XXVIII. ADJUSTING AND CLOSING THE BOOKS
=Adjustment Entries—Kinds and Place of Record.=—In Chapter XV it was shown that the records as they are usually kept do not reflect the true condition of the business at any time during the fiscal period. For this reason before summarizing the book record for the current period it is necessary to bring onto the books a number of entries the purpose of which is to “adjust” the mixed accounts and thus make the ledger reflect the true condition. These adjustments may be effected by entry made directly on the face of the ledger, but it is better to run them through the journal, thus making it possible to give ample explanation. A further advantage of first recording the adjustment entries in the journal is that in this way all such entries appear in one place in the books of account. The ledger should always be kept as a book of secondary entry, with supporting data in some book of original entry.
Seven types of adjustment entries are needed for the ledger of a mercantile concern. They are:
1. Merchandise Inventory 2. Depreciation 3. Bad Debts 4. Accrued Income 5. Deferred Expenses 6. Accrued Expenses 7. Deferred Income
All such items must be given consideration and entered upon the books before the final results for the period can be correctly shown. It is oftentimes necessary to make correcting entries for items the improper entry or the omission of which are not detected until the close of the fiscal period. These errors, whenever discovered, should of course be corrected at once. Because entries of this kind are in the nature of adjusting entries, consideration of them is included in this chapter.
It may be observed here that if a business manager has an intelligent insight into the development of his enterprise, and carefully watches the volume of sales, purchases, and expenses, he may be able to forecast with some degree of accuracy the approximate results for a given period; but only by making the actual count of stock now on hand and by carefully estimating the classes of items just mentioned, can accurate and dependable results be assured.
All these types of adjustment entries are not always found in every such business, however. Each type will be discussed in turn.
=Inventory of Stock-in-Trade.=—One of the most important adjustment entries is that by which the inventory of stock-in-trade is set up separately on the books. By reference to Chapter XIII it will be seen that none of the accounts connected with merchandise, viz., purchases, sales, returns, etc., contain any definite and up-to-date information as to the value of merchandise on hand. To determine the gross profit on sales this value must be known, and until the gross profit is determined the net profit cannot be ascertained. The balance sheet, the statement of profit and loss, and the Profit and Loss account, call for this information. Therefore, before these statements are made, and before the books can be closed, the value of goods on hand must be determined. The process by which this is done is called “inventory-taking.”
Without discussing the detail of a system of inventory-taking, three fundamental principles can be stated relative thereto:
1. Make sure that all goods belonging to the firm on the date of the inventory are included.
2. Make equally sure that there is no duplication of count, i.e., that no goods are counted twice.
3. See that the condition of the goods, viewed from the standpoint of salability, is indicated.
Two factors of importance enter into the determination of the inventory, viz., the quantity of the goods on hand and their value per unit. Inaccuracy in either factor may lead to a gross error in the final amount. By falsifying the count of the goods the inventory can, of course, be inflated. A usual and more elusive method, often resorted to, consists in raising the price per unit, since the addition of even a fraction of a cent per unit may have the effect of converting an actual loss into an apparent profit. Without further indication of the reason for such valuation, it is now generally required that the inventory be valued on the basis of cost, or market if market is lower than cost. The term “cost” should include all costs, incurred up to the point of placing the goods in condition ready for sale, not only the purchase price, but also duties, freight, drayage, insurance during transit, etc.
After the amount of the inventory has been determined, it is placed on the books. However, before this is done it is necessary that the Merchandise Inventory account be cleared of the goods on hand at the beginning of the period by transferring the amount to Purchases. The following journal entry effects the transfer:
Purchases Merchandise Inventory To transfer the opening inventory to Purchases.
The posting of this entry automatically clears the Inventory account and, by its addition to Purchases, causes that account to show the “total goods to be accounted for.” Purchases, as it now stands, contains both the cost of goods which have been sold during the current period and those which are still on hand as shown by the inventory just taken. Accordingly, to separate the two items, the following journal entry is necessary:
Merchandise Inventory Purchases To set up the inventory of goods now on hand.
This entry when posted shows in the Merchandise Inventory account the asset element, and leaves in the Purchases account the cost of the merchandise sold. The effect of these two entries, then, is to adjust the books to true conditions so far as the merchandise is concerned.
=Depreciation, and Loss on Doubtful Accounts.=—As indicated in Chapter XV, the amount of depreciation of particular assets and the losses due to bad and doubtful accounts are carefully estimated at the close of the fiscal period. The individual depreciation items are all summarized in a single depreciation account—an expense account—whose total debit is closed out to Profit and Loss. The depreciation reserves, however, which are credit items, are handled under separate account titles, and constitute the valuation account of the corresponding assets. The journal entry covering depreciation reads as follows:
Depreciation Depreciation Reserve Buildings Depreciation Reserve Furniture and Fixtures Depreciation Reserve Delivery Equipment Depreciation Reserve Machinery
The Reserve for Doubtful Accounts is the valuation account of Accounts and Notes Receivable. Assume, for instance, that the debit balances of the latter two accounts are $15,900, and the credit balance of their valuation account is $600. The difference between these two accounts, viz., $15,300, represents the present estimated value of Accounts and Notes Receivable. The journal entry made periodically to record the estimated loss from uncollectible items is:
Bad Debts Reserve for Doubtful Accounts
When the two entries above, for estimated depreciation and bad debts, are posted, the present appraised values of those particular assets are brought on the ledger; i.e., from the values, as shown by the respective asset accounts, are taken the portions estimated to have been used up, lost through depreciation, or uncollectible. These lost portions are set up as expense items, leaving in the adjusted asset accounts true asset values as existing at the close of the period.
=Accrued Income.=—As to the asset portion of items of this kind, it is indicated in the account in a manner similar to deferred expenses, as explained on page 242. Take the case of interest income earned but not due. The entry for adjusting it is:
Interest Income (Accrued) Interest Income
The credit part is posted immediately, thereby showing an addition to the income already recorded as earned during the current period. The debit part is posted after the current account is adjusted and allowance made for the closing transfer entry to Profit and Loss. The debit part of the adjusting entry is then entered on the debit side of the new portion of the account. Assume this debit item to be $50, and the interest received during the next period to be $170. The new account will indicate a credit balance of $120, which is the amount actually earned during that period, since the previous period took credit for the $50 accrued or earned during that period.
=Deferred Expenses.=—When a part of the expense paid during the current period applies to the next period, the prepaid portion must be taken out of the current expenses and held over—deferred—as a charge to the expenses of the next period. Taking insurance as an example, the following journal entry effects the required adjustment:
Insurance (Deferred) Insurance
In posting this entry, the credit part is posted first in order to take out of the excessive cost shown chargeable to this period the portion equitably belonging to the next period. When this is done, the debit balance of the Insurance account indicates the amount to be charged to the current period and is the correct charge against the Profit and Loss for the period. After making allowance for the space needed for closing the account, the debit side of the above entry is posted, this debit becoming the first charge in the account for the next period. Note that the use of the bracketed “Deferred” is as a guide in posting. It indicates that that portion of the entry is not to be posted until provision has been made for closing the account. After posting is completed, the Insurance account appears as follows:
INSURANCE ==================================== Jan. 2 125.00 | Dec. 31 200.00 Apr. 10 250.00 | Aug. 15 300.00 | ------ | 675.00 | ====== | Jan. 1 200.00 |
There remains, of course, the transfer to Profit and Loss of the current balance before the account is closed. This closing work is treated later in the chapter.
=Accrued Expense Items.=—These items cover expenses which the business has incurred but has not yet paid, and which are properly chargeable to this period but have not yet been charged on the books. For instance, salaries earned up to the close of the period but not paid at its close constitute an additional charge to the period’s operations which must be entered on the books before they will show true conditions. This amount also constitutes a liability of the business. Accordingly, the journal entry is:
Salaries Salaries (Accrued)
thus charging the Salaries account with the amount due but not paid, and bringing this amount down as a credit balance to the new account for the next period. Assuming this unpaid amount to be $72, the account after closing will show this $72 as a liability on the closing date. Its effect, however, during the next period will be to reduce the amount charged to salaries during that period, because this $72, although paid during that period, has already been charged to the previous period.
The credit to Salaries, therefore, serves two purposes, viz., that of showing the outstanding liability at the close of the current period, and that of effecting a reduction of what would be, without this credit, an overcharge to next period’s salaries. For example, if the total salary paid during the next period is $600, the balance of $528 is the amount applicable to that period, although the amount actually paid is $600.
=Deferred Income.=—Income received by the business during the present period which, however, belongs to the subsequent period is called “deferred income,” as for instance, rent received in advance from a tenant. As to the liability portion of items of this kind, it is indicated in a manner similar to the accrued expense items. In this case the journal entry is:
Rent Income Rent Income (Deferred)
the effect being to decrease the amount of rent income for the current period and to show the portion belonging to the next period deferred to that period’s account.
=Corrections.=—When an error has been made in any entry on the books, it should not be erased or scratched out, because by so doing suspicion may be raised as to what was expunged. The wrong item should be ruled out and the correct item written above it or wherever it belongs. This applies particularly to books of original entry whose use as evidence has often been destroyed because many erasures appeared in them.
Another way of making a correction, when an amount has been posted to a wrong account, is first to cancel the wrong posting through a similar entry on the other side of the same account, and then to post it to the correct account. Cross-reference to the two accounts must be made.
When an amount has been posted to the wrong side of the correct account, e.g., $100 to the credit side of John Doe’s account, when it should have been posted to the debit side, the incorrect credit may be canceled by a debit of $100, and after this the original $100 should be entered on the debit side; or the cancellation and correction may be combined by entering $200 on the debit side. Better still, the incorrect posting may be ruled out and a correct posting made of the original entry whose wrong posting caused the error. Adequate cross-reference should be given so as to make the tracing of the items easy and to indicate exactly what was done.
As these entries are of a somewhat unusual nature, their exact purpose should be plainly indicated in the explanation columns. According to the methods mentioned above, the various correcting entries are made directly on the face of the ledger. It is often preferable, however, first to make the required correction entries in the journal with full explanation, and then to post them to the ledger.
=Adjusting Entries Illustrated.=—In order to indicate clearly the routine and method to be followed in summarizing the books at the close of the fiscal period, the formal adjusting and closing journal entries needed for the books of U. R. Smart will now be set up, the illustrative data being the same as were used for the work sheet in Chapter XXVII to which reference should be made. In connection with the work sheet it was stated that the adjustment columns of the work sheet are used as a guide to making the adjusting entries. As to sequence in the journal, these follow immediately, without break, the last current entry for the month. The adjusting entries for U. R. Smart are:
Purchases 30,000.00 Merchandise Inventory 30,000.00 Merchandise Inventory 26,500.00 Purchases 26,500.00 Depreciation 3,630.00 Depreciation Reserve Office Furniture and Fixtures 280.00 Depreciation Reserve Store Furniture and Fixtures 1,200.00 Depreciation Reserve Delivery Equipment 750.00 Depreciation Reserve Buildings 1,400.00 Bad Debts 482.88 Reserve for Doubtful Accounts 482.88 Interest Income (Accrued) 150.00 Interest Income 150.00 Insurance (Deferred) 250.00 Insurance 250.00 Advertising (Deferred) 300.00 Advertising 300.00 Printing and Stationery (Deferred) 150.00 Printing and Stationery 150.00 Selling Supplies and Expense (Deferred) 200.00 Selling Supplies and Expense 200.00 Taxes 340.00 Taxes (Accrued) 340.00 Salesmen’s Salaries 175.00 Salesmen’s Salaries (Accrued) 175.00 Interest Cost 50.00 Interest Cost (Accrued) 50.00 Special Police on Strike Duty 150.00 Special Police on Strike Duty (Accrued) 150.00 Office Salaries 100.00 Office Salaries (Accrued) 100.00 Sub-Rentals Income 50.00 Sub-Rentals Income (Deferred) 50.00
=Purpose of Summarizing.=—After the adjusting entries are posted, the ledger reflects the true financial condition as of the date of these entries. However, at this stage the information contained in the ledger is usually scattered over a large number of accounts. To obtain a concise view of the results of the business, it is necessary to summarize this information. The Profit and Loss account is the means by which the temporary proprietorship accounts are summarized and the net results as to profits or losses are indicated.
In this connection it will be remembered that the adjusting entries have already effected a separation of the elements of the mixed accounts, so that the temporary proprietorship items—expenses and income—applicable to the current period are now separately shown. The transfer of these temporary proprietorship items to the vested proprietorship accounts constitutes the work of closing. The use of the Profit and Loss account as a place of summary—a clearing house—through which the net result can be passed on or transferred to the vested proprietorship accounts, constitutes a part of the method or technique of closing.
=The Closing Entries.=—The student is already familiar with the principles of debit and credit involved in making the closing entries. As indicated above, these are transfer entries and merely effect a transfer of all temporary proprietorship items to the Profit and Loss account for summary there and for the transfer of the net result to some vested proprietorship account or accounts. Like all other entries, these are made first in the journal and are posted from there to the ledger. The current sections of the various expense and income accounts are then ruled off and the ledger is said to be “closed.”
=Method of Closing the Books.=—As explained on page 129, the Profit and Loss account in the ledger is used for summarizing the temporary proprietorship accounts before transferring them, i.e., their net result, to the vested proprietorship accounts. The use of Purchases and Sales accounts for a partial summarization of the various merchandise accounts has also been explained. After this partial summarization has been made, the debit balance of the Purchases account, showing cost of goods sold, is transferred to the Profit and Loss account; and similarly, the credit balance of the Sales account, representing net sales, is transferred to the Profit and Loss account. Profit and Loss then shows on the credit side net sales and on the debit cost of goods sold, the difference being the income portion, i.e., the gross profit of the merchandising activities for the period. If it is desired to show on the face of the account the actual figure of gross profit, the Profit and Loss account may be balanced at this stage, though this is not usually done. The rest of the work of summarization is accomplished directly through the Profit and Loss account.
=Closing Entries Illustrated.=—The formal journal entries necessary to effect this summarization in the ledger are given below, being based on the illustration used for the work sheet and being made up directly from the various sections of the formal profit and loss statement shown on page 234. The way in which this is done should be carefully noted. As to their sequence in the journal, these closing entries will, of course, immediately follow the formal adjusting entries illustrated above.
Purchases 1,350.00 In-Freight and Cartage 1,350.00 Purchase Returns and Allowance 5,400.00 Purchases 5,400.00 Profit and Loss 134,450.00 Purchases 134,450.00 Sales 1,850.00 Sales Returns and Allowances 1,850.00 Sales 193,150.00 Profit and Loss 193,150.00 Profit and Loss 25,225.00 Salesmen’s Salaries 13,675.00 Selling Supplies and Expense 1,400.00 Advertising 4,500.00 Out-Freight 400.00 Delivery Expense 3,300.00 Depreciation 1,950.00 Store Furniture and Fixtures 1,200.00 Delivery Equipment 750.00 --------
Profit and Loss 18,560.00 Office Salaries 5,100.00 Office Expense 4,500.00 General Expense 2,000.00 Printing and Stationery 600.00 Taxes 3,180.00 Insurance 1,500.00 Depreciation 1,680.00 Office Furniture and Fixtures 280.00 Building 1,400.00 -------- Profit and Loss 2,367.88 Interest Cost 950.00 Sales Discount 850.00 Bad Debts 482.88 Collection and Exchange 85.00 Interest Income 1,650.00 Purchase Discount 1,300.00 Profit and Loss 2,950.00 Profit and Loss 1,350.00 Special Police on Strike Duty 1,350.00 Sub-Rentals Income 600.00 Profit and Loss 600.00 Profit and Loss 14,747.12 U. R. Smart, Personal 14,747.12 U. R. Smart, Personal 4,247.12 U. R. Smart, Capital 4,247.12
It will be noted that after the net sales and cost of goods sold are transferred to the Profit and Loss account, all expenses directly connected with sales, such as Salesmen’s Salaries, Advertising, Delivery Expense, Depreciation of Delivery Equipment, of Store Furniture and Fixtures, and similar items, are closed into the Profit and Loss account.
The groups of accounts closed next are those covering General Administrative Expenses, Financial Management Expenses, Financial Management Income, Non-Operating Expense, and Non-Operating Income. It will be noticed that the order of closing follows the order in which the same items appear in the profit and loss statement.
The Profit and Loss account now shows on the credit side the items of income and on the debit side the costs and expenses applicable to the current period. Its balance then gives the net profit (or loss) covering the period’s transactions.
Throughout the period, as the profit accrues, the proprietor may have drawn against it for personal use, as shown in his Personal account. To show the amount of profit remaining in the business, the balance of the Profit and Loss account is transferred to the Personal account, the balance of which then gives the amount of undrawn or overdrawn profit. The balance of the Personal account is closed into the Capital account, the credit balance of which then represents the net worth of the business at the end of this period and at the commencement of the next.
=The Profit and Loss Account.=--In posting the closing journal entries to the Profit and Loss account in the ledger, usually only the group totals as indicated by the entry will appear. In small concerns where expenses and income are not classified in much detail, the individual items composing the group total are often shown. These items are, of course, the same as appear in the part of the journal entry which is contra to the group total charged or credited to Profit and Loss. The ledger Profit and Loss account for the illustration will appear as follows when completely posted:
=Profit and Loss Not an Account for Current Entry.=--It should be kept clearly in mind that the process of closing the books is merely a method or device by which the transactions for the year are summarized and the net result determined. This net result, whether a profit or a loss, belongs to the proprietor and must ultimately be shown in his account. It is, therefore, manifest that the Profit and Loss account is only a summary account and should never be used for current entry. It is the means by which the temporary proprietorship accounts are summarized and the medium through which the net result is cleared into some vested proprietorship account or accounts.
=Effect of Closing the Ledger.=--The transfer of net profit to a vested proprietorship account completes the work of closing the ledger, all temporary proprietorship accounts for the current period being closed out. All open balances now shown on the ledger constitute either assets, liabilities, or vested proprietorship. A post-closing trial balance contains only the accounts shown on the corresponding balance sheet. The income and expense accounts, having been cleared of their current record, are prepared to receive the record of the next period. The business cycle for this particular business has been completed and its correct history recorded.
