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1937

Accounting Questions and Answers

American Institute of Accountants. Bureau of Information

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 Accounting Questions
and
Answers
—

AMERICAN INSTITUTE OF ACCOUNTANTS

135 CEDAR STREET, NEW YORK

January, 1937
 ADDITIONAL COPIES

OF THIS BULLETIN MAY BE OBTAINED

FROM THE

American Institute of Accountants

135 CEDAR STREET, NEW YORK

AT

50 CENTS PER COPY

Accounting Questions
and Answers

Selected from the files of the

American Institute of Accountants

Bureau of Information

American Institute of Accountants

135 Cedar Street

January, 1937
COPYRIGHT, 1937, BY AMERICAN INSTITUTE OF
ACCOUNTANTS, ALL RIGHTS RESERVED, IN­
CLUDING THE RIGHT TO REPRODUCE THIS
BOOK, OR PORTIONS THEREOF, IN ANY FORM.

PRINTED IN THE UNITED STATES OF AMERICA

 PREFACE

This book contains accounting questions and answers selected from

the files of the American Institute of Accountants bureau of informa­
tion. Most of the material has been published in The Journal of
Accountancy or in special bulletins during the past fifteen years, but
much is of more than transitory interest and it has been thought
worth while to bring the best of it together in this form, with an
index, for reference purposes.
The Institute’s bureau of information does not answer questions
itself, but refers them to practising accountants for answer. All the
material in this book, therefore, emanates from individual account­
ants and reflects their own views. The Institute’s executive com­
mittee, in authorizing publication of this matter, distinctly disclaims
any responsibility for these views, which are in no sense an expression
of the Institute or of any of its committees, but are considered of
value because they indicate the opinions of competent members of
the profession. The fact that many differences of opinion appear
indicates the personal nature of the answers.
Copies of this book are available at fifty cents each.

John L. Carey,
Secretary.

New York,
January 14, 1937.
 Valuation of Inventories
(May, 1931)

QUESTION: We are preparing a balance-sheet as of March 1st,

for one of our clients. Our report will be rendered about May 20th.
Inventories were valued at cost or (March 1st) market, whichever
was lower. Between the date of the balance-sheet and the date of the
submission of the report, there has been a decline in market prices of
the raw materials in the inventory.

(1) Should a reserve be provided for this decline in market

prices, and if so, on what basis?
(2) If no reserve is set up, should a comment upon the decline
in market prices be made in the certificate or report? or
(3) Should the decline in market prices be disregarded since it
occurred after the date of the balance-sheet?
ANSWER NO. 1: It is our opinion that the inventories, the sub­
ject of your inquiry, are properly valued in the balance-sheet at the
lower of cost or market. At the same time, a reserve should be
provided for the decline in market prices, the amount of such reserve
being the difference between the inventory valuation and the value to
which the market has declined. We are assuming a decline in prices
stabilized within reasonably definite limits, since, if the downward
price movement still continues, the stated reserve must be based on a
consideration of the circumstances, and governed by a prudent con­
servatism. If, on the other hand, no reserve is made, appropriate
comment should be offered in the certificate.
ANSWER NO. 2: In reply to questions one and two, we believe
that either a reserve should be set up or suitable comment made
disclosing the fact of the decline of market prices and its effect on
the financial position of the company. The answer to question three
is, of course, that the decline in market prices should not be dis­
regarded.
We believe, however, that the inquirer should consider other
factors than those mentioned in your letter. It is quite conceivable
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 American Institute of Accountants
that a substantial decline might have occurred between March 1st
and May 20th without impairing the financial status as shown on the
March 1st balance-sheet. That is, the entire inventory might have
been liquidated before the decline in prices occurred. It is manifest
that if such were the case any reference to the decline in market
prices would give an unjustified impression as to the client’s financial
condition.
The measure of the reserve or of the qualifying comment should
be the loss actually sustained and the potential loss still to be
realized, in respect to the values shown as of March 1st. If the client
had liquidated one half his inventory at a definite loss, such loss,
together with the decline in value on the unliquidated portion, should
represent the reserve requirement or amount to be embodied in the
comments.
It is seldom possible to trace the liquidation of inventory satis­
factorily so as to determine the exact loss incurred at a given date.
It is not necessary to comment on the difficulties in establishing the
actual and potential loss, but merely to state the principle which
must be followed in order that no injustice be done to the client.

Valuation of Inventories of Metal Mining Companies

(February, 1936)

QUESTION: A company in the metal mining and milling business

has its stock listed on the New York stock exchange and is required
to report quarterly to the exchange the net income and the amount
of net income a share on the outstanding stock. The company’s
finished product is concentrates, which customarily are shipped under
contract to the smelter as soon as they are produced. Recently the
company has stored part of its production in expectation of better
metal prices, and the stored concentrates are valued in the company’s
accounts at mining and milling cost, which is less than market. Dur­
ing a period in which the stored concentrates increase, the net income
is less than it would be if the concentrates had all been sold or if net
income had been computed on the basis of valuing them at market.
Conversely, for a period in which the inventories of stored concen­
trates are reduced by shipments to the smelter, income is greater
2
 Questions and Answers
than if it were computed on the market value of the stored con­
centrates.
The officers of the company feel that a statement of net income
computed on the basis of inventories stated at cost has the effect of
distorting the income from what is actually made as the produce is
readily marketable and sold as soon as placed on the cars for ship­
ment at the price determined by the market quotations of the various
metals.
The question concerning which we desire your opinion and sug­
gestions relates to the presentation of operating results so as to avoid
misleading investors and stockholders and, in particular, we would
be much obliged to be informed if it would be proper and is cus­
tomary with metal mining companies to state inventories at market.
We believe this practice was followed in earlier years by large
operators but has largely been discontinued on account of income-tax
regulations which prohibit the use of inventories at a higher value
than cost.
We have suggested to the company that report be made to the
New York stock exchange along the lines of the following paragraph
and would appreciate your opinion as to the propriety of such a state­
ment in which income is taken into account before fully realized:
“The ....................... Mining Company for the quarter ended
June 30 made a net profit of $.............. after taxes and deprecia­
tion but before depletion, which is equal to $.............. a share on
the............ shares of $...............par common outstanding. During
the quarter inventories of concentrates which are being stored in
anticipation of higher metal prices and are valued at cost were
increased. Net income for the quarter based on valuing inven­
tories of concentrates at market was $.............. which is equal to
$.............. a share on the outstanding common.”
During periods of decreasing inventories the report would indi­
cate conversely a smaller net income on basis of inventories at market
than at cost.
ANSWER NO. 1: It is not customary for mining companies to
value their inventories at market except in the case of by-products
such as precious metals produced with the mining of copper, lead,
zinc or other primary metals. The exception to this is that when the
market value is less than cost the inventories are usually reduced
to market.
3
 American Institute of Accountants
In the case of your client we believe the net profit should be shown
on the cost basis. It also seems proper to us to give the additional
information shown in the second part of your proposed paragraph.
This is on the assumption that both beginning and end inventories
are valued for this purpose on the basis of the market price at the
respective dates.
Would it not be better to make the last sentence of your paragraph
read “Net income for the quarter if calculated on a basis of valuing
inventories of unsold concentrates at market values both at the be­
ginning and end of the period was $.............. which is equal to
$.............. a share on the outstanding common stock”?
The net income of a company which stores metals such as you
have described will necessarily be made up of two elements, the
profit on operations based on the market price of the product at the
time of production and a speculative profit or loss reflecting the dif­
ference between this market value and the amount eventually real­
ized for the product. Although it is not usual to recognize such a
segregation either in the accounts or in reports to stockholders in
certain circumstances, it would seem that such a segregation might
be necessary to give proper information as to the results of opera­
tions.
“Two other members of the Institute have submitted suggestions
for the last sentence in the proposed report of the company to the
New York stock exchange as follows:
I. Net income for the quarter based on valuing inventories of
concentrates at market rather than cost would have been $........... ,
which would be equal to $.............. a share on the outstanding
common stock.
2. Net income for the quarter would have been increased by
$ if the increase in the inventories of concentrates had
been valued at market instead of at cost.”

NO. 2: From the standpoint both of income taxes and

financial accounting, it is in our opinion best to state inventories of
concentrates at cost rather than at market value. Market would of
course be used if lower than cost at the date of a balance-sheet.
While we understand that the concentrates could be readily sold,
the same would be true of many items in the finished-goods inven­
tories of most companies, and it does not seem advisable in the cir­
cumstances mentioned to depart from the usual practice of carrying
4
 Questions and Answers
inventories at cost if cost is below market and stating income ac­
cordingly.
We approve the idea of a special statement to the New York stock
exchange setting forth the facts and calling attention to the differ­
ence of earnings if the inventories of concentrates were valued at
market rather than cost, but we recommend that the last sentence
should read as follows:

“Net income for the quarter based on valuing inventories of

concentrates at market rather than cost would have been $........... ,
which would be equal to $.............. a share on the outstanding
common stock.”

Losses on Commodity Inventories and Contracts

(December, 1935)

QUESTION: We have a client dealing in a commodity which is

traded in on recognized commodity exchanges. Our client sells the
actual commodity to users and trades in the commodity on the
exchange as a hedge against inventory on hand and also for specu­
lation.
At the close of the fiscal year, our client has realized losses on
contracts closed out on the exchanges but has not yet disposed of
the inventory on hand, so that there is a profit in the inventory at
present market values. The custom of this particular client in the
past has been to value its inventory at the lower of cost or market
and to take into its operating accounts for the year the profits or
losses realized on closed contracts on the exchanges. It now desires
to defer the loss on closed contracts on the exchange until the period
in which the profit is taken on the actual merchandise to be sold.
Will you please advise us what other accounting firms consider
the proper practice in the treatment of losses on contracts of this
nature? If your answer could cover the following questions which
have arisen in this matter, it would be very helpful:
1. Should the loss on closed hedge contracts be added to the in­
ventory value of the merchandise on hand? If so, must the inven­
tory be stated on the balance-sheet as at “cost or market, whichever
is lower, plus loss on commodity exchange contracts”?
5
 American Institute of Accountants
2. Should the loss on dosed hedge contracts be treated as a de­
ferred expense to be written off in the future period against profits
realized on the inventory now on hand?
3. Could the inventory be carried on the balance-sheet at market
values, less a reserve which would be sufficient to bring the net in­
ventory down to cost plus the loss on closed contracts on the ex­
change? If this is good accounting practice, how should the item be
expressed?
4. Is there any other way in which this matter is handled by
representative accounting firms?

ANSWER NO. 1: It is assumed from the question that:

(a) A commodity, let us say, cotton, was bought and physically
delivered some time prior to the end of the year, at 11¼c.
(b) At about the date of the purchase, the same quantity was
sold short, at the same price.
(c) Prior to the end of the year, the short was filled at the then
market of 11½c.
We are of the opinion that it would be good practice to value the
cotton on hand at 11½c (or market, whichever is lower).
The reason for hedging is to eliminate the speculation incidental to
carrying a stock of merchandise. The hedge in question was for the
purpose of selling the original purchase, and, although the purchase
to fill the short was not taken into stock physically, the price of it
should be used for inventory purposes.
ANSWER NO. 2: It is our opinion that where there is a definite
relation between a commodity on hand and the commodity con­
tracts, the profit or loss on commodity inventory may be offset
against losses or gains on contracts. In that event, we see no objec­
tion to adding the loss on such closed hedge contracts to the inven­
tory value of the merchandise on hand. We believe that it should
then be stated that the inventory is at “cost or market whichever is
lower, plus loss on commodity exchange contracts applicable thereto.”
We prefer this treatment to that mentioned in the second and
third specific questions raised by your correspondent.
Where the commodity contracts, either open or closed, are specu­
lative rather than hedges against inventory or sales contracts, we
believe that any profit or loss on such contracts should be reflected
in the accounts at the year-end.
6
 Questions and Answers

Interest Paid on Bonds or Notes as Cost of Inventory

(September, 1934)

QUESTION: Why should not interest actually paid on bonds or

notes be included in cost of inventory on the balance-sheet? (This
has to do with the paragraph on page 10 of the “Verification of
Financial Statements” which reads as follows: “That no selling ex­
penses, interest charges, or administrative expenses are included in
the factory overhead cost.”)

ANSWER: Interest actually paid on bonds or notes is not to be

included in cost of inventory on the balance-sheet because it forms
no part of the cost of the inventory of goods. Of course, if interest
on notes has been paid in advance, the unexpired portion of such
interest may properly be included in the inventory.
The question infers that the inventory referred to is an inventory
of goods. Interest on borrowed capital does not form a part of the
cost of goods at any time. Some accountants try to include return
on the investment as part of the cost of producing goods, but au­
thorities generally agree that return on investment forms no part
of the cost of the production and is calculated as part of the profit
to be made, rather than a part of the cost.

Additional Charges to Cost Price of Commodities

(May, 1932)

QUESTION: Commodities like lead ore, coal, grain, greasy wool,

coffee and pulp, purchased f. o. b. point of shipment, are subject to
loss of weight in transit. Freight is paid on original gross weight,
which includes moisture. Special charges, such as brokers’ commis­
sions, weighing and inspection fees, loading and unloading, etc., are
incurred. The total outlay divided by the quantity actually received
is the unit price which I have found recorded.
Does paragraph 55 (j) of “Verification of Financial Statements”:
“If duties, freight, insurance, and other direct charges have been
added, the items should be tested to ascertain that no error has been
made. Duties and transit charges are legitimate additions to the
7
 American Institute of Accountants
cost price of goods, but no other factors should be added except in
extraordinary circumstances,” intend that each of the elements of
cost enumerated below (even when adjusted to lower market prices)
if set up in a book inventory is to be written off or is to be excluded
from a computation of inventory value?
(a) Loss of weight—essence of commodity.
(b) Loss of weight—evaporation of moisture.
(c) Freight on moisture content.
(d) Moisture paid for at price of commodity.
(e) Brokers’ or buyers’ commissions or expenses or purchas­
ing department expenses.
(f) Weighing and/or inspection fees.
(g) Loading and/or unloading.
(h) Hauling.
(i) Insurance—transit and/or storage.
(j) Cost of foreign exchange.
(k) Additional loss of weight after receipt—either of essence
of commodity and/or of moisture.
(1) Storage charges or expenses.
ANSWER: Many commodities like those referred to are pur­
chased today upon the basis of analysis, or if the packages contain
foreign elements, they are graded and priced, so that, when the
foreign elements are eliminated, the real cost of what is usable is the
cost of the lot purchased.
All the items mentioned may, under conditions, enter into the cost
of usable product laid down, either in the warehouse to be with­
drawn, or in the plant ready for processing; and the auditor or ac­
countant who has these elements to deal with can readily decide
whether or not they are properly to be added to an initial invoice
in order to bring the commodity to the point where it is to be used.
This is covered by paragraph 55, if read in its broadest sense.

Treatment of Inventories in Intercompany Accounts

(March, 1933)

QUESTION: We find there is a difference of opinion as to the

proper treatment of the profit on inventories in consolidated state-
8
 Questions and Answers
ments when there is a minority interest. We are familiar with the
several text-books which treat the subject and with the arguments
upon which their several opinions are based. But what we would
like to learn is which method is adopted most frequently by ac­
countants who in practice are called upon to handle this question.
The question deals with the following cases, in which a minority
interest in the subsidiary is assumed.

A. Inventory in the hands of the subsidiary sold by the holding

company.
Treatment proposed:
I. Eliminate all the profit against the holding company’s
surplus.
2. Eliminate a percentage of profit against the holding
company’s surplus based on the percentage of sub­
sidiary stock in the holding company’s possession.
B. Inventory in the hands of the holding company sold by the
subsidiary.
Treatment proposed:
I. Eliminate all the profit against the holding company’s
surplus.
2. Eliminate all the profit and apply the reduction against
the holding company’s surplus and the minority in­
terest in amounts proportioned to their respective
interest in the subsidiary’s surplus.
3. Eliminate a percentage of profit against the holding
company’s surplus based on the percentage of sub­
sidiary stock in the holding company’s possession.

ANSWER NO. 1: We may say that we have found in each of

the two kinds of cases cited that the method most frequently adopted
in general practice is to eliminate all the intercompany profit against
the holding company’s surplus.
Of course, the practice of eliminating all of the unrealized inter­
company profit in the cases in question may be criticized on theo­
retical grounds. However, because of the fact that the accounts of
partly owned subsidiary companies are not usually consolidated with
the accounts of the parent company, unless the percentage of the
minority interest is small, it follows that the amount of intercom­
pany profit in the inventories which would be applicable to such
minority interest would also be relatively unimportant.
9
 American Institute of Accountants
ANSWER NO. 2: Our policy with respect to the adjustment of
inventory valuations of merchandise sold to or purchased from a sub­
sidiary would be to reduce the values of all stocks on hand in the
consolidated accounts to either cost or market values, thereby elimi­
nating all intercompany profits, the profit so eliminated to be charged
against the parent company’s surplus and the inventories correspond­
ingly reduced.
In the consolidated balance-sheet, we would prefer to show under
the caption of liabilities, as representing the interests of minority
stockholders, such percentage of the capital stock and the subsidi­
ary’s surplus as the number of outstanding minority shares repre­
sented of the total shares issued by the subsidiary.
We assume that the intercompany billing prices have been made
on a reasonably sound basis, not above the realizable prices to cus­
tomers, and we think in the circumstances the minority stockholders
are entitled to their pro-rata share of the surplus indicated on the
subsidiary company’s books and that this equity should correspond
with that shown in the parent company’s accounts.

Sales of Inventory to Affiliated Company

(August, 1931)

QUESTION: An auditor (A) has been doing the work of a manu­

facturing company (X) for a number of years. This manufacturing
company is affiliated with a processing company (P) which the
auditor does not examine. At the close of 1930, X company had a
large inventory of its main raw material and, being desirous of re­
ducing this, sold a substantial amount (practically one-third of its
entire inventory) to P company. Company P borrowed money on
warehouse receipts on this merchandise and paid company X in cash
in full. Company X thereupon paid off a large amount of current
indebtedness, which, of course, had the effect of improving its cur­
rent ratio.
In 1931 company X will gradually repurchase from P, either in
processed state or original raw state, the raw materials sold by it
at the end of 1930 to company P.
Company X having sold the raw materials to company P at cost,
10
 Questions and Answers
insists that no mention of this transaction be made by the auditor
in his report. The auditor, on the other hand, feels that since this
was not a transaction in the ordinary course of business, since it
involved a relatively large percentage of the inventory and was con­
summated at the end of the year with an affiliated company, some
mention should be made of it in his report. In your opinion, what
position should the auditor take, and how emphatic should he be
if not in agreement with the client?

ANSWER NO. 1: It seems to us that the question turns to a con­

siderable degree upon what is meant by an affiliated company. If the
affiliated company is a controlled or substantially owned company,
then we think that the auditor in his report should mention the
transaction. On the other hand, if the affiliated company is inde­
pendently owned by the same interests and there is no onerous obli­
gation on company X, then on the statement of facts in your letter
we do not think the auditor could insist on making mention of the
transaction in his certificate.
The question is one of so-called “window dressing,” which always
gives rise to some of the most difficult situations with which an
auditor has to deal. In certain cases where a company resorts con­
tinuously to such practices the auditor’s only remedy is to decline
the audit on the ground that it is a bad moral hazard. This particu­
lar transaction was apparently fully disclosed to the auditor, but it
is quite possible that information regarding similar transactions
might be withheld from him.

ANSWER NO. 2: From the facts, as stated by the correspondent,

we are disposed to think that he need not be insistent upon stating all
the facts regarding the transaction in his report. We are influenced
in this decision largely by the statement that company X will grad­
ually repurchase the stock from company P; that is to say, the
transaction was not obviously a window-dressing subterfuge which
was reversed at the beginning of the succeeding period. Further it
is difficult to see that the transaction was prejudicial to the interests
of the stockholders of the creditors of company X.
ANSWER NO. 3: This is one of many cases which come close to the
border line and in respect of which one should have considerably
more information than that presented in the inquiry.
Generally speaking, if either a written or oral agreement exists
11
 American Institute of Accountants
between the respective companies regarding the repurchase of mate­
rial, or if previous practice or admission on the part of either indi­
cates that such will be the case, the transaction must be disclosed
by a qualification in the auditor’s certificate. On the other hand, one
may well suppose cases in which a change in the policy of a com­
pany might justify the disposition of a substantial portion of in­
ventory, at costs, and if it were clearly demonstrated that the trans­
action did relate to such a change in policy no such disclosure would
be necessary. Obviously such a change in policy could not contem­
plate a repurchase of such material in the ensuing period.
When it is stated that the companies are affiliated we assume that
neither is a subsidiary of the other, but rather that both are con­
trolled by the same interests. The question of intercompany rela­
tionships between parent and subsidiary therefore does not enter
into the case.
The auditor in this case seems to have made up his mind that
the materials in question will be repurchased in the ensuing period,
and in the circumstances it is incumbent upon him to insist upon
reference to such repurchase arrangement in his certificate.

Customer’s Accounts
(November, 1922)

QUESTION: What executive in an organization should, under

best and most modern recognized accounting principles, be respon­
sible for keeping the customer’s accounts and the reasons for such
opinions?
The particular question in mind is “Should customer’s accounts
be kept under the supervision of the treasurer where the treasurer
is not the accounting executive?”

ANSWER: We are of the opinion that the responsibility for

customer’s accounts should rest with the comptroller’s department
or some department exercising similar functions, if not so named.
We do not regard it as desirable that the treasurer should have
supervision of the customer’s accounts. The treasurer is essentially
a custodian, and handles cash and securities. It is not consistent to
combine the handling of cash with the keeping of customer’s ac-
12
 Questions and Answers
counts, and many irregularities have in the past occurred because
this combination has been permitted.

Cash Surrender Value of Life-Insurance Policies

(May, 1933)

QUESTION: I would like to know the prevailing practice with

reference to loans of corporations from life-insurance companies on
policies carried on the lives of officers. Should the full cash surrender
value be shown as an asset and the loan against the policy shown as
a liability, on the theory that a liability should never be deducted
from an asset? Or should the loan be deducted from the cash value
and the excess, if any, be extended as an asset?
I find that some clients want the cash surrender value put in cur­
rent assets because it is recognized as such by the federal reserve
bank, and it also improves their current position. In fact, in one
case, this asset of cash value of life-insurance determined whether
or not the paper of the concern was subject to re-discount. What is
the prevailing practice in placing this item on the balance-sheet?
ANSWER NO. 1: Certain details in the form of presentation in
financial statements are reflections of the views of credit grantors.
Some years ago it was more or less general practice to include the
cash surrender value of life-insurance policies among current assets.
This practice can, we believe, still be justified, though in recent
years some bankers have indicated that in their opinion the cash
surrender value of such life-insurance policies should not be in­
cluded in current assets, but should be stated in the balance-sheet
below the current asset section. We understand that the reason
these bankers give for their opinion is that usually the cash sur­
render value will not be received in cash within a year from the
balance-sheet date.
If you will refer to the January, 1932, number of The Journal
of Accountancy, you will find an article by Anson Herrick, entitled
“What should be included in current assets.” On page 59 Mr. Her­
rick submits a balance-sheet prepared in what he terms “the usual
procedure.” In this balance-sheet the cash surrender value of life-
insurance is included in current assets. On page 60 Mr. Herrick
13
 American Institute of Accountants
gives a balance-sheet prepared in accordance with his suggested pro­
cedure, and in this balance-sheet you will find the cash surrender
value of life-insurance included under investments.
Occasionally a balance-sheet will be found in which it may not
be desirable to include cash surrender value of life-insurance in
current assets for the reason that the proceeds when received must
be used for some purpose other than payment of liabilities or gen­
eral corporate purposes. For example, the corporation may have en­
tered into an agreement to purchase the stock of an officer whose
life is insured, or perhaps the stockholders may have entered into an
agreement by which the proceeds of a policy must be withdrawn
from the corporation to carry out a similar purchase agreement be­
tween the estate of a deceased stockholder and the surviving stock­
holders. Under such conditions the cash surrender value of the life-
insurance policy probably should be shown below current assets.
If there is a loan on a life-insurance policy, we consider it per­
missible either to show the cash surrender value as a current asset
and any loan against it as a current liability or to show the cash
surrender value below the current asset section with the loan as a
deduction. Usually the source of the loan does not determine whether
or not it should be included in current liabilities. However, since a
loan against the cash surrender value of a life-insurance policy need
not be repaid until realization of the cash surrender value or the
face amount of the policy, there seems to be no good reason for
requiring the loan to be included in current liabilities if the cash
surrender value of the policy is not included in current assets. On
the other hand, if there is a commitment to use the proceeds from
the life-insurance policy for some purpose other than payment of
current liabilities or general corporate purposes, any loan against
the cash surrender value of the policy may be a current liability
even though the cash surrender value is not included in current
assets. In these circumstances, upon the death of the insured, if the
company is to carry out fully its obligations under the contract, it
would be obliged immediately to obtain (by borrowing or other
means) an amount equal to the loan against the policy, since an
amount equal to the proceeds of the policy must be disbursed under
the corporation’s commitment.

ANSWER NO. 2: The best practice, we believe, is to show the

net value of insurance policies immediately following current assets.
14
 Questions and Answers
Such values, though not current in the sense that they are being
converted into cash in the normal course of business, still constitute
a quick asset almost as liquid as cash in most cases. It is our prac­
tice to show the full cash surrender value with deduction for any
loans thereon. We do not think it necessary to show the loan among
the liabilities for the reason that as a practical matter it never be­
comes a charge against any of the assets other than the surrender
value, and if the loan were included among the liabilities the ratio
of assets to liabilities would be deceiving.

