Balance 
Sheet of a corporation, where shares of stock received from a 
purchaser to whom they have been issued as fully paid, and who 
had returned them in settlement of a claim for fraudulent mis- 
representation in respect of the property sold by him to the cor- 
poration? C. P. A. Ex. 

5. In making a Balance Sheet audit, you find an account 
with Treasury Stock debited $20,000.00. This represents a 
purchase of 250 shares of the company's common stock, par 
value $100.00. How would you treat this item on the Balance 
Sheet? C. P. A. Ex. 

B. LEGAL QUESTIONS 

1. What is meant by issuing of stock, and in return for 
what may stock lawfully be issued? C. P. A. Ex. 

2. What is usually necessary before a subscriber to cap- 
ital stock can be sued for the amount of his subscription? 

C. P. A. Ex. 

3. Is the agreement between shareholders and the cor- 
poration that all shares shall be deemed fully paid up effectual 
as against creditors? Explain. Inst. Ex. 

4. Subscribers to the capital stock of a corporation pay in 
only 70% of their subscriptions. Its business proves unprofitable 
and it suspends with insufficient property to pay its debts. Have 
creditors any remedy on account of the unpaid portion of the 
subscription for stock? C. P. A. Ex. 

5. In a certain stock corporation only 50% of the sub- 
scribed capital hsLis been called. David Scheld has paid all the 
installments called, and has loaned to the company an additional 
sum, for which he has taken its promissory note, and has trans- 
ferred the note to William Deen, who demands payment. May 
the company call further installments on David Scheld's stock, 
and offset the amount so called against the promissory note 
held by WUliam Deen? C. P. A. Ex. 



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8o PUBLIC ACCOUNTING AND AUDITING 

C. ACCOUNTING PROBLEMS 

1. (a) A and B, partners, organize a corporation with 
a capital stock of $500,000.00 to take over their business. The 
corporation issues its entire capital stock to A and B in pay- 
ment of their plant and equipment, which is valued at $300,- 
000.00. The entry recording this transaction is as follows: 

Plant $500,000.00 

Capital Stock $500,000.00 

For the purpose of furnishing working capital, A and B 
each donate to the corporation $100,000.00 of their stock. 
What entry would you suggest to show the exact state of affairs 
at this point? 

(b) Assuming the plant to be valued at $500,000.00, 
^ive the proper entry to record the stock donation. Give 
reasons for your entries. C. P. A. Ex. 

2. A corporation is organized under the laws of the State 
of Michigan, with capital stock $250,000.00, of which $100,000.00 
is preferred and $150,000.00 is common stock, shares $100.00 
each. The purchasers of preferred stock at par are to receive 
an equal amount of common stock free, all the preferred stock 
is subscribed and paid for, leaving $50,000.00 of common stock 
unsubscribed. 

It is found that the remaining common stock cannot be 
sold for sufficient cash for requirements, and the holders of 
preferred stock donate to the treasury $50,000.00 of, their com- 
mon stock. The common stock is sold at 50 cents on the dollar. 

Provide journal entries covering the above. C. P. A. Ex. 

3. A corporation is organized with a capital of $1 ,000,000.00 
in 100,000 shares at $10.00 each, 50,000 shares of which are 
common stock and 50,000 shares preferred stock. 20,000 
shares of the preferred stock have been sold at par, on which 
an assessment of $5.00 per share has been paid. 

Subsequently it was determined by the stockholders to 
donate one' share of the common stock of the company to the 
purchaser of each share of the preferred stock, the original 
subscribers to the 20,000 shares on which an installment of 
$5.00 per share was paid to receive the benefit of such offer 
upon the payment of the balance of their subscription. The 
effect of this offer was that all the preferred stock was sold 
and the balance of the installment due was also paid. 

Give journal entries for all the above, placing the trans- 
actions at intervals of one month. C. P. A. Ex. 



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Chapter Six 

CORPORATION ACCOUNTING 

1. ACCOUNTING THEORY 

Diyidend Defined. "A dividend is that portion of the 
profits and surplus funds of the corporation which has been 
actually set apart by a resolution of the board of directors, or 
by the shareholders at a corporate meeting, for distribution 
among the shareholders according to their respective interests, 
in such a sense as to become segregated from the property of 
the corporation, and to become the property of the stockholders 
distributively." — Cyclopedia of Law and Procedure. 

From this definition we may deduce the following facts: 

(a) A dividend is a distribution of profits. 

(b) A dividend is declared by resolution of the 
board of directors. 

(c) A dividend must be distributed among the 
stockholders pro rata according to their respective 
holdings. 

(d) After dividends have been declared, they 
become the property of the stockholders, and constitute 
a trust fund in the hands of the directors for the benefit 
of the stockholders and cannot be disposed of in any 
manner other than as intended except by permission 
and with the formal consent of the stockholders. 

(e) After declaration of dividends, the stock- 
holders in reality become creditors of the corporation. 
(If a stockholder is indebted to the corporation the 
dividend may be applied as an offset to the debt.) 

Kinds of Dividends. While dividends are usually dis- 
tributed in cash, it is not infrequent that dividends are dis- 
tributed in property, capital stock, or scrip. If a corporation 
has accumulated a large surplus, and the funds have been in- 
vested in fixed assets or stock-in-trade, it might be found ad- 
visable to distribute the dividend in treasury stock, unissued 
capital stock, property or in scrip so as to retain the funds in 
the business until some future date. If the firm had invested a 
large amount of funds in liberty bonds during the war, it 
might distribute these liberty bonds as a dividend. 

Cash Dividend. The most common dividend is known as 
a cash dividend. In fact, unless otherwise designated, the 
term "dividend" refers to a distribution of cash. Sometimes a 
company will declare a dividend out of profits and may be 

8i 



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82 PUBLIC ACCOUNTING AND AUDITING 

forced to borrow the money with which to piy the dividend. 
It must be understood that profits are not always represented 
in the cash balance, and that while the Balance Sheet of a 
corporation may show a very large surplus there may be a 
very small cash balance. 

Stock Dividend. A stock dividend may be declared out 
of surplus when funds are not available fof distribution of a 
cash dividend. Treasury stock or unissued capital stock may 
be used for the purpose of distributing a stock dividend. If 
all the authorized capital stock is outstanding, it may be neces- 
sary for the corporation to provide for an increase in the capital 
stock by securing permission from the proper state official, 
usually the Secretary of State. A distribution of stock as a 
dividend always causes an increase in the amount of outstanding 
capital stock, and may represent an increase in the authorized 
capital stock. 

Scrip Dividend. In some cases, corporations may wish 
to retain the funds in the business temporarily and may, there- 
fore, distribute dividends in the form of scrip, which is simply 
a^ certificate of indebtedness, or a promissory note. These cer- 
tificates are usually interest-bearing. The benefit to the com- 
pany in issuing a scrip dividend is that it can retain the funds 
for working capital for the time being, but, of course, the funds 
must finally be used in liquidating the scrip that has been 
issued. 

Property Dividend. A distribution of any kind of prop- 
erty other than cash may be termed a ''property dividend." 
Many dividends have recently been paid in liberty bonds, and 
in 1916, a large munitions manufacturer declared a dividend 
payable in Anglo-French bonds. 

Ex-Dividend. This is a term used in connection with a 
dividend paid to the holder of record of stock sold between 
the date of the declaration of the dividend and the date of 
payment. 

Liquidating Dividend. A distribution of assets at the 
time of dissolution of a corporation is known as a ''liquidating 
dividend." Such a dividend has no relation to profits or sur- 
plus, but relates entirely to a realization of assets and a dis- 
tribution of the proceeds. 

Declaration of Dividend. A dividend is declared by 
formal resolution of the board of directors at a corporate meet- 
ing. After a dividend has been declared, the secretary may 
either notify the stockholders of the declaration, indicating the 



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CORPORATION ACCOUNTING 83 

rate, the amount, date of payment and any other details of 
importance, or a formal notice of declaration may be published 
in the newspapers. 

Payment of Dividend. A dividend may be declared to 
be paid at some future date. In small corporations, payment is 
usually made by currency or by check, the stockholders signing 
a receipt. The practice in lar^ corporations is to deposit the 
required amount in the bank in a specific fund for dividends 
and draw checks against this fund. If a dividend is paid in 
currency, the stockholder is usually required to acknowledge 
receipt of same by his signature in a dividend book. Naturally 
this policy can be carriwl out in only very small or close cor- 
porations. 



2. CORPORATION LAW 

Dividends. Dividends may be declared only from the net 
profit or surplus. It is illegal in all states to declare dividends 
out of capital, except in case of dissolution. The advisability 
of declaring dividends is left to the board of directors. Should 
the directors declare a dividend and such dividend act as an 
impairment of capital, they may be held individually and 
criminally liable for having done so. 

Dividends Must Be Declared Out of Profits. There is 
no doubt but that it is the intention of the law in all the states 
to protect the general creditors of the corporation by forbid- 
ing directors to declare dividends that might impair the capital 
of the corporation. Any dividend declared in excess of the 
current and accumulated profits would constitute a certain im- 
pairment of the capital. This might easily prove a matter of 
serious consequence to the creditors. The United States Supreme 
Court has defined profits as "surplus over and above the capital 
and debts of the corporation." Dividends need not necessarily 
be paid out of current profits, but may represent a distribution 
of the accumulated profits, and in some cases the courts have 
held that dividends may be paid out of profits resulting from an 
increase or appreciation of assets. 

The New York Supreme Court in a decision in 1914 stated 
that **A corporation has a very wide discretion in determining 
when a dividend shall be made. There might be a difference 
of opinion in a given case as to the wisdom of accumulating 
a large surplus which otherwise would be applicable to the 
payment of dividends, but that would not be a subject for 
legal interference where the discretion is fairly exercised. If 
the defendant corporation has the right to accumulate a surplus, 
it has the right to invest the surplus in securities, and if the 



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84 PUBLIC ACCOUNTING AND AUDITING 

securities appreciate in value, there is no reason why the profits 
arising from the investment should not be regarded as the 
profits of the business of the corporation." 

Distributing Capital in the Form of Dividends.* 

'There is a popular notion, especially among stockholders of 
companies owning and operating mineral, timber, oil, and quarry 
lands, buildings on leased ground, etc., that such companies 
are exempt from the general rule that the original capital must 
be kept intact, and are consequently permitted to exhaust 
their capital by distributing to stockholders the balance of their 
surplus accounts without making provision for depletion or 
amortization of mineral deposits, stumpage, etc. There appears 
to be no legal sanction for this belief, but, as the provision of 
law to the effect that capital may not be impaired by the pay- 
ment of dividends is solely for the protection of creditors and 
stockholders, in the absence of any protest by them to distribu- 
tions consisting partly of income and partly of return of capital, 
the courts have no occasion to interfere. 

"The theoretical result of distributing to stockholders the 
profits without providing for depletion, etc., is that upon ex- 
haustion of the property (or termination of the lease, when the 
property reverts to the lessor), and after all liabilitie? are paid, 
and the net profits shown by the Surplus account distribute 
to stockholders, only two accounts remain on the books, Property 
and Capital Stock — there being no property, the capital stock 
is valueless. However, examples of such a procedure are now 
rare, as most corporations whose products are obtained from 
natural deposits or growth charge their cost of production with 
the cost (actual or estimated) of the material removed, crediting 
their property accounts. The principle is well illustrated by a 
comparison of two coal mining companies — one leasing and the 
other owning its property. The former pays a royalty of a 
certain amount per ton mined, which is charged to cost. The 
latter has paid for its coal in advance by buying the property; 
therefore, cost should be charged at a rate per ton representing 
the total cost of the property divided by the estimated total 
tonnage — the Property account being credited. Under such a 
methcxl, the total net profit shown by the books may be distrib- 
uted, and after the property is exhausted and all liabilities paid, 
the Capital Stock account will be offset by cash or some invest- 
ment thereof other than property. Manifestly, if adequate pro- 
vision for depletion be made by charges to surplus, any distribu- 
tions to stockholders not in excess of the credits to surplus are 
dividends out of income. They can constitute repayments on 
account of capital only to the extent that they exceed the 
credits to surplus. 

'From a thesis on Corporation Ora:anization and Accountine^ by 
William H. Bell. Accepted by the St. Louis University in partial fulfillment 
of the requirements for the degree of Master of Commercial Science. 



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CORPORATION ACCOUNTING 85 

"Some mining corporations in making provision for deple- 
tion of mineral deposits credit the amounts to reserves instead 
of to the property accounts. Then they make distributions to the 
stockholder, in addition to regular dividends, said to be out of 
the depletion reserves and, therefore, constituting repayments on 
account of capital. If the distributions were actually charged 
to the depletion reserves, the provisional charges to surplus 
would be nullified, as the net book value of the property would 
not be reduced; but the distributions would constitute repay- 
ments on account of capital only if the entire net income credited 
to surplus had been paid out as dividends. Regardless of the 
bookkeeping entries, if the company makes provision for deple- 
tion, the rule stated above holds; namely, that any distributions 
to stockholders, under whatever designation, constitute repay- 
ments of capital only to the extent that they cause a deficit 
to be shown in the accounts." 

Who May Declare Dividends. Except in case of specific 
limitation imposed by the statutes, the Articles of Incorpora- 
tion, or the by-laws of the corporation, the directors have entire 
control over the declaration of dividends. Hpwever, there are 
circumstances under which the stockholders may institute pro- 
ceedings in a court of equity to compel a distribution of divi- 
dends. 

Cases are -numerous in which the minority stockholders 
have brought successful legal action against the directors com- 
pelling them to declare dividends. In these cases, the stock- 
holders proved that the directors were not acting in good faith, 
but were concealing the true profits by paying themselves large 
salaries as officers and that they were withholding profits not 
actually needed in the business. When it can be shown that 
the boat-d of directors is guilty of fraud or misappropriation of 
the corporate funds, and refuses to declare dividends when the 
corporation has a surplus which can be divided among the 
stockholders without detriment to the business^ it may be 
forced by the stockholders to make a distribution of profits. 

Surplus Available for Dividends. In the case of non- 
cumulative preferred stock, it will readily be seen that should 
the directors not declare a dividend, the stockholders may lose 
their right to dividends; hence, the courts will be more likely 
to take action. There is one outstanding fact in the distri- 
bution of dividends, and that is the board of directors cannot 
declare dividends except out of profits. Even when profits 
justify a dividend, the matter is left largely to the discretion 
of the board of directors. While there seems to be no doubt 
but that dividends may be declared out of surplus resulting 
from appreciation of assets, donations by stockholders, or from 
surplus resulting from the sale of stocks and bonds at a pre- 
mium, it is doubtful if such a distribution of the surplus would 
represent a wise policy. 



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86 PUBLIC ACCOUNTING AND AUDITING 

Dividends on Stock Not Fully Paid. Subscribers to be 
entitled to dividends must have paid for their stock in full, and 
such stock must be recorded in their names. Only stockholders 
of record are entitled to dividends. If it happens that all sub- 
scribers have made only partial payments on stock subscriptions 
and if they are all on the same basis, a dividend may be dis- 
tributed. The question then arises as to whether the dividend 
should be credited to the stock accounts of the subscribers or 
should be paid in cash. Either plan may be adopted. The 
better plan would seem to be to credit the accounts of the 
subscribers with the amount of the dividend, thus reducing the 
amount due on account of their subscriptions. 

Dividends Paj^ble Only to Stockholders of Record. 

Since dividends are payable only to holders of record, it will 
be seen that a stockholder to be entitled to his share of the 
dividend must see that his holdings are properly recorded on 
the books of the company. Usually the directors, when declaring 
a dividend, specify that it is to be paid to all stockholders of 
record on a certain date. When purchasing outstanding capital 
stock, it is important that it be immediately transferred on the 
books of the issuing company. Original issues of capital stock 
should, of course, be properly recorded without any action on 
the part of the subscriber. 

Dividends on Preferred and Common Stock. Divi- 
dends on preferred stock must be paid before the common 
stockholders share in the dividend. If the dividend on preferred 
stock is cumulative, then all dividends in arrears must be paid 
before common stockholders are to share in the dividends. 
After the preferred stockholders are satisfied, all the common 
stockholders share alike in the dividends. While the dividends 
on preferred stock may be limited to a certain per cent., usually 
six or seven per cent., no such limitation exists as to common 
stock. All dividends must be equal as between holders of the 
same class oT stock, whether preferred or common. Holders of 
either class of stock cannot be favored either as to time of 
payment or as to the amount of payment. The usual plan is 
for the company to mail all dividend checks at the same time. 

Treasury Stock Does Not Draw Dividends. To pay 

dividends on stock held in the treasury would constitute a pay- 
ment by the company to itself. Sometimes the stock is held 
by a trustee, in which case dividends may be paid thereon, 
and the trustee will be charged for the amount paid. 

Stock Dividends. Dividends may be paid in stock instead 
of in cash when the company has the right to increase the 
capital stock. This may be done when all the stock authorized 
has never been issued or when the company secures permission 
to increase the amount of its capital stock. 



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CORPORATION ACCOUNTING 87 

3. ACCOUNTING FOR DIVIDENDS 

No difficulties are encountered in the accounting for divi- 
dends. Sound accounting requires that upon declaration of a 
dividend, it should be charged to Profit and Loss or Surplus 
and credited to the Dividend account. When payment is made, 
such payments should be charged to the Dividend account. 
The Dividend account will balance when the total dividend 
has been distributed. In a small or close corporation the di\'i- 
dend might be distributed in cash as soon as declared. In such 
cases, the dividend might be immediately charged to Profit and 
Loss or Surplus, though it is doubtful if this would be considered 
the best procedure. It would seem more sound in all cases to 
set up a Dividend account, numbering each consecutive dividend. 

How Dividends are Paid. In a small corporation the 
dividend might be paid in cash or by check and the stockholders 
may acknowledge receipt of same by signing the dividend list or 
record. In this case the payments will oe entered in the cash 
book and posted to the debit side of the Dividend account, 
writing the name of each stockholder in the explanation column. 
It will, however, be seen that in a large corporation this pro- 
cedure would not be practical. 

To avoid the necessity of making a large number of entries 
in the cash book for dividend payments and posting such entries 
to the Dividend account, one check may be drawn for the 
amount of the dividend. This check will be deposited in the 
bank as a special dividend fund. Another check book may 
be used to draw individual checks against this fund. At the 
time the dividend check is deposited, an entry should be made 
crediting Cash and debiting a special Dividend Drawing ac- 
count. As the dividend checks are presented for payment at 
the bank, and when the bank has submitted a statement 
thereof, the amount paid is credited to the Dividend Drawing 
account and debited to the Dividend account. When this plan 
is carried out, the balance of the Dividend account represents 
checks outstanding. The balance of the Dividend account 
is, however, offset by the balance of the Dividend Drawing ac- 
count. 

Entries Incident to Distribution of a Cash Dividend. 

This is the most common form of distributing a dividend; in 
fact, it is the usual method pursued. The accounting procedure 
is indeed simple and seldom are any difficulties encountered. 

Proposition A 

To illustrate the proper procedure, let us assume that the 
Johnson Manufacturing Co. has an outstanding capital stock of 
$100,000.00 and a surplus of $25,000.00. The board of directors, 
at its annual meeting on December 31, 1920, declares a divi- 
dend of 10 per cent, payable in cash to stockholders of record 
on February i, 1921. 



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88 PUBLIC ACCOUNTING AND AUDITING 

Solution 

At the time of the declaration of the dividend the foU 
lowing entry should be made in the corporation journal : 

December 31, 1920 

Surplus $10,000.00 

Dividend No. i $10,000.00 

A dividend of 10% payable 
to stockholders of record on Feb- 
ruary I, 1921, has this date been 
declared by the board of direct- 
ors, as per minutes of meeting. 

The bookkeeper might next prepare a dividend list showing 
the number of the dividend, date declared, date payable, name 
and address of each stockholder, number of shares owned, 
amount of dividend to be paid, date of payment and number 
of dividend check. If it is desired to add a column providing 
for the signatures of the stockholders upon receipt of dividend 
it may be done, and the plan may be carried out without diffi- 
culty in the case of a small corporation. 

Assuming that the corporation on February i, 1921, drew 
a check for $10,000.00 and deposited in the bank as a special 
dividend fund, the following entry may be made in the cash 
book: 

February 1, 1921 

Deposit for Dividend No. i $10,000.00 

Cash $10,000.00 

Deposited $10,000.00 in 
First National Bank as a special 
fund for dividend purposes. 

Individual checks may now be written in favor of each 
stockholder of record for the amount of the dividend to which 
he is entitled. These checks should be mailed on the same 
date to all the stockholders. It would be best to use a special 
check book for this purpose, because these checks are drawn 
against the special fund deposited for dividend purposes, and 
the writing of these checks in no way affects the company's 
regular bank account. Nothing more than a memorandum 
entry need be made on the books. Let us further assume that 
on February 28 the bank renders a statement showing that all 
dividend checks have been presented for payment. The only 
entry necessary at this time is what might be termed an ''ad- 
justing" entry In the corporation journal. 



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CORPORATION ACCOUNTING 89 

February 28, 1921 

Dividend No. i $10,000.00 

Deposit for Div. No. i $10,000.00 

All dividend checks issued 
February i, 1921, have been 
honored by the bank per bank 
statement of this date. 

If all dividend checks had not been paid by the bank, the 
adjusting entry should be made the same as above with the 
exception that the amount charged to the Dividend account 
and credited to the Deposit account would represent the exact 
total of dividend checks honored by the bank. The balance of 
the Dividend account is the same as the balance of the Deposit 
account, and is equal to the total of dividend checks outstanding 
which have not as yet been presented to the bank for payment. 

Entries Incident to Distribution of a Property Divi- 
dend. We have already shown in this discussion that the 
board of directors may declare a dividend in property, such as 
liberty bonds. 

Proposition B 

To illustrate the proper procedure, let us assume that the 
Johnson Manufacturing Company owned liberty bonds with 
a par value of $15,000.00 and the board of directors had decided 
in their meeting on December 31, 1920, that a dividend of 10 
per cent, should be paid by distributing liberty bonds on Feb- 
ruary I, 1921. 

Solution 

There is only a slight change in the accounting for a property 
dividend as compared with a cash dividend. There appears 
below the necessary entries in journal form with suitable ex- 
planation but without further comment: 

December 31, 1920 

Surplus $10,000.00 

Dividend No. i $10,000.00 

A dividend of 10%, payable 
in liberty bonds to stockholders 
of record on February i, 192 1, 
has this date been declared by 
the board of directors as per 
minutes of meeting. 



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90 PQBLIC ACCOUNTING AND AUDITING 

February 1, 1921 

Dividend No. i $10,000.00 

Liberty Bonds $10,000.00 

A 10% dividend has this 
day been distributed to stock- 
holders in liberty bonds. 

Entries Incident to Distribution of a Scrip Dividend. 

Scrip is a certificate of indebtedness constituting a promissory 
note, and the object of its issue is to retain the funds temporarily 
in the hands of the company for working capital. Such certifi- 
cates may be interest-bearing, and there are instances where 
long-term scrip certificates have been issued on which stock- 
holders were entitled to dividends, though this is not common. 



Proposition C 

To illustrate the proper procedure, let us assume that the 
Johnson Manufacturing Co. declared the regular annual divi- 
dend of 10 per cent, on December 31, 1920, payable in 6 per cent, 
scrip to stockholders of record on February i, 192 1, the 
scrip certificates to be payable six months after date of issue. 

Solution 

There follows a series of journal entries incident to the 
declaration and payment of a scrip dividend per the above 
proposition. 

December 31, 1920 

Surplus $10,000.00 

Dividend No. i $10,000.00 

A dividend of 10%, payable 
to stockholders of record on Feb- 
ruary I, 1 92 1, has this day beejj 
declared by the board of di- 
rectors as per minutes of meet- 
ing. The scrip certificates are 
payable in cash with interest at 
6% six months after date of 
issue. 

February 1, 1921 

Dividend No. i $10,000.00 

Dividend Scrip $10,000.00 

Scrip payable, amounting to 
$10,000.00, has this day been 
distributed to stockholders as a 
dividend. 



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CORPORATION ACCOUNTING 91 

August 1, 1921 

Dividend Scrip $10,000.00 

Interest 300.00 

Cash $10,300.00 

Scrip payable, $10,000.00, 
with interest at 6%, $300.00, has 
this day been paid in cash. 

Entries Incident to Distribution of Stock Dividends. 

If a dividend is paid in stock, the accounting procedure will 
not diflfer materially. If treasury stock is distributed, the credit 
will be to Treasury Stock account instead of to a cash or prop- 
erty account. If unissued capital stock is distributed, the 
credit will be to Unissued Capital Stock account. If no stock 
is held in the treasury and all authorized capital stock has been 
issued, the board of directors may secure permission to increase 
the capital stock and then distribute the unissued capital stock 
in the form of a dividend. In distributing a stock dividend 
the company really parts with nothing at all. Such a distribu- 
tion of dividend involves no withdrawal of cash or other assets. 
In fact, it is nothing more than a manipulation of the accounts. 
The value of a stockholder's interest in a corporation is not 
affected one cent by the distributioa of a stock dividend. It 
must be remembered that the value of a share of capital stock 
is not dependent upon the amount written on the certificate. 
The actual value of a share of stock may be quite different 
from its par value. If a corporation, capitalized at $100,000.00 
has built up a surplus of $100,000.00, it will readily be seen 
that the actual value of one share of stock will be $200.00 
while the par value is still $100.00. If a stock dividend of 
100 per cent, is distributed, the holder of one share of stock will 
be given another share, and, instead of owning one share of 
stock worth $200.00, he will then own two shares of stock 
worth $100.00 each. 

Proposition D 

To illustrate the proper procedure, let us assume that the 
Johnson Manufacturing Co. held $10,000.00 of its^ own capital 
stock in the treasury, such stock having been acquired by pur- 
chase. The board of directors, December 31, 1920, decided to 
distribute a dividend of 10 per cent., payable in treasury stock 
on February i, 1921, all other conditions being the same as in 
Proposition A. 

Solution 

The following entries in journal form indicate the account- 
ing procedure in connection with the above proposition: 



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92 PUBLIC ACCOUNTING AND AUDITING 

December 31, 1920 

Surplus $10,000.00 

Dividend No. i $10,000.00 

A dividend of 10%, payable 
in treasury stock to stockholders 
of record on February i, 1921, 
has this day been declared by the 
board of directors as per min- 
utes of meeting. 

February 1, 1921 

Dividend No. i $10,000.00 

Treasury Stock $10,000.00 

Treasury stock, with a par 
value of $10,000.00, has this day 
been distributed to the stock- 
holders as a dividend. 

If the corporation had not issued all its authorized capital 
stock, it might have decided to distribute a stock dividend 
out of the unissued capital stock instead of treasury stock. The 
only difference in the accounting procedure in this case would 
be in the credit going to Unissued Capital Stock instead of to 
Treasury Stock. 

Dividend No. i $10,000.00 

Unissued Capital Stock $10,000.00 

Unissued capital stock, with 
a par value of $10,000.00, has 
this day been distributed to the • 
stockholders as a dividend. 

As to the benefits to be derived from a distribution of a 
stock dividend, we can do no better than to quote a paragraph 
from the "Principles of Accounting" by Paton and Stevenson. 

"The issue of a stock dividend, evidently, obscures the 
amount of accumulated surplus and the amount of original in- 
vestment. This statement suggests a common reason for such 
dividends. Corporations which are making huge profits, and 
which wish to pay but an ordinary rate of dividends on formal 
capitalization will often gradually transfer their accumulated 
earnings from the Surplus to the Capital Stock account. It 
is then possible to declare much larger aggregate cash dividends 
at the same normal rate on formal capital. In connection with 
public utilities, this practice may also be made the basis of an 
argument for the maintenance of rates. A corporation, it is 
urged, should be allowed a fair rate on its outstanding securities. 
Evidently, such an accounting practice gives the corporation 
an opportunity to beg the real question as to what rate per cent, 
is being earned, or should be allowed, on actual investment." 



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THEORY AND LEGAL QUESTIONS 93 

A. THEORY QUESTIONS 

1. What is a dividend? State when and how dividends 
become effective. State how declaration and payment of divi- 
dends are usually recorded in books of account. C. P. A. Ex. 

2. What do you understand by the term "dividends paid 
out of capital"? What, in your opinion, would constitute such 
payment, and mention any circumstances that may occur to 
you to justify such payment. C. P. A. Ex. 

3. How would the excessive distribution of dividends affect 
the individual stockholders of a corporation? C. P. A. Ex. 

4. In a case where the preferred shares of a company are 
issued under a provision that the annual dividends to which 
they shall be entitled shall be "cumulative," would you consider 
it necessary to show any arrears of dividends as a liability on the 
Balance Sheet, or how would you deal with it? C. P. A. Ex. 

5. An Indiana company is incorporated with a capital 
stock of $100,000.00, of which $90,000.00 was paid in. 

In making their application for the charter, all the stock 
was subscribed. Th^ full capital, however, was not required. 

It was recently decided that, inasmuch as a surplus of 
$15,000.00 had accumulated, they would declare a stock divi- 
dend, pro rata, for the $10,000.00 of stock unissued but sub- 
scribed for by one of the present stockholders. 

No action on the transaction was taken by the board of 
directors, and no record of it appears in the minutes of the 
corporation. 

Is it necessary that a transaction of this character be 
recorded in the minutes, inasmuch as all of the stock was origi- 
nally subscribed? 

What would be your recommendations in regard to the 
proper procedure in this matter? C. P. A. Ex. 



B. LEGAL QUESTIONS 

1. From what funds may dividends be paid, and who 
determines whether and when they shall be paid? Inst. Ex. 

2. What are the rights of the holders of preferred stock 
as to dividends? Inst. Ex. 

3. Some days before a cash dividend is declared A sells 
his shares to B, without stipulating as to the ownership of 
the dividends. Do they belong to A, who owned the stock 
when the dividend was earned, or to B, who owned it when 
the dividend was declared? C. P. A. Ex. 



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94 PUBLIC ACCOUNTING AND AUDITING 

4. (a) Discuss net profits out of which dividends may 
lawfully be declared and when, if at all, the capital may be 
distributed in dividends. 

(b) What right, if any, has a corporation to set off 
against the stockholders' share of the dividends a debt owed 
by him to the corporation at the time the dividend is declared? 

(c) Before a dividend has been declared, what right or 
action has a shareholder, both in law and equity, in case the 
dividend has been earned? C. P. A. Ex. 

5. A sells some railroad stock to B, who fails to have 
the certificate, which has been signed in blank on the back, 
replaced by a new one. A dividend is declared to stockholders 
of record, and the check is sent to A. 

Who is legally entitled to the dividend? Explain. 

C. P. A. Ex. 

C. ACCOUNTING PROBLEMS 

1. At a meeting of the board of directors of a corporation 
held August 15, 1920, the treasurer reported that the profits 
for the year as audited amounted to $118,574.00. It was voted 
that a stock dividend of $80,000.00 be paid October i, 1920, 
out of treasury stock, to the stockholders of record September 
15, 1920, and that $20,000.00 of the profits be distributed as 
a bonus to employes. 

Prepare the necessary entries to properly record the action 
of the directors as it appears in the minutes of the meeting. 
Also show entries for payment of bonus to employes and dis- 
tribution of dividend to stockholders on October i, 1920. 

C. P. A. Ex. 

2. The books of the Butter, Egg & Cheese Company, 
with an authorized and outstanding capital stock issue of $25, 
000.00, are kept by single entry. 

It annually inventories all of its assets and liabilities and 
from such inventory prepares a financial statement. At Decem- 
ber 31, 1913, this inventory is as follows: 

Office Cash $ 1,584.00 

Balance Bank, A 10,824.00 

Accounts Receivable 29,521.00 

10 Shares Stock in Competing Company 1,000.00 

Plant and Equipment 64,938.00 

Merchandise Inventory 21,737.00 

Prepaid Expenses 5,081.00 

Overdraft Bank, B 5,003.00 

Accounts Payable 19,747.00 

Mortgage Payable 25,000.00 

Notes Payable 20,000.00 



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ACCOUNTING PROBLEMS 9S 

From a comparison of the financial statements at the 
beginning and end of year, you find that the item of Plant 
and Equipment is stated in an amount less by $11460.00 than 
it was at the beginning of the year, plus additions during the 
year. 

The financial statement for the beginning of year showed 
a surplus of $35»703.oo. 

From your analysis of the disbursements and unpaid Ac- 
counts Payable at beginning and end of year, you find a total 
of purchases amounting to $661,910.00 and expenses for salaries, 
wages, supplies, repairs, etc., amounting to $120,115.00. 

The purchases, however, included $450.00 paid out for 
John Smith, an employe, for which he had not reimbursed the 
company, and the total expenses of $120,1 15.00 included $250.00 
in the hands of a buyer as a working fund. 

The inventory of merchandise at the beginning of the 
year was $18,125.00 and of prepaid expense was $2,653.00. 

There was canceled on the customers* ledger during the 
year $3,206.00 of uncollectible accounts. 

There was paid for interest and discount on Notes Payable 
$1,061.00 and for interest on mortgage $1,500.00. 

A 10% dividend was declared but not paid. 
From the foregoing prepare — 

(a) A Balance Sheet as at December 31, 1913. 

(b) A Profit and Loss statement exhibiting Net Sales, 
Cost of Sales and Gross and Net Profit for the year. 

C. P. A. Ex. 

3. Below is the Balance Sheet of the X. L. O. Mfg. Co., 
January i, 1920: 



ASSETS 

Cash $ 31,718.40 

Accounts Receivable. . 118,455.00 

Inventory: 

Raw Material 50,560.80 

Finished Goods 18,958.20 

Office Furniture and 

Fixtures 4,500.00 

Land 108,000.00 

Machinery 150,000.00 

Buildings 90,000.00 

Total Assets $572^19240 



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g6 PUBLIC ACCOUNTING AND AUDITING 

LIABILITIES 

Accounts Payable $21,289.20 

Dividends Payable, Preferred 

Stock, February i, 1920. . . . 4,500.00 
Dividends Payable, Common 

Stock, February i, 1920. . . . 6,000.00 
Twenty- Year Mortgage Bonds, 

6%, dated January i, 1919.. 60,000.00 

Premium on Bonds 3,000.00 

Capital Stock, Preferred 150,000.00 

Capital Stock, Common 300,000.00 

Reserve for Bad Debts 2,830.80 

Surplus 24,572.40 

Total Liabilities and Net 

Worth $572,19240 

The transactions for the year ending December 31, 1920, 
were as follows: 

Cash Received from Customers $476,100.60 

Rents Received 360.00 

Raw Materials Purchased 147,840.00 

Sales 494,000.40 

Discount and Allowances on Sales 14, 11 1.40 

Bad Debts Charged Off 1,285.80 

Cash Disbursements: 

Accounts Payable $146,013.60 

Factory Expenses 4,493.40 

Factory Labor 210,855.60 

Factory Repairs 14,305.80 

Office Expense 1,156.20 

Selling Expense 31,748.40 

Salaries 35,082.60 

Taxes 4,711.80 

Inventories December 31, 1920: 

Raw Material $ 54,462.54 

Finished Goods 18,505.20 

Land Estimated at 120,000.00 

Semiannual dividends of 3% on preferred and 2% on 
common stock, declared in June and December, payable August 
I and February i. Reserve for depreciation of buildings, 3%; 
machinery, 5%; office furniture and fixtures, 10%, and bad 
debts reserve, 2% of accounts receivable. 

Prepare: Operating statement and Balance Sheet as on 
January i, 192 1. 

Assume that the semiannual bond interest of $1,800.00 was 
paid when due. 

C. P. A. Ex. 



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Chapter Seven 

CORPORATION ACCOUNTING 
1. ACCOUNTING THEORY 

Combinations. The public accountant in these times is 
frequently called upon to draft organization entries, prepare 
annual statements, make audits, and prepare tax returns for 
holding companies and corporations representing combinations 
of two or more companies. Such combinations are the result 
of mergers and consolidations for the purpose of controlling the 
operations of affiliated or subsidiary companies. 

Merger. A merger is brought about through amalgama- 
tion of constituent companies. No new corporation is formed. 
One company simply acquires title to the property of another 
company. 

Kester says: 'The rights, franchises and interest are 
deemed to be transferred to and vested in the corporation into 
which the various companies have been merged without any 
deed or transfer, and the liabilities follow the rights." 

Accounting in Connection with Mergers. Ordinarily 
no difficult accounting problems are encountered in connection 
with the formation of mergers. Cox, in "Business Accounting," 
says: "The purchase transaction if simple and usual in char- 
acter, may be recorded in one journal entry, which, reduced to 
the most simple terms, consists of a list of assets of the subsi- 
diary concern offset by its liabilities, capital stock, and profit 
or surplus." In other words, if one corporation purchases the 
entire property of another corporation, the accounts may be 
consolidated on the books of the purchasing company by draft- 
ing a journal entry, debiting the assets acquired, crediting the 
liabilities assumed, and crediting Cash for the difference which 
represents the purchase price. Of course, it is true, that many 
peculiar accounting questions may be encountered in the valua- 
tion of the property items and in the statement of the liabilities. 
The above discussion, however, is applicable after the books 
of the merged company have been audited and a Balance Sheet ' 
prepared to show true values. 

Kester says: "The bookkeeper is not concerned with the 
valuation of any of the items taken over, but must make his 
entries in accordance with the valuation report turned in by 
the appraisal committee. The main problem in the merger, 
then, is of valuation and not of accounting." 

Holding Companies. The formation of a holding com- 
pany may be brought about through the organization of a new 
company for the purpose of acquiring the controlling interest 
in certain subsidiary companies and controlling their operations. 
In states where the law permits, one company may simply pur- 
chase all or a majority of the capital stock of other companies, 

97 



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98 PUBLIC ACCOUNTING AND AUDITING 

with the idea of controlling their operations. In the former in- 
stance, the holding company is usually a financial organization. 
Its income is derived entirely from dividends of its subsidiary 
companies. In the latter, the holding company is both a finan- 
cial and an operating organization. It can readily be seen that 
the Balance Sheet of a holding company, which is nothing more 
than a financial organization, would show nothing more than 
its investments in subsidiary companies as assets and capital 
stock and surplus as liabilities, plus accounts resulting from 
intercompany transactions. 

Advantages of Consolidation. The advantages of con- 
solidation may be summed up briefly as follows: 

1. Reduction of Expenses. By reducing the number of 
salesmen in common territory made possible by elimination of 
competition, by eliminating duplicate executive officers, and by 
consolidating certain departments, selling and administrative, 
expenses may be reduced. 

2. Specialization. By specialization along certain lines 
in each factory, duplication in manufacturing and equipment 
may be eliminated. Each factory may confine itself to a product 
which it is best fitted to produce most economically, either be- 
cause of location, equipment, or labor conditions. 

3. Release of Working Capital. After consolidation, 
the surplus stock of finished goods, stock patterns and sizes, 
may be much smaller than the stock previously carried by all 
the companies when operated independently; hence a smaller 
amount of working capital is tied up in surplus stock to meet 
future demands, resulting in additional working capital for other 
operations. 

4. Better Qualified Men. The consolidated company 
with its larger organization, greater production, and broader 
opportunities, naturally attracts men of higher qualifications 
and greater ability for executive positions. The company is 
able to employ better qualified men since the cost may be dis- 
tributed over all the constituent companies and need not nec- 
essarily be borne entirely by a single company. 

5. Ease in Securing Capital. The consolidated company 
possesses better facilities for borrowing money and obtaining 
additional capital when needed. The holding company may be 
able to finance certain subsidiary companies as a result of its 
ability to borrow money, whereas the subsidiary company 
operating independently might be seriously handicapped be- 
cause of its inability to borrow money. 

6. Larger Profits. More substantial profits and less 
danger of unexpected losses result from a partial monopoly and 
an opportunity to regulate the selling price without being 
influenced by the supply in demand, or by competition. How- 



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CORPORATION ACCOUNTING 99 

ever, should the holding company operate unfairly and elimi- 
nate competition to the extent of ''restraining" trade, it may 
come into conflict with such laws as the Sherman Anti-Trust 
Law and the Clayton Act. 

7. Elimination of Competition. This was touched upon 
in the preceding paragraph. The effect of consolidation is 
to eliminate competition between the consolidated companies. 
The affiliated companies, by agreement, may regulate prices, 
divide territories, distribute material and products, etc. It 
will be seen that if all the companies producing a certain product 
were to amalgamate, they would be in a position to entirely 
control prices of their products. Competition would be elimin- 
ated. Such an affiliation of concerns is commonly known as a 
monopoly or trust. 

Consolidated Statements. As has already been stated, 
when a merger is completed, the accounts are usually consoli- 
dated by means of a journal entry on the books of the pur- 
chasing company. This is a simple procedure. The books of 
the merged companies are closed and the companies dissolved. 
With the formation of a holding company, there is no change 
in the financial accounts of the subsidiary companies. They 
are not dissolved, but continue to operate and to keep accounts 
entirely independent of the holding company's accounts. There- 
fore, in preparing statements that will show true conditions and 
results of the operations of all the companies comprising the 
consolidation, it is necessary to prepare consolidated statements. 
A Balance Sheet of the holding company would not show the 
financial condition of the subsidiary companies upon which the 
holding company is dependent. 

Dickinson, in ''Accounting, Practice and Procedure," says: 
"By reason of the misleading character of the ordinary Balance 
Sheet in such cases, there has been evolved the Consolidated 
Balance Sheet; the basis of which is the recognition of the 
common-sense fact that a network of companies connected with 
each other by control of stockholdings is still, in effect, one 
undertaking, and that if the stockholders in the holding company 
are to have before them a clear statement of its position, legal 
technicalities must be brushed to one side, and the position of 
the holding company shown in its relation, not to these sub- 
companies, but to the general public. The position of the hold- 
ing company can be changed only by outside influences affecting 
itself or its constituent companies, and not by any change in 
the relation between itself and these companies, or in the re- 
lation among the latter. The Consolidated Balance Sheet 
represents the true position of the whole group of the constitu- 
ent companies to the outside world, and is thus not the Balance 
Sheet of a corporation, but of a condition after eliminating all 
the relations of the constituent companies one to another." 



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100 PUBLIC ACCOUNTING AND AUDITING 

2. INCOME TAX PROCEDURE 

Consolidated Returns. Corporations which are affiliated 
are required to submit consolidated returns of tiheir income 
and invested capital. The taxes are computed and determined 
on Uie basis of the consolidated return. 

Income Tax Law. (Section 240-A.) That coiporations 
which are affiliated within the meaning of this section shall, 
under regulations to be prescribed by die Commissioner with 
the approval of the Secretary, make a consolidated return of 
net income and invested capital, ♦ ♦ ♦ and the taxes there- 
under shall be computed and determined upon the basis of such 
return. 

How Tax is Assessed. The tax is assessed upon the basis 
of the consolidated return, and is computed as'an account and 
then assessed upon the respective affiliated corporations in 
such proportions as they may agree upon. Or, in the absence 
of an agreement among the affiliated corporations, it is assessed 
on the basis of the net income properly assignable to each of 
the affiliated corporations. 

Income Tax Law. (Section 240-A.) In any case in which 
a tax is assessed upon the basis of a consolidated return, the 
total tax shall be computed in the first instance as a unit and 
shall then be assessed upon the respective affiliated corporations 
in such proportions as may be agreed upon among them, or, 
in the absence of any sudi agreement, then on the basis of 
the net income properly assignable to each. There shall be 
allowed in computing the income tax only one specific credit 
of $2,000.00 (as provided in Section 236); in computing the 
war-profits credit (as provided in Section 311) only one specific 
exemption of $3,000.00; and in computing the excess-profits 
credit (as provided in Section 312) only one specific exemption 
of $3,000.00. 

When Corporations are AflSUated. (Reg. 45.) Corpora- 
tions will be deemed to be affiliated (a) when one domestic cor- 
poration owns directly or controls through closely affiliated inter- 
ests or by a nominee or nominees substantially all the stock of the 
other or others, or (b) when substantially all the stock of two 
or more domestic corporations is owned or controlled by the 
same interests. The words * 'substantially all the stock can- 
not be interpreted as meaning any particular percentage, but 
must be construed according to the facts of the particular case. 
The owning or controlling of 95 per cent, or more of the out- 
standing voting capital stock (not including stock in the treasury) 
at the beginning of and during tlie taxable year will be deemed 
to cohstitute an affiliation within the meaning of the statute. 
Consolidated returns may, however, be required even though the 
stock ownership is less than 95 per cent. When the stock owner- 
ship is less than 95 per cent., but in excess of 50 percent., a full 



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CORPORATION ACCOUNTING loi 

disclosure of affiliations should be made, showing all pertinent 
facts, including the stock owned in each subsidiary or affiliated 
corporation and the percentage of such stock owned to the 
total stock outstanding. Such statement should preferably be 
made in advance of filing the return, with a request for instruc- 
tions as to whether a consolidated return should be made. In 
any event' such a statement should be filed as a part of the 
return. The words ''the same interests" shall be deemed to 
mean the same individual or partnership or the same individuals 
or partnerships, but when the stock of two or more corporations 
is owned by two or more individuals or by two or more partner- 
ships, a consolidated return is not required unless the percentage 
of stock held by each individual or each partnership is sub- 
stantially the same in each of the affiliated corporations. 

Income Tax Law. (Section 240-B.) For the purpose of 
this section two or more domestic corporations shall be deemed 
to be affiliated (i) if one corporation owns directly or controls 
through closely affiliated interests or by a nominee or nominees 
substantially all the stock of the other or others, or (2) if sub- 
stantially all the stock of two or more corporations is owned or 
controlled by the same interests. 

Affiliated Corporations. (Reg. 45.) The provision of the 
statute requiring affiliated corporations to file consolidated returns 
is based upon the principle of levying the tax according to the true 
net income and invested capital of a single business enterprise, 
even though the business is operated through more than one 
corporation. Where one corporation owns the capital stock of 
another corporation or other corporations, or where the stock 
of two or more corporations is owned by the same interests, a 
situation results which is closely analogous to that of a business 
maintaining one or more branch establishments. In the latter 
case, because of the direct ownership of the property, the in- 
vested capital and net income of the branch form a part of the 
invested capital and net income of the entire organization. 
Where such branches or units of a business are owned and con- 
trolled through the medium of separate corporations, it is nes- 
essary to require a consolidated return in order that the invested 
capital and net income of the entire group may be accurately 
determined. Otherwise opportunity would be afforded for the 
evasion of taxation by the shifting of income through price 
fixing, charges for services and other means by which income 
could be arbitrarily assigned to one or another unit of the group. 
In other cases without a consolidated return, excessive taxation 
might be imposed as a result of purely artificial conditions ex- 
isting between corporations within a controlled group. 

