CHAPTER XXVI

PROBLEMS IN CONNECTION WITH THE PROFIT AND LOSS SUMMARY 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: