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BUSINESS, COMMERCE AND FINANCE



ACCOUNTING

AND

AUDITING



BY

WILLIAM MORSE COLE, A. M.

ASSISTANT PROFESSOR OF ACCOUNTING IN THE HARVARD UNIVERSITY
GRADUATE SCHOOL OF BUSINESS ADMINISTRATION






CREE PUBLISHING COMPANY

MINNEAPOLIS CHICAGO SEATTLE

1910



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Copyright, 1910

BY

CEEE PUBLISHING COMPANY






Chicago, Illmois, U. to. a.
1010

All riglits reserved



t '. 'i * * • • • •



c.



PREFACE

One thing which distinguishes bookkeeping and
accounting from most other lines of human activity
is that they deal with figures which are more or less
abstract. One does not handle in bookkeeping and
accounting definite things which can be counted,
looked at, examined, and held in the mind's eye
while one is thinking about them. One's thinking
must be done through the imagination. One must
reason and draw conclusions about things which,
though real, can be grasped only by the brain; for
the accountant cannot cut up every article of mer-
chandise and every note into a portion w^hich is
investment and another portion which is profit. This
involves at first a certain amoimt of hard thinking,
but by long practice one may become so familiar with
fundamental principles that for common transactions
one reaches right conclusions unconsciously, from
force of habit. So one escapes the confusion of try-
ing to think about several sets of abstract things at
once. Tiat is to say, if the figures themselves are
abstract and require on the accountant's part some
effort to hold them firmly in his mind, he ought not
to be trying at the same time to reason out the
method which he shall use in making an entry; for
he may find the effort to do two lines of thinking at

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239101









4 PEEFACE

once so confusing as to lead to wrong results. The
principles of bookkeeping and of accounting, there-
fore, should be so thoroughly familiar that they are,
for most transactions, matters of second nature.

Everyone who is not an expert pianist wonders
how a skilled performer can work his fingers with
such rapidity and hit the right notes with just the
right force, hold them for just the right time, and
at the same time work the pedals so that no note
shall be sustained beyond its due season. It appears
as if the pianist were reading the signature to indi-
cate sharps or flats, the notes to indicate what keys
should be pressed, the value of the notes to indicate
the duration, the marks of expression, the keys under
his fingers, and the pedals under his feet, all at the
same time. This looks like superhuman power. As a
matter of fact, of course, the experienced performer
is perfectly unconscious, after he has begun to play,
of the signature — because once in the swing of the
key he unconsciously introduces the proper sharps or
flats because of long practice — he unconsciously holds
the notes the right length of time — because from long
practice the sight of a certain type of note produces
almost automatically in his fingers the right length
of pressure upon the key, — and without his con-
sciousness of it the sight of the pedal-mark on the
page depresses his feet, or the ring of the notes in his
ear results in an automatic pressure of the pedal.
The player, in other words, though he appears to be
doing many things at once, involving the sight of
many things at once, is doing most of his work almost
unconsciously, and is governed almost entirely by
the sensation produced in his ear by the automatic



PEEFACE 5

connection between the printed notes and his fingers
and feet. The same thing is true of any practical
work. Only after we have had much experience
in any line of work can we do difficult things
easily, but those things which to a novice seem
beyond comprehension are matters of commonplace
after the wonders of reflex action have had oppor-
tunity to work.

The singular thing about reflex action is that
instead of waiting for the nerves to carry a message
to the brain, and then the brain to send another mes-
sage back to a muscle telling it to move, a short cut
has been made directlv from a nerve to a muscle,
which causes the muscle to act even before the brain
knows what is going on. If, for instance, I move my
hand unconsciously against a thistle, before I am
really aware of the fact that I am in pain my hand
has involuntarily shrunk away from the sharp point.
I become aware of the pain practically at the same
moment, or even after the withdrawal of the hand,
because the nerve which felt the pain sends a message
directly to the muscle and causes the hand to be
withdrawn at the same time that it sends the message
to the brain notifying it of the discomfort. This is
the secret, as has been suggested, of all skill, and the
bookkeeper is not competent to do rapid work — or,
we may ^most say, even accurate work — unless the
principles to govern his operations are so far a part
of his mental equipment that without stopping to
think how the thing ought to be done he does it in
the correct way. The first step for anyone wishing
to learn to be an accountant is, therefore, to master
thoroughly the fundamental principles — to master



6 PEEFACE

them so thorouglily that he never has to stop to think
what should be debited or what credited in any trans-
actions but those which are of an unusual nature.