XXIX. TYPES OF ACCOUNTING RECORDS AND THEIR DEVELOPMENT
=Evolution of Analytical Journals.=--Though the only books absolutely necessary for an accounting record under the double-entry method are the journal and the ledger, even the small business finds some subdivision of the journals advantageous, and so makes use of sales, purchases, and cash receipts and cash disbursements journals. As a business grows and its transactions increase in volume and complexity, further subdivision is needed. When the scope of its organization becomes too great for a personal oversight, a method or system must be devised for keeping the proprietor or manager in close touch with the various departments and lines of business endeavor. This is accomplished by means of reports from the accounting department, which exists largely for the purpose of furnishing this kind of information.
=Principle to be Followed in Securing Analysis.=--In an earlier chapter it was laid down as a fundamental principle that the information desired by the management should be furnished from analytical records made at the time of original entry, rather than by analyzing a composite record at the time the information is wanted. Such analytical records make possible a quicker and more up-to-date report to the management, and they save labor in securing the information by making the analysis at the time of record when all the facts related to it are readily available.
=Types of Sales Journals and Methods of Handling.=--The first step in the analysis of business transactions is the subdivision of the general journal into separate journals, and this analysis is carried still further by the use of columnar journal records. Reference has already been made, in Chapter XVIII, to the use of additional columns in the sales and purchase journals. Here a brief sketch will be given of the methods of recording sales in various kinds of sales journals.
1. The earliest type of sales journal, not often used today, consisted of a letter impression book containing the press copy of invoices sent to customers, with columns for the extension of the amounts and sometimes with additional columns for purposes of analysis. Such a journal has the advantage that the original entry is an exact copy of the invoice. Oftentimes, however, the impression is poor and nearly or quite illegible; it takes much room; the detail shown is not often used; and it increases the work of making and handling the record.
2. Another method makes use of a perforated invoice book with a columnized interleaf solid-bound between the perforated invoice sheets. The sales invoice is written on one of the perforated sheets and a carbon underneath gives a duplicate on the interleaf, the latter constituting the formal sales record. The advantages and objections are practically the same as for the impression book method.
3. Another method is to make a separate carbon copy of each invoice and use the duplicate as the source of entry in the sales journal. The journal entry gives only the file number of the duplicate invoice so that in case of need the duplicate can easily be referred to. Such a sales journal may, of course, contain analytical columns with any desired heads.
4. Still another method uses the duplicate invoice for posting to the customer’s account, after which it is filed in binders. The latter are usually provided with recapitulation sheets which show the totals and analysis for each day, week, or month as the case may be. Just as above, the invoice file provides the detail in support of the ledger account and the recapitulation sheets constitute the journal from which credits to the various sales accounts are made. Either one of these last two methods eliminates most of the objections and embraces most of the advantages of the other methods mentioned above.
Where several sales ledgers are used, the sales journal is sometimes subdivided on the same basis as an aid in posting and for the purpose of securing controlling figures as explained in following chapters.
=The Sales Returns and Allowances Journal.=--The use of any special form of sales journal, particularly if it provides for an analysis of the sales, requires a similar record of sales returns and allowances. Either a separate book, similar in form to the sales journal, may be employed for recording these items or the pages in the back of the sales journal may be used instead.
=Development of the Purchase Journal.=--The development of the purchase records from the old-time scrapbook for invoices to the modern analytic voucher record resembles the development of the sales journal. The old-fashioned invoice book was usually a big, loose-bound, coarse paper volume in which were pasted the invoices for goods bought. An extension column was provided for the amount of the invoice, and the total of this gave the purchases for a given period. The use of columns for various classes of purchases provided the required analysis, but, as it was a cumbersome, nondescript record, it was bound to give place to something better--the formal purchase journal or register of today.
The purchase journal or register consists of a bound or a loose-leaf book ruled to suit individual needs and purposes. Where sales are analyzed by classes, an exactly similar analysis of purchases must be made in order to secure a gross profit figure for each class. Therefore its form follows very closely that of the sales journal. Entries are made in the purchase journal of the name of the creditor, the amount of his invoice, and the number of the file where the invoice can be found in case of need.
Where a separate purchasing department is maintained, the duplicate purchase orders, corrected if necessary to correspond with the purchase invoice received, may be used as the basis of the purchase journal. In this case recapitulation sheets are inserted just as with the sales journal. The handling of purchases is simplified by the fact that as a rule they are much smaller in number than sales. The same general considerations apply to the handling of returned purchases as to returned sales.
=Handling Expenses through the Purchase Journal.=--It is the practice of some concerns to treat expenses such as labor, rent, salaries, supplies, etc., as purchase transactions. Under this method, instead of postponing the entry until the item is paid, it is made at the time of securing the service or supplies. The basis for the entry may be either: (1) the bill or purchase invoice; (2) a formal purchase memo or voucher made out for each transaction; or (3) the fact that the expense has been incurred may suffice for the entry on the books with no formal paper to vouch for it. The use of such formal papers as the basis for entry is known as the voucher record system. The details of this system are fully explained in the second volume. Discussion is here limited to a brief outline of the method and of the advantages of its use.
When expense invoices are entered and analyzed in the voucher record form of purchase journal, their posting requires debits to the various expense accounts and credits to the individual creditors’ accounts in the ledger. If the ledger contains only a controlling account, this account must be credited with the total of the expense and other purchases, while the individual accounts in the creditors subsidiary ledger must be credited with the details which make up the total. When the bill is paid, entry in the cash book will not be, as usual, to the debit of the expense account in the general ledger, but to the debit of the creditor’s account in the subsidiary ledger. The reason for this procedure will be made clear in the discussion of controlling accounts to follow.
The entry of expense invoices in the above manner secures an immediate record of all liabilities as incurred and therefore makes the books show at all times the true state of affairs as regards liabilities. The method, however, necessitates a little more work in making the record, and for this reason many concerns do not enter expenses until paid, making the debit to them through the cash book. In this latter case all unpaid expense bills should be kept in an expense file for reference when information as to the unrecorded liabilities is desired.
=Note Journals.=--As explained previously, note journals are sometimes used instead of the general journal for the record of note transactions, where these are sufficiently numerous. Provision is sometimes made for securing a proper analysis in order to distinguish between notes from customers and notes from other sources. It will be seen later that such an analysis is necessary when controlling accounts are operated.
=Analysis in the Cash Book.=--The cash journals may be ruled to furnish any desired analysis, showing on the debit side (i.e., the cash receipts journal) the sources of receipts, and on the credit side the objects of expenditure. As the sources of cash receipts are usually more limited than the objects of expenditures, they do not require so much analysis. The analysis may be very detailed, the only limit to the number of columns being the width of the page. A minute analysis of expenditures, however, is usually made, not in the cash journal, but in the purchase or voucher record, which thus relieves the cash book of a mass of detail.
The chief advantage of using additional columns in books of original entry lies in the fact that time and labor are saved in posting. The column total is posted in one item, whereas each of the numerous items composing it would have to be posted separately to the account named in the column heading if no analytical column were provided. Hence it would be a waste of space to provide separate columns for items which recur so infrequently as to make their summarization unnecessary. Care should be taken to avoid needless columnization.
It is customary to have the following columns on the debit side of the cash book: General or Sundry, Accounts Receivable, Sales Discount, and Net Cash or Bank; on the credit side: General or Sundry, Accounts Payable, Purchases Discount, and Net Cash or Bank. (See page 282 for illustration.) The proof of the distribution is secured by checking the sum of the net cash and discount columns against the sum of the totals of the other columns. In both receipts and disbursements journals every item must appear in the respective Net Cash columns, and from these distribution is made to the other columns. For example, in the cash receipts journal, receipts from customers are distributed into the Accounts Receivable column for the gross amount of each item, and into Sales Discount for the discount, if any is taken. All other items are carried into the General or Sundry column. Where several sales ledgers are kept, additional columns may be provided so that instead of having one accounts receivable column, there are columns for each ledger. Similar treatment is given to the disbursements.
=Analysis in the General Journal.=--Where the general journal is used for returned goods, allowances, and other adjustments with customers and creditors, use is made of analytic columns with these captions for both the debit and credit: Accounts Receivable, Accounts Payable, and General. Here, however, there is no column in which to enter all items for distribution to the other columns. If a customer’s or a creditor’s account is affected, entry is made in that column in the first place. All other entries are in the General column. (See page 281 for illustration.)
With regard to analysis columns in the general journal, some accountants maintain, with good reason, that if the number of transactions of a particular kind is sufficiently large to justify their segregation in a separate column, this in itself would be ample justification for the use of a separate journal to record these items. Whenever the analysis of recurring transactions in the general journal is facilitated by the use of separate columns, the advisability of opening a new journal for the record of such items as appear in the general journal most frequently should be considered.
=Subdivision of the Ledgers.=--The next step in the subdivision of the records is made in the ledgers. The general or impersonal accounts of the business are of a more permanent character than the accounts with persons--customers and creditors. Consequently, when once it is determined under what account titles information is desired and those accounts are set up, there is usually little need to change their titles. Personal accounts, however, are constantly changing as some customers are lost and new ones are added, and also because creditors change with purchases in new markets. Hence, when a business outgrows its small beginnings, it is customary to keep these changing accounts in separate books. The basis for the first subdivision of the ledgers, therefore, is the separation of the accounts into personal and impersonal. The accounts with customers are carried in a separate ledger called variously the sales, customers, or accounts receivable ledger, and those with creditors in a ledger called purchase, creditors, or accounts payable ledger. All other accounts are kept in the main ledger known as the general ledger. One advantage of this subdivision is that several bookkeepers can work on the various ledgers at the same time.
A further subdivision of the customers ledger is frequently made into “city” and “country,” the former containing the accounts with customers located within the city where the business is situated, and the latter the out-of-the-city accounts. Other subdivisions may be made on an alphabetical basis, i.e., customers ledger No. 1, containing all accounts from A to G; customers ledger No. 2, H to M, etc. Sometimes the concern’s sales territory is divided into arbitrary districts and the ledgers are subdivided to correspond with such districts.
=Kinds of Ledgers.=--There are several kinds of ledgers, which may be classified (1) as to their rulings, and (2) as to their bindings.
1. RULINGS. As to their rulings, ledgers are either standard, balance, or progressive. The standard ruling has two duplicate parts, a debit and a credit, and is usually divided in the center of the page, one money column appearing at the extreme right of each part, although sometimes the arrangement is symmetrical with both debit and credit money columns at the center, and the date columns at either side of the page. (See Forms 29 and 30.)
The balance ruling is a three or four-column ledger with the money columns either at the center or at the right-hand margin, or at both the center and the right-hand margin. The extra columns are for the account balances. If the balance is usually either a debit or a credit, only one balance column would be necessary; where it is apt to be a debit at one time and a credit at another, a debit balance column and a credit balance column are advantageous. The balance ruling is used particularly with personal accounts where there is need for an up-to-date balance. Where this kind of ledger is used, entry of new debits or credits should always be on the next blank line as shown in the balance column, so as to allow the extension of the new balance opposite the last entry even though this should leave blank several of the preceding lines on the debit and credit sides. Typical forms of some of these are shown in Forms 31 and 32.
The Boston, progressive, or tabular ledger, as it is variously called, makes provision for a horizontal progress of the account as to sequence of time; the title of the account is written at the left-hand margin, and one or more lines are allowed to each account according to the degree of its activity. The account title is written once at the left margin of the master or main sheet, and is sometimes repeated at the right margin if the sheet is very wide. The page is divided into columns for each day of the period. To effect this, short-margin insert sheets must be bound in to give the desired room for accommodating a whole period’s record. This style of ruling was formerly much used in banks where a daily balance for each depositor’s account was necessary. It is capable of adaptation to other uses, however. One form is shown, Form 33.
2. BINDINGS. Ledgers may be classified also as solid-bound, loose-leaf, and card, the titles being self-explanatory. One of the great advantages of the loose-leaf and card ledgers over the solid-bound ledger is their flexibility. They lend themselves easily to any desired grouping of the accounts; they may be numerically arranged where accounts are numbered instead of named; they may be arranged as to classes and each class made self-indexing; or a geographical grouping may be made. Another great advantage of this form of ledger is the ability to discard or file away in other binders all “dead” accounts, thus making for ease and facility in the use of the “live” ledger. Also it is possible for several clerks to work simultaneously, since the leaves or cards are removable and may be distributed among any number of clerks. There is always the danger, however, of failure to return a leaf or card, or of placing it out of regular order when returning it, or of destroying it, if it were desired fraudulently to do away with any particular account. The use of loose-leaf and card ledgers for personal accounts is pretty thoroughly established, notwithstanding the disadvantages just mentioned.
XXX. CONTROLLING ACCOUNTS
=Introductory.=--Reference to controlling accounts has been made several times in preceding chapters. It is purposed now to define them and explain their use. The separation of the various journals on the basis of an analysis of transactions frees the general journal of a vast mass of detail it formerly carried. This separation, however, in no way affects the underlying debit and credit scheme of the whole system. Each journal is an integral part of the whole; every entry therein has its equal debit and credit which are in due course posted to its proper account, thus maintaining the equilibrium of the ledger. The separation of the ledger into three or more special ledgers in the interest of economy of effort and ease of use has also been mentioned. Still, each of these special ledgers is an integral part of the whole ledger and the accounts in the special ledgers must be entered in the trial balance to secure proof of equilibrium.
The customers ledger is usually the most active of the various ledgers, i.e., more postings are made in it because the majority of business transactions involve dealings of various sorts with customers, and more accounts are required to keep the records with customers. It is usually, therefore, the largest part of the whole ledger, but its accounts are all of the same kind, viz., accounts receivable. When taking a trial balance, the total of the balances of the customers ledger accounts is usually set up under the title “Accounts Receivable,” leaving the details to a supplementary list or schedule.
=Advantage of a Controlling Account.=--The advantage of thus condensing the trial balance is apparent and suggests the desirability of obtaining the “accounts receivable” balance independently of the customers ledger. If this is done the bookkeeper in charge of the general ledger can not only draw up his trial balance without reference to the customers ledger, but has also the correct figure for the total of the account balances in the customers ledger. In other words, he has a figure which controls the customers ledger and which therefore furnishes him with a check on the accuracy of the ledger clerk or bookkeeper who keeps that ledger. The most convenient method of recording the accounts receivable figure is evidently by means of a formal account on the general ledger. When such an account is kept, the effect is to make it a summary account whose detail is carried in the customers ledger.
=Controlling Account Necessitates Changed Idea of Ledger Equilibrium.=--By having a customers controlling account (or “Accounts Receivable” as it is commonly called, though other terms are also used) in the general ledger, the customers ledger is no longer used as an integral part of the whole ledger and becomes a “subsidiary” ledger; that is, its function is reduced to that of a supporting schedule or list of detail for the summary controlling account. The equilibrium of the general ledger is now maintained by summary posting to the controlling accounts. Though the customers ledger has ceased to be a “ledger” in the proper sense of the term, it is still a vital part of the system, carrying as it does the detail of the summary controlling account. Moreover, it is linked up to the system by being provable against its summary account. Yet it should be borne in mind that its scheme of debit and credit is now an independent one and is not linked up to the debit and credit equilibrium of the general ledger; that is, the postings in the subsidiary ledger are merely memorandum entries of the detail posted in summary form to the general ledger. Thus the mathematical basis of the controlling account is simply that the whole is exactly equal to all its parts, the balance of the summary account being equal to the total of the balances of all the customers’ accounts of which it is the summary. To illustrate, if we have customers’ accounts whose balances are $1,000, $2,000, $3,000, $4,000, and $5,000 respectively, then the summary account must have a balance of $15,000.
=Debits to the Controlling Account.=--The principle and the purpose of the controlling account having now been explained, the next problem to consider is how best to gather the summary figures for its debits and credits. If every debit to a customer’s account must be posted also to the controlling account and every credit to a customer’s account must be shown as a credit in the controlling account the work involved would be almost doubled and little would be gained by thus duplicating the postings in another ledger. Therefore it is important to secure the figures for entry in the controlling accounts with the least effort, i.e., in the form of debit and credit summaries. Hence, to determine the sources of these debits and credits of the controlling account, analysis must be made of the sources of the debits and credits to the customers’ accounts.
Most of the debits to customers’ accounts are from the sales journal. Additional debits may be from the cash disbursements journal when cash payments are made as a rebate or a refund for overpayment or some other similar transactions; still others from the general journal for adjustments of various kinds. The debits to customers, however, for cash paid them are very few in number, because such adjustments usually are not made by means of cash payments. The sales journal, as usually operated, carries a column for credit sales, whose total represents in one amount the total of all detailed debits to customers’ accounts. The total of the credit sales column, therefore, controls the total debits to all customers on account of charge sales to them. In summarizing the sales journal the summary entry should show that this total is to be posted not only to the credit side of the Sales account but also to the debit of the controlling account in the ledger. This is so because the customers ledger has ceased to be an integral part of the general ledger, the controlling account having taken its place. Accordingly, the general ledger contains no record of either the debits or credits of the entire group of sales transactions until the end of the month, when this group must therefore be brought into the general ledger in summary form, both debit and credit.
Where the total sales in the sales journal include an analysis of sales into cash sales and credit sales, the following summary entry should be made:
Accounts Receivable Cash Sales
The cash debit is set up only to show the equilibrium of the summary entry and is not posted, because it is entered also in the cash book and is posted from there. This debit posting to “Accounts Receivable” in the general ledger secures in one posting a debit amount equal to all individual debit postings to the customers ledger from this source. The controlling account in the general ledger is variously termed “Sales Ledger,” “Accounts Receivable,” “Trade Debtors,” “Customers,” etc.
The two other sources of debit posting to customers’ accounts are the general journal and the cash book. The debit side of the journal is provided with an Accounts Receivable analysis column in which, as explained in the previous chapter, debits to customers’ accounts are entered. At posting time the total of this Accounts Receivable column will therefore give in one figure a debit posting item to the general ledger Accounts Receivable account equal to all individual debit postings from the general journal to customers’ accounts in the customers ledger.
Usually it is not necessary to provide an Accounts Receivable column on the credit side of the cash book, since debit postings from there to customers’ accounts are very infrequent. Hence no total or controlling figure for entry in the Accounts Receivable account can be obtained. Every item which is posted from this source to the debit of a customer’s account must be also posted--item by item--to the debit of Accounts Receivable in the general ledger. This is of course a double debit posting, but one of these debits is to a subsidiary ledger which is no longer a part of the equilibrium scheme and therefore does not throw the general ledger out of balance. Great care must be exercised to make sure that each of these items is posted both to a customer’s account and also to the Accounts Receivable account.
=Credits to the Controlling Account.=--An analysis of the credits to customers’ accounts shows four main sources:
1. The cash receipts journal for payments made by customers.
2. The sales returns journal, if one is kept, for goods returned by customers.
3. The note journal for notes received in payment.
4. The general journal for various adjustments and also for the purpose of recording notes and returned sales where special journals are not kept for these transactions.
