Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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the minimum required in any event, may be sold but-
only where the covered circulation is withdrawn. The
impossibility of realizing an appreciation of these addi-
tional bonds is less absolute than in the case of the re-
quired minimum holding, but here again the principle of
the going concern applies. The bank cannot 'continue the
note-issuing function and at the same time realize on the
bond premium. So here too the variation in market price
seems to be of no import. The same conditions exist in
regard to holdings of stock acquired by a railroad to give
it control in the management of another road or of some
allied enterprise. The market price of this stock may vary,
but such changes in value cannot be realized by the pur-
chasing company while it still continues to exercise the
function for which it acquired the stock that is, to con-
trol the other road.

In many cases, however, there is no such indissoluble
connection between holding some given security and the
maintenance of the business. Securities are held not be-
cause required by some provision of law, not for the sake
of controlling business nor even for the sake of income
alone. It is desirable to hold some funds as air available
reserve against emergencies and a low-rate marketable
security is somewhat less expensive and almost as service,
able a reserve as the bare cash. The sale of such securities
at the market price would not at all interfere with tho
business of the concern ; and the appreciation, as shown by
the market price, indicates merely that the reserve to-day
really contains more than the sum that was originally
invested. May not the inventory here rely solely on the


market quotation? Strict consistency would seem to give
an affirmative answer. On the other hand the .present
price is only one point in a fluctuating scale of market
prices and there is no ground for assuming that it will
be realized. If it has risen there is at least a possibility
that it will fall. The emergency that will call for the sale
of the securities is likely to be at the time of a monetary
stringency and hence of low prices, so that a high valua-
tion would be purely illusory. The attitude of statute
law and of the courts on this point is that where the secur-
ities are permanent holdings, disregard of market prices
is proper whether these prices are above or below cost.
This is clearly set forth by the English courts in Verner v.
The General and Commercial Investment Trust Limited.
([3894] 2 Ch. 239) where the distinction is made between
securities held as investments for the sake of the income,
and those carried as the stock in trade of a dealer in invest-
ments. In France, too, the Bank of France holds all gov-
ernment securities which were bought for permanent hold-
ing at cost price irrespective of market quotations. In
Germany, however, the law provides that the market price
is to be taken except where it is higher than cost price,
which is equivalent to saying that of the two prices, cost
and quoted market price, the lower is always to be taken
as the basis of the inventory. This provision of the Com-
mercial Code leads therefore toward conservatism at the
expense of logical consistency. In Austrian law the quoted
market price is always to be taken whether higher or
lower than the cost. The general practice of conservative
American accountants, especially in banks, insurance com-
panies and other fiduciary institutions, is in line with
German law, and favors marking down the investments
when the market price is below the cost price, but opposes
taking recognition, except in an explanatory footnote to
the Balance Sheet, of the appreciation due to a rising


market. Thus the New York Banking Department asks
banks to charge off the excess of book value over market
value of securities, but where the difference is slight or sup-
posed to be a mere temporary fluctuation, no attention is
paid to the variation. Occasionally in America both prac-
tice and law, as for instance the Maine Savings Bank Law,
adopt an even less logical rule that securities may not
be listed above par even though they cost a considerable
premium, but if costing less than par they are to be listed
at cost.

In the justification of listing permanent holdings at
cost it has been assumed that the lapse of time has, in itself,
worked no change in the serviceability of the security.
This is true only in case of permanent securities such as
corporation stock in this country, or the perpetual an-
nuities used by most foreign governments. Time differ-
ences may be ignored also in certain bonds which while
due at a definite time have so long a duration as to be
practically perpetual, the bonds of the West Shore Rail-
road running 475 years being an illustration. But wher-
ever an ordinary bond is bought at a premium it is to be
recognized that the purpose of this premium is to make
the nominal rate of interest conform to the market rate
for the given security, and is a payment in lump sum to
offset the receipts from future interest payments whose
rate is higher than the market rate. If the current market
rate is five per cent., a six per cent, bond running five
years will not be worth as much as a bond bearing the
same rate of interest but running twenty years. In one
instance there is, in addition to the normal rate of five per
cent., an annuity of one per cent, running for five years,
in the other case the annuity runs twenty years. To con-
tinue to list the bond in successive annual inventories at
its cost price is incorrect. At the time of purchase an esti-
mate is made of what rate the bond nets the investor, the