Filing Consolidated Returns. (Reg. 45.) Affiliated cor- 
porations are required to file consolidated returns on Form 11 20. 
The consolidated return shall be filed by the parent or principal 
reporting corporation in the office of the collector of the district 



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102 PUBLIC ACCOUNTING AND AUDITING 

in which it has its principal office. Each of the other affiliated 
corporations shall file in the office of the collector of its district 
Form 1 122, along with the several schedules indicated thereon. 
The parent or principal corporation filing a consolidated return 
shall include in such return a statement specifically setting forth 
(a) the name and address of each of the subsidiary or affiliated 
corporations included in such return, (b) the par value of the 
total outstanding capital stock of such corporations at the 
beginning of the taxable year, (c) the par value of such capital 
stock held by the parent corporation or by the same interests 
at the beginning of the taxable year, (d) in the case of affiliated 
corporations owned by the same interests, a list of the individ- 
uals or partnerships constituting such interests, with the per- 
centage of the total outstanding stock of each affiliated cor- 
poration held by each of such individuals or partnerships during 
all of the taxable year, and (e) a schedule showing the propor- 
tionate amount of the total tax which it is agreed among them 
is to be assessed upon each affiliated corporation. Foreign cor- 
porations and personal service corporations need not file con- 
solidated returns. 

Personal Service Corporation. (Reg. 45.) A corporation 
cannot be considered a personal service corporation when another 
corporation owns or controls substantially all of its stock, or when 
substantially all of its stock and of the stock of another cor- 
poration (not itself a personal service corporation) forming part 
of the same business enterprise is owned or controlled by the 
same interests. 

Consolidated Net Income of Affiliated Corporations. 

(Reg. 45.) Subject to thp provisions covering the determination of 
taxable net income of separate corporations, and subject further 
to the elimination of intercompany transactions, the consolidated 
taxable net income shall be the combined net income of the 
several corporations consolidated, except that the net income 
of corporations coming within the provisions of Article 635 shall 
be taken out. In respect of the statement of gross income and 
deductions and the several schedules required under Form 1120, 
a corporation filing a consolidated return is required to prepare 
and file such statements and schedules in columnar form to the 
end that the details of the items of gross income and deductions 
for each corporation included in the consolidation may be 
readily audited. 

Domestic Corporation Affiliated with Foreign Corpora- 
tion. (Reg. 45.) A domestic corporation which owns a majority 
of the stock of a foreign corporation shall not be permitted or 
required to include the net income or invested capital of such 
foreign corporation in a consolidated return, but for the purpose 
of Section 238 of the statute, a domestic corporation which owns 
a majority of the voting stock of a foreign corporation shall be 
entitled to credit its income, war-profits and excess-profits 



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CORPORATION ACCOUNTING 



103 



taxes with any income, war-profits or excess-profits taxes paid 
(but not including taxes accrued) by such foreign corporation 
during the taxable year to any foreign country or to any pos- 
session of the United States upon income derived from sources 
without the United States in an amount equal to the propor- 
tion which the amount of any dividends (not deductible under 
Section 234) received by such domestic corporation from such 
foreign corporation during the taxable year bears to the total 
taxable income of such foreign corporation upon or with respect 
to which such taxes were paid. But in no such case shall the 
amount of the credit for such taxes exceed the amount of such 
dividends (not deductible under Section 234) received by such 
domestic corporation during the taxable year. 

3. ACCOUNTING PRACTICE 

Proposition A 

The following problem is stated for the purpose of illus- 
trating the preparation of consolidated statements. A solution 
with detailed discussion of principles involved follows the state- 
ment of the problem. 

A, a holding company, which is also an operating company, 
owns 95% of the stock of B, and 100% of the stock of C. The 
stock of B appears on the books of A at $80,000.00. The stock 
of C appears on the books of A at $175,000.00. The surplus 
of B at date of acquisition was $5,000.00, and the surplus of 
C at date of acquisition was $25,000.00. Dividends during the 
year following acquisition were paid as follows: B, $10,000.00; 
A, $100,000.00. 

Balance Sheets of A, the holding company, and of B and 
C, subsidiary companies, appear as follows; 



A (HOLDING COMPANY) 
Balance Sheet 



Assets 

Cash 

Accounts Receivable . . . 


$150,000.00 
175,000.00 

330,000.00 

80,000.00 

175,000.00 

100,000.00 

35,000.00 

350,000.00 

900,000.00 

2,075,000.00 


Liabilities 

Accounts Payable $ 50,000.00 

Notes Payable 100,000.00 


Inventories 

Investments: 

B, Capital Stock (par 
value $05,000.00) . 

C, Capital Stock (par 
value $100,000.00).. 

Intercompany Accounts 

Deferred Charges 

Goodwill 


Bonds 500,000.00 

Net Worth: 

Capital Stock 1,000,000.00 

Surplus 435,000.00 


Properties $1,000,000.00 
Less Depr. , 100,000.00 




$ 


$3,075,000.00 



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104 



PUBLIC ACCOUNTING AND AUDITING 



B 
Balance Sheet 



Assets 

Cash $ 10,000.00 

Accounts Receivable . . . 50,000.00 

Inventories 100,000.00 

Goodwill 50,000.00 

Properties . . $1 00,000.00 

Less Depr.. 10,000.00 90,000.00 



$300,000.00 



Liabilities 

Accounts Payable $ 75,000.00 

Intercompany Accounts 85,000.00 

Notes Payable 30,000.00 

Net Worth: 

Capital Stock 100,000.00 

Surplus 10,000.00 

$300,000.00 



Balance Sheet 



Assets 
Cash t 20,000.00 



Inventories. 

Properties. .$200,000.00 

Less Depr. 20,000.00 



75,000.00 

180,000.00 

$275,000.00 



Liabilities 

Accounts Payable $ 70,000.00 

Intercompany Accounts 5,000.00 
Net Worth: 

Capital Stock 100,000.00 

Surplus 100,000.00 

$275,000.00 



Draft journal entries to make necessary adjustments and 
eliminate intercompany transactions. Prepare Consolidated 
Balance Sheet. 

Solution 

Stock Acquired at a Discount. It will be noted that 
the surplus of B at time of acquisition by A, the holding company, 
amounted to $5,000.00. The par value of B's capital stock was 
$100,000.00. A purchased 95% of the capital stock, or $95,- 
000.00, and in addition 95% of the surplus, or $4,750.00. This 
investment appears on the books of A at $80,000.00, conse- 
quently it is evident that the stock was acquired at a discount. 
It is generally held that a premium paid above par value repre- 
sents good will, but in case the price paid falls below the sum 
of the surplus and par value of the capital stock purchased, it 
is an indication that the assets on the subsidiary companies' 
books are overvalued. In either case, an adjustment must be 
made through the Property or Good Will accounts. In this 
problem, the adjustment can be made for the discount on 
stock purchased from B by means of a credit to Good Will for 
the difference between the amount paid and the book value on 
the books of A. 

(i) B, Capital Stock $95,000.00 

Surplus , 4,750.00 ' 

Investment in B, Capital 

Stock $80,000.00 

Good Will 19,750.00 



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CORPORATION ACCOUNTING 105 

Minority Stockholders' Holdings. After making the 
above adjustment, it will be seen that ^5,000.00 of the capital 
stock remains in the hands of the minority stockholders. In 
other words, it is left in the hands of the general public. It 
is desired to show separately the outstanding capital stock 
of the holding company from the stock of the subsidiary com- 
panies not owned by the holding company, hence the following 
adjusting entry: 

(2) B, Capital Stock $5,000.00 

Minority stockholders' hold- 
ings in B, Cap. Stock $5,000.00 

Par value of B, Capital Stock, 
not held by controlling company, 
but remaining in the hands of the 
public. 

Surplus. It will still be noted that of the surplus on the 
books of B at date of acquisition, there remains $250.00 that 
has not been adjusted. This is the proportion of the surplus 
at that date applicable to the stock held by minority stock- 
holders, and this should be transferred from surplus to the 
account with Minority Stockholders. 

(3) Surplus $250.00 

Minority stockholders' in- 
terest in Surplus of B $250.00 

Proportion of surplus of B at 
date of acquisition applicable to 
stock in the hands of minority 
stockholders. 

The actual surplus on the books of B at date of above 
Balance Sheet is $10,000.00. hence it is evident that $5,000.00 
of this surplus has accrued since date of acquisition. 5% of 
this is applicable to the stock owned by minority stockholders 
and this must be transferred to their account. 

(4) Surplus. $250.00 

Minority stockholders* in- 
terest in Surplus of B $250.00 

Proportion of surplus of B 
since date of acquisition applicable 
to stock in the hands of minority 
stockholders. 

Stock Acquired at a Premium. In acquiring the capital 
stock of C, it will be noted that the holding company purchased 
all the capital stock, amounting to $100,000.00. At date of 
acquisition, the surplus of C amounted to $25,000.00, hence the 
book value of the capital stock acquired by A amounts to 
$125,000.00. This is carried on the books of A at $175,000.00. 
The holding company paid a premium of $50,000.00 on die stock 
acquired. It is, therefore, evident that A has paid $50,000.00 
for good will. 



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io6 PUBLIC ACCOUNTING AND AUDITING 

(5) C, Capital Stock $100,000.00 

C, Surplus 25,000.00 

Good Will 50,000.00 

Investment in C, Capital 

Stock $175,000.00 

To charge to Good Will the 
difference between the par value 
and surplus of C, Capital Stock, 
at date of acquisition by A and the 
actual sum paid. 

Intercompany Accounts. In examining the intercom- 
pany accounts on the Balance Sheets of the tihree companies, 
it will be noted that on the Balance Sheet of A, the intercompany 
account appears as an asset amounting to $100,000.00. On the 
Balance Sheet of B, the intercompany account appears as a 
liability amounting to $85,000.00, and on the Balance Sheet of 
C, it appears as a liability amounting to $5,000.00. Combining 
the intercompany accounts from the Balance Sheets of B and 
C, it will be seen that the combined liability is $90,000.00, 
$10,000.00 less than the amount appearing on the Balance 
Sheet of A, hence it is evident that the intercompany accounts 
are not in agreement. 

Let us assume that an investigation shows that the dif- 
ference arises because of a shipment of goods, made by one 
company and valued at $5,000.00, had not been received or 
taken up by the receiving company, and that a remittance of 
$5,000.00 made by one company had not been received by the 
oSier company. 

(6) Inventories $5,000.00 

Intercompany Accounts $5,000.00 

Shipment by A to B not taken 
up by B. 

(7) Cash $5,000.00 

Intercompany Accounts $5,000.00 

Cash in transit. Remittance 
by C to B not yet received by B. 

Profits on Intercompany Sales. While it is true that 
transfers of products and sales of service between the affiliated 
companies should be at cost, yet it sometimes occurs that 
intercompany sales include a profit, in which case an examina- 
tion of the books must be made to determine whether any of 
this intercompany profit is included in the inventory of stock 
on hand. 

In this problem, we shall assume that one of the companies 
sells to another and that there is an intercompany profit in 
inventories of $10,000.00 requiring adjustment. Such inter- 
company profit should be adjusted as follows: 



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CORPORATION ACCOUNTING 107 

(8) Surplus $10,000.00 

Inventory $10,000.00 

Intercompany profit in inven- 
tories at end of year. 

The above shows the proper adjustment for intercompany 
profits in inventories at end of year resulting from the fact 
that goods are not transferred between the affiliated companies 
at cost. If a profit will result in inventory at end of the year, 
it is natural that profits will result similarly in inventories at 
the beginning of the year. To illustrate this principle, let us 
assume that the intercompany profits at the beginning of the 
year amounted to $7,500.00. 

(9) Surplus at beginning of year — ^A. $7,500.00 

Profit and Loss $7,500.00 

For intercompany profits in 
inventory at beginning of year. 

Where inventories are reduced to net integration cost be- 
fore being taken up on the books of the various affiliated com- 
panies, the last two adjusting entries are not required. 

Surplus Working Sheet. In making the eliminating and 
adjusting entries for the Surplus Working Sheet, the debits and 
credits to Surplus on the Working Sheet for Consolidated Balance 
Sheet have to be applied to the various items in the analysis 
of the surplus. In this problem, all the entries can be readily 
applied to the proper items with the exception of the debit of 
$250.00 for the proportion applicable to the stock in the hands 
of minority stockholders of the surplus of B accumulated since 
acquisition of the controlling interest by A. 

Surplus from date of acquisition* to beginning of year, 

5% of $2,500.00 $125.00 

Proportion of profits for year, 5% of $12,500.00 625.00 

$750.00 
Less — Proportion of dividend, 5% of $10,000.00 500.00 

$250.00 

The Working Sheet for the Consolidated Balance Sheet 
and Surplus Account are illustrated on following pages. It will 
be noted that the above adjusting entries have been transferred 
and that the accounts are properly consolidated so that it is a 
simple matter to set up a Consolidated Balance Sheet from the 
information given in the last column. Working Sheets are not 
called for in the problem and are not necessarily a part of the 
required solution, but are illustrated here in order to simplify 
the solution and that the principles may be more easily com- 
prehended. 

* The date of acquisition is not shown in the problem. The proportion 
of surplus accrued previous to beginning of year is arbitrarily arrived at. 



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io8 



PUBLIC ACCOUNTING AND AUDITING 



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CORPORATION ACCOUNTING 



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no PUBLIC ACCOUNTING AND AUDITING 

A. THEORY QUESTIONS 

1. In examining several manufacturing properties with 
a view of consolidation, what general rules should govern the 
examinations? C. P. A. Ex. 

2. Four corporations, which have been doing business with 
each other, consolidate. In each set of books, accounts are 
open with the other three. How will these be treated in the 
Consolidated Balance Sheet? C. P. A. Ex. 

3. If in consolidating the accounts of a holding company 
and its subsidiary companies, you find that in the case of one 
of the subsidiary companies the holding company owns only 
60% of its voting stock, state briefly how you would treat this 
subsidiary company's accounts in the Consolidated Balance 
Sheet and why your proposed treatment reflects the true financial 
position of the combined companies more clearly than other 
methods with which you may be familiar. Inst. Ex. 

4. In making up a Consolidated Balance Sheet of a holding 
or parent company, and two subsidiary companies where, in 
the case of one of the subsidiary companies, its entire capital 
stock has been acquired at less than par, and in the case of the 
other, at a substantial premium, how would you deal with such 
discount and premium, respectively, in the Consolidated Balance 
Sheet? C. P. A. Ex. 

5. In the event that all the stock of the subsidiary com- 
panies was not owned by the parent company, how should such 
proportion of said stock belonging to the minority stockholders, 
together with the proportion of surplus appertaining thereto, 
be stated in the Balance Sheet? C. P. A. Ex. 

INCOME TAX QUESTION 

Name two conditions under which corporations should file 
consolidated returns and the requirements of evidence of affil- 
iation. C. P. A. Ex. 

B. ACCOUNTING PROBLEMS 

1. The A Company buys on January i, 95% of the stock 
of the B Company. The Balance Sheet of the latter company 
on that date is as follows: 

BALANCE SHEET— B COMPANY 



Assets 

Current Assets. . .$ 850,000.00 
Property Accts. . . 500,000.00 



$1,350,000.00 



LlABIUTIES 

Cur. Liabilities. .$ 250,000.00 

Capital 1,000,000.00 

Surplus 100,000.00 

$i,350>QOO»oo 



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ACCOUNTING PROBLEMS in 

# 
The A Company pays par for 90% of the stock, and 120 
for 5% of it. During the next six months, a doubtful claim of 
the B Company, whidi prior to January i had been written off, 
turns out to be good, and $5,000.00 cash is realized on it. 

At the end of the first six months, B Company has made 
$100,000.00 net profit from operations, and a dividend of 
$200,000.00 is paid. 

In making up a Consolidated Balance Sheet of A Company 
and its subsidiaries at January i (date of purchase) state, giv- 
ing briefly your reasons, how you would treat: 

(a) A Company's interest in the B Company and at July i. 

(b) The doubtful claim recovered. 

(c) The dividend paid. 

(d) The interest of outside B stockholders in B Company. 

Inst. Ex. 
2. The following items appear on the Balance Sheet of 
the American Pin Company, June 30, 1912: land, buildings, 
equipment, etc., $335,000.00; capital stock of the Bronx Pin 
Ticket Company, par $50,000.00; cost, $57,400.00; patents, 
$15,000.00; working and trading assets, $37,500.00; cash 
$10,000.00; accounts receivable, $32,000.00; due from Bronx 
Pin Ticket Company, $375.82; deferred assets, $1,500.00; first 
mortgage 6% gold bonds payable, due 1922, $100,000.00; taxes 
accrued, $3,250.00; salaries and wages accrued, $4,327.82; 
accounts payable, $123,749.83; notes payable and interest, 
$80,125.00; interest accrued on first mortgage bonds payable, 
$2,500.00; reserve for depreciation of building and equipment, 
$35»ooo.oo; preferred capital stock outstanding, $75,000.00; 
common capital stock outstanding, $50,000.00; profit and loss 
surplus, $14,823.17. 

The American Pin Company having acquired all the capi- 
tal stock of the Bronx Pin Ticket Company, the Balance Sheet 
of which appears below, it is proposed to merge the two com- 
panies as of July I, 1912. 

THE BRONX PIN TICKET COMPANY 

Assets — ^Land, buildings and equipment, etc., $260,000.00; 
capital stock of the Blauser Pin Tray Company carried at par, 
$35,000.00; patents, $22,625.00; working and trading assets, 
$10,000.00; cash, $10,365.27; accounts receivable, $37,943.86; 
sinking fund, $3,236.92; deferred charges to expense, $1,200.00. 
Liabilities and Capital — First mortgage 5% gold bonds pay- 
able, due 1925, $50,000.00; taxes accrued, $2,750.00; salaries and 
wages accrued, $3,147.83; due to creditors, $144,720.30; due 
to American Pin Company, $375.82 ; notes payable and interest, 
$31,372.53; interest accrued on first mortgage bonds payable, 
$1,250.00; reserve for depreciation of plant and equipment, 
$27,500.00; common capital stock outstanding, $50,000.00; 
profit and loss surplus, $69,254.57. 



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PUBLIC ACCOUNTING AND AUDITING 



Prepare: 
(a) 

(b) 

(c) 



The entries on the books of the American 

Pin Company. 
The entries on the books of the Bronx Pin 

Ticket Company. 
Balance Sheet of the American Pin Company 

after the merger. 



3. On January i, 1916, Company X purchased the entire 
capital stock of Company Y at $175.00 per share, and all the 
stock of Company Z at $80.00 per share. 

A Balance Sheet, as stated below is handed to you, as at 
June 30, 1916, with the request to prepare a Consolidated Balance 
Sheet of the X Company and its subsidiary companies at that 
date. 

BALANCE SHEET— COMPANY X 



Property and Good 

Wll $510,000.00 

Stock of Subsidiary 

Companies 900,000.00 

Current Assets 420,000.00 



$1,830,000.00 



Capital Stock $1,350,000.00 

Current Liabilities 90,000.00 

Surplus, 1/1/16 315,000.00 

Undivided profits for 

half year ended 
' 6/30/16 75,000.00 

$1,830,000.00 



BALANCE SHEET— COMPANY Y 



Property and Good 

Will $390,000.00 

Current Assets 36,000.00 



$426,000.00 



Capital Stock $240,000.00 

Current Liabilities 6,000.00 

Surplus, 1/1/16 120,000.00 

Undivided profit for 

half year ended 

6/30/16 60,000.00 



$426,000.00 



BALANCE SHEET— COMPANY Z 



Property, 1/1/16.... 


.. $678,000.00 
108,000.00 


Capital Stock $600,000.00 


Current Assets 


Current Liabilities 144,000.00 

Surplus, 1/1/16 18,000.00 

Undivided profit for 

half year ended 

6/30/16 24,000.00 




$786,000.00 


$786,000.00 



There are no intercompany accounts or inventories. 



C. P. A. Ex. 



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Chapter Eight 

SYSTEMATIZATION 

Accounting Systems. Public accountants d evise systems 
for various classes of concerns including mercantile, manufac- 
turing, financial, public service, municipal, ecclesiastical, etc. 
Systems are quite commonly described as general accounting 
systems and cost accounting systems. Strictly speaking, any 
accounting system is a cost system, for is it not one of the prin- 
cipab objects of any accounting system to show costs — prime 
cost, cost of production, cost of sales, cost of operations, etc.? 

The Federal Trade Commission on July 15, 19 16, addressed 
a letter to retail merchants saying in part: "The Federal Trade 
Commission has found that the majority of retail merchants do 
not know accurately the cost of conducting their business, and 
for this reason they are unable to price their goods intelligently. 
There must be decided improvement in this direction before 
competition can be placed upon a sound basis and before we 
can expect a decrease in the heavy business death rate among 
retail merchants." 

About the same time, the Commission in a letter to Amer- 
ican manufacturers, said in part: "The Federal Trade Com- 
mission has found that an amazing number of manufacturers, 
particularly the smaller ones, have no adequate system for de- 
termining their costs and price their goods arbitrarily." 

While it is possibly true that cost accounting is a special 
branch of accounting, yet it must be remembered that it is only 
a branch of general accounting and that experience has proven 
that cost accounting systems which are not a part of the general 
accounting systems are a failure. 

Preliminary Information. The accountant called upon 
to devise . a system of accpunts will need certain information 
before he can proceed in a satisfactory manner. He will want 
to know how the company is organized, whether a single pro- 
prietorship, partnership or a corporation; the nature of the 
business engaged in; the volume of the annual business; the 
r^pprts and statements desired by the management; wherein 
the present system is inadequate or faulty; the number of book- 
keepers employed ; the cost of maintaining the present system ; 
the mechanical appliances in use in the bookkeeping depart- 
ment, and such other information as will prove helpful in de- 
vising a system to fit a particular concern. Conditions differ 
in nearly every concern, and the accounting system must be 
adapted to existing conditions. 

The accountant called in to devise a system of accounts to 
replace a system that has not been producing desired results is 
very much in the same position as the physician called to pre- 

"3 



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114 PUBLIC ACCOUNTING AND AUDITING 

scribe a remedy for a sick man. He should feel the pulse, look 
at the tongue, take the blood pressure, ascertain the temperature 
and make a thorouj[h examination of the system preliminary 
to the devising of a new system. 

Fundamental Principles. In devising a system of ac- 
counts for any concern, either mercantile, manufacturing, or 
otherwise, there are certain fundamental principles to be ob- 
served by the accountant. The principal objects which should 
receive careful consideration may be stated as follows: 

1. To Properly Design Books of Account. The books 
of account are, of course, divided into two classes — ^those of 

^original entry and ^thp,^ iJt.&QSlLwtry* The books of original 
entry sFouIa Ible cTevi^ed with suftab l^ arrangement of columns 
in which to recprd. and -distribute the various items in such a 
manner as to afford such data foe ibf prepi^'^^inn ^f a Balance 
Sheet and Stat ement o f Profit and L oss in standard, form. The 
accountant must see through from the books of original entry 
to the final statements resulting therefrom, and the items ap- 
pearing on the books of original entry must directly contribute 
to the aggregate items appearing on the financial statements. 

In planning the books of final entry, the accountant will be 
governed by the volume. of_ business and the size of the force 
required to record the transactions. In a very small business, 
it is possible that a single ledger with the accounts divided into 
three groups— jg^isfralr ^gdlt^rSi arrrl ^"g^^^^^, might prove 
sufficiei)t. If, however, the volume of business is such that 
several bookkeepers will be required to do the posting, it will 
be seen that separate ..larlnrftrfi .should be provided. Instead of 
dividing a single ledger into three sections, it would be better 
to provide a general ledger to contain the general and controlling 
accounts; a creditors* ledger for accounts with Trade Creditors, 
and a customers' ledger for accounts with Trade Customers. 
Again, it may be necessary to subdivide the subsidiary ledgers 
with creditors and customers into several sections. This is 
especially true with regard to customers. It may be necessary 
to subdivide the customers' ledger into several sections to enable 
several bookkeepers to work on them. The division may be 
made on an alphabetical, geographical, or some other basis. 

2. To Properly Classify the Accounts. It is important 
that the accounts be prope rly cl assified. To do this it is 
necessary: 

(a) To ascertain the character of the assets and liabilities; 
to determine their order of classification and to what extent they 
may to advantage be contained in separate accounts to the end 
of arriving at a permanent form in which the Balance Sheet may 
be clearly stated. 

(b) To ascertain the sources of income and expense inci- 
dental to operations of the business, taking into consideration 



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MERCANTILE ACCOUNTING iiS 

the elements of cost, fixed charges, administrative expenses, 
maintenance or up-keep, depreciation, reserves, etc., to the end 
of arriving at a comprehensive and intelligible Profit and Loss 
statement. 

Separate accounts should be provided for the assets, lia- 
bilities, expenses, and sources of income. Merchandise accounts, 
expense accounts, and similar accounts should be properly sub- 
divided. A general account with merchandise or expense is 
nothing more than a "dumping account," and certainly has no 
place in a modem accounting system. In determining a proper 
classification of accounts, the old saying that there should be 
"A place for everything, and everything in its place" is quite 
appropriate. 

3. To Promote Efficiency in Procedure and Office 
Routine. It is the duty of the accountant to institute suitable 
procedure and organization in the methods of treating with 
details and in recording of the transactions on the books of 
account with a view to economy of time, accuracy of work, and 
facility of balancing the accounts, and the preparation of finan- 
cial statements. 

4. To Provide for Internal Check and Audit. The 

system should be so planned as to secure the best internal check, 
thereby readily making apparent any irregularity which may 
arise from ignorance, stupidity or dishonesty on the part of 
employes in the accounting department. 

The general principle to be followed is that no one person 
shall be in complete control of any important part of the busi- 
ness, but that the work of each employe shall be subject to check 
or supervision by other employes by being made to fit in with 
the work of others. 

Controlling accounts must be kept on the general ledger 
with each subsidiary ledger ^ith customers, in case there is more 
than one. Cash receipts should be recorded by more than one 
person so that fraud or embezzlement could not take place with- 
out collusion between two or more employes. Vouchers for 
payments should be accompanied by invoices from creditors, 
properly certified pay rolls, etc. Sales tickets should be made 
in duplicate so that the ticket which goes to the customer shall 
be an exact copy of the one filled in the shipping room. 

The system should be susceptible of a thorough and rapid 
periodical audit 'by public accountants. Provision for an in- 
ternal check is particularly desirable in mercantile accounting 
systems hf.raiisfi.thf; Yohimfi of .derail in. rouoectiooi. with the 
"^Prdinig of J^VJTCb^S^j^ fliyl-lP^^^T both cash and credit, is so 
great as not to ^nd it^lf"^^fjilyj:Q ^x),^\i^t. In a Ralanrg 
^hfft a"^i>, the auditor could do no more than test die accura cv 
ni thp aa1p« anH rppfiptff thf:r^XrP^ A detail audit would be 
quite out of the question because of the expense attached thereto. 



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ii6 PUBLIC ACCOUNTING AND AUDITING 

Mercantile Accounting. The devising of accounting sys- 
tems for mercantile concerns offers an interesting field of work 
for the public accountant. It is true that mercantile accounting 
will be found less tec hnical than accounting for manufacturing 
concerns. In this discussion, we shall confine ourselves to a 
general accounting system for a mercantile concern. No attempt 
will be made to adapt the discussion to a system for a specific 
concern, but rather an effort will be made to discuss the general 
principles covering systematization. 

Objects of an Accounting System for Mercantile 
Concerns. There are certain general objects to be obtained 
from a sound accounting system for mercantile concerns .prop- 
erly devised and properly kept. A few of the more important 
objects might be summed up as follows: 

1. To meet current needs and provide for expansion of 
business in the future. The system devised should not be based 
solely upon the present volume of business, but should be flex- 
ible enough to allow for Tuture expansion. 

2. To enable the merchant to price his goods intelligently. 
There has been a tendency among retail merchants in the past 
to conduct their business without an adequate accounting sys- 
tem, hence selling prices were determined arbitrarily. 

3. To furnish the management with proper and sufficient 
information to be used as a guide in conducting the business on 
sound principles; a system that will provide the necessary 
information from which to prepare operating and financial state- 
ments, and to compile needed statistics to be used in determining 
future policies. 

4. To provide for a logical distribution of work, and for 
a proper classificatipn of r<?ceiiit§ jand disbursements. The dis- 
tribution of the work should be made in a manner that will 
provide a satisfactory internal check. 

5. To provide complete and permanent records that can 
be maintained at the smallest expense. Too often, accounting 
systems are devised without regard to the possible cost of keep- 
ing, and it is soon found that the cost is greater than the addi- 
tional benefits obtained. 

6. To enable the management when seeking credit to 
produce a statement of financial condition upon which a banker 
might, extend full credit to which the company is entitled. If 
unable to produce a proper statement for credit purposes, a 
possible expansion of the business might thereby be limited. 
Bankers are giving more and more attention to the accounting 
methods used by merchants to whom they extend credit. 

Bankers Base Extent of Credit oh Financial Condi- 
tion. Bankers are willing to give larger loans and very often 
more liberal terms to the merchant who keeps his books in a way 



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MERCANTILE ACCOUNTING 117 

that enables him to show the bank at any time just how his 
business is progressing. A merchant who can show progress 
will undoubtedly receive more consideration with the same 
amount of assets than one who cannot. Even if he is successful, 
but cannot show it because of his bookkeeping methods, the 
bank will not consider him a desirable credit risk. 

Another very important point to which the bank gives 
consideration is whether the prospective borrower is making 
proper provisions for depreciation on stock, buildings, and fix- 
tures, and his books should be so arranged as to show the amount 
of these provisions. No merchant can be said to be managing 
his business properly unless adequate provision is made for 
depreciation. 

Adaptability of Sjrstem to Existing Conditions. It is 

almost impossible to describe in detail an accounting system for 
a mercantile concern without assuming certain existing condi- 
tions. Any accounting system that might be devised must be 
adapted to the business and must provide for a certain volume 
of business. It will readily be seen that an accountant might 
be called upon to devise a system for a small mercantile con- 
cern, one in which there need be no departmentalization of the 
accounts, a concern in which there is required the greatest sim- 
plicity. Again, the accountant might be called upon to devise 
a system for a concern maintaining numerous departments and 
where it is desired to show the results of operations in each 
department. It is to be seen that the system fitting the former 
would not be adapted to the latter concern. 

An Accounting System for a Small Mercantile Con- 
cern. The system of accounts outlined here is intended to meet 
the requirements of retail merchants. The object has been to 
describe a system that will. give information essential to suc- 
cessful management of a small mercantile establishment. The 
author believes that the best accounting system for any business 
is the one which will furnish the required information with the 
least effort and cost. No attempt is made to departmentalize 
the accounts, though this will be taken up in a later discussion. 

Books of Account. To operate the accounting system 
described herein requires the use of but four books of account — 
the journal, cash book, purchases book and ledger. Sales 
tickets and credit tickets will be used for recording sales and 
sales returns and allowances. 

Journal. An ordinary two column journal can be used. 
This is the form of journal with which all bookkeepers are 
familiar. No special rulings are required, there simply being 
two money columns required on each page. 

Cash Book. This might be termed a general cash book, 
for in it will be recorded all cash transactions whether repre- 
senting receipts or disbursements. The left hand or debit side 



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2. 


Name of account. 


6. 


3- 


Explanation. 


7- 


4- 


Check No. 


8. 



ii8 PUBLIC ACCOUNTING AND AUDITING 

is for recording receipts. Special columns should be provided 
in the order named: 

1. Date. 5. General accounts. 

2. Name of account. 6. Accounts Receivable. 

3. Explanation. 7. Cash Sales. 

4. Ledger folio (L. F.). 

The right hand or credit side is for recording disbursements 
and special columns should be provided as follows: 

Date. ^ 5. Ledger folio (L. F.). 

General accounts. 
Accounts Payable. 
Discounts on Purchases. 

Purchases Book. A purchases book is designed in which 
to record the invoices representing purchases of merchandise 
only. Special columns should be provided as follows: 

1. Date of record. 5. Address. 

2. Date of invoice. 6. Ledger folio (L. F.). 

3. Number. 7. Terms. 

4. From whom purchased. 8. Amount. 

Sales and Credit Tickets. The use of sales and credit 
tickets for recording sales and sales returns and allowances has 
almost become universal with merchants. The sales ticke t is 
the original reoord of the sales transaction . The^tTcket is usually 
made out by the sales person when making the sale; though in 
some cases, these tickets are made out by special clerks on a 
special register machine. The ticket shows the following in- 
formation : 

1 . Number. 6. Description of article sold . 

2. Date. 7. Price. 

3. Name of sales person. 8. Terms (whether paid in full, 

4. Name of customer. or deposit given and balance 

5. Address of customer. C. O. D., or "will call"). 

Ledger* Either a loose-leaf or a bound ledger may be used. 
Loose-leaf forms add greatly to the elasticity of a S3r8tem of 
accounting and are in most cases more economical than bound 
forms. The accounts should be arranged in the following order: 

1. General accounts. 

2. Accounts with Creditors. 

3. Accounts with Customers. 

If the volume of business will warrant a division of the 
ledger accounts, it will be best to provide a general ledger for 
the general accounts and subsidiary ledgers for Accounts Re- 
ceivable and Accounts Payable. In this case, the general ledger 
will also contain the controlling accounts for the subsidiary 
ledgers. The general ledger must be so kept that it balances 
independently of the subsidiary ledgers. The subsidiary ledgers 



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MERCANTILE ACCOUNTING 119 

'for creditors and customers can also be made self-balancing by 
opening a controlling account in each. This controlling ac- 
count would be just the opposite from the one in the general 
ledger and requires a sort of double posting. It enables the 
bookkeeper to take off a Trial Balance without access to the 
general ledger which, of course, serves as a sort of internal 
check on his work and avoids the necessity of his having access 
to the general ledger which is sometimes objectionable. 

Outline of Accounts. An accountant in devising a system 
of accounts should prepare an out line of the accounts to be kept. 
The exact outline will always depend upon the nature of the 
business, the volume of the business and the information de- 
sired by the management. To fit the system under discussion, 
we shall assume a classification of accounts as follows: 

Real Accounts: 

1. Cash. 

2. Accounts Receivable (Trade Customers). 

3. Notes Receivable (Trade Customers). 

4. Insurance. 

5. Store Property. 

6. Warehouse Property. 

7. Store Equipment. 

8. Office Equipment. 

9. Delivery Ex^uipment. 

10. Inventory. 

11. Res. for Doubtful Accounts. 

12. Res. for Depr. of Store Property. 

13. Res. for Depr. of Warehouse Property. 

14. Res. for Depr. of Store Equipment. 

15. Res. for Depr. of Office Equipment. 

16. Res. for Depr. of Delivery Equipment. 

17. Notes Receivable Discounted (Trade Customers). 

18. Notes Payable (Trade Creditors). 

19. Notes Payable (Banks). 

20. Accounts Payable (Trade Creditors). 

21. Accounts Payable (Others). 

22. Mortgages Payable. 

23. Proprietor's Drawing Account. 

24. Proprietor's Capital Account. 

Nominal Accounts: 

51. Purchases. 

52. Sales. 

53. Sales Allowances. 

54. Salaries and Wages of Buying Force. 

55. General Buying Expense. 

56. Salaries and Wages of Sales Force. 

57. General Selling Expense. 

58. Advertising. 

59. Salaries and Wages of Delivery Force. 



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120 PUBLIC ACCOUNTING AND AUDITING 

60. General Delivery Expense. 

61. Office and Management Salaries. 

62. Office Supplies and Expense. 

63. Insurance. 

64. Taxes. 

65. Interest. 

66. Miscellaneous General Expense. 

67. Rent. 

68. Losses from Bad Debts. 

69. r^sh DifirnilPt on Purchas es. 

70. QasiiJQiscfiUDt oa.Saks. 

Manufacturing the Books of Account. The accountant 
Hi^vispa thfi RvstfitTd drawinpr up proper forms indicating headings 
to be printed, ruling desired, style of binding wanted, and then 
an order is given a printing company or manufacturers of blank 
books. Some accounting firms furnish the printer with blue 
prints of the forms and books desired. In any evpnt, the printer 
must be furnished with information sufficient to enable him to 
print and manufacture the books of account. The printer will 
submit proofs to the accountant and these must be carefully 
verified with the original copy. Otherwise, the accountant will 
be responsible for errors should any occur in printing, ruling or 
binding. It probably is not out of place to state that the ac- 
countant should reach an understanding with his client as to 
the handling of the bills in connection with the manufacturing 
of the books. Usually the accountant secures permission from 
the client to give the order to the printing company, but the 
bills are to be sent direct to the client and are handled entirely 
separate from the bill for the accountant's services. 

Accountant's Report. When the books and forms are 
ready for installation, the accountant usually gnpprvigp*^ i^j^f; 
"oneniny of thfi hooks." He also furnishes the head book- 
keeper with a retx>rt containing detailed instructions regarding 
the keening of the bopks of ac count and the proper use of the 
forms provided. The report should contain a descri ption of 
each book of original entry, tracing the items from theseTx)oks 
to the ledgers and from the ledgers to the statements. Each 
account should be described as to its use and purpose. If the 
accountant can prepare a report covering all the transactions, 
it can readily be seen that the bookkeeper will find such a 
report most helpful while becoming accustomed to the new 
system. It will also save confusion and dissatisfaction resulting 
from the bookkeeper's failure to understand the proper method 
of recording certain transactions and in preparing monthly or 
annual statements. Much of the success of the system will de- 
pend upon the ability of the bookkeeper to follow the instruc- 
tions of the accountant. 



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MERCANTILE ACCOUNTING 121 

The following report is presented to illustrate a simple 
report to fit the system herein described. Space permits only 
an explanation of the use of the books of account. 

ACCOUNTANT'S REPORT 

Books of Account. A journal, cash book, purchases book, 
and ledger are provided. The following instructions should be 
observed with regard to the recording of transactions in these 
books. 

Journal. At the date the books are to be opened, a state- 
ment of assets and liabilities should be prepared. This will be 
used as the basis of the opening entry. Accounts^ representing 
assets should be debited and accounts representing liabilities 
should be credited. The proprietor should be credited for the 
present investment which will be the difference between the 
total of the assets and liabilities. The entry should be sup- 
ported by a schedule of Accounts Receivable or Accounts Pay- 
able. These schedules will be used in posting to the individual 
accounts with customers and creditors. 

The total of the account Sales for each month as shown by 
the sales tickets should be entered in the journal, debiting Ac- 
counts Receivable (controlling account) and crediting Sales. 
The total of the credit tickets for each month representing sales 
returns and allowances are also entered in the journal, debiting 
Sales with the returns and Sales Allowan ces with any allowances 
in the form of price concessions and crediting Accounts Receiv- 
able (controlling account). 

Transactions which do not go through either the cash book 
or purchases book should also be journalized. These entries 
comprise such items as Notes Receivable and Payable, allow- 
ances or corrections of invoices on account of merchandise pur- 
chases previously entered in the purchases book, the various 
adjusting entries at the end of the month, and the closing entry 
at the end of the fiscal period. 

Journal entries affecting accounts with customers and 
creditors will also have to be posted individually to the con- 
trolling account for Accounts Receivable and Accounts Payable 
in the general ledger. 

Cash Book. The total cash receipts for each day should 
be deposited in the bank and all payments should be made by 
check. In case small cash disbursements are necessary for such 
as car tickets, telegrams, and minor items, it would be advisable 
that this be handled on the petty cash plan. A check should be 
drawn for an amount to cover the disbursement for a certain 
period, possibly one month. At the end of the period, the 
cashier should prepare a petty cash statement which should be 



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122 PUBLIC ACCOUNTING AND AUDITING 

supported by vouchers and a check drawn for the exact amount 
of die statement, thereby restoring the petty cash fund to the 
original amount. This check should be entered in the cash book 
in the regular way charging the various expense accounts as 
shown by the petty cash statement.* 

The total of cash sales for the mon th as s hown j?y the 
footing of the cash sales column should b e'checked against th e 
total of the cash sales tick ets and then posted to the credit of 
§ale8. The total of the Accounts Receivable column for the 
month is posted to the credit of Accounts Receivable (con- 
trolling account). The total of the Accounts Payable colunm 
is posted to the debit of Accounts Payable (controlling account). 
The total of the discount on the purchases column is also posted to 
the debit of Accounts Payable (controlling account). All pay- 
ments for expense items other than petty cash should be en- 
tered in the cash book as made and posted therefrom to the 
proper accounts. At the end of the month, all expense bills for 
the month should be paid so as to insure the expense being 
charged in the proper month. (It must be remembered that 
this is a description of a system for a small mercantile concern 
and that simplicity is the principal feature of the system.) 

The total cash receipts for the month should be posted to 
the debit of the Cash account in the general ledger. The total 
cash payments for the month should be posted to the credit of 
the Cash account in the general ledger. 

The cash .book balance at all times should check with the 
balance as shown by the check book plus the amount Th" the 
petty cash fund. 

No special check book is required. At the end of the month, 
the cash book should be balanced, or a statement secured from 
the bank together with canceled checks. These should be 
checked with the stubs, the checks being arranged in numerical 
order. If any checks are outstanding, note them on the stubs 
and deduct from the total checks written. The check book 
balance should then agree with the bank book balance. 

Purchases Book* The postings are made direct from this 
book into the purchases ledger and the total at the end of the 
month is posted to the debit of Purchases and to the credit of 
Accounts Payable (controlling account). 

Sales and Credit Tickets. Sales tickets must be made 
out for every sale and the daily total of these gives the total 
sales for the day. The cash sales tickets are checked against the 
cash received and the charge tickets go to the bookkeeper. 
Credit tickets must be made out to the credit of customers and 
these likewise go to the bookkeeper. 



*For complete ditcua aio n of petty cash fund, see page 203, "aoth Century Bookkeeping 
and Accounting." 



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MERCANTILE ACCOUNTING 123 



Ledgers. The general accounts should be classified 
general ledger in the following order: 


in the 


I. 


Assets. 




2. 


Liabilities. 




3. 


Capital. 




4. 


Income. 




5. 


Expenses. 





The accounts in the sales ledger represent trade customers. 
These are charged with merchandise sold on account, the book- 
keeper securing his information from the sales tickets. These 
tickets are first listed, then turned over to the bookkeeper who 
posts them to the debit of the proper accounts listing the amounts 
as he posts them, then comparing his total with that of the first 
list which must agree. Credit entries for allowances, deductions, 
cash discounts, or returned goods are made from credit tickets 
in exactly the same manner. Posting to the ledger, therefore, 
comes from one of three sources: 

1. Sales and credit tickets. 

2. Journal. 

3. Cash book. 

The accounts in the purchases ledger represent trade cred- 
itors. These are credited with purchases on account and debited 
when paid. Allowances, deductions, cash discounts and returns 
are also debited to these accounts. The postings to these accounts 
may come from three sources: 

1. Purchases book. 

2. Journal. 

3. Cash book. 

Monthly Statements. Monthly statements will furnish 
information of inestimable value to the management and will 
also be available for comparative purposes. At least a Balance 
Sheet, Profit and Loss statement, and a comparative summary 
of sales and expenditures should be prepared. These state- 
ments do not involve a monthly closing of the books, which 
can be kept open until the end of the fiscal year or half year, 
it being quite customary in mercantile concerns to close the 
books semiannually, either December 31 and June 30, or 
January 31 and July 31, so as to divide the spring and fall 
seasons. 

In the following pages are shown pro forma statements. 
These statements, it will be noted, are similar in form to those 
prepared by the Federal Trade Commission and incorporated 
in "A System of Accounts for Retail Merchants." 



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124 PUBLIC ACCOUNTING AND AUDITING 

PRO FORMA BALANCE SHEET 



Inventorv of Merchandise (at cost) . 

Prepaid Insurance 

Accrued Interest Receivable 



ASSETS 

Current Assets 

Cash on Hand and in Bank 

Notes Rec. (Trade Customers) . . . . 

Accounts Rec. (Trade Customers) . 

Less Reserve for Bad Debts 



Total Current Assets 

Fixed Assets 
Store Property . 



Warehouse Property. 



Less Reserve for Depreciation on 
Store and Warehouse 



Store Equipment 

Office Equipment 

Delivery Ekiuipment. 



Total Fixed Assets. 



Total Assets 

LIABILITIES AND CAPITAL 

Current Liabilities 
Notes Payable (Trade Creditors) . . . . 

Notes Payable (Banks) 

Accounts Payable (Trade Creditors). . 

Accounts Payable (Others) 

Accrued Interest Payable 

Accrued Salaries and Wages 

Accrued Taxes 



Total Current Liabilities 

Fixed Liabilities 
Mortgages Payable (Warehouse). 

Total Liabilities 

Proprietor's Capital Account 



xxxx.xx 

XX. XX 



xxxx.xx 
xxxx.xx 



Total Liabilities and Capital. 



xxxx.xx 

XXX. XX 

xxxx.xx 
xxxx.xx 

XXX. XX 
.XX 



xxxx.xx 

XXX. XX 

xxxx.xx 

XXX. XX 
XX. XX 
XX. XX 

x.xx 



XXX. XX 

XX. XX 

XXX. XX 



xxxx.xx 

XXXX.XX 

xxxx.xx 
xxxx.xx 



(EXHIBIT "A") 

(NOTE. In the above statement, it is evident that the Depreciation on 
Store, Office and Delivery Equipment has been credited directly to the asset 
accounts, instead of crediting specific reserves for depreciation. This is fre- 
quently done with regard to equipment accounts. In case specific reserves 
were set up, they should be deducted from the book value of the assets on the 
Balance Sneet. 

If the business was organized as a partnership, each partner's capital 
should be shown individuallv. If the business was organized as a corporation, 
the amount of capital stocK outstanding should be shown. The remainder 
of the Net Capital would appear as Undivided Profits or Surplus.) 



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MERCANTILE ACCOUNTING 125 

PRO FORMA PROFIT AND LOSS STATEMENT 



Sales 

Less Sales Allowances. 



Net Sales 

Inventory of Merchandise at be - 
ginning. 

Merchandise Purchases (cost de- 
livered at store) 



Deduct Inventory of Merchandise 

at Closing . . 

Less btocK Depreciation 



Net Cost of Goods Sold . 



Gross Profit from Trading. . . 

Buying Expense 

Salaries and Wages of Buying 

Force 

General Buying Expense 



Total Buying Expense 

Selling Expense 
Salaries and Wages of Sales Force. 

Advertising 

General Selling Expense 



Total Selling Expense 

Delivery Expense 
Salaries and Wages of Delivery 

Force 

General Delivery Expense 



Total Delivery Expense 

General Expense 
Management and Office Salaries . 

Office Supplies and Expense 

Insurance 

Taxes 

Losses from Bad Debts 

Rent 

Miscellaneous General Expense. . 

