Accounting practice and procedure

Front matter

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Preface

The profession of accountancy is at a great disadvantage in comparison with that of law, by reason of the fact that the decisions reached on the important questions which arise from day to day are not publicly rendi^red and available as authorities for the rest of the profession, but are made privately and as a rule are accessible only to a few.

In issuing this volume, therefore, it is my hope that the record it contains of some of the problems encountered in the course of twenty-five years of practice on both sides of the Atlantic may be of value to my fellow accountants and may in some measure serve to discharge some part of the debt I owe to the profession to whicb I belong.

The first eight chapters deal with probleme relating to the income account and balance sheet. These are followed by one on some problems involved in cost accounting; while the last chapter deals with the accountant's responsibility to the public — a subject that is becoming more important every day.

It has been my endeavor to avoid technicalities and so to render the book useful to the student entering the profession and also to lawyers, bankers and professional men generally, who are vitally interested in accounting but have not had the accountant's training.

In my practice it has been my good fortune to be in dose touch, in partnership and otherwise, with many leading practitioners both in the United States and England, and in association with them to deal with many of the problems herein discussed, so that, while the responsibility for the views expressed is solely mine, the value they may possess is drawn from wider sources.

A. Lowes Dickinson.

October lo, 1913.

iii

Chapter I. Bookkeeping Double-Entry Bookkeeping

Impersonal Accounts

Function of Impersonal Accounts

Opening the Books

The Trial Balance

Early Bookkeeping Methods

The Subsidiary Ledger

Controlling Accounts

Loose-Leaf Records

Mechanical Aids in Bookkeeping

Modern Bookkeeping Methods— ^fv Forma System

(1) Sales and Customers Records

(2) Cash Records

(3) Passing Bills for Payment

(4) Creditors or Purchase Records

(5) Expense and Cost Accounts

(6) Journal Entries

(7) General Ledger Accounts Progress of Bookkeeping

. Chapter IL The Balance Sheet

Balance Sheet an Approximation Causes Affecting Net Worth Balance Sheet Accounts Form of Balance Sheet Order of Assets and Liabilities

V

VI CONTENTS

Analysis of Balance Sheet Assets

(1) Fixed Assets

(4) Working Assets

(6) Suspense Debits

Analysis of Balance Sheet Liabilities

Capita] Stock

Funded and Unfunded Debt

Depreciation

Suspense Credits

Surplus

Appropriated Surplus

English Requirements as to Balance Sheet

Balance Sheet Forms

Misleading Statements in Balance Sheets

Condensed Financial Statement

Statutory Forms of Balance Sheet

Chapter III. The Profit and Loss Account and the General Principles Governing Its Preparation Loss and Gain Terminology

Varying Purposes of Financial Statements

Classification of Activities

(1) Manufacturing

(2) Merchandising

(4) Transportation

(5) Banking

(6) Professional Activities

(7) Private Accounts Suggested Terminology

Forms for Statements of Loss and Gain

Items Properly Chargeable to Profit and Loss

Nature of Profits

Single-Entry Determination of Profits

Corporate Profits

Corporate Profits — English Rule

Corporate Profits — American Rule

Corporate Profits — General Rule

CONTENTS VII

Chapter IV. Balance Sheet Aaaeta I. CAPITAL ASSETS (1) Fixed FioPEarY Land and Improvements Buildings and Structures

Plant, Machinery and Fixed Tools Movable Equipment Furniture and Fixtures Patterns, Drawings, Dies, etc.

Patents, Goodwill and Franchises Changes in Value of Capital Assets

(2) Permanent Investments Investments for Purposes of Control Investments Controlling Facilities or Output Minor Investments

Non-Income Producing Investments Advances

IL WORKING ASSETS

(1) Stores and Supplies

(2) Advances to Agents

(3) Expenses Incurred in Advance of Accrual

\ Chapter V. Balance Sheet Assets (Continaed)

