Principles of accounting

Front matter

BUSINESS ADMINISTRATION

"-[ SAMUEL D. HIRSCHL, S.B., J.D.

. L Member of the Illinois Bar

Preface

Within recent years there has been a noticeable growth of interest in scientific accounting. The day of the traditional bookkeeper whose principal interest was to keep his books in balance is rapidly passing, and his place is being taken by an executive — the scientific staff auditor, whose field is as wide as the extent of the business itself. Many have been attracted by the exceptional opportunities afforded by accountancy and have eagerly perused such texts as were available. During the past decade, a number of excellent books have been added to the literature of the accounting profession, but most of such works have been written as reference books for the professional public accountant.

Under these conditions, one who has been denied a long training in the school of experience, upon seeking to acquire a comprehensive grasp of accounting science, finds that most treatises on the subject are better suited for reference purposes than for mastering the working principles of accounting in a systematic and organized manner.

In the following pages the author has endeavored to develop the fundamental principles of accounting science according to a basic plan. A number of illustrations and problems are given to illuminate the textual discussion. The purpose of the book is not to promulgate the specialized treatment of any particular phase of the subject, but rather to present the basic principles of the science of accounting in a graphic and comprehendible manner.

iii iv Preface

While it is not believed that any text on accounting principles would prove inappropriate for the layman, the following pages have been written primarily for those having some training or experience in the art of bookkeeping.

The author believes that no apology is necessary for "personifying the business, " since experience indicates the desirability of this approach to the subject of accounting theory. It is nowhere maintained that proprietorship accounts reflect a legal liability ; rather they reflect a theoretical one, and this, after all, is the crux of the argument.

The author desires to express his appreciation and to give due credit to his father, Professor Stephen W. Oilman, A. B., LL. B., C. P. A., of the University of Wisconsin, for his invaluable assistance in reading the manuscript, and to his colleague, Mr. John B. Tanner, C. P. A., for his many helpful suggestions.

Contents

I. PRELIMINARY SURVEY

Symbols 1

Symbolizing the Account 2

Chapter I

An individual engaged in business might conduct that business successfully without keeping records. He could do so only if the business was small and the transactions such as to be remembered easily. As a matter of fact, no business, however simple in its nature, does entirely without records of some sort, primitive though they may be. As business becomes complex, adequate records are essential. The reason for this is the inability of any human being to remember complicated transactions accurately. Man, therefore, symbolizes.

SYMBOLS

Symbols of one sort or another have been in use by the human race since the beginning of recorded time. A "symbol" is that which stands for or represents something «lse ; a visible sign or representation of an idea or quality or of another object.1 Thus the heathen 's idol is a symbol. Maps, drawings, and paintings are symbols. A baseball Scoreboard is a symbol. Models of all sorts are symbols. The printed or written word is a symbol.

In the chief engineer's office in Panama there is a small-scale working model of the canal. Every detail is complete. By means of electrical control every opera-

i Webster's New International Dictionary, tion taking place anywhere on the canal is reproduced in miniature. Ships move from one ocean to another; locks open and close. All normal functions are symbolized. The chief executive may watch this working model and exercise adequate control over the activities of his entire organization. He has the same comprehensive viewpoint as that which an aviator would have when flying over the canal zone. The importance of the word " comprehensive" is very great because it illustrates the chief function of a symbol.

The highly complex business must utilize this principle if it is to be managed adequately. Managers work with the aid of symbols almost entirely in order that they may obtain a comprehensive view of their business, which is possible in no other way.

SYMBOLIZING THE ACCOUNT

Every reader is familiar with the usual bookkeeping symbol — the account. For the sake of bringing out certain important principles, another symbol may be temporarily adopted. This symbol is the ordinary pair of scales or balances. For illustration let us assume a very simple case and then apply this symbol to it. An individual named Brown is employed as business manager by Ames. Ames is entitled to all profits and is responsible for all losses, Brown being paid a salary.

Inasmuch as Brown is responsible for results to Ames, he must keep a record of all business transactions as an aid to administrative data. He may do so by visualizing or symbolizing the different business transactions which take place, with the aid of balances or scales and some small metal cubes, each representing one dollar.2

2 This and following illustrations are for the purpose of developing the fundamental theory of double entry accounts and should not be taken seri-

At the beginning of business Ames may, for the purpose of this illustration of primitive transactions, be considered to have invested $15.00 in cash. This is recorded (Figure 1) and may be illustrated by depositing fifteen metal cubes in the scalepan marked and assumed to represent "assets" and another fifteen in the one marked "liabilities." By this means is recorded the fact that the business has come into the possession of certain assets ($15.00 in cash) and owes, or must account for, an equivalent amount ($15.00 to Ames).

ASSETS LIABILITIES

$15.00 TilbOTotd Totolfl5.00

FIG. 1. — Registering the Investment

Suppose Brown took $10.00 and bought 10 bushels of grain. How would he record this by the symbols 1 The difficulty is obvious, since he has simply exchanged one asset for another. If, however, we replace the scalepan on the left side, previously described, with two scalepans and label one "cash" and the other "merchandise" this transaction can be illustrated. (See Figure 2.)