Accordingly, analytic columns for accounts receivable are provided in the cash receipts journal and the general journal. The totals of their columns are posted to the credit of Accounts Receivable, and the detailed amounts to the credit of the various customers’ accounts. The credit postings from these sources to the customers ledger accounts and to the general ledger Accounts Receivable account are therefore the same so far as totals are concerned. The sales returns journal is summarized at posting time by means of an entry similar to that in the sales journal, as follows:
Sales Returns Accounts Receivable
In this case the credit posting to the Accounts Receivable account is equal to the detailed credits to customers’ accounts.
Similarly, a summary entry for the notes receivable journal secures a controlling figure for Accounts Receivable. If the notes are all received from customers to apply on their accounts, the summary entry is:
Notes Receivable Accounts Receivable
the amount being the total of that journal.
In this way the total of all debits and of all credits to the individual customers’ accounts is represented by the summary items entered in the general ledger controlling account, Accounts Receivable. Consequently, the balance of this single account is equal to the balance of the customers ledger. For the trial balance, therefore, one account takes the place of hundreds or even thousands of customers’ individual accounts. As a result of this, much time is saved and the possibility of error on the general ledger is greatly reduced.
=Proving the Customers Ledger.=--The use of a controlling account in the general ledger, however, does not eliminate the necessity of proving the accuracy of the customers ledger. It merely makes it possible to take a trial balance without bringing the numerous customers’ accounts into it. It is just as much a part of the proof of the work to make a list of customers’ accounts balances and check it against the balance of the Accounts Receivable general ledger account, as it is to prove the general ledger by means of a trial balance. If there is a discrepancy between the subsidiary ledger and its controlling account on the general ledger that discrepancy does not necessarily prevent a trial balance of the general ledger, but it does show error in the work which must be searched out and corrected.
=Accounts Payable Account.=--A similar arrangement will make possible a controlling account on the general ledger for the creditors or purchases ledger. This account is variously termed Accounts Payable, Purchase Ledger, Creditors, or Trade Creditors account. Its mechanism is the same as for Accounts Receivable. Analysis of credit postings to creditors’ accounts shows the purchase journal as their main source. Other credits come through the general journal and a very few through the cash receipts journal. The summary entry for the purchase journal is:
Purchases Accounts Payable Cash
This shows a debit to the Purchases account for the total amount of the purchases, a credit to Accounts Payable for the liability to creditors, and to Cash for the amount paid on cash purchases. The cash item is not posted. The Accounts Payable column total on the credit side of the journal, and the separate items from the cash receipts journal, furnish the other credits to the Accounts Payable account in the general ledger.
The debits come from the Accounts Payable columns in the cash disbursements journal and in the general journal, and the summaries for the notes payable and purchases returns journals.
=Basic Principle as to Postings to Controlling Accounts.=--In the handling of controlling accounts, the one fundamental requirement is to make sure that every entry in books of original entry which affects any account in the subsidiary ledger is reflected in the postings to the controlling account in the general ledger. This principle resolves itself into the mathematical axiom stated above that a whole is equal to all--not just some--of its parts. Only thus can a true control be established.
=Making the Subsidiary Ledger Self-Balancing.=--Through the use of the two controlling accounts explained above, the trial balance is relieved of a large number of accounts, and the general ledger is made independent of the subsidiary ledgers. On the other hand, the subsidiary ledgers are dependent for their proof on the controlling account balances in the general ledger. In an effort to make every ledger “self-balancing,” a further refinement of the controlling account idea is frequently incorporated in each subsidiary ledger. It is accomplished in the following manner: An exact duplicate of the controlling account on the general ledger is set up in the subsidiary ledger, with this difference, that the sides of the account are reversed so that the subsidiary ledger account has for its debits the credits of the general ledger account, and for its credits the debits of the general ledger account.
Take the Accounts Receivable controlling account for illustration. On the general ledger its balance is of course a debit balance representing the total outstanding accounts due from customers. Similarly, the schedule or list of customers’ accounts taken from the sales ledger will represent debit balances whose total is the same as the controlling account balance. If, then, the controlling account itself is placed on the customers ledger as an additional account, the sides being reversed, the balance of this one account will be a credit equal to the total debit balance of all the other accounts in the customers ledger. Therefore, if the customers ledger is correct, its own balance will be offset exactly by the credit balance of the one additional account, and the ledger then is said to be self-balancing. There is no theory or principle of debit and credit involved in this; the device is simply introduced in order that the ledger may provide an internal proof of its correctness. The title of the balancing account on the subsidiary ledger is “Adjustment” or “Balance” and has no significance other than that mentioned. In a similar manner any subsidiary ledger may be made self-balancing.
XXXI. HANDLING CONTROLLING ACCOUNTS
Chapter XXX concerned itself with the statement and explanation of the principles on which the controlling account rests, the manner of its construction, its advantages, and with the changed application of the fundamental scheme of debit and credit under a system of records operating controlling accounts. The present chapter will be devoted to a consideration of the problems met with in the practical operation of these accounts.
=Introduction of the Controlling Account.=--Upon the installation of a new system or set of books, the controlling account feature may be incorporated from the start. The new system must provide for the separation from the general ledger, of the ledgers over which control is to be established. The method of securing controlling totals for posting to the general ledger controlling accounts was indicated in the preceding chapter.
Where it is desired to introduce controlling accounts into a system which has not formerly used them, certain adjustments must be made, i.e., the accounts to be controlled must be segregated and controlling account columns must be provided for in the books of original entry. With the transfer of these accounts to a separate ledger, together with the introduction of the controlling accounts into the general ledger, the equilibrium of that ledger is maintained. The opening entry in the newly established controlling account is of course the sum of the balances of the transferred accounts.
If it is desired to establish the new controlling account by journal entry, that entry would appear somewhat as shown on page 279, Form 34, with suitable explanation added. All these items should be posted to the general ledger as shown by the entry, and in addition the detailed items should be posted as debits to the accounts in the customers ledger. The effect of these postings would be, first, to close the individual customers’ accounts formerly carried in the general ledger and open up in their stead the controlling account; and second, to set up on the subsidiary ledger the detail of the customers’ accounts.
=Recording Withdrawals of Stock-in-Trade.=--The original basis for separating the main journal into its subsidiary parts was the analysis of transactions by kinds, such as sales, purchases, cash, etc. The sales journal was presumed to contain only sales of stock-in-trade. Departure from this principle was advisable in the case of goods drawn at cost, for use in the business or by the proprietor or for other purposes. This is done because withdrawals of stock-in-trade, at whatever price and for whatever purpose, can be recorded more conveniently in the sales journal than elsewhere.
It is theoretically incorrect, however, to enter such items in the Sales account because withdrawals at cost do not represent actual sales, and for this reason they should be regarded as deductions from purchases or from inventory. The only proper place for their record, under this view, is the general journal, entry in which would have to be by detailed debit and credit for each item. However, because this requires much more work than entry in the sales journal, this last method is more commonly employed. Usually the volume of such transactions is not large and would not seriously vitiate the use of the Sales account as the basis for estimating percentages of cost of goods sold, gross profit, selling expenses, etc. Moreover, as the total amount of these withdrawals is often fairly constant as between periods their record in the sales journal is countenanced.
=The Problem of the Sales Journal Summary.=--When withdrawals from stock at cost price are recorded in the sales journal, a new problem arises in summarizing the sales journal when operating under a controlling account system. The customers or sales ledger is usually limited absolutely to customers’ accounts. Accounts with the proprietors, and with all other titles under which withdrawals for other purposes may be recorded, are almost invariably carried in the general ledger. Therefore, while most of the items entered in the sales journal are posted to the customers ledger, these withdrawal items must be posted in detail to the general ledger. Thus the total of the sales journal does not represent the correct debit to accounts receivable in the general ledger. Evidently an analysis of the content of the sales journal must be made in order to obtain the correct controlling figure.
Such analysis may be made in several ways. Where possible, three columns in addition to the departmental columns should be used. The column titles would be “Sales Ledger,” “Cash,” and “Sundry.” The sum of these three would give the total to check against the total of the other distributive columns, but only the “Sales Ledger” total would be posted to Accounts Receivable, and the individual items in that column would be posted to the customers’ accounts in the sales ledger. The items in Sundry column would be posted to their named accounts in the general ledger. This method secures an automatic separation of the controlling account total from other items, and should be used where possible.
If the number of these extraneous items is too small to warrant the use of a separate column, they may be recorded in the Sales Ledger column and indicated by means of an “❌” or some other mark. At summary time, the sales journal must be looked over and these items picked out. Subtraction of their sum from the Sales Ledger column total would give the correct controlling account posting.
Still another method requires a correcting general journal entry at the time the sales journal entry is made. Under this method these special items are included in the Sales Ledger column, thereby causing an overcharge to Accounts Receivable. The correcting general journal entry must therefore credit Accounts Receivable by the amount of the overcharge for each item. For instance, if stock has been drawn by the proprietor, the general journal entry at the time the sales journal entry is made would be:
Proprietor, Personal Accounts Receivable
the debit to proprietor being checked here and posted from the sales journal, or vice versa. This method, however, results in a duplication of work. It would be preferable not to enter these items in the sales journal and to make the record only in the general journal, and so leave the Sales Ledger column total in the sales journal the correct controlling figure.
In a complicated controlling account system, where for current entry a simple bookkeeping routine must be established and all items of whatever kind be handled in the same way, the withdrawals by proprietors are recorded in accounts opened with them in the sales ledger just as with customers. At the end of the period, before closing the books, these proprietors’ accounts are transferred by general journal entry to the general ledger, requiring one entry--like the one last shown above--for the drawings of the period.
Cash sales may also be handled without the use of a separate column in the sales journal. Two methods are used for this. Under the one, cash sales are included in the Accounts Receivable debit total of the sales journal, although the individual items are not posted to the subsidiary ledger, and they are also included in the Accounts Receivable credit total of the cash receipts journal. The inflated debit in the general ledger controlling account is thus offset by an equally inflated credit, the balance therefore being the correct amount to control the sales ledger.
Under the other method the postings to the general ledger controlling account are the same as in the first method. The two methods differ, however, in that under the second method an account is opened in the subsidiary ledger entitled “Cash Customers” or “Cash Sales,” to the debit of which are posted in detail the cash sales items from the sales journal and to the credit of which are posted in detail the cash sales items from the cash receipts journal. The account is thus only a “wash” or clearing account. This method, however, prevents the inflated debits and credits in the controlling account.
The methods last described for handling proprietors’ withdrawals and cash sales are the ones most frequently used in large businesses where simplicity of routine for current entry must be secured.
=The Problem of the Purchase Journal Summary.=--The practice of recording extraneous transactions in the purchase journal brings about at summary time a situation similar to that of the sales journal, when a controlling Accounts Payable account is maintained. The purchase journal is, and should be, the place of record for purchases made for the business. If the proprietor (or other person), for his personal account and use, purchases through the business merchandise which never goes into stock, accurate accounting requires such transactions to be charged direct to the proprietor and not to the Purchases account of the business. Inasmuch as the liability is assumed by the business and the creditor’s account will appear in the purchase ledger, the use of the purchase journal total for credit to the Accounts Payable controlling account gives the correct figure. The trouble comes in because this same figure cannot be used as the debit to Purchases. Subtraction of these extraneous items must be made to determine the proper amount chargeable to the Purchases account, thus necessitating an analysis at summary time.
=Accounts Both Receivable and Payable.=--It frequently happens that purchases from, and sales to, the same party are made, i.e., goods are sometimes bought from and sold to a customer. If the account of this debtor-creditor is normally a purchase account, it is set up in the purchase ledger. If a sale is made to this debtor-creditor and charged to his purchase ledger account, such transaction should not be included in the Accounts Receivable controlling figure from the sales journal unless an adjusting entry is made through the general journal. Such entry would affect only the controlling accounts and would be:
Accounts Payable Accounts Receivable
Or the item might be omitted from the sales journal controlling figure and stated separately in the summary entry for the sales journal.
A more satisfactory method is to set up two accounts with such parties--one as a creditor, the other as a customer. Then no adjustment need be made at the time of summarizing the journals, because the two accounts are treated as entirely independent of each other. The settlement of these two accounts may be handled separately or by a payment of the balance between the two. If settled by balance, an adjusting journal entry should be made to show on the books the two separate elements involved. This would of course affect both the controlling accounts and the two individual accounts.
=The Problem of the Note Journals Summaries.=--Of notes receivable the large majority are usually received from customers. The summary entry for such is:
Notes Receivable Accounts Receivable
Where notes are received from other sources, as from officers, partners, or from outside parties to whom loans have been made, it is evident that these must not be included in the credit to Accounts Receivable, and it may be advisable also to eliminate them from Notes Receivable unless they are short-term, current items, as only such should be carried under Notes Receivable. These special notes may be carried in a “Notes Receivable Special” account.
If, as sometimes happens, interest is included in the face of a note, this must be adjusted by the summary entry, as follows:
Notes Receivable Accounts Receivable Interest Income
The considerations stated above as applicable to the notes receivable journal, are of equal importance in handling the notes payable journal. A very careful analysis of the note journals should be made at a summary time, which analysis should be shown by the summary entry.
=Summary Entries for Columnar Books.=--Illustration will now be given of some standard forms for summarizing the columnar journals. Sometimes the summary entries for the various subsidiary journals are made in the general journal. This seems to accomplish no good purpose and is not usually recommended. Theoretically it is desirable to show a formal debit and credit summary for each journal footing posted to the ledger. If, however, the number of columns is small and it is readily seen that the debits and credits are equal, the formal summary is often dispensed with. So also, if there are many distributive columns of the same effect, i.e., debit or credit, as in the large departmental sales journal or the voucher register referred to on page 144, formal summary is not shown, the posting being made from the column totals as illustrated for Petty Cash on page 369.
=The Sales Journal Summary.=--An illustration of the sales journal summary is given in Form 35. The Sundry items should be posted in detail from their column and their total checked in the summary entry. Where a Sundry column is not used and the Sundry items are included in the Sales Ledger column, they must be separated before the summary entry can be made.
Where, also, a Cash column is not carried, as is so often the case, there being just one column for Sales Ledger, Cash, and Sundry items, from which distribution is made, the separation of the Cash items need not be shown in the summary entry, provided those items are entered also in the Sales Ledger column of the cash book. Where, due to the large number of distributive columns, the sales journal can ill afford the room for a Cash column, the above method offers the best solution of the problem.
The purchase journal summary is similar to that of the sales journal, and therefore no separate illustration need be given here.
=The General Journal Summary.=--As shown by the illustration in Form 36, in summarizing the general journal the Accounts Receivable and Accounts Payable columns are formally totaled, ruled off, and their totals brought into the General columns on both debit and credit sides and these columns are totaled and ruled off, thus showing the equilibrium of the journal. This summary entry is posted to the proper accounts in the general ledger. There is no particular advantage, however, in this formal summary entry because the postings could easily be made directly from the column totals.
=The Cash Book Summaries.=--As illustrated in Forms 37 and 38, the formal summary for each side of the cash book shows the equality of the Bank and Discount columns total against the General and Accounts Receivable and Payable columns. To show the correct debit to the bank for the present month, the balance brought forward from last month and entered in both the General and Bank columns on December 1, must now be subtracted from both.
On the disbursements side no explanation of the summary entry is necessary. It will be noted that, to show the balance of the bank account, a restatement of the Bank column total is necessary.
=Other Controlling Accounts.=--It is frequently desirable to keep some accounts of the business private, such as those showing partners’ investments, drawings, ratios of sharing profits, the adjusting and closing entries, the profit and loss, etc. This can be accomplished through the use of a private ledger supported by a private journal and sometimes a private cash book. For their operation a controlling account of the private ledger is set up in the general ledger, and similarly a controlling account of the general ledger appears in the private ledger. The use of private books is explained in Volume II of this work.
Sometimes subsidiary expense ledgers are used to carry a minute division of each expense group, with corresponding controlling accounts, such as Selling Expense, Office Expense, General Expense, Factory Expense. Similarly, if the consignment sales of a business are large enough to justify a separate record in a consignments ledger, a controlling account is set up in the general ledger. In a manufacturing business, Raw Materials, Goods in Process, and Finished Goods accounts are often controlling accounts for the stores, jobs, and finished stock ledgers. In a corporation the Capital Stock account (or accounts) is a controlling account over the stock ledger.
=Principle Governing Content of Subsidiary Ledgers.=--Before closing this chapter, it should be stated as a fundamental principle that no accounts should be carried in a subsidiary ledger except such as are of the same general kind and can without misrepresentation be carried under the group title of the controlling account.
XXXII. PARTNERSHIP FROM THE BUSINESS VIEWPOINT
=Partnership Defined.=--In Chapter II, reference was made to some of the features of a partnership--the purpose of its formation, advantages, disadvantages, etc. The laws of the state of New York define a partnership as follows: “A partnership, as between the members thereof, is the association, not incorporated, of two or more persons who have agreed to combine their labor, property and skill or some of them for the purpose of engaging in any lawful trade or business, and sharing the profits and losses as such between them.”
This definition brings out in a general way the reasons for the formation of the partnership and its essential features. Under this type of organization, where several persons combine their capitals, it is possible to secure a larger fund of capital than under the sole proprietorship. This opens to the partnership avenues of business usually closed to the sole proprietor. The bringing together of the man with a special aptitude or skill, or of a man with a following in the community on account of social standing and acquaintanceship, with another who has money or a plant for the operation of a business, often makes successful an otherwise unpromising undertaking.
=Operating Feature and Working Organization.=--Mutual agency is the essential operating feature of the partnership. By this is meant that any one of the partners can act for the others, and in the eyes of the law all are equally responsible for the management of the business. Except in the case of a limited partnership, to be explained later, each partner has an equal voice in the management and control of affairs. Unlike the corporation where for management purposes the owners’ powers are delegated to a controlling board, the essential character of the partnership is that each partner has, regardless of the amount of his investment, an equal right in the direction of its business. As between themselves, for purposes of division of duties and specialization of effort, definite power to exercise control over certain features of the business may be delegated to individual partners. But such delegation means nothing more than a method of dividing the work and is simply the working organization of the firm which may be changed at any time the majority of the partners see fit. Thus, while a partner may be limited in his actions for the firm by agreement among the partners, so that he is not a general agent for the firm, still as to outsiders who know nothing of this internal arrangement, he has power to bind the partnership by his acts, because an outsider has a right to expect that any partner has power to act as an agent for the firm. This is so because such power is of the essence of the partnership form.