III. CURRENT ASSETS

(1) Stocks on Hand

Essentials for Ascertaining Correct Profits

Taking the Inventory

Cost Accounting

Distribution of Expense Burden

Allocation of Expenses

Selling Expenses as Part of Manufacturing Cost

Status of Interest

Increasing Value of Seasoning Material

Treatment of Carrying Charges

Profits on Work in Progress

Reserves for Contingencies

VIII CONTENTS

Book Inventorie3

Physical Verification of Book Inventories

Monthly Charges

Contracts of Purchase

Inventory Credits and Liabilities

Accuracy of Inventory Valuations

(2) Accounts and Bills Receivable

Present Values of Accounts and Bills Receivable

(3) Investments Unissued Stock or Bonds

Issued Stock or Bonds Held in Treasury Valuation of Investments

(4) Cash

Cash on Current Account Outstanding Checks Restricted Cash Balances

(5) Foreign Exchange Dealings in Foreign Exchange

(1) Capital Stock

Capital Stock Without Par Value Redemption of Capital Stock Treasury Stock Treasury Stock — English Rule

(2) BoNDKo Debt

Effective Interest Rate of Bonds

Annual Income Charges

Varying Conditions Affecting Annual Charge

Methods of Determining Charge to Income

Operation of the Various Methods of Determining Annual Charge

to Income Determining Annual Charge When Proportionate Discount is

Written Off Discount on Bond Issues Not a Proper Charge to Capital

(3) Available Capital Resouscbs

(4) Cusrent Liabilities

(5) Contingent Liabilities

CONTENTS IX

(6) Sinking Fund Rsseivks for Redemption or Debt

(7) Other Provisions or Appropriations

(8) Secret Reserves

* Chapter VIL Repairs, Renewals, Depreciatiofi and New Constmctioii

(1) Property Expenditures Classification Reconstruction and Improvements

Interest and Overhead Charges in Capital Outlay Profits on Construction Work Not Permissible

(2) Maintenance Expenditures

Treatment of Maintenance Expenditures by Raikoads Classification of Maintenance Expenditures

(3) Renewals and Depreciation General Considerations

(4) Methods op Providing for Depreoatiov Annuity Method

Straight Line Method

Diminishing Balance Method

Combination Method

Treatment of Interest on Accumulated Depreciation

Exhaustion of Minerals

Amortization of Leaseholds

Conclusion

Chapter VIIL Special Points in Corporation Accounting and Finance

(1) Accounting for Holding Companies

The Consolidated Balance Sheet and Income Account Legal Status of Consolidated Balance Sheet Intercompany Profits and Accounting What is a Constituent Company?

Other Forms of Consolidated Statements

(2) Profits Earned Before Date of Consolidation

(3) Questions Arising on the Organization of a Corporation* Initial Surplus

Losses on Current Assets Acquired

Adjustment of Inventories on Purchase and Sale of a Business

X CONTENTS

Chapter IX. Some Theories and Problems in Cost Accounting

Nature of Plant Constituent Elements of Cost Conditions Affecting Cost Purposes of Cost Accounting Constituent Elements of Commercial Costs Distribution of Overhead Expense Selling Costs

Importance of Accurate Cost Keeping Relation of Interest and Rent to Manufacturing Cost Nature of Commercial Investments Interest and Rent Not a Manufacturing Cost Rental Charges

\Difficulties of Including Interest as a Manufacturing Cost Suggested Treatment of Interest in Connection with Costs Statistical Comparisons Between Production and Capital Invested Profit-sharing in Its Relation to Costs Cost as a Price Basis

Chapter X. The Duties and ResponsibOities of Um PiAEe Accountant

(1) In Respect of the Prospectus Necessity for Accountants' Certificates English Requirements as to Prospectuses Period to Be Covered by Prospectus Treatment of Unusual Profits or Losses Fluctuations of Profits

Results for Broken Periods

Interest in Its Relation to Profits

Salaries as Affecting Profits

Depreciation and Renewals in Their Relation to Profits

Varying Requirements of Statements of Profits

Adjustments

Estimates of Anticipated Economies

Estimates of Future Earnings

Certificate of Financial Condition

Certificate of Profits Without Certificate of Assets

Liability of Certifying Accountant

(2) In Respect op Audit Audit Practice in England

American and English Practice as to Company Audits

CONTENTS XI

Canadian Audit Practice

Accountant's Responsibility for Audit Certificates

Qualified Certificates

Accountant's Moral and Legal Responsibility

(3) In Respect op Liquidation and RECONSTRUcnoN Responsibility of Accountant in Case of Business Failure Causes or Conditions Leading Up to Insolvency Reorganization

Appendix

I. Sections of the English Law Relating to the Inspection and Audit of Accounts [Companies (Consolidation) Act, 1908].

li. Extracts from Schedule I to Companies (Consolidation) Act, 1908, Known as Table A.

