Chapter XXXII…

Chapter XXXII

SUSPENSE ACCOUNTS; NUMBERED ACCOUNTS; ADJUSTMENT OF FIRE LOSSES

SUSPENSE ACCOUNTS

Definition of Suspense Accounts—General Purpose

Any account which is used as a place of temporary record for items pending a determination of their final status or allocation may be called a suspense account. The definition points out the general purpose for which such accounts are opened. It frequently becomes necessary to record items on the books as soon as the transactions giving rise to them have taken place. At the time, the information needed to determine their final place of record may be lacking. Stock certificates may find their way into the secretary’s office with the name of the party to whom transferred omitted; cash may be received through the mails with the identity of the sender not disclosed; provision must be made for bad debts before it is known what accounts will prove uncollectible—these and similar items call for record before their final status is determinable.

When cash is either short or over, the Cash Short and Over account serves as a temporary adjustment account. Discrepancies between the book record and the physical inventory of cash due to various causes are temporarily thrown into this account until further information discloses the cause. When it becomes evident that such information cannot be secured, any balance is usually treated as a profit and loss item at the end of the fiscal period. Similarly, discrepancies between the bank’s cash record and that of the business may be thrown into an account called “Bank Adjustments” or some other similar title, to show the nature of the items there recorded. The Petty Cash account, between the periods of its adjustment by means of a replenishing check, is in the nature of a suspense account. Only when an analysis of the petty cash expenditures and the replenishing check are recorded on the books is Petty Cash an asset account. Failure to locate an error in the trial balance is sometimes recorded on the books through the medium of a Trial Balance Adjustment account so as not to carry the difference over into the trial balance of succeeding months. Where such an account is set up it is a suspense account pending the finding of the error.

Again, it may sometimes become necessary to adjust arbitrarily a difference between a controlling account and the total of the ledger which it controls pending the finding of the discrepancies between the two. Thus, an Accounts Receivable Control may not accord with the sum total of the customers’ accounts carried in the sales ledger, and it may be deemed advisable to accept the subsidiary ledger record as correct rather than the figures of the controlling account. The adjusting item is usually incorporated in the controlling account but is in the nature of a suspense item pending the allocation of the difference. As mentioned above, a cash receipt from an unidentified customer must be recorded in a suitably named suspense account. Similarly, unclaimed wages which have been charged on the books to the proper ledger account and credited to cash must be carried until they are called for or until their record may with reasonable certainty be closed on the books. Unclaimed dividends must also be held in suspense until such time as a definite settlement of their disposition may be determined. Advances to subsidiaries when recorded as a charge in open account against the subsidiary are frequently of the nature of suspense items. The subsidiary may settle the account by payment of cash, by payment of its bonds or stock, or the account may not be settled and it then becomes necessary to write it off as a bad debt.

Similarly, purchase invoices and other like items in dispute may be booked as suspense items under suitable titles. However, in cases of this kind it is more usual to hold the invoices until some basis of settlement is reached before recording them on the books. If the fiscal period closes with these items still unsettled, it will be necessary to bring them on the books as contingent liabilities.

The Reserve for Depreciation may be looked upon as a suspense account. The credit entries therein which serve the several purposes explained elsewhere, are in the nature of items belonging to asset accounts which are held in suspense pending the final disposal of all or some part of the asset. This final disposition may take place either because of sale, loss by fire, or the discard of the asset on account of complete depreciation. At such a time it becomes necessary to transfer the portion of the reserve belonging to the asset finally disposed of as a credit to the asset account in order to clear that account of the asset values therein shown.

Reserve for Doubtful Accounts as a Suspense Account

In like manner the Reserve for Doubtful Accounts is a suspense account because at the close of the fiscal period it becomes necessary to make an estimate of the probable amount of uncollectible items in order to appraise correctly the value of outstanding claims against customers. This estimate must be carried as a credit in the Reserve for Doubtful Accounts because at that time it is not known definitely to what particular customers’ accounts it applies. During the following periods, as the information becomes definite as to what accounts are absolutely uncollectible, the credit held temporarily in the reserve account is transferred to the particular customer’s account which has proved uncollectible. Thus, we often speak of charging an uncollectible customer’s account against the reserve, which is another way of saying that we transfer from the reserve a portion of the credit held there in suspense, to the customer’s account after it has been determined to what customer’s account it belongs.

Use of Suspense Ledger

In an effort to keep closer track of doubtful accounts and notes receivable, such accounts are frequently transferred to what is known as a suspense ledger. A fundamental misunderstanding seems to exist with regard to the meaning of such a transfer. A business man often points with pride to the fact that he has transferred a number of items from his regular customers ledger to a suspense ledger, implying thereby a policy of conservatism in the value at which he carries his customers’ accounts on his books. As a matter of fact, the transfer to the suspense ledger in no sense changes the valuation at which the accounts are carried on the books. Separation of the doubtful items from those considered good provides a convenient basis for analysis according to which, at the end of the fiscal period, it will be possible to make a much more accurate and intelligent estimate of the probable loss from uncollectible items. Aside from that and another fact of importance, namely, that by keeping all such accounts in a suspense ledger it becomes much easier to watch them closely, nothing is to be gained by the use of a suspense ledger. As to the proper method of handling this ledger, it is best to carry in conjunction with it a separate control on the general ledger supplementary to the customers ledger controlling account. This would be effected at the time of removing an individual account to the suspense ledger, by transferring the same item from the customers ledger controlling account to the suspense ledger controlling account.

The form of the suspense ledger is somewhat different from that of the regular ledger in that provision is made for gathering information as to the efforts made to collect the items and the result of those efforts. A loose-leaf or card ledger serves the purpose best. While the form is not standardized, such information as the report of the mercantile agency at the time of granting the original credit; the agent in whose hands the account is placed for collection; the date of placing the claim in his hands; his report on his efforts to collect the account; the lawyer to whom the account is given in case suit is brought; the attorney’s report; the name and address of the trustee or receiver in case the customer has gone into bankruptcy; the date of filing a claim with the trustee; the judgment secured; the particulars as to settlement; and provision for additional remarks—all this information is of value and provision should be made to record it. It may also be sometimes desirable to make use of a suspense journal where information in addition to that for which provision has been made on the ledger account can be collated and kept for reference.

Accounts Receivable Hypothecated

In connection with the handling of accounts receivable it may be well to draw attention to the growing practice of discounting open accounts receivable in much the same way in which notes receivable are discounted. In recent years a group of non-professional bankers have initiated this kind of financing. It may sometimes happen that a merchant exhausts his credit with his regular banker and is unable to raise further necessary funds in the usual way. By applying to the so-called commercial credit companies or these non-professional bankers it is frequently possible for him to discount his new accounts as he creates them through current sales to customers and so secure funds for tiding him over a temporary stringency. The practice, however, is looked upon in business and regular banking circles as evidence of the financial instability of the merchant and his probable bankruptcy in the near future. The cost of raising funds in this way is almost prohibitive excepting in cases of dire need and it is not resorted to by business houses whose financial condition is sound.

The practice works out somewhat as follows. A merchant desiring to discount his accounts turns over to the credit company with whom he has made the arrangement, the invoices of all accounts to be discounted as evidence of the sales just made to customers. The credit company on the strength of these invoices advances anywhere from 70% to 80% of their face value, thus maintaining a margin of safety of from 20% to 30%. The charge made is called commission rather than interest, and varies from 2% to 5%. To protect the credit company, frequently such invoices, as they go out to customers, bear a notation to the effect that payment of the bill is to be made to the credit company and not to the merchant selling the goods. An obvious and serious objection to this practice is that it gives the customer information as to the method of financing to which the seller has been reduced. In view of this objection a few bankers are willing for payment to be made as usual to the merchant, who must in turn transfer the identical item or the merchant’s own check for an equivalent amount to the banker. A periodical settlement with the banker secures from him a statement and return of the moneys held by way of margin. The accounts as settled are paid in full to the banker who has previously furnished, say, 70% of their face value in cash to the merchant. The banker thus holds 30% more money than he has furnished to the merchant, and as these margins accumulate it may sometimes happen that the banker is loaning the merchant the latter’s own money. Consequently, it becomes imperative for the merchant to keep careful record of all accounts discounted with, and of their payment to, the banker so that he can protect himself by requiring a settlement as may be shown necessary.

Accounting for Accounts Receivable Discounted

The accounting procedure in keeping track of these items is very similar to that for notes receivable discounted. Inasmuch as the practice does not involve an outright sale of the accounts to the banker, a contingent liability is created in case the customer does not pay his account, which the merchant will have to make good to the banker just as in the case of notes receivable unpaid at maturity. The bookkeeping record of discounted accounts may be considered under four aspects:

1. At the time of discount. 2. At the time of the banker’s report of customers’ payments. 3. At the time an account is charged back by the banker because of inability to collect. 4. At the time of final settlement with the bankers.

1. At the time a group of accounts is discounted the charges are to Cash for the amount of cash received, to Commissions Paid on Discounted Accounts for the amount of commission, and a charge to the Bankers or to a Bankers’ Margin account for the margin. The credit offsetting these debits is to an account called Customers’ Accounts Discounted. No further entry is necessary until the banker’s report of customers’ payments.

2. At the time an account is reported as paid by the banker, the contingent liability thereon as carried in the Customers’ Accounts Discounted account has ceased to exist and a reversing entry becomes necessary, Customers’ Accounts Discounted is charged, and the customer’s account is credited.

3. When an account is not collected and is charged back by the banker, the contingent liability as carried under Customers’ Accounts Discounted becomes a real liability which has to be settled by payment to the banker of the amount of the cash originally advanced by him at the time of discount. At such a time the entry made will be a debit to Customers’ Accounts Discounted offset by credits to Cash and to Bankers or Bankers’ Margin account, as the case may be.

4. At the time of final settlement with the bankers, all that remains to be done is for them to pay over the balance of cash in their hands belonging to the merchant. This balance of cash is reflected by the amount of margins which they have demanded at the time of discount. Hence, on the merchant’s books the transaction will be recorded as a debit to Cash and a credit to Bankers or Bankers’ Margin account.