Total General Expense 



Net Profit from Trading 

Income From Other SouRr Rs 

Interest Earned 

Caah Diflcnnntfi on Piirr.haaea. . . 

Rent Income (net) 

Miscellaneous Outside Income. . . 

Total Income 



Deductions From Inco me 

Interest Cost — . . 

Cash Discount on Sales 



Net Profit. 



xxxx.xx 

XXX. XX 



XX. XX 
XX. XX 



XXX. XX 
XX. XX 

x.xx 



XXX. XX 

x.xx 



XXX. XX 
XX. XX 

x.xx 
x.xx 

XX. XX 
XX. XX 
XX. XX 



(EXHIBIT *'B") 



XX. XX 
X.XX 

XX. XX 
X.XX 



XX. XX 
X.XX 



Per cent. 



100. 



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126 PUBLIC ACCOUNTING AND .AUDITING 

A. THEORY QUESTIONS 

1. What general principles should govern a public ac- 
countant in the establishment of a system of accounts in any 
business? C. P. A. Ex. 

2. Outline a system of internal check for a wholesale 
grocery concern doing a business of $3,000,000.00 a year, with 
about 2,000 customers. The system should co-ordinate with 
an annual audit by professional accountants. Inst. Ex. 

3. Rule a cash book to provide for controlling accounts 
of debtors and creditors, also for discounts in settlement of both 
receivable and payable accounts; embrace also a method to 
include bank records. C. P. A. Ex. 

4. In auditing department store A, you find that cash 
discounts on purchases are regularly deducted from invoices 
when they are entered in the books, while in store B, the in- 
voices are entered in full and the discounts are credited to a 
discount account as and when received. 

Discuss the relative advantages and disadvantages of the 
two methods, and state what variations, if any, would occur in 
the valuing of inventories under the two methods. Inst. Ex. 

5. The proprietor of a mercantile store asked you to pre- 
pare a set of blanks to be used by them for checking all of their 
delivery wagons, including the returned goods which the driver, 
collected. He wants to be able to trace every package. Outline 
such a set. C. P. A. Ex. 



B. ACCOUNTING PROBLEMS 

1. In a certain department of a large dry-goods houses 
the purchases for a year were $30,000.00. They were in the 
first place marked up for "selling" purposes to $45,000.00. Later 
additional mark-ups amounting to $2,000.00 were made and 
mark-downs were also recorded aggregating $5,000.00. At the 
end of the fiscal period, there were found to be on hand goods 
of the marked selling value of $10,000.00. 

State how you would ascertain their inventory value for 
the purpose of closing the books and calculate the amount. 
Explain fully. Inst. Ex. 

2. The following Trial Balance was taken from the books 
of R. R. McClurg who conducts a retail mercantile business. 
It shows the accounts as of January 31, 1921, after the books 
had been closed and the net profit had been credited to the 
proprietor's capital account. 



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ACCOUNTING PROBLEMS 127 

TRIAL BALANCE 
January 31, 1921 

Cash on Hand and in Bank $ 3,223.34 

Notes Receivable (Trade Customers) 383.68 

Accounts Receivable (Trade Customers) . . 7,037.62 

Merchandise Inventory 5,818.12 

Prepaid Insurance — 200.28 

Accrued Interest Receivable 1.42 

Store Property 9,000.00 

Warehouse Property 3,950.00 

Store Equipment 54542 

Office Equipment 148.74 

Delivery Equipment 793-34 

Notes Payable (Trade Creditors) $ 2,421.00 

Notes Payable (Banks) 1,800.00 

Accounts Payable (Trade Creditors) 7,371.44 

Accounts Payable (Others) 970.00 

Accrued Interest Payable 38.46 

Accrued Salaries and Wages 164.00 

Accrued Taxes 15-50 

Mortgages Payable (Warehouse) 2,500.00 

Reserve for Bad Debts 67.12 

Reserve for Depreciation on Store and 

Warehouse 53-96 

Proprietor's Capital 15,700.48 

$31,101.96 $31,101-96 

Construct a Balance Sheet in accordance with the form 
illustrated on page 124. 

3. An audit of the books of R. R. McClurg revealed the 
following information in addition to that shown in the above 
Trial Balance: 

Merchandise Inventory, December 31, 1920. $6,902.18 

Purchases 5»5i9-34 

Sales 9»3i5-92 

Sales Allowances 4.00 

Stock Depreciation 306.22 

Salaries and Wages of Buying Force 50.00 

General Buying Expense 28.00 

Salaries and Wages of Selling Force 354-66 

Advertising 60.00 

General Selling Expense 7.50 

Salaries and Wages of Delivery Force 205.34 

General Delivery Expense 16.16 

Management and Office Salaries 538.00 

Office Supplies and Expense 44.06 

Insurance on Stock and Store Equipment. . . 3.22 

Taxes on Stock and Store Equipment 5.00 



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128 PUBLIC ACCOUNTING AND AUDITING 



from Bad Debts $ 67.12 

Miscellaneous General Expense 53-58 

Rent 142.50 

Interest Cost 34.18 

Cash Discount on Purchases 13.10 

Rent Income 33-04 

Miscellaneous Outside Income 4.00 

No physical inventory was taken on January 31. Neither 
had stock records been kept. The auditor has ascertained » 
however, that the average gross profit from trading for the 
previous three-year period has been 29 1/10%. You are, re- 
quired: 

(a) To calculate the inventory as of January 31, 1921. 

(b) To prepare a Profit and Loss statement in form as 
illustrated on page 125. 

4. Brown erects a business block at a cost of $100,000.00 
At the end of the year he finds that the rents from the stores in 
the building amounted to $7,500.00; offices, $3,750.00. The 
expenses for the year were as follows: 

Janitor, $750.00; repairs and alterations, $500.00; water 
and gas, $400.00; taxes, $1.97}^ per $100.00, on an assessed 
valuation of $87,000.00; incidental expenses, $150.00. 

Prepare statement showing results of the year's business 
and per cent, of profit on capital invested, charging 5% interest 
on investment and $2,500.00 for depreciation. C. P. A. Ex. 



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Chapter Nine 

SYSTEMATIZATION (Continued) 

DEPARTMENTAL ACCOUNTING 

The previous discussion of an accounting system for a mer- 
cantile concern was based on the assumption that the volume 
of business was small and that it was not necessary to depart- 
mentalize the accounts. It was shown that a very simple set 
of records might suffice. All transactions might be recorded in 
but three books of original entry — the journal, cash book and 
purchases book, sales being recorded only on sales tickets, dupli- 
cates of which go to the bookkeeper. A single ledger might be 
sufficient, the accounts being subdivided into three divisions — 
general, creditors and customers. ^ In a larger concern, the vol- 
ume of business might make it advisable to subdivide the general 
ledger, subsidiary ledgers being provided for creditors and cus- 
tomers, controlling accounts for each being kept in the general 
ledger. In a very large mercantile concern, several ledgers might 
be provided for customers, the accounts being subdivided numer- 
ically, alphabetically or geographically. 

Departmentalization. We shall now attempt to describe 
a system of accounts for a mercantile concern in which it is 
desired to show the res ults in various departments . In order 
that our discussion may be as definite as possible, we will assume 
a wholesale meramtile establishment of five different depart- 
ments. It is desired to show the nionthly results obtained in 
each department . The manager desires monthly operating and 
financial statements to be used as a basis in directing th e affairs 
of the concern . 

The Federal Trade Commission in "A System of Accounts 
for Retail Merchants" said with reference to departmentalization 
of accounts: "Any concern operating distinct departments can 
readily adjust the system to show the results obtained in each 
department." 

No attempt is made to show how this adjustment may be 
made, hence it would seem to be so simple a procedure as not 
to require any further discussion. At any rate, no further ref- 
erence is made to it in the Federal Reserve Bulletin. It is be- 
lieved, however, that a discussion of the records, accounts and 
statements with emphasis on departmentalization of accounts 
will prove interesting and possibly enlightening to some who 
may not be familiar with departmental accounting. 

Loose-Leaf Records. The system described and illus- 
trated in the following pages is planned as a loose-leaf S3^tem. 
This form of record adds greatly to the elasticity of a system of 
accounting and is, in the long run, more economical than bound 
forms. 



W9 



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130 PUBLIC ACCOUNTING AND AUDITING 

Voucher System. The voucher system is not often used 
in mercantile concerns, because these concerns find it preferable 
to carry individual accounts with creditors, whereas the voucher 
system is best adapted to concerns which pay their bills 
promptly and do not make pavments on account, but pay each 
invoice in full. To attempt to operate a_youcher system where 
numerous payments are madexMi account is to invite confusion; 
hence the system described hereinafter does not provide for the 
voucher system of handling invoices, though as stated, the 
voucher system would be entirely suitable for a concern that 
pays its bills oromotlv and in full as they mature . 

Distribution of Expenses. When it is desired to depart- 
mentalize the accounts so as to show the results obtained in 
each department, it is necessary to provide for distributing all 
buying, selling and administrative expenses, both direct and 
indirect, to the proper departments. 

Direct expenses represent expenditures which are incurred 
directly by or for a particular department or departments, hence 
these may be definitely charged to that department. Among 
the direct expenses may be classed wages of sales persons, salaries 
of department managers, insurance on merchandise in stock, de- 
partmental advertising and rent. It is customary to_djstribute 
the reojtta departments. Qn.thebasis.of the floor space and posi- 
tion occupied by the department. 

^'^llirfl^^ ^^ '^'^'^^^^^'^ pvp^nc^g (sometimes termed "burden") 
are expenditures incurred by and for thf; hllfilneas afi a whole. 
These are not direct charges to individual departments. They 
consist of administrative and general office salaries and expenses, 
general advertising, losses from bad debts, taxes, depreciation, 
etc., and are charged to nondepartmental expense accounts. 

In the distri^tjon of indirect ewense.? to the different de- 
partments, tliere are several methods in general use. (To be 
discussed in detail later) . The most commonly used methods are : 

(a) Net sales. 
- ^ (b) Costiif sales, 

(c) Direct labor. 

Purchases Record. By reference to the illustration of 
Forms loi and lOi-A on the opposite page, it will be noted that 
forms have been devised on which all purchases and expenses 
are journalized and distributed by departments. In a large 
concern where there may be many departments, it would, of 
course, be advisable to separate the purchases and expenses 
providing separate books of account for each. In this concern 
with but five departments, the purchases and expenses may all 
be recorded and distributed in the same book. 

Form loi is the left hand page of the purchases and expense 
record, and it will be noted that columns are provided for record- 
ing the purchases of each department; while on Form loi-A, 
the right hand page, columns are provided for distributing the 



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DEPARTMENTAL ACCOUNTING 131 



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132 PUBLIC ACCOUNTING AND AUDITING 

departmental expenses. All invoices, whether they represent 
purchases or expenses, must be journalized in this recorf. All 
items appearing in the general ledger column would, of course, 
be posted to the credit of the proper account in the general 
ledger. The total of the purchases ledger column at the end of 
each month would be posted to the Purchases Ledger controlling 
account in the general ledger, the individual items having been 
posted to the accounts with creditors in the purchases ledger. 
The total of the purchases distribution columns will be posted to 
the proper departmental purchases account. 

Freight In. Freight paid on purchases adds.. to. the cost 
nf n^f^tprial piirrhaspH and, Strictly Speaking, should be distHb^ 
uted over the individual items purchased in order to arrive at 
their true cost. However, in most mercantile businesses, it is 
out of the question to attempt to distribute the freight over the 
individual items. The freight may easily, however, be distrib- 
uted by departments and this should always be done where 
the freight amounts to any considerable sum. Its further dis- 
tribution must depend upon circumstances. 

Invoices for freight charges should be recorded on the left 
hand page and distributed by departments the same as pur- 
chasea* However, it will probably be best to open separate 
accounts with Freight In for each department. If this is 
done, it will be necessary to aQate? .tJbl? colymns at the end of 
the month and post the freight charges separate from the pur- 
chases. This will not be difficult, and, if desired, freight charges 
might be entered in ink of a distinctive color during the month 
so that it would be a very simple procedure to analyze the en- 
tries for the month, posting freight charges to the proper depart- 
mental Freight In account, and the balance to the proper depart- 
mental Purchases account. If desired, additional columns 
might be provided for distributing freight on purchases by 
departments. This would avoid the necessity of analyzing the 
items before posting the totals of the departmental purchases 
columns. 

Only one expense column for each department and only 
one general expense column has been provided. If it were at- 
tempted to provide separate columns for each kind of expense 
in each department, the book would be too cumbersome to be 
practical. The number of expense entries in one month will not 
be very great, and anyone familiar with the bookkeeping can 
make an analysis of the, entries in a short time. This analysis 
should be madlTat the end Xif tbfi month and to correspond with 
the general ledger accounts with expense. The postings to 
these accounts will be iXWtde.Xrom -the analysis in." total The 
details of this analysis may_be„writteij just below the footings 
forjthe month so that there may be a permanent record serving 
as a connecting link between the expense columns and the 
general ledger. 



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DEPARTMENTAL ACCOUNTING I33 

If desired, the departmental expense accounts can be carried 
on a special ruled ledger form. As many columns as may be 
necessary may be provided and one expense account can be 
carried in each column. There should also be a total column so 
that the total expenses for the department will appear in one col- 
umn. This should prove with the corresponding column on the 
original record where the distribution is made. By providing 
such a special ruled ledger form, one sheet can thus be made to 
carry all the expense accounts of one department. A blank 
column is provided on Form loi-A for use as desired. A general 
ledger debit column is provided for recording any transactions 
that cannot be distributed to any of the other debit columns. 

Sales Record. Form 102 on next page represents a sales 
ticket to be used by sales persons in reconling all sales, w hether 
cash or credit. This is a very simple form of sales ticket. At the 
end of each day, the cash sales tick ets wi ll be totaled and proved 
with the cash receip ts. Account sales tickets will go to the indi- 
vidual bookkeepers. Each sales person may be required to m ake a 
re capitulation of sales for the day, this recapitulation to be 
turned in to the department manager at the end of the day. 
The department manager may be required to prepare a reca- 
pitulation of sales for the department, this to go to the head- 
office. 

' Abstract of Sales. At the end of each month, an ab- 
stract of cash and credit sales should be made on Form 102-A. 
This shows the total sales both on accoun t and for cash, with a 
proper distribution by departments. Note also that a Freight 
Out column is provided so that freight paid on merchandise 
sold and charged to the customer's account will not be included 
in the sales distributed to departments. Ei:eight„chaJCge§ are 
not a.part^jpf sales, and should not be included with the sales, 
but are included in the amount charged to the customer's ac- 
count. This provision is, of course, required only in case it is 
a practice of the concern to charge the customer with any de- 
livery expenses. In the larger cities, retail mercantile establish- 
ments in some cases have found it more economical to make all 
deliveries by Parcel Post mail, thereby doing away with all de- 
livery equipment. However, it is usually the custom of the 
concern to make the delivery without charge to the customer, 
in which case all of the delivery expenses are to be classed as selling 
expenses and should not be charged to the customer's account. 
It is only when these expenses are charged to customers that 
a column for Freight Out would be required on the Abstract 
of Sales form. 

General Gash Book. If the volume of business is such 
as to make it advisable to separate the cash book, this can be 
done by simply keeping cash receipts in one record and cash 
payments in another. The rulings would be the same whether 
receipts and payments are kept separate or whether they are 
bound in one book. Form 103 is devised for recording all cash 



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134 
Form 103 
Sold To... 



PUBLIC ACCOUNTING AND AUDITING 

Sales Ticket 



Address. 
Terms: 



No.. 
Date. 



Quantity 



Description of Articles 



Price 



Total 



Form I02-A 



Abstract of Sales 

Month of 



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On Account Cash 



Sales 



Freight 
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DEPARTMENTAL ACCOUNTING 135 

receipts. A general ledger and a sales ledger column are pro- 
vided. All items appearing in the general ledger column will 
be posted individually to the proper accounts. The total of the 
sales ledger column will be posted to the credit of the Sales 
Ledger controlling account in the general ledger, the individual 
items having been posted to the proper accounts in the sales 
ledger. The total of the discount column is posted to the debit 
of the Discounts on Sales account in the general l«lger. The 
total of the cash sales column is posted to the Cash Sales account 
in the general ledger, provided a separate account is maintained, 
otherwise it is posted to Sales account. A total receipts column 
and a bank deposits column are provided and it is recommended 
that in all cases the practice of depositing all receipts be followed. 
If this is done, the total of the receipts and deposits columns at the 
end of the month will be equal. It will not be necessary to carry a 
bank account in the general ledger, for the difference between the 
bank deposits column and the checks column, on Forms 103 
and 103-A, will be equal to the cash balance provided, of course, 
that on the last day of the month all receipts are deposited before 
the cash book is ruled and footed. The total of the receipts 
column should be posted to the debit of the Cash account in 
the general ledger and it is recommended that a cash account 
be kept so that the general ledger will balance independently of 
all other records, and the bookkeeper will thus be able to take a 
Trial Balance off the general ledger without reference to any 
of the other books of account. 

Form 103-A is for cash payments. General ledger and 
purchases ledger columns are provided. All items entered in 
the general ledger column will be posted to the debit of the proper 
accounts in the general ledger. The total of the purchases 
ledger column will be posted to the debit of the Purchases Ledger 
controlling account in the general ledger, the individual items 
having been posted to the proper accounts in the purchases 
ledger. The total of the discount column will be posted to the 
credit of the Discount on Purchases account in the general ledger. 
It is not necessary to provide a column for total payments be- 
cause if all payments are made by check, the total of the check 
column will be the total payments for the month. Two blank 
columns are provided for use as may be necessary. 

General JoumaL Form 104, shown on page 138, indicates 
the ruling of the journal. Special columns are provided for the gen- 
eral ledger and for subsidiary ledgers with purchases and sales. 
Debit and credit columns are provided for each ledger. If pre- 
ferred, three columns might be shown to the left and three to 
the right of the explanation column ; the ones on the left being 
provided for all debits and the ones on the right for credits. 
Both forms are in general use, and it is only a matter of preference 
as to which is desired. All transactions not to be recorded in 
the other books of original entry should be recorded in the gen- 
eral journal. At the end of the month, all adjusting entries 
would be recorded in the journal, and at the end of the fiscal 



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DEPARTMENTAL ACCOUNTING 137 

year, when the books are closed, closing entries would be recorded 
in the general journal. 

Stock Ledger* Form 105 is provided for keeping a going 
inventory of merchandise. If_ monthlj^ statem(?,nts . are to be 
pre pared, it will be necessary to ascertain the inyentpiy pn the 
last day of each month. It it were necessary to take a physical 
inventory nGTorder to do this, the labor required might be so 
great as to make it practically out of the question to attempt 
to prepare monthly statements. This is, of course, only one 
reason for keeping stock records. The prime object of a book 
inventory is not^ to suj^reede a physical inventory, but to sup- 
pleme nt it and'tbproviHe at tlie end ol each month, or as often 
as may be desired, the value of the stock which should be on 
hand* at that particular time. Annually or oftener physical 
inventories should be taken and compared with the book inven- 
tories at which time the book inventories should be adjusted. 
The accuracy of book inventories will depend lareelv upon the 
p erson or persons in charge nf th<> rprnrd s. With a careless 
person in charge, there may be a very great differentiation, 
while if as much care is used in keeping the book inventories as 
is used in keeping a record of cash, accurate results may be 
obtained. 

The methods of keeping stock records in arriving at book 
inventories differ in detail according to the nature and size of 
the business. Special methods have sometimes been adopted 
within the same business for certain departments, but as a rule, 
stock records are kept on one of the following bases: 
^ (a) Cost basis. 

(b) Cost and retail basis. 

(c) Retail basis. 

The form of stock ledger sheet illustrated provides for 
showing quantity and value. In some concerns, it is only nec- 
essary to provide stock sheets s howing quantit y. If the form 
illustrated is used, it will not be necessary to calculate the cost 
of each sale, as all information regarding cost will be derived 
from the stock book. Of course, th e cost of sa les can be cal- 
culated only at the close of each period, while if the individual 
s ales are costed a nd th e cost carried to the sales abstrac t daily, 
there i s nothing left to be done at the close of the period exce pt- 
i ng to foot the abstract of sales . 

Form 105 will show complete financial information on 
every line of merchandise. Three divisions are shown — receipts, 
sales and balance. The first entry in the receipts division will 
be to record the inventory at date of opening the books. Pur- 
chases during the period will be entered at cost, the information 
being obtained direct from the invoices. All sales will be entered 
in the sales division, the information being obtained from the 
sales tickets. If a monthly statement is required, every accouot 
in the book must be footed and balanced and the balance ex- 
tended in the balance division at the end of each month. In 



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PUBLIC ACCOUNTING AND AUDITING 















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DEPARTMENTAL ACCOUNTING i39 

the quantity column will be entered the difference between the 
total quantity received and the total quantity sold. In the 
unit cost column will be found the average cost pe r unit which 
is found bv d ividing the foo tings m th e total cost colum n in 
the receipts division bv the footings in the quantity column in 
the receipts division. This av erage unit co st will tn en be mul - 
tiplie d by the quantity on hand and the result carried into the 
totaTcost column of tne~Balance division. After the stock led- 
ger has been footed and balances extended at the end of the 
month, an abstract for each article may be prepared showing: 

(a) Total receipts to date (total cost column, receipts 
division). 

(b) Total sales to date (sales price column, sales division). 

(c) ^ Total cost of stock on hand (total cost column, bal- 
ance division). 

Adding machines may be used for such calculations. Other- 
wise the work would prove burdensome. 

The total receipts as shown by the abstract should agree 
with the purchases as shown in the ledger, and the total sales 
as shown by the abstract should agree with the sales shown in 
the ledger. 

To ascertain the gross profit from the information given 
on the abstract, to the total sales to date add the total cost of 
stock on hand and subtract the total receipts to date. To as- 
certain the cost of sales, subtract the gross profit from the total 
sales to date. 

Installment Sales. In some lines of business it is cus- 
tomary to sell merchandise on the installment plan. Title 
usually does not pass to the purchaser until the final installment 
has been paid. It is customary to charge the full cont ract price 
to the customer at time of s ale. There are two methods of 
accounting for the profits on such sales. 

1. Contract sales may be treated the same as actual sales 
and the Sale s accoun t mav be credited at the time the contract 
is made, and the amount charged to the customer. In this case, 
a reserve should be prov ided equaj^ to the anticipated loss on 
deferred installme nts. The^mount .of the reserve will depend 
largely upon the character of the merchandise sold. Since the 
dealer holds title to the merchandise until final installment is 
paid, he can take the merchandise back in case of failure to make 
payments as agreed, and the amount of loss may be practically 
nothing, the a ctual loss being the difference between the amount 
c harged to tfie custo mer on the contract and the amount col- 
lected jn . installments, plus the amount realized by the resale 
of the merchandise after having been taken back. This loss 
should be cTiarged to lie reserve account. 

2. Installment Sales account may be credited at the tipie 
the customer is charged for the amount of the contract. As 
each installment is paid, an entry is made in the c£ish book 
debiting Cash and crediting Customer for the amount received. 



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140 PUBLIC ACCOUNTING AND AUDITING 

At the same time an entry is made crediting Sales and de biting 
Installment Sales. Thus, when the final installment has Tieen 
paid, the accounts with the Customer and Installment Sales 
will balance. The Cash account will show the receipts and the 
Sales account will show the amount of the sales to date. The 
balance of the Install ment Sales account is a deduction from 
A ccounts R eceivable on the Balance Sheet. U is not necessaiy 
to set up a reserve for loss on the deferred payments. It is 
necessary, however, to calculate the profit on each installment 
sale before preparing the Profit and Loss statement. 

Branch Store Accounting. Mercantile concerns often 
operate one or more branch stores. These may be located in 
the same or other cities. A complete set of books may be kept 
in each store, or the accounting may all be done at the main 
store. If the accounting is all done at the main store, the sys- 
tem will be si milar to a departmental system^ it being necessary 
to show results of operations of each store. 

A controlling account only may be kept on the books at 
the main store, con tammg a summary of thV transa'c^^^^ with 
the branch^tore. The account may be debited with the in- 
ventbiy of property on hand when the books are opened, or 
when the store is established. • In other words, the account 
would be debited for the total assets of the branch store. Sub- 
sequently, the account should be debited for: 

(a) Merchandise transferred to the store from the main 
store. 

(b) Merchandise or other property purchased and shipped 
direct to the branch store. 

(c) All branch store expenses including wages paid em- 
ployes. 

The accbunt should be credited for amounts received from 
the sale of merchandise. Usually the branch store manager 
remits only in cash as he collects on the sales. At the close of 
the fiscal period, the account would be credited for the invento ry 
of merchandise and other property on hand. 

If the Branch Store account is debited with the cost price 
of the merchandise transferred to it or purchased for it and is 
credited with the returns, which will usually be in cash, it will 
be seen that the balance, after having made the necessary ad- 
justment for the closing inventory, will represient the profit or 
loss resulting from the operations of the branch store. If desired, 
instead of opening a single controlling account, special accounts 
might be kept with Branch Store Inventory, Branch Store Pur- 
chases and Branch Store Sales. The inventory account would 
not only contain the merchandise on hand, but would also con- 
tain the fixed assets and current assets of the store; though if 
desired, these could be kept in separate accounts, leaving the 
inventory account for merchandise only. 



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ACCOUNTING PROBLEMS 141 

Another plan that is widely followed is to charge the branch 
store with merchandise at retail prices. If the Branch Store 
account should be charged with the beginning inventory at 
retail price with merchandise transferred to the store or pur- 
chased for the store during the period at retail prices, and was 
credited with the inventory on hand at the end of the period 
at retail price, it can readily be seen that the balance of the 
account will represent the returns from sales at the branch store. 
When the account is credited with the returns from the branch 
store, it will balance. 

To ascertain the profit, it will be necessary to take into 
consideration the cost of the merchandise previously charged 
to the Branch Store account. One advantage of this method 
is that the branch store manager will not know the results from 
operating the store. Since he does not know the cost of mer- 
chandise charged to his store, he cannot ascertain the profits 
resulting from his sales. 

ACCOUNTING PROBLEMS 

1. Outline a system of books for a concern conducting a 
wholesale drug house, a retail pharmacy, and a jobbing business 
in chemicals and apparatus used by colleges. Some setting up 
and repairing of apparatus is done, and so a shop is conducted. 
Four departments required and but one set of books. 

C. P. A. Ex. 

2. R.L.Eames has a chain of five retail grocery stores. Goods 
are sold to consumers for cash, and to small dealers on credit. 
Additional working capital is required. Three of Eames' friends 
agree to furnish funds providing the business is incorporated. 
Such books as exist have been kept by single entry. The business 
is duly incorporated for an authorized capital of $100,000.00, 
par value of shares $100.00 each. It is agreed that Eames shall 
turn over his business to the company as at July i, 1920, on 
appraised values of physical properties; and values of all book 
accounts (assets and liabilities) as they shall be disclosed; and 
Eames' net worth is to apply on his stock subscription of $25,- 
000.00. In addition, Eames is to be allowed 25% of the net 
worth for good will. Other capital stock subscriptions are, re- 
spectively: 

W. G. Mee $30,000.00 

H. B. Immel 25,000.00 

H. Frazier 20,000.00 

and each is to pay immediately in cash a proportionate amount 
on subscription which, altogether, shall aggregate 50% more 
than the value of capital stock issued to Eames. 

The Union Appraisal Company reports as follows: 
Real Estate: 

Store No. i $4,000.00 

Store No. 2 5,000.00 



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142 PUBLIC ACCOUNTING AND AUDITING 

Reproductive Sound 
Buildings: Values Values 

Store No. i $3,000.00 $2,000.00 

Store No. 2 7,500.00 5,000.00 

Furniture and Fixtures: 

Stores 10,000.00 7,500.00 

General Office 1,000.00 500.00 

Stock Room . 1,000.00 500.00 

Automobiles (2) 5,000.00 3,500.00 

Inventories (Merchandise) : 

In Store Room 14,000.00 

In Storage (Butter and Eggs) 5,000.00 

In Stores 11,000.00 

No. I $2,300.00 

No. 2 1,950.00 

No. 3 3.13500 

No. 4 2,365.00 

No. 5 1,250.00 

The book accounts disclosed are as follows: 

Cash at Bank $1,500.00 

Cash — General Office Petty Cash 100.00 

Cash — Stores 500.00 

No. I $140.00 

No. 2 75.00 

No. 3 160.00 

No. 4 60.00 

No. 5 65.00 

Accounts Receivable — Dealers $2,600.00 

Trade Creditors' Accounts 22,280.00 

Accrued Wages and Salaries 795-00 

Accrued Taxes 100.00 

Unexpired Insurance 50.00 

Mortgage on Real Estate and Buildings — dated 
July I, 1919; principal payable in 5 years; inter- 
est at 6% per annum, payable semiannually 7,500.00 

Notes Payable (Bank) : 

Due 3 months from May i, 1920 (6%) 10,000.00 

Due 3 months from June i, 1920 (6%) 5,000.00 

Interest falling due on mortgage loan has not been paid. 
Interest on the $10,000.00 note is payable at maturity. The 
$5,000.00 note was discounted. 

The following additional facts are shown on the books and 

records of the R. L. Eames Company at the close of the first 

month's business: 

Merchandise Purchases (of which $750.00 was re- 
turned) $35,000.00 

Stores' Sales as per Cash Register Totals: 

Store No. i $6,000.00 

Store No. 2 3,500. 00 



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ACCOUNTING PROBLEMS 143 

Store No. 3 $8,000.00 

Store No. 4 5,000.00 

Store No. 5 2,500.00 

Sales to Dealers $5,000.00 

Issues from General Stock (at cost) : 

Store No. i $5,585.00 

Store No. 2 2,850.00 

Store No. 3 6,470.00 

Store No. 4 4,210.00 

Store No. 5 2475.00 



^^WV W- ^WW^W W...^| 






Heat, Light, 


nixJtxj • ^^ 




Clerks' 




Cleaning, 




Expenses of Stores: 


Wages 


Rents 


Ice, etc. 




Store No. i.... 


.$200.00 


$65.00 


$25.00 


$290.00 


Store No. 2 — 


. 135.00 


25.00 


20.00 


180.00 


Store No. 3.... 


. 235.00 


75.00 


35.00 


345.00 


Store No. 4 — 


. 200.00 


150.00 


35.00 


385.00 


Store No. 5.... 


. 135.00 


100.00 


3500 


270.00 



Management and Office Salaries $385.00 

Store Room and Delivery Wages 265 .00 

Rent of Office and Store Room 3500 

Stationery and Office Supplies 40.00 

Postage 10.00 

Advertising 75-00 

Freight In 50.00 

Heat, Light, and Janitor (Office) 15. 00 

Appraisal and Audit Fees 350.00 

Law and Organization Expenses 250. 00 

Auto Up-Keep 90.00 

Telephone 40.00 

Debts of R. L. Eames not disclosed at date of turnover: 

On Creditors' Accounts $675.00 

On Storage Charges (of which $5.00 

is for current month) 20.00 695.00 

The stores' merchandise inventories at the 
end of the month amount to: 

Store No. i $2,650.00 

Store No. 2 1,875.00 

Store No. 3 2,920.00 

Store No. 4 2,115.00 

Store No. 5 940.00 

The stores' cash funds are reduced to: 

Store No. i $100.00 

Store No. 2 50.00 

Store No. 3 100.00 

Store No. 4 50.00 

Store No. 5 50.00 



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144 PUBLIC ACCOUNTING AND AUDITING 

Diflferences are found in the stores' cash funds at the close of 
the first month's business: 

Store No. i short $ 3.00 

Store No. 2 over i .00 

Store No. 5 over 17.00 

The general merchandise stock shows: 

Spoiled Goods $60.00 

Shortage in Inventory at the End 
of the Month 35-00 

The stores receive credit for spoiled goods: 

Store No. i $15.00 

Store No. 2 10.00 

Store No. 3 20.00 

Store No. 4 15.00 

Store No. 5 30.00 

The upper floor of Store No. i building is tenanted, and 
rentals at $25.00 monthly, payable in advance, are found to be 
three months in arrears, of which $50.00 is paid during July. 

Insurance expires September 30, 1920. All salaries and 
wages are payable one-half each on the ist and 15th of the 
month. 

Dealers have paid on their accounts, $4,200.00. Trade 
creditors have been paid (of which $340.00 is discount) $40,- 
000.00. 

Depreciation charges (annual rates) : 
On Buildings, 5%. 
On Furniture and Fixtures, 10%. 
On Automobiles, 25%. 

Part of Store No. 2 building is used for the general office 
and store room. 

You are asked to submit: 

(a) Opening entries on the books of the corporation (jour- 
nal form with brief explanations), taking over the business of 
R. L. E^mes and including payments on account of capital 
stock subscriptions. 

(b) General Cash account for the month. 

(c) Profit and Loss statement for the month, showing 
also, in a clear and simple manner, the stores' operations with 
percentages of gross profit on cost. It is not necessary to pro- 
rate any of the general business expenses to the stores. 

(d) Comparative Balance Sheet as at July i and July 31, 
1920. 

(e) A brief statement giving the grounds of your conclu- 
sions in explanation of the loss on goods sold in Store No. 5. 

C. P. A. Ex. 



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Chapter Ten 

SYSTEMATIZATION (Continued) 

FLOUR MILL ACCOUNTING 

To continue the discussion of the fundamental principles 
of systematization and to further outline the accountant's 
work in connection with the installation of an accounting sys- 
tem, the present discussion will be confined to a system of 
accounts adapted to a specific concern. We will first describe 
briefly the organization of the concern to which the system is 
to be adapted, as well as the purpose of the accounting system 
to be installed. 

The Edgerton Milling Co. is organized as a corporation 
with a capital stock outstanding of $50,000.00. Wheat and other 
grains are purchased direct from farmers and from elevators. 
Flour, feed and other products are sold direct to farmers at retail 
prices, to merchants at wholesale, and also to jobbers. 

Heretofore, the company has been satisfied with a crude 
system of accounts which might be termed a "single entry" 
system. They were not able to arrive at costs accurately, but 
determined selling prices by arbitrary methods. To ascertain 
true costs, to obtain needed statistics, and to prepare income 
and excess profits tax returns more intelligently, it has been 
decided to call in a certified public accountant for the pur- 
pose of installing a suitable system of accounts. 

In a preliminary investigation of the various phases of 
the flour mill industry, the following facts were ascertained. 

(i) The raw material upon which the industry depends 
is produced in seasons, thus involving periods during which 
no grain is available, and in the event of complete or partial 
crop failures, a regional shortage; therefore, in order to insure 
a steady in-flow of grain for milling purposes, contracts of pur- 
chase are made for future delivery. 

(2) The product of the flour mill is a necessity for which 
there is a constant and continuous demand. In order to insure 
a steady out-flow of flour through the system of distribution, 
it is necessary to enter into contracts of sale for future delivery. 

(3) The trading in "futures" involves what might be 
termed "speculation." While the conservative miller avoids 

. gambling as much as possible, there are millers who combine 
the speculative feature with their milling business. 

(4) In grain growing regions, farmers find it convenient 
to deliver tJie grain to a miller and purchase flour and offal 
(feed). This custom has resulted in what is termed an "ex- 



14s 



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146 PUBLIC ACCOUNTING AND AUDITING 

change." The miller exchanges his products for the raw mater- 
ial of the farmer, allowing the farmer the current mafket 
price for grains and charging the selling price for flour and feed. 
This exchange feature has led to the development of numerous 
small country mills which will probably continue to exist in- 
definitely, regardless of the competition from large and grow- 
ing companies. 

(5) The cost of raw material forms the principal part 
of the selling price. This cost varies from 75 to 80 per cent, 
of the sales price of patent flour. 

(6) To produce a particular brand of patent flour, the 
miller purchases wheat of proper grades and kinds so as to 
maintain a constant mixture of such grades and kinds of wheat 
as will produce the desired brand. 

(7) Generally speaking, about 4H bu. of wheat are re- 
quired for a barrel of flour (196 lbs.), while a by-product of 
approximately 74 lbs. of offal is divided between various grades 
of feed known as screenings (red dog), middlings, brans and shorts. 

(8) In sacking the flour, various sizes and kinds of sacks 
are used, ranging in content from 6 lbs. to 140 lbs. 

(9) The milling industry is such that it may be classed 
with the so-called "by-product industries," in which the pro- 
duction of one article (flour) is attended by the production of 
certain by-products (offal). 

(10) A peculiar system exists in the milling industry for 
charging freight. The miller purchases wheat for shipment 
to his mill, paying the local freight rate from point of purchase 
to the mill. The flour is then milled and shipped at the through 
rate from point of original purchase to selling point, credit 
being extended by the carrier against the rate computed at the 
through rate for the amount already paid at the local rate from 
point of purchase to the mill. This is known as a ''milling-in- 
transit" privilege and may result in a saving of from ten to 
twenty-five cents per barrel of flour, hence is an important 
item to the countiy miller. 

Outline of Accounts. The following outline of ac- 
counts was prepared by the accountant preliminary to devising 
the books of account. Note the system used for numbering 
the accounts. This system can be carried out regardless of 
the number of accounts to be kept. If a classification of accounts 
is to be of the most service, it should have a system of account 
numbers, and an arrangement of accounts that will permit 
the addition of new accounts at any point, as the necessity 
arises, without disturbing the general scheme or order. The 
Dewey system of numbering, or a combination of numbers and 
letters, permits the greatest flexibility, provided tabulating 
machinery is not used. 



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FLOUR MILL ACCOUNTING I47 

OUTLINE OF ACCOUNTS 

1. Assets. 

11 Current assets. 

111 Cash. 

112 Accounts receivable. 

1121 Customers' ledger. 

1122 Reserve for bad and doubtful accounts. 

113 Notes receivable. 

114 Inventories. 

1141 Flour. 

1142 Offal. 

1 143 Other products. 

1144 Wheat. 

1145 Flour packages. 

1146 Offal packages. 

1147 Mill supplies. 

115 Temporary investments, 
no Options. 

12 Deferred assets. 

121 Insurance prepaid. 

122 Expenses prepaid, 
i^ Milling-in-transit. 

13 Fixed assets. 

131 Land. 

132 Mill. 

1321 Mill buildings. 

1322 Reserve for depreciation. 

1323 Mill equipment. 

1324 Reserve for depreciation. 

133 Office. 

1331 Building and equipment. 

1332 Reserve for depreciation. 

134 Storage and delivery. 

1341 Building and equipment. 

1342 Reserve for depreciation. 

135 Permanent investments. 

1351 Bonds. 

14 Special assets. 

141 Contracts for future delivery — flour. 

142 Contracts for future delivery — offal. 

15 Contingent assets. 

151 Claims. 

2. Liabilities. 

21 Current liabilities. 

211 Accounts payable. 

212 Notes payable. 

213 Accrued liabilities. 

2131 Taxes. 

2132 Interest. 

2133 Wages. 



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8 PUBLIC ACCOUNTING AND AUDITING 

OUTLINE OF ACCOUNTS 

22 Fixed. 

221 Mortgage payable. 

222 Bonds. 

23 Contingent. 

231 Notes receivable discounted. 

232 Claims. 

24 Special. 

241 Contracts for future delivery. 

Proprietorship. 

31 Capital stock. 

32 Unappropriated surplus. 

33 Appropriated surplus. 

331 Reserve for contingencies. 

332 Reserve for sinking funds. 

34 Profit and loss — current year. 

341 Dividends. 

342 Income and excess profits taxes. 

343 Appropriations of net profits. 

Revenues. 

41 Sales. 

411 Flour. 

412 Returns and allowances on flour sales. 

413 Offal. 

414 Returns and allowances on offal sales. 

415 Freight outward. 

42 Gains on options. 

43 Other income. 

431 Interest. 

Expenses. 

51 Cost of sales. 

511 Milling. 

512 Packages. 

5121 Flour. 

5122 Offal. 

$2 Selling. 

521 Salesmen's salaries. 

522 Traveling expenses. 

523 Commissions. 

524 Advertising. 

525 Bad debts. 

53 Warehouse and delivery. 

531 Salaries. 

532 Other expenses. 

533 Depreciation. 

54 Administration. 

541 Office salaries. 

542 Office expenses. 

543 Depreciation. 

55 Interest and exchange. 

56 Loss on options. 



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FLOUR MILL ACCOUNTING 149 

Books of Account. There follows illustrations of the 
various books of original entry devised by the accountant, 
together with a detailed description of each book and instruc- 
tion for its use. 

Record of Purchases. (Forms 201, 201-A and 201-B) 
Either a loose-leaf or bound, book may be used for a record of 
purchases. In the illustration, we have subdivided the record 
assuming that it would be better to use two pages rather than 
to attempt to get all the desired information on a single page. 
The purpose of this record is to record the quantity and amount 
of all goods purchased, whether raw material for milling, sup- 
plies representing expense items, or equipment representing 
fixed assets. 

The desired information may be obtained from the invoices 
received or from reports of material receipts. When raw ma- 
terial is purchased direct from farmers, no invoice will be re- 
ceived, hence it will be necessary to provide a record of mate- 
rial receipts. This form is to be used in recording receipts of 
all material from farmers and may be used in recording all 
other receipts of raw material.^ The material received can 
then be checked against the original invoices. 

The total amount of the invoices should be recorded in 
the first money colunm. Each item in this column should be 
posted to the individual creditor's account in the accounts 
payable ledger. At the end of the month, the total of the column 
should be posted to the credit of the Accounts Payable Con- 
trolling account in the general ledger. If it is not desired to 
keep an account with persons from 'whom material is purchased 
for cash, the item may be checked in both the purchases and 
cash books, indicating that it should not be posted to the in- 
dividual's account. 

The material purchased should be distributed to the various 
columns provided therefor. The amount of wheat purchased 
should be entered in the columns headed Wheat, recording 
both quantity and amount purchased. Flour and feed sacks 
and other commodities should be distributed similarly in the 
columns provided. At the end of the month, these columns 
should be totaled and posted to the debit of the proper accounts 
with materials in the general ledger. These accounts will 
represent inventory accounts. In posting other commodities, , 
it will be necessary to analyze the items so that the posting 
will be to the proper accounts. 

Manufacturing, administrative and selling expenses should 
be analyzed and charged in detail to the proper accounts. 
Fixed assets and other items that cannot be classified in the 
preceding columns should be recorded in the columns headed 
Sundries. These items should be posted individually to the 
proper accounts in the general ledger. At the end of the month, 
the total of the debit columns should equal the total of the 
credit columns. 



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ISO PUBLIC ACCOUNTING AND AUDITING 

Form 901 Recofd of PuTchases 





1 


From Whom 
Pttcbawd 


INVOICE 


WHBAT 1 


SACKS 1 


Date 


No. 


Temt 


Amoant 
(Cr.) 


Qomtity 


Amoant 
(Dr.) 


Floor 
(Dr.) 


Feed 
(Dr.) 































Form201-A 



Record of Purchases 





Mff.Bipamt 


Adm.4SeILEx|>. | SUNDRIES | 


AoeooBt 


Amoimt 
(D«0 


AoeooBt 


Amoant 
(Dr.) 


Aoooont 


Amoant 
(Dr.) 


Aoooaot 


Amoant | 
(Dr.) 1 



























Form901-B 



NAME 



TERMS 



Material Receipts Report 



Edgerton MiUing Co- 



date 



in 



FOLIO 



DBBCRIPnON 



Artide 



Weight Quantity 



COST 



Rato 



Amoant 



R KMARIffl 



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FLOUR MILL ACCOUNTING 151 

Record of Cash Receipts. (Form 202) The object of 
this book is to provide a record of all cash received from what- 
ever source. Columns are provided for General Ledger and 
Accounts Receivable Ledger accounts. All remittances from 
customers to apply on account should be recorded in the special 
column provided for the Accounts Receivable Ledger accounts. 
All individual items in this column should be posted to the 
individual customer's account in the accounts receivable ledger. 
At the end of the month, the total of the column should be 
posted to the credit of the Accounts Receivable controlling 
account in the general ledger. 

Interest and exchange should be recorded in the column 
provided. At the end of the month, this column should be 
footed and the total posted to the debit of the Interest and 
Exchange account in the general ledger. Cash sales should be 
entered in the column provided. If cash sales are numerous, 
a special record may be provided and at the end of each day, 
the total may be recorded herein. At the end of the month, 
the total of the Cash Sales column should balance with the 
total of the Cash Sales column in the sales book. 

Net cash received should be recorded in the special column 
provided in order to provide for an internal check by some- 
one within the company or for an audit by a public accountant. 
The total cash received each day should be deposited in the 
bank. If this is done, the total of the cash received will 
equal the bank deposits at the end of the month, provided all 
money received has been deposited on the last day of the month. 
If desired, a petty cash fund may be kept. At the end of 
the month, the total of the debit columns should equal the total 
of the credit columns. 

Record of Gash Disbursements. (Form 202-A) The 

object of this book is to provide a complete'record of cash dis- 
bursements. ' It is needless to say that it is best to make all 
payments by check. Payments to creditors on account should 
be recorded in the Accounts Payable Ledger column. All in- 
dividual items in this column should be posted to the individual 
creditor's account in the accounts payable ledger. At the end 
of the month, the total of the column should be posted to the 
debit of the Accounts Payable controlling account in the 
general ledger. Note that columns are provided for Interest 
and Exchange, Manufacturing Expense, and Administrative 
and Selling Expense. This eliminates considerable posting as 
it will not be necessary to post the individual items. At the 
end of the month, the columns may be footed and the totals 
posted to the proper accounts. 

If all payments are made by check as suggested, it is not 
necessary to provide a Net Cash Paid colunm because the net 
cash paid will be shown in the Checks Issued column. At the 
end of the month, the total debit entries must equal the total 
credit entries. 



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152 



PUBLIC ACCOUNTING AND AUDITING 



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FLOUR MILL ACCOUNTING 153 

Record of Sales. (Form 203) The object of this book 
is to provide a complete record of all sales, whether for cash 
or on account. Every sale should be covered by an invoice. 
Account sales should be debited to the proper customer, the 
amount being Vecorded in the Account Sales column. The in- 
dividual items in this column should be posted^ to the indi- 
vidual customer's account in the accounts receivable ledger. 
At the end of the month, the total of the column should be 
posted to the debit of the Accounts Receivable controlling 
account in the general ledger. 

Cash sales should be entered in the first column. As has 
already been stated, if the cash sales are numerous and varied, 
a special record may be provided so as to eliminate the record- 
ing of a large number of small cash sales in this book. If this 
is done, the total cash sales for the day may be recorded in one 
amount. An analysis of the cash sales made will provide the 
information necessary to credit the respective sales accounts 
representing the various commodities sold. 

