Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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THE

ARTHUR YOUNG

ACCOUNTING

COLLECTION




Graduate School of
Business Administration

Library of the

University of California

Los Angeles



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3RANCH

'ALIFORNIA



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Graduate School of Business Administration

Un: ' ! -" California

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MODERN ACCOUNTING



MODERN
ACCOUNTING

ITS PRINCIPLES AND SOME
OF ITS PROBLEMS



BY



HENRY RAND HATFIELD, PH.B.

PEOFESSOK OF ACCOUNTING
UNIVEBSITY OF CALIFOBNIA




NEW YORK AND LONDON

D. APPLETON AND COMPANY
1920



82923



COPYRIGHT, 1909, BY
D. APPLETON AND COMPANY



PRINTED IN THE UNITED STATES OF AMERICA



Bus. Admin.

Library



HF
5625

PREFACE [|2jT



IN the following treatise an attempt is made to present
tho principles of accounting. In doing so the details of
technic, important though they are, are purposely omitted
or treated with the scantest mention. The essence of ac-
counting, from the author's view point, is the presentation,
first, of a correct exhibit of the financial status of the con-
cern at a given moment of time, and, secondly, a showing
of the results obtained during a given period of time. The
first is embodied in the Balance Sheet; the second in the
Income or Profit and Loss statement.

In the ordinary routine of the accountant's toil there
is, indeed, another function; that of keeping account of
claims and property, in order to secure the concern against
the loss which might arise from forgetfulness, carelessness
or dishonesty. This phase of accounting attains its acme
in governmental accounting where the essential thing is to
insure the proper handling of vast sums. But this seems a
matter of much less scientific interest and is not treated
in this work.

The method of treatment, in general, has therefore been
to consider how a given transaction is made manifest in
the Balance Sheet, the goal which the accountant ever has
in mind. The technical entries to be made in the journal
or in other books of original entry are excluded. They are
not of, such importance for the forms in which such entries
are made vary according to the needs of the office economy,



vi PREFACE

and still more because they are only the steps by which the
Balance Sheet is formed. Keeping the latter constantly
in mind, serves to make clear the logical significance of
each transaction recorded. That being clear the technical
entry to be made is an obvious matter.

The presentation of a correct view of the concern's
financial status and of its past profits involves many
points of theoretical interest and of practical importance.
To present an intelligible view it is essential to have a
rather definitely crystallized terminology so that the terms
used with a technical meaning shall be definitely under-
stood with the exact connotation intended. Unfortunately,
despite the advancement made in accounting practice,
there is a most embarrassing confusion in terminology, so
that one can never be sure of just what is meant by a
given account. Amperes and ohms, miners inches and
foot pounds, have definite meanings free from misunder-
standing. But the current terms of accounting : Reserves,
Depreciation Fund, Manufacturing Costs, even Profits, are
loosely and divergently used. More serious still is the
uncertainty as to the correct principle to follow in many
cases, as for instance in the valuation of fixed assets and
the method of estimating depreciation.

In some cases it is possible to differentiate certain
usages as bad, some methods as involving incorrect prin-
ciples. But this is not always true and when in doubt
there is no ultimate arbiter to whom appeal can confidently
be made. In this dilemma it has, therefore, seemed advis-
able to show the existing variations rather than to attempt
to formulate rigid rules. The comparative study of ac-
counting practice will, perhaps, be a greater service to



PKEFACE vii

accounting science than a more dogmatic treatise. Refer-
ence has accordingly been frequently made to the pub-
lished accounts of corporations which presumably exhibit
current usage, and to the leading English and American
texts. But in addition considerable recourse has been had
to other less obvious sources of information. These include
the decisions of English and American courts, the com-
mercial codes of Germany, France and Austria and the
commentaries of the leading jurists of these countries.
The legal provisions of the Continental countries are, of
course, not binding on American practice. But they are
of considerable significance in discussing the principles of
accounting, for they embody the 'carefully expressed opin-
ion of experts on many difficult problems.