Suppose Brown sells 5 bushels of the grain for $6.00. What adjustment of the balance must he make? Since one-half of the grain ($5.00 worth) has been dispensed, he must take five of the weights out of the "merchandise" scalepan, and since the business received $6.00, he must

ously with regard to the transactions themselves, the amounts involved, or other matters not pertinent to the development of principles.

put six weights in the "cash" scalepan. When he does this, the several scales no longer balance in the aggregate, since there are sixteen weights in the pans on one side

$15.00 fclS.OO

FIG. 2 (a). — Condition before Buying the Grain sio.oo

I 5.00 / I I I I I |

$15.00

FIG. 2 (b). — Condition after Buying the Grain and only fifteen on the other. This discrepancy is caused by the fact that $5.00 worth of grain was sold for $6.00, resulting in a one-dollar profit. To whom does this profit belong? To the proprietor, Ames. It is to be accounted for by the business to the proprietor. Being in the nature of a liability it must be recorded, and this is done by putting one weight in the liability scalepan. (See Figure 3.)

Brown buys 10 more bushels of grain at $1.00 per bushel, but instead of paying for it he buys on account. He, therefore, must register an asset and a liability of the same amount, viz., $10.00. He can put ten weights in ' ' merchandise ' ' and ten weights in ' ' liabilities. ' r One

ASSETS LIABILITIES

$11.00

FIG. 3. — Condition after Selling Five Bushels of Grain (Cost $5.00) for $6.00

objection to this is that he is not properly distinguishing between liabilities to an outsider (for $10.00) and to the proprietor, Ames (for $16.00). Brown will want to keep them separate because Ames is entitled to all profits and is responsible for all losses, while the outsider is entitled to only $10.00 in any event. This distinction can be easily made by hanging two scalepans instead of one on the liability side. (See Figure 4.)

The business, let us assume, does not have to pay for the grain for thirty days, but Brown offers to pay $9.00 immediately in settlement of the entire account. This is accepted. An analysis of the transaction shows that $9.00 in cash is parted with by the business; therefore nine of the weights come out of "cash." The entire liability of $10.00 has been wiped out, which means that ten weights must be taken from the scalepan, "liabilities to others." When this has been done, the scales are again out of balance, there being one more weight in the pans on the left-hand or asset side than on the right-

$10.00

FiG. 4. — Condition after Buying Ten Bushels of Grain on Account hand or liability side. This is because a profit amounting to $1.00 has been made, which must be accounted for to Ames, the proprietor. When one weight is put in his scalepan representing this obligation, a balance is struck, showing that equilibrium has been re-established. (See Figure 5.)

Ten bushels of grain are now sold for $12.00, but instead of giving cash the purchaser gives his verbal promise to pay $12.00 in thirty days. Another scalepan (which may be labeled "accounts receivable") must be hung on the left-hand or asset side to register this class

$2.00

R

$15.00

FIG. 5. — Condition after Discounting Bill of $10.00 for $9.00 and thus Gaining $1.00

$ 100*

$ 5.00

,$19.00

FIG. 6.— Condition after SeUing Ten Bushels of Grain for $12.00 on Account and thus Making a Profit of $2.00 of asset ("promise to pay"). Twelve weights are put in "accounts receivable, " and ten are taken out of " merchandise " as the grain is dispensed. To obtain the balance and to register properly the obligation of the business to account to Ames for the $2.00 profit on the sale, two weights are put in the appropriate scalepan. (See Figure 6.)

$13.00

$ 5.00

$18.00

FIG. 7. — Condition after Allowing Discount of Eeceivable

L.OO on Accounts

Brown gives permission to discount the bill of $12.00 for $11.00 in cash. This will be registered by deducting twelve weights from "accounts receivable" (because that account is settled in full) and adding eleven weights to "cash" (because that is the exact amount received). The difference is due to the loss of $1.00 suffered in the transaction and is registered by deducting one weight from "Ames." (See Figure 7.)

Kent of $1.00 is now due and payable, and Brown therefore pays it in cash. This is handled by deducting one weight from "cash" and also one from "Ames," since he is responsible for all expenditures. (See Figure 8.)

$12.00

MERCHAND1SE> f 5.00 / I I •'! I '

$17.00

FIG. 8. — Condition after Paying Bent of $1.00

Certain fixtures amounting to $8.00 are needed and are bought on account. (See Figure 9.)