This book is intended to discuss all the common
principles of accounting as found in normal business,
and to make them clear to persons who wish to study
them without a teacher. The best teacher is not so
much the one who teaches as the one who gives his
pupils opportunity and guidance in learning. The
learning must be done by the pupil himself. This
book professes only to give the opportunity and the
guidance. It is undesirable in a book of this type to
afford a large amount of practice in bookkeeping or
accounting work, for if that were done the pages
would be filled with repetitions of similar transac-
tions which, though necessary for the beginner,
would deprive him of the opportunity to do his own
thinking. The common transactions of business are
so well understood by everyone above childhood that
practice can usually be provided by each student for
himself through a very simple exercise of the imag-
ination. For instance, one needs to know automatic-
ally that a sale of merchandise for cash involves a
debit to Cash and a credit to Merchandise; and the
student should have come across that transaction and
made the proper entry so many times that instinct-
ively the sight of the words ''sold for cash" brings
up to his mind the words * ' Cash to Merchandise. ' ' It
is recommended, therefore, that anyone undertaking
to use this book as a means of learning the arts of
bookkeeping and accounting construct for himself a
large number of imaginary transactions involving,
over and over, all the common transactions. This



PEEFACE 7

should not be done, however, by outlining a large
number of transactions of the same sort following
one another in immediate succession. If one writes
one hundred transactions of the same sort one after
another one is not cultivating the habit of think-
ing about them; indeed, one is doing nothing more
than training the hand to make entries in the right
form ; for after the first entry, with a knowledge that
the transactions are the same, the brain is not called
into play. The proper method, then, of inventing
transactions for practice is to alternate them so that
very seldom do two of the same sort come together.
If a sale for cash is followed by the issue of a note
in payment of a bill, and that by the payment of
wages, and that by the borrowing of money, or the
payment of a bill in cash, or the receipt of interest
money, etc., so that the mind is obliged to jump
around from one sort of thing to another with great
rapidity, and all these transactions come again and
again and again, the mind soon acquires the ability
to make the entries by the kind of reflex action
already referred to. When one has acquired facility
in making these common entries one should attempt
to make entries of a peculiar type, beginning with
those that are merely unusual, though simple, and
then gradually increasing complexity until one has
mastered the ready handling of practically all cases
that may arise. In the appendix will be found a
number of such rather complex cases to illustrate
the sort of practice necessary.

In the first part of the following pages will be
found not only a careful working-out of the common
transactions of business, each repeated in one form



8 PREFACE

or another several times, but an indication, by
typical illustrations, of the bookkeeping for less fre-
quent transactions. Anyone who has absolutely
mastered the principles here expounded — that is,
has mastered them so thoroughly that he is not likely
to stumble in their application — is competent to
make the entry for any transaction that he under-
stands.

Accounting principles require somewhat the same
sort of practice as that suggested in connection with
bookkeeping, though to construct for it situations
out of pure imagination is not quite so easy. The
reader who wishes to master accounting is recom-
mended to invent for himself situations involving
the principles expounded in the latter part of this
book — such as the distinction between capital and
revenue, between one class of expenses and another,
between stable values and depreciating values, be-
tween values involving only capital and those involv-
ing interest and discount. Then such transactions
may be made more complicated by the introduction
of two or three of these distinctions at the same time,
and so on until a high degree of complication has
been handled successfully. Students of accounting -^
commonly have the experience of thinking they
understand what in reality they do not understand.
Often they understand just what they see before
them as a problem but fail to see just how big
the problem is. Every principle should be worked
out in detail, in hlach and white, and the student
should accustom himself to thinking exactly how
every situation would look upon the books. If all
situations desirable to study were presented in type