All sales recorded in the first two columns should be properly 
distributed in the remaining columns. The distribution calls 
for the recording of kind, quantity and amount of each sale. 
With cash sales, this information may be obtained by an analysis. 
The required information may be obtained from the bill. (It 
is best that all billing be done in duplicate. In some instances, 
it may be equally satisfactory and even preferable to consider 
the carbon copies of the bills as the record of sales. The posting 
to the individual customer's accounts may be made direct 
from the bills and a recapitulation sheet may be provided in 
order that a proper distribution of the sales may be made. 
The recapitulation should show approximately the same in- 
formation as will be shown on Form 203.) At the end of the 
month, the total debit entries must equal the total credit entries. 

Order Book. (Form 203-A) Each order taken should 
be recorded in this book. The record should show the date 
the order was received, the name and address of the customer 
ordering, the quantity and kind of goods ordered, and the price 
at which the goods are to be billed. When the order has been 
filled and the goods shipped, this should be indicated on the 
order, and the customer should be billed. At the end of the 
month, the order book will show the orders on hand unfilled. 
It may happen that some orders have been filled in part but 
not completed and, therefore, not invoiced. In this case, the 
question arises as to whether or not a profit should be taken 
on the partly filled orders. If by "profit" is meant the excess 
of sales over the actual selling cost of sales, the firm would be 
justified in showing the profit on partly filled orders. If it 
is desired to show unfilled^ orders as a contingent asset, this 
should be offset by a contingent liability. If the orders un- 
filled are to be classed as assets, the milling company must also 
consider the liability existing on the unfilled orders. 



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154 



PUBLIC ACCOUNTING AND AUDITING 



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5 1 

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FLOUR MILL ACCOUNTING 



^5S 



FonnaOi 












Journal 














Aeooimto 

Fuj.Led. 

(Dr.) 


AeeoontB 

B«e.Led. 

(Dr.) 


QoLLed. 
(Dr.) 


ACXJOUNT 


QeiLLed. 
(Cr.) 


Aeeoanti 

Rae.Led. 

(O.) 


Aooonnti 

IV.Led. 

(Cr.) 





























Journal. (Form 204) All entries that cannot be record- 
ed in the special books of original entry should be recorded in 
the journal. Correcting and adjusting entries should be journal- 
ized and, at the end of the fiscal period, the nominal accounts 
in the general ledger should be closed by means of closing 
journal entries. Note that in this form of journal, there are 
provided debit columns at the left and credit columns at the 
right. Compare with the form of journal shown on page 138. 

Stock Record. This book is provided for the purpose 
of keeping a perpetual inventory of all materials and products. 
Accounts should be kept with each kind of material, such as 
wheat, packages, etc., also with each product, such as flour, 
feed, etc. 

The record should be divided into three parts — received 
or produced, consumed or sold, and balance on hand. The 
quantity and cost of material on hand should be recorded at 
the beginning of the pericxl. This will be taken from the physical 
inventory. During the month, all purchases of material should 
be recorded, the information being obtained from the invoices 
and material receipts reports. If desired, the total purchases 
for the day may be entered in one item, using the average 
cost. The average cost may be found by dividing the total 
cost by the quantity. All material consumed must be recorded 
as to quantity, average cost, and amount. The information 
may be obtained from the Material Consumption Report. 
(See Form 205.) If material received and material consumed 
is properly recorded, it is only necessary to calculate the bal- 
ance as to quantity and average cost in order to ascertain the 
inventory of material on hand at the end of the month. 

The stock record of prcxlucts such as flour and feed is 
equally important but more complicated. In order to acquire 
the desired information, it will be necessary to prepare daily 
production reports. (See Form 206.) These products are pro- 
duced instead of being purchased; hence it is necessary to 
ascertain the cost of production in order to make a proper 
record of material produced as to quantity and cost. The cost 



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156 PUBLIC ACCOUNTING AND AUDITING 

of production involves the cost of the raw material consumed, 
labor, both direct and indirect, and manufacturing expenses. 
(Inasmuch as the principles of cost accounting is the next topic 
to be taken up, a detailed discussion of the elements of 
cost of production will not be undertaken here.) 

The accounts with products will be charged with the quan- 
tity produced and cost of production, and will be credited 
with the quantity sold at cost price, the difference being brought 
forward as a balance. If it is not desired to keep a record of 
products as to value but in quantity only, the record will be 
greatly simplified as it will only be necessary to charge the 
account with the quantity produced and credit it with the 
quantity sold, the difference being the balance on hand in 
quantity. For a small mill where a sound cost system is not 
in use, this will be best. 

Material Consumption Report. (Form 205) The ob- 
ject of this report is to provide a record of material consumed 
daily as to quantity and cost. The quantity will be ascertained 
by weighing the grain consumed. Most mills are now equipped 
with automatic scales so that the grain is automatically weighed 
as it is milled. The cost of material consumed will be shown 
by the stock record. It will be best to assume that material 
received first is milled first, though if desired, the average 
cost may be used. 

Production Report. (Form 206) The object of this 
report is to furnish a record of the quantity of all products 
produced daily. Columns are provided for each day in the 
week. These may be totaled and the total production shown 
at the end of \the week. This will provide the necessary in- 
formation for the stock record of products so far as quantity 
is concerned. 

Ledgers, in addition to the general ledger, subsidiary 
ledgers for accounts with Customers and Creditors should be 
provided. No special rulings will be necessary. Controlling 
accounts for the subsidiary ledgers must be kept in the general 
ledger. At the end of each month, a schedule of the Accounts 
Receivable and Accounts Payable should be prepared and this 
should be compared with the balance of the controlling ac- 
count. Any discrepancy should be located and corrected. If 
the subsidiary ledgers are to be made self-balancing, it will be 
necessary to provide a controlling account to be kept in each 
subsidiary ledger. This account will be similar to the control- 
ling account in the general ledger except that it will be just 
the reverse, that is, it will be debited for all items appearing on 
the credit side of the controlling account in the general ledger, 
and will be credited for all items appearing on the debit side of 
the controlling account in the general ledger. The bookkeeper 
may then check the schedule of the individual accounts with the 
controlling account, without reference to the general ledger. 



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FLOUR MILL ACCOUNTING 



157 



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158 PUBLIC ACCOUNTING AND AUDITING 

A. THEORY QUESTIONS 

1. In devising an accounting system for a business, what 
are the principal matters to be considered by the accountant, 
and in what order should they have attention? C. P. A. Ex. 

2. Rule a form of cash book to provide for controlling 
accounts of debtors and creditors, for discounts in settlement 
of both receivable and payable accounts. What is the usual 
method of posting these figures? C. P. A. Ex. 

3. You have been asked to prepare a system required 
for a clubhouse where rooms and board are furnished at a fixed 
rate per week. Submit a report to the directors outlining just 
what should be done, and what books and accounts would be 
needed. C. P. A. Ex. 

4. In examining the affairs of a manufacturing concern 
you find, among the assets, finished goods inventory of $175,- 
798.00 and ascertain that included in the above total is the 
sum of $50,000.00 covering goods deposited as collateral to 
secure notes which are included in the Notes Payable account. 
How would you treat this in a statement prepared for credit 
purposes? Explain why. Inst. Ex. 

5. A manufacturing concern asks you to certify to its 
average annual profits for the past five years. After charging 
all costs, expenses, and depreciation and allowances for bad 
debts, etc., it is found that profits for the first year were $30,- 
000.00; second year, $37,500.00; third year, $35,400.00; fourth 
year, $43,200.00; fifth year, $38,700.00. 

Included in the second year's profits is profit on sale of 
real estate, $3,750.00; in third year's profits, $7,500.00 profit 
on investments; in fifth year's profit is $8,600.00 profit on 
real estate. 

What would you certify as the average annual profit? 
Give reasons. C. P. A. Ex. 



B. ACCOUNTING PROBLEMS* 

I. From the Balance Sheet of the Lansdale Monotile 
Company dated December 31, 1920, together with the infor- 
mation following, show the Trial Balance before closing. 



•These problems constitute a review of the principles covered up 
to this point. If you have thoroughly mastered all the preceding work, 
you should experience no difficulty in solving them. 



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ACCOUNTING PROBLEMS 



159 



THE LANSDALE MONOTILE COMPANY 
Balance Sheet— December 31, 1920 



Assets 
Land & Bldffs.l 500,000 
Less Res. for 

Depr 120,000 $ 380,000 

Mach. & Equip. . $ 200,000 
Less ReSk for 

Depr 80,000 120,000 

Cash 58,000 

U.S.Vict. B'ds 100,000 

Mdse. Inv 125,000 

Accts. Rec $250,000 

Less Res. for 

Dbt. Accts . 12,500 
Notes Rec. 



Acer. Int. Rec. 
Total Assets . . . 



237.500 
100,000 
4,500 
$1,125,000 



Liabilities and Capital 

Capital Stock $ 300,000 

Notes Payable 350,000 

Accounts Payable 158,000 

Accrued Int. Payable.. 3»ooo 

Surplus 314,000 



^otal Liabilities and 



Capital $1,125,000 

The accruals at the time of closing were: Interest on 
Notes Payable, $3,000: depreciation of buildings, $20,000; 
interest on Notes Receivable, $2,000; depreciation of ma- 
chinery and equipment, $30,000; interest on Victory Bonds, 
$2,500; provision for doubtful accounts, $12,500. The other 
nominal accounts closed out were: Sales, $325,000; adminis- 
trative expense, $50,000; cost of goods sold, $125,000; selling 
expense, $25,000. Inst. Ex. 

2. THE PASSAIC FALLS WOOLEN MANUFACTURING CO. 
Balance Sheet-nJune 30, 1920 



Assets 

Land $ 10,000 

Buildings (brick) 100,000 

Machinery 150,000 

Steam Power Plant 25,000 

Treasury Stock, Com., 

250 shares costing 20,000 

Accounts Receivable 50,000 

Inventories (6-30-20) 7S.ooo 

Cash 20,000 

Total Assets $450,000 



Liabilities 

Cap. Stock, Com., par 
$100 $125,000 

Cap. Stock, Pfd., 7% cu- 
mulative, par $100 100,000 

Accounts Payable 150,000 

Undistributed Earnings 

(6-30-19) 60,000 

Profits, year ended 

(6-30-20) 35,000 

Total Liabilities « . .$450,000 



Adjust the above figures in regard to the following: 
(i) Land is appraised at $15,000 and is to be adjusted 
to that value. (2) Give effect in the statements to depredation 
of 2j^ % on the brick buildings, 7}^ % on machinery, and 10 % 
on the steam power plant, for the year ended June 30, 1920, 
(3) Dividends on the preferred stock have not been paid for years 
ended June 30, 1919, and June 30, 1920. (4) Inventories are 
valued $5,000 below cost. 

From the above Balance Sheet and data, prepare corrected 
Balance Sheet in appropriate form for the information of stock- 
holders and auditor's certificate thereto, and show statement 
of adjustments to profits and surplus. Inst. Ex. 



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i6o PUBLIC ACCOUNTING AND AUDITING 

3. The Indiana Mining Company submits the following 
Trial Balance as of December 31, 1920. 

Account Dr. Axnt. Or. Amt. 

Cash on Hand $ 74-50 

Cash in Bank 5,9S6.oo 

Accounts Receivable 39,112.25 

Accounts Payable $ 12,500.00 

Notes Receivable 15,000.00 

Capital Stock 100,000.00 

Surplus 67,709.35 

Buildings and Machinery 145,000.00 

Office Building S,ooo.oo 

Blacksmith Shop 4,000.00 

Inside Construction 151675.00 

Car and Mine Rail account 7*534-50 

Horses and Mules 5,600.00 

Coal Sales 267,246.00 

Depr. (Res.) Buildings and Machinery 12,000.00 

Supplies 8,240.00 

Pay Roll, outside 24,701.50 

Pay Roll, inside 110,434.25 

Salaries, mine superintendent 6,000.00 

Salaries, office clerks 4,500.00 

Office Expense 1,14735 

General Expense 750.00 

Claims Paid (injuries) 4,000.00 

Insurance (expires 7-1-21) 5,500.00 

Repairs to Buildings 4,075.00 

Repairs to Construction, inside 3>445.oo 

Barn Expense, outside 1,500.00 

Selling Expense 4*500.oo 

Royalty account 30,500.00 

Water 800.00 

Fuel 935.00 

Timber and Props 5,475.00 

Total $459455.35 $459455.35 

Total output of mine for year 1920 132,300 tons 

Inventories 12-31-20: 

Timber and Props $1,500.00 

Powder 555-00 

Oil and Sundries 175 .00 

Examination of books and records shows following not 
entered : 

Horses and Mules $2,200.00 — Dr. 

Car and Mine Rail account 1,450.00 — Dr. 

Claim Paid (injuries) i. 000. 00 — Dr. 

Error — $3415.00 charged to inside construction should have 
been inside pay roll. 

Coal is mined on a lease. Royalty 20 cents per ton. 

Depreciation at rate of 5% to be considered on buildings 
and machinery. 

REQUIRED: 

Prepare Profit and Loss statement and Balance Sheet, as 
of this date (12-31-20), showing gross earnings, net earnings 

and the average cost per ton of coal. C. P. A. Ex. 



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Chapter Eleven 

SYSTEMATIZATION (Concluded) 

COST ACCOUNTING 

Definition. Cost accounting may be defined as that 
part of general accounting which relates to the recording of 
manufacturing operations, such as the recording of material, 
labor, and manufacturing expenses — all items which enter into 
the cost of manufacture or construction of a definite piece of 
work. A cost accounting system, as ordinarily understood, is 
a system of factory accounts which, properly adjusted to the 
general system of factory operations and accounting, enables 
the manufacturer to ascertain with at least fair accuracy the 
production cost of his products and the constituent elements 
which make up this cost. 

Need for Ascertaining True Costs. Formerly a knowl- 
edge of true manufacturing costs was not as imperative as it is 
today. There was a wider margin between cost and selling 
prices. Production did not exceed consumption. Competition 
was not so keen. A good profit could be realized on the invest- 
ment and costs could be largely ignored. In some small concerns 
where costs are quite well known and in those larger concerns 
where the selling price is far above any possible costs, ignorance 
of exact costs may not involve disastrous results, even today. 

However, the manufacturer who desires to obtain satis- 
factory results permanently or who expects to accomplish any- 
thing worth while, must quit guessing at costs in the factory. 
We may safely say that the point has been reached where no 
manufacturer will attempt to market his product without some 
knowledge of its cost. It is gratifying to those accountants and 
engineers who have for years preached the doctrine of the 
necessity of cost accounting as a vital feature in business to 
know that in the last few years business men have had a real 
awakening on the subject. It may now be safely assumed that 
every manufacturer is endeavoring to secure definite information 
relating to the cost of his product. In an endeavor to secure 
this information, practically every manufacturer has some 
method or system by means of which costs are figured. It does 
not matter how crude such a system or method may be, it rep- 
resents a cost system just the same. 

Place of Cost Accounting. In the early days of cost 
accounting systems, the cost accounts were usually kept distinct 
and separate from the general accounts. It was thought that 
the difference of standards could not be reconciled. Time and 
progress have shown that if best results are to be obtained, the 
cost system must represent an integral part of the general ac- 
counting system. It is true that a cost system kept entirely 
independent of the general accounting system may supply 
information and data of very considerable importance, but 
such a system fails to attain its highest usefulness and value. 

i6i 



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i62 PUBLIC ACCOUNTING AND AUDITING 

A cost system should not be merely a statistical system. 
Materials, labor and manufacturing expenses must be accounted 
for accurately. By means of a sound cost system, raw material 
is traced to goods in process and then to finished goods. At 
this point the cost of production must be known before selling 
prices can be intelligently determined. Without information 
as to actual costs of production, selling prices must be determined 
in ignorance of the true costs. Statistics show that a very large 
per cent, of those concerns which fail, do so because of a lack of 
knowledge on the part of the managjfement as to costs. This 
may be a result of no effort to arrive at costs by means of an 
accounting system, or it may be the result of a cost system that 
that does not correlate with a general accounting system; hence 
is nothing more than a memorandum system. 

Object of Cost Accounting, (a) To Determine the 
Cost of Production per Unit. The fundamental object of cost 
accounting is the determination of production costs on each 
unit of product. This is the simplest and a necessary result- 
ant of any correct and properly operated system of cost account- 
ing. While the fundamental object is the same, there is a wide 
difference in cost accounting between the merchant and the 
manufacturer. The only elements entering into the cost of 
goods purchased by merchants are the purchase price, over- 
expenses and selling expenses. The manufacturer purchases 
raw material and works it into the finished product. In the 
process, many different machines may be used and both pro- 
ductive and nonproductive labor is involved. In addition, there 
are factory expenditures of various kinds which should be pro- 
rated over the finished product on an equitable basis. All these 
production costs must be known before determining selling 
prices. . . 

(b) To Determine Profitable Lines of Production. It is 
necessary for a business man to know on which articles he is 
making a profit and on which he is incurring a loss. Competitive 
conditions are seriously disturbed where losses on one or more 
articles are recovered by profits on other articles. A knowledge 
of true costs of producing all articles will and should result in 
concentration of manufacture on the more profitable articles. 

(c) To Secure Statistics and Reports to be Used in Deter- 
mining Managerial Policies. In these days of large industrial 
concerns wherein personal supervision is impossible, the only 
reliable way by which an executive can judge of the efficiency 
of an organization and plans for future operations is through a 
system of periodic statistical reports. Such reports can only be 
accurately obtained when a good cost system is in operation. 

Advantages of Uniform Systems of Accounts. The 

value derived from an adequate system of accounts is obvious. 
The greatest value is that of making comparisons and analyzing 
differences. But before any fruitful comparison can be made 
between figures of different periods or between figures of different 



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COST ACCOUNTING 



163 



stores, it is absolutely necessary that the systems be uniform. 
With a uniform system of accounts in use, differences in items 
reflect differences in conditions, while without a uniform classifi- 
cation, differences in items may reflect only differences in ac- 
counting classification. 

There has not been much standardization of accounts 
among mercantile concerns, though there has been a marked 
improvement towards the adoption of uniform accounting sys- 
tems within different lines of trade and industry during the last 
ten or fifteen years. Numerous trade associations* have estab- 
lished uniform systems which have been put into operation by 
their menbers. 



Cost Accounting as an Aid to Management. It has 

been said that "The test of industrial accounting as applied in 
any manufacturing plant is its utility as an aid to management." 
A system of factory accounts, to be of practical value, must 
serve as a dependable guide to the management in the adminis- 
tration of manufacturing operations. A proper system should 
furnish the necessary information for the preparation of current 
reports that will reveal to the management any variations 
between actual and standard performance which, in turn, will 
indicate the way to economics and increased production. Cost 

*The committee on Research and Education of the National Association of Cost Account- 
ants has compiled a list of the Trade and Manufacturing Associations which have adopted uni- 
form accounting systems. This list follows: 



Steel Barrel Manufacturers' Association. 

The American Boiler Manufacturing Asso- 
ciation. 

The American Face Brick Association. 

The National Association of Box Manufac- 
turers. 

Folding Box Manufacturers' National Asso- 
ciation. 

The National Association of Brass Manufac- 
turers. 

National Canners' Association. 

The Casket Manufacturers' Association of 
America. 

Portland Cement Association. 

American Association of Pharmaceutical 
Chemists. 

National Association of Finishers of Cotton 
Fabrics. 

The National Cloak. Suit & Skirt Manufac- 
turers' Association. 

National Coal Association. 

National Confectioners' Association of the 
United States. 

National Association of Dyers and Cleaners. 

Electrical Manufacturers' Council. 

National Association of Electrical Con- 
tractors and Dealers. 

Biscuit and Cracker Manufacturers' Asso- 
ciation of the United States. 

The Steel Founders' Society of America. 

American Foundrymen's Association. 

National Foundrymen's Association. 

National Association of Upholstered Furni- 
ture Manufacturers. 

Heating and Piping Contractors* National 
Association. 

National Warm Air Heating and Ventilating 
Association. 

National Association of Ice Industries. 

National Implement and Vehicle Association 
of the United Sutet of America. 



Label Manufacturers' National Association. 

National Association of Employing Lithog- 
raphers. 

Lime Association. 

Southern Sash. Door and Millwork Manu- 
facturers* Amodation. 

North Carolina Pine Association. 

West Coast Lumbermen's Association. 

California White and Sugar Pine Manufac- 
turing Association. 

National Paint and Oil Varnish Association. 

American Photo-Engravers' Association. 

Writing Paper Manufacturers' Association. 

Cover Paper Manufacturers* Association. 

Newsprint Service Bureau. 

United Typothetae of America. 

Atlantic Coast Shipbuilders' Association. 

Missouri Valley Association Sand and Gravel 
Producers. 

National Association of Sheet and Tin Plate 
Manufacturers. 

The Central Association of Stove Manufac- 
turers. 

National Association of Stove Manufacturers. 

Truck Owners' Conference. Inc. 

National Machine Tool Builders' Association. 

The National Tent and Awning Manufac- 
turers' Association. 

American Warehousemen's Association. 

Sweaters and Knitted Textile Manufacturers* 
Association. 

International Garment Manufacturers. 

Anthracite Coal Operators. 

Concrete Mixers* Association. 

American Hardwood Manufacturers* Asso- 
ciation. 

Allied WaU Paper Industry. 

National Paper Trade Association. 

Metal Finishers* Equipment Association. 

Association of Chilled Car Wheel Manu- 
facturers. 



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i64 PUBLIC ACCOUNTING AND AUDITING 

data should be so interpreted through the accounts that the 
factory executives are given accurate information regarding all 
factory activities which they wish to have presented to them, 
and the financial and sales executives are presented with correct 
statements of financial condition and operating profits and 
losses, as well as adequate statistics of sales, costs, and expenses 
of various classification. 

Devising a Ck>8t Accounting System. The devising 
of a cost accounting system and adapting it to a particular plant 
should be attempted only by one who is familiar with the oper- 
ating requirements of the business and who understands the 
necessities of organization in industrial concerns. The factors 
of cost and output which have the greatest influence on ultimate 
profits must be discerned and practical means must be found 
for translating them into reports, statements and charts. A 
suitable type of system and construction of its details cannot 
be determined without an understanding of the general policies 
of the business. 

Many cost systems have failed to accomplish the desired 
results because they were devised and installed without an 
adequate conception of the problems involved or the factors 
that should have been considered. 

Cost Sjrstems. While the fundamental principles of any 
cost system are the same, yet there are at least three distinct 
systems in general use. Since the object of a cost system is to 
allocate the costs to the products on a sound basis, the method 
of allocation will necessarily depend upon the conditions of pro- 
duction. The leading cost systems include: 

(a) The Job Cost or Production Order system. 

(b) The Continuous Production or Process system. 

(c) The Predetermined Estimate system. 

The Job Cost or Production Order System. The 

first step with this system is to provide a form for recording the 
order* The purpose of this form is to give the factory instruc- 
tions as to order work which is to be done. The form should 
piovide for the following information: 

Order No. Distribution of work to 

be done, including speci- 

Date. fications as to material 

needed and shipping in- 

Name and address of customer, structions. 

A job ledger is required. This should be a loose-leaf ledger. 
The form used should provide for information with regard to the 
order number, name of customer, date, cost of material consumed, 
labor, manufacturing expenses, this information being recorded 
as the order passes through the different processes of manu- 
facture. 



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COST ACCOUNTING i^ 

This system may be used with satisfactory results in any 
concern where goods are placed in process of manufacture in 
lots which can be kept separate throughout. This enables the 
recording of costs on each different order or lot during the pro- 
cess of manufacture. Each lot is given an order numl^r and all 
labor and material which can be allocated directly to an order 
is charged to that number, an account being kept on the factory 
books for each number. It is usually best to provide a control- 
ling account known as Work in Process account. Orders in 
Erocess of manufacture at any time are likely to be numerous, 
ut the manufacturing operations may be controlled on the 
general ledger by means of such a controlling account. Individ- 
ual accounts with the various jobs may be kept in a subsidiary 
cost ledger if desired. 

The Continuous Production or Process System. The 

first step with this system is to divide the entire production 
operations into stages or processes. The cost of each process 
is then apportioned over the product secured from that process, 
and the unit cost thus determined. The business must also be 
departmentalized. The departmental divisions under this sys- 
tem will differ from those under the Job Cost system as these 
divisions should be by processes, regardless of whether the work 
is of similar character or not. This system is much simpler than 
the Job Cost or Production Order system, because it is not 
necessary to record the costs by jobs, but by departments or 
processes only. 

The accounts kept are practically the same except that 
there is not the necessity for the same detailed analysis as with 
the Job Cost system. Material is handled in the same manner 
with both systems so far as purchases and delivery to stock 
room is concemejd. There is a difference, however, in accounting 
for the material as it is requisitioned out of the stock room. A 
material account should be opened for each department. As 
the material is withdrawn from stock, it should be charged to 
the proper department. This is true regardless of whether the 
material represents raw material coming from the stock room, 
or whether it represents the finished product of some other 
department. The principle is that the material account of 
each department must be charged at cost price with all material 
sent to that department. The account will be credited for the 
cost of material used on the completed work, the balance of the 
account representing the cost of the material consumed on the 
work in process. Accounts with Labor and Overhead Expenses 
should also be kept by departments. 

After the goods have reached the Finished Goods account, 
the method of treatment is the same with both the Continuous 
Production or Process system and the Job Cost or Production 
Order system. 



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i66 PUBLIC ACCOUNTING AND AUDITING 

The Predetermined Estimate System. The first step 
with this system is to prepare in advance estimates as to cost 
of production for every article manufactured. After these 
estimates have been predetermined, the articles produced are 
valued at these estimated costs, the total value thus determined 
being compared with the actual expenses of operation. The 
degree of accuracy with which the estimates have been prepared 
may then be judged as a whole by the extent to which the total 
estimated cost of all goods manufactured during the period 
varies from the total actual cost of operating the factory during 
the same period. 

This system is not to be recommended in any case where 
either the Job Cost or the Continuous Production systems may 
be used. It will be found practical, however, in many instances, 
owing to the great variety of articles manufactured which vary 
but slightly from each other, or owing to the minuteness or 
intricacy of the factory operations where piece-work rates are 
in effect and the cost of each individual operation can be very 
closely estimated, and it remains only to prove that no element 
of cost has been omitted and that the estimated cost in total is 
approximately correct. 

Criticism of the system lies in the fact that to compare the 
total estimated cost of all the products with the total actual 
cost of operations, does not reveal definitely in what element 
of the costs the variations occur. This objection may be largely 
overcome by subdividing the operations and basing the estimated 
costs on these subdivisions. Corresponding operating accounts 
should be kept on the books for each subdivision. These sub- 
divisions may be based upon departments. Regardless of the 
basis of the divisions in the estimates, the accounts must corre- 
spond. 

Elements of Cost. Costs may be applied to different 
stages. The first is known as prime cost. The elements of 
prime cost are material and labor. The second is cost of pro- 
duction. This is represented by the prime cost plus the manu- 
facturing expenses and represents the cost of fully manufactured 
goods ready for transfer from factory to sales department. 

There are two more elements to be added to the cost of 
production in order to arrive at the selling price. The first is the 
selling and administrative expenses. The second is the desired 
per cent, of profit. Thus, it will be seen that there are four ele- 
ments to be taken into consideration in determining the sales 
price of a manufactured article — prime cost, manufacturing 
expenses, administrative and selling expenses, and desired profit. 

Material + Labor - Prime Cost. 

Prime Cost + Manufacturing Expenses - Cost of Pro- 
duction. 

Cost of Production + Administrative and Selling Expenses 
- Cost of Sales. 

Cost of Sales -h Desired per cent, of Profit - Selling Price. 



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COST ACCOUNTING 167 

Accounting for Material. No complex accounting 
principles are encountered in the handling of raw material. 
With a cost system, it becomes necessary to provide for a book 
inventory. Raw material should be stored in a stock room. 
The stock room should be placed in charge of a stock clerk who 
will keep a record of all material received by means of a material 
ledger, and for this purpose, cards or a loose-leaf record may be 
used. An account should be kept with each article. A control- 
ling account for Raw Material will be kept on the general books. 
The stock clerk will be responsible for all material received. 
When material is purchased, it should be charged to the Raw 
Material controlling account in the general ledger and when 
placed in the stock room will be recorded on the stock records 
by the stock clerk. No material should be taken from the stock 
room except upon requisition signed by the proper persons. 
These requisitions are an essential part of a cost system. 

A special form of requisition should be used and this should 
provide information regarding job numbers, departments, date, 
quantity, description, price, amount, and signature of foreman. 
The cost clerk will extend the amount on the requisition sheet 
and see that it is properly posted. When material is requisi- 
tioned from the stock room, it should be charged to the proper 
departments or to the proper job or production order numbers. 

Accounting for Labor. Labor may be divided into two 
classes — direct or productive and indirect or nonproductive. 
Productive labor is that which can be charged directly to 
certain orders or processes. Nonproductive labor is that 
which cannot be charged to any particular order or process, but 
must be charged to the expenses of some department. The 
general method of recording labor is to have each employe make 
up a time ticket each day. This should show the employe's 
name, number, date and hours employed on each job, also the job 
number and machine number if a machine is used. In the case 
of nonproductive labor, the ticket should also show the depart- 
ment and nature of the work done in lieu of the job number. 
These time tickets go to the office to be recorded. 

Wage Sjrstem. There are many plans commonly em- 
ployed in the paying of wages. A list of the more common of 
these plans together with a brief description of each follows: 

1. Day Rate System. This plan is based on a flat rate 
per day regardless of the output. This plan may be considered 
the original wage system. Practically all other systems are 
a result of an effort to improve upon the day rate system because 
of dissatisfaction with the plan. The fact that it fails to promote 
efficiency, initiative, and does not offer an incentive for increased 
output or individual effort, are its principal objections. Gener- 
ally speaking, the plan is better suited to the paying of non- 
productive labor than to productive labor. No other plan is 
applicable to certain classes of nonproductive labor due to the 



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i68 PUBLIC ACCOUNTING AND AUDITING 

fact that the work performed is based principally upon a lapse 
of time as in the case of watchmen, foremen, firemen, etc. 

2. Piece Rate System. This plan is based on a flat rate 
per unit of output, the rate usually being based on past expe- 
rience. This plan has many advantages over the day rate plan. 
One of the principal advantages is that the manufacturer knows 
in advance the labor cost on goods to be produced. Perhaps 
the principal difficulty in the application of the plan is the 
determining of a satisfactory rate that will be fair to all concerned. 

3. Differential Rate Sjrstem. This plan is based on a 
rate per unit of output which increases as the output is increased. 
Under this plan, a standard of performance is determined. When 
this standard is attained and passed, the rate of pay is auto- 
matically increased. The increased rate may be applicable 
either to the entire production, or only to that part of production 
in excess of the standard set. The plan is more complicated 
than either of the former plans and its principal disadvantage 
is in the difficulty for determining the rates of payment. 

4. Premium System. This plan is based on a flat 
rate per hour plus an extra allowance for time saved. The time 
saved equals the difference between the standardized and actual 
value. The fundamental principle is to reward the efficient 
worker in amount proportionate to the value of the time saved. 

5. The Bonus System. This plan is based on a rate 
per hour which increases with an increased output. There are 
many variations of the plan, all of them designed to increase 
production by offering a reward in the form of a bonus when 
the standard of attainment is exceeded. The so-called Gantt 
system is a variation of the bonus system. The principal feature 
of the Gantt system is the bonus granted to the foreman for 
every man under him who makes his bonus. 

6. Stint System. This plan is based on a flat rate 
similar to the day rate system outlined above, but with this 
plan the employe is given the privilege of going home when the 
assigned day's work is completed. A standard is set representing 
a day's or a week's work and when this work has been completed, 
the employe has earned his day's or week's wages, and the 
remaining time is his own. 

7. Santa Fe System. This plan is based on a standard- 
ized output regarded as ioo% efficiency, all other output repre- 
senting the percentage of the standardized output. The work- 
men are paid on an hour or day rate plan, but are granted an 
additional amount depending upon their efficiency. 

8. Profit-Sharing System. This plan is based on one 
of I he above systems in so far as basic rates are concerned, but 



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COST ACCOUNTING 169 

in addition provides that the workman shall share in a certain 
percentage of the profits. The idea is that the employe will 
consider himself a part owner in the business when he shares 
in the profits, whether distributed in cash or in stock. There 
are many variations of profit-sharing plans. 

Accounting for Overhead Expanses. Factory overhead 
expenses are the expenses connected with manufacturing which 
cannot be charged to any particular order or process. These 
expenses may be divided into two classes — factory departmental 
overhead and general overhead expenses. 

Factory departmental overhead expenses cover all manu- 
facturing expenses which can be charged directly to the various 
departments, such as nonproductive labor, rent, taxes, insurance, 
depreciation, etc. General overhead expenses includes all man- 
ufacturing expenses that cannot be charged directly to the vari- 
ous departments but must be distributed over the factory as a 
whole. There are many bases for distributing overhead ex- 
penses to the various departments. In practice, it is not 
inacticabl e to distribute, jail overhead on one common IbasTs, 
though this might be desirable from a bookkeeping point of 
view. All items of overhead do not vary with the same factors. 
For instance,, rent chargeable to a department would not fluct- 
uate with jthe yolujne of production, while power would vary 
with the volume of production. For each item of overhead, 
there must be selected a basis of distribution which under all 
circumstances will be the most equitable.* 

Methods of Application of Overhead Expenses to 
Products, (a) Percentage on Direct Labor Cost. This meth- 
od is based on the theory that overhead expenses are incurred 
in proportion to direct labor cost. It is a practical method 
where workers are engaged at nearly uniform wages, and where 
they all work under practically the same physical conditions 
and use substantially the same or similar equipment. Where 
workers are employed on a piece-work basis or where they 
receive practically the same wage, the method will give good 
results and will prove popular because of its ease of operation. 

(b) Percentage on Direct Labor and Material Cost. This 
method is based on the theory that overhead expenses are in- 
curred in proportion to direct labor and material cost involved. 
It is seldom practical or appropriate, though the method may 
be used where a factory's workers are employed under nearly 
uniform wage rates, physical conditions, and operations, and 
where the ratio of material cost to direct labor is approximately 
dose to the ratio which the cost of that element of overhead 
expense incident to handling material is to all other elements 
of overhead expenses, providing the materials used are practi- 
cally of the same size and kind. 

*For a detailed explanation of different methods for distributing overhead 
expenses to departments, see pages 275-280 of "20th Century Bookkeeping and 
Accounting." 



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170 PUBLIC ACCOUNTING AND AUDITING 

(c) Direct Labor Hour Rate. This method is based on 
the theory that overhead expenses are incurred through the 
lapse of time. It is a practical method where all workers are 
employed under practically the same physical conditions and 
operations. The degree of appropriateness of the system depends 
largely upon the degree of variation in running cost of equipment, 
etc., used. Where wage rates diflfer, this method is preferable 
to either of the former methods. The amount of the overhead 
expenses is in general more nearly proportional to the number 
of men employed, than to the amount of the pay roll. This 
method is frequently referred to as the Productive Hour 
Method. 

(d) Machine Hour Rate. This method is based on the 
theory that in certain departments, the equipment used varies 
greatly, and that the rate of overhead expenses charged to the 
orders passing through the department should vary correspond- 
ingly. Under the method, a rate per Hour for distribution of 
overhead expenses is obtained for each department. In case 
the machine hour rate is made to include the labor of the machine 
operators, no direct labor charge would be made to orders passing 
through that department. 

Proposition A 

From the following data, illustrate the methods outlined 
above for applying the overhead expenses of a factory to produc- 
tiqn: 

Dept. A Dept. B Dept. C 

Material Used $10,000.00 $5,000.00 $5,000.00 

Productive Wages Paid . . 3,200 . 00 2,500 . 00 3,500 . 00 
Productive tabftrHouLrs. 8,000.00 5,000.00 10,000.00 
Overhead Expenses 4,000 . 00 2,500 . 00 2,800 , 00 

The factory is supposed to run 2400 hours a year. 

Solution 

(a) To ascertain the percentage on_direct labor cost^ 
divide the overhead expenses for each department by the pro- 
ductfve wages paid according to departments. 

Dept. A Dept. B Dept. C 

4,000 2,50a 2,800 

125% 100% 80% 

3»200 2,500 3,500 

(b) To ascertain the percentage on direct labor and ma- 
terial cost, divide the overhead expenses for each department 
by^the sum of material used and productive wages paid. 

Dept. A Dept. B Dept. C 

4,000 2,500 2,800 

30.3% 33H% 32.94% 

I3i200 7,500 8,500 



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COST ACCOUNTING 171 

(c) To ascertain the direct labor hour rate, divide indirect 
expenses for each department by the productive labor hours. 

Dept. A Dept. B Dept. C 

4,000 2,500 2,800 

= 50% 50% 28% 

8,000 5,000 10,000 

(d) To ascertain the machine hour rate, divide the over- 
head expenses for each department by the number of hours the 
factory is supposed to run per year. 

Dept. A Dept. B Dept. C 

4,000 2,500 2,800 

166%% I04K% 1 16%% 

2,400 2,400 2,400 

Proposition B 

To illustrate the application of the results obtained above, 
under the Job Cost or Production Order system, we will assume 
the material and labor (value and time) chargeable to job No. 
100 to be as fojlows: 

Dept. A Dept. B Dept. C Total 

Material $1.00 $2.00 $1.00 $4.00 

Labor Value 1.60 1.50 1.05 4.15 

Labor Hours 4 3 3 10 

Solution 

The following calculations show the different total order 
costs obtained by each method previously explained for applica- 
tion of indirect expenses to production. 

Dept. A Dept. B Dept. C Total 

(a) Percentage on Di- 
rect Labor: 

Material $1.00 $2.00. $1.00 $4.00 

Labor 1.60 1.50 1.05 4.15 

Indirect Expense. . 2.00 1.50 .84 4.34 

Total Cost Order 

No. 100 $4.60 * $5.00 $2.89 $12.49 

(b) Percentage on Di- 
rect Labor and Ma- 
terial Cost: 

Material $1.00 $2.00 $1.00 $4.00 

Labor 1.60 1.50 1.05 4.15 

Indirect Expense. . .79 i . 1 7 .68 2 . 64 

Total Cost Order 

No. 100 $3.39 $4.67 $2.73 $10.79 



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172 PUBLIC ACCOUNTING AND AUDITING 

(c) Direct Labor Hour 
Rate: 

Material $i.oo 

Labor 1.60 

Indirect Expense. . 2 . 00 

Total Cost Order 

No. 100 $4.60 



(d) Machine Hour 
Rate: 

Material $1.00 

Labor 1.60 

Indirect Expense. . 6 . 65 

Total Cost Order 

No. 100 $9.25 



$2.00 

1.50 
1.50 


$1.00 

1.05 
.84 


$4.00 
415 
4-34 


$500 


$2.89 


$12.49 


$2.00 

1.50 
3.12 


$1.00 
1.05 
350 


$4.00 

415 
13.27 


$6.62 


«5-55 


$21.42 



Controlling Accounts. When the cost system is a 
part of the general accounting system, the principles of double 
entry bookkeeping are carried out by means of controlling ac- 
counts. Thus the general bookkeeper will be in a position to 
maintain a check on the work of the cost department. By means 
of the controlling accounts there will be maintained a check on 
the general clerical work in connection with the keeping of the 
cost records. The name and number of controlling accounts to 
be kept will vary, depending upon the cost system in use, and 
the nature of the business. • 

Controlling accounts may be kept in the general ledger 
with raw materials, manufactured parts, labor, factory expenses, 
and such other accounts as may be grouped in subsidiary ledg- 
ers. If desired, a general cost ledger may be kept in which case 
this would contain controlling accounts for each subsidiary cost 
ledger, and the only controlling account that would appear in 
the general ledger would be a Cost Ledger controlling account. 
Regardless of whether one controlling account is kept for all 
cost transactions, or whether separate controlling accounts are 
kept for the different cost elements, such as raw material, manu- 
factured parts, labor and factory expenses, the principles are the 
same. 

Raw Materials Account. This is a controlling account 
for the raw materials ledger kept by the stock clerk. The object 
of the account is to show the cost of materials in the stock room 
at the end of each cost period. The account should be charged 
with (a) the cost of all raw material in the stock room at the 
beginning of the period ; (b) . the cost of all material purchased 
and received in the stock room during the period, plus trans- 
portation charges inward. If no materials are taken from the 
stock room except upon requisition, these requisitions may be 
totaled at the end of the cost period and the sum credited to 



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COST ACCOUNTING 173 

this account and charged to the Work in Process account by 
means of an adjusting journal entry. Thus it will be seen that 
if this account is charged with the cost of all materials on hand 
or received during the period and credited with the total amount 
of material requisioned at cost price during the period, the 
balance of the account will represent the cost of materials in the 
stock room at the end of the period. This should be verified at 
least once a year by means of a physical inventory, and any 
variations should be adjusted. 

Labor Account. This is a controlling account for both 
productive and nonproductive labor. It is charged during the 
period with the total pav ro\\ . At the end_Q£_Sifi-mpnth, the 
account is crf^itMJ with thp tntAl lahnr shnvim on the cost clerk's 
laboiLSummarifia* the Work in Process account is charged with 
t he prodi^ r^ivp lahnr^ and the departmental yxpepse a ccounts 
are c harged wi ^h the nonprndnrtivp lahnr 

If the last day of the cost period does not fall on the end 
of a pay period, the account will not balance but will show a 
credit balance, this representing the amount earned by the 
employes but not paid. In other words, it represents the amount 
of accrued pay roll. 

Parts Purchased Account. If, in addition to raw mate- 
rials purchased, there are certain manufactured parts purchased, 
it may be advisable to keep a manufactured parts ledger and 
to keep a controlling account for manufactured parts. The 
principle of the account is the same as the Raw Materials ac- 
count, it being charged with the cost of manufactured parts 
purchased and credited with the cost of parts requisitioned. • The 
balance of the account is the amount of the manufactured parts 
on hand at the end of the period. This should be verified by 
means of a physical inventory*^ at least once a year and any 
variations adjusted. 

O verh ead Expense Accounts. Accounts with various 
overhead expenses may be opened in the general ledger, or these 
may be grouped in a subsidiary ledger and. a controlling account 
opened in the general ledger. The principle is the same in either 
case. Accounts are usually kept with each class of overhead 
expenditure, such as building expense, power, insurance, taxes, 
depreciation, etc. At the end of the month, the controlling 
account for overhead expenses or the individual accounts (if 
kept in the general ledger) are credited with the proportion of 
the expenses applicable to each department. The departmental 
expense accounts have now been charged with their proportion 
of the fixed charges and with the nonproductive labor. Mis- 
cellaneous expenses, supplies, and repairs will also be charged 
to these accounts. 

During the period, these departmental expense accounts 
are credited with the overhead expenses distributed to the 



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174 PUBLIC ACCOUNTING AND AUDITING 

various orders. .or processes. At the end of the period, the ac- 
counts are credite±,with tJie overhead expenses already distrib- 
uted to work in process, and the Work in .ProceasL account is 
charged. After this entry has been made, the accounts theoretic- 
ally should balance. There will, however, undoubtedly be small 
balances which will have to be adjusted. This is done usually at 
the end of the /ear when the balances are ch arged to Reserv e 
for Overhead. 

Work in Process Account. The purpose of this account 
is to show the factory cost of work in profT*^^ ^^ the end of the 
cost period. We have already shown that the account will be 
charged with: 

(a) Cost of raw material requisitioned during the period. 

(b) Cost of parts requisitioned during the period. 

(c) Cost of productive labor during the period. 

(d) The departmental overhead expenses. 

The account should be credited with the cost of production 
of the fully manufactured output, this being transferred to the 
sales department. The balance of the account represents the 
material cost, plus labor and overhead, of work in process of 
manufacture, this being the factory cost of incompleted work. 

Fully Manufactured Goods Account. This is a con- 
trolling account for goods fully manufactured and on hand in 
the sales department. The account should be charged with (a) 
inventory of fully manufactured goods on hand at the beginning 
of the period; (b) goods manufactured at cost of production 
during period; and (c) purchases of goods fully manufactured 
during period. 

The account is credited with the total goods sold during the 
period at cost price. The balance of the account represents the 
inventory of fully manufactured goods on hand at the end of 
the period at cost of production or purchase price. This should 
be verified at least once a year by means of a physical inven- 
tory, and any variation should be adjusted. 

A. THEORY QUESTIONS 

1. State four principal objects to be obtained by a modern 
cost system. C. P. A. Ex. 

2. What are the constituent elements to be considered 
in fixing the selling price of a manufactured product? 

C. P. A. Ex. 

3. State briefly the elements of cost appearing in the 
following ledger accounts: (a) Raw Materials, (b) Goods in 
Process, (c) Finished Goods. C. P. A. Ex. 

4. Give several methods of distributing indirect expenses 
which may be considered as standard. C. P. A. Ex. 



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QUESTIONS AND PROBLEMS I7S 

5. What, in your opinion, is the best method of distributing 
the overhead or indirect expenses of a manufacturing concern 
so as to apportion the same to the different articles manufac- 
tured? C. P. A. Ex. 

6. Define the following and give a list of expenses which 
would properly come under each heading: 

(a) Shop overhead. 

(b) General overhead. Inst Ex. 

7. (a) Explain in full the theoretical difficulties in regard 
to each of three commonly used methods of distributing over- 
head burden in cost accounting. 

(b) Show how the appropriateness of each system may 
be affected by the nature of the business in which it is employed. 

Inst. Ex. 

8. Name and explain the various methods by which cost 
accounts may be handled, bringing out clearly among other 
Items the difference between the Production Order plan and the 
Process plan. C. P. A. Ex. 

B. ACCOUNTING PROBLEMS 

1. Set up in proper form to show Manufacturing Cost, 
Gross Profit and Net Profit the following: 

Sales; Gross Profit; Productive Labor; Productive 
Material; Commercial Expense; Manufacturing 
Expense; Nonproductive Material; Inventory Be- 
ginning of Period; Inventory End of Period; Non- 
productive Labor; Net Cost of Finished Product; 
Inventory of Finished Product; Finished Product 
During Period; Selling Expenses; Gross Profit on 
Sales; Net Profit; Inventory of Finished Product End 
of Period. 
Give the proper title to such a statement. C. P. A. Ex. 

2. From the books of the Johnson-Koerner Manufacturing 
Company as of December 31, 1920, we gather data as follows: 

Raw Material used $700,000.00 

Productive Labor 934,000.00 

Light, Power and Heat 12,770.00 

Superintendence and Indirect Labor 74,000.00 

Factory Supplies 7,600.00 

Repairs to Machinery and Ekiuipment 11,400.00 

Insurance on Material and Equipment 737.00 

Taxes 3,370. 00 

Insurance on Buildings 2,058.00 

Repairs to Buildings 1,376.00 

Depreciation of Buildings 16,000.00 

Depr. of Machinery and Equipment 24,000.00 

Goods in process December 31, 1919 21,600.00 



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176 PUBLIC ACCOUNTING AND AUDITING 

Finished goods on hand Dec. 31, 1919 $245,000.00 

Goods in process December 31, 1920 45,000.00 

Finished goods on hand Dec. 31, 1920 180,000.00 

Prepare statement showing prime cost and cost of produc- 
tion of goods sold during year ended December 31, 1920. 

