Economics for the accountant

Front matter

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Preface

In these days any text-book in the social sciences or on the principles of business needs an apology. The student with equipment who has the time and opportunity to attempt to contribute to his science should hesitate before burdening the press with another text. I paused, therefore, before adding another text on the subject of economics, but after much deliberation decided that there was a definite ne'ed for a specialized analysis of economic theory for the accountant.

The economist and the accountant deal with substantially the same facts, even though they have different perspectives and somewhat different purposes. The economist is usually a dispassionate philosopher who looks on man 's economic activities for the purpose of studying and explaining them. The accountant is working in the midst of business organization and is gathering and classifying facts for his employer. If he would do his work intelligently, he must have some understanding of the economic system in which his employer is functioning. There are many problems of interest to the economist that have only an indirect relation to the accountant's work. For this reason the ordinary text-books on economic theory include lengthy discussions on many phases of economics in which the accountant is not interested and give insufficient treatment to what he would consider more fundamental problems. It might be supposed that some of the more "practical" economic texts, such as are used in the business schools, might give the accountant what he needs. These so-called practical texts, however, usually collect vi PREFACE

and schematize certain useful facts that are mere commonplaces to the practical accountant. Moreover, it will soon be discovered that it is the most abstract and subtle economic reasoning that underlies the principles of accounting.

When this work was first being planned, it was suggested to me that there is need of an exposition of accounting for the economist. This book should also be of use to the economist who is interested in the theory of accounting. Moreover, any economist who gives consistent thought to accounting will find much of purely theoretical economic interest in the subject. He will find that he must be more careful in defining .capital, interest, and profit and that he will have to make some important distinctions between the different kinds of cost. I feel that through my contact with accounting principles I have been able to present certain more or less important contributions to economic theory.

The student who expects to get the most out of this book should know something about accounting, and if he knows anything about accounting, he will necessarily have some grasp of the fundamentals of economics. In short, this book was not written primarily for the elementary accounting student although, in the absence of any other text of this kind, it could be used even by students of elementary accounting, if supplemented by classroom lectures.

There is one word in regard to the scientific method to be employed in the two studies, and especially in accounting. The economist 's first problem is to determine "what is"; a description of "what ought to be" may follow, but it should be predicated on a knowledge of "what is." The economist may use his science for constructing methods of improving the welfare of society,

PREFACE vii

but he thereupon becomes a reformer or even a propagandist. It is not contended here that an economist should not at times be a reformer or a propagandist, but it is believed that he should be careful to obtain the facts first. The accountant probably needs more warning on this score than the economist. The accountant may work for a producer or for a public body, but he should never change his definitions or adopt a revised set of principles. The concept of ''cost" should never be changed so as to serve as a weapon for enforcing good financial policy or for effecting social reform; the accountant's definitions should be carefully thought out and rigorously adhered to. It is no sound argument against the principle involved in the inclusion of interest in cost that the application thereof would tend to inflate cost and allow the producers greater profits than they would otherwise enjoy. The amount of depreciation the accountant should charge should not be affected by the financial condition of the company or by the wishes of its directors. The accountant should tell the truth as he sees it and should be careful not to revise his classifications for some special purpose, no matter how justifiable the particular cause may seem to be.

The problem of interest as a part of cost is so much disputed, and the light that economic theory can throw on the discussion is so considerable, that a special appendix is devoted to the subject. The problem is discussed in Chapter X as well as in other chapters, but an entirely satisfactory discussion of this question was not possible until all the principles outlined in Chapters X and XI were set forth. Before this problem can be understood by the accountant, he must establish firmly certain careful definitions of the entrepreneur, the capitalist, capital, capital goods, cost, interest, and profit. Certain other viii PREFACE

disputed items, which might have been discussed in Chapter X, were reserved for Appendix II because of their technical accounting interest and because it was difficult to treat them until all the general principles had been set forth.

Kemper Simpson

Contents

PAGE

Preface v

CHAPTER

Chapter I Economics And Accounting

The Development of Accounting. — Since the Civil War business organization has become increasingly complex. Business units have become larger and are not so readily interpreted by simple methods of bookkeeping. Although new fields of industry are constantly being invaded, competition in many lines is becoming keener and keener. The complexity of business organization has been responsible for the replacement of the bookkeeper by the modern auditor, and the keenness of competition, along with other factors, has developed the field of the cost accountant.^ The World War too, through the necessity of price fixing and taxation (especially the income and excess profits taxes), has made it necessary for all business to give some consideration to the problems of accounting.

Although modern accounting has developed from bookkeeping, the modern accountant must have a

* The cost accountant establishes the price below which it would be unprofitable to sell, much larger equipment than the old-fashioned bookkeeper. As business organizations have grown larger and more complex, the producer has been less able to grasp all the facts of his business and has come to depend upon the accountant more and more for a summarization of details. Furthermore, the accountant has developed from a mere keeper of records (that is, a bookkeeper) into an interpreter of those records. The producer relies on his accountants for all those facts that he needs in determining his business policies. But it must be remembered that the producer is not working alone; he is functioning in a complex economic organization, and it is the accountant's business to understand the economic relations of his employer. If the accountants do not understand the system in which the producer functions, of what use to him will their presentation of facts be? In short, accounting is merely a combination of scientific bookkeeping and economics.^

In order to comprehend the differences between the functions and the purposes of the accountant and the economist, it will be necessary to consider the way in which accountancy and economics first attracted the attention of mankind. As early as there was business there was some kind of bookkeeping, but it was not until business became complex that the principles of accounting were formulated and it was not until competition became keen that cost accounting and auditing (as it is understood to-day)

' Economics includes corporation finance, taxation, etc., as well as pure economic theory.

ECONOMICS AND ACCOUNTING 3

began to claim so much attention. Accounting, then, has become a science since the '80s.

The Development of Economics. — ^Economics, or political economy, has had a respectable position among the sciences ever since the Eevolutionary War and its principles have been more or less heeded by governments since the Napoleonic Wars. Political economy descended from two very unlike parents; the finance minister of kings and the academic philosopher. The problems of taxation and money early interested the monarchs of Europe and their ministers of finance. The kings of France thought of the people merely as taxpayers who supplied them with the means for lavish expenditures, but Quesnay warned them that a rich people make a rich country and a rich king. The other parent of political economy was the professor of philosophy, who stopped to consider man in his economic as well as his ethical and political relations. Francis Hutcheson and Adam Smith gave political economy an academic position, which stimulated the keenest scientific minds to give it attention.

Adam Smith's book was called the Wealth of Nations, but would probably have been called Political Economy had not another book by Sir James Stewart with that title appeared a few years before. To-day, ' ' economics ' ' is probably more common than "political economy," but the older term is significant in that it shows that it was the effect of the state on the economic relations of man and on the wealth of nations that was of particular interest to the economist. Economics in England and in the

United States, to-day, lays less stress than formerly on the state and more on the consumers and laborers as classes. It is a fact of some interest that just before the War a German economist of distinction remarked that there were very few American economists who gave sufficient attention to the state in their studies, and that there were few American political economists for that reason. It was characteristic of German economics and of German government that the importance of the state was always emphasized. In England and the United States, a policy of laissez-faire allowed men to develop economic organizations with the least possible governmental interference. The protectionism, government ownership, and taxation of Germany were consistent with German political economy, whereas English free trade, private ownership, and taxation cannot be dissociated from English economics.^

The Economist's Point of View. — ^Although the economists of to-day may be less interested in the state than were the early political economists, they have always retained their interest in society. It is society as consumer and society as producer that the economist considers. No individual or no one group of individuals should occupy the economist's entire attention or receive special treatment. He may work for one or the other of these groups, for example, laborers, entrepreneurs, etc.,* but, then, he becomes

'Protectionism in the United States is erplained by the necessity of helping certain industries to get on their feet, whereas German protectionism was a governmental policy designed to make Germany a self-sufficing political unit.

*See Chapter III, page 26.

ECONOMICS AND ACCOUNTING 5

a propagandist and is in danger of losing his impartial scientific attitude. The economist describes and attempts to show causal relations, but he should be careful whenever he introduces ethics and talks of what "ought to be" rather than of what *4s." It is, to say the least, practical to determine what "is" before deciding what "ought be be."

The Accountant's Point of View. — The accountant is the producer's (entrepreneur's) bookkeeper, grown philosopher.^ Even the public accountant does most of his work for the entrepreneur. He analyzes the activities of the producer's business, and only incidentally considers those of society as a whole. While he sets up his accounts, he always has in mind that they are being prepared for his employer: he is concerned with the laborers merely because they receive wages, which he must include in his employer's costs or expenses. The consumers, for whom it will be shown all production is carried on, claim the accountant's attention only because they pay the producer prices, which constitute the "Sales" of the accountant's Profit and Loss Statement. The accountant in rare circumstances may be called upon to make * ' special examinations ' ' for the benefit of consumers, as in a public-utility case. The accountant, then, usually studies the individual business, whereas the economist studies all businesses and their inter-relations.

It has often been pointed out that accounting is merely a science of classification, analogous to anatomy. Economics not only describes and classi-

» See Chapter III.

fies but attempts to give ultimate explanations. A scientific explanation, however, is, in one sense, merely a description of cause and effect. It may be that the economist should have worked out the principles on which accounting classifications should be based, but economists have been so busy studying society and businesses collectively that they have neglected to consider the science of business from the individual producer's point of view. So the accountant has had to work out principles and set up theories behind his classifications, because all serviceable classifications are built on principles and even theories. But inasmuch as the two professions are dealing with the same phenomena, and since both the accountants and the economists are primarily describing facts, their points of view may be different, but, in the last analysis, they should be reconcilable.

Even though the accountant works for some particular producer, that producer functions in a complicated economic system, about which the accountant must have some knowledge. The producer has contacts with the market, in which there are other producers and consumers; he also has contacts with capitalists and with laborers. The accountant must know something of the intricate system in which his employer functions. He cannot build a wall around the business for which he is making classifications; he cannot tell his employer "so much you must add to cost before arriving at selling price" and '*in this way you should value your assets" if the market refuses to consider the

ECONOMICS AND ACCOUNTING 7

employer's or the accountant's ideas and desires in the matter. That accountant is most successful who is aware of the place of his house in the greater economic organization. It will be shown, for example, that his house seeks through price to get income from the larger economy and that it draws upon that economy for the goods and services for which it meets costs; the difference is profit. Strangely enough, however, costs are not always so easily defined as they might seem to be ; as a result, with the varying definitions of costs, there are varying definitions of profit. The accountant's definition of cost is not always identical with that of the economist, and likewise their definitions of profit will differ. It is evident that some reconciliation is necessary, but a rather careful scrutiny of both economic and accounting categories must precede the statement of this reconciliation. Moreover, the economist does well to consider the accountant's problems and findings. The accountant is working at the heart of economic realities and he sees facts and truths that the economist may be too much in the clouds to recognize. Too many economists maintain their perspective at such a height that they fail to see the homely truths that are apparent to the burrowing accountant. This book attempts to establish between them contacts that should be mutually beneficial.

Chapter II

The accountant must be able to obtain from tbe records of a company data that will answer three principal questions: (1) What were the sales or income and the expenses or outgo of the business in any particular period? (2) What were the specific costs of the different products handled or produced? and (3) How much capital was invested in the business and how can the present worth of the business be estimated? The Profit and Loss account, the Cost Statement, and the Balance Sheet are constructed by the accountant in order to answer these questions. These three statements can be used to answer questions other than those suggested and some of the additional questions, which are significant, will be treated in other places in this book.

The Balance Sheet. — The Balance Sheet is supposed by many accountants to give merely an accurate financial picture of the business at a particular time, but this belief is due to a misconception of the possibilities of determining such an accurate statement. It will be shown that the Balance Sheet should contain the original cost of the assets not their market valuation; but it is a question whether a statement of this kind could be used to give the stockholders or the creditors any idea of the market value of the assets at the time the Balance Sheet is being used. (See Chapter XI.)

