Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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loosely termed. In this, too, the total Debits necessarily
4 35


equal the total Credits as the smaller of each pair of items
has been subtracted from each column, and the sum of
$34,660 being thus taken from equals leaves equal remain-

Such a Balance must exist at any time in books which
are free from errors. But as books are kept, though they
must at any time thus balance, the statement which is
made by the Trial Balance would ordinarily be incorrect
in matter and incomplete in form. Incorrect in matter
because of the presence of mixed accounts, such as the
merchandise account, which give the excess of Credits over
Debits but do not indicate the value of merchandise on
hand, nor exhibit the profit on goods sold. Assuming in
the case given that an inventory shows the merchandise to
be worth $4,000 there is an error of $3,000 which must be
adjusted both in the Merchandise and in some Proprietor-
ship account, normally by crediting Profit and Loss.
There may also be further inaccuracies because other ac-
counts show only the amount of expenses paid or profits
received and not the total incurred or accrued. Thus the
amount of interest or rent appearing in the books does not,
except by chance, indicate the charges actually incurred
during the period covered by the accounts, but merely the
amount which has been paid, which may be either greater
or less than the amount properly chargeable to Profit and
Loss. In the case given it may be assumed that the rent
item of $150 was for six months; but that at the time of
balancing three months more have elapsed on which rent
is accrued but not yet paid, so that there is altogether $225
rent chargeable against the profits of the period. This
simple illustration is, of course, capable of the widest ex-
tension, for in a large concern the unadjusted accounts are
frequently of decided importance.

The Trial Balance is incomplete in form because it
shows several items indicating profit or loss, and these have



not been combined into a single account, so as to present
the facts in a way easily to be understood. A Trial Bal-
ance fails to concentrate the various temporary, subsidiary
accounts which indicate changes in Proprietorship. This
must be done by closing these accounts into the Profit and
Loss Account which then shows :


FORM 18.
Profit and Loss.


General Expenses $1,400

Rent 225

Balance 1,475


On Merchandise Sales $3,000

Commissions 100

Balance... ..$1,475

If the changes here indicated are made in the ledger
there then results a true Balance Sheet which may be pre-
sented in the following form:


FORM 19.
Balance Sheet.


Cash $1,000

Merchandise 4,000

Bills Receivable 12,000


Bills Payable $5,000

Rent Due 75

Proprietor's Account 11,925


The Balance Sheet then differs from a mere Trial Bal-
ance in that correct figures have been introduced through
the inventory and the subsidiary, temporary accounts have
all been gathered together and combined with the more
permanent Proprietorship account. In the instance given
here all is combined in one Proprietor's account, as is
customary in the accounts of private traders. Where a
corporation is concerned the net profits are not added to


the Capital account, but may be stated in a single credit
to Profit and Loss, or perhaps by credits to Surplus, Re-
serve, etc., as shown in later chapters.

The gathering together of all the changes in net wealth
and their condensation into one account presumably takes
place in the ledger itself as well as in the statement known
as the Balance Sheet. It is done by transferring the bal-
ance formerly standing to the debit of Expense to Profit
and Loss; that is, by Debiting the latter and Crediting
the former account. Similarly with the other accounts
concerned, and finally the balance showing in Profit and
Loss is itself transferred by an identical process to the
Proprietor's account. When this is done a trial balance
taken from the ledger corresponds exactly with the Bal-
ance Sheet given above. There are no longer any balances
standing to temporary accounts; there are no longer any
incorrect balances due to the inclusion of mixed accounts.
But this condition is but momentary and as soon as trans-
actions are again recorded the Trial Balance no longer
presents a statement at once correct and condensed. But
it is, of course, possible to prepare a Balance Sheet from
the data obtained from the ledger, supplemented with an
inventory or other estimate of values, without making the
changes in the ledger accounts.