PKEFACE 9

in this text-book, the student would be deprived of
the valuable practice of working them out for him-
self, and would become better accustomed to seeing
them in type than to seeing them in his mind's eye.
He should, therefore, in thinking of situations de-
scribed in this book, try to see how each would look
in books of account, and then he should write the en-
tries for himself. As he reads the text, he may then
see whether the facts there mentioned apply to the
situation that he has put before himself. If not, he
should go back and see what is the discrepancy be-
tween the situation he has recorded and that de-
scribed. Then he is in a position to try the conclu-
sions suggested in the book with the actual figures
before him. This method fixes in his mind the
appearance on the books of all common situations
and enables him in practice to recognize at once the
things which he has here been studying theoretically..
This should be done particularly for things that are
here discussed but not worked out in detail in the
printed form.

For the interpretation of accounts the best prac-
tice is to get hold of the reports of corporations and
partnerships, though the latter are seldom published,
and attempt to read between the lines — to see, for
instance, why each particular kind of asset was in-
creased or decreased from one year to another, from
what source the assets were increased and the liabili-
ties decreased, or how it happened that the assets
were decreased or the liabilities increased. Wherever
statistics can be obtained to show the detailed opera-
tions of any company, as is always possible with
railroads, the attempt should be made to relate those



10 PREFACE

operations to the income sheet and to the balance
sheet so that one may see how far the various parts
of a report are consistent and what light each part
throws upon the others.



CONTENTS



CHAPTER I. INTEODUCTION 13

CHAPTER IL DEBIT AND CREDIT 19

CHAPTER III. THE METHOD OF ENTRY 33

CHAPTER IV. THE COMMON LEDGER ACCOUNTS. 49

CHAPTER V. THE PRACTICAL OPERATIONS OF

BOOKKEEPING 109

CHAPTER VI. DRAWING CONCLUSIONS FROM THE

BOOKS 139

CHAPTER VII. SOME HIGHLY DEVELOPED TYPES

OF BOOKKEEPING 175

CHAPTER VIII. THE PECULIARITIES OF CORPO-
RATION ACCOUNTS 213

CHAPTER IX. PROPERTY OR EXPENSE ? 239

CHAPTER X. DEPRECIATION 263

CHAPTER ^. PROFITS 281

CHAPTER XIL THE INCOME SHEET 305

CHAPTER XIII. THE BALANCE SHEET 315

CHAPTER XIV. THE INTERPRETATION OF BAL-
ANCE SHEETS 331

11



12 CONTENTS i

I
CHAPTEE XV. THE DETERMINATION OF COSTS.. 347 !

i

CHAPTER XVI. SETTLEMENTS BASED ON AC- |

COUNTS— PARTNERSHIPS, IN- !

SOLVENCY, TRUSTEESHIPS.... 375 j

CHAPTER XVII. AUDITING 397 [

APPENDIX 451 \

!
INDEX 475



ACCOUNTING AND AUDITING



CHAPTER I

INTRODUCTION

The art of accounting is commonly thought to
include only making a record of facts. It chances
that as industry has developed in recent years the
making of the record is the least important part of
the accountant's task. Accountancy is something
more than bookkeeping. Bookkeeping is the art of
making the record of known facts in such shape that
the record can be interpreted and mathematical con-
clusions drawn. Bookkeeping, that is to say, assumes
that the fact is known before the records are con-
structed. Accounting, on the other hand, is not an
art of making records but is the art of learning the
facts which bookkeeping is supposed to record. This
may be illustrated by a manufacturing business. The
bookkeeper records the expenses for raw material,
wages, fuel, taxes, rent, interest, insurance, and also
the returns from sales of goods. Speaking roughly,
a comparison of the two sets of figures gives the
profit. This is bookkeeping. The accountant, on
the other hand, will desire to know very much more
than this. He will desire to know just how much a

