Introduction

In Chapter V an effort was made to establish the general principles of valuation as applicable to the main classes of assets found on the average balance sheet. In doing so, the fundamental distinctions between capital and revenue charges were set forth. In the six chapters on depreciation the general principles of depreciation and their application to problems in accounting have been developed, with particular emphasis on the problems of valuation and true costs. It is purposed now to consider in detail the various problems met in the valuation of the individual items found on the commercial balance sheet. It will be necessary also to consider the method of showing these items so as to indicate the basis of valuation and something of the financial policy employed. The various assets will be considered in the order of their appearance on the balance sheet, the arrangement being based on degree of liquidity, beginning with the most liquid.

What Cash Includes

There is little to be said about the valuation of an asset of such evident and definite value as cash. The problem here is rather one of showing the nature of the asset, although certain principles of valuation under given conditions need also to be considered.

The term cash as an item in the balance sheet usually includes all money and whatever serves as money. Thus, all legal tender of the realm, bank notes, checks, bankers’ drafts, postal and express money orders, and occasionally postage stamps and even “IOU’s” are classed as cash. Not all items, however, that may be carried on the books as cash should appear under this caption on the balance sheet. There only the current asset cash should be listed in the group of current assets. All other cash, including that held for specific purposes under deed of trust or otherwise, should, unless it is readily applicable for the cancellation of current liabilities, be shown in some other group.

Where the petty cash or working funds of all sorts are operated on the imprest system, the funds should be replenished before the books are closed and should thus be truly valued at their ledger figures. The bank account should be reconciled with the cash book, and the figure should represent the amount at which the item is to be taken into the balance sheet. This means, of course, that all properly authorized claims against cash in bank are to be treated as cash disbursed if they have been regularly issued, whether presented for redemption at the bank or not. Checks written but not yet mailed are not usually treated as cash disbursed because they are still under control. Similarly, items left at the bank for collection and deposit may be counted as cash on hand. If, however, as might happen in exceptional cases, a comparatively large amount represented dishonored items and a second attempt was being made to collect these dishonored items, the better procedure would be to omit them from the cash total and include them with the receivable items. In this connection attention should be called to the practice occasionally met with of holding the cash open for a few days after the closing date for the purpose of making a better showing as to balance on hand by means of new collections. This, of course, is a practice which cannot be countenanced under any circumstances as it is simply an effort to mislead, even though the effect may not always be bad. A balance sheet is a statement of financial condition purporting to be true as on a certain named date. The values shown therein are therefore to be those applicable to, and true on, that date and no other.

Stamps Remitted as Cash

Some concerns dealing in commodities of small value sold through the mails allow, and even encourage, payment by means of postage stamps, these in turn being used for their own correspondence and parcels post expense. The proper place to record the value of this item at the close of the fiscal period is in the inventory of office supplies or other similar heading instead of treating it as a part of the cash. This necessitates a transfer from cash to office supplies. The transfer can be accomplished in either of two ways without interfering with the usual handling of the cash whereby it is checked against the bank’s record of deposits and checks as explained in Volume I, Chapter XXXV. The customary method is to use the cash book as the place of record for the receipt of stamps and then transfer them to the stamp drawer for office use. All other “cash” being deposited in the bank, the record of cash receipts as shown by the cash book does not thus check against the record of deposits as shown by the bank. To secure this agreement, a check may be made out payable to “Cash,” “Ourselves,” or “Postage,” and passed through the bank periodically as a deposit and so secure the proper agreement between the bank’s record and the concern’s. The record of the check among the cash disbursements thus secures the proper charge to Postage or Office Supplies and also effects the proper agreement between the bank’s record and the concern’s. The use of a “postage” journal, operated on the same lines as the cash book and recording all receipts and disbursements of postage, would accomplish the same purpose and in some circumstances would be advisable.

Temporary Cash Disbursements

The practice of allowing proprietor, cashier, or others to take cash from the cash drawer and leave a memo of some sort to show responsibility or purpose is to be deprecated. Only where the principle is strictly adhered to of depositing all cash and disbursing only by check and by means of a petty cash fund handled under the imprest method, can adequate control over cash even be approximated. Where, however, such is not the practice, the problem is not that of the valuation of cash, for the memos are not cash, but of the valuation of claims receivable—a subject to be treated later in this chapter.