The transactions pictured in Figures 1 to 9 having been followed through, it becomes apparent that this method of "symbolizing" the business is satisfactory in a primitive way, but that it has certain grave defects. It shows, at all times, the current state of affairs as to property and debts, but it tells no history. It is an indicator of present conditions and not a recorder. This is because both additions and deductions of weights are made in each of the various scalepans. This could be remedied by having two scalepans for each class of item whether it is an asset or a liability. Such an arrangement is shown in Figure 10. With this arrangement no subtractions

$12.00

$ 6.00

$ 5.00

18.00

PiG. 9. — Condition after Buying Fixtures on Account for $8.00

are ever made, but the same result is obtained by making additions on the other side. This is a considerable improvement, since by labeling the weights with the date they were put on the balance, an examination would give a graphic picture of the history of the various transactions on any given date; of property on hand at any given date; of the condition of Ames' (the proprietor's) account on any given date.

Having only one place to register all gains (items due to Ames) and all losses (items due from Ames) makes it difficult to analyze the sources and character of these various typified transactions of losses and gains, and it can readily be seen that if any considerable volume of business were done, it would be important to know and to analyze, in detail, the various loss and gain facts.

DISADVANTAGES OF BALANCE METHOD

This system of illustration by using a pair of scales is very good in one way; i. e., when an incomplete record is made — when all facts are not recorded — the scales get out of balance and thus automatically indicate an error; but there are certain obvious disadvantages about such a primitive arrangement which will be apparent. These may be remedied by doing away with the actual physical machinery and substituting therefor the picture or representation of such a pair of scales. We thus forego the advantage of an automatic loss of balance whenever an incomplete record is made but make up for it many times over by increased convenience and effectiveness, and if figures are substituted for the weights, we can check the correctness of our balance by footing the sides and noting whether or not they are equal. The date of the transactions can also be more conveniently recorded. Figure 11 shows such an arrangement using figures which represent the same results attained in Figure 10.

By using the pair of scales originally suggested, it is clear that various sets or pairs of scalepans with the numerous weights on them need not be kept hanging on the scale beam all the time. They might be kept in separate places and all brought together at periodic

1 1 3.00

AMES

IISiOOTotal

$18.00

Total jmoo

FIG. 10 (a). — Same Condition as Shown in Fig. 7, but with Different Arrangement of Scalepans

$13.00

$ 5.00

1.00

FIG. 10 (b). — Condition after Paying Kent of $1.00

ASSETS CASH

$ 1.00

15.00

$2.00

LIABILITIES TO OTHERS

TIG. 10 (c). — Condition after Losing Two Bushels of Grain by Fire

This loss reduces Ames' credit balance by $2.00, bis net worth now being $15.00 ($18.00 — $3.00) offset by assets as follows:

•13.00

ASSETS CASH

$15.00

$4.00

I I I I I I \ j

8.00

Fiiiii \ $ 5 00

UABIL1TIES

TO OTHERS

AMES

$ 5.00

Fig. 10 (d). — Condition after Buying Five Bushels of Grain for Cash and

Five Bushels on Account, Selling Three Bushels on Account for

$4.00, and Paying $2.00 License Fee in Cash

FIG. 11 (a). — Same Condition as Shown in Fig. 10 (d) (assumed date, June 1, 1916)

ACCOUNTS RECDVABLE

AMES

Fig. 11 (b), — Condition of June 2, 1916, after (1) Paying the Amount

Owing to Others, (2) Collecting One-Half of the Accounts Keceivable,

(3) Selling $10.00 Worth of Grain for $12.00 in Cash, and

(4) Buying $5.00 Worth of Merchandise on Account

ASSETSI

ZLJS2 c

Qun rs.

z^

A

A

JTIES

/ V f

Fig. 11 (c). — By the Addition of Certain Kulings We Convert the Balancing

Arrangement into a Practical Working Form without at All

Losing Sight of the Fundamental Balancing Principle intervals to be balanced in the aggregate. It would be necessary to have them all brought together at one time, since it would be seldom that the individual pairs would balance alone. The combination balance, representing all recorded facts, is the test that is needed. In a similar way this pictorial balance (Figure 11) need not be all on one sheet of paper. A separate sheet may be headed ' ' Cash, ' ' another one ' l Merchandise, ' ' another ' ' Accounts Keceivable," a fourth "Liabilities to Others/' and a fifth "Liabilities to Ames," and so on. Totals of each side of each sheet may be taken, and these total figures for all the sheets may be incorporated in the balance even though the sheet headed "Cash" might be separately located from the one headed "Merchandise." This is a very important point since it allows for the greatest possible elasticity, convenience, and efficiency in the keeping of records. By bringing the figures together in one place at a moment of time at the end of regular periods for balancing, the test for completeness of record may be applied.

THE ACCOUNT

Each one of these information units may be called an "account" Thus we speak of the "Cash Account," the "Merchandise Account," etc. The word "account" is for convenience frequently omitted in written work, in which case it is usual to indicate the meaning as follows : cash referring to money but Cash (capitalized) referring to "Cash Account."

Principles of Accounting TEST QUESTIONS

1. What functions are served by symbols?

2. What is the fundamental characteristic of the symbol employed in this chapter?

3. How would Figure 10 (a) appear after buying 10 of grain on account for $1.00 per bushel and selling 13 ^" account for $2.00 per bushel and paying $5.00 f'

4. What is an account?