In order to keep close track of all accounts under discount it is advisable and almost necessary to make use of what may be termed a “discounted accounts register.” Every account, as discounted, should be given a number and entered in numerical sequence in the register. As an account is paid by the customer and reported by the banker it should be there shown as paid. The banker at the time of final settlement must render an accounting for all the accounts not shown as canceled by the register, either in cash or by a return of the claim against the customer.

NUMBERED ACCOUNTS

Allotment of Numbers to Accounts

The allotment of a series of numbers to a certain kind of accounts not only classifies them in an orderly manner by grouping them according to their resemblances and separating them according to their differences, but the notation also greatly facilitates locating them and saves much time and effort in indicating them on vouchers, journal entries, etc. Another advantage is that posting records may be checked as to their general correctness by an official who has only a general knowledge of the system. As an illustration, if the asset accounts have the general classification of 1 and the expense accounts have the general classification of 9, it needs only a cursory survey of voucher, or ledger posting data, to see whether an expense item has been charged to a capital account or vice versa.

The framework of the classification should be so constructed that any account, new or old, not already included in the scheme, can be inserted without disturbing the general order. If this is done, the system can never become obsolete in the sense of becoming impracticable, because changes can be inserted in their appropriate place as soon as they occur.

The different schemes or symbols which have been developed from time to time are the Dewey decimal system with its variations; the mnemonic system; and a combination of the two. The Dewey decimal system is undoubtedly the most complete and highly perfected in theory of any, and, as the name indicates, is a combination of figures and periods giving a symbol of almost unlimited expansion. The use of figures and symbols offers an infinite number of possible combinations, but the straight decimal system is in no way practical for general use, chiefly because a voluminous key is necessary even to interpret the symbol.

The mnemonic system, as its name indicates, was devised for the purpose of supplying a symbol which would be suggestive and which would indicate the object that it was intended to identify. The mnemonic symbol consists of a combination of letters and figures with the occasional use of a period or a dash. In order to classify completely any object in a large system, according to general classifications and special subdivisions, it is sometimes necessary to use five, six, or seven letters to identify one particular piece of machinery. In this case also, the use of a key becomes a necessity. The mnemonic system pure and simple is more often used for identifying machinery and tools or other stock, kept in a factory stock room. It is adapted also to the filing of correspondence.

The two advantages claimed for the mnemonic over the Dewey system are:

1. The letters of the alphabet are used and so give opportunity for a more rational classification than the ten possible groups of the decimal system. 2. A system consisting of letters may be made more easily mnemonic, each letter being, as a rule, the initial of the term symbolized, and may be recalled to mind more easily than a number arbitrarily chosen for that purpose.

The following example shows how easily a machine can be located and described. If:

M is used for machine L for lathes C for core ramming machines P for power machines R for ramming machines

then:

ML would immediately suggest a lathe MCR a core ramming machine MPR a power ramming machine Etc.

Where there are several styles of the same type of machine, numerals may be added, as MPR₁, MPR₂, etc.

A combination of these two systems which has been applied to large institutions is characterized by grouping all departments which perform the same class of service under one letter of the alphabet, and then numbering their functions. Frederick A. Parkhurst[72] has outlined a very useful system which may be used in a manufacturing or other plant somewhat as follows. Group A with subdivisions would include:

1A Accounting Room 1B Sales Department 2A Cost Department 2B Order Department 3A Credit Department 3B Stenographic Department 4A Billing Department 5A Filing Department

[72] “In Symbols.”

Each department of the factory has an arbitrary letter allotted to it and is always referred to in all records by this letter and number.

The Interstate Commerce Commission uses a numerical system of numbering accounts by first grouping each class under “general accounts”; then under each group of general accounts, special accounts called “primary accounts” are numbered consecutively. These accounts have been analyzed so minutely that not much leeway is given for inserting new accounts and for this reason the method is not so elastic as a good classification requires. Thus, Operating Revenue accounts are classified generally into:

I Transportation—Rail Line II Transportation—Water Line III Incidental IV Joint Facility

The primary accounts under these general subdivisions are numbered as follows:

Transportation—Rail Line from #101 to #116 Transportation—Water Line from 121 to 128 Incidental from 131 to 143 Joint Facility from 151 to 152

Operating Expense Accounts are classified under the following general accounts:

I Maintenance of Way and Structures II Maintenance of Equipment III Traffic IV Transportation—Rail Line V Transportation—Water Line VI Miscellaneous Operations VII General VIII Transportation for Investment—Cr.

The primary accounts under these are numbered from 201 to 462.

Another numerical method which can be used for general businesses and which corresponds somewhat to the above is arranged as follows:

100 to 700 Assets and Deferred Charges 800 to 1100 Capital Stock, Liabilities, Reserves, and Surplus 1500 to 2500 Profit and Loss Accounts

The even hundred accounts are the controlling accounts in the general ledger. The details are carried in subsidiary ledgers and are numbered consecutively from 101 to 199, etc.

This system also is not so elastic as one constructed on the theory of the Dewey decimal system, which may be expanded indefinitely without disarranging the system as a whole. First of all the general ledger accounts may be classified into nine fundamental groups as follows:

1 Asset Accounts 2 Investments and Treasury Securities 3 Prepaid Items 4 Liabilities 5 Accrued Items 6 Valuation Reserves 7 Capital and Surplus 8 Income 9 Expense Accounts

These general groups may be further subdivided indefinitely into groups of nine, keeping in mind continually that the process of division should be from general to special and that the progress should be gradual.

1 Asset Accounts 11 Fixed Assets 111 Land 1111 Used and Useful in Operation 11111 Details in Subsidiary Books 1112 Held for Speculative or Investment Purposes 11121 Details in Subsidiary Books 11122 112 Buildings 113 Machinery 114 Tools 115 116 117 118 119 12 Current Assets 121 Cash in Bank 1211 Local Bank 1212 New York Bank 1213 Chicago Bank 122 Petty Cash Fund 123 Notes Receivable 124 Accounts Receivable 125 Merchandise 1251 Inventories 1252 Purchases Raw Material 1253 In Process 1254 Finished Goods 1255 1256 126 127 128 129 8 INCOME ACCOUNTS 81 Sales 811 Merchandise 8112 By Departments, etc. 812 Consignments 8121 Details in Subsidiary Records 9 EXPENSE ACCOUNTS 91 Manufacturing 911 Prime 9111 Wages 9112 Freight 912 Manufacturing Expenses 92 Selling Expenses 921 Salaries 9211 Details in Subsidiary Records 922 Traveling Expenses 923 Commissions 924 Advertising 925 General Selling 93 Administrative Expenses 94 General Expenses

All accounts under 100 are general ledger accounts, and accounts over 100 are accounts kept in subsidiary records.

From this outline it is apparent that even though each series is limited to nine as in the Dewey decimal system, it may be indefinitely expanded to include a large number of accounts, and will be elastic enough to accommodate any number of future additions to the system. It also classifies accounts so definitely that errors in posting are very rare. A skilled bookkeeper would not be likely to post an income account in any account beginning with 9 for instance.

If this system is used by a large corporation or holding company which operates branches or factories in different sections of the country, all forming part of the general system, letters of the alphabet may be allotted to each factory or branch in addition to the numerical classification. By this means the accounts of each branch may be kept separate on the books of the head office, but the corresponding expense accounts will have the same numbers and may be incorporated in the head office books or balance sheet without any difficulty. This illustrates the principle of grouping all accounts belonging to the same classification and separating all accounts which belong to different units of the same organization.

In establishing a special system of classification for any purpose whatever, the main points to be kept in mind are that the following requirements shall be fully met:

1. To enumerate all the kinds of information which may be classified. 2. To group these items into a limited number of classes. 3. To give each class a definite and unchanging symbol. 4. To provide for expansion of the classification under each group, and symbolize each subdivision by an addition to the symbol for the group.

If these general rules are observed, the notation may be numerical or alphabetical, whichever serves the purposes noted above, and also is most easily memorized without the use of an elaborate key to interpret the system.

ADJUSTMENT OF FIRE LOSSES

The Insurance Contract

A fire insurance policy is a contractual engagement, modified by the conditions stated, to pay or replace, in part or in whole, any loss through fire, covering the property specified for a definite period. The amount to be paid cannot exceed the face value of the policy. The main points covered in the policy are the parties, the property, the risk, the amount, the term, the premium, and the conditions governing. There are three ways in which the contract may be terminated, namely: by expiration, cancellation, or forfeiture. Generally the contract holds good until noon of the day named as the date of expiration. Therefore, if a fire should break out in the forenoon on that day but the greater part of the damage were caused after the noon hour, the whole loss would be covered according to the terms of the policy. The policy can be canceled immediately by the insured by giving notice to the insurance company. The latter, however, must give notice and wait five days before the cancellation will be effective.

In case of cancellation, the premium cost for the expired term is usually higher proportionately than for the whole term; what is known as the “short rate” becoming effective. The causes for the forfeiture of the policy are many and various. Among the reasons are concealment or misrepresentation, or fraud in connection with taking out the policy or in substantiation of claims for losses incurred. Some of the parts of the agreement relative to occupancy, vacancy, change in title, use or allowance of dangerous substances may be the cause. Then again, neglect of the clauses as to the maintenance of an adequate sprinkler system, making provisions for watching the building, etc., may lead to forfeiture.