The condensation and combination shown in the Balance
Sheet given above applied only to Proprietorship accounts.
A somewhat similar grouping of the accounts representing
Goods, both positive and negative, may be performed for
the purpose of making the showing of the Balance Sheet
more perspicacious. Thus the ledger may contain a num-
ber of different accounts of individuals who are debtors.
It were foolish to list these individually in the Balance
Sheet and so they may be subsumed under the title Ac-
counts Receivable, although in the ledger each debtor has
a separate account. Or a bank, while carefully distin-


guishing in its own books between the amounts deposited
with each of its several correspondents, in its Balance
Sheet may not only combine these but may write them with
the actual cash on hand under the single title " Cash on,
hand and on deposit." The Balance Sheet then not only
shows a statement condensed to .correspond to the ledger
after that has been altered by the changes periodically in-
troduced, but may go further in the process of condensa-
tion combining accounts which are kept separate in the

To sum up : A ledger as kept from day to day shows
both Debits and Credits in both permanent and temporary
accounts, and contains incorrect amounts in the mixed ac-
counts, and unadjusted accounts such as " Interest Pay-
able." A trial balance of these footings, or of the balances
would indicate whether the book as a whole balanced, but
would give a poor survey of the condition of the concern,
To make a clearer exhibit there should be a consolidation
of accounts, a correction of the mixed accounts by the in-
troduction of the inventory, an adjustment of accruing
expenses and income, a closing of the subsidiary accounts
into the general Profit and Loss account. A list of the
ledger balances after this has been done would be a Bal-
ance Sheet. But in the approved form still greater sim-
plicity may be secured by grouping together similar items
and the cancellation of certain positive and negative items
even where these processes are not performed in the ledger.

In the preceding chapter was sketched the development
of a scheme of accounts from an ideally simple, but un-
serviceable set of three accounts, to one which by the
division and subdivision of different classes, and the sepa-
ration of the Debit and Credit sides of a single account
into independent accounts, secures a mass of detail neces-
sary to the thorough understanding of the business oper-
ations. The formation of the Balance Sheet is the reverse


process. From a mass of details in which the forest is
hidden by the trees, there is prepared by synthesis and
simplification a statement in which the main facts are pre-
sented succinctly and intelligibly. The process of differ-
entiation and integration has no fixed limit. It is carried
on so long as it proves economically justifiable. The re-
verse process involved in the preparation of a Balance
Sheet, similarly has no absolute limit. For its daily rou-
tine, a bank, for instance, needs to have accounts showing
the amount due to each individual; for other purposes it
may desire to show separately its " Savings deposits," its

41 Time Certificates," its " Checking Accounts," etc., for
still others a single item " Amount due Depositors " suf-
fices. The purpose for which the Balance Sheet is prepared
determines the extent to which condensation is to be car-
ried and the form in which it is to be presented.

The advantages of the Balance Sheet being obvious, it
seems strange that its use was so long delayed. In the
earliest treatises the taking of even a trial balance of foot-
ings was not suggested as a means of verifying the correct-
ness of postings. That was, done by carefully checking
ach Debit entry with its corresponding Credit and when
everything checked off the ledger was assumed to be cor-
rect. Nor were the ledgers balanced at regular or frequent
intervals. Of early account books still extant one was not
balanced at all in nine years, another not until the end of
twenty-seven years. Early trading being largely of the
nature of separate ventures, the sending of a caravan to
one place or a ship to another, profits were reckoned sepa-
rately on each completed venture. But those still uncom-
pleted, the ships not yet come in, were left out of account.
Hence it was not necessary to balance the ledger as a
whole, and the practice recommended by Paciolo of bal-
ancing only when a new book was opened seems to have
been generally followed by trading companies. The Brit-


ish East India Company prepared a general balance in
1665, but not again until 1685. The French ordonnance of
1673, however, required an inventory and Balance Sheet
each two years and in a treatise by Schurtz in 1695 a quar-
terly balancing of the ledger is inculcated.

