XXV. THE SINKING FUND
Origin and Use
The sinking fund is a recognized and well-established instrument for the financing of business. A great deal has been written about the subject, and over some of its phases much wordy warfare has raged. As usual, however, the controversy has had little or no effect on the practical application of the principle of the fund.
The sinking fund seems to have been first used as a practical instrument for the repayment of debt in the year 1716, although the idea germinated some time before this. At first its application was limited entirely to public finance. Through the efforts of Sir Robert Walpole, legislation was enacted in England which made certain specified taxes perpetual. Any surplus remaining after applying them to the purpose for which they were levied was to be put into a sinking fund for the purpose of paying off the public debt. Due to bad administration of the fund, it was not successful. Its use was attempted a second time in 1786 by William Pitt, at the instance of a Dr. Price. Since then it has had a rather checkered career in public finance. In some fields, notably among municipal corporations, the device has been very successful. Through the extension of the principle to the field of business the sinking fund found the use to which it was best adapted.
Definitions
A sinking fund may be defined as “a fund formed by the investment of annual savings or other contributions with a view to the ultimate application of the moneys so accumulated in the payment of a previously incurred ... debt.” An English accounting authority defines a sinking fund as “a fund set aside out of assets and accumulated at interest for the purpose of meeting a debt.”[67] This latter definition draws attention to the fact that the sinking fund is a fund of assets—not simply a book account set up to indicate recognition by the board of directors of the need of providing for payment of a debt, but certain definite assets set aside and, after accumulation, to be used for that purpose. Attention should also be called to the fact that usually the fund is not dependent solely for its increase upon interest accretions. As generally handled, the fund is added to at regular intervals by setting aside more or less regular amounts of assets to be applied to the same purpose. Frequently the contract agreement entered into between the company and the creditors holding the debt to be repaid governs in detail the way in which the fund is to be provided and the way in which it is to be handled.
[67] George Lisle in “Accounting in Theory and Practice.”
A sinking fund may be used for other purposes than the payment of debt. Thus, occasionally one finds it created for the purpose of providing funds for the retirement of capital stock issues, notably preferred stocks of various kinds.
It may be well again to point out the unfortunate lack of uniformity in the use of the term. Thus “Sinking Fund” as an item in the balance sheet is found sometimes among the debits and sometimes among the credits. Other titles under which the item appears are: Sinking Fund Account, Sinking Fund Reserve, Sinking Fund Investments, Sinking Fund Trustee, and Sinking Fund Cash. While in this chapter the term will be used to indicate assets set aside in a definite fund—and limitation to this use is growing among the best authorities—explanation will also be given of what the other uses indicate as to financial policy and the manner of booking such policy.
Mathematical Principles on which Based
The mathematical principles on which the computation of the sinking fund rests will first be explained. The problem involved here is the calculation of the amount which set aside periodically and invested at compound interest will provide a sum sufficient to pay off the debt when it matures. Needless to say, the sinking fund is usually applied only to the redemption of long-term debts, as only over a comparatively long period is the real potency of the compound interest principle secured. For the solution of the problem it must be known whether the periodic increments to the fund are set aside at the end or at the beginning of the period. It is usually understood to be at the end of the period unless otherwise specified.
Assume, therefore, that a bond issue is made with maturity in n years and that the contract with the bondholders calls for the creation of a sinking fund with payment thereinto at the end of each period. It is required to find the amount to be paid into the fund periodically. We will assume that:
P = the principal sum to be redeemed at maturity n = the number of periods till redemption A = the amount paid into the sinking fund at the end of each period r = the rate per cent per period at which the moneys in the sinking fund are invested at compound interest R = 1 + r
Reference to Chapter XV, page 271, gives the amount, A, of a sum of money put at compound interest at r% for a term of n years, as A(1 + r)ⁿ⁻¹. It is evident here that the sum, A, paid into the fund will accumulate for n-1 years and that each succeeding payment remains at interest one year less than the next preceding amount, the last amount earning no interest. Accordingly, the first A—we will denote it as A₁—will amount to A(1 + r)ⁿ⁻¹; A₂ will amount to A(1 + r)ⁿ⁻²; A₃ to A(1 + r)ⁿ⁻³; etc. The sum of all these amounts must be equal to P, the debt to be redeemed. Therefore, the equation may be formed:
A(1 + r)ⁿ⁻¹ + A(1 + r)ⁿ⁻² ... + A(1 + r) + A = P or
A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1) = P, whence
( Rⁿ - 1) A(--------) = P and ( R - 1 )
P(R - 1) Pr A = -------- or ------, Rⁿ - 1 Rⁿ - 1
which being interpreted means that the theoretical amount to be set aside at the end of each period can be found by multiplying the amount of the debt by the fraction
r ------- . Rⁿ - 1
If the annual payment is made into the fund at the beginning of each period instead of at the end, then
Pr r A will be -------- and the multiplying fraction --------- . R(Rⁿ - 1) R(Rⁿ - 1)
It is evident that in practice some allowance will usually have to be made for failure to keep all payments in the fund and interest accretions thereto constantly invested at the calculated rate. This is not a matter of serious import, however, for small inaccuracies can be adjusted during the last period or the last few periods by increasing or decreasing the annual payments as may appear necessary at those times. From a financial standpoint it should be borne in mind that there is no absolute necessity for the accumulations in the fund to be sufficient in all cases to retire the entire debt. Refunding a portion of it may be resorted to. Other conditions being equal, it should be a much easier task to borrow only a portion as compared with borrowing the original amount.
Accumulation Based on Agreement
It is necessary to call attention to the inapplicability of the above method to all cases. Of course, where the contract between the borrower and the lender makes definite provision for the manner of creating and handling the sinking fund, that contract must therefore govern. However, in the case of a concern operating wasting assets, a frequent provision of the trust agreement in the case of a bond issue is that the periodic payments into the fund shall be proportional to the amount of the natural product extracted or used. Thus in the coal mining industry the trust agreement may provide that, say, five cents for every ton mined shall be placed in a sinking fund. In determining the amount for each ton, the total amount of the debt to be extinguished is divided by the estimated number of tons of coal in the mine. This gives the amount of the debt which each ton must bear. Conservatism and business prudence require an ample allowance for mistakes in the estimate of tonnage which it will be profitable to mine and, also, for a liberal margin of safety. The relation between the life of the bonds and the estimated annual output has an important bearing also, for the charge per ton must be sufficient on the basis of the tonnage mined during the period covered by the bonds to retire the bonds at their maturity, regardless of how much coal there is still in the mine at that time—unless a refunding operation is contemplated.
Similarly in the case of timber properties, sinking fund payments are usually roughly proportional to the amount of timber cut; in earthwork or quarry enterprises, to the amount of material removed or quarried; in real estate development companies, to the number of divisions made ready for the market. In such cases the compound interest method, scientifically accurate, often gives place to annuity methods more or less roughly calculated, under which, by trust agreement, definitely named sums, approximately sufficient to accomplish redemption at maturity, are set aside periodically.
Other methods fix the amount as so many per cent of gross or net profit, of the bonds outstanding, of total business done, etc. Oftentimes, scientific accuracy, even if desirable, is impossible because of provisions in the trust agreement to the effect that the moneys in the sinking fund are to be used for the purchase of the company’s own bonds at market but providing a maximum price above which none are to be bought. This involves purchases at a premium, or possibly a discount, unknown at the time the periodic amount must be calculated. An amount figured on the maximum price would be conservative; or the amount may be based on par with the stipulation that the difference between par and market shall be handled each period through the profit and loss.
Effect of Settlement of Debt
As an introduction to the discussion which will follow of the relation of the sinking fund to profits, we will first consider the several ways in which a debt may be settled. For that purpose there is nothing which makes clear the principle involved better than the fundamental schedule of debit and credit, showing the interplay of all transactions as they are brought onto the books. At the risk of unnecessary repetition, that schedule is accordingly set up here for ease of reference.
SCHEDULE OF DEBIT AND CREDIT =============================================================== Debit: | Credit: (1) Increase of assets | (a) Decrease of assets (2) Decrease of liabilities | (b) Increase of liabilities (3) Decrease of proprietorship | (c) Increase of proprietorship
From this it is seen that the redemption of a debt—a number (2) transaction—may be accompanied, and therefore accomplished, by any one of the three offsetting credits or by a combination of them. A debt may be settled (a) by the conversion of an asset; (b) by the creation of another liability; or (c) by an increase in net worth. Cash or other assets may be used for the purpose, resulting in a decrease of assets, as in (a) of the schedule. It should be noted that the borrowing of, say, $1,000 and its repayment in cash leaves the borrower in the same relative financial condition as before, except for the gain derived from the use of the money borrowed. Such loans, to be repaid in this way, are usually of a temporary nature, to tide over an emergency—such as the handling of the load of seasonal activity, or other similar situation. This method of settlement is, of course, not confined to payment of debts for money borrowed, but includes debts contracted for merchandise purchased on credit and other current liabilities.
Again, a debt of one kind may be settled by the creation of a debt of another kind, as in (b) of the above schedule. Thus, an open account payable may be converted into a note or acceptance payable. Here, the liability canceled and the new one created are usually of the same class, viz., current liabilities, and the need for a more or less permanent increase in working funds is not contemplated. So also, a current liability, or a group of them, may be converted into a funded debt. This may be deemed advisable when it is seen that there will be a permanent, or at least a long-term, need for funds which have up to this point been provided by short-term borrowings and credits. Again, a refunding operation would have the effect of a decrease of one liability offset by the increase of another.
Finally, a debt may be canceled through an increase of proprietorship, as in (c) of the schedule. By this means the redemption of the debt may be direct or indirect. Capital stock, either treasury or previously unissued stock, may be accepted by creditors in satisfaction of their claims. They thus change their status from creditors to proprietors and the result is an increase of the concern’s net worth. Indirectly a debt may be settled by the reservation of profits. Instead of distributing the profits as dividends, they may be retained in the business and so provide funds, i.e., assets, for the redemption of debts. In either case the settlement of the debt has been effected by means of increased net worth evidenced by new issues of stock or by reserved profits.
In these various ways, therefore, a debt may be settled. As pointed out above, the first method contemplates no permanent need for increased working funds and the extinguishment of the debt leaves the borrower in approximately the same position financially as before its incurrence. Under the second method, the relative positions before and after are the same excepting in the case of funding a floating debt. Here a permanent or long-term increase in working funds is secured. With the third method a permanent increase is secured in the capital funds available for use in the business. Financial policy, governed by the needs of the business and its markets, will always dictate the method to be used for extinguishing or contracting a debt.
Relation of Fund to Profits
The relation of the sinking fund to profits will next claim our attention. This point has been much debated, reaching the acrimonious stage at times. It is variously contended: (1) that there is a necessary relationship between profits and the payment of a debt; (2) that for final settlement only assets will suffice; and (3) that the policy of reserving profits to an amount equal to the sinking fund is a policy not dictated by any fundamental principle of relationship between profits and debt redemption.
With regard to the first claim, it is sufficient to call attention to the discussion above where the various ways of paying a debt were considered. As there pointed out, a reservation of profits may offer the only available means of providing assets with which to redeem debts. Accordingly, at least an indirect relationship between profits and debt redemption is established.
As regards the second point, that only assets can be used for the final payment of debts, this also is seen to be too broad a claim, for the issue of new stock may accomplish the same end—directly, as where issued to creditors, or indirectly, as where sold and the proceeds applied to liquidate the claims of creditors.
As to the third claim, it might be said with equal relevance that there is no basic relationship between debt redemption and any method of settlement. The assertion can be made with little fear of contradiction that so long as the claims of creditors are satisfied, the manner of doing it is of small importance. Of course, only the currency of the realm is a legal tender for debts but, if other forms of payment prove satisfactory and are accepted, the matter ends. It is therefore solely a question of financial policy, no principles of accounting are involved, and the only point in which accounting is concerned is in making the record so as truthfully to show what is taking place, i.e., to reflect accurately the financial policy adopted.
If the needs of the business require a permanent addition to the capital, as mentioned above, that can be secured in only two ways, viz.: (1) the sale of stock and (2) the reservation of profits. If, on the other hand, the debts to be repaid have provided funds for the emergency or purpose for which they were contracted and that emergency or purpose no longer exists, then the repayment of those funds to the creditors is the business policy dictated. Under these circumstances, to load the business with capital funds not needed in the enterprise might well be the height of business folly. According to the conditions to be faced, there may or may not be any necessary connection between debts and profits.
It should be pointed out that the kind of debt—i.e., the long-term obligation—for the settlement of which the sinking fund method is often employed, is almost invariably an indication of the need of a larger capital fund. Recognition of this is frequently evidenced by the provisions of the trust agreement requiring the payment into the sinking fund out of profits of the periodic contributions. This forces the ultimate increase of capital to be made by the owners. Two other alternatives are open, viz.: borrowing again at the maturity of the debt—a refunding operation—and securing additional capital through the sale of stock. Conditions of the financial market at the time the funds are needed, the policy of the concern as to the admission of other owners, and the relative bargaining strength of the two parties to the loan—these are determining factors in the financial policy to be adopted.
Accounting for Sinking Fund
The various problems met in accounting for the sinking fund will now be discussed. First among these is the manner of showing its status on the balance sheet. This may be done in four different ways. Here, also, the chief problem involved is an accounting problem only so far as it concerns the best manner of setting forth truthfully the facts of financial policy.
1. The sinking fund, then, under suitable title, may appear only among the assets. As to financial policy, this indicates the creation of a distinct fund of assets for the purpose of the sinking fund but it does not show definitely the way in which they are being provided. They may be secured by cutting down certain assets previously carried in larger amount than is now deemed necessary; by a reinvestment of profits; or by the sale of additional capital stock. The balance sheet is silent as to what method is being employed.
2. The balance sheet may record the sinking fund status among the assets as a definite fund and also among the items of net worth as a sinking fund reserve. As to financial policy this not only indicates the creation of a fund of assets, but shows that this was accomplished by a withholding of profits from the stockholders and a reservation of them for this very purpose.
3. There may appear on the balance sheet as the only evidence of a sinking fund policy the sinking fund reserve among the net worth items. This shows a reservation of profits for this purpose and therefore their investment in the business. The reserve is not a covered reserve, however, no definite assets being set apart as representing these profits, or, if set apart, as having been already applied to the cancellation of a portion of the debt. This latter phase is explained more fully on page 458 following. Unless the assets have been applied in this way, the balance sheet gives no assurance to the creditors that funds will be available for the settlement of their claims at maturity. It may be that the reserved profits are being used for further extensions of plant and so will not be easily available at maturity of the obligations. Again they may be invested in increased stocks of current assets and so be readily available. Only an analysis of the balance sheet will show the financial policy that is being pursued.
4. There may be no record of the sinking fund transactions shown on the balance sheet. This might come about through the cancellation of some portion of the debt by the conversion of assets. The balance sheet, except by comparative analysis, carries no indication of the way in which it is accomplished. It may be that it is being done at the expense of current activities—a poor policy—or through the withholding of owners’ profits. The balance sheet is non-committal.
Whatever method indicates the policy being followed with regard to the sinking fund is the one which should be employed. So far as possible indefiniteness of expression as well as nomenclature should be avoided; not only does an indefinite statement fail to show the policy but it may be misleading.
The Sinking Fund on the Balance Sheet
In drawing up the balance sheet, the sinking fund assets usually appear under the caption “Investment of Sinking and Other Funds.” Occasionally one finds the Sinking Fund account treated as a debit valuation account, being shown as a deduction from the Bond account. Such treatment indicates the amount of bonded indebtedness not yet provided for by the sinking fund—an item of hardly enough importance to justify its separate showing, particularly when an easy comparison, under any other method, will give the same information. The cancellation of assets against liabilities or of liabilities against assets is not good accounting practice. Where, however, the trust agreement provides for the investment of the sinking fund cash in the company’s own bonds and the cancellation of these bonds as purchased instead of holding them in the fund for the sake of their income accretions, the bonds so canceled would, of course, be deducted from the amount previously outstanding and only the present liability for bonds be shown. There is no objection to showing this deduction on the face of each balance sheet, as it thus shows the amount redeemed during the current period. If the company’s own bonds are purchased but kept live, it is better to show the sinking fund among the assets. All sinking fund reserves should, of course, be listed in the net worth section of the balance sheet.
Entries to Sinking Fund
Accounting for the sinking fund presents nothing new in principle. There are, in the main, three kinds of entries to be made, viz.:
1. Those dealing with the original and subsequent periodic payments into the fund.
2. Those required to book the trustee’s periodic report of his handling of the fund.
3. Those to show the redemption of the debt and the final disposition of the accounts relating to the fund.
In the illustration, for the sake of definiteness, it will be assumed that the governing financial policy is the second one discussed above, according to which not only is a sinking fund created but also an equal amount of profits is reserved each period; that the funds are placed in the hands of a trustee for investment and that any income from the investments is to go into the fund; and that it is desired to show both the investments of the trustee and the unexpended balance of cash in his possession. The account titles are suggestive only, many varying titles being used. The entries required to show the original payments into the fund are:
(1) Sinking Fund Cash in Hands of Trustee $..... Cash $..... To record payment to trustee of first payment into the sinking fund created according to terms of trust agreement to retire the first mortgage 6% bonds.
(2) Surplus Sinking Fund Reserve To show the creation of a reserve to provide funds for the redemption of bonds.
Subsequent payments into the fund would be recorded in exactly the same way as the original payments.
