XL. CURRENT AND CLOSING ENTRIES FOR THE CORPORATION
=Relation between the Corporation and Its Owners.=—It should be noted that the owners of a corporation are on a somewhat different basis in their relationships and activities to the business than are the owners of a partnership or single proprietorship business. The legal theory that the corporation is an entity, a person, separate and apart from its owners, necessitates a change in the status of accounts with owners as compared with similar accounts in the other types of organization. A charge against a stockholder as a customer of the corporation is on the same basis as a charge against any other customer. A stockholder may become a creditor of the corporation in exactly the same way as any other person. In a partnership, on the other hand, charges against a partner and credits to his account are looked upon as charges against and credits to his proprietary interest in the event of liquidation of the firm. This is not true in the case of a corporation, stockholders in such dealings being considered “outside” parties.
=Current Record on Corporation Books.=—After the corporation has been organized and the opening entries made on its books, the record of current transactions proceeds on practically the same basis as in all other types of business organization. Sales, purchases, cash receipts and disbursements, notes receivable and payable, and all the transactions arising out of them, are recorded currently in the same types of books and in the same manner as the similar transactions of a single proprietorship or a partnership.
While the record of current transactions is practically the same for all types of business organizations, there are some kinds of current transactions of a corporation which differ somewhat from those of the other types. They arise out of the nature of the corporation and are recorded under account titles peculiar to the corporate form. Some of these transactions and other accounting records will be discussed briefly.
=Treasury Stock.=—In some classes of enterprise and also under some methods of organizing and financing the corporation, no provision is made for the securing of a fund of working capital, all of the original capital being tied up in fixed assets—as a mine or some other plant. A similar condition is sometimes encountered even after a corporation has been operating for a number of years. Lack of business judgment and financial foresight sometimes brings about a condition in which the company has allowed an undue proportion of its current assets, and therefore its working capital, to become tied up in plant extensions.
In both such cases a frequent method of raising working capital is for the stockholders to donate to the corporation a pro rata portion of their holdings of stock to enable it to secure the needed working capital by selling the stock. When such stock comes back into the company’s treasury, it is termed “treasury stock.” Having once been issued and presumably fully paid for, it has this characteristic which does not attach to the original shares before their issue, viz., that it can be sold at a discount without the purchasers being liable to creditors, in case of bankruptcy, for the amount of the discount. Par-value stock which is originally sold at a discount or which is being sold on the instalment plan and has not therefore been paid for in full is subject to levy for the unpaid amount in the event of bankruptcy of the corporation. Thus, the man who buys a $100 share of original stock for $90, is subject to a $10 levy in the event that the assets of the corporation are not sufficient to pay its debts.
Accordingly, in financing highly speculative ventures such as mining, oil, and other similar companies, it is customary to issue the entire capital stock of the company to the owner or owners of the mining or oil property taken over by the corporation as the basis for its operations. Inasmuch as the value of the properties taken over is not determinable, it is usually impossible to show that the stock issued for them does not represent their true value. Accordingly, such stock is legally fully paid stock and not subject to the liability for additional assessment which attaches to stock sold at a discount. Working capital is provided through the donation of a portion of the capital stock to the treasury of the corporation, which is then in a position to sell to others the stock now fully paid and non-assessable. It is easier to find purchasers for this stock because it can be sold at whatever discount is necessary to dispose of it and carries with it no liability for future assessment.
Treasury stock may arise also through repurchase by the company. It may sometimes be desirable for a company to buy back some of its own stock. This is not allowed in all states but where allowed such stock repurchased becomes treasury stock.
The student should distinguish carefully between treasury stock and unissued stock.
=Accounting for Treasury Stock.=—The record of treasury stock transactions is not complicated. They are discussed under three heads as follows:
1. RECORD AT TIME OF ACQUISITION. Only the acquisition through donation will be explained here. Acquisition through purchase usually involves an adjustment of purchase price to par value and the vexed problem of valuation. This problem will be found discussed on page 18, Volume II.
Assume that a company has issued all its capital stock, $1,000,000 in amount, for the acquisition of a mining property, and that the shareholders donate to the treasury $400,000 of the stock to provide working capital. This stock donation will be recorded on the books as follows:
Treasury Stock 400,000.00 Donated Surplus 400,000.00
Like any other gift, this gift of stock in theory creates additional capital and must therefore be recorded in a proprietorship account. The title “Donated Surplus” is used to indicate the source of this additional capital. Capital arising from this source should never be recorded in the general Surplus account, largely because of its problematical value but also because of the information which it gives concerning the financing of the company by making a separate record.
2. RECORD AT TIME OF SALE. Assume that $250,000 of the treasury stock is sold at 50. Inasmuch as the stock was brought on the books at par, the portion sold must be taken off at the same figure. The 50% discount, instead of being recorded in a Capital Stock Discount account, will be recorded as a charge against the Donated Surplus, thus adjusting a portion of this donated surplus, recorded originally at par value, to its realizable value. The following entry records the sale and adjustment:
Cash 125,000.00 Donated Surplus 125,000.00 Treasury Stock 250,000.00
The student should understand that the customary procedure of opening the subscription books, making the entries with subscribers for treasury stock subscriptions, payment in cash or by instalments, and finally, the issue of the stock, may be the procedure followed in the sale of treasury stock just as in the sale of other stock. The net result will, however, be as shown by the above entry.
3. RECORD OF TREASURY STOCK ON THE BALANCE SHEET. On the balance sheet treasury stock is treated in the same way as unissued stock, namely, as a deduction item in the net worth section of the balance sheet. Using the above figures for illustration, the net worth section will appear as follows:
Net Worth Represented by: Capital Stock: Authorized $1,000,000.00 Treasury Stock 150,000.00 ------------- Issued and Outstanding $850,000.00 Donated Surplus 275,000.00 ----------- Total Net Worth $1,125,000.00
=Bonds Payable.=—Generally, when a corporation borrows money on long-term notes secured by a portion of its fixed assets, chiefly its holdings of real estate, the notes (usually of uniform amounts so as to make them more marketable) are called “bonds.” Thus, such notes or bonds are frequently in $100, $500, and $1,000 denominations, making it possible for one of limited means to take advantage of the mortgage offered as security for the loan. Bond issues are floated in pretty much the same way as capital stock issues, being offered for subscription at a price depending both on the interest rate which the bonds bear and the prevailing interest rate at the time of their offering. Thus, if the bonds bear 5% interest and the market rate for bonds of the same general character is 6%, an investor will naturally not be willing to pay par for them and the company will therefore have to sell them at such a discount as will put the yield to the investor approximately on a 6% basis. The company, by receiving for its bonds an amount less than par value but by being required to pay interest on the par amount, is thus paying higher than the nominal or agreed rate.
There is thus a very definite relationship between the bond discount and the interest rate which the bonds bear.
The accounting record of bond transactions is very similar to that of other liability transactions, and is shown under three heads as follows:
1. SALE OF BONDS PAYABLE. Assume that a $100,000 issue of bonds bearing 5% interest, payable semiannually, and maturing in 20 years, is sold at 90. The record will be:
Cash 90,000.00 Bond Discount 10,000.00 Bonds Payable 100,000.00
Bonds payable are always set up at par, since that represents the liability which must be met at maturity of the issue.
2. BOND INTEREST PAYMENT. At the close of the first six months, 2½% interest, or $2,500, will be paid to the holders of the bonds. Since the corporation will have to redeem its bonds at par, it has been deprived of the use of $10,000, represented by bond discount, because the issue was brought out at 5%. The $10,000 discount is therefore in the nature of a lump sum interest cost incurred in advance—prepaid—and must be spread equitably over the life of the bonds. Accordingly, at each of the 40 interest payments during the life of the issue, a pro rata share of this prepaid interest should be taken into account as bond interest. The distribution of bond discount over the interest payments made during the life of a bond issue is termed “amortization” of the discount. Scientifically, amortization is worked out on a compound interest basis, discussion and explanation of which are found on page 269, Volume II. Here, all we are concerned with is the principle involved and for the sake of simplicity the amortization is prorated evenly over the 40 interest periods, resulting in an additional interest charge of $250 each period. The record is therefore:
Bond Interest 2,750.00 Bond Discount 250.00 Cash 2,500.00
3. CANCELLATION OR THE BONDS AT MATURITY. When the bonds come due and are paid, the record is the same as the cancellation of any other liability, viz.,
Bonds Payable 100,000.00 Cash 100,000.00
=Bond Premium.=—Bonds are also often sold at a premium. As with discount, the premium is intimately related to the interest rate which the bonds bear. At the time of the sale of bonds, the premium is brought on the books as a credit, which together with the par value at which the bonds are booked, offsets the cash received from their sale. At the regular interest periods the premium is amortized over the life of the bonds and so results in a lessening of the periodic bond interest charge. The student should set up the entries to record the sale of bonds at a premium and the interest payment for such bonds.
=Sinking Fund.=—The sinking fund is a fund of liquid assets created by periodic sums, usually of equal amounts, set aside during the life of a bond issue or other liability to provide ready funds for the cancellation of the liability at maturity. This method is very commonly followed in public finance and is not infrequent in private corporations. It is not purposed here to explain the methods of determining what periodic sum is necessary to be set aside so that these principal sums and their interest accumulations will provide sufficient funds for the cancellation of the liability at maturity. Nor will the complicated problem of sinking fund investments in the hands of a trustee, and the expense and income arising out of it, be discussed here. These and related problems are covered fully in Chapter XXV, Volume II. Only the creation of the fund and its final disposition are treated here, under two heads as follows:
1. CREATION OF THE FUND. Assume that $1,000 cash is set aside at the end of each six months to provide for the retirement of the bonds at maturity. The entry for this, every six months, will be:
Sinking Fund 1,000.00 Cash 1,000.00
2. CANCELLATION OF THE BOND LIABILITY. The student will understand that the cash set aside periodically for the sinking fund will be invested in securities in order to accumulate an income, which usually accrues to the fund. The securities in the fund must be sold just before the maturity of the bond issue, in order to provide cash. It will be assumed that in this instance the securities in the fund have been sold, that the cash in the sinking fund at the time of maturity is $101,500, and that the bond issue to be retired is $100,000. The entries will be:
(a) Bonds Payable 100,000.00 Sinking Fund 100,000.00 (b) Cash 1,500.00 Sinking Fund 1,500.00
Entry (b) returns to the general cash the unused cash in the sinking fund. In case of a deficiency in the sinking fund it will be necessary, of course, to draw on the general cash for the amount of the deficiency.
=Sinking Fund Reserve.=—It is often the policy of a corporation, which has to provide for the redemption of a bond issue, to reserve from the yearly profits a sum equal to the periodic payment into the sinking fund and the accumulations of the fund during that period. Such a policy prevents the distribution by dividends of all the current profits to stockholders, and insures that the increase in the assets represented by these profits will be held in the business and so provide each period an increased amount of assets for use in the business and ultimately, by conversion of the assets into cash, for the use of the sinking fund. The entries crediting the sinking fund reserve and showing its disposition at the maturity of the bonds are as follows:
(a) Surplus (or Profit and Loss) 1,000.00 Sinking Fund Reserve 1,000.00 (b) Sinking Fund Reserve 100,000.00 Capital Surplus (or Surplus) 100,000.00
The first entry shows the periodic reservation of profits. The second entry transfers the total profits so reserved during the life of the bonds, back to surplus—capital surplus if it is desired that these profits be made a part of the permanent capital of the corporation, or to general surplus in the event that these profits are to be made available for future dividends.
=Closing the Books of the Corporation.=—The results of the period’s operations are summarized and the books closed in very much the same way as with the partnership. From what has been said above, it will be understood that there are some types of transactions to be considered at the time of closing the corporation’s books that are not found in the partnership and single proprietorship. These concern largely the bond interest, the sinking fund reserve, and the dividend transactions. Bond interest is an expense. The sinking fund reserve is a reserve of net profits. Two methods are employed in showing the appropriation of net profits. Under the one method the total net profit is transferred to Surplus account, which then shows not only the profit for the current year but also the undistributed balance of previous years. The current appropriations of profits for whatever purpose are then booked as a charge against Surplus. Under the other method the current appropriations of profits are shown as charges against the net balance in the Profit and Loss account. Any unappropriated profit remaining is then transferred to the Surplus account.
=Dividends.=—A business is being operated always for the benefit of its owners, to whom the profits belong. In the case of a corporation, before the owners may secure any of the profits, a formal declaration of dividends must be made by the board of directors. During the term of its election the board is supreme in its management of the business. It is intimately in touch with the condition of the business. It knows the needs of the corporation and its obligations and must provide for them. If, after considering all the circumstances, it decides that some or all of the profits should be divided among the shareholders rather than be retained in the business for purposes of expansion, it meets in regular session and passes a formal dividend resolution.
=Ultimate Control of Stockholders.=—Thus it is seen that the board of directors is supreme during the period of its incumbency. Its actions are, however, subject to the review of the stockholders at their periodic meetings, which are usually held annually. If their policies are not favored by the shareholders, a new board, presumably one which will carry out the will of the majority of stockholders, is elected.
=Dividends Out of Profits Only.=—It is forbidden by law to pay dividends out of the capital of the corporation. Such payments would encroach upon the net assets of the organization and thereby weaken the creditors’ security for the payment of their claims. Dividends need not be paid out of the profits of the current year, provided the undistributed profits of former periods are still available.
=Distribution of Profits.=—The appropriation of profits in a corporation differs, therefore, from that in a partnership. The entries recording the appropriation of profits cover in the main two kinds: (1) reserves, and (2) dividends. These entries are not necessarily the same for all corporations nor for all periods. No set disposition of profits is prescribed, authority resting with the directors. Their decision, therefore, as recorded in the minutes of their meetings is the basis for this group of entries. Some of the usual entries are illustrated in the following paragraphs.
=Reserves and Dividends.=—As stated above, the two methods for handling the appropriation of profits are: (1) as a charge against Surplus after the net profit for the current period has been transferred to that account; and (2) as a charge against the current Profit and Loss credit balance and a transfer of the remaining balance, if any, to the Surplus account.
A part of the profits may be retained in the business to provide funds for certain future needs, as for the payment of fixed debts, the extension of fixed plant, etc. Such items are transferred to the credit of properly named reserve accounts. Profits for distribution as dividends are similarly transferred to a Dividends Payable account. The dividend is always based on the amount of outstanding stock, not on the unissued or treasury stock. It is reckoned either as a percentage of the par value of each share, as a 6% dividend, or as a stated amount on each share, as a dividend of $4 or 10 cents per share.
The following illustration will show the necessary entries in accordance with the two methods.
PROBLEM. Assume that the net profits of Jackson & Co. are $25,000. The directors declare an 8% dividend on the outstanding capital stock of $100,000, and order $5,000 to be transferred to a reserve for buildings and $7,000 to a reserve for the cancellation of a bond issue.
FIRST METHOD Profit and Loss 25,000.00 Surplus 25,000.00 To transfer net profits to Surplus. Surplus 20,000.00 Dividends Payable 8,000.00 Building Fund Reserve 5,000.00 Sinking Fund Reserve 7,000.00
SECOND METHOD Profit and Loss 20,000.00 Dividends Payable 8,000.00 Building Fund Reserve 5,000.00 Sinking Fund Reserve 7,000.00 To appropriate profits as per resolution of the directors. Profit and Loss 5,000.00 Surplus 5,000.00 To transfer balance to Surplus account.
=Dividend Liability.=—The student should note that the effect of a dividend declaration is to change a portion of the proprietorship into a liability. Surplus is decreased and liabilities are increased. The liability so created ranks with other liabilities, i.e., the assets of the corporation may be used to pay the liability to its stockholders equally with the payment of liabilities to outside creditors. The payment of such dividend is recorded by the cancellation of the dividend liability, as follows:
Dividends Payable 8,000.00 Cash 8,000.00
Where there is more than one class of stock outstanding, it is customary to keep separate dividend accounts with each class.
=Other Methods of Adjusting and Closing the Books.=—It seems desirable at this point, although the material is applicable to any type of business organization, to discuss other methods of adjusting and closing the books than those heretofore explained. In Chapter XXVIII and previous chapters, the methods of handling deferred expense and income, and of summarizing the merchandising transactions were shown. The method given there of adjusting the ledger because of deferred expenses rested upon a classification of the various expense accounts to be adjusted as temporary proprietorship accounts. The method of adjustment effected a transfer out of the current part of the account, the asset portion of the expense, and carried it over into the next period. The balance remaining in the account after this adjustment shows the expense, that is, the amount of service or use, chargeable to the current period.
Another method of handling such items is based on an asset classification of the accounts recording them. Under this hypothesis such account titles as Postage, Stationery, Wrapping Supplies, and even Insurance (that is, unexpired insurance), are classed as asset accounts. At the close of the period when the adjustments are made, it is necessary to transfer from such asset accounts only the portions used or consumed during the current period. The balances left in the accounts represent the unused assets carried over into the next period. The difference between the two methods is indicated by the two sets of adjusting and closing entries given below.
PROBLEM. Assume that $1,000 of insurance has been purchased during the current period and that at its close unexpired insurance is $250.
FIRST METHOD. The adjustment of the Insurance account classified as an expense account is here made by the following entry:
Insurance (Deferred) 250.00 Insurance 250.00
The closing entry would be:
Profit and Loss 750.00 Insurance 750.00
The ledger account would show as follows:
INSURANCE =========================================================== 19— | 19— Jan. 15 500.00 | Dec. 31 Deferred as unexpired 250.00 June 15 500.00 | Profit and Loss 750.00 -------- | -------- 1,000.00 | 1,000.00 ======== | ======== 19— | Jan. 1 250.00 | |
SECOND METHOD. The Insurance account is here looked upon as an asset account. The only adjustment necessary, therefore, is to remove from it the portion used, the portion remaining unused being an asset. This is effected by the following entry:
Profit and Loss 750.00 Insurance 750.00
The ledger account would appear as follows:
INSURANCE ======================================================= 19— | 19— Jan. 15 500.00 | Dec. 31 Profit and Loss 750.00 June 15 500.00 |
In favor of the first method it may be said that it brings out more sharply the difference between asset and expense accounts and the need for separating mixed accounts into their two elements of expense and asset. The second method requires less work.
=The Trading or Selling Account.=—For the purpose of summarizing the merchandising activities a separate account called Trading or Merchandise Trading is sometimes used to effect the partial summarization heretofore explained as being made in the Purchases and Sales accounts respectively. Where so used the Trading account becomes virtually the old Merchandise account with totals in place of details. The following entries will show its content and the method of handling it.
Trading 10,000.00 Merchandise Inventory 10,000.00 To transfer opening inventory. Merchandise Inventory 12,000.00 Trading 12,000.00 To set up new inventory. Trading 100,000.00 Purchases 100,000.00 To transfer purchases for the period. Trading 3,000.00 In-Freight and Cartage 3,000.00 To transfer in-freight and cartage expense. Purchase Returns and Allowances 5,000.00 Trading 5,000.00 To transfer. Sales 150,000.00 Trading 150,000.00 To transfer. Trading 6,000.00 Sales Returns and Allowances 6,000.00 Trading 48,000.00 Profit and Loss 48,000.00 To transfer the gross profit on sales.