In recent times the preparation of an annual Balance
Sheet is nearly universal. It is required by law in Eng-
land, France, Germany, and other countries of all corpo-
rations. And while in the United States there are few
legal requirements in regard to the form of accounts, yet
certain classes of corporations which are regulated by law,
such as banks, insurance companies, and public utility
companies, frequently are required to submit statements
including Balance Sheets to state or federal officials. The
Interstate Commerce Commission, under authority of the
amended law of 1906, has prepared a form for the Balance
Sheet to which all railroads under their supervision must
conform. A Balance Sheet in this form is given on page 59.
The Massachusetts business corporation law of 1903 also
provides a form of Balance Sheet to be annually prepared
by all corporations within the State.

A Balance Sheet being a summary of the ledger must
contain two groups of figures, showing respectively Debit
and Credit balances. Usually these two groups are ar-
ranged in parallel columns, similar to the conventional
arrangement of a ledger account. Indeed in earlier days,
and even to-day in continental countries, the Balance Sheet
is in fact a ledger account, all of the accounts being actu-
ally closed out and their balances transferred to a " Bal-
ance Account " which, of course, itself balances. When
this is done the ledger is actually closed, no outstanding
balances any longer appearing to the Debit or Credit of
any account. English and American bookkeepers long ago
tired of the useless work of actually closing the accounts
in the ledger, necessitating as it does the immediate re-


entering of the items in new accounts. The Balance Sheet
is now prepared as an outside abstract of the ledger rather
than as an actual ledger account.

Some confusion is, however, caused by divergence in
practice in regard to the relative position of the column
containing ' ' Asset ' ' items and ' ' Capital and Liabilities ' '
items respectively. The general custom throughout the
world is to place the asset items in the left hand column.
But in England the reverse is customary, and asset items
appear in the right hand column. Much discussion has
taken place on this point. The chief argument against the
English custom is that it is at variance with the practice of
the rest of the world, even Scottish accountants not follow-
ing the English model, and it seems also to be at variance
with common sense, that a summary of the ledger should
reverse the accounts from the position which they hold in
the ledger itself. On the other hand it is urged in sup-
port of the English practice that the Balance Sheet is not
in itself a summary of the ledger but an account sub-
mitted by the company or by the directors to the stock-
holders, for which purpose it is, of course, actually pre
pared. As such it is logical to charge the directors with
the capital and other funds furnished to the company and
to take credit for the assets on hand, which at the time of
the report are constructively tendered to the stockholders
in satisfaction of the account.

The extended debate on the subject seems largely a
logomachy, and doubtless no one ever was misled by the
divergence in practice. Uniformity is however desirable,
and even among British accountants there is much opposi-
tion to this national idiosyncrasy. " The custom seems to
have arisen," says Lisle, " through the influence of the
forms given in Acts of Parliament, chiefly the Companies
Act, 1862, which must have been prepared by those unac-
quainted with the theory of accounts. The Profit and Loss


Account is taken from the Ledger, and the sides are not
transposed, and there is no logical reason why the sides in
the Balance Sheet should be reversed when the items in it
are supposed to be the balances remaining in the Ledger,
after certain balances have been taken to the Profit and
Loss Account. ... It is certainly most desirable that the
form of Balance Sheet with the assets on the left side which
is founded on correct principles, should become universal,
conforming to the best traditions and the accepted practice
of the rest of the world. ' '

Technically expressed the difference is that the British
Balance Sheet is the opening balance account, while the
rest of the world uses the ' ' closing balance ' ' account. As
shown above, in the formal method of balancing, all ac-
counts are closed into a balance account on the debit side
of which appear the debit balances of the various ledger
accounts. But in this system the accounts must imme-
diately be reopened, which is also done by means of a Bal-
ance Account, the " Opening Balance." The new asset
accounts, " Cash," " Merchandise," etc., being debited
with the outstanding balances, a corresponding credit is
made in the Balance Account, which evidently is identical,
save that the sides are reversed, with the " Closing Bal-
ance " account. But it is difficult to find any logical pref-
erence for the account showing the opening of the new
year over that showing the momentarily antecedent closing
of the old year.