Booking the Trustee’s Report
Upon receipt of the trustee’s report on the handling of the fund, entries must be made to bring a summary of the report onto the books. This report should cover a full accounting of the funds turned over to the trustee, his investment of them, all expenses of the trust, and any income received or accrued. The funds may be left for accretion in a savings bank; they may be used to purchase high-grade securities; or with them the very bonds which they are to redeem may be bought and canceled immediately, or allowed to run, the interest accretions going into the fund also. Securities for investment may be bought at a premium or a discount. Expenses will be incurred by way of commission or salary for the trustee, expenses of the trust, advertising, brokers’ commission, etc.; and income will be received by the trustee from the securities held and even from the unexpended balance of cash.
As to the purchase of securities at a premium or discount, the problem involved is the proper handling of the premium or discount. Theoretically, whether in the hands of a trustee or under own control, premiums and discounts on securities bought for long-term investment should be amortized. The reader is referred to Chapter XV, page 267, for the various methods of booking such investments. Oftentimes, however, the premium is charged at once against the sinking fund income along with all other expenses.
To book the investments of the trustee, the entries needed are:
(3) Sinking Fund Investments $..... Sinking Fund Cash in Hands of Trustee $..... (List here the securities purchased and their price.)
(4) Sinking Fund Expenses Sinking Fund Cash in Hands of Trustee (Itemize here all expenses chargeable against the fund or its income.)
(5) Sinking Fund Cash in Hands of Trustee $..... Sinking Fund Income $..... (Record here the income from interest on unexpended cash balance and from securities, with proper adjustments on account of amortization of premium or discount.)
Treatment of Income and Expense
Practice varies as to the proper handling of the income and expense of the sinking fund. Sometimes they are treated as affecting—i.e., increasing or decreasing—only the sinking fund reserve and as having no place in the current profit and loss. That seems a mistaken view; the fact that the investment is beyond the company’s control none the less renders its income and expense a fact of current profit and loss, and it should be so shown. Accordingly, the sinking fund expense and income accounts above should be closed into profit and loss, after which their net result will be transferred from surplus to Sinking Fund Reserve, to show the net increment or decrement as a result of the trustee’s operations. Thus:
(6) Sinking Fund Income $..... Profit and Loss $..... (7) Profit and Loss Sinking Fund Expenses (8) Profit and Loss Surplus
Entry (8) is not strictly a sinking fund entry but transfers the entire balance of the period’s profit and loss to surplus, out of which the net increment or decrement of the sinking fund operations is transferred to Sinking Fund Reserve by entry (9):
(9) Surplus $..... Sinking Fund Reserve $.....
An amount equal to the compound interest increment must always be transferred to the reserve, if accurate results are desired.
Practically the same entries will serve if the investments are the company’s own bonds. If the bonds are canceled, instead of entry (3) the following entry would be made:
(10) First Mortgage 6% Bonds $..... Sinking Fund Cash in Hands of Trustee $.....
Here the item of premium or discount is usually to be found and the question then arises as to whether the item is not better handled as a charge or credit direct to Sinking Fund Reserve rather than through the current profit and loss.
Final Disposition of Fund
There remain to be considered the entries recording the payment of the bonds at maturity and the disposition of all sinking fund accounts. The securities of the trustee must be reconverted into cash to be used for redeeming the bonds, often resulting in a difference between the book value of securities and the actual amount realized therefrom. This must be adjusted by charge or credit to the Sinking Fund Reserve. After cancellation of all the bonds, any cash balance is turned back by the trustee to the company. The entries on the books would be:
(11) Sinking Fund Cash in Hands of Trustee $..... Sinking Fund Investments $..... To record sale of securities in the sinking fund.
(12) Sinking Fund Reserve Sinking Fund Investments .....
or
(13) Sinking Fund Investments ..... Sinking Fund Reserve ..... To adjust the difference between book and realized values of the securities.
(14) First Mortgage 6% Bonds ..... Sinking Fund Cash in Hands of Trustee ..... To record redemption of all bonds.
(15) Cash ..... Sinking Fund Cash in Hands of Trustee ..... To record transfer to company of cash balance in hands of trustee.
Treatment of Sinking Fund Reserve
Only the Sinking Fund Reserve account now remains on the books. Having served its purpose of providing funds by retaining profits in the business for the redemption of the bond issue, resulting in an addition to the net worth of the business, this reserve is now free to be used as deemed best. It may be thrown into surplus and so become available for dividend purposes; or it may be used as the basis for an increase in capital stock and be distributed as a stock dividend, thus making the increase in net worth permanent. The following entries respectively accomplish these ends:
(16) Sinking Fund Reserve $..... Surplus $..... (17) Surplus Stock Dividend Payable (18) Stock Dividend Payable Capital Stock
Relation between Depreciation and Sinking Fund
A final problem deals with the relation between depreciation and the sinking fund. If the trust agreement requires that a sinking fund reserve shall be created by charge against profits, must provision be made also for the depreciation of the mortgaged property held as security for the bonds? The fact of depreciation is omnipresent and cannot be escaped. Also, the trust agreement must be lived up to. To carry out both requirements simultaneously would manifestly result in a double charge. The charge for depreciation is an expense charge which must be made before net profits can be determined. The charge for the creation of the sinking fund reserve is against surplus, i.e., it takes effect after the determination of net profits. Theoretically, therefore, the provision for depreciation must be made, else true profits cannot be determined. Equally certain must be the provision for the sinking fund reserve. Authorities seem to agree that not only is there no need for provision for both but that to provide for both places an unnecessary burden on the stockholders during the periods of the creation of the sinking fund.
It is true that if the periodic amounts of the estimate for depreciation and the sinking fund are practically the same, and if provision is made only for the sinking fund reserve, there will be in that reserve a sufficient amount to care for the depreciation. Assuming the life of the asset and the life of the bonds to be the same, such a policy means simply that the asset, usually a fixed asset, has been converted by use into current funds which have been applied to the liquidation of the bonds. There has been no reservation of real profits for this purpose. Upon the complete depreciation of the asset, the book value not having been written down in the meantime because no depreciation has been booked for it, the asset must be charged against the reserve, thereby mutually extinguishing each other. No principles of accounting are necessarily violated.
Failure to book the depreciation as such results, however, in an inflated showing of net profits. If the sinking fund reserve is charged against current profit and loss instead of surplus, the showing of net profits is thus corrected but there has been no real reservation of profits, the sinking fund reserve being in reality a valuation account for the depreciating asset, and thus the letter of the trust agreement is violated. If the intent of that agreement was to increase proprietorship, as discussed on page 456 above, this procedure will not accomplish that purpose.
Provision for both depreciation and the reserve does not effect a double charge against profits. As pointed out above, the one is an expense charge without which true profits cannot be shown, and the other is a charge against real profits, resulting in a lessening of dividends. Where there is no trust agreement to compel the creation of a sinking fund reserve, it is merely a matter of financial policy as to how the bonds shall be redeemed, and there is no objection in theory to the conversion of the depreciating asset to that purpose. Much more is this the case when the mortgaged asset is a wasting asset, the exhaustion of which is inevitably bound up with the operation of the business. Here there is no need either to increase proprietorship or even to maintain capital intact, and the conversion of the wasting asset, without providing for its replacement, to the payment of the bond issue is legitimate and wholly unobjectionable as a financial policy.
XXVI. PROBLEMS IN CONNECTION WITH THE PROFIT AND LOSS SUMMARY
Interrelation of Profit and Loss and Balance Sheet
Because of the supplemental character of the profit and loss summary to the balance sheet, no study of the latter is complete or adequate, whether viewed from the standpoint of valuation or from any other aspect, without at least a consideration of the profit and loss summary in its larger bearings. Some general features of the summary will here be considered, followed in the next chapter by a discussion of its terminology, form, and content.
Every change in an asset which is not reflected among the other assets or the liabilities relates to proprietorship; or, as stated from the profit and loss point of view, every change in proprietorship, except it be merely a transfer between proprietorship items, is reflected as a change in assets or liabilities. The original contribution of capital is reflected among the assets. Other items of vested or permanent proprietorship have been discussed in Chapter XXIII, “Surplus and Reserves,” leaving for consideration here the temporary proprietorship, i.e., the profit and loss items. Of these, every income item results either in an increase of assets or a decrease of liability, while every expense shows as a decrease of assets or increase of liabilities.
The relation of the profit and loss phase of an enterprise to the problem of valuation is apparent—the majority of the changes in value of the assets being connected with profit and loss activities. Thus sales result in cash or claims against customers, and a valuation of these claims gives the amount of bad debts expense. The valuation of fixed assets determines the amount of depreciation expense. On the valuation of the stock-in-trade depends the cost of goods sold and therefore the gross profit. Only those profit and loss items which are realized or settled in cash are not dependent upon the valuation of related assets, and even here, in so far as cash must under some circumstances be valued, these may be, at least remotely, dependent upon valuation. As, therefore, the balance sheet is primarily an expression of opinion and judgment, rather than a statement of fact, so also in large measure must the profit and loss summary be regarded as an expression of opinion. The same factors which enter into appraisals and valuations determine profits and losses.
Periodic Adjustments
In Chapter XXIII, on “Surplus and Reserves,” attention has been called to the use of a statement of surplus for the purpose of showing the changes which take place in surplus from period to period. These changes are due to profits earned, dividends declared, extraordinary profit and loss items not handled through the profit and loss summary, and adjustments in profit and loss applicable to previous fiscal periods—such adjustments being necessary because of errors in the profit and loss summaries of those periods, due to insufficient information for making an accurate summary at the time. The periodic profit and loss summary is limited in its purpose and scope to the activities of the current period and to an equitable share of those income and expense items running over a number of periods. Because the adjustments just mentioned are frequently necessary, the periodic profit and loss summary as it appears on the books is never an entirely accurate reflection of the profit and loss activities for any period, but it is usually sufficiently so to serve all current needs. When, however, the earning capacity of a concern needs to be judged with great accuracy, over a number of periods, it is not safe to depend entirely upon the periodic profit and loss summaries. It may, for example, be necessary to judge earning capacity because of a contemplated sale or merger. Here the basis for determining value should be not the earnings of one period but the average of several periods. It then becomes necessary to reconstruct the periodic profit and loss summaries as carried on the books in the light of any additional information that may have become available later.
The adjustments to be made in such cases comprise not only the most obvious ones, caused by the oversight of accruals and deferred items of various sorts, changes in inventory valuations due to an incorrect inclusion or exclusion of some items, etc., but also changes in those items which in the light of a longer experience are shown to be inaccurate. This latter class of adjustments embraces particularly the estimated items the amounts of which are not definitely determinable. As time passes, more complete knowledge may indicate insufficient or excessive estimates of such items as depreciation, bad debts, provision for contingent liabilities, and similar reserve items, the valuation of which must be corrected for an accurate showing of earning capacity. Thus a distinction must be made between summaries compiled to show the current profit and loss results and those which give a true index of earning capacity over a longer period.
Interest as a Cost of Manufacture
A controversial point with a bearing on the profit and loss summary is whether or not interest on invested capital should be included as an item of manufacturing cost. One school of thought on the subject maintains, with a considerable degree of argumentative warmth, that interest should be included; while another school takes the opposite point of view. An attempt will here be made to summarize the arguments for and against the treatment of interest as an item of manufacturing cost. The one school bases its main contention on the economic theory of profits; namely, that profits represent the balance remaining after deducting the cost of land, capital, and labor. The function of the entrepreneur, it is contended, does not in itself involve the owning of capital. Profit is the reward for combining the other factors of production and assuming the risk involved. Interest is a cost for the use of capital and it does not matter who owns the capital.
It is further contended that, in order to bring a fair return on the capital invested, the selling price must include interest on capital investment. While this contention is true, the fact remains that no manufacturer would think of fixing selling price as a matter of general policy at a figure which would not return a fair rate of interest on his investment. But why that necessitates taking into the books interest as an element of cost is not explained by this theory.
It is also argued that to determine whether it is better to manufacture or to buy goods in the open market, and whether it is better policy to manufacture by means of expensive machinery and other equipment or by manual labor, interest on investment must be considered. While these arguments also are well taken, they again offer no satisfactory justification for the showing of interest on the books. It is furthermore contended that the cost of carrying the inventories for which the purchasing, stores, and planning departments of a manufacturing concern are responsible, should be shown with interest on the money invested in them taken into consideration—this for the purpose of providing a check on the efficiency of these departments. Where also both old and new machinery is used side by side and it is desirable to compare their costs of production, the element of interest should be considered.
Further argument for the inclusion of interest as an item of cost is the fact that in numerous processes time is an important element. Thus, the smelting of ore, the tanning of leather, the curing of tobacco, the seasoning of lumber, etc., are examples of relatively lengthy processes the cost of which should include interest on the capital invested. Interest on investment is also a factor that may sometimes determine manufacturing and selling policies, especially during slack periods when production is curtailed, part of the plant stands idle, and the fixed charges on the unused manufacturing capacity need to be taken into consideration. The same argument also applies to the accumulation of a large inventory of raw materials or finished stock during a period of low prices. The soundness of such a policy can only be judged when the item of interest on the capital investment is considered.
Arguments against the Inclusion of Interest
The majority of accountants are, however, opposed to the inclusion of interest as an item of manufacturing cost. The chief objections raised to its inclusion are:
1. The difficulty of determining the rate at which interest should be charged.
2. Inasmuch as the amount of investment in current assets is difficult to determine since it fluctuates daily, is interest to be charged both on fixed investment and on current investment, or only on the fixed?
3. If interest is to be charged, how shall the offsetting credit be handled on the books?
4. The introduction in production costs of a more or less constant element tends to obscure fluctuations in actual cost due to causes which may be corrected, and thereby partly defeats the very purpose of cost-keeping.
5. As the business world is accustomed to consider interest and dividends as of the same nature, namely, as a return on capital invested, to treat interest as a cost of operation would produce financial statements which are misleading.
With regard to the rate of interest, three different theoretical rates have been suggested: (1) a so-called “pure” interest rate, i.e., one yielded by the safest investment; (2) the rate at which money might be borrowed for the particular type of industry; and (3) a rate sufficient to attract permanent investment in the enterprise. From the practical standpoint of results there are serious objections to all these suggestions. As it is beyond the scope of this chapter to discuss this phase of the question, the interested student is referred to the numerous writers who deal with the question.
Problem of Charging Interest on Books
Where interest is treated as a manufacturing cost, the booking of it raises a perplexing accounting problem. The charge has to be made to some factory expense account, while the credit must be carried over to possibly a financial management income account. If the entire output of the factory were sold out by the close of the fiscal period and no product was in process of manufacture at that time, the result of booking interest in this way, so far as net profit is concerned, would be nil. It would be like taking money out of one pocket and putting it in another. This situation, however, is never met at the close of the fiscal period. Almost invariably some finished stock is on hand and goods are in process of manufacture. Where interest is added, the result is to inflate the value at which the goods must be carried on the inventory—a very undesirable procedure from an accounting and financial viewpoint. By such means it is conceivable that a factory might be made to show a handsome profit even before any of the product had been sold.
Considering both the ends to be attained by, and the defects and disadvantages of, the inclusion of interest as an item of factory cost, its exclusion seems best. In this connection it is to be noted that all government contracts on a “cost-plus” basis do not allow the inclusion of interest as one of the cost items. Furthermore, all the ends aimed at by its inclusion may be secured almost if not equally as well by statistical records, thus eliminating the objections to the bringing of interest as an item of cost onto the financial records.
Unrealized Profits
A similar problem to the above is the practice of charging a manufacturing profit to the selling department. The practice is prevalent in some concerns, of transferring the output of the factory to the selling department at a value above the cost to manufacture. The purpose of such a transfer is to show on the books the profit arising from the policy of manufacturing the product instead of buying it on the open market. The value at which the product is transferred from the factory to the selling department is usually the wholesale market value, though it may be at a fixed per cent above the cost of manufacture. The effect of this is, of course, to limit definitely the showing of factory profit. Where the compensation or the efficiency of the factory management is measured by the savings effected over the wholesale market price of the output, there is perhaps some practical advantage in the allowance of a manufacturing profit.
The main objection to charging the factory output to the selling department at any price other than cost is that such a policy introduces an element of unrealized profit. This objection is not serious if, at the time the books are closed for the purpose of showing results for the fiscal period, the unrealized profit is eliminated from the stock-in-trade inventory. So far as the profits on the portion of the output which has been sold are concerned, the net result is the same. The effect is to diminish the profit of the selling department by the amount of profit allowed to the factory. To bring assets onto the books at inflated values is, however, always objectionable, both because of the temptation to inflate profits by valuing the goods for the inventory at an inflated figure, and also because of the ease with which the adjustment of such items may be overlooked or forgotten at the close of the fiscal period. Where the adjustment is made with care, correct results can be shown as well by the one method as by the other. The adjustment needed applies only to the inventory of goods remaining unsold at the close of the period, which adjustment is usually shown by means of a valuation reserve account, by means of which the book value of the inventory is brought down to the factory cost value.
The whole problem of profit between departments is one phase of the larger problem of the intercompany profits of a holding company. In such a case it usually happens that one of the subsidiaries with separate corporate organization turns over its product to some other subsidiary company at a price which returns a fair rate of profit. As the product passes through the hands of the various subsidiaries, by the time it is ready for final distribution to the public the accumulated profits represent those of all the companies engaged in its production. If, now, all these subsidiaries belong to the same parent company, the book value of the unsold product shows, at the close of the fiscal period, a large unrealized profit which must be adjusted in order not to show the stock-in-trade at an inflated value. This problem is discussed more fully in Chapter XXXIV where the main problems of the holding company are taken up.
