This, however, is not sufficiently specific. Each organization is engaged in some particular line of business for profit. For such an undertaking, capital is made available and the assumption is that any given concern will upon organizing supply itself with such an amount of capital as is adequate to carry on the business in question. Such capital will be in the form of assets which are required for the purposes of the business. For example a concern may invest in land upon which to construct a building; it may subsequently construct the building and equip it with the necessary facilities for transacting the business. A part of the capital may be in the form of cash and after a period of operations some of the capital will usually be in the form of accounts and notes receivable. Whether engaged merely in trading or in manufacturing and selling, some capital will be in the form of materials and supplies or merchandise either partially or wholly completed and ready for sale.
In the ideal case the proportion of capital invested in these various assets would be distributed proportionately to the need of the business. Money will not be tied up in land or buildings to such an extent that there is no cash available for liquidating current liabilities. A concern will not overstock itself in the matter of merchandise to such an extent that it is embarrassed for cash with which to meet its pay rolls. If profits result from the transaction of business they will presumably be converted into cash and paid out in the form of dividends, thereby reducing the surplus.
It sometimes happens that a concern accumulates or acquires profits which are greater than the dividends necessary to allow a fair return on the invested capital. Such undivided profits constitute a surplus. The cash may increase to such an extent that there is more on hand than that required for current purposes and dividends. It may then be converted into various forms of assets known as investments. Such a class comprises stocks and bonds, bonds and mortgages and land or buildings not required in the conduct of the business. They may be income producing, but such income is not the result of operations incident to the principal business of the organization. It is to be considered as secondary income or income from sources other than operations. The income may take the form of interest, dividends, or rent.
Such items may be represented on the general ledger by one account for investments. However, the accounts will usually be such as to show the classification of investments if they are numerous. By this is meant that ordinarily if there were securities, bonds and mortgages and real estate, there would be separate accounts for each of the above mentioned class on the general ledger. Frequently, especially in large concerns such investments become sufficiently numerous to warrant subsidiary records, supporting the controlling account, in which the details of the investments are recorded. It is especially desirable that such books should provide for all the information pertaining to the assets.
Bonds call for the payment of a fixed amount of money at a given time. They may be purchased at par, above par when they are said to be bought at a premium, or below par, when they are said to be bought at a discount. The face of the bond is payable with interest at a certain rate per cent. The interest although calculated annually may be payable semi-annually or quarterly on specified dates. Thus there arises the question of the accrual of the interest. There is also the no less important question of what is to be done with the premium, in case the bonds were purchased or acquired at a figure above par, or what to do with the discount if they were purchased or acquired below par.
A bond for $1,000, payable 20 years hence, if purchased at 120 will only produce at maturity $1,000. The premium of $200 will be lost. On the other hand the same bond purchased at 80 will produce at maturity $1,000 and there will be a gain of $200. In the case of the bond purchased at a premium, if no steps are taken to prevent, upon maturity $200 will be charged to profit and loss. In the opposite case $200 will be credited to profit and loss. The best practice in both these instances dictates spreading either the premium or discount over the remaining life of the bond. These processes are known as amortization in the case of premium and accumulation in the case of discount.
The principles involved in amortization and accumulation are well illustrated as applied in estate accounting to a life-tenant and a remainder-man. The life-tenant is the party who enjoys the benefit of the income of the estate during life, after which time the principal passes to the so-called remainder-man. The illustration which follows is purposely freed from any element of compound interest, such as attends the scientific evaluation of bonds and division of interest, in order that the principles may be the more easily understood.
A bond the par value of which is $1,000 is appraised on January 1, 1910, at $1,200. The bond bears interest at 4% per annum and matures January 1, 1930. Under the terms of the will the bond is bequeathed to A, but the income is to be enjoyed by B during his life. B is the life-tenant and A is the remainder-man. A has received a bequest of $1,200.
If B receives the annual interest of $40 he will during the period of twenty years have collected $800. Upon the maturity of the bond at the expiration of twenty years there will be no further income and the proceeds of the bond ($1,000) would presumably be re-invested if B were still alive. It will be noted that there has been a loss of $200, all of which under the circumstances A would have to bear. In other words, the principal of the estate has been decreased $200. This occurs because no provision has been made to amortize the premium, which was included in the appraisal. B has apparently been receiving more interest than he should have received.
The facts are that B has received annually more than he should have received. Provision should have been made for the loss of premium at maturity. The premium of $200 should have been provided for by annual amortization extending over the period of ten years. Ten dollars ($10.00) should have been deducted from the interest paid to B every year, and instead of receiving $40.00 each time he should have received only $30.00. Thus during the twenty years $200 would have accumulated to make good the loss of premium upon maturity of the bond.