Requirements in Case of Loss

When a loss occurs the first thing necessary is to give at once a written notice to the insurance company and to endeavor to protect the property from further damage. The next step is to separate the damaged and the undamaged movable property, and to put these two classes in order so as to facilitate checking up. Then follows the making out of an inventory giving accurate details concerning the kind, the amount, the cost, and the damage claimed in respect to the goods. Upon the arrival of the adjuster of the insurance company, adjustment may be made immediately, or it may be a protracted affair, depending on conditions. The insured is required by the terms of the policy to submit a sworn proof of loss within 60 days. This proof must enumerate the facts and beliefs of the insured regarding the origin and time of the fire, the interest the insured has in the property, together with the interest, if any, held by others, the cash value of each item, the sum total of the loss sustained, the encumbrances on the property, other insurance, whether valid or not, a copy of all descriptions and schedules of all the policies, any change in title, use, occupation, location, possession, or exposure of the property since the issuance of the policy. It is also required to state by whom and how the insured building was occupied at the time of the fire. Sometimes the insurance company may require that this proof be verified by plans or specifications of the building, machinery, or fixtures that have been destroyed or damaged. At its option, it may request a certificate from an impartial magistrate or notary public substantiating the correctness and honesty of the claims presented. It is further required that the insured keep himself ready to exhibit any remains of the property in question. He may also be required to submit to an examination under oath and produce at the option of the insurance company any books of account, bills and other vouchers, and permit copies or extracts to be made from them.

Determination of Value of Loss

The insurance policy gives no hard and fast rule regarding the determination of value. The usual phraseology is: “This Company shall not be liable beyond the actual cash value of the property at the time any loss or damage occurs and the loss or damage shall be ascertained or estimated according to such actual cost value, with the proper deduction for depreciation, however caused, and shall in no event exceed what it would then cost the insured to repair or replace the same with material of like kind and quality.”

The insurance company has accordingly the option of using the lower of two bases of settlement, viz.: (1) actual cash value at the time of the fire; or (2) what it would cost the insured party to replace the property lost. The price which governs, cost or selling, will depend upon the nature of the property. As a general rule, it is the cost price. For goods which cannot be readily or advantageously reproduced, like cereals and cotton, the adjustment basis is the local open market price prevailing immediately before the fire. In adjusting values, adequate depreciation allowance is made not only for ordinary wear and tear, but also for losses incidental to changes of fashion, demand, etc.

Adjustment of Differences

Whenever there is a dispute regarding the standards applicable in the adjustment or a disagreement regarding the method by which the standards are applied, one or the other of the parties generally invokes the provisions of the policy for an appraisal. In accordance with the terms of the policy, the insurer and insured may each appoint an appraiser who in turn selects an umpire. This official does not act except when called on for a decision if the appraisers disagree on some point. The appraisers proceed to make a joint appraisement of the damage caused and the value of the loss. If this appraisal is incorporated in a written award and signed by the appraisers, it is binding on both parties, and will be upheld by the courts. This provision is applicable to total and partial losses, but is limited to questions of value and damage. The appraisers are generally experts, but may call in any other person to give testimony. They are not bound by any legal rules of evidence, but may determine their own procedure.

After the value of the loss has been arrived at, by agreement or appraisal, the liability as modified by the conditions or limitations comes up for consideration. There are generally a number of these clauses present in every policy although they are not always in force. One of these is the pro rata or the contributing clause. In the standard policy this clause reads as follows: “This Company shall not be liable under this policy for a greater proportion of any loss ... than the amount hereby insured shall bear to the whole insurance, whether valid or not, or by solvent or insolvent insurers covering such property.” The apportionment of the loss on this basis is often a complicated affair.

Effect of Coinsurance Clause

Another limitation clause is the “coinsurance,” sometimes called the “average clause” or “reduced rate” clause. The object of this clause is to make the relation between value and insurance somewhat more stable and to adjust the rates in accordance with the ascertained probability of big and small losses. The assumption is that partial losses to the property will also be partial losses to the insurance company. Rates can be adjusted in the light of the ascertained probability of the respective occurrence of slight and serious losses, and on the assumption that partial losses to the property will also be only partial losses to the insurance company. This clause does not operate to reduce the insured’s recovery if either the loss or insurance equals or exceeds the named percentage of value. Where applied, it does so only after any apportionment under the contribution clause has been determined.

The effect of the coinsurance clause is usually to make the insured a coinsurer with the company for the difference between an amount limited in the policy and the face of the policy. The limiting amount is usually 80%, though it may be any other agreed per cent. The clause in the policy may read somewhat as follows:

“In consideration of the premium for which this policy is issued, it is expressly stipulated that in event of loss this company shall be liable for no greater proportion thereof than the sum hereby insured bears to eighty per cent of the cash value of the property described herein at the time when such loss shall happen, nor more than the proportion which this policy bears to the total insurance.”

Thus, in order to make the insured a coinsurer, in the event of loss the company’s liability is limited to that proportion which the sum insured bears to 80% of the cash value of the property described in the policy at the time of loss. Where the loss or the insurance equals or exceeds 80% of the value, the clause has no effect; when both are less, the insured and the insurer bear the loss in certain proportions. A few illustrations will show the way in which the liability of the company is determined. In the case of an 80% coinsurance clause, the formula by which the liability can be determined is derived as follows:

A = the sum insured, i.e., the face of the policy B = the amount of the loss C = the cash value of the property at the time of the loss L = the liability of the company

Then, in accordance with the provisions of the coinsurance clause,

A AB L = ----- × B or ---- .8C .8C

Three applications of the formula will be illustrated. In the first, both the face of the policy and the amount of loss are less than 80% of the cash value of the property. In the second, the policy carries 80% of the value of the property but the loss is less than 80% of the property value. In the third, while the face of the policy is less than 80%, the loss is more than 80% of the property value. From the formula, it is evident that where A is 80% of C, the formula reduces to B; and where B is 80% of C, it reduces to A. It must be borne in mind, however, that the insurance company is never liable for more than the amount insured, i.e., the face of the policy, nor for more than the amount of the loss.

Face of Cash Value Amount of Liability of Policy of Property Loss Insurance Company “A” “C” “B” “L”

(1) $3,000 $5,000 $2,500 $1,875 (2) 4,000 5,000 2,500 2,500 (3) 3,000 5,000 5,000 3,000

Applying the formula in:

AB 3,000 × 2,500 (1) ----- = --------------- = 1,875 .8C .8 of 5,000

AB 4,000 × 2,500 (2) ----- = --------------- = 2,500 .8C .8 of 5,000

AB 3,000 × 5,000 (3) ----- = --------------- = 3,750 .8C .8 of 5,000

It will be noted in (3) that, inasmuch as the policy is $3,000, only $3,000 can be collected.

When the amount of the liability has been determined, the insurance company has three options:

1. Payment may be made in cash within 60 days after the completion of the proof of loss.

2. It may rebuild or replace the property. Notice of such intention must be given within 30 days from the filing of proof. 3. It may pay the “sound” value, i.e., the actual cash value of the property and dispose of what remains of it for its own account.

In most cases the first method is followed.

Method of Record-Keeping to Facilitate Ready Adjustment

Under the standard contract the insurance company must make adjustment within 60 days after the report of the loss. Where no differences exist or only such differences as are capable of easy adjustment between the company and the insured, payment of the loss is usually made without any delay because of the advertising value in the community of a quick adjustment of fire losses. Most of the differences which cause delay in the making of adjustments result from the inability of the insured to prove satisfactorily the amount of his loss. Failure to prove loss usually results from a slipshod manner of keeping the records and a loss of the supporting vouchers. The standard policy provides that the insurance company may require the production of original bills and vouchers to establish the cost of the property destroyed. Where these are not obtainable the process of adjustment may be delayed until data on which to figure the original cost can be secured which is satisfactory both to the insurance company and the insured. Accordingly, in order to secure adjustment of fire losses without delay, the record of all assets should be supported by original vouchers. Where the asset account is a group account, i.e., one composed of numerous pieces of property, a subsidiary ledger or register, or inventory record as it is sometimes called, should be carried, in which appear the details of the group account. If, then, the assets covered by the group account are only partially destroyed, it is then possible readily to determine the cost value of the portion destroyed by comparison with the portion left. In the case of machinery and tools, furniture and fixtures, delivery equipment, etc., the use of such a register is particularly advantageous. If the voucher system of account-keeping is in use, there will be supporting data for all charges to asset accounts and an examination of these will make it possible to determine the legitimacy of all such charges.

Another point to be kept in mind if ready adjustment is desired is to make sure that the policy covering particular property makes a sufficiently definite statement of the property covered so as to indicate clearly the exact property to which the policy applies. Oftentimes policies are taken out on buildings with the description so indefinitely worded that it becomes very difficult, where there are many buildings, to know just what is covered by any particular policy. Where policies are taken out covering new equipment as it is purchased, and at some future time the equipment is moved from building to building, the problem of allocating the policy with the property covered by it becomes particularly difficult. To surmount these difficulties it may be wise even to draw up charts and maps of all buildings and their equipment, indicating on the insurance policies the particular pieces of property covered by them as shown on the map. As mentioned above, clear, businesslike records kept by the insured and properly supported by original data will always make for speedy adjustment of fire losses.

Adjusting Entries for Fire Losses

To make the books record properly the loss suffered by fire, it is necessary to set up a special account called “Fire Loss.” To that account will be charged the full amount of the loss, including any expenses incurred in connection therewith and also the portion of the unexpired insurance premium which is canceled by the fire. This account will be credited with the amount of insurance received or allowed by the insurance company. Stated otherwise, to the account will be transferred the book value of all property destroyed and all expenses in connection with the fire. After the account is credited with the amount of insurance received, the balance shows the net loss suffered by the fire and will be closed directly into surplus so as not to affect the results of the current period’s operations. As a rule, at the time of the loss of a fixed asset, depreciation has accrued from the close of the last fiscal period and this must be taken into consideration in making the adjustments on the books. The amount of such accrued depreciation must be charged to the current period’s Depreciation account because the period must bear its proper proportion of the expense. The offsetting credit to such charge will be made directly to the asset account rather than to its Depreciation Reserve account. The depreciation applicable to the asset destroyed which has accumulated in the past must now be transferred as a credit to the asset account. After such transfer and entry in the asset account of the accrued depreciation, the balance of the asset account shows the appraised value of the asset as at the time of the fire. If this appraised value is accepted as the true value by the insurance company, no further adjustment is needed and this becomes the figure or amount which is transferred to the Fire Loss account. If, however, settlement is made on a lesser valuation, in strict theory, the difference between the book value of the asset and the value accepted as the basis for settlement should be charged to surplus as an adjustment item occasioned by insufficient depreciation charges in former periods. Usually, however, no cognizance is taken of such adjustment and the total book value of the destroyed asset is charged to Fire Loss account.