=Essential Characteristics of the Partnership.=--Limited life is an essential characteristic of the partnership. The partnership relation is a very personal one. It can be terminated in a number of ways, but the death or retirement of any member automatically works a dissolution of the firm, even though another man takes his place. The legal theory is that the old partnership is dead and a new one, even though bearing the same firm name, has come into existence. Thus a partnership cannot be perpetual. The relationship between the partners is so intimate that the success of the undertaking depends fundamentally on the good faith and honor exercised by each partner towards the others, and therefore any addition to the personnel of a partnership can be made only with the consent of all members of the existing firm.
The partnership being the outgrowth of the sole proprietorship, certain of the aspects of its earlier form still cling to it. For suit at law it is looked upon as a collection of single owners, and action on contract must usually be taken against the individual members of the firm. Suit by or against the partnership cannot as a rule be brought in the firm name. Some states, however, allow this under recent enactments. Title to personalty can be held and transferred under the firm name, but realty must be in the name of the individual members or in the name of one member acting as trustee for the firm. Thus, while in the view of the business community the copartnership is a business entity under a firm name, in the sight of the law it is not an entity but merely a collection of single owners. This legal view accounts also for the full debt liability of every partner--except in a limited partnership. In case the firm assets are insufficient to meet the claims of creditors, any or all the partners’ private resources may be levied upon.
Co-ownership of the profits of a business is another feature essential to the copartnership. No sharing in the profits on any other basis than that of co-ownership will constitute a partnership. When the question comes before the courts, the intention of the parties governs, and evidence showing that each acted as principal for himself and as agent for the others, and has shared profits as profits, would be sufficient to constitute the relationship.
=The Partnership Contract.=--A partnership being a contract relationship, all the requirements governing legality of contracts, such as agreement, consideration, lawful object, competency of contracting parties, etc., apply to the copartnership. The contract may be oral or in writing. In case of dispute an oral contract, on account of the difficulty of proof, is of little force in regulating the relations of the partners, and the general law of partnership would usually govern. Inasmuch as there is so great an opportunity for disputes in a relationship of this sort, it is imperative, if efficient working relations are to be maintained, that very carefully drawn articles of copartnership be agreed upon before active business is begun. These articles should contain, at least, the following:
1. The name of the firm and of the partners. 2. The kind and place of business. 3. The duration of the partnership. 4. The method of terminating it. 5. A detailed statement of the relations between the partners, such as duties and powers, capital contributions, withdrawals of capital, salaries, division of profits and losses, interest on capital, and the time of closing the books to secure a definite determination of the partners’ interests.
Even when the utmost care is exercised in drafting the articles of partnership, it almost always happens that some portion is not understood alike by all or that some contingency arises not specifically provided for. Nevertheless, it is the only way in which a comparative avoidance of misunderstanding and dispute can be obtained.
=Partnerships Classified.=--As to the scope of their business operations, partnerships are usually classified into general and special. The general class embraces those for the conduct of some general or ordinary lines of business. The special class comprises those formed to undertake a definite task or some particular line of business. Joint ventures would come under this latter class.
As to the liability of their members, partnerships may be classified as general and limited. The general partner has the full liability, referred to above; the limited partner’s liability never exceeds the amount of his investment. In a limited partnership one or more, but not all, members may limit their liability. This class of partnership can be formed only under direct authority of statute law. A limited partner is not active in the management of the business, being more in the nature of a lender of money to the firm, who gets his return in profits instead of interest. Should he become active in the firm’s management, he will constitute himself an ordinary partner with full liability. The New York statute governing the formation of the limited partnership is as follows:
Two or more persons may form a limited partnership which shall consist of one or more persons of full age, called general partners, and also of one or more persons of full age who contribute in actual cash payments, a special sum as capital, to the common stock--or fund--called special partners, for the transaction within this state of any lawful business, except banking and insurance by making, severally signing and acknowledging and causing to be filed and recorded in the clerk’s office in the county where the principal place of business of such partnership is located, a certificate in which is stated:
1. The name or firm under which such partnership is to be conducted and the county wherein the principal place of business is to be located.
2. The general nature of the business intended to be transacted.
3. The names, and whether of full age, of all general and special partners therein, distinguishing which are general and which are special partners, and their places of residence.
4. The amount of capital which each special partner has contributed to the common stock--or fund.
5. The time at which the partnership is to begin and end.
Affidavit of the payment of capital must be made and a notice of the formation of the partnership published in a paper of general circulation. The limited partnership is thus hedged about with safeguards for creditors, bankers, and other interested parties, particularly by the rule that a limited partnership cannot exist unless there are one or more general partners with full liability.
=The Joint-Stock Company.=--The joint-stock company is a partnership or association in which ownership, voice in the management, and profit-sharing ratio are evidenced by transferable shares of stock. Control and management are exercised through a board of directors chosen by the stockholders. If the company becomes bankrupt and the firm assets are insufficient to satisfy creditors, the members are personally liable to the full extent of their private property in the same way as in a general partnership.
The mining partnership is a form of joint-stock company which operates in mining communities. Usually the mining property itself is beyond the scope of such a partnership, only the development of this property by means of a lease being contemplated. Unlike the ordinary partnership, the members of a mining partnership may assign their shares of ownership. Upon their death or bankruptcy, their interests pass to others who take their place in the partnership without the consent of the remaining partners. Thus, the confidential relationship based on the right of selection of its members, characteristic of the ordinary partnership, is largely lacking in the mining partnership.
=Partners Classified.=--Finally, brief mention may be made of the following terms applied to partners to indicate varying degrees of activity within the ordinary partnership:
1. Ostensible partners--those who hold themselves out and are known to be partners.
2. Nominal--those who are known as partners but who have no real interest in the firm.
3. Dormant or silent--those who are not known to outsiders as partners and who take no active part in the management of the firm’s affairs.
4. Secret partners--those who are not known as partners to outsiders but who have an interest and take active part in managing the firm.
For more detailed information as to a partner’s rights, duties, and responsibilities to his copartners and to outsiders, a standard legal text on partnerships or business law should be consulted. The student should also read Chapter II in connection with this chapter and the next.
XXXIII. PARTNERSHIP FROM THE ACCOUNTING VIEWPOINT
From the fact that the law looks upon the partnership as a combination or collection of sole owners, some of the accounting problems arising out of the partnership form of organization are unique, and a partial or full treatment of some of these problems will be given in this chapter.
=Profit-Sharing in the Partnership.=--Of these problems perhaps the one occurring most frequently is that concerning the division of profits. Attention was called in Chapter XXXII to the need of explicit statement on this point in the articles of copartnership under the head of the intrapartnership relations. Since men combine their capitals for the purpose of realizing profits, it would naturally be supposed that all partnership agreements would be specific on that point. Yet it very often happens that many contingencies relating to the matter of profit-sharing have not been foreseen and as a result disputes arise.
The fundamental principles governing profit distribution may be stated as follows:
1. Where the agreement is silent, the law provides that profits shall be divided equally among the partners regardless of the amounts of their respective investments of capital. Some partners may have made no investments of money or property, setting up their particular skill and aptitude or standing in the community as their share and contribution to the profit-earning capacity of the organization. Unless it is specifically agreed otherwise, these will share equally in any profits.
2. Where profits are to be shared in the same ratio as capital, the agreement should specify whether the basis of division is to be the original investments or the capitals as shown at the beginning of each period, which would be the original investments plus profits left in the business. This latter interpretation would usually result in a changing ratio for succeeding periods, whereas under the former interpretation the ratio of profit-sharing would be always the same.
3. Provision should be made, either in the original articles or at a subsequent time, for a change in the profit-sharing ratio in the event of a partner’s withdrawing some portion of his original investment if such withdrawal is allowed. It may be stated here that an agreement between the partners as to any ratio for division of profits can be made at any time and will govern such ratio, but must be on a determinable basis.
4. Where the articles are silent as to the division of losses, the profit-sharing ratio governs. Where a different ratio is desired, specific statement of it must be made. Of course, upon the inception of an undertaking losses are not contemplated, but the experience of others should cause provision to be made for apportionment of losses in order to avoid possible difficulties or disputes.
5. Unless the articles--or subsequent agreements--provide for the payment of salaries to any or all of the partners, none are allowed.
6. The conditions governing the partners’ drawings should be explicit as to the amount to be drawn during a given period. It should be stated explicitly whether excess drawings shall be regarded as a charge against capital, or as the basis for an interest charge, or simply as an excess drawing standing in the partner’s current account without penalty other than a disallowance of future drawings until lapse of time brings the total amount drawn within the agreed limitations.
7. The manner of handling undrawn profits should be made definite. Are they to be transferred to the capital account and so be made a part of capital, resulting in changing capital ratios; or are they to be carried as open balances in the drawing accounts and thus take on the nature of temporary loans subject to withdrawal at any time?
=Average Investment as a Basis for Profit-Sharing.=--Attention should be called to a basis for profit-sharing sometimes employed for special partnerships, entered into for the performance of a specific contract or for doing any special work. In these cases the capital needed may not be known at the start, or if known may not all be required then but is to be furnished by whichever partner may have available funds at the time of need. In such cases the basis of profit-sharing may be made the amount of capital furnished by each partner and the length of time of its use in the enterprise. Two methods of determining the ratio may be employed.
FIRST METHOD. Each investment may be multiplied by the number of days occurring between the date on which the investment was made and the date of profit determination, giving a result which may be called “day-dollars” of investment in a sense similar to the term foot-pound in physics. From the total day-dollars of investment must be subtracted the day-dollars of withdrawals, arrived at similarly, thus showing net investment in terms of day-dollars. The sum of all the investments in day-dollars becomes the basis on which to prorate profits, each partner’s share being the part which his individual net investments bear to this total net investment.
SECOND METHOD. The original investment of each partner may be multiplied by the time it remains unchanged, i.e., until it is added to or some portion is withdrawn. Similarly, this changed capital is multiplied by the time it remains fixed, and so for every change. The total of these items constitutes each partner’s net investment, from which the profit-sharing ratio is determinable as above. In the problem given below, for purposes of illustration the dates are so taken that the calculation can be made on a month-dollar instead of a day-dollar basis, thus shortening the operation. The capital accounts of the partners, showing investments and withdrawals, are as follows:
A. B. CARD ========================================= 19— | 19— Jan. 15 2,500.00 | Jan. 1 10,000.00 Apr. 1 4,500.00 | Mar. 15 7,500.00 June 15 1,500.00 | June 1 5,000.00
D. E. FOLWELL ========================================= 19— | 19— Feb. 1 3,000.00 | Jan. 1 5,000.00 May 15 2,000.00 | 15 5,000.00 | Apr. 1 5,000.00 | June 15 2,500.00
Profits as on July 1, 19—, were $5,000. Determine each share.
SOLUTION (Using the second method)
Amount Months Month-Dollars A. B. CARD: $10,000 × ½ $ 5,000 7,500 × 2 15,000 15,000 × ½ 7,500 10,500 × 2 21,000 15,500 × ½ 7,750 14,000 × ½ 7,000 ------ ----- ------- 6 $63,250
D. E. FOLWELL: $ 5,000 × ½ $ 2,500 10,000 × ½ 5,000 7,000 × 2 14,000 12,000 × 1½ 18,000 10,000 × 1 10,000 12,500 × ½ 6,250 ----- ------- 6 55,750 -------- Total investment in month-dollars $119,000 -------- 63,250 Card’s share of the profit: -------- of $5,000 = $2,657.56 119,000 55,750 Folwell’s share: ------- of $5,000 = $2,342.44 119,000
The first method will, of course, give identical results. The second method has the slight advantage that the Investment Months column will always total the same as the length of the fiscal period, provided each partner makes his initial investment at the first of the period—which is not always the case—and acts as a check on the accuracy of that part of the calculation.
=Interest on Partners’ Investments.=—A second problem of importance in connection with partnership accounting is the interest on partners’ investments. The purpose of allowing such interest is twofold: First, it may serve as an indication of the excess of the profits in this enterprise over the return on the investment of a like amount in the money market, thus dividing the partnership profits into two parts, interest and management earnings; and second, it may serve as a method of distributing profits up to a certain amount on the basis of capital investments, where the agreed-on ratio is different from the capital ratio, thus distributing the period’s profits on two different bases or ratios.
This is done sometimes to equalize somewhat the comparatively smaller-ratio profits of the partners who have made the larger investments. This problem, however, will be treated more fully in a later chapter where the methods of booking the interest, its treatment in case of a loss instead of a profit, and the computation of interest on drawings as well as on investments will be discussed and illustrated. Suffice it to say here that disputes frequently occur in connection with these problems and that detailed provision as to their handling should be made in the partnership agreement.
=Valuation and Correct Booking of Original Investments.=—A third matter of importance is the valuation and correct booking of the original investments other than cash. In the case of the sole proprietor this is of comparatively little importance because he will always reap the entire gain and therefore suffer no harm ultimately from present undervaluation of his property investments. In the partnership, however, where separate investment and personal accounts must be kept with each member, the correct valuation of the assets is of importance, inasmuch as the property of the partnership is the joint property of all partners and all will share ultimately in the effect of any under-or over-valuation at the time of investment. The partners’ accounts are set up for the purpose of showing their respective interests in the enterprise, and after investments are once brought onto the books these accounts govern the equities of the various partners.
=Distinction between Buying Out an Interest and Making an Investment to Secure an Interest.=—The taking in of a partner by a sole proprietor or his admission as a new member to an existing partnership raises a point about which there must be a very definite understanding. A distinction must be made between purchasing from the owners an interest in the business as it stands at any given time and making an investment in a business to secure such an interest. The first transaction is of a personal nature between the owners and a third party who is a purchaser; in the other transaction the third party, who is an investor, puts in money to acquire an interest and his investment becomes the common property of all the owners of whom he is now one. In the one case the capital of the business is not increased, in the other case it is increased by the amount of the new investment. For example, if a balance sheet shows:
Cash $ 5,000.00 Liabilities $ 6,000.00 Other Assets 15,000.00 A. Jackson, Capital 14,000.00
and Jackson sells a half-interest to B. Killian for a given consideration, the new balance sheet becomes:
Cash $ 5,000.00 Liabilities $ 6,000.00 Other Assets 15,000.00 A. Jackson, Capital 7,000.00 B. Killian, Capital 7,000.00
In this case no new capital has come into the business because the purchase price does not go to the business as such but to A. Jackson as a private individual.
If, however, Killian is admitted as a half-interest partner by making a cash investment equal to the amount of Jackson’s interest on the basis of book values, the balance sheet of Jackson and Killian will read:
Cash $19,000.00 Liabilities $ 6,000.00 Other Assets 15,000.00 A. Jackson, Capital 14,000.00 B. Killian, Capital 14,000.00
showing an investment of double the capital in the original Jackson business.
The question of good-will which frequently comes up when an interest in a going business is secured will be treated in Chapter XXXV, where also the manner of closing the books of the old business and opening those of the new firm will be shown.
=Final Considerations.=—From the foregoing discussion it is evident that the partnership relation gives rise to some of the most vexing questions which confront the accountant and the lawyer. It is a truism, therefore, that in drawing up the partnership agreement, all eventualities should be foreseen as nearly as possible and that they should be carefully provided for. As a final safeguard it is well to provide for the submission to arbitrators of disputes subsequently arising, the decision to be binding upon all the partners. This will avoid endless, expensive, and usually unsatisfactory actions at law and will more nearly secure justice to all. As a step in the same direction, it is suggested that provision be made for the drawing up of correct balance sheets and profit and loss statements, that sufficient time be allowed each partner to examine them as to their correctness and, if satisfied, that each be compelled to subscribe to them. This will localize any dissatisfaction within a limited time period and secure its adjustment while all salient points are still fresh in the minds of the interested parties.
XXXIV. CAPITALIZATION OF THE PARTNERSHIP
=Sources of Capital.=—From an accounting viewpoint, the capital of any business enterprise is the excess of its assets over its liabilities. Usually, the main fund of capital is secured by original contribution. In a partnership, the partners’ investments provide the common partnership fund. Thereafter, additions to the capital may be secured in several ways:
1. Profits may be left in the business instead of being withdrawn.
2. Specific contributions may be made by the partners, which are either to be considered as additions to their capital investment, or are to be treated as more or less temporary loans to the business.
3. A new partner may be taken in, his contribution increasing the partnership capital.
The present chapter deals with original investments and with the first two types of additional capital mentioned above, while the next chapter discusses the admission of new members and the consolidation of partnerships.
=Original Contributions.=—It sometimes happens that the partnership agreement does not state specifically how much each partner shall invest in the business. For example, the agreement may state that partner A is to contribute certain properties, i.e., place of business and equipment; that B is to contribute a stock of goods, and that the investments of the remaining partners are to consist of cash, the exact amount of which is not stated because it depends upon the valuation to be placed upon the property and merchandise invested by A and B.
After such a valuation has been made and the amounts of the cash contributions have been determined, it may be found that the total investment is more than the business requires; or it may develop that some of the partners do not have sufficient funds available to pay their shares, while others may be able to contribute more than their respective shares. It thus happens that the partnership agreement is not always rigidly enforced, some partners contributing more, and others less, than the agreed amounts. At the time this is looked upon as a temporary arrangement, but it often results in a permanent condition. The partnership agreement should contain provision for such a contingency. If it does not, a later agreement should be made to regulate the relations between the partners.
=Adjustment of Capital Contributions.=—Whenever a partner contributes more than his agreed share, it is customary to allow him interest on the excess amount, and other partners whose investment may be less than the agreed amount are usually charged with interest. This is obviously an equitable method of meeting the situation.
As a rule, these interest adjustments are handled through the Profit and Loss account, i.e., the partners who invest less than the agreed share are considered to owe interest to the partnership, and those who invest more have an interest claim against the business—not against the other partners individually. The debit or credit balance in the Profit and Loss account resulting from these adjustments is in turn distributed among all the partners in the profit-or-loss-sharing ratios. It should be clearly understood, however, that although these adjustments are made through the Profit and Loss account, there is no element of business profit or expense involved. For this reason, these interest entries should be made direct in the appropriation section of the Profit and Loss, and should never be booked in the regular Interest accounts.
The following illustrations will bring out the different methods of adjustment:
PROBLEM. A, B, and C are equal partners under an agreement to contribute each $15,000. Provision is made that excess contributions are to be credited with interest at 6% and that deficits are to be charged at the same rate. The records show that actual contributions were: A, $18,000; B, $13,000; and C, $11,000.
Three methods of adjustment will be shown.
FIRST METHOD A’s excess is $3,000, interest on which is $180. B’s deficit is $2,000, interest on which is $120. C’s deficit is $4,000, interest on which is $240.
These three interest amounts are brought upon the books by the following journal entries:
Profit and Loss 180.00 A 180.00 B 120.00 C 240.00 Profit and Loss 360.00
The Profit and Loss account then shows a credit balance of $180, which is distributed as follows:
Profit and Loss 180.00 A 60.00 B 60.00 C 60.00
The net effect of these adjustments is a credit to A of $240, and debits to B and C of $60 and $180 respectively.
Note that A is credited with $180 for his excess of $3,000, and Profit and Loss is debited with the same amount, because it is the business that owes him this interest. If this Profit and Loss debit is distributed separately, A’s share of it is $60, so that his real credit on his $3,000 excess is not $180 but $120. On the other hand, the combined debits to B and C result in a credit to Profit and Loss of $360, and if this item is distributed as such, A’s share of it is $120, thus making his total credit on the complete adjustment $240. A similar explanation applies to the adjustments for B and C.
SECOND METHOD. The first method was based on a consideration of the respective excesses or deficits on capital investments, but the same result may be obtained by comparing all contributions with the amount of the smallest investment, viz., $11,000 by C. This would show A’s excess over C as $7,000, and B’s excess over C as $2,000, and these two amounts may be treated as loans to the business. The result is that A is credited with 6% on $7,000, and B with 6% on $2,000, as follows:
Profit and Loss 540.00 A 420.00 B 120.00
The debit to Profit and Loss is charged in equal shares to the three partners as follows:
A 180.00 B 180.00 C 180.00 Profit and Loss 540.00
The final result shows a net credit to A of $240, a net debit of $60 to B, and a net debit of $180 to C, the same as by the first method.
THIRD METHOD. The total capital contributed is $42,000. To be equal partners under the agreement, each should have contributed one-third of the common fund, or $14,000. Actually, A’s investment is $4,000 in excess of this, while B’s is $1,000 less, and C’s $3,000 less. The excess contribution of A, $4,000, may be looked upon as a loan to B and C as individuals, bringing their shares up to the $14,000; viz., $1,000 to B and $3,000 to C. Instead of making the adjustment through the Profit and Loss account as in the first two methods, the interest is now adjusted between the three partners as private persons, the entries affecting only the partners’ personal accounts. This adjustment results in a credit to A and a debit to B for $60, A having loaned B $1,000; and in a credit to A and a debit to C for $180, A having loaned C $3,000. A’s total credit is $240, and B’s and C’s debits are respectively $60 and $180, the same as by the other two methods.
Thus it is seen that any of the three methods employed leads to the same results. It will be observed, however, that in the example given the contemplated investments are to be equal for the three partners ($15,000), and the profit and loss is to be shared on the same basis. The three different methods of adjusting interest lead to the same result only when the profit-sharing ratio is identical with the ratio between the contemplated investments.
=Averaging Investments.=—In temporary partnerships, organized for carrying out a particular undertaking, the amount of capital needed is often not known and may vary at different stages of the undertaking. Here the partners usually contribute as need arises, and withdraw when funds not needed in the business become free. Under such conditions, the partnership agreement should always state the manner in which the partners’ interests are to be adjusted. A common method, as explained and illustrated in Chapter XXXIII, is to compute the average investment of each partner and to use these amounts as the basis for profit-sharing. In this way the problem of interest adjustment as such is completely eliminated.
=Accretions of Capital through Profits.=—At the close of the fiscal period, when results are summarized, the net profits are transferred to the partners’ accounts. As the amount of profit left in the business usually differs for different partners, it is evident that the partners’ capital accounts at the end of the period will show a different ratio from that existing at the beginning. Assume that a given partnership consists of two members, A investing $2,000 and B $1,000, and that profits are to be shared in the same ratio as these original investments, i.e., 2:1; assume further that A withdraws the greater part of his profits while B allows his share to accumulate, and that at the end of a number of years the capital ratios have completely changed, the capitals being, say, $8,000 for A and $24,000 for B. Obviously, under such circumstances it would not be just for A still to receive twice as much profit as B on the basis of the original investment ratio of 2:1.
Whenever it is intended that profits are to be shared on the basis of investments, the profit-sharing ratio should be changed from time to time in order to correspond with actual investments, and this should be plainly stated in the partnership agreement; or increments to capital through the accretion of profits should be treated as temporary loans subject to withdrawals and bearing interest until withdrawn. It should be the policy of the firm to offer an incentive to its members to leave their surplus profits in the business and so prevent the need of borrowing from outside.
Finally, it may be said that in the event of dissolution, accretions through profits constitute claims against the firm ranking before the partners’ capitals. Such accretions partake of the nature of loans and for this reason they are sometimes carried in partners’ loan accounts, to keep them separate from the original capital investments, or are left in the “Personal” accounts which are not then closed into the “Capital” accounts.
=Additional Contributions and Loans.=—When contributions are made by partners there should be a specific understanding as to whether such funds are to be considered as additional capital or as loans to the partnership. In the first case the items should be shown in the capital accounts of the partners, thus requiring a reconsideration of the profit-sharing ratio—although a change is not always made; in the second case they should be entered in the partner’s loan accounts with corresponding interest adjustments, as has been explained.
Loans by partners may be evidenced by firm notes signed by all the partners. However, these notes should not be carried in the regular Notes Payable account because that account represents the firm’s liability to outsiders, which must ordinarily be met promptly according to the terms of the instrument. At common law a partner may not bring suit against the firm of which he is a member; hence there is an essential difference between these two kinds of notes. For this reason a new account is opened entitled “Partners’ Notes Payable,” which is credited whenever the firm issues a promissory note to any of its members. Where the loan is not evidenced by a formal note, record should be in the partner’s loan account. As stated on page 324, any loans made by partners to the business rank before regular capital claims, and this priority is not changed when such loans are evidenced by promissory notes.
=Partners’ Loans in Relation to Firm Credit.=—Loans made by partners to the business may be viewed in two very different ways, depending upon the credit rating of the firm. If there is distrust as to the partners’ standing and financial condition, the fact that they themselves, who know the real condition better than any outsider, are willing to put additional capital into the business, is the best evidence that the firm is not so badly off. Consequently, loans made by partners under such conditions help to increase the firm’s credit.
On the other hand, if the integrity of any member of the firm is questionable, his loans to the business do not necessarily increase the credit of the firm; for in case of financial trouble he may attempt secretly to withdraw part of the assets from the business and to conceal the true condition of affairs from the creditors. Being on the inside, he is in a position to do this before outsiders can even scent trouble. Normally, however, the loan of a partner makes a better impression than a loan from an outsider, since in case of insolvency and dissolution the partner’s loan ranks after the claims of outside creditors.
It sometimes happens that in a partnership one or more of its members lends the firm comparatively large amounts of money and accepts demand notes as evidence of such loans. If the partner holding such a note is unscrupulous, he may present it for payment at an unfavorable time and, if the business is unable to pay, may demand an “accounting.” He may even go so far as to cause its dissolution, repurchase the business at much less than its true value and so “freeze out” his partners.
=Borrowed Capital.=—It may happen that a firm is obliged to borrow funds from outside in order to increase its working capital. For instance, the partners may have no available private funds for further investment and yet may not desire to admit new capital on a profit-and-loss-sharing basis. Such loans usually are on a long-time basis, and should not be included in the Notes Payable account. A special account should be opened, e.g., Notes Payable Special, Mortgage, or some other title plainly indicating the nature of the loan. Sharp distinction should be made between funds borrowed for the purpose of increasing the permanent capital, and money borrowed for current needs. The need for additional current funds usually results from seasonal fluctuations in business, slow collection of customers’ accounts, or slow movement of stock, and is met by current borrowing at a bank; while the need for increased capital is caused by the original capital investment being insufficient to meet present conditions.
XXXV. OTHER PARTNERSHIP PROBLEMS
=Admission of a New Partner.=—In Chapter XXXIII a distinction was made between buying out an interest in a business and making an investment in a business. In the former case no new capital is acquired, while in the latter the capital of the firm is increased by the amount of the new partner’s contribution.
When a new partner is admitted he usually acquires not merely the right to share in the profits, but he also obtains a share in the net worth (often called “net assets”) of the enterprise. For this reason it is necessary that all the partners, including the new member, agree on the value of the net assets, and in this connection any of the following possibilities may arise:
1. Upon admission of the new partner the book accounts may be considered to represent the true status of the business. A balance sheet is drawn up and the new partner is admitted on the basis of the net worth it shows.
2. It may be agreed that the assets are not worth the amount at which they are carried on the books and that a new valuation be placed upon them.
3. The business may be considered to be worth more than the amount shown by the balance sheet.
=First Case.=—In the first case little difficulty is met in making the opening entry admitting the new partner. For instance, if the balance sheet shows a net worth of $30,000, and the new partner wishes to make an investment in order to secure a one-fourth interest in the firm, the amount to be contributed is manifestly $10,000. Assuming that he makes a cash investment of $10,000, the following entry meets all accounting requirements:
Cash 10,000.00 A, Capital 10,000.00
As a result of this cash investment of $10,000, the net worth of the new firm is increased to $40,000 and the one-fourth interest belonging to A is evidenced by his capital account at $10,000. The new firm may now continue the old records and no further adjustments need be made.
=Second Case.=—In the second case it is necessary to place a new valuation upon the assets of the old firm and the accounts of the old partners must be adjusted accordingly. For instance, suppose A and B are equal partners and the financial status of the firm is shown by the following balance sheet:
BALANCE SHEET OF A & B
Cash $ 1,000.00 Notes Payable $ 3,000.00 Accounts Receivable 10,000.00 Accounts Payable 5,000.00 Merchandise 6,000.00 Mortgage on Bldg 4,000.00 Building and Equipment 16,000.00 A, Capital 10,500.00 B, Capital 10,500.00 ---------- ---------- $33,000.00 $33,000.00 ========== ==========
More capital is needed and C is invited to make an investment. Upon investigation he finds that there are included under Accounts Receivable many old items, of which it is estimated $1,000 will be uncollectible; that the merchandise is overvalued to the amount of $500; and that the building and equipment are worth $1,500 less than is shown on the books. He offers to make an investment to secure a one-fourth interest and his offer is accepted.
As a result of the new valuations placed upon the assets, the net worth of the firm is now $18,000, against the old showing of $21,000. Consequently, the capital accounts of A and B are reduced from $10,500 to $9,000 each. The new partner is to invest a certain sum sufficient to acquire a one-fourth interest in the new business. Hence the combined capital of A and B, amounting to $18,000, will represent three-fourths of the new capital, and consequently the amount to be invested by C is $6,000. Thus the new capital of the firm will amount to $24,000, one-fourth of which, or $6,000, is credited to C’s capital account.
The balance sheet of the new firm will show:
BALANCE SHEET OF A, B & C
Cash $ 7,000.00 Notes Payable $ 3,000.00 Accounts Rec. $10,000 Accounts Payable 5,000.00 Less—Reserve 1,000 9,000.00 Mortgage on Bldg 4,000.00 ------- A, Capital 9,000.00 Merchandise 5,500.00 B, Capital 9,000.00 Building and Equipment 14,500.00 C, Capital 6,000.00 ---------- ---------- $36,000.00 $36,000.00 ========== ==========
The firm has thus secured $6,000 additional capital, on a basis somewhat unfavorable for the present, but inasmuch as the books now show conservative values, no real injustice results.
=Third Case.=—The third case shows the firm in a position to demand something more than book values as the basis for admission of the new partner. The presumption is that the old firm is favorably known, has an established trade and patronage, built by fair dealing and judicious advertising, by its favorable location, and the numerous other ways in which a substantial business may be developed. Its standing in the community is a factor of value to the firm because it brings trade to its doors. Other conditions being equal, a firm which enjoys a good reputation is worth more than a new venture. Such a reputation is known as “good-will” and constitutes an exceedingly valuable though an intangible asset. The essence of good-will is the ability to produce more than normal profits, i.e., profits above the average in that line. Consequently, whenever the members of a firm consider the admission of a new partner, good-will is regarded as one of the assets of the existing enterprise, thereby increasing its net worth.
The valuation of good-will, however, is a difficult matter and it is a well-established principle that good accounting will not allow the asset good-will to be set up on the books of a concern unless it has come into possession of it by purchase or unless a part of its own good-will is sold to a new partner. In this case the price received for the portion sold represents an outsider’s valuation and may therefore become the basis for valuing the whole of it.
The following case will serve as an illustration:
PROBLEM. Assume that X has a one-half interest in a firm, and Y and Z a one-fourth interest each, the balance sheet showing the following summarized facts:
BALANCE SHEET OF X, Y & Z
Cash $ 2,000.00 Liabilities $10,000.00 Other Assets 48,000.00 X, Capital 20,000.00 Y, Capital 10,000.00 Z, Capital 10,000.00 ---------- ---------- $50,000.00 $50,000.00 ========== ==========
An outsider, R, is now to be admitted to a one-fifth interest by making an investment in the business. The relative shares of the others are to remain as before. Hence, after R’s admission, X will have two-fifths, and Y, Z, and R one-fifth interest each. It is further assumed that no revaluation of the tangible assets is necessary.
The net worth of the old firm, according to the books, is $40,000, and if this were taken as the basis for admitting R, an investment of $10,000 would be sufficient to acquire a one-fifth interest in the new firm. However the business is considered to be worth $10,000 more than the $40,000 shown in the balance sheet, and for this reason, instead of paying $10,000, R is required to invest $12,500. The excess of $2,500 is paid by R as an offset to the shares of the others in the good-will of the firm.
There are three ways of treating this good-will element, viz.:
FIRST METHOD. Debit the Good-Will account for the amount actually paid for it by R, viz., $2,500, and credit the capital accounts of the old partners in proportion to their shares in the profits:
Good-Will 2,500.00 X, Capital 1,250.00 Y, Capital 625.00 Z, Capital 625.00
As a result of this entry, the capital account of X is $21,250, and those of Y and Z $10,625 each. The capital account of R, however, shows a credit of $12,500. In other words, R’s interest in the net assets—although not in the profits—of the business as shown by his account is larger than that of Y and Z, while as a matter of fact he is to have an equal share. For this reason, this method of treating good-will is not satisfactory.
SECOND METHOD. This method regards the matter from a different standpoint. Taking book values as a basis, the share bought by R is worth only $10,000. However, on account of good-will, the real value of this share is considered to be higher and R is required to pay $12,500 for it. Hence, in order that the books may show actual values, the good-will item must be added to the assets of the old firm, at the same time increasing the capital accounts of X, Y, and Z in proportion to their shares in the profits. The entry is:
Good-Will 10,000.00 X, Capital 5,000.00 Y, Capital 2,500.00 Z, Capital 2,500.00
As a result of this adjustment the capital of the old firm is shown as $50,000. R now invests $12,500, and the capital is thereby increased to $62,500. The capital accounts of the four partners now show $25,000, or two-fifths for X, and $12,500 or one-fifth each for Y, Z, and R.
THIRD METHOD. Under this method of handling good-will, the extra $2,500 invested by R is treated as a bonus for distribution among the members of the old firm, their capital interests in the new firm remaining the same as in the old and R’s appearing at $10,000. There is no objection to this method if R is satisfied.
Of the three methods, the second usually proves the most satisfactory.
A similar problem involving the handling of good-will is encountered when a member of an existing firm sells out his interest, including a share of the good-will, to one who takes his place in the firm. Here the transaction may be looked upon as a private deal between buyer and seller, in which case the buyer merely succeeds to the seller’s interest in the firm, his capital appearing on the books at the same amount as the seller’s former capital figure even though the new partner pays more for it; or the good-will may be brought onto the books and the capitals of all the partners be shown at increased figures, as under the second method discussed above.
=Consolidation of Partnerships.=—There are various reasons why the consolidation of partnerships may be of mutual advantage to the individual firms concerned. When two or more firms consolidate, the competition which formerly existed between them is eliminated and co-operation takes its place. Also by uniting their businesses, many of the operations which were formerly performed separately are now amalgamated with resulting savings. Many other advantages may result from such consolidations.
From the standpoint of the accountant, the consolidation of partnerships is essentially the same as the admission of new partners, the same principles applying to both. Before actual consolidation takes place, it is necessary for each of the partnerships to place a new valuation upon its assets and for all concerned to agree upon the new figures. In almost all cases good-will is an important factor. The valuation of good-will requires an investigation of the profits and profit-earning capacity of the member firms. Conditions affecting the profits of the various firms must be equalized as nearly as possible so that the earning capacity of each can be compared on an equitable basis. Such questions as the way in which partners’ salaries, interest on capitals, withdrawals, and loans have been handled; the relation of outside sources of income, if any, to the profit of any of the member firms; and whether the consolidation contemplates taking over such source of profits—these and similar questions must be considered and treated equitably for all concerned.
The following illustration is given to indicate the bookkeeping problems incident to consolidations:
PROBLEM. A and B, equal partners in an established business, consolidate with C and D, equal owners of an allied business. A and B are each to have a one-third, and C and D each a one-sixth interest in the new firm. The following balance sheets show their financial positions:
BALANCE SHEET OF A & B Cash $ 2,500.00 Notes Payable $ 5,000.00 Notes Receivable 1,000.00 Accounts Payable 8,000.00 Accounts Receivable 22,000.00 Mortgage on Real Merchandise 10,000.00 Estate 4,000.00 Furniture and Fixtures 2,500.00 A, Capital 16,000.00 Delivery Equipment 1,500.00 B, Capital 16,000.00 Real Estate 9,500.00 ---------- ---------- $49,000.00 $49,000.00 ========== ==========
BALANCE SHEET OF C & D Cash $ 5,000.00 Notes Payable $ 5,000.00 Accounts Receivable 15,000.00 Accounts Payable 7,750.00 Merchandise 8,000.00 C, Capital 9,000.00 Furniture & Fixtures 2,000.00 D, Capital 9,000.00 Horse & Wagon 750.00 ---------- ---------- $30,750.00 $30,750.00 ========== ==========
A careful valuation of the various properties shows the figures of the balance sheet of C & D to be conservatively estimated. In regard to A & B’s figures, however, it is decided to allow $2,000 for possible bad debts, and to value their merchandise at $9,000, delivery equipment at $1,000, and real estate at $9,000. Furthermore, it is agreed that C & D’s good-will is to be valued at $5,000, and A & B’s at $10,000.