Corporation Dividends
In addition to these general problems of the profit and loss summary, some further questions arise at the time of closing the records of a corporation for the fiscal period. Much more care must be taken in closing the books of a company than is necessary in the case of either of the other general types of business organization. Thus, the corporation authorized to issue a number of different kinds of stock must see that the dividend declaration is based only on the amounts of the various classes of stock outstanding, and not on the stock unissued or brought back into the treasury. It is customary to set up separate dividend accounts for each class of stock. Oftentimes the terms of issue covering the various kinds of stock introduce complexities in the calculation of the dividend. This is particularly true in the case of stocks which have the privilege of participating in all dividends over a certain amount. Some stocks are cumulative as to their dividend, while others may be non-cumulative. All these conditions of issue must be considered carefully at the time of the declaration of the dividend.
Discount on Bonds
Another problem requiring care is the treatment of discount or premium on bonds as they are related to the bond interest charge. In Chapter XV where bonds are discussed, the relation between the bond premium or discount and the bond interest rate is brought out. This necessitates at the time of the payment of the bond interest an entry to bring about the gradual amortization of the bond premium or discount so that by the expiration of the life of the bond issue the premium or discount is written off the books. Where the interest period does not coincide with the close of the fiscal period, for an absolutely accurate showing not only must the accrued bond interest be taken into account but also the accrued amortization of bond premium or discount.
Sinking Funds
A third problem at the time of closing the corporation’s books relates to bringing the sinking fund transactions up to date. Where the sinking fund is in the hands of a trustee, the corporation’s books can show the status of the fund only upon the receipt of the report of the trustee showing the changes in the fund for the current period. Care must be exercised to demand a report from the trustee as on the date of the closing of the corporation’s fiscal period. The character of the adjustments needed and the entries necessary to book them have been explained in Chapter XXV.
Working Capital
A fourth problem which sometimes needs to be considered is that of “working capital.” Technically the working capital of a business is represented by the excess of current assets over current liabilities. As pointed out in Chapter XXV, a credit account called “Sinking Fund Reserve” is frequently set up to indicate the financial policy pursued in making provision for the retirement of a bond issue at maturity. At the time of the retirement of the bonds this reserve need no longer be shown as a separate item to indicate financial policy and should therefore be closed out. It may be thrown back into general surplus or it may be transferred—to indicate that it is a part of the permanent capital of the corporation—to an account entitled “Working Capital” or “Working Capital Surplus.” In all cases where an item of surplus is created for a specific purpose, care must be exercised to see that the conditions surrounding the creation of the item are lived up to in its final disposition. In cases of surplus created by gift, as in scholastic institutions or hospitals, this problem is particularly important.
A similar problem is also met at the time of the redemption of an issue of preferred capital stock, inasmuch as such redemption is usually at a figure above par.
The Correction of Closing Errors
A final consideration has to do with the correcting of errors in the closing work of previous periods. Any omissions and wrong valuations of items in previous periods demand correction, but such correction must not be allowed to affect the results of the current period. These corrections must therefore be made either direct through surplus or by means of an entry in the final section of the profit and loss account as will be indicated in the next chapter. Sometimes where entries of this kind are numerous an account called “Profit and Loss Adjustment” is opened as a clearing account through which these items are carried net into surplus. The chief objection to this procedure is that the adjustments are too easily lost sight of when only the net results appear in surplus. These entries usually carry information of value to shareholders and they should therefore be set forth as a part of the statement of condition rendered at the close of each fiscal period.
XXVII. THE PROFIT AND LOSS SUMMARY—FORM AND CONTENT
Standardization of Form
As stated in Chapter XXVI, the profit and loss summary is supplementary to the balance sheet and should always accompany it whenever it is desirable to make a full and comprehensive showing of condition. This summary is given various titles and is shown in various forms, depending somewhat upon the general class of enterprise to which it relates, the particular purpose for which it is compiled, and sometimes on the predilection of the person who draws it up or for whom it is drawn. With the passage of time the form of the summary, and to a less degree its content, tend to become standardized. The regulations of various governmental bodies have given an impetus in this direction. The Interstate Commerce Commission, the Comptroller of the Currency, public service commissions of various states, superintendents of state banks and of insurance—all require standardized reports from the concerns under their jurisdiction. The Federal Reserve Board has recommended certain forms of statement of both balance sheet and profit and loss to be submitted as the basis of credit by merchants and manufacturers. Investigations made by the Federal Trade Commission point out the desirability of a more uniform method of presenting the results of business activities than now exists. These regulations and requirements as to standard forms of statement do not interfere with the presentation of other forms of statement for other purposes than those required by the regulatory bodies. As local conditions frequently give rise to problems which are peculiar to individual concerns, standard forms of statement will not always meet local needs. Flexibility to meet given conditions, and deviation from set forms must always be permissible if the accounting department is to render the highest kind of service of which it is capable.
Synonymous Terms
Various titles are used as synonyms for the profit and loss summary, among which are the following: Statement of Profit and Loss, Loss and Gain, Outlay and Income, Revenue, Revenue and Expenditures, Income, Income and Expenses, etc. Of these, the term most generally used is “Profit and Loss.” “Business Statement” and “Statement of Outlay and Income” are phrases seldom if ever employed nowadays, while “Loss and Gain” finds little favor. Of the two terms, “Revenue” and “Income,” Revenue is used more often in connection with non-profit-making concerns, particularly in connection with state and municipal accounts. “Income and Expenses” is usually limited to the profit and loss statement rendered by clubs, churches, libraries, hospitals, etc., although the term “Revenue” is frequently used in this connection. “Income Statement” and “Account” are terms frequently applied to the profit and loss summary of trading, industrial, and professional concerns; but except where custom has established certain well-defined uses, as indicated above, the title “Profit and Loss” is all-sufficient; there is no doubt as to its meaning or content, and its use for summarizing the temporary proprietorship items is thereby established, particularly in connection with profit-making concerns.
Cost of Goods Sold—Manufacturing Concern
Profit-making enterprises may be roughly divided into several groups as follows: industrial or manufacturing selling, agency and commission, public carriers or transportation, and financial. The profit and loss summary for these different groups is, in the main, the same although, of course, the content of the summary depends materially upon the nature of the business. In all cases the source of income is from sales—whether of a commodity or of services makes little difference. The first deduction from gross earnings under the title “Sales” or other similar title is the cost of sales. At this point the first marked divergence among the various groups is met. In an industrial enterprise the cost of sales is the cost of goods manufactured and sold as well as the cost of any goods purchased for immediate resale. This latter cost is met only in enterprises which combine manufacture with selling. This does not imply that manufacturing concerns have no selling problem, but rather that in many cases they also purchase other products for sale along with their own product, perhaps as side lines.
For a manufacturing concern which sells only its own product, the first deduction from sales is the cost of the goods manufactured and sold. As stated in Chapter III, the elements of the cost of manufacture are: (1) material, (2) labor, and (3) factory expense. The cost of goods manufactured must be combined with any unsold output at the beginning of the period and a similar output at the end of the period, in order to determine the cost of the goods sold. Cost of manufacture corresponds roughly to the net purchases of a trading business.
Cost of Goods Sold—Trading Concern
For a trading business, i.e., a business which buys its commodity for resale, the first deduction from sales is likewise the cost of goods sold as determined by a “cost of goods sold” formula as follows: To the goods on hand at the beginning of the period is added the full cost of the net goods purchased, and from the sum of these two items is deducted the cost of the goods on hand at the end of the period. In the case of both the industrial and the trading enterprise, when the cost of the commodity sold is deducted from the sales the result is the first significant figure as to profits known usually as “Gross Profit.” Among public carriers the first deduction from sales is the “Cost of Services Sold or Rendered”; this is usually carried under the title “Costs of Operation” or “Operating Expenses,” giving the figure of net earnings.
For the other types of business mentioned—agency and commission concerns, and financial enterprises of various sorts—the allocation of the direct costs of the service rendered is much more difficult and is seldom attempted. The so-called general and administrative expense and the expense of selling are usually so inextricably merged with the direct cost of rendering the service that a separate showing of the items is seldom attempted. However, where any expenses are directly applicable to the service rendered, they should be deducted first, before the general administrative and selling expense.
Further Differentiation of Terms
Before going into a detailed explanation of the elements of the profit and loss summary, it may be wise to make a further differentiation of terms sometimes employed, such as: Income and Expenditures, Receipts and Disbursements, Receipts and Payments, etc. All three terms are often met and are frequently misused as titles for the profit and loss summary. Their proper use should limit them to cash transactions or activities only. It is true that in some instances the profit and loss summary is mistakenly made up on a so-called cash basis, cognizance being taken of the income and expense items only when realized in cash. It would hardly seem necessary to convince the modern business man that sales made on credit and not yet realized in cash are part of his income as much as the items of income realized in cash, the chief difference being that provision must be made in the one case for uncollectible items, while in the other case no such provision is necessary. Yet even today it is sometimes difficult to convince the proprietor of a small business of the necessity, from the standpoint of accurate accounting, of taking cognizance of accrued and deferred expense items. Instances may sometimes, though rarely, arise in which all income has been received in cash at the end of the fiscal period and all expenses applicable to that period have been met in cash and that no deferred items need to be taken into account. Where such is the case, a statement of cash receipts and disbursements might give a fair indication of the profit and loss for the period. In the case of clubs, churches, and other institutions, practically all that is required of the managing officers in accounting for their trusteeship is a statement of trusteeship of cash, i.e., a statement of receipts and disbursements. The point of this discussion is merely that the terms, “Receipts and Disbursements,” “Receipts and Payments,” and, to a less extent, “Income and Expenditure,” should be limited to a statement of cash activities and never applied to the profit and loss summary.
Desirability of Uniformity in Terms Used
So far as the standardization of the sections of the profit and loss summary is concerned, much the same remarks are applicable as to the general title of the “Temporary Proprietorship Summary.” Such terms as Gross and Net Profit, Gross Revenue or Income, Net Revenue or Income, Gross Trading Profit, Net Trading Profit, Net Profit or Profit from Operation, or simply Business Profit, are used with little uniformity by the business world at large and even by the accounting profession. While it is never desirable to lay down many hard and fast rules or definitions because any statement or method of showing results should always be flexible and adapted to the conditions met, still the use of the same terms for different purposes and the use of different terms for the same purpose or section of a statement are, to say the least, confusing to the student. The committee of the Federal Reserve Board which drew up tentative forms for the profit and loss account and balance sheet, has done a good work in the interest of uniformity in accounting terminology. Their suggested form is applicable, however, only to the business of a manufacturer or merchant. In the case of public carriers the regulation of their accounting systems by the Interstate Commerce Commission has brought about a very desirable uniformity of terminology. Other regulating bodies in various states have performed a similar service in the case of public utility concerns, although because of divided authority their rulings lack uniformity.
Profit and Method of Showing
In general it may be said that the term “Gross Profit” is properly applicable to what is left after deducting from the main income the cost of that income. In a merchandising concern this figure is sometimes called “Gross Trading Profit,” though the term “Gross Profit” serves the purpose equally well and does not introduce a confusing adjective. When, from this gross profit, the two groups of selling expense and general administrative expense are deducted, there remains what is termed “Profit from Operation” or “Net Operating Profit.” One occasionally finds the group of selling expenses deducted by itself from the figure of gross profit, leaving what is termed the “Net Trading Profit.” Such a method of presentation serves no useful purpose and shows a figure which has little or no significance. The net trading profit merely represents what is left after deducting one group of expenses, and gives no essential information which the total of selling expenses would not give equally as well.
There is some difference of opinion as to whether the figure of net operating profit should be arrived at before considering any of the items of financial management, i.e., as to whether such items as interest income and expense, cash discount items, bad debts, etc., which are more or less common to every business, should be included before determining net operating profit or should be set up separately after its determination. The best practice seems to be to use the term “Net Operating Profit” as indicated above, and to show the financial management items in a separate section. In public service utility statements and also in those of some manufacturing concerns, such terms as “Gross and Net Earnings” and “Gross and Net Income” are met. Where these terms are used the gross earnings correspond approximately to sales and indicate the amount of the main income before any deductions are made. After the deduction of the direct cost of securing this income, the item is frequently called “Net Earnings.” Alternative terms for these two are “Total Operating Revenue” and “Total Net Revenue.” When, to the item of the net earnings or net revenue, income from other sources is added, the figure of total Gross Income is arrived at. When, from this figure of total income the “Charges Against Income” are subtracted, which are roughly the financial management expenses, we arrive at the figure of net income which corresponds to the figure of net profit. The use of the terms “Earnings” and “Income” in this restricted way is illogical, and must be regarded as the outgrowth of custom—a custom which is, as stated above, fairly uniform in the case of public utilities.
Form of Presentation—Account Form
As to the form of the profit and loss summary, in the main, two types are met. One is known as the account form because the items of income and expense are set up like credits and debits in an account. The other is known as the statement or report form. This is sometimes referred to as the non-technical method of presentation because the items are set up in running form without regard to a debit or credit terminology, the order of arrangement being dictated by the logic of the ordinary business man. In the case of the account form the sales or main items of income are placed in juxtaposition on the one side with the direct costs of that income on the other side, the balance of the two sides being brought down as the gross profit. Against this are set up the groups of selling and general administrative expenses. The difference between the two sides is again brought down as the figure of net operating profit to which are added other items of income. The charges against that income, i.e., the expenses incurred in financing the business, are then shown. The balance at this stage is the net profit for the fiscal period and opposite this appears its disposition, showing the portion appropriated to dividend purposes, to reserves of various sorts, and finally to surplus of the portion remaining unappropriated to other uses.
Non-Technical or Report Form
When the profit and loss summary is set up in non-technical form, the figure of sales is first shown. Beneath this rather than in juxtaposition as in the other case, the cost of sales is given, which cost deducted from sales gives the figure of gross profit. Below this appear the groups of selling and general administrative expenses, the deduction of which from the gross profit figure gives the figure of net operating profit or, as sometimes stated, the figure of “Net Profit on Sales.” To the net profit on sales are added the other items of income, and from the sum of these are subtracted the expenses of financial management, leaving, as in the other case, the net profit for the period.
Examples of Forms of Presentation
It is impossible and undesirable, as stated above, to lay down any hard and fast form which must be rigidly followed, because a basic principle of all accounting is that it must adapt itself to the needs and requirements of particular conditions. Therefore, only the bare skeleton of a form can be set up with any hope of its being applicable to all conditions. In other words, the form of arrangement and method of showing the statement to be presented at the close of the fiscal period must be flexible, depending upon the use to which the statement is to be put and also depending upon the information which it is desired to set forth.
The skeleton form given below which is suggested by A. Lowes Dickinson[68] follows the general lines laid down in this chapter. It is designed to serve as a framework for all uses.
MANUFACTURING AND MERCHANDISING: Gross Earnings from Sales $..... Less—Returns, Allowances, and Discount ..... ----- Net Earnings from Sales $..... Deduct—Cost of Production or Service ..... ----- Gross Profit $..... Deduct—Cost of Selling $..... Expenses of Management ..... ..... ----- ----- Net Profit from Operations $..... =====
AGENCY AND COMMISSION: Commissions Earned $..... Deduct—Expenses of Management $..... Cost of Guarantees ..... ..... ----- ----- Net Profit from Operations $..... =====
TRANSPORTATION: Earnings from Operations $..... Deduct—Operating Expenses $..... Taxes ..... ..... ----- ----- Net Profit from Operations or Operating Income $..... =====
BANKING: Earnings from: Interest $..... Commissions ..... Other Profits ..... $..... ----- Deduct—Expenses of Operation and Management ..... ----- Net Profit from Operations $..... =====
PROFESSIONAL: Gross Earnings from Fees $..... Less—Out-of-Pocket Expenses included therein ..... ----- Net Earnings from Fees $..... Deduct—Expenses of Operation and Management ..... ----- Net Profit from Operations $..... ===== (The form for the remainder of the statement will be the same in all cases, viz.:)
Net Profit from Operations $..... Other Income ..... $..... ----- Deduct—Interest on Bonds $..... Other Fixed Charges ..... ..... ----- ----- Surplus for the year $..... Extraordinary Profits (detailed) ..... Surplus brought forward from preceding year ..... ----- $..... Deduct—Extraordinary Charges ..... ----- Total Surplus available $..... Dividends on Stocks ..... ----- Surplus carried forward $..... =====
[68] In “Accounting Practice and Procedure.”
Form for Manufacturers and Merchants
The form suggested by the Federal Reserve Board as suitable for manufacturers and merchants is presented below. It is shown as a comparative statement of several years, but the same content and order of arrangement of items would, of course, be followed for any individual year. When presenting a single year’s activities, the money columns should be so used as better to present significant figures and their interrelations. The use of one column for items and another for totals accomplishes this. The form shown presents, after the figure of Net Income—Profit and Loss, a statement of extraordinary charges and credits to profit and loss tied up with the former balance of surplus, an appropriation made of profit and surplus at the end of this period, giving as a final figure the new surplus at its close—which is the figure carried on the balance sheet. This last portion of the statement is often shown as a separate statement of surplus. The items which are best handled as charges direct to surplus so as not to affect the profit and loss showing for the current period, have been discussed in Chapter XXIII on “Reserves and Surplus.” There the illegitimate use of surplus as a dumping ground for items which it is desired to conceal was mentioned. To prevent this misuse of surplus the final section of the profit and loss statement is often shown as set forth above. Where, however, a separate statement of the surplus is included as a part of the exhibit of the condition for the fiscal period, the statement of profit and loss will, of course, end with the figure of net profit, if that profit is transferred to surplus, out of which all appropriations of profit to its various uses are made. If, however, appropriations of this period’s profits, as distinguished from the accumulated profits of other periods, are to be made for specific purposes, their disposition is best shown in a final appropriation section as a part of the current statement of profit and loss.