Still further divergence exists in regard to the title to
be given the two sides of the balance sheet. That contain-
ing the assets is frequently headed " Assets " or " Re-
sources." The other side has perhaps most frequently
been entitled " Liabilities." To this much criticism has
been made on the ground that the Capital or Proprietor-
ship accounts, which in many cases are the most important
are, strictly speaking, not liabilities of the company, still


less of the individual proprietor. To avoid this difficulty
the title " Capital and Liabilities " is often used.

Other accountants prefer to head the two sides Debit
and Credit, as an ordinary ledger account or account cur-
rent is headed. But the application of the terms Debit
and Credit offers an additional difficulty where the Eng-
lish form of Balance Sheet is adopted. It is a well-nigh
inviolate convention (but only a convention and not, as
claimed by many writers, a principle) of double entry
bookkeeping, that the left hand column is called " debit."
But another sacred convention is that assets are ' ' debits. ' '
When he finds the assets in the right hand column the ac-
countant is indeed perplexed. Shall the right hand column
be called Credit because of its position or Debit because
of its content ? Practice, for here as elsewhere in account-
ing there is no absolute authority, varies. Thus the head-
ings and position of the two columns of this most impor-
tant accounting form, show, in good usage, the following
variations :

Assets Liabilities

Resources Liabilities

Liabilities Resources

Liabilities Assets

Debit (Assets) Credit (Liabilities)

Debit (Liabilities) Credit (Assets)

Credit (Liabilities) Debit (Assets)

Active Passive.

It thus appears that there is not merely divergent usage
as to the position of the asset items, but that these assets
are sometimes called Debits and sometimes, as for instance
in the Balance Sheet of the Bank of France, Credits, and
sometimes the first column not only contains the liabilities
but is labeled Credit.

The headings " Active " and " Passive " deserve fur-


ther mention. They are given to the two sides of the Bal-
ance Sheet by practically all the world except the English
speaking peoples. Reason as well as custom gives prefer-
ence to them over the other simple descriptive titles, .for
the one side of the Balance Sheet sometimes contains items
which are not assets or resources while the other side
always contains items which are not liabilities, and fre-
quently includes those that are neither liabilities nor
capital. Debit and Credit too are undesirable as being
technical but not significant. English and American ac-
countants have nevertheless been loath to adopt this better
nomenclature. It is recommended by Sprague in his val-
uable treatise " The Accountancy of Investment," but it
is practically unknown in balance sheets published in the
United States.

A slight variation in the forms given above consists in
using the phrase " Capital and Liabilities " in place of
the single word Liabilities to designate one side of the
Balance Sheet. By many accountants this is considered
an important improvement. It certainly has the advan-
tage of more completely describing the contents of the
column, and removes the confusion which arises from
treating the proprietors' capital as though it were legally
a liability.

As the Balance Sheet is designed to give an intelligent
synopsis of the business it is evidently advantageous not
only to consolidate ledger accounts of an identical nature
into a single collective account, as the sums due from vari-
ous customers are subsumed under the title " Accounts
Receivable " but also to group the various items, which
while differing enough to be kept separate, have certain
similar characteristics. Thus while Accounts Payable and
Bills Payable are separately shown it adds to clearness to
have them appear near each other in the Balance Sheet.

Subheads are frequently introduced into Balance



Sheets to make more clear the grouping of items. The
particular terms thus used vary according to the taste of
the accountant and the nature of the corporation. In a
grpuping coming into considerable use the headings are:
Capital Assets, Current Assets, and Deferred Assets, with
a similar division of liabilities. By Capital Assets is here
meant the permanent plant of the corporation, presumably
purchased with the proceeds of the Capital Liabilities
that is, the stock and bonds. Current Assets are cash,
realizable securities and accounts, or merchandise or mate-
rial to be currently consumed. On the other hand Current
Liabilities are those that are not permanent or funded.
Deferred assets generally represent expenses paid in ad-
vance. Their inclusion among assets is discussed in Chap-
ter V. This classification is used for instance by the
Chicago and Alton Railway.

