Roy B. Kester

“ In compiling a balance sheet it is not sufficient to give simply the figures of proprietorship or net worth; schedules of assets and liabilities must be drawn up to show the items making up that net worth. From the viewpoint of a prospective investor or purchaser, a banker to whom the business has applied for a loan, or a concern considering the advisability of extending it credit on a bill of goods, it makes all the difference in the world to know that with a net value of $10,000 the business has assets of $15,000 and liabilities of $5,000 ”

“ Buying must always have regard to the sales activities. To buy without reference to the ability to sell is suicidal. Both overbuying—buying more than can be disposed of at a profit—and underbuying—buying less than is needed to meet the sales demand—are conditions to be avoided. Underbuying means a loss of sales. Unless their needs are met promptly in accordance with their orders, customers will go elsewhere. Overbuying means the unnecessary tying up of capital in a stock of goods which increases the possibilities of loss resulting from changes in fashions and the level of prices. ”

“ BASIC RELATIONSHIPS—PROPRIETORSHIP
Records and Their Functions.—As far back as our knowledge reaches, records of some sort have been kept and used and they have frequently formed the basis on which our knowledge rests. In a broad sense a record may be defined as a written memorial, a register or history of events, a testimony. Even though the desire to make and hand on to the future a record of achievement is a deep-seated characteristic, record-making has seldom been an end in itself. Knowledge of what has been done has always been a starting point and a guide for future achievement. ”

“ We may define a business transaction as an exchange of values. It may be between persons, as when a sale is made, or it may be between accounts within the business itself, as when a transfer is made between accounts, i.e., when an item is taken from one account and transferred to another for the sake of more clearly showing its nature. Some authors further analyze transactions as complete when the bargain is fully consummated between the parties, as when delivery is made and the money is paid in cash ”

“ For instance, although the net profits of a single proprietorship and of a partnership are usually determined in the same manner, there is nevertheless variation in the treatment of some items such as salaries, drawings, interest on capital invested, etc. The partnership form, like the single proprietorship, contemplates an investment on the part of the owners not only of capital but also of time and effort. This is one of the differences in working organization between these forms of business and the corporation. Investment in the corporation is of capital only. ”

“ Distinction between Buying Out an Interest and Making an Investment to Secure an Interest.—The taking in of a partner by a sole proprietor or his admission as a new member to an existing partnership raises a point about which there must be a very definite understanding. A distinction must be made between purchasing from the owners an interest in the business as it stands at any given time and making an investment in a business to secure such an interest. ”

“ The sale price of commodities at a given time is not always determined on the basis of the original cost of the commodity plus the costs of maintaining a store for its sale. Competition sometimes enters in to drive the price down below this amount. While every merchant expects in the long run to receive from the sale of his merchandise not only what he himself has paid for it but also the cost of conducting his store and a fair margin of profit, for a given period and for a given item of merchandise he may not be so fortunate. ”

“ The legal theory is that the old partnership is dead and a new one, even though bearing the same firm name, has come into existence. Thus a partnership cannot be perpetual. The relationship between the partners is so intimate that the success of the undertaking depends fundamentally on the good faith and honor exercised by each partner towards the others, and therefore any addition to the personnel of a partnership can be made only with the consent of all members of the existing firm. ”

“ Other conditions being equal, a firm which enjoys a good reputation is worth more than a new venture. Such a reputation is known as “good-will” and constitutes an exceedingly valuable though an intangible asset. The essence of good-will is the ability to produce more than normal profits, i.e., profits above the average in that line. Consequently, whenever the members of a firm consider the admission of a new partner, good-will is regarded as one of the assets of the existing enterprise, thereby increasing its net worth. ”

“ That system of accounts which groups only one kind of data under each particular account title is better than a system which mixes its records by grouping dissimilar data under a single head. Yet, caution is always to be exercised against too great detail and an unnecessary multiplication of accounts. Oftentimes essential facts and forces of business activity are lost sight of in a maze of detail. ”

“ The vertical division of the ledger separating an account into its left and right sides, may with little stretch of the imagination be considered an equality sign, which thus makes one big equation out of all the accounts in the ledger. Under double-entry bookkeeping, therefore, the principles of entry in the ledger are based on no logic or philosophy other than that which attaches to the fundamental proprietorship equation of the balance sheet. Double entry is an invention, a device, and its use requires adherence to the principles of entry necessary to maintain its equation. ”