Disposition of Cash Funds

In the showing of cash for purposes of management, it is essential to indicate the present disposition made of the various cash funds or to show the immediacy of the control over them. Thus cash should be listed as:

• 1. Safe or drawer
• 2. Various working funds
• 3. Petty cash fund
• 4. Bank

Under “Bank” should be indicated how much is held on “current” account and how much is restricted to special purposes. Of the current balance it is desirable to show the portion subject to check for immediate needs and the portion representing surplus funds not immediately needed and therefore held to earn interest. These amounts subject to interest are almost always available on short notice, but usually only with the sacrifice of interest earnings to date.

Cash from the sale of capital stock or bond issues, or from the sale of old plant or any portion of it, under authorization from the stockholders that it be held for purchase or construction of new plant, or for other capital purposes, comprises that held for specific purposes. Sometimes even cash in the sinking funds might be included in the list. As it is usually of importance to keep the management informed as to the amounts of cash available for the various purposes stated above, an effort should be made to give this information, without too much detail, in the balance sheet if it is drawn up for internal use.

Cash Held Abroad

There remains to consider moneys held in a foreign branch and thus subject to fluctuations of exchange. In Chapter XXXI, where the subject of the foreign branch is treated, a full discussion of the problem of exchange in its relation to the accounting records will be given. Here it is sufficient to say that as between countries where exchange rates vary little, the general practice is to use an arbitrary conversion figure for incorporating the results of the foreign branch with those of the head office. This conversion figure applies to cash as well as to all other items. The use of such an arbitrary basis will give substantially correct results under the conditions named.

The assets of the foreign branch are the properties, usually and for the most part, of proprietors and stockholders residing in the country of the home office, who are concerned merely with the distribution of the earnings of the foreign branch. Profits are made in one currency to be distributed as dividends in another currency. Hence, the rate of exchange prevailing at the time of closing the books would usually give the most accurate results and should, of course, be used when exchange is not fairly stable between the two countries. It may even be conservative and advisable to set up a reserve for fluctuations in exchange, with the object of absorbing what might otherwise be too great a charge or credit to the current period’s profit and loss if a particularly unfavorable or favorable rate were prevailing on the date of conversion.

Accounts and Notes Receivable

In the valuation of accounts and notes receivable the problem is largely one of appraising the uncollectible items. The book account and note are intermediate stages in the conversion of merchandise into cash. Were they always worth their face value there would usually be no problem in their valuation except for the element of theoretical interest which is not commonly taken into account by commercial enterprises. In considering this problem of valuation, the question of the correct use of terms arises. For the sake of clearness, when showing the items on the balance sheet, attention will be first directed to this latter phase of the subject.

Objection to the Title, Accounts Receivable

The governing principle here is that only current items can be included in this group of assets when shown on the balance sheet. In accounting, as in economics, there is no distinctive scientific terminology. The economist makes use, for the most part, of every-day words and phrases. These are often open to misunderstanding and are sometimes capable of being used even for wilful misrepresentation. Recognition of this fact has made necessary a more careful definition of some terms. In the language of the street, almost any claim against outsiders may be spoken of as an “account receivable.” The term is thus so broad as not only to include current claims against customers in regular course of trade, and accrued income, such as rents, commissions, interest, dividends, etc., earned but not yet received, but also to serve as a cloak covering many other kinds of claims and deposits. Among these may be enumerated:

It is necessary, therefore, to employ a term of more definite meaning which cannot be misused. The word “Customer” is sometimes used and is not objectionable. However, the term “Trade Debtors” is more generally employed and will be so used here as denoting all claims against customers, clients, etc., in regular course of business. Its appearance in a balance sheet is usually evidence of a careful discrimination among the various classes of claims and is not therefore a misleading term.

Risk from Credit Losses

As stated above, the chief problem in valuing accounts and notes receivable is that of estimating bad debts. It is a matter of general experience that some of those to whom credit is extended do not pay their bills. Hence, at the close of the fiscal period it is necessary, so as not to overstate the asset, to estimate the amount which probably cannot be collected. The necessity for this is recognized in a decision of the United States Supreme Court in Providence Rubber Co. v. Goodyear, 9 Wall. 788, and has the sanction of conservative business policy.

The effect of such an estimate is that the period in which the sale is effected is made to stand the loss, and not the one in which failure to secure collection is experienced. There is a close relationship between the actual loss from bad debts and the credit policy of a concern. Where the sales force is allowed to grant credit, the loss from bad debts is almost invariably large. Where the extension of credit is controlled by a credit department, the loss is less than in the other case but depends on thoroughness of information and investigation of the risk. However much care may be exercised, there will be nevertheless some loss, but a live credit supervision should keep the loss at a minimum.