For whom is the Balance Sheet made ? Obviously for those who own the business. To the common stockholders (or, as will be shown later, the entrepreneur), who own the business, the accountant is responsible; his statements are made for them. On the one side (according to American custom, the left side), the different assets are enumerated and some monetary evaluation is set beside each ; legally these assets belong to the common stockholders. On the right side, the stockholders ' obligations to the banks and to the bondholders (or other creditors) are first shown and underneath these liabilities are included the Common Stock and Surplus, which represents the excess of assets over liabilities, and which belong to the common stockholders. The form of Balance Sheet recommended for the use of manufacturers by the Federal Eeserve Board is presented on pages 10 and 11.

This Balance Sheet is supposed to serve a number of purposes. First, it should give the accountant a record of the amount of capital invested in the business ; as a basis for an interest charge or for measuring the return earned, the amount of capital invested represents a very important figure. The Balance Sheet will give the amount of capital invested, if assets are shown at original cost. Second, it is commonly used by the stockholders, directors, and managers to obtain an estimate of the financial condition of their business at any time. Third, it furnishes them with a statement for the bank from which

Form of Balance Sheet Recommended

ASSETS

Cash:

la. Cash on hand — currency and coin

16. Cash in bank

Notes and accounts receivable:

3. Notes receivable of customers on hand (not

5. Notes receivable discounted or sold with indorsement or guaranty

7. Accounts receivable, customers (not past due) . 9. Notes receivable, customers, past due (cash

value, $)

11. Accounts receivable, customers, past due (cash

Less:

13. Provisions for bad debts

15. Provisions for discounts,

freights, allowances, etc

Inventories:

17. Raw material on hand

19. Goods in process

21. Uncompleted contracts

Less payments on account thereof.

23. Finished goods on hand

Other quick assets (describe fully) :

Total quick assets (excluding all investments) .

Securities:

25. Securities readily marketable and salable without impairing the business

27. Notes given by officers, stockholders, or employees

29. Accounts due from ofl&cers, stockholders, or employees

Total current assets

Fixed assets:

31. Land used for plant

33. Buildings used for plant

35. Machinery

37. Tools and plant equipment

39. Patterns and drawings

41. Office furniture and fixtures

43. Other fixed assets, if any (describe fully) .

Less:

45. Reserves for depreciation.

Total fixed assets

Deferred charges:

47. Prepaid expenses, interest, insurance, taxes, etc. Other assets (49)

Total assets

BY THE FeDEKAL RESERVE BOARD

UABILITIES

Bills, notes, and accounts payable: Unsecured bills and notes:

2. Acceptances made for merchandise or raw

material purchased

4. Notes given for merchandise or raw

material purchased

6. Notes given to banks for money borrowed . .

8. Notes sold through brokers

10. Notes given for machinery, additions to

plant, etc

12. Notes due to stockholders, officers, or employees

Unsecured accounts:

14. Accounts payable for purchase (not yet

due)

16. Accounts payable for purchases (past due). 18. Accounts payable to stockholders, officers,

or employees

Secured liabilities:

20o. Notes receivable discounted or sold with indorsement or guaranty (contra)

206. Customers' accounts discounted or assigned (contra)

20c. Obligations secured by liens on inventories

20c?. Obligations secured by securities deposited as collateral

22. Accrued liabilities (interest, taxes, wages,

etc.)

Other current liabilities (describe fully) :

Total current liabilities

Fixed liabilities:

24. Mortgage on plant (due date )

26." Mortgage on other real estate (due date )

28. Chattel mortgage on machinery or equipment

(due date )

30. Bonded debt (due date )

32. Other fixed liabilities (describe fully) :

Total liabilities

Net worth:

34. If a corporation:

(a) Preferred stock (less stock in treasury). (6) Common stock (less stock in treasury).

