XV. PERIODIC ADJUSTMENTS AND SUMMARIZATION
=Why Current Records of the Ledger Need Adjustment.=—At the end of the fiscal period the ledger does not present a true record of financial condition. The fixed assets of the business are constantly depreciating in value; merchandise tends to become out of date, shopworn, stale, or soiled; some merchandise has been sold, while some is still on hand; some of the accounts receivable may prove uncollectible, and some of the notes receivable may be dishonored. Also, at the end of the period liabilities such as taxes, salaries, rent, and the like may have been incurred, but because there is no creditor’s invoice or other business paper as evidence of such liability they are not usually entered on the books until payment is made.
Again, it may be that the services paid for during this period, as shown by the various expense accounts, have not been entirely used, as where a supply of coal for heating purposes remains on hand, or when, as in the case of insurance bought for a given period of time, a part of the protection period extends beyond the close of the current fiscal period. In these and similar cases, the items must be separated into their two component elements, one part belonging to the current period, and the other part to a later period. The part of the expense to be deferred and used up in a later period represents an asset at the close of the current period and must therefore appear on the balance sheet under the heading of “Deferred Charges.”
Similarly, income is sometimes received in advance to cover services which have not yet been rendered, or rendered only in part, as when rent is received in advance to cover a given number of months, some of which belong to the next fiscal period. Consequently, only a part of this income applies to the current period, the balance being deferred to later periods.
For these reasons certain asset accounts need to be adjusted and certain liability accounts must be opened to bring the ledger into accord with the actual condition of things and show the true financial status of the business. The entries required for this purpose are called “adjustment entries” to distinguish them from the closing or summarizing entries to be described later in this chapter.
First in importance among the adjusting entries are those required to show the correct value of the stock-in-trade, the fixed assets, and the accounts receivable. Whether the merchandise items are kept in one or several accounts, the value of the stock on hand is not shown at any given time during the fiscal period. Goods have been purchased at one price and sold at another, and no record of the value of the merchandise inventory on hand is available. Similarly, no current record has been made of the depreciation of buildings, furniture, fixtures, or other equipment, nor has any provision been made for the accounts receivable that may prove uncollectible.
=Basis of Adjustment Entries.=—These items, then, merchandise, asset depreciation, bad debts, prepaid and accrued expenses and income, are the occasion of the adjustment entries. An inventory is required to find the value of the stock-in-trade; an appraisal is made of the depreciating assets to determine the amount of depreciation for the current period; and proper consideration must be given to the prepaid and accrued income and expense items for the period under review. The following illustrations are concerned with the several classes of adjustment entries. The detail of the account is not shown in each case, but only the balance.
=Adjusting and Closing the Merchandise Records.=—Unlike the method shown in the debit and credit schedule for merchandise in Chapter XIII, the modern practice is to keep the merchandise record by means of the separate accounts used in the profit and loss statement, viz., Merchandise Inventory, Purchases, Inward Freight and Cartage, Returned Purchases, Purchases Rebates and Allowances, Sales, Returned Sales, and Sales Rebates and Allowances. It should be understood that this detailed record of merchandise transactions is preferable to the single merchandise account only because it gives more information. The detailed record does not in any way maintain a sharper separation of the asset and income elements of the merchandise transactions than does the single merchandise account. It does, however, make immediately available information as to volume of business, purchases, returns, and so forth—items which in any well-managed business are watched carefully. These detailed accounts taken together comprise the merchandise record and are equivalent to the single merchandise account.
It is apparent from a consideration of the single merchandise account that at any given time it includes these three items: (1) the net cost of the total goods to be accounted for; (2) the decrease in the asset merchandise brought about by sale; and (3) the profit on the goods sold. In order to bring about the separation of the merchandise records into the two elements (a) goods still on hand, that is, the asset element, and (b) the profit on goods sold, that is, the income element, it is necessary to bring the detailed accounts together for the purpose of summarization. This summarization is accomplished in much the same way as in the profit and loss statement. The net amount of sales and the net cost of goods sold are determined and set up against each other in order to indicate the gross profit. In arriving at the cost of goods sold it is necessary to bring together the opening inventory, the purchases, the inward freight and cartage, and from their sum to subtract the purchase returns, the purchase rebates and allowances, and the final inventory. How this is accomplished in the ledger is explained by an illustration, in which the adjustments or transfers between accounts are traced by means of cross-index letters.
Assume the following facts: Goods on hand January 1, 19—, $10,125.67; purchases for six months $47,897.42; inward freight and cartage $560.25; returned purchases $2,125.40; purchase rebates and allowances $267.92; sales $65,283.21; returned sales $3,924.83; sales rebates and allowances $392.48; and goods on hand June 30, 19—, $11,267.40. Each of these items appears as the first entry on the proper side of its account, and is distinguished by not being marked with a bracketed letter. The items comprise the ledger record previous to summarization at the close of the fiscal period.
MERCHANDISE INVENTORY ================================================================== 19— | 19— Jan. 1 10,125.67 | June 30 Purchases (B) 10,125.67 --------- | --------- June 30 (E) 11,267.40 |
PURCHASES ================================================================== 19— | 19— June 30 | June 30 (Total purchases) 47,897.42 | Returned Purchases Inward Freight | (C) 2,125.40 and Cartage | Pur. Rebates & (A) 560.25 | Allow (D) 267.92 Mdse. Inventory, | Inventory, Jan. 1 (B) 10,125.67 | June 30 (E) 11,267.40 | Profit & Loss (F) 44,922.62 --------- | --------- 58,583.34 | 58,583.34 ========= | =========
INWARD FREIGHT AND CARTAGE ================================================================== 19— | 19— June 30 (Total) 560.25 | June 30 Purchases (A) 560.25 ------ | ------
RETURNED PURCHASES ================================================================== 19— | 19— June 30 Purchases (C) 2,125.40 | June 30 (Total) 2,125.40 -------- | ---------
PURCHASES REBATES AND ALLOWANCES ================================================================== 19— | 19— June 30 Purchases (D) 267.92 | June 30 (Total) 267.92 ------ | ------
SALES ================================================================== 19— | 19— June 30 | June 30 Returned | (Total) 65,283.21 Sales (G) 3,924.83 | Sales Rebates & | Allow (H) 392.48 | Profit & Loss (I) 60,965.90 | --------- | --------- 65,283.21 | 65,283.21 ========= | =========
RETURNED SALES ================================================================== 19— | 19— June 30 (Total) 3,924.83 | June 30 Sales (G) 3,924.83 -------- | --------
SALES REBATES AND ALLOWANCES ================================================================== 19— | 19— June 30 (Total) 392.48 | June 30 Sales (H) 392.48 ------ | ------
PROFIT AND LOSS ================================================================== 19— | 19— June 30 Purchases (F) 44,922.62 | June 30 Sales (I) 60,965.90 --------- | ---------
To show the total cost of goods bought during the period, the freight-in of $560.25 is transferred or closed into Purchases. To show the “gross cost of goods to be accounted for,” amounting to $58,583.34, the inventory of January 1 of $10,125.67 is transferred to the debit side of Purchases account. To show the net cost of goods to be accounted for, the returned purchases and allowances are deducted from this gross cost by being transferred to the credit side of Purchases. The balance in Purchases account at this point, viz., $58,583.34 minus $2,393.32, or $56,190.02, indicates the net cost of goods to be accounted for.
This item of $56,190.02 is not indicated in the account, however, but is given here simply to make the discussion intelligible. Part of this $56,190.02 (net cost of goods to be accounted for), amounting to $11,267.40, is the cost value of the unsold goods according to the inventory of June 30, and the balance of $44,922.62 ($56,190.02 minus $11,267.40) constitutes therefore the cost of the goods sold. This final inventory is also shown as an asset on the debit side of Merchandise Inventory in the new section of the account, i.e., the portion of the account following the initial inventory section which has now been closed and ruled off as shown on page 118.
Put in a somewhat different form, we may say that the cost of goods sold is found by subtracting from the gross cost of goods to be accounted for, $58,583.34, first the returns and the rebates, $2,393.32, and then the amount of the closing inventory of June 30, $11,267.40. The balance left of $44,922.62 represents the cost of goods sold. This balance is now transferred to the debit of Profit and Loss account.
All the transfer entries given above have their debits and credits determined as explained in Chapter XIV. The student should note that the same additions and subtractions are thus brought about in the Purchases account as are made arithmetically in the section of the profit and loss statement given over to cost of goods sold.
The Sales account is debited with the balances of the Returned, Sales and Sales Rebates and Allowances, thus showing a balance of net income from sales which is transferred to the credit of Profit and Loss. The Profit and Loss account then shows net income from sales on the credit side, and cost of goods sold on the debit side. The difference between the two sides is gross profit on sales. All of the merchandise accounts, except the Inventory account, are now balanced, and should be ruled off in the manner explained in Chapter XIV.
The second illustration covers the case where the stock-in-trade record is kept in one mixed account called Merchandise. Using the same data as in the other illustration, the account appears as follows:
MERCHANDISE ==================================================================== 19— | 19— Jan. 1 Inventory 10,125.67 | June 30 Sales 65,283.21 June 30 Purchases 47,897.42 | Returned Purchases 2,125.40 Returned Sales 3,924.83 | Sales Rebates | Purchases Rebates and Allow 392.48 | and Allow 267.92 Inward Freight | and Cartage 560.25 | Inventory, June 30 11,267.40 Profit and Loss 16,043.28 | --------- --------- | 78,943.93 | 78,943.93 ========= | ========= June 30 Inventory 11,267.40 |
When the merchandise record is kept under separate accounts the freight-in is transferred to the debit of the Purchases account; but when a single mixed account is kept with merchandise, freight-in is usually entered directly to the debit of that account. To adjust the account when kept in this manner, the new inventory is entered to the credit of Merchandise. The balance of the Merchandise account now shows the gross profit on sales, $16,043.28. This is transferred to the credit of Profit and Loss. (It will be noted that this transferred item is identical with the balance of the Profit and Loss account of the first illustration.) The Merchandise account is now totaled and ruled off. On the debit side, beneath the ruling, the new inventory is entered, being the contra to the credit entry of $11,267.40 above the ruling. The equilibrium of debits and credits is thus maintained. In this open item of $11,267.40 the account shows an asset, the goods on hand June 30.
The handling of merchandise transactions according to the second illustration is not considered good accounting but is shown because it is frequently met with in bookkeeping practice.
=Underlying Theory in the Adjustment of Merchandise Records.=—Careful analysis and study of the adjustment of the merchandise records should be made in order to see the way in which the logic of the trading section of the profit and loss statement is worked out in the ledger. The record of the merchandise asset should be kept, in strict theory, in the same way as that of every other asset, namely, the accounts should be charged with the full cost of the asset and credited at cost price with the portion sold, the profit or loss on the sale being carried in a separate account. The balance of the Merchandise account would then show the value of the asset merchandise on hand at any time.
Theory, however, gives way to the practical difficulties of handling the account in this way. Therefore, periodically the mixture of asset decreases and income increases brought about through this practical method of handling merchandise records must be corrected, or “unmixed,” so that these elements will appear separately. The Purchases account, after the opening inventory, the inward freight, and the purchase returns, rebates, and allowances are transferred to it, gives the net total of the merchandise asset for the period. This net total represents two things: (1) merchandise still on hand, and (2) merchandise sold. By way of adjusting the records, the goods on hand, as shown by the physical inventory, are separated from the total and put into the Merchandise Inventory account, which shows by its title that it is an asset. That leaves in the Purchases account the cost of goods sold. The credits which should indicate the decrease in the asset, equal to the cost of goods sold, are found in the net merchandise sales, as shown by the Sales account after transferring to it the sales returns, rebates, and allowances. But these credits are here mixed with the gross profit. The portion of the net sales representing the cost of sales of merchandise should now, in strict theory, be transferred from the Sales account to the Purchases account. This transfer would effect the balancing of the Purchases account, indicating that there are no merchandise asset values in that account, these having been transferred to the Merchandise Inventory account. The result of this theoretically correct procedure would be to bring about a segregation of the merchandise records into their two elements, the asset element as shown by the Merchandise Inventory account and the income element as shown by the remaining balance in the Sales account.
Once again, however, strict theory gives place to the more practical need of requiring the accounts to give full information for management purposes. Accordingly, instead of handling them in the way just indicated, the adjustment procedure explained on pages 118 to 120 is followed.
=Handling Depreciation of Fixed Assets.=—As shown in Chapter XIII, the method of handling depreciation of assets consists of nothing more than separating the expense element from the asset element, both of which are carried currently under the title of the asset. For reasons explained in Chapter XIII, the credit to the asset which effects the separation is not recorded in the asset account but in a supplementary account entitled “Depreciation Reserve” for the particular asset. This reserve account is an integral part of the asset record and must always be considered in connection with the asset account in determining the value of the asset. The credit entry in the reserve account is a sort of suspended credit, recorded there temporarily for purposes of information. The offsetting debit to this credit is made in the expense account Depreciation.
The adjustment entry thus effects a separation of the asset account into the two elements, (1) present value of the asset as shown by the asset account and its depreciation reserve account, and (2) the expense element recorded under the Depreciation expense account. The following illustration indicates the bookkeeping procedure:
FURNITURE AND FIXTURES ================================================================= 19— | Jan. 1 750.00 |
DEPRECIATION RESERVE FURNITURE AND FIXTURES ================================================================= | 19- | June 30 (A) 75.00
DEPRECIATION ================================================================= 19— | 19— June 30 (A) 75.00 | June 30 Profit & Loss (B) 75.00 ----- | -----
PROFIT AND LOSS ================================================================= 19— | June 30 Depreciation (B) 75.00 |
The asset Furniture and Fixtures, valued at $750 at the beginning of the year, is estimated by appraisal to have depreciated 10%, or $75, during the half-year. This cost or expense is charged to an account called Depreciation, and credited not to Furniture and Fixtures, but to the valuation account “Depreciation Reserve Furniture and Fixtures.” The Furniture and Fixtures account and its valuation account, taken together, show the appraisal value of $675. Thus the credit adjusting entry is made to record a decrease in asset values. The Depreciation account, carrying the debit of $75, is an expense account and is closed into Profit and Loss, just as any other expense account is closed.
=The Estimate for Doubtful Accounts.=—At the close of a fiscal period, when an accurate statement of the financial condition of the business is to be drawn up, all assets must be very carefully valued. The bookkeeping procedure necessary to show the correct value of fixed assets subject to depreciation has been explained. The outstanding claims against customers also require evaluation. Every business man knows from past experience that he will be unable to collect all of his outstanding accounts. He may not know which of the accounts will prove uncollectible, but he does know that there will be a loss in the sum total of these claims against customers. The amount of this estimate is based on past experience in each business.
A standard basis for the estimate is not possible because in some businesses credit is extended much more carefully than in other businesses and in some collections are followed up more vigorously than in others. In making the estimate two methods are used, one being a certain percentage of the outstanding accounts, the other being a certain percentage of the sales made during the period. Where experience shows the necessity, the loss from both outstanding accounts and notes receivable is provided for.
The same bookkeeping procedure is used here as with the estimate of depreciation. An expense account, usually entitled “Bad Debts,” is debited, and an account called “Reserve for Doubtful Accounts” is credited for the amount of the estimated loss. The effect of the entry is to separate the claims against customers into their two elements, namely, the true asset element, represented by the difference between the asset account and its valuation reserve account, and the expense element as indicated by the Bad Debts account.
The following illustration sets forth the method of handling bad debts on the books of account:
ACCOUNTS RECEIVABLE ================================================================== 19— | June 30 100,000.00 |
RESERVE FOR DOUBTFUL ACCOUNTS ================================================================== | 19— | June 30 (A) 2,000.00
BAD DEBTS ================================================================== 19— | 19— June 30 (A) 2,000.00 | June 30 -------- | Profit and Loss (B) 2,000.00 | --------
PROFIT AND LOSS ================================================================== 19— | June 30 Bad Debts (B) 2,000.00 |
It is known, from past experience, that the asset Accounts Receivable, $100,000 in this instance, will not be collected in full. To bring this book value down to its real value, the estimated loss, which it is thought will be 2% of the outstanding accounts, is reserved from their value, that is, credited to a reserve account, which is to be taken in conjunction with the asset account. The offsetting debit is to Bad Debts, an expense account. It represents an expense which the current period has to bear, and is closed into Profit and Loss with other expense accounts.
=Handling Prepaid and Accrued Expenses and Income.=—The method of handling the estimates or inventories of prepaid and accrued expenses and income is very similar to that shown for handling the mixed Merchandise account. Illustrations follow:
INSURANCE ==================================================================== 19— | 19— Jan. 1 (Paid) 150.00 | June 30 (Unexpired) 125.00 | Profit and Loss 25.00 ------ | ------ 150.00 | 150.00 ====== | ====== June 30 (Deferred) 125.00 |
RENT INCOME ==================================================================== 19— | 19— June 30 (Unearned) 250.00 | June 15 (Received) 300.00 Profit and Loss 50.00 | ------ | ------ 300.00 | 300.00 ====== | ====== | June 30 (Deferred) 250.00
WAGES ==================================================================== 19— | 19— June 30 (Paid) 2,125.00 | June 30 Profit and Loss 2,325.00 (Accrued, unpaid) 200.00 | -------- -------- | 2,325.00 | 2,325.00 ======== | ======== | June 30 (Accrued) 200.00
INTEREST INCOME ==================================================================== 19— | 19— June 30 Profit and Loss 145.00 | June 30 (Received) 127.50 | (Accrued, due us) 17.50 ------ | ------ 145.00 | 145.00 ====== | ====== June 30 (Accrued) 17.50 |
The first account, Insurance, shows the method of handling a deferred or prepaid expense. At the close of the period the account is a mixed account, the unexpired portion of the insurance representing an asset to be shown on the balance sheet as a deferred charge, the expired or consumed portion representing an expense for the period to be closed into Profit and Loss. Insurance has been paid, in this case for a three-year term; hence only one-sixth of it is chargeable to the first half-year, the remainder being deferred to later periods. The amount of the inventory or unexpired portion is entered to the credit of the account in order to effect subtraction of the amount, the balance of $25 thereby showing the insurance cost for the current period. This balance is carried to Profit and Loss. After closing the account, the inventory is entered to the debit side below the ruling, thus showing the so-called “deferred asset” portion which will appear in the balance sheet.
The next account, Rent Income, is a mixed account with income and liability elements. It shows that rent has been received for a period which extends beyond the current fiscal period. On June 15, rent for the period of, say, June 15 to September 15 was received. Only one-sixth of this income applies to the term January 1 to June 30; therefore the balance of $250 must be deferred or carried over to the next fiscal period. The adjustment is made by an entry of $250 for unearned rent on the debit side to effect its subtraction from the earnings for the current period, thus reducing them to $50. This income of $50 is transferred to the credit of the Profit and Loss account. After the Rent account is ruled off, the deferred income is entered below the ruling on the credit side, forming a part of the earnings of the next period. It is shown among the liabilities in the balance sheet for the current period, usually under the caption of “Deferred Income.”
The third account, Wages, shows wages paid to June 30 of $2,125. At that date wages earned but not yet paid, perhaps because the pay-day did not coincide with the date of closing the books, amounted to $200. This item is obviously an expense of the current period incurred during the short interval between the last pay-day in June and June 30. The adjustment is therefore made by entering $200 on the debit side of the Wages account, to effect the addition of this sum to the expense already shown there. The total amount of the account is transferred to Profit and Loss and the account is ruled off. The amount of unpaid wages, $200, is shown on the credit side beneath the ruling. In the balance sheet it appears as a liability, usually under the caption of “Accrued Expense.”
Similarly with the fourth account, Interest Income. Income to date is $127.50; earned but not yet due on June 30, $17.50, showing full earnings of $145 for the current period. This total is transferred to Profit and Loss, the account is ruled off, and the earned but not received portion is shown as a debit beneath the ruling, and as an asset in the balance sheet.
Great care must be exercised in the adjustment of all inventories to maintain the equilibrium of the ledger by the entry of each amount to both the debit and credit sides.
Besides the four illustrations given above, there are many other accounts requiring the same kind of adjustment entries. In certain special cases it may be necessary to make adjustments on both sides, as for example in a general expense account or in a mixed interest account showing both interest income and interest expense. For illustration a mixed interest account is shown. The debit opening item of $100 in the new section of the account represents an asset, an interest claim against outsiders, while the credit opening item of $50 represents the liability to others for interest due them but not yet paid. For the sake of accuracy and clarity, however, the better bookkeeping practice is to keep separate accounts for Interest Income and Interest Cost.
INTEREST ================================================================== 19— | 19— June 30 (Paid) 400.00 | June 30 (Received) 500.00 (Unpaid) 50.00 | (Accrued, due us) 100.00 Profit and Loss 150.00 | ------ | 600.00 | 600.00 ====== | ====== June 30 (Accrued) 100.00 | June 30 (Unpaid) 50.00
=Summarizing the Ledger—The Profit and Loss Account.=—After all the types of adjustments have been made, the accounts in the ledger are restored to their fundamental classifications, namely, assets, liabilities, and proprietorship. There is now no intermixture of these basic elements. The proprietorship group of accounts shows both the vested proprietorship, that is, the capital at the beginning of the period, and the temporary proprietorship, that is, the increases and decreases (as indicated by the income and expense accounts) which have taken place during the current period.
At the close of the fiscal period, when the temporary proprietorship accounts have served their purpose by showing the day-to-day changes in proprietorship and the results must be summed up, these accounts are closed for the current period so as to keep the records separate from those of the next period. For the purpose of summarizing the profit and loss group of accounts, an account called Profit and Loss is opened in the ledger and to it the balances of all temporary proprietorship accounts are transferred.
The Profit and Loss account in the ledger must not be confused with the formal statement of profit and loss, made up outside the ledger just as is the balance sheet. On the credit side of Profit and Loss will appear all credit or income account balances, and on the debit side will appear all debit or expense account balances. Accordingly, if the balance of the Profit and Loss account is a credit balance, it shows a net profit for the period; if a debit balance, it shows a net loss for the period.
The net profit or net loss shown by the Profit and Loss account represents either an increase or decrease in proprietorship, and as such is transferred to the proprietor’s personal account. As explained in Chapter XII, this account usually shows his drawings during the period against these profits as they were assumed to be accruing. The personal account thus indicates whether the amount which he has drawn out is larger or smaller than the net profits as determined by the Profit and Loss account. If his profits are larger than his drawings, his capital has been increased by the amount of the credit balance in his personal account and the transfer of this balance to the credit side of his capital account will then show the total net worth of the business. If his drawings are larger than the profits, there is a decrease in capital, as shown by the debit balance of his personal account, and the transfer of this balance to the debit side of the capital account reduces the former capital amount.
The summarization of results at the close of a period is called “closing the ledger.” The procedure consists, first, in a transfer, i.e., in a closing out, of all the temporary proprietorship accounts to the Profit and Loss account; second, in the transfer of the balance of this account to the owner’s personal account; and third, in the transfer of the balance of the personal account to the owner’s capital account. After all temporary proprietorship accounts, the Profit and Loss account, and the owner’s personal account have been closed, the only accounts remaining open on the ledger are those showing either assets, liabilities, or capital. A formal statement of the balances of these accounts constitutes the balance sheet. The accounts through which the income and expense records of the business are closed, summarized, and transferred to the vested proprietorship account, are shown below, with typical entries:
PROFIT AND LOSS ================================================================== 19— | 19— June 30 | June 30 Purchases (Cost | Sales (Net income of Goods Sold) 15,000.00 | from sales) 30,000.00 Sales Salaries 5,000.00 | Delivery Expense 500.00 | Office Salaries 2,400.00 | Supplies, Postage, | etc. 200.00 | Insurance 150.00 | Bad Debts 500.00 | Interest 150.00 | Depreciation 200.00 | John Doe, Personal | (Balance) 5,900.00 | --------- | --------- 30,000.00 | 30,000.00 ========= | =========
JOHN DOE, PERSONAL ================================================================== 19— | 19— Jan. 5 Cash 300.00 | June 30 Profit and Loss Feb. 10 ” 250.00 | (Net profit) 5,900.00 Mar. 3 ” 150.00 | Apr. 1 ” 200.00 | May 10 ” 300.00 | June 3 ” 250.00 | 30 John Doe, Capital | (Balance) 4,450.00 | -------- | -------- 5,900.00 | 5,900.00 ======== | ========
JOHN DOE, CAPITAL ================================================================== | 19— | Jan. 1 75,000.00 | June 30 John Doe, | Personal | (Net increase | in proprietorship) 4,450.00
XVI. SOURCES OF DATA FOR THE LEDGER
=Insufficiency of the Ledger Record.=—In an earlier chapter a business transaction was defined as an exchange of values, and the ledger as the book in which transactions are grouped under predetermined titles or names. Thus, all transactions relating to machinery are grouped under the title “Machinery”; those relating to cash under the title of “Cash”; those to purchases under the name “Purchases”; etc. Even in a small business the ledger may contain a large number of accounts, all necessary to give a clear-cut presentation of the volume and significance of business transactions.
The ledger record presents an analysis of transactions into their component elements, each transaction being classified and recorded, usually, in at least two ledger accounts, and frequently in more. Consequently, in order to learn the nature of a given transaction, to see it in its entirety, it may be necessary to refer to a number of separate ledger accounts. This process, even if the ledger is small, is not always easy; and when the ledger contains a large number of accounts, it becomes practically impossible. Accordingly, another kind of record is needed.
=The Book of First Record.=—This other record shows in one place the transaction in its entirety; it gives a complete statement of the conditions and all other data relating to the transaction. It also shows the fundamental analysis of the transaction into its debit and credit elements under appropriate titles. It is called the original or first record. Usually it is not the very first record made of the transaction but it is the first record made in the books of account. The book in which this record is kept is called the “Journal.” The record as kept in the ledger is a secondary record based on the original or first record in the journal. Because of its secondary nature, courts will not accept the ledger as evidence without verification.
=Posting to the Ledger.=—The act of transferring the original entry from the journal into the ledger is called posting to the ledger. In order not to lose sight of the original record in the journal it is important that the ledger entry show by letter and number the book and page where the original entry can be found. This index is entered in what is called the reference column of the ledger account, which is just to the left of the money column. In this manner every entry in a ledger account has a reference to the original entry pertaining thereto.
=The Journal.=—A journal may be defined as a diary or log in which the happenings or transactions of a business are recorded in chronological order; that is, consecutively day by day as they arise. Formerly it was sometimes called a day-book or blotter. As usually operated, however, the day-book or blotter contained a rough record giving all the essential data relating to each transaction without regard to accounting terminology, i.e., without regard to the formulation of the debit and credit of each transaction. The day-book entry was a sort of memorandum from which a formal record was made in the journal. This day-book or blotter, though still in use in some places, has very largely been discarded and only the formal journal is used. This latter was originally a single book but in modern accounting practice it has become separated into many special journals.
=Characteristics of the Journal.=—1. Being of the nature of a diary, the journal shows each day’s transactions in consecutive order with little regard to grouping. The first characteristic, therefore, of the journal is that it is a book of chronological entry, a record of each transaction just as it took place, with the entries made according to the dates of the transactions.
2. Another characteristic of the journal entry is that it is an analytical and classifying record. Before the entry is made, the transaction is analyzed into its two elements of debit and credit, determined according to the effect the transaction has in increasing and decreasing assets, liabilities, or proprietorship. The account titles used in the journal are the same as those used in the ledger and are selected on the basis of a detailed subclassification of the three fundamental groups of accounts. The degree of detail in classification depends on the desired minuteness of the information required. The guiding principle in giving these titles is to use such names as will tell truthfully and accurately what kind of information is recorded under each head. A journal entry is therefore an analytical record as to debit and credit, which classifies the different elements of the transaction under such titles as will later be used in the ledger.
3. A final and a very essential characteristic of the journal is that every entry should carry in addition to account titles, with their debit and credit amounts, a brief but complete summary of all the conditions and data relating to the transaction, so that, if referred to in the future, the journal record will call to mind the essentials of the entire transaction.
Because of these three characteristics, and particularly the last two, the journal record is of prime importance.
=Equilibrium of the Journal Entry; Compound Entries.=—As explained in a preceding chapter, the debit and credit elements of all transactions must be equal in amount. Since the journal entry is an analysis of the transaction, it must obviously show equal amounts in the debit and credit columns. In case the analysis and classification require an entry consisting of more than one debit and one credit item, the total of the several debit items must equal the total of the several credit items. Such an entry is called a compound journal entry.
=Standard Form of Journal.=—The standard form of journal provides spaces for the following information: date, classification as to debit and credit, ledger index column, money columns to show both the debit and credit amounts, and full record of the essentials of the transaction. The following form illustrates a complete journal entry:
================================================================== 19— | | | | | Jan.| 10 | Notes Receivable | 10 | 1,000.00 | | | James Jackson | 14 | | 1,000.00 | | 60-day note, payable at | | | | | First National Bank, | | | | | Perryville, Maryland, | | | | | with interest at 6% per | | | | | annum. Due March 10, 19— | | |
Form 6. Standard Form of Journal
The date is sometimes shown in the middle of the first blank line; but it is better to place it at the extreme left. The account titles are placed on separate lines unencumbered with other data, because they are of first importance in posting. The name of the debit account is shown on the extreme left of the explanation column, with a uniform margin to the right for the credit account. The debit and credit amounts are placed in the left and right money columns respectively. Data giving full explanation of the entry are shown directly below the classified debit and credit entry, slightly to the right of the margin of the credit account title, and a uniform margin is maintained down the page. The column to the left of the money columns shows the ledger pages to which the entry is posted. The entry is read thus: Notes Receivable, debit; James Jackson, credit, $1,000.00.
XVII. THE SUBDIVISION OF THE JOURNAL
=Inadequacy of the Old Journal.=—As explained in the previous chapter, every business transaction was formerly entered in the journal. This necessitated the making of a formal debit and credit entry for every item, many of which were of the same kind. As the object of every business is to sell something, during any business day a large number of sales, in consequence, had to be analyzed, classified, and entered separately. The entry in each case was a credit to Sales, and either a debit to the customer if the sale was “on time,” or a debit to Cash if the sale was for cash. It was soon perceived that instead of making a separate entry for each sale, one entry could be used for bringing into the books all the sales for a given day. This was accomplished by carrying a memorandum of the individual transactions until the close of the day when a formal summary or compound entry was made in the journal. Such a summary or compound journal entry is illustrated below:
A. Jackson 175.00 D. Hayes 25.00 J. M. Marshall 132.50 T. P. Pollard 79.40 I. M. Cranston 93.20 M. V. Johnson 17.15 Sales 522.25 To record the day’s sales.
The memorandum of each sale was made in a blotter to record the quantities and kind of goods sold but such entry formed no part of the double-entry record, being merely the source of information for the formal summary entry.
=The Special Journal a Labor-Saving Device.=—This use of the journal can also be made in connection with other transactions, with similar great saving of labor. Throughout the day in every business there is a large number of cash transactions—receipts and disbursements—which require a debit and credit record. Also purchases of merchandise, although not numerous for any particular day, comprise a large number of entries during the course of a month or year. To save the labor of so many entries, the original journal is divided into separate books known as special journals, each containing the original entries for a particular group of similar transactions, the number of books corresponding to the number of groups into which the various transactions are divided.
For instance, where the policy of the business is to encourage the settlement of outstanding customers’ accounts by notes, the use of a notes receivable book or journal effects a very appreciable saving of labor. Through the use of such a book, limited to a record of nothing but notes receivable, it is unnecessary to write each time a note is received, a complete journal entry as follows:
Notes Receivable 1,500.00 James Jackson 1,500.00
Instead, the entry of Jackson’s name in the notes receivable journal is in itself evidence of a debit to Notes Receivable account. Thus only the credit side of the entry need be shown, with appropriate explanation and detail, the formal debit being suppressed. When, however, the books are closed at the end of each regular period, the total of all these entries in the notes receivable journal is formally labeled “Notes Receivable, Dr.” and posted to the debit of the Notes Receivable account. This procedure brings on the ledger one debit entry for the transactions of the entire month. The corresponding credits have been posted in detail day by day from their journal record.
So also, when it is the practice of the business to issue many of its own notes either in payment of purchases or for discount purposes, a “Notes Payable Journal” may be used. The method of handling this book is similar to that of handling the notes receivable journal as described above. A similar procedure is followed in the case of sales, purchase, and cash transactions referred to above. The method of handling these four groups of transactions will be explained in detail in the chapters which follow.
=Basis of Subdivisions.=—The basis for dividing the one general journal into special journals is the relative frequency with which transactions of a similar nature occur. It would evidently be of no utility to create a special journal if the number of transactions to be recorded in it was small, as the saving in the labor of making the entries would be more than offset by the trouble of using an extra book.
=Customary Subdivisions.=—The special journals most frequently met with are those for purchases, sales, and cash. The Purchase Journal contains the original entry of purchases, the Sales Journal the original entry of sales, and the Cash Journals the original entry of cash transactions. All other original entries are made in the general journal. For the sake of brevity, the general journal is usually designated by the single term “Journal.”
It should be thoroughly understood that no matter how many special divisions of the journal may be in use, such books combined with the general journal comprise the journal record of transactions. None of them is merely a memorandum record to be summarized and to be formally recorded later. The record made in each is formal, although abbreviated, and each must be posted completely, both debit and credit, in order to secure in the ledger a full record of all business transactions.
A brief explanation will be given in following chapters of the more simple forms of special journals.
XVIII. THE PURCHASE AND THE SALES JOURNALS
=Types of Purchase Journal.=—For recording purchases of stock-in-trade, a separate special journal called “Purchase Journal” is used. Sometimes this special journal takes the form of what is called an “Invoice Book,” explanation of which is given in a later chapter. The purchase journal is sometimes used to record all sorts of purchases, as for example, purchases of store and office supplies, of advertising and printing, and even of services such as labor, and of uses, such as the use of a building. Such use of the journal is more commonly made by manufacturing concerns than by mercantile houses and the journal is then known as a “Voucher” or “Accounts Payable Register,” which is explained in Volume II. The present discussion is limited to the purchase journal as a record of purchases of stock-in-trade by a mercantile firm.
=Analysis of the Purchase Transaction.=—The debit and credit analysis of a transaction covering a purchase of stock-in-trade may result in either one of two groups of entries: (1) if the transaction is on credit, a debit to Purchases and a credit to either a personal account payable or to Notes Payable account; or (2) if the transaction is for cash, a debit to Purchases and a credit to Cash. Whether the purchase is on open account, on a note, or for cash, it is often desirable to keep the accounts in such a way as not only to indicate the vendor in each instance, but also to show the volume of business done with each creditor. This is accomplished when the purchase is for cash or for a note, by opening an account with the creditor in much the same way as when it is on open account.
Thus every purchase transaction is first recorded as follows:
(1) Purchases Vendor
If the purchase is a cash purchase, the liability to the vendor is immediately canceled by the entry:
(2) Vendor Cash
The vendor’s account is canceled by being credited and then immediately debited with the same amount. This leaves on the books as the net result of these two entries a debit to Purchases and a credit to Cash. This record of the transaction is seen therefore to agree with the analysis of the cash purchase transaction as previously explained.
Instead of opening individual accounts with each vendor, in the case of cash purchases, the same result is sometimes accomplished by the use of one account called “Sundry Cash Creditors.” To it all such cash purchase transactions are posted both from purchase journal and cash book. This method records the combined liability to all vendors in one account. It does not, however, show the volume of business done with each creditor.
If the purchase is on a note, the liability to the vendor as set up in entry (1) is immediately canceled by the entry:
(3) Vendor Notes Payable
The net result of these entries, (1) and (3), is seen to be a debit to Purchases and a credit to Notes Payable—a record which corresponds with the original analysis of the transaction.
Since a purchase on open account also results in a debit to Purchases and a credit to Vendor, it is seen that all types of purchase transactions may be recorded as a debit to Purchases and a credit to Vendor. Accordingly, in making the current record in the purchase journal, the debit element may be omitted, since it is always the same, and only the credit element, which differs in each case, may be set up. Periodically, usually at the close of each month, the debit element is formally set up for the total amount of purchases for the period. (See Form 7, a typical purchase journal.) Thus the one formal debit is made to offset the numerous credits set up during the month. The purchase journal is thus seen to be as fully a debit and credit journal as the general journal, even though in making its day-to-day record the debit element is, for the sake of economy in labor, omitted.
Other methods of handling the cash and note purchase transaction are explained on page 152.
=Form and Method of Using the Purchase Journal.=—The simplest form of purchase journal is the same as that of the standard journal. It provides space for date, classification, explanation, ledger index, and two money columns. In the purchase journal the money columns do not have “debit” and “credit” significance, but the first may be used for the detailed extensions and the other column for the total of each purchase. Assume, for the sake of illustration, that the following purchases have been made:
January 10, 19—, from S. C. Bontell, terms 2/10, n/30: 5 tons hay @ $12.00 100 bu. corn @ .90 1,000 bu. wheat @ 1.10 30 tons coal @ 4.50 January 18, 19—, from P. V. Stewart, terms 2/10, n/30: 50 tons hay @ $12.00 130 tons coal @ 5.00 January 22, 19—, from I. S. Van Doren, terms n/30: 100 tons coal @ $ 4.50 600 bu. wheat @ 1.00 January 28, 19—, from S. M. Sax, terms 2/10, n/60: 510 bu. wheat @ $ 1.10
The purchase journal record, using the simple form of the standard journal, would be as follows:
Usually, however, a form of purchase journal is used which is better adapted to its purpose. In this, instead of giving the detailed explanation, the file number of the original invoice is written as part of the explanatory matter, which usually comprises only this file reference and the terms of the purchase. This modern type of journal is illustrated below.
=Posting the Purchase Journal.=—In posting the purchase journal, it is customary to post daily the credits to the various vendor accounts as they are entered from day-to-day in the journal. In this way the true status of the amounts due these creditors may be known at any time by reference to their ledger accounts. The offsetting debit to Purchases account is posted only at the end of the month when the purchase journal is summarized. In the meantime the ledger is out of equilibrium because only the credit side of all purchase transactions has been entered in the ledger. This equilibrium is restored, however, by the monthly posting of the debit to Purchases account which must always be made before the trial balance is taken.
An essential part of posting is the cross-indexing of the two records, the journal and the ledger. The cross-reference column in the ledger account must show the initial and page of the journal from which each item is posted. For example, “P. 10” in the ledger would refer to purchase journal, page 10. Likewise the ledger folio (L.F. or Folio) column in the journal must show the ledger page of the account to which the item has been posted. Thus, in the illustration, Stewart’s account is on page 125 of the ledger, where he is credited with $1,250. At the end of the month the purchase journal is footed and the summary entry, “Purchases, Dr.,” is made and posted to the debit of Purchases account on page 10 of the ledger. This one debit item in the ledger brings about the equilibrium with the individual credits posted to the various personal accounts payable. The purchase journal is then ruled off and thus made ready for new entries for the next month immediately below the rulings.
=Departmental Analysis of Purchases.=—When it is desirable to separate various classes of purchases so as to determine the profit from each class, particularly in a business which is departmentized, a purchase journal similar to the one shown in Form 9, which has an additional money column for each class of purchases, may be used. If there are three classes or departments, at least four money columns are required. The entry in the first column is for the total amount of the purchases; and the entries in the other three columns, which are headed each with the name of a class or department, are for the total purchases of the respective departments. It is evident that the totals of these three columns, added together, must at all times be equal to the total of the first column. This affords a check on the accuracy of the distribution. At posting time a separate account is opened in the ledger corresponding to each of these classes of purchases. The summary entry in a purchase journal of this kind appears as follows:
Purchases are classified under separate titles, usually because it is desirable to make a corresponding classification of sales and so secure departmental results of operation.
=The Sales Journal—Analysis of the Sales Transaction and Method of Record.=—For recording sales of stock-in-trade, a record called the “Sales Journal” is used, which is limited to sales of merchandise. A sales journal practically identical in form with the purchase journal serves this purpose. Its columns are ruled and current entries are made in it just as in the purchase journal.
The analysis of a sales transaction shows a credit to Sales and a debit either to Customer, Cash, or Notes Receivable, according as the sale is “on time,” for cash, or against a note given by the customer. In handling cash sales and sales against the customer’s note, the same procedure is followed as with purchases, i.e., accounts with customers are opened for all sales, and are immediately closed off if cash or a note is received at the time of the sale.
The current entry in the sales journal shows only the debit item, i.e., the charge to the customer’s account, the credit to Sales account being omitted. At the end of the month, however, the total of all sales is indicated by the summary entry and is posted to the credit side of the Sales account in the ledger. In order to keep the customers’ accounts up to date, the current entries in the sales book, giving the names of the customers and the amounts, are transferred to the customers’ accounts in the ledger at the close of each day.
=Summarization of the Sales Journal.=—At the end of the month or other posting time, the sales journal is totaled and the summary entry is made and posted, thus bringing the ledger into equilibrium by one credit to Sales account for the sum of all the debits to customers accounts made day by day. The closing rulings are then made. The treatment is exactly similar to the work in the purchase journal, the only difference being in the summary entry, where “Sales, Cr.” takes the place of “Purchases, Dr.” If it is desired to keep the sales record by departments or classes of commodities, analysis columns will effect the distribution. In this type of sales record the closing summary indicates the various departmental or other sales accounts to which postings are to be made, instead of the one general account, Sales, precisely as the departmental purchase journal (Form 9) indicates the departmental or other purchases accounts to which purchase entries are to be posted.
=Goods Sold to the Owner.=—The treatment of goods sold to the owner of the business requires brief consideration. The proprietor usually withdraws goods at cost price. There is thus no element of profit in the transaction as there is in other sales. A strict analysis of the transaction shows that it brings about only a decrease of the asset unmixed with any element of income. Theoretically, then, such transactions should not be recorded with the regular sales, but should be shown as a credit to Purchases account. In practice, however, entering them in the sales journal is the easiest method of recording them, and since they are not usually large in volume, this method does not vitiate the total sales figure as a basis for estimating percentages of profit. This matter is discussed in detail on page 273.
XIX. THE CASH JOURNALS
=The Cash Book.=—For recording transactions involving cash, two journals are used. One of these records receipts and the other disbursements of cash. They are known respectively as the “Cash Receipts Journal” and the “Cash Disbursements Journal.” Instead of being separate books, however, they are usually bound together and comprise what is called the “Cash Book.” When bound together their pages alternate throughout the book. The cash receipts journal occupies the left-hand pages, i.e., the even numbered pages—2, 4, 6, etc.—and the cash disbursements journal the right-hand pages—3, 5, 7, etc.—page 1 not being used. This method sets up the cash record, receipts and disbursements, on facing pages and the movement of cash is thus under easy and constant review.
=The Cash Receipts Journal—Analysis of a Cash Receipt.=—If $100 cash is received on account from John Doe, a customer, an analysis of the transaction shows “Cash” debit and “John Doe” credit.
Cash 100.00 John Doe 100.00
So with all receipts of cash; the “cash” element is a debit. The record of cash receipts being made in a journal devoted exclusively to receipts of cash, the “Cash, Dr.” element of the entry may be omitted and only the “credit” element need be shown; the very fact that the entry is made in the cash receipts journal is sufficient to indicate that “Cash” is a debit. The cash receipts journal (Form 10)—the left or debit side of the cash book—is operated, therefore very much like the purchase journal.
=The Cash Disbursements Journal—Analysis of a Cash Disbursement.=—If $10 is paid for expenses of some kind, the analysis gives “Expense” debit and “Cash” credit.
Expense 10.00 Cash 10.00
So with all disbursements of cash. A separate journal being devoted exclusively to cash disbursements, the “Cash, Cr.” element of the entry may be omitted and only the debit shown. The cash disbursements journal is thus seen to be operated in the same way as the sales journal.
Thus, all left-hand pages in the cash book show receipts and all right-hand pages show disbursements. Because it is unnecessary to write the debit element of cash received and the credit element of cash paid out, a great saving of labor is effected. Nevertheless, it must be remembered that the entry on either side of the cash book is essentially a journal entry, and that the missing elements—cash debit on the left page and cash credit on the right page—are supplied at the end of the period by the totals when the two journals are summarized in preparation for posting to the Cash account in the ledger.
=Form of the Cash Journals.=—In the cash journals, just as in all other journals, provision is made for date, account classification, explanation, ledger posting index, and money columns. In a simple form of cash book, just as in the purchase and sales journals, two money columns are usually provided, the one for detail—a day’s or week’s detail—and the other for totals. Such a form is shown in Forms 10 and 11. The student should note carefully how the cash receipts journal is summarized. The balance of cash brought forward from the previous week is entered in the second or total column so that the detail column shows only the current week’s receipts. Inasmuch as the Cash account in the ledger already shows the balance of cash at the beginning of the week, i.e., $5,000, this amount must not be included in the summary entry for the current week. In summarizing the cash receipts journal, therefore, the total only of the detail column, showing the cash received since the last summary, is set up as a “Cash, Dr.” item. In summarizing the cash disbursements journal, since there is normally no balance carried over from the previous week, the total of the journal—representing the cash disbursed since the last summary—is set up as a “Cash, Cr.” item. This is shown as $365, the amount being posted to the credit of the ledger Cash account on page 1.
=Cash Book Taking the Place of the Cash Account.=—Because the two cash journals are set up on facing pages, the record contains essentially the same information as a detailed Cash account in the ledger. The double page record brings together both the receipts and the deductions from receipts—cash being normally a debit account. For this reason the cash book record is itself sometimes used as a ledger account and when it is so used its totals are not posted to the ledger account. The balance of the cash book must, however, be included in the trial balance of the ledger, because when so used the cash book is not only a journal but a ledger account as well.
When, however, the totals of both cash receipts and disbursements are posted to a Cash account in the ledger, the balance used in the trial balance is taken from the ledger account and not from the cash book, although of course the balances in both are the same.
Whichever of these two methods is used, it must always be remembered that the cash book is essentially a journal and that therefore its classifications of business transactions must be transferred to their proper accounts in the ledger.
Best accounting practice, however, requires that a Cash account be carried in the ledger so that the ledger will be a complete record of all transactions and will be independent of all other records for proof of its equilibrium.
=Posting the Cash Book.=—In posting the debit side of the cash book to the ledger, it is important to remember that the debit element of the transaction is merely indicated by the fact that the entry appears on the left-hand page of the cash book. The account name written in the Account Classification column is the credit element and must be posted to the credit of the corresponding account in the ledger. Similarly, on the right-hand side of the cash book, the cash credit element of the entry is suppressed and the named account should be posted to the debit of the corresponding ledger account.
After the posting of the individual items has been completed, the “Cash, Dr.” and the “Cash, Cr.” as shown by the summary entries must be posted to the ledger Cash account, as explained on page 143.
As stated above, each side of the cash book is, in reality, a journal in itself—a cash receipts journal and a cash disbursements journal—and it is only because these two journals are shown side by side that the cash book is sometimes made to serve the purpose of a ledger Cash account.
=Balancing and Ruling the Cash Book.=—The cash book in its simple form is balanced and ruled in the same manner as a ledger account. When the balance is brought down to the new section it is usually entered in the second or total column, thus reserving the first or detail column for the daily or weekly cash receipts, and separating these items from the balance brought down from the previous period. (See Forms 10 and 11.)
When the record is to be transferred to a new page, either the current page (double page) is balanced and ruled and only the balance is carried forward, or the current page is totaled and both debit and credit footings are carried forward as shown in Chapter XIV for the ledger cash account. The cash book is closed, ruled, and transferred as of the same date and on the same line for both sides, although usually there is room for more entries on one side or the other, which may be closed by diagonal ruling. This is done in order to keep the record of the receipts of a given period and that of the disbursements in nearly exact juxtaposition, and thereby facilitate a review of the cash movements for that period.
=The Cash Short and Over Account.=—It sometimes happens that when the cash book is balanced, the amount which ought to be on hand as shown by this balance, does not agree with the amount of cash on hand as shown by actual count. The discrepancy may be due to failure to enter some items of receipts or disbursements in the cash book, or to errors in making change; or it may be due to petty thieving by the cash clerk. If the error cannot be rectified at the time, an entry is made in the cash book, on whichever side necessary, in an amount sufficient to bring the book balance into agreement with the actual cash balance. The account to be debited or credited, as the case may be, is entitled “Cash Short and Over.” If the correct charge or credit is afterwards determined, the item or items should be transferred from Cash Short and Over to their proper accounts. Usually the Cash Short and Over account is treated as an income or expense account and closed into Profit and Loss at the close of the period. Sometimes it is treated as an asset or liability account, depending upon the nature of its contents, i.e., the amount of the discrepancy shown and its probable cause.
=The Cash Purchase and Sales Transactions.=—A standard method of handling the cash purchase transaction when it is desired to keep a record of the volume of business done with each vendor, was explained on page 140, where the purchase was shown to be “washed” or cleared through the vendor’s account. A more direct method is sometimes used.
When purchases are made for cash, a complete record of the transactions is made by the entry:
Purchases Cash
Here there is evidently a conflict of places of original record. The transaction being a purchase, record should be made in the purchase journal; and since it is also a cash transaction, record should also be made in the cash book. However, if an independent record were made in both places, a duplication of the transaction would result, since entry in either journal is a complete debit and credit record. The transaction would be entered twice in full, causing an inflation of the purchases and cash disbursements. In the purchase journal, the credit to Cash would be set up at the time of the transaction and at the time of summarization the debit to Purchases would be included in the total of the Purchases, thus completing the ledger record. In the cash book the debit to Purchases would be set up at the time of the transaction, and when the summary was made the credit to Cash would be in the Cash total. Entry in both journals would, when posted to the ledger, bring about two debits and two credits for the same transaction.
To overcome this difficulty the following methods are commonly employed:
1. The record is made complete in both journals, but the credit to Cash from the purchase journal record is not posted, because that credit will be posted from its record in the cash book. Similarly, when posting the cash disbursements journal, the debit to Purchases is not posted, because that will be posted from the purchase journal. In this way original record may be made in both journals and each journal will then show by its total what it is intended to show, viz., total purchases and total cash disbursed, respectively. In the secondary record, the ledger, only half of each journal entry is set up, the debit to Purchases from the purchase journal and the credit to Cash from the cash book. This prevents the inflation mentioned above and does not destroy the equilibrium of the ledger because there is omitted, when posting from the cash book, a debit equal in amount to the credit omitted when posting the purchase journal.
2. The method explained on page 140 is used with this variation: The record in each journal shows the individual vendor’s account, but at posting time no vendor account is set up in the ledger, neither the credit to the vendor’s account shown in the purchase journal nor its offsetting debit shown in the cash disbursements journal being posted.
It is necessary, when making the original entries in the journals, to indicate all postings which are to be omitted, by entering a check mark, ✔, or a cross, ❌, in the ledger folio column of the journal.
The purchase on a note payable, one method of recording which was explained on page 140, may also be handled more directly by either of the methods explained above for a cash purchase. In the case of the note, however, the journals used are the purchase and general journals.
Similar methods are employed, also, for handling the cash sale and the sale against a customer’s note.
=Columnar Analysis of Cash Receipts and Disbursements.=—As illustrated in the chapters on purchase and sales journals, additional money columns are often used for the purpose of analyzing the purchases and sales by departments or classes of commodities. A similar analysis of both the cash receipts and cash disbursements may aid in segregating certain classes of cash items and thus save labor in posting. Of cash receipts, two classes are usually more active than all others combined. More cash is received from cash sales and from customers on account than from any other source. Accordingly, two additional columns may be used with these headings. All cash receipts must be entered in the Total, Bank, or Net Cash column, as it is variously termed, and then distributed into any special columns provided. Thus all “Cash Sales” would be extended, both in the Net Cash and in the Sales column, and all receipts from customers would be entered in the Net Cash and in the Accounts Receivable column.
In the case of cash disbursements, the number of columns depends upon the degree of analysis desired. At least two additional columns are frequently found, one for creditors and one for expenses. Where cash purchases are numerous they may be segregated, or where any particular class of expense is of frequent occurrence it may be shown in a separate column. Where one ledger is used for customers, creditors, and general accounts, there is little gain in segregating customers and creditors by special columns in the cash book, except as a slight aid in posting. Where separate ledgers are used, it is important to have separate customers and creditors columns in the cash book, as will be shown later in connection with the subject of controlling accounts. Illustration and explanation of the columnar cash book are given on pages 158 and 159.
=Cash Discounts Analyzed.=—Sales and purchase discounts are another class of transactions best handled through the cash book, although, strictly speaking, they are not cash transactions. When a customer buys goods on account, he is usually offered two bases of settlement, depending on the length of the credit term allowed. Thus, 2% off is frequently allowed if payment is made within 10 days; otherwise the full amount of the invoice must be paid. Because the vendor does not know, at the time of entry on his books, on which basis settlement will be made, he makes the charge at the full invoiced amount. If the customer takes advantage of the discount offered, he pays less than the amount at which his account stands debited, yet the vendor must credit his account for the full amount of the original charge, in order to cancel his entire claim against the customer. To illustrate, a customer buys $100 worth of merchandise, with 2% off if paid within 10 days. On the 10th day he pays $98. The sale entry would be:
(1) Customer 100.00 Sales 100.00
The cash entry would be:
(2) Cash 98.00 Customer 98.00
But this does not cancel in full the $100 claim against the customer. The $2 discount, an allowance for early payment, is an expense to the business and must be charged to an expense account called “Sales Discount,” and the customer must be given $2 additional credit, the entry being:
(3) Sales Discount 2.00 Customer 2.00
Entries (2) and (3) are usually combined in one as follows:
(4) Cash 98.00 Sales Discount 2.00 Customer 100.00
Entry (4) is known as a compound entry. If entry (2), which is the part involving cash, is made in the cash book, then the additional entry (3) will have to be made in the general journal because there is no cash element in it and theoretically nothing but cash should be recorded in the cash book.
=Handling Discounts in the Cash Book.=—This recording in two separate places of what is really one transaction has led to the introduction into the cash book of a non-cash column in order to bring the whole transaction together. The customer’s payment being a receipt of cash, the record must be made on the debit side of the cash book. Reference to entry (4) shows that Sales Discount is also a “debit.” Where the cash book is limited strictly to cash transactions, the cash debit record shows only the “credit” element of the entry. The use of a Sales Discount column on the debit side of the cash book for the sake of making a complete record in one place thus introduces an extraneous element, one out of harmony with the other entries made there. In posting, great care must be exercised not to transfer Sales Discount to the credit side of its ledger account but to the debit side.
=Alternative Treatment for Cash Discounts.=—Sometimes another treatment of sales and purchase discounts in the cash book is met with. This treatment for sales discount is based on the fiction that the full amount of the original charge is received from the customer and that an immediate return is made to him of the amount of the discount. To use the example cited on page 155, the entries would be:
Cash 100.00 Customer 100.00
showing receipt of the full invoice price and therefore full credit to the customer; and
Sales Discount 2.00 Cash 2.00
representing the fictitious payment in cash of a discount on sales of $2. In the cash book these two entries would appear as follows:
Dr. CASH CASH Cr. ========================== ========================== Customer 100.00 Sales Discount 2.00
This method of entering discount on sales would have the same ultimate result in the ledger as the columnar method, but the objection to it is that it makes the cash book show more money received and paid out than has actually been the case, thus making it difficult to check the cash against the bank record of deposits and checks. Another objection is that by this method the cash book does not show in one place a full record of the transaction, since the two items are shown on opposite sides of the cash book. Moreover, these items are seldom on contiguous lines because one side of the cash book is often considerably “ahead” of the other. Cash discount on purchases is sometimes handled by a similar unsatisfactory method.
The first method shown, requiring special discount and net columns on either side of the cash book, is the approved method.
=Illustration and Explanation of the Analytic Cash Receipts Journal.=—An example of a columnar cash book debit side is given (Form 12) for the purpose of illustrating some points in the discussion. It should be understood that there is little uniformity in the columnization of cash books. The needs of the business govern the ruling suitable in any given case. The illustration shown is therefore not presented as a standard form but is given only for the purpose of illustrating the method of analysis of cash receipts.
As shown in the illustration, all actual cash receipts are entered in the Net Cash column, which in connection with the Sales Discount column comprises the total corresponding to the Total column of the other subsidiary journals when an analytic record is made. All items received from customers are entered in the Accounts Receivable column; but it is important to note that the amount entered in that column is not the actual cash receipt but the full amount of the original charge to the customer. Sales discount, if any, is entered in the Sales Discount column, and the net amount, the actual cash received from the customer, is the amount appearing in the Net Cash column. Cash sales are entered in the Cash Sales column and also in the Net Cash column. All other kinds of receipts are extended to the Sundry column.
In the ledger folio column, checks are placed for the individual cash sales entries, the posting usually being made from the summary in the sales journal, as explained a little later, or from the total of the Cash Sales column in the cash book if the other method is not employed. In the summary entry of the illustration, it is assumed that a Cash account is kept in the ledger. Hence “Cash, Dr.” is shown posted to ledger Cash account on page 4; and the total Sales Discount, also debit, on page 20. The student should note the method of showing the amount of cash received during the current week, this amount comprising the “Cash, Dr.” posting to the ledger Cash account. Of course, the itemized credits, except the cash sales, are posted to their respective accounts, as indicated in the ledger folio column.
The use of the Sundry column for extension of the miscellaneous items makes proof of the distribution possible. The sum of “Net Cash” and “Sales Discounts”—both debit items—must equal the sum of all the other columns.
=Handling Columnar Analysis of Cash Sales.=—If all sales, both cash and “on time,” are entered in the sales journal, the totals of these two classes of sales are posted to the ledger Sales account from the summary in the sales journal. In this case there is no need of a separate Cash Sales column in the cash book, because such a column would simply duplicate the Cash Sales entry in the sales journal. Needless to say, cash sales always appear in the Net Cash column of the cash book, because they are cash receipts, but the “Ledger Folio” must be checked.
Sometimes two sales accounts are kept in the ledger, one for cash and the other for “time” sales. Here, also, if there is a Cash Sales column in the sales journal, no posting of cash sales from the cash book is necessary. On the other hand, if cash sales are omitted from the sales journal, then the cash book should provide for a Cash Sales column and the posting must be made from the total of this column in the cash book.
=Illustration and Explanation of the Analytic Cash Disbursements Journal.=—The cash disbursements columnar record corresponding to the cash receipts shown above, would appear as in Form 13. As with cash receipts, the illustration is not presented as a standardized form but merely for the purpose of showing the method of analysis. Postings are made or omitted, and the same considerations govern the making and posting of the summary entry, as in cash receipts. Being few in number, cash purchases are not shown in a separate column. The treatment of discounts received on purchases is exactly parallel to that of sales discount.
Since all net cash appears in Net Cash column on either side of the cash book, the cash balance is found by taking the difference between these two columns. The two sides must be ruled up and closed on corresponding lines and as of the same date.
XX. THE MODERN JOURNAL
=Matter Left for Record in the Journal.=—By the use of a cash receipts, a cash disbursements, a purchase, and a sales journal, four principal classes of transactions are taken out of the old-time journal and entered in separate books of record. If transactions of any other class are numerous enough to justify the use of a separate book of record, such a record should be set up. Although the number of subsidiary journals, each recording one kind of transaction, may become very large, nevertheless in practically all cases it is necessary to retain the general journal (often referred to simply as “the Journal”), in order to take care of such miscellaneous items as are not recorded in any of the special journals.
The standard form of journal was illustrated in Chapter XVI, where it was stated that a journal must provide space for date of entry, account classification, ledger folio index, debit and credit money columns, and explanation. As an explanation of the form, method of use, proper observance of margins, etc., was made there, it need not be repeated here.
=Kinds of Transactions Recorded in the Journal.=—When the number of subsidiary journals used is limited to the cash receipts, cash disbursements, purchase, and sales journals, as is frequently the case, all items not affecting these four books should be entered in “the Journal”; i.e., transactions involving notes receivable and notes payable; adjustments with customers and creditors resulting from return of goods or claims and allowances thereon; and all formal opening, adjusting, and closing entries. Furthermore, there is usually a number of other transactions, which because of their special and unusual nature cannot be grouped with the items of the special journals and must therefore be entered in the general journal.
=Journal Explanations.=—When these various classes of transactions are entered in the Journal, a very complete explanation should be given the entry. In fact, all entries covering settlements and adjustments with outsiders and within the business itself are of primary importance and the explanation should be so carefully worded as to make the intent of the entry plain and intelligible.
=Closing and Posting the Journal.=—No particular formality attaches to the closing and posting of the ordinary standard form of journal. There is no summary entry, no totaling, and there are no rulings to be made. Ordinary care must be exercised to see that the debits and credits are correctly posted. Since the entry in the Journal is given in its complete form and no debits or credits are suppressed, as is the case in the special journals, posting is not difficult.
=The Analytic Journal with Divided Columns.=—One form of the journal has its debit and credit columns separated, the debit money column appearing at the extreme left of the page, followed in order across the page by columns for date, account classification, ledger folio, and credit money amount. This kind of journal is called a divided or split-column journal and is ordinarily used to collect the totals to be posted to controlling accounts and thus to secure control over subsidiary ledgers. This matter will be fully discussed in later chapters. When the journal is so used it is provided with additional debit and credit analysis columns on each side according to the subsidiary ledgers employed. A divided-column journal with three debit and three credit columns is shown in Form 14. There is always a general money column on each side, the other columns depending on the kind of analysis required by the business.
In the illustration referred to, an Accounts Receivable and an Accounts Payable column are provided. It is obvious that the Accounts Receivable column should usually appear on the credit side and the Accounts Payable column on the debit side; although in some cases provision is also made for an Accounts Receivable column on the debit and an Accounts Payable column on the credit side. The account of S. J. White, a customer, which is paid by his note, should be credited for the amount of $510.20 and consequently the item is extended to the Accounts Receivable column.
=Illustrations—Opening Entries.=—Illustration will be given of a few typical transactions requiring journal entry. The standard two-column journal will be used.
For the purpose of illustrating opening entries, assume the following data:
On September 30, 19—, Jack Gibson started in business, with the following assets and liabilities: Cash $3,500; Notes Receivable $800; Merchandise $4,000; Furniture and Fixtures $450; Accounts Receivable $2,100; Accounts Payable $1,500; and Notes Payable $1,200.
An analysis of this transaction shows that no part of it belongs to either the purchase or sales journals. The part relating to cash is entered in the cash receipts journal. However, in order to show the complete investment in one place, the entire transaction including the cash part, is entered in the Journal and posted from there, with the exception of the cash item. The reason for this exception is that the cash investment is also entered in the cash book and will find its way to the ledger Cash account through the total cash debits at the end of the period. Because of this the cash item in the Journal should be checked and not posted to the Cash account in the ledger.
Likewise, the investment item in the cash book, showing a credit of $3,500 to Jack Gibson, Capital account, should be checked and not posted to the credit of his account in the ledger because this item forms a part of the total investment of $8,150 posted to his credit from the Journal entry.
If the student has difficulty in determining the debits and credits of entries of this kind, it may be helpful to set up the data informally first, in the form of a balance sheet. Using this as a guide, he should then make his journal entry, debiting the asset items and crediting the liability and net worth items.
The above entries bring the transaction completely on the books of original entry and show the ledger folios to which the various items are posted. Notice the check in the L. F. column in the Journal opposite “Cash” and in the cash book opposite “Jack Gibson, Capital,” which is inserted to prevent posting the same item twice.
For opening entries full explanation and details, where necessary, should be given in the Journal, covering lease agreements and contracts entered into when commencing business, and other similar data. It should be noted that with opening entries it is customary for the explanation to precede the formal showing of debits and credits, rather than to follow it as in the case of all other journal entries.
=Adjusting and Closing Entries.=—Other typical entries to be illustrated are those made at the close of a fiscal period: (1) to adjust the books in accordance with certain data that were not obtainable before; (2) to transfer all temporary proprietorship accounts to the summary account, Profit and Loss; and (3) to transfer the net profit, i.e., the balance of the Profit and Loss account, to the proprietor’s personal account, and the balance of this latter account to the proprietor’s capital account.
The debits and credits of the entries necessary to effect the record of the data and transfers mentioned, can be determined as in the operations with ledger accounts previously shown.
The following data relate to Jack Gibson’s business and are given to illustrate the three classes of entries mentioned above:
During the year, sales amounted to $33,000; purchases to $25,000; selling expenses to $3,500; and general administrative expenses to $2,025. It is estimated that of outstanding accounts $350 are uncollectible; that furniture and fixtures have depreciated in value $45. Merchandise inventory shows $5,000 on hand. Gibson drew $1,000 during the year.
The first thing necessary is to make the adjustments on account of depreciation, bad debts estimate, and present inventory. These adjustment entries are made in the Journal as follows:
19— Sept. 30 Depreciation 20 45.00 Depreciation Reserve Furniture and Fixtures 6 45.00 To bring on the books the expense due to estimated depreciation and to effect the proper valuation of Furniture and Fixtures. Bad Debts 21 350.00 Reserve for Doubtful Accounts 3 350.00 To bring on the books the expense due to estimated loss from uncollectible accounts. Purchases 16 4,000.00 Merchandise Inventory 4 4,000.00 To transfer the goods on hand at the beginning of the year to Purchases. Merchandise Inventory 4 5,000.00 Purchases 16 5,000.00 To transfer the inventory of merchandise now on hand to Merchandise Inventory account.
The first two entries, when posted, will bring on the book valuation accounts for furniture and fixtures and accounts receivable, and will set up the expense accounts, Depreciation and Bad Debts. The third Journal entry, when posted, will transfer the goods on hand at the beginning of the year so that they can be added to the Purchases made during the year. In this connection it will be remembered that the sum of these two items, old inventory plus purchases during the year, constitutes the primary factor of “cost of goods to be accounted for.” The fourth entry shows the asset Merchandise now on hand and, by its credit to Purchases, effects a subtraction from Purchases, so that the balance of Purchases, $24,000, shows the “cost of goods sold.”
The books are now adjusted and ready for summarization by means of the Profit and Loss account. The following Journal entries, transferring all temporary proprietorship items to the Profit and Loss account, will effect the closing operation:
19— Sept. 30 Sales 15 33,000.00 Profit and Loss 14 33,000.00 To close. Profit and Loss 14 29,920.00 Purchases 16 24,000.00 Selling Expense 18 3,500.00 General Administrative Expense 19 2,025.00 Bad Debts 21 350.00 Depreciation 20 45.00 To close. 29,920.00 Profit and Loss 14 3,080.00 Jack Gibson, Personal 11 3,080.00 To transfer net profit for the year. Jack Gibson, Personal 11 2,080.00 Jack Gibson, Capital 10 2,080.00 To transfer the portion of the year’s net gain left in the business.
The first entry transfers the sales income to the credit of Profit and Loss. The second entry charges the Profit and Loss account with the cost of goods sold and all other expenses for the fiscal year. When the posting has been completed up to this point, the balance of the Profit and Loss account shows a net gain of $3,080, which, belonging to the proprietor, is transferred to the credit of his personal account, as shown by the third entry. He has drawn against prospective profits to the extent of $1,000, leaving $2,080 of profit remaining in the business as an addition to his permanent investment. Hence, this balance is transferred to Gibson’s capital account by the fourth entry.
=Objection to the Direct Ledger Method of Adjusting and Closing the Books.=—These adjustment and closing transactions are sometimes recorded directly in the ledger without first entering them in the Journal. Usually this is not satisfactory because it does not show in one place a complete record of all the adjustment and closing summaries necessary at the close of a fiscal period. These summaries are matters of sufficient concern to the business to warrant their entry in the Journal where full and complete explanations can be given. The more complex entries often needed to adjust and close the books of a business where numerous income and expense accounts are kept, follow the same general principles as those discussed above. Adjusting and closing entries are given fuller treatment in Chapters XXVII and XXVIII.
The two illustrations given above cover certain types of Journal entries which are of a more difficult character than the customary purchases, sales, and cash entries. A keen analysis is often required to formulate the debits and credits of these entries, and the explanatory matter should be worded with sufficient care to render them intelligible even after the immediate interest in them has been lost and their recording ink has become “cold.”
=Entries Affecting Several Journals.=—Transactions sometimes require entry in two or more journals. A basic principle of bookkeeping is that there should be no duplication of entry in the various journals. A transaction that can be completely entered in one journal should not be entered in any other journal. The one exception to this principle is made in the case of an investment transaction, as explained on page 171. Sometimes, however, there may be a conflict of places of entry, as in the case of cash purchases and sales, already explained, where entry is made in both journals in order to allow each journal to perform its proper function. Two examples will illustrate the proper method of handling such transactions.
PROBLEM 1. Assume that a customer, James Robbins, buys $1,000 worth of goods, paying $300 cash, giving a note for $500 and leaving the balance on open account.
The following entries should be made:
(a) James Robbins 1,000.00 Sales 1,000.00 (b) Cash 300.00 James Robbins 300.00 (c) Notes Receivable 500.00 James Robbins 500.00
It will be noted that three journals are involved. Entry (a) is recorded in the sales journal; entry (b) in the cash receipts journal; and entry (c) in the general journal. The net effect of the three entries is:
James Robbins 200.00 Cash 300.00 Notes Receivable 500.00 Sales 1,000.00
Because special journals are used, however, the transaction must be split up as indicated above.
PROBLEM 2. Assume that the business purchases from the Investment Trust Co. a building site valued at $5,000, paying for it $2,000 cash and a note for the balance supported by a mortgage.
Two methods are used to record this transaction, neither having any special advantage over the other.
FIRST METHOD: (a) Land 2,000.00 Cash 2,000.00 (b) Land 3,000.00 Mortgage Notes Payable 3,000.00
Entry (a) is made in the cash disbursements journal, and entry (b) in the general journal. This method of entry requires the splitting of the land value into two parts and breaks up what is really a unit transaction by recording it in two places. Because of this, the general journal portion of the entry should be followed by a very full explanation of the entire transaction, in which reference to the partial cash payment should be made. In the cash disbursements journal the only explanation needed will be a reference to the general journal entry.
SECOND METHOD.—To bring about a complete record of the land item in one place, the following method is often used:
(a) Land 5,000.00 Investment Trust Co. 5,000.00 (b) Investment Trust Co. 2,000.00 Cash 2,000.00 (c) Investment Trust Co. 3,000.00 Mortgage Notes Payable 3,000.00
Entry (a) in the general journal sets up an account with the vendor, the Investment Trust Co. Entry (b) in the cash disbursements journal and entry (c) in the general journal show the cancellation of the liability to the vendor through the payment of cash in the one case and the giving of a mortgage in the other. The net effect of the entries is:
Land 5,000.00 Cash 2,000.00 Mortgage Notes Payable 3,000.00
It will be noted that this method sets up a formal account with the vendor—a desirable thing—but that it requires one more entry than the first method.
The other entries recorded in the Journal ought not to give the student any particular difficulty.
XXI. BUSINESS PAPERS—NEGOTIABLE INSTRUMENTS
The books of original entry, i.e., the journals, having been explained, the attention of the student will be directed next to the sources of information on which the entries in the various journals depend. Accordingly, some of the important papers and methods used in business will be discussed, after which further accounting principles and methods will be given adequate treatment.
=Use of the Note Receivable.=—The purpose of sales is the ultimate conversion of stock-in-trade into cash to provide for the payment of services and for the purchase of commodities for future sale. This conversion of stock-in-trade into money may be immediate, as when goods are sold for cash, or deferred, as when goods are sold on account. In the latter case the conversion is indirect, because the charge against the customer must be collected before conversion is complete.
Frequently the “note receivable” acts as an intermediate step in the process of converting stock-in-trade into cash. It is an instrument in which the customer formally promises to pay his debt at a fixed time in the future. The kind of claim represented by a note receivable is, legally, different from the open account claim; generally speaking, a note is considered a better claim than an open account. This is because the note implies a prima facie acknowledgment of the correctness of the original charge, and in event of suit relieves the holder from proving the original items of the claim.
Accordingly, when a promissory note is received from a customer, the open account claim against him ceases to exist and a different kind of claim evidenced by his promissory note is acquired. Therefore the open account is credited to show cancellation of the original charge, and Notes Receivable is debited to show the new claim. It may be well to remark here that the same instrument which is a note receivable to the vendor is a note payable to the customer.
In some businesses, it is the policy to encourage customers to give notes. In such cases it is often advantageous, particularly for the credit information shown, to set up the note transactions with each customer under individual names, e.g., “John Doe, Notes Receivable.” Such a title plainly indicates the nature of the items listed under it; viz., claims against John Doe, witnessed by his promissory notes. As a general rule, however, the notes received from any one customer or all customers are usually relatively small in number and for this reason they are for the most part brought together under one class title, Notes Receivable.
=Negotiable Instruments—Their Use and Requisites.=—Notes receivable belong to a class of business papers termed negotiable instruments, the distinctive feature of which is that in many ways and for many purposes they take the place of money. The negotiable instrument, usually of small size but often representing a large sum of money, is used in the commerce of the world as a medium of exchange, in place of heavy and bulky coin or valuable bank notes which when lost or stolen can be passed as currency.
From a legal standpoint a negotiable instrument is one which gives a bona fide holder an absolute right to it, whether the preceding holder had acquired it lawfully or not. It is in this respect distinguished from other objects of value, as a horse, for example, the present possessor of which is the legal owner only if he acquired it in good faith from one who in turn had acquired it lawfully.
To be negotiable, an instrument must have the following requisites:
1. It must be in writing and signed by the maker or drawer.
2. It must contain an unconditional promise or order to pay a fixed sum of money—and the payment must be made in legal tender.
3. It must be payable on demand or at a time which is either fixed or can be determined.
4. It must be payable to bearer or to order.
=Negotiable Instruments—Kinds and Definitions.=—Any formal or informal written promise to pay possessing these essentials is a negotiable instrument. Examples are: promissory notes—notes receivable and notes payable—drafts, checks, money orders and, with certain restrictions, warehouse receipts.
A promissory note may be defined as an unconditional promise to pay a specified sum of money at a certain time. It usually has a form similar to the following:
=The Draft.=—A draft is a written order by one party on a second party to pay to a third party the amount of money named. To be negotiable, it must be so drawn as to meet the requirements of negotiability named above. A draft may have a form similar to the following:
It will be noticed that there are three parties to a draft—the drawer, the drawee, and the payee. The drawer is the person who draws the draft and whose signature appears at the lower right-hand corner of the draft. The drawee is the person on whom the draft is drawn, George S. Perkins, above. He is sometimes called the payer. The payee is the person who is to receive the payment ordered, James Stanley Jackson & Co.
To understand the use of the draft as an instrument of business, suppose the following relations exist between the three parties named above:
1. George S. Perkins bought goods from Bert V. Robbins on account for $175.
2. Robbins bought goods from James Stanley Jackson & Co. to the amount of $125.75 on account.
The problem will be discussed from the standpoint of Bert V. Robbins. From the above data it is clear that Robbins has a claim against Perkins for $175 and owes $125.75 to Jackson & Co. Instead of collecting the claim against the former and paying his debt to the latter, he writes out a draft for $125.75 on Perkins, with Jackson & Co. as payee, thereby requesting (or ordering) Perkins to pay $125.75 to Jackson & Co. This draft he sends to Jackson & Co. and they present it through their bankers to Perkins. Under ordinary circumstances Perkins acknowledges the correctness of the draft and writes his acceptance on the face of it, thereby promising to pay the amount when due. Acceptances are usually worded in the following manner:
Accepted, Oct. 6, 19— Payable at First National Bank of Providence GEORGE S. PERKINS
It should be said that the three-party draft is not usually made use of without the consent of the drawee previously obtained, as in the case of a bank check, which is a draft on the bank drawn by the depositor. Very often in ordinary drafts, particularly when drawn against an export of goods, the drawer makes out the draft in favor of himself and indorses it in blank, thus making it transferable to bearer.
=The Accepted Draft.=—When accepted, the draft becomes, to all intents and purposes, an ordinary promissory note—Perkins’ promise to pay Jackson & Co. $125.75. Until the draft is accepted by Perkins, it simply constitutes a request from Robbins to Perkins to pay the amount named and the draft as such does not bind Perkins in any way. Hence, no entry is made on the books of account of any of the three parties until acceptance. Of course, a memorandum is kept of all drafts drawn.
=Illustrative Entries.=—Upon acceptance by Perkins, the following entries are made:
1. On the books of Jackson & Co., the payee:
Notes Receivable 125.75 Bert V. Robbins 125.75 Robbins’ draft on G. S. Perkins, accepted by Perkins, payable December 5.
Perkins’ acceptance, in possession of Jackson & Co., constitutes a claim against Perkins, and Jackson & Co. therefore debit Notes Receivable. They credit Robbins because this draft was sent to them by Robbins in payment of Jackson’s open claim against Robbins for $125.75.
2. On the books of Perkins, the drawee:
Bert V. Robbins 125.75 Notes Payable 125.75 Accepted Robbins’ draft at 60 days’ sight, favor of J. S. Jackson & Co.
This entry cancels Perkins’ liability on open account to Robbins, and shows as a substitution therefor the amount of his acceptance in favor of Jackson & Co. at Robbins’ request.
3. On the books of Robbins, the drawer:
James Stanley Jackson & Co. 125.75 George S. Perkins 125.75 To record the cancellation of our liability to Jackson & Co. on open account, and to credit Perkins with his acceptance of our draft on him at 60 days’ sight.
From the point of view of Bert V. Robbins, the acceptance by Perkins means two things: (1) the cancellation of a part of Robbins’ claim against Perkins, and for this reason Robbins credits Perkins with $125.75; (2) the cancellation of Robbins’ debt to Jackson & Co., hence Jackson & Co. is debited on Robbins’ books for $125.75.
It is important to note here that in case Perkins fails to pay the note at maturity, Robbins becomes liable to Jackson & Co. Robbins may therefore be considered the first indorser of the accepted draft. The discussion of the manner of booking Robbins’ liability contingent upon Perkins’ failure to pay is deferred to Chapter XLIII.
=Entries After Payment of the Draft.=—Upon payment by Perkins, the following entries are made:
1. On Perkins’ books, a debit to Notes Payable and a credit to Cash.
2. On Jackson & Co.’s books, a debit to Cash and a credit to Notes Receivable.
=Draft and Cash Compared as Instruments of Payment.=—The following two diagrams may further illustrate the utility of the draft as an instrument of trade.
1. Showing the settlement of the several claims in cash—in case Robbins had collected $125.75 from Perkins and had paid $125.75 to Jackson & Co., the payments being made independently in each case:
2. Showing a settlement by draft—a clearing house method:
The commercial, three-party draft is little used now. With the larger function of banks in the conduct of modern business, other kinds of drafts as discussed below have come into use. The three-party relationship is the basis of all draft transactions, however, and must therefore be thoroughly understood.
=Classification of Drafts.=—There are several kinds of drafts, which may be either sight or time instruments. A draft drawn “at sight” is a request on the drawee to pay at sight, i.e., immediately upon presentation to him. The use of the sight draft in making collections is quite common. A delinquent customer is drawn on at sight and collection is attempted through the bank. The method is oftentimes effective because refusal to pay may reflect on the drawee’s credit with his own bank. Usually no formal book entry is made of such drafts until paid. A draft drawn, say, “at 60 days’ (or 30 days’) sight” is a request to pay 60 (or 30) days after presentation. Hence, the dating of the acceptance of such a draft is of prime importance. Such a draft is, of course, a time draft.
A draft drawn “60 (or other number) days after date” is called a date draft and is payable 60 days from the date of the instrument—not, as in the first case, 60 days after presentation or acceptance. It also is a time draft. It is not necessary, although customary, to present time drafts for acceptance.
Drafts may be “commercial” or “bank” according as the drawee is a merchant or a bank, respectively. B. V. Robbins’ draft on Perkins shown above is a merchant’s draft. A bank draft is a request by one bank on a correspondent bank to pay a given amount of money to a named payee. A customary method of remitting money is by the purchase and remittance of a bank draft, for the issuing of which banks usually charge a fraction of a per cent. To illustrate its use, take the following situation:
L. W. Roberts of Denver owes Field & Co. of Chicago $210 on account. Roberts goes to his Denver banker and buys a bank draft which may read as follows:
Before sending this draft to Field & Co., Roberts indorses it in favor of Field & Co., who upon its receipt deposit it with their own bank and through it secure its collection from the Second National Bank. Roberts pays his bank for the draft $210 plus exchange.
Drafts may be foreign or domestic. They are domestic when they are drawn and payable within the same state or country; otherwise they are foreign. According to the present usage, the term “draft” is used whenever the parties concerned live within the United States, although they may reside in different states, and the term “bill of exchange” is applied to all such instruments where some of the parties live abroad.
=The Trade Acceptance.=—The Federal Reserve Board defines a trade acceptance as “a bill of exchange drawn by the seller on the purchaser of goods sold and accepted by such purchaser.” The chief characteristic of this document as contrasted with the ordinary draft is the showing on its face of the origin of the transaction giving rise to the draft, usually by means of the following statement: “The obligation of the acceptor hereof arises out of the purchase of goods from the drawer.” The following requirements to make a trade acceptance eligible for rediscount by the federal reserve banks have been laid down by the Federal Reserve Board:
1. It must have arisen out of an actual commercial transaction, usually the purchase and sale of commodities.
2. It must have been drawn under a credit opened for the purpose of conducting or settling accounts resulting from business transactions involving the shipment or storage of goods.
3. At the time of presentation to a federal reserve bank for discount or as collateral for the loan of money, it must have a maturity of not more than three months exclusive of days of grace.
Trade acceptances are promissory notes just as are any other accepted drafts. Because they comprise a very liquid asset, it is not unusual to record them in an account, Trade Acceptances, and so distinguish them from other notes and drafts. If they are few in number, they are more usually recorded as Notes Receivable.
=Checks.=—A check is a draft on a depositary bank. It is an individual’s order to his bank of deposit to pay a named or designated payee a certain sum of money. Two illustrations are given below, somewhat different in form but identical in nature. In the first, likeness of the check to a draft is very evident.
The certified check is usually an individual’s or firm’s check bearing the certification of the bank’s cashier that the check is good. This certification is evidenced by writing across the face of the check these or similar words:
Good when properly indorsed FIRST NATIONAL BANK F. G. MOFFITT, CASHIER
Such a certification makes the bank responsible for its payment.
A cashier’s check is a bank’s own check drawn on itself in favor of a third party and signed by its cashier. As a medium of exchange it ranks higher than the check of a private person, due to the superior credit of the bank and to the fact that the bank is usually more generally known in a community.
=Other Negotiable Instruments.=—Express and postal money orders are drafts payable at sight, drawn respectively by one express agent on another and by one postmaster on another.
A warehouse receipt is a receipt from a warehouse, elevator, or other storage concern acknowledging the receipt of goods or property. Such a receipt usually contains the contract agreements entered into by the parties, covering the conditions according to which the goods are accepted for storage. The warehouse receipt is usually negotiable, or partially so, in that title to the property may pass with its transfer.
=Principles Governing the Writing of Commercial Paper.=—Ordinary prudence requires commercial paper to be drawn in a way that will make forgery difficult if not impossible. To this end the following two rules should be observed:
1. Leave no blank spaces, particularly where the amount is written. This is not so important when the amount is perforated, with a perforated star at each side.
2. Write the indorsement at the top margin. Unless this is done, some statement might be inserted which would change materially the effect of the signature; e.g., the payer might later write above the signature that the check is accepted in full payment for a definite bill.
=Kinds of Indorsement.=—An indorsement is usually for the purpose of transferring title. There are several kinds of indorsement, as follows:
1. A blank indorsement, which consists only of the payee’s signature; this renders the instrument payable to bearer.
2. A full indorsement, which reads as follows: “Pay to the order of .........,” giving the name of the indorsee, i.e., the person to whom the instrument is transferred, and followed by the signature of the indorser, who before his indorsement was the payee.
3. A qualified indorsement, which is either a blank or full indorsement with the words “without recourse” added to it. This kind of indorsement transfers title with no liability attaching to the transferor in case of non-payment by the maker at maturity.
4. A restrictive indorsement, giving the name of the party to whom the check is transferred, the words “for collection” or “for collection and deposit” being added and followed by the signature. This indorsement does not transfer title but merely appoints the person or bank named as agent for the purpose of collection.
XXII. BUSINESS PAPERS—THE GOODS INVOICE AND BILL OF LADING
=Definition.=—When a business transaction takes place, a record or memorandum of its amount and nature is usually made out. Thus, the amount of cash received for a sale may be rung up on the cash register or a sales clerk may make out a duplicate sales ticket and turn over the carbon copy as a sales memorandum to the bookkeeper; for cash disbursed a receipt, to be the basis for formal entry on the books, may be demanded from the person to whom the payment is made.
These memoranda of business transactions are called “business papers.” They comprise all of the more or less formal and informal documents which constitute the firsthand evidence of most transactions. Among the most common business papers may be mentioned: the goods invoice for purchases or sales; negotiable paper, including the check, note, draft, money order, and warehouse receipt; the statement and account sales; the shipping order and bill of lading; the bill of sale; the lease agreement; and contracts of all sorts. A few of the business papers most frequently used will be explained.
=The Invoice.=—When a merchant sells goods to a customer he writes out an itemized “bill” which is sent along with the goods. This bill, loosely called an “invoice,” is from the seller’s viewpoint more accurately described as a sales invoice, and from the customer’s or buyer’s viewpoint as a purchase invoice. It is an itemized statement of goods bought or sold, and should state the names of vendor and vendee, the address of the vendor and the date of sale, the quantities, kinds, and prices of the goods, the terms of sale, and additional information as to method of shipment, etc.
=Handling the Purchase Invoice.=—When goods are bought the purchase invoice should be verified or audited. The method of audit depends upon the organization of the business. In a small business, if the invoice is received before arrival of the goods, it is usually held till their arrival and then checked against them as to quantities, quality, and price. The extensions and total are verified and entry made in the purchase journal, using the audited invoice as a basis. The invoice should then be placed in a temporary file till paid, after which it is usually filed under the vendor’s name for future reference. The check in payment of the invoice, when returned canceled by the bank, is frequently attached to the invoice for which it was issued as evidence of its settlement. At any rate the paid invoice should bear on its face a notation to show the payment.
In a large business where the clerical work is divided among departments, several copies of the original purchase order sent to the vendor are usually made out—one copy, for instance, for the purchasing department, one for the receiving room, one for the auditing department and so on. The procedure of auditing is then more complex. The copy furnished the receiving room is usually left blank as to quantities, and sometimes the description of the goods ordered is also omitted. When the goods are received, quantities and kinds are filled in by the receiving department, and the copy is sent to the auditing department where it is checked against the auditor’s copy of the original order and the purchase invoice from the vendor. If found correct as to quantity, kinds of goods, extensions, and additions, the invoice becomes the basis for entry in the purchase record—journal or voucher register as the case may be—after which it follows the customary routine as to filing. The invoice remains in a temporary file as long as it is unpaid. Upon payment it is placed in a permanent file, either under the name of the vendor, by invoice number, or according to whatever system may be in use.
=Handling the Sales Invoice.=—Practically all systems of handling sales require that at the time of the sale some record or memo of the transaction be made. In retail establishments the use by each salesman of a book of sales tickets with provision for duplicate or triplicate impression is very general, whether the sale be cash or charge. The cash and charge tickets are usually put up in separate books and a different color of paper is used for each. At the close of the day the total cash tickets are checked against the cash received from cash sales, and the total charge tickets give a controlling figure for charges to customers. The total of the cash tickets plus that of the charge tickets gives the total credit to Sales.
These sales tickets are usually entered on a daily sales sheet provided with distributive columns for analysis according to departments or kinds of commodities. A recapitulation giving the totals of each of these columns is made and posted to the ledger, while the customers ledger accounts may receive their charges direct from the sales ticket. This recapitulation really constitutes the sales journal record, as is explained in Chapter XLVII.
Where the number of charge accounts is not large, a folder system is sometimes used. Each charge sales ticket is placed in the folder which takes the place of that customer’s account, thus avoiding the necessity of making a formal entry on the ledger. When the customer pays this bill, the sales ticket is so marked and is either left in the folder or transferred to a permanent file. The successful operation of the folder system presupposes that the customer will pay the exact amount of his bills shortly after the date of the ticket, no provision being made to care for overlapping credits. Whatever the system, the sales ticket is the original record of the transaction and therefore valuable as evidence in case of dispute. These tickets should be filed away and kept until all danger of dispute is past.
=Credits and Returned Goods Invoices.=—If for any reason goods purchased prove unsatisfactory and are returned, record of their return should be kept by the shipping clerk and used as a basis for securing proper credit from the vendor. The vendor usually sends a returned goods invoice, which, though similar in form to the purchase invoice, constitutes a credit to the purchaser instead of a charge. These credit memos, as they are termed, are always of some distinctive color, frequently red, in order to distinguish them readily from the regular invoice.
Similarly, when dissatisfied customers return goods, or when the business makes them an allowance on goods sold, a credit invoice or credit memo is sent them and the duplicate copy of this memo retained in the office becomes the basis for entering the transaction on the books.
=Shipping Goods—The Bill of Lading.=—The purchase and sale of goods usually involve dealings with railroads. It is not the purpose of this chapter to give an extensive system or method of handling shipments, but merely to explain the purpose of the railroad documents and their use as business papers.
A shipment of goods is evidenced always by a “bill of lading,” a contract under which the railroad accepts freight for carriage, defines its liabilities as a transportation company or warehouseman, and states its duties and those of the shipper. Its standard content is prescribed by the Interstate Commerce Commission, although any additions to it not in conflict with the standard content are not forbidden. If the shipper so desires, he may have bills of lading printed to conform in size with his own files, instead of using those furnished by the railroad. There are two standard forms, the straight bill of lading which is not negotiable and the order bill of lading which is negotiable.
The bill of lading is always made out in triplicate, the original and the two copies being identical except as to titles and signatures. The original is signed by the shipper and the railway agent, and constitutes the shipper’s receipt for the goods delivered to the railroad. The second copy called the “shipping order,” is signed by the shipper only. It is his order to the railroad to ship the goods, and is held by the railroad as evidence of its authority. The third copy or memo is an exact duplicate of the original. Like the first copy, it is signed by the shipper and the agent, and is held by the shipper as a duplicate receipt. Sometimes it is forwarded with the invoice to the customer, but otherwise should be filed by the shipper with the original bill of lading. In case of claim against the railroad for loss or damage to goods in transit, the original bill of lading is required as evidence and should therefore always be kept in the shipper’s possession.
=Freight Notice and Expense Bill.=—A notice, called “freight notice,” is sent by the railroad to the consignee upon arrival of the goods. A more or less formal order is given by the consignee to the teamster or drayage company to call for the freight. This order authorizes the railroad to deliver it to the teamster or drayage company. Upon its delivery, an “expense” or freight bill is sent to the consignee itemizing the freight charges due on the shipment. The freight notice and the freight bill are usually made at one impression, the heading on the one being a notice of the arrival of freight, while on the other the heading is that of an ordinary invoice or bill showing the freight charges on the designated goods. Some railroads make three copies at one impression, consisting of (1) the freight notice, (2) the delivery receipt, and (3) the freight bill. Copy (2) is a receipt surrendered by the consignee upon delivery of the goods.
=C. O. D. Shipments.=—C. O. D. shipments are handled through the agency of an express company, the post-office, or a bank. Express companies accept for shipment freight which is to be paid for upon delivery, agreeing to collect and remit the amount of the invoice to the consignor less collection and remittance charges. This method of shipping sometimes gives the consignee the privilege of examination before acceptance. It is used with customers who are unknown to the shipper or with those whose credit is doubtful.
When the parcels post service is used for shipping goods C. O. D., the post-office makes the collection for the shipper. The shipper must, of course, always prepay the postage, although this may by agreement become a charge against the customer.
When a bank is made the shipper’s agent to collect on delivery, a draft is drawn on the consignee and sent to the bank along with a special C. O. D. bill of lading, the order bill referred to above. This original C. O. D. bill together with the attached draft is sent by the bank to its correspondent located in the same city as the consignee. The correspondent bank presents the draft to the consignee for acceptance or payment, as the case may be, and thereupon delivers the special bill of lading to him. The shipper’s order to the railroad provides that the goods are to be delivered only upon presentation by the consignee of this special bill of lading. In the use of the order bill of lading, it is customary for the original copy to show the goods consigned to the order of the shipper himself. This copy, indorsed by the shipper, and the attached draft are the documents used by the bank in making the collection.
=Duties of the Traffic Department.=—In a large business a special department known as the traffic department is authorized to handle all shipments. Briefly, its duties are to look after all incoming freight, its receipt in good condition and its proper distribution to the several departments; to handle all outgoing freight, its proper routing so as to secure lowest tariffs and speedy delivery; and to secure the adjustment of claims for damage or loss of goods in transit.
=The Statement of Account.=—When goods are sold, an invoice or bill showing terms of sale, quantities, items, prices, and total amount of sale is sent to the customer. Periodically, frequently the last of the month, a statement is rendered each customer whose account shows a debit balance. Frequently the date of sending the statement is recorded in the explanation column of the ledger account, which, from a credit point of view, is a desirable practice.
The statement of account is a transcript, sometimes a summary, of the customer’s ledger account, i.e., it contains all charges and all credits for the period covered. If there is a balance outstanding at the beginning of the month, the current statement opens with the balance item and is followed by lists of all charges, payments, and other credits for the current period; the total credits are subtracted from the total charges and the balance constitutes the amount now due and owing. Sometimes a statement of account is made out in detail, giving a copy of the original invoices which evidence the several sales transactions. Statements of account are issued in many different forms, but the following illustration shows all the essentials:
XXIII. BANKS AND THEIR METHODS
=Service of the Bank to the Community.=—Practically all business houses at the present time take advantage of the banking facilities to be found in every community where there is enough business transacted to justify the establishment of a bank. A bank is sometimes defined as an institution which deals in money and credit. One of its chief functions and the one on which its main income is based is that of acting as a place for the deposit of moneys, these deposits forming the basis for its loans and discounts. Among its other important functions and services are to collect drafts and checks drawn on other banks; to issue and sell its own drafts on other banks, thereby enabling its customers to make payments to out-of-town creditors; to discount commercial paper, i.e., to loan money to its patrons on approved security; and to issue paper currency.
=Opening an Account with the Bank.=—Because so much of the bank’s business is based on the honor and integrity of its customers, a prospective depositor is usually required to present a card of introduction signed by a customer of the bank or someone else known to it. A depositor who wishes to open a checking account is asked to file a “signature” card bearing the signatures which he will use in signing checks. As considerable expense attaches to handling depositors’ accounts, some banks require that the balance of the account shall never fall below a fixed minimum.
=The Deposit Ticket.=—When an account is opened, the depositor is provided with a pass-book and check book. All deposits are made by means of deposit tickets, discount memoranda, or collection notices. The deposit ticket is in form similar to the following:
All moneys and checks deposited are listed on this ticket under the indicated classifications. The deposit is handed to the receiving teller of the bank, who, after verifying the ticket, makes an entry of the amount in the depositor’s pass-book. Duplicate deposit tickets are usually kept by the depositor. It is important to note that checks must be indorsed before they are deposited, so as to make them collectible by the bank.
=The Pass-Book.=—The pass-book is the record of the depositor’s dealings with his bank and, although written up by the bank teller, it is usually kept from the depositor’s viewpoint, i.e., the bank is debited with all deposits and credited with all checks presented for payment. At stated intervals, say monthly, the book is left with the bank for balancing, at which time the total amount of checks paid by the bank is entered in the pass-book and the canceled checks are returned to the depositor. Sometimes the pass-book is kept in account form, the left page indicating deposits, and the right page payments by the bank. More frequently, however, the pages of the pass-book do not have debit and credit significance but constitute a continuous record. In this case, at the end of the period, the deposits are footed and the total of the checks is subtracted from the total deposits, thus showing the balance due the depositor.
A method coming into quite general use among banks is to send a monthly statement of account just as trading concerns do. This statement is a transcript of the bank’s ledger account kept with each depositor, showing deposits and withdrawals. When this is done, withdrawals are not entered on the pass-book, which thus serves only as a memo or receipt of the moneys deposited.
=The Check Book.=—The check book is provided either with a stub, counterfoil, or interleaf, for making a duplicate record of the check drawn. Provision is usually made in the check book for the entry of the deposits. Sometimes each check is subtracted from the previous balance and the amount of the new balance shown; more often, total checks and total deposits are shown separately and in this way, while it is an easy matter to find the balance by subtracting the total checks from the total deposits, the actual figure does not appear and hence is not available to curious eyes.
The balance shown in the monthly statement or by the periodic balance of the pass-book is seldom the same as that shown in the depositor’s check book, due to the fact that certain checks issued by the depositor have not yet been presented for payment to the bank. The method of reconciling the pass-book with the bank balance is treated in Chapter L, “Accounts Current.”
=Securing a Loan through the Discount of a Note.=—A common practice of business men in borrowing money is to discount or sell to their bank or to a broker their own promissory notes and those received from customers. When merchants discount their own notes at a bank, the notes bear only one signature, that of the merchant, and for this reason they are called “one-name” paper. If a merchant receives a note from a customer, indorses it, and then discounts it at the bank, two signatures appear on it—that of the original maker and that of the indorser. Notes of this kind are called “two-name” paper. Banks usually prefer two-name paper because, if the maker fails to pay the note at maturity, the indorser can be held liable for its payment, while in the case of one-name paper the bank has recourse to no one except the maker.
When a merchant makes out a promissory note of, say, $1,000 due 90 days after date, and discounts it at his bank, the bank usually deducts interest at, say, 6%, from the face of the note; i.e., the merchant is credited not for the full $1,000 but only for $985, and when the note matures he either pays the amount, $1,000, or his account is debited with it. The $15 is called “discount” because it is “subtracted” from the face of the note; but since this item is paid for the use of the amount loaned by the bank, it is of the same nature as interest. There is no reason, therefore, for keeping two separate ledger accounts, one for discount and one for interest paid, the two usually being combined under one title, “Interest and Discount” or “Interest.”
=Principles to be Observed in the Calculation of Interest.=—In connection with interest computations it is important to observe the following points, the principles involved in each case being best explained by making use of suitable illustrations.
1. In commercial practice, when the interest period is expressed in months, the interest for each month is one-twelfth of the annual interest, i.e., a note for $1,000 dated April 11, 19—, due “three months from date,” matures July 11 and the interest at 6% is 6% of $1,000 divided by 12 multiplied by 3, or
$1,000 × .06 × 3 ---------------- = $15 12
2. Were the same note worded “ninety days from date,” it would mature July 10 instead of July 11, the number of intervening days being 19 in April, 31 in May, 30 in June, and 10 in July; total 90 days. The interest would amount to
$1,000 × .06 × 90 ----------------- = $15 360
3. If a note is dated March 6, 19—, and matures, say, on April 30, the interest period is 55 days (25 in March and 30 in April). Usually, in computing the number of days in the interest period the opening date is omitted but the closing date is included. In some instances the practice is to include both days.
It is important to note that it is almost a universal custom to use 360 as a denominator in all these cases, although the theoretically correct number is 365. This is done for the reason that the use of 360 greatly facilitates the computation. The government of the United States makes an exception to this rule and counts the year as 365 days, and disregards the month as a unit base; i.e., instead of counting the month of January as ¹/₁₂ of a year, its computation requires the use of the fraction ³¹/₃₆₅ as the multiplier. Interest on $1,000 for, say, 12 days, by this method, amounts to
$1,000 × .06 × 12 ----------------- = $1.97 365
instead of
$1,000 × .06 × 12 ----------------- = $2 360
The incorrectness resulting from the commercial method (using 360 days as denominator) usually is negligible and is fully justified by the economy of time in computation. It may be noted that under this practice the amount of annual interest is ¹/₇₂ more than under the method used by the government.
4. When paper is discounted by a bank, even though its term be given in months, the bank invariably counts the exact number of days in estimating the amount of the discount. Take a note dated June 25 with a term of 3 months and due therefore on September 25, but discounted at the bank on July 25. The term of discount, instead of being 2 months, would be for 62 days, a gain to the bank of 2 days on a 360-day basis.
=Short Methods of Interest Computation.=—In calculating interest or discount, the so-called 12% or 6% method seems the easiest of application. Its base is taken as $1. In the 12% method the interest for a year is therefore 12 cents, for a month 1 cent, and for a day ⅓ mill. In the 6% method, the interest for a year is 6 cents, for a month ½ cent, and for a day ⅙ mill. Using these fractions with the years, months, and days as multipliers, the result is the interest on $1 for the given period. This result multiplied by the face of the note gives the required interest, assuming that the interest rate is 12% or 6%.
A variation of the above gives the following rule, somewhat easier to apply. Reduce the time to days—using a 360-day year, 30-day month basis; multiply the time by the face, point off three places (i.e., treat the product as mills), and divide by 3 or 6 according as the calculation is on a 12% or 6% basis. If the basis used is 6%, but the actual rate is different, add or subtract whatever aliquot part the given rate is more or less than 6%; i.e., if the rate is 8%, add ²/₆ or ⅓; if 5%, subtract ⅙; etc. The following example will illustrate:
A note for $1,000 dated June 10, 19—, for 4 months, with interest at 7%, was discounted July 30 at 8%. Find the net proceeds. The note when due will be worth $1,000 plus 4 months’ interest at 7%. That becomes the basis for the discount calculation.
Applying the 6% method:
4 months = 120 days Multiplied by 1,000 (face of note) ------- 120,000 Marking off 3 points 120 Take ¹/₆ (index for 1 day) ¹/₆ --- 20 = interest @ 6% Add ¹/₆ 3.33 ---- 23.33 = interest @ 7% Add 1,000 -------- Value of note on October 10 1,023.33 -------- This amount (1,023.33) is the basis on which the discount is to be figured.
Multiply by the term of discount (72 days[2])
1,023.33 72 --------- 2,046.66 71,633.1 --------- 73,679.76 --------- Marking off 3 points 73.68 Take ¹/₆ (day index) ¹/₆ --------- 12.28 = discount @ 6% Add ²/₆ or ⅓ 4.09 --------- 16.37 = discount @ 8% --------- Value of note on October 10 1,023.33 Less discount 16.37 --------- Net proceeds on July 30 1,006.96 =========
[2] The 72 days are arrived at as follows:
1 day in July 31 days in August 30 ” ” September 10 ” ” October -- 72
XXIV. METHODS OF POSTING
=The Journal and Ledger Records Differentiated—Posting.=—When a correct and complete record of business transactions has been made in the various journals, practically all the current information needed by the business has been secured. However, because this information is recorded in chronological order, it is not available for use. It requires sorting, grouping, and indexing. To meet this requirement the original chronological record must be transferred to other records which provide for the desired grouping. The separation of the general journal into journals for different classes of transactions such as sales, purchases, and cash, results in making certain kinds of information somewhat more available, but more than this is required for business management. The original records must be grouped and summarized under proper account titles, so that the total results for the period may be had under review at one time. The book containing these account titles is called the ledger, and the transfer of the original record to the ledger is called posting.
=Time of Posting.=—Where subsidiary journals are used, it is not customary to post all entries at the same time. The entries affecting personal accounts, i.e., those of customers and creditors, should be posted daily. Inquiries from customers as to their balances are received every day, and in order that this information may be given promptly and correctly, customers ledger accounts should be kept up to date in every respect. This is a matter of great importance because, if the information desired by the customer is not given promptly, or if an error is made in giving it, thus calling for correction at a later date, the customer’s good-will may be lost and his trade transferred to others. For this reason personal accounts, especially those with customers, should be posted daily, and great care should be exercised in doing the work.
All other accounts may have their postings made periodically—once a week or once a month—the frequency depending upon the need of the business for the information furnished by the accounts. The flow of cash—always of importance—is shown daily by the cash book record; the volume of sales each day can be had from the sales journal; but information as to expenses can usually be had only from the ledger after completing the weekly or monthly postings.
=Methods of Posting.=—Knowing that errors in posting are easily made and that when made they may cause great confusion, it is important for the bookkeeper to know what kinds of errors occur most frequently, and to study means of avoiding them. Certain methods of posting have been found to produce a minimum of error. Some points in connection therewith will be considered here.
One of the chief errors in posting is to make entry on the wrong side of the account, i.e., to post a debit as a credit, or vice versa. The use of subsidiary journals has done away with a large part of errors of this kind, yet it is advisable to keep the following points constantly in mind when posting:
1. The sales journal is a “charge” journal, i.e., the individual items represent debits and must therefore be posted to the debit side of the proper ledger accounts. The sales summaries, however, are credits and must be posted as such.
2. The purchase journal is a “credit” record and all postings, except summaries, are made to the credit side of the respective accounts.
3. In the cash receipts journal, each individual item represents a credit, as explained in a previous chapter, and each individual item in the cash disbursements journal represents a debit. Hence, postings of the individual items on the debit side of the cash book must be made to the credit side of the ledger account, and postings of items on the credit side of the cash book must be made to the debit side of the ledger accounts. The posting of the summary entries of the cash book follows the debit and credit designation made at the time of summarization. The principles here involved were fully discussed in Chapter XIX.
4. In the Journal the debits and credits of each entry are fully expressed, i.e., neither element is suppressed. In posting from this record it is best to transfer all the debits consecutively and then all the credits. The possibility of posting a debit item as a credit is thereby greatly reduced.
=Cross-Indexing the Entries.=—An essential part of posting, in addition to recording the date and the amount, is to cross-index every entry, i.e., to index it both in the book of original entry and in the ledger. The “folio” column in each book is used for this purpose. The index in the ledger consists of the first letter of the book of original entry followed by the page number, and the index in the book of original entry shows the number of the ledger page to which the item is posted. (See Form 22.)
In this way, when the indexing in both books is completed it is possible without loss of time to trace the entry from the journal to the ledger, and vice versa. Usually the ledger folio is entered in the book of original entry immediately after each item is posted. When this is done the absence of a reference number in the journal indicates that the item has been omitted in posting. This check is frequently helpful in tracing errors. Some bookkeepers, however, before doing any posting, go through the book of original entry and from the account index of the ledger enter in the ledger folio column of that particular journal the ledger page numbers. By this method, much time is saved in finding the account in the ledger, but a check mark should be placed after each item as soon as it is posted, to indicate the fact. Then the absence of the check mark indicates an unposted item.
=Explanatory Matter in the Ledger.=—In posting personal accounts it is customary to show the terms of credit in the explanation column of the account. In this way the face of the account shows whether the customer pays promptly or not, and affords a basis for his credit rating.
Notes Payable and Notes Receivable accounts in the ledger should show essential data, such as due date, interest rate, etc. However, when a separate note or bill book is used, these data are given therein and may be omitted from the account in the ledger.
With all other accounts, except sometimes the Profit and Loss account, little or no explanatory matter is carried. However, when a posting is made that is at all unusual, it is well to enter explanatory matter in the ledger. From the business man’s point of view, the ledger is the most important book of account, and if its record can be so made as to require a minimum of reference to original books, it serves its purpose so much the better. Where possible, the Profit and Loss account should carry the names of the accounts closed into it; in fact all transfers, whether made on the face of the ledger or by journal entry, should carry the account title and the ledger folio to which and from which the item is transferred. It is a fundamental principle that every entry must be indexed in such a way as to render reference to it easy at any time.
XXV. THE TRIAL BALANCE AND METHODS OF LOCATING ERRORS
=The Trial Balance.=—In Chapter XIV the trial balance was defined as a list of account totals, debit and credit, or account balances, debit or credit, for all the open accounts in the ledger. This list is set up in two columns, debit and credit, and if the original entries in the journals and the postings to the ledger have been done correctly, the totals of these two columns should be the same.
Neither method of showing the trial balance has any inherent advantage over the other. Some concerns desire the account totals to be shown in the trial balance, as that indicates to some extent the volume of business. This would be true of all accounts which had been opened during the current period. As to those carried over from a previous period little current information would be given. As a general thing, however, the status of customers’ accounts is better indicated when both total charges and total credits are shown. Where only the balance is shown, it does not provide any basis for determining whether that balance is normal for that particular account. In judging a request for a further extension of credit there is a rather close relationship between the volume of trade with a customer and the amount of his unsettled balance.
Sometimes, even the totals of accounts that balance are shown in the trial balance, thus giving the status of all accounts appearing in the ledger. Again, concerns desirous of knowing the net amount owing on customers’ accounts and the net amount owed on creditors’ claims, require balances of all personal accounts and cash, but debit and credit totals of all other accounts. No unalterable rule can be given. The manner of showing the accounts in the trial balance is governed by the way in which the trial balance is to be used and the purpose it is to serve. Manifestly, however, the trial balance cannot give information of every kind desired by a manager. As personal accounts are usually handled by canceling offsetting credits against corresponding debits and carrying only balances forward, the trial balance cannot well show at the same time both total transactions and outstanding balances. Only in small concerns could the trial balance give the information which in larger concerns would be gathered statistically and furnished in addition to the trial balance.
The tendency in modern accounting is to make the ledger record so detailed that all accounts are currently “uniphase,” i.e., have entries on but one side, and in connection with such accounts the two methods of entering them in the trial balance are identical, because the total of the one side of the account is at the same time the balance of the account. It must be observed that as a matter of course this modern tendency does not apply to personal accounts nor to adjustment and closing accounts.
=Errors in the Trial Balance.=—The manner of entering the small pencil footings of both sides of each account and also the account balances previous to taking the trial balance, was explained in an earlier chapter. This preliminary work should be done carefully so as to reduce errors to a minimum.
It is not purposed here to discuss all the kinds of errors that find their way into the accounting records. Errors are frequently made in the original analysis and classification of the transaction, which, as previously stated, result in an entirely incorrect showing of financial condition. Such errors do not affect the balance of the books and are not detected by the trial balance. Their detection is one phase of the professional auditor’s work. This discussion has been qualified by saying that if the work of original and secondary entry has been done correctly, then the ledger should prove. Some points in connection with errors which often occur in posting will be treated here.
The equality of the two totals of the trial balance proves that for every debit entry on the books there has been made an equal credit, or at any rate that the sum of all debit entries equals the sum of all credit entries; i.e., it proves only the mathematical correctness of the work.
It might happen that an item, though posted to the correct side of the ledger, has been entered in the wrong account. The trial balance would not detect an error of this kind. For example, John Doe’s account might be debited with a charge belonging to Richard Roe, both being customers. This of course would make the books show wrong balances in those particular accounts, but would not cause an incorrect showing in the total assets. However, more serious results may come from an error caused by posting to the wrong account.
According to the schedules shown earlier, all transactions bring about increases and decreases in the three main groups of accounts, viz., assets, liabilities, and proprietorship. A transaction resulting in an increase of assets may have its credit in any of the three classes—decrease of assets, increase of liabilities, or increase of proprietorship. A credit entry in any one of these would result in an exact offset to the debit and would therefore so far as that transaction was concerned, result in equal debits and credits in the trial balance; but were entry made to the wrong group of accounts, it would bring about absolutely false results. This would be the case if a proprietorship account were credited, resulting in an increased profit, when the credit should have been to the liability group with a resulting increase of the liabilities—two divergent results.
Thus, while the trial balance does not detect errors in posting to the wrong account, it has great value in that its equality is considered as good evidence of the correctness of the books. This is so because errors of the kind just referred to are not of so frequent occurrence as those involving only the mathematics of the work.
=Suggestions for Locating Errors.=—Where trial balance totals do not agree, it is certain that one or more errors have been made somewhere. The following suggestions may be useful in locating them:
1. If there is a difference of 1 in any column, i.e., .01, .10, 1.00, 10.00, etc., the error very likely results from wrong addition. Check additions of the trial balance and if the error is not located there, those of the ledger accounts must be checked as well.
2. If the difference between the two trial balance totals is an even number, divide this difference by two and look through the trial balance for an item of that amount but entered as a debit instead of a credit or vice versa. The amount of the error must be divided by two because the placing of a given item in the wrong column would result in a difference of twice this amount in the totals of the trial balance. If the error is not located in the trial balance, it may be necessary to look through the ledger accounts because the wrong placing may have occurred there.
In checking through the ledger for an error of this kind, some aid is afforded by the fact that all postings from even pages in the cash book (i.e., the cash receipts) appear on the credit side of the ledger accounts, and all postings from the odd pages in the cash book appear on the debit side of the ledger accounts. If, therefore, in any of the credit reference columns in the ledger is seen a reference like “C 13” or “C 29,” or in any of the debit reference columns an index like “C 40” or “C 58,” it is probable that the error is due to posting to the wrong side.
3. If the mistake has not been found in this way, the trial balance should be checked against the ledger to be sure that no open accounts have been omitted. Examine all closed accounts to see that they balance.
4. Examine the posting index column of all books of original entry to see that no items have been omitted in posting.
5. When the totals of the trial balance are unequal, the error may lie either in the debit total or in the credit total, or both may be wrong. Even when the trial balance “proves,” both totals may contain the same error. In order to determine what is the correct footing, the following method may sometimes be applied: Take the total of the previous trial balance, add to it the current totals from the several journals, and deduct the total of all accounts closed during the period. The result shows the correct footing for the present trial balance. Where the number of accounts closed during the period is large, the work entailed by this method may be prohibitive. The method is of easy application only when the trial balance is taken by means of debit and credit totals.
It may be left to the student to prove why this is a correct method for determining the present trial balance total. Suffice it to say that it is based on the fundamental fact that for every credit item in any of the journals there is of necessity a debit or group of debits the total of which corresponds with the credit item. Duplicating entries in two or more journals must be eliminated from the journal total.
The following table will serve to illustrate the above method:
Previous trial balance total $12,967.30 Sales journal total for current period 8,429.60 Purchase ” ” ” ” ” 5,627.40 General ” ” ” ” ” 564.90 Cash receipts ” ” ” ” 2,572.60 Cash disbursements ” ” ” 1,962.75 ---------- $32,124.55 Closed accounts total 1,211.41 ========== Correct trial balance total $30,913.14
6. If the difference between trial balance totals is divisible by 9, the error may be due to a transposition of figures or to a transplacement, sometimes called a slide. A transposition is an interchange of figures, as 96 for 69, 215 for 512, 6,274 for 4,276, etc. The first is called a simple or one-column transposition, the second a two-column, and the last a three-column transposition. One-column transpositions may also occur in numbers of three or more figures, as 172 for 712, or 3,129 for 1,329.
=Transpositions.=—The following rules will be of help in locating errors of transposition. To determine divisibility by 9, the easiest way is to “cast out” the 9’s.
(a) If the difference between the trial balance totals is divisible by 9 and consists of less than three figures, i.e., 9, 18, 27, 36, a one-column transposition may be the cause of the error. Divide this difference by 9. If the quotient is 1, the difference between the two transposed figures is 1. If the quotient is 2 or 3 or 4, the difference between the transposed figures is 2 or 3 or 4, etc. For instance:
Correct Transposed Number Number Difference
54 45 9 divided by 9 = 1 87 78 9 ” ” 9 = 1
75 57 18 ” ” 9 = 2 97 79 18 ” ” 9 = 2
30 03 27 ” ” 9 = 3 85 58 27 ” ” 9 = 3
Thus the figures in the last column indicate the difference between the figures of the original item.
(b) If the difference is divisible by 9 and consists of two significant figures followed by one or more naughts, the error may be caused by a one-column transposition between columns of a higher order. For instance:
The correct amount being 6,394 and the transposed amount 3,694 ----- the difference is 2,700
which divided by 9 gives 300. This indicates a transposition between figures in the “100” and “1,000” columns, the difference between these figures being 3. Reference to the example given will show this to be the case.
(c) When the difference between the trial balance totals is divisible by 9 and lies between 99 and 1,000, the error may be due to a two-column transposition. Here the middle figure of the error is always a 9, e.g., an error of 297 resulting from writing 512 as 215. Dividing the number (27) formed by the two outside figures of the difference by 9, the quotient (3) is the difference between the two transposed figures, i.e., the 5 and the 2. For instance:
Correct Transposed Number Number Difference
514 415 99 9 divided by 9 = 1 735 537 198 18 ” ” 9 = 2 981 189 792 72 ” ” 9 = 8
Thus, the figures in the last column (1, 2, 8) indicate the difference between the two transposed figures in the correct item. Instead of dropping the middle figure of the difference and dividing by 9 as above, the entire difference figure may be divided by 99 with the same result.
(d) Similarly, when the difference is 999 or a four-figure amount with two 9’s in the middle, a three-column transposition may be indicated thereby. For instance:
Correct Transposed Number Number Difference
5,174 4,175 0,999 09 divided by 9 = 1 6,392 2,396 3,996 36 ” ” 9 = 4 7,081 1,087 5,994 54 ” ” 9 = 6
the figures in the last column (1, 4, 6) again indicating the difference between the transposed figures in the original.
Instead of dividing the number formed by the outside digits (9, 36, 54) by 9, we might divide the full amount of the difference (999, 3,996, 5,994) by 999; this would give the same result.
The reason for the divisibility of this difference by 999 in an error of this kind is apparent when a number is given algebraic notation instead of Arabic. The Arabic number 2,197 expressed algebraically would be 2,000 + 100 + 90 + 7. Generalizing, we may formulate any number of four figures by 1,000a + 100b + 10c + d, in which a, b, c, and d may have values from 0 to 9 inclusive. A transposition between the thousands and units digits, the “a” and the “d,” would result in the following number: 1,000d + 100b + 10c + a. The error would therefore be:
Original number 1,000a + 100b + 10c + d Transposed number a + 100b + 10c + 1,000d ---------------------------- Difference 999a - 999d
This error is plainly divisible by 999, and the resulting quotient (a-d) is the difference between the two transposed digits.
It may be shown similarly why 99 is a divisor of the error cited under case (c) above.
=Transplacements.=—A transplacement or slide occurs when some or all of the digits of a number are moved one or more places to the right or left without change in the order of the figures; for instance, 736 written as 73.60, as 7.36, or as 700.36. The first is called a one-column slide, the second and third two-column slides. The error caused by a one-column slide is always divisible by 9, a two-column by 99, a three-column by 999, etc. The division by 9, 99, 999, etc., disregarding decimals, always gives the figures whose transplacement has caused the error. Thus the error caused by writing 736 as 73.60 is 662.40, which divided by 9 is 736; or 736 written as 7.36 produces an error of 728.64, which divided by 99 gives 736; or 736 written as 700.36 causes an error of 35.64, which divided by 99 gives 36, the part transplaced. The reason is similar to that given above for the transposition.
When a whole number of dollars is written as cents, the resulting error is divisible by 9 and moreover the cents added to the dollars gives 99 in each case. For instance in writing:
.73 instead of 73.00, the resulting error is 72.27 .58 ” ” 58.00, ” ” ” ” 57.42 .16 ” ” 16.00, ” ” ” ” 15.84
When the error in the trial balance is of this kind, the amount transplaced may be found by subtracting the cents of the error from 100. In the above examples this difference would be 100-27, 100 -42, 100-84, or 73, 58, and 16 respectively, which are in each case the figures of the transplaced amount as seen in the example. Having determined this, the trial balance and ledger accounts should be gone over to look for a slide of the given number.
=Checking the Postings.=—From the above discussion, the impossibility of determining in all cases the nature of the error is quite evident—particularly as to whether it is one caused by a transposition or a slide. Unless the kind of error is readily discernible, it is usually advisable to employ the method of checking, i.e., going over all the work of posting to determine its correctness—or other methods to be discussed in Chapter LI. After all, careful work in making the record with legible figures and in proving additions and subtractions, wherever possible, more than pays for itself in the time saved hunting for errors caused by slovenly and inaccurate work.
XXVI. THE CLASSIFICATION OF ACCOUNTS
=Accounting Routine Related to Account Classification.=—The basic relationships between the accounts and the statements of financial condition were explained in Chapter IX, where a chart of accounts was given to illustrate the fundamental equation of the ledger. The complete record-making routine, comprising the use of business papers for memorandum entry, the use of the journals for the first formal record of transactions, and the use of the ledger for the classified entry, has now been explained. There remain, however, two classes of entries, the adjusting and closing, whose relationship to the journal-ledger routine has not yet been fully discussed although their relationship to each record has been separately considered. Since the closing of the books contemplates the drawing up of financial statements and since all record-keeping must have in view from the very beginning a proper classification of accounts giving the desired information to be reflected finally in the statements, it seems best at this point to consider some phases of account classification before proceeding with a detailed explanation of the method used in adjusting and closing the books.
=The Need for Classification.=—As explained in preceding chapters, accounts may be broadly classified into the three main divisions of assets, liabilities, and proprietorship. This threefold division, however, is inadequate for the purpose of presenting detailed information as to the kinds of assets owned by the proprietor, the nature of his liabilities, and the causes that have produced increases or decreases of proprietorship. Subdivisions of the three main groups must, therefore, be made, the minuteness of subdivision being determined by the amount of detailed information desired.
One of the main purposes of account-keeping is to summarize results on the financial statements. The items which appear on these statements represent the balances of one or more groups of accounts. Items, for instance, such as “Land” and “Buildings,” may each represent a single ledger account recording the value of the land, the factory, and the office buildings respectively; whereas the item “Accounts Receivable” represents the group of customers’ accounts, the number of which may run into the hundreds and even thousands and which may be kept in a ledger devoted exclusively to the recording of their detail. The reasons for grouping assets and liabilities on the basis of degree of liquidity, and the advantages resulting from such grouping when drawing up the summary statements of the period, were discussed and illustrated in Chapter III.
It is evident from the above that the classification or grouping of the ledger accounts is reflected in the items on the financial statements; and that, conversely, the kind of information which it is desirable to present on the statements will to a large extent govern the groupings in the ledger. This dependence of the account titles and groupings in the ledger upon the end and aim in view makes it necessary to draw up the original classification with great care. To aid in securing a record correct in the first instance, certain fundamental groupings or classification of accounts must always be made.
=Basic Classification.=—While other groupings of accounts have been made, the classification used here has been from the beginning a three-phase one, consisting of an asset, liability, and proprietorship nomenclature. The third group of accounts, proprietorship, is further divided into the two subclasses, temporary and vested, as explained in Chapter XII. At the end of the fiscal period, after the ledger has been closed, there appear only asset, liability, and vested proprietorship accounts; but during the fiscal period, the temporary proprietorship accounts come into being and certain asset and liability accounts take on a mixed character resulting from the method in which the record is kept. This method is dictated not by a pure accounting theory, but by a theory designed to accommodate itself to the practical requirements of the average business. It is because the practical method of making the record falls short of the theoretically exact method, that adjustments must be made before summarizing.
For this reason, a record is not made daily of the portion of assets which has been consumed each day, but the asset accounts are adjusted at the close of each fiscal period to separate their asset and proprietorship elements. Also, when a note is discounted at the bank, its entire face value is set up as a liability. From the standpoint of accurate accounting, however, the face value of the note overstates the liability for the current fiscal period, if the note falls due in the following period, by the amount of the prepaid interest charge belonging to that next period. Only on the due date of the note does the record show the true condition of the liability. Thus, a “practical” method of keeping the record necessitates the use of certain “mixed” accounts. Fundamentally, however, the three-group classification given answers every necessary purpose.
=Fundamentals of a Good Classification.=—In judging the fitness of a particular classification, the end and purpose for which it is made must always be the criterion. Any classification of accounts must, therefore, have in view the fact that all accounts lead up to the balance sheet and profit and loss statement, and that they must provide the data necessary for the summaries of these statements. Classifications may be made from many different viewpoints and for many different purposes, but a classification which is logical and carries titles clearly indicating the purpose for which the accounts are intended, and which therefore needs little or no explanation, is a satisfactory classification. The three-group classification—assets, liabilities, and proprietorship—meets these requirements.
A two-group classification—real and nominal—is frequently used. Under this classification, asset and liability accounts are grouped as real, and proprietorship accounts comprise the nominal class. This is the standard classification. The student should be familiar with it, although the meaning of the groups is not so apparent as in the case of the three-group classification, referred to above.
=Classifying Business Transactions.=—When making the record of business transactions on the books of account, it is necessary, first, to determine the main account group or groups affected by the transaction. After this is done, it is usually easy to determine which particular account in the group is affected. Great care must be used in the determination of the main groups, since a wrong classification results in an incorrect showing in the summary statements at the close of the fiscal period.
To illustrate, in Chapter XIII reference was made to the fundamental distinction between capital and revenue expenditures. When making the original entry of some transactions this difference is frequently lost sight of and what should be charged to an asset account is charged to some expense account or vice versa. This charging to an asset account, of items which are rightly expense items and therefore cut down the proprietorship element of the business, is one of the easiest ways of inflating the profits for a period and so of making a better showing than would be the case if the facts were recorded correctly.
Correct classification of transactions is a matter of vital importance. An accurate analysis of every transaction must therefore be made before bringing it on the books. After determining the main group of accounts in which record is to be made, further analysis as indicated above is necessary in order to fit a particular transaction into its place under a suitable account title belonging to the main group.
=Detailed Classification.=—In dealing with account classification, the more detailed groupings must also be considered. Such consideration deals, (1) with account titles in detail and even with the kinds and classes of transactions to be recorded under particular titles, and (2) with the arrangement and use of these detailed accounts in the various sections of the summary statements at the close of the fiscal period. Certain broad principles have already been laid down which are to be followed in the selection of the account title, and the objection to the inclusion of unlike items under the same title, and the care to be exercised against a more detailed analysis than is required by the needs of the business, have also been explained. That system of accounts which groups only one kind of data under each particular account title is better than a system which mixes its records by grouping dissimilar data under a single head. Yet, caution is always to be exercised against too great detail and an unnecessary multiplication of accounts. Oftentimes essential facts and forces of business activity are lost sight of in a maze of detail.
Below is given a somewhat detailed classification of accounts in accordance with the two considerations stated above. No attempt is made at completeness; only the more usual titles are presented. This classification will be used throughout the rest of the volume.
