Accounting Principles – Secondary Income

In the same manner that deducting cost of sales—from income from sales—produced gross profit on sales, so the deduction of cost of sales, plus selling and administration expenses, from income from sales produces net profit on sales.

This profit, in the case of a manufacturing and selling organization, is known as the income from operations. It corresponds to the income derived in a railroad company from deducting operating expenses from operating revenues.

In the modern conception of organization and its attendant operations capital is the medium through which the business is transacted. Just as money is the medium for exchange of values, so capital is the medium for the transaction of business. Theoretically, the capital of an organization should be just sufficient, and no more, for its needs. Not one bit of this capital, in any form whatsoever, should get into the hands of outsiders. The ideal situation would be exactly the same as if the organization were conducting a strictly cash business; that it were engaged in only one line of business, having no transactions foreign to this line, and occupying its own plant entirely. In such an ideal organization there would be no income other than that from operations. That the ideal does not exist is shown by the fact that at times capital of the organization which is not required for its own business is invested in stocks and bonds of other companies; that it is sometimes permitted to get into the hands of outsiders, through extensions of credit, thus giving rise to accounts and notes receivable; that a portion of it is always deposited in the bank. It also happens frequently when goods are purchased, for example, at sixty days, that there is a discount offered by the vendor for the payment of cash in less than sixty days. Thus, theoretically, a part of the capital is loaned to the vendor.

The above transactions give rise to income from sources other than sales (or primary income.) This income is called secondary income, because of the fact that the concern in question is not in the business of loaning capital, but rather in the business of manufacturing and selling goods. The principal object of the business is the manufacture and sale of goods. Therefore, the primary income of the organization must be from the same source. Incident to the manufacture and sale of goods there are these transactions of capital, and from them income is derived. While it is income, it is secondary to the principal object from which income is sought. Such income exists in the form of interest on bonds, dividends on stock, interest on bonds and mortgages receivable, interest on accounts receivable, interest on notes receivable, interest on bank balances and cash discounts on purchases. There is also included in this group royalties receivable, commissions receivable, considerations for endorsing notes, accumulation of discount on bonds, and rent. With regard to the last-mentioned item, it should be borne in mind that the rent is not that received through sub-letting a portion of premises for which rent is paid. It represents, rather, rent received from property not used in the operation of the business. Royalties and commissions are included in this group not because they are outside operations, but operations which are not related to the primary purpose of the organization.

The point to be kept in mind with regard to the interest items is that they should be accrued at the end of the accounting period. As a matter of convenience, and in order to distinguish between an asset and a liability, many accountants have adopted a technical terminology which indicates the distinction. This scheme contemplates referring to the asset as accrued interest, while the liability is called interest accrued. There would be no particular reason for calling the asset accrued interest, rather than interest accrued, if every one were to use the same terms in describing the asset; but where some use the term interest accrued for the asset and interest accrued for the liability, in connection with interest expense, it is most confusing. It is, therefore, an attempt to prescribe a working nomenclature, comprehensive, and understood by every one, that has led accountants to use certain expressions, such as the one above described, to mean certain things.

Dividends on stocks owned may not be accrued at the end of the accounting period. A dividend, unlike interest, is instantaneous. It comes into being with the declaration of directors. At the end of a given period the net profits may be ample to allow a return of fifty per cent. on the investment. Stockholders in the corporation are, however, just as far away from a return on their investment as if they held no stock. They have no right whatever to consider that their investment has earned a return. The situation is quite changed, however, when the directors declare a dividend. The declaration of a dividend by the directors gives to the stockholders a right against the company which they may enforce. The enforceable right thus gives rise to income. When a dividend on stock has been declared the holder of the stock is entirely justified in taking the dividend into his income, even though not yet collected. If the dividend has not been declared there is no warrant whatsoever for so doing. Thus it may be said, interest may be accrued always, but dividends never.

It is possible that some question may arise with regard to cash dividends on purchases. Not every one treats cash discounts on purchases as other income. By many accountants they are treated as deductions from gross purchases, the same as trade discounts. By some accountants, cognizance is taken of cash discounts on purchases applying to invoices which will be paid during the first few days of the next succeeding period. In other words, if it is the practice of the purchaser to pay cash within ten days for all goods purchased, the accountant will, at the end of a given period, and supposing that there are invoices to the extent of $30,000, subject to discount at 2 per cent., charge accounts payable and credit cash discounts on purchases in the amount of $600. This procedure is entirely correct from the point of view which this accountant takes. It is not correct from the point of view of the accountant who follows what may be called the more advanced lines of thought, namely: those which consider capital as the medium for the transaction of business, and recognize the income and the expense attending such capital. If discount is considered in the light of interest, then it will be seen that the payment of a purchase invoice before it is due gives rise to interest for the use of money advanced to the vendor before he was entitled to receive it. It is, therefore, apparent that the question of interest may not arise until such time as the payment has been made. It is not necessary, as a consequence of this theory, to provide at the time of closing the book for discounts on invoices which will be paid in the early part of the next period.

