The Two Problems of the Balance Sheet.—There are two major problems connected with the balance sheet: (1) the problem of form, and (2) the problem of content. The form of the balance sheet, which was discussed rather fully in Chapter III, has to do with the arrangement of the items for the purpose of intelligent reading. It deals with the principles in accordance with which the asset, liability, and net worth items are to be marshaled and set up in groups and arranged within the group with a view to facilitating the comparisons between groups and the calculations made in judging the financial condition of the concern.

The second problem of the balance sheet, that of content, which was also mentioned in Chapter III, concerns itself mainly with the valuation of the items in the balance sheet, assuming of course that all the assets and liabilities are included in the statement. A balance sheet may be correct in form but, unless its content is reliable, it has little or no value when judged from the standpoint of its chief purpose, namely, that of showing the financial condition of the concern. The problem of the form of the balance sheet has to do with the technical or mechanical side of accounting, while the problem of its content or the valuation of its items has to do with the questions of the concern’s financial administration, for the solution of which the accounting department must furnish in proper form the necessary information.

Kinds of Value.—It is first necessary to state the limitations within which the principles of valuation to be laid down are applicable to the commercial balance sheet. In business many different kinds of value are found and used. Thus we have the terms, sale or liquidation value, cost value, and replacement value. By the term “sale value,” when applied to a going business, is meant the value which a willing buyer offers to a willing seller. “Liquidation value” means the value or price offered for a commodity or an entire business when the concern is winding up its affairs and going out of business. Liquidation is, therefore, forced value. There is thus a marked difference between sale value and liquidation value. The term “cost value” is understood to mean the price paid for a purchased article. From the discussion of the principles of debit and credit as applied to merchandise and to fixed assets, it has been shown that the price paid should include not alone the invoice cost but the other expenditures needed to put the article purchased in such a position that it can be used by the business in the customary way. Replacement value means the cost to replace an article. It differs from first cost mainly in that the price level may have changed between the date of the original purchase and the present time. Thus, because of the changes in prices, an article, costing $1,000 in 1914, might have had a replacement cost of $1,800 in 1917, and $1,400 in 1922.

Manifestly, before the principles to be followed in valuing balance sheet items can be laid down, there must be some understanding as to what kind of value is under discussion. The kind of value used in the ordinary commercial balance sheet is termed “going concern value.” By this is meant the value which is applied to a going business—a business which expects to continue in operation, not one which expects to sell out to other owners nor one which expects to discontinue operations.

Source of Data as to Values.—In a going concern the information as to value is found chiefly in the books of account. The data in the accounting records are, of course, supported by the original documents evidencing the purchases and sales. It is a necessary corollary that if the books of account are to give reliable information as to values, a correct analysis must be made of all transactions previous to their entry. Mention was made in an earlier chapter of the necessity of a clear differentiation between capital and revenue charges and the effect of failure to make such differentiation. If at the time of an expenditure a correct classification of accounts has been made, particularly of the broad classes of assets, liabilities, and proprietorship, the accounts should reflect the true values as of the various dates of record. For purposes of detailed information it is equally necessary that a correct classification be made of the accounts affected by an entry within any of these main groups. It has been seen that because of practical difficulties no effort is made to have the accounts reflect day by day the correct value of the various items. It is considered sufficient to bring the book record into agreement with the facts in respect to value once each fiscal period, namely, at its close. The true financial condition and correct operating results are then determined.

It will thus be seen that a correct analysis of every transaction recorded in the accounts is an absolute prerequisite to the use of the accounts for determining correct values. It is very vital that a clear line of demarcation be maintained between capital and revenue expenditures—that great care be exercised that no cost is charged into the asset group of accounts unless such cost really enhances the worth of an asset. A cost incurred for the purpose of maintaining the value of the asset is an expense charge, and repairs and maintenance charges must be very carefully distinguished from replacements. Maintenance has to do with those costs which maintain an asset in good operating condition; repairs have to do with those costs necessary to put an asset in operating condition after a condition of inefficiency has been reached which the maintenance costs have not been able to prevent; a replacement cost is incurred when it becomes necessary to replace some part or the whole of an asset, neither maintenance cost nor repair costs having been able to maintain the asset in efficient operating condition. Where only a part of an asset is to be replaced, it is often spoken of as a renewal of parts. When so used, the term “replacement” is limited to the renewal or the replacement of the whole asset.