The Trading account is thus used as a means of separating the net sales into its two elements: (1) income, or gross profits; and (2) decrease of assets, or the cost of goods sold. This method makes the Profit and Loss account a purely summary account of income and expenses. Its chief disadvantage, however, is that a picture of the entire operations for the period is not presented in one account. One seldom finds the Trading account used in actual practice. It does serve, however, as an efficient teaching device to bring out clearly the way in which the merchandise accounts are adjusted and summarized in order to effect a separation of the income and decrease in asset elements.
XLI. HANDLING THE CASH
=General Considerations.=—In keeping record of the various properties of a concern, the greatest care is usually exercised in accounting for the asset cash. This is done because of the difficulty in tracing money that is lost or stolen and the ease with which the thief may get rid of it, due to its universal use as a medium of exchange, and due also to its great value in comparison with its small bulk. Merchandise, supplies, and the like, may be purloined or misappropriated, but not so easily and profitably. Oftentimes, however, unless care is exercised in safe-keeping it, large losses occur also in merchandise. Absolute prevention of losses cannot be expected even with the employment of all possible precautions, but experience shows that certain general safeguards may be placed about both cash and merchandise. In the ultimate analysis the best safeguard is the integrity of the employee; still the employer should not tempt the employee by making the abstraction of his cash an easy performance.
=Principle of the Double Record.=—A fundamental principle in the handling of cash is to secure a double—not a duplicate—record of its receipt and disbursement. The practice of depositing in a bank all cash receipts and making disbursements only by check should be followed invariably, because it secures this double record—the bank’s record and the cashier’s record. Any discrepancy is detected whenever comparison of the two records is made. When the bank’s record is compared with the cash book record, the balances shown by each are seldom in agreement, chiefly because of the outstanding checks which have not yet been presented to the bank for payment. This requires a reconciliation of the two balances before proof of correctness is secured, which is usually accomplished by subtracting from the bank balance the amount of the outstanding checks. Other adjustments are sometimes necessary. These are explained and a form of reconciliation statement is shown on page 475.
Most concerns object, however, to issuing checks for small amounts, and set therefore a minimum below which they do not issue them. For the purpose of paying smaller amounts, a petty cash fund is provided from which disbursements are made in cash. This fund is established, in the first instance, by a check on the general cash and is from time to time replenished in the same way. In this manner the double record is maintained.
=Handling the Petty Cash.=—There are two general methods of handling the petty cash. Under the one, entry of the check creating the fund is made as an immediate charge to some expense account and no further accounting is required. This method is based on the theory that the cash is to be used for petty expenses anyway, and might as well be so charged now as later. Subsequent amounts for replenishment of the petty cash are treated in the same way. The objection to this method, from the accounting viewpoint, is that it results in an inaccurate record of expense distribution and a misstatement of the facts in that it charges to expense an item which at the time of the charge is still a part of the general cash fund. The second and chief objection is that it encourages in the petty cashier loose methods in handling and accounting for the fund, as usually no strict reckoning is required.
The second method, known as the “imprest method,” is in more general favor. This charges the original check creating the fund to an account called “Petty Cash.” The petty cashier is required to secure a receipted bill, sales ticket, or other voucher for every petty cash item of expenditure, so that at all times the amount of cash in his possession added to the receipted bills and vouchers must equal the original amount in the fund. Usually the fund is a fixed amount, its size depending upon the needs of the business for these small expenditures. When the cash in the fund becomes low, the petty cashier turns over his receipted bills to the general cashier, who issues a check for their exact total to replenish the petty cash by the amount of its depletion, thus restoring it to its original fixed amount.
The expenditures as shown by the receipted bills and vouchers are classified and entered by either of the following two methods: (1) as a charge to the several accounts through the general cash book, offsetting the petty cash replenishing check; in this case no charge appears in the “Petty Cash” account except the item covering the original check; or (2) by an entry through the journal debiting the various expenses and other items and crediting Petty Cash. This latter method necessitates charging in the general cash book the replenishing check to Petty Cash as an offset to the journal credit of the same amount. Most accountants consider the postings to the Petty Cash unnecessary—except the original—and so check both in cash book and journal. If, however, posting to the Petty Cash account in the general ledger is made whenever the fund is replenished, this will serve to indicate the activity of the fund on the face of the ledger account—information which could just as easily be obtained from the petty cash book. The imprest method thus effects a careful accounting of the petty expenditures.
=The Petty Cash Book.=—The petty cash book is usually a columnar record with the amount columns to the right of the explanation space. The first column is the receipts column, the second the disbursements column, and the others show under appropriate titles the distribution of disbursements. One form of the book is shown in Form 39, with typical entries and balancing.
Sometimes the classified summary which is made the basis of the general cash book or journal entry referred to above, is shown in the petty cash book, the account titles being written in the explanation column, with the amounts opposite in the credit column underneath the $100 total. The items of this summary are then posted to the ledger, and the debit of the replenishing check to Petty Cash on the general cash book is “checked” in the ledger folio column. Or if the distributive column titles give sufficiently analyzed account titles, their totals may be posted without formal summarization, posting being shown by the small-figure ledger page in each column, as in the illustration. Where the petty cash book is used as a posting medium, of course no summarization of it is made either in the journal or the general cash book.
=Keeping the Bank Account.=—Several different methods of keeping the bank account are in use. Sometimes the check stub is the only record kept; in Chapter XXIII reference was made to the two methods of keeping the account for the entry of deposits—either on the face or the back of the stub. When the entry is made on the face, each check is usually subtracted from the previous balance and the new balance is shown. When deposits are recorded on the back of the stub—or on a special deposit interleaf—check totals and deposit totals may be carried forward from leaf to leaf without showing any balance.
A better method is to use the stub only as a memo from which to make formal entry in the cash book columns—one for deposits on the debit side and one for checks on the credit side. These bank columns may be used, first, for the purpose of keeping the bank account, by showing the totals of deposits—but not the items composing each deposit—and the totals of the checks that have been drawn; and second, for the purpose of furnishing weekly or monthly totals for posting to a ledger account kept with the bank, thus making the ledger self-balancing without having to bring in the cash book balance.
If, however, the principle of double record (explained earlier in the chapter) is followed, there is no need of a special bank deposits column, since the total of the Net Cash column gives the amount of each day’s deposits, and similarly the Net Cash column on the credit side shows the checks drawn against the bank. Thus the policy of depositing in the bank all receipts and disbursing only by check has an added advantage in that it simplifies the keeping of the record of cash as well as proving it. Under this method, the cash journals may be summarized, just as the other journals, and posted to a Cash account in the ledger. Detailed instructions for the handling of the entries, balancing, and closing under this method are given in Chapter XXXI.
Another and rather unusual method of keeping the cash book is to carry a Currency column on each side, supplemented by Bank columns for deposits and checks on the debit and credit sides respectively. In the debit Currency column are entered all receipts of money in regular course. When the bank deposit is made up, its amount is entered as a charge to the bank in the credit Currency column and also, as a memo, in the debit Bank column. As checks are drawn they are entered in the credit Bank column. Thus the balance of the Currency columns should show the actual amount of cash in the cash drawer at any time, and the difference between the Bank columns should show the balance in the bank. Though somewhat complicated, the method has its advantages under conditions where currency accumulates before being deposited in the bank.
Of course, under all methods of keeping the cash record, the requirement that all cash received be deposited and payment be made only by check should be strictly adhered to.
=Entering Checks on the Cash Book.=—When all disbursements are by check, every check drawn must be entered on the cash book and accounted for. Entry should be made in numerical sequence with suitable explanation of any spoiled checks. The amount of the spoiled check may be left blank or entered as usual, but in the latter case the spoiled check must also be included in the day’s deposits, and the bank’s cancellation stamp must be secured. Neither the deposit nor disbursement is posted, each entry being marked “contra” by way of explanation. This effects an inflation of the total receipts and disbursements, but inasmuch as the bank’s record also shows the inflation, an adequate safeguard is secured. The new check replacing the one spoiled is entered in regular order.
The method just discussed is perhaps the best way of recording the exchange of checks for cash. Sometimes a concern is asked to exchange its check for currency, the party making the request desiring to send the check through the mails or for some other purpose. The entry is best made on both the debit and the credit side of the cash book with reference “contra” in each case, but neither entry need be posted. This makes the cash book record check against the bank record and shows the full history of the transaction. When a check is cashed in currency, or when a check of larger amount is received in payment of a debt and the difference is returned in cash, no record need be made of the check, as only the nature—not the amount—of the deposit for the day is changed and no disbursement is made which affects the bank account. When, however, a check is issued for “change” in lieu of currency, record should be made, debit and credit, as shown above.
=Branch Cash—The Working Fund.=—Frequently cash working funds must be provided for the current expenses of branches or of a factory located at a distance from the main office. When the branch or factory keeps a separate set of books, it must be charged with the advances of the working fund and a careful audit of the way the fund is handled must be made periodically, just as would be done with an independent concern.
Such cash transfers may also be handled by the imprest method as explained above. The original advance is charged to “Factory” or “Branch Cash,” and is deposited in the branch’s local bank to the credit of the head office, the branch having the privilege of using it. The branch may draw checks against the fund, sending the canceled checks to the head office as supporting vouchers for its disbursements. These canceled checks become the basis for the replenishing checks and also for the charges for branch expenditures made on the head office books.
If the branch is a selling agency making sales for cash and on account, a modification of the system is necessary. Daily reports should be required from the branch. Its cash receipts should be deposited daily and a duplicate deposit ticket should be forwarded to the head office by the bank. The bank should be asked also to forward all canceled checks. All collections on customers’ accounts should be made from the head office. This does not prevent the abstraction of cash before deposit, but it at least places control or oversight of the bank cash account in the hands of the head office and secures a careful accounting of it.
=Safeguarding Cash—General Principles.=—Proper safeguards for the cash should always be provided. The method of the double record—the bank’s and the owner’s cash book—is good so far as it goes and acts as a check on cash transactions after the record is made, but does not insure that the cash book record will be made correctly in the first place. There are ways in which cash received may get into the cashier’s or salesmen’s pockets instead of the cash book. No system or method has yet been devised to prevent this entirely. Every system must rest at some point upon the integrity of the human agent, and will fail of its full efficiency and intended results if the agent fails in the trust reposed in him. Every effort should be made to prevent both petty thievery—the abstraction of small sums at every opportunity—and systematic robbery mapped out and planned with infinite care and detail. Only everlasting vigilance and a system of “checks” will secure satisfactory results, as occasionally it is the trusted employee who is not true to the trust placed in him.
=Internal Check.=—By internal check is meant the method by which employees check each other’s records, control not resting entirely in any one clerk. Thus a system of record-making which combines the work of the cashier and bookkeeper under one clerk or which gives the cashier access to the ledgers is one which invites dishonesty.
Where the cashier has entire control of the cash, and besides opens the incoming mail, makes up his daily deposits, has his pass-books balanced periodically, and files the canceled checks, he has every opportunity to abstract cash and falsify his records. But where he must make detailed daily reports of the cash to the manager, treasurer, or some other officer; where he is denied access to the records—except his own cash record—and where his record is subject to periodic proof; where the mail is opened first and receipts listed by an independent clerk; where a careful system of proving receipts from cash sales and of allowing no unauthorized deliveries over the counter is employed; where every member of the office force is required to take a vacation during which his work and records are cared for by other employees—there is a very satisfactory system of internal safeguards and checks.
All these devices and systems are applicable in full only in large concerns where minute division of duties is possible. In smaller concerns where many duties have to be combined under one person, the problem of safeguarding the cash and providing other measures to prevent fraud of various sorts is more difficult. In such a concern, at least the cash received through the mail should be listed first by someone other than the cashier or bookkeeper, and the daily deposit slip should be compared with this list to see that all the cash items are included. The cash received from cash sales should also be proved daily against the sales tickets.
=Statement of Receipts and Disbursements.=—A periodic report of cash is usually made by means of a statement of receipts and disbursements. This statement is an abstract or summary of the cash book, showing the total receipts from various sources and the causes of the disbursements and their totals. A simple form is given below:
To assist in checking past deposits, an itemized record of daily cash receipts is often kept, analyzed as to gold, silver, currency, notes and checks. To be of value this record should be filed with the daily deposit tickets and should be later available for purposes of comparison.
XLII. NOTES RECEIVABLE AND PAYABLE
=Conditions Precedent to the Present Use of Notes and Bills.=—During the twelfth and thirteenth centuries there was much bad money in circulation in Europe because of the widespread practice of coin-shaving and the entire lack of standards of purity of the coins. If a monarch needed funds for war or government purposes, his easiest way of getting them was to increase the amount of base alloy in the coins of the country or to increase the rate of seigniorage. As the former method might be resorted to several times during the reign of one sovereign, the weight and relative purity of metallic coins had no relation to the denominated value of the coins, and they fell under general suspicion. Consequently, only the money dealers, who could determine the actual value of coins by assaying them, were willing to trade for coins. These men gradually became the custodians of moneys for merchants, who were given receipts showing the assay value of the coins deposited. Because the receipt represented tested and proven value, it was a more acceptable medium of exchange than the coins themselves.
Medieval trade was subject to many perils, chief of which was that from robbers. Any safeguards placed about the transportation of money from one place to another, or any method devised for settling debts without the transportation of coin and bullion, were more than welcome. Out of these conditions arose the method of settling debts by means of drafts. The draft, not countenanced by law at first, had standing, however, under the “law merchant,” the code of rules recognized by merchants as governing commercial relations. This code was later incorporated by statute into the law of the country.
These two kinds of paper, the one a receipt for coin which was in the nature of a demand promise to pay, the other a counterpart of the modern draft, were the forerunners of our promissory notes and bills of exchange of the present day. The law with regard to the bill or draft became settled as the result of the practice of merchants sooner than that relating to notes.
=The Titles “Notes” and “Bills.”=—In this way, the word “bill” became an established term. The titles “bills receivable” and “bills payable” still cling to both classes of items. Inasmuch as the accepted bill is practically identical with the promissory note, and the title “bill” is so often used interchangeably with the word “invoice,” it is advisable to use the terms notes receivable and notes payable instead of bills receivable and bills payable. Some advocate the use of the title “acceptances” in order to distinguish accepted bills from promissory notes. Unless these two classes of paper are large enough in volume to justify it, little advantage is secured by this separation of their bookkeeping record. However, in the case of trade acceptances, i.e., acceptances based on particular sales of goods and therefore evidencing bona fide commercial transactions as the basis for the extension of credit, it is advisable, because of their superior rating in the money markets, to segregate this class of acceptances from notes and other acceptances.
=Relation of the Note to the Open Account.=—In the preliminary discussion of the relation of the note to the open account in Chapter XXI, it was pointed out that both the note and account are claims against the person liable for payment; and that the one is carried under a class title “notes receivable,” because the number of such notes is usually small, while each account receivable is carried under a separate title which designates the person liable for payment. The essential difference between the two kinds of claims is that the note is an acknowledgment of the justice of the claim and the correctness of the amount, whereas the claim under the open account may be disputed and in case of dispute requires outside proof; besides, the open account may always be offset by counterclaims and sometimes by a return of all or a part of the goods bought.
Any defenses of value under the contract for which the note was given are good defenses as between the original parties to a note; but not so as between the maker and a third party who is an innocent purchaser for value. To him the maker is liable according to the exact terms and tenor of the note. Only so could the element of negotiability be insured and the note pass from hand to hand as money. In no other sense is the note a preferred claim over the open account.
In case of bankruptcy a claim against the bankrupt under an open account and a claim under a promissory note or an acceptance made by the bankrupt before his insolvency, rank alike, both sharing pro rata in the net assets available for the satisfaction of the total claim of unsecured creditors.
=Relative Liquidity of the Note and Open Account.=—Compared with the liquidity of open accounts, promissory notes have a slight advantage in that they can more readily be turned into cash and at a better rate. Although an assignment of open accounts is possible by hypothecating them with a third party, the cost of such assignment is almost prohibitive and is resorted to only where the customary sources of credit are not available.
The legitimacy and the low cost of discounting notes greatly increase their liquidity. Oftentimes the question of risk, i.e., the degree of certainty of their payment when due, enters into the determination of the relative liquidity as between open accounts and promissory notes, but from this standpoint there is little, if any, difference between the two claims. Occasionally a firm, which refuses to pay its debts on open account, will meet its notes and acceptances in an effort to bolster its credit at the local banks. This phase of the question does not usually enter into the discounting operation, where the credit of the discounter is the determining factor in raising money. Of course, this may be only a temporary expedient if the note is dishonored and charged back to the bank. In some lines of business it is very common practice to secure notes for overdue accounts. If the Notes Receivable account contains many such items, its liquidity is seriously to be doubted. However, the note is usually classed as a more liquid asset than the open account.
=Method of Recording Notes.=—As to the accounting phase, a record is made of each note received or given, entry being to Notes Receivable or Payable, as the case may be. If the note transactions are few in number, the general journal is used for their record. Ample explanation must be given as to the essential facts of date, maker, for what received, rate of interest, due date, etc. Notes receivable must be watched carefully, as failure to present them when due releases all indorsers. There is nothing unusual in the entry when made in the general journal, its debit and credit being determined as indicated in Chapter XI.
=The Note Journals.=—Because the general journal does not lend itself to an easy record of the essential data pertaining to note transactions, a separate book is oftentimes kept for this purpose. This special book may be used merely as a memorandum record for carrying the detailed explanation of the Journal entry; or it may become a special journal that is used as an integral part of the accounting system, and, when so used, posting to the ledgers is made direct therefrom. The use of this special journal is always advisable when note transactions are numerous. A bills or notes receivable journal may be ruled as shown on Form 41. The notes payable journal differs but slightly from the notes receivable journal.
If the bill book is for memorandum use only, the “Amounts Credited” columns may be omitted. If it is a real note journal, its debit and credit equilibrium is shown through summary entry at posting time. The total debit is to Notes Receivable for the amount of that column’s total. If it were not for the fact that sometimes notes are received in whose face amount is included not only the credit to the customer but an interest item as well, there would be no need of credit columns. The note journal would then be operated just as is any simple special journal, with a debit to Notes Receivable and the same amount credited to the customer; but when interest is included, the note is best recorded in an additional column, separating the credit to Customers from that to Interest. If notes are numerous, a distributive column in the cash book should be used for receipts from notes, in order to secure a total posting to the credit of Notes Receivable account.
Referring to the left-hand page of the illustrated ruling (Form 41), the face amount of the note receivable is entered in the Notes Receivable column, and the due date in one of the narrow columns headed “When Due,” each of these columns representing a separate month. In this way it is easy to find the total of all the notes due in a given month and the amount of cash to be expected from their payment. For this purpose, however, it is best to use a note journal arranged by months of maturity on the principle of a “tickler.” In such a journal one page is reserved for each month, and the notes are entered, not on the page for the month when received, but on that for the month when due. Thus a note received in January and due in March should be entered on the March page. To secure a summary of all notes received during each month for posting to Notes Receivable account at the end of each month, the various month pages are totaled and “recapped” on a special page. On this “recap” page, at the end of January, say, will be entered the total of the January page, giving the notes received in and maturing during January; the total of the February page, giving the notes received in January but maturing in February; etc., for each month during the year. The grand total is the amount to be posted to the general ledger, representing all notes received during January.
This type of journal gives easy control over maturities, and forecasts for a given month the amount of cash receipts from notes.
=Notes Entered at Face Value Always.=—Some notes are interest-bearing from their date of issue; others only after their due date when not paid. Even on non-interest-bearing notes, the law allows the charging of interest for their overdue period. From the standpoint of strict accuracy, a note payable at a future time is not worth its face value at the time of entry, unless it is interest-bearing from date at approximately as high a rate as the current discount rate. Its present value is such an amount as when placed on interest will equal the face at its due date. That value increases day by day until it reaches par or face on the due date. Because of the practical difficulties encountered in the numerous adjustments necessary under any other method of entry, universal practice countenances the bringing of the note onto the books at a slightly inflated value, i.e., face value, at the time of entry. Face value is the amount of the credit to the customer’s account; it shows the amount to be collected on account of the note; and if interest-bearing, the amount on which the interest is based. Accordingly, the note transaction is entered at its face value. Where the note is interest-bearing and the face plus the interest is paid at maturity, credit is in two items, one to Notes Receivable for the face, and the other to Interest Income for the amount received as interest.
Occasionally, the interest for the period the note is to run is added to the amount of the debt, and the sum is made the face of a non-interest-bearing note. The purpose of such procedure is to secure a compounding of interest for the first period if the note is not paid at maturity. The entry of the note on the books is a debit to Notes Receivable for its face, and credits to the customer for the amount of the debt and to Interest Income for the amount of the interest. Only a credit to Notes Receivable is made when the note is paid. The credit to Interest Income, before the interest is actually earned and received, is necessitated by its pre-estimate and inclusion in the face of the note. Were a balance sheet drawn up on that date, the entire amount of this interest would be shown as deferred income.
=The Interest Accounts.=—As explained in Chapter XV, when interest items are numerous two interest accounts are usually carried on the ledger, one for Interest Income and one for Interest Cost. Sometimes, however, only the one account, Interest and Discount, is carried, and if it is desirable to separate the two classes of interest, it may be done by entering the debit and credit totals of the Interest and Discount account—instead of simply the balance—when the trial balance is taken. Needless to say, bank discount—interest paid in advance—is the only kind of discount recorded under this account title; it must not be confused with discounts on sales and purchases, which receive different accounting treatment.
Chapter XLIII
PROBLEMS ENCOUNTERED IN RECORDING NOTES RECEIVABLE AND PAYABLE
=Entries in the Account.=—The elementary discussion of entries to the note accounts in Chapter XIV will be reviewed and amplified here.
Where the Notes Receivable account in the ledger shows each note separately rather than the totals of the items, good practice countenances the recording of the credits in this account in non-chronologic order. Thus, when a customer settles his promissory note and the document is returned to him, the credit to Notes Receivable should be entered directly opposite the original debit item. This brings each complete note transaction on a single line and shows at a glance which notes are outstanding, as evidenced by the blank lines on the credit side of the account.
When, however, the credit items are entered in chronological order, the same purpose may be accomplished by the use of an index figure for the original debit and the corresponding credit item.
What has been said above applies equally to notes payable.
=The Discounted Note.=—In the booking of notes receivable discounted and accepted drafts, a problem arises because of the legal right accorded the holders of notes, in case of non-payment by the maker, to look for payment to any or all of the indorsers, provided certain formal requirements are complied with. Whenever a business house transfers a note by any method of indorsement (except the qualified), it incurs a contingent liability, which may become a real liability if the maker of the note fails to meet the obligation at maturity. Since it is the function of good accounting to present all the financial facts bearing on the business, it is evident that whenever a contingent liability is incurred, it should be entered in the books of account. Very frequently, however, this liability is ignored, with the result that it is eventually lost sight of altogether.
The usual, though incorrect, method of journalizing a note discounted transaction is as follows:
Cash Interest Cost Notes Receivable
Usually when an asset is sold, a credit to the account of the asset sold is correct, but not so in the case of notes sold, i.e., of notes discounted. For the purpose of showing the complete facts, the entry at the time of discount should be made as follows:
Cash Interest Cost Notes Receivable Discounted
and at maturity when the note is paid by the maker:
Notes Receivable Discounted Notes Receivable
The effect of the first entry is to set up a suspense account, Notes Receivable Discounted, representing the contingent liability on the discounted note. The effect of the second entry is, first, to cancel the credit of the Notes Receivable Discounted account, because upon payment of the note by the maker the contingent liability ceases; and second, to cancel the original debit to the Notes Receivable account which was made at the time the promissory note was received but which remained unchanged when the note was discounted, because it was still needed to record the contingent asset which would become a real asset in case the contingent liability became a real liability.
It has been argued that the above treatment of discounted notes stretches the theory of debit and credit nearly to the breaking point. It must be observed, however, that unless accounting records are so kept as to give the necessary information, they are not serving the purpose which justifies their existence. Any theory which prevents the proper functioning of the records must be changed; there is no place for it.
It would be incorrect, however, to regard Notes Receivable Discounted as an independent liability account, because it only represents a contingent liability. The two accounts, Notes Receivable and Notes Receivable Discounted, must be considered together, the latter account being set up merely for the purpose of keeping notes discounted under review until their final status is determined. The purpose of the Notes Receivable Discounted account is in a way similar to that of the valuation accounts of depreciating assets. The asset account is held at its original figure, and in order to determine the present value of the asset, the valuation account must be referred to. Similarly, the asset account, Notes Receivable, is held at its original figure, even though some or all of the notes are discounted, and in order to know the amount of notes receivable actually on hand, the credit of the Notes Discounted account must be subtracted from the debit of the Notes Receivable account. In the balance sheet, Notes Receivable Discounted is not shown as a liability item, but appears as a deduction from Notes Receivable, only the difference, representing the amount of notes actually in possession, being extended among the assets. It should be noted, however, that this contingent liability is oftentimes shown on the liability side of the balance sheet, the corresponding asset, Notes Receivable, then being separated into two items, “Notes on Hand,” and “Notes under Discount per contra.” Banks uniformly follow this practice in showing these and similar items.
At maturity of the note the final entry (Notes Receivable Discounted debit and Notes Receivable credit) is placed upon the books as illustrated above. Usually no formal notice is received by the indorser that the note has been paid by the maker. In case the note is dishonored, prompt notice would be sent, and failure to receive such notice implies that the note has been duly paid.
What has been said above concerning notes applies equally to accepted drafts, the legal character of which is identical with that of notes, the status of the drawer of an accepted draft being the same as that of the first indorser of a promissory note. The contingent liability arising from the transfer of all negotiable instruments should usually be shown.
In some instances, however, there may be good practical reasons for not adhering to the above principle. When, for instance, a large number of notes and acceptances are handled and the experience of the business shows that few of them are ever dishonored, or if the matter is under constant review by the financial manager, it might be considered an unnecessary requirement to make use of a separate Notes Receivable Discounted account. It must be left to the judgment of the accountant to decide which method is preferable in connection with the needs of the business. However, if no current account is kept to show the contingent liability, at the end of the period the balance sheet must be made to show the amount of discounted notes still outstanding as of the closing date of the period.
=The Dishonored Note.=—A note is dishonored either when the maker refuses payment upon its legal presentation at maturity or when there is sufficient evidence that he intends to refuse. When a note is dishonored, a formal protest is required in order to hold the indorsers. The payee appears before a notary public or some other officer with notarial powers, and makes oath that legal presentment of the note has been made and that the payment was refused. The notary then takes the note and personally presents it for payment to the maker. If payment is still refused, the notary makes a certificate of protest and mails notices of the protest to all indorsers desired to be held. Such notice is sufficient basis for action to recover from the party or parties thus notified.
In making the accounting record of a dishonored note, a number of problems may arise. These problems deal with these two situations: (1) when the note is dishonored in the hands of the named payee; and (2) when the note has been discounted by him and is charged back on account of dishonor. To illustrate the entries required, take the following two cases:
PROBLEM. Case 1. Promissory note made by P. Canning for $100. Payee, D. Johnson. Due December 15. At maturity Johnson presents the note for payment, but payment is refused.
Case 2. Promissory note for $250 made by P. Canning. Payee, D. Johnson. Due December 15. Note was discounted by Johnson. Final holder is A. Andrews who presents the note for payment on December 15, but payment is refused.
The questions arising in connection with these two cases may be stated as follows: What record should be made on December 15—
(a) By D. Johnson in case 1. (b) By A. Andrews in case 2. (c) By D. Johnson in case 2.
(a) D. Johnson, at the time he received the note from Canning, made the following entry:
Notes Receivable 100.00 P. Canning 100.00
and on December 15, in order to show that the note is dishonored, he may make either of the following two entries:
(1) P. Canning 100.00 Notes Receivable 100.00
or
(2) Notes Receivable Dishonored 100.00 Notes Receivable 100.00
Entry (1) takes the charge out of the note account and sets it up again as a claim on Canning’s open account. Entry (2) transfers the charge to a Notes Receivable Dishonored account. Entry (2) is theoretically a better entry than entry (1), because from the latter it might be inferred that the nature of the claim has changed from a note claim to an open account claim. Such change has not taken place, however; Johnson’s claim against Canning is still on the note. Therefore, entry (1) is not true to the facts.
On the other hand, entry (1) has an important advantage over entry (2), because by posting entry (1) Canning’s personal account in the ledger is made to show the fact that one of his promissory notes was dishonored. This is a matter of very great importance, especially if Canning should again apply for an extension of credit.
If the second method is adopted, it is clear that the posting of the entry will not show the dishonor of the note on Canning’s account. It is essential, therefore, that the bookkeeper should make a special memo of the fact in that account. If the bookkeeper could be depended upon to make such memorandum entry, the desired purpose of making Canning’s account show a complete record of all dealings with him would be accomplished. Any treatment consistent with accounting principles and securing a complete history in one place of all dealings with the same individual satisfies all requirements.
(b) A. Andrews, who is the last indorsee of the note, should make the following entry at the time the note is dishonored:
Notes Receivable Dishonored 250.00 Notes Receivable 250.00
The Notes Receivable Dishonored account represents Andrews’ claim against any or all the indorsers whom he wishes to hold responsible. Instead of this, an entry might be made corresponding to entry (1) discussed above.
(c) In case the note should be charged back to Johnson, either by Andrews or by one of the other indorsers, he should make the following entries:
Notes Receivable Discounted 250.00 Cash 250.00 P. Canning (or Notes Receivable Dishonored) 250.00 Notes Receivable 250.00
It will be noticed that these two entries completely reverse the two original entries made by Johnson, viz.:
Notes Receivable 250.00 P. Canning 250.00
at the time he received the promissory note from Canning, and
Cash 250.00 Notes Receivable Discounted 250.00
when he transferred the note by indorsement.
It is to be understood that all expenses in connection with the dishonored note should be charged either to the personal account of the maker or to the Notes Receivable Dishonored account, as the case may be.
Where the Notes Receivable Dishonored account is used, it secures a good analysis of the claims against customers from the standpoint of probable realization and gives a relatively better basis for the bad debts estimate than that offered by the other manner of treatment. Of course, the use of such an account is limited to the ledger; it never appears as such on the balance sheet, being included there in the customers’ accounts with ample reserve for uncollectible items.
=The Classification of Notes.=—The Notes Receivable account should carry only the short-time notes of customers, and thus be a truly current asset. Long-time notes and those secured by mortgage should be booked under separate account titles. For a similar reason, the notes receivable given by officers, employees, or stockholders of the corporation should have separate booking, as these notes are given for the purpose of making formal record and acknowledgment of indebtedness, usually without regard to time of payment. Such notes do not constitute easily convertible assets, and therefore should not be recorded under the same account with short-time customers’ notes.
=Notes Receivable Out as Collateral.=—Notes receivable are sometimes given as collateral security for a loan. When they are so used, no bookkeeping problem is involved—though a memorandum to show their use as such should appear in the note account, and in case a balance sheet is drawn up, a cross-reference or a footnote should indicate the liability secured by the notes. However, the sale of the notes to satisfy the loan constitutes a regular business transaction, which should be recorded in the proper manner.
=Note Renewals and Partial Payments.=—The renewal of notes and partial payments are other features met in the accounting for notes. The renewal of a note is rather a question of business policy than of accounting procedure. When a note is renewed, it is usually better to deliver up the old note and secure a new one in its stead. The accounts should reflect the transaction by showing cancellation of the old and receipt of the new note. If the old note is extended, a memorandum of that fact should be entered in the ledger account.
From the financial standpoint, if neither note is interest-bearing, the amount of the renewal note should be larger than that of the old note, to cover the cost of deferring payment to a future date. For example, if the old note amounts to $1,000 and is renewed two months later, the amount of the new note should be fixed at $1,000 plus 1% interest, or $1,010.
In accounting for partial payments, no new accounting principle is involved. When such payments are numerous, additional space in the note journal and in the ledger should be provided for the purpose of facilitating the actual work of making the book record.
XLIV. DISCOUNTS
=Definition and Kinds.=—A discount is a deduction from a listed or named figure. The manufacturer or wholesaler in making up his catalogue for the trade usually enters his products at certain prices—called “list prices”—which are not selling prices but only nominal amounts on which the actual sale prices are based. For reasons to be explained later, he offers buyers a deduction from list prices which is called “trade discount.” The usual quotation of sale prices is at so many per cent below the list prices.
Among practically all merchants it is a very common practice to bill goods to customers with settlement allowed on an optional basis. The goods may be billed “net,” i.e., the full amount shown in the invoice must be paid. Since there is a relationship between the time allowed for payment and the amount to be paid, most concerns have an established credit term, at the end of which they expect full settlement of the account, but, as an inducement for earlier payment, they offer a reduction in the amount to be paid. This is stated usually at so much per cent below the billed price, and is generally called “cash discount.” The practice had its origin in conditions prevailing at the close of the Civil War when business failures were numerous and the risk on open accounts even for short credit terms was very great.
Bankers when making loans usually deduct from the face of the loan the interest charge for the use of the money. This deduction is called “bank discount.”
Merchants usually allow a deduction for the prepayment of a customer’s note, and this is called “commercial discount,” to distinguish it from bank discount, although the two kinds of discount are essentially identical; the only difference being that in the one case a bank buys a merchant’s note, while in the other case it is a transaction between two commercial houses, the one buying back its own note before it is legally due.
Trade discounts are very seldom recorded on the books, the actual selling price and not the list price being entered. Cash discounts are invariably recorded. If the merchant knew at the time of the sale which optional basis of settlement the buyer would choose, he could record the transaction at a net figure on that basis without entering the discount portion. This would, of course, result in a varying figure at which sales were booked. Accordingly, the almost invariable practice is to record sales at the gross amount and show by means of the Sales Discount account the acceptance of any lesser sum in settlement in accordance with the sales contract. Bank discount has to be booked in order to show the cost of the loan which is the difference between the asset received, cash, and the asset parted with, notes. The matter of bank discount has been treated in some detail in Chapter XLII.
=The Method and Purpose of Trade Discount.=—Trade discounts are so universally met with in business that an extended discussion of them will be of value to the student. As has been stated, a trade discount is a deduction from the list price and it serves two purposes. It is apparent that the prices listed in the catalogue cannot be changed until a new catalogue is printed and that it would not be practicable to print a new catalogue to make a change in selling prices. Therefore, instead of reprinting the catalogue whenever market prices fluctuate and a change in the list prices must be made, sheets containing the discounts allowed from list prices are published, the expense of which is much less than that of a new catalogue.
The other purpose served by the trade discount is in partly concealing the real quotation. Without the rate of discount allowed from that list, the catalogue tells nothing of the real price. In this way a concern in publishing its catalogue does not lay itself open to the risk of being underbid by competitors publishing later catalogues.
Prices may be quoted at a single discount or by means of a series of discounts, each taking as its base the net amount left after deducting the next preceding discount. Examples will illustrate:
1. Goods listed at $250 are quoted at 20% off. The sale price here is $200. 2. Goods listed at $500 are quoted at 50% and 20% off. 50% off $500 leaves $250. 20% ” $250 ” $200—the same real sale price as in No. 1. 3. Goods listed at $750 are priced at 50%, 33⅓%, and 20% off. 50% off $750 leaves $375. 33⅓% ” $375 ” $250. 20% ” $250 ” $200—the same as in Nos. 1 and 2.
It is apparent that the list prices without the trade discounts tell nothing as to the real prices.
=Methods of Calculation.=—Short methods for calculating trade discounts when given in a series are often employed. For a series of only two discounts, a single rate equivalent to the two may be found by subtracting their product from their sum—always treating them as decimals. Thus a series of 20 and 20 is equivalent to a single rate of 36,
(.20 + .20 = .40; .20 × .20 = .04; .40 - .04 = .36).
Another method of calculating trade discounts, and one applicable to a series of any number of discounts, is to treat the discount off as equivalent to one-minus-the-discount on. Thus a discount of 15% is equivalent to 85% of the list. An additional discount of 10% is equivalent to 90% of the new base, or 90% of 85% of the original list, or 76.5%. Thus a continued multiplication of the “percentages on” gives the single sale price multiplier to be applied to the list price. If the single discount rate is desired, it is secured by subtracting the multiplier from 1, or 100%. Take the series 60, 20, 10, and 10 off. This is equivalent to 40, 80, 90, and 90 on, or 25.92% on
(.40 × .80 × .90 ×. 90 = .2592).
The single discount rate equivalent to the series is, therefore, 74.08% (100%-25.92% = 74.08%).
The order in which the discounts of a series are used is immaterial, as the order of the factors does not affect the product.
The method just illustrated develops the reason for the first special rule given above for a series of two discounts. Let the discounts be “a”% and “b”%. The “percentages on” are, therefore, (1 -a)% and (1-b)% whose product, algebraically, is 1- [(a + b)-ab], which is the single “percentage on”; from which it is readily seen that the single rate discount is a + b-ab, i.e., the sum of the two rates minus their product. Similar rules can be developed for longer series, but they are too complicated for easy application.
There is now available a “discolog” table, an ingenious reference table, which is operated somewhat like a logarithmic table. It gives quickly and easily the single discount rate equivalent to any series of discounts.
The chief value of the single rate equivalent to the discount series is in its use for comparative purposes, as it indicates which of two discount series is the more favorable. When a large number of selling prices must be computed, all having the same discount series, the single rate method of calculation also has a great advantage over the long method, which makes use of the series. This is true especially when the work is done with the use of a calculating machine.
=The Nature of Cash Discount—Its Basic Elements.=—Where goods are sold on credit with a cash discount offering, four main factors of cost, not incurred when goods are sold for cash, must be provided for. These are:
1. Credit investigation and collection expense. 2. Bookkeeping and billing expense. 3. Loss from uncollectible accounts. 4. Interest for the use of the money—credit.
The cash discount is offered to free the vendor especially from costs (3) and (4), which are the heaviest of the four.
There is a direct relation between the credit period and the loss from bad debts. Thus, if a credit period of 30 days results in a given volume of such losses an extension of the credit term to 60 days would undoubtedly result in increased losses, assuming that all factors, such as investigation of the risk, credit supervision, collection effort, etc., remain the same. Inasmuch as the sale price must be sufficiently high to provide for loss from bad debts, the credit term enters into the determination of the price.
The other of the two main factors of cost, the interest charge on the cash sale price, represents the cost of being deprived of the use of the capital tied up in outstanding accounts.
Thus, when a discount is offered for early settlement, under normal conditions the controlling factors are the risk or cost of insurance against loss from bad debts and the interest cost. Special circumstances, however, may make it expedient to offer more or less favorable terms of settlement. Normally, terms of 2% off if paid within 10 days, the billed price being on a 30-day credit period (2/10, n/30), measures two things: (1) the saving secured by receipt of the money 20 days earlier; and (2) the saving in the item of bad debts expense brought about by shortening the term for which credit is extended from 30 to 10 days. How much of the cash discount is for interest and how much for bad debts can be seen by comparing the current interest rate, say 6%, with the discount rate reduced to a yearly basis. A discount of 2% which effects the collection of a debt at the end of 10 days, when the net credit term is 30 days, secures the use of the money by the vendor 20 days earlier than the full credit term would effect. 2% for 20 days is equivalent to 36% on a yearly basis.
=Showing Cash Discount in the Trading Section.=—Opinions differ among accountants as to the proper treatment of cash discounts in the profit and loss summary at the close of a period. Some maintain that the discount is a trading or selling item, and show it, therefore, in the trading section of the statement. Their theory is that discounts on sales partake somewhat of the nature of trade discounts, that the real selling price is, after all, what is received for a particular bill of goods. According to this theory, if goods are billed at $1,000, and $980 is accepted as full settlement, the sale should be shown only at $980 on the books. At the time of offering an optional basis for settlement, however, the merchant does not know which basis the customer will accept, and he therefore enters the sale on his books at the highest offer. Later, if the customer settles on the more favorable option, the discount he takes is logically a deduction from sales.
On the other hand, if the discount is explained as a bait offered to secure customers, it should be treated as a selling cost. Consequently, on either of these two theories, cash discount would have to be shown in the trading section of the profit and loss statement, in the one case as a direct deduction from sales, in the other as a selling cost.
=Correct Method of Showing Cash Discount.=—Other accountants maintain that cash discount is a financial management item; that a manager, in order to secure ready funds with which to take advantage of the discounts offered him on his own purchases, extends to his customers sufficient inducement to secure the early and prompt payment of their bills. The difference between the saving on purchases payments and the cost of securing early payment on sales, is the measure of the efficiency of such financial policy.
While this explanation of cash discount on sales as a cost of securing funds may have some foundation, it does not give a fully satisfactory explanation of the practice. If cash discount has been correctly analyzed as being composed of the two factors, interest and bad debts expense, there can be no question as to the place of its showing. Both factors are financial items and they should therefore be placed in that section of the profit and loss statement. In this work cash discounts will be treated as a financial management item.
=Account Titles for Cash Discounts.=—In booking cash discounts, two accounts are used—one for the discounts on sales, and the other for the discounts on purchases. Self-descriptive titles are Sales Discount and Purchases Discount, which seem better than Discounts Allowed and Discounts Received and other similar titles sometimes met with.
=Methods of Booking Cash Discount.=—In booking cash discounts, any one of four methods may be used. In Chapter XIX, “The Cash Journals,” two of these methods were shown and the explanations will not be repeated here. Explanations of the other two methods follow.
1. Entry is made only in the cash book through the use of a non-cash-discount column on the receipts side. This was also fully explained and illustrated in Chapter XIX. In the illustration given there, this discount column was not used in finding the cash balance, because net cash columns were employed, thus making unnecessary the use of any other column to find the cash balance.
2. Entry is made as in method 1 above, but the discount column is used in finding the cash balance. Where, as sometimes happens, the net cash column is omitted, the true receipts can be found only by subtracting the amount of the discount from the other column totals.
The closing summary for the columnar cash book, explained in Chapter XIX, shows one method of handling the discount column total. While all other summary entries for the cash receipts are credits, the discount summary is a debit. Because of this fact, the discount total is sometimes shown on the disbursements side of the cash book among the summary entries of the other columns, in which case the word “contra” is written after the words “Sales Discount,” showing that the amount has come from the discount column on the opposite page. Similarly for the Purchases Discount.
The only advantage of this method is to bring all summary debit postings on one side of the cash book and all credits on the other. Where the cash book is operated according to method 2, the closing summaries are made as shown in Form 42, using columns on the debit side for Customers, Sales Discount, and Sundry; and on the credit side for Creditors, Purchases Discount, and Sundry. As there is no net cash column, the totals for Customers and Creditors are not all cash. To clear them of their non-cash elements, the discounts can be subtracted from their respective Customers’ and Creditors’ totals, and only the net brought over into the Sundry columns; or the subtraction can be effected by adding the discounts to the opposite side. The use of a Net Cash column simplifies the summarization of the cash book and should always be employed. Treatment 2 is shown only because it is sometimes met with in practice.
=Securing Information as to Neglected Discounts.=—Some accountants have pointed out the desirability of bringing before a manager or proprietor the cost of his failure to take advantage of discounts offered him. To show this cost the following method of entering a purchase has been suggested:
Purchases 100.00 Purchases Discount 5.00 Vendor 105.00
The net amount of the bill is thus charged to Purchases, the discount offered to Purchases Discount, and the Vendor is credited with the billed amount. When payment is made on any of the optional bases offered, entry is made as follows:
(1) Vendor 105.00 Cash 105.00
or
(2) Vendor 105.00 Cash 103.00 Purchases Discount 2.00
In the case of entry (1), the net result of the whole purchase transaction is a loss or expense of the amount in Purchases Discount, because of failure to take the discount. In entry (2), if the best option is taken, viz., the entire 5%, Purchases Discount shows no balance; any less favorable option, say 2%, results in a debit balance in Purchases Discount of 3%, measuring the expense incurred through failure to take the best option. Unquestionably, the information given a manager by this Purchases Discount debit balance will claim his notice and immediate attention.
A sales transaction handled on a similar basis results in a Sales Discount credit balance representing the excess of the offering of discounts over the amount taken by customers and has to be treated as income additional to the booked sales income.
Inasmuch as the sale or purchase, under this method, must be booked on a cash option basis, this treatment seems to result in a departure from true cost or in the mistake of booking only some of the elements which enter into the cost of merchandise. The price at which a merchant can sell his product must include all direct and indirect costs and provide a margin for profit. The sales discount offered is simply one of these indirect costs. It cannot be more accurately estimated than can the salesman’s salary which is a part of the sale price. It is inconsistent practice to separate the invoice price into two elements and term one real selling price and the other sales discount cost when the real selling price is still a composite item. Rather, the sale should be booked at its full invoiced price and actual costs recorded as they accrue, to be closed out against Sales Income at the end of the fiscal period.
After all, the sales policy of each concern enters largely into the determination of its normal selling price. A concern with a normal credit term of 30 days fixes its sale price on that basis; one with a 60-day credit term will, in determining its sale price, take into account the risk and interest costs of the longer credit period; and one doing a cash business will determine its sale price accordingly. However, as a means of furnishing the information necessary for guidance under a particular sales policy, sales should be recorded on the basis of the normal credit term.
To secure the information sought as to neglected discounts, it is suggested that memorandum accounts be opened for that purpose and entry be made of the expense only when incurred. Thus failure to take a purchase discount would be recorded under these or similar captions:
Neglected Purchase Discounts Reserve for Neglected Purchase Discounts
At the time the books are closed these memorandum accounts would be closed against each other, having served their purpose of giving the desired information through their inclusion in the trial balance submitted to the manager or owner.
=Trade Acceptances and Cash Discounts.=—Brief mention should perhaps be made of some recent discussions of the probable effect of the extended use of trade acceptances on the practice of allowing cash discounts. Some sellers, to whom the cash discount practice is troublesome and unsatisfactory, welcome the use of trade acceptances as an avenue of escape from the practice. Others have gone so far as to say that the trade acceptance will eventually do away with cash discounts. It should be said that the use of trade acceptances, while attractive from the seller’s standpoint, has not as yet made a strong appeal to buyers, largely because of the fact that it offers little that the open account method does not secure for them and it may, on the other hand, interfere somewhat with the taking of cash discounts.
XLV. BALANCE SHEET VALUATION
=The Two Problems of the Balance Sheet.=—There are two major problems connected with the balance sheet: (1) the problem of form, and (2) the problem of content. The form of the balance sheet, which was discussed rather fully in Chapter III, has to do with the arrangement of the items for the purpose of intelligent reading. It deals with the principles in accordance with which the asset, liability, and net worth items are to be marshaled and set up in groups and arranged within the group with a view to facilitating the comparisons between groups and the calculations made in judging the financial condition of the concern.
The second problem of the balance sheet, that of content, which was also mentioned in Chapter III, concerns itself mainly with the valuation of the items in the balance sheet, assuming of course that all the assets and liabilities are included in the statement. A balance sheet may be correct in form but, unless its content is reliable, it has little or no value when judged from the standpoint of its chief purpose, namely, that of showing the financial condition of the concern. The problem of the form of the balance sheet has to do with the technical or mechanical side of accounting, while the problem of its content or the valuation of its items has to do with the questions of the concern’s financial administration, for the solution of which the accounting department must furnish in proper form the necessary information.
=Kinds of Value.=—It is first necessary to state the limitations within which the principles of valuation to be laid down are applicable to the commercial balance sheet. In business many different kinds of value are found and used. Thus we have the terms, sale or liquidation value, cost value, and replacement value. By the term “sale value,” when applied to a going business, is meant the value which a willing buyer offers to a willing seller. “Liquidation value” means the value or price offered for a commodity or an entire business when the concern is winding up its affairs and going out of business. Liquidation is, therefore, forced value. There is thus a marked difference between sale value and liquidation value. The term “cost value” is understood to mean the price paid for a purchased article. From the discussion of the principles of debit and credit as applied to merchandise and to fixed assets, it has been shown that the price paid should include not alone the invoice cost but the other expenditures needed to put the article purchased in such a position that it can be used by the business in the customary way. Replacement value means the cost to replace an article. It differs from first cost mainly in that the price level may have changed between the date of the original purchase and the present time. Thus, because of the changes in prices, an article, costing $1,000 in 1914, might have had a replacement cost of $1,800 in 1917, and $1,400 in 1922.
Manifestly, before the principles to be followed in valuing balance sheet items can be laid down, there must be some understanding as to what kind of value is under discussion. The kind of value used in the ordinary commercial balance sheet is termed “going concern value.” By this is meant the value which is applied to a going business—a business which expects to continue in operation, not one which expects to sell out to other owners nor one which expects to discontinue operations.
=Source of Data as to Values.=—In a going concern the information as to value is found chiefly in the books of account. The data in the accounting records are, of course, supported by the original documents evidencing the purchases and sales. It is a necessary corollary that if the books of account are to give reliable information as to values, a correct analysis must be made of all transactions previous to their entry. Mention was made in an earlier chapter of the necessity of a clear differentiation between capital and revenue charges and the effect of failure to make such differentiation. If at the time of an expenditure a correct classification of accounts has been made, particularly of the broad classes of assets, liabilities, and proprietorship, the accounts should reflect the true values as of the various dates of record. For purposes of detailed information it is equally necessary that a correct classification be made of the accounts affected by an entry within any of these main groups. It has been seen that because of practical difficulties no effort is made to have the accounts reflect day by day the correct value of the various items. It is considered sufficient to bring the book record into agreement with the facts in respect to value once each fiscal period, namely, at its close. The true financial condition and correct operating results are then determined.
It will thus be seen that a correct analysis of every transaction recorded in the accounts is an absolute prerequisite to the use of the accounts for determining correct values. It is very vital that a clear line of demarcation be maintained between capital and revenue expenditures—that great care be exercised that no cost is charged into the asset group of accounts unless such cost really enhances the worth of an asset. A cost incurred for the purpose of maintaining the value of the asset is an expense charge, and repairs and maintenance charges must be very carefully distinguished from replacements. Maintenance has to do with those costs which maintain an asset in good operating condition; repairs have to do with those costs necessary to put an asset in operating condition after a condition of inefficiency has been reached which the maintenance costs have not been able to prevent; a replacement cost is incurred when it becomes necessary to replace some part or the whole of an asset, neither maintenance cost nor repair costs having been able to maintain the asset in efficient operating condition. Where only a part of an asset is to be replaced, it is often spoken of as a renewal of parts. When so used, the term “replacement” is limited to the renewal or the replacement of the whole asset.
When a renewal or replacement is made, it becomes necessary to determine whether the cost of the renewal or replacement is more than the cost of the part or the whole replaced. For example, if an asset costing originally $1,000 is replaced by one costing $1,200, there has manifestly been an addition of $200 to the value of the asset. The new asset may be an exact duplicate of the old but if prices have risen so that the new actually costs more than the old, the books must record the asset at its new cost value. The amount by which a new asset or part of an asset exceeds the cost of the old asset or old part is called a betterment. A betterment is always an asset.
The student will readily see that at times it must be difficult to draw the line between repairs and replacements. In practice the line is usually drawn only when the expenditure exceeds a certain amount. This amount is not uniform and is determined by each individual business. For example, when the cost of placing the asset in efficient condition for operation is less than, say, $100, it is charged as repair cost and therefore does not increase the book value of the asset. If the cost exceeds $100, an analysis is made to determine what portion of it, if any, increases the value of the asset. The amount of the betterment is of course a charge to the asset account, while the rest of it is a charge to some expense account.
=Treatment of Special Items.=—In the determination of the classification of charges, some kinds of items require special consideration:
ORGANIZATION EXPENSE. The group of expenditures explained in Chapter XXXVIII, as incident to the organization of a corporation, is recorded under the title “Organization Expenses” and is classified for purposes of the balance sheet as an asset. It is a kind of asset, however, which has no tangible value and most businesses desire to consider it more in the nature of a deferred charge to operations. It is recognized that frequently intangible assets add no strength to the business. While, therefore, in strict theory organization expenses are assets, in practice it is best to write them off against income during a period of from three to five years.
COST-CUTTING CHANGES. Another similar class of charges is met in costs incurred in making changes in the arrangement of building and other facilities which will tend to bring about a more economical handling of some phases of the business; for example, a rearrangement of a receiving and packing room in order to facilitate the receipt and delivery of goods. Where these costs are inconsiderable it is best to charge them against the income of the period in which they are incurred. Where, however, a big expenditure is necessary, it seems best to set the costs up under a suitable descriptive title and spread them over several periods. In other words, at the date of their incurrence the costs are treated as an asset whose value is to be written down at the end of successive fiscal periods until finally it has all been charged against the operations of the business.
INTEREST DURING CONSTRUCTION PERIOD. Where a business builds its own home, all costs incurred during the period of construction are proper charges to the costs of the construction. Thus, if a mortgage or bond issue is used as a means of partially financing construction of the building, the interest paid to the mortgagee or bondholders during the period of construction is a proper charge to the building account. Costs of this kind follow the general principle laid down previously, that all costs up to the point of placing the asset in condition ready for use are proper charges to the asset.
=Basic Rules for Valuation of Balance Sheet Groups.=—We may now consider the principles applicable to the valuation of the various groups on the balance sheet. In the standard form of balance sheet the assets are divided into the three groups: (1) Current, (2) Deferred Charges, and (3) Fixed.
It has been seen that the assets of the current group are used for purposes of settling debts, the payment of expenses, and the purchase of merchandise. In judging the sufficiency of these assets for this purpose, it is absolutely essential to know that the values at which they are carried will be realized when they are converted into cash. From the standpoint of conservative business management an understatement of realizable value may be made, but never an overstatement. Accordingly, the fundamental principle of valuation applicable to this group is that these assets are to be valued at cost or market, whichever is the lower. When so valued, the figures at which they are carried in the balance sheet will usually represent an amount slightly less than the amount which it is expected will be realized from their conversion into cash.
The function of the deferred charges group of assets is to secure an equitable distribution of expense charges between the current and the following period. It is only because certain expenditures have been made during the current period which will benefit the succeeding period, that it is necessary to set up this group of assets. Here the problem of valuation is, therefore, simply the problem of dividing the cost of the expenditures between the current and the next period on the basis of the benefits accruing to each. In some cases the basis of division is one of time, as where an insurance policy is purchased for a definite term. The portion of the policy which has expired during the current period is the portion of its cost to be charged to the current period, the balance being deferred to succeeding periods and therefore carried as an asset. In other cases a physical inventory is necessary to determine the distribution of the cost of expenditures, as when supplies of fuel have been purchased and not entirely consumed during the current period. The basis of the value carried over to the next period is of course a fair portion of the original cost. Market or replacement cost does not have any effect on the valuation of the deferred portion.
Fixed assets are acquired as more or less permanent equipment without which it is impossible to operate the business. The time during which an asset continues in use is the customary basis for a classification of its cost as between expenses and fixed assets. Thus, an asset acquired for purposes of business operation which, however, will be used up completely during the current period is charged immediately to some expense account, whereas an asset which will continue in use over several periods is charged to an asset account. Fixed asset purchases are never for purposes of resale. It is expected that they will continue in use until they are discarded because of failure to perform the service for which they were acquired. Neither the sale value nor the replacement cost value of such assets has, therefore, any influence on their value to the business. That value is the full cost adjusted periodically by an equitable distribution of that cost over the operations of the periods benefited by the services rendered by the asset. This principle of valuation is usually expressed by the formula, cost less depreciation.
=Valuation of Assets=
CASH. Cash as carried on the balance sheet is the asset which is used, without conversion, for payment of the liabilities of the business. There should, therefore, ordinarily be no problem of valuation. However, because of the practice of including checks, drafts and notes due and in course of collection, cash balances held abroad and therefore subject to the fluctuations of exchange, and other similar items in the account Cash, it is oftentimes necessary to examine all these items carefully and arrive at a figure which represents the amount expected to be realized from them.
NOTES AND ACCOUNTS RECEIVABLE. The claims against customers, both on note and open accounts, constitute an intermediate step in the conversion of merchandise into cash. At the time credit is extended to a customer it is expected that he will pay the amount due. The experience of every business man shows, however, that during each period there is a shrinkage in these claims due to some customers failing to pay the amounts they owe. In valuing these claims it is therefore necessary to take cognizance of the amount of the shrinkage. This amount is different in different businesses, depending on the length of the credit term, the policy as to investigation of credit risks, and on the rigor of the collections policy. On the basis of the experience within a given business, it is therefore necessary to make an estimate of the loss from uncollectible accounts.
The manner of making the record of estimated bad debts has already been explained. The reason for placing the amount by which the asset is estimated to shrink as a credit in the Reserve for Doubtful Accounts account rather than in the Accounts Receivable account has also been explained. The custom of estimating the amount of loss on the basis of the sales for the period rather than on the amount of claims outstanding at the close of the fiscal period has been referred to. Here it is desired to explain the manner of handling the reserve at the time claims are definitely determined uncollectible. Until a claim is determined uncollectible it is carried as a part of the assets, Notes or Accounts Receivable. The amount of the estimated shrinkage in these assets due to failure to collect claims is indicated by the Reserve for Doubtful Accounts account. This amount cannot be applied directly to particular notes and accounts until it is definitely known that such notes and accounts cannot be collected. When that is learned, it is necessary to transfer from the reserve account the amount needed to cancel from the books the uncollectible notes and accounts receivable. This is done by the following entry:
Reserve for Doubtful Accounts Notes (and Accounts) Receivable
PROBLEM. Assume that the accounts receivable amount to $75,000, of which it is estimated that $5,000 will not be collectible. During the succeeding period a customer owing $500 becomes bankrupt and nothing is realized on his account.
The accounts will then appear as follows:
ACCOUNTS RECEIVABLE ============================================================= Dec. 31 75,000.00 | Feb. 28 500.00
RESERVE FOR DOUBTFUL ACCOUNTS ============================================================= Feb. 28 500.00 | Dec. 31 5,000.00
It will thus be seen that the decrease in value of the accounts receivable as estimated by the amount in the Reserve for Doubtful Accounts can never be applied to the asset until it is definitely determined what particular customer’s account included in the Accounts Receivable account is bad and must therefore be written off the books. Inasmuch as the Bad Debts account set up at the close of each fiscal period to indicate the loss or expense due to uncollectible accounts, has been charged as an expense of operating for that period, it would manifestly be duplicating the expense charge if a debt that proved bad were charged to the Bad Debts account rather than to the Reserve for Doubtful Accounts. Only during the first period of operation of a business are debts, if determined bad during that period, charged to the Bad Debts account. Even here, if it is expected at the close of the first period to base the estimate of uncollectible accounts on the sales for the period rather than on the amount of outstanding accounts at the end of the period, it would be necessary to charge the debts becoming bad during the period against the Reserve for Doubtful Accounts account—even though at the time of the charge it contained no credit entries—and not to the Bad Debts account. The desirability of establishing a standard routine for the handling of all items should be kept in mind. Best practice, therefore, demands that all debts shall be charged against the Reserve for Doubtful Accounts whenever they are determined to be bad, regardless of the amount held in reserve in that account. If such practice creates a debit balance in the Reserve for Doubtful Accounts, it is an indication that the estimate of uncollectible accounts made in previous periods has not, as a matter of fact, been sufficient and a larger estimate must be made for future periods.
MERCHANDISE. Merchandise is purchased for the purpose of resale at a profit. Sale price is dependent, in a free market, on the force of demand and supply and not at any given time on cost. Until the goods are sold no profit, as a matter of fact, has been secured. Conservatism, therefore, demands that sale price should not ordinarily be used as the basis for the inventory valuation. Unless there has been a decided change in prices, it is the confident expectation of the management that at least the cost price of the merchandise will be realized when the goods are sold. Ordinarily, therefore, merchandise will be priced in the balance sheet at cost. When, however, there has been a change in price levels, particularly when the indication is that there is a generally declining market and not simply a temporary fluctuation in prices, it is the part of conservatism to value the merchandise at its replacement cost, or even at a lower figure, if stocks are large and market conditions are such that customers are withholding their purchases until price levels have dropped still further. The basic principle for valuing all current assets requires that they be valued as nearly as possible at the realization figure. Therefore, the amount expected to be realized governs or influences the valuation basis. The valuation formula or rule-of-thumb method, in accordance with which merchandise inventory is usually valued, is expressed as cost or market, whichever is the lower. As indicated above, there are times when exception is taken to this basis.
INVESTMENTS. Stocks and bonds representing the investment of temporary surpluses of cash are valued on a realization basis. Inasmuch as the tying up of cash in these securities is only temporary and it is expected that they will be converted again into cash as needed, the amount which can be realized from their sale on the date of the balance sheet is the amount to be considered when judging the financial condition on that date. A large amount of discretion must be used in valuing these securities, because of the violent fluctuations to which quotations on the various stock exchanges are subject. Here also conservatism does not usually authorize value at the market if the market is higher than the cost. Accordingly, the valuation formula is cost or market, whichever is the lower.
ACCRUED INCOME. The income accrued on the date of the balance sheet is determined on the basis of a fair distribution between the periods during which the income accrues. Thus, the income from money loaned during the current period but not due until a succeeding period must be distributed over two or more periods. Where the income is dependent on time, the portion applicable to the current period is determined on a time basis. Where the income is dependent on some other basis, such as sales or units of work done, the portion applicable to the current period is determined by the ratio of the whole to the amount completed during the present period. Thus, in the case of a contract entered into to sell goods on a commission basis, the commission income accrued during the current period will usually be based on the amount of sales made during that period.
DEFERRED CHARGES. The valuation principle for deferred charges has been stated above in connection with the principles of valuation to be applied to the various groups of accounts on the balance sheet.
FIXED ASSETS. Fixed assets may usually be divided into two classes: (1) assets not subject to depreciation, and (2) assets subject to depreciation. The usual example of assets not subject to depreciation is the land on which a building stands. Land used for growing crops may easily be subject to depreciation. Land subject to the exploitation of the natural resources under its surface is similarly subject to depreciation. To distinguish the decrease in value of such natural resources because of the fact that they enter into and become a part of the commodity dealt in, the term “depletion” is used. Thus, a coal mine or oil well decreases in value with every unit of product taken therefrom. It is not purposed hero to discuss the principles of valuation applicable in such cases, the assets under discussion being limited in meaning to those of a mercantile business. (See Volume II, page 312, for a discussion of depletion.)
The valuation formula for assets not subject to depreciation is cost. Increase in value due to changed market conditions is not usually to be taken account of.
The second group of assets, those subject to depreciation, are to be valued on the basis of original cost less the amount of depreciation accrued to the date of the balance sheet. The valuation of such assets, therefore, requires the determination of the amount of depreciation.
Depreciation arises from several causes, the chief of which are:
1. Wear and tear, due to use. 2. Decrepitude or age, due to lapse of time. 3. Obsolescence, due to a changed demand for the article or to an advance in the arts which makes the continued use of the asset uneconomical. 4. Inadequacy, brought about by several causes, one of which may be the change in the market which renders the asset inadequate for furnishing the product or service in the amount required.
Obsolescence and inadequacy, because of their very nature, are usually difficult of determination and frequently cannot therefore be considered in determining the amount of depreciation accrued at a given time. Where measurable they should, of course, be taken into account. Depreciation due to lapse of time is calculable on a time basis. Depreciation due to wear and tear is calculable on the basis of the use to which the asset has been subjected. It is in practice difficult to separate these two types of depreciation. The estimate for depreciation is in the majority of cases made on a time basis. In manufacturing establishments, oftentimes a use or output basis proves more satisfactory. These more difficult problems met in the determination of depreciation are discussed in Volume II. Here only the most usual method of depreciation estimate on a time basis, known as the straight-line method, will be explained.
For determining the periodic amount of depreciation of any asset it is necessary to know: (1) the original cost of the asset; (2) its scrap value, that is, the estimated value as scrap on the day it is junked; and (3) the estimated life of the asset in years or fiscal periods. The following symbols will be used in working out the formula:
V₁ = Original value. Vₙ = Scrap value at the end of n years, its estimated life. n = The estimated number of years in the life of the asset. D = The amount of depreciation during a period. r = The rate to be applied to V₁ in order to determine D.
It is apparent that V₁-Vₙ is the amount to be depreciated over the life of the asset. The amount to be charged off periodically as depreciation is, therefore:
(V₁ - Vₙ) ------------ n
Accordingly
V₁ - Vₙ D = ----------- (1) n
The amount to be written off each year is thus seen to be constant. The percentage to be applied to the original cost in order to determine the periodic depreciation D is, therefore, found by dividing D by V₁. Hence the formula:
D r = ---- (2) V₁
Having determined by careful estimate the method of calculating the periodic amount of depreciation, the problem of valuation of the asset at any given time during its life is ordinarily simple. In the case of renewal of any parts, the question of betterment comes in and requires careful handling. In unusual cases it may often be necessary to revise the rate of depreciation in order to write off the betterment during the remaining life of the asset. Depreciation is at the best but an estimate and unless there are major betterment items it is not usually necessary because of them to revise the estimate of depreciation. When a renewal takes place it is theoretically necessary to determine the value of the replaced part at the time of its replacement. The excess of the cost of the new part over this value is the amount of the betterment, when only the values of the old and new parts are considered. In such cases, however, the new part will not usually have value apart from the asset to which it is attached. In practice, therefore, the amount of the betterment recorded is the difference between original—not present—value of the old part and the cost of the new part. An example will illustrate the problems involved and the accounting treatment.
PROBLEM. Assume that an asset—office equipment—costing $1,000 has an estimated life of ten years and no scrap value. After six years of this life it becomes necessary to replace a part of the asset, estimated to have cost originally $100, the cost of the new part being $150. At the time of the replacement the depreciation reserve carries an amount of $600.
The first step in booking the transaction is to transfer from the reserve account to the asset account the original cost of the part replaced. Just as in the case of bad debts, now that a part of the asset has been discarded and the amount of the decrease in value of the asset is definitely known, this amount held in suspense until the present time in the reserve account must be applied as a definite reduction in the carrying value of the asset. The entry to effect the transfer is:
Depreciation Reserve, Office Appliances 100.00 Office Appliances 100.00
The next step is to set up the cost of the new part which replaces that discarded. This follows the usual entry at the time of purchase of any equipment. The entry needed is:
Office Appliances 150.00 Cash 150.00
The student will note that the office appliances account now carries a value of $1,050, of which the $50 represents the value of the betterment.
It might appear that since the renewal occurs at the end of six years there has been accumulated in the reserve by that time only $60 covering this specific part, and that therefore only $60 should be transferred from the reserve account, the other $40 being charged to a proprietorship account to represent the additional expense or loss not yet provided for by the depreciation charges during the past six years. That is not the situation, however, for if the periodic depreciation has been correctly estimated, the entire amount, $100, has already been charged off and is therefore included in the reserve. When the asset was originally installed and the length of its life estimated for the purpose of determining the periodic depreciation charge, the policy as to repairs and renewal of parts was taken into consideration. Such estimates cannot, of course, be absolutely accurate. However, until such time as a definite basis is given on which to check the amount of the over-or under-estimate, it is the standard practice to charge against the reserve the original value of the renewed part. Always at the time of discard of the entire asset—and sometimes sooner—such a definite basis is given and adjustment must be made in accordance with the facts then ascertained. A problem will illustrate the considerations involved.
Continuing the foregoing example, assume that the office appliance, now valued at $1,050 with a reserve of $500, is discarded after ten and a half years’ service.
At the end of the tenth year the annual depreciation charge of $105 will have brought the reserve account to a total of $920. Six months later, at the time of discard of the asset, there will be accrued depreciation, not yet booked, amounting to $52.50. It is, accordingly, necessary to book this amount by means of the following entry:
Depreciation 52.50 Depreciation Reserve Office Appliances 52.50
This entry charges the current period with its share of the consumed value of the asset. The next step is to transfer the reserve account to the asset account, to show in that account the amount of the inaccuracy in the depreciation estimate—the amount by which the actual depreciation differs from the estimate. The entry is:
Depreciation Reserve Office Appliances 972.50 Office Appliances 972.50
The office appliance account now shows a debit balance of $77.50, which indicates the value or amount of the asset which has been consumed but which has not been charged against the income of the periods during which the asset was used. It is manifestly inequitable to charge this amount against the income of the six months of the current period, and it is impossible to go back and spread it over the previous periods because their records have been closed. The charge must therefore be made direct to the Surplus account in the case of a corporation, or to a final section for extraordinary profits and losses of the regular Profit and Loss account in other cases. It may be handled by this latter method also in the case of a corporation. The entry needed is, therefore:
Surplus 77.50 Office Appliances 77.50
In case the reserve is more than the value of the asset at the time of discard, it means that more than the cost of the asset has been charged as expense. Accordingly, the excess represents real profit and must be transferred to surplus. The necessary entry is:
Office Appliances Surplus
GOOD-WILL. Good-will is an intangible asset depending for its value upon the ability of a business to make more than normal profits. It is not usual for a business to show an asset of good-will unless it has purchased another business and has paid for the latter’s good-will. In other words, good-will is not brought on to the books until a purchase determines its market value. Where good-will is purchased, it is customary to carry it at its cost value. Depreciation is not taken into account. Because of the intangible nature of good-will and its more or less speculative value, some businesses prefer not to show it. In such cases it may be written off against surplus at any time and in any amount until it has all disappeared from the books. While, therefore, good-will is not subject to depreciation, it is subject to this writing off process, which usually bears little or no relationship to time. It should not be charged against the profit of any period or several periods, but when written off should be charged direct against surplus.
=Liabilities.=—The problem of valuation of liabilities is simple. From the standpoint of a going concern, its liabilities decrease only when they are paid off, and increase only because of services or assets purchased and not paid for. The main problem in connection with balance sheet liabilities is the determination of the fact that all liabilities are shown on the balance sheet. This oftentimes involves the consideration of contingent liabilities. The amount of a liability may sometimes be in dispute, in which case a careful and conservative estimate of the probable amount must be made and shown.
=Proprietorship.=—Since proprietorship is always the difference between assets and liabilities, the problems of valuation of proprietorship are solved almost automatically if the valuation of assets and liabilities have been handled properly. There may sometimes be problems in connection with the various items in the proprietorship group. These concern surplus, undivided profits, and various reserves. The problems here are largely those of determining whether a company has lived up to its contract or other agreements in the maintenance of the proper values in the various proprietorship accounts.
=Conclusion.=—The problems of valuation are vital to any business and intimately concern its financial integrity. In order to maintain at least the original capital investment in a business, it is necessary to make provision for the decrease in asset values due to different causes. The financial management of the business must watch this feature closely, else capital will be dissipated and the business rendered incapable of performing the functions for which it was organized.
XLVI. BUYING AND STOCK CONTROL
=Importance of Buying.=—Buying as a major function in a mercantile concern is intimately related to, and dependent on, the other functions of the business. Buying must always have regard to the sales activities. To buy without reference to the ability to sell is suicidal. Both overbuying—buying more than can be disposed of at a profit—and underbuying—buying less than is needed to meet the sales demand—are conditions to be avoided. Underbuying means a loss of sales. Unless their needs are met promptly in accordance with their orders, customers will go elsewhere. Overbuying means the unnecessary tying up of capital in a stock of goods which increases the possibilities of loss resulting from changes in fashions and the level of prices. The relation of the rate of turnover to profits in merchandising was discussed in Chapter VII. Manifestly the ideal situation, so far as the amount of stock carried is concerned, is one in which the least amount of capital is used to provide an adequate stock for meeting the requirements of customers and in which the loss from unsalable stock is reduced to the lowest level.
Many business houses fail to realize the wastes resulting from slow turnovers. The Chamber of Commerce of the United States has called attention to these losses and has analyzed them under the following heads:
1. The unnecessary use of capital in merchandise that could be more profitably employed in other productive sources.
2. The increased cost of borrowed capital, the carrying of larger stocks and their slow turnover, necessitating the borrowing of larger amounts of capital for longer periods.
3. The marking down of the sale price due to the fact that the goods will not move at the higher sale price.
4. An increase in overhead expenses due to the larger storage and display equipment needed for goods and to the costs incident to handling the larger stock, and re-marking the stock when it is necessary to lower sale prices.
5. The loss of prestige and reputation from carrying unstylish and shopworn goods.
=Relation between Buying and Finance.=—From what has already been said, it is evident that there is a very necessary relation between the buying policy of a business and its ability to finance purchases. Even though it may be possible to increase sales, unless the business is in a position to finance not only the additional credits extended to customers but also the additional purchases needed to take care of the increased sales, it will not be feasible to pursue a policy of sales expansion and therefore of increased buying. Hence, buying cannot be considered as a business activity by itself, but as one dependent upon the sales activities and the financial resources of the business.
=Organization for Buying.=—In large merchandising businesses the duties and authority of the buying department are not uniform. In some, this department is organized entirely distinct from the selling department; in others (and this is particularly true of the large department stores), the buyer is head merchandise man with control over the selling activities of the business. It is also quite usual for the buyer to be in charge of a given department and his success or failure to be judged by the profits he makes in that department. A profit quota is sometimes assigned to each department, for which the buyer is responsible. In other words, in the management of the buying and selling activities and therefore in the control of his merchandise stock the buyer is supreme, subject to the general limitations placed by the financial resources at his disposal. Under the control of the buyer, therefore, will be stock clerks, the clerks which mark and re-mark the merchandise, and the sales force. Above and in control of all the departmental buyers is usually an executive or high official of the company whose chief function is to correlate the activities of the buyers with the concern’s general buying, selling, and financial policy.
=Characteristics of the Buyer.=—To perform his functions properly, the buyer must be a man of broad experience, with a keen sense of values and the marketing possibilities of merchandise. On the buying side he must have complete information as to the available sources of the merchandise he desires to secure, both in staple and in novelty lines. On the selling side he must know the demands of his customers and the possibility of creating new demands. The best index of the buying power of his customers is the volume of sales made in previous years. Past performance, considered in connection with general trade conditions and plans for the further development of the business, is the only basis for judging the sales possibilities of the future. He must know the quality of merchandise and the reliability of the people from whom he buys. He must be a keen judge of prices. He must know the financial resources of his own store and strive to secure the best possible credit and discount terms.
=Buying Procedure.=—In Chapter XXII, where the goods invoice was discussed, a typical purchasing procedure was set forth. Here only the chief points in that procedure will be mentioned. In a large establishment the buying requisition should be the basis of all purchase orders. This is particularly true when the buyer does the buying for several departments. The requisition should be made out in triplicate by the department head, two copies going to the buyer and one being retained in the department. Upon the issuance of the buying order, the second copy of the requisition is returned to the department as evidence that the goods have been ordered.
The purchase orders are made in manifold, the original going to the vendor, one copy to the treasurer to notify him of the future need for funds, one to the controller or accounting department, and one being retained by the buyer as a basis for follow-up. Upon receipt of the invoice, which usually precedes the goods, the buyer compares it with the order and if it is found correct, he passes it to the accounting department, where it is held until the receiving slip, showing the receipt of goods, is received from the receiving room. If the three documents now in possession of the accounting department, namely, the copy of the original order, the invoice, and the receiving slip, agree, the invoice is passed for entry on the books and is filed for payment in accordance with the financial policy of the business. After payment, the invoice with its supporting documents is filed. Great care must be exercised to make sure that an invoice is not put through more than once for payment and that every invoice represents goods properly ordered and actually received.
=Requirements of Successful Buying.=—Successful buying rests on a knowledge of two things: (1) when to buy, and (2) what to buy. The timeliness of buying has regard rather to the sales requirements than the market possibilities. Goods are bought for the purpose of satisfying needs of customers. A knowledge of the trend of the market is necessary but buying wholly in accordance with market trends too often leads to speculation in merchandise, due weight not being given to the sales requirements. A knowledge of the specific commodities needed to satisfy the requirements of customers is equally important. The regular use of the “want slips” of customers calling for goods not in stock is one source of information. The records of the paid “shoppers” as to the commodities and prices of competitors is also some indication.
In answering both these questions, when to buy and what to buy, the records of the business itself should furnish the fundamental information needed to secure a proper control of the movement of merchandise. Some system of perpetual inventory is almost indispensable. In a small business where the buyer, usually the owner, is in intimate contact with all departments, a fairly satisfactory control of merchandise can be secured without a perpetual inventory. In a business of some size, however, the perpetual inventory is an almost absolute essential if movement of stock is to be kept under control.
=Control of Merchandise Movement.=—The beginning of merchandise control is the fixing of the sales quota, that is, the making of an estimate of sales for the next period. Without a definite goal to be aimed at control is impossible. Buying and finance are dependent on it. A knowledge of the stock on hand at any time is needed to determine the buying requirements. Even in a small business the inventory can at least be estimated on the basis of past performance as to percentage of gross profit and therefore the percentage of cost of goods sold. The application of this figure of percentage of cost of goods sold to the sales for the period gives the cost of goods sold, which, subtracted from the opening inventory plus goods purchased, gives an estimate of the goods in stock. A perpetual inventory kept by quantities rather than by values serves the purpose in many establishments. What is known as the “retail system,” by means of which the value of the stock on hand can be estimated at any time, is used in many large retail establishments. In addition to, and in conjunction with such a system, the use of commodity control cards, as illustrated in Form 43, gives a sure index of the condition of stock and the movement of merchandise at any time.
=The Retail Method of Inventory.=—The retail system of inventory is based on the carrying of all goods purchased at a retail sale price as well as at cost price. In the financial records purchases are, of course, always booked at cost. A stock record is kept, however, which carries purchases at retail sale price as well as at cost price. The principle of the perpetual inventory under this method is shown by the fundamental formula:
Opening Inventory + Purchases - Cost of Goods Sold = Final Inventory
It is apparent that if all the values on the left side of the equation are retail sale values, the right side of the equation represents the final inventory valued at the retail sale price. Thus, if the opening inventory for use in the stock record is set up at the marked sale price, and purchases are similarly set up, the subtraction of the sales to date from the sum of the opening inventory and purchases gives the amount of stock on hand valued at the sale price.
In order to reduce an inventory, valued at retail sale price, to a cost basis, the per cent of mark-on of the cost price to give the original sale price must be applied. This per cent is based on the sale price and not the cost price, being determined by dividing the difference between sale and cost price (that is, the gross profit figure) by the sale price. Thus, a commodity, costing $60 and marked to sell at $100, will, if sold, yield a gross profit of $40, which, given in terms of the sale price, is a 40% gross profit. This 40% is spoken of as the “mark-on per cent.” The cost is, therefore, the difference between 100% and the per cent of mark-on, in this case 60%. That is, 60% of the sale price gives the cost price.
Accordingly, to reduce the inventory value at selling price to a cost price basis, it must be multiplied by 100% minus the per cent of mark-on.
The use of the retail method is thus seen to require a stock record from which the goods on hand as valued at selling price can be determined almost instantly and from which the per cent of mark-on can also be determined. In principle the method is simple. In practice it must be operated very carefully, else unreliable results will be secured. It seldom happens that merchandise will always move at the marked sale price. Adjustments are necessary. On an upward market, perhaps, a higher price can be secured than the marked price. On a downward market or in order to move certain colors and styles, it is necessary to mark down from the original sale price. The fluctuations arising from mark-ups and mark-downs are treated in Chapter XI of Volume III and will not be discussed here. Some applications of the retail method will be explained, however.
=Some Buying Records and Their Use.=—The chief purpose of the main records kept in business is the securing of control over the activities of the business. The control over merchandise must always be based on records. The first step in securing the necessary control is a proper departmentization of stock. Analysis of purchases and sales by departments is fundamental. In addition, a knowledge of what others in the same line are doing serves as a criterion by which to judge one’s own results. Trade associations and research bureaus are giving invaluable information by furnishing standards for judging results.
Three major problems from the buyer’s standpoint are always met. They are not independent problems but, as indicated above, are intimately related to selling and financial policies. These problems are: (1) the determination of the average stock to be carried; (2) the determination of the buying quota for a given period; and (3) the determination of the “open-to-buy” amount at a given time. Too often these matters are decided in a haphazard fashion. Only by means of a careful analysis of all the factors and the results obtained in the various departments as compared with average or standard results can a sound basis of stock control be secured.
=Average Stock to be Carried.=—Stock control rests, in the first place, on estimated requirements for the future. Estimates for the future must always be based on past performance, as modified by present market conditions and contemplated changes in basic merchandising policies. In estimating the amount of stock to be carried, the volume of expected sales must be taken into account. The other factor is the rate at which the merchandise should turn during the period. Thus, if estimates are made for a period of six months, the estimated sales for the period divided by the number of times the stock is expected to turn during the six months will give the average amount of stock to be kept on hand. Seasonal fluctuations must be taken cognizance of in determining the changes from average stocks to be carried at particular times during the period. Thus, if the estimated sales in a given department are $50,000 for the next six months and the merchandise turns twice during that time, manifestly a stock of $25,000, as priced at retail, must be carried. If the mark-on is 40%, the cost of the average stock will be 60% of $25,000, or $15,000, representing the average capital to be tied up in stock for that department.
=The Buying Quota.=—The determination of a buying quota for a given period must take cognizance of the stock on hand at the beginning of the period, the stock which it is planned to have on hand at the end of the period, and the estimated sales for the period. If, from the sum of the stock planned to be on hand at the end of the period and the sales estimate for the period is subtracted the stock on hand at the beginning of the period, the buying quota for the period is determined. This buying quota is, of course, at retail price and must be reduced by use of the mark-on percentage to a cost basis. An illustration will show the method:
Stock planned to be on hand at end of period $25,000 Estimated sales for period 50,000 ------- $75,000 Stock on hand at beginning of period 23,000 ------- Buying quota at retail price $52,000 ------- Mark-on is 40%, i.e., cost is 60% of selling price. Therefore $31,200 = buying quota at cost
=The “Open-to-Buy” Estimate.=—The buying quota is estimated at the beginning of the period. At various times throughout the period, if stock is to be properly controlled, it is necessary to know how much of the buying quota is available. Furthermore, because estimates made at the beginning of the period never quite coincide with the facts of actual performance, it is necessary to take cognizance of these data of performance in determining the amount of stock to be bought at a given time. The difference between the estimated sales for the period and the actual sales to date is the estimated sales to be made during the remainder of the period. If from the stock on hand at a given date is subtracted the estimated sales for the rest of the period, the difference will be the estimated stock remaining on hand at the end of the period, providing no more purchases are made. If this amount is less than the amount of stock planned to be on hand at the end of the period, the department is “open-to-buy” to the amount of the difference. If the estimated amount on hand at the end of the period is more than the planned inventory for the end of the period, no additional stock should be purchased, except of course to replenish certain stocks which have become depleted and which it is necessary to have on hand to meet the needs of customers. In calculating the stock on hand at a given time, cognizance must be taken of stock in the warehouse, in transit, and on order. A typical open-to-buy calculation is shown below:
Stock on hand today $ 40,000.00 Stock in warehouse 15,000.00 Stock in transit 10,000.00 Stock ordered (to be received before end of period) 25,000.00 ----------- Total available stock $90,000.00
Sales planned for period $175,000.00 Sales made to date 105,000.00 ----------- Estimated sales for balance of the period 70,000.00 ---------- Estimated stock at end of the period $20,000.00 Planned stock at end of the period 30,000.00 ---------- Open-to-buy amount $10,000.00 ==========
This open-to-buy figure should be amended in the light of experience with regard to the way in which actual sales are running as compared with the estimated sales. If it is apparent that the sales are running ahead of the estimate, the sales quota should be enlarged accordingly, which will in turn increase the open-to-buy balance. A similar adjustment should be made in the event that actual sales are not keeping pace with the estimated quota.
=The Stock Control Card.=—The problem of stock control is not solved solely by a maintenance of buying quotas and limits. The movement of individual commodities must be watched very closely. The tying up of funds in large stocks of slow moving commodities may soon use up the buying quota needed for faster moving commodities. To maintain control over the movement of individual commodities, a record called the “stock control card,” which is similar to the stock book, is of great value in some lines. To other lines it will not be found adaptable. It is not the purpose of this chapter to attempt to lay down specific methods adaptable to all situations but only to discuss basic principles and to illustrate them by methods found applicable to certain situations. The control card illustrated in Form 43 is one used in a retail shoe store.
On the form shown as Form 43, Style, Bought From, Description, and Material, are self-explanatory. On the line below, cost is shown in the first column, size in the next, and the month with days along the rest of the line follows. Horizontally are entered on the dates shown the quantities of stock received (Rec’d), on hand (O. H.), sold (Sold), and on order (O. O.).
According to the form, on August 1 there were on hand 19 pairs of shoes, size 9, and 11 pairs of size 9½. During that week, on consecutive days, 3, 4, 3, 6, 2 pairs of size 9 shoes were sold, of which 2 pairs (circled) were returned on the 4th and 5th; and 2, 2, 1, 3, 4 pairs of size 9½ shoes were sold, of which 1 pair was returned but again sold on the 5th.
On the first day of the following week 24 pairs of each size which had been ordered on the 2d of August were received. Upon their receipt the O. O. (on order) figures were inclosed in circles. On that day also the O. H. (on hand) figure was placed in its proper place in the size 9 group. All of size 9½ had been sold during the first week of August and there was of course no figure to be entered there.
The record is continued by daily postings of sales and by a weekly posting or entering of the stock on hand. Orders are entered on the day they are placed.
With such a stock record a perpetual inventory is maintained and control over the movement of merchandise is secured.
=Problems Connected with the Merchandise Inventory.=—Proper accounting for merchandise at the time of inventory-taking and the close of the fiscal period requires a consideration of the following points:
GOODS IN TRANSIT. It may happen that certain goods have been ordered during the period, and that the invoice has been received but that the goods themselves are still in transit. The question whether or not such goods shall be included in the inventory may be viewed from different angles, as follows:
1. If the goods have been paid for in advance, they have undoubtedly been entered on the books as a charge to Purchases. If this is the case, the goods in transit must of course be included in the inventory as if actually received.
2. If the goods are still in transit but have not been paid for, it is customary not to charge them to Purchases until they arrive. If not charged to Purchases, or other similar account, they must not be included in the inventory. However, theoretically, this method is incorrect. The fact that the goods have been ordered and are now in transit makes the business liable for their purchase price, and although not actually received, in reality they form a part of the asset merchandise. It is true that until the goods are received, inspected, and accepted, the purchaser has the privilege of refusing them if they are not as ordered, but this privilege is exercised only in exceptional cases. Generally speaking, therefore, it is better to consider such goods as a completed purchase, include them in the inventory and credit the vendor for the amount of his invoice. Instead of being charged to Purchases account, such goods may be charged to Purchase Commitments which will better indicate their status.
GOODS RECEIVED BUT NOT YET BOOKED. In concerns where a separate shipping and receiving department is maintained, it may happen that the goods received by this department are not immediately transferred to stock or storage, in which case they may not have been taken up on the books. At the end of the period it is important to see that all such goods are properly recorded as purchased and are included in the inventory.
GOODS IN OR OUT ON CONSIGNMENT. Still another problem in connection with the inventory has to do with goods which do not belong to the business because they have been consigned to it for sale on account of their owner. Inward consigned goods must not be included in the inventory, if taken into stock, it is very important that they be so marked as easily to distinguish them from the regular stock.
Similarly, if goods are out on consignment to another market, they still belong to the business and must not be overlooked at inventory time. If the proper record is made at the time the goods are shipped, as will be explained in Chapter XLVIII, the memorandum accounts on the ledger will call attention to them. In some concerns all such goods are entered as sales at the time of shipment. If at the end of the period part of these consigned goods are still unsold and in the hands of agents, they should be deducted from the sales for the period and included in the inventory at full cost.
GOODS FOR FUTURE DELIVERY. Goods sold for future delivery are best handled at inventory time in the manner suggested in Chapter XLVII, even if they are set aside ready for delivery.
GOODS READY FOR CURRENT DELIVERY. Finally, goods sold for current shipment but delayed in delivery on account of congestion in the service or for some other cause are best treated as sales and excluded from the inventory.
XLVII. SALES
=Importance of the Sales Department.=—Of the major departments into which business activities are commonly classified, the selling department ranks first in point of relative importance. Regardless of the efficiency secured in the other branches, regardless of the economy in buying and the excellence of administration, the life of a business largely depends upon the results obtained by the selling division. Since the sales department plays such an important part in the development of the business, it is evident that the accounting and financial problems connected with sales should be given careful attention and should be handled by the most scientific and up-to-date methods.
As before stated, one of the most important principles of modern accounting is that the system by which the records are to be kept must be planned in advance. The modern accountant must first know the kind of information that is desired and he then can classify the accounts so that the information may be obtained from the ledger or other records at any time, with the least possible effort.
=Basis for Sales Classification.=—The majority of enterprises at the present time deal in a number of commodities, the kind, quality, and grades of which are of such variety that careful classification is imperative. Formerly all goods sold were classed together under a single title “Merchandise,” with the result that no detailed information concerning the sale of particular goods, qualities, and grades was available and the manager or proprietor was unable to study the movement of specific classes of commodities.
Applying the principle of classification to sales, the basis for classification depends on the character of the business and the nature of the goods sold. Where the commodities dealt in are of such variety that it is impracticable to have a separate account for each kind, a more general grouping by classes may be necessary. Where the concern manufactures some of its commodities and buys the remainder in the open market, an analysis of sales on the basis of “own” product and “other” product may be wanted. Sales may be classified also on the basis of the sales contract, as cash, credit, instalment, sales to branches, consignment sales, approval sales, etc. Accounting problems in connection with these various types of classification will be treated in the present chapter.
=Principles Governing Analysis in Books of Original Entry.=—It is evident that the kind of classification shown in the ledger determines the journal analysis. That is to say, the analysis in books of original entry, and therefore their columnar ruling, always depends upon the way in which the accounts are classified and grouped in the ledger.
The various types of analyses, both in journals and in ledgers, make use of either (or both) horizontal or vertical distribution. In most forms or records, except in banking and allied institutions, the generally accepted practice is to reserve vertical distribution for showing chronological sequence, and horizontal distribution for any other kind of classification. The reason for this lies in the fact that the time basis requires practically unlimited space and the requirement can be met only by vertical distribution, consecutive pages being considered as the continuation of preceding pages. Horizontal distribution, on the other hand, is limited to the width of the page.
By reference to Chapter XLI, “Handling the Cash,” it will be noted that for the purpose of horizontal classification the sheet contains a number of money columns, each headed by an individual class title, and that each item is first entered in the general column and then extended to one of the subsidiary columns. This serves as a check against error, since it is evident that the total of the general column must be equal to the sum of the totals of the other columns, thus furnishing a fair though not complete proof that the extensions have been made correctly. All books where analytical processes are involved should provide some kind of internal check. The student should refer to Chapters XVIII, XIX and XX, where form of analytic journals and explanation of them were given.
=Use of the Sales Ticket in Analysis.=—Since the sales invoice or ticket is the basis for entry and analysis in the sales journal, it must give on its face the information necessary for making the analysis. In accordance with the basis of classification used, it should show the department number, the kind of goods sold, whether for cash or credit, etc. The use of invoices with printed department numbers and of different colors for cash, charge, and C.O.D. sales, aid in making the record effective.
In a business of any size, the entry on the main sales journal only shows the total for the day’s sales. The sales tickets lend themselves easily to grouping, and therefore a day’s sales may be analyzed by sorting and grouping the sales tickets. Under any method of this sort, of course, each ticket must be used for the record of only one class of goods. Thus the totals of each of these sorted groups may be entered in the sales journal at the end of the day. Besides furnishing the totals for each group of sales, the individual tickets are used also for the purpose of posting the sales to the accounts of the particular customers.
After use in these various ways the tickets are filed away in binders for reference. Thus, the main books are freed of a mass of comparatively unimportant detail, to which it is necessary to refer only in rare cases.
=Analyzing Sales Returns.=—Attention should be called to the necessity of analyzing returned sales, allowances, and rebates, on the same basis as sales. Provision should also be made for a separate sales returns journal since the ordinary journal does not lend itself economically to an analyzed record of that kind.
=Purchases and Returned Purchases.=—It has been pointed out that the basis of classification of sales in the ledger determines the analysis in the sales journal. The same classification should also be applied to purchases, returned purchases, and inventories, because only in this way is it possible to determine the profit from the different classes of merchandise.
Similarly, all inward costs, such as duty, freight, insurance, handling, etc., which enter into the cost of goods sold must be analyzed on the same basis and apportioned to each group on some equitable basis. Because of practical difficulties, however, this analysis or apportionment usually is not made upon the first entry of these items on the records, but a distribution on a more or less arbitrary basis is made at the close of the period. In a large concern where very detailed information as to results is desired, an analysis of many other expenses and costs applicable to each sales group is made. Such a distribution of expense, however, leads into the field of cost accounting which is beyond the scope of the present discussion.
=The Handling of Cash Sales.=—Where an analysis by kind of commodity is unnecessary, a simple method of booking cash sales is by entry in a “Sales” column provided in the cash book, the total of which is posted to the credit of “Sales” in the ledger. Under this method, cash sales need not be entered in the sales journal. In previous chapters where the functions of the subsidiary journals were discussed, the practice of entering a cash sale in both cash book and sales journal was advised, so that the summaries of each may show true totals for those groups of business activities. However, this principle is often departed from and the method just described for booking cash sales is followed. Where an analysis of the sales is desired, the practical difficulty of providing analysis columns in the cash book for the cash sales in addition to analysis columns in the sales journal for the sales on account gives added weight to the principle stated.
It is sometimes desirable to distinguish between cash and charge sales, thus requiring two accounts, the “Sales on Account” and the “Cash Sales,” to show the total sales for the period. This is easily accomplished by the use in the sales journal of the “On Account” and “Cash” columns whose totals furnish the amounts for posting to the two ledger accounts. Even were it desired to have two sales accounts, the cash and charge, for each department, the necessary information can be secured by providing in the sales journal two columns, a cash and a charge for each department and posting their totals to the two sales accounts carried for each.
A more complicated problem arises when it is desired to keep an account to show the total cash sales of all departments and at the same time to keep one sales account for each department, in which will be recorded both cash and charge sales. The information can be placed on the ledger, but not without destroying the usual meaning of the Cash Sales account. The purpose is accomplished by providing the sales journal with two total or general columns—in addition to the departmental columns—one for charge and one for cash sales, and by carrying a Cash Sales column in the cash book. The items in the Cash Sales column in the sales journal are distributed to the proper analytic columns for classification. At the end of the period the totals of these analytic columns (which include both cash and charge sales items) are posted to the credit of the proper departmental accounts in the ledger. The total of the Cash Sales column in the sales journal, however, is posted to the debit of Cash Sales in the ledger, which will be offset by a corresponding credit item from the Cash Sales column in the cash book. These two totals should agree provided the books are completely posted.
=Sales to Branches.=—Sales to branches are made on different bases in different concerns. Sometimes such sales are charged to the branch office at cost, sometimes at full selling price, and sometimes at a fictitious figure. The first method is theoretically the best, but is not always desirable because head offices frequently prefer to keep their branches ignorant of cost prices. For this reason such sales are frequently charged to the branch office at the regular selling price. By this method, however, the books of the head office record the goods as if actually sold, while in reality they have been merely transferred to a branch office. Consequently, the books show a profit which is not yet earned. In order to correct this, it is necessary at the end of the period to make an adjustment entry covering all goods still in the possession of the branch office unsold at that time. By billing the goods at a fictitious figure the branch is also kept in ignorance as to real profits, but proper adjustment should be made at the close of the period for the reason explained just above.
Whichever method is followed, sales to branches should always be kept separate from the regular sales accounts. Where shipments of goods to branches are frequent and a matter of regular routine, a branch shipments journal similar to the sales journal should be provided; otherwise a special column in the sales journal will suffice. The total of such sales should be credited to a Branch Shipments, Branch Consignments, or some similar account, so as not to confuse these transactions with regular sales. The subject of accounting for both domestic and foreign branches is treated in Volume II.
=Consignment Sales.=—Consignment sales—which in some respects resemble branch sales—should also be recorded separately from regular sales. This is so because the title to goods out on consignment is still vested in the consignor and no element of profit appears in the transaction until an actual sale is made. However, in the case of an occasional consignee as distinguished from a factor who deals regularly in consigned goods, it has usually been held that the title has passed to the consignee so far as the consignee’s dealings with all except the consignor are concerned. Only in this way can the interests of innocent third parties be adequately protected.
The accounting for consignments is treated in Chapter XLVIII.
=Instalment Sales.=—The instalment sale should be treated in a different manner from regular sales because of certain special features connected with it. The chief characteristic of the instalment sale is the probability of the goods coming back into the seller’s possession through forfeiture because of non-payment of instalments, the profit on the transaction of course being affected thereby.
The sale of goods with the privilege of payment in instalments is a well-recognized custom in certain lines, particularly in the furniture, piano, book subscription, and similar businesses. To protect the seller, the sale contract almost invariably contains a clause to the effect that title to the goods shall remain in the seller until final payment has been made, that failure to pay any instalment when due shall result in the cancellation of the contract, and that in such case the goods shall be returned to the seller. Experience with this class of sales shows that a large number of contracts are forfeited with or without return of the goods. Where the goods are returned, there is frequently a large loss through depreciation, the returned goods having to be treated as second-hand. In some instances, to enforce return of the goods might entail greater expense than loss of the goods themselves. These are, of course, questions of business policy rather than of accounting, although the results shown by the accounting department enter into their settlement.
=Accounting for Instalment Sales.=—The accounting for sales under the instalment plan is not different from accounting for other sales. They are, in their first record, charged to the customer and credited to Sales or various departmental sales accounts. If the goods are forfeited and returned, the record is to Returned Sales for the debit and the customer is credited for the unpaid instalment. Whatever profit or loss there may be on the transaction will be shown in the Profit and Loss account when the inventory is taken and the returned goods are appraised. If the customer fails to pay his instalments but does not return the goods, the loss is one from bad debts.
=Separation of Instalment from Regular Sales Records.=—Where both instalment and regular sales are made, as is usually the case since few concerns limit their activities entirely to the instalment method, it is best to keep a separate instalment ledger with a controlling account, called “Instalment Accounts Receivable” or “Instalment Contracts.” The two classes of customers should be kept separate because of the greater liability to loss in the one class than in the other. Before profits for the period can be correctly determined, it is necessary to estimate the probable loss on contracts closed during the period. In the balance sheet separate showing should be made of the reserve for this class of accounts receivable and the reserve for the other class. The estimated loss on the instalment accounts is of course a figure based upon experience, but a conservative policy requires that the amount should be fairly liberal.
=Delinquency Records.=—Forfeiture of contracts is not usually enforced upon first failure to pay an instalment, but such delinquencies should be brought to the attention of the management and particularly of the credit and collection department. Delinquency may even be recorded in the books by transfer from the Instalment Accounts Receivable to a “Delinquent Instalment” account. This makes an up-to-date analysis of the Instalment Receivable account and so furnishes a better basis for estimating losses from bad debts than where no separation is made.
=Chief Considerations in Handling Instalment Sales.=—From the accounting standpoint, the chief question is that of making the estimate for loss from uncollectible accounts. From the standpoint of financial management, instalment sales present the problems of passing on credits before taking the risks and afterwards of pushing collections so as to prevent, whenever possible, forfeiture and consequent loss. It is not purposed to treat of these phases here, for which the student is referred to standard works on credits and collections.
=Sales for Future Delivery.=—From a legal point of view, the receipt of a purchase order gives rise to certain rights and obligations enforceable at law between buyer and seller. While the seller may not be able to enforce specific performance of the contract, yet he is entitled to the damage incurred through nonperformance. Every merchant knows, however, that the cost of securing the remedy is usually higher than the resulting gain and, furthermore, an action against the customer frequently causes the loss of his trade.
Sales for future delivery do not always materialize, since either the buyer or the seller may wish to cancel the contract. A conservative policy therefore demands that the sale be not booked until delivery is made. The order, however, may be received in one fiscal period and the sale be credited to the period in which the goods are delivered, while the major part of the expenses in connection with the sale may have been incurred during the period in which the order was received. The current period then is charged with the expenses but does not receive the credit to which it seems entitled. Therefore, the portion of the selling expense incurred during the period in which the order was secured should be deferred to the period which receives the credit for the sale.
This policy should be followed even when the goods covered by the future sale are set aside specifically for future delivery and the sale should not be booked until delivery is made. At inventory time such goods should be included at cost, with the deferred expense charge as above. Occasionally an unscrupulous merchant in need of cash will bill such goods and discount the invoice; but for the reason given above such goods should not be charged to the customer until delivery is made.
=Department Store Sales.=—As indicated above, in a department store sales are usually classified by departments. The two classes of sales tickets, cash and credit, are sorted by departments and the totals are entered daily either in the sales journal or on the loose sales sheets which, when filed in a binder, make up the sales journal. At the end of the month the journal is posted to the various department sales accounts. Each day the entries on the sales journal are checked against the cashier’s record of cash received from sales and the bookkeeper’s record of charges posted to customers.
=C. O. D. Sales.=—For this class of sales the credit is booked in the usual way but the debit is made to a C.O.D. account. The packages are charged on the shipping department’s memorandum records to the various delivery men who are credited with the collections turned in. These collections form the basis for the credit to the C.O.D. account on the ledger. Any balance in the C.O.D. account shows the amount of the undelivered goods still on hand in the shipping department or on the wagons and therefore charged against the various drivers.
=Approval Sales.=—In many lines of business approval sales are common. Merchandising concerns frequently send goods to customers for trial and inspection, with the privilege of return if the goods prove unsatisfactory. Publishing houses often send out books—both single volumes and whole sets—with a few days’ examination privilege. This class of business is often handled in a rather unsystematic fashion. Usually it is impossible to discriminate among prospective customers, since offers of this kind must be made to all alike. Consequently the privilege is often abused by the unscrupulous.
=Accounting for Approval Sales.=—This abuse creates the problem of a correct method of handling approval sales. The difficulty is rather one of organization and administration than of accounting procedure; the record-keeping presents no new difficulties and under certain conditions may be likened to the methods of recording outward consigned goods. In no sense are such transactions to be regarded as sales and handled in the regular sales records, thereby showing a profit not yet earned. The correct method, both from an accounting and a legal viewpoint, is to keep a memorandum record of approval sales similar to that made for consignments.
Unlike consignments, however, the price shown in the invoice is the actual selling price of the goods, and the sale if consummated is treated as a regular sale, no effort being made to keep the profit or loss on approval sales separate from the profit on regular sale transactions.
In the retail trade the prevailing practice in handling approval sales is to enter the charge to the customer’s account when the goods are sent out and to credit the account for all returns. In this way the books keep record of all goods out on approval and provide an adequate check against lost or misplaced goods.
When transactions of this kind are large in number, subsidiary books devoted exclusively to their record may be kept.
=Tickler File Method of Handling Approval Sales.=—Approval sales transactions must usually be completed within a comparatively short space of time, either by acceptance or by return of the goods, and in such cases a shorter method of recording them is followed. The sales tickets or invoices covering approval sales are made with some kind of a distinctive mark—color of paper, title, etc.—to allow their easy separation from the regular sales tickets. These tickets are kept in a temporary tickler file in the order of the expiration dates of the approval period. If the sale is consummated, the ticket bearing a stamp to that effect is sent through for record as a regular cash or credit sale. If the goods are returned, the ticket may be filed as a part of that particular customer’s record; in this way a cumulative record is secured which would in some cases give an interesting commentary on human nature. If the customer is one who makes it his or her practice to buy on approval to secure the free use of nice wares for an evening or for some social function, the record would show it. A rigorous and unrelenting collection and follow-up system, supplemented by a full credit and information record, is the only safeguard against unscrupulous customers and oftentimes even this proves inadequate.
At inventory time all goods out on approval as shown by the approval sales file must be included in the inventory at inventory price, for the goods are still owned by the firm. As stated above, they must never be treated as sales.
=The Bill and Charge System.=—By this name is known the method of writing up the customer’s bill and using it as the basis for the charge to his account. The system is operated somewhat as follows: The duplicate sales tickets go to the auditing department, where they are first sorted by departments to secure the departmental analysis of the sales, and then re-sorted according to customers. Thus, if a customer has made purchases in more than one department, the tickets covering all his purchases are brought together. Each customer’s monthly bill or statement of account is started at the beginning of the month on a folded billhead perforated at the fold, the duplicate or under portion usually being somewhat wider, with loose-leaf binder punchings. On these bill and duplicate blanks the charges for the day are entered from the sorted sales tickets. This work is usually done on a billing machine with carbon roll or with carbon paper insertion.
At the end of the day the total amount of the charges entered on all monthly statements is either found by means of an adding machine or is indicated by the “tally strip” of the billing machine. This total must of course be equal to the aggregate amount of all sales tickets for that day, thereby proving the work of the billing clerks.
Customers’ bills after entry each day may either be passed on to the bookkeepers who charge each customer’s account with the day’s total purchases as shown by the bill, or the bills are returned to the file until used again for subsequent purchases. In such case the bookkeeper enters the total monthly charge to the customer’s account, only once a month.
Returned goods and allowances are also entered on these customers’ bills, but in a separate column or on another portion of the sheet.
The total charges entered on these statements must check against the total credit sales for the month, thus proving the additions of the bills.
At the end of the month the bill is torn from its duplicate and is passed to the bookkeepers. They enter the previous month’s balance, if there is one, and the current payments on account, and extend the amount now due. After the bills or statements have been mailed to the customers, the duplicate bills are filed away, being virtually the detail of the ledger account, for use in case of dispute.
This method of handling credit sales provides a ready means of getting the bills out on time, of assuring agreement between the ledger accounts and the bills, of freeing the ledger accounts of unnecessary detail, and of checking the total billings against the total sales tickets.
=Salesmen’s Commissions and Efficiency Records.=—Salesmen are often paid a commission in addition to salaries. Where the commission is based on the amount of sales, the sales ticket is made use of as the source of information for computing the commissions earned. To this end the tickets are sorted according to salesmen, and a record sheet, either separate or as an adjunct to the sales journal sheets, is filled in with each salesman’s total sales for the day. These totals should prove against the salesman’s record in the back of his book of sales tickets. At the end of the month his total sales are shown by his record sheet and his commission is determined therefrom. Of course, the total for all salesmen as shown by these sheets must equal the total sales for the period.
If the commission, often known as “spifs” or “P. M.’s,” is allowed only on certain classes of sales in order to encourage the movement of old stock, each sales ticket should indicate the amount of premium or commission due, so that a record can be made without the necessity of depending on the records of the individual salesmen.
Salesmen’s records besides being used for the particular purpose of computing commission, or bonuses due them, serve a wider object in that they contain fairly complete and reliable data in regard to the value and efficiency of individual salesmen. For this reason such records should be kept at all times, no matter whether a commission or bonus system is operated or not. Whenever an increase in a salesman’s salary is considered or when the sales force is to be decreased in number, these efficiency records are a valuable aid in making the right decision.
XLVIII. CONSIGNMENTS
=Definition.=—When goods are shipped to another party to be sold by him for account of the shipper, the transaction is called a “consignment.” In its original sense, to “consign” means to seal, sign, mark, or label in a formal way. In commerce this term has come to signify goods sent for sale through another party. Usually such goods are marked or labeled to distinguish them from those belonging to the consignee. The owner or sender is designated “the consignor”; the selling or receiving party “the consignee.” Sometimes the word “shipment” is used by the consignor to designate the goods sent away for sale, and the word “consignment” to indicate the goods received by the consignee. Differentiation on this basis is convenient, but the terms “consignments-out” and “consignments-in” are more descriptive and will be used here.
=Legal Status.=—Before treating the accounts required to record consignment transactions, it is well to understand the legal relations between the consignor and consignee. The general law of bailments and of agency applies in a restricted sense to consignments. A bailment is defined as, “A delivery of goods for the execution of a special object, beneficial to the bailor, the bailee or both, upon a contract expressed or implied, to carry out this object, and dispose of the property in conformity with the purpose of the trust.” Agency is the term used to indicate the legal relation between a principal and the agent who represents him. A person appointing another to act for him in his dealings with third parties is called the principal. The one appointed to represent the principal is the agent. A bailment is therefore a special class of agency transactions with particular rules governing the safe-keeping of the goods of the principal in the possession of the agent. In the case of a consignment, the consignor is the principal and the consignee the agent. The relation of the consignee to the consignor as regards the care to be exercised in handling the consignor’s goods is a bailment relationship.
=The Broker.=—A broker, although he acts as agent, usually is not a consignee. He acts “as a middleman, bringing people together to trade, or trading for them in the private purchase or sale of any kind of property, which property, ordinarily, is not in his possession.” The charge for his service is usually in the form of a commission, sometimes called brokerage. There are several classes of brokers, named according to the kind of commodity they deal in; for instance, there is the exchange broker, the note broker, the insurance broker, the stock broker, the real estate broker, the merchandise broker, etc.
=The Factor.=—Other types of middlemen are the manufacturer’s agent, who is a broker or sales agent, effecting sales usually by means of samples; and the factor or commission merchant who actually handles and sells the goods of his principal. The chief distinction between the broker and the factor is that the broker sells goods in the name and for the account of his principal, but the goods are delivered directly to the purchaser by the principal, who also collects the account; whereas the factor has the goods of his principal in his possession and sells them either in his own name or in the name of his principal.
The factor may operate under a specific contract with his principal, covering a single consignment, or under a general contract governing all consignment transactions between the two parties. Again, there may be no formal contract between them, in which case the law sets up a contract relationship based on trade usage and customs in any particular line. Where the factor operates under a specific or general contract, certain points may arise which are not provided for in such contract, and on these points trade custom governs.
=Duties of the Factor.=—Barring specific instructions, the factor may conduct the consignment transactions for his principal on the same basis and in the same general way as he would conduct them were the goods his own. In other words, he is expected to exercise the same care in the handling of consignment goods as he employs in handling his own property. In selling goods consigned to him he may extend credit to the buyer if it is the custom in that particular line to do so, and he must exercise due care as to the rating of the customer. He must push his collections with ordinary diligence. He may warrant the goods sold if that is customary. He can give good title to goods sold, and this title may even be better than the one possessed by the owner of the goods. A bona fide purchaser who does not know the principal is protected in a sale made by a factor even if the factor exceeded his authority.
=Factor Must Protect Goods.=—So long as any part of the principal’s goods are unsold and in the possession of the factor, he must protect and safeguard them. He is not liable, however, for damage from forces or conditions over which he has no control. The degree of diligence required of him largely depends on the nature of the goods. What would be considered due diligence in one case, might be construed as gross neglect in the case of more valuable or perishable goods.
=Consignments to be Kept Separate.=—It is a fundamental requirement and of the very essence of the factor relationship, that the principal’s goods must be kept distinct from all other goods in the factor’s possession. This applies not only to the consigned goods as such, but also to the assets received by the factor upon the sale of such goods—as cash, accounts and notes receivable, etc. To satisfy this latter requirement it is usually held that actual separation is not necessary, but that it is sufficient to record these properties in such a manner that they can always be separated if the need arises. The principal’s properties are held in trust for him by the factor but are subject to the legitimate claims of the factor.
=Expenses Charged against Consignment.=—Barring specific instructions to the contrary, the factor may incur certain expenses necessary to safeguard the interest of his principal and to effect the sale of his goods. These include such items as freight, insurance, duty, handling charges, allowances and rebates to customers for unsatisfactory goods, etc. All these are proper charges against the consignment, i.e., against the principal.
=Factor’s Lien on Consigned Goods.=—For any legitimate expenses incurred and for any payments made the principal in advance of the settlement date, the factor has a lien on the consigned goods. It has been held in some cases that the factor has the right to sell the goods in satisfaction of the lien, and if the proceeds of the sale are not sufficient to satisfy the factor’s claims against the principal, the latter is liable for the amount of the deficiency. The factor’s commission from the principal is also protected by this lien and, if necessary, the factor may apply part or all the proceeds of the sale toward the payment of his commission. A lien, of course, is binding only so long as the goods are in the factor’s possession.
=Account Sales.=—Upon completion of his service the factor must make a strict accounting of his transactions to the principal. In case of dispute he can be required to open to the inspection of the principal his records covering the consignment dealings. The usual method of settlement is by means of an “account sales” rendered by the factor to his principal. The account sales is a summarized statement of all transactions connected with a particular consignment. It constitutes the formal accounting for the consignment transaction. It must show the amount or quantity of goods received, the sales made, and the expenses incurred, the balance being the amount due the principal. This amount may be either remitted or credited to the principal’s account, according to the contract between them. The usual form of account sales is shown in Form 44.
Goods may be billed to the factor at cost, at the current market price, or at some fictitious figure. This billing price does not enter into the accounting of the factor at all. It is the selling price of the factor which is the basis of income against which expenses are charged. The principal may indicate a selling price for his goods but this serves merely as a guide to the factor as to the price desired. If, however, the principal gives specific instruction as to sale price, the agent must govern himself accordingly.
=Compensation of Factor.=—The factor usually receives his compensation on a commission basis—so many per cent of the sales he makes. When the contract makes specific provision for it, he may sell the goods at a higher price than that fixed by the principal and retain part or all of the excess as compensation.
=“Del Credere” Agency.=—Where a factor sells on credit, the accounts belong to the principal and any loss through uncollectible accounts is borne by the latter. Sometimes the factor guarantees the collection of all accounts; in this case he is known as a “del credere” agent and receives additional compensation for assuming this risk. Such a guarantee really amounts to a sale of the accounts to the factor.
=Advantages of Consignments.=—While the practice of consignment trading is not so prevalent now as it was formerly, it still prevails in some lines and under certain conditions. Shippers to the produce market frequently consign their goods to city brokers whom they instruct to take advantage of the prices prevailing in the open market, and in this way they may realize higher prices than when they sell outright to the wholesaler. The consignment shipment has another advantage to the shipper, in that the title to the goods remains vested in him; hence a consignment is safer than a sale on credit to a consignee unless his rating is satisfactory. The practice of consignment trading is of sufficient importance to require a discussion of the accounting principles involved. These will be given first from the viewpoint of the consignor, and then from that of the consignee.
=The Consignor’s Entries.=—The chief interest of the consignor lies in the net outcome of each sale in order to determine the advantage, if any, of the consignment policy over a straight sale policy. To accomplish this, he must keep a separate account with each consignment, either on the general ledger or on a subsidiary ledger with a total summary account on the general ledger. When the consignor sends the goods, whether they be invoiced at cost, sale, or some other price, entry should not be made direct to his Sales account, for no sale has been made as yet. He has merely placed some of his stock in another market, being still the owner of the goods.
=Two Methods of Entering Sales on Consignor’s Books.=—There are two ways of recording correctly a consignment on the consignor’s books at the time the goods are sent. According to one method, the goods are transferred from Purchases to another merchandise account, having for its title the word “Consignment,” followed usually by the name of the consignee and the number of the particular consignment made to him, as “Consignment No. 4, J. B. Arscott.” To this account are charged not only the goods at cost price but also all expenses of the transfer, as freight, duty, insurance, etc., the corresponding credits being to Cash or to Purchases as the case may require. This is the only record made, until the account sales is received from the factor. Upon the receipt of the account sales, the Consignment account may either be credited with the net proceeds or be charged with the expenses and credited with the gross sales, as shown in the account sales. If the money is remitted by the factor the Cash account is debited; otherwise the factor’s account is debited for the net proceeds.