CHART OF ACCOUNTS Asset Accounts
CURRENT Cash Petty Cash Notes Receivable Accounts Receivable Reserve for Doubtful Accounts[3] Merchandise Inventory Stocks and Bonds (for current investment) Accrued Income DEFERRED CHARGES TO OPERATION Shipping Supplies Insurance Interest Office Supplies Etc.
FIXED Furniture and Fixtures Depreciation Reserve Furniture and Fixtures Delivery Equipment Depreciation Reserve Delivery Equipment Buildings Depreciation Reserve Buildings Good-Will Etc.
Liability Accounts
CURRENT Notes Payable Accounts Payable Dividends Payable Accrued Expenses
DEFERRED INCOME Rentals Interest Subscriptions Etc.
FIXED Mortgages Payable Long-Time Notes Payable Bonds Payable Debentures Etc.
Proprietorship Accounts
VESTED Proprietors, Capital Proprietors, Personal Capital Stock Surplus (Profit and Loss) Reserves of Profit (not valuation items)
TEMPORARY Income, Operating Sales Sales Returns and Allowances
Cost of Sales: Initial Inventory Purchases Inward Freight and Cartage Purchases Returns and Allowances Final Inventory
Expenses, Operating Selling Expenses Salesmen’s Salaries and Commissions Salesmen’s Traveling and Entertainment Expenses Delivery Expense (wrapping, shipping room, horse and motor expenses, delivery salaries, etc.) Outward Freight Sales Management Salaries and Expense Advertising Depreciation on Salesroom Equipment, Delivery Equipment, etc. Sundry Selling Expenses
General Administrative Officers’ Salaries General Salaries Stationery and Printing Legal Expense Postage Telephone and Telegraph Sundry Office Expense and Supplies Depreciation on Office Building, Equipment, etc. Light, Heat, and Power[4] Taxes Insurance[5] Financial Management Expense and Income Interest Expense Rent[6] Bad Debts Sales Discount Collection Expenses Interest Income Purchase Discount Non-Operating Expense Non-Operating Income
[3] The items in italics in this chart are to be handled as subtraction items from the account below which they are placed or from the group in which they appear.
[4] Light, heat, and power expense should in strict theory be distributed over the departments using it; the selling department to be charged with its share and the general administrative with its share. Where such procedure is difficult or undesirable, the expense is best classified as above.
[5] These items are sometimes distributed partly to Selling and partly to General Administrative where an equitable basis for distribution can be determined.
[6] These items are sometimes distributed partly to Selling and partly to General Administrative where an equitable basis for distribution can be determined.
=Method of Arranging Accounts in the Ledger.=—As to the order of arrangement of accounts in the ledger, one principle governs: Arrange all accounts in such a manner as to facilitate the drawing up of the final statements. Thus, assets should come first, arranged in the degree of their liquidity or availability, and each valuation account following its particular asset. Liabilities, coming as they do after the asset accounts, should be arranged in a similar order. Next should come the proprietor’s accounts, the summary Profit and Loss account, and the income and expense accounts in the order in which they are to be used in the statement of profit and loss. Where only one ledger is kept, the personal accounts receivable and payable are usually recorded in distinct groups, after all the other accounts, towards the back part of the ledger rather than in the position required by the principle just stated.
A trial balance taken from a ledger in which the order of arrangement of the accounts is strictly in accordance with this principle, is called a “classified trial balance.”
XXVII. THE WORK SHEET AND SUMMARY STATEMENTS
=Procedure Preliminary to Adjusting and Closing.=—Before tracing the detail of the adjusting and closing entries through the books, explanation will be given of the usual method of insuring the accuracy of this periodic work preliminary to the formal closing of the books. This preliminary work comprises the technical procedure employed in drawing up the balance sheet and profit and loss statement before the books are closed. It thus brings about a summarization of the period’s results made outside the books instead of in them. Therefore, a proof of the accuracy and correctness of the work of adjusting and closing can be secured before the summarization entries are made in the books. After proof of accuracy has thus been secured, the statements are used as a guide in making the formal adjusting and closing entries.
The information for the balance sheet and profit and loss statements comes mostly from the regular monthly trial balance taken at the end of the period just before the adjusting entries are made. This trial balance must of course be modified in order to include the effect of the adjustments. For the purpose of incorporating the adjustments in the trial balance and then separating the accounts into the two groups, namely, those which are to be summarized in the profit and loss statement and those which are to be used for the balance sheet, a regular form is used known as the accountant’s “work sheet.” This form and the method of its use will now be explained.
=The Work Sheet.=—For the work sheet “analysis” paper is used, which is ruled in its simple form as shown in the illustration on pages 226 and 227, space being provided for:
1. Account titles 2. Trial balance items 3. Adjustment items 4. Profit and loss items 5. Balance sheet items
For the purpose of illustration, a trial balance and a list of adjustments are given below, followed by the work sheet and the necessary explanatory detail.
The student must understand that the work sheet is no part of the formal accounting record, nor is the procedure employed by it a part of the formal work of closing the books. It is only a means by which a rough summarization of the period’s results may be made outside the regular accounting records and all the data needed for the formal statements be brought together. Its purpose is to secure and prove the accuracy of results before the formal adjusting and closing work is entered on the books. Where many or complicated adjustments are to be made, with a resulting probability of error and difficulty in an orderly arrangement of the adjusting entries, the method of the work sheet is almost indispensable. The formal adjusting entries are then made up from the adjustment columns of the work sheet.
=Illustration=
TRIAL BALANCE, December 31, 19—
1 New York National Bank $ 17,600.00 2 Petty Cash 100.00 3 Notes Receivable 15,000.00 4 Trade Customers 35,000.00 5 Reserve for Doubtful Accounts $ 875.00 6 Liberty Bonds 3,000.00 7 Merchandise Inventory 30,000.00 9 Office Furniture and Fixtures 2,800.00 10 Depreciation Reserve Office Furniture and Fixtures 700.00 11 Store Furniture and Fixtures 12,000.00 12 Depreciation Reserve Store Furniture and Fixtures 3,000.00 13 Delivery Equipment 4,500.00 14 Depreciation Reserve Delivery Equipment 2,250.00 15 Buildings 35,000.00 16 Depreciation Reserve Buildings 7,000.00 17 Land 15,000.00 18 Notes Payable 12,000.00 19 Trade Creditors 25,000.00 20 Mortgages Payable 17,500.00 21 U. R. Smart, Capital 90,000.00 22 U. R. Smart, Personal 10,500.00 24 Sales 195,000.00 25 Sales Returns and Allowances 1,850.00 26 Purchases 135,000.00 27 Purchases Returns and Allowances 5,400.00 28 In-Freight and Cartage 1,350.00 29 Salesmen’s Salaries 13,500.00 30 Selling Supplies and Expense 1,600.00 31 Advertising 4,800.00 32 Out-Freight 400.00 33 Delivery Expense 3,300.00 34 Office Salaries 5,000.00 35 General Expense 2,000.00 36 Office Expense 4,500.00 37 Printing and Stationery 750.00 38 Taxes 2,840.00 39 Insurance 1,750.00 40 Interest Cost 900.00 41 Collection and Exchange 85.00 42 Sales Discount 850.00 43 Interest Income 1,500.00 44 Purchase Discount 1,300.00 45 Sub-Rentals Income 650.00 46 Special Police on Strike Duty 1,200.00 ----------- ----------- Total $362,175.00 $362,175.00 =========== ===========
ADJUSTMENT DATA, December 31, 19—
Inventory of Merchandise $26,500.00
Estimated Depreciation: Office Furniture and Fixtures, 10% of original cost Store Furniture and Fixtures, 10% of original cost Delivery Equipment, 16⅔% of original cost Buildings, 4% of original cost Doubtful Accounts, ¼% of Net Sales
Accrued Income: Interest Accrued on Notes Receivable 150.00
Deferred Expenses: Insurance Unexpired 250.00 Advertising Paid in Advance 300.00 Printing and Stationery Supplies on hand 150.00 Selling Supplies and Expense 200.00
Accrued Expenses: Taxes 340.00 Salesmen’s Salaries 175.00 Interest on Notes Payable 50.00
Special Police on Strike Duty 150.00 Office Salaries 100.00
Deferred Income: Sub-Rentals Paid in Advance 50.00
The initial step in the use of the work sheet is to enter the trial balance in the first two columns, as shown on pages 226, 227. The accounts in the trial balance should be arranged in classified form before being entered on the work sheet, as this aids greatly in drawing up the statements. The various adjustment entries, debit and credit, which are almost the same as in the ledger, are then entered in the adjustment columns. The work sheet may be looked upon somewhat as a ledger, entries in whose accounts are to be made horizontally instead of vertically. The analogy to the ledger cannot be carried too far, however. It should be noted that when it is necessary to adjust any account in the trial balance by increasing its debit, this is accomplished by entering the item in the debit adjustment column on the same line with the account to be adjusted. On the other hand, if a subtraction is to be made from a debit amount shown in the trial balance, the amount to be deducted is entered in the credit adjustment column. A complete debit and credit entry must be made in the adjustment columns for each adjustment.
There is given below a debit and credit list of these entries as they are to appear on the work sheet. The manner of making and cross-indexing these adjustment entries is indicated by the cross-reference letters used. It will be noted that, while in most instances these entries are exactly the same as the formal adjusting journal entries, there is a difference in the case of the merchandise inventories.
The student should understand that the list of adjustment entries given below does not appear anywhere in the formal accounting records. It is shown here in journal form only to indicate the debits and credits of the entries to the work sheet. Entries of the adjustment transactions are always made direct to the work sheet, never being set up in journal form. Each of these entries should be traced into the adjustment columns of the work sheet. The figures in parentheses just preceding the debit and credit amounts are, of course, not ledger folios but refer to the similarly numbered items on the work sheet so that the student will have no difficulty in tracing them.
(a) Merchandise Inventory—Final ( 8) 26,500.00 (a) Merchandise Inventory—Final ( 8) 26,500.00 (b) Depreciation Office Furniture and Fixtures (51) 280.00 (b) Depreciation Reserve Office Furniture and Fixtures (10) 280.00 (c) Depreciation Store Furniture and Fixtures (51) 1,200.00 (c) Depreciation Reserve Store Furniture and Fixtures (12) 1,200.00 (d) Depreciation Delivery Equipment (51) 750.00 (d) Depreciation Reserve Delivery Equipment (14) 750.00 (e) Depreciation Buildings (51) 1,400.00 (e) Depreciation Reserve Buildings (16) 1,400.00 (f) Bad Debts (50) 482.88 (f) Reserve for Doubtful Accounts ( 5) 482.88 (g) Interest Income (Accrued) (52) 150.00 (g) Interest Income (43) 150.00 (h) Insurance (Deferred) (53) 250.00 (h) Insurance (39) 250.00 (i) Advertising (Deferred) (53) 300.00 (i) Advertising (31) 300.00 (j) Printing and Stationery (Deferred) (53) 150.00 (j) Printing and Stationery (37) 150.00 (k) Selling Supplies and Expense (Deferred) (53) 200.00 (k) Selling Supplies and Expense (30) 200.00 (l) Taxes (38) 340.00 (l) Taxes (Accrued) (54) 340.00 (m) Salesmen’s Salaries (29) 175.00 (m) Salesmen’s Salaries (Accrued) (54) 175.00 (n) Interest Cost (40) 50.00 (n) Interest Cost (Accrued) (54) 50.00 (o) Special Police on Strike Duty (46) 150.00 (o) Special Police on Strike Duty (Accrued) (54) 150.00 (p) Office Salaries (34) 100.00 (p) Office Salaries (Accrued) (54) 100.00 (q) Sub-Rentals Income (45) 50.00 (q) Sub-Rentals Income (Deferred) (55) 50.00
In order to set up some of these adjusting entries, it becomes necessary to add some new accounts on the work sheet. The student will note these appended at the end of the regular trial balance shown on the work sheet. They are, first, Bad Debts and Depreciation, under the latter of which the detail of the fixed assets subject to depreciation is given, and then follow in order the balance sheet classifications of Accrued Income, Deferred Charges to Operation, Accrued Expenses, and Deferred Income, provision being made to show under each of these titles the detail of the accounts involved.
It will be noted that some of the adjusting entries are not set up in the adjustment columns in exact accord with the way in which the same items are entered on the ledger, but rather in accord with the use to be made of the particular items in drawing up the periodic statements. The purpose of the columns is not to make the adjustments and summarization in a formal manner as is done in the books, but to gather together all the adjusting data so that a correct separation of the balance sheet and profit and loss items can be made for use in the formal summary entries and in the statements. Thus, instead of transferring the initial inventory to the Purchases account, it is allowed to remain under its own title, because it will be needed as a separate item in drawing up the cost-of-goods-sold section of the profit and loss statement. Similarly, the final inventory is not shown deducted from Purchases, but is set up, debit and credit, in the adjustment columns, opposite the title “Merchandise Inventory—Final,” which is inserted immediately following the account “Merchandise Inventory—Initial.” At the time of summarizing, the debit item goes into the balance sheet, while the credit item goes into profit and loss. This method of handling provides in the profit and loss columns the detailed information needed for the cost-of-goods-sold section of the statement, comprising Initial Inventory, Purchases, In-Freight, Purchases Returns and Allowances, and Final Inventory.
The bad debts adjustment is entered in the adjustment columns as a debit to Bad Debts and a credit to Reserve for Doubtful Accounts. Similarly, the depreciation entry is shown as a debit to Depreciation in detail, the credits going to the various depreciation reserve accounts.
The adjustments covering deferred charges are shown as debits to the “Deferred Charges to Operation” classification in detail, the offsetting credits being to the various expense accounts as shown in the trial balance. These credits in the adjustment column will, when combined with the corresponding debit in the trial balance column, indicate the net amount of the charge to profit and loss. The other classes of adjustment entries follow the same procedure.
After all adjustments have been made, a complete distribution of the items in the trial balance and adjustment columns is made either to the profit and loss or the balance sheet columns. The difference between the profit and loss columns will thus show the net profit or loss for the period and must be transferred to the balance sheet as a vested proprietorship item. Instead of being shown as a definite addition to the proprietor’s capital, the transfer is indicated as the final item on the work sheet, being a debit in the profit and loss columns to balance them, and a credit in the balance sheet columns. This difference, $14,747.12 in our illustration, constitutes the net profit for the period, and when added to the credit side of the balance sheet columns should give a total equal to the total of the debit balance sheet column. This transfer of net profit effects a proof of the accuracy of the work.
When this proof has been secured, the formal profit and loss statement should be drawn up, all of the material for which will be found in the profit and loss columns of the work sheet, where it is arranged in almost the exact order needed for the formal statement. The information for the balance sheet is found similarly in the balance sheet columns, all of the detail being properly grouped but a rearrangement of the order of some items being necessary. Thus, while the detail of the deferred charges to operation has been gathered together in one place in the work sheet, in the formal balance sheet this group of items must appear immediately after the current asset section. See page 234 for the profit and loss statement and page 232 for the balance sheet.
It is thus seen that the work sheet provides a convenient method of passing through the trial balance the adjustments necessary to a summarization of the results of the period and of effecting a rough summarization of these results. The work sheet becomes the source of information for the formal statements and a preliminary stage to the adjustment and closing of the books.
The purpose of the formal adjusting entries and the manner of framing them are fully explained in Chapter XXVIII. After the information on which they are based is brought together and entered on the work sheet and after the work of summarization has been proven, the adjustment columns of the work sheet are made the source for these entries. The formal adjusting entries as they appear in the journal are given on page 245. They should be compared with the debit and credit list for the work sheet as given above and the differences noted.
=Need for the Summary Statements.=—Before setting up the formal journal entries necessary to adjust and close the books, the balance sheet and statement of profit and loss will be shown. These two periodic statements do not form an integral part of the books of account. They are drawn up periodically and submitted to the proprietor, because the latter does not always have ready access to the books of account and often lacks sufficient knowledge of accounting to interpret correctly the information shown by the journal and ledger. The periodic statements are intended to show the results of the year in a concise, non-technical form, so that a proprietor, even though not versed in the science of accounts, can readily understand them.
=The Two Forms of Balance Sheet.=—The balance sheet may be arranged in either of two forms. The first form (illustrated on page 232) follows the principles already laid down in Chapter III. This is called the “report form” and is based on the proprietorship equation when written
Assets - Liabilities = Proprietorship
Being non-technical, it is perhaps more favored by executives not versed in technical account-keeping.
The second form (illustrated on page 233) follows the proprietorship equation when written
Assets = Liabilities + Proprietorship
This form shows financial condition by means of the account form, the subtraction of the liabilities from the assets being indicated by their respective debit and credit positions in the account. It will be noticed, however, that this method of showing the subtractions is not strictly adhered to, some deductions being actually performed, as for instance in the case of the valuation reserves which are subtracted from the respective assets to which they apply. This is done in order to render the statement more intelligible. The same principles govern the arrangement of the items and groups of items as in the first form, viz., degree of liquidity for the assets and a similar arrangement for the liabilities. The account form is used almost always when the statement is submitted for publication.
=Two Forms for the Profit and Loss Statement.=—The statement of profit and loss is also made up in either of two forms, called the report form and the account form, based on the same principles as the two forms of balance sheet just discussed. Explanation of the report form has already been given in Chapters V and VI. The account form (illustrated on page 235) is very nearly a transcript of the ledger Profit and Loss account. It differs chiefly in that the information concerning “sales” which is summarized in the Sales account on the ledger is here set up in an inner column and shown summarized on the face of the statement. The information as to cost of goods sold is similarly summarized.
=Interim Statements.=—In many businesses, where the fiscal period is six months or a year, it is often desirable and important that at least approximate results be secured at interim periods. This can be accomplished by means of the work sheet without entailing the burdensome work involved in a formal closing of the books. At the time of the taking of any trial balance, the work sheet can be used as a means of making the necessary adjustments before securing results as to financial and operating condition. Accurate results would of course require as careful work as at the end of the regular fiscal period. The purpose of interim summaries is to indicate trends rather than to show accurate and definite results. At such times, therefore, the inventory is usually estimated, oftentimes the same amount being used as at the beginning of the period. Accruals and deferred items are not so carefully estimated nor in so great detail. Bad debts and depreciation must be taken into account. In this way approximate results for any period—frequently every month—may be secured without interfering with those for the regular fiscal period.