Accounting Principles – Preparing Financial Statements
Financial statements may be generally classified as follows:
Statements of income and profit and loss;
Statements of affairs;
Statements of realization and liquidation;
Statements of receipts and disbursements.
It is not improbable that various kinds of statistical statements may be included in this classification. It is thought, however, to be more consistent to confine the classification to the above and consider statistical tables, which are invaluable for administrative purposes, as schedules supporting the above statements.
There has been much discussion concerning the various names of the above-mentioned financial statements. Concerning balance sheets it would seem that there need be little or no discussion. The balance sheet may be general or detailed in the manner in which the information is presented. It may be condensed or consolidated. Irrespective of these matters it still remains a balance sheet. The question is sometimes raised as to whether it is more appropriate to present it in account form or report form. There would seem to be but one answer to this question, and that is: whichever suits the fancy of the person who is preparing the balance sheet. The information is there, whether assets and liabilities are presented side by side or one group above the other.
With regard to the statement of income and profit and loss there is perhaps room for more discussion. One author has tabulated the different names by which this statement is known and presents some fifteen of such. It has been variously referred to as the profit and loss account, the income and profit and loss account, the trading and profit and loss account, the manufacturing, trading and profit and loss account, etc., etc. The information contained should be the same, no matter by which name the statement is known. It will be observed that the difference seems to occur in that some are known as statements and some as accounts. The difference is usually technically referred to as that which exists between the account form and the report form. The account form, as its name implies, contemplates the presentation of the information classified and arranged with regard to debit and credit. The report form undertakes to present the information more or less in narrative or running form, deducting debits from credits and vice versa. The especial advantage of the report form is that it is adapted to comparison.
The balance sheet is a financial statement which shows the financial condition of an organization at a given moment of time.
The statement of income and profit and loss is a financial statement which sets forth the financial operations of an organization comprehensively grouped about the divisions of organization and connecting the financial condition of the organization at two different dates.
A statement of affairs is a financial statement setting forth as an estimate the deficit and the amount which unsecured creditors would receive through enforced realization and liquidation and the relative positions of preferred and secured creditors.
A deficiency account is a financial statement which serves to explain the manner in which a deficit has occurred and to connect the deficit with the proprietorship as shown on the balance sheet.
A statement of realization and liquidation is a financial statement which shows through the realization of assets and the liquidation of the liabilities the reduction of net assets to cash.
A statement of cash receipts and disbursements is a financial statement of an organization which shows the actual cash received and the actual cash paid over any given period of time, together with the balances at the beginning and at the end of the period, respectively.
Of the above the balance sheet and income statement are most prominent. They appear in connection with a going concern, whereas a statement of affairs and deficiency account arise in connection with insolvency as a rule, while the statement of realization and liquidation shows the subsequent transactions of the receiver. The purpose of the balance sheet is to set forth the financial condition. The purpose of the statement of income is to set forth the story of operations. Each must be complete as to content and arranged comprehensively if it is to be of use. In considering this point it may be well first to look for a moment at the parties at interest in an organization. These are, first, those who contribute the capital or finance the organization; second, those who manage the organization; and, third, those who develop relations with the organization as debtors and creditors. The classification of parties is apparently broad enough to cover any contingency, since the respective parties are connected with phases which are fundamental to organization. Under the head of contributors of capital we find sole proprietors, copartners, stockholders, members, and, in the case of municipalities, taxpayers. Each of these is interested in knowing that his funds have been not only advantageously employed, but that they are secure. Financial statements offer a means of satisfying the desire for such information. To the manager they offer in the same way a means of satisfactorily accounting for his stewardship, but they also furnish him with excellent facilities for getting in touch artificially with the divisions of his organization which size or other conditions prevent him from coming into personal contact with and thus transcending the limits of his personal observation. Through his financial statements he is offered an opportunity of extending his administrative functions to the most remote and insignificant portions of his plant. As to the outsiders, comparatively little can be said concerning debtors. The creditors, however, play an important part. Before trade creditors or banks will extend credit or make loans they must know that the concern is in good financial condition and what its prospective earning power is. Both these facts may be disclosed by balance sheets and statements of income.