three factors of time, rate and price being considered.
Thus if 112.46 per cent, is paid for a bond running twenty
years and paying annually six per cent, interest it nets
the investor five per cent. In each successive inventory
the bond should be listed not at 112.46 but at the price at
which the bond with its shortened duration would net five
per cent., that is, at 112.08, 111.69 and so on until the
nineteenth year when its value is 100.95. Or, looking at
it in another way, the annuity of one per cent, running
for twenty years was estimated to be worth 12.46 per cent.
It is clearly faulty to consider a similar annuity running
nineteen, and a constantly diminishing number of years, as
worth the same price; but it should be estimated on the
same basis, that is, at such a price that it continually yields
the holder five per cent, interest. The figures for the
valuation of bonds of different rates and maturities are
easily obtained from tables of Bond- Values, many of which
are in the market.

The formula by which these values are obtained is
derived as follows :

Letting :

V n = the present value of a bond running for n inter-
est periods.

I = the amount of interest paid on each $100 at each
interest payment.

i = the rate of interest to be yielded the holder for each
interest period.

It is clear that the present value of the bond is made up
of a series of values composed of each coupon maturing
at successive periods and of the principal, assumed to be
$100, due at the end of the n years. But the first coupon
due in one period (for convenience the period will be

assumed to be a year) has for its present value - , the



coupon due in two years is worth at present that

I d + i) 2

in three years and so on until the last coupon which


is worth : . Adopting the conventional symbol

v then the entire series of coupons is worth at

1 -H 1 v n

present I (v -f v 2 + v 3 -f v 4 . . . + v n .) or I : . The


principal of $100, also due in n years, is worth 100 v n so

1 v n

that the equation reads : V n I \- 100 v n . This,


for the bond used as illustration in the text, would be


" (1.05) 20 100

.05 (1.05) 20

In other words the present value of the bond represents
two sums: One the present value of an annuity (I) fur-
nished by the series of coupons, running for n years, the
other the present value of the principal due in n years.

The same result is gained by considering, in the for-
mula, only the excess of interest (over the market rate)
which the bond pays. A bond bearing five per cent, in-
terest would, of course, sell at par when the market rate
is also five per cent. A bond paying a higher rate of in-
terest will be worth a premium equal to the present value
of an annuity whose annual installment is the difference
between the nominal rate of interest and that taken as the
basis of calculation.

The formula, derived in a manner similar to that given
above, is 1 v n
P= (I 1001). . : ,


or, substituting the values used above:



(1.05) 20

P= (6-5)


or the value at five per cent, of a twenty-year terminable
annuity of $1.00. Where the nominal rate of interest is
less than that taken as the basis the result will, of course,
show a discount instead of a premium.

The value of the bond at the time of each successive
inventory is obtained by merely changing the value of n
so that it equals the number of interest periods still re-
maining before maturity.

Interest is more customarily paid semiannually. "Where
that is the case the same formula is used but n represents
the number of half-year periods, and i of course, the rate
to be obtained not for the year but for the half-year. Thus
for a twenty-year six per cent, bond with interest payable
semiannually n would be 40, i would be .025 and I would
be 3. Tables are published for bonds with annual, semi-
annual and quarterly interest and also to show the price
at which a bond bearing interest annually would be as
remunerative as one bearing interest semiannually, etc.