If the loss is complete or the insurance company makes a settlement of the total amount of the policy, the policy is canceled and all unexpired premiums applicable to it are used up and constitute an additional loss occasioned by fire. The amount of such unexpired premiums is therefore charged to Fire Loss account. If settlement is not made for the total amount of the policy, the amount of the settlement is indorsed on the policy in order to show the amount of insurance still in force for which the company is liable. The due proportion of the unexpired premium will be charged off to Fire Loss account. This proportion will be represented by the ratio of the amount of the settlement to the face of the policy.

In the case of loss of stock-in-trade by fire it is very necessary to have available as the basis for determining the value of the merchandise destroyed the inventory record as at the close of the previous fiscal period. The record of all purchases, purchase returns, sales, and sales returns from then until the time of the fire, and the records of previous years, should also be available in order to determine the average rate of gross profit. If such rate of gross profit is not available, there must be a rate agreed upon by the insured and the company as the basis for settlement. The method of determining the value of the goods on hand at the time of the fire by means of the data just mentioned is explained in full in Volume I, page 506, under the head of “Book or Estimated Inventories.” Here also, as in the case of fixed assets, clear, businesslike records lead to a speedy adjustment of the loss.

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Chapter XXXIII

STATISTICS IN BUSINESS; PRIVATE BOOKS; JOURNAL VOUCHERS; BUILDING EXPENSES AND INCOME

STATISTICS IN BUSINESS

Value of Business Statistics

Because of the complexity of modern business it is practically impossible for the management or an executive of a large organization to rely on personal observations and impressions when formulating plans and policies. To do so would lead to frequent errors and costly mistakes of judgment. The human mind cannot adequately grasp the significance of a multitude of facts in the variety of their occurrence. In consequence many problems of management are today being solved by the intelligent use of statistical records or tabulations of past and present operations. By this means the pertinent facts regarding a business are classified and summarized, and the analysis of complicated figures and large aggregates is made possible. The relation of the groups to each other and of each group to the past, the relation of the unit to the whole, and so on, is best shown by the tabulation of facts in the form of figures. By reducing the facts to figures comparisons can easily be made and the proportion of one thing to another is more accurately presented. By divesting facts from their aspect in daily life and the caprices of temperament, a truer estimate of tendencies can be made. Because statistics generally deal with large masses or great numbers, standards, ratios, and types can easily be established. The mortality statistics of insurance companies afford a good example of general averages or ratios that hold true when applied to such an uncertain proposition as the length of human life. Business statistics, however, cannot attain this accuracy because facts of a similar kind are not of such frequent occurrence and consequently the average is not so reliable. But the manager who is acquainted with the limitations of the statistical method and who intelligently understands the business forces with which he is dealing, finds it sufficiently accurate in the great majority of instances. The frequent and almost universal use of the sampling method of testing mailing lists, the use of figures as to the density of population in selling campaigns, and the increasing use of time studies in factories, show that statistics can be made to serve as a valuable guide in arriving at important decisions.

Railroad Statistics

Railroad companies have for a long time used statistics to aid them in interpreting the mass of detail involved in operating over a large area. The figures are generally grouped into two classes: (1) those showing results of operations, such as annual reports; and (2) tabulations of operating details. The latter are devised mainly for the purpose of checking and control. Another classification, more minute, is the grouping of railroad statistics according to their nature into:

1. Statistics pertaining to maintenance of roadbed, track, buildings, signals, etc. 2. Cost of maintaining locomotives, cars, and rolling stock in general in good condition. 3. Expenses connected with the movement of trains. 4. Expenses in connection with the securing of new business. 5. Administrative expenses.

By comparing the figures for each group the existing relationship leads to valuable conclusions.

The compilation of figures showing receipts per passenger, average journey per passenger, average haul of merchandise, receipts per ton of freight, relation of cars run to business done, proportion of loaded and empty car space, cross hauling of empty cars, percentage of empty to loaded cars, compilations showing cost per passenger mile or ton mile—these are all valuable and pertinent facts about railroad operation. The most significant way of stating some facts is by means of figures. This is especially true of such important and related phases of operation as, for example, the ratio of the pay-roll to operating revenue, a comparison of the pay-roll of engine men and trainmen with the engine and train mile, or a comparison of the business done with the pay-roll at each station.

Manufacturing Statistics

Statistics are being increasingly utilized for recording facts in connection with production, especially in factories where a system of cost-keeping is in vogue. Various forms and cards are frequently used to collect the required data which is then grouped or classified in various ways. The performance of each workman is recorded and the various records are combined into groups and compared. Statistics as to output, orders on hand and in process, figures showing idle time, capacity of machines and actual use, are examples.

Mercantile Statistics

The use of statistics in mercantile establishments is perhaps even more prevalent than in factories. This is chiefly because factories handle comparatively few lines, whereas mercantile houses generally carry or deal in a large number. The figures compiled are generally concerned with one or more of the following:

1. Sales. The comparison here is by totals, departments, cash and charge sales, salesmen, territories, lines, percentages to total, new business, etc.

2. Profits. The same classification is applied as for sales. Generally discounts and profits are compared.

3. Inventory of stock. Comparison made by cost or selling price, purchases, quantities sold, used, balance, percentages of sales, departments, lines, etc.

4. Cost of conducting the business. Comparison made by classes of expense, departments, percentage of sales, etc.

5. Collection. Comparison made by percentage of sales, territory, etc.

6. Notes, etc., due. Comparisons made with sales, territories, lines.

7. Goods returned. Comparisons made with lines, territories, percentage of sales.

8. Efficiency of employees. Tabulations made showing profits, percentage on standard of work performed, comparisons between departments.

9. Advertising. Compilations by departments, mediums, results, etc.

10. Turnover. Compilations showing total business and rate of turnover, compared by departments, lines, number of sales, etc.

11. Cash. Statistics giving receipts and disbursements in convenient groups.

12. Mark-ups and mark-downs. Statistics by departments, percentages, etc.

13. Summaries of operation. These are generally compiled periodically but are carried on continuously as long as is desirable.

14. Production. Statistics showing amount, completed work, work in process, orders on hand, time lost, total costs, unit cost, labor cost, material cost, overhead. All are classified into groups or further subdivided for comparison.

Each individual manager selects the particular set of facts which he thinks will best show the trend of the business. The complexity of the business usually determines the number of reports.

Use of Graphs in the Presentation of Statistics

Long experience or special aptitude may qualify a man to grasp readily the full significance of statistical compilations in a variety of forms without the use of charts or graphs. The quicker and surer method, however, in driving home the essential points of statistics is their graphic presentation. For the majority of business men the graphic method will accomplish what statistical tabulation fails to do. While facts are of prime importance, their method of presentation affects their usefulness and is therefore of greater importance. The great mass of figures that accountants and efficiency men only too often present in incomparable form, sometimes far in excess of requirements, is best classified by means of charts.

Advantages of the Use of Graphs

The arguments in favor of the use of charts are that the importance of written words or figures is apt to be judged from the amount of space used, or the time spent in writing or compiling them; whereas the graphic method shows the vital facts in a way which compels attention. The statistics are easily compared and when figures are visualized in graphic form relations are seen at once. One week is readily compared with another, one year with the previous year, one man’s performance with another’s, and so on.

Graphic methods are not only in many cases better but also cheaper. This is especially true if a number of copies have to be made. It requires more work to copy a mass of figures than to draw a few lines or figures by means of blue-print tracings. If many copies are needed, the photographic method of reproduction may be used. Then again, in statistical tabulations it is necessary to rearrange the figures in various orders so as to make different tabulations comparable.

Principles of Graph Construction

The following principles should be observed in making graphs:

1. Graphs should be simple so that the full significance is readily seen. If a chart requires a great deal of study its very purpose is defeated. As a general rule, only two lines should be used. This is especially true if the lines are apt to intersect one or more times. If there are a number of interrelated figures to be presented, it is better to make separate charts on one sheet or to place them together in some other way.

2. Most statistics can be presented by one or more curves where the quantity is expressed by the distance of the curve from the base line, and the time is represented by the horizontal movement of the curve.

3. For a curve the vertical scale should be so selected that the zero line will appear on the diagram. This may require a break in the graph, as shown on page 585.

4. When the scale represents percentages the 100% line should be emphasized in some distinctive way.

5. The curves should be sharply distinguished from the ruling of the paper.

6. The lettering and the figures should be so placed as to be read as easily from the base as the bottom, or from the right-hand edge of the diagram as the bottom.

7. The titles should be clear and complete and, if necessary, subtitles and descriptions should be used.

The illustrations on pages 585-588 show how data lend themselves to graphic presentation.

PRIVATE BOOKS

Purpose and Content

Private books are sometimes kept when it is not desirable for employees to know certain important data relative to the business. Secrecy then is the main purpose in their use in a great many businesses. The general knowledge of certain facts about the business or certain processes or methods of procedure which belong peculiarly to the business might be harmful. Where competition is particularly keen between two or more concerns, instances have been known of the employees of one concern being the paid agents of the other, thus securing information essential to underbidding on contracts. It is desirable at times to keep the employees of a partnership or a corporation in ignorance of the earning capacity of the business or of any secret contracts covering price agreements that may be in effect according to which larger rebates are to be allowed one concern than another. Other items about which it may be necessary to maintain secrecy are: the valuations at which patents, franchises, and other intangible assets are carried; partner’s capitals, drawings, and salaries; manufacturing costs; the method and rate at which the overhead expense is apportioned over the product; the policy as to the creation of reserves of various sorts; the profit and loss account; the methods of financing as indicated by notes payable; and so on.

