Form and Valuation

The problem of handling liabilities on the balance sheet is usually not so complicated as that of assets. The questions of arrangement, form, groups, and suitable nomenclature have in the case of liabilities an equal or even greater importance than that of the assets, the governing principle being clearness and fullness in the information given, with due regard to the purpose and intended use of the balance sheet.

The problem of valuation, which assumes great importance in the treatment of the assets, has normally little or no significance in the consideration of liabilities. This is due to several causes. In the first place, human nature being what it is, there is normally little danger of an overstatement of liabilities; they are usually sufficiently large, and no desire exists to make them appear more than they really are. Secondly, and likewise based on human frailty, while a concern may desire to undervalue its liabilities, the other party to the liability, the person holding the claim, can usually be depended upon to press his claim with sufficient insistence as to make the concern aware at all times of the amount of its liabilities.

From the viewpoint of a going concern, while all business experience points to a decrease and a necessary diminution in the values at which certain assets may appear on the books, no such diminution in the value of liabilities can be looked for; as legitimate claims must be met if a business is to exist as a going concern. Similarly, there is normally no tendency to inflate the liabilities by the inclusion of items which do not rank fully in this class—intangible liabilities seldom find place in any balance sheet.

On the other hand, there is frequently a very real hesitancy about the inclusion of some liability items until their claim becomes urgent or their full liability status becomes determined. Occasionally, and usually with ulterior intent, the liabilities may be inflated in value and items included therein which are fictitious; but our present concern is not with such conditions.

The one principle underlying the showing of both assets and liabilities is that their true status should be indicated. As applied to liabilities this means that they should be shown not only in correct amount but also in their true light, viz.: that all facts bearing on their relation to the business which ought to be known properly to judge conditions must be stated. The chief problem in handling liabilities is, therefore, how to show and list them so as to accomplish this purpose of truth and usually the further purpose of full truth. In a consideration of this problem, the auxiliary one of the inclusion of doubtful items among the liabilities will also receive consideration.

Arrangement on Balance Sheet

As to the classification and arrangement of liabilities on the balance sheet, it may be stated in a general way that whatever classification and arrangement are adopted for the assets, the liabilities should be shown similarly. For most purposes a standard grouping under the captions, Current, Deferred Income, Fixed or Funded, will suffice. The order of the groups as given here follows the order given for the assets. This is desirable for purposes of easy comparison, because in this way current liabilities are brought into juxtaposition with the group of assets to which current creditors must look for payment of their claims; and fixed liabilities and capital are opposed to the assets in which for the most part they have been invested.

Items within Groups

Arrangement within the group may be attempted on the basis of relative degree of liquidity of the items. This, however, is not always determinable nor is it an end to be sought; the chief desideratum is to show items in the main group to which they properly belong.

The manner of listing the items within the group is not a question of relative order so much as it is of nomenclature and clearness of expression. Thus, desirable and valuable information would be given by a separation of the items to show (1) those past due; (2) those due but not payable because of their credit term; (3) those neither due nor payable, such as accruing items; and (4) contingent liabilities.[48] It may be remarked that such an analysis is seldom seen on the ordinary balance sheet. Corporations which have to report to a regulating body may be required to give more information concerning their business than those not so regulated. For internal use the suggested analysis has undoubted merit. For public use, it is neither necessary nor usually desirable that the information be given in that form; a showing of the items under the usual titles within the group to which they properly belong being here deemed sufficient.

Cancellation of Liabilities against Assets

Occasionally the practice is met of cancelling the liabilities, or some group of them, against corresponding assets, showing only the net assets remaining. Thus, Current Assets less Current Claims might appear as an item among the assets. Even for publication purposes this would not be deemed sufficient; for the outsider as a prospective creditor or investor has a right to judge for himself the relative sufficiency of the assets to meet the claims of creditors. No basis for such judgment is offered by a cancellation of the one against the other with a showing of the net amount only. A somewhat analogous situation arises in the double-account form of statement used by some English companies. Here, the capital assets are canceled against the capital and fixed liabilities and only the net surplus—usually of capital—appears in the balance sheet proper. The criticism is not so pertinent here, however, because almost invariably the balance sheet is accompanied by the so-called capital account which shows the full detail of the net item in the balance sheet. So also, the practice is often condoned wherever an accompanying schedule shows the full facts as to assets and liabilities. As a matter of principle, it should be condemned because accompanying schedules do not always “accompany.”

