Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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ment of crediting the premium at once to Profit and Loss
is manifestly incorrect, for the premium is in no sense
profit and least of all profit of the single year in which it
is received. The apportionment of premium between the
years is most scientifically done on the basis of the declin-
ing value of the annuity which it represents, according to
the method described in discussing the valuation of invest-

Exactly the same principle applies to bonds issued at
a discount, just as the same principle applies to bonds
bought below par. The discount should appear at first
among the assets, but should gradually be written off as
the years pass, thus making the annual charge to interest
correspond to the real rather than the nominal rate paid.
This practice is frequently met with as, for instance, in
the accounts of the Lackawanna Steel Company, and the
Chicago and Alton Railway. At times the annual charge
is based on the actuarial estimate of the value of the an-
nuity, at times merely divided into equal annual charges,


at times, still less scientifically, but even more conserva-
tively charged off much more rapidly, or even all charged
off to expense in the first year.

Among American Railways, however, the custom is to
charge discount on bonds to the construction account.
The temptation to do this is great, as in the early years of
a railroad's life the burdening of the income account with
any additional charges is, of course, unpleasant. But curi-
ously enough this practice is justified by many writers,
among whom may be mentioned T. L. Greene and Rehm.
Greene makes the statement absolutely, as applying to all
discount on bonds issued. Rehm more cautiously applies
it only to the discount on bonds whose nominal rate is
equal to the current market rate, or to that part of the
discount which represents a rate higher than the market.
The argument in favor of this is that the discount repre-
sents, at least in so far as it makes the actual rate paid
higher than the current market rate, an additional cost
of the road, a cost due to the lack of credit. Thus if five
per cent, is deemed the normal rate, the discount on a four
per cent, bond necessary to make it net five per cent, repre-
sents interest; but discount on a five per cent, bond, or
discount on the four per cent, bond in excess of 12.46,
represents not interest, but the cost due to poor credit.

But such a differentiation is extremely difficult to ap-
ply. All that one can confidently assert, in the case as-
sumed, is that the market rate for a twenty-year bond of
this particular company is five per cent., while the nominal
rate was made four per cent. Furthermore, the charging
of discount to construction results, in the absurdity of
making the road cost more the longer the bonds have to
run. In the case mentioned for each million dollars re-
ceived from bonds and expended on construction there
would need to be added some $140,000 for discount, but
had similar bonds running fifty years been issued, for each


million thus provided there must be added approximately

To be consistent, those who argue that discount due to
deficient credit is part of the cost of construction should
go further and increase the cost annually whenever the
company pays more than the normal rate. The company
whose poor credit forces it to pay 11.47 per cent, discount
on a five per cent, bond, could have sold a six per cent,
bond at par. But this would necessitate an annual pay-
ment of one per cent, additional interest above the normal
market rate. Why should not this annual payment be
charged to cost of construction if the equivalent and alter-
native payment of 11.47 per cent, once for all is thus to
be charged? Yet no one of those writers who attempt to
differentiate between discount due to a subnormal nominal
rate, and discount due to deficient credit, advocates such
a practice. The Interstate Commerce Commission at-
tempts 'the difficult distinction between discount on securi-
ties and commissions on their sale. The former is held
not to be properly included in the cost of property, the
latter may be.

Occasionally bonds are issued repayable at a premium.
Where such repayment is optional on the part of the bor-
rower the provision for the premium is in the nature of
a special reserve. If, however, the repayment at the pre-
mium is accepted as part of the financial policy of the
concern, the premium as well as the par value of the bonds
becomes an obligation and should appear in the Balance
Sheet. The two elements may, however, be kept separate.
Where bonds thus redeemable at a premium are sold at a
price other than the redemption figure, the difference be-
tween the two should be treated just as premium or dis-
count on bonds redeemable at par are treated.