Assemble this statement in such form as you believe to 
conform to proper accounting practice. C. P. A. Ex. 

3. The Buzzer Automobile Company manufactures an as- 
sembled car. Following is a synopsis of its factory activities 
for a given period. Build up from the figures shown all of the 
relative accounts as they would appear in the factory ledger 
with summary of stores ledger at closing. Prepare Trial Bal- 
ance from factory ledger. 

Purchases including opening inventory: 

Parts Purchased $ 65,000.00 

Parts Manufactured (material) 225,000.00 

Productive Labor 281,250.00 

Factory Expense 451,200.00 

Cost of Finished Cars: 

Parts Purchased 55,000.00 

Parts Manufactured (material) 75,000.00 

Productive Labor 188,500.00 

Factory Overhead Expense 226,200.00 

Material on hand $200,000.00. 

C. P. A. Ex. 

(Note. It is suggested that the following accounts be opened in the 
factory ledger: , 

Raw Materials. Factory Expense. 

Parts Manufactured. Productive Labor. 

Parts Purchased. Assembled Cars. 

General Ledger. 

Journalize the above data, post to the accounts opened on the factory 
ledger, close the accounts and bring down the balances. Prepare Trial Balance 
to determine if factory ledger is in balance. 

The object in keeping a General Ledger account in the factory ledger, is 
to make the factory ledger self-balancing. This is a summary account of all 
the factory transactions. It is just the reverse of the Factory Ledger controll- 
ing account in the general ledger. The amount appearing as a cr^it balance 
to the General Ledger account in the factory ledger appears as a debit balance 
to the Factory Ledger controlling account in the general ledger.) 



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Chapter Twelve 

FEDERAL INCOME TAXES* 

Income Tax Le^slation In the United States. The 

first income tax law in the United States was enacted in 1861 
during the Civil War. It was several times amended and finally 
expir«i by limitation at the end of the year 1871. Congress 
adopted another income tax law in 1894 as a part of the Wilson 
Tariff Bill, but it was held to be unconstitutional by the Supreme 
Court of the United States the following year in the case of 
Pollock vs. Farmers' Loan and Trust Company, 157 U. S. 429, 
on the ground that it was a direct tax and was not, in pursuance 
of the Constitution, apportioned among the States. In 1909 
Congress enacted a third income tax law in reference to cor- 
porations worded somewhat differently from the law of 1894 
and the Supreme Court upheld this law on the ground that it 
was an excise tax instead of a direct tax. 

In order to remove any doubt as to the power of Congress 
to levy taxes on incomes of any nature, the Sixteenth Amend- 
ment to the Constitution was proposed and was adopted on 
February 25, 1913. This Amendment provides, that "Congress 
shall have power to levy and collect taxes on incomes from what- 
ever source derived, without apportionment among the several 
States, and without regard to any census or enumeration." In 
pursuance of the authority granted by this Amendment, Con- 
gress enacted the Income Tax Law of October 3, 1913, which 
imposes a tax on the incomes of both individuals and corpora- 



*No doubt the tax on the incomes of both individuals and corporations 
will be a permanent part of our tax system. The present high rates will be, 
in all- probability, somewhat modified within the next few years. The Excess 
Profits Tax Law may be repealed and some other form of taxation substituted. 
However, the indications are that for many years to come the income tax 
rates will be sufficiently high to be of considerable importance in their relation 
to the incomes of both individuals and corporations. The rates may be 
changed, but the general principles of the income tax law are not apt to be 
materially altered, consequently in this discussion, it shall be our aim to 
discuss the general principles of the law as well as its application, the prepar- 
ation of the returns and the computation of the taxes. A knowledge of the 
present law is of prime importance as a basis for understanding any future 
law which may supersede it. 

Our discussion may be subdivided into two principal parts :^ (i) The 
income tax on individuals and (2) the income tax on corix>rations. The 
discussion on income tax on individuals will be subdivided into two parts, 
the first relating to income to be reported and income exempt from taxation, 
and the second relating to deductions from gross income. The discussion 
on income tax on corporations will be subdivided into two parts, the first 
relating to taxable income, deductions from income, the filing of returns 
and computation of the normal income tax, and the second relating to the 
excess profits tax. 

177 



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178 PUBLIC ACCOUNTING AND AUDITING 

tidns, and which superseded the law of 1909 in so far as it applies 
to incomes accrued subsequent to March i, 1913. The Revenue 
Act of September 8, 1916, contained a new income tax law 
which was made retroactive to January i, 191 6, and this super- 
seded the law of 1913. This law was, in turn, amended and 
supplemented by the law of October 3, 1917, eflfective as of 
January i, 1917, which in addition to the former tax on the 
incomes of individuals and corporations imposed an excess 
profits tax on the incomes of individuals, partnerships, and 
corporations. The present law was approved by the President 
on February 24, 1919, and was retroactive to January i, 1918. 
It imposes a tax at increased rates on the incomes of individuals 
and corporations and an excess profits tax on the incomes of 
corporations. It also imposes a war profits tax on the incomes 
of corporations for the year of 19 18. It does not impose the 
excess profits tax on the incomes of individuals and partner- 
ships as did the law of 191 7. 

It is in the law contained in the Revenue Act of 191 8 that 
we are chiefly interested, since the previous laws are effective 
only as to the income accrued prior to January i, 191 8, but we 
shall have occasion to refer to the various regulations and deci- 
sions rendered under the prior laws since they will be of assist- 
ance in the interpretation of the present law.* 

*The basis of this discussion is the Revenue Law of 1918. The Treas- 
ury Department has from time to time issued regulations in pamphlet form 
dealing with the interpretation and application of the laws of 191 6, 1917 
and 1918. Those dealmg with the Income Tax Law of 1917 are known as 
Treasury Regulations No. 33. Those dealing with the Excess Profits Tax 
Law of 191 7 are known as Regulations No. 41 . Those dealing with the Income 
and Excess Profits Taxes under the laws of 191 8, applicable during 1918, 
1919 and 1920, are known as Regulations No. 45. 

Since we will be chiefly interested in the interpretation and application 
of the 19 1 8 Revenue Law, it is suggested that you secure a copy of Regulations 
No. 45. In addition to these regulations, the Treasurv Department has ren- 
dered various decisions with reference to questions which nave arisen under 
the past as well as the present law. These decisions are binding as to the 
enforcement of the law unless overruled by the federal courts. They are, 
therefore, very important in the interpretation and understanding of the 
law. Various cases in connection with the application and enforcement of 
the various income tax laws have been decided by the federal courts and these 
decisions, of course, supersede the decisions and regulations of the Treasury 
Department. 

The Internal Revenue Department has issued a pamphlet known as 
the Income Tax Primer. This consists of a series of questions and answers 
with regard to the more imoortant phases of the law. A copy of the Revenue 
Law of 191 8, Regulations No. 45, and the Income Tax Pnmer may be ob- 
tained from the Government Pnnting Oflice at Washington, D. C, or the 
Collector of Internal Revenue of your district. 

In addition to the above, you should also secure from your internal 
revenue collector or the government printing office, copies of the forms used 
for making returns for individuals whose net income is not more than $5,000.00 
(Form lo^oA); individuals whose net income is more than $5,000.00 (Form 
10^0); fiduciaries (Form 1041); partnerships and persona! service corpo- 
rations (Form 1065); corporations (Form 11 20); and such other forms as 
will be referred to later or may be found to be useful in the study of Federal 
Income Taxes. 



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INCOME TAX ON INDIVIDUALS 179 

THE INCOME TAX ON INDIVIDUALS* 

Income to be Reported. The gross income received 
from all sources must be reported with the exception of that 
which is exempt as explained hereinafter. In the case of income 
accrued prior to March i, 1913, it need not be reported since 
the Sixteenth Amendment to the Constitution, which granted 
Congress the right to tax incomes, did not become effective until 
February 25, 1913, and as a matter of convenience, March i, 
1913, is taken as the date after which income is deemed taxable. 

Reporting on Cash or Accrual Basis. The individual 
may report his income on either a cash or accrual basis, which- 
ever he prefers; that is, if an individual has earned income in 
one year which is not payable until the following year, he may 
include it in the return of the year when earned, or he may wait 
and include it in the return of the year in which it is received. 
For instance, an individual who is making a return upon the 
basis of the calendar year 1920 may have earned a salary of 
$300.00 for the month of December, 1920, but this may not be 
paid to him until sometime during the following month of 
January. In making his return for 1920, he may include this 
amount in his return for that year, or he may wait and include 
it in the return for the calendar year of 192 1. However, he 
must follow a consistent policy and report all income on the 
same basis; that is, he cannot report part of his income on the 
accrued basis and part of it on the paid basis. He must also 
report his expenses on the sa:me basis as his income. 

Gross Income. The term "gross income" includes gains, 
profits, and income derived from salaries, wages, or compensa- 
tion for personal service of whatever kind and in whatever form 
paid, or from professions, vocations, trades, businesses, com- 
-merce, or sales, or dealings in property, whether real or personal, 

*The Revenue Law of 19 18 provides for two taxes on the incomes of 
individuals. The first known as the '^normal tax" is a tax which applies at 
the same rate to every individual regardless of the amount of his income. 
The second known as the ''surtax'* is a tax imposed on the taxable income 
in excess of $5,000.00, with an increase in the income. In other words, the 
surtax applies the principle of progressive taxation. 

"Gross income" as defined in the revenue law means all income which 
must be reported for the purpose of taxation. "Exempt income" is that 
income which is not subject to the tax and which need not be reported for 
the purpose of taxation. "Deductions from income" include those items 
whicn can be deducted from the gross income in arriving at the net income. 
As indicated above, "net income" is the difference between gross income 
and the deductions from income. It is the amount which serves as a basis 
for the computation of the tax. 

After the net income is determined, there are certain items which can 
be subtracted from it for the purpose of the normal tax but not for the purpose 
of the surtax. These items are .known as "credits." It is important to see 
the distinction between a deduction from gross income and a credit ; the chief 
distinction being that a deduction can be subtracted from gross income for 
the purpose of both the normal and surtax, while the credit is subtracted 
from the net income for the purpose of the normal tax only. 



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i8o PUBLIC ACCOUNTING AND AUDITING 

growing out of the ownership or use of or interest in such prop- 
erty; also from interest, rent, dividends, securities, or the 
transaction of any business carried on for gain or profit, or 
gains or profits and income derived from any source whatever. 
Compensation of All Kinds Included. All forms of 
compensation for personal services are income. This includes 
compensations of all kinds whether received by way of salaries, 
fees, wages, commission, percentage of profits, or by whatever 
other means. Marriage fees, baptismal offerings, sums for 
saying masses for the dead, etc., are taxable income. Salaries 
of federal officers and employes are taxable under the new law. 
Salaries may be reported either on the accrual or cash basis; 
that is, they may l>e reported as of the year when earned or of 
the year when received. Compensation of an executor or trustee 
should be included in the return for the year when it was received 
although the services may have been entirely performed in 
other years. Where professional services are billed in one year 
and entered as income in the accounts, they must be reported as 
income in that year even though they are not collected until later. 

Allowances in Addition or in Lieu of Compensation. 

Where living quarters, board and lodging, rent, or expenses are 
allowed in lieu of salary, they must be counted as inconie. For 
instance, when government employes are given quarters in addi- 
tion to their salary, the estimated value of these quarters should 
be reported for income tax purposes. The same is true in the 
case of a minister who is provided a parsonage in which to live 
in addition to his salary. Where an expense allowance is made 
to a traveling man, any excess over the allowance in the expense 
incurred, must be reported as income. 

Compensation Paid other than in Cash. If compensa- 
tion for services is paid in property, such compensation will be 
reported to the amount of the market value of the property at 
the time received. If premiums are paid by an employer on 
life, accident, or health insurance policies for the benefit of an 
employe, it is income to the latter. If compensation is received 
in the form of notes, it should be reported to the amount of the 
discounted value of the notes. 

Bonuses. Amounts received in the form of bonuses are 
income to the recipient if they are intended as a payment for 
services, but not if they are a gift. In some cases it is rather 
difficult to determine as to whether the amount is a gift or com- 
pensation for services. The Treasury Department has held that 
Christmas gifts are not taxable and since bonuses are frequently 
distributed at the end of the year, it is sometimes difficult to 
tell as to whether or not they are intended as a gift or otherwise. 
It is probably safe to assume that in most cases, where a material 
amount is given to the employe at the end of the year, it is 
intended as an additional compensation for services rendered 
and should be treated as an expense by the employer and as 
taxable income to the recipient. 



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INCOME TAX ON INDIVIDUALS i8i 

Pensions and Pension Funds. Pensions received from 
the United States Government or from private individuals or 
firms are taxable income, but the pensions received from a state 
or political subdivision thereof are exempt. If a retired worker 
receives a pension from a former employer, it is taxable income 
since it is additional payment for prior services. Deductions 
from salaries or wages made by the employer to pay compulsory 
or voluntary contributions for pensions, or for accident, life, and 
health insurance should be added to the amounts received as 
salaries when reporting income subject to the tax. 

Gratuities and Tips. Where a tip represents compensa- 
tion for services, it is income for the person receiving it notwith- 
standing that the amount is optional with the giver. This 
includes tips to waiters, bell-boys, Pullman porters and others 
who are customarily paid for their services in this way. Gra» 
tuities not in the form of money, such as cigars, candy, or other 
presents are not regarded as income, but as gifts only. 

Manufacturing or Trading Business. In the case of a 
manufacturing or trading business, gross income means the total 
sales less the customary deductions such as allowances, discounts, 
and credits given to purchasers. In addition, any special income 
from other sources should be added. Of course, the cost of the 
goods sold is subtracted from the gross sales in arriving at the 
gross profit on sales, but under recent regulations the cost of 
goods sold is treated as a deduction and, therefore, a discussion 
of the method of ascertaining the cost of the goods sold will be 
postponed until the discussion of deductions from gross income 
is considered. 

Long-Time Contracts. In the case of long-time contracts, 
the taxpayer may defer the reporting of both the income and 
expenses in connection therewith until the completion of the 
contract, if he so desires. If he prefers, however, he may estimate 
the amount of the income earned and the amount of the ex- 
penses incurred at the end of the taxable year and make his 
return accordingly. If later it is found that an error has been 
made in the making of the estimate, it may be corrected by the 
filing of an amended return. To illustrate: If the taxpayer has 
entered into a contract continuing over a period of three years, 
he may not report any income or any expenses in connection 
with the contract until the end of the third year. Or, if he pre- 
fers, he may, at the end of the first taxable year after which he 
enters into such a contract, estimate the amount of income 
earned on the contract, also the amount of expenses incurred 
in earning this income and report on this basis. A good illus- 
tration of such a contract would be that of a building contractor 
to construct a building which it would take more than one year 
to complete. 

Installment Sales. In the case of installment sales, if the 
initial paym ent is twenty-five per cent, or more of the^sales price, 
the entire p rofit of the sale Is consldfered as earnedln the year 
when the sale is made. If, however, less than twenty-five per 



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i82 PUBLIC ACCOUNTING AND AUDITING 

cent, of the sales price _is_collected at the time of the sale, the 
profit may be distributed over the life of the contract and be 
reported for tax purposes in the ye ar in which the payments 
are_made. For instance, if furniture which cost ^oo.oo is sold 
on July I for $500.00 with an agreement that it is to be paid 
for in twen^ equal payments of I25.00 each, it will be assumed, 
since there is a totaljirofit of $iqq«QO« that $5.00 of profit will be 
received at the time of each payment. If, therefore, during the 
current year six payments are received, it will be assumed that 
$30.00 of taxable income has been received. The foregoing 
principles govern in reference both to the sales of chattels and 
the sales of real estate. 

Real Estate Subdivisions. Where a tract of land is 
purchased and divided into lots for the purpose of resale, the 
cost of the land should be appnrtinned to the individual l9t8. 
Consequently at the time of the sale of each lot the profit aris- 
ing therefrom is regarded as realized for income tax purposes. 

Income of Farmers. All income or profits derived from 
the sale of farm products is reported for tax purposes in the year 
when sold. The taxpayer may, however, make a return on the 
inventory basis if he so desires. To illustrate*. A farmer who 
reports on a basis of the calendar year may take an inventory 
of all the farm products which he has on hand December 31, 
including those produced during the year, and report the value of 
these for the current year. He may, however, if he so desires, 
disregard the farm products produced during the year until they 
are sold and then report them as income for that year. If farm 
animals are sold, the excess of sales price over cost is taxable 
income. If farm products are bartered for merchandise, the 
market price of the merchandise should be reported as income. 
When shares of the crop are received as rent, this should be 
reported as income when reduced to cash. When stock is pur- 
chased for resale, the difference between the sales price and the 
cost is subject to the tax. A farmer need not include in his 
gross income the value of the rent of the farm house occupied 
by his family or farm products consumed by his family. A^ per- 
son operating a farm for pleasure, which involves a continual 
loss, is not regarded as a farmer, and is not permitted to deduct 
such loss from his gross income. Consequently, if such a tax- 
payer should, in certain years, have an income in excess^ of the 
expenses, only the excess should be reported as gross income 
since the expenses are not permitted as deductions.* 

Sale of Real Estate. If real estate purchased since March 
I, 1913 is sold, the excess of its sales price over its cost is re- 
portable as gross income.^ If purchased prior to March i, 1913, 
the excess of the sales price over its jnarket value on March i, 
1 9 13 is subject to the tax. The cost will include, in addition to 
the origina l purchase price, all expenses incurred in connection 

♦If the return for 1920 is made on a cash basis, a "Schedule of Farm 
Income and Expenses" must be prepared on Form I04X>F. If the return ia 
made on an accrual basis, the filing of this schedule is optional. 



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INCOME TAX ON INDIVIDUALS 183 

with its purchase, such as commission fees, charges for the con- 
verting of the title, and similar outlays. It also includes ex- 
penses incurred in connection with the holding of the property, 
such as interest charges, taxes, etc., if the property is not used 
for the purpose of earning an income. For instance, a real estate 
company may purchase a subdivision near a city and hold it 
five years before opening it for sale. The carrying charges dur- 
ing the five years may be considered as an addition to cost. The 
cost will also include any amounts spent for improvements on 
the property. If the property was purchased prior to March i, 
1 913, the return must state how the market value on that date 
is determined. Where there is an established market value, as 
stocks traded in on the exchange, the quoted value is the fair 
value. In the case of merchandise, machinery, or other property 
which does not have a public market price, any relevant evidence 
may be considered such as the opinion of experts, prices asked, 
or offered for similar property at the time, or other facts. In 
every case this is a question of facts to be established by the* 
taxpayer. The estimated value should not include any pros- 
pective or speculative profits, but should represent the price at 
which the property could have been sold under all conditions 
then existent. 

Property Exchanged. When property is exchanged for 
other property with a definite or ascertainable market value, 
or where it is valued by parties at a fair amount for the purpose 
of exchange, such value must be treated as the price received 
for the property originally held to determine profits or losses 
upon the exchange, and the same amount is the cost of the new 
property to be used in connection with a later sale. If there is 
no valuation or market value, there is no closed transaction and 
the cost of the original property must be treated as a cost of the 
property acquired; in which case, when the property is sold, 
the original cost of the property exchanged for it will be de- 
ducted from the sales price in order to determine the profit 
subject to the tax. 

To illustrate: J. A. Fogt owns real estate, the value of 
which on March i, 1913 was $40,000.00. Arthur Williams owns 
real estate, the value of which on March i, 1913, was $50,000.00. 
In 1920 Fogt and Williams exchanged real estate, Fogt giving 
Williams $20,000.00 in cash as a bonus. Fogt's deed to Williams 
recites a consideration of $60,000.00 cash in hand received, 
and Williams' deed to Fogt recites a consideration of $80,000.00 
cash in hand received. In this illustration, improvements and 
betterments, depreciation previously claimed and the like are 
disregarded. 

An analysis of the transaction discloses a taxable profit to 
both parties: Fogt receiving $20,000.00 and Williams $30,000.00 
over the values of their respective properties as of March i, 1913, 
which profits are calculated in the following manner: 

Value of Fogt's property as of March i, 1913, $40,000.00. 

Value of Williams* property as of March i, 1913, $50,000.00. 



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i84 PUBLIC ACCOUNTING AND AUDITING 

Fogt receives from Williams property valued at $80,000.00. 

Williams receives from Fogt property valued at $60,000.00 
plus a cash bonus of $20,000.00, amounting in all to $80,000.00. 

The selling price of Fogt's property, $80,000.00, minus 
$40,000.00, representing its value as of March i, 1913, plus the 
$20,000.00 bonus paid to Williams, leaves a profit to Fogt of 
$20,000.00 from the transaction. 

The selling price of Williams' property, $80,000.00, minus 
$50,000.00, representing its value as of March i, 1913, leaves a 
profit of $30,000.00 realized by Williams from the transaction. 

The Siale of Stocks. When a number of shares of stock 
are held by the taxpayer which he has purchased at different 
times and prices, he should, if possible, at the time of sale, 
determine the original cost price of the stock sold. This, of 
course, can be done only if it is possible for him to determine 
when the particular share sold was purchased. If it is impossible 
for him to do this, it will be assumed that the first shares sold 
were the first shares purchased and the profit subject to the tax 
will be the difference between the cost and selling price thereof. 
If stock is received as a bonus when other stock or bonds are 
purchased, if possible, the cost should be allocated between the 
bonus stock and the stock or the bonds purchased. If it is 
impossible to make this allocation, no income will be reported 
until both the stock or bonds purchased and the stock or bonds 
received as a bonus are sold. At the time of sale, the difference 
between the total sales price and the original cost will be reported 
as income. When stock rights are received by stockholders, 
the value thereof need not be reported for taxation purposes 
until sold, in which case, the entire sales price is taxable. 

Sale of Patents and Copsrights. When patents and 
copyrights are sold, the difference between the cost and the sell- 
ing price constitutes income subject to the tax. If the patent 
or copyright was obtained prior to March i, 1913, the profit 
subject to the tax is the difference between the market price of 
the patent or copyright on March i, 19 13 and the selling price. 
This is in accordance with the method of determining profit 
derived from the sale of any property owned prior to March i, 
1913. If in previous returns depreciation has been claimed on 
patents and copyrights, this depreciation must be subtracted 
from the original cost in determining the profit subject to tax 
at the time of sale. To illustrate: If a patent is purchased for 
$1,000.00 on January i, 1915, and $100.00 is claimed as depre- 
ciation on the patent each year and the patent is sold on January 
I, 1920 for $800.00, the profit subject to the tax is the difference 
between $500.00, the book value of the patent and the selling 
price. 

Sale of Good Will. Good will is not considered in deter- 
mining income subject to tax unless it is sold, in which case, the 
difference between its cost and selling price constitutes income 
subject to the tax. Since good will is not considered subject to 
depreciation or appreciation in determining income subject to 



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INCOME TAX ON INDIVIDUALS 185 

tax, the profit at the time of sale is always the difference between 
its' original cost and the selling price. 

Rents. Income from rents may be reported like other 
income, on either a cash or accrual basis. Irxome from this 
source must be reported whether it is paid in cash or other prop- 
erty. Farmers, for instance, may receive a part of the crops 
produced on the land as rent and this must be reported as income, 
although they are permitted to defer reporting it until it is 
reduced to cash, if they so desire. 

If tenants construct buildings or improvements upon leased 
property, the title to which goes to the owner of the property 
at the termination of the lease, the value of such improvements 
must be reported as income by the owner. Interest and taxes 
paid by a tenant on behalf of the landlord are income for the 
landlord when paid and also may be deducted by the landlord 
as payment by him. Ordinarily, repairs made by the tenant 
are not income by the landlord, but expenses by the tenant. 
The value of the use of property by the owner need not be 
counted as income by the owner nor may it be deducted as rent 
paid. 

Interest. Interest on obligations of every kind accrued 
since March i, 1913, except that as stated exempt under "exempt 
income," is taxable. Such interest must be reported when it 
becomes subject to the demands of the owner whether or not 
it is reduced to his possession. For instance, interest on bank 
deposits must be reported as income when they are credited to 
the account of the depositor although he may not withdraw 
them at that time. Interest accrued on bonds prior to their 
purchase need not be reported by the purchaser. For instance, 
if a bond bearing six per cent, interest and with a par value of 
$100.00 is purchased for $103.00, and six months later the 
purchaser collects $6.00 in interest, he need report only $3.00 
as income, the remaining $3.00 being considered as a return 
of part of the purchase price. 

Bond Premium and Discount. When bonds are pur- 
chased at a premium or discount, this premium or discount 
need not be reported in entirety in the year when purchased, 
but may be amortized over the life of the bond. If a city pur- 
chases a public utility and assumes the bonds, the interest on 
such bonds is subject to the tax. If the city had issued the bonds 
originally, the interest would be exempt, but since the purchaser 
of the bonds at the time of their purchase anticipated a payment 
of the tax, its payment is not waived because the city later 
assumes the payment of the bonds. Similarly, the income from 
corporations, which are themselves exempt, is not necessarily 
exempt to the recipient. 

'Income from Fiduciaries. Income received from fidu- 
ciaries may or may not be exempt, depending on its source. In 
other words, it is necessary to determine from what source the 
fiduciary received the income before determining whether or not 



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i86 PUBLIC ACCOUNTING AND AUDITING 

it is taxable in the hands of the one who receives it from the fidu- 
ciary. 

Partnership Income. A partnership, unlike a corpora- 
tion, has no legal existence aside from the members who compose 
it, and, therefore, the income which it receives belongs imme- 
diately to the partners with no declaration of dividend, just as 
if it was received directly by them. The income of the partner- 
ship for the calendar year or fiscal year must be shown on a 
partnership return and the amount belonging to each partner 
indicated on the return.* 

Individuals carrying on business in partnership are liable 
for income tax only in their individual capacity. There must 
be included in computing the net income of each partner his 
distributive share of the net income of the partnership for the 
taxable year, whether distributed or not, or, if his net income for 
such taxable year is computed upon the basis of a period different 
from that upon the basis of which the net income of the partner- 
ship is computed, then his distributive share of the net income 
of the partnership for any accounting period of the partnership 
ending within the fiscal or calendar year upon the basis of which 
the partner's net income is computed. The net income of the 
partnership shall be computed in the same manner and on the 
same basis as that of an individual except that the deduction 
for charitable contributions is not allowed. 

Any citizen or resident, who is a member of a partnership, 
shall be credited with his proportionate share of any income, 
war profits or excess profits taxes of the partnership paid during 
the taxable year to a foreign country or to any possession of 
the United States as the case may be. 

The term ''individual beneficiary" may include a partner- 
ship beneficiary. Accordingly, a partnership is not required to 
include in gross income the proceeds of life insurance policies 
paid to it upon the death of the insured. Every partnership 
must make a return showing the gross income, the deductions 
allowed by law and the net income; also the distributive interest 
of each partner in the partnership profits, whether such profits 
have been distributed or not, with the names and addresses of 
the persons who would be entitled to such profits if distributed. 
The return may be sworn to by any one partner. 

Partnership Contributions. The partnership itself shall 
not be subject to either the excess profits or the income tax. In 
computing the net income of the partnership, no deductions shall 
be made for contributions or gifts made by the partnership. The 
partners shall take credit in their individual returns of their 
proportionate share of any such contributions or gifts so made 
by the partnership, not to exceed 15 per cent, of the individual's 
net income. 



*Form 1065 should be used in reporting the income for partnerships 
for the year 1920. No tax is assessable on this return. Shares or net profit 
or loss should be reported on "Individual Returns," Form 1040 or 1040A. 



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INCOME TAX ON INDIVIDUALS 187 

Dividends. Dividends received from domestic corporations 
and the dividends received from a foreign corporation, whose 
entire income is from United States sources, are subject to the 
tax. The Revenue Law of 1918 defines a ''dividend" as follows: 
"That the term 'dividend,' when used in this title, except in 
paragraph ten, subdivision A, Sec. 234, means (i) any distri- 
bution made by any corporation other than a personal service 
corporation to its shareholders or members, whether in cash or 
other property, or in stock of the corporation out of its earnings 
or profits accumulated since February 28, 1913, or, (2) any such 
distribution made by a personal service corporation, out of its 
earnings or profits accumulated since February 28, 1913, and 
prior to January i, 1918." 

Miscellaneous Types of Dividends. Dividends received 
from private banks organized as corporations are subject to the 
tax. Dividends from paid-up insurance policies are treated the 
same as other dividends from corporations. Taxes paid by a 
bank on its stock for the owners of the stock are considered as a 
dividend to the owners. Dividends paid from surplus created 
by the appreciation of assets are not considered as taxable. 

How Taxed. Dividends received by an individual from a 
corporation, the income of which is subject to the corporation 
income tax, are subject to the surtax, but are not subject to the 
normal tax. However, they must be included in gross income 
and then taken as a credit in determining the amount subject 
to the normal tax. 

Stock Dividends. In the case of Towne vs. Eisner, it was 
held by the U. S. Supreme Court that stock dividends were not 
taxed under the Revenue Act of 1913, which did not expressly 
refer to them, and Macomber vs. Eisner recently decided by the 
Supreme Court, held that they are not taxable under the Revenue 
Act of 1916, although it expressly so provided. The provision 
in the Revenue Act of 1918 is, in effect, the same as in the Rev- 
enue Act of 1916 and specifically taxes stock dividends. In 
accordance with the later decision, stock dividends are not sub- 
ject to taxation and, accordingly, taxes paid upon any stock 
dividends will be refunded upon the submission of proper claims. 

Sources of Dividend as to Year. Under the new law, 
dividends are presumed to be from profits so long as any profits 
exist. In other words, a corporation cannot declare a dividend 
and specify that it is a liquidating dividend and thereby exempt 
from the income tax so long as there are any profits from which 
dividends might be declared. It is also presumed that any 
dividend declared is from profits earned since February 28, 1913, 
until all such profits have been distributed. As may readily 
be surmised, the purpose of this is to prevent the declaration 
of dividends by corporations which had a surplus accumulated 
prior to February 28, 1913, and making them exempt from the 
tax by stating that these dividends are from profits earned 



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i88 PUBLIC ACCOUNTING AND AUDITING 

prior to the passing of the Sixteenth Amendment. Under the 
new law, the dividends are taxable at the rate of tax of the year 
when paid regardless of the year in which the profits were 
earned. 

Liquidating Dividend. As stated previously, a dividend 
can be considered as a liquidating dividend only when all profits 
of the corporation have been distributed. When liquidating 
dividends are made, if they are in amount greater than the 
original cost of the interest of the stockholder in the corpora- 
tion, this excess is considered as a profit subject to the tax. To 
illustrate: If Brown buys lo shares of stock for $1,000.00 in 
the X corporation, and later this corporation dissolves and pays 
Brown $1,200.00 for his interest, the $200.00 excess is taxable. 

Dividend from Depletion Reserve. In a case of a cor- 
poration which has a depletion reserve, a dividend can be paid 
and charged to this reserve only when the surplus and other 
reserves of the corporation have been exhausted. Such a divi- 
dend, when paid, is not considered subject to the tax unless it 
is in excess of the cost of the stock which the recipient holds in 
the company. 

Special Source of Income. Income may be received 
from many different sources, and in the main, income received 
from any source whatever, except those stated under exempt 
income, is subject to the tax. 

Royalties from mines, patents, franchises, etc., are income 
subject to the tax; also any profit derived from the sale of royal- 
ties, patents, and copyrights. If a debt is charged off as bad 
and is later collected, it must be reported as income in the year 
when collected. Where property is lost by shipwreck, fire, or 
other casualty, or taken by right of eminent domain and more 
is received in compensation theftefor than the property cost, 
the excess must be reported as income. In case property is 
taken over by the government for any purpose and the amount 
paid by the government for the property is greater than the 
cost of replacement, the excess must be reported as income. 
If, however, it is desirable for any good reason that the replace- 
ment of the property is postponed, a replacement fund may be 
created temporarily and no income reported until the property 
is later replaced. 

If an individual is released from a debt which he owes to 
another in return for services performed by the debtor, it is 
regarded as income for the latter. If, however, the release is 
granted merely as a benefit to the debtor, it is regarded as a gift 
and not income subject to the tax. If a stockholder releases a 
corporation from a debt due from it to him, it is regarded as a 
capital contribution to the corporation and, therefore, is not 
subject to tax in the hands of the corporation and cannot be 
treated as a deduction by the stockholder. If a corporation 
releases a stockholder from a debt due by him to it, it is regarded 
as a dividend and must be reported by the stockholder as such. 



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INCOME TAX ON INDIVIDUALS 189 

Income Exempt from Taxation 
^ Life Insurance. Proceeds of life insurance policies paid to 
an individual as beneficiary or to the estate of the deceased upon 
the death of the insured need not be reported for taxation. Any 
amount received by the insured as a return of premiums paid 
by him on life insurance, endowment, or annuity contracts, 
either during the term of insurance, at maturity, or upon the 
surrender of the policy can be subtracted from the proceeds of 
the policy in arriving at the amount subject to taxation. To 
illustrate: If an individual receives $5,000.00 at the maturity 
of an endowment policy and he has paid $4,000.00 in premiums 
on this policy, he would report for taxation only the difference 
between the premiums paid and the amount received, or 
$1,000.00. 

Property Acquired by Gift, Bequest or Descent. The 
value of property acquired by gift, or descent, is not subject to 
the income tax, but any income derived from such property is 
taxable. If the property is sold or disposed of, any profit de- 
rived from its sale is taxable as income. If the property was 
acquired prior to March i, 1913, the profit is the difference 
between its market value on that date and the sales price. If 
acquired since March i, 1913, the profit is the difference between 
the cost price and the sales price, making suitable allowance for 
depreciation. To illustrate: If property is sold for $20,000.00 
in January, 1919, which wals purchased in 1910, it would be 
necessary to estimate the market value of Such property on 
March i, 1913, in order to arrive at the profit which is subject 
to the tax.* If it is as^med that the property cost $10,000.00 
in 1910, but had a market value of $15,000.00 on March i, 1913, 
the profit which is subject to the income tax would be $5,000.00. 
On the other hand, if property purchased on January i, 1915, 
for $5,000.00 is sbld in 1919 for $6,000.00 and during the years 
1915, 1916, 1917 and I9i«, $250.00 a year or $1,000.00 total 
had been claimed as a deduction from income because of depre- 
ciation on this property, the profit arising from thfs sale subject 
to the income tax would be $2,000.00. 

Income from State and Municipal Offices. Gross 
income does not include interest on bonds or other obligations 
of a state or political subdivisions of a state. The term * apolitical 
subdivision'' includes any special assessment district or division 
created by the proper authority of a state acting within its 
constitutional powers for the purpose of carrying out some pub- 
lic work. This includes drainage districts, school districts, 
highway districts, etc. 

Interest on Obligations of the United States. The 
law exempts interest on the obligations of the United States 
issued before September i, 1917, and on those issued after that 
date, if and to the extent, provided in the act authorizing their 

*Only the profit accruing since March i, 19 13, is subject to tax because 
the Sixteenth Amendment did not become effective until February 25, 1913, 
and for convenience March i, 1913, is fixed by law as the date of computation. 



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190 PUBLIC ACCOUNTING AND AUDITING 

issue. United States bonds of the first Liberty Loan and all 
prior issues are wholly tax exempt. All subsequent issues of liberty 
bonds are wholly exempt as to the normal tax on income of indi- 
viduals. In addition, the income on an amount not exceeding 
$5,000.00 held by any individuial, partnership, association, or 
corporation is exempt from the surtax, income tax on corpo- 
rations, and the excess profits tax. There are also additional 
provisions by which larger amounts may be held exempt from 
all tax if they are properly distributed among the various 
issues. Reference should be made to the detail regulations 
which are given in Treasury Regulations No. 45 in order to 
determine as to whether the income from liberty bonds is exempt 
in filing returns for individuals whose income is in excess of 
$5,000.00, and who hold over $5,000.00 of these obligations of 
the United States. The Schedule of Taxable Interest on Liberty 
Bonds should be prepared on Form 1125. See page 191. 

Health and Accident Insurance. The new law pre- 
scribes that amounts received through accident or health insur- 
ance, or under workmen's compensation acts as compensation 
for personal injury or sickness, are exempt. The same is true 
with reference to the amount of any dama^ges received whether 
by suit or agreement on account of such injuries or sickness. 

Salaries of U. S. Soldiers and Sailors. Gross income 
does not include so much of the salary and compensation received 
during the present war for active service in the military or naval 
forces of the United States as does not exceed $3,500.00. Com- 
pensation of persons in the Army and Navy in excess of $3,500.00 
18 subject to tax as also is income received by such persons from 
sources other than from the Government. To illustrate: Cap- 
tain John Brown may receive $2400.00 salary during the year 
1919. In addition he may have an income of $4,000.00 from 
property owned. The $3,400.00 is exempt, but the $4,000.00 
must be reported. 

Salaries of State and Municipal Employes. Salaries 
of all officers and employes, whether elected or appointed, of 
any state or territory or any political subdivision thereof, are 
held to be exempt under the new law. Although the law does 
not specifically mention the income of such classes as being 
exempt, the Commissioner of Internal Revenue has so ruled, 
and their income need not be reported in so far as it may be 
derived from such sources. This includes the salaries of all 
municipal employes and all teachers receiving their salaries 
from public funds. It does not exempt the salaries of teachers 
in private schools. The income of such employes received from 
other sources is, of course, subject to the tax. 

Alimony. Any amount received as alimony or as an 
allowance under a decree of court or separation agreement, need 
not be included in gross income of the recipient, nor may it be 
deducted by the person who pays it. 

Federal Farm Loan Act Securities. The Federal Farm 
Loan Act as well as the income tax law provides that the securi- 
ties issued under the former act shall be exempt from income 
taxation. The same is true of dividends received from Federal 



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INCOME TAX ON INDIVIDUALS 



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192 PUBLIC ACCOUNTING AND AUDITING 

Reserve Bank Stock. This exemjption applies only to dividends 
on stock of Federal Reserve Banks, and not to dividends on 
stock of member banks. 

Bonds of the War Finance Corporation. Interest on 
bonds issued by the War Finance Corporation is exempt, if and 
to the extent, provided in the respective acts authorizing the 
issue thereof. 

Nonresident Aliens. In the case of nonresident aliens 
only the income received from sources within the United States 
is taxable. In the case of resident aliens, however, all income 
from whatever source derived is taxable by this Government. 
A nonresident alien is an alien living elsewhere than the United 
States or an alien living temporarily in the United States. If 
the alien manifests his intention to remain here permanently, 
he becomes a resident alien and is taxed the same as a citizen. 

INCOME TAX QUESTIONS AND PROBLEMS 

1. Is the income of interest on liberty bond issues taxable 
under the present revenue law? If so, to what extent? 

Inst. Ex. 

2. (a) Under the federal income tax laws, how are the 
profits determined in an exchange of real estate for stock of 
a corporation? In the sale of stocks or bonds or other property? 
In the exchange of one stock for another stock? 

(b) A purchased a plot of vacant land in 1903 for $5,000.00. 
In 1920, he sold it still vacant for $7,500.00. How should this 
transaction be treated by A in preparing his income tax return? 

Inst. Ex. 

3. A during 1920 sells B for $50,000.00 certain property 
which A purcha^ in 1914 for $30,000.00 and B agrees to pay 
A, in addition to the purcliase price, the income taxes which A 
may be required to pay on the profit of $20,000.00. 

Does the payment of such taxes to A amount to income 
to A which he will be required to report as taxable income? 

C. P. A. Ex. 

4. A, being the owner of 100 shares of the capital stock 
of the X company, which he purchased in 1914 for $10,000.00, 
in 1920 exchanged them for a plot of real estate in the dty of 
New York. Is this transaction to be considered for income tax 
purposes, and if so, what further data would you need to de- 
termine whether or not it would affect the income tax return of 
the individual in question, and why? Inst. Ex. 

5. A man purchased in the year 1912, 100 shares of stock 
in a local manufacturing corporation at cost of $100.00 per share. 
On March i, 1913, the market value of the stock amounted to 
$150.00 per share. In the year 1917, its market value amounted 
to $500.00 per share and he donated the stock to his wife. In 
the year 1920, there had been no change in market value and 
the wife sold the stock for $500.00 per share, which constituted 
all her income. 

What was the income tax of the wife? C. P. A. Ex. 



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Chapter Thirteen 

FEDERAL INCOME TAXES 
THE INCOME TAX ON INDIVIDUALS (Continued) 

Deductions from Gross Income. After the gross in- 
come has been determined, certain deductions from gross in- 
come are allowed in computing net income. The income tax 
is on the net income and not the gross income. The net income 
is determined by subtracting the allowable deductions from 
the gross income. Under the law, the following items are con- 
sidered allowable deductions from gross income: 



I. 


Business expenses. 


2. 


Taxes. 


3. 


Interest. 


4. 


Losses. 


5. 


Bad debts. 


6. 


Depreciation. 


7. 


Amortization. 


8. 


Depletion. 


9. 


Charitable contributions. 



General Business Expenses. For the purpose of the in- 
come tax it is very necessary to make a clear distinction between 
business expenses and personal expenses. Business expenses are 
expenses incurred in connection with carrying on a business by an 
individual and are deductible in determining the income subject 
to the tax. Personal expenses are the personal expenses of the 
individual or his family and are not deductible in determining 
net income. 

In reporting his business expenses the individual may re- 
port them on either the cash or accrual basis. However, his 
expenses must be reported on the same basis as his income. If 
he elects to report his income on the cash basis he must report 
his expenses accordingly and vice versa. 

Expenses incurred in earning exempt income are not de- 
ductible. For instance, expenses incurred in connection with 
the purchase of municipal bonds or the collection of interest 
on municipal bonds would not be deductible since the interest 
from the bonds is exempt from taxation. 

The cost of repairs incurred in the maintenance of property 
or equipment used in carrying on the business is deductible, 
but the cost of repairs in connection with the home in which 
the individual lives or the equipment in the home or of prop- 
erty, such as automobiles used for private purposes, is not de- 
ductible. 

193 



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194 PUBLIC ACCOUNTING AND AUDITING 

An individual engaged in the rendering of professional 
services, such as a physician or lawyer, may deduct the cost of 
all supplies necessary for the carrying on of his professional 
work and of all expenses incurred in the operations thereof. 

Compensation for personal services may be deducted if 
paid to others than the taxpayer himself or to a minor child of 
the taxpayer. In case of a corporation, compensation paid to 
the taxpayer himself may, of course, be deducted. In the case 
of a business organized other than as a corporation, the claiming 
as a deduction of compensation paid to the taxpayer would 
serve no purpose, since if he claimed it as an expense of the 
business he would have to report it as an income to himself and 
the net result would be the same. 

Bonuses paid to employes as compensation for services 
may be treated as a deduction. If, however, the bonus is made 
merely as a gift to the employe, it is not regarded as an expense 
and may not be treated as a deduction. No doubt, bonuses are 
always given in return for services rendered; therefore, they 
should always be deducted. 

Compensations paid to individuals for injuries received in 
the business or to dependents of such individuals are deduct- 
ible. Contributions to pension funds which are held by the 
business for the benefit of employes are not deductible. 

Payments for rent may be deducted regardless of the form 
in which paid. Where a leasehold is purchased, the cost of the 
leasehold should be allocated over its life and not claimed as a 
deduction of the year purchased. Taxes paid by the tenant for 
the landlord are regarded as additional rent. The cost of erect- 
ing buildings on leased property which are to go to the landlord 
at the termination of the lease may be allocated over the life 
of the lease. 

A farmer may deduct all expenses incurred in connection 
with the production and disposition of all products produced 
on the farm. This includes the cost of labor used in connection 
with the production of crops or live stock, the cost of seed, 
fertilizer, and the original cost plus the cost of feed of stock 
purchased for resale. Repairs to farm buildings, fences, and farm 
machinery may be treated as an expense, but repairs on the fam- 
ily dwelling may not be so treated. Reasonable depreciation 
on all property and equipment other than the family dwelling 
may be treated as a deduction. 

Miscellaneous Business Expenses. It has been pre- 
viously stated that it is impossible to give all the miscellaneous 
sources of income which is subject to the tax. In the same 
manner it is impossible to name all the individual items of busi- 
ness expense which may be deducted. For purposes of illustra- 
tion, however, a number of miscellaneous items will be men- 
tioned. 



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INCOME TAX ON INDIVIDUALS 195 

The expenses of advertising may be deducted by a mer- 
chant. Wages, heat, light, water, telephone, and entertainment 
of out-of-town guests may also be deducted by a merchant. A 
taxpayer cannot deduct wages paid to his minor child. This is 
based on the theory that he is entitled to the services of such 
child without compensation and any compensation paid is 
merely a gift or gratuity to the child. As a general rule, the cost 
of clothing cannot be deducted, but actors may deduct the cost 
of clothing used for stage purposes only. The wages of personal 
servants cannot be deducted, since these are regarded as per- 
sonal expenses. The cost of maintaining an auto for personal 
use cannot be deducted, but if the auto is used for business 
purposes, such expenses can be deducted. Car fare incurred 
in traveling to and from one's place of business is regarded as a 
personal expense and cannot be deducted. Dues paid to social 
clubs cannot be deducted, but dues of commercial or profes- 
sional clubs may be deducted as an expense. The cost of tech- 
nical magazines relating to the taxpayer's profession may be 
deducted, but the cost of literary magazines cannot be deducted. 

Depreciation may be claimed on books purchased for the 
taxpayer's library. Premiums paid on a fidelity bond is con- 
sidered as a business expense. Expenses incurred on business 
trips are deductible, but the cost of lodging is not. Insurance 
on business property may be deducted, but insurance paid on 
the home in which the taxpayer lives is not deductible. The pre- 
miums on life insurance or personal insurance of any kind is not 
deductible. Lobbying expenses and campaign contributions are 
not regarded as deductible expenses. 

Distinction between Business Expense and Capital 
Outlay. It is sometimes quite difficult to determine when an 
expenditure should be considered as an expense and when it 
should be considered as a capital investment. A few illustra- 
tions will be given to serve as a guide. The expenses incurred 
in the organization of a corporation cannot be treated as an 
expense, but are considered as capital expenditures. Assess- 
ments on capital stock are not regarded as an expense to the 
stockholder, but as an additional investment. Expenses such 
as insurance, the benefit of which may be derived for a period 
of years, should not be treated as an expense at the time of its 
occurrence, but should be spread over the period which is to be 
benefited. Maintenance expense and repairs are deductible, 
but betterments to property are not. The defending and pro- 
tecting of title is considered as a capital charge and not as a 
business expense. Architect fees in connection with the con- 
struction of a building is considered as part of its cost and not 
as an expense. The cost of copyrights and patents are not de- 
ductible, although depreciation may be claimed in connection 
therewith. The cost of carrying property which is not being 
used in the conduct of the business is regarded as a capital charge 
and not as an expense. 