To make the accounting procedure clear the following entries and skeleton ledger accounts may serve:
January 1. Bonds $1,200
To Principal $1,200
To Reserve for Amortization $200
(covering the period of 20 years)
To Cash $600
(for income paid to B)
January z. Cash $1,000
Reserve for Amortization 200
To Bonds $1,200
(upon maturity of bonds)
These accounts, it will be seen, show that the principal of the estate has been maintained at $1,200, notwithstanding the fact that the assets have been converted from bonds into cash.
Accumulation is the opposite of amortization and describes the process where discount obtains. Thus it may be reasoned out that the bond inventoried in an estate at a discount increases gradually in value as maturity approaches. The accumulation in this case accrues to the remainder-man and has the effect of decreasing the effective rate of income. The interest will correspondingly be credited part to income and part to principal, thereby increasing the principal of the estate.
The application of the principles to mercantile or other organizations has the effect of measuring through amortization and accumulation the exact amount on interest bearing securities like bonds which can be taken into income. The scientific method of calculation takes into consideration the compound interest but as this is a matter of mathematics which tends to cloud the elucidation of principles and tables are available for the purpose of determining the yield of bonds it will not be discussed here.
In considering the matter of accrued interest it might be assumed that the interest on a bond of $1,000 amounted to $60.00 and was payable semi-annually on July 1st and January 1st. Under these circumstances in closing the books for the quarter ended March 31st it would be necessary to take into consideration the accrued interest of three months, or $15. To carry the illustration a step further in connection with the purchase of a bond and assuming it to have been purchased on February 28th at par, the purchaser would pay to the seller $1,010, representing the face value of the bond and the accrued interest. The seller has transferred to the buyer, having been paid therefor, the right to collect the interest on the bond from the beginning of the year and when the buyer receives the interest for the first six months he will receive $60.00 and not $50.00.
Taking into consideration all of the above facts, it appears then that the records for bonds should be rather elaborate and provide for many possibilities. Thus such a record should show the date of the bond, the par, the purchase price, the accrued interest, the rate of interest, the dates of payment of interest, the date of maturity of the bond, the accumulations of discount, the amortization of premium, the sale of bonds with the amount of par sold, the sale price and the accrued interest at time of sale. Such possibilities are provided for usually by columnar ledgers, having appropriate headings for the columns.
Stocks differ from bonds in that instead of being promises to pay a certain sum of money at a certain stated time, they are evidences of share ownership in the net assets of some corporation. The income differs from bonds in that it cannot be accrued like interest. The income on stocks is in the shape of dividends whereby profits are distributed, and become available only by an act of the directors of the corporation declaring such a distribution of profits and such a dividend payable. Dividends may be taken up as income only after having been declared. A concern owning certain shares of stock in the Pennsylvania Railroad Company where dividends continued uninterrupted at a fixed rate over a period of years would not be justified if upon closing the books at March 31st the quarterly dividend on Pennsylvania stock had not been declared. If, however, such a dividend were declared on March 27th, payable on April 15th to stockholders of record on March 31st, then a concern owning stock in the Pennsylvania Railroad might properly take such a dividend into income even though it had not yet been actually received. The books in such case should provide adequately for all details concerning stock showing the date of purchase, the par purchased, the market price whether with or without dividends, the date of sale, the sales price, the par sold and whether with or without dividends. Columnar ledgers are generally used for this purpose.
Bonds and mortgages as investments constitute two instruments. A bond is the instrument which promises to pay a certain sum of money at a specified date at a certain rate of interest. The mortgage is the instrument which secures the bond. For accounting purposes the mortgage may be ignored and the attention directed to the bond. The interest on this class of securities may be accrued like that on any other bond, and in closing the books cognizance should be taken of the amount accrued whether or not at such time it has been actually received. If for example, a bond and mortgage of $10,000 bears interest at the rate of 5% per annum, upon closing the books at March 31st, provided the bond has been held for the three months preceding such date, the interest should be accrued and the corresponding amount taken into income. The entry in such case would consist in charging accrued interest on mortgage and crediting interest earned on bond and mortgage. The accrued interest constitutes an asset. The careful use of words in describing such an entry is desirable. By common consent among many accountants it has become customary in describing this asset as well as various other assets involving accruals, to make the word accrued the first word of the title. For example: “Accrued interest on bond and mortgage,” rather than “Interest accrued on bond and mortgage.” The former expression is accepted as indicating an asset whereas the latter is usually understood to denote a liability. This rule applies as well to other forms of bonds, and the income from land or buildings. Thus in practice the expressions are used to denote the accrual of income represented by assets as “accrued interest on securities,” or “accrued rent,” etc. The books providing for the record of the details in the case of bonds and mortgages should as in the other instances provide for all the possibilities. There is, however, in this case no question of par, premium or discount involved, as in the case of corporation bonds bought and sold in the market. The records should show the date of the bond, and date of maturity, the face of the bond, the rate of interest and the dates on which such interest is payable. Attention should in this case be given to any interest accrued on the instrument at time of acquisition in order that upon actual receipt of the interest in cash the proper account may be credited.