In short, it would seem that financial statements which would convey the proper information to the administrative officers would be perfectly satisfactory to any one of the other parties at interest. There has been omitted from this classification of parties the government, and, while the government may be admitted as a party at interest, for some reason or other it appears that statements that are perfectly comprehensive and satisfactory to every one else are not, as a rule, satisfactory to the government. It seems to be customary for the government in the majority of cases to insist on financial statements in the form of reports which differ entirely from the usual run of financial statements and are understood with difficulty by the parties who are required to prepare them. In many cases they do not appear to follow any known rules of accounting and the results obtained at times are little short of ridiculous. It is difficult to see just why balance sheets and statements of income and profit and loss which are ordinarily accepted as being clear and comprehensive are not received and used by the government.
A classified balance sheet would appear to meet the requirements of all interested parties. By classified balance sheet is meant one in which the assets and liabilities are classified. Assets are of several kinds, namely: capital, working and trading, current, miscellaneous and deferred. Liabilities follow very much the same order, namely: capital, current, miscellaneous and deferred. Such a classification would give to any one interested information concerning the assets and liabilities. It would also enable any one to compare any group of liabilities with any corresponding group of assets. As to the general arrangement, a great deal of discussion has been had. There are those who contend that the current assets should be shown first, arranging them in the order in which they will be realized; that the current liabilities should appear at the head of the statement on the other side, arranged in the order in which they will be liquidated. Others contend that capital assets and liabilities respectively should head the statement. Those who argue for preference for the current assets and liabilities seem to have principally in mind the interest of creditors, and they also seem to go on the assumption that the business is to be liquidated. Those who prefer the capital assets and liabilities seem to look at the situation from the standpoint of the proprietor or stockholder. With a little care in the arrangement it would seem that every one might be satisfied. If the capital assets and capital liabilities are placed at the top of their respective sides of the balance sheet the working and trading assets follow the capital assets, and these in turn are followed by the current assets; whereas the capital liabilities are followed by the current liabilities, then, subject to consideration of miscellaneous assets and liabilities and deferred charges to expense and credits to income, there may be seen at a glance not only how the capital has been invested and maintained but the relation of current liabilities to current assets. It is an easy matter to show the logical order of assets and liabilities with regard to realization and liquidation in the case of a going concern, whereas it is much more difficult to attempt to state the order of realization and liquidation in case a concern is to be wound up.
There are a number of controversial points which arise in connection with balance sheets. Prominent among these is the order which the current assets shall take. These should be arranged in the order in which they will ordinarily be realized, namely: cash, accounts receivable, notes receivable. In the case of a going concern, if goods are not sold for cash they are sold on account. When the customer finds out that he cannot pay the account as promptly as he expected to he asks for a further extension of time and offers his note. It should be understood that the note is not any better security than the account. What the note does is to effect an agreement as to the items making up the account and thus render it unnecessary to prove the items in the account should litigation arise. It has often been argued that a note may be realized upon much more quickly than an account, since notes are frequently discounted. It may be remarked with equal truth and facility that accounts in some parts of the United States are in effect discounted. While both of these statements may be true, they are the exceptions to the rule that an account will ordinarily precede a note; however, it seems only logical to give preference, in the order of arrangement, to the accounts as representing the bulk of the credit.
Similar discussion may also be had with regard to current liabilities. As to the items of taxes and wages, there need be little argument, since the law makes both preferred claims, taxes and all claims to the government taking preference over wages. The same argument which was used in the case of accounts receivable and notes receivable may be used in the case of accounts payable and notes payable. Notes are not preferred over accounts, but rate with them in liquidation. They have no stronger claim on the business, than have the accounts and, in view of the fact that in the history of the business transactions the accounts usually precede the notes, it is thought consistent to follow this arrangement in the balance sheet.
Good-will frequently comes up for discussion and the question which presents itself is whether it shall be included among the capital assets or as a miscellaneous asset. Its allocation depends entirely upon the circumstances surrounding its creation. If it is purchased in exchange for assets of the concern, it should be included as a capital asset. If it is raised by the concern without having been acquired in exchange for value which can be measured, it should be shown as a miscellaneous asset.