The Consignment account is now a true proprietorship account, showing income on the one side and cost of that income on the other side. The difference is either a profit or a loss according as the balance is a credit or a debit. In order readily to distinguish complete consignment transactions from those only partially completed, it is best to close the completed accounts by a transfer of the balance to a “Consignments Profit and Loss” account where it is held until the close of a fiscal period, at which time it is carried to the general profit and loss.
The second method of recording the transaction at the time of sending the consignment is to set up two memorandum accounts, Consignment and Consignment-Out (or Consignment Sales), debiting and crediting these respectively with the invoiced value of the consigned goods. In this case there is no credit to the Purchases account as under the first method given above. Any expenses incurred are charged to the regular expense accounts instead of to the Consignment account. For handling the consignment shipments no special books are required, original entry being in the general journal. If there are many such transactions, however, a special column in the sales journal or a special consignments-out journal is desirable.
Upon receipt of the account sales, the regular sales account is credited either with the net or with the gross proceeds; and the other accounts—as cash, the consignee, and expenses—are debited according to the manner of booking as explained in connection with the first method.
The two memorandum accounts, having served their purpose of calling attention to the fact that some goods have been sent to other markets for sale, should now be canceled by a reversing entry, since the goods have been sold and the record of their sale has been made in the regular sales account. The effect of this second method is to merge consignment and regular sales transactions into one record, making impossible a separate showing of the profit or loss on consignments. The particular method to be used, therefore, will depend upon the information desired.
=Consignor’s Inventory.=—If the consignor’s fiscal period closes before an account sales in full settlement is received, and if accounting treatment is by the first method, the goods shown in the Consignment account are included in the inventory of goods on hand and so represented in the balance sheet. If the second method is used, the Consignment and Consignment-Out accounts are both omitted from the balance sheet, being merely canceling memorandum entries, and the unsold portion of the consigned goods are included in the inventory. In determining the value of consigned goods, the expenses incurred in sending the goods to the new market may properly be included as a part of the cost.
=The Consignee’s Entries—First Method.=—Two methods of making entries on the consignee’s books at the time of receipt of goods are used. In the first method, two memorandum accounts, Consignments and Consignments-In, are set up, Consignments being debited for the billed value of the goods received, and Consignments-In being credited for the same item. The purpose of these accounts is merely to set up on the general books a reminder of the transaction.
A third account, John Doe, Principal, is used for current record. This account is charged with the expenses incurred in connection with the consignment and is credited with the sales made therefrom; it is charged also with the consignee’s commission. The balance of the account is, at the completion of the sale, the amount due the consignor, Doe. When this is paid, the account is closed by a debit to John Doe, Principal, and a credit to Cash or Notes Payable. So long as the balance is unpaid, the account, John Doe, Principal, shows the factor’s liability to his principal. This is a special kind of liability, that of a trustee, which is indicated by the inclusion of the word “Principal” in the account title; in case of insolvency a portion of the assets equal to the balance of John Doe, Principal’s account belongs to John Doe and, unless merged beyond possibility of separation, must be so treated. When the sale has been completed, the memorandum accounts, Consignments and Consignments-In, are canceled against each other, having served their purpose.
=The Consignee’s Entries—Second Method.=—Under the second method, instead of an entry on the general books, the receipt of the goods is recorded in a blotter or memorandum book of consignments received, in which are entered all essential data, covering the name of consignor, quantity, price, legend or distinguishing marks, etc. Expenses incurred are charged to John Doe, Consignment account on the general books, and sales are credited to the same account. Settlement is made as with John Doe, Principal, as explained above, except that when the balance is not paid it frequently is transferred to a simple John Doe personal account, where so far as account title is concerned it loses its character as a trust account and is merged with all other creditors.
=Consignments Must Have Distinguishing Marks.=—In making his sales from the various consignments, the factor must be careful to record them in a way to distinguish the goods taken from different consignments. This is particularly true of sales on account, for if the accounts prove uncollectible it is important to know to which lot the loss must be charged. This is accomplished by recording the consignment legend or mark with the sale.
=Factor’s Books at Close of Fiscal Period.=—When the factor’s books are closed, the commissions earned to date on consignment sales, whether the entire consignment transaction is fully or only partially completed, should be taken into account. Commissions earned on completed consignments should already be on the books as debits to the various principals’ accounts and credits to “Commissions Earned.” The commissions on incomplete consignments are brought on the books by entry of the accrued income in the Commissions Earned account, the amount being based on the sales made from the incompleted consignments during the period. The accounts with these incomplete consignments may show either debit or credit balances. If a debit balance is shown, the account is an asset representing the consignee’s claim against his principal for expenses incurred in excess of sales made. If a credit balance is shown, the account represents a trust liability as above. At a closing time the memorandum accounts of incomplete transactions should be adjusted to their present inventory values.
=Consignee’s Inventory.=—Just as the consignor must be careful to include in his inventory all goods out on consignment, so the consignee must be equally careful to exclude from his inventory all goods of his principal’s still unsold and in his possession.
=Illustrative Entries on Consignor’s and Consignee’s Books.=—An illustration of a simple consignment transaction from the viewpoint of both consignor and consignee is given below. It is assumed that a consignment transaction takes place between J. J. Querles and I. M. Factor as follows:
PROBLEM. Querles sends to Factor to be sold on his account goods amounting at cost to $1,250. He pays cartage $15, and insurance $25; while Factor pays freight, duty, and cartage amounting to $52.50. Factor makes sales of $1,600 and renders an account sales showing also allowances to customers of $27.30, a 5% commission charge and 1% for guaranteeing collection of all accounts, and the net proceeds credited.
1. Querles’ books at the time of sending the goods to Factor:
Consignment, I. M. Factor, No. 1 1,250.00 Purchases 1,250.00 Consignment, I. M. Factor, No. 1 40.00 Cash 40.00 Cartage $15, insurance $25.
2. Factor’s books at the time of receipt of Querles’ goods:
Consignment 1,250.00 Consignments-In 1,250.00 To set up memo accounts of the receipt of Querles’ goods. J. J. Querles, Principal 52.50 Cash 52.50 Freight, duty, and cartage on Querles’ goods.
3. Factor’s books during the course of consignment transactions:
Customers 1,600.00 J. J. Querles, Principal 1,600.00 To credit Querles with the sales. J. J. Querles, Principal 123.30 Customers 27.30 Commissions 80.00 Collections Guarantee 16.00 To charge Querles with all expenses.
Consignments-In 1,250.00 Consignment 1,250.00 To reverse.
4. Querles’ books upon receipt of the account sales:
Consignment, I. M. Factor, No. 1 175.80 I. M. Factor 1,424.20 Consignment, I. M. Factor, No. 1 1,600.00 To credit the consignment with its sales and charge it with its expenses, including commission and to charge Factor with the balance due. Consignment, I. M. Factor, No. 1 134.20 Consignments Profit and Loss 134.20 To transfer the profit on this consignment.
5. When Factor finally remits the balance of $1,424.20, his entry is:
J. J. Querles, Principal 1,424.20 Cash 1,424.20
thus canceling his liability to Querles.
6. Querles’ books will show:
Cash 1,424.20 I. M. Factor 1,424.20
canceling his claim against Factor.
If the second method (see page 455) of making the consignor’s record is used, the entries under No. 1 will appear as follows:
Consignment, I. M. Factor, No. 1 1,250.00 Consignments-Out 1,250.00 Cartage 15.00 Insurance 25.00 Cash 40.00
and No. 4 would be:
Freight 52.50 Sales Allowances 27.30 Commissions 96.00 I. M. Factor 1,424.20 Sales 1,600.00 Consignments-Out 1,250.00 Consignment, I. M. Factor, No. 1 1,250.00 To reverse.
In these last entries made under the second method, consignment sales are included in the regular Sales account, and the profit or loss is merged with that from regular sales.
Decision as to which of the two accounting methods should be used must be made according to the information desired by the principal. Where consignment transactions are a side line, the record is usually kept by the first method which shows the profit or the loss on each transaction and thus furnishes valuable information for executives. This is sometimes called the occasional consignment theory or method. Where the consignment transaction is the usual method of effecting sales, the second method illustrated above is generally to be followed, because by this method all consignment transactions are properly included in the regular sales and expense records.
XLIX. ADVENTURE SALES
=Adventure Transactions.=—Before the day of easy transportation and communication between markets, adventure or venture undertakings were quite common. The inherent willingness of men to take a chance, and the desire to speculate, often led to the fitting out of cargoes of merchandise for sale in distant ports and the equipping of trading expeditions into unknown regions. Many dangers had to be met, the hazards and risks being great. Success attended many adventurers, and many also met with failure. Even today this method of seeking a market has its allurements.
=Single and Joint Ventures.=—Adventures are of two kinds, single and joint. The single adventure is merely an outward consignment by a single proprietor and is treated in accounting as such, i.e., it is charged with all its costs and credited with its returns, the balance being either a profit or a loss. The joint venture is accounted for on the same principle, although the procedure may be much more complicated. A joint venture account may be defined as the record of “commercial transactions of a particular kind, usually of a temporary nature, entered into jointly by several parties who combine together for the purpose, contribute the capital and the services, as may be arranged, and agree to share the losses or profits in certain proportions.” Speculation in stocks, the chartering of a ship for a particular purpose, a particular voyage, or a fixed period of time—these are some lines of present-day joint venture endeavor.
=Relations between Parties.=—From the legal point of view, the combination under a joint venture is a special partnership, i.e., one entered into for the accomplishment of a special purpose, the several parties to it having control, as in a partnership, and sharing profits and losses either according to contract or, in its absence, equally. Usually, in a joint venture one of the parties or an outside agent is entrusted with the entire enterprise.
=Accounting for the Joint Venture.=—Accounting for the joint transactions is comparatively easy. If the undertaking is simple, one account for each such joint undertaking, viz., “Joint Venture,” will suffice. This account will be carried on the records of the regular business of each party to the venture. The account is debited with the costs of the venture and credited with the returns from it.
If the enterprise is more complicated, it may be required to set up a number of separate accounts, or even a separate set of records, but the summary or clearing account for these will still exhibit costs set over against returns. If the partners are all in the same city and have access to the records, one set of accounts is all that is necessary. Where the partners are in different places, each should keep a record of all transactions as reported by the manager of the venture. Since the manager reports all transactions to each of the parties, the “Joint Venture” accounts as kept by the different partners will all be the same.
The other accounts affected by the joint transactions will either be the same or reciprocal. Upon the inception of the venture, some of the partners having contributed cash, others merchandise, still other facilities, services, etc., the Joint Venture account is charged with all contributions and each partner is credited. If the venture is managed by one of the partners, instead of a credit to his own personal account, his cash or merchandise account will receive the credit for his contribution. If the managing partner desires to separate his investment in the joint venture from his investment in his regular business, he will set up a Joint Venture Investment account to which the amount of his contribution to the joint venture will be transferred from his regular capital account. Expenses incurred are charged to the joint account and credited to the partner paying them. All sales made and collected are credited to the joint account and charged to the partner retaining the money.
=Interest Allowances and Charges.=—Because some partners may have made larger contributions than others, the agreement may provide that interest be credited the partners on their contributions. On the other hand it frequently happens that one or some of the partners have the use of the moneys received from joint sales until date of settlement of the venture, and the agreement may provide that interest shall be charged to those retaining the collected funds. This can be accomplished by charging the joint account and crediting the partners with interest from the dates of their contributions to the date of settlement, and by charging the partners retaining joint funds and crediting the joint account from the date when the funds come into their possession until the settlement date. A salary or a commission may be allowed the managing partner or partners. This also is a charge to the joint account and a credit to the partner.
=Distribution of Profits.=—After all transactions have been completed and all charges and credits made, the joint account for each venture will show by its balance the net profit or loss. This is distributed among the partners in agreed ratio, or in equal ratio in the absence of agreement. After this is done, only the partners’ accounts remain, some with debit and others with credit balances. The managing partner should collect the debit balances and remit to those with credit balances, thus making a complete settlement of the joint undertaking.
Should the fiscal period of any of the partners close during the term of the venture, conservatism would generally require that his own accounts do not show a profit on the sales made to date, on the theory that losses on the incomplete portion may wipe out any profits on the completed portion. This is because the joint undertaking is considered as a whole and inseparable transaction and not as composed of numerous separate sales. The element of risk is always an important factor in undertakings of this sort. However, there might be circumstances under which the taking of at least a partial profit could be justified. Assuming that no profit is taken, the joint account becomes a balance sheet account at closing, asset or liability according as costs have been more or less than the sales as on the date of closing.
=Joint Venture Accounts Illustrated.=—An illustration will bring out the salient points in the above discussion:
PROBLEM. A, B, and C enter a joint venture to Mexico, with C as manager. A and C contribute merchandise valued at $5,000 and $8,000 respectively, and B $11,000 cash for the purchase of additional merchandise. C is to receive 3% commission on sales. C pays freight, duty, and insurance of $890 from his own cash, and buys merchandise with B’s contribution. He makes sales, according to reports sent by him to A and B, aggregating $30,000, and holds the amount in his possession one month till settlement. The investment period is six months. Interest at 6% is to be credited to partners on their original investments and is to be charged to C on the $30,000 held by him for one month.[7] A, B, and C share profits in the ratio of their original contributions. Settlement is made by C in cash.
[7] Whatever agreement is made by the partners for interest adjustments governs. In practice the usual procedure in a case of this kind would be to allow C interest on the $890 cash advanced by him for expenses from date of advance to date of settlement, and to charge him with interest on all moneys received by him from dates of the various sales to date of settlement. To simplify calculations, it is assumed in the illustration that C’s use of funds received from sales during the first five months approximately compensates him for the $890 advanced by him.
The following entries show the record of the above transactions on B’s and C’s books.
1. At the beginning of the venture the record will be:
On B’s books:
Joint Venture, A and C, to Mexico 24,000.00 A 5,000.00 Cash 11,000.00 C 8,000.00 To set up the venture transaction.
B, Capital 11,000.00 Joint Venture, A and C, Investment 11,000.00 To show capital invested in joint venture. Joint Venture, A and C, to Mexico 890.00 C 890.00 Freight, duty, etc., paid by C.
On C’s books:
Joint Venture, A and B, to Mexico 24,000.00 A 5,000.00 B 11,000.00 Purchases 8,000.00 (As above.) C, Capital 8,000.00 Joint Venture, A and B, Investment 8,000.00 (As above.) Joint Venture, A and B, to Mexico 890.00 Cash 890.00 (As above.) C, Capital 890.00 Joint Venture, A and B, Investment 890.00 Freight, duty, etc., paid by C.
2. On B’s books at the time of settlement:
Joint Venture, A and C, to Mexico 1,620.00 A 150.00 Interest Income, Joint Venture, A and C 330.00 C 1,140.00 6% interest on original contributions of each partner for six months; 3% commission to C on sales. C 30,150.00 Joint Venture, A and C to Mexico 30,150.00 6% interest charged C on $30,000 for one month; C charged with his collections from sales $30,000.
On C’s books:
Joint Venture, A and B, to Mexico 1,620.00 A 150.00 B 330.00 Interest Income, Joint Venture, 240.00 A and B Commission Earned, Joint Venture, 900.00 A and B Cash 30,000.00 Interest Cost 150.00 Joint Venture, A and B, to Mexico 30,150.00
3. On the records of all the partners the Joint Venture account shows a credit balance, i.e., a profit of $3,640, the distribution of which will be as follows:
On B’s books:
Joint Venture, A and C, to Mexico 3,640.00 A 758.33 Profit and Loss, on Joint Venture, 1,668.34 A and C C 1,213.33 To distribute profits on the venture in the agreed ratio 5:11:8.
On C’s books:
Joint Venture, A and B, to Mexico 3,640.00 A 758.33 B 1,668.34 Profit and Loss on Joint Venture, A and B 1,213.33
B’s accounts now show a balance due A of $5,908.33; a claim against C for $18,906.67; his own share therefore being the difference, or $12,998.34. That this is the correct amount is seen by comparing it with the amount of B’s Joint Venture, A and C, Investment account showing $11,000, his Interest Income Joint Venture, A and C, showing $330, and his Profit and Loss on Joint Venture, A and C, showing $1,668.34.
4. C now makes settlement in cash with his copartners for the respective amounts due them. The settlement transactions will appear as follows:
On B’s books:
Cash 12,998.34 C 12,998.34 Cash from C in settlement of Joint Venture. A 5,908.33 C 5,908.33 C reports settlement with A.
On C’s books:
A 5,908.33 B 12,998.34 Cash 18,906.67 Settlement with A and B on Joint Venture.
After these entries have been made on B’s books, the joint venture with A and C will be shown completed. His books show a full net profit on the venture of $1,998.54, reflected in the excess of cash received from C over cash given him for investment. At the end of B’s regular fiscal period, the profit on the venture will ordinarily be shown separately on the statement of profit and loss after the item, Net Profit from Operations. It will be set up as follows:
Joint Venture, A and C, to Mexico $1,998.34 (Schedule B-5) Gross Returns in cash from C, $12,998.34 Managing Partner Original Investment 11,000.00 ---------- Net Profit, as above $ 1,998.34 ==========
Schedule B-5 should give a complete report of the venture, somewhat as follows:
JOINT VENTURE, WITH A AND C, TO MEXICO
Gross Returns as reported by C, Managing Partner $30,000.00 Costs: Merchandise Purchases $24,000.00 Expenses 890.00 24,890.00 ---------- ---------- Gross Profit $ 5,110.00 Commission to C 900.00 ---------- $ 4,210.00
Add: Interest paid by C for use of funds after completion of venture 150.00 ---------- Net Profit to be distributed: $ 4,360.00 A, Interest on Capital $ 150.00 Profit and loss share, ⁵/₂₄ of $3,640 758.33 $ 908.33 --------- C, Interest on Capital $ 240.00 Profit and loss share, ⁸/₂₄ of $3,640 1,213.33 1,453.33 --------- B, Interest on Capital $ 330.00 Profit and loss share, ¹¹/₂₄ of $3,640 1,668.34 1,998.34 $ 4,360.00 --------- ---------- =========
At the close of the period the account, Joint Venture, A and C, Investment, having served its purpose, is transferred back to B’s regular capital account.
C’s accounts show a balance due A of $5,908.33; due B, $12,998.34; the remainder of the joint income, $11,243.33 {$30,150 - ($5,908.33 + $12,998.34) = $11,243.33}, being his own share.
After the same manner as B, C will make, at the close of his regular fiscal period, a summary of the joint venture, showing it in his statement of profit and loss somewhat as follows:
Joint Venture, A and B, to Mexico: Commission as Managing Partner $ 900.00 Share of Profit (see Schedule B-5) 1,453.33 $2,353.33
Gross Returns in cash $11,243.33 Original Investment 8,890.00 ---------- Profit, as above, $ 2,353.33 ==========
The student will note that the $150 interest paid by C for the $30,000 joint funds used by him for one month is not recorded as an interest cost of the venture, but is charged to C’s regular Interest Cost account because the funds must have been used for the conduct of his regular business.
The accounts on each partner’s books with his copartners are not ordinary asset and liability accounts but are more of the nature of capital accounts and might be entitled “A, Contribution,” “B, Contribution,” etc. The records of the joint venture comprise a group of accounts which constitute a unit within themselves, showing the partnership relation existing among the several parties from the inception of the partnership to its liquidation.