The grouping of similar items leads to the marshaling
of the entire list in some systematic order. This is espe-
cially the case in regard to the assets, where the system
generally used is based on the degree of ease with which
they may be converted into cash; or, in ether words, the
assets are ranked according to their liquidity. At one end
of the scale is cash in which liquidity is perfect, on the
other end those assets which cannot be realized at all
while the business continues its existence, as perhaps the
roadbed of a railroad or the good will of a factory. But
disagreements appear as to whether the proper order is
from liquid assets to fixed, or from fixed to liquid. Stated
concretely the question is whether the list of assets should
begin or end with cash.

The argument in favor of showing Cash first among
the assets is perhaps a little forced, for it rests on the
false assumption' that cash is in all cases the most impor-
tant item. It is true that in some institutions, for instance
a commercial bank, cash on hand is the most significant of


the assets, showing the ability of the bank to meet a sud-
den run. It may even be true that cash is generally more
important than any other item of similar amount, but it
seems a gross perversion to say that in a railroad the rela-
tively small amount of cash is more important than the
great fixed plant. Even an insurance company must
surely attach more importance to its many millions of
investments than to its cash, for unlike a bank the demands
made upon an insurance company are such as to give time
for realization of assets. Foreign accounting practice
seems to recognize the varying importance of cash in dif-
ferent classes of institutions. Thus in Austria and Ger-
many the Balance Sheets of banks very generally give
cash as the first of the assets while in those of industrial
corporations cash appears farther down the list. In the
United States and England n the contrary, it is very
unusual to find cash listed nrst either by banks or other

Strict consistency compels a marshaling of the liabil-
ities similar to that of the assets. Convenience of inspec-
tion certainly demands that similar assets and liabilities
appear opposite each other. Cash is naturally compared
with the liabilities on which immediate payment may be
demanded. Yet strangely some accountants who place
cash at the beginning of the assets do not change the con-
ventional order of the items on the other side but head
the list with the permanent item Capital. This results in
the juxtaposition of Cash and Capital Stock, items which
in a growing concern have the least possible connection
with each other. One may, perhaps, not insist on cash
coming first. Even in a bank statement, one is habituated
to look at the last item as the most significant of the assets.
But certainly strong objection is to be made to having a
different order of arrangement on the two sides of the
balance* sheet. Occasionally consistency in this respect is



found in Balance Sheets. That of the American District
Telegraph Company of New Jersey may be mentioned, in
which the assets run from Cash to Plant, and the liabilities
begin with Bills Payable and end with Capital and Sur-

Another variation in the form of the balance sheet is
that prescribed for the so-called parliamentary companies
of England, and known as the Double- Account Balance
Sheet. An example is as follows:


FORM 20.
Capital Account.


Cost of property 195,000

Balance 5,000


Share capital 100,000

Debentures 100,000


General Balance Sheet.



Capital account, balance. . 5,000

Bills payable 10,000

Profit and loss 3,000


Materials, etc 4,000

Cash 6,000

Accounts receivable 8,000


It is to be noticed that the Balance Sheet proper does
not contain the entire outstanding capital but merely the
portion of the capital receipts, including receipts from
funded debts, which have not been expended in acquiring
the company's plant. Nor does the Balance Sheet itself
include the plant in the asset column. Information on
these points is gained from the accompanying capital ac-
count, the balance of which is brought down as a liability
in the General Balance Sheet.

The origin of this peculiar arrangement is that the law



governing such companies provides that the money re-
ceived on capital account, that is, from subscription to
shares or from sales of debentures, etc. may be used solely
for investment in the plant of the company, and the
Double Account Balance Sheet is designed to show how
far this requirement has been fulfilled. This form is
rarely used in American practice but it has practically

Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 4 of 27)