Risk and Length of Credit Period

The amount of loss, or rather the percentage of loss, is not the same for different lines of business nor even for different concerns in the same line. The normal credit period for a particular business has some relation to the loss. Thus if credit supervision and collection effort are the same for two concerns, the one with the shorter credit period will usually have the smaller loss. In a business, for example, where the credit term is 60 days, we would expect fewer uncollectible accounts than in one whose credit period extends for a year or more. As between two concerns in the same line of business, where conditions are fairly uniform, however, there should be little variation in the loss from bad debts. As pointed out in Volume I, Chapter XXXVI, the sales discount policy is for the most part a device for overcoming the element of risk in the extension of credit.

Analysis of Customers’ Accounts as the Basis for Estimate of Bad Debts

In estimating the amount of bad debts, experience within the particular business is the only safe guide. Oftentimes, however, the manager or proprietor is not the most competent person for the task. The auditor, in consultation with the manager, may often arrive at a better estimate than could someone closely connected with the business. In making the estimate, it is an aid to analyze the accounts according to the length of time they are past due. Thus, there would be, after analysis, the amount of those overdue not more than 30 days, the amount of those overdue not more than 60 days, the amount of the 60 to 90 days overdue items, those 90 days to six months, those six months to a year, and all those more than a year overdue. The total amount outstanding minus the sum of these overdue classes represents the portion not yet due. Some part of the not-yet-due portion is, of course, still subject to discount if paid within the discount term. With the claims against customers thus analyzed, a much better basis is afforded for testing the adequacy of the provision for bad debts. The various methods of estimating this provision are discussed on page 219.

It may here be noted that when making up the estimate of bad debts it is by no means always necessary to analyze the outstanding items as suggested above. Such an analysis is of value in three cases:

The value of the analysis in cases (1) and (2) is based on the principle that the longer an item is overdue, the greater is its likelihood of proving uncollectible. The need of an increasing rate for the different classes as analyzed above is apparent. In case (3) its value lies in the fact that it reveals the general effect of the collection policy and incidentally points out any change in policy. Any additional factors which may have wrought a change in the general financial situation must, of course, be taken into account.

Basis of Estimate of Bad Debts

Three methods of making an estimate of bad debts are found, in all of which a percentage of some given base is used. The various bases are respectively:

Trade Debtors as the Basis. The use of trade debtors as a base is obvious because it represents the uncollected charges from which alone can any loss from bad debts arise. The use of such a base seems correct in principle. This is so in cases where a balance sheet is made up only once a year, so that conditions as to the periodicity of the sales are practically the same from year to year. The amount of loss from uncollectible items is then somewhat nearly proportional to the amount of claims outstanding at the close of the fiscal year. But where it is necessary to make the estimate monthly, or oftener than once a year, it is very probable that at some of the intermediate periods the amount of outstanding claims will bear no logical relation to the loss from bad debts. Thus, in the garment industry the sales for practically the whole year are made within a few months, and during the other months the processes of manufacture and collection are carried on. For these reasons the amount of bad debts is not proportional to the outstanding claims at the end of each month, nor does such a base properly allocate the losses to the periods in which the sales are made. Accordingly one of the two other methods previously mentioned is used.

Sales as the Basis. Inasmuch as there cannot be any loss from bad debts in the cash sales, theoretically the credit sales provide the proper base for making the estimate. Practically, total sales, either gross or net, furnish the base most frequently employed because the total is always available without the necessity for analysis. So long as the ratio of the two kinds of sales remains fairly constant, the loss from bad debts does bear a direct relation to total sales.

Summary. It may be said with respect to the use of trade debtors as a base, that it gives satisfactory results where conditions are uniform from period to period. In its use, however, cognizance must be taken of any change in the credit policy of the business whereby the term of credit is shortened or lengthened as that in itself would tend to change the ratio of the base to the estimated loss from uncollectible items. As between credit and total sales, theory favors the former but practical considerations the latter. If for any reason the ratio of cash to credit sales should change, the change would have to be taken into consideration when making a comparison between periods of the loss from bad debts. No justification can be found for a fourth method sometimes met with, which makes the provision for bad debts bear some relation to the net profits—large if profits are large, and small or none if profits are small.

In handling the estimate of bad debts on the books, the same considerations are to be observed as in booking depreciation. Care must be exercised not to allow the reserve to grow beyond liberally estimated requirements and so create a secret reserve, nor to fall below such requirements. This must be watched closely and, if need be, the rate changed to accomplish the desired result.