When a renewal or replacement is made, it becomes necessary to determine whether the cost of the renewal or replacement is more than the cost of the part or the whole replaced. For example, if an asset costing originally $1,000 is replaced by one costing $1,200, there has manifestly been an addition of $200 to the value of the asset. The new asset may be an exact duplicate of the old but if prices have risen so that the new actually costs more than the old, the books must record the asset at its new cost value. The amount by which a new asset or part of an asset exceeds the cost of the old asset or old part is called a betterment. A betterment is always an asset.

The student will readily see that at times it must be difficult to draw the line between repairs and replacements. In practice the line is usually drawn only when the expenditure exceeds a certain amount. This amount is not uniform and is determined by each individual business. For example, when the cost of placing the asset in efficient condition for operation is less than, say, $100, it is charged as repair cost and therefore does not increase the book value of the asset. If the cost exceeds $100, an analysis is made to determine what portion of it, if any, increases the value of the asset. The amount of the betterment is of course a charge to the asset account, while the rest of it is a charge to some expense account.

Treatment of Special Items.—In the determination of the classification of charges, some kinds of items require special consideration:

Organization Expense. The group of expenditures explained in Chapter XXXVIII, as incident to the organization of a corporation, is recorded under the title “Organization Expenses” and is classified for purposes of the balance sheet as an asset. It is a kind of asset, however, which has no tangible value and most businesses desire to consider it more in the nature of a deferred charge to operations. It is recognized that frequently intangible assets add no strength to the business. While, therefore, in strict theory organization expenses are assets, in practice it is best to write them off against income during a period of from three to five years.

Cost-Cutting Changes. Another similar class of charges is met in costs incurred in making changes in the arrangement of building and other facilities which will tend to bring about a more economical handling of some phases of the business; for example, a rearrangement of a receiving and packing room in order to facilitate the receipt and delivery of goods. Where these costs are inconsiderable it is best to charge them against the income of the period in which they are incurred. Where, however, a big expenditure is necessary, it seems best to set the costs up under a suitable descriptive title and spread them over several periods. In other words, at the date of their incurrence the costs are treated as an asset whose value is to be written down at the end of successive fiscal periods until finally it has all been charged against the operations of the business.

Interest During Construction Period. Where a business builds its own home, all costs incurred during the period of construction are proper charges to the costs of the construction. Thus, if a mortgage or bond issue is used as a means of partially financing construction of the building, the interest paid to the mortgagee or bondholders during the period of construction is a proper charge to the building account. Costs of this kind follow the general principle laid down previously, that all costs up to the point of placing the asset in condition ready for use are proper charges to the asset.

Basic Rules for Valuation of Balance Sheet Groups.—We may now consider the principles applicable to the valuation of the various groups on the balance sheet. In the standard form of balance sheet the assets are divided into the three groups: (1) Current, (2) Deferred Charges, and (3) Fixed.

It has been seen that the assets of the current group are used for purposes of settling debts, the payment of expenses, and the purchase of merchandise. In judging the sufficiency of these assets for this purpose, it is absolutely essential to know that the values at which they are carried will be realized when they are converted into cash. From the standpoint of conservative business management an understatement of realizable value may be made, but never an overstatement. Accordingly, the fundamental principle of valuation applicable to this group is that these assets are to be valued at cost or market, whichever is the lower. When so valued, the figures at which they are carried in the balance sheet will usually represent an amount slightly less than the amount which it is expected will be realized from their conversion into cash.