Another point worthy of discussion is th* treatment of reserves. Many accountants follow the practice of deducting the reserves from the respective assets, while others show them broad. The reason for deducting them is that it is argued that reserves are merely bookkeeping expedients for reducing the values of certain assets; that what an observer is interested in when he looks at the balance sheet is the net value of the asset; that it is a waste of time and source of annoyance for him to be obliged to find the reserve on the liabilities side and make the necessary deduction from the asset. This is, of course, a prac-’ tical reason for the treatment just suggested. The adherents of the other theory, which holds that the reserve should be set up broad, seem to have more or less philosophy on which to base the practice. Their reasoning is as follows: Proprietorship is the excess of assets over liabilities. It is an equity in all the assets taken collectively. The proprietor shares with creditors the ownership of the assets. It would not be correct to assign certain of the assets to creditors and to say that the equity of the proprietor was vested in the remainder. A reserve is a portion of proprietorship set aside for a particular purpose. Proprietorship being an equity and reserves being a part of proprietorship they may not be deducted from any specific assets any more than proprietorship. The Interstate Commerce Commission makes a distinction between reserves for depreciation and reserves for other purposes, deducting the depreciation reserves from the assets and setting the others up broad. This would appear to be a good distinction. There is nothing in the idea that to deduct, or not to deduct, reserves has any bearing on the relations of the organization to fire insurance companies in the case of a fire loss.
Another interesting point presents itself in connection with sinking funds. As is well known, sinking fund cash may be used for the purpose of buying up bonds of the company before they mature, usually at a slight increase over par. The treatment of such purchases and the manner in which they are shown in the balance sheet takes one of two forms. One way is to show them broad. The other is to deduct them from the liability in a manner similar although on the opposite side to that in which reserves are deducted from assets. If such bonds when purchased are actually canceled then there would seem to be no question about the treatment to be accorded them. That is, they should be charged against the liability for bonds outstanding, thereby reducing it. In this way the reduced liability would appear in the balance sheet without any question concerning it. If, however, the bonds were not actually canceled, as sometimes happens, they may either be carried on the balance sheet on the asset side as an investment, whereas the liability in full is shown on the opposite side; or they may be deducted from the liability side and the net account extended. The latter method would seem to be preferable, since the bonds at time of purchase are in the possession of the company or its agent and there can be no further liability to the public.
Whether investments or securities owned shall be classed as fixed or capital assets or as current assets is also a debatable point and will depend upon the purpose for which they are held. It is not probable that any one would think of considering shares of stock of a subsidiary concern held for purposes of control, or desirable affiliation, as a current asset. On the other hand, scarcely anything is more marketable, nor can anything be more readily converted into cash as a rule than securities. Since we look upon current assets as those which may be realized upon for the purpose of liquidating current liabilities it would not seem amiss to class securities as current assets. If the stocks were pledged as security for some capital liability it would seem further to complicate the situation. We might sum the matter up by concluding that when securities are held for purpose of control, affiliation, permanent investments of excess capital, or when pledged for capital liabilities, they are to be considered as fixed or capital assets, but when held as temporary investments of excess capital, until the time when the usual current assets will not be realized upon fast enough, or when pledged as security for current liabilities, they should be considered as current assets. As to advances to subsidiaries, if they are to be repaid in cash they are usually considered as current, whereas if they are to be repaid in securities they are considered as investments under fixed or capital assets, since the securities when received will constitute control or affiliation.
There very often arises in connection with the preparation of balance sheets the question as to whether or not consignments received and shipped shall be shown on the balance sheet and if so how. The best practice probably dictates the use of a memorandum or foot-note showing to what extent consigned goods are on hand. If consignments received are to be carried on the balance sheet at all they should, it seems, be shown on the asset side as the very last item, whereas the corresponding accountability should appear in the same relative position on the liabilities side. It is not desirable that consignments should be shown as a part of the working and trading assets of the concern in order that the accounts payable on the other side include as a liability the corresponding amount. With regard to consignments shipped many accountants favor ignoring any reference to them in the balance sheet. It would seem that they might with propriety be shown therein as deferred credits to income, provided, however, that the corresponding amount which has been charged to accounts receivable is set forth separately so that there can be no question as to the value of the accounts receivable in so far as the consignments are concerned.