Cash-Surrender Value of Life-Insurance on Balance-Sheet

(November, 1934)

QUESTION: A corporation carried an insurance policy on the

life of a former officer. This policy had been carried for a consider­
able time and had a substantial cash-surrender value. The corpora­
tion had borrowed money from the insurance company on this pol­
icy. The insured became permanently disabled and the corporation
called upon the insurance company to meet the terms of the con­
tract, the insurance company, naturally, doing its best to protect
its own interest and pay out no money for which it was not con­
tractually liable.
At the close of the corporation’s fiscal period, when the audit was
made, the controversy was in progress, and a short time later, in the
next fiscal period, the insurance company acknowledged liability
and made a cash payment and cancelled the outstanding notes on
the policy.
The accountant, in his report, listed the surrender value of the
policy as an asset and the notes outstanding against the policy.
What notation, if any, should be made on the corporation’s
balance-sheet or what comments should be made in the report con­
cerning the controversy between the corporation and the insurance
company and the subsequent settlement?
ANSWER: It is my understanding that the question which reads
in part—“What notation, if any, should be made on the corpora­
tion’s balance-sheet, etc. . . .”—is intended to refer to the balance-
sheet and to comments included in the auditor’s report.
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 American Institute of Accountants
There are several possible interpretations of the question. The
first paragraph states “The insured became permanently disabled,”
and it then refers to the “terms of the contract” without furnishing
complete information as to what the terms were.
If it be assumed that the corporation was asking for payment by
the insurance company of the excess of cash-surrender value over
loans made in accordance with amounts shown in the balance-sheet,
and if the settlement was made before the auditor’s report was
completed, then it would hardly seem necessary for the auditor to
make any special reference to the controversy in his report.
On the other hand, if the insurance policy carried a “disability”
clause or some other provision under which the corporation was
claiming an amount substantially different from any shown in the
balance-sheet or one which could be computed therefrom, then I
believe different procedure would be in order. In such circumstances
it would seem to me that if the auditor’s report was actually com­
pleted prior to the time of settlement of the controversy between
the corporation and the insurance company the auditor’s duty would
be reasonably fulfilled if, in his comments, he stated the amount
which the corporation was claiming from the insurance company,
gave a brief statement of his understanding of the controversy, and
indicated the effect which the corporation’s winning or losing the
controversy would have on the balance-sheet.
If, on the other hand, the controversy related to amounts differ­
ent from those on the balance-sheet and was settled before the com­
pletion of the auditor’s work, it would seem to me that it would be
advisable for the auditor to include in his comments a brief state­
ment as to the result of the settlement and to indicate the effect of
the settlement upon the balance-sheet. If the amount of the settle­
ment was sufficiently large to affect substantially the results shown
by the balance-sheet, then it might be well to state in a note on the
balance-sheet the date of settlement, the fact that settlement had
been made and to indicate the effect of the settlement on the
balance-sheet. I think that decision as to whether notation should
be made on the balance-sheet or only in the comments would have
to depend upon opinion and judgment in the light of all of the cir­
cumstances in the case.
The foregoing paragraphs are written on the assumption that the
delay in payment was due to a real controversy and not merely to
time consumed in furnishing required proof of a fact, such as dis-
16
 Questions and Answers
ability; also on the assumption that the amounts involved are large
enough to be of importance in the balance-sheet. If the amounts are
relatively unimportant, then it might be unnecessary for the auditor
to comment upon the matter at all or to make any notation regard­
ing it upon the balance-sheet.

Stock of Subsidiary on Balance-Sheet of Parent Company

(January, 1935)

QUESTION: Corporation “A”, no par value, capital $5,000,000

has a wholly owned subsidiary which we will call corporation “B”.
Corporation “B” holds stock and securities in other companies
domestic and foreign including the stock of corporation “A”.
Corporation “A” buys the stock of “B” and corporation “B”
buys the stock of corporation “A” therefore “A” through its owner­
ship of “B” is buying its own stock and it should be noted that
corporation “A” has no surplus but has liquid funds and compara­
tively small debts to general creditors.
The question is: Should we show on the balance-sheet of corpo­
ration “A” merely the cost of its stock in corporation “B” or should
we show on the face of “A” balance-sheet that it owns its own
stock? The only method that occurs at this writing is to earmark
the wholly owned subsidiary stock on the balance-sheet of the parent
company, “A”, by saying “B” corporation stock including so many
shares of corporation “A”. This would be an incomplete showing
objectionable to the management although it would give notice of
the number of shares held through the subsidiary.
One other question would be as to whether the wholly owned sub­
sidiary could be included in the item of stocks and bonds of other
companies or stated separately as being wholly owned.
The A corporation stock is not now listed on any exchange. The
management who hold the majority of the A corporation stock would
prefer to simply say stocks and bonds of other companies, although
their responsibility must be met not alone to stockholders but to
banks and other creditors including federal reserve banks.
ANSWER NO. 1: It is our opinion from the facts submitted that
a consolidated balance-sheet should be prepared of company A and
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 American Institute of Accountants
its wholly owned subsidiary company B, the latter company’s hold­
ings of the parent company’s stock thus being treated as treasury
stock and described as A’s stock held by subsidiary.
If, however, a consolidated balance-sheet be not prepared, even
though such a presentation seems proper, then we suggest that the
“legal” balance-sheet of company A be supplemented by a balance-
sheet of its subsidiary, the parent company’s investment in its sub­
sidiary being specifically so described, B’s investment in company A
being identified by description in like manner.
The alternative outlined is, we may say, permissive rather than
desirable.
Dealing with the further question, it would be improper to in­
clude the investment in the subsidiary in the item described as
“stocks and bonds of other companies.” Such investment should ap­
pear as a separate item properly described. Of course, this question
does not arise if the accounts are consolidated.

ANSWER NO. 2: We favor showing the situation as follows:

Investment in shares (cost) of wholly owned sub­

sidiary which in turn owns.... .. shares of blank
company .............................................................. $...............

Loss on Operation of Building

(December, 1930)

QUESTION: Is it proper in any circumstances to capitalize the

loss for the first year’s operation of a new office building? I do not
refer, of course, to carrying charges during construction but have in
mind the fact that it usually takes some time to get a new building
fully rented and the question is whether this loss could be properly
capitalized?

ANSWER NO. 1: I do not know of any circumstances in which

it would be advisable to capitalize the loss resulting from the first
year’s operations of a new office building.
It is, of course, often true that for the first year at least the
building is not fully occupied and, therefore, the loss in operation
results. This loss, however, might continue for the second, third and
18
 Questions and Answers
fourth years and, therefore, this contingency would seem to preclude
the arbitrary capitalization of losses at the end of the first, second,
third or fourth years. The results of operation should be measured
from the date the building was completed and ready for occupancy.

ANSWER NO. 2: In reply to the question “Is it proper in any

circumstances to capitalize the loss for the first year’s operations of
a new office building?” there necessarily must be a dividing line be­
tween preparing to operate and operating, and ordinarily the line
falls between the two distinct periods of construction and operating
for profit. When there is a no-man’s land between the two we have
to deal with an intermediate net expense which strictly speaking is
neither capital charge or operating item and this in-between period,
of course, is measured not by time but by results.
In the analogous situation of most new mills, starting-up expense
is common, and we believe the customary view is that such expense
is a proper charge against profits but not the whole amount against
the profit of any one year, the theory doubtless being that starting-
up expense benefits all years. Theoretically, exact treatment would
apportion such expense over the entire life of the project, but that
being unknown the usual practice is to care for it over the fewest
number of years which conveniently can absorb it.
Our suggestion in answer to the specific question, therefore, would
be to mark the first month in which current rental equals current
expense as the beginning of the true operating period and treat as a
deferred charge, to be written off proportionately over a reasonable
number of years, the net expense of the prior partial or partially
effective operation.

ANSWER NO. 3: This is one of the border-line questions. I al­

ways advocate the sound practice of capitalizing as little as possible.
Your question goes on to exclude specifically “carrying charges dur­
ing construction,” which are of course permissible and indeed proper.
It is difficult to say that in no conceivable circumstances would a
certain course be proper. For instance, I can imagine the erection
of a large office building or apartment house in a newly developed
section or in a part of the town or city not yet fully developed. In
this case the land would be relatively cheap, but the building would
be erected with the full knowledge that it was in anticipation of fu­
ture requirements. It might easily happen that the building was
only half rented for the first two or three years, but on the other
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 American Institute of Accountants
hand by the time it was fully rented, bringing in a good revenue,
the further developments of the district would have added consider­
ably to the land value.
In such a case as the foregoing, where it is beyond doubt that
real-estate values are going up and it was foreseen that there would
have to be losses for one or more years, I think it would be proper
to capitalize the proportion of interest and taxes applicable to the
unrented portion of the building, but a case like this would have to
be considered on its merits and no hard and fast rule could be laid
down. I do not think any portion of operating expenses should be
capitalized because they are for the benefit of the tenants and the
vacant space will not require any proportionate outlay for opera­
tion.
A question may be raised as to whether the items of interest and
taxes and of accrued operating expenses, or, as an alternative, the
net loss on operating could not be carried forward as a deferred
charge. In many cases this might be preferable to capitalizing the
amount, as deferred charges are always assumed to be written off
within three or five years at the most.

Capitalization of Repair Items

(April, 1935)

QUESTION: The client (a manufacturing company) carries ma­

chinery and equipment at original costs in excess of $750,000. It
has been customary in the past to charge to the repair account
items, say, of $50 or under, which are not considered wholly as
capital expenditures, with the exception, however, that such items
as painting, re-surfacing, etc., are charged to the repair account.
The board of directors of the concern felt that with increasing
investment in. new machinery, etc., the total amount of deprecia­
tion was so steadily increasing as to cause the company considerable
concern in the computation of costs of manufacturing of various
commodities. In due course, it was suggested that many of the items
charged against repairs were in fact wholly or partly of a capital
nature; and with this idea in mind it has been the custom for sev­
eral years to capitalize one-half of its repairs by monthly journal
20
 Questions and Answers
entries. This procedure had the approval of the directors of the
company, although the full original charges to repairs had been
deducted for income-tax purposes and allowed by the internal­
revenue bureau.
We do not know of any case where a similar procedure is prac­
tised, and for the preparation of certificates of audit I am writing
to ask you if in your opinion this practice is “in accordance with
accepted principles of accounting.”

ANSWER NO. 1: It seems to me that the whole question turns

upon the rates of depreciation which are in use and for what such
depreciation is to provide. The practice of charging small items of
what would otherwise be capital expenditure, say of $50 or less, to
an expense account is not an unusual one in large corporations and
can well be defended. It is a practicable and conservative practice.
The deliberate charging of 50 per cent. of the regular repair ac­
count to capital expenditure is, however, quite another proposition
and can not be defended in any circumstances, unless it is done
merely as a measure to equalize charges for repairs from year to
year. If this practice were followed there might be equal justifica­
tion for charging the whole repair account to capital. The justifica­
tion for such an action could, of course, only be found in establishing
such a rate of depreciation as would take care of normal repairs. If
the company has used rates of depreciation which will do this there
can be no great criticism.
Possibly a better plan, however, would be to charge off all repairs
in the year when they are made, with the exception, possibly, of
major repairs of material amount—such, for instance, as the re­
roofing of a whole building or the replacement of a costly fence
which in the course of years has become unserviceable. In these cir­
cumstances there would be justification for spreading such cost over
a limited period of from three to five years. I think this would be a
better plan than that apparently followed by your correspondent’s
client. The case in point could only be considered as “in accordance
with accepted principles of accounting” if the rates of depreciation
were undoubtedly sufficiently large to carry this added burden.

ANSWER NO. 2: The question here appears to be entirely one

of fact. If the items capitalized do not in the opinion of the ac­
countant extend the useful life of the equipment beyond that con­
templated by the rates being used for depreciation and obsolescence,
21
 American Institute of Accountants
such capitalization could not be said to be “in accordance with ac­
cepted principles of accounting.”
In other words, if the only reason for this procedure is to reduce
the apparent expense of doing business so that the apparent costs
of manufacturing various commodities will be less than they would
be if properly calculated, the procedure would not appear to be
correct.

Interest Payable During Construction

(June, 1932)

QUESTION: I am one of the receivers of the X Hotel Corpora­

tion. One of the auditors feels that certain of the items can not be
handled the way I would like to have them and we would both
greatly appreciate an expression on the matter.
The problem relates to how we should treat interest payable on
certain notes, the proceeds of which were used in the construction
of the X hotel. The corporation was organized April 9, 1930. It
thereupon assumed payment of certain notes, the proceeds of which
were used for the construction of the X hotel. It also assumed pay­
ment of interest on these notes from December 1,1929. For the pur­
pose of this letter, you may consider that the hotel was completed
October 1, 1930, and after that was in operation.
You will note therefore that there are three periods:
1. December 1, 1929, to April 9, 1930, period for which cor­
poration assumed payment of interest but in which the corpora­
tion itself was not in existence.
2. April 9, 1930, to October 1, 1930, period during which cor­
poration was in existence but had no income. Hotel was being
constructed during this period.
3. October 1, 1930, onward, period of operation of hotel.

Mr. Doe is of opinion that the interest applicable to the first

two periods, that is, the pre-corporation period and the construction
period up to October 1, 1930, should be charged to the cost of the
hotel building as a capital expenditure. He has shown me several
books on accountancy indicating that this may be done.
I believe that there is some discretion in a matter of this sort,
22
 Questions and Answers
and that it would be permissible and would also be considered good
accounting to handle the matter in the following way:
The interest for the pre-corporation period, that is, from Decem­
ber 1, 1929, to April 9, 1930, payment of which the corporation
assumed April 9, 1930, should be capitalized as of April 9, 1930, as
“pre-organization loan expense.” This should then be amortized
over the remaining life of the loan just like so much additional in­
terest.
The interest applicable to the period from April 9, 1930, to Octo­
ber 1, 1930, that is, the period after the corporation was organized
but during the construction of the building, should be considered
simply as interest and would be treated as a deduction from income,
thus resulting in a loss for the period. It would not be capitalized
at all.
I feel that my method is more conservative than Mr. Doe’s. I
think that it is just as logical to consider this interest as a cost of
getting the money as it is a part of the cost of the building. It seems
to me that it would be conservative and would be good accounting
to get all of this interest and finance charge out of the way during
the course of the loan, as I propose doing, and not to have it added
to the cost of the building where it would stay on the books long
after the loan had been paid off.
I also have in mind that by considering this interest as an income
item a better showing is made for income-tax purposes. The receiv­
ers of the corporation are, of course, obliged to prevent the imposi­
tion of any income taxes which may not properly be due.
I think this fully presents the question. What we would like to
know exactly is this:

1. According to good accounting principles, must we capitalize

and charge to the building interest paid after the organization of
the corporation but during the construction period on money
which was used for the construction of the building, or
2. Is it discretionary and also consistent with good account­
ing not to capitalize the interest paid after the organization of the
corporation during the construction period, but to consider it an
income item and a proper deduction for computing net income for
that period?
ANSWER NO. 1: It is generally recognized that interest accru­
ing during a period of construction is a proper charge to capital as-
23
 American Institute of Accountants
sets. As a matter of accounting theory, this treatment may be amply
supported by reference to any of the works of well-known authors
on accounting. Capitalization of interests during construction is
prescribed for railroads and other public utilities by the interstate
commerce commission and other regulatory bodies.
In the case of commercial concerns, while it is unquestionably
correct theoretically to capitalize interest charges during construc­
tion, there are doubtless instances in which, for good and sufficient
reasons, it is justifiable not to capitalize such interest charges. In
such instances the accounts should show clearly the procedure fol­
lowed. On the other hand, we do not see that there is a connection,
as your correspondent suggests, between the life of a loan and the
period during which interest accruing thereon prior to the commence­
ment of operations should be written off, either directly by charges
to profit and loss or indirectly through depreciation charges.
With regard to the statement that “by considering this interest
as an income item a better showing is made for income-tax pur­
poses,” we can not see how this could be the case if the effect of
charging off interest during a non-operating period would be to pro­
duce a loss to the extent of the interest charges. In reporting for
federal income-tax purposes, interest may, generally speaking, be
deducted in the period in which it has been paid or accrued in spite
of the fact that it may have been capitalized on the books; but
where this is done a corresponding amount must be deducted from
the relative assets in computing depreciation charges.

ANSWER NO. 2: Recognized principles of accounting procedure

require that interest paid during the course of construction of a
building, where the money is borrowed for the purpose of financing
such construction, should be capitalized and added to the cost of
the building. It is true that under such procedure the cost of the
building in the case given would be more than in another case where
the owner of the property could furnish more of the required capital
out of his own funds, but the difference in cost is an actual fact.
It is not considered good practice to show a loss during the period
of construction of the building merely by reason of the financing
operations of the corporation in construction. Such treatment is
generally not regarded as discretionary but as the only proper pro­
cedure in the circumstances.
The setting up of the interest for the pre-corporation period as
24
 Questions and Answers
“pre-organization loan expense,” presumably the equivalent of a dis­
count on the loan, to be amortized over the life of the loan, is not in
our opinion the proper procedure. Such interest should be treated
in exactly the same manner as the interest paid by the corporation
for the period from its organization to the completion of the con­
struction of the building. Interest for the period after the completion
of the building is, of course, charged to expense.
With respect to the tax status of the interest paid during the
course of construction, attention is directed to Art. 561, of Reg. 74
as amended August 6, 1931, by T. D. 4321: . . In computing the
amount of gain or loss, however, the cost or other basis of the prop­
erty shall be properly adjusted for any expenditure, receipt, loss,
or other item properly chargeable to capital account, including the
cost of improvements and betterments made to the property since
the basic date. Carrying charges, such as interest and taxes on un­
productive property, may not be treated as items properly chargeable
to capital account, except in the case of carrying charges paid or
incurred, as the case may be, prior to August 6, 1931, by a tax­
payer who did not elect to deduct carrying charges in computing net
income and did not use such charges in determining his liability for
filing returns of income ..In other words, prior to August 6, 1931,
without reference to proper accounting procedure, the income-tax
regulations permitted the treatment of carrying charges either as a
deduction from income or as an addition to the cost of the property
in respect of which the carrying charges were paid. Subsequent to
August 6, 1931, such carrying charges could not be capitalized but
were required to be treated as deductions on the taxpayer’s income-
tax return.

ANSWER NO. 3: The accounting rule is well established that

interest accruing on securities issued to provide funds for construc­
tion purposes should be capitalized as part of the property, for the
period from the date of issue of the securities to the date the con­
struction project goes into operation.

25
 American Institute of Accountants

Officers’ Salaries in Construction of New Plant

(June, 1936)

QUESTION: A parent company organizes a subsidiary corpora­

tion (wholly owned) to construct and operate a new plant. The offi­
cers of the parent company devote a considerable time to the new
enterprise and, therefore, feel that a part of their salaries and parent
company expenses is chargeable as capital cost of constructing the
new plant, placing such items in the same category as interest cost
of financing during construction. Is this a general and acceptable
procedure among companies constructing new plants?

ANSWER NO. 1: We have your request in which is propounded

the question of capitalizing part of the time of the principal execu­
tives of a company who are removed from supervision of the going
plants for a period in order to supervise new capital expenditure, in
this particular case related to the establishment of an entirely new
plant. While an argument may be adduced in favor of this practice,
our general feeling on the subject would be in the negative. We
believe that the normal salaries of all executives of a company which
must continue in any circumstances, whether these executives are
engaged in current operations or in new development, should be
looked upon as current necessary costs of the business and as such
charged at all times to current profit and loss.

ANSWER NO. 2: We know from actual experience that the gen­

eral and acceptable procedure among companies constructing new
plants is not to capitalize a portion of the salaries of officers engaged
partly in supervision of construction. Nevertheless, it appears to
us that if it is possible accurately to ascertain the proportionate
value of executives’ time spent in planning the work of financing and
construction of the new plant, it would be proper accounting to
capitalize that proportion of executive salaries, together with travel­
ing expenses incurred. It seems to us that the difficulty would be
to segregate correctly the executives’ time, because it is possible
that such time spent at the main office on the company’s affairs as
a whole had not been impaired; consequently there would be no
justification for relieving the current operations of an expense right­
fully chargeable to that period.

26
 Questions and Answers

Deferred Income of Finance Companies

(August, 1933)

QUESTION: We are interested in learning the method or methods

that have been found most satisfactory and practical in determining
the amount to be set up as deferred income of finance companies.
Often the amount reserved as deferred income includes several
classes of items, such as unearned interest on notes purchased, inter­
est on borrowed money, operating expenses and other items that
might be incurred during the collection of the note. In other cases the
unearned interest is carried in one reserve and the amount reserved
for expenses in another.
In your reply please give a complete explanation and also advise
if the varying maturities of notes have any effect upon the calcula­
tions.

ANSWER: We infer that your correspondent is not in sympathy

with the practice of some companies of taking into the current income
account the apparent profit which has been made at the time the
notes were purchased, disregarding any unearned interest, possible
collection expenses or losses. This method is so fundamentally un­
sound that it requires no further comment.
There does not seem to be any standard method in use by finance
companies for determining that portion of income which should be
deferred until some later accounting period. In all cases, the interest
charge or discount which, together with the service charge, is usually
deducted from the face value of the note or notes before the loan is
made, is a factor which is definitely ascertainable as to the period in
which it is earned. The service charge, on the other hand, is an item
which gives rise to many questions as to its proper treatment. It
may contain the interest expense for borrowed capital, certain oper­
ating expenses, an arbitrary charge for estimated future collection
expenses, the cost of acquiring the loan, or selling expense, a provi­
sion for probable bad debts, and other sundry items.
Several methods for segregating this differential (the difference
between the face amount of the note and the actual amount advanced
thereon) into current and deferred income are set forth below:
1. Interest or discount, being definite in amount, is allocated to
the period in which earned. No difficulty is encountered as to this
27
 American Institute of Accountants
item. The service charge, on the other hand, is spread pro-rata on a
flat percentage basis over the life of the note or notes on the theory
that the cost of collection and other operating expenses which may
be included are approximately the same for any note regardless of
maturity.
2. Interest is treated in the same manner as above but the service
charge is spread on the basis of the reducing balances of loans out­
standing on the theory that this charge is primarily to cover possible
losses which are likely to be suffered due to the nature of the
business.
It would seem that the choice between these methods depends upon
the nature of the items included in the service charge. When this is
determined, the desirability of either method should be fairly obvious.
3. The average maturity of all notes is first determined and the
net increase in the unearned finance charges account during the cur­
rent accounting period is then spread equally over as many periods
as there are to the average maturity date, beginning the distribution
with the current period. This will give the amount which is to be
taken into current income as earned finance charges. The method has
the virtue of being fairly simple in its workings.
4. Interest or discount is set up as deferred until earned. The
service charge, representing as its title implies, the fee for the accom­
modations and services rendered or to be rendered is segregated into
so-called reserves for future expenses or costs and current expenses
already incurred. For example, experience will furnish data on the
average percentage of loss per loan, collection expenses, etc. Reserves
are then set up for these items. Expenses in obtaining the account
are deducted from the service fee and the balance of such service
charge taken into current income. The method is as simple as any
and is sound from an accounting point of view.
Each of the above methods has its advantages and the choice of
any one will depend on the nature of the accounts which are main­
tained and the charges which are included in the service charge.

28
 Questions and Answers

Liability of a Subsidiary Corporation

(February, 1932)

QUESTION: An industrial corporation with a long and prosper­

ous history proposes to sell a substantial portion of its capital stock
to the public. The buildings in which it operates are owned by a sepa­
rate corporation, the capital stock of which is owned entirely by the
first-named corporation. For purposes of abbreviated identification,
we shall refer hereafter to (a) the industrial corporation and (b)
the realty corporation.
The realty corporation has leased its property for a long term of
years to the industrial corporation at a rental sufficient to care for
principal amortization and interest on a bonded debt of $500,000
which is a first lien against the realty. The property is appraised at
$2,000,000, hence the net equity of the realty corporation is $1,500,-
000. Aside from the property and the mortgage debt, the assets and
liabilities of the realty corporation are nominal and need not be con­
sidered for our purposes.
Bankers have undertaken to market the stock of the industrial cor­
poration and, incidentally, financial and operating statements are
required. The bankers wish the balance-sheet to show the assets and
liabilities of the industrial corporation only and are opposed to a con­
solidated financial statement. The bankers insist that the investment
of the industrial corporation in the realty corporation shall be shown
among the assets as “net worth of a wholly-owned realty corporation,
at appraised valuation, $1,500,000.” It is contended that the dis­
closure of the bonded debt of $500,000 will render more difficult the
sale of the stock of the industrial corporation.
To the contention that an important liability of the affiliated group
is hidden, the bankers reply, “We are selling the stock of the indus­
trial corporation and the public is interested primarily in its indi­
vidual financial status and earning power and, furthermore, the
liability is that of the realty corporation only and the industrial
corporation is not affected.”
May an accountant issue such a balance-sheet as the bankers de­
mand? If the answer is “No,” a statement which will effectively over­
throw the bankers’ position is desirable.
29
 American Institute of Accountants
ANSWER NO. 1: There can be no doubt that in the present in­
stance the funded-debt liability of the subsidiary is a matter of
greater importance to the stockholders of the parent company (by
reason of the fact that this funded debt is a lien against the premises
in which the parent company conducts its operations) than would be
the case if the subsidiary stood, so to say, in a definitely separated
position. Since this funded debt of the subsidiary is so closely related
to the business of the parent company, it seems to us that the bal­
ance-sheet to be presented should indicate the existence of this lia­
bility against the operated premises of the parent company.
The recently promulgated instructions of the New York stock ex­
change, regarding agreements to be made by companies listing their
securities, require extensive information with regard to any subsidi­
ary omitted from the consolidation. It is true that the information
required does not go so far as to involve a disclosure of a liability
of this nature; but we are of opinion that, as these requirements of
the New York stock exchange represent a distinct progress in the
matter of revelation to the public of pertinent information, further
progress in the future will embrace such matters as that mentioned
in your letter.
As we view the matter, the proposed balance-sheet caption cover­
ing the parent company’s investment in the subsidiary—“net worth
of a wholly-owned realty corporation, at appraised valuation, $1,500,-
000”—should at least be expanded to indicate, if not the amount,
certainly the existence of such funded debt; perhaps some such
parenthetical expression after “net worth,” as “property less mort­
gage indebtedness” might do. We presume that the bankers, in giving
information in the offering circular concerning the affairs of the com­
pany to be financed, will mention the ownership by the wholly-owned
subsidiary of the premises occupied by the parent company; such
mention, together with the above-suggested parenthetical remark,
would, it seems to us, be the least that should be brought out regard­
ing the matter.

ANSWER NO. 2: In the circumstances we do not think the ac­

countant need insist upon a consolidated financial statement, but we
do think that if the accounts of the realty corporation are not con­
solidated, the amount of its bonded indebtedness must be shown
clearly upon the face of the balance-sheet to be issued. The wording
suggested by the bankers, “net worth of a wholly-owned realty cor-
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 Questions and Answers
poration at appraised valuation—$1,500,000,” does not seem to us
satisfactory, since it merely hides the existence of a very substantial
liability behind the one word “net” and can not be considered a fair
disclosure. The argument put forward by the bankers, namely, that
the public is interested primarily in the individual financial status
and earning power of the company whose stock they are buying, is
the very reason, it seems to us, why the liability in question should
be disclosed. In circumstances such as these, the profits of the busi­
ness (for instance where the business in question is that of a depart­
ment store) may depend to a very great extent upon its location,
and the arrangements which the company has made to secure that
location have a direct bearing on the prosperity of the business and
hence on the value of the stock being sold. It is from the profits of
the business, as your correspondent’s letter indicates, that the inter­
est and amortization on the bonded debt will have to come, and this
fact we think is pertinent and should certainly be disclosed.
In one particular instance where a similar question arose in our
own practice, the facts were shown as follows:

Outside properties $3,000,000

Less—Real estate mortgages (obliga­
tions of subsidiary companies) 1,000,000

$2,000,000

Some such disclosure seems to us to be necessary in the present

case.

Exchange of Mortgage for H. O. L. C. Bonds

(August, 1935)

QUESTION: A fiduciary trust had a mortgage, past due, of $5,000

with accumulated interest of $600.
The trust received in exchange $5,150 face value of H. O. L. C.
bonds. The trust credited $5,000 to principal and $150 to interest.
The bonds were sold shortly afterwards for, approximately, 95.
The trust wishes to distribute $142.50 to the beneficiaries as inter-
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 American Institute of Accountants
est, this amount being the net proceeds of the $150 face value of
bonds considered by them as interest income.
It is my opinion that the entire net proceeds from the sale of
H. O. L. C. bonds, or $4,892.50, should be credited to principal,
because this amount is less than the cost of the original mortgage
of $5,000 for which the H. O. L. C. bonds were received.

