Interrelation of Profit and Loss and Balance Sheet

Because of the supplemental character of the profit and loss summary to the balance sheet, no study of the latter is complete or adequate, whether viewed from the standpoint of valuation or from any other aspect, without at least a consideration of the profit and loss summary in its larger bearings. Some general features of the summary will here be considered, followed in the next chapter by a discussion of its terminology, form, and content.

Every change in an asset which is not reflected among the other assets or the liabilities relates to proprietorship; or, as stated from the profit and loss point of view, every change in proprietorship, except it be merely a transfer between proprietorship items, is reflected as a change in assets or liabilities. The original contribution of capital is reflected among the assets. Other items of vested or permanent proprietorship have been discussed in Chapter XXIII, “Surplus and Reserves,” leaving for consideration here the temporary proprietorship, i.e., the profit and loss items. Of these, every income item results either in an increase of assets or a decrease of liability, while every expense shows as a decrease of assets or increase of liabilities.

The relation of the profit and loss phase of an enterprise to the problem of valuation is apparent—the majority of the changes in value of the assets being connected with profit and loss activities. Thus sales result in cash or claims against customers, and a valuation of these claims gives the amount of bad debts expense. The valuation of fixed assets determines the amount of depreciation expense. On the valuation of the stock-in-trade depends the cost of goods sold and therefore the gross profit. Only those profit and loss items which are realized or settled in cash are not dependent upon the valuation of related assets, and even here, in so far as cash must under some circumstances be valued, these may be, at least remotely, dependent upon valuation. As, therefore, the balance sheet is primarily an expression of opinion and judgment, rather than a statement of fact, so also in large measure must the profit and loss summary be regarded as an expression of opinion. The same factors which enter into appraisals and valuations determine profits and losses.

Periodic Adjustments

In Chapter XXIII, on “Surplus and Reserves,” attention has been called to the use of a statement of surplus for the purpose of showing the changes which take place in surplus from period to period. These changes are due to profits earned, dividends declared, extraordinary profit and loss items not handled through the profit and loss summary, and adjustments in profit and loss applicable to previous fiscal periods—such adjustments being necessary because of errors in the profit and loss summaries of those periods, due to insufficient information for making an accurate summary at the time. The periodic profit and loss summary is limited in its purpose and scope to the activities of the current period and to an equitable share of those income and expense items running over a number of periods. Because the adjustments just mentioned are frequently necessary, the periodic profit and loss summary as it appears on the books is never an entirely accurate reflection of the profit and loss activities for any period, but it is usually sufficiently so to serve all current needs. When, however, the earning capacity of a concern needs to be judged with great accuracy, over a number of periods, it is not safe to depend entirely upon the periodic profit and loss summaries. It may, for example, be necessary to judge earning capacity because of a contemplated sale or merger. Here the basis for determining value should be not the earnings of one period but the average of several periods. It then becomes necessary to reconstruct the periodic profit and loss summaries as carried on the books in the light of any additional information that may have become available later.

The adjustments to be made in such cases comprise not only the most obvious ones, caused by the oversight of accruals and deferred items of various sorts, changes in inventory valuations due to an incorrect inclusion or exclusion of some items, etc., but also changes in those items which in the light of a longer experience are shown to be inaccurate. This latter class of adjustments embraces particularly the estimated items the amounts of which are not definitely determinable. As time passes, more complete knowledge may indicate insufficient or excessive estimates of such items as depreciation, bad debts, provision for contingent liabilities, and similar reserve items, the valuation of which must be corrected for an accurate showing of earning capacity. Thus a distinction must be made between summaries compiled to show the current profit and loss results and those which give a true index of earning capacity over a longer period.

Interest as a Cost of Manufacture

A controversial point with a bearing on the profit and loss summary is whether or not interest on invested capital should be included as an item of manufacturing cost. One school of thought on the subject maintains, with a considerable degree of argumentative warmth, that interest should be included; while another school takes the opposite point of view. An attempt will here be made to summarize the arguments for and against the treatment of interest as an item of manufacturing cost. The one school bases its main contention on the economic theory of profits; namely, that profits represent the balance remaining after deducting the cost of land, capital, and labor. The function of the entrepreneur, it is contended, does not in itself involve the owning of capital. Profit is the reward for combining the other factors of production and assuming the risk involved. Interest is a cost for the use of capital and it does not matter who owns the capital.