Notes receivable discounted are frequently the subject of heated discussion. One person may prefer to show them merely as a foot-note with the statement that a contingent liability exists in connection therewith in whatever the amount may be. Another practice consists in placing the contingent liability among the current liabilities on the theory that the notes are included in the current assets. Still another practice excludes the notes from the current assets and places them below among the miscellaneous assets, while the contingent liability offsetting them is shown among the miscellaneous liabilities. It is important that this matter should not be overlooked, since notes receivable discounted play an important part many times in the financial condition of a concern. It is probable, however, that the preferable practice is to make mention of them through the medium of a foot-note on the balance sheet.
Where the details of certain items appearing on the balance sheet are numerous and the detailed information is necessary to a comprehensive statement, it is customary to supply them in the form of supporting schedules. Such schedules appear most frequently as those which show the details of plant and equipment, securities owned, accounts receivable, notes receivable, capital stock outstanding, accounts payable, notes payable, etc. Schedules are also used in the case of’ co-partnership to show the adjustment of proprietorship as affected by additions and withdrawals of capital, interest, salary and division of profits, etc.
Consolidated balance sheets and income statements are used to show the combined financial condition and results of operations of two or more controlled or affiliated companies. They are usually prepared in cases of holding companies where it is desirable to consolidate the showing of the subsidiaries with those of the parent company, or when it is desired to know the combined financial condition and operations of a group of companies about to be consolidated.
The holding company maintains its control over subsidiaries through stock-ownership. The profits from the subsidiaries are taken up by the holding company through dividends on the capital stock. The stock is supplemented at times by bonds so that in such cases the income of the holding company is made up of both dividends on stocks owned and interest on bonds owned. As a rule the holding company has little other income.
There may be financial transactions between the holding company and its subsidiaries, such as advances and loans. The same transactions may also take place among subsidiaries as well as inter-company sales of materials and supplies, parts to complete and finished goods. The mere fact of the existence of such transactions is sufficient in itself to raise a considerable problem in preparing consolidated statements, but the problem is usually complicated by the further fact that such inter-company sales have been booked as sales so as to show a profit instead of being mere transfers at cost. It is much the same practice as that wherein one department of an organization turns over partly finished product to that which performs the next operation at the market price, allowing departments to show profits.
From the above it will be seen that before consolidated statements may be prepared considerable work must be done in reconciling the various accounts pro and con to the end that they will agree and offset one another when they are put together for elimination. The most common accounts which require such treatment are capital stock, bonds, advances, accounts, notes, interest, sales and consignments.
Let it be assumed that the New York Mfg. Company is a holding company owning the capital stock of the Bronx Mfg. Company in the amount of $100,000 and the capital stock of the Manhattan Mfg. Company in the amount of $500,000. The two latter companies as subsidiaries own and operate plants in the respective boroughs. Let it be further assumed that the cost to the holding company of the Bronx Mfg. Company stock was $95,000, and if the cost of the Manhattan Mfg. Company stock was $525,000, the stocks of the respective operating or subsidiary companies will be carried on the books of the holding company at $95,000 and $525,000, respectively. The earnings of the holding company will with respect to these investments appear in the form of dividends on the stocks. If the Bronx Mfg. Company pays an annual dividend of 10 per cent. and the Manhattan Mfg. Company an annual dividend of 12 per cent., the earnings will appear as dividends in the amounts of $10,000 and $60,000, respectively, except in the case of a consolidated balance sheet or consolidated statement of income and profit and loss. These will be the only transactions and entries appearing on the books of the holding company. If, however, the holding company has other assets and liabilities and other income and expense, and it is desired to show the combined financial condition of the holding company as well as the subsidiaries and corresponding statements of income and profit and loss, then it will be necessary in preparing the statements to resort to certain eliminations. It will be a matter of combining the assets, liabilities, income and expense of all the companies. Since the investments in the subsidiary companies have been shown as capital stock and the specific assets and liabilities of the subsidiary companies are to be brought into play so as to show their true financial condition in place of the investments, it will be necessary to offset the capital stock shown as the asset on the books of the holding company against the accountability for said capital stock shown on the books of the subsidiary companies, and if perchance, as is the case here, the stocks have not been carried by the holding company at par, an adjustment of the combined surplus of the three companies will be necessary. In the case of the Bronx Mfg. Company, from the point of view of the consolidated balance sheet, the capital stock carried at $95,000 will have to be brought up to par and the consolidated surplus correspondingly increased in the amount of $5,000. The stock of the Bronx Mfg. Company carried as an asset by the New York Mfg. Company may then be offset against the accountability for capital stock outstanding shown by the Bronx Mfg. Company in the amount of $100,000. In a similar manner in preparing the consolidated balance sheet the stock of the Manhattan Mfg. Company carried as an asset by the New York Mfg. Company in the amount of $525,000 will have to be adjusted by charging the combined surplus with $25,000, so that the capital stock as an asset may be offset against the accountability for same on the books of the Manhattan Mfg. Company. The dividends shown as earnings by the holding company will have to be offset against the charges for dividends on the part of the subsidiary companies.