ANSWER: It is our opinion that the trust may properly make the
proposed distribution as income.
No doubt the treatment affords room for debate, but from the
facts submitted it seems to us that a reasonable interpretation of the
transactions is that, the original mortgage of $5,000 having been
replaced by H. O. L. C. bonds, the loss on sale of such bonds is a
loss of capital. In other words, when $5,000 H. O. L. C. bonds were
received in exchange for a $5,000 mortgage there was a substitution
of security but no impairment of principal: the loss of capital re­
sulted from the subsequent sale of the bonds then forming the
principal.
On the other hand, the proceeds of $150 H. O. L. C. bonds re­
ceived in payment of interest continues to be income, the amount of
which does not fall to be applied against the loss of principal.
The contra view, disregarding a completed exchange of securities,
rests on the premise that any impairment of principal relates back
to the original security. That premise, it seems to us, is not sustained
by the facts submitted or by the attendant circumstances.

Premium Bonds
(April, 1930)

QUESTION: A corporation has sold through underwriters a mort­

gage bond issue of $500,000. The indenture provides for annual
retirement of $10,000 of bonds at $105 and creates a reserve annu­
ally to provide for the premium obligation.
The corporation has purchased in the open market $75,000 of its
bonds at $95. To do so it has been necessary to borrow an equal
amount at the bank and has pledged as security against the loan the
$75,000 of bonds in question. Barring unforeseen circumstances, the
corporation has decided not to resell the bonds purchased but they
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 Questions and Answers
must, of course, be kept alive inasmuch as they are “hocked” to
secure a loan.
Should the bonds so purchased be carried at cost or par?
In any event, isn’t there an immediate realization of a five point
profit on each bond and should it not be reflected in profits at the
time of purchase?
Inasmuch as the bank loan is a current liability, shouldn’t pledged
bonds be carried as a current asset?
Until the bonds are canceled there is the legal obligation to the
trustees that an adequate reserve be created annually to provide for
the premium factor at date of actual redemption. This is now being
done and it applies also to bonds purchased. So much of the reserve
applicable to the bonds purchased is, however, ineffective and con­
sequently sets up an over-stated liability.
What entry, if any, is required to equalize the bond premium lia­
bility that in effect is canceled when the bonds are purchased?
Bear in mind the legal necessity for carrying the reserve provisions
until it has been proved to the satisfaction of the trustees that the
bonds so purchased have actually been canceled.

ANSWER: If it were the intention of the corporation to resell

these bonds, and if their repurchase had been actuated by the ex­
pectation of the management that the market value of these bonds
would go up and allow the corporation to resell them at a profit,
then the corporation should be permitted to carry these bonds as a
current asset during the period that it is holding them for resale.
The foregoing statement assumes, of course, that there is an active
market for the bonds. If the bonds were purchased for resale they
should be carried on the balance-sheet at their cost price of $95.
In the situation in question, however, it is stated that the bonds
were not purchased for resale, but were purchased with a view to
their eventual retirement. In this event, as we see it, the situation
is altogether different. The corporation has incurred a current liabil­
ity of $71,250 (95% of $75,000) and has, in effect, retired a funded
obligation of $75,000. In stating these transactions on the balance-
sheet the total bonds actually outstanding should be shown and there
should be deducted therefrom at their principal amount the $75,000
of bonds repurchased for retirement.
In this event the five point discount received should be applied
first of all to wiping out the unamortized discount, if any, relating
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 American Institute of Accountants
to these $75,000 of bonds in question. If the unamortized discount
is in excess of the five point discount received, this difference should
be written off.

Serially-Maturing Funded Debt

(January, 1925)

QUESTION: Will you please advise us as to the general practice

in treating serially-maturing funded debt for balance-sheet purposes.
ANSWER: There is little uniformity of treatment in American
balance-sheets of funded debts represented by serial notes maturing
monthly or at other frequent intervals. Instead there seem to be three
methods as follows:
1. It is quite generally the practice with regard to public utilities
to consider all funded liabilities as being classifiable under the long­
time liabilities heading. This practice is followed even though some
of the notes may mature very soon after the date of the balance-sheet.
The reasoning back of this treatment is that such a debt is usually
refundable, that the debt did not create any of the current assets,
and that the working capital should not be reduced because of such
indebtedness. The disadvantage in such treatment lies in the fact
that it does not serve warning to the inspector of such a balance-
sheet that a liability in addition to those in the current liability group
must be met at an early date. Unless arrangements have been made
for the early renewal or refunding of such debt, the balance-sheet
does not properly display the immediate financial problems of the
business.
2. A method frequently followed is to split such a funded debt into
two amounts, bringing into the current liabilities group the total of
such notes maturing in the current financing period, allowing the
remainder of the group to appear among the long-term liabilities.
This treatment is not wholly satisfactory as it is more desirable for
a particular debt with its necessary comments to appear but once
on a balance-sheet. Further, the question immediately arises as to
how much of the debt should be put into the current group. In other
words, how long is the “current financing period.” There seems to be
a growing tendency to consider twelve months as a proper basis for
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 Questions and Answers
the majority of commercial concerns, though this is far from being a
generally accepted period.
3. While it is true that balance-sheets should follow certain defi­
nitely prescribed and generally accepted forms, this must not prevent
initiative in the treatment of special problems. While generally the
liabilities are grouped under two broad classes—namely current and
long-time—the problem of the serial funded debt above referred to
is probably best met by the creating of a third group to be placed
between the long-time and the current. This group may appear on
the balance-sheet as follows:

Serial equipment notes payable

(Maturing $20,000 on the first day of each month) $1,200,000

Such a treatment shows the current liabilities in total, uninfluenced

by these funded notes, and at the same time allows the observer
of the balance-sheet to exercise his own judgment as to the amount
of serial notes which he desires to consider as current for his own
interpretation. In such usage the heading for the long-time group of
liabilities would probably be other funded debt or other long-time
liabilities.

Unamortized Debt Discount, Expense and Premiums on

Bonds Refunded
(June, 1936)

QUESTION: In view of the changed economic conditions, is it

now regarded as good accounting practice to carry forward the un­
amortized debt discount and expense of and premiums paid on bonds
refunded and to spread these items over the life of a new refunding
bond issue, together with the discount and expense incident to the
new issue?
To be more specific, let us assume the following: A company issues
$10,000,000 of 3%, 25-year bonds, and the discount and expense
incident thereto amount to $300,000. The proceeds of this 3% issue
are applied to the redemption, at 104%, of a 6% $10,000,000 prior
20-year issue, which still has 10 years to run and on which the
unamortized debt discount and expense amounts to $200,000.
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 American Institute of Accountants
Should the $400,000 premium paid on the old bonds refunded,
with the $200,000 balance in the debt discount and expense account,
be written off at the time the old bonds are refunded or may the
sum of the two, viz., $600,000, be added to the $300,000 discount
and expense incident to the new issue and the total, viz., $900,000,
be amortized over a period of 25 years, the life of the new bond issue?
Also, if it is not considered proper to carry forward both the debt
discount and expense and the premium incident to the old issue,
would it be proper to write off the former and to carry forward the
latter on the theory that the premium was paid solely as an incident
of the new issue?
Also, if the bonds were those of a public-utility corporation, should
special consideration be given to that fact?

ANSWER NO. 1: I believe that the correct solution of the prob­

lem submitted is in no way affected by economic conditions. It is
ordinarily a matter of the proper periodical distribution of the cost
of borrowed money. I do not consider in the circumstances cited that
it would be proper to charge surplus with the amount of discount and
expense remaining unamortized at the date of refunding. To do this
would imply that the amount thus written off represented cost of money
for the past period whereas, in reality, it represents part of the cost
of money for the ten years following. The treatment which should
be accorded in respect, not only to the discount and expense remain­
ing but also to the premium paid on the retirement of the old issue,
would be to apportion these charges equitably over the period for
which the old bonds were still to run.
It is apparent that the new bonds were issued for two reasons:
first, to provide funds at a lower cost than was being borne while the
old bonds were outstanding and, second, to provide funds for a
longer period. The total expense of the new bond issue for discount
and expense should, therefore, be equally distributed over the entire
period of its life. The effect of this will be to charge the first ten
years with part of the cost of the old and part of the cost of the new
and to charge the remaining fifteen-year life with an equitable pro­
portion of the cost of the new issue.
It is evident that this is reasonable for, even with the total charge,
the cost of money will be less for the first ten years of the new issue
than would have been the case if the old bond issue had been al­
lowed to remain in force.
36
 Questions and Answers
The answer to this question is definitely “yes.” The accounts of a
public-utility corporation are very strictly regulated by the com­
mission under whose jurisdiction it operates, and definite considera­
tion must be given to the regulations which have been prescribed.

ANSWER NO. 2: In our opinion it is permissible to amortize as a

financial cost the old discount and expense plus the premium paid
on the old bonds refunded over the period covered by the new issue.
There is, however, an important income-tax situation in this prob­
lem, which should be considered in the interest of the client. If the
new bonds are merely a substitution and were not issued to the
public through the usual financial procedure, the deferred discount
and expense on the old bonds at the time of refunding will not be
allowed as a deduction for income-tax purposes after the refunding
date. The treasury department has been upheld in its contention
that where a new issue of bonds is used to retire an old issue by
substitution only, all deferred discount and expense of the old issue
must be regarded as a deduction for income-tax purposes in the
period prior to the date of refunding.

Accounting for the Exchange of Municipal Bonds

(November, 1934)

QUESTION: One of our clients operates a quasi-public trust in

which is held a considerable quantity of municipal bonds, most of
which were purchased several years ago. The bonds of some of these
municipal communities have a present market value considerably less
than cost and the directors of the company contemplate exchanging
some of these bonds for bonds of other municipal units which they
feel have a better chance to recover values than those of the com­
munities sold. On these exchanges the actual cash involved will be
comparatively small amounts necessary to make up the differences of
value in the exchange. Furthermore, no question of income-tax lia­
bility is involved because the corporation is exempt from income tax.
It is our opinion that in the case of such exchanges it is necessary,
from the point of view of proper accounting procedure, to have the
books reflect each of these transactions in detail rather than to have
the new securities show on the books value equal to the cost of the
37
 American Institute of Accountants
securities which were exchanged, subject to whatever cash adjust­
ment there may be. The directors of the company feel that the latter
procedure is permissible.
ANSWER NO. 1: We wish to advise you that we agree with the
person who made the inquiry that in the case of such exchanges it
is necessary to treat the respective phases of the exchange as closed
transactions, i.e., to treat the disposition of securities as a sale at
the then market value, and the acquisition of the new securities as
a purchase at the then market value. While in certain circumstances
the procedure in determining taxable gain or loss might permit of
the acquired securities taking the base of those exchanged, the ac­
counting treatment accorded the transactions on the books of the
company should, nevertheless, comply with the principle stated.
ANSWER NO. 2: We think it would not be good accounting
practice to record the new securities on the books at a value equal
to the securities which were exchanged, subject to whatever cash
adjustment there may be. It seems to us that a profit or loss should
be registered when securities such as those mentioned in your letter
are disposed of either by sale or by exchange, that profit or loss to
be measured by the fair value of the consideration to be received.
The fact that the disposition of these securities is effected by an
exchange does not, to our mind, alter the conclusion that there has
been a consummated transaction, resulting in a loss (in this case)
to the trust, and that the new securities should be recorded on the
books of the trust at their fair market value as of the date of the
exchange.

Bond Discount
(March, 1926)

QUESTION: A question has arisen regarding the definition or

meaning of good accounting practice in dealing with the term “bond
discount.” The question arises in connection with the computation
of invested capital under the federal revenue acts of 1917 and 1918.
The facts are as follows:

1. A corporation offers to exchange its interest bearing bonds

for the stock of another corporation.
38
 Questions and Answers
2. At various dates, which extended over a considerable period
of time, stockholders of the second corporation exchanged their
stock for interest-bearing bonds of the first corporation. The offer
of exchange dealt only in par values of the stocks and bonds.
3. On or about the dates these exchanges were made, the stock
of the second corporation was selling on the New York stock
exchange at prices below the face value of the bonds. As stated
above, the exchanges were made over a period of time. The prices
on the New York exchange varied from day to day.
4. The bonds were redeemed at par several years before 1917.
5. The second corporation was dissolved and its assets merged
with those of the first corporation before 1917.

The treasury department contends that the difference between the

market price of the stock of the second corporation and the face
value of the bonds of the first corporation should be set upon the
books as discount on bonds, and that such amount should be amor­
tized over the life of the bonds. The effect of this ruling is that actual
earnings are eliminated from invested capital.
The taxpayer contends that the bonds should be treated as the
equivalent of cash; that it obligated itself to pay the face value of
the bonds for the stock of the second corporation; that the treasury
department can not under the law or the regulations indirectly amor­
tize any part of the purchase price of the stock. Even though it
might be admitted that an unwise purchase had been made, the cost
of the stock was mostly transferred to goodwill when the second
corporation was dissolved so that an attempt is being made to write
down the book value of goodwill. As a matter of fact the goodwill
is worth several times the par of the bonds issued to acquire it.
Queries:
1. What is bond discount?
2. If the treasury department’s position is correct, under what
theory of accounting can it be justified?
3. As a matter of accounting procedure how could the accounts
be accurately written up, especially as stockholders made ex­
changes at various times over a period of two years when the
market price of the stock and bonds fluctuated from day to day?

Note. The only purpose of the query is to secure a trustworthy

definition of the term “bond discount.” The tax situation is ex-
39
 American Institute of Accountants
plained at length in order to show the position of the treasury de­
partment.

ANSWER NO. 1: Good accounting practice requires that bond

discount should be set up as an asset and amortized over the life of
the bonds.
There is a most logical reason for this, which I will endeavor to
elucidate as follows:
Bond discount is an expense incurred for the benefit of a corpora­
tion and per se for its stockholders. As bonds are issued with the
view of deferring the repayment of the capital so obtained to a
future date, and during their tenure the shares of stock may change
hands, and as the benefit to the corporation of issuing the bonds
extends over their life, it would not be correct treatment to charge
to the stockholders the total cost of issuance of the obligation at date
of issue because the then stockholders would bear a greater portion
of the cost than was actually theirs and future stockholders would
obtain an unjustifiable advantage.
From Montgomery’s Auditing Theory and Practice is quoted an
opinion by the Superior Court of Pennsylvania in the Ben Avon-Ohio
Valley Water Company case, in which the court held, among other
things, that:

“While corporations should not be permitted to capitalize their

lack of credit, still, where bonds are sold at a reasonable discount
and bear a fair rate of interest, such discount should be allowed.”

In the case cited, the government’s position, the difference between

the fair market value of the stock given in exchange for the bonds
and the par value of the bonds is held to be equivalent to bond
discount.
In all the revenue acts the commissioner is authorized to prescribe
a system of accounting that will correctly reflect income. True in­
come under good accounting practice would not be reflected by enter­
ing the exchange on the basis of par for par because the stock the
first corporation received in exchange for its bonds was not fairly
worth par, and to show the new stock as an investment at par in
the corporation’s books would inure to the benefit of the stockholders
at date of transaction and the possible detriment of the shareholders
of later years.
Good accounting practice provides that books be kept to show
40
 Questions and Answers
cost of assets and expenses. Good accounting practice, however,
permits deviations from this practice to account for fluctuations in
value over or under cost, as affected by appreciation and deprecia­
tion of fixed assets, and in fluctuations in value of stock in trade,
investments, etc.
The stock of the second corporation seemed to cost par value to
the first corporation, but the financial status of the first corporation
would not be accurately reflected by valuing this stock at date of its
acquisition at par value.
This loss in the transaction is exactly equivalent to a case where
a corporation sells its bonds for cash at less than par value. In the
latter case good accounting practice would require the setting up of
the difference between cash received and the par value of the bonds
as a deferred asset to be amortized over the life of the bonds.
The fact that the exchange was effected over a period of time at
different prices for the stock does not alter the situation for it fol­
lows that the obligation on the bonds did not take effect until they
had been sold.
Conclusion:
(1) Bond discount is the price or bonus paid for borrowed
money or value.
(2) The treasury’s position can be justified by the sections of
the several acts that require taxpayers to keep their books in such
a manner as will correctly reflect income in accordance with the
best accounting practice.
(3) As to accounting procedure in the instant case the accounts
could be accurately written up by making entries at dates the
actual exchanges were made of bonds for stock, somewhat as
follows:

Bond discount ------------

Stock of B Corporation at ------------
market value at date of ex­
change to bonded debt -----------

ANSWER NO. 2: An expression of opinion is desired as to what

is a proper definition of the term “bond discount”. The inquirer has
expressed the opinion that if stock of one corporation is acquired by
another corporation in exchange for the latter’s interest-bearing
bonds, the cost of the stock acquired should be entered on the books
41
 American Institute of Accountants
of the purchaser at the par value of the bonds and that no bond
discount exists in such a transaction.
The inquirer points out, on the other hand, that the treasury de­
partment holds that the bonds were issued for the market value of
the stock exchanged for them and, consequently, the difference be­
tween the market value of the stock on the date it was exchanged
and the par value of the bonds should be set up as bond discount
on the books of the purchaser and amortized over the life of the
bonds.
The term bond discount, in the ordinary case, represents the dif­
ference between the par value of issued bonds and the actual cash
proceeds received by the issuing corporation at the time the bonds
were issued. Bond discount represents the additional amount which
has to be paid at the time of maturity of bonds issued, over and
above the cash or its equivalent received at the time of issue.
The question, therefore, is whether the consideration received
upon the issue of the bonds is the market value of the stock ex­
changed therefor, or whether the stock should be considered as being
of a value equal to the par value of the bonds issued in exchange.
We think there can be no doubt that the corporation issuing the
bonds received property of a cash value equal to the market value
of the stock and, therefore, it would be proper accounting practice
to charge the difference between the market value of the stock
and the face value of the bonds to bond discount and prorate the
same over the life of the bonds.
The real question at issue, as no actual cash passed, is “what are
the respective market values of the bonds and stock?” We have
assumed that the bonds have no quoted market and that their value
would be at the time of issue the same as the stock acquired. If,
however, the bonds were actually sold at par or better immediately
after their issue, then, in our opinion, it would be proper to charge
the par value of the bonds as the cost of the stock and there will
be no “bond discount”. This would no doubt mean, however, that
the individuals exchanging the stock would have made a profit which
would be taxable in the year in which it was exchanged; the amount
of the profit being the difference between the face value of the bonds
and the original cost of the stock or March 1, 1913, value if acquired
prior to that date.
We see no insuperable difficulty because the bonds were issued
at different times over a period of years and that the stock had
42
 Questions and Answers
different values on different dates of acquisition. The facts as to each
transaction are determined at the time and the proper amount could
be charged to bond discount. There should be no difficulty in deter­
mining the annual write-off of bond discount over the life of the
bonds.

ANSWER NO. 3: We have given consideration to your inquiry

and submit the following opinion thereon:
1. Bond discount is the difference between the value received when
bonds are issued and the nominal amount that is to be paid to liqui­
date that liability. Wildman in his “Principles of Accounting” de­
scribes it as interest collected in advance for the difference between
the amount of the principal and its present worth. If the value re­
ceived is in a form other than cash there may be difficulty in
measuring the resultant bond discount. This seems to be the diffi­
culty that prompted the question that you have submitted to us.
2. Discount being interest, collected in advance as stated above,
it is an expense chargeable ultimately to surplus. It should be amor­
tized over the period between the date the liability is incurred and
the date when it is liquidated. In the interim, the unamortized por­
tion of the discount is a deferred charge. The treasury department
therefore rightly holds that bond interest as it is amortized is a
deductible expense which reduces invested capital.
3. The inquirer undoubtedly has a record of the dates at which
the bonds were issued to acquire the stock and the amounts re­
spectively issued and acquired. There should be no difficulty then in
ascertaining the market value of the stock acquired by referring to
the stock-exchange transactions nearest the dates of exchange. The
difference between the market value of the stock acquired and the
par value of the bonds issued therefore is the amount of discount.
The inquirer does not state how the transactions were recorded
in the books. We assume from the information given and from the
fact that the treasury department contends that the discount should
now be set up that both the stock acquired and the bonds issued were
set up at par. We can readily understand the difficulty which your
inquirer has in seeing the import of the treasury department’s con­
tention.
This difficulty may possibly be lessened by consideration of the
following illustration, for which purpose it is assumed that the stock
had a par value of $100, a market value of $75, that bonds of a
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 American Institute of Accountants
denomination of $100,000 were offered which the holders of the
stock declined to accept, and that the bonds were then sold through
a banking house which took them at 75. From the sale of $100,000
par value of the bonds the corporation received in cash $75,000. To
retire the bonds the corporation has covenanted to pay $100,000;
therefore, the bonds have been sold at a discount of $25,000, which
sum must ultimately be charged to surplus, thereby reducing the
corporation’s invested capital. With the $75,000 in cash received
from the sale of the bonds the corporation went into the market and
acquired $100,000 par value of the stock at its market value of $75.
The effect of these transactions upon the surplus and invested
capital of the corporation is exactly the same as it would be had
$100,000 of bonds been issued directly to the holders of the $100,000
par value of stock.
The inquirer is in error when he contends that the amount paid to
retire the bonds determines the value of the stock acquired. Such is
not the case as will be seen if it were considered that the corporation
had covenanted to retire the bonds at no. In such a case there would
be further deductible expense in the premium paid upon retirement
of the bonds, being the amount of cash paid over the nominal value
of the bonds.
The cash payments only liquidate the liability. The factor that
determines whether or not bond discount enters into the original
transaction and the amount of the discount is the value of the con­
sideration received upon the issue of the bonds. Therein appears to
be the inquirer’s only possible opportunity to avoid the effect of dis­
count upon its invested capital and that is to marshal an array of
facts which will show that the price at which the stock was traded
on the exchange did not represent the true market value. This will
be a difficult proceeding but not necessarily an impossible one. Fac­
tors other than the actual condition of the company often influence
the trading prices. If such factors existed they should be cited. For
example, the corporation may have had a good earning power but
for reasons satisfactory to itself reinvested its income rather than
distributed it in the form of dividends, which would have the effect
of lowering the trading price. Another factor which might be cited
is the actual value of the assets back of the stock which again is not
necessarily a determining factor in fixing the trading price.
The difficulty in dealing with the treasury department on this mat­
ter will be that the trading exchange value is generally recognized as
44
 Questions and Answers
a fair and reasonable one and that the burden of proof is upon one
who would assert another value.
The transfer of the cost of the stock to the goodwill account does
not necessarily render the latter proof against assault by the income
tax unit; on the contrary it may support the treasury department’s
contention that upon the dissolution of the second corporation there
remained no asset of a reasonable value that could be set up on the
books in place of the value previously carried for the stock. In other
words the books of account appear to support the treasury depart­
ment’s contention that the stock when acquired was not worth its
par value and that consequently the bonds were issued at a discount
and the invested capital has been reduced by the amortized amount
of such discount.

ANSWER NO. 4: Your definite query as to a trustworthy defi­

nition of the term bond discount can only be answered, it seems to
me, by stating that bond discount represents the difference between
the amount realized from the sale of bonds and the face amount of
such bonds when they are sold for less than the face amount.
I appreciate the fact that the practical meaning of bond discount
as applied to the problem in question is now a matter between the
treasury department and your inquirer. No outside opinion is of any
value. However, I can not forego saying that I believe the treasury
department to be in error in its position for the reason that the
quoted market price of any stock does not necessarily represent its
real value to a buyer for control. In the case cited it is quite within
reason to assume the stock acquired in exchange for bonds was actu­
ally worth the face amount of the bonds. If this were true then the
fact that bonds were given in exchange for stock would not make the
fact measurably different than if cash had been paid therefor.
In order to accept the treasury’s position as correct it must be as­
sumed, first, that the company’s credit conditions were such that its
bonds could not have been sold at par for cash and stock acquired in
exchange for the bonds was not worth the face amount of the bonds
issued in payment for same.
Your query as to accounting procedure may be answered by say­
ing that I believe if a bond discount is recognized as proper that no
attention should be given to the fluctuations in the market price of
the stock during the period in which the exchanges were made. It
45
 American Institute of Accountants
seems to me that the basis taken should be the market value at the
date when the offer to holders of the stock was made.
ANSWER NO. 5: We submit the following:
1. Bond discount, as the term is generally understood in account­
ing practice, represents the excess of the face value of the bonds over
the cash, or cash equivalent, received by the issuing corporation at
the time of their original issuance.
Ordinarily bond discount should be amortized over the life of the
bonds, but if any of the bonds are retired before maturity, the un­
amortized portion of such bond discount as is applicable to the
bonds so retired should be charged off to profit and loss during the
year of their retirement.
2. Referring to the case cited, it appears that the issuing (first)
corporation acquired stock of another (second) corporation in pay­
ment for its bonds, and that the cash value of said stock, based on
representative sales of such stock on the stock exchange, was less
than the par value of the bonds. If this be an established fact it
seems to us that the difference between the cash value of the stock
and the face value of the bonds represents bond discount. However,
if any of the bonds were sold for cash about the time of these trans­
actions at a higher value, such transactions may be considered as
better evidence of their true cash value at the date of issue than the
cash value of the stock, on the assumption that the issuing corpora­
tion could have obtained cash for its bonds in this amount had it
not exchanged such bonds for the stock of the second corporation.
3. As to the accounting procedure required to accurately record
the numerous transactions which occurred at various times, we think
that the discount involved in each transaction should be separately
determined. Of course, if the cash value of the stock remained con­
stant for a period of time, the discount in all transactions within
that period could be determined in one computation. In our prac­
tice we have had several engagements in which a series of such
transactions was involved, and in each case we found it necessary to
actually determine the premium or discount in each day’s transac­
tions.