“ While it is true that a great deal of valuable information can be secured from a comparative balance sheet, and that this form of balance sheet locates definitely the changes in the asset and liability items, summarizes those changes, and shows the net profit, it nevertheless fails to disclose the forces within the business organization which have brought about the changes—it sets forth effect or result but not cause. ”

“ Sale price is dependent, in a free market, on the force of demand and supply and not at any given time on [Pg 412] cost. Until the goods are sold no profit, as a matter of fact, has been secured. Conservatism, therefore, demands that sale price should not ordinarily be used as the basis for the inventory valuation. Unless there has been a decided change in prices, it is the confident expectation of the management that at least the cost price of the merchandise will be realized when the goods are sold. Ordinarily, therefore, merchandise will be priced in the balance sheet at cost. ”

“ The fixed assets of the business are constantly depreciating in value; merchandise tends to become out of date, shopworn, stale, or soiled; some merchandise has been sold, while some is still on hand; some of the accounts receivable may prove uncollectible, and some of the notes receivable may be dishonored. Also, at the end of the period liabilities such as taxes, salaries, rent, and the like may have been incurred, but because there is no creditor’s invoice or other business paper as evidence of such liability they are not usually entered on the books until payment is made. ”

“ The fact that the goods have been ordered and are now in transit makes the business liable for their purchase price, and although not actually received, in reality they form a part of the asset merchandise. It is true that until the goods are received, inspected, and accepted, the purchaser has the privilege of refusing them if they are not as ordered, but this privilege is exercised only in exceptional cases. Generally speaking, therefore, it is better to consider such goods as a completed purchase, include them in the inventory and credit the vendor for the amount of his invoice. ”

“ Maintenance has to do with those costs which maintain an asset in good operating condition; repairs have to do with those costs necessary to put an asset in operating condition after a condition of inefficiency has been reached which the maintenance costs have not been able to prevent; a replacement cost is incurred when it becomes necessary to replace some part or the whole of an asset, neither maintenance cost nor repair costs having been able to maintain the asset in efficient operating condition. Where only a part of an asset is to be replaced, it is often spoken of as a renewal of parts. ”

“ If the proprietor begins business with an investment of cash only and without any obligations, an entry in the cash book of the amount invested as a credit to the proprietor’s capital account is all that is necessary. If the investment consists of a variety of properties and liabilities to creditors, and obligations on leases, salaries, etc., are assumed, a very careful and complete record should be made in the journal, showing the kinds and values of the properties invested, and the kinds and amounts of the liabilities assumed. ”

“ There are different kinds of partnerships, as will later be shown, but the essence of each from the point of view of a working organization is mutual agency, each partner being the agent of the others, and, within the limitations of the partnership agreement, capable of acting as a principal for the firm. The partnership is subject to practically as few restrictions as the individual. In some localities, to secure the right to sue and be sued in the firm name, it is necessary to file in a public office a brief statement of the firm name and the names of its members. ”

“ The ratio of total assets to total liabilities is almost as important information to an investor, purchaser, banker, or creditor as is the character of the assets and liabilities. If the assets are in properties for which there is not a ready market and the liabilities are claims which mature soon and will have to be met, the situation is unfavorable. If there are large values invested in easily salable assets; if there is a large balance of cash on hand after meeting current claims and providing for those which will soon mature ”

“ But such delegation means nothing more than a method of dividing the work and is simply the working organization of the firm which may be changed at any time the majority of the partners see fit. Thus, while a partner may be limited in his actions for the firm by agreement among the partners, so that he is not a general agent for the firm, still as to outsiders who know nothing of this internal arrangement, he has power to bind the partnership by his acts, because an outsider has a right to expect that any partner has power to act as an agent for the firm. ”

“ Income.—Income is usually of two types: operating and non-operating. These terms are always relative; that is, what is an operating income in one business may be a non-operating income in another business. The term “operating income” is used to indicate the main sources of income in a given business. It is always the duty of the accounting department to indicate the sources of income. Thus in a trading or mercantile business, the selling of goods to customers is the main source of income. ”

“ Kinds of Records.—A business must have assets and usually must incur liabilities; a plant must be used, stock-in-trade must be bought, and sold, and usually sufficient capital must be provided for the extension of credit to customers. Capital for the payment of the operating expenses of the business, the maintenance of the plant, the payment of salaries and wages of employees, and so forth must at all times be provided. While it is true that the balance sheet shows the financial condition of the business, it gives little information as to the volume of business operations. ”