After the adjustments the new balance sheets appear as follows:
BALANCE SHEET OF A & B Cash $2,500.00 Notes Payable $5,000.00 Notes Receivable 1,000.00 Accounts Payable 8,000.00 Accounts ” $22,000 Mortgage on Real Less—Reserve 2,000 20,000.00 Estate 4,000.00 Merchandise 9,000.00 A, Capital 19,000.00 Furniture and Fixtures 2,500.00 B, Capital 19,000.00 Delivery Equipment 1,000.00 Real Estate 9,000.00 Good-Will 10,000.00 $55,000.00 $55,000.00 ========== ==========
BALANCE SHEET OF C & D Cash $ 5,000.00 Notes Payable $ 5,000.00 Accounts Receivable 15,000.00 Accounts Payable 7,750.00 Merchandise 8,000.00 C, Capital 11,500.00 Furniture and Fixtures 2,000.00 D, Capital 11,500.00 Horse and Wagon 750.00 Good-Will 5,000.00 ---------- ---------- $35,750.00 $35,750.00 ========== ==========
It is agreed that C and D’s capitals are each to be taken as representing one-sixth of the capitalization of the new firm, and A and B are each to contribute $4,000 in cash to bring their capitals up to the required amounts.
The opening balance sheet of the consolidated firm will then read as follows:
BALANCE SHEET OF A, B, C & D Cash $15,500.00 Notes Payable $10,000.00 Notes Receivable 1,000.00 Accounts Payable 15,750.00 Accounts Mortgage on Real Receivable $37,000 Estate 4,000.00 Less—Reserve 2,000 35,000.00 A, Capital 23,000.00 Merchandise ------- 17,000.00 B, Capital 23,000.00 Furniture and Fixtures 4,500.00 C, Capital 11,500.00 Delivery Equipment 1,750.00 D, Capital 11,500.00 Real Estate 9,000.00 Good-Will 15,000.00 ---------- ---------- $98,750.00 $98,750.00 ========== ==========
XXXVI. PARTNERSHIP PROFITS
=Ambiguity of Definition of Profits.=—The term “profits” as applied to business is perhaps used with as little uniformity as any term met with. When a concern speaks of its profits, it is difficult to know exactly what is intended, because the meaning of the term depends very largely on the methods of accounting of that particular concern. The reported profits of different firms are not, therefore, a true basis for judging their relative worths. For instance, although the net profits of a single proprietorship and of a partnership are usually determined in the same manner, there is nevertheless variation in the treatment of some items such as salaries, drawings, interest on capital invested, etc. The partnership form, like the single proprietorship, contemplates an investment on the part of the owners not only of capital but also of time and effort. This is one of the differences in working organization between these forms of business and the corporation. Investment in the corporation is of capital only. If services are employed by the corporation, they are paid for and charged as services, salaries, etc.
=Compensation for Time and Services.=—In the partnership form of organization, the active and direct management of the business is usually vested in the owners. Where this is not the situation, as in a limited partnership, or whenever one or more of the partners does not take an active part in the management of the business, his share of the profit is usually curtailed by the allowance of salaries to the managing partners before any distribution of profits in the agreed ratio is made to the partners. Thus, partnership profits include not only the salaries of the owners but, in general, a recompense for the time and ability of the proprietors. The man who makes an investment in a partnership does so usually because he desires to invest his time as well as his capital. He expects, therefore, to receive not only a fair rate of interest on his money but also pay for the services he renders.
=Interest on Investment.=—The rate paid for the use of money is dependent both on the money market and on the element of risk involved in the particular investment. In mining ventures, for instance, where there is frequently considerable uncertainty as to the return of the principal, the interest rate is sufficiently high to offset, during the life of the loan, the possible loss of the principal at the end. So an investor in a partnership, because of the greater element of risk in comparison with other and safer investments, requires a higher rate of return in interest than he would ordinarily secure through the investment of his capital in sound securities.
=Partnership Profits Defined.=—Partnership profits, therefore, contain these two elements—interest and recompense for services. If profits are extraordinary or above normal, such excess may be and usually is the measure of the more-than-average ability of the partners, unless it results from the monopolistic character of the business.
In speaking of profits the term is used in a technical accounting sense and has reference to the manner of their showing in the Profit and Loss account and its content. That account or the Profit and Loss statement usually develops a so-called “net profit” which is distributed to the partners. Such profits are more easily defined by stating what should not be considered in their determination, than by attempting to give an itemized list of the income and expense items entering therein.
In accordance with the theory of the law of partnership, the net profit of a partnership is the balance of the Profit and Loss account before interest on owners’ capital investments and the recompense to the partners on account of time and services are taken into account. In the accounting for an ordinary partnership, such items as interest on capital investments, salaries to partners, etc., are not to be considered as expense items to be deducted from profits before the net earnings are determined, but as a part of the net profits to be distributed to the several owners of the business. The payment of salaries and interest on capital is made simply for the purpose of distributing net profits according to certain methods agreed upon by the members of the firm.
=Profit and Loss for Comparative Purposes.=—For the purpose of comparing results between different periods, the Profit and Loss account should have a fairly uniform content from year to year. It should set forth the amount of the net operating profit, in the calculation of which account should be taken of all ordinary income and expenses incurred in the operation of the business. This will provide the basis for comparison, as between periods, of the ordinary normal activities of the business.
In the “Non-Operating” or “Other Income” sections any “outside-the-business” income and expense should be shown, such as income from outside investments, and expenses in connection therewith. Items of extraordinary income and expense, however, such as the profits arising through the sale of good-will, the sale of real estate, extraordinary losses from fire, etc., usually are taken directly into the partners’ accounts so as not to destroy the value (for purposes of comparison) of the results shown by the Profit and Loss account from year to year.
In this way, while the purpose of the Profit and Loss account is to summarize the temporary proprietorship accounts, some proprietorship items may be omitted for the sake of making the summary of greater value to the proprietors. Such a method of handling does not conflict with principles previously laid down, but rests upon the general principle that accounting methods and forms must be flexible in order to conform to the requirements of particular cases; else they fail in fulfilling their full purpose.
=Allowance of Salaries.=—The allowance of salaries to partners is not so much for the purpose of measuring the excess of the profits of the partnership over what the individual owners might have earned by working for others, as it is for the purpose of equalizing or adjusting their interests on an equitable basis. When, on the one hand, men invest their abilities and services in addition to their capitals, and on the other hand, the profit and loss-sharing ratio is determined on the basis of capitals invested, the greater ability of a given partner may be recognized and compensated by a salary. Thus a partner of exceptional ability secures a larger share in the profits by receiving a fixed amount under the head of salary, the remaining part of the net profits being divided among all the partners in the profit and loss-sharing ratio.
=Allowance of Interest.=—As explained in Chapter XXXIII, it is not unusual in partnerships where the profit and loss ratio differs from the capital ratio, to allow interest on capital. The effect of such a provision is to secure a distribution of profits on a dual basis, viz., a part as interest on the capitals in the capital ratio and the remainder in the profit and loss ratio. Thus, two partners, A and B, whose capitals are $10,000 and $15,000 respectively, with a 6% interest allowance on capital and a subsequent half-and-half distribution of profits, share the profits in effect on two different bases. Suppose the profits are $6,000. The interest requirement will give A $600 and B $900, after which $4,500 will be divided equally. Interest on partners’ capitals is thus in no sense an operating expense and should be handled always in the appropriation section of the Profit and Loss.
If the partnership agreement makes specific provision (but not otherwise), interest may be charged on partners’ drawings. This is merely an additional device for adjusting the partners’ interests, and causes a slight difference in the net shares of profits. Where interest is allowed on capitals and also charged on drawings, the partners’ accounts, Personal and Capital, when considered together, comprise virtually an account current, and the interest computations may be made as will be explained in Chapter L in connection with accounts current.
Another method of profit-sharing sometimes introduced in the partnership agreement is the device of an interest allowance for a contribution in excess of the agreed amount and an interest charge on partners’ deficiency of capital. This method of equalizing unequal investments, as illustrated in Chapter XXXIV, is a fair arrangement to all concerned.
=Interest on Partners’ Loans.=—Careful differentiation must be made between interest on partners’ capitals and on partners’ loans. If a loan is secured from outside parties, its interest cost is a business expense, to be taken into account before determining net profits. A loan from a partner does not in the least change the manner of showing its cost. Interest on partners’ loans is not, therefore, to be handled in the appropriation section of the Profit and Loss account, but should be charged to the regular Interest Cost account, which is cleared in the regular way through Profit and Loss. The credit is to Cash if actually paid, or to the partners’ personal accounts if unpaid, although the amount is sometimes credited to the partners’ loan accounts in order to secure a compounding of the interest.
=Reserved Profits.=—In rare cases, before the partners’ shares in the net profit are determined, a portion of it may be reserved for some specific purpose. The portion so reserved is transferred from Profit and Loss to some specified reserve account, to indicate the retention of the profits in the business. If the profits were transferred to the partners’ accounts, they would be subject to withdrawal from the business. Even when shown in the reserve account, however, they belong to the proprietors and are just as much a part of the net worth of the business as if credited to the proprietors’ accounts. Such reservation of profits may be for the purpose of providing for the replacement of some fixed asset when it wears out, as buildings, machinery, etc., or for meeting a liability when it comes due, or for some similar purposes. Such reservations, however, are seldom made in partnership accounting and a complete treatment of the subject is reserved for the work of the second year in connection with corporation accounting.
It should be noted that reserves created from profits are not to be confused with valuation accounts, such as reserves for depreciation and doubtful accounts. Valuation accounts in no sense represent a reservation of net profits. They represent the credit side of certain asset accounts. The contra debits—to depreciation or bad debts—of these credit reserves are expenses of the business which must be taken into account before the amount of net profit can be determined.
=Closing Profits to Partners’ Accounts.=—The disposition of profits under a partnership does not differ materially from that under the single proprietorship form. When the net profits are determined, they belong to the proprietors and are usually transferred to their accounts. The method of transfer may be either by way of the partners’ personal accounts or direct to the capital accounts. The principle involved in either treatment was discussed at the time of closing the books for the single proprietorship and will not be repeated here. Where the partners do not desire to have any change shown in their original capital accounts, the profits may be transferred to the loan accounts of the partners or stand as open balances in their personal accounts.
=The Appropriation Section—Distributing a Deficit.=—The appropriation section of the Profit and Loss account shows the distribution of net profits to the partners’ accounts. A thorough understanding of the partnership agreement is necessary before the proper distribution can be made. If the agreement provides for salaries and interest on capitals and drawings, these requirements must first be met, even though the net profits are insufficient to satisfy them. Their purpose, as explained above, is to equalize conditions and interests among the partners preliminary to their sharing in the profit and loss ratio. If this equalization results in a deficit, such deficit will be distributed in the agreed ratio and to that extent nullify some portion of the profits distributed as salaries and interest. If specific provision in the articles of copartnership requires a different handling of the salaries and interest items, that provision of course governs. Otherwise these items should be treated as above.
If any of the partners leave profits in the business, this usually results in a changing ratio of the capital account balances. Where the distribution of profits is based upon the original contributions, it is advisable to transfer the profits left in the business to separate loan accounts for the partners. The partners’ capital accounts then always show their original contributions.
=Partners’ Withdrawals.=—Partners’ withdrawals and salaries are usually handled in a very unsystematic way. The amount of the drawings allowed each partner during a given period—week or month—should be definitely determined by agreement, and regular checks should be issued for these amounts. The payment of partners’ personal bills and the handling of any other personal items should, as a matter of standard practice, be made out of personal funds.
If the partnership agreement provides for salaries these should be credited, when due, to the partners’ drawing accounts which will then be charged with all actual drawings, whether for salary or otherwise. The offsetting charge at the time the salary credit is made should be to a “Partners’ Salaries” account, which at the close of the fiscal period is closed into the appropriation section of the Profit and Loss account, thereby showing in it the proper distribution of profits as salary.
=Profits Determination upon Admitting a New Partner.=—Particular care should be taken to determine as nearly as possible the correct net profit at the time of any change in the partners’ relations. Upon the admission of a new partner, failure to make entry in the old partners’ accounts of any profit rightfully belonging to them leads to its being shared with the new partner and consequently results in a loss to the old partners. In like manner the deferring of an expense charge—rightfully belonging to the period before the admission of the new partner—to the period after the admission, results in a wrongful charge to the new partner. Similarly, when a partner is admitted on a changing profit ratio basis (as when, for example, he is to receive a one-fourth share for three years, at the end of which time he is to have a one-third share), an incorrect determination of profits at the end of the three-year period may mean a loss either to him or to the old partners. So long as the same partnership and the same profit and loss-sharing ratios continue, no injustice results through failure to include some such items in their proper periods, as they are cumulative and their effect will be recorded in later periods. However, this is no excuse for the inaccurate determination of profits at any time.
XXXVII. PARTNERSHIP DISSOLUTION
=Temporary Nature of Partnership.=—Because of its personal character, a partnership has necessarily a limited duration. It must look forward to the time when its business will have to be closed up. The chief causes leading to a dissolution are briefly reviewed here.
=Causes of Dissolution=
1. The withdrawal of any partner. Under ordinary circumstances a partner cannot be held to a specific performance of his contract. If he becomes dissatisfied, suspicious, or desires for other reasons to withdraw from his contract before its expiration, he has that power. Such withdrawal cannot be looked upon as a right but only as a power to be exercised under unusual circumstances. If his withdrawal before the agreement terminates results in damage to his copartners, they have a lawful claim against him for the amount of the damage. Under extraordinary conditions, specific performance of the contract might be decreed, i.e., the partner would not be allowed to withdraw.
Withdrawal does not relieve a partner from liability for partnership debts incurred while he was a member of the firm. Any creditors not paid by the firm may hold the withdrawing partner liable for the debts. To be relieved from the liability on debts arising after his withdrawal, personal notice of withdrawal must be given to all the firms with which the partnership has been dealing; a published notice being considered sufficient for the parties not dealing with the firm until after withdrawal.
2. Sale of a partner’s interest or admission of a new partner. When a partner, with the consent of his copartners, sells his interest in the firm to another, or when a new member is admitted to the partnership, in the eyes of the law the old partnership has ceased to exist and a new one has taken its place.
3. Limitations in the partnership agreement. The agreement may specify the period for which the partnership is to exist. If it is a special partnership, the object it is to accomplish may be stated and the law considers the firm automatically dissolved as soon as that object is attained.
4. Mutual consent of the partners. Whether or not the partnership period is limited by the agreement, the partners may at any time rescind their contract by mutual consent.
5. Misconduct, insanity, death, assignment, or bankruptcy of a partner. The happening of any of these contingencies effects a dissolution. By misconduct may be understood a member’s failure to pay the agreed contribution of capital, failure to perform his duties, his acting in bad faith towards his copartners, etc.
6. Illegal object. A partnership entered into for the pursuit of an object which later becomes illegal is automatically dissolved.
7. War between nations of which partners are citizens. This dissolves the partnership, though such dissolution may be more in the nature of a suspension, inasmuch as the relation may be resumed upon cessation of hostilities.
8. Bankruptcy of the firm. This results in the firm’s assets being sold to satisfy the claims of its creditors and the firm as such ceases to exist.
9. Sale or transfer. A firm may sell out to another firm or change its form of organization to that of a corporation. The old firm, therefore, no longer exists.
=Problems Incident to Dissolution.=—It is purposed to consider some of the problems involved in winding up the affairs of a partnership. From the schedule of causes of dissolution given above it will be seen that a firm may be either solvent or insolvent at dissolution. The three statements sometimes set up in the case of insolvency—the Statement of Affairs, the Deficiency Account, and the Realization and Liquidation Statement—will not be explained here but results obtained through them will be taken into account. These statements are seldom met in practice and are not standardized either as to form or content. Their treatment is deferred to the work of the second year.
=Partnership Provisions Covering Liquidation.=—Because of the certainty of final dissolution, it is not unusual for the partnership agreement to make definite regulations concerning the method of liquidation. The appointment of one of the members as liquidating partner, the manner of distributing the proceeds from liquidation whether by instalments or otherwise, the manner of paying the liquidator for his services—all these contingencies should be provided for.
Where dissolution is forced by the death of one of the partners, to determine the interest of his heirs it is necessary to take inventory and make appraisal of the firm’s assets. To avoid this inconvenience to the business, provision is sometimes made in the agreement that the remaining partners shall continue the business until the end of the regular fiscal period. The deceased partner’s share in the profits for the current period up to the date of his death is determined by prorating the year’s profit over the period in which the deceased had an interest. The method of calculating the firm’s good-will is usually provided for in the partnership agreement so that the estate of the deceased partner will share in it also. Usually interest is allowed the estate of the deceased partner from the date of his death until the settlement of his share.
=Partners’ Rights and Procedure During Liquidation.=—When dissolution is accompanied by liquidation, as happens in many instances, all the partners have an equal right to share in the work of liquidation. Since the work usually does not require the time of all the partners, a customary procedure is to appoint one member—or an outsider—as the liquidator. Notice of the dissolution, in which the name of the liquidator is given, is published in the leading newspapers. If liquidation is necessary because of the death of a partner, great responsibility rests upon the liquidator. He must act in strict good faith and endeavor to realize the best price possible for the assets of the firm in the interest of the deceased partner’s estate. A similar responsibility rests upon him when liquidation is carried on in the interest of absent members.
The expenses and losses incident to liquidation must be borne by all in the profit and loss ratio. The liquidator may be paid either by means of a commission on the sums realized or by a salary. If the liquidator is a partner, settlement may take place privately between the partners but usually his commission or salary is charged to the firm’s liquidation expenses.
Liquidation may proceed by sale of the assets in regular order and may even permit the purchase of additional goods where necessary to fulfil existing contracts or to complete partly manufactured goods, or where stock on hand can be disposed of to better advantage by the addition of side lines or specialties.
=Distribution of Proceeds.=—Upon the realization of the assets, application of the proceeds must be made in the following order: First, the claims of outside creditors must be met in full or by compromise where not fully recognized. Second, the claims of the partners on account of loans or advances made to the firm must be satisfied. Third, the partners share in the remainder, by first taking out their respective capital contributions and then, if there is a balance, by sharing it in their profit and loss ratios. If there is a loss, this must be shared in the profit and loss ratio before withdrawal of any capital contributions. The remainder, if any, is divided among the partners in the ratio of their capitals as diminished by the loss. Whether the net assets are either more or less than the total amount of the capitals, the difference is shared in the profit and loss ratio, and what remains is shared in the capital ratio. If a careful accounting is made of the profit or loss at the time of the sale of each piece of property and these profits and losses together with the dissolution expenses are summarized and distributed to the partners’ capital accounts, those accounts will of course show the claims of the various partners on the net assets of the business after all assets have been converted into cash and all liabilities paid.