Such attention to foreign authorities is all the more
necessary since in this country far too little attention has
been given to matters of principle. American accounting
is famed for short cuts and practical efficiency. At the
same time the accounts of American corporations, until
Very recent years, have been replete with questionable
practices, oftentimes vicious in principle and misleading in
their results.

While the work is mainly a discussion of the problems
of practical accounting, it has seemed advisable to insert
an introductory section on the theory of double entry book-
keeping. Those who are familiar with the literature of the
subject need not be told of the author's indebtedness to
J. F. Schaer whose clear writings have done much to put
bookkeeping on a more rational basis. Of especial value
has been that writer's: " Versuch einer wissenschaftlichen
Behandlung der Buchhaltung. "



viii PKEFACE

The twofold classification of accounts herein adopted
differs materially from the customary treatment in Ameri-
can text-books. The conventional division of accounts into
real, personal and fictitious, as Jones pointed out in 1841,
* ' renders all theorizing impossible, and v shuts up every
avenue to the more general principles of the subject on
which the analysis of accounts so immediately depends."
So too there is a marked divergence in the treatment of
the terms Debit and Credit, the mere rules of thumb so
generally used being abandoned for what, it is hoped, is
not only more rational but actually of greater practical
value to the student wrestling with the problems of ele-
mentary bookkeeping.

HENRY RAND HATFIELD.



CONTENTS



CHAPTER I
THE PRINCIPLES OF DOUBLE ENTRY BOOKKEEPING

PAGES

The Fundamental Equation of Bookkeeping Goods Pro-
prietorship Exchange, Profit and Loss, and Mixed Trans-
actions The Development of a System of Accounts
The Classification of Goods Accounts The Classification
of Proprietorship Accounts The Purpose of the Double
Set of Accounts Mixed Accounts The Introduction of the
Inventory Debts or Negative Goods Summary of Prin-
ciples 1-15

CHAPTER II
THE PRINCIPLES OF DOUBLE ENTRY BOOKKEEPING (Continued)

The Ledger Debit and Credit The Clearing of Mixed Accounts
Negative Accounts The Balance of Accounts Imper-
fections in Double Entry Bookkeeping Bibliographical
Note to Chapters I and II 16-34

CHAPTER III
THE BALANCE SHEET

The Trial Balance The Formation of the Balance Sheet The
Two Sides of the Balance Sheet: (1) The English Inverted
Order; (2) Variations in Headings The Grouping and
Marshaling of Items The Double-Account Balance Sheet
Valuation Accounts in the Balance Sheet The Balance
Sheet in Relation to Profits Accuracy in the Balance
Sheet Examples of the Balance Sheets of Corporations
Bibliographical Note 35-69



x CONTENTS

CHAPTER IV

ASSETS AND THE PRINCIPLES OF VALUATION

The Difficulty in Distinguishing Assets from Expense Items
Revenue Expenditure and Capital Expenditure The
Problems of the Inventory: (1) What Items are to be In-
cluded? (2) What is the Cost Price? (3) What is the
Basis for Revaluation? Undervaluation in the Inventory
Bibliographical Note 70-85

CHAPTER V

THE VALUATION OF PARTICULAR ASSETS

Land: (1) Permanent Holdings Valued at Cost; (2) Land Held
as Merchandise Buildings Machinery, Tools, etc. In-
vestments: (1) The Significance of Public Quotations; (2)
The Market Price Logically Negligible for Permanent In-
vestments; (3) Legal Regulations Regarding Valuation;
(4) Value as Affected by Time Mercantile Credits Mer-
chandise: (1) Cost the Normal Basis for Appraisal ; (2) Prob-
lems in Determining Cost Bibliographical Note . . 86-106