The treatment of bonds authorized but not yet issued
is not different in principle from that of unissued stock,


already discussed. Any one of the alternative forms given
on page 148 may be applied to such bonds. But, as in the
case of stock, if the unissued bonds appear in the Balance
Sheet among the assets, the nature of such holdings must
be clearly shown. It is illegitimate to include them with
outside investments under a general heading, " Invest-
ments," or " Bonds and Stocks." Where the unissued
bonds are secured by a lien on specific property there is
additional justification in including them among the as-
sets rather than in merely deducting them from the out-
standing debts. The property pledged to secure the bonds
gives them a somewhat independent value, and makes them
perhaps an available asset even in the case where the com-
pany is in a poor financial condition.

Furthermore, bonds, unlike stock, may, in the absence
of special legislation, be freely issued below par. Hence
it is not important to distinguish in the case of bonds, as
it is in the case of stock, between those which are unissued
and those which have been reacquired.

But in any case the most complete and hence the most
satisfactory way of presenting all the facts is to exhibit
the unissued bonds on both sides of the Balance Sheet.
This treatment is found, for instance, in the Balance
Sheets of the Chicago and Northwestern Railway, and may
be simply illustrated as follows:

FORM 72.
Dr. Balance Sheet. Cr.

Miscellaneous Assets
Bonds of Company held

in Treasury $50,000

etc., etc.

Bonded Debt

Outstanding $100,000
Held in

The treatment of bonds purchased in the market is sim-
ilar to that of stock thus purchased and held in the treas-


ury. The purchased bonds may, however, at any time be
canceled and the outstanding debt thus ' reduced without
any further formality, while the purchase of its own stock
by a company does not in itself work a reduction of the
nominal capital, to accomplish which certain legal pro-
cedures must be followed. A distinction should be made
between a bond redeemed, especially where it is formally
canceled, and one merely bought on the open market and
held in the treasury as a live bond. Where the former
takes place it must disappear entirely from the Balance

The showing of contingent liabilities, that is of liabili-
ties for which the proprietor may be held under certain
contingencies but which he never expects to have to meet,
is a perplexing problem. An illustration is where a manu-
facturer sells machinery with a guaranty. Ordinarily
such an obligation to indemnify the purchaser in case the
machinery fails to render proper service does not show
in the books at all, and yet it may constitute an important
fact in determining the financial status of the manufac-
turer. Probably the best way of treating such a transac-
tion is by establishing a special reserve to provide against
an uncertain contingency, rather than to treat it as an
absolute liability. More simple is the case where accep-
tances or indorsements are given as an accommodation to
trade associates. This, of course, constitutes a real liabil-
ity and should at once appear on the books of the indorser,
being offset by an asset representing the claim against the
one who has been accommodated. Again funds may be
raised by indorsing and rediscounting trade paper, in
which case the obligation is not incurred as a mere accom-
modation but as a regular business transaction. Pecul-
iarly enough, in ordinary bookkeeping, such obligations are
customarily omitted. The discounting of the trade paper
formerly held cancels that item from the books and noth-


ing further appears to indicate a possible obligation. This
is in contrast to usage in transactions, which at heart are
identical, that is, where funds are obtained on the prom-
isor's own note, secured by trade paper as collateral.
Where this is done the custom is to show the trade paper
still among the assets and the collateral note itself as a lia-
bility. But whether the funds are secured by indorsing
the trade paper and rediscounting it, or by hypothecating
it as collateral does not affect the real position of the bor-
rower. Yet it is exceptional to exhibit the liability as
indorser on rediscounts, the usage of National Banks being
the most prominent example.

A dividend which has been declared becomes at once a
liability of the company and must accordingly be shown in
the Balance Sheet. This corresponds with the legal posi-
tion, for while undivided profits are not a liability of the
corporation, and the stockholders have no right to compel
their distribution, the declared dividend is an obligation,
for which, in case of bankruptcy, the stockholder has the
same rights that any other creditor has against the com-
pany. Undeclared dividends do not appear at all on the
books, unless in the case where there are cumulative pre-
ferred dividends in arrears. The position of such divi-
dends is somewhat unique. So far as the company and the
preferred stockholders are concerned there is no obligation
to pay, indeed the company cannot pay unless profits are
earned. But from the view point of the common, or de-
ferred stockholder delinquent cumulative dividends on
preferred stock are a liability which must be met before
anything can be paid to him. Consequently there is a
good argument for making an exhibit of the amount in
arrears. Practice is, however, not uniform on this point.
Perhaps the best treatment is to follow Pixley's suggestion
that they appear in an appendix to the Balance Sheet
rather than in that statement .itself.