Inventory of Liabilities

The principle of showing the full truth as to the liabilities raises the problem of the complete inclusion or inventory of the liabilities. Under this will be considered any adjustments that must be made in the book record in order to show the true state of the liabilities, and also the proper treatment of contingent liabilities so as to show their relation to the state of the business.

The adjustment of the book record is not usually complicated. The necessary data are for the most part available. All that is required is an analysis of each item to determine what, if any, adjustment is needed to bring the books to a true statement of conditions as on the date of the balance sheet. These adjustments fall into six main groups, only two of which appear among the liabilities, while one of the others is often based on information obtainable only from an analysis of the liabilities. These groups are:

• 1. Accrued Expenses
• 2. Deferred Income
• 3. Deferred Expenses
• 4. Accrued Income
• 5. Valuation Reserves
• 6. Merchandise Inventory

The first three groups are discussed below, as well as another analogous group.

Accrued Expenses. These expenses comprise the liability existing at the close of a fiscal period because of expenses incurred but not settled for and oftentimes not yet due. Information as to these may be gathered—not in completeness however—from an examination of the various expense accounts and a somewhat intimate knowledge of the operations of the business. Unless a record is kept of all services being rendered to the business, it is very easy to omit some items of this kind. These will be discussed in detail under “Current Liabilities,” page 350.

Deferred Income. This income comprises the items of income received in advance of the full performance of the service required to earn it. In cases of this kind there are in the possession of the business certain assets which must be used to perform the service not yet completed in order to entitle the business to the full enjoyment of the income. That is, the property of the owners is liable for the service not yet rendered. Also, in order to make a correct showing of results as between the current fiscal period and the next, this unearned income must be carried forward for credit in the period in which the service is performed.

Premium on Bonds. Somewhat analogous to deferred income is the item of premium on bonds. As indicated in Chapter XV this is preferably treated as a direct deduction from the periodic interest payments on the bonds, because the bonds were marketed at a rate higher than the interest rate prevailing at the time of their flotation. Inasmuch as the premium must be spread over the life of the bonds, its unexpired portion will appear as of the nature of deferred income at all intermediate stages. A more detailed showing of this is given in Chapter XX, in the discussion of the liability, bonds.

Deferred Expenses. These expenses have been explained in detail in Chapter XIV. Here it is to be noted that, while this group of adjustment items is always an asset, for the proper determination of deferred interest an examination of the liability, notes payable, is often necessary. Notes payable given for a loan at the bank, or given to a creditor, with prepaid interest added to the principal of the debt as a part of the face amount of the note, will give the data for calculation of the amount of interest or discount to be deferred to later periods.

Contingent Liabilities

As stated above, the second group of items under the head of inventory of the liabilities is that of contingent liabilities. It is taken for granted that all items which on the date of the balance sheet have assumed a status of full and direct liability will, of course, appear as such on the books. Here, all that can be said without trespassing on the distinctive field of auditing, is that all such items must appear. For the method of detecting their omission, whether omitted with fraudulent intent or through carelessness and inaccuracy, the student is referred to a standard work on auditing.

We have here to consider, however, a group of items the status of which is one of suspended or indeterminate liability. Expressed otherwise, they are items concerning which it is hoped—it may be even expected—that the business will never incur liability but for which in the event of certain happenings liability must be assumed. There are, of course, degrees of contingency, ranging from almost certainty to negligible remoteness. It would seem that no business man would omit the almost certain type from his books, and in case of doubt prudence demands that decision be rendered in favor of at least the greater probability.

Yet there is often seen a failure to book even the liability on account of goods purchased and shipped, but not received. If it is argued that the liability is not fully established until receipt and acceptance of the goods, every manager knows that non-acceptance of purchases is the exception, not the rule. On the other hand, upon receipt of consigned goods to be sold on account of a principal, no liability except to exercise ordinary care usually attaches to a broker until some part of the goods has been sold by him. Between these two extremes are many shades and degrees of probability, all of which in some cases are recorded as liabilities; in others none are so recorded. The importance of the information as to contingent liability on account of notes receivable discounted and discounted acceptances is now accorded general recognition. As to liability under court judgments awaiting appeal, guarantees of work and product, deposits made on contracts or bids—these and other similar matters will be treated fully in following pages.

These, then, constitute the main problems in connection with liabilities on the balance sheet. The group of current liabilities will now be considered, followed by a discussion of the nature of contingent liabilities.