CHAPTER VI
IMMATERIAL ASSETS

Goodwill: (1) Legitimacy of Including Goodwill Among Assets;
(2) Value Limited to Actual Cost; (3) The Purchase of
Fictitious Goodwill; (4) Factors Determining the Value
of Goodwill; (5) The Rate of Capitalization; (6) The
Writing-off of Goodwill Deferred Assets: (1) Definition;
(2) The Writing-off of Deferred Assets; (3) Losses Appear-
ing among Deferred Assets Bibliographical Note . . 107-120

CHAPTER VII

DEPRECIATION

The Economic Significance of Depreciation Depreciation and
Anticipation Accounts Depreciation and Profits De-
preciation in the Courts The Rulings of the Interstate
Commerce Commission Methods of Booking Deprecia-



CONTENTS xi

tion Methods of Estimating Depreciation: (1) Percentage
of Original Cost; (2) Percentage of Diminishing Value; (3)
Annuity Method; (4) Comparison of Above Methods De-
preciation in Relation to the Total Cost of Production
Irregular Charges to Depreciation Excessive Depreciation
Depreciation and Replacement Depreciation for Other
than Wear and Tear Specific Rates Charged Bibliograph-
ical Note 121-143

CHAPTER VIII

CAPITAL STOCK. I. ISSUED FOR CASH

The Capital Account of Individual Traders The Different
Treatment of Capital in Corporation Accounts Subscrip-
tions to Capital Stock: (1) Subscription Implies Payment in
Full; (2) Unsubscribed and Treasury Stock; (3) Uncalled
Subscriptions ; (4) Subscriptions at a Premium The Sale of
Capital Stock: (1) Discussion of Decision in Handley v.
Stutz; (2) Proper Booking of Stock Sold Below Par The
Reduction of Capital Stock 144-160

CHAPTER IX

'

CAPITAL STOCK. II. ISSUED FOR PROPERTY, ETC.

Distinction between Issues for Property and for Cash Stock
Issued for Less than Par: (1) The Legal Distinction between
Par and Market Value; (2) The Issue of Stock at "Market
Value"; (3) The Proper Accounting for Such Issues; (4)
Subterfuges Found in Accounts Stock Watering Stock
Dividends Donation of Stock to the Company The Use of
the Term "Working Capital" Stock Issued to Combine
Corporations Bibliographical Note to Chapters VIII and
IX 161-183

CHAPTER X
LIABILITIES

Liabilities as Negative Goods Accounting Problems: (l)The
Classification of Liabilities; (2) Interest Adjustments; (3) Un-
issued Bonds; (4$ Repurchased and Treasury Bonds; (5)
Uncertain Liabilities Bibliographical Note . . . 184-194



xii CONTENTS

CHAPTER XI

PROFITS

PAGES

The Profit and Loss Account: (1) Definition; (2) Purpose; (3)
Relation to Other Accounts Charging Losses to the Profit
and Loss Account: (1) The Exploitation of "Wasting
Assets"; (2) The Loss of "Fixed Capital"; (3) The Relation
of Previous Losses to Current Profits; (4) Decisions in
American Courts 195-213

CHAPTER XII

PROFITS (Continued)

The Relation of Capital Losses to Dividends: (1) The Legality of
Paying Dividends when there has been a Capital Loss;
(2) The Business Policy of Such Dividends; (3) The Proper
Booking of Capital Losses The Credit Side of the Profit and
Loss Account: (1) Premium on Stocks and Bonds; (2) Appre-
ciation of "Capital Assets"; (3) Unrealized Profits; (4) The
Doctrine that Profits Must Consist of Cash Receipts Legal
Decisions Concerning the Relation between Profits and Un-
paid Debts The Payment of Dividends out of Borrowed
Funds Summary of the Attitude of the Courts in Regard
to Profits Bibliographical Note to Chapters XI and XII 214-232