It is further contended that, in order to bring a fair return on the capital invested, the selling price must include interest on capital investment. While this contention is true, the fact remains that no manufacturer would think of fixing selling price as a matter of general policy at a figure which would not return a fair rate of interest on his investment. But why that necessitates taking into the books interest as an element of cost is not explained by this theory.

It is also argued that to determine whether it is better to manufacture or to buy goods in the open market, and whether it is better policy to manufacture by means of expensive machinery and other equipment or by manual labor, interest on investment must be considered. While these arguments also are well taken, they again offer no satisfactory justification for the showing of interest on the books. It is furthermore contended that the cost of carrying the inventories for which the purchasing, stores, and planning departments of a manufacturing concern are responsible, should be shown with interest on the money invested in them taken into consideration—this for the purpose of providing a check on the efficiency of these departments. Where also both old and new machinery is used side by side and it is desirable to compare their costs of production, the element of interest should be considered.

Further argument for the inclusion of interest as an item of cost is the fact that in numerous processes time is an important element. Thus, the smelting of ore, the tanning of leather, the curing of tobacco, the seasoning of lumber, etc., are examples of relatively lengthy processes the cost of which should include interest on the capital invested. Interest on investment is also a factor that may sometimes determine manufacturing and selling policies, especially during slack periods when production is curtailed, part of the plant stands idle, and the fixed charges on the unused manufacturing capacity need to be taken into consideration. The same argument also applies to the accumulation of a large inventory of raw materials or finished stock during a period of low prices. The soundness of such a policy can only be judged when the item of interest on the capital investment is considered.

Arguments against the Inclusion of Interest

The majority of accountants are, however, opposed to the inclusion of interest as an item of manufacturing cost. The chief objections raised to its inclusion are:

With regard to the rate of interest, three different theoretical rates have been suggested: (1) a so-called “pure” interest rate, i.e., one yielded by the safest investment; (2) the rate at which money might be borrowed for the particular type of industry; and (3) a rate sufficient to attract permanent investment in the enterprise. From the practical standpoint of results there are serious objections to all these suggestions. As it is beyond the scope of this chapter to discuss this phase of the question, the interested student is referred to the numerous writers who deal with the question.

Problem of Charging Interest on Books

Where interest is treated as a manufacturing cost, the booking of it raises a perplexing accounting problem. The charge has to be made to some factory expense account, while the credit must be carried over to possibly a financial management income account. If the entire output of the factory were sold out by the close of the fiscal period and no product was in process of manufacture at that time, the result of booking interest in this way, so far as net profit is concerned, would be nil. It would be like taking money out of one pocket and putting it in another. This situation, however, is never met at the close of the fiscal period. Almost invariably some finished stock is on hand and goods are in process of manufacture. Where interest is added, the result is to inflate the value at which the goods must be carried on the inventory—a very undesirable procedure from an accounting and financial viewpoint. By such means it is conceivable that a factory might be made to show a handsome profit even before any of the product had been sold.

Considering both the ends to be attained by, and the defects and disadvantages of, the inclusion of interest as an item of factory cost, its exclusion seems best. In this connection it is to be noted that all government contracts on a “cost-plus” basis do not allow the inclusion of interest as one of the cost items. Furthermore, all the ends aimed at by its inclusion may be secured almost if not equally as well by statistical records, thus eliminating the objections to the bringing of interest as an item of cost onto the financial records.

Unrealized Profits

A similar problem to the above is the practice of charging a manufacturing profit to the selling department. The practice is prevalent in some concerns, of transferring the output of the factory to the selling department at a value above the cost to manufacture. The purpose of such a transfer is to show on the books the profit arising from the policy of manufacturing the product instead of buying it on the open market. The value at which the product is transferred from the factory to the selling department is usually the wholesale market value, though it may be at a fixed per cent above the cost of manufacture. The effect of this is, of course, to limit definitely the showing of factory profit. Where the compensation or the efficiency of the factory management is measured by the savings effected over the wholesale market price of the output, there is perhaps some practical advantage in the allowance of a manufacturing profit.

The main objection to charging the factory output to the selling department at any price other than cost is that such a policy introduces an element of unrealized profit. This objection is not serious if, at the time the books are closed for the purpose of showing results for the fiscal period, the unrealized profit is eliminated from the stock-in-trade inventory. So far as the profits on the portion of the output which has been sold are concerned, the net result is the same. The effect is to diminish the profit of the selling department by the amount of profit allowed to the factory. To bring assets onto the books at inflated values is, however, always objectionable, both because of the temptation to inflate profits by valuing the goods for the inventory at an inflated figure, and also because of the ease with which the adjustment of such items may be overlooked or forgotten at the close of the fiscal period. Where the adjustment is made with care, correct results can be shown as well by the one method as by the other. The adjustment needed applies only to the inventory of goods remaining unsold at the close of the period, which adjustment is usually shown by means of a valuation reserve account, by means of which the book value of the inventory is brought down to the factory cost value.