Operation of Private Books

No particular difficulty is experienced in the keeping of private books. A full set of records composed of journal, cash book, and ledger, may be maintained, though there is often no need for a cash book. These records, while containing essential information about the business, are usually spoken of as being subsidiary to the general books in the sense that the general books are operated by an employee who maintains a controlling account for the private books. In order to gather the material for the controlling account the books of original entry of the general records must be provided with additional columns for the private ledger. Any item about which it is desirable to keep employees in ignorance is simply charged or credited to private ledger with no explanation on the general books as to its ultimate disposition. The same item as taken into the private books is, by means of a journal entry, given its proper disposition, with the offset as a charge or credit, as the case may be, to a general ledger controlling account which is carried on the private ledger. These two controlling accounts—the one on the general ledger with the private ledger, and the one on the private ledger with the general ledger—are complementary to each other, thus making both ledgers self-balancing. A consolidation of the two trial balances, the one from the general ledger and the other from the private ledger, with both controlling accounts eliminated or treated as canceled items, is necessary in order to present the full statement of the business.

To illustrate the way in which secrecy covering certain types of transactions may be maintained, it may be well to trace a few transactions through the books. Suppose it is desired to make a cash rebate to a favored customer. The check is drawn payable to private ledger account and run through the cash book as a charge in the private ledger column, to be posted ultimately to the private ledger controlling account on the general ledger. The check is entered as a cash receipt on the private cash book with the credit to general ledger. A check is then drawn on the private ledger cash payable to the favored customer, with the proper charge to Sales Rebates and Allowances or other similarly named account, and posted to that account on the private ledger. In a similar way checks for dividends, salaries, etc., can be drawn to the order of private ledger and their proper distribution be shown only on the private books.

At the time of closing the books, if some temporary proprietorship accounts are carried on the general ledger and some on the private ledger, those carried on the general ledger are closed off by transfer to the Private Ledger Controlling account instead of, as usually, to the summary Profit and Loss account. The adjustment of the books is usually made both on the general ledger and on the private ledger. If certain fixed assets subject to depreciation are carried on the general ledger, the adjustment of their values will have to be made by debit as usual to Depreciation account, with a credit to the suitable Depreciation Reserve account. This Depreciation account, of course, is in closing charged to Private Ledger instead of to Profit and Loss. If the Merchandise Inventory account and the Sales and Purchases accounts are carried on the general ledger, the cost of goods sold will be developed as usual on the general ledger and then transferred to the Private Ledger account. More often, however, most of these adjustments on account of depreciation reserves and reserve for doubtful accounts and the merchandise inventories are handled only on the private ledger. The Profit and Loss account as carried on the private ledger shows the net profit and usually all appropriations of that profit. The result is that the dividend accounts, the various reservations of profits, and Surplus account are handled only on the private books.

The private books are usually kept by the general auditor, the secretary, or general manager of a corporation, and by one of the partners or a trusted employee in the case of a partnership.

JOURNAL VOUCHERS

Need for the Journal Voucher

Since the introduction of special journals to take care of cash, sales, and purchases, the present-day journal is used principally as a record for adjusting entries between accounts, the opening and closing entries of the ledger, and any other unusual transactions for which no other specialized form of book has been provided. For this reason it is very important that all the evidence which may be necessary to explain or to prove the correctness of an entry, together with the authority for making it, shall be instantly available in some convenient form. This not only saves much time and irritation in hunting up scattered data to explain an unusual entry, but it relieves the bookkeeper of any personal responsibility which might attach to him for making entries not strictly in accordance with correct accounting principles. It has been seen in an earlier chapter that the authorization of cash disbursements by means of the formal voucher gives a valuable control over cash and the bookkeeping record of it. In like manner, for entries appearing in the journal, the use of the journal voucher accomplishes these purposes.

The forms in which journal vouchers are made out vary with the requirements of each business, but in general they are very simple and follow the same general principles. Two features are essential: (1) the voucher must show clearly the purpose for which it is drawn; and (2) it should provide proper authority, with full explanation of the reasons for making the entry. The usual form is illustrated below:

The entries at the top of the back of the voucher give information for filing purposes only. Where the original vouchers are kept in a loose-leaf binder (thus constituting the journal), only the duplicates, folded lengthwise and filed in an upright binder, need have the notations made on the back.

Method of Use

The same form of voucher may be used in two ways. A regular journal may serve as the posting medium to the various ledger accounts affected. In this case each entry is given a number which corresponds with the number on the voucher. All the original data and the explanations which are necessary to authorize the entry are attached to the vouchers which are filed away by months in numerical order.

The second method is to make out vouchers in duplicate. The original, with the approval of the proper officials and a brief explanation, is filed in a loose-leaf binder which constitutes the journal. The duplicate, numbered like the original, has attached to it all bulky papers, correspondence or other evidence, and is filed away by months in numerical or alphabetical order, whichever best serves the purpose of the accountant. This method saves the time of recopying the debits and credits in a bound book, and also makes it possible to separate journal entries for use in different posting departments.

There is still some objection to loose-leaf general journals, however, though it is gradually disappearing with the use of proper safeguards.

Index to Journal Vouchers

If vouchers are filed numerically and it is found advisable to keep an alphabetical list for the purpose of bringing together all journal vouchers on one subject or from one firm, a supplementary card index giving year, month, and voucher number, may be kept which will serve for several years—as shown below:

If it is desirable to keep a record of the amounts also, this simple form may be extended to include voucher numbers and amounts as follows:

Content of Voucher

Vouchers for the different journal entries should comprise the following information: in general, correspondence or memoranda approved by proper authority, which should explain the reason for the entry and refer to the original charge or item against which the entry applies. Vouchers for returned purchases should have the following information attached: the shipment record, the stock record, the credit memorandum from the vendor, and correspondence or signed memoranda explaining why requirements were not up to standard.

Monthly depreciation charges should have attached a list of the capital accounts, the percentage of depreciation charged to each, and the one-twelfth which applies to the present month.

Adjustments for allowances on contracts should have the reference or copy of the contract agreement, all correspondence which finally disposes of the settlement, and references to any other legal or official authority which was instrumental in effecting the present settlement.

In making unusual deductions or reserves at the time the books are closed, all the data bearing on the subject should be gathered, or, if this is not possible, very clear references should be made to the places where such material may be found. This is important, because investigations may be made at any time either to readjust or to confirm the entries, or to locate the responsibility for making them.

Little time is needed to gather all the facts bearing on a transaction at the time it is entered on the books, but if the present officials are promoted or leave, it may at a later date take days or weeks to collect the information necessary to explain the reason for the entries made.

Other Methods of Authorizing Entries

A method sometimes used of authorizing journal entries requires the use of a loose-leaf journal for its easy operation. Every entry made by the bookkeeper is sent for approval to the auditor, manager, or other responsible person. Approval is evidenced by signature or initialing. Where the use of the formal journal voucher is found to be cumbersome, this method gives satisfactory results.

Similar to the journal voucher as authority for entry is the debit and credit slip used for authorizing inter-ledger postings. In a large establishment where the sales ledger, for instance, is divided alphabetically among a number of ledger clerks, adjustments as between the different ledgers are usually made by means of these debit and credit slips, which when properly signed by the head bookkeeper give the authority for making the necessary ledger entry.

BUILDING EXPENSES AND INCOME

Allocation of Building Expense

It is purposed here to draw attention to two problems in connection with the bookkeeping records of buildings owned by the business. The one problem has to do with the proper allocation of the various building expenses as between the different departments of a business such as manufacturing, selling, general administration, etc., and even the subdepartments within these general classifications. It frequently happens that the same building is used partially for manufacturing and partially as a warehouse and sales room, while it may also contain the administrative offices. Within each of these groups there may be various subdepartments. A large store may be departmentalized and it may be desirable to show the results of operation by departments. If cost accounting by departments is determined upon, it becomes necessary to carry the departmental analysis beyond the gross profit stage, in which case building expense must be taken account of and spread equitably over the various departments. Likewise, within the factory it may be desirable to allocate the item of building expense over the various departments of storeskeeping, costing, and production proper, and even a further analysis may be necessary depending somewhat on the detailed information desired. Where building expense has to be spread over these various departments and subdepartments, an equitable basis of distribution must be found. A common basis is the amount of floor space used by the various departments. This method is not always fair inasmuch as some portions of the building are subject to heavier wear and tear, and therefore to heavier maintenance and depreciation charges, than other portions. Consideration must be taken of all the physical factors involved in order to secure an equitable distribution of the expense.

Ownership versus Renting

The second problem has to do with the gathering of information as to the relative advantages of owning or renting a building. The chief elements of expense which must be met in connection with the ownership of buildings are maintenance, depreciation, taxes, and insurance. In determining the relative advantages of ownership or leasing, the item of interest on investment in buildings must also be taken into consideration. It is doubtful, however, whether this last item should be brought onto the books as a cost of ownership. As in the case of a manufactured product, the item of interest is best handled by means of a statistical record rather than as an entry upon the financial records of the business.

Methods of Bookkeeping

Two methods of presenting the information on the books are met with. In the one case, an account is kept with Building Expense and Income to which are charged all expenses in connection with the building and to which are credited any items of income, as from subleasing, etc. Instead of having the one account, separate accounts may be kept and cleared at the end of the fiscal period through Building Expense and Income account before transfer to Profit and Loss. The difference between the net cost of building ownership, as indicated by Building Expense and Income account, and the market rental value of similar space and accommodations elsewhere will represent the net advantage or disadvantage of ownership as compared with leasing. At this point, before making the comparison, it will be necessary to take into consideration the item of interest on the money invested.