46
 Questions and Answers

Classification of Funded Debt

(February, 1936)

The following letter did not pass through the bureau of informa­
tion of the American Institute of Accountants but was written by
the chairman of the special committee on accounting procedure in
response to an inquiry. Its general interest merits publication, but
it must not be regarded as an official expression of the Institute:

Answering your request for an authoritative opinion on the pro­

cedure considered preferable for disclosing and classifying funded
debt falling due within one year from the date of the balance-sheet,
it appears that most accountants do not take serious objection to
either of the methods outlined by you, namely: (1) classifying all
instalments on bonds due within one year as current liabilities or
(2) showing the total funded debt as a deferred obligation with
proper notations describing the sinking fund or serial maturities to
be met in the coming year. However, certain accountants have ex­
pressed a preference for one or the other of these two methods, and
an attempt will be made to summarize the reasons which they have
advanced in support of their views.
At the outset, it should be pointed out that the regulations of the
securities and exchange commission require instalments of funded
debt due within one year to be classified as current liabilities but do
not require sinking-fund payments to be so classified. This classifi­
cation is followed by a number of companies and is advocated in the
pamphlet “Reports to Stockholders.” It must, therefore, be recog­
nized that this procedure is considered acceptable accounting prac­
tice.
The arguments of those who support this view may be summa­
rized as follows:
Serial maturities of funded debt maturing within one year should
be classified as current liabilities, unless there is definite knowledge
that they are not to be paid—which is seldom the case. As to entire
issues maturing during the year, the treatment depends upon whether
or not the bonds are expected to be paid or may be refunded in
some manner. They should be treated as current liabilities unless
there is reason to believe that they will not be paid, and in that case,
it is desirable to state in the balance-sheet that the total of current
47
 American Institute of Accountants
liabilities is exclusive of funded debt maturing within a year. The
question of real-estate mortgages—which are practically in the same
category as funded debt—is sometimes a troublesome one. Fre­
quently, we have real-estate mortgages which are even past due but
are not expected to be paid in the near future. Superficially, these
are demand obligations, but practically, in many cases, it is unfair
to the client to treat them as current liabilities. In such cases, at
least the amounts and dates of current maturities should be dis­
closed, and in many, if not all, of such cases the total current liabili­
ties should be qualified as excluding past-due mortgages or those
maturing within a year.
Manifestly, if any bonds which mature within a year are held in
the treasury, they should be deducted from those which are to be
shown as current liabilities. Also, if there are deposits with trustees
which can be definitely identified with bonds maturing within a year,
and such bonds are classified as current liabilities, the deposits should
be classified as current assets.
The following is a summary of the views of those who advocate
showing the total funded debt as a deferred obligation with suitable
notations as to maturities.
A balance-sheet would appear to be more informative when the
total of one kind of liability, such as a class of bonds, is included as
one amount with suitable notations as to maturities. It does not
seem desirable to follow literally the rule that all amounts due
within one year should be included in current liabilities. The current
liabilities can not be considered to represent the cash outlay which
will have to be made in the next year and the changes in almost all
of the balance-sheet accounts will be affected by the payment of the
liabilities and by other transactions of the year. The funds to pay an
instalment of a debt when it becomes due may be the result of profits
earned subsequent to the date of the balance-sheet. An interpreta­
tion of a balance-sheet depends upon comparisons and analyses,
only one of which is the ascertainment of the ratio of current assets
to current liabilities; and due consideration must be given to other
factors.
There seems to be general agreement that no different treatment
of funded debt instalments due within a year should be adopted as
between companies earning a profit and those which are not.

48
 Questions and Answers

Discount and Premium on Corporation Bonds

(March, 1931)

QUESTION: In a recent audit, the enclosed problem presented

itself. Having followed numerous opinions expressed by you through
The Journal, we would be interested in knowing just how you
would have handled the situations surrounding the purchase of the
bonds.
Company A has outstanding 5% bonds of $200,000. These are
30-year bonds maturing in 1937 and are not callable. Records un­
available and current balance-sheet shows no unamortized debt dis­
count and expense.
Company B has outstanding 5% bonds of $700,000. These are 40-
year bonds maturing in 1950 and are not callable. Original discount
and expense $100,000.
A and B merge. Consolidated corporation is known as company
B. Company B assumes all liabilities of company A.
Company B executes a first and refunding mortgage and issues
bonds maturing in 1957 for the purpose of “(a) paying or
refunding or to be exchanged for bonds heretofore issued by com­
pany A and by company B and/or for bonds of any other series
that shall have been issued in pursuance of this indenture; (b) to
provide capital for enlarging, etc.; (c) to pay obligations heretofore
contracted, etc.; (d) to acquire and/or develop additional plant
capacity.”
At the time of the issuance of the first and refunding bonds, the
unamortized balance of discount and expense on the old bonds was
$75,000.
Of the new bonds $800,000 were sold for cash at 98, $650,000
were exchanged for old bonds of company B and $195,000 were ex­
changed for old bonds of company A, leaving $50,000 of old com­
pany B bonds and $5,000 of company A outstanding.
Provisions of the new mortgage are that all reacquired bonds of
previous issues are to be held as collateral on the new mortgage.
In acquiring some of the old bonds a premium was paid, in no
specific amount, but just the amount necessary to effect the acqui­
sition. This premium amounted to $12,000.
In setting up the modified balance-sheet what disposition should
be made of:
49
 American Institute of Accountants
(a) The unamortized balance of discount and expense on bonds
which have been reacquired.
(b) The premium paid at acquisition of $12,000.
The fourth paragraph of your letter states that:
“A and B merge. Consolidated corporation is known as com­
pany B. Company B assumes all liabilities of company A.”

If A and B merged, there was no consolidation and no new com­

pany was formed. We assume, therefore, that instead of the word
“consolidated” it was intended to use the word “merged” in the
second sentence of the foregoing paragraph.
After all of the new 5^4% bonds have been issued, company B
will have on its books a balance of $75,000 of unamortized dis­
count and expenses applicable to the $700,000 of old 5% bonds.
Since only $50,000, or 1/14 of the old bonds remain outstanding,
only 1/14 of the foregoing sum, or approximately $5,357, should be
carried as an asset on the balance-sheet. The remainder should be
charged off against surplus. The premium of $12,000 paid on acqui­
sition of the old bonds should likewise be charged to surplus. How­
ever, there is some justification for the view that the balance of the
old discount-and-expense account—$69,643—as well as the $12,000
premium should be amortized over the life of the new bonds issued
in exchange. The first treatment is more conservative and, on that
account, preferable.
The problem does not state specifically whether the new bonds
were exchanged for the old on a par-for-par basis but, since $800,-
000 of the new bonds were sold for cash at 98, it has been assumed
that the exchange was on a par basis, and that the difference be­
tween 98 and 100 represented financing expenses.
ANSWER: It is our opinion that the unamortized balance of dis­
count and expense on bonds which have been reacquired should be
deferred on the “modified” balance-sheet and written off over the
remaining life of these bonds. We are also of the opinion that the
premium paid in acquiring some of the old bonds should be deferred
and written off over the life of the new issue, this premium repre­
senting a part of the cost of issuing the new bonds.

50
 Questions and Answers

Treatment of Treasury Stock on Balance-Sheet

(September, 1931)

QUESTION: May I obtain, if possible, an idea as to the position

that accountants generally are taking as to the treatment of treas­
ury stock in the preparation of balance-sheets at this particular time.
Proposition:
X Company purchased approximately 36,000 shares of its own
no-par common capital stock of a total of 400,000 shares outstand­
ing, which is listed on the New York stock exchange, during the
period from about October 15 to December 15, 1930. This stock has
a book value of $37 a share and was purchased at an average cost of
$36 a share. The market value of the shares was $19.50 at Decem­
ber 31, 1930, the date of the balance-sheet to be certified. The to­
tal cost of the shares purchased amounted to approximately $1,295,­
000. The total assets of the corporation amounted to approximately
$23,500,000. The corporation has several subsidiaries and the total
assets above stated are the consolidated assets. The consolidated
surplus at December 31, 1930, was approximately $1,500,000, of
which approximately $200,000 was represented by parent company
surplus, the balance by surpluses of subsidiaries. The parent corpo­
ration is incorporated under the laws of Delaware. The corporation
intends to resell the reacquired stock when market conditions war­
rant.
At what value should the treasury stock be listed in the balance-
sheet at December 31, 1930; or how should this item be treated?

ANSWER NO. 1: This question indicates the fallacy of showing

treasury stock among the assets of a corporation. The inclusion of
this asset in this position at once raises the question as to what
value is to be placed upon it, and with depressed security values in­
dicated by the proposition, a factor is brought into the balance-
sheet of the corporation which certainly has no place there.
The market value of the shares of stock of corporation X should
certainly have no bearing on the presentation of the balance-sheet of
that company whether treasury stock is owned or not.
If the treasury stock is to be deducted from the stock issued at
par and the net amount of stock outstanding shown, no question is
raised as to what value the treasury stock should be given. In the
51
 American Institute of Accountants
instant case, there will be an adjustment of surplus measured by the
difference between the cost of the treasury stock and its par value.
ANSWER NO. 2: We note that the amount of stock involved is
substantial and that the stock is one listed on the New York stock
exchange. Your correspondent would therefore doubtless be inter­
ested in the following extract from a letter addressed by the stock
exchange to a corporation, which recently came to our notice:
“During the last fifteen months, problems arising out of reacqui­
sition of their own securities by listed corporations have forced upon
the attention of this committee the necessity for the observance of
sound accounting practices in connection therewith.
“Approved practice in this respect is set forth in paragraph 48 of
pamphlet entitled, ‘Verification of Financial Statements’ (Revised),
a method of procedure submitted by the Federal Reserve Board for
the consideration of bankers, accountants and others. This reads:
“ ‘When corporations have temporarily invested funds in the pur­
chase of their own stocks and bonds, these securities technically
should be deducted from the corporation’s outstanding securities.
Custom, however, has sanctioned the inclusion of such temporary
holdings as investments, but where they are so held, the fact should
be clearly indicated on the balance-sheet. Investments of this kind
are not usually regarded as current assets.’
“This committee feels that where a corporation has so reacquired
any of its securities and desires to set them up on the asset side of
its balance-sheet that the number of shares of each class of stock
acquired and the par value of bonds acquired should be shown sep­
arately upon the balance-sheet and not as a part of current and
working assets. The cost of such reacquired securities should also be
shown, but may be shown in the aggregate if more than one class of
securities has been reacquired.”
Supplementing the above, it seems clear that if the stock is to be
regarded as an asset, it can only be regarded as an asset to the ex­
tent of its market value. We think that the practice of carrying such
stock as an asset is fundamentally unsound and that all accountants
should insist on full disclosure if it is followed. This seems to us the
more necessary because the purchase on the exchanges of a corpo­
ration’s own stock, with a view to resale at a profit, is itself a trans­
action of very questionable soundness.

52
 Questions and Answers

Balance-Sheets
(July, 1922)

QUESTION: The company under consideration was organized in

1919 under the laws of the state of New York and was authorized
to issue common stock of no par value to the aggregate of $500,000
at a minimum value per share of $5, which was the then existing
law in this state in regard to capital stock of no par value. The first
shares issued were to the president and a director of the corporation
for goodwill and services for part of the first year. These shares
were placed on the books at the minimum value of $5 per share. All
other shares since that time have been issued for cash or property at
the rate of $100 per share. The amount of stock issued to the presi­
dent, which was given a value of $5 per share, enabled him to have
the controlling interest in the outstanding capital stock. In the prep­
aration of the balance-sheet we shall of course show the number of
shares of stock outstanding and the aggregate value of the total
shares. It will be obvious then that the value per share will be much
less than $100 on account of the original issue to the president and
a director on the basis of $5 per share. Our question is as to whether
or not a specific footnote to the balance-sheet calling attention to the
manner in which the stock was issued is necessary and also as to
whether a succinct statement of the facts should be made as a defi­
nite part of the comments of the report.
We feel a duty towards stockholders and the public in preparing
this report and we wish to be very technically correct in our pres­
entation of the facts. Any opinion that you may care to procure for
us in regard to the matter will be very greatly appreciated.

ANSWER: We are of the opinion the case submitted warrants a

specific reference in the balance-sheet or as a footnote thereon as to
the basis on which the two lots of the common capital stock of no
par value have been issued. It might be contended that the stock­
holders who contributed property and cash on the basis of $100 per
share should have had knowledge of the number of shares outstand­
ing and the balance-sheet valuation of these shares immediately
prior to their transactions, thereby recognizing that, as a result of
their transactions, the value per share would really be less than
$100. In the average body of shareholders, there would undoubtedly
53
 American Institute of Accountants
be a number who would not be sufficiently alert as to observe the
effect of the transactions so far as the resulting value per share is
concerned. On that account, it would seem to be well to clearly state
the position. But what makes it more necessary is the wide variation
in value per share between those originally issued for goodwill and
services and those subsequently issued for property and cash, the
fact that the shares issued at $5 per share were acquired by the
president and a director and that the shares thus issued to the presi­
dent gave him a controlling interest. While the statement in the
balance-sheet would be sufficient, if it goes so far as to indicate the
number of shares issued at $5 and the number at $100, with the
values set against each, the reference necessary in the report should
be made more extended.

Valuation of Treasury Stock

(April, 1933)

QUESTION: Information is requested regarding the valuation of

treasury stock after declaration of preferred-stock dividend.
In 1931 company “A” purchased 47 shares of its own common
stock (at $180) for $8,460. In 1932 a preferred-stock dividend was
declared, 20 shares par $100 being allotted to the treasury stock.
The preferred stock was sold out of the treasury at $100 the same
day it was issued, and it is desired to place a value on the 47 shares
common remaining in the treasury.
It is claimed by company “A” that no profit or loss arises out of
the transaction, and that the stock remaining in the treasury is
merely reduced in value by $2,000.

ANSWER: In our opinion, the contention of the company, that

no profit or loss arose out of the transaction, is correct. The effect of
what happened, as far as the company is concerned, is that it sold
20 shares of preferred stock at its par value, $2,000. The stock will,
of course, be set up as a liability at $2,000, and that amount of cash
was received. We do not, however, agree that “the stock remaining
in the treasury is (merely) reduced in value by $2,000.” As a mat­
ter of fact, the value of the common stock is not changed at all be­
cause, although the common stockholders became subject to a prior
54
 Questions and Answers
lien on the assets in the form of preferred stock, they received the
par value thereof in cash.
The foregoing, we believe, covers the question of the effect upon
the value of the treasury stock of the declaration of the stock divi­
dend. It may be questionable, however, as to whether it is proper to
carry the treasury stock at its cost of $180 a share. This would de­
pend to some extent upon whether the stock is to be resold or not,
and if so, at what price. Unless there is a fairly definite intention to
resell it, and at a price not less than its cost, it should not be car­
ried at the amount in excess of its par or stated value—possibly not
in excess of its current market value.

Disclosure on Balance-Sheet of Commission

for Sale of Stock
(September, 1933)

QUESTION: A corporation issued 50,000 shares of non-par value

stock, authorized by the directors to be sold at $5.00 per share, less
a commission of 10 per cent. for selling, or a net sale price per share
of $4.50. The gross sale price of all of the shares was $250,000, and
the total commission $25,000, net proceeds being $225,000.
In preparing a balance-sheet for the company the accountant was
requested to include therein the capital stock of the company as
follows:
Capital stock:
No par value, authorized and issued, 50,000 shares $225,000

without making any disclosure on the balance-sheet (certified) or in

a report to the stockholders regarding the amount of the selling
commission.
Is it proper for him to comply with this request?
ANSWER NO. 1: We wish to say that it appears to have been
the intent of the directors of the corporation to sell the 50,000 shares
of no-par-value stock for $225,000. That amount is in fact the capi­
tal with which the corporation starts business. The very purpose of
no-par-value stock is to afford a disclosure of the actual amount of
capital paid in for such stock, and certainly no one can question the
55
 American Institute of Accountants
fact that the corporation in this case started business with a capital
of $225,000 and not $250,000.
Some might argue that the gross amount of $250,000 should ap­
pear as the value of the capital stock and that the commission
should be shown per contra as organization expense, to be subse­
quently amortized. This would unquestionably have to be done in
the case of a par-value stock. Ordinarily, however, in the case of no­
par-value stock the board of directors have the right to sell it for a
reasonable value which the board of directors may determine.

ANSWER NO. 2: If commission is legally payable under the

state laws, we are inclined to think that it would be proper to state
the figures net.
From an accounting standpoint, however, we think it would be
preferable to add the words “net cash proceeds” or other indication
that some deduction had been made. It might be a good thing to
point out that the stockholders must have been aware that they had
paid $5.00 per share for the stock and it would prevent inquiries as
to why some people had apparently received it for less.
If there are no requirements under state law to state the amount
of commission allowed on the sale of shares, we would not be pre­
pared to go so far as to say it was improper to certify the balance-
sheet as required, but consider the other course better.

Capital Stock Without Par Value

(December, 1926)

QUESTION: A reorganization of X Corporation provides for the

issue of the following classes of stock:

1,000 shares preferred stock, par value $50.

1,000 shares Class A common stock, par value $100.
1,000 shares Class B common stock without par value.
1,500 shares Class C common stock, par value $1.

The preferred stock is entitled to annual cumulative dividends at

6% and has preference over the common stock both as to dividends
and assets.
56
 Questions and Answers
The three classes of common stock are on a parity and equal in all
respects.
The stock is issued in lieu of 1,000 shares of common stock of the
old corporation, as follows:
One share of preferred stock and one share each of Class A and
B common stock for every share of old stock outstanding.
Stockholders have the right to purchase at par one share of Class
C common stock for every share of the old stock, the remaining 500
shares are to be sold as the board of directors may decide but not
for less than $1 per share.
1, 200 shares of the Class C common stock have been sold for
$5,200, 1,000 shares to the old stockholders and 200 shares to
others.

At date of reorganization the net assets of the corpo­

ration were $110,000
Add Proceeds from sale of Class C common stock 5,200

Total $115,200

How should the capital stock and surplus be shown on the bal­
ance-sheet?

ANSWER: We note that it is stated that “the three classes of

common stock are on a parity and equal in all respects,” whereas
the figures give the parity for A stock as $100, for B stock as inde­
terminate and for C stock as $1.
Accepting the figures, and not the written statement referred to,
the balance-sheet should show:

Capital stock:

1,000 shares pfd., par $50 $ 50,000

1,000 “ com., Class A—par $100 100,000
1,200 “ “ “ C—par $1 1,200
1,000 “ “ “ B—without par value

$151,200

57
 American Institute of Accountants
and per contra:
Assets—Acquired for stock (net) $110,000
Proceeds sale capital stock 5,200

$115,200
Goodwill 36,000

$151,200

The par value stock must be set up as a liability at its par value.
On sale of the remaining 300 shares of the Class C common stock
any proceeds in excess of $1 per share should be credited against
goodwill.

Non-Par Value Shares

(September, 1921)

QUESTION: I would appreciate it very much if you would ad­

vise me what experience members of the Institute have had in re­
gard to the proper handling of non-par value shares for a corpora­
tion.
We have a client who has had one thousand (1,000) shares of
stock, par value $100 outstanding, and a surplus of approximately
$150,000. The company is reorganizing, changing to non-par value
stock. Should the surplus of $150,000 be closed into the capital
account?
We are of the opinion that it should be unless the client has a rea­
son to the contrary. We are also of the opinion that the profits for
subsequent years should be carried into a surplus account so as to be
a guide to the management and in this way avoid impairing the
original capital stock by declaring dividends in excess of accumu­
lated earnings since the reorganization. If the client desires to de­
clare a dividend at the time of reorganization, this amount should
be held in the surplus account and not closed into the capital ac­
count.

ANSWER: It is optional whether or not the surplus in question

be transferred to the capital account.
There is no particular advantage in so doing.
58
 Questions and Answers
On the contrary there is the possible disadvantage that if profits
after the change in form of stock are not sufficient for dividend re­
quirements and the previous surplus has been transferred to capital
and such amount stated in the certificate as the capital with which
the corporation will carry on business, the corporation presumably
may not then use any of such former surplus without violating sec­
tion 20, paragraph 2, of the New York stock corporation law, as
follows:

“No such corporation shall declare any dividend which shall

reduce the amount of its capital below the amount stated in the
certificate as the amount of capital with which the corporation
shall carry on business.”

If the corporation desires to declare a dividend at time of reor­

ganization or has reason to believe the surplus at time of reorgani­
zation will be required for future dividends, the amount of the sur­
plus should be allowed to remain in the surplus account.
Profits subsequent to reorganization should be closed into a sur­
plus account against which dividends should be charged.

Dividends
(September, 1932)

QUESTION: A corporation expected to go into a proposed con­

solidation about ten years ago. The deal did not go through. This
corporation had had an appraisal made which showed the value of
the building and machinery as being $200,000 in excess of the book
figures. This appreciation was placed upon the books at that time.
This amount cannot be included in computing invested capital un­
der the federal income-tax laws.
Owing to the heavy slump in prices at this time, it appears that
the surplus account may be cut down below the amount of appre­
ciation, viz., $200,000.
Now then; what New York state laws govern whether dividends
may, or may not, be paid out of this unearned profit in the surplus
account?
Since that time a stock dividend has been declared which divi­
59
 American Institute of Accountants
dend was over the amount of the $200,000. How would that affect
the situation?
ANSWER: In reply to your letter, in which you recite a question
as to the legitimacy of drawing upon surplus created through record­
ing the appreciation in value of buildings and machinery to the
extent of $200,000. In our opinion—which may not, however, be
the opinion of lawyers—the distribution of such a surplus fund, the
earnings of the business having previously been distributed, would
constitute an impairment of capital such as is in violation of the gen­
erally accepted fundamental principle that dividends may not be paid
except out of earned profits, and in violation particularly of section
28 of the stock corporation law of New York State, the first sen­
tence of which reads as follows:
“The directors of a stock corporation shall not make dividends,
except from the surplus arising from the business of such corpora­
tion, nor divide, withdraw or in any way pay to the stockholders
or any of them, any part of the capital of such corporation, or
reduce its capital stock, except as authorized by law.”

In the case you cite, however, a stock dividend has been declared
in excess of the amount of the $200,000 appreciation and it is only
logical to assume that the stock dividend was first intended to capi­
talize the accretion in value of the capital assets. If the directors in
their declaration designated the appreciation as the source from
which the stock dividend was drawn, there could have been no ques­
tion about it, as the intention of the company would be controlling
in this matter, but even without such a specific declaration we think
it would be generally admitted that the appreciation had been con­
verted into capital stock through the stock dividend—if for no other
reason because it could not be distributed.
It, therefore, appears that in the question proposed the company
is not obliged to maintain a surplus equal to the amount of the ap­
preciation of property accounts previously written up, but may dis­
tribute the remaining surplus below the amount of such appreciation.

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 Questions and Answers

Retirement of Preferred Stock

(February, 1924)

QUESTION: A preferred stock issue is sold under an agreement

calling for the retirement of parts of this stock at regular intervals.
Should the debit at this time of retirement be to treasury preferred
stock or to preferred stock authorized? The reply might hinge on
whether the corporation would, under the law, have the right there­
after to reissue any part of the preferred stock thus repurchased with­
out again going through the formality of securing the authorization
of the secretary of state for an increase in the capital stock.

ANSWER: The proposition as stated is: “A preferred stock issue

is sold under an agreement calling for the retirement of parts of this
stock at regular intervals.” There seems little doubt that this arrange­
ment as to the periodic retirement of the stock would be embodied
in the certificate of incorporation filed with the secretary of state at
the time of obtaining authorization of the issue, and that the effect
of so doing would be to authorize the corporation to reduce its capi­
tal accordingly from time to time. It may be, however, that in strict
compliance with the law it would be necessary, in order to carry out
the obvious intent at the time of the issue of this stock, to file an
amended certificate before proceeding with the actual retirement of
the stock from time to time. This feature, however, appears not to
be germane to the point at issue.
It being manifest that the intention at the time of the issue of
the stock was to actually reduce the capital periodically, it seems
that the treatment of the stock redeemed as treasury stock is out
of the question. It is difficult to imagine a situation where stock
would have been sold under such an arrangement for partial retire­
ment from time to time had it been contemplated that the stock thus
“retired” would be subsequently reissued. In issuing preferred stock
with a redemption provision the interests of all the preferred stock­
holders and of the common stockholders are involved. For the pro­
tection of the interest of the preferred stockholders whose stock is
not redeemed, and of the common stockholders, it seems manifest
that a corporation would be acting in contravention of the original
agreement if it were to reissue the stock redeemed without specific
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 American Institute of Accountants
authority therefor being granted by both the preferred and common
stockholders.
In view of the foregoing, it is our opinion that the entry to be
made in the accounts at the time of retirement of any part of the
preferred stock should be to debit the account representing the pre­
ferred stock outstanding however that account may be designated,
thus reducing the preferred capitalization.

Disposition of Excess Credit from Sale of Stock

(March, 1935)

QUESTION: We propose to acquire the consent of our stock­

holders for reducing the authorized no-par shares to the extent of
our treasury stock on hand.
We are incorporated under the laws of New Jersey and I am in­
formed that it is compulsory under the law that when stock is
legally cancelled the capital stock account must be reduced by the
original amount set up as a credit when such stock was issued for
value received.
Our treasury stock was purchased at a price somewhat below the
amount we received when originally issued; and practically my whole
question is the disposition of this excess credit figure on deleting our
treasury stock account carried at cost.
It is understood that there is, of course, only one account to which
this excess credit can be placed, viz., surplus. But is it an earned
surplus available for dividends or must it remain as a capital surplus
comparable to paid-in surplus?
It has been my understanding that the sale of treasury stock would
create either a profit or a loss affecting the earned surplus of a cor­
poration, and it might seem that a similar profit or loss would be
created on a legal reduction of the authorized capital stock via can­
celling and deleting the treasury stock owned from our assets.

ANSWER NO. 1: We would state that the well recognized ac­

counting rule is to credit capital surplus, and not earned surplus
available for dividends, with the excess of the par, or original issue
price, over the cost of capital stock purchased and cancelled. “Profit
and loss” arising from the sale of treasury stock is similarly treated;
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 Questions and Answers
namely, credited or charged to capital surplus and not to earned
surplus available for dividends. This rule is based upon the prin­
ciple that it is not the business of a corporation to deal in its own
shares.

ANSWER NO. 2: In our opinion, this difference should be cred­

ited to capital surplus and not to earned surplus. We do not believe
the situation with respect to profit or loss upon sale of treasury stock
is the same as the situation with respect to the purchase and cancel­
lation of treasury stock.
The question as to the availability of the difference between cost
and original issue price of treasury stock for the payment of divi­
dends is a legal one, the answer to which depends largely upon the
laws of the state involved.

Stock Dividends
(February, 1923)

QUESTION: When a stock dividend is declared in the case of a

stock having par value, it is clear that the surplus account will be
reduced and the capital stock account increased by an amount equal
to the number of shares issued as a stock dividend multiplied by the
par value thereof.
In the case of a stock dividend declared in no-par capital stock,
what amount, if any, should be transferred from the earned surplus
account to the stated value of the no-par capital stock?

ANSWER NO. 1: A stock dividend declared in no-par capital

stock should read to the effect that a dividend of blank dollars per
share is payable in stock. At the date of payment a corresponding
amount will be transferred from earned surplus to capital, thereby
reducing the available earned surplus for cash dividends and accom­
plishing one of the main objects of a stock dividend. The amount of
surplus so transferred would, of course, be optional with the board.