COMPARATIVE STATEMENT OF PROFIT AND LOSS Year Year Year Ended Ended Ended 19— 19— 19—
Gross Sales $...... $...... $...... Less Outward Freight, Allowances, and Returns ...... ...... ...... ------- ------- ------- Net Sales $...... $...... $...... ======= ======= ======= Inventory beginning of year $...... $...... $...... Purchases, Net ...... ...... ...... ------- ------- ------- $...... $...... $...... Less Inventory end of year ...... ...... ...... ------- ------- ------- Cost of Sales $...... $...... $...... ======= ======= ======= Gross Profit on Sales $...... $...... $...... ======= ======= ======= Selling Expenses (itemized to correspond with ledger accounts kept) $...... $...... $...... ------- ------- ------- Total Selling Expense $...... $...... $...... ======= ======= ======= General Expenses (itemized to correspond with ledger accounts kept) $...... $...... $...... ------- ------- ------- Total General Expense $...... $...... $...... ======= ======= ======= Administrative Expenses (itemized to correspond with ledger accounts kept) $...... $...... $...... ------- ------- ------- Total Administrative Expense $...... $...... $...... ======= ======= ======= Net Profit on Sales $...... $...... $...... ======= ======= ======= Other Income: Income from Investments $...... $...... $...... Interest on Notes Receivable, etc. ...... ...... ...... ------- ------- ------- Gross Income $...... $...... $...... ======= ======= ======= Deductions from Income: Interest on Bonded Debt $...... $...... $...... Interest on Notes Payable ...... ...... ...... ------- ------- ------- Total Deductions $...... $...... $...... ======= ======= ======= Net Income—Profit and Loss $...... $...... $...... Add special credits to Profit and Loss ...... ...... ...... Deduct special charges to Profit and Loss ...... ...... ...... ------- ------- ------- Profit and Loss for period $...... $...... $...... Surplus beginning of period ...... ...... ...... ------- ------- ------- $...... $...... $...... Dividends Paid ...... ...... ...... ------- ------- ------- Surplus ending of period $...... $...... $......
Content and Manner of Showing
Some problems in connection with the content of the various sections of the profit and loss summary and also with the manner of showing the content will now be taken up. The first item to be considered is the handling of the deductions from sales. On the Federal Reserve form of statement not only are sales returns and allowances deducted but also outfreight charges and, in some instances, other expenses which are regarded as direct selling costs as distinguished from the indirect costs shown in the group of selling expenses. Practice is not at all uniform in this regard. It should be stated that where the policy of the business is to sell goods f.o.b. destination, the outfreight charges may be regarded as a proper deduction from the figure of gross sales, as otherwise that figure is inflated by the item of freight, the cost of which is no part of the business organization nor is it under its control. Where, however, goods are only sold occasionally f.o.b. destination, the outward freight is more properly treated as a cost of making the sale in the same way as advertising. It should therefore be included in the group of selling expenses rather than be treated as a direct deduction from sales.
Supporting Schedules
With the object of presenting a bird’s-eye view of the profit and loss activities for the year, it is desirable that as little detail be shown on the face of the statement as may be necessary to furnish the information desired. The profit and loss statement under this method of treatment must be supported as to its detailed content by schedules giving the full information which may at times be valuable to proprietor or manager. The first supporting schedule may well be headed “Cost of Goods Sold.” Therein should be shown the statement of inventory on hand at the beginning of the period, goods purchased during the year, inward freight and carriage costs, purchase returns and allowances, and goods on hand at the close of the year, the result being the figure carried on the profit and loss summary. Where manufacturing is also carried on, this cost of goods schedule should include a statement of manufacturing activities, set up in the following order: raw materials used in manufacture which will be derived from a statement of raw materials inventory at the beginning, purchases, inward freight, purchase returns, and raw materials on hand at the close of the period. To this figure of raw materials consumed in manufacture should be added the direct labor costs for the period, the sum of the two giving the significant figure of prime costs. The addition to this of the factory expense set up in detail gives the cost of manufacture for the period.
Adjustment of Inventories
An adjustment should be made somewhere in this manufacturing section of the inventories of goods in process at the beginning and end of the period. This adjustment is usually made at the end of the manufacturing statement, but the position depends largely on the cost system in use and therefore the cost elements which make up the value of goods in process. If these values include raw materials, direct labor, and factory expense, and a separation of these elements is difficult or impossible, the adjustment is perhaps best made at the close of the manufacturing statement. Where, however, the elements referred to are easily separable, the difference between the cost of materials in the opening inventory of goods in process and the closing inventory should be added to the materials used in manufacture during this period or subtracted from them, as the case may be. Likewise, the difference between the labor items in the two inventories should be added to, or subtracted from, the direct labor cost for the current period. This makes possible an exact showing of the prime cost for the period.
The element of factory expense in goods in process should then be handled in the factory expense section, in this way doing away with the adjustment at the end of the statement as in the other case. While this method is more difficult and complicated, it is usually to be preferred. The cost of the finished product turned out during the period, as shown by the manufacturing section, must be added to the inventory of the finished product on hand at the beginning of the period, and from the sum of these two items must be deducted the finished product on hand at the close of the period in order to develop the cost of the manufactured product sold during the period. If, now, other commodities are bought and sold in addition to those manufactured, the cost of the goods bought and sold should be shown as for a trading business.
Selling Expense and Administrative Schedules
The second schedule to be shown in support of the profit and loss statement will be the selling expense schedule. Herein will be included all the customary selling expense items, the total of which is carried on the face of the profit and loss statement. It may be desirable in some instances to omit advertising costs from this group and show them on the face of the statement as a separate item. This is a particularly desirable policy either where advertising is a large item, or where results are to be shown during an advertising campaign.
The third schedule is the general administrative items. It seems hardly worth while to attempt a separation of so-called general expense items from those of administration, as any basis of separation must necessarily be arbitrary.
The fourth schedule will show the financial management expense and income items. These are the items which are shown on the statement under the heads of “Other Income” and “Deductions from Income.”
These are the customary schedules presented. When the statement of surplus is made a part of the profit and loss statement, as is sometimes the case, and there are many detailed entries during the period direct to surplus, a final schedule should present these charges and credits to surplus during the period.
Schedules for Special Needs
It frequently happens that it is desirable to carry additional schedules to those explained, in order to show an analysis of certain earnings or operations which may be of special interest to the individual concern. Thus, it might be desirable to show an analysis of sales by departments, by geographical districts, or by branches. Similarly, expenses might be analyzed on the same basis. A branch organization, for example, might show all its activities, including the net operating profit by branches, the sum of the branch operating profits being taken into the combined profit and loss statement, after which appear the items of financial management expense and income. As heretofore stated, all these are problems concerning which no arbitrary ruling can be made, the organization of the business and the information desired being always the determining factor.
The problem of valuation as related to the commercial balance sheet has now been completed. Some miscellaneous matters of corporation accounting and finance follow and these complete the second year’s course of study.
XXVIII. LIQUIDATION OF A CORPORATION
Reasons for Liquidating—Partial and Complete Liquidation
There are a number of ways in which a corporation may cease to exist and a liquidation take place. The charter, if created for a fixed number of years, may expire. The state may see fit to repeal the charter in accordance with the right reserved at the time it was granted. The corporation may of its own accord surrender its charter; or the courts may decide that the corporation has forfeited its charter rights by reason of non-performance or because of some wrongful act. Failure to pay taxes due the state is an instance. The liquidation of a corporation may take place because of a consolidation resulting in loss of its original identity. In the case of a merger the merged corporation ceases to exist under the terms of the agreement made which may call for a more or less complete liquidation. Sometimes a reorganization effects the liquidation of an insolvent corporation. If the new corporation obtains the assets of the previous corporation under a forced sale, the money received would be applied to the satisfaction of the old creditors’ claims.
Insolvency is the most usual reason for liquidating a corporation. Insolvency may be either actual or legal. By the National Bankruptcy Act insolvency is defined as the condition in which the assets of a person, firm, or corporation are less than the debts. This definition emphasizes the economic point of view. A corporation is legally insolvent when the cash assets are not sufficient to pay debts when they become due. Either of these conditions may exist without necessarily disastrous results, though it generally leads to disaster sooner or later. However, the fact that these conditions do exist indicates that the business in question is not well managed. It is well, therefore, to bring out the more prevalent causes leading to insolvency.
Current Assets Transferred into Fixed Assets
A common cause of insolvency is the tying up of current assets in plant and equipment. While this may be the actual cause, the post-mortem assigns the cause generally to lack of “working capital.” When a business expands and orders are coming in in excess of the facilities at hand, there is a great temptation to put a large part of the incoming funds into plant in order to take full advantage of the opportunities in sight. The result is that eventually the point is reached where it is impossible to get the cash necessary to meet maturing obligations. While the need for plant and equipment may justify the outlay, they cannot readily be converted into cash for they are usually of such a special nature as to be of small value without the organization.
Tying up Cash in Stocks of Material
The conversion of the cash resources of a company into stocks of material is another cause of insolvency, especially if the turnover is slow or the business is of such a nature as to require large sums invested in materials. Though capital in this form is generally being converted into cash or other forms of working capital, the fact that large sums are invested in material does not always mean that its cash value measures the amount of working capital. On the liability side of the balance sheet there may be items such as short-time loans or accounts payable which must be deducted in order to determine the net working capital. If the stock carried is disproportionate to requirements, it is a sign of poor management. When this state of affairs is allowed to continue for some time, the chances are that stocks will become obsolete or deteriorate, resulting in a loss. This will eventually result in the accumulation of current liabilities or floating debts and so bring about a condition of insolvency.
Unwise Use of Cash for Paying Dividends
Dividends are sometimes paid at a rate entirely out of proportion to average earnings, or a rate is maintained that is at variance with current earnings. Profits depend to a large extent upon economic and financial conditions. Business does not move on an even level throughout the years. The rule with conservative corporations is that dividends must not be allowed to rise, even in most prosperous periods, above a conservative estimate of the average earnings. In periods of prosperity the demand on the cash resources of a business increases as the prices of material, labor, and money rise. The result is that while a company may make large profits it may not be in a position to pay more than the usual rate of dividends. Many a corporation after paying big dividends in prosperous times has ended by placing its affairs in the hands of its creditors. Dividend payments are dependent not only upon profits but to a greater extent upon the concern’s cash position. To endeavor to do a large volume of business with a small working capital is generally a sure and a quick way of landing in bankruptcy. The prudent way is to withhold dividends until in the normal course of events cash is accumulated beyond the requirements of the business. The book surplus must be reinforced by a satisfactory cash balance as a basis for the declaration of cash dividends.
Sometimes corporations may find it sound practice to pay dividends with the proceeds of temporary bank loans. This is not open to objection under certain circumstances. For example, the company’s business may be subject to wide seasonal fluctuations’ or it may be of such a nature that it nominally operates with a small working capital. Even in these cases the assumption must be that the loans can be repaid when due without any undue strain or effort. There is some question regarding the soundness of the practice, sometimes resorted to, of issuing long-term obligations or of selling additional stock for the purpose of obtaining cash to pay dividends. If the profits are extraordinarily large and the probabilities are that they will remain so, then the increased capitalization may not be a serious handicap in itself. However, where the surplus shown on the books is fictitious or when a legitimate showing of profits cannot be made, then such a transaction would clearly be fraudulent.
Inability to Secure Cash for Refunding Operations
Corporations sometimes issue bonds because of the fact that a larger return is gained to the stockholders than if more stock were sold. The interest rate on bonds is generally much less than the rate of profits and even less than on short-term loans or notes. The distinction between bonds and notes is mainly that of time. The proceeds from the bonds are commonly used for permanent improvements, while the notes are issued to bridge over the changing of some form of quick assets into cash. Generally the bonds are issued during a period of easy money but they may mature when the money market is hard. If a sinking fund has been provided, all that is necessary is to convert the securities in which the funds have been invested into cash and take up the bonds. But the fact that the returns on the securities in the sinking fund are as a rule much less than can be realized by placing the money in betterments, operates against its use.
When, therefore, the bond issue becomes due in a period of financial stringency, or even during normal times if the business has not been highly successful or if its credit has been impaired, the company may be unable to liquidate its assets and pay it off. The consequence is that a foreclosure of the mortgaged property is made.
Excessive Borrowing on Short-Term Securities
A frequent cause of insolvency is excessive borrowing by means of short-term securities in the form of accounts payable, acceptances, and notes. The notes may be classified into: (1) notes discounted at some bank; (2) notes sold to the public; and (3) merchandise notes. There are three legitimate uses to which they may be put, namely: (1) to take care of a temporary lack of funds; (2) to extend further credit to customers; and (3) to increase the stock of easily marketable goods on hand. Definite provision must be made to meet the notes at maturity, which in the case of bank loans run from 30 days to six months—generally 60 to 90 days. The use made of funds obtained in this manner is a matter of importance to bankers when extending loans.
To use any one of these forms of borrowing for the purpose of financing betterments and additions is dangerous and essentially unsound. Such obligations are generally contracted during a period of prosperity and expanding business for the purpose of taking care of temporary needs. They frequently become a source of embarrassment when a period of money stringency sets in. If the borrowings are in excess of the quick assets, the policy is unsound at all times. Conservative managers make provision for meeting their notes at maturity before they issue them.
The short-term notes sold to the public usually are for longer periods than those discounted at the banks—the period ranging from one to five years. When the time is not appropriate for a bond issue and it is desirable to defer it, short-term notes are generally issued and marketed through note brokers, often throughout the country. This is an effective means of deferring a bond issue until money is easier and better terms can be obtained for the larger issue. When the bonds are sold the notes are retired with a part of the proceeds. The danger of this financial practice is that the notes may mature before the bonds can be marketed, as would probably be the case if a period of depression ensued. This would involve disaster if provision for refunding had not been made, especially as the proceeds of such notes, like the proceeds of a bond issue, are generally used for betterments and additions.
Losses in Conducting the Business
A business, through defects of management, does not always fulfill the expectation of its promoters. The price of the product may be set without regard to true costs, and losses pile up with or without the knowledge of the management. Competitive conditions may have to be met and efficiency of management be an absolute requisite if profits are to be made. An organization is of slow growth and the price paid for experience may eat up all the profits. Poor workmanship, duplication of effort, poor planning in the factory, resulting in a high unit cost—these are all factors which may bring disaster if not detected and remedied in time. The promoters may have been unusually optimistic in regard to the business that could be done, with the consequence that a plant is constructed much in excess of actual market possibilities. Losses of a serious nature then result from the poor utilization of fixed assets. “Lack of ability” is the phrase commonly used in describing this cause of insolvency. The usual symptom of the malady is a reduction in current assets and greater difficulty in obtaining credit.
Loss through Fraud, Theft, or Unavoidable Causes
The corporate form of business lends itself to exploitations of many kinds. The public is usually victimized, but sometimes the stockholders suffer through a breach of trust on the part of officers—as for example, the granting of contracts or the payment of exorbitant salaries to the detriment of the large body of stockholders. Another form of exploitation is the diversion of profitable business to some other corporation controlled by the untrustworthy officers. Then again the officers may buy up unprofitable ventures and sell them to the corporation at a large profit. The juggling of accounts may cover up fraud and exploitation. The profits may be sacrificed for the purpose of squeezing out the minority stockholders, or contracts may be made with a subsidiary whereby it takes most of the profits, or the profitable features of the corporation may be sold to a new company. These modes of freezing out the minority are naturally promoted by the majority stockholders. Whatever may be the means used, these various methods of exploitation may lead to insolvency, their ultimate effect depending upon the condition of the company and the extent to which they are carried on.
Unavoidable causes which may lead to the impairment or complete loss of a corporation’s assets are the disruption of the organization and its earning capacity through fire or earthquakes or other natural causes; or new inventions may kill the demand for its product; or improvements in machinery and equipment may render obsolete a large capital investment.
Methods of Liquidation
There are several forms of procedure in case liquidation is found advisable or necessary, and in general there are three courses open, viz.: bankruptcy, voluntary dissolution, and receivership.
Bankruptcy. This perhaps is the most common method. It is of two kinds—voluntary and involuntary. If voluntary bankruptcy is contemplated, the debtor files a petition in the federal court for his district, stating the number and amount of his debts and the amount of his assets. Creditors are then served with the notice and copies of the petition. Further proceedings are similar to those in involuntary bankruptcy. Involuntary bankruptcy proceedings may be brought if the debts are not less than $1,000 and an act of bankruptcy has been committed.