Current Liabilities

Notes and accounts payable, using the terms broadly, constitute practically all of the current liabilities. Not all notes nor all accounts payable are, however, current items. The term “current” cannot be standardized; it varies and will perhaps always vary according to customs and practices in any particular trade. In the main, the 90-day period may be taken as the average. That is, on the given date of the balance sheet a knowledge of the debts that must be met within the next 90 days is a minimum of necessary information for the purpose of judging business condition, particularly so far as concerns the credit extended to it. When a balance sheet is submitted to the bank as the basis for credit, other data concerning notes payable are usually called for—such as notes given for merchandise, notes negotiated to own banks, notes otherwise disposed of. The Federal Reserve Bulletin for April, 1917, under the title “Uniform Accounting a Tentative Proposal” suggests for balance sheet presentation a list of notes analyzed as to acceptances made for merchandise or raw material purchased; notes given for merchandise or raw material purchased; notes given to banks for money borrowed; notes sold through brokers; notes given for machinery, additions to plant, etc.; notes due to stockholders, officers, or employees. R. H. Montgomery[49] suggests a division of notes into the groups: notes issued for merchandise; notes discounted by own banks; notes sold through brokers; and demand loans. He suggests further that an additional separation into notes accompanied by collateral and notes with which no collateral is given would be desirable.

From the above it is seen that the present tendency of bankers is to insist on a full statement of essential facts needed to pass intelligent judgment as to the exact status of affairs. Even in the case of balance sheets, the accuracy of which has been certified by someone, some bankers require a certificate as to the character of the certifier unless he is well known. More and more is the fact being recognized that legitimate business has nothing to fear and much to gain by making a full and free statement of exact condition, and that the sooner business supported by fraudulent statement is eliminated, the better will it be for legitimate enterprises. In certain cases, however, the interests or purpose of a business would not be well served by the detailed information demanded by the banker and, here as elsewhere, no specific rule can be laid down other than that the purpose should in all cases govern the form and particularly the amount of detail.

Loans from Bank

In connection with advances from the bank it should be noted that the banker does not expect to become a permanent partner in the business, but that one of his legitimate functions is to furnish funds for seasonal fluctuations. Oftentimes a concern does not start with enough capital to carry its load of maximum trade, from the fear that advantageous investment of surplus funds during the dull season will not be possible. It may rightly expect its bank to furnish funds for this purpose when expenses are heaviest, and to await repayment of the loan out of the income, as accounts are collected after the peak of the seasonal trade is passed. This is one of the fields of legitimate banking and the banker has a right to whatever information is necessary to assure himself that his aid is being put to proper use.

General Classification of Notes

For general purposes, a separation of notes into notes for trade purposes and notes for other purposes is desirable. Trade purposes would be limited to merchandise purchases and loans for working capital. Other purposes would be long-time loans, purchase money notes often secured by mortgage on equipment, and notes of officers and employees. These last would best be classified by their showing as fixed rather than current liabilities.

Accounts Payable

The use of the term, accounts payable, to cover only creditors for stock-in-trade and other trade purposes is too indefinite and inaccurate, the term being too comprehensive and inclusive. The considerations applying to trade debtors have equal weight in requiring the use of the term trade creditors for the purposes mentioned above. Accounts payable to trade creditors are usually the current items, whereas those payable to stockholders, officers, etc., and those due to a parent or holding company are more or less fixed, as there is usually no particular urgency as to the time of their payment. An analysis of trade creditors into “not due” and “past due” will at least bring out the information as to neglected discounts and some idea as to the amount of cash needed to pay off debts and to secure their discount.

There is no necessary relationship between accounts and notes payable, nor any significance in their relative amounts. In some trades notes are given in order to obtain the discounts; in others notes are given at the date of purchase of the commodities.

Deposits. Another group of accounts payable of a more or less current type consists of deposits of various sorts. The business may accept deposits from customers or employees for various purposes. Consumers’ deposits with gas and electric light companies as guarantee to cover payment of bills and possible damage to meters or other company property; deposits covering locker privileges, breakage of materials, keys issued, and the like, are examples of this kind. These deposits are seldom all claimed at any one time; experience only can indicate the necessary financial provisions to be made currently for them. In some instances there is an accruing liability on account of interest on these deposits which must also be cared for.