III. Sections of the English Law relating to Prospectuses

[Companies (Consolidation) Act, 1908].

IV. Sections of the English Law Relating to Payment of In-

terest Out of Capital [Companies (Consolidation) Act, 1908].

V. Sections Relating to Shareholders' Audit in the Canadian Bank Act, 1913.

VI. (1) Form of General Balance Sheet Statement as Prescribed by the Interstate Commerce Commission for . Steam Roads.

(2) Form of General Balance Sheet Statement for Carriers by Water as Prescribed by the Interstate Commerce Commission.

VII. Form of Statement for National Banks as Prescribed by the Comptroller of the Currency.

VIII. Form of Annual Statement of Life Insurance Company as Prescribed by the Superintendent of Insurance, State of New York.

ACCOUNTING

Practice and Procedure

Chapter I Bookkeeping

Bookkeq)ing is the essential foundation of accountrng*^ and a thorough knowledge of its elementary principles and general methods is necessary to the proper understanding of accounting principles. While, therefore, it is not within the scope of the present book to put forth an exhaustive treatise on bookkeeping, it will serve a useful purpose to devote some space to a consideration of the principles involved and to modem methods of carrying these prmciples into effect.

Double-Entry Bookkeeping

The term "bookkeeping^' is commonly and loosely used to describe any method of entering accounts of transactions in money, but the only scientific system which is worth notice here is that known as "double-entry bookkeeping," which is based on the fact that every transaction involves a transfer of property or its equivalent from one person to another, the terms "property" and "person" being used in the widest possible sense. This operation of receiving and giving is expressed in bookkeeping by the use of the terms "debit" and "credit" which may be thus defined :

A person is debited with whatever is received from another.

A person is credited with whatever is transferred to another.

Every debit necessarily involves a corresponding credit, and after any number of transactions have been thus entered it follows that the sum of all the debits will exactly equal the sum of all the credits.

Impersonal Accounts

It is customary in treatises on bookkeeping to draw a somewhat sharp line of distinction between a personal and an impersonal account, meaning by the first an account kept with some definite person or group of persons whether corporate or otherwise, and by an impersonal account one which expresses merely a condition. In effect, however, all impersonal accounts are merely subdivisions of the personal account of the person or group of persons by or for whom the accbunts are kept, who may briefly be termed the "principal." These accounts are devised, according to modem ideas, not so much for the purpose of determining the financial relation of the principal to those with whom he deals (although of course this is important) as to show his own incomings and outgoings, possessions and obligations, in such full detail as will enable him best to control his affairs and to determine his own financial position*

Function of Impersonal Accounts

The demands of bookkeeping would be satisfied if A, carrying on a business, debited himself with all he received and credited himself with all he parted with, correspondingly

IS crediting and debiting those from whom he received and to whom he transferred. In such a case all his side of the transactions would be merged in one account only in his books; and a very detailed analysis of this account, and a complete inventory of all his property and assets, would be required to furnish information of his own position, either as to profits or capital.

In order to furnish continuously this detailed analysis, impersonal or nominal accounts so-called have been introduced, and the principle of debit and credit has been applied to them as if they were persons. Such accounts may, therefore, be considered as a continuous and daily anal3rsis of the principal's own account; or, from another aspect, may be treated as a division of his personality into a number of pockets, each one of which represents some specific part of his activities, and the gathering together of all of which will represent his condition. It is in this gathering together of impersonal accounts that bookkeeping passes the imaginary dividing line that separates it from accounting. The balancing of the conditions surrounding each one of these accounts, and the determination of the exact bearing of each upon the position of the principal, is the duty of accounting. The problems involved in the determination of the value in money to be placed upon each, form the main subject of this volume.