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196 PUBLIC ACCOUNTING AND AUDITING 

Interest. The Revenue Law of 1918 says '*AI1 interest 
paid or accrued within the taxable year on indebtedness, except 
on indebtedness incurred to purchase securities, the income upon 
which is exempt, may be deducted." It will be noticed that the 
law says "all" interest, therefore, interest on both personal and 
business indebtedness may be deducted. This seems rather 
illogical, but nevertheless it is permissible under the law. At one 
time the Commissioner of Internal Revenue ruled that the law 
referred only to interest paid on the indebtedness of the taxpayer 
incurred in the conduct of his business. ^ This decision, however, 
was later overruled and at the present time interest on both per- 
sonal indebtedness and business indebtedness can be deducted. 
It will be noticed that interest on indebtedness incurred to pur- 
chase securities, the income of which is exempt, is not deduct- 
ible. 

As a consequence, interest on funds borrowed to purchase 
obligations of the United States, issued prior to September 24, 
191 7, is not deductible, but interest on money borrowed to pur- 
chase United States bonds issued since the above date is deduct- 
ible, since the interest on such obligations is only partially and 
not entirely exempt. Interest on money borrowed to purchase 
municipal or state bonds is not deductible. Interest on capital 
of the taxpayer invested in the business is not deductible. 
Interest, like other expenses, may be reported on either the cash 
or accrual basis, but, of course, the method emplo}^ must be 
the same for all expenses. A nonresident alien can deduct only 
the interest paid on indebtedness which has been incurred in 
order to earn income which is taxable in the United States. 

Taxes. Individuals may deduct all taxes paid or accrued 
except income and excess profit taxes levied by the United States 
and assessments levied for local benefits. Examples of the latter 
kind are assessments paid by the property owner for the paving 
or extension of streets in a city, or by the landowner for irriga- 
tion or drainage in agricultural districts. These assessments 
are not regarded as a deductible expense because they are sup- 
posed to increase the value of the property to the extent imposed. 
Although excess profit taxes cannot be treated as a deduction, 
they may be treated as a credit in arriving at the amount of the 
net income subject to the income tax. Under the new law, an 
individual is not subject to the excess profits tax, so this item 
would not be considered in connection with any income accruing 
since January i, 191 8. 

Inheritance taxes are not deductible, for they are charged 
against the corpus or body of the estate and not against its 
income. Taxes paid on property used as a home may be treated 
as a deduction. It will be noticed that though insurance on a 
home or rent paid for a home are not deductible, that the taxes 
paid on a home or interest paid on indebtedness incurred in 
order to purchase a home are deductible. Although this seems 
somewhat inconsistent, it has been the holding of the Treasury 



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INCOME TAX ON INDIVIDUALS 197 

Department since the passage of the first income tax law, there- 
fore, there is little chance of its being changed. In case of custom 
duties, such as duties imposed by the tariff, they are deductible 
if paid on goods for resale by a business, but are not deductible 
if incurred upon personal property. 

The deductible taxes include the taxes on railroad tickets, 
theatre tickets, soda water and toilet articles, but the incon- 
venience of keeping a record of such taxes paid is probably 
sufficient to deter most people from taking advantage of the 
right to deduct them. 

Business Losses. The law provides that not only losses 
incurred in the trade or business, but also all losses sustained 
during the taxable year and not compensated for by insurance 
or otherwise, if incurred in any transaction entered into for profit, 
though not connected with trade or business, may be treated as a 
deduction. Likewise, losses sustained during the taxable year of 
property not connected with the trade or business arising from 
fires, storms, shipwreck, or other casualty, or from theft, and if 
not compensated for by insurance or otherwise, are deductible. 

If personal property such as jewelry, automobiles, etc., are 
stolen or destroyed by fire or other elements, their value may be 
' deducted. Thefts of merchandise are not treated as a deduction 
since the loss thus incurred will be taken care of when the in- 
ventory is taken. If a loss is covered by insurance, the amount 
of the insurance received will be reported as income. In cases 
of losses incurred through acddents, they are deductible if 
incurred in the scope of the business, otherwise not. 

It has been held that where an old building is removed in 
order that it may be replaced by a new one, the cost of removal 
is a capital charge and cannot be treated as an expense. Like- 
wise, in case of loss by destruction of buildings pursuant to 
orders of government authority because of their unsafe or un- 
sanitary condition, no deduction is permitted. 

To illustrate a deductible loss, assume that a man buys 
half of the stock of a corporation whose business is to operate 
a moving picture show. The assets of the corporation consist 
of a lease for two years of premises in which the moving picture 
show is operated. He pays $900.00 for the half interest. The 
earnings average $100.00 per month for two years, a total of 
$2400.00. The stock then becomes worthless. In making a 
return of income, A may deduct $900.00 paid for the stock as a 
loss. The stock is regarded as a loss, but if A had received bonds 
instead of stock, the $900.00 deduction would have been as a 
bad debt. 

In further illustration, assume that A is regularly engaged 
in the business of buying oil leases and in the producing and 
marketing of oil. During the year 1920, he suffered business 
losses to the amount of $5,000.00, due to the drilling of dry holes, 
etc. During the same year, he received from oil corporations 



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198 PUBLIC ACCOUNTING AND AUDITING 

as dividends the sum of $10,000.00. The losses sustained, due to 
the drilling of dry holes, may be deducted from the amount 
received as dividends. In this case, the deduction serves to 
reduce the surtax, dividends not being subject to any normal tax. 

Bad Debts. The law provides that "debts due to a tax- 
payer and actually ascertained to be worthless and charged off 
during the year may be deducted." There has been much 
criticism of this provision of the law since it does not permit a 
deduction for anticipated los ses on^ b ad debts. From the view- 
point of good accountingTIt is desirable that the estimated loss 
on account of bad debts, based on the experience of past years, 
be placed on the books at the end of each fiscal period. The law 
will not permit, however, that the amount thus estimated be 
treated as a deduction. The debt cannot be deducted until it is 
actually ascertained to be worthless and charged off the books. 

There has been some confusion as to when it is ascertained 
to be worthless. The Treasury Department has ruled that in 
order to comply with this provision it must be ascertained with- 
out reasonable doubt that it is bad; however,, the Department 
has held that in the case of a bankrupt corporation which has 
some assets, debts which it may owe cannot be regarded as 
ascertained to be worthless until the trustee in bankruptcy has 
wound up the estate and has been discharged by the court. In 
the case of a debt which has arisen from income due, it cannot 
be treated as a deduction when ascertained to be bad unless 
the income which it represents was reported at the time it 
accrued. For instance, if interest is due on money loaned and 
later it is found that the amount of the interest is uncollectible, 
it cannot be treated as a deduction unless it has been previously 
reported as income. In case of a dispute as to the amount due, 
if a compromise is made and a less amount is accepted in pay- 
ment than was first claimed, the difference cannot be treated 
as a deduction; however, if there is no dispute as to the amount 
of the debt, and if the smaller amount is accepted in order to 
obtain immediate payment, the difference may be treated as a 
deduction. 

If the endorser of a note has to pay it on the default of the 
payor its amount may be treated as a deduction. In case of a 
foreclosure of a mortgage held by a taxpayer, the difference be- 
tween the amount received as a result of the foreclosure and the 
amount due on the mortgage may be treated as a deduction, 
if the property is not purchased bj*^ the mortgagee. In the latter 
case, no deduction can be made until the property is finally 
disposed of and the loss incurred actually ascertained. 

Depreciation, Obsolescence and Amortization. The 

law provides that a reasonable allowance for exhaustion, wear 
or tear of property arising out of its employment in business 
or trade may be treated as a deduction. No depreciation is 
allowed, however, upon the property used as a residence either 



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INCOME TAX ON INDIVIDUALS 199 

in city or country. When the full value of the property has 
been deducted by means of depreciation, no further allowance 
is permitted. For instance, if the taxpayer estimates that 
an asset which cost $800.00 will last for ten years and claims as 
a deduction $80.00 each year., but finds that at the end of the 
ten years the asset has still a value of $200.00, he is not permitted 
to claim any further deduction after the tenth year. 

No allowance for depreciation is permissible upon items 
of personal property. For instance, depreciation cannot be 
claimed upon an automobile used only for personal purposes. 
Neither depreciation nor appreciation of land is considered. In 
case of renewals or replacements which do not appreciably 
lengthen the life of the property and which are charged against 
depreciation reserves, no deduction can be claimed. In order 
that depreciation may be claimed as a deduction, it must be 
entered upon the books. It was formerly held it must be credited 
to the asset to which it related, but later rulings permit it to be 
expressed in a reserve account. The latter mediod is, of course, 
the one approved by good accounting practice and should be 
followed in every case. 

At one time the Treasury Department held that the amount 
of the depreciation reserve must be set aside as a special fund 
and could not be used in the conduct of the business, but this 
has also been reversed and now the amount of the depreciation 
reserve can be represented bv the general asset^ of the business 
and need not be shown separately. This is, of course, in accord 
with sound accounting practice. No depreciation on good 
will is permissible. The law of 1918 provides that a reasonable 
allowance for obsolescence may be considered in the calculation 
of depreciation. 

In the case of buildings, machinery, equipment acquired, 
or vessels constructed or acquired on or after April 6. 1917, for 
the purpose of contributing to the prosecution of the present 
war, there is allowed a reasonable deduction for the amortization 
of such part of the cost pf such facilities or vessels as has been 
borne by the taxpayer.* 

At any time within three years after the termination of 
the war with Germany, the Commissioner of Internal Revenue 
may, at the request of the taxpayer, make a re-examination 
of the taxpayer's returns in order to determine if proper al- 
lowance has been made for this item of amortization; and if 
upon re-examination, it is found that the original deduction 
allowed was incorrect, the amount of taxes for the years affected 
will be redetermined and any tax which may be found to have 
been overpaid will be refunded or credited to the taxpayers. 



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aoo PUBLIC ACCOUNTING AND AUDITING 

Depletion. The distinction between depreciation and 
depletion should be clearly understood. Depreciation is a de- 
crease in the value of assets due to their use in the business, 
while depletion refers to the decrease in the value of the asset 
because it enters into the making of the commodity sold. For 
instance, depreciation occurs in connection with the machinery 
used in a coal mine, but depletion occurs in connection with 
the mine itself because the coal is actually being removed and 
sold. 

In the case of mines, oil and gas wells, other natural deposits 
and timber, a reasonable allowance for depletion and depreciation 
of improvements will be allowed according to the. peculiar con- 
ditions in each case, based upon cost, including cost of develop- 
ment not otherwise deducted, and in case of property acquired 
prior to March i, 1913, the fair market value on that date may 
be taken in lieu of cost. 

In the case of the above properties (except timber) dis- 
covered by the taxpayer on or after March i, 1913, where the 
fair market value of the property is materially disproportionate 
to the cost, depletion allowance may be based upon the fair 
market value of the property at the time of discovery or within 
, 30 days thereafter. In the case of leases, the deductions for 
depreciation and depletion allowed shall be equitably apportioned 
between the lessor and lessee. 

Contributions or Gifts. Contributions made to cor- 
porations organized and operated exclusively for religious, 
charitable, scientific, or educational purposes, or for prevention 
of cruelty to children or animals, no part of the net earnings 
of which inures to the benefit of any stockholder or individual, 
or contributions to the special fund for vocational rehabilitation 
authorized by Section 7 of the Vocational Rehabilitation Act, 
may be deducted,* providing they do not exceed fifteen per cent, 
of the net income of the individual. This deduction is allowable 
only to individuals and not to partnerships or corporations. 
In the case of a nonresident alien, a deduction is permissible 
only in case the contribution has been made to a domestic 
corporation. 

Items Not Deductible. In arriving at net income for 
the purposes of the tax, the following items must not be deducted 
from gross income: 

(i) Personal living or family expenses, such as cost of 
maintaining a home, servants* wages, family life insurance 
premiums, allowances made as gifts to dependents, cost of 
purchase and upkeep of pleasure automobiles, chauffeurs' hire, 
railroad commutation fares to and from place of business and 
similar items. 



*Such contributions or gifts have been construed to mean gifts of money 
or property. The value of services rendered to charitable institutions may 
not be allowed as a deduction under the law. 



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INCOME TAX ON INDIVIDUALS 201 

(2) Any amount paid out for new buildings, or for per- 
manent improvements or betterments made to increase the 
value of any property or estate. 

(3) Any amount expended in restoring property or in 
making good the exhaustion thereof for which an allowance 
is or has been made. 

(4) Premiums paid on any life insurance policies covering the 
life of any officer or employe or of any person financially interested 
in any trade or business carried on by the taxpayer when the 
taxpayer is directly or indirectly a beneficiary under such policy. 

(5) Interest paid or accrued within the year on money 
borrowed to purchase or carry securities or obligations (except 
United States obligations), the income from which is wholly 
exempt from tax, such as state or municipal bonds, etc., and 

(6) Interest paid or accrued on indebtedness incurred or 
continued to purchase or carry obligations of the United States 
issued prior to September 24, 1917. 

Credits Allowed. After the deductions have been made 
from the gross income, the net income is obtained and on this 
net income the individual may be required to pay two taxes, the 
normal tax, and the surtax. The amount of these taxes and the 
method of calculation will be explained later. It suffices for the 
present to^ know that in the calculation of the normal tax, the 
following items may be deducted from net income as defined 
above, although they are not deductible for the purpose of the 
surtax. In odier words, after the net income is obtained, the 
items mentioned below may be subtracted and the remainder 
is the basis for the calculation of the normal tax, but if the 
individual has sufficient income to be subject to the surtax, it 
is calculated on the total net income without the consideration 
of the following credits: 

1. The amount received as dividends from a corpora- 

tion which is taxable under this title upon its 
net income and amounts received as dividends 
from a personal service corporation out of the 
earnings or profits earned prior to January i, 
1918. 

2. The amount received as interest from the obliga- 

tions of the United States and bonds issued by 
the War Finance Corporation, which is included 
in gross income as above discussed. 

3. In the case of a single person a personal exemption 

of $1,000.00, or in the case of the head of a 
family or of a married person living with hus- 
band or wife, a personal exemption of $2,000.00. 
A husband and wife living together shall receive 
but one personal exemption of $2,000.00 against 
their aggregate net income, and if they make 



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202 PUBLIC ACCOUNTING AND AUDITING 

separate returns, the personal exemption of 
$2,000.00 may be taken by either or may be 
divided between them. 

4. $200.00 for each person (other than husband or 

wife), dependent upon and receiving his or her 
chief support from the taxpayer, if such de- 
pendent person is under eighteen years of age, 
or is incapable of self-support because mentally 
or physically defective. 

5. In the case of a nonresident alien individual who 

is a citizen or subject of a country which imposes 
an income tax, the credits allowed in subdivisions 
three and four shall be allowed only if such coun- 
try allows a similar credit to citizens of the 
United States not residing in such country. The 
law further provides that in case of a citizen or 
resident alien, a part of whose income is obtained 
from sources without the United States on 
which a tax is imposed by some other govern- 
ment, the amount of this tax may be d^ucted 
from the tax due under this law. 

A, who is the holder of $185,000.00 liberty bonds. First 
4s, is entitled to $35,000.00 exemption, with income of $6,000.00 
on the balance of $150,000.00, and a personal exemption of 
$1,000.00, being unmarried. B is the holder of $210,000.00 of 
the same issue of bonds, $35,000.00 free of taxes, and $175,000.00, 
income on which is $7,000.00, and entitled to $2,000.00 personal 
exemption, being married. In both cases, the parties hold no 
other investments and have no other income. The bond issue 
in question is exempt from all normal tax, but is subject to 
graduated additional income tax or surtax on the interest on 
an amount of such bonds, the principal of which exceeds 
$35»ooo.oo. The personal credits of $1,000.00 and $2,000.00, 
respectively, are allowed only for the purpc^ of computing the 
normal tax. There being no normal tax in the cases above, 
there are no such credits allowed. It is evident that in the first 
case there is an income of $6,000.00 (not $5,000.00), $1,000.00 of 
which is subject to a graduated additional income tax of $10.00; 
and in the second case, there is an income of $7,000.00 (not 
$5,000.00), $2,000.00 of which is subject to a graduated addi- 
tional income tax of $30.00. 

Making of Returns. The law provides that the indi- 
vidual may make his return either on the basis of a calendar or 
fiscal year. If his return is made on the basis of a calendar year, 
it must be filed with the Collector of Internal Revenue of the 
district in which he lives, on or before March 15 of the year 
following the one for which the return is made. If the return 
is made on the basis of a fiscal year, it must be made on or before 
the fifteenth day of the third month following the end of his 



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INCOME TAX ON INDIVIDUALS 203 

fiscal year. Forms for making this return can be secured from 
the Collector of Internal Revenue or the various substations 
which are usually established in connection with banks and 
similar institutions. 

Every individual haying a net income for the taxable year 
of $1,000.00 or over, if single, or if married and not living with 
husband or wife; or $2,000.00 or over, if married and living with 
husband or wife, shall make under oath a return specifically 
stating the items of income and deduction and credits allowed 
by law. If husband and wife living together have an aggregate 
net income of $2,000.00 or over, each shall make such a return 
unless income of each is included in a single joint return. If the 
husband and wife make a joint return, they are allowed the 
exemption of $2,000.00 or if they make a saparate return, either 
one may take an exemption of $2,000.00 or each may claim an 
exemption of $1,000.00. Whether they make a joint or separate 
return, their incomes will be considered separately in the calcu- 
lation of the surtax. 

It is held that a minor is an individual in the sense in which 
this term is used in the law and, therefore, if his income is in 
excess of $1,000.00 he must make a return or it must be made for 
him by his guardian or parent. If the minor does not make a 
separate return, his income must be included in that of his 
parent. Although the head of a family is permitted to claim 
an exemption of $2,000.00, he must file a return if his net income 
is in excess of $1,000.00, although it is not in excess of $2,000.00 
and make a claim for the $2,000.00 exemption. A partnership 
must render a return showing the net income for the partnership 
and the partners to whom the profits are credited, although as 
previously mentioned, the partnership does not pay a tax as 
the partners are taxed individually for the profits received from 
the partnership. 

Where to File Returns. Returns in the case of indi- 
■ viduals shall be made to the collector for the district in which 
is located the legal residence or principal place of business of 
the person making the return; or, if he has no legal residence 
or principal place of business in the United States, then to the 
collector at Baltimore, Maryland. 

Extension of Time for Filing Returns. If for any 

reason return cannot be made by the due date, application 
may be made to the Collector of Internal Revenue for the 
district in which the taxpayer is located, setting forth the 
facts as to the taxpayer's inability to file on or before the 
due date, and upon a showing of a reasonable excuse, such as 
absence, sickness, etc., the collector will grant an extension of 
time not exceeding thirty days in which to file the return. Jf 
a further extension of time is required, application is to be made 
to the Commissioner of Internal Revenue at Washington, D. C. 
in the same manner. The Collector of Internal Revenue only 
has the power to grant an extension of time not exceeding 



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204 PUBLIC ACCOUNTING AND AUDITING 

thirty days. The commissioner may grant an extension of 
time for filing returns on a reasonable cause shown, not exceed- 
ing six months, except in case of absence abroad. 

When an extension of time has been granted, the date of 
the expiration of the period of extension shall be deemed to be 
the time fixed by law for filing the return. In any case in which 
the time for the payment of any installment is thus postponed 
because of an extension of time for filing the return, there shall 
be added, as a part of such installment, interest thereon at the 
rate of one-half of one per cent, per month from the time it 
would have been due, if no extension had been granted, until 
paid. 

Rates of Tax. The law provides for two taxes on indi- 
viduals — the normal tax and the surtax. 

Normal— 4% and 8%. 

Surtax — Graduated rates — Same as in 1919. 

Rates of Normal Tax on Individuals. There shall be 
levied, collected and paid upon the net income of every citizen 
or resident of the United States a normal tax at the rate of four 
per cent, upon the first $4,000.00 of net income in excess of the 
credits and at the rate of eight per cent, upon the remainder. 

The term ''taxable year" means the calendar year, or the 
fiscal year ending during such calendar year, on the basis of 
which the net income is computed. 

Rates of Surtax on Individuals. In addition to the 
normal tax, there shall be levied, collected and paid for each 
taxable year upK>n the net income of every individual a surtax 
calculated at different percentages for different amounts of net 
income. 

The surtax for 1920 is the same as it was for 1918 and 1919. 
It ranges from one per cent, of the amount by which the net income 
exceeds $5,000.00 and does not exceed $6,000.00 to 65 per cent, 
of the amount by which the net income exceeds $1,000,000.00. 
Accordingly, a taxpayer whose net income exceeds $1,000,000.00 
may be subject to a tax of 73 per cent, of the amount by which 
his net income exceeds such sum. In computing the surtax, 
the taxpayer is not entitled to the credits against net income 
allowed for normal tax. 

Computation of Tax. In the case of an individual 
citizen or resident, the normal tax is four per cent, on the first 
$4,000.00 over the personal exemption and credit for depen- 
dents, and eight per cent, upon the net income in excess of the 
first $4,000.00 plus credit for dependents and specific exemption. 

To illustrate the computation of the tax for individuals, 
we shall assume certain propositions and show the calculations 
made in order to compute the total tax. 



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INCOME TAX ON INDIVIDUALS 205 

Proposition A 

Assume that a citizen who is married and living with his 
wife has an income of $8,000.00 for the calendar year 1920. 
Compute the amount of his income tax. 

Solution 

Net income $8,000.00 

Exemption 2,000.00 

Amount subject to normal tax $6,000.00 

Calculation of Normal Tax: 

4% on first $4,000.00 $ 160.00 

8% on balance of $2,000.00 160.00 

Total normal tax $ 320.00 

Additional Tax: 

Net income $8,000.00 

Exemption 5,000.00 

Amount subject to additional tax $3,000.00 

Calculation of Additional Tax: 

$1,000.00 at 1% $ 10.00 

$2,000.00 at 2% 40.00 

Total surtax $ 50.00 

Amount of Normal and Additional Taxes Payable: 

Normal $320.00 

Additional 50.00 

Total tax $370.00 

Proposition B 

^ Assume that the taxpayer in the preceding illustration and 
his" wife, living together, had a joint income of $8,000.00, but 
of this amount $5,000.00 was his income and $3,000.00 was his 
wife's income. Compute the tax and show whether it would 
be advantageous to file a combined return or separate returns. 

Solution 

In the form of combined returns: 

Income of husband and wife $8,000.00 

Marital exemption 2,000.00 

Net income subject to normal tax $6,000.00 

Calculation of normal tax: 

4% on first $4,000.00 $ 160.00 

8% on balance of $2,000.00 160.00 

Total normal tax $ 320.00 



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2o6 PUBLIC ACCOUNTING AND AUDITING 

In the form of separate returns: 

Wife's income — $3,000.00. Husband's iiicome — ^$5,000.00 

Husband and wife divide the exemption of $2,000.00 
($1,00000 each.) 

Wife $3,000.00 Husband $5,000.00 

Share of exemption 1,000.00 Share of exemption 1,000.00 

Amount taxable. .$2,000.00 Amount taxable $4,000.00 



Husband, $4,000.00 at 4% $ 160.00 

Wife, $2,000.00 at 4% 80.00 

Total normal tax of husband and wife $ 240.00 

Apparently there is an advantage in filing separate returns. 

The surtax is actually an additional tax, being levied in 
addition to the normal tax, and when referred to as either ad- 
ditional tax or surtax, has the same meaning. As the husband's 
income is $5,000.00, he is not liable for any additional tax, his 
income not being in excess of $5,000.00. As the wife's income 
is only $3,000.00, no additional tax is due for her income does 
not exceed $5,000.00; therefore, no additional tax would be 
paid upon the joint income of the husband and wife, only the 
normal tax being assessable. No additional tax is due upon the 
income of either husband or wife unless either his or her income 
exceeds $5,000.00 individually. 

Pajmient of Tax.^ The tax may be paid in four install- 
ments, covering the entire year, up to December 15, 1921. The 
first payment is due at the time of filing the return, that is, 
March 15, 1 921, if the return is made on the basis of the calendar 
year 1920. The second payment is to be made on June 15, the 
third payment on September 15 and the fourth and final pay- 
ment on December 15. 

Penalties. For failure to render returns, whether of 
income, withholding, or information, at the proper times, for 
understating the income or tax, and for failure to pay the tax 
or installments of it when due and payable, the statute pre- 
scribes various penalties. These include severally or in com- 
bination the addition of interest to the tax, and the addition 
of specified percentages of the tax and the imposition of fines. 
If the failure to file a return or list is due to sickness or absence, 
the collector may allow an extension of time not exceeding 
thirty days for making and filing the return or list. 



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QUESTIONS AND PROBLEMS 207 

INCOME TAX QUESTIONS AND PROBLEMS 

1. Are domestic partnerships obliged to make income tax 
returns? Inst. Ex. 

2. To what extent are losses deductible in computing net 
income for federal taxes in the case of a resident individual? 

Inst. Ex. 

3. A widowed mother died, leaving three children under 
15 years of age. An unmarried uncle took charge of the children 
on January i, 1919, and supported them during the year. 

The income of the uncle consisted of: 

Dividends received from corporations, from 
surplus accumulated since January i, 
1912, of $1,000.00 each year $8,000.00 

Interest received on $5,000.00 Fourth Lib- 
erty Bonds 212 . 50 

Net kicome from farming operations 1,000.00 

Total income $9,212.50 

Prepare statement showing the amount of federal tax lia- 
bility. C. P. A. Ex. 

4. Mr. Richard Roe, a married man, requests you to pre- 
pare his federal income tax return for the ten months ended 
December 31, 1920, from the following information which he 
has submitted to you: 

Income Received During the Year 

Salary $5,000.00 

Directors' fees 105 .00 

Rent of property (net) 7,596.54 

Interest on investments 1,648.32 

Dividends on bank stock 2,500.00 

Dividends on stock held in industrial 

companies 11,500.00 

Dividends on stock of a corporation or- 
ganized and doing business in a province 

of Canada 1,500.00 

He has paid out: 

Interest on his personal indebtedness $2,500.00 

Taxes on income-producing real property. . 1,600.00 
Taxes on real property not producing in- 
come 400.00 

Personal household expenses 2,500.00 



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2o8 PUBLIC ACCOUNTING AND AUDITING 

He also reports: 

Loss of a dwelling house, from which he 
had received rents, by fire, no insurance 
being carried $1,200.00 

Judgment rendered against him in his suit 
to collect on the past due note of Harry 
Hanson — 

Principal $ 2,000.00 

Interest 320.00 

Legal expenses 150.00 $2,470.00 

Prepare statement showing computation of tax. The 
rates for individual taxes for 1920 were: 

First $4,000.00 — 4%; thereafter — 8%. 

Surtax 
Incomes Per cent. 

$ 5,000.00 to $ 6,000.00 I 

6,000.00 to 8,000.00 2 

8,000.00 to 10,000.00 3 

10,000.00 to 12,000.00 4 

12,000.00 to 14,000.00 5 

14,000.00 to 16,000.00 6 

16,000.00 to 18,000.00 7 

18,000.00 to 20,000.00 8 

20,000.00 to 22,000.00 9 

22,000.00 to 24,000.00 10 

24,000.00 to 26,000.00 II 

26,000.00 to 28,000.00 12 

28,000.00 to 30,000.00 13 

A married man is entitled to an exemption of $2,000.00. 

Inst. Ex. 



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Chapter Fourteen 

FEDERAL INCOME TAXES 

THE INCOME TAX ON CORPORATIONS 

Corporations Subject To Tax. All corporations* not 
exempted are taxable on their net income. A few special applica- 
tions may be given by way of illustration. In case of a holding 
company with various subsidiary companies, the old law required 
that a separate return be made by each company and that each 
company pay a separate tax on its income. The new law provides 
that under regulations prescribed by the Commissioner of In- 
ternal Revenue, subsidiary companies shall have their income 
combined in one joint return made by parent or holding company, 
that they shall pay one tax, and have one exemption. Although 
a corporation may be owned by an exempt corporation, that does 
not exempt it from the payment of the tax if it does not belong 
to the classes mentioned above. Corporations in existence only 
part of a year must file a return for that portion of the year. 
Such a case may arise where the corporation is organized within 
the year or where a corporation previously organized is dissolved 
within the year. Corporations fully organized must file a re- 
turn whether they are doing business or not, and this applies 
equally to newly organized corporations which have not com- 
mence business, and corporations which harve formerly done 
business and have ceased to do so. Corporations not fully 
organized need not file a return. Corporations engaged in agri- 
cultural pursuits for profits must file a return the same as those 
engaged in mercantile industries. Corporations which lease 
part of their property to others, with tne agreement that the 
rentals are to be paid directly to the stopkholders, must consider 
the amount so paid as income and report it in their returns. 
Private banks must render returns if they have the corporate 
form of organization, but need not make a return if they are 
organized as a partnership or the bank is owned or operated by 
an individual. 



*The term "corporation" refers not only to the ordinary statutory 
corporations, but also to business trust associations called "Massachusetts 
Trust," joint stock companies, limited partnerships, mutual saving banks 
and insurance companies, and all analagous business associations, the net 
income of which is distributed among the members on the basis of the shares 
which each holds, or the proportion of capital which each has invested. Cor- 
porations organized in this country are taxed upon their income received from 
all sources. Corporations organized in foreign countries are taxable on the 
net income received from sources in this country only. 



209 



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210 PUBLIC ACCOUNTING A<ND AUDITING 

Net Income. The net income of a corporation is obtained 
in the same manner as that of an individual — by subtracting from 
the gross income the deductions which the law permits to be 
made. It is, therefore, necessary to see what is included under 
the gross income of corporations and the deductions which are 
permitted. The income which is exempt from tax in the hands 
of the individual, as previously explained, is also exempt in the 
hands of a corporation. 

Gross Income. The law provides that "in the case of a 
corporation subject to the tax imposed by Section 230, the gross 
income means the gross income as defined in Section 213 (which is 
the section which defines the gross income of the individual) 
except that: 

1. In the case of life insurance companies there shall 

not be included in gross income such portion 
of any actual premium received from any indi- 
vidual policyholder as is paid back or credited 
to or treated as an^ abatement of premium of 
such policyholder within the taxable year. 

2. Mutual marine insurance companies shall include 

in gross income the gross premiums received by 
them, less the amounts paid for reinsurance. 

3. In case of a foreign corporation, the gross income 

includes only the gross income from sources 
within the United States." 

Gross Income of Corporations. Although the gross in- 
come of corporations is defined by the act to be the same as the 
gross income of an individual, except as mentioned above, there 
are a few particular points worthy of notice which have not been 
mentioned in the previous discussion of the gross income of 
individuals. For the purpose of convenience in discussion, the 
gross income of corporations may be classified as follows: 

1. From operations. 

2. From rentals and royalties. 

3. From interest. 

4. From dividends. 

5. From other sources. 

Income from Operations. In arriving at the gross income 
from operations, the gain or loss is determined by the inventory 
method. The sales should be shown net; that is, any deductions 
which have been made in the way of return sales, allowances, or 
abatements, should be subtracted. The inventory should be 
taken at cost or market price, whichever is the lower. *This 
refers, of course, only to the inventory of stock-in-trade, for in 
the case of securities and similar properties, the cost price must 
be taken, except in the case of a dealer in securities, where the 

*A taxpayer may, regardless of his past practice, adopt the basis of 
"cost or market, whichever is lower," for his 1920 inventory, provided a 
disclosure of the fact and that it represents a change is made in the return. 
(T. D. 3108, Dec. 30, 1920.) 



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INCOME TAX ON CORPORATIONS 211 

market price may be used. The inventory may be efther a 
physical inventory or it may be a book inventory, if the latter 
method is in current use by the firm in question. Purchases 
should be shown net; that is, less any returns or allowances, but 
freight and drayage in may be added to die invoice cost of same. 
After the above amounts have been obtained, the gross profit is 
arrived at by subtracting from the sales, plus the inventory at the 
end of the year, the purchases made during the year, plus the in- 
ventory at the beginning of the year. The above is die method 
outlined in the Treasury regulations. The same result is ob- 
tained, of course, by adding die purchases during the year to the 
inventory at the beginning of the year and subtracting the inven- 
tory at the end of year, thus obtaining the cost of goods sold, 
which is subtracted from sales to obtain the gross profit. In case 
of a manufacturing concern, there are three inventories to be 
considered — that of raw materials, goods in process, and finished 
goods. The same method should be followed in arriving at 
their value, cost or market price, whichever is lower, being used. 

Income from Rentals and Roj^lties. All receipts for 
rent, whether in cash or its equivalent, must be reported as part 
of the gross income. If a tenant makes improvements or repairs 
on the land, which it is the duty of the landlord to make in lieu 
of rent, the cost of these must be considered as an addidon to 
the rent received. Where permanent improvements are made 
which revert to the owner at the termination of the lease, their 
value, less the accrued depreciation, must be regarded as income. 
All amounts received as royalties from patents, copyrights, or 
similar privileges must be reported as income, but a reasonable 
allowance for depreciation thereon may be deducted. In the case 
of mines, which are operated on the royalty basis, a reasonable 
allowance for depletion, as explained later, may be made. 

Income from Interest. All interest received or accrued 
should be reported, except: 

1. Interest on obligations of a state or a political 

subdivision thereof. 

2. Interest on obligations of the United States issued 

prior to September i, 191 7, and the interest on 
the obligations of the United States issued since 
September i, 1917, to the extent provided for 
in the acts authorizing their issue. 

3. Interest on securities issued under the Foreign 

Loan Act of 1916. 
Income upon bonds should include only the interest eamied from 
the date of purchase. Where bonds are purchased between 
interest dates, the amount paid for accrued interest should be 
deducted from interest received. When bonds are purchased 
at a premium or discount, the amount of the premium or dis- 
count should be amortized over the life of the bonds and only 
a^ portion of the addition or deduction deriv«i therefrom con- 
sidered during the current period. In the case of interest re- 



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212 PUBLIC ACCOUNTING AND AUDITING 

ceived on securities held in a sinking fund, this must be reported 
as income of the corporation. 

Income from Dividends. In general, all dividends re- 
ceived by a corporation must be included in its gross income. 
Under the head of deductions, it will be explained that the 
amount of dividends received from corporations, which are them- 
selves subject to the income tax, may be treated as a deduction 
by the company receiving the dividends. However, they must 
be reported in stating gross income and taken as a deduction 
under the proper heading. Dividends on stock of federal 
reserve banks are held as exempt from the tax and need not be 
reported. As previously explained, stock dividends are not 
subject to the tax. 

Income from Miscellaneous Sources. If a deduction has 
been claimed on account of a bad debt which has been written 
off, and this debt has been later collected, it must be reported 
as income in the year when collected. Assessments made 
by a corporation on its stockholders are not considered as 
income by the receiving corix>ration, but are considered as 
additional investment on the part of the stockholders, con- 
sequently, they are not counted as income by the corporation, 
nor can they be treated as a deduction by the individual pay- 
ing them. If the corporation buys its own bonds at a discount, 
it is held that the savings thus made must be treated as in- 
come. If assets are traded for capital stock of another cor- 
poration, the difference in the cost of the assets and the value 
of the stock received is regarded as income. However, if the 
stock of one corporation is exchanged for capital stock of the 
same par value of another corporation, it is deemed that no 
profit arises as a result thereon. Amounts received from insur- 
ance policies held by the corporation less the premiums pre- 
viously paid are regarded as income. No appreciation of assets 
is recognized by the income tax law, therefore, if a corporation 
writes up its assets and credits the amount arising as a result 
thereon to its Surplus account, this is not regarded as income. 

In the same manner no appreciation nor depreciation of 
good will is recognized. However, if the good will of a cor- 
poration is sold at a greater value than it cost, the difference 
is reportable as income. If capital assets of a corporation are 
sold, the difference between their cost price and sales price is 
reported as income if purchased since March i, 1913. If pur- 
chased prior to that date, the difference between their market 
value on March i, 1913, and their sales price is regarded as 
income. 

Foreign Corporations. Foreign corporations are tax- 
able only upon income derived from sources within the United 
States, including the interest on bonds, notes or other interest- 
bearing obligations of residents, corporate or otherwise, divi- 
dends from resident corporations and including all amounts 
received (although paid under a contract for the sale of goods 



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INCOME TAX ON CORPORATIONS 213 

or otherwise) representing profits on the manufacture and dis- 
position of goods within the United States, Foreign corpor- 
ations are not allowed the specific exemption of $2,000.00 for 
income tax, nor $3,000.00 for excess profits tax. 

Corporations Exempt from the Income Tax. The law 
provides that the following corporations are exempt from the 
income tax: 

1. Labor, agricultural, and horticultural organiza- 

tions. 

2. Mutual savings banks not having stock represented 

by shares. 

3. Fraternal, beneficiary societies, orders, or asso- 

ciations, organized and operated for the mutual 
benefit of their members. 

4. Domestic building and loan associations and co- 

operative banks without capital stock organized 
and operated for mutual purposes and without 
profit. 

5. Cemetery companies owned and operated exclu- 

sively for the benefit of their members. 

6. Corporations organized and operated exclusively 

for religious, charitable, scientific, or educa- 
tional purposes, or for the prevention of cruelty 
to children or animals, no part of the net earn- 
ings of which inures to any sp)ecific individual. 

7. Business leagues, chambers of commerce, or 

boards of trade not organized for profit. 

8. Civic leagues, or organizations not organized for 

profit, but operat^ exclusively for the promo- 
tion of social welfare. 
9* Clubs organized and operated exclusively for 
pleasure, recreation, and other nonprofitable 
enterprises, no part of the net earnings of which 
inures to any stockholder or member. 

10. Farmers' or other mutual associations — 

(a) Hail, cyclone, or fire insurance companies. 

(b) Ditch or irrigation companies. 

(c) Telephone companies. 

(d) Like organizations of purely local char- 

acter, the income of which is collected 
merely for the purpose of meeting ex- 
penses. 

11. Farmers' and fruit growers' associations, if or- 

ganized and operated as sales agencies for the 
purpose of marketing products of their members 
and turning back to them the proceeds of sales 
less the necessary selling expenses on the basis 
of the quantity of products furnished them. 

12. Corporations organized for the exclusive purpose 

of holding title to property, the net income from 
which is to be turned over to an organization 
which itself is exempt from the tax. 



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214 PUBLIC ACCOUNTING AND AUDITING 

13. Federal land banks and national farm loan as- 
sociations created under the Act of July 17, 1916, 
to provide capital for agricultural development. 

14. Personal service corporations. 

Personal Service Corporations. For tax purposes, per- 
sonal service corporations are treated as partnerships, and are 
not as such liable to income tax, but the stockholders must 
include in their returns the proportionate part of the earnings 
of such corporations, whether received as dividends or not, 
according to the respective stock holdings. Foreign personal 
service corporations shall not be accorded the privileges of 
domestic personal service corporations, but shall be taxed as 
corporations. 

A personal service corporation is a corporation whose in- 
come is due primarily to the activities of the principal owners 
or stockholders who are themselves regularly engaged in the 
active conduct of ^ the affairs of the corporation and in which 
capital (whether invested or borrowed) is not a material in- 
come-producing factor. For instance, a corporation composed 
of commission merchants or advertising men, whose principal 
owners or stockholders are themselves actively engaged in the 
conduct of the business, whose income is due principally to 
their personal services, and whose capital is employed for the 
purposes of paying for office equipment and employes* salaries, 
is a personal service corporation. 

In the case of a personal service corporation, if 50 per 
cent, or more of the gross income consists of (i) gains derived 
from trading as a principal, or (2) gains, profits or commissions 
derived from Government contracts, made between April 6, 
1917, and November 11, 1918, both dates inclusive, it shall 
not be treated as a personal service corporation subject to the 
provisions which apply to a partnership, but shall be taxed as 
a corporation. 

Every personal service corporation, although not subject 
to the tax, must file a return showing the gross income, the 
deductions allowed by law, the net income and the amounts 
distributed, with the names and addresses of the recipients. 
Where a part of the net income has not been distributed, the 
names and addresses of the stockholders who would be entitled 
to the profits if distributed must be given, with the portion 
assignable to each. 

Stockholders Taxable as Partners. The individual 
stockholders of personal service corporations shall be taxed in 
the same manner as the members of partnerships, and all the 
provisions of the Act relating to the partnerships and members 
shall, so far as practicable, apply to personal service corpor- 
ations and their stockholders. Any portion of the net income 
remaining undistributed at the close of the taxable year shall, 
for the purpose of taxation, be assigned to the stockholders 
in proportion to their respective shares. 



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INCOME TAX ON CORPORATIONS 215 

Deductions from Income. In many ways the deduc- 
tions allowed to corporations are very similar to the deductions 
allowed to individuals but there are certain difiFerences for two 
reasons: 

1. The individuaPs income usually is derived chiefly 

from services and, therefore, there are few ex- 
penses which the individual can deduct, while 
income of the corporation is derived from oper- 
ations of the business and, therefore, there are 
numerous expenses which can be deducted. 

2. There are some items which the individual is per- 

mitted to deduct which the corporation cannot 
deduct and vice versa; consequently, it is thought 
worth while to discuss deductions allowed to 
corporations separately from deductions allowed 
to individuals. This will, of course, involve a 
repetition of what has already been said to some 
extent. 
The expenditures of a corporation may be divided into two 



1. Capital expenditures. 

2. Revenue expenditures. 

Capital expenditures add to the value of some asset and are 
not deductible from the gross income. Revenue expenditures 
are those which are incurred in connection with earning the 
gross income of a corporation and are a proper deduction in 
determining its net income. 

Classification of Deductions. As a matter of conven- 
ience in discussion, the deductions allowed a corporation may 
be classified as follows: 

1. Ordinary and necessary business expenses. 

2. Interest and taxes. 

3. Losses. 

4. Depreciation and depletion. 

5. Deductions by insurance companies. 

6. Miscellaneous. 

Ordinary and Necessary Business Expenses. The 

expenses of a corporation may be deducted on the accrual 
basis if the gross income is reported on the same basis. Pre- 
paid expenses should be deferred and treated as a deduction 
in the year to which they apply. Illustrations of these 
are: Prepaid insurance, taxes, interest, advance payments on 
contracts, etc. Expenses paid in property or stock are deduct- 
ible the same as if paid in cash. If capital stock is given in pay- 
ment for services rendered, the fair market value of the stock 
at the time of delivery can be deducted as an expense. ^ All 
salaries and wages payable by the corporation are deductible, 
whether paid in cash, property or stock. Salary and wages in 
order to be deducted, however, must be entered as an expense 
on the books of the corporation. In the case of salaries of 



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2i6 PUBLIC ACCOUNTING AND AUDITING 

officers and employes, who are stockholders in the company, 
the regulations prescribe that they will be given careful scrutiny, 
and if considers! too large, they will be regarded as a distribu- 
tion of profits instead of an expense. Salaries paid soldiers or 
sailors in the service of the Government are regarded as a legiti- 
mate expense and may be deducted. 

Pensions paid to retired employes are regarded as a de- 
ductible expense. Gifts to employes are not deductible. Bonuses 
paid to employes may be deducted when they are made in good 
faith as additional compensation for services rendered. If made 
as a gratuity or gift, they cannot be treated as an expense. 
Souvenirs given to customers are deductible as an advertising 
expense. Campaign contributions and lobbying expenses are 
not allowable. If donations are niade subject to a condition 
that certain services may be received in return, they may be 
treated as an expense and deducted accordingly. For instance, 
donations to a hospital in consideration of an agreement by the 
hospital that a ward will be provided for the use of the em-' 
ployes of the company has been held as an allowable deduction. 
Donations made for obtaining good will are held not to be 
deductible. This ruling seems to be arbitrary, since in many 
cases such payments are proper expenses on the^ part of a 
corporation. For instance, it has been held that prizes offered 
at a county fair could not be treated as an expense by the firms 
who offered them. This would seem to be making quite an arbi- 
trary distinction, but under the present ruling they must be 
excluded in arriving at the proper expense of the firm. 

Money spent by salesmen in entertaining customers of the 
company is held an allowable expense. The distinction between 
a gratuity and an expense is sometimes hard to make. The 
general theory is that if an expense is made from which no 
benefit accrues to the corporation, either directly or indirectly, 
it cannot be treated as a deduction, but if the corporation ex- 
pects to obtain a return as a result therefrom, it can be treated 
as a deductible expense. In the case of expenses incurred in 
making ordinary and incidental repairs to property, a reduction 
may be made, but if the expenditure results in prolonging the 
life of the asset or appreciably increasing its value, it is treated 
as an additional investment and can not be deducted. Premiums 
on life insurance paid by a corporation on the life of its officers 
or employes can not be deducted at the time, paid, but they 
can be subtracted from the amount received when the policy 
is paid. 

* The Treasury Department has ruled that organization ex- 
penses are a capital expense. They are neither deductible nor 
subject to depreciation. This, however, is contrary to their 
treatment by accountants, who regard them as an expense 
which should be written off against income as soon as possible. 
All ordinary rental and royalty payments are deductible, as 
are also expenses incurred in making any improvements de- 



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INCOME TAX ON CORPORATIONS 217 

manded by the lease. The cost of the latter, of course, should 
be prorat^ over the years during which they are used. If 
interest or dividends are paid to stockholders in lieu of rent, 
they may be deducted the same as if rent was paid. 

Interest and Taxes. Interest paid on indebtedness of 
corporations may be deducted, whether paid in cash or its 
equivalent. It may be reported either on the accrual or cash 
basis, depending on the method pursued by the corporation in 
reporting its expenses. Interest paid on money borrowed to 
purchase securities, the income from which is exempt, except 
securities of the United States Government, is not deductible. 
For instance, if a corporation should borrow money to buy 
municipal or state bonds, the interest on which is exempt from 
the income tax, the interest paid on such money would not be 
deductible. 

All taxes paid or accrued within the taxable year are de- 
ductible except: 

1. Special assessments which are deemed to increase 

the value of the property to which they pertain. 

2. Inheritance taxes. 

3. Income and excess and war profits taxes. For 

instance, all taxes imposed by states and politi- 
cal subdivisions thereof and by the United States 
Government, except as mentioned above, are 
deductible. This includes excise and franchise 
dues, custom duties, etc. Accrued taxes are 
deductible, and if .the exact amount is not known, 
an estimated amount, therefore, is deductible. 