The function of the deferred charges group of assets is to secure an equitable distribution of expense charges between the current and the following period. It is only because certain expenditures have been made during the current period which will benefit the succeeding period, that it is necessary to set up this group of assets. Here the problem of valuation is, therefore, simply the problem of dividing the cost of the expenditures between the current and the next period on the basis of the benefits accruing to each. In some cases the basis of division is one of time, as where an insurance policy is purchased for a definite term. The portion of the policy which has expired during the current period is the portion of its cost to be charged to the current period, the balance being deferred to succeeding periods and therefore carried as an asset. In other cases a physical inventory is necessary to determine the distribution of the cost of expenditures, as when supplies of fuel have been purchased and not entirely consumed during the current period. The basis of the value carried over to the next period is of course a fair portion of the original cost. Market or replacement cost does not have any effect on the valuation of the deferred portion.

Fixed assets are acquired as more or less permanent equipment without which it is impossible to operate the business. The time during which an asset continues in use is the customary basis for a classification of its cost as between expenses and fixed assets. Thus, an asset acquired for purposes of business operation which, however, will be used up completely during the current period is charged immediately to some expense account, whereas an asset which will continue in use over several periods is charged to an asset account. Fixed asset purchases are never for purposes of resale. It is expected that they will continue in use until they are discarded because of failure to perform the service for which they were acquired. Neither the sale value nor the replacement cost value of such assets has, therefore, any influence on their value to the business. That value is the full cost adjusted periodically by an equitable distribution of that cost over the operations of the periods benefited by the services rendered by the asset. This principle of valuation is usually expressed by the formula, cost less depreciation.

Valuation of Assets

Cash. Cash as carried on the balance sheet is the asset which is used, without conversion, for payment of the liabilities of the business. There should, therefore, ordinarily be no problem of valuation. However, because of the practice of including checks, drafts and notes due and in course of collection, cash balances held abroad and therefore subject to the fluctuations of exchange, and other similar items in the account Cash, it is oftentimes necessary to examine all these items carefully and arrive at a figure which represents the amount expected to be realized from them.

Notes and Accounts Receivable. The claims against customers, both on note and open accounts, constitute an intermediate step in the conversion of merchandise into cash. At the time credit is extended to a customer it is expected that he will pay the amount due. The experience of every business man shows, however, that during each period there is a shrinkage in these claims due to some customers failing to pay the amounts they owe. In valuing these claims it is therefore necessary to take cognizance of the amount of the shrinkage. This amount is different in different businesses, depending on the length of the credit term, the policy as to investigation of credit risks, and on the rigor of the collections policy. On the basis of the experience within a given business, it is therefore necessary to make an estimate of the loss from uncollectible accounts.

The manner of making the record of estimated bad debts has already been explained. The reason for placing the amount by which the asset is estimated to shrink as a credit in the Reserve for Doubtful Accounts account rather than in the Accounts Receivable account has also been explained. The custom of estimating the amount of loss on the basis of the sales for the period rather than on the amount of claims outstanding at the close of the fiscal period has been referred to. Here it is desired to explain the manner of handling the reserve at the time claims are definitely determined uncollectible. Until a claim is determined uncollectible it is carried as a part of the assets, Notes or Accounts Receivable. The amount of the estimated shrinkage in these assets due to failure to collect claims is indicated by the Reserve for Doubtful Accounts account. This amount cannot be applied directly to particular notes and accounts until it is definitely known that such notes and accounts cannot be collected. When that is learned, it is necessary to transfer from the reserve account the amount needed to cancel from the books the uncollectible notes and accounts receivable. This is done by the following entry:

• Reserve for Doubtful Accounts
• Notes (and Accounts) Receivable

It will thus be seen that the decrease in value of the accounts receivable as estimated by the amount in the Reserve for Doubtful Accounts can never be applied to the asset until it is definitely determined what particular customer’s account included in the Accounts Receivable account is bad and must therefore be written off the books. Inasmuch as the Bad Debts account set up at the close of each fiscal period to indicate the loss or expense due to uncollectible accounts, has been charged as an expense of operating for that period, it would manifestly be duplicating the expense charge if a debt that proved bad were charged to the Bad Debts account rather than to the Reserve for Doubtful Accounts. Only during the first period of operation of a business are debts, if determined bad during that period, charged to the Bad Debts account. Even here, if it is expected at the close of the first period to base the estimate of uncollectible accounts on the sales for the period rather than on the amount of outstanding accounts at the end of the period, it would be necessary to charge the debts becoming bad during the period against the Reserve for Doubtful Accounts account—even though at the time of the charge it contained no credit entries—and not to the Bad Debts account. The desirability of establishing a standard routine for the handling of all items should be kept in mind. Best practice, therefore, demands that all debts shall be charged against the Reserve for Doubtful Accounts whenever they are determined to be bad, regardless of the amount held in reserve in that account. If such practice creates a debit balance in the Reserve for Doubtful Accounts, it is an indication that the estimate of uncollectible accounts made in previous periods has not, as a matter of fact, been sufficient and a larger estimate must be made for future periods.

Merchandise. Merchandise is purchased for the purpose of resale at a profit. Sale price is dependent, in a free market, on the force of demand and supply and not at any given time on cost. Until the goods are sold no profit, as a matter of fact, has been secured. Conservatism, therefore, demands that sale price should not ordinarily be used as the basis for the inventory valuation. Unless there has been a decided change in prices, it is the confident expectation of the management that at least the cost price of the merchandise will be realized when the goods are sold. Ordinarily, therefore, merchandise will be priced in the balance sheet at cost. When, however, there has been a change in price levels, particularly when the indication is that there is a generally declining market and not simply a temporary fluctuation in prices, it is the part of conservatism to value the merchandise at its replacement cost, or even at a lower figure, if stocks are large and market conditions are such that customers are withholding their purchases until price levels have dropped still further. The basic principle for valuing all current assets requires that they be valued as nearly as possible at the realization figure. Therefore, the amount expected to be realized governs or influences the valuation basis. The valuation formula or rule-of-thumb method, in accordance with which merchandise inventory is usually valued, is expressed as cost or market, whichever is the lower. As indicated above, there are times when exception is taken to this basis.

Investments. Stocks and bonds representing the investment of temporary surpluses of cash are valued on a realization basis. Inasmuch as the tying up of cash in these securities is only temporary and it is expected that they will be converted again into cash as needed, the amount which can be realized from their sale on the date of the balance sheet is the amount to be considered when judging the financial condition on that date. A large amount of discretion must be used in valuing these securities, because of the violent fluctuations to which quotations on the various stock exchanges are subject. Here also conservatism does not usually authorize value at the market if the market is higher than the cost. Accordingly, the valuation formula is cost or market, whichever is the lower.

Accrued Income. The income accrued on the date of the balance sheet is determined on the basis of a fair distribution between the periods during which the income accrues. Thus, the income from money loaned during the current period but not due until a succeeding period must be distributed over two or more periods. Where the income is dependent on time, the portion applicable to the current period is determined on a time basis. Where the income is dependent on some other basis, such as sales or units of work done, the portion applicable to the current period is determined by the ratio of the whole to the amount completed during the present period. Thus, in the case of a contract entered into to sell goods on a commission basis, the commission income accrued during the current period will usually be based on the amount of sales made during that period.

Deferred Charges. The valuation principle for deferred charges has been stated above in connection with the principles of valuation to be applied to the various groups of accounts on the balance sheet.

Fixed Assets. Fixed assets may usually be divided into two classes: (1) assets not subject to depreciation, and (2) assets subject to depreciation. The usual example of assets not subject to depreciation is the land on which a building stands. Land used for growing crops may easily be subject to depreciation. Land subject to the exploitation of the natural resources under its surface is similarly subject to depreciation. To distinguish the decrease in value of such natural resources because of the fact that they enter into and become a part of the commodity dealt in, the term “depletion” is used. Thus, a coal mine or oil well decreases in value with every unit of product taken therefrom. It is not purposed hero to discuss the principles of valuation applicable in such cases, the assets under discussion being limited in meaning to those of a mercantile business. (See Volume II, page 312, for a discussion of depletion.)