Logically bonds bought at a discount should similarly
be treated by being marked up in value with each annual
approach toward maturity. If a six per cent, bond is
worth 112.46, that is, it nets five per cent., a four per
cent, bond would have an actuarial value (its market value
would probably vary somewhat from this) of 87.54. That
is, the bond bearing a nominal rate one per cent, above
the net rate of five per cent, is worth a premium of 12.46
per cent. ; one whose nominal rate is one per cent, below
the normal should sell at a discount of 12.46 per cent. To
continue to list the latter bond at the purchase price is
mathematically incorrect, for at maturity the holder will


receive not only the regular payment of interest and his
invested principal of 87.54 but an additional sum of 12.46,
the full face of the bond being then payable. The value
of a promise to pay this sum of 12.46 increases as the date
for its payment draws near, and a correct valuation would
therefore demand that each year the bond purchased at a
discount should be marked up just as the bond purchased
at a premium should annually be marked down.

But accounting practice has not fully accepted this
principle. In many cases the annual writing off of pre-
mium paid is justified, but there is hesitation at writing
up the bond bought at a discount. This is largely an evi-
dence of the conservative tendency which looks askance
at anything which tends to swell the value of assets, but
encourages undervaluation. Moreover the courts in the
apportioning of receipts of estates between the one with a
life interest and the remainder-man, generally hold that
premiums given and received are a part of the corpus of
the estate and do not enter into revenue, but that where a
bond is bought at a discount the tenant for life receives
only the nominal rate of interest ; and while the rulings of
the courts in probate matters do not necessarily apply to
ordinary commercial accounting, the practice in the treat-
ment of premium and discount on bonds is similar in
both fields.

Interest accrued on investments should be estimated
and shown on the Balance Sheet. This is not analogous to
taking recognition of an appreciation in market value, for
the interest is earned and is as much an asset as the face
of the bond itself. "Whether interest accrued but not yet
due, or interest due but not yet paid, may be used as a
basis of dividends is a question discussed in Chapter XII.
But accounting practice uniformly estimates interest,
whether due to or by the company, even though the law
may object to a dividend in anticipation of its receipt.



The holding of mercantile credits book accounts, ac-
ceptances, promissory notes, etc. being an essential part
of .ordinary commercial life they must be treated somewhat
differently from investments. They are so clearly a part
of the circulating assets ( are ' * circulating capital, ' ' to use
the term employed by the courts) that there can never be
any justification for allowing them to appear at more than
their real value. The argument frequently made that
shrinkage in the real value of fixed assets, inasmuch as it
works no change in the conduct of the business, may be
ignored is not without some plausibility. But a loss in
any of the circulating assets cannot be disregarded. It
immediately manifests itself in reducing profits and must
appear in some form in the Balance Sheet.

For convenience Mercantile Credits are entered and
carried on the books at their face' rather than at their
present actual value. Thus a thousand-dollar note due
without interest in sixty days appears in the Bills Receiv-
able account at $1,000 not at $990, leaving the adjustment
to be made through an interest or discount account. This
is much more convenient in checking over the contents of
the bill portfolio, and, unless a daily revaluation of the
notes is made, it is also as accurate as to list the note at the
discounted value on the day when it is acquired. But when
a new inventory is to be made it is necessary to take full
account of interest adjustments.

The adjustment of interest is, however, a mere matter
of arithmetic and offers no problem in accounting. The
estimate of probable loss due to insolvency of debtors, being
an estimate merely, is a debatable and interesting problem.
A company may hold a thousand notes of customers aggre-
gating $100,000, its books showing:




FORM 34.

Balance Sheet.


Merchandise $140,000

Bills Receivable 100,000

Cash 10,000


Capital $220,000

Profit and Loss 30,000


If some of these notes are clearly worthless they should
at once be stricken from the list of assets, without waiting
even for the annual inventory. No justification can be
found for retaining on the books the note of A for one hun-
dred dollars if it is known to be worthless. As soon as-
that fact is manifest the note must be eliminated by charg-
ing it at once to Profit and Loss, or pending the annual
balance of the books to some subsidiary account indicating
a loss. The accounts would then furnish the following:


FORM 35.