Little need be said with regard to the detail records for rent except in such cases as where tenants are numerous. Instances of this kind require that the detail records shall show the name of the tenant, the period covered by the lease, the annual rental and the manner in which it is payable, whether in advance or at the expiration of the month.
Two questions arise frequently concerning the above mentioned investments. One is the value at which they shall be carried in the balance sheet, and the second whether they are capital assets or current assets. In attempting to answer these questions it would seem that land and buildings might be eliminated, for the reason that they could scarcely be considered as current assets under any circumstances and for the further reason that the subject has been discussed rather thoroughly in the chapters dealing with land and buildings. With bonds and mortgages it is somewhat different. As to their value probably no one will dispute that they should be carried at cost. The fact of their being capital assets is open to discussion. It is not believed that they should be considered current assets, for the reason that they represent an excess of capital over and above that required by the business, and that while they may be in the majority of cases easily convertible into cash it is only in the event of some extraordinary circumstances or unusual demand that such proceeding takes place. They seem to be looked upon more in the nature of fixed capital and not as something which is fluctuating constantly in conformity with the volume of business.
What has been said concerning bonds and mortgages in respect to their being current assets is believed to be also true of other bonds and stocks. Such a conclusion eliminates from the discussion everything then except as to the value at which they shall be carried as assets. Some organizations adjust them to market prices at closing dates. In some of these cases such a procedure is merely a part of the policy of the company, in other cases where the government exercises supervision and control over them, it is because of the requirements of the government regulations. To carry them on the books at cost seems proper. In showing them on a balance sheet it is desirable to show, either as a footnote or in parentheses opposite or immediately under the caption, the market value. Where they are carried at cost and the market has declined at closing dates the effect of the market fluctuation is sometimes indicated on the balance sheet by a reserve without making any change in the figures shown on the asset side.
Treasury stock is sometimes included under investments. While this is quite proper, precaution should be taken where it is so included to make sure that the item so represented is in reality treasury stock and not capital stock unissued. Unfortunately the term treasury stock is at times given two different meanings. It is sometimes used to denote capital stock which is unissued.
Capital stock may be considered as issued when it is signed, sealed and delivered for value. Until the last named of these steps has taken place it must be considered as unissued. It is hard to see how unissued stock can ever be considered as an asset. Up to the time of issue it is not in reality capital stock in any sense of the word. The certificate of stock is evidence of the fact that capital has been received and must be accounted for to the party from whom it was received to the extent indicated by the certificate. The difference between the capital received and the amount of capital which the corporation is authorized to secure is represented by nothing except figures expressing this amount. The words treasury stock carry with them a significance of value. For this reason it appears rather incompatible to consider this amount, descriptive of nothing but a measure of possibilities, as treasury stock.
If the evidence of receipt of capital, namely a certificate of stock has once been issued for money or property, then something of value attaches to it and it becomes representative of an asset. Stock issued in this manner and subsequently acquired has a value, instead of being a worthless piece of paper, it represents something for which value has been received. Upon having been acquired subsequent to its original issue for value, it may be properly considered as treasury stock. To acquire it presumably means that the accountability for capital for which it was originally issued has been reduced. Why not then ask the question, “Why is it carried in the treasury?” “Why not cancel the accountability represented on the books by the capital stock outstanding accounts?” The answer to these questions is that there is a possibility that it may again be issued or in reality sold, and it seems useless to go to the trouble of cancelling the outstanding accountability and subsequently restoring it in accordance with the fluctuations of treasury stock. Then there is the added reason that the original issue of capital stock cannot be disposed of at less than par without a corresponding liability for the difference between what it was issued for and par attaching to it. Treasury stock is presumed to have been issued once for its par value and therefore may subsequently be sold at any price or given away if desired. Attention is again called to the fact that if treasury stock is shown on the books or balance sheet as an investment or in fact in any other group of assets, the above mentioned distinctions must be observed.
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