The valuation formula for assets not subject to depreciation is cost. Increase in value due to changed market conditions is not usually to be taken account of.

The second group of assets, those subject to depreciation, are to be valued on the basis of original cost less the amount of depreciation accrued to the date of the balance sheet. The valuation of such assets, therefore, requires the determination of the amount of depreciation.

Depreciation arises from several causes, the chief of which are:

Obsolescence and inadequacy, because of their very nature, are usually difficult of determination and frequently cannot therefore be considered in determining the amount of depreciation accrued at a given time. Where measurable they should, of course, be taken into account. Depreciation due to lapse of time is calculable on a time basis. Depreciation due to wear and tear is calculable on the basis of the use to which the asset has been subjected. It is in practice difficult to separate these two types of depreciation. The estimate for depreciation is in the majority of cases made on a time basis. In manufacturing establishments, oftentimes a use or output basis proves more satisfactory. These more difficult problems met in the determination of depreciation are discussed in Volume II. Here only the most usual method of depreciation estimate on a time basis, known as the straight-line method, will be explained.

For determining the periodic amount of depreciation of any asset it is necessary to know: (1) the original cost of the asset; (2) its scrap value, that is, the estimated value as scrap on the day it is junked; and (3) the estimated life of the asset in years or fiscal periods. The following symbols will be used in working out the formula:

It is apparent that V₁-Vₙ is the amount to be depreciated over the life of the asset. The amount to be charged off periodically as depreciation is, therefore:

Accordingly

The amount to be written off each year is thus seen to be constant. The percentage to be applied to the original cost in order to determine the periodic depreciation D is, therefore, found by dividing D by V₁. Hence the formula:

Having determined by careful estimate the method of calculating the periodic amount of depreciation, the problem of valuation of the asset at any given time during its life is ordinarily simple. In the case of renewal of any parts, the question of betterment comes in and requires careful handling. In unusual cases it may often be necessary to revise the rate of depreciation in order to write off the betterment during the remaining life of the asset. Depreciation is at the best but an estimate and unless there are major betterment items it is not usually necessary because of them to revise the estimate of depreciation. When a renewal takes place it is theoretically necessary to determine the value of the replaced part at the time of its replacement. The excess of the cost of the new part over this value is the amount of the betterment, when only the values of the old and new parts are considered. In such cases, however, the new part will not usually have value apart from the asset to which it is attached. In practice, therefore, the amount of the betterment recorded is the difference between original—not present—value of the old part and the cost of the new part. An example will illustrate the problems involved and the accounting treatment.

Problem. Assume that an asset—office equipment—costing $1,000 has an estimated life of ten years and no scrap value. After six years of this life it becomes necessary to replace a part of the asset, estimated to have cost originally $100, the cost of the new part being $150. At the time of the replacement the depreciation reserve carries an amount of $600.

The first step in booking the transaction is to transfer from the reserve account to the asset account the original cost of the part replaced. Just as in the case of bad debts, now that a part of the asset has been discarded and the amount of the decrease in value of the asset is definitely known, this amount held in suspense until the present time in the reserve account must be applied as a definite reduction in the carrying value of the asset. The entry to effect the transfer is:

The next step is to set up the cost of the new part which replaces that discarded. This follows the usual entry at the time of purchase of any equipment. The entry needed is:

The student will note that the office appliances account now carries a value of $1,050, of which the $50 represents the value of the betterment.