The provision for pensioning employees raises a ques-
tion as to whether there exists a liability which should ap-
pear in the Balance Sheet. An agreement definitely made
to pay pensions is nothing more than one way of paying
wages. In order to apportion charges properly between
years, the amount necessary to provide for future pensions
must be counted among the expenses of each year ; and th&
corresponding sum is a real obligation payable to employ-
ees some time in the future. Evidently in such a case to
omit such a liability from the Balance Sheet is incorrect.
But if the provision for the pensions is not a definite mat-
ter of bargain, but is rather an optional beneficence of the
proprietors, the accumulated fund is of the nature of a re-
serve rather than a liability. In some cases, where the
pension system is well established the annual appropri-
ations thereto are paid to trustees who hold them, and
the accumulations thereon, in trust for the beneficiaries.
In such cases both the assets and the liability entry may
properly be left entirely out of the accounts of the com-
pany. Here the payment of wages consists of two parts,
one paid currently to the workman, the other paid to his
trustees. After such payment the company need, in
neither case, make further accounting. The treatment of
pensions therefore depends on the exact legal nature of the
pension agreement, and on the financial policy adopted in
its administration.


DICKINSON, A. L. Interest and Sinking Funds. Accountant, XVII,

p. 715.
PIXLEY, F. W. Auditors, their Duties and Responsibilities, I, pp.

351-357. Ninth edition. London, 1906.
REHM, H. Loc. tit., pp. 272-342, 477-493.
SIMON, H. V. Loc. tit., pp. 173-201. [The last two authors

present opposing views of the nature of discount on



THE Profit and Loss Account, called also Revenue,
Income, Loss and Gain and other similar names, is a tem-
porary, collective account, recording the changes in net
wealth due to the business operations of a stated period.
In some cases it indicates, as well, the disposition which
has been made of the net profits. It is temporary, as it
covers only a given period, usually the fiscal year, and is
in the end closed out, in partnerships by being divided
between the proprietors' accounts, in corporations by
transference to Dividends, Reserve, Surplus, or other simi-
lar accounts. It is a. collective account in that it embraces
the balances shown by other subsidiary ' ' Proprietorship ' '
accounts, such as expense or the various subdivisions there-
of, and the various accounts indicating profits received
during the year, such as Merchandise, Interest, Rent. It
shows changes in net wealth and is therefore subsidiary
to the Capital, or other main proprietorship accounts. It
shows not merely the net wealth as a single sum, nor
the accretions of wealth during the entire previous busi-
ness career, as distinct from the original capital, but as
well, just w T hat changes in the net wealth have been
brought about during the fiscal year. It shows, properly,
changes due to business operations, not those due to other
causes, although here the line is uncertain and practice

Like other accounts it contains two sides. On the one
are entered items, of which Expense is the type, whose
!4 195


effect, per se, is to indicate a diminution of net wealth.
On the other side appear items which indicate an increase
in net wealth. The debit side may, in addition, contain
not merely expenses and losses, but also the disposition,
or allocation of the net profits, which sometimes, as when
it shows dividends paid, indicates a reduction of the net
wealth belonging to the concern, but not a loss ; and some-
times, as when a sum is carried to Surplus or Reserve,
merely a technical bookkeeping transfer.