The following are legal acts of bankruptcy:
1. To convey, transfer, conceal, or remove, or to permit to be concealed or removed, any part of the debtor’s property with intent to hinder, delay, or defraud his creditors. 2. To transfer while insolvent any portion of the property to one or more creditors with intent to give preference to them. 3. To make a general assignment for the benefit of creditors, or being insolvent to apply for a receiver or trustee for the property. 4. For the debtor to admit in writing his inability to pay his debts and his willingness to be adjudged a bankrupt on that ground. 5. To suffer or permit, while insolvent, any creditor to obtain preference through legal proceedings and not have vacated such preference at least five days before the sale or final disposition of the property affected by such preference.
After the petition has been presented the next step is the appointment of a receiver or trustee for the purpose of protecting the creditors, and also in the case of the individual to secure the application of his property to the settlement of his debts so far as possible and so secure for him a discharge from further liability.
Bankruptcy proceedings are regulated by the National Bankruptcy Act of 1898. The courts of the Federal Government have jurisdiction in these proceedings. Under the National Bankruptcy Act, a person is insolvent “when the aggregate of his property, exclusive of any property that he has conveyed, transferred, concealed or removed, or permitted to be removed with intent to hinder, delay or defraud his creditors, is not, at a fair valuation, sufficient in amount to pay his debts.”
Voluntary Dissolution. A corporation may or may not be insolvent when making a voluntary dissolution. The reasons for the decision on the part of the stockholders to take this step may be various. Perhaps business is falling off and further profitable use cannot be made of the capital, or the company while solvent is losing money and drawing on its surplus. Again the cause may be due to legal complications, especially when concerns are adjudged combinations in restraint of trade. Voluntary dissolution in general is due to the fact that the condition of affairs seems to be unprofitable and the near future promises nothing better.
Receivership. One method of liquidating an insolvent corporation is by means of a receivership. The appointment of a receiver in equity is different in purpose from that of a receiver in bankruptcy. The function of the receiver in equity is to continue the business until it is wound up. In bankruptcy proceedings a receiver is appointed temporarily to preserve the property until a trustee can be elected. He does not conduct the business, but merely takes care of the goods, and pays taxes and dues, until the election of the trustee. A receivership in equity is frequently a preliminary step to reorganization. While the concern is technically insolvent in that the quick assets are not sufficient to meet maturing obligations, the total assets really exceed the total liabilities. Were the fixed assets sold, only a small fraction of their value might be realized. Under these circumstances the appointment of a receiver in equity is a valuable measure, giving time to provide for permanent remedies.
Liquidation under Bankruptcy
In involuntary bankruptcy proceedings the creditors file a petition in the federal courts located in the judicial district where the bankrupt has his place of business or in which his property is located. A copy of the petition is served on the bankrupt. The petition generally asks for the appointment of a receiver to protect the property until a trustee can be elected. The receiver is appointed by the court and is given charge of all property of the bankrupt until the first meeting of the creditors. The proceedings are generally conducted before a referee in bankruptcy appointed by the court. After the expiration of 20 days, during which the bankrupt is allowed to make his reply, he is required to file a list of all claims against him. A meeting of all creditors whose claims have been allowed by the court is then called and, if the petition is granted, a trustee is elected. Creditors who have some security for their claims are not allowed to vote for the trustee unless the security is insufficient to cover their claims, in which case they may vote on the amount of claim which is unsecured.
As soon as the trustee has been elected the creditors should file their claims with him together with the proof of the claims. This may consist of an affidavit stating the nature and amount of the claim, and the security held, if any. The bankruptcy proceedings are carried through unless the creditors and debtor agree to compromise.
The trustee’s first duty on his appointment is to collect all the property and any debts owing to the bankrupt, and to turn everything into cash in as short time as possible without unduly sacrificing the assets. As a general rule it is necessary to keep the business going for some time in order to get the most out of it. From the receipts the trustee pays taxes, filing fees, court costs, attorney’s fee and wages due, and then the creditors. Servants and persons employed for three months prior to the bankruptcy proceedings are entitled to be paid before any other claims are settled. After that the secured debts are discharged to the value of the security. When these items have been paid, if there remains enough to pay 5% of the total amount of all other claims, the creditors are entitled to have a dividend declared within 30 days after the debtor has been adjudged a bankrupt. If not, they must wait until the trustee has collected a sufficient amount. Afterwards the creditors are entitled to dividends from time to time until the entire amount in the hands of the trustee has been paid out. When the final dividend has been paid the trustee makes up his accounts, presents them at court, and asks for a discharge. He then is entitled to his fee based on the value of the funds that have gone through his hands.
Liquidation under Voluntary Dissolution
A corporation may be dissolved and its affairs wound up by the proper procedure if all its stockholders consent. In some states a majority is sufficient, and in certain cases even less. Statutory provisions prescribe the procedure in most of the states. The process of voluntary dissolution consists simply of gradually closing down the business by realizing on the assets, and distributing the funds among the creditors and stockholders. This usually involves a vast amount of detail work, such as the transfer of contracts, the sale of parts of the business, the taking of inventories, the making of appraisals, and so on.
Liquidation under Receivership
The receivership in bankruptcy is only a step in the chain leading to the appointment of a trustee under whom the process of liquidation takes place. As already stated, the receivership in equity is sometimes not a process of liquidation but a means of carrying on the business pending reorganization. In case the assets are greater than the liabilities, it may be advisable to effect some sort of reorganization to continue the business. The receiver can continue the business in whatever way the court will permit. Any of its unprofitable and unessential parts may be sold and in this way a partial liquidation may be effected.
With permission of the court the receiver may issue receiver’s certificates to meet immediate and necessary running expenses. The certificates usually have the first claim on the assets. It seldom happens that these remedies are sufficient to put the company on its feet and the receiver in the end will wind up the business by disposing of the assets and distributing the proceeds as instructed by the court.
A receiver is an officer of the court and acts under its instructions. In all dubious matters he can protect himself from liability by procuring an order of court or by refusing to act until authorized by an order of court.
Status of Creditors in Liquidation
Creditors may be divided into two groups—secured and unsecured. Those that have a lien upon some specific part of the assets, such as buildings, machinery, or materials, and holders of bonds are among those whose claims are secured. Trade credits and bank loans often have no other security than the standing of the firm.
If the business has been in a receiver’s hands and receiver’s certificates, have been issued, these may be given priority over all debts except those for taxes. The bondholders are usually given the opportunity to appear and present their arguments for or against the issuance of receiver’s certificates. The court directs the issuance at its discretion.
Preferred and common stockholders receive what is left after everyone else has been paid. If the preferred stock is preferred as to assets, it takes priority over the common stock. Often, however, the preference is only as to earnings, in which case the two stock issues share equally in the liquidation. Directors are prohibited by law from declaring dividends except out of earnings. If it should appear that dividends have been paid out of capital and not out of earnings, the stockholders are liable for any amounts thus paid out to them. If the stock issued is only partly paid, the stockholders are liable up to the amount which remains unpaid.
Accounting for Liquidation
Accounting for liquidation may be simple or complex, depending upon circumstances, but it involves practically nothing new in principle. The main bookkeeping features for a liquidation which takes place because of bankruptcy or receivership are treated in Chapter XXXV where some specialized forms of statement are discussed and illustrated. Here it is purposed merely to point out the accounting procedure necessary in the case of a voluntary dissolution. Under a voluntary liquidation the same books of account are used as for the regular record of business transactions, and the procedure is merely a matter of recording the conversion of assets into cash. This involves taking into consideration, in the case of depreciating assets, the adjustment between the asset account, the depreciation reserve, and the loss or gain realized upon the final disposal of the asset. It may be desirable to separate these losses and gains on the sale of fixed properties from the losses and gains of the stock-in-trade, particularly if operations are continued up to the point of the final disposal of the merchandise stock on hand through the regular channels of trade. If, however, the sale of the whole property, including stock-in-trade, is effected, there is no occasion for the separation of the results of the liquidation of the two types of assets. But if this is desirable a separate clearing account, sometimes called “Liquidation Profit and Loss,” may be opened to summarize the losses and gains on fixed assets before transferring the net result of both into surplus. As the assets are sold and converted into cash the liabilities will be liquidated in due course, the accounting features here being the same as during the period of regular operation. After all assets have been converted into cash and all liabilities liquidated, only the cash and net worth accounts will remain on the books of the corporation. If the net result of the liquidation has been to encroach upon the original capital, the net worth accounts will consist of a deficit account and one or more capital stock accounts. If, however, a profit has resulted or if the resulting deficit is not sufficient to wipe out any previously accumulated surplus, the net worth accounts will consist of a surplus account and the various capital stock accounts.
The final step in liquidation will be the declaration of a liquidating dividend of the amount of cash on hand; this will be apportioned, just as all other dividends, on the basis of the stockholdings of the various shareholders. The books will be finally closed by charging the dividend and deficit, if any, to the various capital stock accounts in the one case; or by charging the dividend against the various capital stock accounts and surplus in the other case. In practice the closing of all accounts on the books is seldom carried out, the bookkeeping ceasing with the declaration of the liquidating dividend which disposes of the cash. Except as a matter of complete record, nothing is to be gained by closing off the accounts.
XXIX. COMBINATIONS AND CONSOLIDATIONS
Reasons for Combination
The primary purpose of the formation of a combination or a consolidation of two or more corporations, or of the taking over of a partnership business by a corporation, is to secure greater profits through unity of control. To this end the various parties to the consolidation agree to subordinate their own interests if the effectiveness of the larger unit is thereby increased. The main object in view is the control of any external or internal factors that affect earnings. Profit may be increased by economy of operation resulting from large-scale production, by economies in use of by-products, by the standardization of product and improvement of quality, and by the elimination of duplicate effort; or the control of sources of supplies or of a marketing organization, or greater ease in obtaining capital, or greater facility in dealing with labor, may be among the advantages obtained. In the past the most important of all factors has been the elimination of competition by the control of selling prices, thus securing a greater hold on the market and reducing selling expense. A consolidated enterprise enjoys the advantage of adding to its plant facilities and rounding out the scope of its activities without the expenditure of new construction or capital purchases entailing the raising of large sums of money.
Types of Consolidation
In the popular mind the terms, combination, trust, holding company, consolidation, and merger stand very much for one and the same thing. The end sought is generally the same, namely, the power to control in some degree the conditions surrounding a particular industry. The means used are dictated by the actual conditions governing the situation, such as the possibility of coming to an agreement, legal aspects, financial factors, etc.
Where the elimination of competition was the main consideration, the end sought was most easily achieved by arrangements variously termed a “gentleman’s agreement,” an “interlocking directorate,” a “community of interest,” a “pool,” or a “voting trust”—the results of which were generally referred to as “combinations.” Like the earlier form of the holding company, the “trust,” they are known in the federal courts as “combinations in restraint of trade,” are illegal, and are no longer entered into.
The trust derived its name from the fact that it was controlled by a board of trustees who issued trust certificates in lieu of the stock of the participating companies. Popular aversion to this form of control has led to the formation of another and better type of organization known as the “holding company.” While the holding company is generally classed among the combinations in restraint of trade and in a number of instances, like its predecessor, has come to grief through the enforcement of the anti-trust laws, its legality is recognized in those states where ownership of the stock of other corporations is allowed by law and where no restraint of trade or interference with competition is effected. A holding company organized in one state may control corporations organized under the laws of other states. The holding corporation can itself be controlled by the ownership of 50 or 51 per cent of its stock, and the control of its subsidiaries is obtained with stock ownership in the same ratio. Thus a relatively small capital investment may exercise a far-reaching control.
A holding company as a rule buys up the controlling stock interest of the companies in which it is interested, and elects its own men on the board of directors of the subsidiaries. Frequently the larger stockholders of competing corporations get together and form the holding company. In this case very little difficulty is experienced so far as financing is concerned, which is usually a matter of exchanging the stock of the various companies for the stock of the holding company.
One of the advantages accruing to the holding company, aside from the favorable financial and legal aspects of the enterprise, is that the subsidiaries remain as operating and business units. This is often desirable because of the value of the good-will accruing to the constituent companies from years of business dealing with their customers. The advantages of the close consolidation may be often obtained by stimulating rivalry between the various plants of the same industry and by exchanging information as to successful methods of operation.
A holding company does not generally own all the stock of the subsidiary. Often, however, this is necessary because of the trouble that a small minority of the stockholders can create if the interests of the subsidiary and the holding company clash; such as might be the case if, for reasons of efficiency, the plant of the subsidiary were closed down. It would naturally be a gain to the holding company but a loss to the minority stockholders of the subsidiary if the productive capacity of another plant could be utilized to better advantage.
Accounting for the Holding Company
In Chapter XV where the principles of valuation of permanent investments were discussed, reference was made to the method of valuing the holdings of the stock of subsidiaries as carried on the books of the holding company. A distinction was there made between the accounting procedure in showing the holdings of the subsidiary stocks when the parent company has complete ownership, and when its ownership is only partial—though usually a controlling—ownership. If the ownership is complete, as there pointed out, to show the consolidated balance sheet and profit and loss summaries is the best and only intelligible presentation of condition. Where ownership is not complete the balance sheet of the holding company must carry the stock of the subsidiary at a valuation which varies in accordance with the earnings and dividend policy of the subsidiary. In addition to the method of showing the valuation of the holdings in the subsidiary, it may for certain purposes and particularly for internal use, be desirable to append to the statements of the holding company financial statements of each of the subsidiaries so as to give an intelligent view of the condition of the properties of all the companies. These appended statements are, of course, not an integral part of the financial statements of the holding company but are necessary as furnishing information which the officers of the holding company may need in their direction of the policy of the subsidiary. For a detailed discussion of the consolidated balance sheet and profit and loss summaries the student is referred to Chapter XXXIV.
Aside from the financial statements, no special accounting problems or peculiarities arise in accounting for the holding company. Where, as is usual, accounts with the subsidiaries appear on the books of the holding company other than stock accounts showing the investment, the chief problem lies in the valuation of these accounts. That feature was also discussed in Chapter XV to which the student is referred.
Distinction between Consolidation and Merger
Consolidation, in the legal sense, refers to the complete union of two or more enterprises. It is a fusion whereby each company loses its identity in the larger unit of the new corporation. The prior corporations are dissolved and cease to exist. The stock of the old corporation is exchanged for that of the new corporation upon an agreed ratio. The usual procedure for statutory consolidation is as follows:
1. Agreement by the directors of the various companies as to terms, etc. 2. Assent of the stockholders of each company to the directors’ agreement. 3. Filing of certified copies of the agreement, with the vote in its favor, in the same offices in which the certificates of incorporation of each corporation were originally filed. 4. The exchange and issuance of new stock for the old stock of the constituent companies.
The merger of a number of corporations is generally held to be a method of consolidating. The difference is that a consolidation is a fusion while a merger is rather an absorption. The constituent companies are merged into an existing one and no new corporation is formed. The rights, franchises, and interest are deemed to be transferred to, and vested in, the corporation into which the various companies have been merged without any deed or transfer, and the liabilities follow the rights.
Formation of Consolidation and Merger
In the formation of a consolidation or a merger the services of a promoter may be necessary. This is especially true if the various companies are direct competitors and deep-rooted jealousies exist. Under the circumstances an outsider has the best chance of effecting an agreement between the parties. The difficulty encountered in all consolidations and mergers is the exaggerated idea of officials regarding the importance and value of their own plant and organization as related to the rest. This difficulty is accentuated in effecting a merger because of the irrevocable nature of the compact and the almost complete disappearance of lines of demarcation as to the tangible and intangible assets of the various units. These difficulties are overcome in many instances by the promoter’s keeping the terms arrived at with each company a secret. Direct dealing is possible in the case of a merger when the various companies are supplementary to each other, such as would be the case where a selling organization is merged into a manufacturing corporation the product of which it distributes.
Principles of Valuation of the Constituent Companies
In all the foregoing cases the question at once arises as to the principles which should govern in arriving at a valuation. Should the value of the net assets comprising plant, equipment, etc., or the earnings for a number of years serve as a basis in arriving at the ratio of exchange in cash or stock? What relative weight should be given to the various items? A concern with large assets when not running its plant to full capacity would be averse to having the apportionments based on earnings. The corporation with relatively small assets but with large earnings on the capital invested would not want the value computed on net assets.
If the net assets are an important factor of valuation, an appraisal should be made either through a committee or by independent appraisers. If such an appraisal cannot be made, the books should be examined to see that the valuation of each plant and equipment is correct. Great care should be exercised to see that capital additions represent actual additions to the plant or serve to increase its capacity or lower its cost of production. The method of handling improvement expenditures should be uniform. It is necessary to determine that proper entries have been made in respect of property abandoned or equipment removed from service. Another point requiring careful investigation is the provision of ample reserves for depreciation, and the same method of calculation and consideration of the different elements of depreciation and the conditions under which they are operative must be taken into account in all the companies.
The main problem in using earnings as the basis for valuation is the determination of the number of years’ profits to be averaged. Care must be exercised to handle uniformly the earnings and expenses of the various companies.
Fundamental Principle of Equalization of Conditions
Before an intelligent estimate or computation can be made of the relative value of each unit in the proposed consolidation or merger, the various items that make up the assets and earnings of each company should be examined from the same point of view. Accounting systems and methods are so varied that a common basis of computation must be constructed or agreed upon before a comparison can be made. In general, the following points should be considered:
1. A uniform accounting system for all the companies to be merged, in order to have the same basis in arriving at the results. 2. The reserves for depreciation should be based on an analogous system of calculation. 3. Costs should be determined in the same way if the companies carry on the same industry; if the industries are not similar the cost should be reduced to the same basis. 4. The apportionment of labor, factory expense, and factory overhead should be uniform. 5. Only real items of cost should be included under the head of cost of plant and all income charges should be eliminated so as to give a basis for comparing manufacturing items. 6. The same methods of inventory-taking, both of working assets and fixed capital, should be used. Proper valuation of accounts receivable should be made. The accounts payable should be properly shown. 7. The amount of orders on hand should be considered. The past year may have been poor and the books may not reflect the true state of affairs.