CHAPTER XIII
SURPLUS AND RESERVES

The Nature of a Surplus Surplus to be Distinguished from
Valuation Accounts: Illustration and Definition of Terms
Used Purposes for which Surplus Established: (1) To
Provide Additional Permanent Capital; (2) To Provide for
Emergencies; (3) To Equalize Dividends General and
Special Reserves Criticism of Claim that Reserves must
be Specially Covered: (1) Confuses Two Sides of Balance
Sheet; (2) A Specially Covered Reserve no more Secure or
Available; (3) Leads to False Financial Theories; (4) Cita-
tion of Authorities Reserves and Reserve Funds Re-
serves in Banking and in Insurance Secret Reserves
The Application of a Reserve: (1) To Cover Losses, etc. ; (2)
, To Make Extensions, etc. Reserve for Insurance Biblio-
graphical Note . . 233-260



CONTENTS xiii

CHAPTER XIV

SINKING FUNDS

PAGES

Definition The Four Methods of Booking a Sinking Fund
Sinking Fund Installments in Relation to Income Interest
on Sinking Fund Investments The Payment of Bonds from
the Sinking Fund The Calculation of Amount Necessary
for Sinking Fund Sinking Funds and Depreciation
Bibliographical Note 261-273

CHAPTER XV
TRADING, MANUFACTURING, AND INCOME ACCOUNTS

The Purpose of Subdividing the Profit and Loss Account Types
of Such Accounts: (1) The Trading Account; (2) The Manu-
facturing Account; (3) The Income Account of Railroads
The General Principle Involved in thtf Form of Such Ac-
counts Problems Relating to Such Accounts: (1) The
Valuation of Manufactured Goods; (2) The Items to be
Included in the Trading Section; (3) The Determination of
Selling Price ; (4) The Treatment of Taxes ; (5) Depreciation
Bibliographical Note 274-292

CHAPTER XVI
COST ACCOUNTS

The Purpose of Cost Accounting Different Conceptions of
Cost The Elements of Cost: (1) Direct or Prime Cost; (2)
Indirect Factory Expenses; (3) General Establishment
Charges General Problems in Applying Cost Accounting:
(1) Expense of the System; (2) Accuracy to be Obtained; (3)
The Use to be Made of Cost Estimates The Technic of Cost
Accounting Bibliographical Note 293-315

CHAPTER XVII

PARTNERSHIP ACCOUNTS

The Establishment of the Partnership: (1) The Amount Con-
tributed; (2) A Share of the Profits and a Share in the Busi-
ness; (3) Contributing a Share and Buying a Share Inter-
est on the Partners' Capital: (1) On Total Contribution;



xiv CONTENTS

PAGES

(2) On Excess or Deficit Liquidation: (1) The Appor-
tioning of Assets in Liquidation; (2) Distribution of Assets
in Installments Bibliographical Note .... 316-334

CHAPTER XVIII
THE STATEMENT OF AFFAIRS AND DEFICIENCY ACCOUNT

The Use of the Statement of Affairs and Deficiency Account

Discussion of Variations in Forms Bibliographical Note 335-340

CHAPTER XIX

TECHNICAL IMPROVEMENTS IN ACCOUNTING PRACTICE

Improvements in Relation between Chronological and Classified
Records Improvements in the Form of the Ledger: (1)
Method of Ruling; (2) Abbreviation of Entries; (3) Cards
and Loose Leaves Mechanical Devices in Accounting: (1)
Adding Machines; (2) Calculating Machines; (3) Tabulating
Machines Effect of Economic Changes on the Develop-
ment of Accounting: (1) The Factory System; (2) The
Corporate Form of Industry Bibliographical Note . 341-357

INDEX 359



MODERN ACCOUNTING



CHAPTER I

THE THEORY OF DOUBLE ENTRY BOOKKEEPING

DOUBLE entry bookkeeping, the basis of all modern
accounting, was first made known to the world in a mathe-
matical treatise published in 1494 by Luca Paciolo. This
work, the " Summa de Arithmetica, Geometria, Propor-
tioni et Proportionalita, " not only contained the first
printed work on bookkeeping but also included the first
European treatise on Algebra.