The purpose of the Profit and Loss account is, primar-
ily, to show the net profits of the concern for the period,
with special reference to the amount of net profits avail-
able for dividends. This may at times be derived from
the Balance Sheet, indeed some writers, of whom Rehm
is a prominent example, claim that the prime purpose of
the ordinary Balance Sheet is to exhibit profits available
for dividends. But in practice this is not true, and in
any case the Profit and Loss account by its greater ex-
plicitness and completeness is a valuable adjunct to the
Balance Sheet, so that the two statements are generally
published together, as being mutually complementary.

If a distinction is to be made, it may be said that the
Balance Sheet interests more particularly the creditor,
the Profit and Loss account the proprietor or stockholder.
The depositor in the bank finds in the former the com-
parison between deposits and cash reserves, the nature of
investments, and the amount of guaranty, facts all of
which affect his determination as to continuing his ac-
count. The wholesale merchant learns from the Balance
Sheet of his customer the relation of assets to liabilities,
and the kind of each, and decides as to increasing the line
of credit. The stockholder, on the other hand, is interested
more particularly in profits, and the examination of the
Profit and Loss account should show him whether the stook
is a desirable investment. But the distinction here made


is only relative. The creditor is unwilling to continue to
trust a losing concern, and the investor will resist the
temptation to buy stock with high dividends, if these are
gained by doing a business with insufficient reserves and
imminent liability to bankruptcy. So, creditor and pro-
prietor alike need both Balance Sheet and Profit and Loss
statement to give the information desired in business nego-

Before considering more particularly the details of the
Profit and Loss account and the problems pertaining to it,
it is necessary to show' the connection between this account
and the various classes of accounts which were discussed
in the preceding chapters.

The Profit and Loss account being merely a subdivision
of the Capital account and indicating current changes in
the net wealth, it is evident that its connection with the
Goods accounts is most vital. Any changes in the net
value of the assets must, with certain exceptions to be
noted later, be reflected in the Profit and Loss account..
Consequently, any of the transactions previously discussed,
or any of the bookkeeping estimates which more or less
accurately portray transactions affecting the book value of
the assets, must also be represented in the Profit and Loss
account. Any change in the Goods accounts, representing
business changes other than mere exchange transactions,
must, in ordinary cases have a counter entry which is ulti-
mately included in the items posted to the Profit and Loss

The problems of Profit and Loss are generally, then,
not new questions but the same that have already been dis-
cussed. The valuation of assets (the problem of the inven-
tory) is clearly a question as to Profit and Loss, for changes
in the book value of assets mean corresponding changes in
the net wealth. The .question as to whether Organization
Expenses should go into the inventory is clearly a ques-


tion as to whether they should be kept out of the Profit
and Loss account. Depreciation, if established, must be
booked by a charge to Profit and Loss. Thus the Profit
and Loss account is merely another view of the general
problems of accounting, and much which has already been
discussed, while pertinent to the consideration of Profit
and Loss need not be repeated in this chapter.

Most of the charges made to the Profit and Loss ac-
count are unequivocal and undisputed. An expense is, in
most cases, easily recognized, and the necessity for charg-
ing expenses against Profit and Loss is generally not ques-
tioned. But there are two classes of cases in which a di-
lemma really arises as to whether a given item should
appear in the Profit and Loss account or elsewhere. In
the first class the alternative to entering it in the Profit
and Loss account is to include it among the Goods listed
in the inventory. In the second class the alternative is
the entry in the Capital account direct, or where that is
impossible because of the requirements of corporation law,
the entry into some subsidiary account showing that a
deduction should be made in the nominal capital, but one
which need not go through the medium of the Profit and
Loss account.

1. The first of these problems has been discussed in con-
nection with the inventory. Is the interest paid during
construction, is the expense of organization, a real loss,
something to be debited against profits, or is the payment
represented by an immaterial asset, or at least by a De-
ferred Charge, which for present purposes is to be con-
sidered as an asset? Was the money paid for improving
the road-bed properly an expense, or is it an added ele-
ment in the cost of construction and, as such, to appear
among the assets? Assets and losses, expenses and im-
provements, exchange transactions and those affecting net
wealth, are mutually exclusive conceptions. Determina-


tion that a disbursement was for one of these purposes
excludes it from the other, so that all this class of ques-
tions is merely a restatement of the problem of the in-
ventory already discussed.