ANSWER NO. 2: Our opinion must be given with certain reser­

vations, because the state in which the corporation operates is not
supplied but, generally speaking, in absence of action by the directors
fixing the dollars per share or amount to be transferred, there would
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 American Institute of Accountants
be a choice of two ways: one, the number of shares included in the
dividend times the stated value per share, or that percentage of the
stated or of the actual capital, which the number of shares of the
dividend bears to the number of shares previously outstanding.
ANSWER NO. 3: Where a company is incorporated in a state
requiring no stated value to be carried of no-par-value stock, surplus
account might be taken as representing the value or equity of such
stock and only a memorandum capital stock account, without values,
need be carried. In this case, no transfer would be made and nota­
tion only of the dividend and the corrected number of shares out­
standing would be necessary.
As a general rule, however, companies incorporated with no-par­
value stock have on their books a capital stock account for such
stock in the amount that the assets acquired were in excess of the
total of liabilities and the par value of preferred stock issued or at
least a proportion of such excess. In such instances where no stated
value is required, no transfer from surplus would be necessary.
Where, however, the certificate of incorporation calls for a stated
capital of so much per share outstanding, a transfer of that amount
times the number of shares distributed as a dividend should be trans­
ferred to the already opened capital stock account. This account
would then show the total shares outstanding at the stated value
per share.
Again, if the certificate of incorporation calls for a round amount
of stated capital and not a per share value of stock outstanding, this
round amount would appear on the books as the capital, and would
not be altered by a transfer upon the payment of a stock dividend
of no-par-value shares, unless with that end in view the charter was
altered, in which case a corresponding figure would be transferred
from earned surplus.
ANSWER NO. 4: A stock dividend on no-par-value stock is in
itself merely a means of increasing the number of outstanding shares.
Such a dividend, if coupled with the capitalization of a part of the
earned surplus, appears as reasonable a proceeding as the declaration
of a stock dividend on a par-value stock. The transfer to capital
account of a portion of the surplus could probably be accomplished
by a resolution of the directors, but this is a legal question concern­
ing which state laws may vary, and upon which one should obtain
competent legal advice.
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 Questions and Answers
The usual method followed in declaration of stock dividends is
for the board of directors to pass a resolution containing about the
following:
“.............. to stockholders of record of....................... date a divi­
dend of.......... per cent, payable in the common capital stock of
this company to be issued at par.” Quite frequently the total amount
to be distributed is named in place of or in addition to the per cent.
It would seem that if there were a stated value per share of the
no-par capital stock, that if a stock dividend were then declared and
that if the resolution provided for distribution of a given number of
shares of stock without mention of the amount of money, which
those shares represented, then the transfer from surplus to the stated
value of the no-par common stock would be the stated value per
share multiplied by the number of shares distributed. However, the
query arises why a corporation should desire to distribute a stock
dividend declared in no-par stock unless it also desired to sell addi­
tional shares to obtain new capital and the stock dividend is resorted
to in an attempt to equalize equities as between the old shareholders
and the new shareholders in the event the latter should buy shares
at a lower price than the known or assumed true value of the
stock.
The differences in no-par stock laws of different states and the
doubtful points involved in their interpretation are so great and the
entire subject of no-par stock is so beset with uncertainty and oppor­
tunities for transgressing both moral and economic laws, that we are
loath to answer this abstract question by any statement of general
application. All of the facts involved in and surrounding the pro­
posed action should be known before deciding upon either the pro­
priety of the stock dividend itself or the bookkeeping entries involved
thereby.

ANSWER NO. 5: The question of the values to be set up for

no-par capital stock is one that is subject to a great many inter­
pretations. In the first place, no-par capital stock is quite frequently
issued without any amount being paid in therefor, either in cash or
in other property. The real value behind each share of no-par stock
is the total of the capital stock account (if any is set up), plus the
total surplus account divided by the number of shares of no-par stock
issued. If a stock dividend is issued in no-par stock, the total of
these two accounts remains unchanged and the value of each share
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 American Institute of Accountants
of no-par stock is reduced corresponding to the increase in the num­
ber of shares brought about by such stock dividend declaration.
It would, therefore, appear to be necessary that the directors in
declaring a stock dividend on no-par stock should state in their reso­
lution that so much value should be taken from the surplus account,
transferred to the stated capital stock account, to be divided in the
issuance of no-par stock of a certain number of shares at a fixed
amount, thus making capital out of what was formerly surplus.
This would have the effect of taking out of this surplus account
an amount that would otherwise be subject in the discretion of the
directors for distribution as cash dividend.
In declaring a stock dividend on no-par capital stock, no distribu­
tion in money value could certainly be considered unless that amount
was stated, and under the new revenue law a serious question might
arise as to what portion of earned surplus would be accumulated,
which might be subject to a 25 per cent. additional tax.

ANSWER NO. 6: I find on looking through my library that my

copy of “Corporation Procedure,” by Conyngton, Bennett and Pin­
kerton, states on pages 1152 and 1153 that “when a stock dividend
is payable in stock without par value, the only entry required on
the general books is one indicating the number of shares thus dis­
posed of,” and that no change is made in the amount of the surplus
account or of the capital stock account.
I find, however, on looking at The Journal of Accountancy for
December, 1920, on page 459, that Mr. Finney, editor of the Stu­
dents’ Department, furnished as a part of the answer to the question
therein contained the following statement:
“The account with stock without par value should be credited
with only those amounts actually paid in on the stock, and with
any surplus transformed into fixed capital by action of the directors,
such action being analogous to the declaration of a stock dividend.”
Since receiving your inquiry, we have had quite a discussion in
the office on your question, and we have come to the conclusion that
we agree with Mr. Finney rather than with Mr. Conyngton, et al.
My reasoning is in this manner:
I have always assumed that the real purpose of a stock dividend
was to transfer from the surplus account to the capital account an
amount which, so far as possible, would increase the capital account
to a sufficient amount to represent approximately the actual capitali-
66
 Questions and Answers
zation, or an amount which fairly represented the capital which the
corporation needed to carry on its business.
If, in the case of declaring a stock dividend of no-par-value stock,
it is contended that no change is made in the surplus account, it
leaves the corporation where it cannot take out of the surplus ac­
count, which is available for dividends, an amount to be added to
permanent capital, and this disability prevents withdrawing the
amount to a position where it will not be subject to the payment of
dividends.
If, however, a cash dividend is declared and the amount of this
cash dividend is paid in for new stock, there is no argument against
adding the price that the company receives for the new stock to the
capital account. This procedure would have exactly the same effect
as transferring a similar amount from the surplus account to the
capital account and issuing the same number of shares as a stock
dividend except that, in the latter case, the stockholders would not
be subject to a surtax on the dividend at the time the dividend was
declared, but would defer the payment of the tax until the stock
received as a dividend was realized upon in cash by them.
Under these circumstances, it would seem entirely obvious that a
corporation having no-par-value common stock should not be de­
prived of its privilege of investing permanently in the capital of the
company’s accumulated earnings which were actually needed in the
conduct of the business and which the directors felt it would be for
the interest and safety of the business to have designated as capital
instead of as surplus. As I see it, there is no other means of accom­
plishing this except by declaring a stock dividend, unless a cash
dividend is paid to the stockholders and then paid back to the com­
pany for new stock.
We have also studied the New York state law regarding no-par­
value stock and thus far have been unable to find any requirement
of the law which prohibits the payment of a stock dividend.
It is, therefore, our conclusion and opinion that in a case of this
kind we should recommend to our client that a stock dividend be
declared, that the amount of dividend decided upon be transferred
from the surplus account to the capital account, and that the requi­
site number of shares be added to the outstanding stock. We should
expect, of course, to call in the old stock certificates and exchange
them for new certificates, which would show the total shares of stock
outstanding after the stock dividend.
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 American Institute of Accountants
I presume the question arises, if this is done, as to how many
shares should be issued to cover the amount which it was decided
to transfer to capital. As you have not asked this question, I will not
attempt to answer it except to say that I should judge this might
depend very largely upon the circumstances in the case of each cor­
poration and what the directors considered to be the wisest course
under those circumstances which might exist.
ANSWER NO. 7: Any dividend declared, whether in cash or
stock, must be capable of translation into dollars and cents. Divi­
dends may be declared as a lump sum; an amount per share; a per
cent. of the par value of the outstanding capital stock, or a per cent.
of the credit to the capital stock, no-par-value. The credit to capital
stock account, by a charge to surplus, would be the amount of the
dividend declared.
Assume that 10,000 shares have been issued and that a dividend
of $10 per share payable in stock has been declared, the amount to
be transferred from earned surplus to capital stock, no-par-value,
would be $100,000. The dividend being payable in stock raises a
number of points. If the stock has been authorized to sell at $10
per share, it would simply be a matter of the issuance of 10,000
shares of stock. Theoretically, there would be no advantage in issuing
the additional 10,000 shares, as the original 10,000 shares would
have the same book value as 20,000 shares. Practically, there may be
quite a decided advantage from the standpoint of selling the shares.
It is a well established fact that it is easier to sell 20,000 shares at
$10 each than to sell 10,000 shares at $20 each. This law of psychol­
ogy is often the reason why stock dividends are declared.
When the stock dividend declared per share is less than, or greater
than a multiple of the amount at which additional shares of no-par­
value have been authorized to sell, then it becomes necessary to issue
fractional stock certificates to such stockholders whose dividends are
less than the authorized selling price of a share or in excess of any
multiple thereon.

ANSWER NO. 8: Naturally, any surplus remaining after all

charges and dividends of preference have been taken care of, belongs
to the no-par stockholders. Furthermore, the very nature of no-par
stock requires that any dividends to its stockholders have to be paid
at a given amount per share rather than a percentage per share which
obtains in the cases of capital stock having par value.
68
 Questions and Answers
This being true, it will be necessary that any stock dividend would
have to be declared in a definite amount of dollars and in order to
cover the outstanding stock in even shares, would have to be in such
an amount as represents the per share value then covered on the
books or else such value as would represent a fractional value based
on the outstanding book value as a capital stock liability.
In this connection I bring to your attention the point made by
an extremely able attorney on the question of taxing surplus, that
the surplus remaining after all other charges had been covered be­
long to the no-par stockholders and simply increases the intrinsic
value of their holdings. Therefore such surplus would not be taxable
by the federal government provided such a tax is eventually insti­
tuted.

Transfer from Common-Capital-Stock Account to

Surplus Account
(May, 1932)

QUESTION: A corporation is organized under the laws of....

and the by-laws contain the following paragraph:
“The board of directors shall have power from time to time to fix
and determine and to vary the amount of working capital of the
corporation and to direct and determine the use and disposition of
any surplus over and above the capital stock paid in.”
The board of directors has power to allocate to surplus any sums
received by the corporation from the sale of its common stock in
excess of the amount allocated to capital by the board.
The corporation sells 100,000 shares of its common stock of no
par or nominal value at $50 a share (the 100,000 shares being the
original issue) and receives $5,000,000 in cash. It credits this $5,-
000,000 to common-capital-stock account, and subsequently in ac­
cordance with the foregoing by-law the board of directors authorizes
the transfer of $4,000,000 from common-capital-stock account to
surplus account.
In preparing a certified balance-sheet of the corporation subse­
quent to the date of the transfer, would an accountant be justified
in showing the amount of $4,000,000 on the balance-sheet as “sur-
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 American Institute of Accountants
plus paid in” without any comment, or showing it as “surplus arising
from sale of common stock in excess of amount allocated to capital
stock by directors,” or should it be added back to common capital
stock outstanding?
Would it alter the conditions if it were ascertained that subsequent
to the date of the balance-sheet, the greater part of the $4,000,000
credited to “surplus paid in” had been disbursed to preferred stock­
holders in the form of dividends?
The company has no other credits to surplus.
ANSWER: We must assume that the question of legality is settled
affirmatively by the extraordinary provision which allows the board
of directors to “vary the amount of working capital of the corpora­
tion.”
The question may be divided into two sections, one purely legal
and the other accounting. The statement that the directors may from
time to time vary the working capital of the company raises a legal
point as to whether the term “working capital” means the actual
capital of the company and whether this legally authorizes the direc­
tors to reduce or increase the capital without the usual legal for­
malities. We are assuming that it does so and the only point that
remains is the method of stating the accounts. The question does not
say how long subsequent to the paying in of $50 a share on the
issued stock, the directors made the transfer of $4,000,000 to surplus,
but we assume this also was justified legally. Even with these as­
sumptions, the powers are, of course, unusual and dangerous. If the
transfer to surplus was made practically concurrently with the issue
of the stock, we see no objection to designating it as surplus paid in.
If, on the other hand, it was made after some time had elapsed, we
think it desirable that the surplus should be shown as a transfer
from capital account by the board of directors, or, as suggested by
the inquirer, as surplus arising from sale of common stock in excess
of amount allocated to common stock by directors. We do not see
how it could be debited back to capital stock assuming the legality
of the by-laws and a motion of the directors. It would not appear
to us that the fact that a portion of the surplus paid in had been
distributed as a dividend or applied to operating losses in accordance
with the laws of the state of..................... would affect the manner in
which the original credit was stated.

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 Questions and Answers

Accounting Treatment of Self-Insurance Reserves

(February, 1934)

QUESTION: We should be greatly obliged for your opinion of the

following question:
A mining company under the Utah compensation and employers’
liability law elects to carry its own insurance. Provision has been
made in its books by crediting reserve for compensation insurance
with the amounts which it would have been required to pay as pre­
miums if the insurance had been carried with the state insurance
fund, and this reserve has been charged with actual payments made
on account of its liability to employees or to their dependents.
From time to time awards were made by the state industrial com­
mission and, by the end of 1932, the liability of the company for
outstanding awards consisted of several industrial blind and total
disability cases, under which the company is required to pay approxi­
mately $16 a week during the life of the injured employee, and sev­
eral fatal accident cases for which awards have been made of
approximately $5,000 each, payable in weekly instalments of $16
to the dependents of the former employee. In the fatal accident cases
the amount outstanding is the original award less payments made
on it to date.
The point concerning which we desire your opinion is whether the
balance-sheet should reflect a liability for awards which already have
been made and if so what is the proper method of computing the
liability.
Under the industrial blind and total disability cases, taking insur­
ance mortality statistics as the basis, and multiplying the weekly
payment by the number of years of expected life of the insured at
their respective ages and reducing this amount to its present worth
say on a 6 per cent. basis, we find the liability to be in excess of the
amount provided in the reserve set up on the books, and we also
find that if the company should purchase annuities for these injured
employees the cost would exceed the amount of reserve, giving con­
sideration also to the liability for fatal accidents explained in the next
succeeding paragraph. The question naturally arises as to whether
insurance statistics are a fair basis on which to make this estimate
for the reason that the persons to whom payments are being made
under awards of the industrial commission are either blind or other­
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 American Institute of Accountants
wise seriously injured and possibly the expectation of life would be
quite different from that shown by insurance mortality statistics.
Moreover, the number of cases involved is so small that there could
be no confidence that average mortality rates would be applicable
to them.
As to fatal accidents the awards are definite in amount and the
liability may be approximately computed at its present worth sub­
ject to the determination of the interest rate to be used. While in
some circumstances the liability may be terminated before the full
amount of the award is paid, as for example by re-marriage of a
widowed dependent, experience indicates that this is not an impor­
tant factor to consider.
For federal income-tax purposes, the treasury department, the
board of tax appeals and the courts have held that additions to a re­
serve of the nature described above are not deductible from gross
income. Reference is made in particular to the decision of the board
of tax appeals in “Spring Canyon Coal Company v. Commissioner,”
docket number 23902, 25743, and Commerce Clearing House, docket
number 4300. In the board decision reference is made to supreme
court decisions of the state of Utah under the compensation act;
and under these decisions it appears that the compensation provided
for in the act is not to be considered in the sense of damages for
injuries sustained but that it is compensation pure and simple. The
board’s decision in this case was affirmed by the court of appeals.
In this case the petitioner appears to have claimed only that the
additions to the reserve were deductible, and the question as to de­
ductibility of awards actually made does not appear to have been
raised.
From an accounting point of view, it appears to us that the sus­
taining of the accident and the resulting award by the industrial
commission creates a real liability, and, even if it is an award for
compensation and not for damages, provision should be made for it
not later than the time at which the award is made, as the self-in­
surer is required to make the payments in the future without receiv­
ing any further benefit from the services of the injured employee.

ANSWER NO. 1: Accident expense is practically as certain as any

other expense and when the employer assumes the attendant risk
there at once arises a liability—certain as to the event, contingent
72
 Questions and Answers
as to the amount. Experience—not stipulated premiums—is the
practical basis for finding that contingent amount.
We should recommend a monthly charge against operations suffi­
cient to set up an adequate general accident reserve and, as liabilities
become fixed or determinable by award or otherwise, the transfer
of such amounts (ascertained on any reasonable basis) from the gen­
eral reserve to one or more specific reserves against which payments
are charged. If in time the credit balance of the general reserve fails
to afford or exceeds a reasonable provision for the company’s poten­
tial risk, the monthly charge to operations would be adjusted accord­
ingly. When cases covered by specific reserves are closed or modified,
any differences between the original and adjusted figure would be
transferred back to the general reserve.
To the specific question we should therefore reply that in our
opinion the balance-sheet should reflect a liability for awards already
made and, since there is no possibility of exactly computing the
amount ultimately to be paid, conservative accounting would permit
any method under which the maximum possible liability receives due
consideration.

ANSWER NO. 2: There seems to be no question that the awards

made by the Utah state industrial commission constitute liabilities
of the company for which provision should be made on the balance-
sheet. The difficulty arises in calculating the exact amount of this lia­
bility at the balance-sheet date.
The proper method of calculating this liability is to compute the
present worth of the estimated payments which will have to be made.
In computing the present worth the interest rate used should be
equal to that which could be earned by the company upon a special
fund set aside for the purpose of meeting these payments as they
fall due. This interest rate would probably not be in excess of 3 per
cent. or 3½ per cent. per annum. To use a higher rate would, in our
opinion, understate the liability.
In the case of fatal accidents, the awards are definite in amount
and can readily be calculated, ignoring the possibility of terminating
the payments before the full amount of the award has been reached.
In the industrial blind and total disability cases, in which the
award is a weekly payment during the life of the injured employee,
it is necessary to estimate the number of weekly payments in each
case. In the absence of any statistics relating to the expectation of
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 American Institute of Accountants
life of industrial blind and totally disabled workers of various ages,
it would seem that insurance mortality statistics would have to be
used. Inasmuch as these tables are notoriously high, a reduction
of about 25 per cent. from them could reasonably be made in calcu­
lating probable future payments to any group in average health. It
might not be unreasonable to make a further reduction of 25 per
cent. to allow for the shorter expectation of life of the blind and
totally disabled former employees. However, through a consideration
of individual cases it may be possible to raise or lower this percent­
age or to work out separate estimates for each case.

Determination of Earnings and Surplus with Regard to

Dividends

(October, 1934)

QUESTION: I would appreciate what information you can give

me on a question involving good accounting practice in the deter­
mination of earnings and surplus and the right of directors to declare
dividends.
A corporation with no-par-value stock with a book value of say
$10,000,000 has an operating deficit of $2,000,000. It is proposed to
change the no-par-value capital stock to stock having a par value
totaling $4,000,000, transferring the balance of $6,000,000 to sur­
plus. Against this surplus would be charged the operating deficit of
$2,000,000, leaving a surplus of $4,000,000.
Assuming that the company in its next year of operations loses
$1,500,000 and in the following fiscal year makes $1,000,000 in net
profits, can the directors at the close of the second year declare a
dividend of say $600,000 out of the net profits?
Would it be good accounting practice to charge against the initial
surplus of $4,000,000 after the reorganization of the capital structure
the first year’s loss from operations of $1,500,000, reducing the sur­
plus to $2,500,000 and if this is done can that in effect be considered
the final result of all previous years’ operations, and can the com­
pany in effect start afresh with the following year, in which we are
assuming earnings of $1,000,000, and pay a dividend of $600,000
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 Questions and Answers
out of those earnings without paying any attention to the operating
deficit of earlier years?
In asking this question I am assuming that all necessary legal
details have been covered, and the only answer desired is as to
accounting practice usual in such cases and whether there would be
a technical accounting objection to the payment of this dividend
of $600,000 out of the profit of $1,000,000.
I realize the distinction that should be made between capital sur­
plus and earned surplus, but would like an opinion as to whether
it would be technically correct to charge the first year’s operating
loss against the capital surplus (which would be the only surplus
then existing), leaving the balance of capital surplus at the net figure
of $2,500,000, and whether it would be proper to set up the earned
surplus at the end of the second year at $1,000,000 for the earnings,
less the $600,000 of dividends paid out of those earnings, or a net
surplus from earnings of $400,000. Is it, on the contrary, necessary
to have the earned surplus represent the accumulated history of the
company from the beginning, showing the accumulated results from
earnings, less any dividends paid from earnings, ignoring the facts
of proper legal charges of operating deficits against capital surplus?

ANSWER NO. 1: We do not think it would be good accounting

practice to charge against the initial or capital surplus of $4,000,000,
the first year’s loss from operations of $1,500,000. On the contrary,
we think that the capital surplus should be carried forward in one
account, and the loss on operations should be carried forward in the
balance-sheet in a separate account. We do not believe that the net
amount of $2,500,000 can be considered as representing the final
result of all previous years’ operations. The remainder of the ques­
tion in which it is assumed that in the subsequent year earnings of
$1,000,000 are realized and a dividend of $600,000 paid out of those
earnings, presumably is a legal, rather than an accounting, question,
inasmuch as the applicant inquires whether this dividend can be
declared “without paying any attention to the operating deficit of
earlier years.” However, he goes on to say that the only answer de­
sired is as to the accounting practice usual in such cases, and whether
there would be a technical accounting objection to the payment of
the dividend of $600,000 out of the profit of $1,000,000. We know
of no accounting objection to showing the dividend as being paid
out of the profits and, indeed, without a resolution of the directors
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 American Institute of Accountants
to the contrary, we think that from an accounting point of view the
dividend would be considered as having been paid out of the current
year’s profits.
We understand that the New York stock exchange for some time
past has requested that listed companies show in their balance-sheets
the earned surplus representing the accumulated results from oper­
ations, less any dividends paid therefrom. Therefore, in the event
that the previous operating deficit of $2,000,000 is charged against
the capital surplus, we think a notation to that effect should be car­
ried forward in the balance-sheets for succeeding years.

ANSWER NO. 2: The question as to whether or not a company

can pay dividends when there is an operating deficit at the begin­
ning of the year is a legal question, to be settled under the laws of the
state in which the company is incorporated.
The accounting question involved is what, in the circumstances,
the balance-sheet should disclose. It is our opinion that at the close
of the period in which the change of stock from no par to par value
is made, the transfer from capital-stock account to surplus and the
charge against surplus of the operating deficit should be clearly
shown. It is assumed that proper corporate action would have been
taken about these items. If the company, in its next year of opera­
tions, loses $1,500,000 and the directors of the company formally
authorize the offsetting of such loss against the capital surplus ac­
count, this should be clearly shown in the report for the year. If in
the following year the company makes $1,000,000 in net profits and
the directors legally declare dividends of $600,000 out of such net
profits, it is our opinion that the surplus of net profits over dividends
should be shown in the balance-sheet as earned surplus, provided
it was designated as “earned surplus from January 1, 193—.”

ANSWER NO. 3: Fundamentally the rules are, or were, simple

and it was safe to say that dividends could be declared only out of
the accumulations of earned surplus; capital could not in any circum­
stances be encroached upon and had to be held intact. This simple
rule, however, has been invaded in recent years by statutory changes
in many states, particularly where there is no-par stock or stock of a
nominal or stated value, the surplus in excess of such stated value
being, even when of the nature of paid-in surplus, available for dis­
tribution in dividends. This, however, does not alter the economic
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 Questions and Answers
error involved in the paying of dividends out of paid-in or capital
surplus and, broadly speaking, the correct accounting practice should
follow the economic law. In accounts, however, it is impossible to
ignore the statutory law, and where statutes permit the payment of
dividends out of paid-in capital the accounting officers can only bow
to the statute, making clear, however, the facts.
If a deficit should, however, have accumulated in the past so that
the capital is actually impaired, the correct procedure would be,
particularly in the case of a par-value stock, to go through the for­
malities necessary to reduce the capital stock and, provided the facts
were made clear to the stockholders taking such action, the surplus
arising from such reduction could with propriety be used to wipe
out the deficits referred to effecting, for all practical purposes, a
reorganization and starting the profit-and-loss and surplus account
anew from zero.
Applying these rules now to the particular problems enunciated in
your communication, and of course having in mind that what may
be here stated is subject to modification by reason of special state
laws, it would appear that it would be entirely proper to reduce the
capital from $10,000,000 to $4,000,000, but the balance of $6,000,-
000 should, strictly speaking, be transferred to capital surplus. As,
moreover, this capital surplus of $6,000,000 is distinctly, it is as­
sumed, made available for the liquidation of past losses, the accu­
mulated operating deficits of $2,000,000 could then be charged
against it, which would leave a surplus of $4,000,000. This, however,
should be regarded as a capital surplus and not, generally speaking,
available for division in the form of dividends or even for the liquida­
tion of later losses, although if a special provision were made for
the utilization of the $4,000,000, or any part of it, to liquidate later
losses, probably to the extent of such provision passed upon by the
stockholders, no exception could be taken. The statutory and legal
rights of creditors would, however, have to be properly secured.
The propriety of permitting each year’s transactions to stand on
its own basis so that dividends be declared out of the surplus earn­
ings of any one year, irrespective of whether a deficit is brought
forward from prior years or not, opens up another question and the
law in various states and countries is not uniform. The local law
must, of course, govern, but again looked upon as a purely account­
ing question I would not regard it good practice to declare dividends
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 American Institute of Accountants
if there is an accumulated balance of operating deficit still unliqui­
dated, with the exception, of course, that after a reorganization, or
what amounts to a reorganization, there would be propriety in start­
ing, as I have already indicated, once more from scratch, ignoring
all previous deficits wiped out by the reorganization.

Creation of Capital Surplus to Eliminate Deficit

(February, 1935)

QUESTION: A question has arisen relative to the frequent prac­

tice of creating capital surplus by reducing par value or number of
shares of capital stock for the purpose of eliminating a deficit.
I have a client whose capital structure on December 31, 1933,
was as follows:

Capital stock outstanding 1,711 shares of a par

value of $100 $171,100.00
Deficit 62,950.12

Net Worth $108,149.88

During March, 1934, the stockholders, by proper action, voted to

reduce the par value of the capital stock of the corporation from
$100 to $25 per share thereby creating a capital surplus of $128,325.
They also voted to charge the deficit of $62,950.12 against the capi­
tal surplus of $128,325, leaving a capital surplus of $65,374.88.
In the preparation of future balance-sheets for this corporation,
will it be necessary to state the capital structure as follows:

Capital stock outstanding, 1,711 shares par value

$25 $ 42,775.00
Capital surplus arising from reduction of capital
stock 128,325.00
Deficit 62,950.12

Net Worth $108,149.88

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 Questions and Answers
Or would the following conform to good accounting practice:

Capital stock outstanding, 1,711 shares par value

$25 $ 42,775.00
Capital surplus 65,374.88
Earned surplus or deficit from operation since Janu­
ary 1, 1934 ...................

$108,149.88

ANSWER NO. 1: Either plan is satisfactory, but on the first set

of accounts the effect of the change should be fully noted either on
the balance-sheet or in supplementary exhibits. For example:

Balance-Sheet
(Liabilities)
Capital stock outstanding—1,711 shares at par
value $25 $ 42,775.00
Capital surplus—arising from reduction in par value
of capital stock from $100 to $25 per share less
operating deficit to December 31, 1933 of
$62,950.12 65,374.88

$108,149.88

Subsequent accounts may be stated in less detail as shown in last

paragraph of the question.

ANSWER NO. 2: If, in the opinion of the accountant, all the

necessary steps have been taken, no exception can be taken to the
second form of presentation of the capital stock and capital surplus.