Instead of a complete liquidation of the firm’s assets, certain of the assets may, by mutual consent, be taken over by each partner at agreed values and applied toward the satisfaction of his capital and loan interests. Such use of assets is spoken of as a conversion to that particular purpose. It must be distinctly understood that this is not a right which any partner can demand, but only a privilege granted by the mutual agreement of the partners. Any partner can demand that all the assets be sold and that the proceeds be applied in satisfaction of the interests concerned.
=Sharing Losses.=—In the case of insolvency, the partners are compelled to share the losses in the profit and loss ratio, not in capital ratio, and these losses are chargeable against their capital accounts. If the capital account of any of the partners is not large enough to satisfy his share in the losses, a deficit in that partner’s interest results, which is represented by the debit balance in his capital account. This shows the amount which he must contribute to the firm in order that all claims may be satisfied. The rule that profits and losses in liquidation cannot be shared in the same ratio as capitals, unless this ratio is also the profit and loss ratio, is responsible for the fact that upon dissolution one or more partners may have to make additional contributions, while others may not be obliged to do so. This duty of contributing to make up a deficit is inherent in the partnership relation and can be enforced by the copartners.
A few illustrations will set forth the main problems in connection with the liquidation of partners’ capitals:
=1. Sharing Losses Equally=
BALANCE SHEET OF A, B & C Cash $10,000.00 Liabilities $10,000.00 Other Assets 60,000.00 A, Capital 15,000.00 B, Capital 20,000.00 C, Capital 25,000.00 ---------- ---------- $70,000.00 $70,000.00 ========== ==========
A, B, and C share profits and losses equally.
The above balance sheet shows, in summary form, the condition of the firm previous to liquidation, and also indicates the shares of the partners in the net assets as on that date, i.e., the partners share in the net assets in the ratio 15:20:25 or 3:4:5. Dissolution becomes necessary and in the course of liquidation the expenses and losses incurred amount to $15,000. After the net loss of $15,000 is divided equally among the partners, the capitals will amount to, A $10,000, B $15,000, and C $20,000. The result is that the capital ratio has changed from 3:4:5 to 10:15:20, or 2:3:4, and the net assets of $45,000 are to be shared in this new ratio.
=2. Capital Deficit=
BALANCE SHEET OF JONES & SMITH Cash $10,000.00 Jones, Capital $20,000.00 Losses in Liquidation 15,000.00 Smith, Capital 5,000.00 ---------- ---------- $25,000.00 $25,000.00 ========== ==========
Jones and Smith share profits and losses equally.
The above balance sheet shows the condition of the firm after liquidation. It is necessary, first, to distribute the liquidation losses among the partners, after which they share in the net assets according to capital ratios. Accordingly, each capital account is debited with an equal share in the loss of $15,000, after which Jones’ capital is $12,500 and Smith’s account shows a debit balance of $2,500. This means that Jones not only gets the entire cash of $10,000, but Smith must contribute $2,500 to the firm and this also goes to Jones.
=3. Personal Insolvency of One Partner=
BALANCE SHEET OF SMITH, JONES & GREEN Cash $16,000.00 Smith, Capital $15,000.00 Jones, Capital 9,000.00 Green, Capital 10,000.00 ---------- ---------- $25,000.00 $25,000.00 ========== ==========
Smith and Jones each have a ⅖ share and Green a ⅕ share in profits and losses.
The above balance sheet shows the financial condition of the firm after taking into consideration the losses incident to liquidation. From this it is seen that Jones owes the business $9,000. Assume that he is personally insolvent and cannot contribute the share due from him. The net assets available for distribution consist of $16,000 in cash. Inasmuch as Jones’ interest is entirely wiped out and a contribution is due from him which he cannot pay, the amount of that contribution is an additional loss to be borne by the two remaining partners. Their respective shares in this loss are determined by their original profit and loss ratios ⅖ and ⅕, so that as between themselves Smith must bear ⅔ of the loss or $6,000, and Green ⅓ or $3,000; after which Smith’s capital and share in the net assets is $9,000, and Green’s $7,000.
Where a partner, in his private capacity, and the firm of which he is a member are both bankrupt, his personal creditors have first claim on his personal estate and the firm’s creditors on the assets of the firm.
=Distribution by Instalments.=—Where the liquidation is of long duration, the partners may desire to receive what is due them by instalments rather than wait to receive their respective shares in one amount. Where the capital ratio differs from the profit and loss ratio, it is difficult to determine the proper ratio in which the instalments should be paid, due to the fact that expenses and losses have not yet been determined. Consequently it is impossible to tell what the ultimate ratios will be in which the partners are to share the net assets. As the payment of instalments on an arbitrary basis might result ultimately in an overpayment of some partners and an underpayment of others, the only safe method of handling the situation is to pay the first instalments to those partners whose capital ratios are in excess of their profit and loss ratios until their capitals are reduced to the point where the capital ratios of all the partners are the same as their profit and loss ratios. As soon as this point is reached, the proceeds of the assets may be distributed to the partners on the basis of their profit and loss ratios, because these are now identical with their capital ratios. A more complete treatment of this problem will be found on pages 650 to 654 of the author’s second volume.
=Treatment of Good-Will upon Liquidation by Sale.=—When dissolution is brought about by the sale of the entire business, it may happen that the amount realized on the assets is smaller than their book value, and the difference must be treated as a loss in accordance with the principles previously stated. Similarly, where the assets are sold and the price realized is larger than their book value, the excess constitutes a profit and must be distributed among the partners in profit and loss ratio. Usually such an excess is treated as a receipt on account of good-will, and two standard methods of booking it are employed. When good-will is mentioned in the sale contract and its value has been determined, it is brought on the books as an asset and transferred immediately to the partners’ accounts. Thus, if the value is $15,000 and the profit and loss ratio is ⅖ to A, ⅖ to B, and ⅕ to C, the entry is:
Good-Will 15,000.00 A, Capital 6,000.00 B, Capital 6,000.00 C, Capital 3,000.00
Good-will is now shown as an asset, and the entry closing it off is the same as for the sale of the other assets, viz., a debit to Cash and a credit to Good-Will.
On the other hand, when good-will is not specified as such in the sale contract, but the amount realized on the sale of the assets is larger than their book values, this excess may be credited to Good-Will, which is then treated not as an asset account (as in the case given above) but as a profit and loss account. The balance of this account is closed out to the partners’ accounts in profit-sharing ratios in the same way as above. The ultimate result is the same in either case; the first method is a little more complete since it shows the value of the asset good-will previous to its sale.
The formal entries by which the sale of any business is recorded on its books, whether single proprietorship, partnership, or corporation, are treated in Chapter XXXIX under corporations.
XXXVIII. THE CORPORATION
=Definition.=—The definition of a corporation, given by former Chief Justice Marshall as “an artificial being, invisible, intangible, and existing only in contemplation of the law,” sets forth its fundamental characteristics, viz., artificial personality and creation by the law. Blackstone says, “A corporation is an artificial person created for preserving in perpetual succession certain rights which being conferred on natural persons only would fail in the process of time.” Blackstone’s definition lays particular emphasis on a characteristic not specifically mentioned by Marshall, that of perpetuity of succession. It is apparent that the corporation within the limits prescribed by statute has most of the attributes and powers of a person—it can sue and be sued, can hold and pass title to property, real and personal, can carry on business in its own name, is responsible to the extent of its entire property for the payment of its debts, etc.
=Growth of the Corporate Form of Organization.=—The corporate form of organization is being increasingly utilized for the conduct of business of almost every kind. It offers a much more attractive field to the investor who desires to place his surplus funds in productive enterprises and share in their profits without having the burdens of active management or the risk of losing his private fortune to satisfy the claims of business creditors should the undertaking prove unsuccessful. Just as the partnership is an advance over the sole proprietorship in point of business organization, efficiency, and ability to cope with larger undertakings, so the corporation in some of its forms represents an advance over the partnership form of business organization. Its advantages and disadvantages in comparison with the partnership will be reviewed briefly.
=Advantages.=—Some of its advantages are:
1. Limited liability. Only corporation property can be levied on to satisfy the claims of creditors; the private fortunes of the individual stockholders cannot be touched. 2. Continued existence. The death, withdrawal, or bankruptcy of any of its members does not interfere with its existence. Its life may be terminated by voluntary dissolution, insolvency, expiration of charter life, forfeiture of charter to the state for misuse, non-use, or abuse of its privileges. 3. Transferability of its shares, and their use as collateral for private loans without injury to the credit of the corporation. 4. Larger capital. A partnership becomes unwieldy and inefficient if the number of partners becomes too large. The number of stockholders in a corporation is not limited and varies from one to many thousands in the larger corporations. Accordingly much more extensive fields of endeavor are open to the corporation because it can bring together and use advantageously the combined capitals of many persons. 5. Centralized control. Its method of internal organization is such that one man can be made the responsible head instead of the many heads of the partnership.
=Disadvantages.=—The chief disadvantages of the corporation may be summarized thus:
1. Comparative absence of personal interest of the managing officer. This is largely a theoretical drawback, inasmuch as it is usually required that the managing officer be a stockholder.
2. As a creature of the state, the corporation is subject to state legislative control. It is taxable by the state and is required to make periodic reports.
3. Its credit is dependent on the amount of its net assets and not on the fortunes of its individual owners.
4. Corporations are sometimes restricted as to the character of their business. In some states certain lines of business cannot be carried on by corporations.
5. In some states it is illegal for corporations to hold stock in other corporations.
In spite of these and other disadvantages, most of which are not serious, the advantages of the corporate form of organization far surpass those of the sole proprietorship or partnership.
=The Formation of a Corporation.=—Formerly a corporation could be brought into existence only by a special act of the legislature. As this method proved cumbersome and was subject to much abuse, it gave place in all states to general corporation statutes or enabling acts whereby an application in due form and according to statutory provisions is all that is necessary for organizing a corporation. Though the statutes differ for each state, they are uniform in the main points. The method of formation under the New York statute will be explained.
=Certificate of Incorporation—New York State.=—The form of application for a charter to do business as a corporation is known as a “certificate of incorporation.” This document must be prepared by at least three natural persons, two-thirds of which number must be citizens of the United States and at least one of whom must be a citizen of New York State. These persons are called the “incorporators.” Their certificate must be made out in the English language, signed by each incorporator, acknowledged before a notary public, and must contain:
1. The name of the corporation, in the English language. This must be different from the name of any other domestic or foreign corporation doing business in the state and must not contain in its title the words, “bank, trust, insurance, etc.”
2. The purpose or purposes for which it is created. There is practically no limitation as to the lines of endeavor the corporation may declare itself desirous of following, with the exception that banks, trust, transportation, and insurance companies, etc., come under special laws.
3. The amount of capital stock of the corporation, common and preferred if both are to be issued. Preferred stock of various classes may be authorized after incorporation. The minimum amount of capital required by the New York law is $500. One-half of the capital must be paid in within one year from the date of incorporation. The certificate must state also the amount of capital to be paid in before the corporation can commence business and this must not be less than $500. No debts can be contracted before that amount is paid in.
4. The number of shares into which the authorized capital is divided and the par value of each. This must not be less than $5 nor more than $100, although more recently capital stock has been authorized with no named par value.
5. The place in which the principal office is to be located, which must be within the state.
6. The contemplated duration of its life. This may be made perpetual.
7. The number of directors, which must not be less than three.
8. The names and post-office addresses of the directors for the first year. Directors usually are stockholders and at least one-fourth of the directors are subject to election annually.
9. The names and post-office addresses of the subscribers to the certificate of incorporation, and the number of shares in the corporation subscribed by each.
=Filing the Certificate—New York State.=—The certificate of incorporation is usually made out in triplicate. The original must be filed and recorded in the office of the Secretary of State; the duplicate certified by the Secretary must be filed with the clerk of the county in which the principal business office is to be located; and the certified triplicate is retained by the corporation in its own files. The fees for filing the certificate with the Secretary of State are $10, and for recording 15 cents per folio. The county clerk’s fees are 6 cents per folio for filing.
=Organization Tax—New York State.=—Before the filing of the certificate, an organization tax of 1/20th of 1% of the authorized capital stock must be paid to the State Treasurer. Record of this payment is forwarded to the Secretary’s office.
=Initial Acts of Corporation.=—When the corporation is ready to commence business, its first act is usually to call a meeting of the incorporators and directors for the purpose of adopting a set of by-laws—although this matter may be delegated to the board of directors. This meeting also authorizes the issue of stock at or above par in exchange for cash, labor, or property.
=State Control.=—The outside control of the corporation is vested in the state. The state constitution, the general corporation law, the statutes relating to business organizations in general, and the specific contract between the corporation and state embodied in its charter or certificate of incorporation—these form the basis for state control and the limits within which the corporation may act as an authorized person. If the corporation does an interstate business, it is subject also to the regulations of the Interstate Commerce Commission.
=Working Organization and Management.=—The corporation’s owners, that is, the stockholders, are the source of all authority and control. Unlike the partnership where control and voice in the management are equally shared by the partners regardless of any inequality in their investments, the corporation ownership is evidenced by shares of stock and each share is given one vote. Thus each owner’s authority and voting power are dependent upon the amount of his ownership of stock. He has, however, the right to delegate this power to another person by “power of attorney,” and in this way it frequently happens that one stockholder exercises a power far beyond the amount of shares owned by him. Delegation of voting power frequently occurs when the stock is widely distributed geographically and is owned in small lots. In theory the agent or attorney entrusted with the voting power of others is simply carrying out the will of his principal, the real owner of the stock.
=Annual Election of Directors.=—Because of the number of stockholders and because many of them are engaged in other pursuits, one of the characteristics of the corporate form of management is that the owners frequently do not have direct control of their enterprise. Accordingly, at regular times, usually annually, the stockholders elect directors to whom are delegated the general oversight and control of the business. The board of directors thus elected stands in the place of the stockholders during the period between the annual meetings at which it renders account of its management.
=Officers.=—The board of directors elects officers of the company—usually a president, vice-president, treasurer, and secretary—to undertake the active management of the business; or the directors may appoint a general manager or superintendent on whom rests the active management and who is the executive head of the corporation. Thus the chief characteristic of the working organization of the corporation is the delegation of authority to a responsible head. The accountability of the officers to the board of directors, and of the directors to the stockholders, has so far proved the most efficient method of conducting modern business.
=The Showing of Proprietorship.=—The chief difference, from an accounting viewpoint, between the corporate form and other forms of business organization is in the showing of proprietorship. Vested proprietorship in a sole owner or partnership business is carried under the title of the different owners’ capital accounts, and credit is extended by the public to such owners, not on the basis of what the particular business is worth, but on the reputation of the owners and what they are known to be worth outside the business as well as in the business. On the other hand, the law has relieved the owners of a corporation of individual liability for the debts of the corporation. Only the corporate property can be held liable for the satisfaction of creditors’ claims. For their protection, the corporation is not allowed to impair its capital stock by the payment of any portion of it in dividends to the owners or to change the amount of its capital stock without special authority. The outstanding capital stock, in theory, represents to the prospective creditor the minimum value of the corporation assets which are supposed to be sufficient to meet in full the claims of creditors. Accordingly, the portion of the capital of a corporation represented by its capital stock is a fixed amount, and the increments or decrements of proprietorship are usually shown in a separate account called Surplus. This account must always be read with the Capital Stock account to ascertain the current or present capital as distinguished from the original.
The Surplus account is sometimes divided and shown under such titles as Profits, Reserves, Undivided Profits, Working Capital, etc. To ascertain full proprietorship or net worth, all such accounts must be included.
RECORDS PECULIAR TO A CORPORATION
=The Subscription Book and Subscription Ledger.=—Upon the proper filing and acceptance of the certificate of incorporation, authority is given the incorporators to secure subscriptions to the capital stock. Subscription books or blanks may then be opened, which usually contain a form of agreement somewhat as follows:
We, the undersigned, do hereby subscribe for and agree to take the number of shares of the capital stock of the Blank Company, par value ........ set opposite our names and pay for the same, ........ per centum down, the remainder subject to the call of the board of directors.
Where the number of subscribers is large and especially if record must be made of the payment of calls, a Subscription Ledger or Instalment Book is used. This ledger has no set form but usually carries columns showing when the calls are to be made, when actually made, when paid, and the balance still due. A controlling account called “Subscribers” or “Subscription” is carried on the general ledger, with a special column in the cash book to gather the totals for posting.
=The Stock Certificate Book and Stock Ledger.=—A subscriber is, as such, a stockholder in the corporation even though his stock certificate may not yet have been issued to him. The stock certificate is merely evidence of ownership. It is usually issued from a book with perforated leaves similar to a check book, with stub to carry the essential data of the certificate. Directly from this stub, or through the medium of a stock journal, postings are made to the individual accounts in the stock ledger. This ledger which, in turn, is controlled by the Capital Stock account or accounts on the general ledger, carries the detailed information as to the number of shares issued, shares canceled, and balances held by each owner.
=The Stock Transfer Book.=—In the state of New York a stock transfer book must be kept, showing all the data in connection with transfers of shares, such as old and new stock certificate numbers, names of the parties, etc.
=The Minute Book.=—To preserve a record of the meetings of the directors and stockholders, and the business transacted thereat, use is made of a minute book kept by the secretary. This book, as the source of authority for all the important acts and policies of the corporation, is a most important record. The record should be a complete history of the corporation from its organization through the entire period of its existence.
=Other Records.=—When the stock is sold on the instalment plan, formal receipt of the payment of each instalment is sometimes made by means of an “Instalment Scrip Book,” whose certificates or receipts are issued upon payment of each instalment. When full payment has been made, the instalment certificates are exchanged for the regular certificates of stock. A dividend book for recording the payment of dividends is sometimes kept, though the need for such a record has been largely eliminated through the use of dividend checks.
XXXIX. OPENING THE CORPORATION BOOKS
=Corporation Accounting Records.=—The method of recording the ordinary business transactions of a corporation is essentially the same as in the types of business organization previously discussed. The opening and closing of corporation accounts, however, as also the method of making the periodic summarization, call for the special treatment given in this chapter and the next.