It seems scarcely necessary to go through the details incident to elimination in the case of the other items mentioned, since in each case the procedure consists in first bringing the items into agreement with respect to each of the two companies involved and then offsetting one against the other. It should be noted, of course, that eliminations may have to do not only with the accounts between one subsidiary and the holding company but that similar relations may exist among the various subsidiary companies. Such items as bonds and advances will usually be found in cases where the holding company is involved in these particulars with one or more of the subsidiary companies. In the cases of accounts, notes, interest, sales and consignments, the necessity for elimination occurs probably with greater frequency. Inter-company sales where same have been recorded at the prices at which goods are sold to outsiders will have the effect not only of fictitiously increasing the volume of sales, but in cases where certain of such goods remain on hand at the time of taking inventories such goods will, unless the condition is corrected, appear in the consolidated balance sheet at an inflated value. It is customary to correct this erroneous statement of assets by making a deduction from the inventories. In cases where the profits are not entirely vested in the inventories the correction is made through the medium of a reserve. There is presented below a specimen consolidated balance sheet and a statement of income and profit and loss accompanied by working sheets showing the procedure incident to their preparation.
The statement of income and profit and loss appears to be the work of evolution. Statements of this character apparently began with a simple profit and loss statement in account form in which the nominal accounts were classified with respect to debit and credit. This statement had the effect of connecting the balance sheet at the beginning of the period with that at the end, but it was far from comprehensive. It showed that a collection of credit items exceeded a similar collection of debit items and that the excess of credits over debits was equal to the difference between the proprietorship as shown by the first balance sheet and that of the second.
A demand apparently on the part of the proprietor for information which would be of more use to him brought out the trading and profit and loss account. This was, of course, used only in cases of concerns engaged in trading. For manufacturing and trading concerns there was a similar statement which included an added section for manufacturing preceding the trading section. Doubtless a remark to the effect that the trading and profit and loss account is now somewhat passe will be challenged with a great deal of vehemence. There are many who have used it for several years and have become so accustomed to its use that they blindly refuse to recognize any other form of statement. An unbiassed investigation of the relative merits of the trading and profit and loss account and the statement of income and profit and loss must, it would seem, find in favor of the latter. It would almost appear to be so far in advance of the trading and profit and loss account as not to permit of comparison.
The purpose of the statement of income and profit and loss is not merely to connect the proprietorship at two dates. While this is, of course, essential, its prime purpose is to group transactions of the period around the three main functional divisions of organization, so that such information will be of administrative value. It also aims to separate from the above mentioned transactions those incident to the acquisition, use and protection of capital and to classify the profit resulting not only with regard to its origin, but to show the income from operations separate and distinct from income from other sources. The statement takes the report form rather than the account form. It is thought that this makes it more easily understood by the business man, who often lacks a technical knowledge of bookkeeping and accounting. If the layman were attempting to ascertain profits he would set down first, probably, his sales. From these he would deduct the cost of his sales. With just this same thing in mind the statement under consideration is begun by showing the gross sales. Realizing that returns decrease the gross sales they are, therefore, deducted. This deduction then shows the net sales. Sales returns are quite distinct from sales allowances. The latter may take the form of trade discount, rebates, allowances for breakage, damage, loss in transit, etc. These allowances may be supplemented by outward freight and cartage and together will constitute the deductions from sales, so designated because of the fact that there will in reality be, to the extent of the deductions, less income produced by the sales. A trading concern derives its income usually from two sources. The principal or primary source is sales. The secondary source is usually interest on surplus capital. It is, therefore, thought that the expression income from sales may be appropriately used to describe that earning which results after deductions from the net sales have been made. The first section in the statement may be said to constitute the sales. Following this there comes the cost of the goods sold, and it should be borne in mind that the construction of this group will depend upon whether the concern is engaged solely in trading or m manufacturing and trading. If engaged in trading solely, the problem is a very simple one and the section may show first the inventory at the beginning of the period, plus the purchases, less the inventory at the end of the period, with the cost of goods sold resulting; or it may show simply as one item the cost of the goods sold