Balance Sheet.


Merchandise $140,000

Bills Receivable 99,900

Cash 10,000


Capital $220,000-

Profit and Loss 29,900


Where there remains a slight chance that the debt may
some time be paid and yet one on which it is not safe to-
count, it may be desirable to keep a reminder of the debt
on the books without appreciably swelling the assets by
including doubtful debts. This is conveniently done by
charging off the bulk of the note, but leaving a purely nom-
inal sum, perhaps one dollar, or even a smaller sum, as a
reminder that there is still an unsettled claim outstanding.

But a more delicate question arises in connection with.



probable losses which have not been made known. Of the
remaining 999 notes in the assumed case no one of the
makers has as yet failed, and yet past experience shows
that it is a certainty that some of the notes will not be paid
in full, and the probabilities are that at least one of them
will ultimately prove worthless. Each one of the notes
must in the meantime be kept on the books at the face
value, allowing the estimated shrinkage to appear as a re-
serve for doubtful debts. The entry to be made is to debit
Profit and Loss and credit Reserve for Doubtful Debts or
some equivalent account. In the formal publication of the
Balance Sheet this would appear as


FORM 36.
Balance Sheet.


Merchandise $140,000

Bills Receivable.. $99,900
Less Allowance

for doubtful

debts 100 99,800

Cash 10,000


Capital $220,000

Profit and Loss 29,800


That such allowance should be made is not only dictated
by business prudence and accounting practice, but is as
well commanded by the United States Supreme Court in
Providence Rubber Co. v. Goodyear (9. Wall. 788), and by
the English courts In re Oxford Benefit Building & Inv.
Soc. (35 Ch. Div. 502). The amount to be allowed is to be
decided in each individual case but it certainly should not
be much below what has been generally accepted in the
specific business concerned. The basis of figuring is also
subject to individual preference; some preferring to take
a percentage of gross sales, some a percentage of debts
outstanding, still others a percentage of credits given.


"With business of a constant character correct results could
be reached as well with one method as another. But a
change in the character of the business done would neces-
sitate a change in the rate adopted. Thus if 2 per cent,
on total sales was correct with a business which was 50
per cent, cash it would probably be insufficient if the
change in business methods gave 80 per cent, of the sales
for credit and only 20 per cent, for cash. Similarly an
increase in term of credit granted would invalidate an
allowance based on debts outstanding. And any rates
would need to be changed if there arose a general panic
or other commercial disturbance.

It is incorrect to list in the Balance Sheet merely the
excess of debts due to the concern over the amounts due
from it. The canceling of one against the other does not
exhibit the true condition, for the failure of the concern's
debtors to pay does not at all affect the necessity of pro-
viding for the claims of its creditors. This, however, is
done in the Balance Sheet of the Illinois Central, but the
defect is partly remedied by reference to statements giving
the detailed information.


General usage prescribes that merchandise on hand
shall be inventoried at cost rather than at selling price.
Prudence further demands that merchandise which evi-
dently cannot be sold except at a loss, be marked down even
below the cost price. I one could count not only on good
faith but as well on unbiased judgment in making inven-
tories, the taking of the present market value, instead of
the cost price would not be objectionable, but rather to be
commended. Indeed, the first principle of valuation laid
down above, that of the ' ' going concern "in strict logic
demands that merchandise for sale be valued at the pres-


ent selling price, with a reduction to cover selling ex-
penses. A real change having taken place in selling value
the original cost is of no effect, for whether bought at a
high or low cost its value to the concern is determined at
the normal price at which it can now be sold. But the
German commercial code, in many respects a guide to those
whose accounting practices are so free from legal control,
in attempting to prevent overvaluation prescribes that the
cost price of merchandise must be taken, except where
there is a publicly quoted price as for instance for grain
in a produce exchange which is lower than the cost price.
Logic perhaps demands that the quoted price should be
taken as well when over as when below the cost price, but
this is not permitted by German law, although the Austrian
law allows it to be done.