The second method is simply a variation of the first so far as securing the information desired is concerned. Under it the Building Maintenance account is charged with all expenses as above and credited with a fair rental value as determined by market conditions for similar space elsewhere. The difference between the charges and credits to the Building Maintenance account will be an indication of the profit or loss on the policy of the ownership. A theoretical objection to this last method is that the crediting of a fair rental to the account makes necessary a charge to a rent account, which will have to be shown as a charge to some department or phase of business activity, such as the factory, sales department, etc. As in the case of interest, the best authority inclines towards treating rent as an item of financial management rather than as a burden to the other departments of the business. Practically, however, where the expense of rent is actually incurred through the use of a building belonging to outside parties, the prevailing practice at the present time is to charge rent expense to the departments using the accommodations. Consistency seems to demand that both interest and rent be treated in the same way, and handled as financial management items.

Workmen’s Dwellings and Social Betterment Work

To maintain a fairly constant supply of labor, a corporation frequently finds it necessary to provide housing accommodations for its employees. This may be because the concern is located far from a settled community and outside capital cannot be induced to provide the needed accommodations. Accordingly, corporations oftentimes spend large sums in so-called social betterment work, and it is customary for the corporation to charge a fair rental on workmen’s dwellings. The expense in connection with such work is to be treated rather as an item of extraordinary expense just as the income from the corporation’s investment in workmen’s dwellings must be treated as income outside the regular operations of the business. The problem here is simply the determination of the proper place to show the items of expense and income in the profit and loss summary for the period.

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XXXIV. THE CONSOLIDATED BALANCE SHEET AND PROFIT AND LOSS SUMMARY

Purpose and Function

The consolidated balance sheet is a form of statement distinctively American. As indicated in previous chapters, its use has arisen as a result of the corporation laws of some of the states which allow the formation of the holding company. This, if strictly a financing company, has a very simple operating organization. Its chief assets are usually the securities, capital stock and bonds, of the subsidiary companies which it owns in part or in full. Accordingly, its balance sheet is comparatively simple; in fact this very simplicity results in giving little information as to its real financial condition or that of the subsidiaries which it owns. If, however, the holding company is at the same time both an operating and a financing corporation, all the complexities encountered in the balance sheet of a manufacturing company will be found on that of the holding company. However, the financial statement of an operating holding company is not any more intelligible because of its complexity than that of a purely financing corporation.

The items on the balance sheet of either type of corporation which are evidence of the activities peculiar to a holding company are, as stated above, the securities of the subsidiary concerns held by the holding company and whatever advances have been made on open account to the various subsidiaries in order to provide funds for making extensions or for recouping losses incurred by the subsidiaries. The principles governing the valuation of the securities of the holding company have already been stated and explained in Chapter XV. In that chapter were stated the different applications of the principles of valuation to the three conditions met; namely, (1) the condition in which the holding company owns the entire capital stock of the subsidiary; (2) the condition in which a controlling but partial interest only is held; and (3) the condition in which the holding company is a minority stockholder of the subsidiary. In making up the balance sheet of the holding company the application of these principles to the valuation of the holdings of the corporation must be carefully handled. Aside from this problem of valuation, the balance sheet of the holding company presents no new problems. Such a balance sheet, however, gives very little information as to the actual financial condition of the corporation because its finances are tied up so completely with the financial condition of the various subsidiaries. In order, therefore, to present a statement which will intelligently show the real condition of the holding company, it becomes necessary to combine or consolidate the statements of financial condition of all its subsidiaries.

Problem of Partial Ownership

Where the ownership of the subsidiaries is complete, the consolidated balance sheet in which are brought together all the various assets and liabilities of the subsidiaries, presents a true, full, and intelligent statement of the financial condition of the holding company. Where, however, ownership is not complete, in which case there may be majority or minority holdings, the problem of drawing up a statement which will present the actual condition of the holding company is more difficult and much more complex. Manifestly, a consolidated balance sheet under either of these latter conditions as to partial ownership cannot be applicable alone to the holding company, inasmuch as in such a statement there must be included interests over which the holding company has no direct control or authority.

Because of this difficulty, three different ways of attempting to show the holding company’s condition are met with. One method makes no attempt to overcome the difficulty but limits itself to showing simply the balance sheet of the holding company as explained in the early part of this chapter. A second method consists in showing the balance sheet of the holding company supported by the separate balance sheets of all of the subsidiary companies. The third method is the method of the consolidated balance sheet which has just been briefly explained. This last is, perhaps, the most satisfactory method of the three. The insufficiency of the first method and the objection to it have been referred to already. The second method gives all essential information but presents it in such form that it is practically impossible for anyone but a trained student of finance and accounting to correlate the various parts and arrive at an intelligent understanding of actual conditions. The stockholder or the outsider is usually completely at a loss to know the meaning of all the figures and statements presented. Under the third method the data as to the condition of the various companies are brought together and presented in logical form on the consolidated balance sheet so that the combined statement shows as clearly as is possible the condition of the holding company.

Conditions under which Used

It should be clearly understood that the consolidated balance sheet is not a balance sheet of the holding company except and only when the holding company owns the entire capital stock of all the subsidiaries. A consolidated balance sheet, therefore, is a statement which presents the condition of all of the subsidiary companies. If it reflects the condition of the holding company better than the latter’s balance sheet, then, and then only, should a consolidated balance sheet be used. A fine distinction must sometimes be drawn to determine when it is more desirable, in the interests of an accurate showing of condition, to present a consolidated balance sheet rather than the balance sheet of the holding company, and a delicate appreciation is needed of the various financial problems involved. When the holding company is not the complete owner but nevertheless has a controlling interest in all the subsidiaries, the method of the consolidated balance sheet is usually the better way of showing its financial condition. Where the holding company, however, holds only minority interests, it is oftentimes open to question as to whether the consolidated balance sheet gives a true presentation of the facts of financial condition, especially in view of the fact that the holding company cannot always control the policies of its subsidiaries.

The Setting Up of the Consolidated Balance Sheet

With this explanation of purpose and function of the consolidated balance sheet, it is purposed now to draw attention to some of the problems met in drawing up such a statement. The first essential condition to facilitate the consolidation of the balance sheets of the various subsidiaries with that of the holding company is that standardized methods of accounting resulting in a similar classification of accounts and presentation of results be used by all the subsidiaries. The consolidated statement is then merely a combination of the values of similar items in all the balance sheets to determine the valuation at which the consolidated items shall appear.

On the balance sheets of the various companies certain accounts will appear which represent intercompany relationships. Thus, on that of the holding company appear the securities which are represented on the statements of the subsidiaries by their net assets. In other words, the securities of the holding company are assets represented by the proprietorship items of the various subsidiaries. Sometimes on the consolidated balance sheet both items are shown. This results, of course, in an almost exact duplication of items inasmuch as the holding company’s securities are a statement of the net asset values of the subsidiaries. The better method of presentation, however, seems to be the elimination of the securities of the holding company against the proprietorship items of the subsidiaries. It may frequently happen that the values of these two items to be eliminated are not the same. This will always be the case if the holding company values its securities either above or below the par of the capital stocks of the subsidiaries, plus any surplus belonging to the subsidiary at date of purchase by the holding company.

It is to be presumed that the values at which the securities are held on the books of the holding company represent the latter’s estimate of the value of its interests in the various subsidiaries. If this value is more than the net worth of the subsidiary as shown by its capital stock outstanding and surplus at the time of purchase by the holding company, the difference between the value at which the securities are carried by the holding company and the net worth of the subsidiary must represent the value placed by the holding company on the good-will of the subsidiary. This good-will does not appear, of course, on the books of the subsidiary. Hence, in consolidating the balance sheet of the subsidiary with that of the holding company, it is necessary to set up the asset good-will and thus increase the net worth of the subsidiary to the point where it can be exactly canceled against the value of the securities on the balance sheet of the holding company. If, however, the value of the securities on the holding company’s books is less than the net worth of the subsidiary, that condition indicates that in the opinion of the holding company the assets of the subsidiary as carried on the subsidiary’s books are overvalued. In this case it becomes necessary, upon consolidation, to set up a depreciation reserve under suitable title.

The effect of this, so far as the eliminations on the consolidated balance sheet are concerned, is merely to set up under the title Depreciation Reserve the portion of the subsidiary’s capital stock—or capital stock and surplus—not canceled by the amount at which the holding company carries on its books the value of its interest in the subsidiary. Instead of carrying this difference in values under the title Depreciation Reserve, it is sometimes shown as Capital Surplus. This is merely another way of saying that the portion of the subsidiary’s capital stock not canceled by the holding company’s investment in the subsidiary is simply carried on the consolidated balance sheet under another name. Another method of handling this uncanceled amount is to carry it into the consolidated balance sheet as a credit to Good-Will account, and so secure a reduction in the value at which this intangible asset is shown in the balance sheet of the allied companies. This may sometimes result in reducing the value of good-will to a negligible figure, or in writing it off the books entirely, or even in showing it with a credit balance. There is little to choose between the methods; the author prefers the use of the depreciation reserve. The balance sheets of all of the subsidiaries are in this way consolidated with the balance sheet of the holding company.

On the consolidated balance sheet as at the date of the purchase of the various subsidiaries, there will not therefore be shown any item of surplus, inasmuch as the items of surplus on the balance sheets of the various subsidiaries have been eliminated together with their capital stock items against the securities on the balance sheet of the holding company. This is as it should be. Surplus account properly used should represent only profits reserved from operation. The holding company cannot, therefore, previous to its operation, show any item of surplus even though the subsidiary companies have accumulated profits which they, of course, are entirely right in showing under the title Surplus.

A distinction must be made here between what is termed “contributed” surplus and “operating” surplus. Any corporation, the holding company included, may at the time of its organization have some portion of its capital represented by contributed or capital surplus. It has been pointed out that this may arise either through subscription to its stock at a premium, or by a later donation of stock by its stockholders which, when sold, may be recorded as working capital surplus or contributed surplus. It is not possible, however, for any corporation, previous to its operation, to show as a balance sheet item an operating surplus from which it might be possible to declare dividends.