Opening the Books

On the principles already outlined the principal first distributes all his property to various imagfinary locations, crediting himself as the transferor, and debiting the localities, each of which has a suitable name, such as Land, Buildings, Investments, Cash, etc., with what each receives in this imaginary distribution. Similarly, he credits himself with amounts received by other individuals from him which at this stage represent debts owing to him, and debits himself with what he has received from other individuals which also represents debts owing by him to them. When this distribution is completed in his books the sum of all the debits, now representing various classes of property and debtors, must exactly equal the sum of all credits representing creditors and his own account, this latter showing his capital or worth in gross while all the remaining accounts, both debit and credit, show of what this worth is composed. This process, which is generally known as ^'opening the books,'' is followed by an exactly similar record of each subsequent transaction, each being debited and credited to the particular account concerned, whether Property, or Debtor, or Creditor. In the same way amounts due to others from himself for use of their facilities or due to him by others for their use of his facilities (such as rent, interest, wages, etc.) are debited or credited to accounts in his books representing his outgoings or incomings under their various headings, other than property, and credited or debited to the other parties to the transactions.

The Trial Balance

At any stage the same equation between the sums of all debits and all credits should exist if the entries have all been made with clerical accuracy, so far as the two sides, debit and credit, are concerned. Errors due to debits or credits being made to a wrong account cannot be detected by this means, but require a critical re-examination of each entry, a process which is essential at some time before a final balance is reached. This equation of debits and credits is known as a Trial Balance, and its main object is to prove the clerical accuracy of the work and to form a basis for the further critical examination required.

The methods by which, under modern conditions, this equation between debits and credits is reached are of considerable importance.

Early Bookkeeping Methods

The old-fashioned routine of bookkeeping was as follows :

Firstly, a record was made in a book known as a ''Day Book" of each transaction as it occurred, e.g. —

''Bought 100 tons of pig iron from B at $15

per ton.

Accepted B's draft for $1,500/'

and so on.

Secondly, the entries in the day book were converted into a form specifying the accounts which should be debited and credited in each particular case, known as "journalizing" the entry from the fact that this was entered in a book known as a "Journal," e.g. —

Pig Iron, Dr. $i>500

^ For 100 tons of pig iron at $15 per ton.

To Bills Payable, Cr. $1,500

For B's draft accepted this day.

Thirdly, each side of each entry in this journal would be entered, or "posted," to a debit (left-hand) or credit (right-hand) page in a third book called a "Ledger," headed with the account name shown in the journal entry, so com* pleting the record.

As business developed it was found that if this elementary process were applied to a business of any magnitude, the. work involved would be enormous; and accordingly it became customary to group transactions of similar character so that in the ledger the totals only of a number of similar transactions might be dealt with.

The most important elementary examples of such grouping are found in the "Cash Book" and the "Sales Day Book," which contain characteristics of both the day book and the ledger of our first example. The cash book is in itself in its common form a ledger account for cash, which from the fact that it is easily counted and balanced in money values, a quality possessed by no other kind of property, came to be considered of some special importance. This ledger account of cash, therefore, instead of being written up or posted from the day book to the journal, and the journal to the ledger, came to be used as a book of original entry, in place of the day book, for all cash transactions, whether incoming or outgoing, the other half of the entry being obtained by posting each individual item directly from the cash book to the ledger, thus eliminating altogether the intermediate journal. In the case of the sales day book a similar method was adopted, all sales being entered in a separate day book, the items being posted directly to the accounts of the customers and the total to the credit of the sales account, thus again completing the double entry and entirely eliminating tfie journal.

The Subsidiary Ledger

As business increased in volume, so the opportunity for clerical error in carrying transactions through the various books and the consequent difficulty of obtaining an accurate trial balance also increased, and attempts were made at sectional balancing by which portions of the ledger might be proved and balanced without the necessity of dealing with the whole. This was applied firstly to the sales, which affected only a certain class of accounts. The ledger was divided into two portions, one of which contained only customers' accounts ; the debits to these accounts came from the sales day book, and the credits were obtained by employing a separate cash book or a separate column in the general cash book for all amounts received from customers, the totals of which were carried into the general cash book or "general" column of the cash book at fixed intervals. By making separate summaries of the sales day book and sales column in the cash book, and by also keeping a separate list of all discounts allowed on customers' accounts, all the debits and credits which affected the sales ledger could be put together and balanced with the totals of that ledger independently of any other part of the books. Then it was found simpler, and more conducive to accuracy, to take the totals of all the individual entries and put them through the journal, which had fallen into disuse, these totals being posted to an account in the main part of the ledger or "General Ledger" with some such title as "Customers Account" or "Sales Ledger Account."

The process thus shortly described may be more clearly shown by an example :

(i) A customers' ledger contains accounts with 100 different individuals, showing on January ist a number of balances, or debts, due, aggregating say $1,500.

(2) During the month of January sales are made to various customers, each of which is entered in the day book as made and subsequently posted to the debit of some account in the customers ledger (i). The day book at the end of January is added up and the total found to be $10,000.

(3) During the month of January collections are made from customers, and entered individually, as received, in a book, and posted to the credit of the corresponding account in the ledger (i). As these postings are made a note is made in the cash book, against the cash receipt, of the amount of discount allowed. At the end of the month the cash and discount items are separately added up and found to amount to $10,200 and $300 respectively.

(4) At January 31st the balances on the customers ledger (i) are again taken off and found to amount to $1,000, and it is desired to know whether or not this is the correct amount.

(5) The proof is as follows:

Balances at January ist (i) $ 1,500

Add — Sales for month (2) 10,000

Total $11,500 Deduct: Cash received (3) $10,200

Discount allowed (3) 300 10,500

Balance should be and is (4) $ 1,000

The following would be specimen journal entries for such a group of transactions :

Customers Account, Dr. $10,000 To Sales Account, $10,000

For total of sales for the month as shown by sales day book, p. —

Digiti zed by Google

Discount allowed, Dr. 300

To Customers Account, 300

For discounts allowed to customers during the month as per discount day book (usually a separate memorandum column in sales cash book).

Cash Account, Dr. 10,200

To Customers Account, 10,200

For cash received from customers during the month.

Controlling Accounts

From the nature of these entries it will be seen that all debits and credits which have been posted individually to the accounts in the customers ledger have also been posted in total through the above entries to the Customers account in the general ledger, and that consequently the balance on the latter account must always equal the sum of all balances in the former ledger.

Accounts such as "Customers Account*' above-mentioned are known as "controlling accounts,'' and their use is now common in all large concerns and is applied not merely to sales but to any group of accounts of sufficient magnitude to make such a course desirable. Their use necessitates a number of subsidiary books or subsidiary columns in principal books, each one representing some separate controlling account or even some subdivision of such an account The elementary example just given, which involves nothing but simple arithmetic and common sense, is typical of all such controlling systems and no other principle is involved therein.

Loose-Leaf Records

Up to this point only bound books, in which all the necessary entries were made, have been considered. As the magnitude of business concerns increased, further subdivisions became necessary if the accounts were to be kept reasonably up to date. This was at first accomplished by dividing subsidiary books into two or more portions for use on alternate days as books of original entry; and in the intervening periods for posting and other bookkeeping purposes. This method served the purpose for a long period and is still considerably used. Progressive minds, however, advanced the idea of using loose sheets for original record, which after transfer of the information to the final books of account, i.e., the ledgers, were bound up and filed away for reference purposes; and this process has been extended very largely to subsidiary ledgers and under suitable pr^autions even to principal ledgers. In the offices of banks iand brokers and other similar institutions the original entry frequently consists of a rough memorandum on a small piece of paper. These, known as "tickets," have by the end of the day served all their bookkeeping purposes and are filed away in bundles for reference if need be. It would be thought that such methods must lead to a large increase in errors, but in practice this is not found to be the case, while the time saved is undoubtedly very great. The fact that by these methods the work is segregated and each class of entry grouped under the supervision of one clerk who is thoroughly familiar with it and has at short intervals to prove and balance his portion of the work, has conduced to greater care and accuracy; and the loss of any portion of a loose original record before at least one side of it has found a more permanent abiding place, is very rare.