Another item which sometimes appears in this group is consideration for endorsing notes. This is, perhaps, a theoretical item rather than otherwise. The author has not in his experience encountered an example of this kind, although such instances are said to have existed. The income represents, practically, a fee received for the guaranteeing of the notes of others. It is, perhaps, questionable, where an item of this kind occurs so infrequently, whether it ought not rather to be a credit to profit and loss than a credit to income. Income is intended to represent something which recurs; profit-and-loss credits comprise unusual and infrequent items.

Another item in this group to which very little attention is paid is the income corresponding to the accumulation of a bond purchased below par. According to the most modern and scientific theory, a bond the interest on which is 6 per cent. purchased below par will yield more than 6 per cent. on the investment. This is due to the fact that the maker of the bond will pay not only 6 per cent. on the par principal during the life of the bond, but will pay the par principal at maturity. For example, a $1,000 bond, purchased at 95, would cost $950. The bond, at maturity, would be redeemed at $1,000. The investor, whose investment consists of $950, will receive 6 per cent. on the par of the bond, but more than 6 per cent. on his investment of $950. It is true, of course, that each year he will receive in cash $60. At the maturity of the bond he will receive not only his investment of $950, but, in addition, $50 more, representing the difference between his investment and par. This amount, while received in a lump sum, has, in reality, been earned over the period during which he has held the bond, and it is quite unfair to allow the profits of the year in which the bond matures to benefit by the entire amount. What should have been done was to spread the $50 in question over the number of years which the investor held the bond. It is, therefore, apparent that the return on his investment would have been greater than 6 per cent., possibly 6!/2- This is called the effective rate of interest, as compared with 6 per cent., the nominal in this case. The excess of yield over the nominal will depend upon several things, namely: the purchase price of the bond, the nominal rate of interest, the interest periods, and the length of time which the bond has to run. What happens is that the interest earned on bonds will be credited not only with 6 per cent. which is received in cash but y£ per cent. which is being periodically added to the face of the investment. Supposing, for example, that on an investment of $950 in a certain bond the yield was 6l/2 per cent., the earning then for the year would be $61.75. At the time of closing the books the following entry would be made:

Accrued interest on bonds $60.00
Bonds 1.75
To Interest on bonds $61.75
Upon receipt of the interest the following entry:
Cash $60.00
To Accrued interest on bonds $60.00

It will be seen that the bond investment would now be carried on the books at $951.75. The value of this investment would increase from time to time in accordance with the amount of the excess income taken into the interest account, and would continue to increase periodically until at the time of maturity it would amount to $1,000. An entry would then be made converting the bond at $1,000 into cash. The process of increasing the value of the bond has sometimes been called amortization. It is not amortization, but the reverse of same. It is properly called accumulation, the accumulation consisting of the increase in the investment until, at the time of the maturity of the bond, it reaches par. The term amortization presumably came into use because it was considered that the discount representing the difference between the investment price and par was being amortized, or reduced.

This group corresponds to the fourth section of the statement of income and profit and loss, which appears as follows. The items representing the accounts involved are closed out into the group account income from other sources:
Interest on bonds owned $400.00
Dividends on stocks owned $250.00
Interest on bonds and mortgages (receivable).. 300.00
Cash discounts on purchases 750-00
Interest on bank balances 50.00
Interest on accounts (receivable) 75-°°
Interest on notes (receivable) 375-°°
Rent (receivable) 14500
Royalties (receivable) 300.00
Commissions (receivable) 250.00
Accumulation on bonch 5-°°
Total income from other sources $2,900.00

Access the contact form and send us your feedback, questions, etc. We are always welcome to help someone out. You can also contact us if you wish to submit your writing, cartoons, jokes, etc. and we will consider posting them to share with the world! The Facebook and LinkedIn groups are also good areas to find people interested in accounting like yourself, don’t hesitate to join as everyone of all levels are welcome to become part of the community.

Are You Ready to Take Your Accounting Skills to the Next Level on the Information Highway?

How Can We Help?