Valuation of Partnership
Where, as frequently happens, a partnership is a party to the merger, it is necessary to consider the method of handling certain items in the partnership accounting which differs from their handling under the corporate form, so that the valuation of the assets and earnings of all the properties can be placed on an equitable basis. Such items are partners’ salaries and drawings, and the interest on capital and drawings for the purpose of adjusting the various partners’ interests. In partnership accounting the proper treatment of partners’ salaries, drawings, and interest on capital and drawings requires that these appropriations of profits be shown in the profit and loss summary; i.e., the figure of net profits for a partnership is determined before taking into consideration the items mentioned. However, one occasionally finds partners’ salaries and adjustments on account of interest handled as expenses of the business. To place the earning capacity of the partnership on an equitable basis for comparison with the earnings of a corporation, a reasonable figure for the salaries of the partners as managers of the business must be agreed upon and treated as an expense chargeable to operations before the determination of net profits. Partners’ drawings and interest adjustments on account of capital and drawings should not be taken into account in the determination of earning capacity. In determining the amounts of partners’ salaries, that which would be appropriate for similar capacities in a corporation should be allowed as deductions from earnings. All the items mentioned above in connection with placing the properties of the several corporations on an equitable basis for valuation apply with equal force to the properties of any partnerships which may become parties to the merger.
Earning Capacity
Any extraordinary profits or losses not due to the ordinary operations of the business should be eliminated when computing profits. Interest on borrowed money should not be included. The charges to operating expense on account of repairs should be adequate, and care must be taken to see that charges to the repair accounts do not show a sudden falling off toward the close of the period under review. The reserve for depreciation should be credited with the proper amounts. Sales, effected for a subsequent period, are not to be considered in the accounts of the current period as this would tend to inflate the profits. Shipments made to branch offices or on consignment account should not be regarded as sales. Ample provisions should be made for all liabilities for expenditures incurred during the period under review and outstanding at the close thereof. The inventories should be checked over carefully and certified by the parties taking them. Allowance for old or obsolete material should be made.
Good-Will
The determination of the value of good-will is generally a delicate proposition unless the parties to the consolidation or merger first agree as to the basis on which it is to be computed. This is generally anything that the interested parties choose to make it.
The two methods commonly used for estimating the value of good-will have already been discussed in Chapter XVIII.
Capitalization of a Consolidation or a Merger
The capitalization of a corporation, in a legal sense, is the sum total of the par value of the authorized capital stock. From an investment or economic point of view it is the sum total of all the stock and bonds issued or outstanding.
There are three different bases of capitalization: (1) cost of property plus accumulated surplus value; (2) cost of reproducing the property; and (3) earning power. According to legal theory the investment or the cost plus surplus is the proper basis. This idea has been fostered by the fact that shares have been assigned a definite face value. While at the beginning of a new enterprise investment value and capitalization may closely correspond generally, they soon diverge widely—due to smaller or greater earnings than were estimated or to depreciation or accretion in the value of the assets. When the potential earning power of the business begins to be realized, conditions begin to change and the value of the tangible and intangible assets fluctuates. The basis of capitalization changes with these fluctuations and the laws regulating it are in practice only complied with nominally. The custom is to adjust the value of the assets to harmonize with the capitalization rather than vice versa. Such a policy is to be deprecated.
The cost of reproducing the property as a basis of capitalization is as yet only seriously considered in theory. It is very doubtful if the method will ever be used in actual practice.
Earnings, past or potential, perhaps form the basis for capitalization most frequently used. Investment value closely corresponds to the rate earned and the degree of permanency of the earning power. To secure an income is the motive of all investment. In practically all consolidations and mergers the estimated increase in earnings due to the application of better methods of operation plays an important part not only in the promotion and formation of the new company, but also in deciding upon the capitalization. While the plant value and the past earnings of each of the companies may be considered in allotting them their respective interests, these are not a safe guide as to future earnings. In the case of partnerships especially and often in the case of corporations, there is a loss of valuable good-will. It is generally held that the benefits of consolidation greatly overbalance these disadvantages. The savings due to the elimination of duplicate work in factory and office, the cutting down of the item of rent, the saving in the cost of selling, the greater effectiveness of advertising, etc.—all are reasons held out as warranting this or that capitalization.
Payment of Amalgamated Interests
In a consolidation or a merger the usual practice is to pay the various interests in the companies which are amalgamated with bonds, preferred and common stock, and in some instances with cash. The proportion and kind of payment will depend upon the conditions surrounding each case. The prevalent custom is to pay for the net assets in preferred stock and to issue common stock for good-will. Often, however, bonds are used to pay for the tangible assets; preferred stock is issued for the intangible assets; and common stock represents the additional profits that are expected to accrue to the corporation through the consolidation or merger. The issue of bonds to cover all the tangible assets is generally a dangerous procedure because of the high fixed charges resulting therefrom—though advantageous when the difference between the fixed charges and the net earnings is large. Bonds generally carry relatively small interest because of their safety, whereas the use of preferred stock entails a smaller equity for the common. The bondholder is not concerned with the capitalization or nature of the issues over which he takes precedence. For the same reason it is not usual for the preferred stockholder to complain about overcapitalization through the use of common stock. The business risk involved depends upon the nature of the business and the ability of the management. No financial arrangements should be made that do not take into consideration the fluctuations that are inherent in the business and their effect upon net income.
Another apportionment sometimes made is to issue bonds for the fixed assets; preferred stock for the working capital; and common stock in proportion to the prospective earnings of the consolidation or merger. New bonds are exchanged for the old bonds or preferred stock of the constituent companies, while the common is exchanged for the corresponding issues in the merged corporations. The balance is used for the purpose of paying organization expenses and the fees of the promoters, and to provide working capital for the consolidation. The ratio and the medium will depend to a great extent upon the nature of the business, the attitude of those who are interested in the merger corporations, and the optimism or hopes of the promoters.
Closing the Books of the Merged Concerns
Closing the books of the merged concerns presents the problems of accounting for the sale of the subsidiary companies. This may be effected in two ways. Where the sale is made at the book values as carried on the records of the subsidiary, no adjustments whatever become necessary. Where, however, the price received is less or greater than the book value of the concern, it becomes necessary to show the difference between book and sale valuation. In taking account of these differences two methods are employed. Under the one an adjustment is made of all the detailed valuations of the items of property as taken over. It becomes necessary, therefore, to adjust each property account through its depreciation reserve or through surplus, in order to bring it to the value at which it is taken over. This may, and frequently does, necessitate setting up a good-will account on the books of the vendor company. After the books are thus brought into accord with the sale agreement, the closing of the accounts follows the procedure laid down in Chapter XXVIII for the liquidation of a company.
Under the second and more common method, no attempt is made to adjust the individual items of properties sold in accordance with the appraisal committee’s report, but all differences are cleared in a lump sum through the surplus or deficit accounts. If the sale is made for cash, the amount received is then disbursed as a liquidating dividend to the shareholders. If the property is sold for stock and bonds in the merged company, either this stock is handed over en bloc, in which case it is likewise distributed as a liquidating dividend, or the merger company may issue the stock and bonds as a liquidating dividend for the vendor company on the basis of the report of the shares belonging to each stockholder. Upon notice that such stock and bonds have been issued to its shareholders, the vendor company closes up its records completely by cancelling its proprietorship accounts against the charge account set up against the merger company until the stock is issued.
Opening the Books of the Merger
As a merger is a corporation, the opening of its records follows the same lines as that of any other corporation, excepting that when payment of subscriptions for capital stock is to be recorded, cognizance must be taken of the manner of payment. The subscription contract, in so far as it relates to the various subsidiaries, is usually canceled by turning over the properties of the subsidiaries. The assets are taken over at an appraised price which becomes the basis for the amount of subscription to the stock of the merger by each subsidiary. In Chapter I, where mention was made of the payment of stock subscriptions in property, it was pointed out that it may be desirable to bring onto the books the lump sum representing the appraised purchase price paid for the subsidiary some time before the appraisal committee has submitted its report on the detailed valuation of the various items of property taken over from the subsidiary. The customary method of handling the situation on the books of the merger was there shown. The bookkeeper is not concerned with the valuation of any of the items taken over, but must make his entries in accordance with the valuation report turned in by the appraisal committee. The main problem in the merger, then, is one of valuation and not of accounting. As stated above, payment to the subsidiaries may be made by the merger in either of two ways. An entire block of stock may be turned over to the subsidiary company and be distributed by it as liquidating dividends to its stockholders, or the merger may issue shares to the individual stockholders of the subsidiaries in accordance with information furnished by the subsidiary.
XXX. BRANCH HOUSE ACCOUNTING
Advantages of Branch and Agency System
The branch and agency forms of increasing sales in large enterprises are an outgrowth of the policy of “service” combined with economy of management which dominates all present-day capitalistic enterprises. The tendency of a successful business is to absorb other businesses in the same line through combinations and amalgamations, and thus the policies of apparently independent units in a single district or throughout the entire country may be controlled by the central management at a head office.
Where a business serves consumers direct by means of retail stores, as for instance, the chain tea stores, the chain cigar stores, the 5c and 10c stores, the system offers one of the best means of bringing the business into close personal touch with customers. It gives customers an opportunity to examine the wares at their convenience, and at the same time it gives the local branch manager an opportunity to build up good-will for the distant proprietor.
By these means also, stocks of merchandise can be better selected for local needs, and the buying power of each territory and the quantities carried on hand can be better adjusted to secure the greatest possible turnover of stock during an operating year.
There is no doubt that a campaign of education to introduce new goods or appliances can be more successfully conducted through local branches or by personal visits of local agents residing in the territory. Illustrations of this are the present methods of selling sewing machines, phonographs, pianos, electric and gas appliances, etc. When branches are given authority to sell on credit and collect their own accounts, credits can be more intelligently extended and collections can be more carefully watched by a local branch manager.
Agency and Branch Differentiated
There is a great deal of difference between the organization and management of agencies and of branch houses. An agency simply acts as a local salesman for a certain territory. It secures orders and forwards them to the head office. The head office passes on the credit of the purchaser and assumes the risk of refusing or accepting the order. If it accepts the order it also collects the account when it is due. Naturally it must keep a memorandum of sales, either to pay a commission to the agent, or to ascertain whether or not the agency is a paying venture, or for both reasons. A branch, on the other hand, has a much higher degree of self-management. It may receive at least the greater part of its stock of merchandise from the head office, but it usually makes its own sales. It may pass on its own credits and may collect its own accounts receivable; and sometimes it pays all its own expenses.
There are many modifications of the self-management of branches, especially in the matter of financial control. Some branches deposit all their receipts to the credit of the head office and have no authority to withdraw money for any purpose. In such cases the branch is supplied with a separate petty cash fund kept at a fixed sum on the imprest cash system. Other branches receive and pay money and simply make periodic remittances of surplus amounts to the head office as if they were entirely independent units. Various policies of control have been formulated to suit the nature of the business and the degree of self-management granted to the local branches.
Degree of Control Desired
The question of the particular kind of branch or the size of the agency or branch which it is desired to establish depends entirely on the peculiar needs of the business under consideration, and the degree of head office control which is necessary to secure the maximum results with the minimum of expense. An agency by its very nature is completely under the control of the central office. The agent has no powers other than those granted by his principal.
If the business is such that a large stock of merchandise is necessary, and a high degree of discretion and executive ability must be exercised, or if it is desirable to establish practically independent units with only central executive control over the entire purchasing and financial systems, branch stores may best serve the purpose.
The same system, however, will not meet the needs of every business, or even of every branch in the same business. Changes must be made for diversified local conditions which are peculiar to each establishment.
Factors of Successful Management
Certain points must be watched in all systems and under all conditions. Since the total net profits or losses are determined largely by the average turnover of circulating capital invested in the merchandise, the control of the quantity of merchandise, as well as the price, is a question which must have very careful attention and intelligent supervision. The stock on hand must be that quantity which will insure a supply adequate at all times to meet the demands of the trade, and which at the same time will be the minimum necessary to accomplish such a result. Each article turns in accordance with certain fixed principles. Certain goods turn faster than others, but there is a general relation between the rate of turnover and the profit per turn which should be carefully watched.
In the last analysis the success of every branch store system depends upon three things:
1. A fair gross profit on sales, augmented by 2. A proper rate of turnover on the merchandise carried, and 3. Economical management.
Since expenses are a more or less fixed item, their relation to the total volume of business transacted must have the constant attention of the manager. Statistical charts made up from the reports sent in by the various branches, with summaries of total results, compared either by territories or by branches or by product will show to the manager the past history and also the present trend of the business as a whole or in parts. From these charts he is able to form an intelligent basis for inaugurating future policies of control.
Main Principles of Branch Accounting
The underlying principles upon which branch store accounting is based are very simple, but the superstructure will be simple or complex according to the nature of the business and the information which the head office requires for its accounts and records.
The main points to be kept in view in installing a system of accounts are to insure:
1. Control or supervision by the head office. 2. Separate results for the trading of each branch. 3. Facilities for centralizing and comparing such separate results.
In discussing the question of branch accounting any treatment of the problems peculiar to it is so dependent on the particular system employed that only a very general statement of principles can be made unless the comment is confined to a particular system and this might not be relevant to all systems. There are, however, certain principles which apply fundamentally to all systems. The question of the degree of control desired by the head office and the resulting information which must be given by the branch to the head office governs largely the detailed ramifications of general principles which will be necessary. Also the amount of information as to the results of the business done at each branch which it is desirable for the branch management to know has an important bearing on the manner of keeping the accounts. Sometimes it is not desirable that the branch manager should know the amount of profit which his branch is earning. While, of course, it is impossible to keep a shrewd manager in entire ignorance of the results of his management, yet the exact figure of profit earned by his branch can be kept from him if the books are handled properly. It is purposed here to develop by statement and illustration most of the problems which are peculiar to branch and agency accounting.
Agency Accounts
What has been said with regard to the difficulty of presenting a widely applicable statement of branch accounts is equally true of agency accounts. There is no well-marked line of distinction between agency and branch organization. What may be termed an agency by one concern will be looked upon as a branch by another concern. For the purpose of this discussion, however, the distinction stated above between these two forms of organization will be adhered to. Where, therefore, the agency is for the most part simply a sales agency, practically nothing in the way of accounts and accounting control is necessary other than what must always be used in connection with traveling salesmen. The agency must be furnished with an expense fund and must, of course, send in to the head office all its orders and sales. The expense fund is best operated under the imprest system. To keep track of the results of the various agencies it will be necessary on the head office books to keep the records of the activities of each branch separate from one another and from those of the head office. At the close of the fiscal period a comparison of agency sales with the direct costs of making those sales and with the expenses of maintaining the agency will develop the net result of the agency’s activities. The problem, therefore, of agency accounting is simply one phase of the general problem of accounting, viz., furnishing, by means of whatever analysis may be necessary, the information which will be of greatest advantage, to the management of the business.
Branch Accounting Records
The accounting records of the branch will be simple or complex according to the conditions to secure control over which they must give information. Sometimes a very simple set of records will furnish all the data needed. In other cases just as elaborate detailed records as are employed at the head office may be required to secure the information desired. Sometimes it may appear best for the branch to keep but few records, and for the head office to keep all the main accounting records by means of duplicate reports of all branch transactions. Again, to exercise proper control over the branch, even where it keeps a full set of records, it may be advisable to require periodic reports of all branch activities. Sometimes these are required daily, but more often a weekly or monthly summary of activities serves the purpose equally well.
Illustration of Simple Branch Accounts
The simplest method of keeping the branch and head office accounts can be illustrated by a short problem in summarized form. In the illustration given it is assumed that the head office furnishes the cash necessary to inaugurate the branch, and that all stock-in-trade is supplied by the head office. It is further assumed that the branch keeps a complete set of records which will furnish information as to profits and losses at the close of the fiscal period. On the branch books it will be necessary to open accounts with Merchandise (here, for the sake of brevity, carried under one title rather than as usually shown), with Cash, with Expenses (again, for the sake of brevity, carried under one head), with the Head Office, and with Profit and Loss. These accounts present no peculiarities excepting the Head Office account which stands on the branch books as the net worth or proprietorship account. It is credited with all values received from the head office and charged with all values returned to the head office or expended on head office account. The net profit for the period is closed from the Profit and Loss account into the Head Office account in order to show the present net worth or proprietorship with which the branch enters the new fiscal period.
On the head office books there need be carried only an account with each branch by name or number. The charges and credits in this account are the exact reverse of those in the Head Office account carried on the branch books. At the close of the fiscal period it is necessary to receive the report of the branch profit or loss before that can be incorporated in the branch account on the head office books. The following problem will show the manner in which these accounts are kept.
Problem. The head office sends to the branch during the year $5,000 cash and $50,000 worth of merchandise. The branch makes sales to customers on account amounting to $45,000 and cash sales of $10,000. It incurs expenses of $7,500. Its collections from customers on account amount to $25,000. It remits $37,000 to the head office. The inventory of merchandise at the close of the year is found to be $12,500.
