Accounting Principles – Deductions from Income

Capital expenses should be distinguished from capital expenditures.It should be thoroughly understood that what is not meant is an expenditure of the funds of the organization, which is capitalized, or set up as an asset. It distinguishes the expenses in connection with capital from the expenses in connection with operations. While capital is necessarily involved, and is employed in the operations, the expenses of obtaining, using or protecting capital are set up separately, in order to show what the income from operations would be if there were no expenses in connection with capital.
Aside from being based on sound, economic principles, this theory requires a classification which greatly facilitates the comparison of different organizations. Only like quantities may be compared. In the same way, only like organizations may be compared. It is in the matter of items comprising this group in which there is greatest conflict when comparison is attempted.

The principal items in the group are interest on bonds and mortgages payable, interest on accounts payable, interest on notes and loans payable, cash discounts on sales, rent (payable), insurance expense, taxes, interest on capital and royalties (payable). Of these, the interest items are probably easiest to comprehend, as coinciding with the theory advanced. Interest on bonds and mortgages, accounts or notes is paid because of the fact that the organization has not sufficient capital of its own with which to transact business. If the owned capital were sufficiently large there would be no occasion for borrowing on any of the instruments just mentioned. It is because of the fact that interest is an expense of obtaining capital that it is classified in this group.

Cash discount is not so easily reconciled, because of the custom which is, at the present time, perhaps, rather general, of considering cash discount as a deduction from sales, the same as trade discount. In order to get the proper conception of the theory, as applied to cash discount, it is necessary to consider it practically the same as interest. A merchant who buys an invoice of goods makes a contract. The contract of purchase and sale arises when certain specific goods ready for delivery have been offered and accepted. Under the terms of the contract, delivery may be made immediately; but the purchaser, if the question of cash discount is to enter into the question, will probably be permitted thirty, sixty, or possibly ninety days, to make settlement. If this question of credit were not involved cash discount would not enter into the problem. It is because of the fact that a contract has been made, and the payment of the purchase price stipulated at thirty days, or longer, that the vendor offers a cash discount as an incentive to the purchaser to make an earlier settlement. In other words, the vendor offers to pay interest for the use of the money if he may obtain it before it is due under the terms of the contract. The vendor is, therefore, in the position of having borrowed money from the purchaser, for which he virtually pays interest. Thus it becomes perfectly logical to include cash discount on sales as a deduction from income, on the theory that it is an expense of obtaining capital. It need scarcely be pointed out that as a matter of financial policy the offering of a cash discount is good finance. To the concern engaged in a business in which the profits are large the money is worth very much more than the small amount of cash discount paid for its use.
There are two very good reasons for treating rent as a deduction from income. The first one is that rent is considered, by the economist not an expense of the business but a share of the profits, which the tenant turns over to the landlord for the use of the premises. The second is that a concern paying rent does so either because of the fact that it does not own its own property, on account of lack of capital, or because it is inexpedient to do so. In either case, rent seems to be analogous with interest, since it is paid for the use of capital in the form of property. As an expense, therefore, of capital it is properly treated as a deduction from income. The question is often raised as to the propriety of treating the rent of the general office of an organization as deduction from income. The question is often asked, “Would you consider the rent of an office in New York City in this class?” The question is probably prompted by men who have in mind the thought that a great number of industrial and mercantile organizations throughout the country maintain general offices in New York City. It seems strange to them that such concerns should arbitrarily be placed in the position of borrowing capital. The tendency is to consider rent paid for such offices as an administrative expense. The disposition is to connect the expense specifically with the department of the organization for which the expense was incurred rather than as an expense of capital.
Illogical as it may seem to many, there is no exception, so far as the author is aware, to the treatment of rent as a deduction from income, under the theory that the concern is occupying borrowed property or capital. True, a large industrial organization may not rent an office in New York City because of the fact that it has not sufficient capital to own its own building. The point is that it does not find it expedient to invest the large sum of money necessary to purchase or construct a building of its own where it requires general offices. It is cheaper to rent than to own. This view does not alter the fact that when it does rent it occupies the property of another rather than tie up its own capital in the investment, and, therefore, does pay a rent which is analogous to interest for the use of capital.

Insurance is a premium paid for the protection of property. It is a risk assumed by the company in behalf of the assured against through loss by fire, theft, accident, or loss from acts of nature. It is money paid for the protection of capital. It is, therefore, an expense of capital, and as such is properly considered as a deduction from income. Here again many find it difficult to disassociate insurance from the particular property which is insured. Perhaps the average student of the subject will insist that insurance on materials and supplies in stores is not properly treated otherwise than as an expense of the operating department. The question often asked is, “How can you consider insurance paid for the protection of your factory property as an expense of capital?” The answer is that capital is invested in the factory property, and just as interest paid for the use of money so employed is considered as an expense of capital, so insurance paid for the protection of this capital is a similar expense of capital. More than one student seeking the light, or perhaps attempting to find a flaw in the reasoning advanced in accordance with this theory, has asked the question, “Why not charge the wages of the watchman at the factory to insurance, or treat it as a deduction from income?” A specific answer to the question might consist in saying that no money is invested in the watchman, and therefore there is no expense which can be traced directly to capital. This line of reasoning, though somewhat simple, will, it is believed, always produce the correct result.

Taxes are included in this group for the reason that they are likewise paid for the protection of capital. The State undertakes to exercise the police power. It protects the property of the citizen as well as the property of the business man. For this protection it exacts a tax. The business organization with capital invested is, therefore, protected. The taxes are an expense of such protection. The questions raised in connection with considering taxes as deduction from income are generally irrespective of organization taxes and the tax on net income. It is possible, without a great deal of difficult reasoning, to place these items in the same class. These taxes apply only to corporations. Obviously, a corporation may not own capital until it has been organized. If the tax is paid for organization it gives to the corporation the right to own capital. The fee for this right is in connection with capital, and, therefore, becomes an expense of capital. The federal corporation tax law imposes on corporations, joint stock companies, or associations organized for operation and having a capital stock represented by shares, a special excise tax with respect to the carrying on of or doing business. It further provides that the tax of one per cent. shall be assessed upon the net income over and above $5,000. Here again it will be seen that the theory is logical, since, in the first place, the tax is imposed by the government for the privilege of doing business, in which privilege the corporation is protected; and in the second place, the net income is shared with the government for such privilege. It cannot be argued, it seems, that this tax is a part of the cost of the goods sold, the expense of selling them, or the expense of administering the business, but rather a specific deduction from the income. The difficulty involved in making this point clear has more than once arisen when the question has been asked, Shall such taxes be considered before the net income is arrived at? Clearly this is not possible under the law, any more than it is a pertinent question. In making up its return to the government the corporation will determine its net income. The government will then compute the tax. This report, however, is something quite different from the company’s statement of income and profit and loss.

On account of the importance of interest, insurance and taxes, apart from the role which they play in disclosing true economic or operating results, they will be made the subject, as in the case of depreciation, of separate chapters whiph follow.

In preparing the statement of income and profit and loss the items in this group, as appearing below, will constitute the sixth section, and in closing the books will be closed into the group account—deductions from income:

Interest on bond and mortgage payable $2,000.00
Interest on accounts payable 200.00
Interest on notes and loans payable 500.00
Cash discount on sales 300.00
Rent (payable) 400.00
Insurance 100.00
Taxes 200.00
Royalties (payable) 300.00