Guarantees. Sometimes goods are purchased and only partly paid for, a portion of the purchase price being retained as a guarantee of quality until opportunity is given for adequate examination and acceptance or rejection. Similarly, in the case of construction work done by contract or subcontract, the owner—or, if a subcontract, the general contractor—retains a certain percentage of the contract price as a guarantee of performance of the whole according to contract agreement. This liability for the portion retained is a current liability, as a usual thing, and is to be listed under accounts payable with suitable subtitle.

Long-Term Notes. Long-term notes and accounts, bonds, and other fixed liabilities become current as their maturity closely approaches and provision for payment must be made.

Future Deliveries. On the border lines between contingent and full liabilities may be classed the liability because of goods purchased with long future dating. This is sometimes allowed by a seller to secure warehouse room for new product. It is undoubtedly best to set up both the asset and the liability, even where the goods have not yet been received.

Consigned Goods Sold. The factor’s real liability on account of consigned goods sold should, of course, be shown as a current liability, offset by any claims for expenses incurred on account of the consignor and any accrued commissions earned on sales to date.

Dividends Not Yet Paid. Another item belonging to accounts payable is dividends declared but not yet paid. Though it may be the custom of a company always to declare a dividend on a given date, no liability is incurred on account of dividends until they are actually declared. Upon declaration of a dividend the company makes itself liable to stockholders for the amount of the dividend. This liability ranks as an unsecured debt on the same footing as unsecured liabilities to other creditors. The dividend liability in large part is usually soon liquidated. Any unclaimed dividends constitute a liability until claimed or authority is given for other disposition. The item is usually small and is best shown as a current liability even though the chance of its being claimed may be remote. The method of handling and safeguarding the dividend transaction is treated in Chapter XXIV.

Accrued Expenses

The final item to be considered among the current liabilities is the group of accrued expenses. These constitute such items as wages, salaries, rents, royalties, expense supplies purchased but unpaid for, interest, advertising, sales commissions, traveling expenses, freights, water and other taxes, etc.—in fact, all services which have been rendered the business previous to the date of the balance sheet but which on that date are unpaid. These usually comprise the most urgent of the liability items and so are properly classed as current. There is seldom any business in which items of this kind are not encountered and, as stated on page 343, a careful examination of the records and familiarity with the business is needed to secure a full statement of them.

With regard to some of these items, difference of opinion exists. It is argued that until the amount of the liability is known, no real liability can be said to exist. Thus, taxes for the current year may not be known until the following year. Proverbially taxes are as certain as death, and there would seem to be no unreality or contingency about their incidence. As the current year passes by, the accounts should include a charge for taxes. Since the real amount is not known, it must be carefully estimated; for any difference must be taken up when the real amount becomes known, and so may disturb and somewhat invalidate the results for comparative purposes. Because of the fact that the current amount is an estimate, the title given the liability thereunder is sometimes called “Reserve for Taxes” rather than “Accrued Taxes.” No matter what the caption may be, it should usually be listed as a current liability.

Booking of Accrued Expenses

As in the case of deferred expenses, so in the booking of accrued expenses, in some quarters it is thought highly unscientific to record both the expense and liability elements in the same account at the time of adjusting the books. Use is made of a separate liability account entitled “Interest Accrued,” for example. When so used immediately at the opening of the new period, this account is either transferred to the expense account where it will act as an offsetting credit to the expense when paid, so automatically reducing the amount to the part properly applicable to the new period; or the account may be allowed to stand untouched (and therefore having no real significance) till the end of the next period when only the difference between it and the new amount accrued is made the basis of the new adjusting entry. Both these methods, while securing a more evident separation of the expense and liability elements, do so only at the cost of a needless multiplication of accounts and work. To one acquainted with the significance of bookkeeping methods, the old way of treating the liability element as an inventory in the expense account makes a definite allocation of the two elements, and does so with less burden on the bookkeeper and is to be preferred in most cases.

Deferred Credits

Deferred credits, as already explained, are analogous to current liabilities in that they represent unearned income. The enjoyment or earning of this income requires the rendering of certain services which are a claim on the current assets. In this sense, then, they belong to the current liability group, for the payment of which the current assets must be available.