Appropriate to this early connection with algebra,
double entry bookkeeping starts out with an equation.
The recording of all subsequent business transactions con-
sists in altering the form of the equation without affecting
the equality of the two members. This original equation,
or Balance as it is called in the bookkeeper's technical lan-
guage, when reduced to its simplest form is :

The value of the various Goods one owns = The amount
one is worth.

Or, to use shorter terms :

Goods = Proprietorship. 1

Goods is here used in the technical economic sense of
anything, material or otherwise, to which value attaches.
The left-hand member of the equation therefore represents

1 The term Proprietorship, as a collective term for all the accounts
representing the "Amount one is wor j ,h" is adopted from Charles E.
Sprague's most valuable "Philosophy of Accounts." It is better than
other terms which have been used, as it is free f r.om technical ambiguity.

1



2 MODERN ACCOUNTING

a complete list or inventory of all valuable possessions ; the
right-hand member expresses the total Proprietorship, that
is, the capital or net present worth of the proprietor.

This initial equation appears whenever a man first
starts a set of books. It may be illustrated by a new busi-
ness in which the proprietor starts with $5,000 cash on
hand, the equation here being :

Cash $5,000 = Proprietorship $5,000.

For the present, consideration of debts owed may be
postponed, and the proprietor may be . assumed to pay
cash on all transactions and not to borrow any money.
With this limitation it must be clear that all possible
business transactions, or all possible operations, whether
purchases or sales, the payment of expenses, the receipt of
rent or interest, the loss of property by fire or theft, the
taking of profits by the proprietor, additional contributions
to or withdrawals from the original capital ; all operations
of any form whatever which come under the cognizance of
the accountant may be reduced to the following:

(a) Operations in which the kind of Goods owned is
altered by exchange of Goods of one form for other Goods
of equal value ;

(6) Operations in which the amount (value) of Goods
is either increased or decreased.

Furthermore, it is to be noted that a business transac-
tion may combine the two changes so that there is a third
class :

(c) Operations in which the kind of Goods owned is
altered at the same time that the amount (value) owned
is either increased or decreased.

These three classes of operations may be respectively
called: (a) Exchange or pure exchange transactions, (6)
Transactions affecting Proprietorship (or Profit and Loss
transactions) and (c) Mixed transactions.



DOUBLE ENTRY BOOKKEEPING 3

Exchange transactions evidently do not alter the value
of either member of the original equation. If the propri-
etor buys 25 horses for $2,500 cash his books no longer
show :

Cash $5,000 Proprietorship $5,000, but

Cash $2,500 -f Horses $2,500 = Proprietorship $5,000.

So with any subsequent transactions which involve the
exchange of goods of equal value, it is evident that there
can be no change in total value.

This may be expressed algebraically : If like values are
both added to and subtracted from one member of an
equation, the value of the equation is not altered. In this
case the original equation takes the form

Cash $5,000 -f Horses $2,500 Cash $2,500 =
Proprietorship $5,000.

Transactions which involve a pure exchange take place
whenever goods are purchased or whenever they are sold
at cost price : where cash is deposited in the bank or other-
wise invested; and in debt transactions to be considered
later.

On the other hand, it is true that any transaction com-
ing under &, changing as it does the total value of the
Goods owned, must be accompanied by an equivalent change
in the value of the other member of the equation. For
instance, if the proprietor in the case mentioned should
lose ten horses by death, there would no longer be the
equation

Cash $2,500 + Horses $2,500 = Capital $5,000
for the Goods now owned are Cash $2,500 -j- Horses $1,500
which do not equal the original Proprietorship of $5,000.

In order to represent the correct position produced by
the loss of the horses there must, therefore, be an equiva-
lent change made in the member representing Proprietor-



4 MODERN ACCOUNTING

ship. The disappearance of the horses was at the same
time a diminishment of the amount the proprietor was
worth. This may be expressed algebraically by subtract-
ing from the original equation another equation represent-
ing the loss of horses, thus :

Cash $2,500 + Horses $2,500 = Proprietorship $5,000
Horses 1,000 = Proprietorship 1,000

Cash $2,500 + Horses $1,500 Proprietorship $4,000.