Accounting for Treasury Stock and Payment of Dividends

from Capital Surplus
(January, 1936)

QUESTION: A close corporation, incorporated in the state of

New York, had capital stock having a par value of $2 5 a share. It
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 American Institute of Accountants
issued 40 shares ($1,000) in exchange for 10 $100 par value shares
($1,000) of another close corporation.
Subsequently a certificate of reduction of capital stock was filed
with the secretary of state, the par value having been reduced from
$25 to $15 a share. Some time after this change was made the two
corporations agreed to cancel the above-mentioned exchange of
shares. The 40 shares (now having a par value of $15 each, $600)
were received and charged to treasury-stock account, $1,000.
When the par value was reduced a capital surplus account was
credited with the full amount of the reduction. Various charges were
made to this capital surplus account at that time, and there still
remains a credit balance of a considerable amount. The corporation
also has a credit balance in its earned surplus account.
The question arises as to whether the treasury-stock account
should not have been charged with $600, the present face value of
the 40 shares and the excess, or $400, charged to either capital sur­
plus or earned surplus. Would it be in order to make such charge
to capital surplus without the approval of shareholders, or should
it be charged to earned surplus?
Another point relating to these 40 shares of treasury stock is that
the corporation is not in the habit of purchasing its own stock, and
therefore desires to know whether it would be proper to cancel this
certificate and not continue to carry it as treasury stock. If this is
permissible, would a resolution by the board of directors be suffi­
cient to effect the cancellation?
When the certificate of reduction of capital stock was ordered
filed by the stockholders, they conferred upon the board of directors
the authority to pay dividends out of the balance of the capital sur­
plus after charging thereto amounts otherwise authorized at the
time. The certificate was filed about two years ago and no charges
were made to capital surplus other than those authorized by the
stockholders. After omitting dividends for several years the corpora­
tion is about to resume payments to its stockholders. In view of the
authority conferred upon the board of directors, will it be in order
to charge future cash dividends to the capital surplus account until
the balance in that account is depleted or, since there is an earned
surplus, must dividends be charged to that account?

ANSWER NO. 1: In the circumstances set out in your letter, as

it is not the company’s intention to sell the 40 shares of the com-
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 Questions and Answers
pany’s capital stock acquired, these shares should be reduced to their
par value, viz., $600, and the difference, $400, written off against
capital surplus created when the par value was reduced. This does
not require the approval of the stockholders.
Nothing was said in your inquiry regarding the provisions of the
by-laws covering the company’s capital stock acquired. In some cases,
the by-laws provide that all such stock must be cancelled. In the
present case the directors could authorize the cancellation of the
treasury stock, obtaining the approval of the stockholders later, or
the stock could merely be carried in treasury. The situation should
be stated in the company’s accounts as follows:

Capital stock:
Authorized and issued (say) 5,000 shares
Less: in treasury or cancelled 40 “

Outstanding 4,960 shares

Presumably all stock certificates were called in at the time the par
value was reduced and endorsed to that effect.
The payment of dividends out of capital surplus is permissible for
corporations organized in New York which are permitted to pay
dividends out of capital surplus where such surplus arises, as in this
instance, out of reduction of par value representing money actually
paid in. Such dividends are return of capital, and the recipients of
the dividends should be advised that the dividends are return of
capital and, therefore, not taxable. However, although the capital
surplus was set up with the avowed intention of paying dividends
out of it, the federal tax law does not permit any non-taxable divi­
dend to be paid out of any surplus while there is an earned surplus
in existence, so that if a dividend be declared, the federal govern­
ment will interpret it as a payment out of earned surplus as far as
the earned surplus suffices to pay it. The question of payment of
dividends out of any funds other than earned surplus should always
be referred to the company’s attorney.

ANSWER NO. 2: 1. In our opinion the excess of the original

value of the treasury shares over the present face value, namely
$400, may properly be charged to capital surplus. There is nothing
unusual in such a treatment and so it does not seem to us that the
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 American Institute of Accountants
approval of the shareholders is necessary, though it may be desirable
in a close corporation.

2. It would be proper to cancel the stock certificate referred to,

a resolution of the board of directors being sufficient, we believe,
to effect the cancellation.

3. The question, and all the pertinent facts of the case, should be
submitted to competent legal authority. We, ourselves, are of the
opinion that such a distribution as is proposed probably has legal
sanction, although the prudent course would be to pay cash divi­
dends out of earned surplus before encroaching on capital surplus.
Further, even though the capital surplus referred to be legally avail­
able, the propriety of a distribution therefrom is subject to the ob­
servance of equitable rights, e.g., creditors’, as well as the require­
ment of prudent business procedure. We should add that the source
of the distributions, particularly if made from capital surplus, should
be intimated to the stockholders and, further, that for income-tax
purposes such distributions of a close corporation would probably
be held to have been made from earned surplus to the extent of that
surplus.

Consolidations
(October, 1921)

QUESTION: Five corporations, all of whose stocks and bonds

are owned by a holding company, are to be consolidated into a new
corporation. The bonds are to stand unchanged and the stock of the
new or consolidated company is to be issued to an amount equal to
the total of the stocks of the consolidating companies. All this stock
will be owned by the holding corporation and the result will be an
exchange only by the holding corporation of the stocks of the five
corporations for an equal amount of that of the new corporation.
I would like to know whether it is proper for the new corporation
to set up the total of the surplus of the consolidating corporations as
surplus in its opening entry, and whether it can declare dividends
out of it to the holding company. By virtue of the ownership of all
the securities of the constituent companies in the first place and the
ownership of all the securities of the new corporation in the second
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 Questions and Answers
place, there is no real change in the corporate relationship, as the
companies were and remain one earning proposition.
ANSWER: In my opinion, the consolidation of the five subsidiary
corporations into one subsidiary corporation, under the conditions
stated in the inquiry, would not change the status of the several cor­
porations as respects the surplus account or the propriety of using that
surplus account for the payment of dividends of the holding company.
In making the above statement it has been assumed that all of the
surplus of each of the five subsidiary corporations is current surplus
which could be used in the payment of dividends of the holding
company. If, however, the subsidiary corporations or any of them
were acquired as going concerns by the holding company and at the
time they were acquired had accumulated a certain amount of sur­
plus, then that surplus at the date or dates they were acquired is
capital surplus so far as the holding company is concerned and would
not be available for the payment of dividends. It is probably not
necessary to explain why such surplus should be dealt with as capi­
tal surplus, because the reasons for doing so can be found in numer­
ous articles which have been published from time to time relating to
the accounts of holding companies and the preparation of consoli­
dated balance-sheets.
If the five corporations or any of them have or should have thus
established capital surplus accounts in addition to their current sur­
plus accounts, then a like distinction should be made on the books
of the new subsidiary corporation and only the current surplus of
that corporation would be available for dividends of the holding
company.

Paid-In and Earned Surplus on Balance-Sheet

(October, 1933)

QUESTION: The audit and annual report for a fairly large com­
pany whose stock is listed, have caused discussion between the com­
pany executives, the accountants and the attorney for the company
as to the way in which the balance-sheet should show paid-in and
earned surplus.
In this particular case, the paid-in surplus represents the earned
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 American Institute of Accountants
surplus of the predecessor companies included in the present com­
pany. The present company has suffered substantial losses in the
last three years which have exceeded the previous profits and, in
fact, have exceeded the paid-in surplus.
The company has previously made a division on its balance-sheet
between paid-in surplus and earned surplus, but the attorney states
that in the current situation the distinction between paid-in and
earned surplus is meaningless. The facts are that the operating deficit
has exhausted the paid-in surplus, as well as the earned surplus, and
that the company is left with merely a net deficit or impairment of
capital. He states further that if the company makes earnings, it
will only be necessary for the earnings to cover this net impairment
of capital before dividends can be paid from a balance of earnings,
and that whatever distinction there once was between paid-in and
earned surplus has been wiped out by the operating deficit exceed­
ing the paid-in surplus. He further states that, as a matter of ac­
counting, the operating deficit should be charged on the books against
the paid-in surplus and that both on the books and on the published
statement there should be shown merely a net balance as deficit.

ANSWER: It would appear that the company in question re­

sulted from the merger of certain predecessor companies and that at
the time of merger there existed paid-in surplus representing the
combined earned surpluses of the predecessor companies.
In cases of a true merger where the merging companies have earned
surplus, it is our opinion that this earned surplus is still available
to the stockholders of the new company and can be paid out in
dividends. It follows, therefore, that if the company has losses which
impair its capital as represented by its capital stock it would only
be necessary to restore this impairment before it can continue to pay
dividends. From a historical point of view we believe that it would
be a mistake to merge the accounts on the books and in the state­
ments. It is important to know the results of the operations of the
new company from the date of its inception.
In an article by J. M. B. Hoxsey published in The Journal of
Accountancy for October, 1930, entitled “Accounting for investors,”
a clear distinction is made between true merger, that is where the
identity of the merged corporation continues, though in different
form, and where the earned surplus of the merged company may be
properly continued as such by the merging company, and the acquisi-
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 Questions and Answers
tion of the stock of one corporation by another. In the latter case no
earned surplus of the acquired company as at the date of acquisition
can be recognized as part of the earned surplus of the combined
companies.

Maintenance Department Costs

(July, 1930)

QUESTION: It has been proposed that our maintenance depart­

ment, the machine shop for example, should, as a practical matter,
use an inventory scheme with respect to the distribution of labor.
For instance, the machine shop total labor cost will be charged to a
labor-process account and will represent the total hours for the de­
partment for the month. This labor-process account will be relieved
by the average labor cost with respect to all the results of the
department for the month. In other words, the labor will be charged
to the process account at varying rates, but will come out of this
account at a standard rate. Our rates for twenty-six men vary from
46 cents to 70 cents per hour, and the average is 63 cents per hour.
A man under the proposed system to whom we pay 46 cents will
work ten hours on a job at an actual cost of $4.60, but the standard
rate will show a cost of $6.30.
This scheme does not seem to me to be theoretically correct, al­
though I am not prepared to say just what the practical aspect of it
may be.
I shall appreciate very much the opinion on this proposition of
any members who may care to consider it.
ANSWER NO. 1: For distribution of labor costs of a maintenance
department, several methods are in use, the more common being
either a standard rate for the department, or the individual rate of
the employee engaged.
The argument in favor of individual rates is that the jobs are
charged presumably according to the time and skill demanded. The
arguments for the department standard rate are:

1. Economy in bookkeeping.
2. The assignment is not always determined according to the
skill required: availability and other factors sometimes enter in.
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 American Institute of Accountants
3. The standard rate may be in the nature of burden, including
overhead expenses, as well as labor cost.

ANSWER NO. 2: When installing cost systems, we have many

times worked out a plan for a maintenance department such as de­
scribed in the question, as we feel that practical accuracy in dis­
tributing the charges and the saving in clerical work from using an
average rate is more important than the loss of theoretical accuracy.
We would, however, usually go further and work out an hourly rate
including maintenance-department burden as well as labor so that
the hourly charge would cover all the service of the maintenance
department.
Assuming a reasonable interchange of maintenance department
men in work for the various manufacturing departments, we believe
that the final results, using an average rate, will be substantially cor­
rect and that in practice any theoretical inaccuracy will be more
than offset by the saving of expense in keeping the records.

Cost of Research as Operating Expense

(July, 1930)

QUESTION: A client for several years has pursued the policy of

charging into operations all amounts spent for research, patents, etc.,
whether or not any benefit was derived from such expenditure. These
expenditures have averaged approximately $200,000 a year for the
past five years, during which the client has developed new processes
and new products from which future profits will be derived. This
research work is to be continued and in the course of time certain
other products will be developed that will be of value. Should the
cost of research be capitalized?

ANSWER: The practice of charging to expense all costs of cur­

rent research work is not unusual; there is much to be said for it.
If a special attempt is made to attain some definite, patentable
improvement, it is permissible to carry forward the accumulating
cost until results are known; if a valuable patent is secured the cost
of research leading up to it may be treated as part of the patent
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 Questions and Answers
value, and written off over either the legal life of the patent or over
its estimated useful life, whichever be the shorter period.
When (as your question suggests) the company maintains, and
expects always to maintain, a general research department its cost
should be absorbed as general expense. If its cost were “capitalized”
future years might show a great accumulation of paper assets with­
out value, for as new processes and new products appear older ones
become valueless. This is especially true of the chemical industry.
In recent years the most progressive and enlightened companies in
manufacturing business have leaned strongly toward the elimina­
tion from their accounts of indeterminable, intangible values; good­
will, trademarks, patents, formulae, have been written down to a
nominal sum, say one dollar.
Upon the whole I think the practice of the client in this case is
admirable.

Overhead Expenses
(October, 1921)

QUESTION: One of the leading bankers of this city has re­

quested that we get the most authoritative opinion possible on the
following problem of distributing overhead expenses:

A motor company has 16 departments, consisting of new

cars, accessories, parts, tractors, tractor parts, plows, harrows,
harrow parts, repair shop, etc. A number of expenses are
chargeable direct to the various departments. The problem is to
determine an equitable basis on which to distribute adminis­
trative salaries, rent, heat and light, and various other overhead
expenses.

Some have suggested that this distribution be made on a basis of

sales; others, on a basis of gross profits previously shown; and still
others, on a basis of floor space, position of same, time devoted by
officers and employees in the various departments.
We would appreciate it if you will turn our letter over to some
member of the Institute, whom you think is well qualified to give us
a scientific method of distribution from the information given above.
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 American Institute of Accountants
ANSWER: My reply to the question must be of a general nature,
because any plan for distributing administrative overhead must be
based upon a definite knowledge of the functional organization, plant
facilities, and operating conditions of the business under considera­
tion.
The usual procedure for distributing administrative expenses in
motor companies provides that as great a proportion as possible of
the general expenses should be allocated to appropriate departmen­
tal burden accounts.
A careful study of the existing conditions will usually suggest a
fair basis for distributing most of the administrative expenses. The
rent and property taxes may be charged to the various departments
on a basis of the relative value of the floor space occupied; light and
power costs may be distributed upon the number of outlets and
rated horse-power requirements of the department, or if greater ac­
curacy is desired, the current used can be measured by simple instru­
ments; fire and compensation insurance may be distributed upon
the value of the insurable contents and payrolls of each department,
etc.
The unapportioned balance of the administrative expenses may be
then spread upon either the direct labor cost, direct labor hour, or
machine hour basis. The basis most commonly used for apportion­
ing the residue of the administrative expenses is the direct labor cost
basis. This practice appears to be most popular, principally because
it is easily applied and generally understood by manufacturing exec­
utives. It is obviously inaccurate where wages for similar classes of
work are not fairly uniform in the various departments. In many
cases it would be more accurate to use the direct labor hour or
machine hour basis.

Distribution of Overhead in Bakery

(June, 1935)

QUESTION: Would you kindly advise me what methods are

used in the distribution of overhead expenses in a bakery having the
following departments: bread, cake, pastry and doughnut?
The direct labor allocable to each of the above departments is
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 Questions and Answers
clearly earmarked, but the overhead expenses, such as depreciation
on buildings and equipment, taxes, insurance, indirect labor, etc.,
overlap to a great extent.
The direct labor basis of distribution does not seem equitable for
the reason that the pastry and cake departments have more hand
work and less machine work than the bread department. The other
possible bases would be retail sales value, production tonnage or
prime cost (material and labor combined); but none of these bases
appears to give a fair distribution.
I would be interested to know what basis is commonly used by
the larger bakery companies which produce the above four kinds of
bakery products.

ANSWER: The distribution of the overhead expenses as between

products presents a difficult problem and in the consideration of any
method of distribution the arbitrary features of the apportionment
of the expenses must be recognized. We have found that certain
prominent baking companies do not distribute the overhead ex­
penses as between products; the departmental statement of opera­
tions reflects only the direct charges to the departments.
The following is suggested as a method of distribution of these
expenses:

Indirect labor— On basis of sales value of prod­

(superintendence, etc.) uct
Depreciation, taxes, rent, plant, On basis of floor space
general repairs, etc.
Salesmen’s salaries Generally paid on commission
basis which may be charged
direct. Other payments on
basis of sales value
Advertising, etc. On basis of sales value
Truck expense— On basis of tonnage
(gasoline, repairs, deprecia­
tion, etc.)
Administrative expenses On basis of sales value

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 American Institute of Accountants

Profits and Losses of Subsidiary Company

(January, 1933)

QUESTION: A large corporation controls a small selling organi­

zation for one class of trade only. This selling organization is sepa­
rately incorporated.
The parent corporation has carried the investment in the selling
organization (1oo%) at cost, since the investment is a permanent
one, and since a consolidated balance-sheet is furnished in addition
to the individual corporation statements.
Is this procedure correct? Or should the profits and losses of the
subsidiary be reflected in the parent-company books? No dividends
have ever been paid on the selling-company stock.
If profits are not taken up, should losses be taken, on the theory
that valuations should be on the basis of “cost or market whichever
is lower”?

ANSWER NO. 1: The presentation of a consolidated balance-

sheet, and presumably consolidated profit-and-loss and surplus ac­
counts, in addition to statements of the same nature applicable to
the parent corporation and to the subsidiary, should provide all the
essential information.
We understand that legally the profits and losses of a subsidiary
should not be entered periodically in the books of the parent corpo­
ration and carried into the surplus account of the latter except as
profits are formally declared by way of dividends. But circumstances
and practical considerations at times may be such as to justify in­
corporation in the books of the parent corporation of the profits and
losses of a subsidiary. In the case under consideration the subsid­
iary is in all probability virtually a branch selling organization. That
being so we see no objection to the incorporation of the results of
the operations of the subsidiary in the books of the parent corpora­
tion. Thus, in effect, the books of the parent corporation would be
representative of the situation which would exist if the subsidiary
had in fact been operated as a branch. By this procedure the in­
vestment in the capital stock of the subsidiary will become adjusted
annually to accord with the net worth of the subsidiary as shown by
its balance-sheet, assuming that the original investment cost corre-
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 Questions and Answers
spends with the net worth of the subsidiary at the time the invest­
ment was made.
When the profits and losses of a subsidiary are not incorporated
in the accounts of the parent corporation, except as dividends re­
ceived, care should be exercised to assure proper disclosure of re­
sults by a footnote to the statements or in other ways—if, for in­
stance, (a) the circumstances are such that the dividends received
are from subsidiaries operated at a profit sufficient to cover the divi­
dends whereas other subsidiaries are operated at a loss which might
exceed the profit of the profitable subsidiary, or (b) dividends may
have been paid by subsidiaries in excess of current earnings of such
subsidiaries.

ANSWER NO. 2: It is our idea that it is quite proper to continue

carrying the investment in the subsidiary at cost on the books of the
parent company and to transfer neither profit nor loss, except as
dividends are received by the parent company.
As a consolidated balance-sheet is furnished, the true situation is
set forth on that statement. However, in submitting a statement of
the parent corporation without consolidation, we believe that suit­
able notation should be made showing that the investment in the
subsidiary company is carried at cost and giving information as to
the actual net worth of the subsidiary—that is to say we believe
reference should be made to the accumulated surplus or deficit.

Treatment of Losses on Financial Statements

(February, 1935)

QUESTION: Will you kindly ascertain for us the usual accepted

practice in the treatment of the following items in the preparation
of annual statements:

1. Should losses arising from the dismantlement of plants and

equipment be considered in the determination of net income for the
year or should such amounts be carried directly against surplus?
Would the manner of treatment differ if the amounts involved were
very substantial?
2. Should losses on securities owned, realized or unrealized, be
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treated as charges against income or should the amount thereof be
applied against surplus? Would the manner of treatment differ if the
shrinkage in value occurred prior to the fiscal year in which the loss
was recognized?

3. During the year 1934, it was determined that the reserve for
uncollectible accounts receivable at December 31, 1933, was in­
sufficient, since it did not provide for a number of accounts, material
in amount, which have since become doubtful. These accounts are
charged off during the year 1934. Should the amount of this loss
be reflected in the determination of net income for 1934 or should
it be charged against surplus?
Will you also inform us what practice is followed in treatment
of such items in the preparation of quarterly earning reports?

ANSWER: Dismantlement losses and security losses customarily

are taken against the net income if they arise from normal circum­
stances which might be expected to occur in any year. In order to
apply such matters directly against surplus, the circumstances would
have to be so unusual as to indicate a complete departure from
ordinary operating routine by the company in that period. In the
case of dismantlements such an extraordinary situation might be
caused by the abandonment of an entire important process of manu­
facture or treatment which would involve dismantlement of a good
portion of plant and equipment.
In the case of securities, unless some periodic routine provision is
made for losses which builds up a reserve, no unrealized losses would
be provided for through income account. Often extraordinary un­
realized losses are provided for by setting up reserves which are
charged direct to surplus. In the case of realized losses if they occur
in the routine investment and reinvestment of surplus funds of the
corporation, losses are obviously and equally routine current items.
If securities are of the nature of investments, rather than the plac­
ing of surplus funds in marketable securities, the losses would apply
against current income or surplus depending upon whether it was
related to current operations or not.
The question whether the loss is of a substantial amount or not
does not govern so much as the question of whether the loss is ex­
traordinary or not.
For uncollectible accounts, provision is made at the date of the
balance-sheet based upon the facts then known. The assumption is
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 Questions and Answers
that the reserve is adequate at that date. Should it prove to be in­
adequate at some later date an adjustment as of the earlier date
should not be made unless the circumstances were known or ex­
pected at that time. Bad debts written off or provided for through
reserves, when determined bad or uncollectible during the period
under audit, generally arise from sales of prior periods.
In the case of a business where a decided change has taken place
in the method of collections, type of sales or clientele, it is conceiv­
able that an adjustment might be made directly to surplus in rela­
tive accounts arising from sales of prior periods. This adjustment
would be expressed as related to a type of operation no longer car­
ried on, and it practically expresses the fact that an old set of trans­
actions or operations ceased and a new set was instituted within the
period. Circumstances such as these are infrequent and the auditors
should not allow themselves to be persuaded too easily that they
exist.
Modern practice as shown by the published accounts of repre­
sentative companies in the last few years indicates that the distinc­
tion between charges to surplus and income is not as important as
full and correct description of the transactions. Many representative
companies prepare combined income and surplus accounts, and the
income in some cases is only one of a number of items which repre­
sents the total change in surplus or net worth during the period.
From many points of view this difference is the significant figure
and, while accounting is always concerned with the division of busi­
ness activities into more or less arbitrary periods, it is just as true
that this attempt always fails and the so-called surplus adjustment
recognizes that this distinction can not be completely carried out.

Cost of Capital Supplied to Subsidiaries

(July, 1932)

QUESTION: A holding company which owns the majority of

stock or the controlling interest in several companies operating pub­
lic utilities provides its constituents with financial, legal, engineer­
ing and management services, in return for which it receives a defi­
nite percentage of the gross revenue of its operating companies. The
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magnitude of the operations and the service required by each of the
operating companies vary according to the communities served and
the services rendered by the holding company. All the operating
companies share the management services in a greater or less degree.
The holding company provides the cash funds required annually
by each of the operating companies. It finances its own operations
through sale of bonds to the public, by loans from bankers and other
fiscal sources and by the sale of common stock, the latter frequently
at a premium. Bonds have been sold bearing interest at varying
rates, not exceeding 5½ per cent. on the nominal value; temporary
loans have been raised at generally lower rates and annual dividends
of 12 per cent. have been paid on the par value of the common
stock.
What should be considered “the cost of capital” supplied to the
operating companies in any one year?

ANSWER NO. 1: Assuming that the phrase “cost of capital” is

intended to refer to the rate of interest at which subsidiaries should
be charged for advances made to them by the holding company
throughout a given year, we may say that, in our opinion, where ad­
vances made to subsidiaries may be earmarked as representing the
proceeds of specific loans, the effective rate of interest payable by
the holding company on such loans indicates the cost of the capital
and should be charged to the subsidiary. On the other hand it would
seem to us that a reasonable rate of interest, not in excess of the ef­
fective rate at which funds might be obtained by the respective sub­
sidiaries in the open market, should be charged in the case of ad­
vances made to subsidiaries from the proceeds of sales of common
stock or from undistributed profits.
While directly applicable to the capitalizing of interest during con­
struction, the following quotation from the interstate commerce
commission’s regulations for steam roads, is, we think, pertinent to
the present discussion:

“When any bonds, notes, or other evidence of indebtedness are

sold, or any interest-bearing debt is incurred . . . the interest accru­
ing on the part of the debt representing the cost of property charge­
able to road and equipment accounts (less interest, if any, allowed
by depositaries on unexpended balances) . . . and such proportion
of the discount and expense on funded debt issued ... as is equi­
tably assignable . . . may be capitalized. Interest during construction
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 Questions and Answers
shall include reasonable charges for interest, during the construction
period ... on the carrier’s own funds expended for construction
purposes.”

As to “what should be considered ‘the cost’ to the holding com­

pany of capital supplied to the operating companies in any one year,”
we do not see that it is possible accurately to determine this in
cases wherein such capital represents proceeds from sale of the
holding company’s common stock and undistributed profits. Any
attempt at finding such a cost would necessarily be arbitrary.

ANSWER NO. 2: According to the question the holding company,

which provides the cash funds required annually by each of the
operating companies, finances its own operations through various
sources, namely:
(1) by the sales to the public of bonds bearing interest at vary­
ing rates not exceeding 5½ per cent. on the nominal value;
(2) by loans from bankers and other fiscal sources at interest
rates generally lower than in (1);
(3) by the sale of common stock, frequently at a premium, annual
dividends of 12 per cent. having been paid on the common
stock.

The several companies, though separate legal units, comprise, for

operating and financial purposes, a composite entity, and the finan­
cial requirements of the group are provided out of a common fund.
It, therefore, follows that the total cost of capital, the interest,
assumed in the first place by the holding company, should be pro­
rated to the constituent companies in proportion to the funds used
by each of the companies in any year.
In other words, the average rate of interest should be determined
on both funded debt and current borrowings and such rate charged
on the average balances due from the operating companies, the
balance of interest paid being chargeable to the holding company.
It does not seem to us that the interest charged by the holding com­
pany should be loaded, inasmuch as, apart from other considerations,
it undertakes, among other things, to provide financial services for
the agreed compensation—though no great objection could be urged
against a small increase to the average interest rate mentioned.
Further, the rate of dividends that have been paid on the holding
company’s common stock is not a factor in the cost of capital. The
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funds derived from capital stock may be transferred in part to the
operating companies but the rate of interest is that at which ex­
perience shows the holding company is able to raise funds by the
issue of bonds and from current borrowings, as distinct from the
rate of income distributed from earnings on proprietors’ capital.

Manufacturing Companies and Sales Subsidiaries

(June, 1931)

QUESTION: A corporation, engaged in manufacturing a com­

modity, owns the entire capital stock of a subsidiary whose functions
are confined to selling the manufactured product. The manufac­
turing corporation has shown substantial earnings each year but
such earnings have fluctuated considerably, due principally to
changes in the value of raw materials. It is the desire of the man­
agement to insure a fair profit to the sales corporation so that the
true manufacturing profit will be reflected in the accounts of the
producing corporation and the selling profit in the accounts of the
sales corporation. During the past three years an attempt has been
made to fix the price to the sales corporation at the beginning of
each year with the above end in view, but in the past three years
the sales corporation has shown a substantial profit in one year, a
substantial loss in another, and has about broken even in the third.
It would appear that the most logical way of bringing about the
desired result would be for the manufacturing corporation to sell
its product to the sales corporation on a cost-plus basis, the per­
centage to be fixed by past experience.
Will you please ascertain, if possible, whether or not such a
method has been generally adopted by organizations similarly situ­
ated and also what other methods have been found practical in
actual use?