It might appear that since the renewal occurs at the end of six years there has been accumulated in the reserve by that time only $60 covering this specific part, and that therefore only $60 should be transferred from the reserve account, the other $40 being charged to a proprietorship account to represent the additional expense or loss not yet provided for by the depreciation charges during the past six years. That is not the situation, however, for if the periodic depreciation has been correctly estimated, the entire amount, $100, has already been charged off and is therefore included in the reserve. When the asset was originally installed and the length of its life estimated for the purpose of determining the periodic depreciation charge, the policy as to repairs and renewal of parts was taken into consideration. Such estimates cannot, of course, be absolutely accurate. However, until such time as a definite basis is given on which to check the amount of the over-or under-estimate, it is the standard practice to charge against the reserve the original value of the renewed part. Always at the time of discard of the entire asset—and sometimes sooner—such a definite basis is given and adjustment must be made in accordance with the facts then ascertained. A problem will illustrate the considerations involved.

Continuing the foregoing example, assume that the office appliance, now valued at $1,050 with a reserve of $500, is discarded after ten and a half years’ service.

At the end of the tenth year the annual depreciation charge of $105 will have brought the reserve account to a total of $920. Six months later, at the time of discard of the asset, there will be accrued depreciation, not yet booked, amounting to $52.50. It is, accordingly, necessary to book this amount by means of the following entry:

This entry charges the current period with its share of the consumed value of the asset. The next step is to transfer the reserve account to the asset account, to show in that account the amount of the inaccuracy in the depreciation estimate—the amount by which the actual depreciation differs from the estimate. The entry is:

The office appliance account now shows a debit balance of $77.50, which indicates the value or amount of the asset which has been consumed but which has not been charged against the income of the periods during which the asset was used. It is manifestly inequitable to charge this amount against the income of the six months of the current period, and it is impossible to go back and spread it over the previous periods because their records have been closed. The charge must therefore be made direct to the Surplus account in the case of a corporation, or to a final section for extraordinary profits and losses of the regular Profit and Loss account in other cases. It may be handled by this latter method also in the case of a corporation. The entry needed is, therefore:

In case the reserve is more than the value of the asset at the time of discard, it means that more than the cost of the asset has been charged as expense. Accordingly, the excess represents real profit and must be transferred to surplus. The necessary entry is:

• Office Appliances
• Surplus

Good-Will. Good-will is an intangible asset depending for its value upon the ability of a business to make more than normal profits. It is not usual for a business to show an asset of good-will unless it has purchased another business and has paid for the latter’s good-will. In other words, good-will is not brought on to the books until a purchase determines its market value. Where good-will is purchased, it is customary to carry it at its cost value. Depreciation is not taken into account. Because of the intangible nature of good-will and its more or less speculative value, some businesses prefer not to show it. In such cases it may be written off against surplus at any time and in any amount until it has all disappeared from the books. While, therefore, good-will is not subject to depreciation, it is subject to this writing off process, which usually bears little or no relationship to time. It should not be charged against the profit of any period or several periods, but when written off should be charged direct against surplus.

Liabilities.—The problem of valuation of liabilities is simple. From the standpoint of a going concern, its liabilities decrease only when they are paid off, and increase only because of services or assets purchased and not paid for. The main problem in connection with balance sheet liabilities is the determination of the fact that all liabilities are shown on the balance sheet. This oftentimes involves the consideration of contingent liabilities. The amount of a liability may sometimes be in dispute, in which case a careful and conservative estimate of the probable amount must be made and shown.

Proprietorship.—Since proprietorship is always the difference between assets and liabilities, the problems of valuation of proprietorship are solved almost automatically if the valuation of assets and liabilities have been handled properly. There may sometimes be problems in connection with the various items in the proprietorship group. These concern surplus, undivided profits, and various reserves. The problems here are largely those of determining whether a company has lived up to its contract or other agreements in the maintenance of the proper values in the various proprietorship accounts.

Conclusion.—The problems of valuation are vital to any business and intimately concern its financial integrity. In order to maintain at least the original capital investment in a business, it is necessary to make provision for the decrease in asset values due to different causes. The financial management of the business must watch this feature closely, else capital will be dissipated and the business rendered incapable of performing the functions for which it was organized.