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14 ACCOUNTING AND AUDITING

dollar's expense in labor has returned in product,
how much every dollar's worth of goods sold has
cost in the factory, what is the relation between the
fuel consumed and the amount of product, whether
all the articles produced show the same ratio between
manufacturing cost and selling cost, or whether the
profit is very much larger on some things than on
others, whether the cost of each step in production
is greater or less this year than in preceding years.
These figures enable him to determine three things:
first, what price he can best afford to put upon his
product; second, what is the most profitable part of
his business and whether any part is unprofitable;
third, whether the greatest economy is practiced in
obtaining the product. He is concerned also to see
that proper allowances are made periodically for
changing values: that is to say, he is concerned to
see that at proper intervals allowance is made for
changes in value of real estate, merchandise on hand,
machinery and tools, investments, and innumerable
other things which share in the vicissitudes of all
things earthly. When these facts have been deter-
mined by the accountant, it is a simple matter for
the bookkeeper to make them matters of record.
Thus it is true, as already suggested, that the ac-
countant is concerned with learning facts which are
not obvious, and the bookkeeper is concerned with
recording both the obvious facts and those which the
accountant has ascertained.

The work of the accountant cannot be made me-
chanical, nor can it be taught by any rules which one
may commit to memory. It is almost entirely
governed by judgment, and judgment is acquired



INTRODUCTION 15

through experience in actual business or through
experience in dealing with imaginary cases which
might well arise in business. Not all people have the
power of cultivating judgment, for certain qualities
of mind are essential. These may be improved by
education, but they cannot be created. It is true,
however, that even those who have not naturally
good judgment may as a result of education become
more trustworthy than other persons of natural good
judgment who have not taken the trouble to acquaint
themselves with the facts of business. It follows,
therefore, that though no book can rightly profess
to furnish judgment, and so to make accountants out
of bookkeepers, study of a good book should make a
better bookkeeper, and one who is capable of doing
some accounting work, even out of one who is not
naturally possessed of good judgment; for so far as
the exact problems to arise can be studied in ad-
vance, accounting solutions may be provided in
advance. So far, however, as problems arising for
any accountant are new to him, he must solve them
out of pure judgment or from their similarity to
other cases of which the solution is familiar to him.
It is the purpose of this volume to take up the
commoner sorts of accounting problems in the vari-
ous forms under which they are likely to arise,
and to work them through so as to furnish illustra-
tions for most of the simpler cases that are likely to
appear in actual business. It is impossible, how-
ever, that all kinds of cases shall be covered, for
things are constantly happening in business unlike
any that ever occurred before — or at least unlike any



16 ACCOUNTING AND AUDITING

that could have been foreseen and provided for by
any teaching.

The first thing to do in an attempt at education

of this sort is to cover the fundamental principles of

bookkeeping. These are really only three in num-

n ber. The first is the distinction between debit and

' credit, and involves a determination for every entry
of the exact responsibility which is involved in the
transaction. The second fundamental principle is
concerned simply with the kind of account which

\ shall be debited or credited for each transaction; that
is to say, not merely the name of the account but the
use that shall in the end be made of that account in
determining profit and loss and values at the end of
any period. The third of these principles is con-
cerned merely with the saving of labor in so arrang-
ing the books that the minimiun amount of writing
and turning of pages shall give the maximum in-
formation; this is done by providing special columns
and special books for special figures, so that they
may be handled in totals rather than in small detailsj
When these three principles have been thoroughly
mastered, one knows practically all there is to be
known about bookkeeping. The remainder of the
art. consists in applying these principles to the
specific conditions found in any particular business.
No man can be familiar with all the bookkeeping
forms which may be best for all lines of business,
for the number is far too great. Yet a man with
originality and judgment should be able for any busi-
ness to devise a system on the three principles just
mentioned.

When this preliminary study of bookkeeping has



INTEODUCTION 17

been made we may pass on to take the accounting
principles — both those which must be applied in
learning the facts for the bookkeeping entries, and
those which must be applied in interpreting the book-
keeping entries so as to give a final judgment about
the profit and value of any business.



