5. As the business world is accustomed to consider

interest and dividends as of the same nature, namely, as a return on capital invested, to treat interest as a cost of operation would produce financial statements which are misleading. 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.