(c) Surplus and undivided profits

Less:

(d) Book value of good will

(e) Deficit

36. If an individual or partnership:

(o) Capital

(6) Undistributed profits or deficit.

Total , they may desire to secure credit. This third purpose explains the arrangement of the assets : the fluid assets, those that can be easily liquidated in case of emergency, are shown first. Probably the greatest theoretical difficulty presented by the Balance Sheet is the principle of evaluation of the assets. Should they always be valued at their original cost, or should they be revalued with an increase in their market value due to an outside demand, increased quantity of money, or greater productivity? These questions, which are really economic rather than accounting questions, can only be answered by accountants who have a clear understanding of the meaning of economic categories. (See Chapter XI).

The Profit and Loss Account. — If the accountant needed to find the profit or loss of the stockholders realized in a period, it might be supposed that he could compare the Balance Sheet for the beginning of the period with the Balance Sheet for the end of the period.^ There are certain practical difficulties involved in arriving at profit in this way: as a matter of fact, the second Balance Sheet is ordinarily derived from the first after the profit during the period has been determined and added to the surplus. Unless assets are revalued, and it will be shown that this would be bad accounting, the two Balance Sheets would only differ by the amount of the profit or loss. Furthermore, even if revaluation were allowed, the accountant would find it necessary

* This profit would not be pure economic profit but a combination of profit and interest on the capital invested by the stockholders.

Profit and Loss Account Recommended bt the Federal Reserve Board

Comparative statement of profit and loss for three years ending 19 ,

Year ending —

Less outward freight, allowances, and returns .

Net sales

Inventory beginning of year

Purchases, net

Loss inventory end of year

Cost of sales

Gross profit on sales

Selling expenses (itemized to correspond with ledger accounts kept)

Total selling expense

General expenses (itemized to correspond with ■ ledger accounts kept)

Total general expense

Administrative expenses (itemized to correspond with ledger accounts kept) . .

Total expenses

...

Net profit on sales

Other income:

Income from investments

Interest on notes receivable, eto

Gross income

Deductions from income:

Interest on bonded debt

Interest on notes payable

Total deductions

Net income — profit and loss

Add special credits to profit and loss

Deduct special charges to profit and loss

Profit and loss for period

Surplus beginning of period

Dividends paid

Surplus ending of period to separate profits from the sales of products produced or handled from gains on the sale of assets. The Profit and Loss account on page 13 was recommended by the Federal Reserve Board in the same pamphlet from which the Balance Sheet on pages 10 and 11 was taken.^

The Profit and Loss account gives a financial summary of the transactions of a business throughout a definite period. It sets forth the income or sales and the outgo or expenses in order to show the difference, that is, the profit realized. The accountant's principal difficulty lies in determining what to do with the producer's or stockholders', that is, the entrepreneur's, sacrifices, which are not represented by actual expenditures, such as depreciation, rent on land owned, and interest. On the treatment of these much disputed items in accounting economic theory can throw much light (see Chapter X and Appendix I).

The Cost Statement. — In a business in which only one product of one grade and of one size is handled, there is no need for any separate Cost Statement provided the items of expense are analyzed and not thrown together in one lump sum such as is done on the foregoing Profit and Loss account. Although the item ''Cost of Sales," as shown, represents a summary of the costs, it is often analyzed on the Profit and Loss account. For a manufacturing busi-

2 There is one obvious criticism of this Profit and Loss account, which was constructed for a jobbing rather than a manufacturing business: Cost of Sales should include Selling and General and Administrative Expense. The item "Cost of Sales" should have been called Cost of Goods Sold.

ness it could be analyzed about as indicated in the following statement:

Cost Statement, January 1-December 31

Quantity of Product Manufactured (pounds, tons, or cases, etc.)

(Add) Quantity of Product on hand January 1

{Deduct) Quantity of Product on hand December 31

Quantity of Product Sold .

Raw Materials . . .

Factory Overhead.

Total Factory

(Add) Cost of Inventories on hand January 1

Total

{Deduct) Cost of Inventories on hand December 31

Manufacturing Cost of Goods Sold

General and Administrative

Selling

Cost of Sales .