LfOSses. The new law provides that the following losses 
may be deducted by a corporation: 

1. Losses sustained during the taxable year and not 

compensated for by insurance or otherwise. 

2. Debts ascertained to be worthless and charged off 

within the taxable year. 
It has been previously explained how losses in connection 
with stock-in-trade is determined by means of the inventory 
method. In connection with securities, no loss can' be claimed, 
except in case of a dealer in securities, unless the securities are 
disposed of and an actual loss realized. In connection with the 
sale of property, it has also been explained how the profit or 
loss is ascertained. There has been much criticism of the de- 
partment's ruling in connection with the treatment of bad debts. 
It is the custom of accountants to estimate at the end of the 
fiscal period the loss incurred because of uncollectible accounts 
receivable and to record this amount on the books as a deduc- 
tion from income of the current period. The Treasury Regula- 
tions, however, will not permit such an estimated amount to be 
treated as a deduction, but will only permit a deduction on 
account of bad debts when a debt has actually been ascertained 
to be worthless and written off the books. 



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2i8 PUBLIC ACCOUNTING AND AUDITING 

Some difficulty has arisen as to when a debt is ascertained 
to be worthless. On this point the Treasury Department has 
ruled that a debt may be regarded as ascertained to be worthless 
when it is determined beyond reasonable doubt that it cannot 
be collected. With reference to bonds, smce they are regarded 
as debts of a corporation, they may be written off if it is ascer- 
tained without reasonable doubt that they are uncollectible. 
They are, therefore, treated somewhat differently than stock 
and other securities since no losses can be claimed on the latter 
until they are actually disposed of. Discount on bonds incurred 
in their sale may be treated as a deduction and prorated over 
the life of the bond. Discount on stock, however, is regarded as 
a capital loss and cannot be treated as a deduction. The old 
law held that a holding company must show all profits which 
had accrued to it on the bcnoks of subsidiary companies, but 
could not treat as a deduction losses, similarly incurred, until 
the assets of the holding company were reduced as a result 
thereof. The new law, however, provides for a consolidated 
return to be made by the holding company, therefore, both 
losses and gains can be considered therein. 

Depreciation and Depletion. The present law provides 
that "a reasonable allowance for the exhaustion, wear and tear 
of property used in a trade or business, including a reasonable 
allowance for obsolescence" may be treated as a deduction. A 
distinction must be made between depreciation and fluctuation. 
Depreciation is the decline in the value of property as a result of 
its use in the business. Fluctuation is a change in the market 
value of assets, either favorable or unfavorable, which is due to 
causes apart from the business. The former is an allowable 
deduction, while the latter is not considered. A distinction 
must also be made in connection with depreciation between 
repairs and renewals. 

The expense of repairs may be treated as a deduction in 
addition to the allowance made for depreciation, but the same 
rule does not apply in the case of renewals. The regulations 
prescribe that they must be charged against the reserve for 
depreciation; therefore, cannot be treated as a deduction. In 
other words, a renewal^ is regarded as a capital expenditure as 
defined above. In arriving at the rate of depreciation, three 
things must be considered, — the original cost of the asset, the 
estimated life of the asset, and the residual value of the asset. 
Neither the law nor the regulations of the Treasury Department 
prescribe the rate of depreciation, which is permissible. Both 
say that a "reasonable" rate is allowable. Collectors of internal 
revenue and inspectors of the department have, however, indi- 
cated their approval of certain rates. In certain cases known 
by the author, they have stated that two or three per cent, may 
be charged on wooden or frame buildings. They have also 
permitt^ a rate of ten per cent, on furniture and fixtures, and in 
some cases as high as twenty per cent, on certain kinds of ma- 



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INCOME TAX ON CORPORATIONS 219 

chiiwry. However, they look with suspicion on high rates of 
depreciation and the tendency in the past has been for them to 
be overconservative rather than otherwise. Only assets em- 
ployed by the corporation in its business are subject to depre- 
ciation. All assets so employed, both tangible and intangible, 
except good will and organization expenses, are regard^ as 
subject to the depreciation provision. 

The amount of depreciation claimed must be entered upon 
the books of the corporation. It may be credited to the asset 
account to which it refers, or it may be credited to a reserve 
account. The latter is, of course, the approved accounting 
method and should be followed in recording the depreciation. 
In the old law no mention was made of obsolescence, but the 
Treasury Department ruled that obsolescence could be consid- 
ered in arriving at depreciation. In the new law, specific men- 
tion is made of obsolescence as an allowable deduction. It can 
probably be best considered in estimating the life of the asset 
as mentioned above. In reference to depletion, the present law 
reads as follows: "In case of mines, oil or gas wells, or other 
natural deposits and timber, a reasonable allowance for deple- 
tion and depreciation of improvements according to the pecu- 
liarities of each case, based upon the cost, including cost of 
development not otherwise deducted," may be treated as a 
deduction. The Treasury Department has issued detailed rul- 
ings as to how the amount of depletion is to be calculated. The 
following important points may be mentioned: 

1. If the property was acquired prior to March i, 

1913, the fair market value at that date is taken 
as the basis for calculating the depletion. 

2. If acquired by purchase since the above date, the 

cost price is taken as the basis. 

3. If "discovered" since the above date, the market 

price thirty days after "discovery" is the basis. 

A distinction must be made between depreciation and de- 
pletion. Depreciation means the lowering of value due to wear 
and tear. Depletion is the decrease or lowering of the supply 
of the natural deposit. Generally speaking, the depletion may 
be calculated as follows: 

1. Determine the original value as stated above. 

2. Determine the total number of units and by divi- 

sion, the unit cost. 

3. Multiply the number of units produced during the 

taxable period by the unit cost and treat this 
as the depletion charge. 

The amount of depletion claimed must be entered upon 
the books the same as in the case of depreciation. As previously 
stated, detailed regulations in regard to the depletion of mines, 
etc., have been issued by the Treasury Department and can be 
obtained on request. 



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220 PUBLIC ACCOUNTING AND AUDITING 

Deductions by Insurance Companies. The law pro- 
vides that in the case of insurance companies, the following 
deductions may be made: 

1. The net addition required by law to be made 

within the taxable year to reserve funds. 

2. Sums that are paid as dividends within. the taxable 

year on policy and annuity contracts. 

3. Further deductions in connection with first, com- 

panics issuing policies regarding life and accident 
insurance combined in one, and second, further 
deductions in connection with mutual marine 
and insurance companies. Details in regard to 
the deductions mentioned under the last sub- 
head may be obtained by reference to the law 
and from the regulations of the Treasury Depart- 
ment. 
Miscellaneous Deductions. Amounts received as divi- 
dends from a corporation which are taxable under the income tax 
law upon its net income and amounts received as dividends 
from a personal service corporation out of earnings or profits 
accrued prior to January i, 1918, may be treated as a deduction 
by the corporation receiving them. In case of anticipated 
losses, the company may claim a deduction by filing a state- 
ment giving details in reference to the anticipated loss and 
providing a bond to cover the amount of the tax which will 
be due if the loss does not occur as anticipated. When the loss 
is actually incurred or it is found that the claim is erroneous, 
an adjustment will be made. 

Items Not Deductible. The law provides that in com- 
puting the net income of a corporation,, no deductions shall 
be allowed which are declared nondeductible in connection 
with the income of an individual. As previously mentioned, 
the following items are declared as not deductible by an in- 
dividual, therefore, they are not deductible on the part of a 
corporation: 

1. Personal, living or family expenses. ^ These, of 

course, would not arise in connection with a 
corporation. 

2. Amounts paid for buildings or permanent improve- 

ments. 

3. Any amount expended in reconstructing property 

for which depreciation has been allow^. ^ 

4. Premiums on a life insurance policy covering life 

of officer or employe. 

Organization Expenses. Expenses of the organization of 
a corporation, such as incorporation fees and attorney and 
accountant's charges, constitute investments of capital and are 
not deductible from gross income. 

Donations. Corporations are not entitled to deduct from 
gross income contributions made to religious, charitable, scien- 



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INCOME TAX ON CORPORATIONS 221 

tific or educational corporations, even though such contributions 
are made to the Red Cross or other war activities.* 

Credits Allowed. The following credits are allowed by 
the present law: 

1. Amounts received as interest upon the obligations 

of the United States and bonds issued by the 
War Finance Corporation prior to September i, 
1917, and on obligations and bonds issued sub- 
sequent to September i, 1917, to the extent 
provided for in the acts authorizing their issue. 

2. The amount of the excess profits tax imposed by 

the revenue bill of 1917, or of subsequent acts 
of Congress. 

3. In the case of domestic corporations a specific 

exemption of $2,000.00. 

The Rate of the Tax. The income tax imposed by the 
present law is twelve per cent, on the net income of the cor- 
poration as above defined, less the credits allowed, for the year 
1918, and ten per cent, on the same for the year 1919 and each 
year thereafter. 

Calculation of the Tax. The calculation of the income 
tax of the corporation is quite simple after the amount on which 
it is imposed has been determined. The gross income, as above 
defined, is stated, the deductions that are allowable are made, 
and this gives the net income of the corporation. From this 
net income the credits permitted are subtracted and the income 
tax for the year of 1919 and each year thereafter, is ten per cent, 
of the remainder. 

Place for Filing Returns. The law further provides 
that "returns shall be made to the collector of the district in 
which is located the principal place of business or principal 
office or agency of the corporation, or if it has no principal 
place of business or principal office or agency in the United 
States, then to the collector at Baltimore, Maryland." 



*A tax decision made December 27, 1920, provides that it will not be 
necessary for corporations to file amended returns in case contributions to 
Red Cross or other reco^zed war organizations were deducted in the returns 
for the year 1918. This rule is made for the benefit of those corporations 
which filed their returns and claimed such deduction prior to the issuance 
of Treasury Decision 2847. 

In order to obviate the necessity of filing amended returns for the year 
1918, these corporations should file immediately with the Collector of Internal 
Revenue a statement showing the amount of such deductions claimed, the 
amount of the net income as reported and as corrected, and the amount of 
additional tax due by reason of the erroneous claiming of the deduction. 
The total amount of additional tax shown to be due by such statement should 
be paid at once, together with interest on each installment from the original 
due date. 



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222 PUBLIC ACCOUNTING AND AUDITING 

Returns and Pasrment of Tax. A corporation must 
file the return for the excess profits tax at the same time it 
files the return for the income tax. As previously explained, 
the corporation may report on the basis of either, A calendar 
or a fiscal year. If it reports on the basis of a calendar year, 
the return must be filed by March 15. of the year following 
the one covered by the return. If the return is made on the 
basis of a fiscal year, it must be filed by the fifteen th d ay of 
the third month after the. end of the fiscal year. The return 
is filed with the Collector of Internal Revenue of the district 
in which the corporation has its principal office. In the case of 
a foreign corporation, the return should be filed with the Collector 
of Internal Revenue of the Baltimore District. 

The income and excess profits taxes are due in four equal 
installments on March 15, June 15, September 15, and Decem- 
ber 15. Except for the first installment, which is due without 
any bill or notice, payment need not be made until notice of 
assessment has been given. Payment of the whole tax may be 
made on or before the due date of the return, but no discount 
is allowed where the return is filed on a fiscal year basis, the 
installments are due when the return is due and on the fifteenth 
days of the third, sixth, and ninth months thereafter. 

There are penalties imposed for a failure to make the return 
at the proper time, the making of a false return or the failure 
to pay installments when due. It is not thought worth while 
to discuss these here. Detailed information with reference 
thereto can be found in the Treasury Regulations and the Law. 

INCOME TAX QUESTIONS AND PROBLEMS 

1. What constitutes a personal service corporation? 

C. P. A. Ex. 

2. Name two conditions under which corporations should 
file consolidated returns and the requirements of evidence of 
affiliation. C. A. P. Ex. 

3. Are contributions made by a corporation to religious, 
charitable, scientific or educational corporations deductible from 
gross income for purpose of ascertaining net taxable income? 

C. P. A. Ex. 

4. To what extent are salaries of officers and bonuses 
given to^ employes deductible in computing the net income of 
corporations under the federal income tax law? Inst. Ex. 

5. A New York corporation received during the year divi- 
dends amounting to $2,000.00 on stock of a Massachusetts cor- 
poration owned by it and $1,000.00 on stock of a British corpor- 
ation owned by it. 

Do these dividends constitute taxable income of the New 
York corporation under the federal income tax law? 

Inst. Ex. 



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QUESTIONS AND PROBLEMS 223 

6. In the preparation of consolidated returns under the 
federal income tax law, on what basis would you apportion 
the tax among the several corporations? Inst. Ex. 

7. Designate the following named expenses that are al- 
lowable deductions in computing the income tax of a domestic 
corporation: 

1. Donation to American Red Cross. 

2. Donation to a local hospital. 

3. Donation to the County Fair Association. 

4. Donation to committee for paying expenses for 

political convention to be held in home town. 

5. National Political Campaign Expenses. 

6. Local Political Campaign Expenses. 

7. Fine for violation of Child Labor Laws. 

8. Membership fee of Chamber of Commerce. 

9. Life insurance premiums on lives of officers, the 

corporation the beneficiary. 
10. Life insurance premiums on lives of officers who 

are the beneficiaries. C. P. A. Ex. 

8. A corporation owned the following bonds for one year 
ending December 31, 1920. What amount of interest would be 
allow^ as a deduction in computing its taxable income? 

First Liberty Bonds, 3}^ per cent $10,000.00 

First Liberty Converted, 4 per cent 10,000.00 

First Liberty Converted, 434 per cent 10,000.00 

Second Liberty Converted, 4J4 per cent 10,000.00 

Third Liberty Converted, 4}^ per cent , 10,000.00 

Fourth Liberty, 4^4 per cent 10,000.00 

Victory Liberty, 3% per cent 10,000.00 

Victory Liberty, 4% per cent 10,000.00 

North Carolina State Bonds, 5 per cent 10,000.00 

City of New York Bonds, 4 per cent 10,000.00 

County of Mecklenburg, N. C, 4,}^ per cent.. 10,000.00 

C. P. A. Ex. 

9. A corporation owns and operates a rolling mill. In 
its expense accounts for 1920 are the following items of dis- 
bursement: 

$1,000.00 to Red Cross for services of nurse and for 
medicines at the mill's emergency hospital; 

$500.00 to the war chest (a local community fund) ; 

$100.00 annual dues in National Mill Owners' 
Association; 

$500.00 to a local hospital for beds provided solely 
for the use of employes of the corporation; 



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224 PUBLIC ACCOUNTING AND AUDITING 

$250.00 to the Society for the Prevention of Cruelty 
to Children. 

Specify which, if any, of these items the corporation may 
deduct from its gross income in determining its taxable income. 

Inst. Ex. 

10. In 1909 A and B formed a corporation for the purpose 
of conducting the business then carried on by them under a 
partnership, the capital stock being divided equally. ^ B died 
on June i, 1917, bequeathing his shares of stock to his son Z 
by will. Because of B's death, the corporation ceased active 
business and began to liquidate. From time to time assets 
were disposed of and dividends were declared and paid from 
the moneys received. What is the status of such dividends 
for federal income tax purposes 

(a) As regards A? 

(b) As regards Z? Inst. Ex. 



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Chapter Fifteen 

FEDERAL EXCESS PROFITS TAXES 

The excess profits tax is a tax imposed on the income 
of corporations in addition to the income tax previously ex- 
plained. It is a tax on the excess of the net income for the tax- 
able year over a certain percentage of the invested capital 
of the taxable year, plus a specific exemption of $3,000.00. In 
other words, Uie excess profits tax proceeds on the theory 
that every corporation is entitled to $3,000.00 plus a certain per- 
centage of its invested capital as free from the excess profits 
tax, while all profits in addition to this are subject to the excess 
profits tax. 

In order to determine the amount of the tax, it is necessary 
to consider two things : 

1. The net income for the taxable year. 

2. The invested capital for the taxable year. 

Net Income for the Taxable Year. The net income 
for the taxable year consists of the gross income less deductions. 
It is determined in the same manner as the net income for the 
purpose of the income tax as is discussed in the preceding 
pages, consequently, it is not necessary to discuss it further 
at this time. 

What is Invested Capital? The chief difficulty in 
ascertaining the excess profits tax is the determination of the 
invested capital of the business. In order to discuss properly 
the determination of invested capital, it is necessary to under- 
stand the definition of the following terms: 

1. Tangible property. 

2. Intangible property. 

3. Borrowed capital. 

4. Invested capital. 

5. Admissible assets. 

6. Inadmissible assets. 

Tangible Property. "The term 'tangible property' means 
stocks, bonds, notes, and other evidences of indebtedness, bills 
and accounts receivable, leaseholds, and other property other 
than intangible property." 

Intangible Property! "The term 'intangible property* 
means patents, copyrights, secret processes and formulas, good 
will, trade-marks, trade-names, franchises, and other like 
property." 

Borrowed Capital. "The term 'borrowed capital' means 
money or other property borrowed, whether represented by 
bonds, notes, open accounts, or otherwise." 

2as 



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236 PUBLIC ACCOUNTING AND AUDITING 

Invested Capital. Invested capital m£aDs.-pi:actically 
owned capit al. In other words, it means the capital which the 
owners of the business have i nvested in th e business. However, 
the law holds that the capital which the owners have invested 
must be represented by the p rope r kind of an asset in order that 
a certain amount ^ mcome arismg from the use of this capital 
may be exempted from the tax. In other words, the law lim its 
the ki nd o f assets in which the capital of the business may be 
invested, if the owners of the business are to claim a certain 
rate of jncome on t his capit al as exempt from the excess profits 
tax. 

Admissible Assets. 'The term 'admissible assets' means 
all assets other than inadmissible assets, valued in accordance 
with the provisions of subdivision (a) of Section 326, Section 
330, and Section 331 of the law." 

Inadmissible Assets. "The term 'inadmissible assets' 
means stocks, bonds, and other obligations (other than obli- 
gations of the United States), the dividends or interest from 
which is not included in computing net income, but where the 
income derived from such assets consists in part of gain or 
profit derived from the sale or other disposition thereof, or 
where all or part of the interest derived from such assets is 
in effect included in the net income because of the limitation 
on the deduction of interest under paragraph (2) of subdivision 
(a) of Section 234 of the law, a corresponding part of the capital 
invested in such assets shall not be deemed to be inadmissible 
assets." 

Computation of Invested Capital. The basis for the 
computation of invested capital is the net worth of th e business. 
If a Balance Sheet of the business is niade showing its assets 
and its liabilities, the difference between the two will represent 
its net worth. The ne t wo rth of a corporation consists of its 
c apital sto ck plus its paid-in, or earned surplus, and this is the 
basis for comp utation of invested capital. The law, however, 
requires that certain adjustments be made before the sum of 
the capital stock and surplus may be regarded as invested 
capital of the business. To make these adjustments, it is 
necessary to know how the_stpck of the company was issued 
and how the s urplus of the corporatio n was' create d. It will 
be necessary, therefore, to notice first the adjustments wluch 
must take place in connection with the Capital Stock account, 
and second, the adjustments which must take place in connec- 
tion with the Surplus account. 

Assets which may be Included in Invested Capital. 

(i) Actual cash bona fide paid in for stock or shares. 

(2) Cash yalue of tangible property paid in for stock or 
shares at the time of such payment, but in no case to exceed the 
par value of the original stock or shares specifically issued there- 
for, unless it is shown to the satisfaction of the commissioner 
that the actual cash value of such property was really and 



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EXCESS PROFITS TAX ON CORPORATIONS 227 

substantially in excess of the par value of the stock or shares 
at the time paid in. 

(3) Paid-in or earned surplus or profits earned prior to 
the taxable year. 

(4) Intangible property bona fide paid in for stock or shares 
prior to March 3, 1917, in an amount not exceeding either the 
actual cash value of such property at the time paid in or the 
par value of the stock or shares issued therefor or in the aggre- 
gate not exceeding 25% of the par value of the total stock 
or shares of the corporation outstanding on March 3, 1917, 
whichever is lower. 

(5) Intangible property bona fide paid in for stock or 
shares on or after March 3, 1917, in an amount not exceeding 
either the actual cash value of the property at the time paid 
in or the par value of the stock or shares issued therefor or in 
the aggregate not exceeding 25% of the par value of the 
total stock or shares of the corporation outstanding at the 
beginning of the taxable year, whichever is lower. 

In no case shall the value of intangible property paid in 
for stock or shares, whether paid in prior to or subsequent to 
March 3, 1917 (the date of inception of the first Excess Profits 
Tax Act), exceed 25% of the par value of the total stock 
or shares of the corporation outstanding at the beginning of 
the taxable year. 

Adjustments of Capital Stock Account. Capital stock 
may be issued for three kinds of property: 

1. Tangible property. 

2. Intangible property. 

3. Mixed tangible and intangible property. 

It will be necessary to discuss the adjustments which may take 
place when stock is issued for each kind of property. 

Stock Issued for Tangible Property. If stock is issued 
for tangible property and the actual cash value of the property 
at the time of its receipt was less than the value of the stock, 
the difference between the value of the property and the par 
value of the stock must be deducted from the net worth of 
the business in determining its invested capital. If, on the 
other hand, the value of the tangible property received was 
more than the par value of the stock issued, the excess may 
be added to the net worth of the business in determining the 
invested capital. This may be done, however, only when it is 
proven to the satisfaction of the commissioner that the value 
of such property was in excess of the par value of the stock 
issued. If the commissioner permits the adding of such an 
amount to the net worth of the business, he must make a record 
of the granting of such permission and furnish such a record to 
Congress, if requested. The fact that such a record is required 
is an indication that the law contemplates that such cases will 
be rare. 



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228 PUBLIC ACCOUNTING AND AUDITING 

Stock Issued for Intangible Property. If stock is 
issued for intangible property prior to March 3, 1917, the amount 
which can be included in invested capital must not exceed: 

1. The actual cash value of the property at the time 

paid in, or 

2. The par value of the stock issued therefor, or 

3. In the aggregate, 25% of the par value of the 

stock outstanding on March 3, 1917, whichever 

is the lower. 
If stock is issued for intangible property after March 3, 1917, 
there can be included in the computation of invested capital 
an amount not exceeding: 

1. The actual cash value of the property at the time 

paid in, or 

2. The par value of the stock issued therefor, or 

3. In the aggr^:ate, 25% of the par value of the 

stock outstanding at the beginning of the taxable 

year, whichever is the lower. 
In other words, when stock is issued for intangible property it 
is necessary to consider three things: 

1. The value of the property received. 

2. The par value of the stock issued. 

3. The amount of 25% of the capital stock outstanding 

either on March 3, 1917, or at the beginning of 

the taxable year. 
When these three amounts are determined, the lowest one will 
be taken in the computation of invested capital. 

Stock Issued for Mixed Tangible and Intangible 
Property. In so far as possible, the tangible property received 
for stock should be separated from the intangible property and 
the amount of stock issued for each determined; in which case 
the amount to which such property can be considered in the 
determination of invested capital is determined as explained 
previously. If it is impossible to determine the amount of stock 
issued for the tangible property and the amount issued for 
intangible property, invested capital will be disregarded and 
the excess profits tax to be imposed on the corporation will be 
determined as explained below, for such cases where invested 
capital can not be determined. 

Adjustment of Surplus. The surplus, as it appears on 
the books, may be subject to certain additions and certain 
deductions in order to arrive at the amount which is to be 
added to the capital stock to determine invested capital. If 
tangible property has been received for stock which has a value 
in excess of the par value of the stock, this excess may be added 
to the surplus. If tangible property is owned by the business, 
but does not appear on the books, such property under certain 
conditions may be put on the books and its value credited to 
Surplus. Such property may be shown as an asset and a credit 
to Surplus under the following restrictions: 



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EXCESS PROFITS TAX ON CORPORATIONS 229 

1. It must be tangible property. 

2. It must have a life extending substantially beyond 

the year in which the expenditure was made. 

3. It must have been charged to current expense 

when purchased or later, 

4. It must still be owned and in actual use. 

5* It must have been acquired prior to March i, 

i9i3.or 
6. If acquired after March i, 1913, it must not have 

been previously claimed as a deduction on other 

income tax returns. 

It large sums have been spent in creating good will, 
these amounts cannot be shown and credited to Surplus. If, 
however, good will has been purchased and then written off, 
it may be reconstructed on the books and credited to Surplus, 
providing it still can be shown to have a definite value. 

If sufficient depreciation has not been allowed on assets, 
such depreciation will be charged against Surplus. If apprecia- 
tion on fixed assets has been recorded after January i, 1913 on 
the records and credited to Surplus, it must be deducted. 

Final Adjustments. After the adjustments above out- 
lined have been made, the Capital Stock account and the Surplus 
account will have had such deductions and additions made as 
will make them comply with the regulations and the law. As 
these two accounts were adjusted, certain asset accounts will 
have been adjusted accordingly. There may, however, be one 
more adjustment which must be made before the total of the 
Surplus and Capital account can be regarded as the invested 
capital of the business. There may be certain inadmissible 
assets owned by the business. If so, there must be deducted 
from the total of the Capital account and the Surplus account, 
a percentage equal to the percentage which the amount of the 
inadmissible assets held during the year is of the total of the 
assets. ^ 

Credits Allowed. The law says that for the purpose 
of determining the excess profits tax the following credits shall 
be allowed: 

1. A specific exemption of $3,000.00. 

2. An amount equal to 8% of the invested capital 

for the year. 

Determination of the Tax. The law states that the 
excess profits tax shall be determined as follows: 

1. 20% of the net income in excess of the excess profits 

credits and not in excess of 20% of the invested 
capital. 

2. 40% of the amount of the net income in excess of 

20% of the invested capital. 



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^30 



PUBLIC ACCOUNTING AND AUDITING 



Computation of Invested Capital 



rinrested Capitol 
for any Period 
Equals Average 
Inveeted Capital 
for such Period). 



INCLUDE 

1. Actual cash paid in for stock. 

2. Actual cash value of tangible property 
paid in for stock (not to exceed 
par value of stock— excess value 
IS paid-in surplus). 

3. Paid-in or earned surplus and undivid- 
ed profits earned prior to the tax- 
able year. 

4. Intangible property paid in for stock 
prior to 3/5/17 in an amount not 
exceeding either the — 

(a) actual cash value 
at time paid in; 

(b) par value of stock 
issued therefor; whichever is 

(c) 2$% of par value lower. Intangibles in 
of total stock out- 4 and 5 not to 
standing on 3/3/ 1 7. J exceed 25% 

5. Intangible propemr paid in for stock of par vadue 
on or after 3/3/17 in an amount of total stock 
not exceeding either the — outstanding 

(a) actual cash value] at beginning 
at time paid in; of taxable 

(b) par value of stock year, 
issued therefor; whichever is 

(c) 25% of par value lower, 
of total stock at 
beginning of tax- 
able year. 

EXCLUDE— 

Borrowed Capital. 
DEDUCT— 
Inadmissible Assets. — (Percentage to be 
deducted is equal to the percenta^ 
which the amount of the inadmissi- 
ble assets held during the year is of 
the total of the assets.) 

Computation of Taxes. It may be assumed that a cor- 
poration has invested capital of $100,000.00 and the net income 
for the current year is $30,000.00. The firm is entitled, as a 
credit, a specific exemption of $3,000.00 plus 8% of its in- 
vested capital or $8,000.00, or a total of $11,000.00. 20% of its 
invested capital is $20,000.00 and the difference between its 
credit of $11,000.00 and .$20,000.60 is $9,000.00. The tax on 
this $9,000.00 is 20% or $1,800.00. Its income is $30,000.00 
or $10,000.00 in excess of 20% of its invested capital, and this 
amount is subject to a tax of 40% or $4,000.00. Its total excess 
profits tax, therefore, is $1,800.00 plus $4,000.00 or $5,800.00. 

The corporation is permitted a specific exemption of $2,000.00 
plus the amount of the excess profits tax or $5,800.00, or a total 
exemption of $7,800.00. Its income is $30,000.00, therefore, the 
amount subject to the income tax is $30,000.00 minus $7,800.00, 
or $22,200.00. The income tax is at the rate of 10%, therefore, 
the income tax of the corporation is 10% of $22,200.00 or 
$2,220.00 and the total of its income tax and excess profits tax is 
$2,220.00, plus $5,800.00 or $8,020.00. 



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EXCESS PROFITS TAX ON CORPORATIONS 231 

On the next page will be found a table showing the total 
Income and excess profits taxes on net incomes ranging from 
$5,000.00 to $1,000,000.00 with the invested capital ranging 
from $3,000.00 to $10,000,000.00. To use the table in ascertain- 
ing the income and excess profits tax in the preceding problem, 
find the invested capital in the first column. This is $100,000.00. 
Find the net income at the head of one of the columns 
following. This is $30,000.00. Trace down the Net Income col- 
umn and the total tax will be found opposite the amount of 
invested capital shown in column one. This is $8,020.00, which 
is the same as that shown in the preceding calculations. 

Where Invested Capital will be Ignored. The law 
provides that invested capital will be ignored in the following 
cases: 

1. Where the Commissioner of Internal Revenue is 

unable to determine the invested capital by the 
method previously explained. 

2. In the case of a foreign corporation. 

3. Where mixed tangible and intangible property is 

paid in for stock or for stock and bonds, and the 
commissioner is unable to determine the amount 
issued for tangible and the amount issued for 
intangible property. 

4. Where upon application by the corporation the 

commissioner finds that the regular operation 
of the law will work a great hardship on the cor- 
poration, owing to abnormal conditions. Com- 
parison of the tax on the corporation asking 
relief with the tax imposed on other corporations 
of same nature will be made in order to judge 
the fairness of the tax. 

In the foregoing cases, the commissioner will assess the tax 
without considering the invested capital of the corporation. 
The tax imposed will be an amoimt which bears the same ratio 
to the net income of this corporation less $3,000.00 (the specific 
exemption allowed all corporations), as the tax imposed on 
representative firms, similarly situated, bears to their net income 
less $3,000.00. To illustrate : The commissioner may decide that 
it is impossible to determine the invested capital of the X Cor- 
poration. By inspection of the returns of a number of firms 
doing the same land of a business and similarly situated, he 
determines that the average excess profits tax which they pay 
is 25% of their average net income minus $3,000.00. The net 
income of the X Corporation is $28,000.00. Subtracting the 
$3,000.00 specific exemption, there is $25,000.00 subject to a 
tax of 25%; therefore, the excess profits tax of the X Corpor- 
ation is $6,250.00. 

The law requires that in all cases where invested capital 
18 ignored in the computation of the tax the conmiissioner must 
make a record and submit this record to Congress upon request. 



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232 



PUBLIC ACCOUNTING AND AUDITING 



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EXCESS PROFITS TAX ON CORPORATIONS 233 

ADDITIONAL PRACTICE IN COMPUTATION 
OF CORPORATION TAXES 

Proposition A 

Corporation A with an invested capital for 1920 of $300,000 
has a net income of $150,000. Calculate the combined tax. 

Solution 

Original invested capital $250,000 

Capital added in 1920 50,000 

Total invested capital for 1920 $300,000 

Net income for 1920 150,000 

First Bracket (Excess Profits Tax) 

20% on invested capital of $300,000 $ 60,000 

Deduct: 
8% on invested capital of $300,000 $24,000 

Specific exemption 3,000 

Total credits 27,000 

Amount taxable in first bracket 33,000 

20% of $33,000, or tax in first bracket $6,600 

Second Bracket (Excess Profits Tax) 

Net income for 1920 $150,000 

20% on invested capital of $300,000 60,000 

Amount taxable in second bracket 90,000 

40% of $90,000, or tax in second bracket 36,000 

Total of excess profits tax $42,600 

Normal (Income) Tax 

Net income for 1920 $150,000 

Deduct: 

Excess profits tax $42,600 

Specific exemption 2,000 

Total credits 44,600 

Amount subject to normal tax $105,400 

10% of $105,400, or normal tax 10,540 

Total tax to be paid by corporation A $53,140 

Proposition B 

Corporation E has an invested capital for 1920 of $30,000 
and a net income of $120,000. Calculate the total tax. 

Solution 

First Bracket (Excess Profits Tax) 

20% on invested capital of $30,000 $6,000 

Deduct: 
8% on invested capital of $30,000 $2400 

Specific exemption 3,000 

Total credits 5,400 

Amount taxable in first bracket $ 600 

20% of $600, or tax in first bracket $120 



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234 PUBLIC ACCOUNTING AND AUDITING 

Second Bracket (Excess Profits Tax) 

Net income for 1920 $120,000 

20% on invested capital of $30,000 6,000 

Amount taxable in second bracket $114,000 

40% of $114,000, or in tax second bracket 45,600 

Total of excess profits tax $45,720 

The total excess profits tax shall not exceed 20% of 
that part of the net income represented by the difference 
between $3,000 and $20,000, or $17,000 plus 40% of the net 
income in excess of $20,000 which in this case is $100,000. 

Computing the tax according to this provision, we have: 

20% of $i7»ooo $ 3400 

40% of $100,000 40,000 

Total $43400 

Since this amount is less than the amount of the excess 
profits tax computed in the ordinary manner, we have as the 
excess profits tax $43400 

Normal (Income) Tax 

Net income for 1920 $120,000 

Deduct: 

Excess profits tax $43400 

Specific exemption 2,000 

Total credits 45400 

Amount subject to normal tax $74,600 

10% of $74,600, or normal tax 7460 

Total tax to be paid by Corporation E $50,860 



INFORMATION AND PAYMENT AT SOURCE 

Returns of Information. In any case where a return 
of information at the source is required, the obligation to file 
such return is imposed upon the person, partnership or cor- 
poration making the payment of income to another person, 
and the failure or delay^ in filing such return will involve pen- 
alties similar to those imposed for delinquency in filing the 
income tax and profits tax return. The date when returns 
of information must be filed is fixed by regulation of the com- 
missioner as March 15, for annual returns and the 20th of 
each month for monthly returns. Such returns must be made 
on the calendar year basis and not for the fiscal year, and are 
filed at Washington by mail, and not with the local collector. 
The instructions printed on the blank form should be carefully 
observed. 



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EXCESS PROFITS TAX ON CORPORATIONS 235 

Payments of $1,000 per Year. On or before March 
15 in each year, without further notice or demand, there is 
due a return showing the amount of all payments made during 
the year of fixed and determinable gains, profits, and income 
(such as salaries, interest, or rent), amounting to $1,000.00 or 
more for the year, and a separate report showing the name 
and address of each recipient and the amount paid. (See form 
illustrated on next page). The requirement is not limited to 
periodical payments, but a single payment of $1,500.00 as fees 
to a lawyer or commissions to a broker would be included. 
Payments which are not purely income to the recipient, for 
example, payment for merchandise, storage, or telephone 
service, are not included. Certain other payments, although 
constituting fixed income of $1,000.00 or more, need not be re- 
ported, but are specifically excluded by the regulations as 
follows: Interest on obligations of the United States, states, 
or political subdivisions; compensation of officers and employes 
of a state or political subdivision, and other income which is 
excluded from the gross income; dividends of domestic corpora- 
tions and payments by brokers to customers; payments made 
to corporations; payments made to employes for board and 
lodging in the course of their employment, or for expenses in- 
cuired in the business; premiums paid to insurance companies; 
annuities representing return of capital; payments of rent made 
to real estate agents (but the agent must report payments to the 
landlord amounting to $1,000.00 or more during the year) ; com- 
pensation paid to nonresident alien employes for services per- 
formed entirely in foreign countries; compensation paid by the 
United States Government; foreign interest and dividends; 
and income paid to nonresident alien individuals and corpora- 
tions, subject to the withholding requirements. 

Corporation Interest and Dividends. By general re- 
quirement of the regulations, every corporation must furnish 
information as to the interest paid upon its bonds or similar 
obligations, without regard to the amount of the particular 
payment. The corporation must forward to the Treasury 
Department the original ownership certificates which are 
required to be filled out and filed by the holders of the bonds 
when the coupons are presented for payment. The corporation 
may prepare the certificate in the case of interest payments on 
registered bonds. A return each month and an annual return 
must be filed. Information with respect to dividends and dis- 
tributions to stockholders must be filed by every corporation 
which is particularly directed by the commissioner to do so or 
by all corporations when a general requirement shall be made 
by the commissioner. The corporation must then report the 
name and address of each stockholder, the number and class of 
shares owned by him, the date and amount of each dividend 
paid, and the time when the surplus was accumulated out of 
whidi each dividend was paid. 



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236 



PUBLIC ACCOUNTING AND AUDITING 



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EXCESS PROFITS TAX ON CORPORATIONS 237 

Brokers. Brokers may be required, either by special 
direction or by general regulations applying to all brokers, to 
make returns showing the names of all customers, details as to 
the profits and losses of each, and such other information as 
the regulations may require. 

Foreign Interest and Dividends. Information returns 
are required of every person in the business of collecting coupons, 
checks, or bills of exchange not payable in the United States, 
in payment of interest on bonds of foreign countries and foreign 
corporations, or dividends on stock of foreign corporations 
and all such payments, no matter how small the amount, must 
be reported. Persons undertaking the collection of such foreign 
items as a matter of business or profit must be licensed by 
the Treasury Department. Where interest on bonds of foreign 
countries or of^ foreign corporations, or dividends upon the 
stock of a foreign corporation is payable in this country b^ 
a resident^ fiscal agent or by check drawn upon a bank in this 
country, information returns are likewise required. As to 
bond interest, the paying agent in this country, or if no such 
agent, then the first bank or collecting agent, is required to 
furnish the information. As to dividends, the first bank or 
collecting agent, accepting the item for collection is the source 
of information. A monthly return and an annual return are 
required. Where a foreign corporation has a fiscal agent in 
this country and issues bonds which contain a tax-free covenant 
clause, payment at the source and the return of such payment 
are required as explained later. 

Payment at the Source. In order to assist in the col- 
lection of the tax, payment is required by the person paying 
the income, rather than the one receiving it, in the case of 
interest on tax-free bonds and payments to nonresident alien 
and foreign corporations of fixed and determinable annual 
or periodical income (but not including interest on tax-free 
bonds or dividends of domestic corporations) without regard 
to the amount of the payment. Upon such income, the tax 
payable at the source is 8% upon the income of nonresident 
alien individuals, and 10% for foreign corporations. On or 
before March i of each calendar year, with no provision of 
fiscal years, every person required to pay at the source a tax 
upon any income other than bond interest, is required to file 
with the local collector an annual return accompanied by 
a separate report for each person to whom such income was 
paid. The amount of tax must be paid on or before June 15 
of each year. The law permits the amount so paid to be deducted 
and withheld from the payment made to the recipient, except 
where there is a contractual obligation to the contrary, as with 
tax-free bonds. Where a nonresident alien claims exemption 
from withholding upon salary or wages, the employer must pre- 
serve the affidavit and file it with the next annual withholding 
return. The employer is not excused from withholding where 



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23» PUBLIC ACCOUNTING AND AUDITING 

the affidavit contains any statement which he knows to be un- 
true or if it shows on its face that the alien is not entitled to the 
credit claimed or that the credit has been exhausted. 

Interest on Tax-Free Bonds. Whenever bonds, mort- 
gages, or similar obligations of a corporation contain a con- 
tract or provision by which the corporation agrees to pay 
the interest upon such obligation without deduction for any 
tax which the corporation may be required or permitted to 
pay thereon or to retain therefrom under the Federal Income 
Tax Law, or by which the corporation agrees to pay, on be- 
half of the owner of the bonds, any portion of any federal 
income tax imposed upon the interest, or to reimburse the 
owner therefor, the corporation is required to pay to the govern- 
ment a tax of 2% of the interest. As there are many different 
forms of "tax-free covenants," it must be determined in each 
case whether the language used covers the federal income 
tax. These provisions apply only to long term or funded ob- 
ligations which may be classed as securities, and not to prom- 
issory notes, scrip, or ordinary commercial paper. Securities 
issued by syndicates, partnerships, or individuals, subject to 
tax-free covenants, are not included, although they may in all 
other respects resemble the obligations of corporations, as to 
which payment at the source is required. The tax must be paid 
without regard to the amount of the particular payments, but 
only when the interest is paid to an individual or partnership 
(or foreign corporation) and not when paid to a domestic cor- 
poration. The tax need not be paid if the owner files a notice 
before February i claiming exemption or credits covering the 
interest received during the previous year. This claim is usually 
made by means of the ownership certificate filed at the time the 
interest is collected. The corporation, which is required to pay 
the tax at the source upon the interest upon its tax-free bonds, 
is required to make a monthly return on or before the 20th day 
of the month following that in which the interest was paid. On 
or before March i of each year an annual return must be filed 
with the collector. The tax must be paid on or before June 15. 

Certificates of Ownership. Any person making pay- 
ments of income for which he is required to pay a tax at the 
source, or to give information at the source, is entitled to de- 
mand the necessary information from the recipient of the income, 
and certificates in appropriate form may be secured for this 
purpose from the collector. Such certificates must be furnished 
whenever there is presented for payment interest coupons from 
bonds or other obligations issued by domestic or foreign cor- 
poration, whether or not containing a tax-free covenant. Form 
1000 is to be used when the interest is subject to payment of 
tax at the source; when not so subject. Form looi, or Form 
looiA for foreign items, is to be used. Whenever actual owner- 
ship is not known, the tax must be paid at the source just as 
if the owner was a nonresident alien. 



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QUESTIONS AND PROBLEMS 239 

INCOME TAX QUESTIONS AND PROBLEMS 

1. What is invested capital under the new Revenue Act? 

C. P. A. Ex. 

2. Can the value of property conveyed to a corporation 
by a stockholder as a gift be treated as paid-in surplus so as to 
become invested capital? Give reasons. C. P. A. Ex. 

3. (a) Will invested capital be increased by a reappraisal 
of capital assets? 

(b) Will such reappraisal operate to increase taxable 
income before such assets are sold? C. P. A. Ex. 

4. A corporation began business January i, 1920, with 
assets consisting of patents for which they paid $100,000.00 in 
cash and capital stock outstanding $100,000.00. 

In computing the income taxes at the end of the year, what 
would be the invested capital? C. P. A. Ex. 

5. A corporation owned on January i, 1919, assets in- 
cluding Accounts Receivable and Cash, $10,000.00; Fourth 
Liberty Bonds, $10,000.00; stocks in other corporations, 
$10,000.00; Pennsylvania Railway bonds, $10,000.00; plant at 
cost, $10,000.00; State of Virginia bonds, $10,000.00. 

The liabilities were, capital stock paid in $30,000.00, and 
surplus paid in, $20,000.00, and profits earned, $10,000.00. 

Submit a statement showing the invested capital for pur- 
poses of computing the income and profits taxes for 1919. 

C. P. A. Ex. 

6. The A. B. C. company agreed to pay its general man- 
ager a bonus of 10% of its net profits for the year 1920, after 
deducting federal income and profits taxes, the bonus being a 
deductible expense in determining net taxable income. After 
the books had been audited, it was found that the net profits 
before deducting federal income and profits taxes, and before 
deducting bonus, amounted to $470,000.00, and that the in- 
vested capital for federal tax purposes for the year 1920 was 
$840,000.00. Calculate the amount of the bonus and federal 
income and profits taxes, proving your answer by showing that 
the bonus amounts to exactly 10% of the profits after deducting 
federal income and profits taxes. The entire bonus comes out 
of the 40% bracket. 

Tax information : 

Excess profits taxes exemption: 

$3,000.00 and 8% of the invested capital. 
Income tax exemption: 

$2,000.00 and amount of excess profits taxes. 
Rates: 

Excess profits taxes: 

20% of the net profits in excess of the exemption 
and not in excess of 20% of the invested capital. 
40% of the balance of profits. 



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240 PUBLIC ACCOUNTING AND AUDITING 

Income tax: 

8% of profit less exemption. 
Tax before bonus, $166,571.20 Inst. Ex. 

7. The books of a Retail Installment Furniture E>ealer, 
covering the two years, 1919 and 1920, show the following: 

ASSETS: 

Dec. 31, 1918 I>ec. 31, 1919 Dec. 31, 1920 

Cash $8,000 $15,000 $20,000 

Installment accounts 25,000 60,000 120,000 

Inventory of Mdse 15,000 35.000 50,000 

$48,000 $1 10,000 $190,000 

LIABILITIES: 

AccounU Payable $ 5,000 $10,000 $25,000 

Notes Payable 5,000 35.ooo 50fOOO 

Capital Stock 30,000 30,000 30,000 

Surplus 8,000 35fOOO 85,000 

$48,000 $1 10,000 $190,000 



PROFIT AND LOSS ACCOUNT: Year ending Year ending 

Dec. 31, 1919 Dec. 31, 1920 

Salaries to officers $ 2,000 $ 5,000 

Cost of merchandise sold 18,000 34,000 

Salesmen's commissions 5,000 8,000 

RenU 1,000 1,000 

Miscellaneous expense 1,000 2,000 

Profits earned 27,000 50,000 

$54,000 $ 100,000 

The collections in 1919 amounted to $19,000.00 of which 
$10,000 was 1918 accounts, and the collections in 1920 
amounted to $40,000, of which $15,000 was 1918 accounts. 
The returns were made up and the income returned according 
to the books and you are asked to redetermine the tax, under 
Art. 42 of Regulations 45. 

(a) Recast and prepare Balance Sheet for Dec. 31, 1919, 
and Dec. 31, 1920. 

(b) Prepare Profit and Loss statement for the two years, 
1919 and 1920, showing taxable income. 

(c) Prepare journal entries that will change the books 
in accordance with Art. 42. 

(d) Submit a statement showing invested capital at Dec. 
31, 1919, and Dec. 31, 1920. C. P. A. Ex. 



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Appendix 



SUPPLEMENTARY PROBLEMS 

The problems following are given for supplementary and 
review work. They are graded so as to naturally follow the 
discussion in the text. If desired, one problem might be required 
as supplementary practice work following each chapter of the 
text. The problems are selected from the C. P. A. and Institute 
examinations, hence are representative of the problems to be 
encountered in future examinations. 

Problem One 

X, Y, and Z enter into the real estate business equal part- 
ners. X and Y being experienced, but without money or prop- 
erty to invest, arrange with Z to loan the firm $27,000.00 at 6% 
which is invested in acreage. It is agreed that the loan is to 
be repaid out of the profits of the busine^ on condition that 
two- thirds of the annual profits are to be set aside in cash for 
that purpose and no profits are to be withdrawn until the note 
with interest is fully paid. Assuming that the profits during 
the first year were just sufficient to warrant a distribution of 
profits leaving the investment undisturbed, and that there were 
no partial payments — 

Prepare journal entries giving effect to the above consider- 
ations, and Trial Balances showing the condition of the books 
at close as relating to the affected accounts: 

(a) Before payment of the note and interest. 

(b) After payment of note, interest and dividends. 