ANSWER NO. 1: The writers have knowledge of several plans

carried out successfully where similar relationships exist and where
in each instance the parent and/or manufacturing company were de­
sirous of supplying their products to the selling companies at suffi­
ciently attractive prices so as to permit the latter to earn a fair mar-
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 Questions and Answers
gin of profit after deducting all expenses without at the same time
unduly burdening their own operations.

Plan 1
The manufacturing company agrees over a specified period to sup­
ply its sales subsidiary with products on the basis of predetermined
prices, subject to revision quarterly or semi-annually, to net the
manufacturer full cost of material, labor, factory overhead, plus a
small percentage, usually not over 10% nor less than 5%, on the
total factory cost, to cover a fair portion of the manufacturer’s
supervision or administrative cost and a small margin of profit.
The manufacturer in determining prices to the selling company
provides that such prices are subject to revision quarterly or semi­
annually, depending on the trade practice followed by the industry
with respect to price revisions. When the manufacturer calculates
his material costs they should not vary much from current prices,
and if the supply on hand is inadequate to meet the selling com­
pany’s needs he usually covers his requirements at definite prices to
guard against a rising market in the raw materials involved.
If the manufacturing company carries diversified products, differ­
entials are allowed between certain classes or types of product to
stimulate sales in the most profitable direction.

Plan 2
The manufacturing company agrees for a specified period to sup­
ply the sales subsidiary with products on the basis of full factory
cost and to divide the net profits of the latter in the proportions of
50% to the manufacturer and 50% to the seller. The manufacturer
requires this 50% share in consideration of his supervision, financial
assistance and other valuable service conducive to a successful sales
program.

Plan 3
Where the manufacturing company itself is also engaged in selling
its products to the trade, in a territory not reached by the subsid­
iary, it agrees for a specified period to supply products to the latter
at its own regular sales prices less its own regular percentage of sell­
ing expense and less half of its own usual margin of profit.
All three plans operate more or less satisfactorily, but the first two
enumerated give the best results.
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 American Institute of Accountants
When these plans fail, the difficulty can usually be traced to the
manufacturer for having endeavored in a period of violent price fluc­
tuations in raw materials to penalize the selling company for mis­
takes of the manufacturer in purchasing its materials. The selling
company should always be placed in a competitive position by being
able to secure its needs on the bases of current or nearly current
market levels. The failure to observe this rule imposes an unfair
hardship on the selling organization, and it involves the loss of pres­
tige or goodwill of its customers. It is recognized in almost every in­
dustry that when raw-material prices decline the prices of the fin­
ished products in which they are used also decline, and however
competent a sales organization may be it can not combat the de­
mands of the trade for lower prices. The manufacturer is compelled
to face this inevitable procedure, and must be prepared to accept
losses due to his own bad judgment in buying or due to other eco­
nomic causes beyond his or the seller’s control.

ANSWER NO. 2: While we have seen an attempt made to reach

the desired result by a manufacturing corporation selling its product
to a sales corporation on a cost-plus basis, the percentage being fixed
by past experience, it has been found that this does not always work
out satisfactorily for obvious reasons. An alternative method, how­
ever, which we have seen in operation satisfactorily is for the manu­
facturing corporation to charge the selling corporation at a discount
from the selling corporation’s normal average selling price, such dis­
count being sufficient to cover the normal overhead of the selling
corporation and to leave a normal profit. There are many considera­
tions that enter into an arrangement of this kind and should it not
be found possible for the manufacturing corporation to make a profit
as well as the selling corporation under such an arrangement, it is
obvious that the manufacturing corporation’s costs are too high
from inefficient management, lack of facilities, improper location,
lack of capital or other reasons. It is, of course, presumed that the
utmost good faith exists between the management of the manufac­
turing corporation and the management of the selling corporation
and that the management of the selling corporation is efficient and
able to obtain the best prices consistent with the market and other
surrounding conditions.

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 Questions and Answers

Bad Debt Losses in Periods of Depression

(August, 1932)

QUESTION: We have been requested to charge separately to sur­

plus bad debt losses considered to be unusual losses during the pres­
ent period of depression, and the clients submit that, at least in part,
such unusual losses are due to inaccuracies in bad debt reserves for
prior periods.
Similarly, requests have been made that we separately charge to
surplus computed amounts considered to be declines in inventory
values due to the market trend of the past year. The argument sub­
mitted in this instance is that the management had no control over
these price declines and therefore the item is of an unusual nature
and not a proper charge to operations. In particular, we have had
this request in one instance wherein the computation of the decline
is based on actual items included in the beginning and ending inven­
tories at different values.

ANSWER NO. 1:
(a) The treatment in the accounts of unusually large losses
from bad debts due to the present business depression.
(b) The treatment of inventory write-downs necessitated by
price declines.

The conditions described in your correspondent’s letter are not

peculiar to one or two companies, and we venture to say that prac­
tically all industrial companies were faced with the same problems in
a greater or lesser degree at the close of the past year.
With regard to (a) it is, of course, obvious that losses from bad
debts are greater in periods of depression than in periods of prosper­
ity, and we believe it has been the experience of industrial compa­
nies generally that considerable increases have been necessary in
provisions for bad debts in the past two years. While it would un­
doubtedly be conservative practice to establish reasonably substan­
tial reserves in prosperous times to provide for possible future losses
from bad debts, we do not think that failure to provide ample re­
serves in the past would warrant charging to surplus losses now in­
curred which conceivably might have been provided for previously.
However, reserves for bad debts are largely estimates at best, and
probably it will be found that the necessity for making unusually
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 American Institute of Accountants
large provisions at this time is not due principally to inaccuracies in
previous reserves but is a result of business conditions arising dur­
ing the current year, which could not have been reasonably foreseen.
It follows, therefore, that bad debt provisions should all be absorbed
in the profit-and-loss account, and it has been our experience that
this practice is being followed practically without exception. Such
charges may, of course, properly be shown as a separate item in the
profit-and-loss statement.
With regard to (b) it may be of interest to quote the following
from the Institute’s “Special Bulletin No. 7” issued in December,
1920:

“It was agreed that it would be in order to show operating profits

on the basis of inventories at cost (less usual provisions for obso­
lete stock, etc.) and the adjustment from cost to market as a special
charge either against profits or surplus, provided that the procedure
adopted was clearly described. In point of fact, the loss from the
decline of prices is an offset to the extraordinary profits from in­
creasing prices realized over a series of years and not an operating
loss of the year, but as the extraordinary profits in the past years
have been included in the ordinary profits, any statement this year
either must similarly absorb the corresponding decline or show
clearly that this decline has not been absorbed in the operating re­
sults.”

While the present conditions in some respects are comparable to

those existing in 1920, it should be borne in mind that in 1920 price
declines took place over a comparatively short period; whereas in
the present instance the trend of market prices has been downward
over a period of some two years. There would not appear to be much
point to the arguments advanced by your correspondent’s client that
the price decline is of an unusual nature because the management
had no control over prices. Price declines and advances occur from
time to time and are usually beyond the control of management, and
it would be quite impracticable to attempt to eliminate from oper­
ating statements the effect of changes in price levels either of pur­
chases or sales or of fluctuations in volume. Furthermore, we are
satisfied that the treatment of an inventory write-down under pres­
ent conditions as a surplus charge would be looked upon with disfa­
vor by bankers and investors generally, and in any analysis of oper­
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 Questions and Answers
ating results the write-down would be applied against the current
profit.
We do not think the fact that some of the items upon which the
price declines are computed appear in both the opening and closing
inventory has any particular bearing on the question. It simply
means that the prices of these items have declined during the year
and the difference must be absorbed in the write-down. It does, how­
ever, raise the question of whether a further write-down is required
for obsolete or slow-moving stock.
ANSWER NO. 2: It is quite rare to find a commercial business
of any size which can accurately ascertain at the end of each ac­
counting period the exact amount of the losses which will be sus­
tained in collection of the accounts receivable at a particular date.
It is, therefore, generally admitted that the balance-sheet allowance
for bad debts, with the resulting charge to the income account, is at
best a careful estimate. There may be an occasional unusual case in
which there would be justification for charging bad debts to surplus,
but, as a rule, such charges should be made to the current income
account.
If a concern has set up reasonable estimates of anticipated bad
debt losses, and if, due to general business conditions such as exist at
the present time, the amount of losses is abnormally high, then it
would seem that such bad debt losses should be charged to the in­
come account of the period in which the accounts are determined to
be uncollectible.
One of the hazards of any business which carries an inventory is
the variation in inventory values due to market fluctuations. Inas­
much as such market variations are an essential part of the conduct
of such a business, there seems to be no justification whatever for
ignoring such variations as proper charges to the income account.
In any year in which there are abnormal declines, it might make a
better presentation to show such abnormal amount as a separate
deduction on the income account. There might conceivably be a
case in which there has been a radical, and probably permanent,
change in market values of some inventory item, and the inclusion
of the full amount of such change might have no particular relation
to the operations of the year in question. For example, if some new
process for producing raw materials had been discovered, and as a
result there had been a radical decline in the market price and it
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 American Institute of Accountants
was fairly certain that such reduced price would continue, then such
a decline might preferably be set out separately in the income ac­
count, but might be charged to surplus, provided adequate disclosure
of such surplus charge were made.
We think it essential that in cases in which justification can be
found for charging to surplus items of a class which ordinarily
would be charged against the income account there should be ade­
quate disclosure of the amounts so charged to surplus and the nature
of such charges.
On the whole, the questions raised in your letter are of common
occurrence under present business conditions, and usually are due
to a desire to make the results of operations appear better than
they actually are and to a failure to face the facts.

ANSWER NO. 5; As a matter of basic principle, every so-called

surplus adjustment is, in fact, a correction of the operating results
of some year. There are cases in which losses arise which clearly ap­
ply to the operations of a prior year and may, therefore, be prop­
erly charged against surplus. In a restatement of the surplus ac­
count, analyzed as to earnings of prior years, such an adjustment
would be directly applied against the operations of the particular
year affected.
If it can be demonstrated logically that a reserve for bad debts,
at the beginning of the year, was insufficient on the basis of facts
ascertainable at the time, the relative increase in reserve for bad
debts should be treated as a charge against surplus.
So far as provisions for market decline in inventory are concerned,
such provisions should be made by charges against operations in the
year in which the declines occur.
Here, again, if it can be clearly demonstrated that inventories at
the beginning of the year have, for one reason or other, been over­
stated, an adjustment of such inventory at the beginning of the year
may be made by a charge against surplus, but the provision for such
decline as may have occurred during the current period should be
charged against current operations.
As to inventory, it should also be noted that it is accepted prac­
tice to provide for substantial declines, which have occurred subse­
quent to the date of the balance-sheet (but prior to the issuance of
statements), by an appropriation of surplus. This provision is made
for the purpose of stating the balance-sheet conservatively on the
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 Questions and Answers
basis of latest available information, but the losses represented by
such an appropriation of surplus should be absorbed in the opera­
tions of the ensuing period and the appropriation should be reversed.

Basis for Computing Depreciation

(August, 1935)

QUESTION: Should depreciation be computed on the basis of

utilization instead of time? Please will you tell me in what degree
the public accountants permit such a depreciation policy.

ANSWER NO. 1: It seems to us that there is no novel principle

projected and that, despite the apparent misconception there is at
bottom merely a change of terminology with no change of meaning.
“Utilization,” as the basis of the charge for plant facilities con­
sumed in production, is really the application of the so-called pro­
duction method of computing depreciation—that method, namely,
whereby the life of the instrument of production is estimated in
terms of units of product, the depreciation per unit being thus de­
termined.
If, then, the public accountant is satisfied that, however computed,
the provision for depreciation is adequate he may with propriety
approve. To this we may add without irrelevance that functional
depreciation may be an important element no less than the physical
depreciation.
ANSWER NO. 2: Schemes of depreciation under which charges
vary with production are common and may be regarded theoretically
as one degree more scientific than those based on lapse of time alone.
Under such schemes the effect on the income account is to provide
more for depreciation in times of prosperity than in unprosperous
times. In pure theory, the propriety of this policy is justified, but it
is hardly practicable to estimate the proportions of periods of pros­
perous times and unprosperous times during the useful life of
property.
It is well known that depreciation goes on even though the machin­
ery is idle, and it might well be that the depreciation in some cases
is actually greater when the machinery is idle than when it is being
used. This factor may well be ignored in a rigid scheme of providing
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for depreciation on the production basis alone. If so, owing particu­
larly to protracted periods of relatively low production, there is the
danger of failing to accumulate from earnings in the required time
the funds needed to replace the machinery when it is exhausted or
rendered obsolete. It has been our experience that corporations that
have used this basis in providing for depreciation both in times of
prosperity and unprosperous times are mindful of its dangers and
have consistently followed the practice of keeping the annual pro­
visions, as a whole, within a reasonable proportion of the amounts
required on the basis of lapse of time and taking into consideration
the factor of obsolescence.

Depreciation Rates on Machinery and Equipment

(June, 1933)

QUESTION: This question is one of a technical nature concern­

ing machinery and equipment, the assets being recorded on the books
of a corporation in a group account and depreciation being computed
thereon at the rate of 15 per cent. per annum. The question is, upon
breaking down the asset account by specific items that have a physi­
cal existence at the time of the breaking down, do you consider the
proper method of ascertaining related depreciation to each specific
item to be 15 per cent. per annum from the date of acquisition of
each item, based on the value thereof?
At the time of this break-down it is ascertained that for various
reasons, such as not clearing the asset account upon the disposal of
any asset, after abstracting the 15 per cent. per annum reserve for
depreciation for each specific item, there remains an excess balance
in the reserve for depreciation account. It is contended that this
excess reserve should be adjusted to surplus. It is also contended that
such excess reserve should be allocated against the oldest specific
item in the inventory until this excess depreciation has been allocated.
This method results sometimes in fully depreciating an asset perhaps
only one or two years old.

It seems to us quite clear that, under the stated con­

ditions, the depreciation relating to specific items would not be cor­
rectly determined by applying against the individual items 15 per
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 Questions and Answers
cent, per annum, based on the value, from the date of acquisition of
each item.
The original composite rate of 15 per cent. per annum is the re­
sultant of a series of varying rates, ranging from a high of, say, 25
per cent. to a low of 10 per cent. so that manifestly it would be
incorrect to apply what is a weighted average, the composite rate,
against specific items which, separately considered, carry a higher
or a lower rate. The following table will illustrate the point:

Annual
Cost less depreciation
residual (straight Depreciation
Item value Estimated life line) rate
I. ....... $ 35,000 6 yrs. (approx.) 6,000 16⅔
2. ....... 15,000 3¾ “ 4,000 26⅔
3 ....... 30,000 10 3,000 10
4 ....... 20,000 10 2,000 10

$100,000 15,000 15% = Composite

Now, while a composite rate of 15 per cent. will provide for the
amortization of the cost of the plant as a whole, it is immediately
apparent that such a rate is not applicable even to a single unit.
It seems to us that the only satisfactory accounting will be to com­
pute the depreciation on the separate units—the correct basis in any
case—and inasmuch as the original group account has now been
broken down into its constituent elements, the necessary data should
be readily available. If, after adjustment for retirements, the reserve
for depreciation as now recorded is in excess of the depreciation so
computed, the difference may with propriety be transferred to
surplus.

Depreciation
(October, 1921)

QUESTION: Corporation X has been engaged in manufacturing

a specialty for ten years, during which period it has had an average
investment in plant and equipment of $500,000. During the first five
years it consistently incurred losses which ultimately aggregated
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 American Institute of Accountants
$200,000, but during the latter five years it made profits aggregating
$250,000. No provision for depreciation was made during the first-
mentioned period on the theory, which the corporation insists is
sound, that since no profits were made there was no available source
from which to provide a reserve for depreciation. During the latter
period since profits were actually earned depreciation was written
off at an annual rate based upon cost and probable life from date of
purchase without in any way reflecting the failure to provide for
depreciation in the earlier period.

Query 1. Is it sound accounting to disregard depreciation of plant

and equipment in use as a charge to profit-and-loss account in periods
when no profits are earned?

2. Is it proper to determine a net loss on profit-and-loss account

without making provision for depreciation?

3. Is a balance-sheet prepared during years of deficits properly

and correctly prepared if no provision has been made for depreci­
ation?

ANSWER: It seems to me clear that depreciation goes on whether

a company is making money or losing money. As long as the plant
is being operated depreciation takes place. My answers to your in­
quiries would therefore be as follows:
Query 1. It is not sound accounting to disregard depreciation of
plant and equipment in periods when no profits are earned.

2. It is not proper to determine profits without making provision

for depreciation.

3. A balance-sheet is not properly prepared if provision is not

made for depreciation.

Freight, Royalties, Packing and Shipping as Expenses

(January, 1935)

QUESTION: The question of the correct treatment of certain

expenses has come up in connection with my practice and I should
greatly appreciate any assistance you can give me in the matter.
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 Questions and Answers
The first question is the proper allocation of the cost of freight
outward. I have deducted this cost from gross sales but I notice that
a number of accountants consider this as a selling expense. Could
you advise me the best practice with respect to the allocation of this
expense?
Another matter is the question of the proper allocation of royalties
paid. In this case a corporation manufactures candy and pays royal­
ties to another corporation for the use of a name which is trade-
marked, and the royalties are paid on the number of cartons sold.
I have treated the cost of royalties as a selling expense but the cor­
poration for whom I do the work wishes me to regard this expense
as a deduction from gross sales. In your opinion, which is the correct
allocation of this expense?
Another matter which has come up is the proper treatment of
packing and shipping supplies and packing and shipping labor. I have
treated these items as a selling expense but the management of the
corporation believes that these expenses should be regarded as manu­
facturing costs. I have held that these items should be allocated to
selling expenses.
The corporation maintains certain branch offices in the West from
which offices sales are made to customers in adjacent territories. I
believe that all the expenses of these branch offices, including the
office salaries, postage and office expenses, are correctly allocated as a
selling expense. Will you please advise me if you consider this a
proper allocation?

ANSWER: The first question refers to the proper allocation of

cost of freight outward. We believe that the correct procedure is to
deduct such freight from the proceeds of sale rather than to con­
sider it as a selling expense because, as a matter of fact, it is not a
selling expense.
The second question has to do with royalty payments. The logical
thing in this case is to charge the royalties paid to cost of sales and
not as a selling expense because it is, in fact, an expenditure for the
privilege of making and selling its product and not part of the ex­
penses incurred in selling.
The third question has to do with packing and shipping supplies
and packing and shipping labor. These expenses are also part of the
cost of sales; they are neither manufacturing cost nor selling ex­
pense.
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 American Institute of Accountants
The fourth question refers to the expenses of a branch office. Inas­
much as the branch office is established and maintained for the pur­
pose of selling, this expense may logically be included among selling
expenses.

By-Products
(September, 1921)

QUESTION: We desire to secure some information as to the usual

accounting procedure adopted by recognized accounting authorities
in recording the cost of net profit of by-products, particularly as they
effect the soap manufacturing industry which produces the by-prod­
uct of glycerine.
It is desired to secure in full, and if possible, a statement from
recognized authorities, as to whether in a case where it is impossible
to properly allocate the actual cost of producing a by-product as
against the cost of producing the soap, the sales of the by-product
should be recorded in the year in which they are actually sold, as it
is possible, in some instances, that although the soap as manufac­
tured is sold within a reasonable period after manufacture, owing to
the steady demands for soap, the by-product would be compelled to
await future demand, which is very unsteady, and cannot be ascer­
tained or anticipated with any degree of correctness.
The main point on which we desire enlightenment is as to whether
the income on the by-product should await the sale of the by-product
or as to whether the by-product on hand at the end of each year
should be inventoried at an estimated cost (the actual cost being
indeterminable) and the cost of the main product be credited with
the estimated cost or market value of the by-product.

ANSWER: Some by-products, so-called, are of such minor im­

portance and value that the amount realized from them is deducted
from the cost of producing the major product. In other cases, the
by-product becomes a greater factor by the introduction, perhaps,
of other ingredients and in that event may be of sufficient magnitude
to warrant its being treated as a product standing by itself on which
its own profit or loss would be determined. In that case, the cost,
as nearly as it can be determined, of the element derived from the
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 Questions and Answers
manufacture of the major product will be credited to that product
and charged against the by-product account.
It really makes very little difference, however, whether the by­
product is of greater or less importance as respects the cost of the
major product, except that in one case the cost would be deducted
from the cost of the major product, and, in the other case, the reali­
zation from the sale of the by-product would be deducted from the
major product cost.
In the latter case it would seem that there would be no difference
in treatment between such a by-product and scrap that might accu­
mulate as a result of manufacturing process. In some operations, such
as stamping out articles from brass sheets, a comparatively small
part of the metal remains in the finished product and the scrap ac­
cumulations are very large. Obviously, the cost of the product cannot
be determined until credit is allowed for these scrap accumulations.
The same principle would seem to be true of by-products. The cost
of the major product cannot be determined accurately until credit
is given for whatever value the by-product may have. There seems
to be no reason why the reduction in cost, or so-called income from
the by-product, should await its sale any more than credit would not
be allowed on scrap until it is sold. If any is on hand at the end
of the year, in our opinion, it should be inventoried at a fair market
value as nearly as that can be determined. If it is to be sold, it
should be inventoried at cost, if that is less than market value, if
the cost can be determined, and it is to be used with other ingredi­
ents in making a minor product to be marketed in due course.

Newspaper Subscriptions
(July, 1922)

QUESTION: In auditing the accounts of a daily and weekly

newspaper publication, we find that all money received from sub­
scriptions has been credited to income in the period in which re­
ceived, and we also find that the method of keeping the records
makes it very difficult to arrive at the amount of prepaid circulation
at any date.
In this particular case the amount of prepaid circulation is im-
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 American Institute of Accountants
portant, and it is also important to know the amount of earnings
in the future on the accrual basis. We should be glad to have you
obtain through the Bureau of Information opinions as to the proper
and practicable method of handling income from subscriptions on
the accrual basis, and give us your results.

ANSWER: We suggest that the installation of a subscription rec­

ord somewhat of the following columnar arrangement may answer
the purpose:

1—Date
2—Number (or other identification) of subscription
3—Subscription period
4— Amount of subscription
Fiscal period to be credited
5— 1st quarter
6— 2nd quarter
7— 3rd quarter
8— 4th quarter
Beyond
9— Period
10— Amount
11— Remarks

All subscriptions should be entered consecutively and the amount

spread over the fiscal periods in which they will be earned. Cancella­
tions should be entered in similar manner but in red. At the close
of each fiscal period the totals of columns 5, 6, 7, 8 and 10 should
be respectively credited to the corresponding revenue accounts, a
revenue account to be opened for each fiscal period. Among the earn­
ings of the current fiscal period, say the first quarter of the year,
only the balance of that particular revenue account should be taken
up and the aggregate of balances of the other revenue accounts will
appear on the liability side of the balance-sheet as a deferred item
of “unearned subscription.”
If monthly statements of earnings are required there should be a
division of the subscriptions by months. If only an annual statement
is desired the division of the subscriptions will be as between current
and future years. Corresponding changes should then be made in the
columnar arrangement of the above suggested record. The columns
“beyond” will give the proportions applicable to the earnings of
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 Questions and Answers
future years as well as the data for opening the subscription record
and the several revenue accounts of the succeeding year.

Payment of Dividends from Net Earnings or Profits

(April, 1933)

QUESTION: The “A” company has net earnings or profits for

the year of $100,000, as shown by the books and the profit-and-loss
account. There has been charged out to profit and loss, on account
of depreciation, the sum of $35,000, which has been credited to the
depreciation reserve. There has been charged to the same reserve the
sum of $10,000 during the year, for renewals and replacements. There
has been expended for additions and betterments and charged to
capital accounts the sum of $60,000, all of which has been paid for
out of earnings.
How much of the net earnings or profits of $100,000 is really avail­
able for the payment of dividends?
There appear to be three methods of solving this problem as
follows:
1 2 3
Net profits $100,000 $100,000 $100,000
Less capital charges 60,000 60,000

$40,000
Plus: net credit in depreciation
reserve 25,000

Available for dividends $100,000 $ 40,000 $ 65,000

Under number one, no account is taken of the capital charges paid

for out of earnings. As, however, these charges are invested perma­
nently in the property, they can not be paid out as dividends, and
should be deducted from the net earnings to arrive at what is avail­
able for dividends. In the commonly spoken of phrase “earnings per
share” used in financial tables and publications, nothing is ever said
of the capital charges paid for through earnings, and the impression
that what is earned is the same as that available for distribution is
erroneous.
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 American Institute of Accountants
Under number two the full amount of the capital charges have been
deducted, leaving the available amount $40,000.
Under number three, not only the capital charges have been de­
ducted, but the net credit to the depreciation reserve for the year,
or $25,000 has been added, as this amount of the capital charges has
been considered to have been paid for out of the depreciation reserve.
In other words, the accumulation of current assets representing the
net increase in the depreciation reserve has been considered as being
invested in permanent improvements.

ANSWER: According to the question, the net profits of “A” com­

pany for the year amounted to $100,000. Depreciation of $25,000
had been charged to profit and loss, reserve for depreciation being
credited, and during the year renewals and replacements had been
charged against the depreciation reserve, while the capitalized ex­
penditure for additions and betterments, “all of which has been paid
for out of earnings,” amounted to $60,000.
The question proposed is: How much of the net earnings or profits
of $100,000 is really available for the payment of dividends?
Your correspondent offers three solutions:

Available for dividends:

(1) The full amount of the profits $100,000
(2) The profits $100,000
Less—capital expenditure 60,000 40,000

(3) The profits $100,000

Less—capital expenditure 60,000

$ 40,000
Add—depreciation reserve 25,000 65,000

With regard to (1) it is said that $60,000 of the profits, having

been permanently invested in the business, would not be available
for dividends, a condition corrected in (2) while in (3) the profits,
less capital expenditure, have been increased by the depreciation re­
serve, on the theory that the accumulation of current assets, repre­
senting the net increase in the depreciation reserve, has been con­
sidered as being invested in permanent improvements.
The difficulty under consideration, it would seem, is largely one of
terminology. Subject to whatever restrictions there may be in its
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 Questions and Answers
articles of association or arising out of contract, e.g., with bond­
holders, the “A” company, having earned $100,000 may legally de­
clare dividends up to that amount. The full amount of the profits is
therefore available for the stated purpose, but it would probably
not be practicable actually to distribute anything like that sum. In
other words the full earnings are available for dividends but the
capacity to distribute is conditioned by the availability of the neces­
sary cash.
Thus availability of profits and capacity to distribute are two
separate, though related, ideas. The former is not affected by the
extent of the capital expenditure out of funds provided by profits,
but such expenditure does of course impair the capacity to distribute.
Again, the reserve for depreciation may be reflected in increased
assets, current or fixed, but consideration of the foregoing shows that
the profits available for dividends are not thereby affected.
Where, as in the instant case, relatively large sums have been ex­
pended on capital assets, it is desirable to make a suitable appropri­
ation from earned surplus so that the balance-sheet will then show
that while—taking the figures of the case submitted—profits amount­
ing to $100,000 have been earned and are legally distributable
$60,000 thereof have been appropriated for additions to plant, leav­
ing the unappropriated surplus available for dividends at $40,000,
thus:

Earned surplus:
Appropriated for plant extensions $60,000
Unappropriated 40,000 $100,000

With regard to the comment on “earnings per share,” there is no

impropriety in so stating the earnings, even though part of the funds
provided by operations have been applied to capital expenditure.
The phrase “earnings per share” indicates earning capacity: it
does not purport to mean that dividends of an equal amount have
been, or can be, declared and paid. In brief, the statement that a
company has earned $2 per share is but a fragment of the information
and financial statements, consideration of which are necessary for a
proper understanding of a particular case. The erroneous impression,
then, is really due to fragmentary information and the mistaken at­
tempt to equate earnings with dividends.
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Accounting for Dividends

(July, 1932)

QUESTION: I would be obliged if you would obtain for me the

proper accounting for dividends received which had been declared
prior to the time the stock on which they were declared was pur­
chased.
In other words, if a corporation buys the stock of another corpora­
tion or a part of it after a quarterly dividend has been declared,
and as a result of the declaration pays a higher price for the stock
than it would have paid had the dividend not been declared, should
the dividend when received be credited to the cost of the stock or
treated as current income from dividends?