Solution Branch Books
Cash $ 5,000.00 Head Office $ 5,000.00 Merchandise 50,000.00 Head Office 50,000.00 Customers 45,000.00 Merchandise 45,000.00 Cash 10,000.00 Merchandise 10,000.00 Expense 7,500.00 Cash 7,500.00 Cash 25,000.00 Customers 25,000.00 Head Office 37,000.00 Cash 37,000.00 Merchandise (Inventory) 12,500.00 Merchandise 12,500.00 Merchandise 17,500.00 Profit and Loss 17,500.00 Profit and Loss 7,500.00 Expense 7,500.00 Profit and Loss 10,000.00 Head Office 10,000.00
Head Office Books
Branch $55,000.00 Cash $ 5,000.00 Merchandise 50,000.00 Branch 10,000.00 Branch Profit and Loss 10,000.00
In making up the head office balance sheet, the Branch account as carried on the head office books will be an asset representing the property of the head office invested in the branch. Instead of carrying this property under the title “Branch,” it is sometimes desirable to include all branch values with similar values at the head office. This results in a balance sheet which is similar to the consolidated balance sheet explained in Chapter XXXIV.
Illustration of More Complex Branch Accounts
As an illustration of a somewhat more complex method of keeping the books, a problem is appended illustrating the sending of goods to the branch at a nominal figure or at sales price. Here it is not desired that the branch management be able to determine the profit and loss of its activities; consequently the goods from the head office are not charged to the branch at cost but at some fictitious value. Where this is done it is best to open two accounts, the one to record the merchandising transactions between the branch and the head office, and the other to record all other interactivities.
Problem. The head office sends to the branch during the year $10,000 cash and $77,000 worth of merchandise as billed at a conventional price. The branch makes sales to customers on account, of $60,000, and for cash $25,000. The expenses of the branch are $10,000. Collections from customers amount to $45,000 and remittances to head office amount to $66,000. The inventory of the stock-in-trade at the close of the year is $14,000, this valuation being on the same basis as the original charge, i.e., at the conventional figure.
Solution Branch Books
On the branch books two accounts are opened with the head office, one entitled “Head Office General,” and the other “Head Office Merchandise.” Neither one of these accounts represents the full proprietorship of the head office in the branch, nor do both of them together represent the true proprietorship because of the fact that the merchandise is priced to the branch at a fictitious figure. The branch books cannot show the true status of relations with the head office so long as the policy, of billing goods in this way is maintained. That is the chief reason why it is best to set up the two accounts, in one of which appear the merchandise transactions at the fictitious figure, while in the other appear all other transactions correctly valued. This Head Office Merchandise account is more in the nature of a memorandum or consignment account and is offset by an account called “Purchases from Head Office.” On the branch books appear also accounts with Customers, Branch Sales, and Expenses—as in the other case. There is no Profit and Loss account because it is impossible to determine on the branch books the correct profit and loss for the period. All expense and income accounts are closed directly into Head Office General. The entries necessary to book properly the activities as set forth in the illustrative problem are as follows:
Cash $10,000.00 Head Office General $10,000.00 Purchases from Head Office 77,000.00 Head Office Merchandise 77,000.00 Customers 60,000.00 Cash 25,000.00 Sales 85,000.00 Expense 10,000.00 Cash 10,000.00 Cash 45,000.00 Customers 45,000.00 Head Office General 66,000.00 Cash 66,000.00
In closing the branch books the inventory is brought into the Purchases from Head Office account which by its balance shows at billed price the goods disposed of by sale. The latter figure is taken into the Head Office Merchandise account so that its balance will also be the amount of goods still on hand as shown by the inventory. Purchases from Head Office and Head Office Merchandise are memorandum accounts calling attention to the fact that the merchandise on hand at the branch is not carried at its correct valuation but must be adjusted before incorporation with the head office accounts. The entries to effect this adjustment on account of the inventory and to close the branch books are as follows:
Purchases from Head Office (Inventory) $14,000.00 Purchases from Head Office $14,000.00 Head Office Merchandise 63,000.00 Purchases from Head Office 63,000.00 Sales 85,000.00 Head Office General 85,000.00 Head Office General 10,000.00 Expense 10,000.00
These entries close the books of the branch so far as is possible in view of the fact that accurate results as to profit and loss cannot be shown from the way in which merchandise is billed to the branch. There is perhaps no objection to using a Profit and Loss account as a summary account for income and expense items rather than the Head Office General account as shown here; though a Profit and Loss account is somewhat of a misnomer since profits and losses cannot be determined. In the problem given all expenses are grouped under one Expense account. This is done for the sake of brevity, and it is to be understood that as detailed an expense record will be kept on the books of the branch as may be necessary to give the information desired.
Head Office Books
Where the head office bills merchandise to the branch at any other figure than cost, the record of such shipments is best made in much the same way as with consignments. Memorandum accounts are set up to indicate that goods have been shipped to the branches. This is necessary because of the fact that shipments should not be entered in the regular merchandise accounts of the head office at any other figure than cost. Periodically, from memoranda carried in these special accounts, the true values of the merchandise shown as handled through them must be brought into the regular merchandising accounts. The manner of making these adjustments is taken up on page 535. Here will be shown all the accounts affected on the head office books by the current transactions with the branch. The entries necessary to record the data of the problem are as follows:
Branch A General $10,000.00 Cash $10,000.00 Branch A Merchandise 77,000.00 Sales to Branches 77,000.00 Cash 66,000.00 Branch A General 66,000.00
It is to be noted that separate merchandise accounts are opened with each branch by name but that only one Sales to Branches account need be opened. The Branch Merchandise account with each branch provides all the necessary data for making the adjustment at the close of the period, the offsetting memorandum account for all the different Branch Merchandise accounts being the Sales to Branches account. At the close of the period, upon report of the total activities for the period at the branch, the following entries are made on the head office books:
Branch A General $85,000.00 Sales $85,000.00 Expenses 10,000.00 Branch A General 10,000.00
An alternative method of summarizing branch activities is sometimes used, as follows:
Branch A General $85,000.00 Branch A Profit and Loss $85,000.00 Branch A Profit and Loss 10,000.00 Branch A General 10,000.00
Under the first method the effect is to merge the activities of the branch with the similar activities of the head office. A statistical abstract of the different branches is then depended upon by the head office management to show the results of the period’s trading at the various branches. Under the second method the effect is to bring onto the books under the various branch Profit and Loss accounts the results of the trading in each case. Whichever method best gives the information desired by the head office will, of course, be adopted.
A brief discussion will now be given of the chief problems met in branch accounting. No attempt will be made to discuss the problem of branch organization from the standpoint of system or control. Such a discussion belongs more particularly to the field of auditing than to that of accounting.
Purchases
From the head office point of view no special problems are met in the matter of purchasing. From the standpoint of the branch the question of purchases is largely the same as the question of sales from the head office standpoint, and the problem of sales is chiefly one of the price at which goods should be billed to the branch. This is treated in the next section. Attention is called here to the need of a very careful control and checking up on purchasing activities of the branch where the branch is permitted to buy some portion of its goods from outside sources. This may become necessary in cases of emergency, or may be a matter of fixed policy in those cases where commodities are sold at some of the branches which the head office does not care to furnish or cannot handle with economy. Where the branch makes purchases both from outside and from the head office, the result may be to complicate the adjustments necessary at the close of the fiscal period. The underlying principles on which the accounts and their adjustments rest are, however, the same.
Sales
From the standpoint of the head office, the problem of sales to the branches is, as mentioned above, largely a problem of policy as to whether goods shall be invoiced at absolute cost; at cost plus a small percentage for overhead expenses; at sales price, i.e., at the price at which the branch is expected to sell the commodity; or at some arbitrary figure which is designed for the purpose of keeping the branch in ignorance of the actual cost of the goods dealt in and therefore of the profit and loss upon the branch’s activities. If goods are billed to the branch at sales price and disposed of at the same price, a comparison of the branch records covering their purchases and their sales should indicate by the difference between the two the amount of stock on hand at any time; i.e., billing the goods to the branch at sales price makes the merchandise records of the branch virtually a perpetual inventory of the goods on hand. This method effects a closer check on losses and waste, for which, of course, a small allowance must always be made. One of the most serious wastes to be checked up is occasioned by too liberal weights and measures to customers. On the other hand, invoicing the goods at sales price gives the branch manager less discretion in adjusting differences with customers inasmuch as defective goods must usually be returned to the head office to secure for the branch full credit. Further, billing the goods at sales price with the purpose of securing accurate control over the branch merchandise necessitates the pursuit of an inflexible policy of sales at the billed price. Daily or weekly adjustments on account of fluctuations in the market cannot be made without losing the control over stock which the policy of billing at sales price secures. In some lines of business this is an insuperable defect.
Where merchandise is invoiced at cost the branch manager has a rather more secure hold on his customers in that he can give immediate satisfaction by making allowances and adjustments to settle difficulties as they come up. Particularly where the manager has an interest in the profits, a much greater incentive is offered him to conduct the affairs of the branch in an efficient and economical manner. This responsibility and power to make adjustments may be abused, however, and a greater degree of control can usually be secured by the head office where merchandise is billed at sales price.
As mentioned above, sometimes goods are billed to the branch at an arbitrary figure. Inasmuch as the question of control by means of a perpetual inventory does not enter into this policy, large discretion can be given the branch manager without unsatisfactory results in checking up the merchandise. He may be allowed to make whatever adjustments with customers seem advisable. Changes in selling price can be made as often as conditions demand, either at the instance of the head office or at the discretion of the manager. A policy of this sort requires a much more thorough system of report from the branch to the head office in order to give the head office a means of checking up periodically the activities of the branch.
It is well to point out that on the books of the head office sales to branches are in no sense income items and must never be recorded with regular sales to outside parties. Similarly, sales or transfers among branches are in no sense earnings. It should be noted that, to keep the head office records correct and up to date, any transfers of goods among branches should be reported immediately to the head office; better still, the authorization of the head office, except in cases of emergency, should be given before such transfers can be made.
Adjustments on Branch and Head Office Books
Head Office and Branch accounts are essentially accounts current between the head office and the various branches. At the close of the fiscal period when the results of the period’s business are being summarized, the four classes of adjustments which are sometimes necessary in the case of accounts current may have to be made. The head office may show a charge to the branch for items which the branch has not yet received at the close of the fiscal period. Similarly, the branch may have charges and credits to the Head Office account which the head office records do not show. If this condition exists, the two accounts must be reconciled in accordance with the method shown in Volume I, page 497. Almost invariably, unless a system of complete daily reports is in effect between the branch and the head office, the head office will have to wait for certain reports from the branch at the close of the fiscal period. The nature of the entries to effect these reports is given in the problem illustrated on page 532.
The chief adjustment which is needed on the head office books is brought about through the policy of charging the branch with merchandise at some other figure than cost. Where this is done, the profit and loss on the branch activities cannot be determined until true costs are taken into the accounts in place of the fictitious figures used during the current period. The basis for converting the fictitious figure into a true cost figure is, of course, a secret known only to the head office. The memorandum accounts covering the merchandising transactions with the branch furnish the basis for determining the cost of goods sold by the branch. Thus, if goods are billed at, say, 30% above cost the billed price becomes 130% of the cost. It is therefore possible to determine the cost of all goods disposed of by the branch and of those still on hand. If it is desired to merge all the branch activities with the similar activities of the head office, the only adjustment necessary at the close of the fiscal period is to convert the sum total of the inventories on hand at the various branches to a cost valuation basis and include them with the head office inventory. This gives the data needed to determine the cost of goods sold and gross profit on the combined activities of the various branches and head office.
It is usually essential that the results of trading at each branch be determined, whether or not such results be incorporated separately on the head office books. Under the assumption that they are to be set up on the records of the head office, the billed cost of the goods disposed of at each branch must be converted to a cost basis and shown transferred from the Head Office Purchases account to the Profit and Loss account with each branch. This separates the total cost of goods sold as among the various branches and the head office. When the various branch Profit and Loss accounts are credited with their respective earnings from sales, the gross profit or loss on the trading activities at the various branches will thus be shown. Similarly, the regular merchandise accounts in which have been recorded the head office merchandising activities will show the gross profit on sales made at the head office. These adjustments are made without interfering in any way with the memorandum accounts carried on the branch books and on the head office books—accounts which have no place in the balance sheet of the head office. In their stead will appear the combined inventory of goods on hand at the branch and the head office converted to a cost basis.
Example of Adjusting Entries
The character of the entry needed to effect these adjustments will now be shown, using the data of the illustrative problem shown above. Comparison of the report of inventory from the branch, $14,000, with the record of goods shipped to the branch, $77,000, shows that goods to the billed value of $63,000 were disposed of at the branch. The records in the head office show that the goods were billed to the branch at 140% of cost. Converting this figure of $63,000 on the basis of 140% of cost develops a true cost of goods sold of $45,000. This is brought onto the head office books by the following entry:
Branch A Profit and Loss $45,000.00 Purchases $45,000.00
Reference to the solution above shows that Branch A Profit and Loss has been charged with $10,000 expenses and credited with $85,000 earnings from sales. The gross profit, therefore, on the period’s activities at Branch A is the balance of the Branch A Profit and Loss account, i.e., $30,000. The only other adjustment necessary is the conversion of the Branch A inventory of $14,000 to a cost basis. The true cost here is, of course, $10,000 since the goods were billed at 140% of cost. The $10,000 will be included with the inventory of goods on hand at the head office before the determination of the head office cost of goods sold and gross profit can be made.
To secure a better understanding of the interrelations of these various accounts it is suggested that the student set up all the accounts and follow through them the transactions given in the illustrative problem above, both on the books of the branch and on the books of the head office.
A final problem of adjustment as between the head office and branch books concerns the treatment of fixed assets carried on the books of the branch. It may happen that the branch makes purchases of various pieces of property which are charged up to fixed asset accounts on the branch books. To secure uniform treatment, particularly as regards depreciation, it is customary at the close of the fiscal period to transfer the record of all fixed assets to the head office books. This is accomplished by entry on the branch books of a charge to Head Office General account, and credits to the various fixed asset accounts. On the books of the head office the record will be a charge to the various fixed asset accounts and a credit to the various Branch General accounts. Usually, therefore, on the branch books appear only current asset items, current liability items, expense and income items.
Reports from the Branch
The reports which the branch makes to the head office depend entirely on the degree of control to be exercised by the head office over its various branches. Accordingly, no general methods of universal applicability can be described. A statement of some of the different kinds of reports and the use made of them will be given. In some cases the branch books are kept in duplicate, the duplicates of all books of original entry being sent to the head office at the close of each month or oftener if desired. From these duplicate records the head office can keep a ledger record with every branch for comparison with the ledgers as kept by the branches. In other cases the head office requires that the branch send in daily duplicate copies of all business papers covering the transactions of the branch. Thus sales tickets are made in manifold, one copy of every sale, whether cash or credit, being sent to the head office. This furnishes the head office with a control over the selling activities of the branch. If the branch has charge of its cash a duplicate ticket of all deposits made should be forwarded to the head office. The canceled checks drawn by the branch must be forwarded by the banker to the head office. This procedure keeps the head office informed as to the cash transactions of the branch, giving both a control over the cash and a fairly complete knowledge of disbursements on account of expenses and of receipts from collections. If, now, all purchases of stock-in-trade are made from the head office, the latter has a close control over all the activities of the branch. It may thus keep a duplicate set of records, although that is scarcely necessary inasmuch as summaries can be made by which to check up the books of the branch at the close of the fiscal period.
Sometimes, instead of daily reports periodic summaries of the branch activities are made to the head office and these provide the basis for checking up on the branch at the close of the fiscal period. Where the head office maintains traveling auditors, such frequent reports are not necessary.
Examples of Reports
Below are given two examples of different kinds of reports from the branch to the head office. The first is a periodic summary of cash transactions followed by a statement of collections from customers. The second form is a type of ledger account carried with each branch on the books of the head office in accordance with detailed reports made by the branch or by traveling auditors from the head office. It will be noted that provision is made in the account by means of special rulings to show the total expenses of each branch, which total will enter into the trial balance; and also for an analysis of the expenses of each branch under suitable heads, these latter being treated simply as memoranda. Any credits or adjustments are entered in red ink, and are to be deducted before showing totals.
PERIODIC CASH SUMMARY =====================================+============================== Receipts | Payments Cash Sales (by days) $...... | Wages $...... ------ | Expenses ...... Total for period $...... | Sent to Head Office ...... Customers Accts. (as below) ...... | Payments into Bank | (dates & amts.) Other Receipts ...... | Balance on Hand, carried ------ | to next statement ...... Total $...... | ------ ====== | $...... Balance, per last statement $...... | ====== |
[69] Credits in red ink.
XXXI. BRANCH HOUSE ACCOUNTING (Continued)
Foreign Exchange
The foreign trading of American firms has grown of late years to such proportions that a practical acquaintance with the exchange values of foreign currencies is necessary for the accountant. The rate of exchange is the equivalent of the currency of one country in that of another. For instance, the standard value of the British sovereign in the currency of the United States is $4.8665; that is, the value of the quantity of pure gold in one sovereign in London is equal to that represented by $4.8665 in New York. Other things being equal, this should always be the par rate of exchange between the United States and England. The question of the rate of exchange between countries which have a gold standard is a comparatively simple matter. Where one of the countries has a silver currency, the variations assume more importance, for the reason that the intrinsic value of silver converted into gold must be accounted for. Paper currency, especially in times of war, causes a still greater complication, because in this case it is uncertain when such paper will be made convertible into gold or silver.