On the other hand, if the proprietor rents his horsea
receiving therefor $100 in cash his statement will then
show Cash $2,600 and $2,500 worth of horses. This will
be correctly shown if to the original equation is added an*,
other equation representing the change produced by the
rent transaction thus :

Cash $2,500 + Horses $2,500 = Proprietorship '$5,000
Cash 100. = Proprietorship 100.

Cash $2,600 + Horses $2,500 = Proprietorship $5,100.

Transactions which thus affect the total value of the
goods owned, and necessitate a change in Proprietorship
occur :

(1) Whenever goods are surrendered without receiving
an equivalent value in exchange. This occurs when there is
a payment of expenses in distinction from a purchase of
goods ; when there is a loss, or when there is a withdrawal
of cash or other property by the proprietor, and

(2) Conversely whenever additional goods are obtained
without a corresponding exchange, as when clear profits
are received, or further contributions are made by the pro-
prietor. 1

1 The purchase of goods on credit does not come under this head but
is an exchange transaction. The obligation to pay the debt, given to
the vendor is a Good given in exchange. At present, however, only
rash transactions are considered, debts being discussed later.



DOUBLE ENTEY BOOKKEEPING



All the principles of double entry bookkeeping can be
observed in an extremely simple set of accounts. This may
be illustrated by a set in which only the most rudimentary
differentiation is made in the Goods, Cash being placed in
one account in contradistinction to all other goods which
are included in another account. In such a system the
accounting of a trader who (1) starts in business with
$5,000 cash, (2) buys 25 horses for $2,500 and a farm for
$2,000, (3) loses 5 horses by death, (4) Brents his horses
for $100, and (5) sells the remaining 20 horses for $3,000
will appear as follows:

FORM 1.



TRANSACTION.


Cash
Account.


Miscellaneous Assets
Account.


Proprietorship
Account.


Starts business v;ith cash
Buys horses and farm
for cash


+ $5,000
4,500


+ $2 500 (Horses)


= +$5,000
=


5 horses die




+ 2,000 (Farm)
500 (Horses)


= 500


Rents horses for cash . . .
20 horses sold


+ 100
+ 3 000


2,000 (Horses)


= + 100
- + 1 000










Closing condition


$3,600


+ $2 000 (Farm)


- + $5 600











The differentiation here made, between cash and all
other goods is an important one because Cash is, in many
respects, the most important form of Goods and also (or
therefore) most likely to be stolen unless carefully ac-
counted for. But in any practical set of books there is of
course further classification of the Goods.

"Where sales are not all for cash the account, perhaps,
aven more important than the Cash account is one indi-
cating the amounts due from customers. This is especially
necessary where the bill is merely charged up against the
customer's account, there being no other evidence of the
debt than that furnished by the trader's books. A primi-



6 MODERN ACCOUNTING

live form of such an account is the slate on which the vil-
lage tapster " chalks up the P's and Q's " consumed by
his regular patrons. But in any systematic business, ac-
counts must be kept showing claims of all kinds, both the
charge accounts and those evidenced by notes given by
the customer. These latter can again be divided into se-
cured and unsecured, foreign and domestic, time and de-
mand, or any other classification appropriate to the char-
acter of the business transaction. Thus the differentiation
is continued, real property separated from personal, mer-
chandise distinguished from plant, and still further sub-
divided into different classes as for instance, dry goods
and groceries, each of these divided into groups such as:
silk goods, linens, notions ; flour, tea and coffee, sugar, and
thus indefinitely according to the nature of the business,
the taste of the proprietor and the particular purpose for
which the accounts are kept. No rule can be laid down as
to the degree to which ramifications may be made, as each
additional subdivision gives to the proprietor additional
information valuable in the conduct of the business. The
only limit is that at some point, varying with the particu*
lar business, the expense of getting the additional infor-



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