Discounts and Collection Costs

In connection with the valuation of trade debtors, the problem of collection costs and cash discounts must be considered. Some authorities connect these costs directly with sales and make provision for them in the valuation of the current trade debtors; i.e., an estimate of the cost of collecting the outstanding claims and of the probable amount of loss from discounts on the amounts outstanding is deducted by means of reserves from trade debtors and so shown on the balance sheet. Where such a practice is followed, strict consistency would require that a similar credit provision be made for discounts on purchases—a practice not often advocated. The weight of opinion is in favor of taking all such costs and credits into account only when they are actually met. This accords with the treatment of these items as financial management items (explained in Volume I, Chapter XXXVI) and as therefore bearing no direct relation to sales. If, however, unusual costs of this or any other kind are anticipated, prudence demands that provision, by means of reserves, be made for them. Usually the costs average up pretty well from period to period.

Valuation of Other Receivable Items on Open Account

The problem of valuing the other classes of receivable items previously mentioned on page 215, does not differ in the main from that of trade debtors just discussed. If they are worth their face value they should be so shown. If worth less, the necessary valuation reserves should be set up. With these items the chief problem, however, is their proper showing on the balance sheet; i.e., their correct classification and a suitable nomenclature. Most of the items are not strictly current, but even their inclusion under this head is not misleading if they are carefully earmarked to show their true nature. Some of them are decidedly fixed, some are in no sense assets. In some cases even trade debtor balances as carried on the books are not strictly current. In concerns where sales are made on an instalment basis, usually the payments extend over several months and oftentimes years. The customer is charged with the whole amount and credited with the regular instalment payments as made. The portion of the outstanding balance covered by the more remote payments is thus not current. In concerns where both regular and instalment sales take place, a separation of the customers’ balances on the basis of the sales contract gives the necessary information for balance sheet purposes. The accounts of instalment trade debtors normally require a much more liberal valuation reserve than those of regular credit customers.

Loss on Notes Receivable

In some cases the expected loss because of uncollectible notes may be less than that from open accounts, due to the greater formality of the note as an instrument of credit and the probably greater loss of credit to the maker in case of dishonor. However, in making provision for bad debts, the practice is almost universal to class the two receivable items together. Such practice is undoubtedly sound. In the case of notes, the request for payment is more forceable because of the definitely stated due date and the loss of standing if unpaid after such date. In some cases the payment of notes is not pressed, nor is any extraordinary provision made for past-due items—as in industries allied with farming when an unusually bad season makes impossible the payment of notes given by farmers. Again, the practice is sometimes made of taking notes for a long overdue, open account. These have usually no better value than the accounts and must be treated accordingly.

The usual method of handling overdue notes receivable is given in Volume I, Chapter XXXVIII. As there stated, where payment is allowed to lapse, it is generally advisable to insist on the giving of new notes in place of the old. There may be circumstances in which this is not advisable, but the proper method will usually be apparent in each case.

Interest on Notes Receivable

The valuation of notes receivable—using the term to include all written promises to pay, i.e., promissory notes, accepted drafts, and the like, requires a consideration of interest. By far the larger number of notes given in trade are non-interest bearing and are not therefore worth their face value until they become due. The interest problem in the valuation of notes is thus whether the notes should be shown at their face value or present, i.e., discounted, value. Notes which are interest bearing from their date of issue are, of course, worth their face, on the assumption that the interest takes care of the discount. Where non-interest bearing notes form a very considerable item it is well to value them on a discounted basis; if their amount is small, theoretical principles of valuation give place to practical considerations and they may be valued at their face. Where notes bearing interest are valued on a discounted basis, care must be exercised not to include the interest accrued both in their face valuation and also under the head of accrued income.

Balance Sheet Titles for Notes Receivable

The problem of terminology is also met in handling notes receivable. Under the balance sheet caption “Notes Receivable” should usually be included only notes received from trade debtors, and certainly it should never represent any but current asset items. Notes received from officers and employees, of indefinite term and the payment of which will not be pressed, should be recorded under some such title as “Notes Receivable Special.” Long-term notes and those representing loans or advances of any sort should be properly earmarked, as should also loans carried on open account, salary overdrafts, and the like. The latter should be shown under Deferred Charges. These nicer points of valuation cannot be presented on a condensed balance sheet, but care should at all times be taken to make such a showing as will not be misleading and will serve the purpose for which the statement is to be used.