Nature of Contingent Liabilities

Statement of Contingent Liabilities

As stated on page 345, contingent liabilities range from those almost certain to materialize to those extremely remote. For some purposes a full statement of all such liabilities is needed to give an adequate view of conditions within the business. For other purposes, so detailed a statement may not be necessary although usually desirable. The Federal Reserve Board requires on a balance sheet submitted as the basis for credit a full statement of contingent liability as follows:

Full answers to the above inquisition would often prove embarrassing but very enlightening. Two additional kinds of contingent liability not listed above sometimes exist, viz.: that arising out of a call for the unpaid portion of stocks owned but not fully paid for; and in the case of a corporation, unpaid accumulated dividends on preferred stocks. Some of these contingent liabilities require detailed consideration.

Notes and Drafts Transferred

The proper method of handling notes discounted, sold, or otherwise transferred, and negotiated drafts is given in Volume I and will not be repeated here. The showing of these items on the balance sheet is by inclusion among both the assets and liabilities, or preferably by inclusion among the assets with the liability element shown deducted. When a person or firm lends its credit by means of an accommodation indorsement, the transaction should be recorded as a charge to the accommodated party and a credit to Notes Payable if the liability is primary; or to Indorser’s Liability, if secondary. In case of primary liability, liability is full and must be listed on the balance sheet as a note payable. In case of secondary liability, liability is contingent, as in the case of discounted notes, and should be so shown on the balance sheet. In either of these cases, the practice of cancelling the liability against the corresponding asset and by a feat of mental dexterity persuading oneself that there is therefore no need to show the item on the balance sheet, is a practice to be universally condemned.

Guarantees as a Contingent Liability

Guarantees are of many sorts—guarantees of product sold or work performed, guarantees of the good faith of others in meeting their obligations, etc. The transferred note is one kind of guarantee. Oftentimes, a parent company may guarantee the principal and interest or the interest only of the bond or note obligations of a subsidiary. While the expectation is usually that the contingent liability will not become real, yet experience shows the need of making adequate provision against it. The recent example of the Denver & Rio Grande as guarantor of the bond interest of Western Pacific bonds drives home that necessity. In a case of this sort provision is best made in the creation of a contingency reserve, for there is no experience on which to base a better estimate. In the case of a policy of guaranteeing the quality of a product or its workmanship, after a few years’ experience very accurate estimates can be made of the loss to be expected therefrom, and at the end of a fiscal period the books can be adjusted on that basis just as they are for taxes. A charge to a suitable expense account and a credit to a reserve or accrued account comprises the book entry, with a listing of the reserve as a real liability.

Long-Term Leases

Contingent liability brought about by a lease covering a long period may be disregarded if the lease has a marketable value sufficient to cover the liability. Otherwise a contingent reserve should be set up. Liability under the subletting of a lease is best handled by means of a reserve.

Purchases for Future Delivery

Purchase contracts for future delivery, if made at a fixed price, may be disregarded unless at the date of the balance sheet market value is lower than cost, when a reserve should be set up. A fuller statement of the facts shows the transaction among both assets and liabilities. If the contract, being speculative, is not at a named price, the showing of the reserve is prudent and conservative.

Pending Lawsuits

In the case of pending lawsuits, the contingent reserve is usually all that is necessary. If the case is on appeal, it might in addition be wise to create a fund which would provide funds for settlement if the decision is unfavorable. Here the item of costs, fees, and accruing interest is usually large and liberal provision must be made.

Stock not fully Paid

Where shares of stock are held which are not fully paid, a liability attaches for the unpaid portion contingent upon call being made for it. Showing the stocks at subscribed price with the offsetting liability for the unpaid amount as a deduction, is perhaps the best method, though there is no serious objection to omit mention of it if the stock has increased in value, or of using the method of a reserve. Where a double liability attaches to stock ownership in case of bankruptcy, no notice need be taken of the contingent liability so long as the business whose stock is held shows an entirely solvent condition. When such is not the case, whatever provision seems necessary should be made, even to the extent of liability to the full value of the stock held.

Accumulated Dividends on Preferred Stock

There is no liability on account of accumulated dividends on preferred stock until profits have been made out of which they may be paid. If the policy of management does not allow their declaration at the present time, although sufficient profits have been made, the accumulation of dividends should be shown as a liability. Where the company is unable to declare dividends because of insufficient profits, mention of the accumulating dividends should be made in a footnote as a possible future liability.

Signature to Surety Bond

The liability arising through signature to a surety bond is a contingent liability resting upon the good faith and honor of the bonded party. The practice of personal bondsmen is not so prevalent as formerly. Experience shows that the liability of the bondsmen may become very real, and not only should suitable provision be made for it but its existence should be shown on the balance sheet.