Proprietorship Accounts Defined.—Proprietorship accounts are the accounts which record the effects, both temporary and ultimate, of business transactions upon proprietorship. The study of the two preceding chapters has made clear the fact that transactions which involve the receipt of income or the payment of expenses result respectively in an increase or decrease of proprietorship, and that these increases or decreases are temporarily recorded in suitable income and expense accounts until the close of the fiscal period, at which time the accounts are summarized to determine the net effect of all transactions upon proprietorship or the capital invested in the business. Therefore, the proprietorship accounts are of two general kinds: temporary and vested. Temporary proprietorship accounts make temporary and immediate record of the results of the agencies or forces at work within the business to produce a profit. They set forth the efforts to increase the net worth of the business. They record the costs of the effort and its yield in earnings, the record being made under appropriate titles to show the kind of cost and the source of the yield. Vested proprietorship accounts record the ultimate or summarized results of business transactions. They therefore record the original investment and its subsequent net increases and decreases.

Fundamental Consideration of Proprietorship Debits and Credits.—Income and expenses comprise the temporary proprietorship items which, after being summarized, show their ultimate effect upon vested proprietorship. In other words, they are proprietorship items set up temporarily to furnish detailed information for aiding in efficient management and control and are later transferred to the ultimate or vested proprietorship records. Since, from the mathematical necessity of the proprietorship equation, proprietorship items normally have credit balances, it is evident that all income, or earnings, must be placed on the credit side of their appropriate accounts. Cost of management and all expenses of operation are deductions from that income and must therefore be recorded on the left or debit side of appropriately named accounts.

Income Debits and Credits.—With regard to their debits and credits, income accounts follow this rule:

Income accounts normally have entries only on the credit side. They are debited, however, for the purpose of deducting from the yield shown on the credit side, (1) because of overstatement of the amount of the yield in the first place; (2) because of error in the original placing of the item of income, which is now transferred to its proper account; and (3) for the purpose of summarizing when it becomes necessary to transfer all income and expense items to one summary account. The entries made for the purposes of transfer and summarization are sometimes called “adjusting” and “closing” entries.

Expense Debits and Credits.—With regard to their debit and credit, expense accounts follow this rule:

Expense accounts normally have entries only on the debit side. Their credits are for purposes similar to the debits to income accounts as stated just above.

Examples of temporary proprietorship items can be found in Chapters V, VI, and VII, where the profit and loss summary is treated.

Vested Proprietorship Debits and Credits.—Two accounts should be kept on the ledger with the proprietor, a capital and a personal account, i.e., “John Doe, Capital” and “John Doe, Personal.” The capital account records the original investment or the amount of capital now in the business as shown by the last financial statement. The personal account shows all direct changes made in the capital during the fiscal period either through withdrawal or the additional investment of funds or properties. The capital account, therefore, shows no change until the close of the fiscal period, when the increase or decrease in net worth is transferred to it.

An exception to this is sometimes made when there is evident intention to withdraw during the period some of the invested capital, in which case such withdrawal is shown in the capital account as a debit or subtraction item. Also, if there is evident intention to increase the investment during the fiscal period, record of it is sometimes made in the capital account. Practice in this regard is not uniform.

The ordinary transactions with the proprietor, such as more or less regular withdrawals of cash or goods and other similar transactions, are recorded in his personal account. This is his current account as distinguished from his more permanent capital account. Both of these accounts may be termed vested proprietorship accounts. Their debit and credit schedule appears as follows:

The capital account usually shows only one item throughout the period until its close; the personal account shows both debits and credits, made according to the above schedule. The personal account ordinarily shows transactions of the following kind: on the debit side, withdrawals in funds or goods, the payment or assumption by the business of the personal debts of the proprietor, and his retention of any funds or properties belonging to the business, such as collections from customers; on the credit side, the investment in the business of any funds or properties, the retention by the business of any funds or properties belonging to the proprietor, as where the business collects and retains a debt due him personally, and the payment or assumption by him personally of any debts of the business.

Further Consideration of Expense Items.—In explaining the debits to fixed asset accounts it was pointed out that all costs necessary to place the asset in position for use by the business constituted a part of the value of the asset and should be recorded in the asset account. Similarly, it was explained that in the Merchandise account there was included as a part of the value of the merchandise all the costs incident to putting the merchandise in position for sale by the business. Costs of this kind are classed as incoming costs and are almost without exception treated as additions to the value of the asset. The costs incurred from this point on, in the course of business operations, are classed as expenses or proprietorship decreases.

It might sometimes appear that all these operating costs—the kind shown in the profit and loss statement—also add to the value of the assets of the business. Such is not the case. In a mercantile concern, business is conducted for the purpose of selling merchandise. Profit arises through the purchase of merchandise at one price and its sale at a price sufficiently higher to pay for all operating expenses and leave a margin. The cost of merchandise to the customer reimburses the proprietor for his original outlay in merchandise and for a fair portion of the operating expenses incident to the maintenance of the store. The customer is willing to pay this additional amount because it is cheaper for him to pay the merchant a margin over the cost of the merchandise sufficient to induce the merchant to conduct a market for merchandise, than to undergo the necessary expenditures—of time, expense, and inconvenience—entailed in making the purchase from the original vendor.

The economic organization of business is based on this hypothesis. In the management of a business there is a very large element of risk. The sale price of commodities at a given time is not always determined on the basis of the original cost of the commodity plus the costs of maintaining a store for its sale. Competition sometimes enters in to drive the price down below this amount. While every merchant expects in the long run to receive from the sale of his merchandise not only what he himself has paid for it but also the cost of conducting his store and a fair margin of profit, for a given period and for a given item of merchandise he may not be so fortunate.

In recording business transactions, therefore, prudence demands that the costs of operating the business be not recorded as increases in the value of the merchandise dealt in, but rather that they be set up separately and charged against the income received from the sale of the merchandise before the increase (or decrease) in the value of the assets is determined and made a part of the asset record. As merchandise is converted into cash the amount received is recorded as an increase in the asset cash. This cash includes the original cost of the merchandise plus some of the costs of operating the business. These are costs which must be incurred and they add value to the business as indicated by the willingness of the customer to pay the merchant for them. Because the added value is problematical at the time the costs are incurred, they are recorded as expenditures which must be made good out of the sale of the merchandise at a sufficiently enhanced price to cover them, i.e., they are expenses which are to be treated as deductions from sales income.

The net difference between the income and the cost of securing the income, as indicated by the expense accounts, will represent the value added to the assets of the business, and will therefore be reflected tangibly in an increase in the value of the assets by that amount. This increase will usually be reflected either in the cash holdings or in claims against customers.

It may not be out of place at this point to call attention to the fact that, as the bookkeeping record is usually handled, the only relationship between asset increases, liability decreases, and expenses (proprietorship decreases) arises from the fact that all of them are debits and are so placed because of the mathematics of the fundamental equation on which double entry rests. Assets, liabilities, and proprietorship are three distinct and separate groups of accounts related only by the logic of the proprietorship equation. As the subject of accounting is developed the student will see the increasing importance of drawing sharply the lines of division among these groups and he will see also the difficulty at times of maintaining this distinction.