In addition to differences in exchange arising from the conversion of one currency into another, called the par rate, other things enter into exchange transactions which have a marked effect upon the actual, or market, rate of exchange. Such conditions as supply and demand for remittances between countries to satisfy debit balances; the necessary expenses, including cost of transmission (which can never be more than the actual cost of transporting the specie itself): interest on the money for the time the draft has to run to maturity or to the time of payment in the foreign country—these and other factors must be taken into account. The expense of cabling and the profits of the bankers who transmit the money must be added. Some intangible factors are the credit condition of the countries and the risks involved in making transfers.
The Accounting Problem of the Foreign Branch
From the viewpoint of accounting, the only problem in connection with foreign branches which differs from those of domestic branches concerns the conversion of the foreign currency—in terms of which the records of the foreign branch are kept—into the currency of the head office. Periodically—usually at the close of the fiscal period—the results as shown by the branch records must be incorporated with those of the head office. The problem involved is for the most part due to the fact that, while the activities of the various branches have been transacted and recorded in terms of one or more currencies, the net results of those activities are to be taken effect of, usually as a disbursement of dividends, in the terms of the head office currency. That is, earnings are made and expenses incurred in one currency, and the net result of the branch’s trading must be disbursed in terms of another currency. The fluctuations in exchange prevailing throughout the year at the time of the various transactions of the branch and at the time when the net results of the branch are disbursed as dividends from the head office, sometimes give rise to a very complicated problem if accurate and satisfactory results are to be secured.
It is impossible, from the standpoint of practice, to convert every transaction of the branch into the currency of the head office at the rate prevailing at the time of the transaction; and furthermore, the funds out of which ultimately some portion of the dividends must be paid are, at the close of the fiscal period, still held in the possession of the branch and so are not available except through the process of conversion. Accordingly, the question of the rate of exchange prevailing at the close of the fiscal period has a very important bearing on the correct showing of the branch’s activities on the head office books.
It is not purposed here to go into the question of organization, or method of keeping accounts for the foreign branch. As was stated above in connection with domestic branches, any system of accounts depends very largely upon the general organization of the head office and its branches, and this in turn depends on the degree of control and amount of information desired. The discussion will be limited to the assumption that the branch has an almost independent organization and is expected to make a full report periodically by means, at least, of a trial balance of the branch.
Accounts Opened on Books
On the books of the branch a Head Office Control or Adjustment account will be carried which represents the ownership of the head office in the branch; and on the head office books a Branch Control or Adjustment account which is the complement of the head office account on the branch books. Frequently, in addition to these interrelated accounts, a Remittance account is carried for the purpose of facilitating reference. In this account are entered the remittances made by the branch to the head office, instead of entering such transactions in the Head Office Control account. The problem to be discussed here concerns the method of converting the branch trial balance before incorporating it, and the root of the problem lies in the determination of the basis for the conversion of the various kinds of items listed therein. Fixed and current asset and liability items, expense and income items, the Head Office Control and Remittance accounts—all must be converted. For an accurate and equitable showing of the branch activities on the head office books under certain conditions, these different classes of items should not be converted at the same rate. Under other conditions no serious inequity results from the use of a uniform rate of exchange for the conversion of all items, and in practice such a rate is handled much more simply than different rates. Of course, the branch trial balance is in balance previous to conversion but is almost invariably out of balance after conversion. It becomes necessary, therefore, to take up the difference by means of a debit or credit to an account called “Exchange” or “Fluctuations in Exchange”—sometimes also called “Reserve for Fluctuations in Exchange.”
Handling Fluctuations in Foreign Exchange
The proper handling and ultimate disposition of this Exchange or Fluctuations in Exchange account requires some consideration. If there is a loss in the conversion of the branch trial balance into the head office currency, that may be treated as a current expense to be charged ultimately to the current period’s profit and loss. Any profit accruing from the same source may be similarly handled. Some concerns set aside all profits accruing in this manner into a Reserve for Fluctuations in Exchange account, against which are charged any losses incurred through conversion. If the first period shows a loss on conversion, it would, of course, be necessary to reserve out of that period’s profits a sufficient amount to take care of the loss. Usually, however, the items of profits and losses on conversion of exchange counterbalance each other fairly well throughout succeeding periods. The item is for the most part comparatively small and either method of handling it is satisfactory and gives sufficiently correct results under normal conditions but often too inaccurate under abnormal conditions.
Conversion of Branch Results
The basis on which the closing entries are converted from the foreign to the local currency is a very important factor. If the ratio between the two countries is more or less stable, an average rate may be adopted without much variation in the established values. All profits or losses on exchange resulting from differences between actual rates on current transactions and this average rate will be entered in the Fluctuations in Exchange account. However, in periods of rapidly fluctuating rates of exchange, or in transactions with branches where silver currency or depreciated paper or non-guaranteed currency are in use, the conversion of all items at some arbitrary or average rate will not give accurate or satisfactory results. In such cases certain practices have been established as being the most equitable in converting the various accounts of the branch balance sheet into the local currency for the purpose of amalgamating them into the home office balance sheet. These practices are summed up as follows:
First convert the foreign currency into dollars at the following rates:
1. Fixed assets at the same rate as before, that is, the rate at the time of purchase, or average rate for the purchases of a fiscal period. The reason for this is that fluctuations in the value of fixed assets, whether expressed in one currency or another, are not allowed to affect the period’s results. 2. Floating assets and liabilities at the rate current as of the date of the balance sheet. 3. Revenue items at an average rate for the period. 4. Remittances at the actual rates paid. 5. Control or adjustment account at the same rate as that which had been established on the head office books at the last period.
To arrive at the average rate in the case of fixed assets it is sufficient to take the rate prevailing at the end of each month throughout the year and divide the total by twelve. This becomes necessary where construction or purchases of fixed properties take place throughout the year. The difference, if the rate is less than par, is credited to the capital expenditure and debited to Profit and Loss on the head office books. The branch is notified of the adjustment and makes a similar entry crediting Exchange and debiting the head office with the amount.
Current assets and liabilities are converted at the rates current at the date of the balance sheet because the balance sheet should represent these values at the exact cost of converting them into cash at the present moment. If in practice they were actually liquidated, this could not be realized but in principle it represents the present condition. Revenue items are convertible at the average rate because they represent items accumulating during the entire fiscal period; they represent the result of the business activities for the past period, at varying rates of exchange. Since the remittance account represents the actual cash paid for cash transmitted, there is no occasion for changing the rate which has been used at various times during the period. The Control or Adjustment account likewise was converted at the time the entries were made to it and represents the exact cost of the various transactions recorded in it.
After all balance sheet items have been converted according to the rates prescribed, it is a general custom to provide a reserve account to cover any losses on exchange not provided in the conversion of the accounts. This is done for the purpose of guarding against overstating values and thus paying dividends out of the capital, since the conversion into head office currency merely serves as a medium of estimating what the foreign investment really represents to the stockholders.
An illustrative problem is given below with its solution based on the principles of conversion just stated. It is to be noted that in practice, within the limitation stated on page 546, a uniform rate of conversion is generally made use of for all items except remittances, for which the actual rate is used.
Illustrative Bookkeeping Problem
Problem. At the close of the fiscal period a condensed trial balance report of the London branch of a New York concern showed as follows:
TRIAL BALANCE—LONDON BRANCH
£ £ N. Y. Control (4.7475) 100,000 Remittance 50,000 Cash 5,000 Customers 75,000 Merchandise Inventory 25,000 Furniture and Fixtures 1,000 Creditors 31,000 Sales 150,000 Purchases 95,000 Expenses 30,000 -------- ------- 281,000 281,000 ======== ======= Final Inventory £30,000
The London Control account on the New York books showed a balance of $474,750, and the Remittance account $237,987.50. Set up, in journal form, the entries necessary to take on the New York books the results of the period’s activity at London and show the London Control and London Profit and Loss accounts after adjustment, using the additional data:
1. The Remittance account comprised 5 drafts of £10,000 each, at 4.75, 4.7575, 4.74875, 4.7625, and 4.78 respectively. 2. The current rate of exchange is 4.7545. 3. The average rate is 4.7525. 4. The rate at time of purchase of fixed assets was 4.83. 5. No account is to be taken of probable loss from uncollectible accounts nor of depreciation. 6. Carry the difference in exchange to a reserve.
Solution
CONVERSION OF LONDON TRIAL BALANCE =================+=======+=======+=======================+============ | | | Rate of | | | £ | £ |Conversion| $ | $ +-------+-------+-----------------------+------------ New York Control | |100,000| 4.7475 | | 474,750.00 Remittances[70] | 50,000| |(See note)| 237,987.50| Cash | 5,000| | 4.7545 | 23,772.50| Customers | 75,000| | 4.7545 | 356,587.50| Merchandise | | | | | Inventory | 25,000| | 4.7475 | 118,687.50| Furniture and | | | | | Fixtures | 1,000| | 4.83 | 4,830.00| Creditors. | | 31,000| 4.7545 | | 147,389.50 Sales | |150,000| 4.7525 | | 712,875.00 Purchases | 95,000| | 4.7525 | 451,487.50| Expenses | 30,000| | 4.7525 | 142,575.00| Reserve for | | | | | Fluctuations | | | | | of Exchange | | | | | 913.00 +-------+-------+----------+------------+------------ |281,000|281,000| |1,335,927.50|1,335,927.50 +=======+=======+==========+============+============ Final Inventory £30,000 @ 4.7545 = $142,635
[70] This item comprised 5 drafts, of £10,000 each, at 4.75, 4.7575, 4.74875, 4.7625, and 4.78 respectively.
JOURNAL ENTRIES TO ADJUST NEW YORK BOOKS
(1) Remittances $237,987.50 London Control $237,987.50 To Credit London with its remittances: £10,000 @ 4.75 = $47,500.00 10,000 @ 4.7575 = 47,575.00 10,000 @ 4.74875 = 47,487.50 10,000 @ 4.7625 = 47,625.00 10,000 @ 4.78 = 47,800.00
(2) London Control $712,875.00 London Profit and Loss $712,875.00 To charge London with its sales: £150,000 @ 4.7525
(3) London Profit and Loss 118,687.50 London Control 118,687.50 To credit London with initial inventory: £25,000 @ 4.7475
(4) London Profit and Loss 451,487.50 London Control 451,487.50 To credit London with its purchases: £95,000 @ 4.7525
(5) London Control 142,635.00 London Profit and Loss 142,635.00 To charge London with final inventory: £30,000 @ 4.7545
(6) London Profit and Loss 142,575.00 London Control 142,575.00 To credit London with its expenses: £30,000 @ 4.7525
(7) London Control 913.00 Reserve for Exchange Fluctuations 913.00 To charge London with the profit arising from conversion.
(8) London Profit and Loss 142,760.00 Profit and Loss 142,760.00 To transfer profit at London branch to general Profit and Loss.
Appended are the London Control account as it would appear after posting the above entries on the New York books; and the London Profit and Loss account on the New York books.
LONDON CONTROL =====================+========+=========+============= Items | Rate | £ | $ ---------------------+--------+---------+------------- Balance one year ago | | 100,000 | 474,750.00 London Profit & Loss | | | (Sales) | 4.7525 | 150,000 | 712,875.00 London Profit & Loss | | | (Final Inventory) | 4.7545 | 30,000 | 142,635.00 Reserve for Exchange | | | Fluctuations | | | 913.00 | | | | +---------+------------- | | 280,000 | 1,331,173.00 |========+=========+============= Balance | | 80,000 | 380,435.50 =====================+========+=========+============= Items | Rate | £ | $ ---------------------+--------+---------+------------- Remittances See | J(1) | 50,000 | 237,987.50 London Profit & Loss | 4.7475 | | (Initial Inventory) | 4.7525 | 25,000 | 118,687.50 London Profit & Loss | 4.7525 | | (Purchases) | | 95,000 | 451,487.50 London Profit & Loss | | | (Expenses) | | 30,000 | 142,575.00 Balance | | 80,000 | 380,435.50 | | | | | 280,000 | 1,331,173.00 +========+=========+=============
LONDON PROFIT AND LOSS[71] ===============================+============================= Initial Inventory $118,687.50 | Sales $712,875.00 Purchases 451,487.50 | Final Inventory 142,635.00 Expenses 142,575.00 | Profit & Loss 142,760.00 | ----------- | ----------- $855,510.00 | $855,510.00 =========== | ===========
[71] This also may be kept in both currencies if desired and only totals carried in the London Control account.
Local Supervision of the Foreign Branch
A question which enters into the accounting with foreign branches arises in connection with the law of the land in which the branch is opened. “Most foreign countries have some regulations as to what books must be kept, and the manner of recording the transactions. In France, for instance, the law requires that a summary of all transactions shall be entered through the journal, which therefore becomes the posting medium for every transaction. This book has, in the first instance, to be produced to a public official, who examines it to see that it is duly paged, none missing, etc., and then stamps it as correct, and anything requiring legal proceedings in which accounts are concerned must be proved from the journals with the official visa.”
“Since the work of organizing and installing systems of accounting in branch houses abroad is of undoubted and growing importance, it is necessary to have not only a practical acquaintance with the currencies in which the foreign books are kept, and the laws of the land in regard to the kind of books which must be kept, but in addition a thorough knowledge of the manner in which transactions are to be transmitted periodically to the home office, and of their assimilation with the home accounts and the drafting of the final accounts, balance sheets and profit and loss statements becomes indispensable.”
The Foreign Sales Agency
Where the foreign branch is merely a selling agency for the home office, and invoices must be made out at the home office in foreign currency, a convenient way to handle these accounts is to keep a separate set of records for each foreign currency. A foreign sales journal, customers ledger, and cash receipts journal, together with foreign notes receivable and sales returns and allowances journals, where necessary, will comprise all books of original entry needed to secure sources for postings to the customers’ individual accounts in terms of foreign money. In this way all charges for goods sent, and credits for returns, allowances, cash and notes received and discounts allowed, can be kept entirely in foreign currency.
Method of Conversion of Results
Periodically—say, once a month—the total transactions for the month must be converted into home currency and brought into the general ledger. In normal times a fixed average rate of exchange based on past experience gives sufficiently accurate results, saves many tedious calculations and much unnecessary work. At certain times and in certain businesses the prevailing rate of exchange on the actual day, or the monthly average of daily rates, may need to be used to secure satisfactory results. With the use of the fixed average rate, as above, the totals of foreign sales and sales returns journals are converted into home currency and carried respectively as debits and credits to Accounts Receivable control, and credits and debits to Sales. The total of the discount column of the cash receipts journal is converted, at the average rate, and charged to Sales Discount and credited to Accounts Receivable control.
The conversion of the cash received must be handled differently, however. The actual rate at which the foreign draft or bill received in payment of the customer’s account is converted by sale to the banker—and so credited to the home office bank account—almost always differs from the average rate at which the item was charged to the customers’ controlling account. This, of course, makes no difference with his individual account which is kept in foreign currency, but does make necessary an adjustment of the general ledger Accounts Receivable control in order to make it agree with the foreign customers ledger when converted at the average rate.
Accordingly, in the general cash book two additional columns are provided, viz.: Profit on Exchange and Loss on Exchange columns, which are used somewhat as is the Sales Discount column. Every foreign draft or bill when received is entered, in foreign currency, in the foreign cash book and posted from there to the credit of the customer. When that draft or bill is sold at the bank (it may be held for some time after receipt for a favorable turn of the money market) and so converted into home currency, it is entered in the Accounts Receivable column at a figure representing conversion at the fixed average rate. The difference between this figure and the actual amount received at the bank is entered in either the Profit on Exchange or Loss on Exchange column as the case may be, with extension of the actual amount into the bank column as a charge to the bank account. Thus, the total of the Accounts Receivable column when posted to the general ledger Accounts Receivable control adjusts that account so that it controls the foreign customers ledger converted at the average rate. The totals of the Profit on Exchange and Loss on Exchange go as credits and debits respectively to the Profit and Loss on Exchange account.
The foreign sales agency often collects the accounts and remits total collections periodically by purchase of one bill or draft on its local bank for the total. There must, of course, accompany each such remittance a statement of the detailed receipts for proper credit to individual accounts. The general cash book will show only the total remittance, however. Regular agency accounts as explained in Chapter XXX will secure the control of the home office over the agency’s expenditures.
It is usually best to make the foreign customers ledger self-balancing. The Adjustment account necessary to effect this may, if desired, be kept in both foreign and home currency, thus showing on its face, by the balance of the home money columns, the agreement of the foreign ledger with its control account on the general ledger. If, instead of one fixed average rate of conversion, varying rates are used, the keeping of the Adjustment account in both currencies becomes imperative.
Where, in the case of foreign sales, the sales invoice and charge to the customer are made in home currency and payment of that amount in home currency is demanded, the problem of conversion, as explained above, is not encountered, foreign sales being recorded and handled in exactly the same way as home sales.
The Foreign Purchasing Agency
If the purchase is made in terms of foreign currency and settlement must be made in that currency, a procedure and system may be used exactly similar to that just explained for handling sales.
In both the sales and purchase record books, returns may be entered in the same record by using red ink, and deducting the red ink totals at the end of each page. This obviates the necessity of keeping subsidiary adjustment accounts in a separate book, and brings all information regarding the branch transactions in one compact record.