Showing of Intercompany Accounts

At the time of consolidation, intercompany accounts of various sorts will also appear. The holding company may have made advances of cash to some of the subsidiaries. These will be shown on the books of the holding company as open account claims against the subsidiaries, while on the books of the subsidiaries they appear as increases among the assets—usually cash or other current items—offset by open liability claims in favor of the holding company. The account receivable on the holding company’s books should be eliminated against the account payable on the books of the subsidiary. Similarly, there may be numerous inter-subsidiary accounts which may be eliminated, the ones against the others. The need for a very careful classification of accounts receivable in order to separate the claims against trade debtors from those against allied companies should be emphasized when it is desirable to consolidate balance sheets on which these various classes of accounts receivable appear.

Showing of Notes Discounted

One kind of intercompany item needs further consideration. A corporation may, as the holder of the notes of an allied company, have had those notes discounted. On the maker’s books the notes appear as a liability. On the holder’s books, after discount, the notes will be shown as a contingent asset offset by a contingent liability of equal amount. Upon consolidation of all the balance sheets, neither the contingent asset nor liability will appear, being canceled against each other, but the full liability as maker of the notes must be shown; for now that the notes have passed into possession of an outsider, the bank, the liability is no longer an intercompany liability but one for which the consolidated interests are fully liable.

Reconcilement of Current Accounts

Previous to the consolidation of the balance sheets, it is possible that some of the intercompany accounts may need reconciliation just as any other current accounts. For instance, Company A may have shipped goods to Company B and have charged B’s account, but A’s account on B’s records may not yet have been credited because the goods have not yet been received. All items in transit will require reconciliation. These are all intercompany transactions which will be eliminated upon consolidation; but to make exact cancellation possible, the intercompany current accounts on the books of the various companies must be reconciled.

Valuation of Inventory

The problem of the valuation of the stock-in-trade inventory on the consolidated balance sheet is perhaps the most troublesome. The situation with regard to inventories of stock-in-trade is often complicated by the fact that the same raw material or partly finished material may pass through the hands of several companies each doing certain processes upon it. The process of manufacture may not be completed until the goods are turned over ultimately to the holding company for sale and final distribution to the consumer. This—or other possible variations of the procedure—is usually the situation so far as stock-in-trade is concerned. Inasmuch as the various subsidiaries are independent corporate organizations, the price at which they transfer their product to the allied subsidiaries is not cost price but a sale price determined, perhaps not by market conditions, but rather by some fixed policy set by the holding company; although it frequently happens that market price is the price at which the partially completed product is turned over to allied subsidiaries. However determined, the price includes an element of profit which from the standpoint of the holding company is not a realized profit until the goods are finally disposed of to the outside consumer. Were the manufacture carried out by a single corporate organization, the product, as it passed through its various stages of manufacture, would be charged into each succeeding stage at the costs accumulated during preceding stages, and the element of profit would not need to be considered until the product was ultimately sold by the holding company.

Thus, the valuation at which the inventory of stock-in-trade is carried on the books of the various subsidiaries is often inflated by the profit in each case, so that by the time the product reaches the holding company it may carry a very large element of unrealized profit. While from the standpoint of each subsidiary company the act of transfer has been legally a sale and therefore the seller is entitled to a profit on the sale, without which there would be no element of profit appearing in the operations of each subsidiary company at any time, from the standpoint of the holding company such transactions are in no sense sales, but are simple transfers from one process or stage of manufacture to another.

In order to show the true condition as to the value of the inventory of stock-in-trade on the consolidated balance sheet, it becomes necessary to eliminate these intercompany items of profit loaded onto the goods at the time of transfer between companies. The figure at which the value of the consolidated inventories will appear in the consolidated balance sheet should represent the actual cost figure, as if the entire process of manufacture were carried on under one corporate organization. The corresponding offset to this reduction in value of the consolidated inventories will appear as a reduction in the surplus as shown on the consolidated balance sheet.

This principle of inventory valuation should always be applied to the full in the case where the holding company is the complete owner of all its subsidiaries. It cannot, however, be too rigorously lived up to under conditions where the holding company may not have absolute control over the policies of the subsidiary companies. It may sometimes even be modified by the fact that the product as turned over by one company to another is in such stage of completion that there is a ready market for it outside that of the allied subsidiaries. The accountant is, however, treading on somewhat uncertain ground when he attempts to incorporate any element of profit in the consolidated inventory. Conservative management as adopted by some of our largest corporations eliminates all elements of profit, and that should be the standard practice. Only under unusual circumstances and after a very careful consideration of all the conditions should the consolidated inventory be carried at any other valuation than that of full manufacturing cost.

Reserve for Intercompany Profits

In eliminating intercompany profits from the valuation of the inventory, use is sometimes made of a Reserve for Intercompany Profits account. The reserve is created by a charge against Surplus. The inflated valuation of the inventory is allowed to stand but it is offset by this reserve in sufficient amount to reduce its value to a cost basis.

Valuation of Inventory—Minority Interests

An interesting problem arises in handling the consolidated inventories and other similar items when there are minority interests to be taken into account. To write down the inventory to a cost basis for the consolidated companies involves a valuation below cost for the subsidiary companies which purchased the commodities from their allied companies. This is hardly equitable to the minority interests in those companies, for they are concerned not with what is the proper basis for valuation on the consolidated balance sheet but rather on their own balance sheet. Their company as a distinct legal organization has the right to show all the profits arising out of a valuation of its inventory on its own purchase-cost basis. Recognizing this right, some accountants advocate carrying the portion of the inventory represented by the ratio of the minority interests to the whole interests, at the cost price to the subsidiary and writing down the rest of it to a true cost basis for the consolidated companies. The effect of this is to leave undisturbed the portion of the subsidiary’s surplus belonging to, or, more strictly, representing the minority interests. Such a method results in the valuation of the inventory on two different bases for the consolidated balance sheet—a practice which is objectionable. The more conservative policy is to write down the whole inventory to a consolidated cost basis, charging the amount written off against the consolidated company’s surplus. This will leave the minority interest surplus unaffected by the changed basis of valuation—a desirable thing from the standpoint of equity to the minority.

Valuation of Liabilities

So far as the liabilities of the corporation are concerned, the values at which these will be carried on the consolidated balance sheet will be the combined values of all the liabilities of the subsidiaries, aside from the intercompany accounts payable and other similar items which have been canceled against the accounts receivable of the subsidiaries and holding company.

Showing of Capital Stock

The showing of the capital stock item on the consolidated balance sheet will depend somewhat on the degree of ownership of the holding company. If the ownership is partial, in addition to the capital stock of the holding company a statement must appear of the consolidated minority interests of the various subsidiaries. This should, of course, be shown separately from the capital stock of the holding company. This becomes necessary because of the fact that items which do not belong in full to the holding company have been incorporated with the assets on the consolidated balance sheet. It is seldom if ever feasible to attempt a separation of the various asset items on the basis of the degree of ownership of the holding company; hence, the only offset to the inclusion of asset values not belonging to the holding company is by showing the outside interest in those assets by means of the minority holdings of capital stock.

Showing of Surplus

The other element of net worth, i.e., the surplus, will also have to be adjusted in order to give the best showing of the interest of the various parties therein. This is, of course, the operating surplus referred to above. The portion of the surplus belonging to the holding company as indicated by its proportion of ownership in the allied companies will be shown separately from the portion of surplus belonging to the minority interests. Sometimes when this is relatively insignificant it is shown as a liability rather than as an item of net worth, on the ground that the minority has a claim on that surplus and will very probably, in the near future, receive it by way of dividends. It would seem to be, however, a truer index of the exact status of affairs at the time of the consolidation, to show the item separately as a portion of surplus in the net worth section of the balance sheet.

Showing of Deficit

When it becomes necessary to incorporate a deficit rather than a surplus, conservative practice usually demands that the entire deficit be shown as belonging to the holding company rather than merely its proportionate share as indicated by its share of ownership in the subsidiary. This is advisable because an initial deficit is often an indication of the inability of the company to be operated profitably, in which case the holding company may have to stand practically the entire deficit.

Showing of Profit and Loss Summary

The consolidated balance sheet should be supported by a consolidated profit and loss summary. Just as with the balance sheet, a distinction is made between the profit and loss statement of the holding company and the consolidated profit and loss statement in which are brought together the summaries of all of the allied companies. If the holding company is primarily a financing company, its chief source of earnings will be from dividends on the stocks of the subsidiary companies held by it. The profit and loss summary of the holding company may be a true reflection of its earning condition for the current year if proper provision has been made for the losses of the subsidiary companies which have been operated unprofitably. The information which the holding company’s profit and loss summary gives, however, is not adequate or sufficient on which to base an intelligent judgment as to whether it is a correct statement of current operations. Much the same difficulties are met in connection with it as in connection with the balance sheet of the holding company referred to above. For instance, if, during a given period, some of the subsidiary companies were operated at a loss or on a narrow margin of profit but dividends were declared out of surplus earnings accumulated from other periods, there would be no indication on the profit and loss summary of the holding company as to the actual conditions under which the earnings of the holding company had been secured. In other words, there would appear on the profit and loss summary of the holding company as earnings for the current period items representing accumulated earnings from previous periods.

Thus, the profit and loss summary of the holding company would not give a true reflection of the earnings for the current period, and furthermore would give no information whereby it would be possible for an interested party to form any judgment as to the current operations of the holding company and its subsidiaries. Inasmuch as the holding company usually owns a majority interest in all the subsidiaries and therefore can dictate their policies, the management of the holding company is always in possession of the true status of affairs, but the stockholder or other interested party can form no judgment whatever as to the actual condition. On the profit and loss statement of the holding company there will be no data as to gross earnings, operating expenses, fixed charges, or miscellaneous income and expense items reflecting the operating conditions of the various subsidiaries. Furthermore, if a subsidiary company has been operating at a loss and has declared no dividend, the absence of that item of earnings from the profit and loss summary of the holding company would not be necessarily a proper reflection of the condition of the subsidiary on the holding company’s summary. It might be necessary, in order properly to show the true condition of affairs, to make provision by way of a reserve for the loss of the subsidiary.