From this statement the different costs per unit of product can be obtained by dividing the quantity produced into the various production costs or the quantity sold into the administrative and selling expenses or the cost of sales. Obviously when a number of different products of different sizes and grades are produced or handled, the problems of cost accounting become more difficult. Even if a careful record is kept for the costs of the raw materials going into each of the different products of the different sizes and grades manufactured, there are many costs that are not so easily allocated. It will be shown in Chapter IX that even with careful records the allocation of the raw-material costs for co-products and joint-products may present a very complicated economic problem. The allocation of labor costs represents another difficulty, particularly if the same laborers work on a number of the different products or on the different sizes and grades of the same products. The most difficult problem, however, is presented by the overhead. A reasonable allocation of light, heat, and power, of rent, or of administrative salaries takes much of the accountant's thought; to the solution of this problem, the economist can add but little. When it comes to the determination of what items should be included in cost, and the reasoning pertinent to the disputed items, however, the economist can add much.

The economist is interested in a speedy and accurate solution of these problems of the accountant. Economically desirable differences in prices for the different commodities of the various sizes and grades can only be determined after accurate costs have been established. Furthermore, economies in production can be best effected by accurate and comprehensive unit costs. The economist talks much of the proper or most economic proportions of labor, capital goods, and land in production. He insists that one of the principal functions of management is the judicious use of these factors. It will be shown that the comparisons of the itemized unit costs of the different factories, or for tlie different processes, or for the same factory or process for different months or years enable those responsible to effect the necessary economies in production.

CHAPTER III CONSUMPTION" AND PliODUCTION

The Definition of Economics and Its Subdivisions.

— Economics is the social science that deals with man in his efforts to make a living or to satisfy his wants. There are two processes involved: one is concerned with the satisfaction of man's wants; the other is concerned with the efforts of man in obtaining those things that he desires. The first of these processes is called Consumption; the second is called Production. In the simplest type of economic organization, Crusoe desired food, clothes, and shelter (this is, he desired to consume) and he, therefore, had to exert ejffort (that is, produce) in order to satisfy his wants. Consumption is both the beginning and the end of economic study: it furnishes the incentive for economic endeavor and it constitutes the ultimate purpose of all economic organization. It is seldom that man produces merely for the love of producing; he produces, or lends others aid in production, ordinarily because he desires to consume and because under no other condition would he be permitted to do so. Economics considers every human being a consumer, whenever he has a desire and obtains (purchases) satisfaction. The consumer procures satisfaction, although what he apparently purchases are ** goods or services. '* A **good" is a physical, but not necessarily a tangible, thing that gratifies the consumer's desire. A ''service" is the result of human effort that takes no purely physical manifestation. Consumption might seem to presuppose a reduction of the amount of matter in existence. When a man eats a peach, he destroys the form of the peach, but the amount of matter in existence is not reduced. Furthermore, much consumption does not even change the form of the thing consumed. The owner of a painting appropriates but he does not destroy or even alter the form of the thing consumed. Furthermore, consumption does not necessitate appropriation. The owner of a painting is not the only one who consumes it, that is, derives satisfaction from it.

Production. — Production logically comprises all the processes that are necessary to give the consumer the goods and services he desires. Production in the economic sense does not mean the actual creation of matter. Man cannot bring matter into being; he can merely change its form. Tables and chairs are made out of wood, which in turn comes from the trees; but the trees grow and are not the creation of man. Production does not consist in changing only the form of goods; it includes also the placing and keeping of goods so as to give the consumer his satisfactions where and when he wants them. Changing the form of goods is called the production of form utilities, whereas changing their location and keeping them until they are needed are called the production of place and time utilities. The economist, therefore, maintains that what he calls place and time utilities are as important as form ntilities. The retailers, the jobbers, the railroads, and the cold storage warehouses are as truly producing agencies as are the farmers and manufacturers, even though they merely store and transport goods and do nothing to change their form/