C. P. A. Ex. 
Problem Two 
A, B, C and D have decided to dissolve partnership. To 
that end they have liquidated all their liabilities, and at the 
date of the first division of cash among the partners the con- 
ditions are as follows: 

Partners Capitals 

A $22,000.00 

B 19,000.00 

C 12,000.00 

D 7,000.00 





Profit and Loss 


Loans 


Ratio 


$ 7,000.00 


40% 


6,000.00 


30% 


14,000.00 


20% 


13,000.00 


10% 



Totals $60,000.00 $40,000.00 100% 

Cash available for distribution $ 20,000.00 

Other assets not yet realized (of doubt- 
ful value) 80,000.00 

$100.000.00 

241 



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242 



PUBLIC ACCOUNTING AND AUDITING 



State which partners should participate in the distribution 
of the $20,000.00; how much cash each should receive; whether 
the payments should be applied ag:ainst the capital accounts 
or the loan accounts. Explain the procedure of determining 
the distribution. Assume that none of the partners has any 
private property. Inst. Ex. 

Problem Three 

X, Y, and Z, foundrymen, unable to meet their obligations' 
suspend payment January i, 1921, and appoint a trustee to 
realize and liquidate for the benefit of their creditors. The 
books showed the following assets and liabilities: 

Balance Sheet 



ASSETS 

Land and Building $1 25,000. 00 

Machineiy and Tools . . 75,000 . 00 
Furniture and Fixtures. 10,000.00 
Materiab and Supplies . 95,000 . 00 

Notes Receivable 15,000.00 

Accounts Receivable. . . 115,000.00 
Cash 450.00 

<43M5000 



LIABILITIES 

Mortgage on foundry 

premises $100,000.00 

Notes Payable 135,000.00 

Accounts Payable 105,040.00 

Int. Accrued on Mtge.. . 1,220.00 

Taxes Accrued 840 .00 

Capital ■ 93»350'00 

<435>450'00 



The trustee's cash receipts and disbursements during the year 192 1 were 
as follows: 

Gash Receipts and Dislmraeiiients 



RECEIPTS 

Notes Rec. (outstand- 
ing, Jan. I, 1921) $ 15,000.00 

Accts. Rec. (outstand- 
ing, Jan. I, 1921) 106,500.00 

Cash Sales 5,435.00 

Notes Rec. (cont. dur- 
ing 1921) 13,500.00 

Accts. Rec. (cont. dur- 
ing 1921) 212,000.00 



Total receipts $35^*435-00 



DISBURSEMENTS 

Notes Payable $ 25,000.00 

Accounts Payable 35,000.00 

Interest on Mtge. i 

year at 5% 5,000.00 

Taxes for year 1920 810.00 

Purchase of material 

and supplies 98,000 .00 

Labor 135,030.00 

General Expenses 45,020.00 

Interest on Bills payable 

to Sept. 30, 1 92 1, at 

5% 2,800.00 

Total payments $346,660.00 



Other transactions were as follows: 

Sales on credit $335»ooo.oo 

Bad Debts written off accounts 
prior to January i, 1921 $8,000.00 

Bad Debts written off accounts 
subsequent to January i, 1921.. . 2,000.00 10,000.00 

Discounts and allowances to Cus- 
tomers' accounts prior to Jan- 
uary I, 1921 500.00 800.00 



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SUPPLEMENTARY PROBLEMS 243 

Discounts and allowances to Cus- 
tomers' accounts subsequent to 
January I, 192 1 $300.00 $ 800.00 

Notes received from customers. . . . 20,000.00 

Notes given to Creditors ($110, 
000.00 being renewals) 180,000.00 

Inventory of Materials, Decem- 
ber 31, 1921 92,000.00 

At the end of the year, the business was returned to the 
owners. Prepare Realization and Liquidation Statement, and 
Balance Sheet. C. P. A. Ex. 

Problem Four 

A firm desires to transfer its property to a corporation 
duly organized to carry on the business. The net assets of the 
firm consist of the following: 

Land and Buildings $150,000.00 

Inventory 100,000.00 

Accounts Receivable 150,000.00 

Good Will and Patents 100,000.00 

Cash 50,000.00 

$550>000'00 

It is proposed to issue in full payment therefor, bonds, 
preferred stock, and common stock aggregating the sum of 
$500,000.00, of which each partner is to receive his proportionate 
share according to his interest in the firm, viz: Jones 60%; 
Brown, 25% and Smith 15%. 

(a) Prepare opening entries for the new company. 

(b) Prepare a statement of assets and liabilities. 

(c) State what amount of each class of securities each of 

the partners should receive. C. P. A. Ex. 

Problem Five 

The Michigan Manufacturing Company was incorporated 
under the laws of the State of Michigan, February i, 1921, 
with a capital stock of $10,000,000.00, consisting of $4,500,- 
000.00 (45,000 shares of $100.00 each) preferred 7% non-cumu- 
lative stock, and $5,500,000.00 (55,000 shares of $100.00 each) 
of common stock. On the same date $2,000.00 of the common 
stock was subscribed for at par as follows: 

A. Van Oss 2 shares $200 

T. L. W. Porte 4 shares 400 

Wiley T. Lyon 4 shares 400 

David Smitih 3 shares 300 

William Leslie 7 shares 700 



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244 



PUBLIC ACCOUNTING AND AUDITING 



On February 4, 192 1, these subscribers paid into the com- 
pany the amount of their subscriptions, and stock was issued 
to &em. February 15, the balance of the authorized capital 
stock of the company, both preferred and conmion, was issued 
by resolution of the board of directors to A. A. Keiser, for 
and in consideration of $750,000.00 in cash and twelve (12) 
manufacturing plants. An inventory of the property purchased, 
made by authorized representatives of the company, resulted 
in the following appraised valuations on the various plants 
and the stocks on hand: 



Factory 


Material 

and 
Supplies 


Mdac. 


Real 
Estate 


Bldgs. 


Machin- 
ery 


A 

B 

C 

D 

E 

I:::::: 

H 

I 

J 

K 

L 


$430,000 

211,000 

495,000 

304,000 

171,000 

86,500 

47.250 

98,000 

101,250 

37,000 

346,000 

121,000 

$2448,000 


$95,000 
44,000 
38,500 
15,000 
32.750 
81,000 
44,000 
35,750 
11,000 
13,000 
49,000 
67,000 

$526,000 


$195,000 

130,000 

475,000 

924,000 

184,000 

60,000 

30,000 

20,000 

10,000 

11,000 

14,000 

37,000 


$20,000 
10,000 
11,000 
13,000 
14,500 
17,750 
32,500 
14,600 
17,200 
19,200 
75,000 
34,750 

$279,500 


$98,000 
84,000 
62,000 
48,000 
8^,000 
26,000 
34,000 
62,000 
11,000 

35,000 
71,000 
44,000 


Totals. . 


$2,090,000 


$664,000 



Open the accounts of the company so that the result of 
the operation of each factory will be known at the end of the 
company's fiscal year. The books of the company are not 
to show the appraised valuation placed on the real estate, 
buildings, tools, machinery, etc., by factories, but in one amount 
only; and it is desired that the account include any expenditure 
incurred by the company for good will, etc. 

Make opening entries in cash book, journal, and ledger, 
covering in full the above transactions. C. P. A. Ex. 

Problem Five— A 

The Detroit United Railway Company, with an authorized 
capital stock of $1,000,000.00 consisting of 5,000 shares each 
of preferred and common stock at the par value of $100.00, 
had on January i, 1921, assets and liabilities as follows: 

ASSETS 

Real Estate and Building $ 200,000.00 

Power Plant and Machinery 250,000.00 

Aerial Construction 200,000.00 

Surface Construction 200,000 .00 

Underground Construction 150,000.00 

Rolling Stock 300,000 .00 

Accounts Receivable 10,000.00 

Cash 5,000.00 

*i,3i5,ooo.oo 



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SUPPLEMENTARY PROBLEMS 245 

LIABILITIES 

Preferred Stock $ 450,000.00 

Common Stock 400,000.00 

First Mortage Bond, 5% 350,000.00 

Accounts Payable 5,000.00 

Surplus 110,000.00 

11,315,000.00 

The Pontiac Electric Company, with an authorized capital 
stock of $500,000.00, had on the same day, assets and liabilities 
as follows: 

ASSETS 

Real Estate $300,000.00 

Power Plant and Machinery 150,000.00 

Aerial Construction 125,000.00 

Underground Construction 100,000.00 

Sundry Assets 15,000.00 

Profit and Loss 10,000.00 

1700,000.00 
LIABILITIES 

Capital Stock $500,000.00 

Mortgage, 6% 100,000.00 

Accounts Payable 100,000.00 

$700,000.00 

The Detroit United Railway Company purchased secur- 
ities of the Pontiac Electric Company in quanities and at prices 
as follows: 

$400,000.00 of the capital stock at $125.00, payable in 

cash. 
$50,000.00 of the capital stock at $130.00, payable with 
$30,000.00 of the preferred stock of the Detroit United 
Railway Company at $150.00 and cash to balance. 
$100,000.00 of the bonds at $115.00, payable in the un- 
issued common stock of the Detroit United Railway 
Company, at $93.00 and cash to balance. 
$10,000.00 of the cash payable for the stock purchased to 
be passed to credit of Profit and Loss account of the 
Pontiac Electric Company by the vendors to cancel 
the charge of like amount to said account. 
To provide funds to meet the above obligations and also to 
retire its 5% Mortgage Bonds at $105.00, the Detroit United 
Railway Company issued $1,000,000.00 of 4% Bonds and sold 
the entire amount for cash at 95%. 

Assuming that the dividend of the Pontiac Electric Com- 
pany declared during the year 192 1 amounted to $25,000.00, 
and the profit of the Detroit United Railway Company from 
operating exclusive of interest on its bonded debt amounted to 
$100,000.00, to what extent has the profit and loss of the Detroit 
United Railway Company been affected, during the year, by 
reason of its acquisition of the securities of the Pontiac Electric 
Company and of the redemption of its own 5% Bonds? Show 
also the condition of accounts of the Detroit United Railway 
Company at the end of the year. C. P. A. Ex. 



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246 



PUBLIC ACCOUNTING AND AUDITING 



Problem Six 

The following is a Trial Balance of The Western Telephone 
Company as of December 31, 1920: j^ ^ 

Cash $ 300.00 

Exchange Bank, Aaon 3,877 .40 

Central Bank, Burton 793 .20 

J and A Bank, Castleton 727.40 

Accounts Receivable, Acton 8*695 -60 

Accounts Receivable, Burton 7t5^.3o 

Accounts Receivable, Castleton 5»328 .00 

Notes Receivable 258 .50 

Accounts Payable $ 3,976 .00 

Notes Payable 53,300.00 

Interest Payable 1,052 .00 

Material and Supplies 20,146.50 

Furniture and Fixtures 12,253 .50 

Real Estate 45,000.00 

Switchboards and booths 23,115.40 

Poles 209,770.50 

Wirelines 131,269.70 

Telephones 127,515 .90 

Capital Stock 350,000.00 

Surplus 171*572 .30 

Tolls paid to foreign companies 4>79i •20 

Rental allowances 5,942 .00 

Rentab, Acton Exchange 44,077 .50 

Rental allowances 3t934.oo 

Rentals, Burton Exchange 26,425.30 

Rentals, Castleton Exchange 20,244.90 

Tolls, Acton Exchange 8,202 .50 

Tolb, Burton Exchange 4,452 .50 

Tolls, Castleton Exchange 2,800 .70 

Pay station tolls, Acton 637 .00 

Pay station tolls. Burton 727 .50 

Pay station tolls, Castleton 988.60 

Supply sales, Acton 126.80 

Supply sales. Burton 57 50 

Refunds, Acton 52 .50 

Salaries, central office 3,000.00 

General expense I3ii2i .30 

Insurance 745 .90 

Operators' wages, Acton 6,935 •oo 

Operators' wages. Burton 4,890.00 

Operators' wages, Castleton 5,700.00 

Repairs of wire plant 14,022 .00 

Repairs of equipment 14,435 .30 

Traffic Expense 485.00 

Profit and Loss 204.50 

Dividends paid 14,000.00 

I688.745.60 $688,745.60 

Allowance for depreciation as follows: 

Furniture and Fixtures 10% per year 

Plant and Equipment 5% per year 

Inventories, July i, 1920: 

Material and Supplies $184.30 

Required: Statement showing results of operation for six 
months ended December 31, 1920. 
Balance Sheet as at January i, 192 1. 

C. P. A. Ex. 



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SUPPLEMENTARY PROBLEMS 247 

Problem Seven 

A proposed merger of four manufacturing companies in- 
volves combined assets and liabilities as follows: 

Cash in Bank $ 14479.00 

Reserve for Bad Debts 34,050.00 

Good Will and Patents 293,132.00 

Reserve for Depreciation of Good Will 

and Patents 159,849.00 

Reserved for Corporation Taxes 5,000.00 

Dividends Accrued on Preferred Stock. . . 875.00 

Pay Roll Accrued 44,893.00 

Buildings i 332,637. 00 

Bills Receivable — Customers 2,333.00 

Invested in Notes of Other Corporations . . 190, 129 . 00 
Accrued Interest on Notes of Other Cor- 
porations 2,000.00 

.Accounts Receivable 345478.00 

Inventories 1,471,201.00 

Sundry Debtors 29,191 .00 

Reserve for Depreciation of Plant 346,144.00 

Securities Owned 14,552 .00 

Reserved for Loss on Securities Owned . . i, 455 .00 

Real Estate 46,075.00 

Deferred Charges to Future Operation. . . 9,350.00 

Accounts Payable 176,888.00 

Machinery and Equipment 862,920.00 

Unclaimed Pay 728.00 

Furniture and Fixtures 27,762 .00 

The Consolidated Tool Company is incorporated under the 
Michigan laws to take over the business of the four companies. 
Authorized capital stock, preferred, $500,000.00; common, 
$1,000,000.00; par value of shares $100.00 each. It is arranged 
that the minimum number of shareholders subscribe and pay in 
cash one share each of common to effect the incorporation, and 
that the remaining shares be subscribed and issued to the Penin- 
sular Trust Company to be divided under agreement among 
the stockholders of die old companies. 

Coincidently an issue of 5% First Mortgage Bonds is made 
amounting to $1,500,000.00 of which $125,000.00 is retained in 
the Treasury. Reorganization expenses paid out of the funds of 
the company amount to $10,250.00. , 

(1) You are asked to make the opening journal entries 

for the Consolidated Tool Company. 

(2) Prepare Consolidated Balance Sheet exhibiting the 

financial condition of the Consolidated Tool Com- 
pany. 

C. P. A. Ex. 



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248 PUBLIC ACCOUNTING AND AUDITING 

Problem Eight 

On December 31, 1921, a Trial Balance taken from the 
books of Jones & Brown, manufactures, shows the following: 

John Jones, Capital Account $12,500.00 

James Brown, Capital Account 10,000.00 

Sales 25,000.00 

Stock, January i, 1921 $ 6,250.00 

Purchases 20,000.00 

Bills Payable 7,500.00 

Debtors ^ 10,500.00 

Creditors 5,000.00 

Carriage and cartage 1,250.00 

Repairs and maintenance 250.00 

Coal 17500 

Gas and water 50.00 

Oil, grease and waste 225.00 

Taxes and insurance 175.00 

Bank interest 50.00 

Discounts and allowances 500.00 

Bad debts 150.00 

Buildings, machinery and plant 10,000.00 

Horses, carts, etc 1,000.00 

Tools and furniture 37500 

Wages 2,500.00 

Salaries 1,000.00 

Incidental expenses 250.00 

Cash in bank 2,000.00 

Cash on hand 50.00 

Bills Receivable 2,500.00 

Partners' salaries 750.00 

$60,000.00 f 60,000. 00 

Stock, December 3 1 , 1 92 1 , $7,500.00. Depreciation $500.00. 
Accrued incidental expenses, $125.00. Loss on debtors' balances, 
$100.00. Discount on debtors* balances 5%. Net profit is 
divided between partners in proportion to their capital, Janu- 
ary I, 192 1. Prepare statement showing Cost of &les. Profit 
and Loss statement and a Balance Sheet. C. P. A. Ex. 

Problem Nine 

(a) A soap company has adopted the policy of giving away 
premiums in connection with its sales, by means of coupons 
which are to be redeemed in quantities provided as per a printed 
list. How should these premiums be treated in preparing a 
Balance Sheet, Profit and Loss statement, etc? 

(b) A milk company sells to its customers strips of tickets 
which are good in payment of the milk delivered to them. These 
tickets are paid for in advance by the customers. What accounts 
would you expect to find on the books and how should the en- 
tries be handled showing the transactions of the sales of tickets 
and the deliveries of milk? C. P. A. Ex. 



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SUPPLEMENTARY PROBLEMS 249 

Problem Ten 

Lay up a complete administrative chart for a large manu- 
facturing concern to show the different departments and depart- 
mental heads from the board of directors down, so as to place 
responsibility, indicate control and to show to whom reports 
should be made. C. P. A. Ex. 

Problem Eleven 

The following problem is based upon the estimate cost 
system. No factory ledger is used, all accounts being kept on 
the general ledger. The business is the making of men's clothes, 
and two principal materials are used, fine woolens and plain 
woolens, of which stock records are kept. Stock records are also 
kept for finished goods. 

(a) The following styles of clothing are made, and they 
are estimated to cost: 

Style Style Style 

801 802 803 

Materials used $12.50 $8.00 $4.00 

Supplies (linings, buttons, 

etc.) 3.00 2.50 2.00 

Labor 9.00 6.00 4.50 

Factory expenses, 60% .... 5 • 40 3 . 60 2 . 70 

$29.90 $20.10 $13.20 

Note that the estimated costs are subdivided into four 
sections and that the accounts must be kept to record the cor- 
responding subdivisions of operating costs. 

(b) The company starts with the following: 

Dr. Cr. 

Machinery and Equipment. . . $10,000.00 

Cash 40,000.00 

Capital Sotck $50,000.00 

(c) The purchases for the first month according to voucher 
record are: 

Materials, fine woolens, 2,000 yds., at 

$3-oo $6,000.00 

Materials, plain woolens, 3,000 yds., at 

$1.50 4,500.00 

Rent of factory 500.00 

Lining, buttons and thread, etc 3,400.00 

Salesmen's commissions paid 700.00 

Office expenses 120.00 

Repairs to machines and equipment 350.00 

Electric power 440.00 

Oil, waste and other factory supplies 225.00 

$16,235.00 

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250 PUBLIC ACCOUNTING AND AUDITING 

(d) The pay rolls are summarized as follows: 

Foreman and timekeepers $ 250.00 

Tailors, cutters, etc. (direct labor) 4,600.00 

Office and salesmen's salaries 750.00 

Inspectors and other indirect factory 

wages 43500 

$6,035.00 

(e) Depreciation on equipment is calculated at 1% per 
month. 

(f) The cutting room foreman reports having taken from 
stock and cut for use on garments in progress, 1400 yds. fine 
woolens and 2,200 yds. plain woolens. 

(g) The tailoring foreman reports the following garments 
finished and placed in stock: 

Style No. 801 200 pieces 

Style No. 802 300 pieces 

Style No. 803 200 pieces 

(h) The sales record is as follows: 

Invoice No. i, Style No. Box, 100 pieces. . .$ 4,000.00 

Style No. 803, 100 pieces. . . 2,000.00 

Invoice No. 2, Style No. 801, 50 pieces. . . 2,050.00 

Invoice No. 3, Style No. 802, 100 pieces. . . 3,000.00 

Invoice No. 4, Style No. 802, 100 pieces. . . 2,800.00 

Style No. 803, 25 pieces. . . 450.00 

$14,300.00 

(i) Hint: make entry for cost of sales. 

(j) Received cash from customers, $9,000.00. 

(k) Paid out cash for wages, $6,035.00, and vouchers, 
$7,650.00. 

(1) Inventories at end of month. (In addition to stocks 
of raw materials and finished goods as shown by stock records.) 

Supplies, $1,000.00 

Unfinished goods: 

Style No. 801, 50 pieces. All material cut. All sup- 
plies provided. Labor half completed. 

Style No. 802, 100 pieces. All material cut. Half of 
supplies provided. Half of labor finished. 

(m) Prepare Balance Sheet and Profit and Loss statement 
for the month. Add or deduct from Cost of Sales, when prepar- 
ing Profit and Loss statement, the unabsorbed labor, expenses, 
etc. Show how balances of raw material and finished goods are 
made up. Inst. Ex. 



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SUPPLEMENTARY PROBLEMS 251 

Problem Twelve 

In June, 1915, A purchased a dwelling for the sum of 
$15,000.00. He resided in the dwelling until December i, 1920, 
when he sold the property at a loss. During 1920, he paid out 
for taxes $186.00, for insurance $60.00, for repairs $130.00, for 
interest on mortgage $250.00. His net loss on the sale was 
$1,200.00. 

In preparing A's Income Tax return for 1920, how would 
you treat the items specified? Inst. Ex. 

Problem Thirteen 

You are asked by an individual (married) to prepare a form 
of return for making application for deductions as provided by 
the Federal Income Tax Law. 

You find his income and expenditures for year ending Dec- 
cember 31, 1921, to be as follows: 

Expenses Income 

Salary $10,000.00 

Interest on Real Estate Mortgage 960.00 

Dividends U. S. Steel Corporation 1,200.00 

Rentals 2,200.00 

Interest, Bonds U. S. Steel Corp'n 1,000.00 

Interest, U. S. Government 3s 2,400.00 

Interest, City of Detroit 4s 4,000.00 

Gain Sale of Real Estate 500.00 

Inheritance, Stock Penna. Ry. Co., Par 25,000.00 

Life Insurance Benefit 5,000.00 

Special fee as commissioner of estate. . 500.00 

Allowance to wife $2,000.00 

Household expenses, including rent 9,620.00 

Fire Loss, Tenement property (net) .... 650.00 

Interest Bank Loans 5,400.00 

Life Insurance Premiums 600.00 

Taxes, City, State and County 220.00 

Automobile.' 2,500.00 

Charitable donations 400.00 

Losses Stock Exchange operations 4,400.00 

Losses Bad Debts 1,750.00 

Taxes — ^Special Paving 50.00 

Depreciation of Buildings 1,000.00 

Prepare in brief statement form your understanding of the 
effect of the law in relation to this individual's affairs. 

C. P. A. Ex 
Problem Fourteen 

From the following information, taken from a single entry 
set of books, you are required to construct a Trial Balance and 
prepare an accountant's working sheet, a Balance Sheet with 
supporting schedules, a Profit and Loss statement with support- 
ing schedules, and an Income Tax return with the necessary 
supporting schedules, etc., for the calendar year 1920: 



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252 PUBLIC ACCOUNTING AND AUDITING 

VALLEY HARDWARE COMPANY 
lUihinre Sheet-4>6C«nbcr 31, 1919 

ASSETS 
Current: 

Cash $10,742.06 

Accounts Receivable $11480.41 

Less Res. for Doubtful Accts. . . 500.00 10,980 .41 

Notes Receivable 202 .45 

Merchandise Inventory 17,108.58 $39,033 .50 

Deferred Charges: 

Prepaid Insurance Premiums 

(Apt. House) 318 .00 

Outside Inveetmentt: 

Real Estate Contracts 

Adams $ 600.00 

Baker 1,124.00 $ 1,724.00 

Land 

Apartment Property $23,500.00 

Garage Property 7,500.00 

2 Lots Suniw Addition 40.00 

Equity in Timber Property . . 2,000.00 33*040 .00 

Buildings 

Apartment House (Brick). . . $41,500.00 

Less Res. for Depr 3,245.00 33,255.00 

Garage (Cement) $14,500.00 

Less Res. for Depr i, 435 00 13,065 .00 

Stocks and Bonds 5,050.00 91,134 .00 

Fixed: 

Land 

Store Property $ 1,500.00 

Store Warehouse Property. . . 1 425 . 00 

Track Warehouse Property. . 75.00 $ 3,000.00 

Buildings 

Store Bldg. (Wood) $ 5,000.00 

Less Res. jfor Depr 4,550.00 450.00 

Store Warehouse $ 500.00 

Less Res. for Depr 365.00 135 .00 

Track Warehouse $ 100.00 

Less Res. for Depr 53.00 47 .00 

Store Fixtures (Inventory value) . i ,006 . 50 

Office Equipment (Inventory value) 185 .40 

Shop Tools and Equipment 

(Inventory value) 320.68 5,144.58 

Total Assets $135*630.08 

LIABILITIES 
Current: 

Accounts Payable 

Trade Creditors $ 1,643 . 13 

Expense Bills 939-43 $ 2,582.56 

Notes Payable 1,400.00 

Accrued Taxes 2,514.22 

Accrued Indust. Ins. (Est'd) 20.00 

Accrued Interest 39.00 

$ 6,555.78 



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SUPPLEMENTARY PROBLEMS 253 

Fixed: 

Mortgage Payable $ 5,000.00 

Total Liabilities "»555-7g 

Nbt Worth $124,074.30 

Represented by 

J. Valley Capital December 31, 1918 $124,074 . 30 



OTHER DATA 



Cash on hand December 31, 1920 $ 23,019.54 

Accounts Rec. December 31, 1920 20,927.85 

Notes Rec. December 31, 1920 6, 178 . 20 

Mdse. Inv. December 3 1 , 1920 24,040 . 37 

Real Estate Contracts: 

Adams $ 500 .00 

Baker 1,068 .83 

Fry i>375.oo 2,943.83 

Factory Land Purchased in 1920 for.. 1,900.00 
Shop Tools and Equipment valued as on Dec. 31, 1919 

Liberty Bonds on hand Dec. 31, 1920 (No stock) 3,000 .00 
Write off 3% depreciation on all buildings 

Write off 10% depreciation on Store Fixtures and Office Equipment 
Launch sold in 1920 for $600 which did not appear in Balance 
Sheet as of December 31, 1919 

Unexpired Insurance (Apartment House) 60 .00 

Accounts Payable December 31, 1920: 

Trade Creditors 9i294.33 

Expense Bills (Business) 651 .95 

Wages 312 . 12 

Industrial Insurance (Business) 30 .00 

Interest (Business) 150 .00 

Notes Payable December 31, 1920 6,147 .90 

Mortgage Payable December 31, 1920 5,000 .00 

Accrued Taxes, December 31, 1920 2,933 .25 

Net Sales for 1920 191,805 .80 

Apartment House Income, 1920 (Collected) 12,029.45 

Garage Income, 1920 (Collected) 1,620.00 

Other Rental Income, 1920 (Collected) 132 .00 

Interest Income (Notes), 1920 (Collected) 333 . 1 1 

Profit from sale of Bank Stock, 1920 300.00 

Fees received as Director of Bank 80.00 

Income from joint venture 52 . 59 

Interest Income (Bonds) 1 12 .88 

Proprietor's Personal Drawings, 1920 4,274.52 

Bad Debts written off in 1920 668 .91 

Set up Reserve for Doubtful Accounts for 1920 668 .91 

Cash paid as follows in 1920: 

Income Tax for 1919 2,643 .32 

To Trade Creditors 135,955.68 

For Freight-In 13,621 . 16 

For Insurance (Business) $ 440.86 

For Insurance (Apartment House) 59.99 500.85 

For Interest (Business) $ 177. 15 

For Interest (Garage) 364.80 541 .95 

For Salaries and Wages (Business) $ 14,756 .74 

For Salaries and Wages (Apt. House) 1,080 .00 15,836 .74 



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254 PUBLIC ACCOUNTING AND AUDITING 

For Taxes (Distribution as below) $ 2,454.49 

For Other Expenses (Distribution as below) 6,500.61 

For Donation to Red Cross 25.00 

1920 Expenses should be distributed as follows: (Items other than 

Insurance, Interest, Salaries). 

Apartment House: 

Taxes $1,469.29 

Fuel 876.00 

Repairs 102.75 

Telephone 105 .00 

Water 353 00 

Lights 177.50 

Painting 232 .70 

GarsLge: 

Taxes 381 .50 

Home: 

Taxes 41 .00 

Business: 

Taxes 981 -73 

Delivery Expense 3,791 . 18 

Advertising 25 .00 

Office and Miscellaneous Store Expenses 550 .00 

Problem Fifteen 

You are requested by the president of the November Cor- 
poration to assist in the preparation of the federal income and 
excess profits tax return of his company for the current calendar 
year. 

You are informed that the company was organized on 
January i, 1910, with an authorized and issued capital of 
$4,150,000.00, divided as to: 

Preferred stock $1,650,000 

Common stock 2,500,000 

You are further informed that of this capital $1,000,000 
common stock was sold to an underwriting syndicate for cash at 
par, less 6% commission, and that the remainder of the stock 
was issued to the vendor company in acquisition of the business, 
property, good will and other assets taken over. The capital 
stock outstanding has been unchanged from the date of organ- 
ization to January i, current year, except as to the redemption 
of the preferred stock indicated, which took place March 31, 
three years ago. The book values of the fixed properties are 
based on an appraisal made by an appraisal company as at 
March i, 1913. In addition to the common stock dividend paid 
during the current year, the company issued a further $1,000,000 
common stock, which was sold for cash at par as follows: 

August 31 $500,000 

October 31 500,000 

On October 31, current year, it also redeemed for cash and 
retired preferred stock at par to the amount of $375,000. 

You may assume the company was not engaged on any 
government contracts throughout the current year. 



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SUPPLEMENTARY PROBLEMS 255 

STATEMENT OF PROFITS AND INCOME 
For the current year ending December 31 

Sales $25,000,000 

Less cost of sales 15,000,000 

Gross profit $10,000,000 

Deduct selling, general and administration expenses: 

Selling expenses 3,500,000 

Advertising 500,000 

Collection expenses 200,000 

Contingent losses on bad and doubtful accounts 200,000 

General office salaries 100,000 

Profit-sharing bonus of executives 250,000 

Taxes: 

Real and personal property taxes 50,000 

Capital stock tax 5,000 

Special assessments 10,000 

Life insurance policy premiums 5,000 

Charitable contributions: 

Public subscriptions 25,000 

Employes* welfare 30,000 

Total expenses $4,875,000 

Net profits from operations $5,125^000 

Add other income: 

Dividends received from domestic corporations $100,000 

Dividends on foreign investments 50,000 

Interest received io,ooo 160,000 

_ , $5,285,000 

Deduct: 

Interest paid $250,000 

Proportion of bond discounts written o6f 10,000 260,000 

Net profits and income $5,025,000 

Deduct: 

Expenses in connection with issue of 

capital stock $ 50,000 

Provision for federal income taxes (pre- 
liminary estimate) 2,000,000 

Special reserve against inventory 500,000 2,550,000 

Surplus net profits " $2,475,006 

SURPLUS ACCOUNT 
For the current year ending December 31 

Balance at the banning of the year $2,650,000 

Net profits for year 2,475,000 

$5,125,000 
Less: 

Excels of federal taxes actually paid over amount 

provided at December 31, preceding year $100,000 

Cash dividends paid on preferred stock during 
current year: 

January 31 $20,000 

April 30 20,000 

July 31 20,000 

October 31 15,000 75iOOO 

Dividends paid on common stock during 
current year: 
In cash 

February 28 $250,000 

August 31 250,000 500,000 

In stock 

August 31 1,000,000 

Preferred stock redemption fund 375,000 2,050,000 

$3»075>ooo 



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256 



PUBLIC ACCOUNTING AND AUDITING 



THE NOVEMBER GORPORATION 

Condensed Trial Balance (After Gloeing) 

For the current year from January 1 to December 31. 



Accounts 



Dr. 



January i 



Properties $2,500,000 

Depreciation Reserve.. . 
Goodwill acquired for 

stock 1,500,000 

Investments in stock of 
other corporations at 
cost: 
Domestic 

(25% interest)... 250,000 
Foreign 

(20% interest). . . 100,000 

Inventories 3,000,000 

Inventory reserves 

Receivables 2,500,000 

Bad Debt reserves 

Cash 1,400,000 



Cr. 
$500,000 



Bond discount 

Commission paid on is- 
sue of common stock 

Prepaid expenses 

Preferred Stock 

Common Stock 

Bonds 

Current Liabilities 

Provision for federal 
income and profits 
taxes 

Contingent reserve. .... 

Preferred stock redemp- 
tion fund 

Earned surplus 

Capital surplus result- 
ing from appraisal of 
properties 



90,000 

60,000 
50,000 



500,000 
100,000 



1,500,000 
2,500,000 
1,000,000 
1,600,000 



700,000 
250,000 

150,000 
2,150,000 



500,000 



$11,450,000 $11,450,000 



December 31 
Dr. Cr. 

$3,500,000 

$700,000 

1,500,000 



250,000 

100,000 
5,000,000 

3,000,000 

2,000,000 
80,000 

60,000 
40,000 



1,000,000 
250,000 



1,125,000 
4.500,000 
1,000,000 
1,105,000 



2,000,000 
250,000 

525,000 
2.575,000 



500,000 



$15,530,000 $I5kS30»ooo 



Draft statements showing: 

(i) The amount of the company's "invested capital" for 
the year, which the treasury authorities will recognize for the 
purpose of computation of taxes. 

(2) The taxable net income for the year. 

(3) The amount of income and excess profits taxes assess- 
able for the year. Inst. Ex. 



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INDEX 



Abstract of Sales i33, I34 

Accounts 

controlling 172 

deficiency 35i 44 

fully manufactured goods.... 174 

intercompany 100 

labor 173 

nominal 119 

outline of 119, 146, i^7» 149 

overhead expense 169, 173 

parts purchased 173 

raw materials ,,,, , 172 

real 119 

work in process 174 

Accountant's Report 120, 121 

Accounting for 
administration of properties 

by receivers 37 

concern in hands of receiver, x 

dividends 87 

installment sales I39» 181 

labor 167 

material . .' 167 

stock acquired by the issuing 

company through purchase 66 
stock donated to the issuing 

company 68 

stock forfeited by subscribers 69 

Accounting Systems 113 

branch store 140 

cost accounting loi 

departmental 129 

mercantile no 

Admissible Assets 226 

Affiliated Corporations loi, 230 

Alimony 190 

Amortization 198 

Articles of Copartnership 8 

Assignment 41 

B 

Bad Debts 198 

Bankruptcy 33 

acts of 40 

courts 39 

partnership 40 

proceedings 40 

trustee in 34 

Books of Account 

bond register 51 

cash book 117, I33, ISI 

journal 117, 121, I3S. I55 

ledger 118, 123, I37, ISO 

manufacturing the 120 

material consumption report. 156 

order book I53 

production report 150 

purchases record. ii8» 122, 130, 149 



sales record I33> I53 

stock certificate book 50 

stockholders' or stock ledger. 50 

stock record 155 

transfer register 50 

Bond Premium and Discount. . 185 

Bond Register 51 

Bonus 100 

Bonus Stock 70 

Borrowed Capital 225 

Branch Store Accounting 140 

Business Losses 197, 217 

C 

Calculation of Tax 204, 221, 229 

Capital Proportional to Invest- 
ments 2 

Capital Stock 

decrease 71 

exchange of property for ... . 73 
increase 70 

Cash Book 117, 133, 151 

Certificates of Ownership 238 

Classification of Accounts 

nominal 119 

real 119 

Classification of Partnerships 

general 10 

unplied 9 

limited 9 

Closing the Receiver's Books of 
Account 38 

Combinations 97 

Commercial Law [loo-iojj 

corporation 51-57, 72, 73, 83-86 

partnership 8-10, 19-21, 39-42 

Compensation of Officers and 
Directors 57 

Computation of 

invested capital 226 

tax 204, 221, 229 

Conditional Subscriptions 72 

Consolidated 
net income of affiliated cor- 
porations 102 

returns 100 

the filing of loi 

statements 99 

Consolidation 
advantages of 98 

Continuous Production or Pro- 
cess System 165 

Copyrights and Patents 
sale of 184 

Corporations 

affiliated 101 

computing income and excess 

profits taxes of 230 

defined 51 

exempt from income tax 213 



257 



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25» 



INDEX— Continued 



foreign 212 

formation 51 

general powers of gi 

law 51-57. 72, 73» 83-86 

personal service 102, 214 

subject to income tax 209 

Corporation Journal 58 

Corporate Records and Books 
of Account 49 



Decrease in Capital Stock 71 

Deficiency Account 35, 44 

Departmentalization i^ 

Depletion 200, 218 

Depreciation 198, 218 

Determination of Excess Prof- 
its Tax 229 

Directors 

compensation of 57 

liabilities of 56 

rights of §6 

Discount on Treasury Stock... 67 

Dissolution 20 

Distribution of 

assets 17, 21 

profits and losses 4, 17, 20 

profits as salary 5 

profits in proportion to in- 
vestments 6 

Dividends 

declaration of 82, 83 

defined 81, 187 

kinds 

cash 81 

ex- 82 

liquidating 17, 82, 188 

property 82 

scrip 82 

stock 82, 86, 187 

payment of 83, 86, 87 

who may declare 85 

Dividend Book 50 

Domestic Cor^ration Affiliated 
with Foreign Corporation . . 102 

Donations 220 

Donation Stock 65 

Dormant Partner 10 



Excess Profits Taxes 

adjustment of surplus 228 

computing the income and ex- 
cess profits taxes of corpo- 
rations 230 

credits allowed 229 

determination of tax. 229 

final adjustments 229 

information and payment 

at source 234, 237, 238 

brokers 237 

certificates of ownership . . . 238 



corporation interest and 

dividends 235 

foreign interest and divi- 
dends 237 

interest on tax-free bonds.. 238 

invested capital 225, 226, 231 

admbsible assets 226 

assets which may be in- 
cluded in 226 

borrowed capital 225 

computation of 226 

inadmissible assets 226 

intangible property 225, 228 

tangible property 225, 227 

stock issued for 
mixed tangible and intangi- 
ble property 228 

Exchange of Property for Cap- 
ital Stock 73 

Expenses 

general business 193 

miscellaneous business 194 

Equal Investments i 

F 

Federal Excess Profits Taxes . . 

225-238 
Filing Consolidated Returns... loi 

Financial Embarrassment 33 

Foreign Corporations 212 

Foreign Interest and Dividends 237 

Forfeited Stock 66 

Fraud 

misrepresentation and 72 

Freight In 132 

G 

General 

business expenses 193 

cash book 117, 133, 151 

journal 135, 138 

partnership 10 

Good Will 
sale of 184 

Gratuities and Tips 181 

Gross Income 210 

deductions from 193 

H 

Health and Accident Insurance. 190 

Holding Companies 97 

How Dividends are Paid 87 

How Tax is Assessed 100 

I 

Inadmissible Assets 226 

Income 

deductions from 215 

exempt from taxation 
alimony 190 



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INDEX— Continued 



259 



interest on bonds of War 
Finance Corporation .... 192 

Federal Farm Loan Act se- 
curities 190 

health and accident insur- 
ance 100 

life insurance 189 

nonresident aliens 192 

interest on obligations of 
the United States 189 

property acquired by gift, 
be<)uest or descent 189 

salaries or state and munici- 

{)al employes 189, 190 
aries of U. S. soldiers 

and sailors 190 

from 

dividends 212 

fiduciaries 185 

interest 211 

miscellaneous sources 212 

operations 210 

rentals and royalties 211 

state and municipal offices. 189 

gross 210 

deductions from 193 

net 210 

of farmers 182 

partnership 186 

special source of 188 

Income Tax 
legislation in the United 

States 177 

corporations 

credits allowed 221 

deductions from income. ... 215 
classification of 
by insurance companies . . 220 
depreciation and depletion 218 

interest and taxes 217 

losses 217 

miscellaneous 220 

ordinary and necessary 

business expenses / 215 

exempt from tax 213 

foreign 212 

gross income 211 

of corporations 210 

income from 

dividends 212 

interest 211 

miscellaneous sources 212 

operations 210 

rentals and royalties 211 

items not deductible 220 

donations 220 

net income 210 

organization expenses . . . 220 
personal service corpora- 
tions 102, 214 

place for filing returns. . . 221 
rate and calculation of 
tax 221 



returns and payment of 

tax 222 

stockholders taxable as 

partners 214 

subject to tax 209 

individuals 
allowances in lieu of com- 
pensation 180 

bad debts 198 

bond premium and dis- 
count 185 

bonuses 180 

business losses 197 

compensation paid other 

than in cash 180 

contributions or gifts 200 

credits allowed 201 

depletion 200 

depreciation, obsolescence 

and amortization 198 

distinction between busi- 
ness expenses and cap- 
ital outlay 195 

gratuities and tips 181 

gross income 179 

deductions from 193 

income from farmers 182 

income from fiduciaries . . 185 

interest 185, 196 

installment sales 181 

items not deductible 200 

long-time contracts 181 

making of returns ao2 

manufacturing or trading 

business 181 

payment of tax 206 

penalties 206 

pensions and pension 

funds 181 

property exchanged 183 

rates and computation of 

tax 204 

rates of normal and sur- 
tax 204 

real estate subdivisions. . . 182 

rents 185 

reporting on cash or ac- 
crual basis 179 

sale of 

good will 184 

patents and copyrights. 184 

real estate 182 

stocks ifi 

taxes 15 

Incorporators 53 

Incorporation 

advantages of 52 

disadvantages of * . . 53 

Implied Partnership 9 

Increase in Capital Stock 70 

Installment Ledger 49 

Installment Sales 139, 181 

Insurance 189, 190 



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26o 



INDEX— Continued 



Intangible Property 22| 

Intercompany Sales 106 

Interest 185, i89> 196, 217 

and dividends 235 

and taxes 217 

on capital 5 

on investment a fixed charge. 6 

on tax-free bonds 238 

Invested Capital 

admissible assets 226 

computation of 226 

inadmissible assets 226 

Investing Good Will 2 



Job Cost or Production Order 

System 164, 165 

Journal ... .59, "7, 121, 135, 138, 155 



Law 

bankruptcy 39» Afi 

corporation 51, 72^ m 

excess profits tax 225-230 

income tax 177-222 

partnership 8, 19, 39 

Ledfi[er..49, 50, 58, 118, 123, I37> 156 
Liability 
for breach of subscription 

agreement 72 

of withdrawing partner 20 

on stock purchased at a dis- 
count 7Z 

on subscriptions to bank stock 73 

to creditors 20 

Life Insurance 189 

Limited Partnership 9 

Liquidating Dividends... I7> 82, 188 

Loan of Partner 21 

Long-Time Contracts 181 

Loose-Leaf Records 129 

Losses 197, 217 



Making of Returns 204 

Manufacturing the Books of Ac- 
count 120 

Material Consumption 

Report 156, 157 

Mercantile Accounting 116 

Merger 97 

Minute Books 50 

Misrepresentation and Fraud... 72 

Monthly Statements i23 

N 

Net Income 210 

for taxable year 225 

Normal Tax 

rate of 204 



O 

Obsolescence 198 

Officers 

compensation of. 57 

Opening the Receiver's Books 

of Account 37 

Order Book. 153 

Organization Expenses 220 

Ostensible Partner 10 

Overhead Expenses 169, 173 

Overvaluation of Inventories... 2 

Outline of Accounts 

119, 146, 147, 149 

P 

Partners — kinds 

dormant 10 

nominal 10 

secret 10 

silent 10 

Partnership 

agreements 7 

bankrupts 40 

classes of 

general 10 

unplied 9 

limited 9 

contributions 186 

dissolution 17 

income 186 

law 8-10, 19-21, 39-42 

Patents and Copyrights 

sale of 184 

Payment of Tax 206 

Penalties 206 

Pensions and Pension Funds... 181 
Personal Service 

Corporations 102, 214 

Premium on Treasury Stock. . . 67 
Problems in Accounting 

corporation 63, 80, 94, no 

cost accounting 175 

mercantile accounting. 126, 141, 158 

partnership 13, 31, 47 

Production Report 156, 157 

Profits on Intercompany Sales. 106 
Predetermined Estimate System 166 

Purchases Record 

118, 122, 130, 131, 149 

R 

Rates of Tax 204, 221 

Real Estate 

sale of 182 

subdivisions 182 

Realization and Liquidation 
statements 36 



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INDEX— Continued 



261 



Receivership 41 

accounting 36 

administration of properties 

by receivers yj 

closing the receiver's books 

of account 38 

concern in hands of re- 
ceiver 38 

opening the receiver's books 

of account 37 

statements to be rendered 

to the court 38 

Recording Corporate Transac- 
tions 57 

Rents 185 

Reserve for Depredation 

of assets invested 3 

Returns and Payment of Tax. . . 222 

S 

Sales 

abstract of. 133, 134 

and credit tickets 118, 122 

installment 139, 181 

of good will 184 

of patents and copyrights 184 

of real estate 182 

of stocks I 

profits on intercompany i< 

record 133 

Secret Partner 10 

Silent Partner 10 

Statement of Affairs 35 

Statements to be Rendered to 

the Court 36 

Stock 

acquired at a discount 104 

acquired at a premium 105 

dividends 187 

kinds 

bonus 70 

donation 05 

forfeited 66 

treasury 65 



record ISS 

certificate book 50 

ledger 50, 137 

Stockholders §5 

ledger 50, S8, 59i 61 

liabilities of 56 

powers of 55 

rights of 55 

taxable as partners 214 

Subscription o r Installment 
Ledger 49 

Subscription Register 49, 58 

Surplus 105 

working sheet I07» 109 

Surtax 
rate of 204 

T 

Tangible Property 225 

Tax 196, 204, 217 

computation of 204 

normal 204 

rate of 204 

surtax 204 

Tips, gratuities and 181 

Treasury Stock. 65 

premium on vj 

discount on (Sj 

Transfer Register 50 

Trustee in Bankruptcy 34 

W 

Wage System 167 

When a Subscription May be 

Withdrawn , 73 

When Corporations arc Affili- 
ated 100 

Who May Declare Dividends... 85 
Working Sheet, Surplus 107 



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ILLUSTRATIONS 

Abstract of Sales 134 

Articles of Incorporation 54 

Balance Sheet 78, 109, 124 

Cash Book 136, 152 

Certificate of Subscription 54 

Computation of Invested Capital 230 

Consolidated Balance Sheet 109 

Corporation Journal 59 

Corporation Tax Table, 1920 232 

Deficiency Account 44 

Information at the Source, 1920 236 

Journal 59, 138, 155 

Material Consumption Report 157 

Order Book 154 

Outline of Accounts 147 

Production Report 157 

Pro Forma Balance Sheet 124 

Pro Forma Profit and Loss Statement 125 

Realization and Liquidation Statement 45 

Record of Purchases and Expenses 131, 150 

Record of Sales 154 

Sales Ticket 134 

Schedule of Taxable Interest on Liberty Bonds, 1920 191 

Statement of Affairs 43 

Stock Certificate Stubs 60 

Stock Ledger 61, 138 

Subscription Register 58 

Working Sheet 27 

For Consolidated Balance Sheet 108 

For Surplus Account 109 



262 



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