without showing how the amount is arrived at . If, however, the concern is engaged in manufacturing its own goods the situation changes considerably. Here it may be necessary to show the inventory of materials and supplies at the beginning of the period, the purchases, including inward freight, inward cartage and, in some cases, duty; the returns and allowances in connection with purchases, the inventory of materials and supplies at the end of the period, with the materials and supplies applicable to cost resulting. In addition to this there will be the manufacturing expenses, such as superintendence, heat, light and power, manufacturing supplies, factory office salaries and expenses, repairs and renewals, depreciation of machinery and tools, etc. The total at this point will of necessity be treated with the differences of inventories of goods in process and finished goods respectively, in order to arrive at the cost of the goods sold. The total cost of sales resulting from the second section will be deducted from the income from sales, as shown in the first section, and the gross profit of sales resulting will be brought down. From this figure will be deducted that resulting from the third section, or selling expense, and the excess brought down will be selling profit. Selling profit is a somewhat new term and will not be as generally understood as gross profit. In fact, it is a sub-division of gross profit as found in the trading and profit and loss account. This latter account combined the selling expenses with the cost of goods sold and opposed the combined result against sales, showing the balance as gross profit on sales. It would appear that this gross profit might, with consistency, be further divided, and that, in short, is what has been attempted in the statement of income and profit and loss. It is thought that this further classification of profit has distinct advantages over the former classification, since it may be very important to know to what extent the gross profit on sales is reduced by selling expenses. Administrative expenses comprise the next section and are deducted in turn from the selling profit in order to ascertain the net profit oh sales. This profit is, in fact, the income from operations, or the primary income, since it is the prime object of the concern to engage in the manufacture and sale of goods for the purpose of profit. With respect to the various classes of profit above described, it will add to the value of the statement if there is shown, with regard to gross profit, selling profit and net profit respectively, the percentage of cost.
The secondary income is usually added to the income from operations, in order to determine the gross income. From this figure there is then deducted the items which offset the other income and which are commonly known as deductions from income. The figure resulting then becomes net income, or profit and loss. With regard to these two sections, the statement will vary at times. The principal variation consists in combining other incom* and deductions from income into one section and either adding or deducting the net figure, as the case may be, to or from the income from operations. The result produced will, however, in each case be the same, the form of sfetting up Hie information varying.
At this point a question sometimes arises concerning certain items as to whether they shall be considered as income or deductions therefrom, or profit and loss debits and credits in accordance with their character. It is sometimes fairly difficult to decide whether a certain item is a profit and loss charge or a deduction from income. The controlling factor in deciding this point is whether or not the charge recurs with regularity and consistency and is connected with the income. It will usually be found upon investigation that most of these questionable items should be included as profit and loss charges and credits rather than items of income or deductions therefrom. To the “net income—profit and loss,” there should be added any profit and loss credits applicable to the period. From the total of these there should then be deducted the profit and loss charges for the period. The balance win be the profit and loss for the period. It may be found necessary to adjust this figure on account of debits and credits occurring during the present period but affecting previous periods. Such adjustments are in truth adjustments of surplus, or proprietorship of a previous period, and will be added to or deducted from the profit and loss for the period after it has been combined with the previous surplus or proprietorship. The final result will be the proprietorship or surplus at the end of the period and should agree with the corresponding items on the balance sheet. In the case of corporations dividends will be shown in the last section and as a distribution of surplus.
The question has frequently arisen as to whether the profits for the period should be connected with the previous proprietorship on the statement of income or on the balance sheet. The answer to this is that it is very largely a matter of personal choice and there does not appear to be very much reason why one method is not as good as another. Tying the figures up on the balance sheet reveals the profits for the period without being obliged to refer to the statement of income in case one does not care to see how the figures are arrived at. On the other hand, tying them up on the income statement relieves the balance sheet of some detailed information which sometimes has the effect of making it appear complicated. The latter method is preferred by the writer, for the reason that it permits of as much adjustment as is desired without detracting at all from the appearance of the balance sheet.
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