The whole problem of profit between departments is one phase of the larger problem of the intercompany profits of a holding company. In such a case it usually happens that one of the subsidiaries with separate corporate organization turns over its product to some other subsidiary company at a price which returns a fair rate of profit. As the product passes through the hands of the various subsidiaries, by the time it is ready for final distribution to the public the accumulated profits represent those of all the companies engaged in its production. If, now, all these subsidiaries belong to the same parent company, the book value of the unsold product shows, at the close of the fiscal period, a large unrealized profit which must be adjusted in order not to show the stock-in-trade at an inflated value. This problem is discussed more fully in Chapter XXXIV where the main problems of the holding company are taken up.

Corporation Dividends

In addition to these general problems of the profit and loss summary, some further questions arise at the time of closing the records of a corporation for the fiscal period. Much more care must be taken in closing the books of a company than is necessary in the case of either of the other general types of business organization. Thus, the corporation authorized to issue a number of different kinds of stock must see that the dividend declaration is based only on the amounts of the various classes of stock outstanding, and not on the stock unissued or brought back into the treasury. It is customary to set up separate dividend accounts for each class of stock. Oftentimes the terms of issue covering the various kinds of stock introduce complexities in the calculation of the dividend. This is particularly true in the case of stocks which have the privilege of participating in all dividends over a certain amount. Some stocks are cumulative as to their dividend, while others may be non-cumulative. All these conditions of issue must be considered carefully at the time of the declaration of the dividend.

Discount on Bonds

Another problem requiring care is the treatment of discount or premium on bonds as they are related to the bond interest charge. In Chapter XV where bonds are discussed, the relation between the bond premium or discount and the bond interest rate is brought out. This necessitates at the time of the payment of the bond interest an entry to bring about the gradual amortization of the bond premium or discount so that by the expiration of the life of the bond issue the premium or discount is written off the books. Where the interest period does not coincide with the close of the fiscal period, for an absolutely accurate showing not only must the accrued bond interest be taken into account but also the accrued amortization of bond premium or discount.

Sinking Funds

A third problem at the time of closing the corporation’s books relates to bringing the sinking fund transactions up to date. Where the sinking fund is in the hands of a trustee, the corporation’s books can show the status of the fund only upon the receipt of the report of the trustee showing the changes in the fund for the current period. Care must be exercised to demand a report from the trustee as on the date of the closing of the corporation’s fiscal period. The character of the adjustments needed and the entries necessary to book them have been explained in Chapter XXV.

Working Capital

A fourth problem which sometimes needs to be considered is that of “working capital.” Technically the working capital of a business is represented by the excess of current assets over current liabilities. As pointed out in Chapter XXV, a credit account called “Sinking Fund Reserve” is frequently set up to indicate the financial policy pursued in making provision for the retirement of a bond issue at maturity. At the time of the retirement of the bonds this reserve need no longer be shown as a separate item to indicate financial policy and should therefore be closed out. It may be thrown back into general surplus or it may be transferred—to indicate that it is a part of the permanent capital of the corporation—to an account entitled “Working Capital” or “Working Capital Surplus.” In all cases where an item of surplus is created for a specific purpose, care must be exercised to see that the conditions surrounding the creation of the item are lived up to in its final disposition. In cases of surplus created by gift, as in scholastic institutions or hospitals, this problem is particularly important.

A similar problem is also met at the time of the redemption of an issue of preferred capital stock, inasmuch as such redemption is usually at a figure above par.

The Correction of Closing Errors

A final consideration has to do with the correcting of errors in the closing work of previous periods. Any omissions and wrong valuations of items in previous periods demand correction, but such correction must not be allowed to affect the results of the current period. These corrections must therefore be made either direct through surplus or by means of an entry in the final section of the profit and loss account as will be indicated in the next chapter. Sometimes where entries of this kind are numerous an account called “Profit and Loss Adjustment” is opened as a clearing account through which these items are carried net into surplus. The chief objection to this procedure is that the adjustments are too easily lost sight of when only the net results appear in surplus. These entries usually carry information of value to shareholders and they should therefore be set forth as a part of the statement of condition rendered at the close of each fiscal period.