ANSWER NO. 1: We understand that the particular case in­

volved is one in which the purchase of stock occurs before the stock
sells “ex-dividend” or, if the purchase is made outside an exchange,
no suggestion is made that the dividend is being purchased sepa­
rately.
It is a general practice to consider the entire cost of the stock as
an investment and to take up the dividend as income when received,
even though the dividend may be paid for as part of the purchase
price of the stock. This view is taken by the United States treasury
for income-tax purposes, although there is some indication that in
a case directly in point the board of tax appeals might adopt the
opinion that the dividend in question is a return of capital.
However, the proper accounting practice is to treat any dividend
which was declared prior to the purchase of the stock and is payable
shortly thereafter as a return of principal rather than income. This
practice is in accord with logic as a dividend received would not be
an actual “earning” or “income” to the investor when, as a matter
of fact, there had been no investment during any substantial period
of time antedating the dividend payment.
If the stock is purchased for a stated price and a separate amount
is shown as the purchase price of the dividend, then clearly the pur­
chase price of the stock should appear separately in the accounts,
and the dividend when received should be credited to the cost of the
dividend, with nothing taken up for it in income.
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 Questions and Answers
ANSWER NO. 2: It is common practice among stock-exchange
houses to credit income account with dividends received on stocks
purchased between the date of the dividend declaration and the
record or ex-dividend date; dividends on stocks purchased between
the ex-dividend date and the date of payment are, of course, received
by the seller. In the ordinary case, therefore, the receipt of a quar­
terly dividend, in circumstances such as these, may be credited to
income.
There are many cases, however, when the receipt of a dividend
(not necessarily of a liquidating nature) may represent a return of
capital to a recent purchaser. Such cases are frequent when control
of one company is acquired by another, and the dividend is, in effect,
paid out of surplus at acquisition. The circumstances surrounding the
acquisition of a substantial block of stock in a company will usually
indicate readily whether or not the dividend payment comes within
this category, but in cases of this nature the accountant must study
the facts carefully before reaching his conclusion.

ANSWER NO. 3: The dividend in question is not income. The

amount of it should be credited to the investment if that account
has been charged with the full cost of the stock, although a better
treatment of the transaction in journal form follows:

On acquisition of stock:
Dividends receivable $...............
Investment in stock of ¥ Co. ..............
To cash
On receipt of dividend:
Cash
To dividends receivable

Qualification on Certificate Regarding Audit of Subsidiaries

(April, 1935)

QUESTION: We have been called upon to make an audit of the

XYZ company, a joint stock association, which owns practically 100
per cent. of the stock of various subsidiary corporations. The XYZ
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company is a large operator in a major industry, while the subsidiary
corporations operate only in kindred lines.
The ownership of the XYZ company is closely held and the gen­
eral public is not interested in its welfare. The XYZ company bor­
rows money from banks. Some of the loans are unsecured, but the
majority is secured. This money is used to finance the operations of
the XYZ company and to make advances to subsidiary corporations.
The XYZ company carries the investments in subsidiary corpora­
tions at the lower of cost or book values of the respective companies,
and these items are to be treated in this manner on the balance-
sheet.
We are requested to prepare a certified balance-sheet of the XYZ
company without examination of the books and accounts of the
subsidiary corporations and give an unqualified certificate as to the
financial position of the XYZ company. Detail statements of the
various subsidiary corporations are available to us in the office of
the XYZ company, all of which have been prepared by XYZ internal
audit department. The XYZ company has a well developed system of
accounting and reports. We are accorded the privilege of sending
out from the office of the XYZ company any verification letters we
may deem necessary regarding the accounts of subsidiary corpora­
tions. The subsidiaries are widely scattered and the XYZ company
does not consider it necessary to incur the expense of auditing the
subsidiaries.
Please advise whether it would be necessary to qualify our certifi­
cate as to the audit of subsidiaries or, providing we could obtain
satisfactory information from the office of XYZ company, if an un­
qualified certificate would be in order.

ANSWER NO. 1: The question does not give any indication of

the relative size of the investments in and advances to subsidiary
companies in comparison with the total assets of the parent com­
pany.
If the investments in and advances to subsidiary companies repre­
sent an important part of the total assets of the holding company,
we do not think that in ordinary circumstances an accountant would
be warranted in signing any certificate on the accounts of the hold­
ing company unless he had made examinations of the accounts of the
subsidiaries either at the date of the balance-sheet or at some rela­
tively recent date. We can not, of course, give a definite opinion as
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 Questions and Answers
to the extent of the examinations. Broadly speaking, however, we
should consider that the examinations to be made of the accounts
of subsidiary companies should be as extensive as would be made if
the same accounts were found in branches of the parent company
not separately incorporated.
On the other hand, if in the accounts of the holding company these
assets in subsidiary companies represent a relatively small part of
the total assets, we believe that a certificate could be given, but only
with a definite qualification. Such a qualification should state that
no examinations had been made of the subsidiary companies and
that the accounts of those companies had been accepted on the basis
of statements prepared by the company’s internal auditors and that
they represented only approximately a given percentage of the total
assets.

ANSWER NO. 2: We are of the opinion that the accountant

should state clearly in his report, with reference to the investments
of XYZ company in subsidiaries, that he has not examined the books
of account and supporting data of such subsidiaries and the extent
of the information regarding the affairs of the subsidiaries furnished
him by the management of XYZ company. Finally, his opinion
should be qualified in respect to such comments. We assume that the
accountant would qualify his report further if the statements of the
subsidiaries examined by him disclosed any condition affecting the
value of investments in subsidiaries as shown in the balance-sheet of
XYZ company.

ANSWER NO. 3: It seems to us, irrespective of the information

available in the office of the holding company regarding the status
of the various subsidiaries, and having in mind the correspondence
between the special committee on cooperation with the stock ex­
changes of the American Institute, and the committee on stock list
of the New York stock exchange, in which a uniform certificate was
decided upon and this particular point was stressed, that it is essen­
tial that the certificate to be issued by the independent auditor of
this company should be qualified by stating that the subsidiary com­
panies’ investments and advances are included at cost or book value
and that no audit of these accounts had been made by independent
auditors. Without this qualification it would naturally be assumed
by anybody receiving the statement of the parent company, with the
auditors’ certificate, that the auditors had satisfied themselves as to
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 American Institute of Accountants
the values assigned to these various investments and advances to
subsidiaries.

Qualifications in Presentation of Financial Statements

(January, 1932)

QUESTION: I have a problem confronting me which deals with

the correct and ethical treatment and presentation of financial state­
ments. If you are in a position to render me an opinion as to your
interpretation of the matter, it will be greatly appreciated.
Recently I was called upon to conduct an audit for an investment
trust during its first year of corporate existence. To my mind a great
many practices of questionable nature were being carried on. How­
ever, in conference with the officers and their attorney, who is of
the most excellent standing in the community, censure was made of
certain proceedings, criticisms being spread upon the minutes of the
corporation and prohibiting further questionable transactions. After
proper action had been taken, a detailed report was rendered by me
which set forth the history of activities, and all statements were
qualified on the statements themselves. This report was, naturally,
of such a character that the officers of the corporation deemed it
inadvisable to make a general distribution of it to their stock­
holders.
Nevertheless, statements have been promised to the stockholders,
who number for the most part residents living in the rural section
of this part of the state. They have proposed that I prepare a finan­
cial statement at the close of July, 1931, for general distribution
among their stockholders.
The problem which confronts me is this: Could I prepare a bal­
ance-sheet without reference to my prior report, after all activities
that border on unethical practices have ceased and since these prac­
tices apparently will not be engaged in again? Or, should I qualify
or refer on the statement itself to a report rendered under a prior
date? Or, could I submit an unqualified statement of condition as
at the first of August?
I feel that a great responsibility is vested in me, due, primarily,
to the class of stockholders involved. I have discussed the problem
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 Questions and Answers
with other local practitioners, one thought being advanced that, since
it was apparently the desire of the officers of the corporation to con­
duct an ethical business enterprise and as the activities had not
ceased just temporarily for statement purposes, in all probability
reference to prior reports and qualifications might cause a great deal
more harm than good to the stockholders themselves.

ANSWER NO. 1: We are of the opinion that, if the questionable

practices which were being carried on at the time of the first audit
have been corrected prior to the second audit and it appears that
they will not again be engaged in and the client is acting in entire
good faith in the matter, your correspondent should not find it neces­
sary, in certifying the accounts, to refer to prior reports and qualifi­
cations, provided the accounts to be certified require no qualification
and disclose all pertinent facts. It would appear to us that reference
to the prior reports and qualifications in such circumstances would
undoubtedly do more harm than good to the stockholders to whom
the report would be mailed. If, on the other hand, there is any
doubt in the mind of your correspondent that the questionable prac­
tices were only temporarily abandoned and will subsequently be
revived, he should refuse to certify the accounts and would be well
advised to sever his professional connection with the company.

ANSWER NO. 2: Any answer to the query propounded in the

letter submitted must, of course, be subject to such changes as a full
knowledge of the practices—which are not explained but merely re­
ferred to as being “of questionable nature” and “unethical”—might
require.
Assuming that these practices do not have an actual bearing on
the correct statement of the assets, liabilities and net worth at July
31, 1931, and in view of the fact that “all activities that border on
ethical practices have ceased” and that “these practices apparently
will not be engaged in again,” we would ordinarily see no reason for
any reference to such practices in the balance-sheet at that date or
in the certificate related thereto. If the practices in question are of
such a nature that a statement of the income account for some period
ending with the balance-sheet date should properly bring them to
light, but no such income account is to be submitted in the proposed
report to be published to the stockholders, then, of course, care should
be exercised to the end that the reader of the proposed report may
not erroneously construe the accountant’s certificate as in any way
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 American Institute of Accountants
extending beyond the verification of assets, liabilities and net worth
as at July 31, 1931, to the point of implying also a certification of the
propriety of past transactions which such an income account (were
one presented) might reasonably be expected to disclose. The ac­
countant should not merely restrict himself to the preparation and
certification of a proper balance-sheet at July 31, 1931, but should
go beyond that to see what use was made of it in the proposed report
to be published to the stockholders. In other words, the remarks of
the president, or other officer, to such stockholders should be sub­
mitted to the accountant for approval, to make sure that nothing is
implied in such remarks to the stockholders that the accountant
might object to as unwarranted by the certificate he has rendered.

ANSWER NO. 3: After a careful reading of the question we are

uncertain whether the practices of questionable nature were such as
to affect the financial statement at July 31, 1931. If the practices
referred to were such that the accountant could not be certain as to
the accuracy and integrity of the July 31, 1931, financial statement,
there would seem to be no question that a qualification should be
made on the statement or in the certificate.
On the other hand, if the practices which we understand stopped
prior to July 31, 1931, did not affect the integrity of the balance-
sheet and the accountant is satisfied that the balance-sheet is prop­
erly stated, we do not see any necessity for a qualification in the
balance-sheet or certificate attached thereto, nor any need for refer­
ence to a prior report.
You understand, of course, that without specific information as to
the nature of the practices in question it is impossible to render a
definite opinion. The foregoing will express our views on the gen­
eral question, but it is quite possible that a full knowledge of the
facts would lead us to change the opinion expressed above.

Audit of General Insurance Agency

(April, 1931)

QUESTION: What special problems are encountered in auditing

the accounts of a general insurance agency? By this I mean an
agency writing all kinds of insurance and distributing this among
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 Questions and Answers
a number of companies. I would like to know the principal things
to be investigated in making such an audit.

ANSWER NO. 1: Certain special items encountered in the audit

of a general insurance agency are as follows:

1. The conditions of brokers’ balances in the brokerage ledger:

These items should be current in nature, otherwise investigation
should be made to determine whether or not the agency is advancing
the premiums for the brokers. If such advances are being made, the
auditor should make provision for possible losses due to non-pay­
ment by the broker.

2. The condition of agents’ balances: A sufficient number of

agents’ accounts should be compared with the monthly accounts ren­
dered by the agents to determine the accuracy of these accounts.
Differences of long standing and of relatively large amounts should
be studied.
Most agencies bond their agents, as they are liable for any mis­
appropriations by their agents. The bonding company requires docu­
mentary evidence to show that the money has actually been paid by
policy holders to the agents. Hence, the auditor should scan all
agents’ balances for their age and should determine the extent to
which the agency is protected in those cases where the balances are
old. A reserve should be provided for probable losses based upon
the analysis of these accounts.
If the agency has established branch offices, it is important that
these accounts be audited to determine the condition of the funds
invested in branches.
In order to stimulate their agents, many agencies grant contingent
contracts which provide an additional commission on the net profit
arising from the business written by them during their contract year.
While no actual liability accrues to the agent until the termination
of the contract year, nevertheless the auditor should make provision
for the additional commission if a study of available statistics indi­
cates the probability of such a liability.
3. Reserve for agents’ commission: Since the agency records some
business on its books before the agents’ commission is deducted by
the agent in his accounts current, the agency must set up a liability
for the agents’ commission. Some agencies estimate this reserve by
calculating the average percentage of commissions paid on business
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written during the period under review and deduct the amount taken
by their agents in their accounts. Other agencies have comptometer
operators determine the premiums on which the commission has not
been paid. Proper percentages are applied to these sums to compute
the reserve for agents’ commissions. In either event, the auditor
should check the calculation in order to satisfy himself that the re­
serve is sufficient.

4. Company balances: These balances represent the portion of

premiums payable to the insurance companies after deduction for all
commissions and expenses chargeable to them. These balances should
be confirmed by direct communication with the companies. Inasmuch
as the companies carefully audit these accounts for amounts of. pre­
mium, commission deductions, etc., this confirmation provides a very
satisfactory check for the auditor of an insurance agency.

5. Agency contracts and company contracts: Practically every

transaction in the insurance business can be traced to a carefully
written contract. The auditor should examine in detail the contracts
with several companies and several important agents to see that the
contracts are followed in the accounts. Insurance companies often
grant contingent contracts to their large agencies just as the agencies
grant such contracts to their agents. Effect should be given to these
contracts by the auditor.

ANSWER NO. 2: The scope of the audit will, of course, depend

on the purpose, and whether it is for the company, for an outsider,
or for the agent himself. It is perhaps needless to point out that care
must be taken to separate the accounts of the different companies
if there be more than one, and the accounts of different kinds of in­
surance. The auditor should see the contracts with each company
showing the rate of commission allowed, distinguishing, in the case
of life, first premiums from renewals. He should also see if any sub­
contracts exist, whereby commission is to be allowed to others for
placing business on account of the agency.
All statements received from the companies and copies of state­
ments rendered to companies should be carefully scrutinized and
compared with the books. Life insurance companies furnish the poli­
cies and charge the agent with the premiums, crediting him, of course,
with returned policies not taken. The same practice usually applies
to renewal receipts and also to receipts for Ioan interest, when loans
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exist on the policy. In checking the life account, the policies not yet
taken and receipts in the hands of the agent should be examined to
see that all policies or receipts delivered are accounted for in cash.
In the case of fire, accident, burglary, indemnity, etc., policies are
usually written by the agent and he reports to the companies. In
these cases the policy blanks, numbered consecutively, are furnished
by the company. The remaining blanks unused should be compared
with the record of blanks used to see that everything is in order.
The numbers that should be on hand, as well as the general status
of the account, may be confirmed by correspondence with the com­
pany.
Premiums returned upon cancellation involve return of commis­
sion by the agent to the company.
In the case of life business, there is usually an equity in the com­
muted value of renewals and sometimes an agent will obtain advances
on the strength of this, but there is no fixed rule and the practice
of companies varies. Renewal equity would belong to the estate in
the case of an agent’s death, and possibly could be transferred if
the agent sold his business to another, but that, of course, would be
subject to the consent of the company.
We have not touched upon features common to audits in general.

Partnership Accounts on Balance-Sheet

(May, 1935)

QUESTION: An opinion is requested as to the proper balance-

sheet presentation of the accounts of a partnership. A trial balance
of the accounts follows:

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 American Institute of Accountants
Cash $ 3,55o.8o
Accounts receivable 74,650.00
Investments 490,830.20
Deferred charges 14,624.43
Notes payable $309,310.09
Accounts payable 217,933.11
A, capital 102,872.70
B, capital 96,852.95
C, capital 35,355.26
D, capital 34,972.43
E, capital 35,308.38
F, capital 30,389.20
G, capital 279,338.69

$862,994.12 $862,994.12

The only question at issue relates to the debit balance in G’s capi­
tal account. Should this item be shown as an asset on the partner­
ship balance-sheet, or should it be shown as a deduction from the
sum of the other partners’ capital?
ANSWER NO. 1: The trial balance contained in the above ques­
tion indicates that there are total assets of $583,655.43, consisting of
cash, accounts receivable, investments and deferred charges, and that
liabilities amount to $527,243.20, consisting of notes payable and
accounts payable. The partnership’s net equity in the assets is, there­
fore, $56,412.23, which is represented by credit balances in the part­
nership accounts of A, B, C, D, E, and F, amounting to $335,750.92,
less a debit balance in the capital account of G of $279,338.69.
No mention is made of the purpose for which the partnership
balance-sheet is to be issued, but as the purpose of a balance-sheet is
usually to set forth, for the purpose of obtaining credit, the partner­
ship’s net worth, it would appear reasonable to expect that, in the
preparation thereof, any debit balances in the capital accounts would
be deducted from the respective partnership credit balances, thereby
showing the amount of the net capital investment. It must also be
borne in mind that any loss, which may be occasioned by the in­
ability of the partnership to collect the debit balance of any partner,
is chargeable against the accounts of the remaining partners.
If a member of a partnership is permitted not only to withdraw
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 Questions and Answers
his entire capital but also an amount which represents a portion of
the capital investment of other partners, it is our opinion that no
accountant is justified in showing the debit balance as an asset of
the partnership. To do so would subject him to ridicule and criticism.

ANSWER NO. 2: I believe that this would be shown in this man­

ner and not among the assets. Only in this manner can the actual
capital employed be indicated. Furthermore, this allows the state­
ment to show the total assets which are in the business available for
the payment of amounts due to creditors entirely apart from the
claim which may be made against any or all of the partners for any
deficiency.

ANSWER NO. 3: Our opinion is that it is better to show partners’

capital in circumstances outlined in the question as credit balances
less the debit balance of $279,000, carrying out a net figure.
There might be an exception in this case if the advance was for a
short time and was secured or there was no question that G was
entirely solvent and willing to repay the amount. In this case the
amount due from G might be shown as an asset owned by a partner
under separate caption, preferably with some particulars as to securi­
ties or other circumstances justifying the carrying of the asset.

Examination of Partnership Books

(September, 1932)

QUESTION: Two partners in one business show a favorable

financial position, assets being ample for payment of liabilities in the
ordinary course of business or even, in all probability, sufficient in
case of forced liquidation. One of the partners, however, is also en­
gaged in another separate and distinct business on his own account,
and such business is in only a fair condition, so that a forced sale
would result in a deficit to be collected from the partnership assets.
The question is what mention should be made in the accountant’s
report or certificate, upon an audit of the partnership, of the outside
business of one partner.
My personal opinion was and still is that no direct mention need
be made, since the mere fact that the organization is a partnership
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is sufficient notice to creditors that it may become involved in a
partner’s difficulties, so that it would be gross negligence on the
creditor’s part not to demand individual statements as well as that
of the partnership.

ANSWER NO. 1: In an examination of the books of a partnership

the auditors usually have little opportunity to ascertain very much
about the outside personal interests, and possible liability to the
partnership therefrom, of the individual partners. In the case men­
tioned, the auditor apparently has some knowledge of one such
outside interest, but specific comment on that might lead to the
assumption by a reader of the report that all such outside interests
had been investigated, unless it were accompanied by a statement
that no other investigation was made.
Whether any comment should be made on this specific matter is
dependent upon its importance and also to some extent upon the
nature of the examination being made. If, for example, the auditor
is making an investigation for a creditor bank, undoubtedly he should
report all pertinent information acquired, irrespective of any techni­
cal limitation of his engagement. If, however, he is employed by the
partnership, he is more or less bound to stay within the limitations
of his engagement, but these limitations should be made completely
evident to any reader of his report.
A report on an examination of a partnership should always indi­
cate clearly that the business is not incorporated, and it is desirable
to include a statement to the effect that the scope of the examination
did not cover the personal outside interests or possible liabilities of
the individual partners.

ANSWER NO. 2: How to certify or report on the accounts of a

partnership in view of the possibility that the firm assets may be
subject to attack from creditors of an individual partner is a very
pertinent question. In all ordinary cases, however, we think it should
be sufficient for the accountant to make clear in his certificate or
report that his examination covers only the business of the partner­
ship. An appropriate certificate might read as follows:

“We have made an examination of the books of account of the

partnership business of....................... and report that in our opinion
the accompanying statements properly set forth the financial condi-
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 Questions and Answers
tion and operating results of the partnership business at the date and
for the period stated.”
Reference to the “partnership business” should generally be a suffi­
cient emphasis of the distinction between the partnership affairs and
those of the individual partners personally.
Circumstances do alter cases, though, and this recommendation
does not mean to say that we would not advise going further with a
more direct qualification if the examination of the partnership were
undertaken during the imminence of contingencies liable to fall from
the outside upon the firm assets. We can conceive of cases where it
would be justifiable to add to the reference to the examination of the
accounts of the partnership business a phrase “but not those of the
individual partners,” and to refer to the statements as showing
the financial condition and operating results of the partnership busi­
ness “as such.”
The same situation arises in an examination of the accounts of a
sole proprietor. In such cases we follow substantially the recom­
mendations first made.
ANSWER NO. 3: We concur in the opinion of the member inquir­
ing that, in general, no direct mention need be made.
The partnership assets are available in the first instance for part­
nership liabilities and usually an individual partner’s creditors have
only the right to receive what he would receive under the terms of
the partnership deed. We can not see, therefore, that his possible
financial embarrassment in an entirely separate business is a matter
that need be incorporated in a partnership return. In fact, in most
partnerships, the accountant is not in position to be able to report
on the property of the partners individually.

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 INDEX

Auditors’ certificates (see “Certifi­ basis for computing, 103

cates, auditors’ ”) machinery and equipment, 104
provisions for, 105
Bad debts, 99 Discount, bond, 35, 38, 49
Bakeries, overhead expenses, 88 Dividends
Balance-sheet from net earnings, 111
commissions on, 55 from profits, 111
consolidated, 17 from surplus, 59, 62, 74, 79, 82
footnotes to, 53 prior to purchase of stock, 114
Bonds, (see also “Funded debt”) stock, 63
discount on, 35, 38, 49
expense on, 35 Earned surplus
mortgage, 31, 32 balance-sheet treatment, 83
municipal, 37, 109 dividends from, 74
premium on, 35, 49
Building management, loss in, 18 Finance companies, accounting, 27
By-products, cost accounting, 108
Financial statements
losses in, 91
Capital qualifications in, 118
for subsidiary company, 93
Freight, as expenses, 106
reduction or increase in, 69
Funded debt
Capital stock (see “Stock”)
balance-sheet treatment, 34
Capital-stock account, transfers
classification, 47
from, 69 liability of subsidiary, 29
Capital surplus, dividends from, 78
Certificates, auditors’, 115, 118
Commissions, balance-sheet treat­ Hedging, 5
ment, 55 Holding or parent companies
Commodities, loss of weight in audit of, 115
transit, 7 cost of capital of subsidiaries, 93
Commodity contracts, losses, 5 dividends of, 82
Consolidations, 82 inventories, 8
Construction of plant, salaries dur­ liability of subsidiary, 29
ing, 26 profits and losses of subsidiaries,
Cost accounting 90
bakeries, 88 sales to subsidiaries, 96
by-products, 108 H.O.L.C. bonds, 31
maintenance department, 85
Customers’ accounts, 12 Insurance, compensation, reserves,
71
Definitions, “bond discount”, 38 Insurance, life, surrender value, 13,
Depreciation, depletion and obso­ 15
lescence Insurance agency audit, 120
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 Index
Interest Paid-in surplus, balance-sheet treat­
as a cost, 7 ment, 83
during construction, 22 Parent companies (see “Holding or
Inventories parent companies”)
cost, 7 Partnership
in intercompany accounts, 8 accounts on balance-sheet, 123
losses on, 5 audit, 125
mining, 2 Prices on commodities in transit, 7
sales to affiliated company, 10
valuation of, 1, 2 Qualifications in certificates, 115,
118
Labor costs, 85
Liabilities, for compensation insur­ Reorganizations, 56
ance, 71 Repairs, capitalization of, 20
Life-insurance, surrender value, 13, Research costs, 86
15 Reserves, compensation insurance,
Losses 71
bad debts, 99 Royalties, as expenses, 106
commodity contracts, 5
in inventories, 5 Salaries during construction, 26
operation of building, 18 Stock
treatment in statements, 91 no par value, 53, 56, 58, 63
on consolidated balance-sheet, 17
Maintenance department costs, 85 preferred, 61
Manufacturing company, sales sub­ treasury, 51, 54, 62, 79
sidiaries, 96 Stock dividends, 63
Mergers (see “Consolidations”) Subscriptions, newspaper, 109
Mining company, inventories, 2 Subsidiary companies (see “Hold­
Mortgages ing or parent companies”)
bond issue, 32 Surplus
exchange for H.O.L.C. bonds, 31 available for dividends, 62, 74
Municipal bonds, 109 capital, 78
dividends from, 78, 82
earned, 74, 83
Newspapers, audit, 109
in reorganization, 56
No par stock (see “Stock”)
of consolidating companies, 82
paid-in, 83
Operating expense, research costs, Surplus account, transfers to, 69
86
Overhead expense, distribution, 87, Treasury stock (see “Stock”)
88
Valuation
Packing and shipping, as expenses, inventories, 1, 2
106 treasury stock, 54

130