American practice agrees with German law. In one
important decision the Massachusetts court, on the con-
trary, stated that depreciation or advance in the value of
the stock unsold must be taken into account. 1 But in this
particular case there had been a loss of merchandise by fire
instead of an appreciation in value; and it is to be hoped
that this obiter dictum is not considered authoritative.
In any event the judgment of accountants is adverse to
such treatment of the inventory. The conservative rule,
generally adopted, is that merchandise is to be inventoried
at cost except where there is a decline in value, in which
case the lower value is to be used.

In the case of merchandise purchased for sale the cost
price ordinarily can be easily obtained. There may, how-
ever, be some room for question even here as to what items,
if any, may be added to the quoted cost price for inventory
purposes. It is apparent that if two consignments be pur-
chased one at $1,000 c. i. f. and the other for $990 f. o. b.
the freight and other charges on the second consignment

Meserve v. Andrews, 106 Mass. 419. (1871.)


being just $10, it would be illogical to list the two lots at
different figures. In other words the familiar principle of
valuing the goods to a going concern applies here as well
as in other cases. The retailer needs the goods in his own
store and the expenses of getting them there, whether paid
by the. manufacturer and included in the cost price, or paid
by the retailer in addition to the cost price are legitimately
included in the inventory value.

It is sometimes urged that while cost, rather than sell-
ing price, should be selected, it need not be the actual cost
price paid, but the price which would need to be paid at
the time the inventory is taken. The clearest case is where
one consignment is purchased say at $1,000 and shortly
after an exactly similar consignment is bought for $1,200.
If an inventory is taken while part of the first consign-
ment is still unsold, the taking of the actual costs will
present, in the inventory, the absurdity of having identical
goods listed as having different values. If all are in-
ventoried on the basis of the later invoice, the profit which
thus appears is said not to be an unrealized profit on
sales, but an already gained profit on a fortunate purchase.

The danger of such a course is apparent. A large stock
of unsold goods can be made to show a profit by a subse-
quent purchase of a small amount at a high price. Per-
haps this is purposely done, and an excessive price is will-
ingly paid just before inventory in order to make a fair
showing to stockholders. A stock of 100,000 yards, cost-
ing and worth only one dollar the yard, could by a tricky
purchase of 100 yards at $1.10 yield an apparent profit of
$10,000. Thus the safeguard which is found in clinging
to cost price would be nugatory and the way made easy
to the pleasing practice of creating profits by marking up
goods. To prevent this the actual cost paid should be
taken despite the objection stated above.

In cases where parts of the different stocks of similar



goods, bought at varying prices, have been sold, a still fur-
ther difficulty arises. Thus, to illustrate, 10,000 bushels
of grain are bought in January "at $1.00 a bushel, 10,000
in July at $1.20, and in August 5,000 are sold at $1.30.
If it is assumed that the sale was of the first consignment
there has been a realized profit of $1,500, but only one-
third as much if the sale was of grain bought in July.
"Where the consignments are kept physically distinct the
proper treatment is apparent; where they are not distin-
guishable the average cost should be taken, thus showing
a profit of $1,000. Evidently the average should be the
weighted average, not the simple average of prices, so that
a purchase of 10,000 bushels at $1.00 and 2,000 bushels at
$1.20 would be treated in the inventory as an average cost
price of $1.03^ so that a sale of 5,000 bushels at $1.30
would give a realized profit of $1,333.33.

When the merchandise to be inventoried has not been
purchased but has been manufactured the determination
of cost price is much more difficult and the general ques-
tion of manufacturing cost will receive further considera-
tion. The principle is clear enough. All the costs which
are immediately necessary to secure the goods may be
included in the inventory price. But difficulties arise in
applying this simple rule, because of the uncertainty

Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 8 of 27)