2. The second alternative is, however, a new one. The
alternative to an entry in the Profit and Loss account,
is here an entry, not among the assets but in some other
of the accounts which have here been called " Proprietor-
ship " accounts. Exclusion from Profit and Loss does not
here force an inclusion in the other group of accounts,
representing assets. It means that an actual deduction in
net wealth has taken place and that, if this is not to ap-
pear in the account showing current business changes in
net wealth (the Profit and Loss account), it must appear
in some other of the same group, either in the Capital
account itself, or in some account, other than Profit and
Loss, which is subsidiary to the Capital account. In a
word, the question is whether all changes in net wealth
should go through the Profit and Loss account. Can capi-
tal be lost, without having such a technical loss as must
appear in the debit of the Profit and Loss account? May
there be an increase in the net value of the assets, repre-
senting a growth of capital, but not profits in the sense
that is meant by a Credit balance to the Profit and Loss
account ?

These two different classes of perplexing entries may
be illustrated by referring again to the fundamental equa-
tion of bookkeeping in which the total Goods, consisting
of plant and other assets, equal the total Proprietorship,
divided into original capital and profits, i. e.

Plant, etc., $100,000 -f- Cash $5,000 = Capital $95,000 -f
Profits $10,000.

In a preceding paragraph reference was made to instances
where cash is paid out, say for an improvement in the


road-bed. The dilemma consisted in the uncertainty
whether, Cash being thus diminished, the validity of the
equation is to be maintained by making an equivalent
addition to the other term of the Goods account, or by sub-
traction from Profits. In one case there results

Plant, etc. $101,000 + Cash $4,000 = Capital $95,000 +;

Profits $10,000,
in the other '."' ( '

Plant, etc. $100,000 + Cash $4,000 = Capital $95,000 +;
Profits $9,000.

But in the second class of doubtful entries there is no
question as to the lessening of total values. There has
been a decline, say in the value of the plant, amounting
to $1,000. The problem here is virtually whether the Bal-
ance Sheet should show:

Plant, etc. $99,000 + Cash $5,000 = Capital $95,000 '+
Profits $9,000,

or whether the correct statement would be either :

Plant, etc. $99,000 -f Cash $5,000 = Capital $94,000 -f
Profits $10,000,

or the equivalent expression:

Plant, etc. $99,000 -f Other assets $5,000 -f Losses $1,000
= Capital $95,000 + Profits $10,000.

In practice, a still different and incorrect treatment is
given to the transaction, which shows:

Plant, etc. $100,000 -f Other assets $5,000 = Capital
$95,000 + Profits $10,000,

despite the undeniable fact that certain values have really

This problem has been discussed at length by the
courts, but, unfortunately, not always from the view point



of accounting. It has perhaps been worked out most mi-
nutely in questions of probate, where a life interest in an
estate is left to one person while the body of the estate
goes to some other legatee. Here it is of vital importance
to distinguish between the income going to the tenant for
life and the body of the estate going to the remainder-man.
In this relation the conception has been introduced of
there being a growth or increase in the body of the estate
which does not constitute , a part of the income. Con-
versely there may be a loss of part of the principal without
effect on the income derived from the remainder. The
theory, while well worked out in detail in its application
to the settlement of estates, is recognized as being pecul-
iar to probate law, and while interesting to the account-
ant is not applicable to commercial accounts. Again the
matter frequently comes up in bankruptcy proceedings,
where the liability of directors, or of stockholders, to
creditors turns on whether a certain dividend paid was
really profit earned. In disputes arising between differ-
ent classes of stockholders, or in the suits brought by the
holders of income bonds, there has also frequently arisen
the question as to what constitutes profits. But in most
of these cases the decisions are not so conclusive as could
be desired. Oftentimes the decision turns entirely on the
construction of some special clause in the articles or by-
laws of the company, 1 or after a long discussion of vital

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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 15 of 27)