Again, it becomes very easy, if control of the holding company is in the hands of an unscrupulous clique, to understate the profits of the holding company by refusal to declare such a dividend on the part of each subsidiary as will reflect the true earnings of the subsidiary for the current period. Such a policy may be used for the purpose of manipulating the stocks of the various companies.

The Consolidated Profit and Loss Summary

For these reasons and others of the same kind as those mentioned in connection with the balance sheet of the holding company, it is best, in order to give an intelligent showing of condition, to set up a consolidated profit and loss account. The comment made on the consolidated balance sheet is here pertinent also. It is not a profit and loss account of the holding company for it includes also items representing other interests. In some respects it is an unwieldy instrument, but it seems to be the best way in which to show the actual condition of the holding company’s operations. On the consolidated profit and loss summary the earnings from dividends which appear as the chief source of the holding company’s earnings on its profit and loss summary will be eliminated and in their stead will appear the combined earnings of the allied companies. This might seem to be an inflation of earnings inasmuch as the goods which were sold by one company and are recorded by it as earnings will be resold by another company on whose books they will appear also as earnings. The sale of the same goods may thus appear as earnings in many of the subsidiaries. However, such a showing of combined results does provide a true basis on which to judge earnings in comparison with the values invested by the various companies from the use of which values the earnings have been derived. Similarly, on the consolidated profit and loss statement will appear all the operating expenses and other items belonging to the individual profit and loss summaries of the subsidiaries. As it is necessary on the consolidated balance sheet to make some adjustments in the surplus on account of the unrealized elements of profits in the values at which the combined inventories were taken over, so this same adjustment will perhaps be best handled as an appropriation of profits in the last section of the consolidated profit and loss summary.

If the holding company owns all of the stock of the subsidiaries, a true profit and loss summary with no inflated values should be drawn up. In this there will appear only the sales to outside consumers; no intercompany sales should be shown. The cost of goods sold will be determined on the same basis, viz., the basis of cost from the standpoint of the consolidated companies as a unit organization, all intercompany profits being eliminated. All the expenses of the subsidiaries are loaded onto, and therefore absorbed in, the cost of the goods sold by the holding company. Usually only the holding company’s expenses—selling, general administrative, etc.—will appear as such on the consolidated profit and loss summary. Where, however, there are minority interests to be taken into account, the method of combining all the elements is doubtless the most satisfactory.

Illustration of Consolidated Balance Sheet

Problem. Company X, the holding company, owns all of the capital stock of Company Z and 60% of the stock of Company Y. Company X is chiefly the financing company, Company Y is the selling company, while Company Z manufactures the commodities and turns them over to Company Y at a price slightly under the market. The following balance sheets of the several companies show their condition at the close of the fiscal period. Company Z records show that the cost of the merchandise carried on the balance sheet of Company Y at $75,000 is $60,000. It is required to draw up a consolidated balance sheet of the affiliated companies.

COMPANY X—BALANCE SHEET ===============================+==================================== Cash $ 50,000.00 | Notes Payable $ 100,000.00 Notes Receivable Y 100,000.00 | Bonds 500,000.00 Advances to Z 250,000.00 | Capital Stock 1,000,000.00 Stock Y 300,000.00 | Surplus 250,000.00 Stock Z 550,000.00 | Patents 500,000.00 | Other Property 100,000.00 | ------------- | ------------- $1,850,000.00 | $1,850,000.00 ============= | =============

COMPANY Y—BALANCE SHEET ===============================+==================================== Cash $ 25,000.00 | Notes Payable X $100,000.00 Accounts Receivable 125,000.00 | Accounts Payable 25,000.00 Notes Receivable 100,000.00 | Bonds 75,000.00 Notes Receivable Z 50,000.00 | Capital Stock 500,000.00 Z (open account) 50,000.00 | Surplus 25,000.00 Merchandise 75,000.00 | Plant 300,000.00 | ----------- | ----------- $725,000.00 | $725,000.00 =========== | ===========

COMPANY Z—BALANCE SHEET ===============================+==================================== Cash $ 40,000.00 | Company X Accounts Receivable 180,000.00 | (open account) $250,000.00 Notes Receivable 230,000.00 | Notes Payable Y 50,000.00 Merchandise 150,000.00 | Company Y (open account) 50,000.00 Plant 350,000.00 | Capital Stock 450,000.00 | Surplus. 150,000.00 | ----------- | ----------- $950,000.00 | $950,000.00 =========== | ===========

Solution

WORKING SHEET =====================+===============+=============+=============+ | Co. X | Co. Y | C o. Z | Assets +---------------+-------------+-------------+ | | | | Cash | $ 50,000.00 | $ 25,000.00 | $ 40,000.00 | Notes Receivable | | 100,000.00 | 230,000.00 | Notes Receivable Y | 100,000.00 | | | Notes Receivable Z | | 50,000.00 | | Accounts Receivable | | 125,000.00 | 180,000.00 | Advances to Z | 250,000.00 | | | Co. Z (open account) | | 50,000.00 | | Stock Y | 300,000.00 | | | Stock Z | 550,000.00 | | 550,000.00 | Merchandise | | 75,000.00 | 150,000.00 | Patents | 500,000.00 | | | Other Property | 100,000.00 | | | Plant | | 300,000.00 | 350,000.00 | Good-Will | | | | +---------------+-------------+-------------+ | $1,850,000.00 | $725,000.00 | $950,000.00 | +===============+=============+=============+ Liabilities and | | | | Capital | | | | Notes Payable | $ 100,000.00 | $ | $ | Notes Payable X | | 100,000.00 | | Notes Payable Y | | | 50,000.00 | Accounts Payable | | 25,000.00 | | Co. X (open account) | | | 250,000.00 | Co. Y (open account) | | | 50,000.00 | Bonds | 500,000.00 | 75,000.00 | | Capital Stock | 1,000,000.00 | 500,000.00 | 450,000.00 | | | | | Surplus | 250,000.00 | 25,000,00 | 150,000.00 | +---------------+-------------+-------------+ | $1,850,000.00 | $725,000.00 | $950,000.00 | +===============+=============+=============+

=====================+==============+=================+============= | Combined | Elimination |Consolidated Assets +--------------+-----------------+------------- | | | Cash |$ 115,000.00 |$ |$ 115,000.00 Notes Receivable | 330,000.00 | | 330,000.00 Notes Receivable Y | 100,000.00 |(a) 100,000.00| Notes Receivable Z | 50,000.00 |(b) 50,000.00| Accounts Receivable | 305,000.00 | | 305,000.00 Advances to Z | 250,000.00 |(c) 250,000.00| Co. Z (open account) | 50,000.00 |(d) 50,000.00| Stock Y | 300,000.00 |(e) 300,000.00| Stock Z | |(f) 550,000.00| Merchandise | 225,000.00 |(g)[73] 15,000.00| 210,000.00 Patents | 500,000.00 | | 500,000.00 Other Property | 100,000.00 | | 100,000.00 Plant | 650,000.00 | | 650,000.00 Good-Will | |(f)[74]100,000.00| 100,000.00 +--------------+-----------------+------------- |$3,525,000.00 | $1,215,000.00|$2,310,000.00 +==============+=================+============= Liabilities and | | | Capital | | | Notes Payable |$ 100,000.00 |$ |$ 100,000.00 Notes Payable X | 100,000.00 |(a) 100,000.00| Notes Payable Y | 50,000.00 |(b) 50,000.00| Accounts Payable | 25,000.00 | | 25,000.00 Co. X (open account) | 250,000.00 |(c) 250,000.00| Co. Y (open account) | 50,000.00 |(d) 50,000.00| Bonds | 575,000.00 | | 575,000.00 Capital Stock | 1,950,000.00 |(e) 300,000.00| 1,000,000.00 | |(f) 450,000.00| 200,000.00 Surplus | 425,000.00 |(g) 15,000.00| 410,000.00 +--------------+-----------------+------------- |$3,525,000.00 | $1,215,000.00|$2,310,000.00 +==============+=================+=============

[73] Intercompany profit between Z and Y.

[74] Subtraction item, usually shown in red.

COMPANY X AND ITS SUBSIDIARIES CONSOLIDATED BALANCE SHEET ================================+=================================== Assets | Liabilities and Capital | Cash $ 115,000.00 | Notes Payable $ 100,000.00 Notes Receivable 330,000.00 | Accounts Payable 25,000.00 Accounts Receivable 305,000.00 | Bonds 575,000.00 Merchandise 210,000.00 | ------------- Other Property 100,000.00 | Total Liabilities. $700,000.00 Plant 650,000.00 | Capital Stock of Co. X 1,000,000.00 Patents 500,000.00 | Capital Stock of Good-Will 100,000.00 | Subsidiaries not | owned by Co. X 200,000.00 | Surplus of Affiliated | Companies. 400,000.00 | Surplus of Minority | Interests. 10,000.00 -------------- | ------------- $2,310,000.00 | $2,310,000.00 ============== | =============

Comments on Problem. There is little in the solution to which attention need be directed. In the handling of the capital stock items, it will be noted that only $300,000 of Company Y’s stock is eliminated, the remainder of $200,000 being shown on the consolidated balance sheet as a minority interest. In eliminating Company Z’s capital stock, it becomes necessary to bring a good-will item of $100,000 onto the consolidated balance sheet. This is shown on the working sheet by means of the three “f” items in the “Elimination” column. On the consolidated balance sheet it will be noted that the minority interest in Surplus (40% of $25,000, Y’s surplus) is not shown affected by the reduction of Y’s inventory to a cost basis. The solution assumes that all the surplus items on the balance sheets of the various companies represent operating surplus accumulated since the purchase of the subsidiaries by the holding company.

This problem calls attention to some of the questions encountered in handling the consolidated balance sheet, although in practice much more complicated situations arise. All that can be hoped for here is to impress upon the student some fundamental principles to be observed and to point out some of the methods used in order best to express the relations of the various interests in the business. The idea of the consolidated balance sheet is simple in concept but usually difficult of full realization.

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