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A & A-2



CHAPTER 11

DEBIT AND CEEDIT

As was indicated in the introduction, one of the
three principles that cover the whole of bookkeeping
is the fundamental distinction between debit and
credit. It must be understood, in the first place, that
in order to make properly a debit or a credit one
must be sure of the point of view. If Jones buys
goods of Smith, and has them charged to his account,
on Smith's books they will appear in a fashion
exactly opposite to that on Jones's own books; that
is to say, Smith's books must show that the money is
ow^ed by Jones, but they do not read to show that it
is owed to Smith, for Smith's books relate only, of
course, to Smith's affairs; but the books of Jones
must show that the money is owed to Smith, though
they do not need to show that it is owed by Jones.
The same transaction, then, will be entered dif-
ferently when it is viewed from different stand-
points, for always the books upon which it appears
are the key note of the situation. Smith's books
must show 6y whom the money is owed to Smith's
business, and Jones's must show to whom money is
owed by Jones's business. If, in making an entry on
Jones's books we make the error of taking the point
of view that belongs to Smith's books, we have
misrepresented the facts. The first step, then, in

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20 ACCOUNTING AND AUDITING

any entry is to see in what relation the transaction
stands to the business covered by the books on which
the record is to be made. It must be understood
always that debit and credit are always relative, —
that is, that their meaning is not known in any
particular case until one knows on what set of books
they appear.

The basis of all entries in the books of account is
the accountability of the person or thing named.
This accountability may arise from any one of
several things, and it may imply either a duty to be
performed by the business for the benefit of a person
or thing named on the books, or a duty to be per-
formed by an outsider, or by a special department of
the business toward the business as a whole. A duty
to be performed by an outsider, or by a department
of the business itself toward the business as a whole,
is always called a debit, and is made through what is
called a ''charge" to the account representing that
person or thing. A duty to be performed by the busi-
ness for an outsider or for one of the business 's own
departments is always a credit. We, in common
language, speak of a thing as creditable when we
mean that it may be counted in the favor of the
person or thing concerned. This is exactly what we
mean when, in bookkeeping, we credit an account.
We may credit not only when it is our duty to pay
for the benefit that we have received, but also when
we wish merely to record the fact that the account
named has conferred upon the business a benefit
which the business will keep for itself. Similarly,
in bookkeeping, we debit an account representing a
person or a department of the business not only when



DEBIT AND CEEDIT 21

the benefit, which the business as a whole conferred,
must be paid for, but also when we wish merely to
record the fact that the account named has received
what the business sacrificed. So, in any case, a debit
and a credit merely register the fact that an account-
ability or a responsibility has been recognized or
transferred. 'Debit means that the account debited
is responsible to the business either as a debtor to
repay the sum debited, as a repository to accoun«t for
property intrusted to it, or as a force explaining the
sacrifice of property by the business. For illustra-
tion, to debit Jones is to indicate either that he must
repay the money as a debtor, or that he has been
paid something for a debt which the business owed
him and so he must cancel the debt; to debit real
estate is to indicate not that the money must be re-
turned, but merely that somewhere in connection
with the business real property should be found to
account for the expenditure of the money; to debit
rent account is usually to indicate that the business
has sacrificed a certain amount of value because of
the fact that men cannot normally use other peoples*
property without paying for its use. Similarly, to
credit an account is to indicate that the sum must be
repaid by the business to the person or department
represented by that account, or that the business
must show what it has done with the property in-
trusted to it on that account, or that the business
force represented by that account has conferred upon
the business a benefit. Thus, to credit Jones is to
indicate that the business owes him or that he has
paid something which he owed to the business; to
credit real estate is to indicate that the property has



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22 ACCOUNTING AND AUDITING

surrendered to the business a certain amount of
value; and to credit interest account is to indicate
that the force in business which requires men to pay
for the use of others' money has brought in income.



Online LibraryWilliam Morse ColeAccounting and auditing → online text (page 1 of 32)