=Proprietorship and Capital Stock.=—As stated before, the members of a stock corporation have their ownership evidenced by certificates of stock. The proprietorship or net worth of a corporation, as of the single proprietorship and partnership, is the excess of its assets over its liabilities. This excess is shown in the books by two accounts or two groups of accounts, viz., the Capital Stock account—or accounts—which represents the amount of outstanding shares; and the Surplus account—subdivided and carried under other titles, if desirable—which represents the excess of the proprietorship over the amount of capital stock. Each stockholder’s share in the corporation is determined by the number of shares he possesses.
=Common and Preferred Stock.=—There may be various classes of stock. If only one kind is authorized at the beginning, the subsequent creation of other kinds requires an amendment of the charter. The usual classes of stock are common and preferred. As its name indicates, preferred stock has some kind of preference over the common or ordinary stock. This preference may be only in regard to dividends, or it may include preference as to ownership in the net assets in case of dissolution. Preferred stock usually carries a fixed dividend, payable before any dividend can be paid to the common stockholders.
Preferred stock is classified as cumulative and non-cumulative. The terms apply to the dividend liability of the corporation in the event that the continuity of dividend declarations is broken. The dividend on cumulative preferred stock accumulates and becomes a preferred claim for the amount accumulated since the time of the last dividend declaration. That is, the common shareholders are not entitled to receive any dividend until the preferred shareholders have received the amount of the accumulated total. Preferred stock that is non-cumulative does not possess this feature. A dividend once passed on such stock is not a preferred claim to profits as compared with the dividend rights of common stockholders, but lapses completely. Preferred stock is cumulative unless specified to the contrary.
The issue of No-par-value stock is authorized by thirteen different states. Very often in a corporation whose stock carries a stated par value, there is little real relationship between the actual value of the stock as indicated by the net assets of the corporation and its stated par value. The law requires that par-value stock be carried on the books at its stated par. If such stock has been sold or exchanged for assets of a lesser value, there is always the temptation to inflate the value of the assets in order to maintain it at the par of the stock issued for them. This tendency is not met in the use of stock carrying no par value. Such stock appears on the books at exactly the amount of the assets received in exchange for it. A purchaser of such stock, because of the fact that it carries no stated par value, is at once put on notice to investigate the values back of it. No-par-value stock may be either preferred or common. In the former instance, if the preference relates to the assets at the time of dissolution, each such share must state the amount of assets applicable to each share in case of liquidation of the corporation. This constitutes a preference claim, not over the creditors of the corporation, but only over the common stockholders.
Thus it is seen that there may be different classes of ownership of a corporation, the owners of one class having some advantages over the owners of the other classes. It should be understood, of course, that within each class the rights and duties of the owners are the same.
=Opening the Books of a Corporation.=—The opening entries of a corporation have to do with a correct treatment of capital stock, subscriptions, calls and instalments, payments by cash and by property, etc.
The charter to do business, granted a corporation by the state, gives it the right to sell shares of stock. These shares have no value in themselves and are worth only what the corporation can exchange them for, either in cash or other assets. There is, therefore, no reason for making a record on the books of account as distinguished from the corporation’s minute book, of the corporation’s right to issue stock and of the amount of the stock which it has a right to issue. Until the stock has been paid or subscribed for, no formal entry need be made on the books of account. Of course, full record of all deliberations and resolutions as to procedure and policy up to the time of the actual sale of the stock is carried in the minute book, and a concise narrative statement of the organization of the corporation, its purposes, the authorized capital stock issue, the number of shares, the par value of each share, if par value stock, and so forth, should always precede the formal opening entries in the journal. This record and that in the minute book should give all the information of this sort needed. There is a too prevalent tendency among bookkeepers to make all sorts of memorandum entries on the books of account. A memorandum entry is an entry which has no financial significance and is made merely as a reminder that transactions of financial significance may arise from that source.
Before a corporation can secure its charter it is necessary to make certain expenditures. These usually consist of fees paid to a lawyer for his services in assisting in drawing up the charter; fees for filing the certificate; the organization tax; the cost of the certificates of stock and stock records; and so forth. These expenditures must be met by the incorporators from their private funds but they are reimbursed from the funds received upon sale of the stock. It is, accordingly, customary in opening the books of a corporation to show first the sale of the stock before showing the expenditures for organization.
A number of different methods of opening the books are employed. The first of these does not make use of the memorandum entries referred to above, whereas the other two do use memorandum entries. The three methods will be illustrated by means of the problem given below. The entries are shown in journal form. It will be understood, of course, that those entries which involve cash will appear in the cash book only. All the other entries appear in the general journal.
PROBLEM 1. The Smith-Brown Company is incorporated with an authorized capital stock of $250,000, of which $150,000 is subscribed and paid for at par; the balance remains unissued for the present. The organization expenses are $1,000.
FIRST METHOD
THE SMITH-BROWN COMPANY A corporation organized under the State of New York, with an authorized capital stock of Two Hundred and Fifty Thousand dollars ($250,000), divided into Two Thousand, Five Hundred (2,500) shares of the par value of One Hundred dollars ($100) each, with all powers necessary to carry on the business of manufacturing, selling, and distributing motors of all kinds.
Case 1. Where the subscription and payment are not simultaneous:
(a) Subscribers 150,000.00 Capital Stock Subscriptions 150,000.00 To record subscriptions to the capital stock as follows: A shares B ” C ” Etc. (b) Cash 150,000.00 Subscribers 150,000.00 To credit subscribers for the payment of their subscriptions. (c) Capital Stock Subscriptions 150,000.00 Capital Stock 150,000.00 To record the issue of stock to all subscribers who have paid in full. (d) Organization Expense 1,000.00 Cash 1,000.00 To record the payment of the costs of organizing the corporation.
Entry (a) sets up the claim under subscription contracts against the subscribers as an asset of the corporation, and is offset by the proprietorship account, carried under the title “Capital Stock Subscriptions,” until payment has been made and the certificates of stock actually issued to the stockholders.
Entry (b) is self-explanatory.
Entry (c) shows the issue of the certificates and therefore transfers the proprietorship from Capital Stock Subscriptions to Capital Stock.
Case 2. Where the subscription and payment are simultaneous:
(a) Cash 150,000.00 Capital Stock 150,000.00 (b) Organization Expense 1,000.00 Cash 1,000.00
In a small corporation where a cash investment constitutes the entire original capital, the entries shown in case 1 above are sometimes abbreviated as here indicated. In such a case there is often no formal subscription contract entered into and there is therefore no need to set up accounts with Subscribers and Capital Stock Subscriptions.
SECOND METHOD. This method makes use of the memorandum accounts, Unissued Capital Stock and Capital Stock Authorized. Omitting the narrative statement of organization, the explanatory matter after the various entries, and the organization expense entry, which are common to all methods, the other necessary entries are as follows:
(a) Unissued Capital Stock 250,000.00 Capital Stock Authorized 250,000.00 (b) Subscribers 150,000.00 Capital Stock Subscriptions 150,000.00 (c) Cash 150,000.00 Subscribers 150,000.00 (d) Capital Stock Subscriptions 150,000.00 Capital Stock 150,000.00 (e) Capital Stock Authorized 150,000.00 Unissued Capital Stock 150,000.00
Entry (a) is a memorandum entry recording the amount of capital stock authorized by the corporation’s charter. This entry has little or no financial significance. Not until stock is sold does the corporation have any real assets.
Entry (b) shows that of the stock which was unissued under entry (a), $150,000, has been subscribed for, thus giving the corporation a legally enforcible claim—an asset—for that amount.
Entry (c) is self-explanatory.
Entry (d) shows the issue of the stock when the subscriptions are paid.
Entry (e) adjusts the memorandum entry (a), to show the present amount of authorized stock still unissued, viz., $100,000. Both accounts under (a) continue as memoranda only, and as they exactly offset each other, they will not appear on the balance sheet.
THIRD METHOD. This method also makes use of memorandum accounts before the sale of the stock. The difference between this and the second method should be noted. It will be seen that the credit of entry (a) is here Capital Stock instead of Capital Stock Authorized. This is theoretically incorrect because as yet the corporation has no proprietorship. The best that can be said for it is that the debit represents a contingent asset and the credit a contingent proprietorship item. The other entries are self-explanatory.
(a) Unissued Capital Stock 250,000.00 Capital Stock 250,000.00 (b) Subscribers 150,000.00 Subscriptions 150,000.00 (c) Cash 150,000.00 Subscribers 150,000.00 (d) Subscriptions 150,000.00 Unissued Capital Stock 150,000.00
=Premium or Discount on Stock.=—The law requires that when stock of par value is issued, the Capital Stock account must be carried always at par. When stock is sold at a premium or at a discount, it necessitates, therefore, the use of supplementary proprietorship accounts to make the proper record. In the state of New York, a corporation cannot sell its stock at a discount, but in states where this is allowed the amount of such discounts should be charged to a “Discount on Stock” or some similar account. Sometimes the charge is made to “Organization Expense.” The use of Organization Expense account for this purpose is contrary to the principle that the account title should show the exact nature of the items recorded under it. It is misleading and sometimes reprehensible. A full discussion of this matter is given in Volume II. When stock is sold above par, the amount of the premium is recorded in the account “Premium on Stock,” which as usually handled constitutes a part of the permanent capital of the corporation. Premiums on stock sales should not be credited to Surplus account. The following illustration will show the kind of entries required:
PROBLEM 2. Of the $100,000 unissued stock of Problem 1, we will assume that $50,000 is later subscribed for at 98, and $50,000 at 102.
Entries to make the record according to the first method, Problem 1, are as follows:
(a) Covering stock subscribed for at a discount: Subscribers 49,000.00 Discount on Capital Stock 1,000.00 Capital Stock Subscriptions 50,000.00 (b) For stock subscribed for at 102: Subscribers 51,000.00 Premium on Capital Stock 1,000.00 Capital Stock Subscriptions 50,000.00
Entries for payment of the subscription and issue of the stock follow the method of entry already shown on page 342. It will be observed that the Capital Stock Subscription and the Capital Stock accounts are always shown at par value.
=Capital Stock on the Balance Sheet.=—The net worth section of the balance sheet of a corporation will usually appear somewhat as follows for the capital stock items. Often, however, more detail is shown in connection with the surplus item. The student should note how full information is given concerning the capital stock.
(1) Net Worth
Represented by: Capital Stock: Authorized $250,000.00 Unissued 100,000.00 ----------- Issued and Outstanding $150,000.00 Premium on Capital Stock 5,000.00 Surplus 60,000.00 ----------- Total Net Worth $215,000.00 ===========
Where the discount on stock has not been charged off against Surplus either because sufficient profits have not been reserved, or because, although sufficient profits have been reserved, it is deemed desirable to build up a larger balance of Surplus before charging off the discount, the net worth section will appear as follows:
(2) Net Worth
Represented by: Capital Stock: Authorized $250,000.00 Unissued 100,000.00 ----------- Issued and Outstanding $150,000.00 Surplus 10,000.00 ----------- $160,000.00 Discount on Capital Stock 15,000.00 ----------- Total Net Worth $145,000.00 ===========
Discount on capital stock should usually be shown as above, although one sometimes finds it listed among the assets on a balance sheet. This is not wholly objectionable unless it is set up under a title which does not indicate its true nature.
=Instalments.=—The subscription contract sometimes provides for payment by instalments. The corporation usually issues to all such subscribers a “call,” i.e., a notice that an instalment payment will come due at a given time. The subscriber is not considered delinquent until the call has been made and he has not responded. The accounts must therefore reflect the difference in status brought about by a “call.” This is accomplished by transferring the claim against the subscriber carried in Subscribers account to a new claim against him carried under Call account. The illustrations below show the accounts required and their handling.
PROBLEM 3. Assume that the $50,000 of stock subscribed for at 102 is to be paid for one-half in cash and the remainder in two equal instalments at the end of successive three-month periods.
For the one-half cash payment the entry is as follows:
Cash 25,500.00 Subscribers 25,500.00
At the end of the first three months, the record is:
Call No. 1 12,750.00 Subscribers 12,750.00 To show the call issued. Cash 12,750.00 Call No. 1 12,750.00 To record payment of the first call.
Similar entries at the end of the second three months are:
Call No. 2. 12,750.00 Subscribers 12,750.00 Cash 12,750.00 Call No. 2 12,750.00
If the call is not paid in full at balance sheet time, the debit balance in the “Call” accounts constitutes an asset, i.e., the amount of unpaid instalments due from subscribers. Upon full payment of all subscriptions, certificates of stock are issued and recorded as shown on pages 341, 342.
=Entries for Common and Preferred Stock.=—Where more than one kind of stock is issued, such as common and one or more kinds of preferred, separate capital stock accounts—and usually other related accounts—should be kept for each class, as illustrated below:
PROBLEM 4. Assume that the stock of a corporation is $200,000 common and $50,000 preferred, and that $100,000 common and $50,000 preferred have been subscribed for. The entries necessary to record the subscription in accordance with the first method explained above, are:
Subscribers—Capital Stock Common 100,000.00 Capital Stock Common, Subscriptions 100,000.00 Subscribers—Capital Stock Preferred 50,000.00 Capital Stock Preferred, Subscriptions 50,000.00
The other entries for payment of subscriptions and issue of stock are essentially the same as explained above, but the record of the transactions affecting common and preferred stock should always be kept distinct and separate.
=Entries for No-Par Stock.=—When a corporation issues no-par stock, the amount of proprietorship resulting from its sale is exactly what the stock brings and is so recorded; there is neither discount nor premium. Booking it is, therefore, simple. The amount of capital so secured, i.e., secured from its sale, should, however, never be mixed with the accretions to capital from reserved profits or other sources. Such items constitute the Surplus just as in the case of stock of par value, and the legal requirement that these amounts be kept separate from the capital stock are just as strict. This is necessary so that the records will clearly show that dividends have not encroached upon the capital. Since the value at which no-par stock is carried on the books bears no relation to the number of shares issued, it is customary to carry on the balance sheet information as to the number of shares outstanding. The net worth section of the balance sheet of a corporation issuing no-par stock should appear as follows:
Net Worth
Represented by: Capital Stock—No Par: Authorized 10,000 shares Unissued 3,000 ” ------ Issued and Outstanding 7,000 ” $369,465.00 Surplus 125,479.00 ----------- Total Net Worth $494,944.00 ===========
=Payment of Subscriptions by Property.=—When payment of subscriptions is by property instead of by cash, the value at which such property shall be brought onto the books is entirely at the discretion of the corporation’s directors, and unless fraud can be shown, their valuations are final. No difficulties are involved in recording such a payment; the paid properties are debited under suitable account titles, and the Subscribers account is credited. The following problem illustrates the change from a partnership to a corporation, at the same time showing how the payment of subscriptions by property must be treated.
=Change from Partnership to Corporation=
PROBLEM 5. A and B, partners, incorporate as the American Baking Company. The authorized capitalization is $250,000. Each partner subscribes for an amount of stock equal to his interest in the partnership, and C, an outsider, subscribes for the remainder of the stock at par. The corporation purchases the assets and assumes the liabilities of the partnership, paying therefor with stock as above. C pays his subscription in cash. The balance sheet of the partnership on that date was as follows:
BALANCE SHEET OF A & B Cash $ 20,000.00 Accounts Payable $ 45,000.00 Accounts Receivable 150,000.00 Mortgage Payable 80,000.00 Merchandise 50,000.00 A, Capital 125,000.00 Plant 130,000.00 B, Capital 100,000.00 ----------- ----------- $350,000.00 $350,000.00
Make the opening entries for the new corporation and also close the books of the partnership.
1. The entries to open the corporation’s books:
(a) Subscribers 250,000.00 Capital Stock Subscriptions 250,000.00 To record subscriptions to the capital stock as follows: A 125,000 B 100,000 C 25,000
(b) Cash 20,000.00 Accounts Receivable 150,000.00 Merchandise 50,000.00 Plant 130,000.00 A & B, Vendors 350,000.00 To record the purchase from A & B of their partnership assets. (c) A & B, Vendors 125,000.00 Accounts Payable 45,000.00 Mortgage Payable 80,000.00 To record partial payment to A & B for their assets by the assumption of their liabilities. (d) A & B, Vendors 225,000.00 Subscribers 225,000.00 To record full payment to A & B for the balance due them, by the cancellation of their subscription indebtedness. (e) Cash 25,000.00 Subscribers 25,000.00 To record payment by C of his subscription contract. (f) Capital Stock Subscriptions 250,000.00 Capital Stock 250,000.00 To record the issue of stock to all subscribers, who have paid in full.
Entries (b), (c), and (d) are sometimes combined in the following compound entry:
Cash 20,000.00 Accounts Receivable 150,000.00 Merchandise 50,000.00 Plant 130,000.00 Accounts Payable 45,000.00 Mortgage Payable 80,000.00 Subscribers 225,000.00
Although this accomplishes the same result so far as the ultimate showing is concerned, it does not present the various steps of the transactions so clearly as the separate entries. The “A & B, Vendors” account in entry (b) indicates the liability of the corporation to A & B, arising from the purchase of their partnership properties. Entries (c) and (d) show the manner in which A and B are paid for this purchase, with consequent cancellation of that liability.
2. The entries to close the books of the partnership of A & B are:
(a) American Baking Company 350,000.00 Cash 20,000.00 Accounts Receivable 150,000.00 Merchandise 50,000.00 Plant 130,000.00 To charge the American Baking Company with the assets purchased under contract of (date). (b) Accounts Payable 45,000.00 Mortgage Payable 80,000.00 American Baking Company 125,000.00 To credit the American Baking Company under their purchase contract for the taking over of the firm’s liabilities. (c) American Baking Company Stock 225,000.00 American Baking Company 225,000.00 To credit the American Baking Company for the payment of the balance due by the issue of its stock at par to the firm. (d) A, Capital 125,000.00 B, Capital 100,000.00 American Baking Company Stock 225,000.00 To show the distribution of the stock.
Where the stock is issued to each partner directly (instead of to the firm and then distributed to the vendors), sometimes the issue is not shown on the partnership books, entry (c) above carrying debits to the partner’s capital accounts in place of the debit to American Baking Company Stock. Whether the actual transaction follows one course or the other, entries as shown above seem to meet either requirement.
The student should make sure that the effect of the entries under (a) and (b) is thoroughly understood. It may be further noted that if good-will or shrinkage of values enters into the sale of a partnership, the necessary adjustments should be made in the partners’ accounts before the sale takes place, after which the closing entries are as shown above.