“ Average Investment as a Basis for Profit-Sharing.—Attention should be called to a basis for profit-sharing sometimes employed for special partnerships, entered into for the performance of a specific contract or for doing any special work. In these cases the capital needed may not be known at the start, or if known may not all be required then but is to be furnished by whichever partner may have available funds at the time of need. In such cases the basis of profit-sharing may be made the amount of capital furnished by each partner and the length of time of its use in the enterprise. ”

“ As competition becomes keener and the margin of return per unit of product becomes smaller, he has to increase his volume of business to secure the same amount of profit as when he did a lesser volume of business.
To produce goods it is necessary to use the saved wealth of former periods to pay the expenses of materials, labor, management, etc., of the present period. One must consume wealth to produce wealth. After his product is made, he must seek the best market for its exchange or sale. ”

“ Shippers to the produce market frequently consign their goods to city brokers whom they instruct to take advantage of the prices prevailing in the open market, and in this way they may realize higher prices than when they sell outright to the wholesaler. The consignment shipment has another advantage to the shipper, in that the title to the goods remains vested in him; hence a consignment is safer than a sale on credit to a consignee unless his rating is satisfactory. The practice of consignment trading is of sufficient importance to require a discussion of the accounting principles involved. ”

“ THE PHILOSOPHY OF DEBIT AND CREDIT
Double-Entry Bookkeeping.—Several systems or methods of keeping business records have at various times been in use. The method which at the present time is used by all businesses, excepting those of the simplest sort, is called “double-entry bookkeeping” and is the method which is being set forth here. It is based on the proprietorship equation expressed in the form: Assets = Liabilities + Proprietorship. It is possible to make a balance sheet if only asset and liability records are kept, because proprietorship is always the difference between them. ”

“ The desirability of establishing a standard routine for the handling of all items should be kept in mind. Best practice, therefore, demands that all debts shall be charged against the Reserve for Doubtful Accounts whenever they are determined to be bad, regardless of the amount held in reserve in that account. If such practice creates a debit balance in the Reserve for Doubtful Accounts, it is an indication that the estimate of uncollectible accounts made in previous periods has not, as a matter of fact, been sufficient and a larger estimate must be made for future periods. ”

“ Accounts with Customers
The balance owing us by a customer is an asset, and therefore a debit item.
Goods sold on account are charged to the customer because our claim against him constitutes an asset; at the same time the income account, Sales, is credited.
When a customer pays us on account, his account is credited and Cash is [Pg 87] debited, showing an increase of the asset Cash and a decrease of the asset Accounts Receivable. Such an entry is simply a transfer from one account to another, an increase of one asset offset by a decrease of another asset. ”

“ A charge against a stockholder as a customer of the corporation is on the same basis as a charge against any other customer. A stockholder may become a creditor of the corporation in exactly the same way as any other person. In a partnership, on the other hand, charges against a partner and credits to his account are looked upon as charges against and credits to his proprietary interest in the event of liquidation of the firm. ”

“ A title which does not clearly and truthfully indicate the nature of the account, or one which is so chosen that under it may be recorded items of various and doubtful kinds, gives prima facie evidence of an imperfect knowledge of accounting principles or of a desire to hide data which will not bear close scrutiny. ”

“ Inasmuch as the sale or purchase, under this method, must be booked on a cash option basis, this treatment seems to result in a departure from true cost or in the mistake of booking only some of the elements which enter into the cost of merchandise. The price at which a merchant can sell his product must include all direct and indirect costs and provide a margin for profit. The sales discount offered is simply one of these indirect costs. It cannot be more accurately estimated than can the salesman’s salary which is a part of the sale price. ”

“ If a careful accounting is made of the profit or loss at the time of the sale of each piece of property and these profits and losses together with the dissolution expenses are summarized and distributed to the partners’ capital accounts, those accounts will of course show the claims of the various partners on the net assets of the business after all assets have been converted into cash and all liabilities paid. ”

“ Relation between the Corporation and Its Owners.—It should be noted that the owners of a corporation are on a somewhat different basis in their relationships and activities to the business than are the owners of a partnership or single proprietorship business. The legal theory that the corporation is an entity, a person, separate and apart from its owners, necessitates a change in the status of accounts with owners as compared with similar accounts in the other types of organization. ”