Mechanical Aids in Bookkeeping

Various mechanical devices have gradually come into considerable use in bookkeeping, such as adding machines; combined typewriter and calculating machines; book typewriters, etc. ; all of which have entirely revolutionized bookkeeping methods as they formerly existed, and while they do not call for a high order of intelligence on the part of those who are responsible for subsidiary records, they require something a good deal beyond a mere knowledge of bookkeeping on the part of those who control and interpret the final processes and results, y

Modem Bookkeeping Methods — Pro Forma System

The following pro forma system illustrates modern bookkeeping methods now in common use, without giving effect to many further refinements, particularly in the use of more mechanical devices which already find a limited but everextending use in^ large accounting organizations.

(i) Sales and Customers Records

Invoices to customers for sales made are typewritten in multiple copies, of which one copy is sent to the customer and another forms the sales record. These are totalled periodically by means of an adding machine after they have been individually posted to the debit of the customers account in the usual loose leaf or card ledger. The totals of the adding machine slips form the basis of a journal entry prepared on a loose-leaf form entitled "journal voucher," and debiting "Customers Ledger Account" and crediting the "Sales Account." Generally there will be two or more customers ledgers arranged for different groups of initial letters, such as A to E; F to L; M to O; P to S; T to Z, the invoice forms in use for each being either printed on a different colored paper or bearing some distinctive reference mark. These invoice forms are sorted out by ledgers, separate totals made of each on an adding machine, and a separate controlling account kept for each ledger, either in the general ledger or in a separate subsidiary ledger which is itself controlled by one Customers Ledger account on the general ledger. In more refined systems the invoice and the entry on the debit of the customers account are made at one writing by means of a book-typewriter ; and a tabulating machine attached gives the total of all invoices automatically.

Detailed analyses of sales, which are now required in most businesses, will frequently be made by means of an electric sorting and tabulating machine, based upon cards punched in such manner as to record thereon all the salient facts on the original invoice.

Credits to customers* accounts are handled in an exactly similar manner to the debits, the debits and credits being of course reversed.

Cash receipts for sales will be entered up, as they are received, on a loose sheet which contains separate columns for cash items and discount items corresponding to each customers ledger; or in a very large business the remittances will be first sorted by ledgers and those relating to each ledger entered on a separate sheet. The daily totals of these sheets will be handed to the chief cashier after the sheets are completed, and by him agreed with an adding machine slip of the remittances which he has received and paid to bank, and will then be entered in his general cash book in separate totals for each customers ledger. The cash sheets will be sent by the entering clerk to the ledger clerks, who post the items into the corresponding customers ledgers and at the same time enter on sheets and ledgers the corresponding dis-

^5 counts. The sheets are then sent to the treasurer for filing in permanent binders, where they are always available for reference. Frequently the postings of debits and credits to customers' accounts are taken off, totalled and balanced daily with the adding machine lists of sales, cash sheets and credit slips so as to insure a correct balance of the customers ledgers at the end of the month.

(2) Cash Records

The daily totals of cash received from customers as shown upon the subsidiary sheets are entered on the principal cash book together with all other general items. This book is sometimes provided with separate analysis columns under frequently recurring headings and with a column for each bank in which the daily payments into bank are entered. If the bank accounts are numerous only one column is kept in the principal cash book for pa3niients into banks, and this is supported by a subsidiary book containing a separate column for each bank in which debits and credits are entered in totals each day from the additions, on a bank paying-in slip, of the receipts and, on stubs of cheque books, of the payments ; the sum of the totals of all columns on this subsidiary book should always agree with the total bank balance as shown by the principal cash book. The best accounting practice provides for all receipts being paid into bank daily; any loose cash required being provided by a fixed sum in the hands of the cashier, which is replenished as often as may be necessary by cheques drawn for the total disbursements made thereout.

Liabilities are usually paid by what is known as a "voucher cheque" or by a voucher against which a cheque is drawn. A typical form of such a voucher contains space at the top for name and particulars of account ; in the centre for details of bills supported by original invoices and the total payable ; and at foot for signatures of the various officials whose duty it is to pass the same for pajrment. On the back will be found a "card" or list of accounts to one or more of which the items on the voucher are chargeable, this list forming a complete distribution of the voucher. Against the voucher when completed the cashier will issue a cheque ; which very frequently forms an integral part of the voucher and the whole document then becomes a voucher cheque.