CHAPTER IV

THE BALANCE SHEET Business Methods under the Microscope The balance sheet is occupying an increasingly large place in all affairs of business and even of state, because the state is taking cognizance of business as never before. All phases of commercial activity are under the microscope. In these war times the government is tapping every available source of revenue. Kinds of property, property values, profits, rates of profit on capital invested—all are under investigation and the publicity resulting therefrom should make for a better conduct of future business. All this is forcing home to the manufacturer and trader some very obvious but long disregarded principles of business conduct necessary to secure health and long life. And these timely lessons will be of even greater use in the struggle for world markets that is imminent. As an interested party to any condition of business, labor also is claiming the right to be heard. The public in its direct dependence on certain classes of corporations for many of its necessities and most of its conveniences is also interested in the proper conduct of those businesses. As a factor in this increasing interest and scrutiny over business enterprises, exercised both from the inside and from external sources, banks are exerting a large and beneficent influence. The extension of credit, both bank and commercial, is no longer done by haphazard rule-of-the-thumb methods as in days gone by. Every applicant for credit must prove his right to it, must show cause why he deserves it, must present evidence of financial condition and standing on the basis of which the banker, the money lender, or the seller will be justified in extending all or some portion of the credit asked. The Reading of the Balance Sheet Because, in these and many other ways, the balance sheet offers the readiest means of securing the necessary information, it becomes an increasingly prominent statement. Before a proper understanding of the balance sheet can be had, and therefore before it can serve the various purposes to which it can be adapted, certain principles governing its make-up, both as to form and content, should be established. A proper reading of the balance sheet cannot be made without a thorough grasp of these principles. The knowledge necessary for this is broadly of two kinds, viz.: (1) a knowledge of accounts, their technique, construction, and meaning; and (2) a knowledge of the principles of valuation as applied to business enterprises. The latter is not a domain of knowledge pre-empted by the accountant nor limited exclusively to his use. It touches more or less intimately all related fields of business endeavor. That is why the modern accountant needs a broad training and something more than a cursory knowledge of business practices and conditions. He should have a close acquaintance with the fundamental currents of business life, its organization and finance, and its basis in law, if he hopes to measure up to present-day requirements. Thus not only is the accountant interested in the form and content of the balance sheet, but a proper understanding of it is valuable and increasingly necessary to all business men. In this chapter and those which follow, it is purposed to study these two problems of form and content, first establishing the broad basic principles and then showing in detail how these apply to various conditions and particular data. This chapter will concern itself with the problem of the make-up of the balance sheet so far as it relates to form. Definition George Lisle[4] defines a balance sheet as “a concise statement compiled from the books of a concern which have been kept by double entry, showing on the one side all the liabilities and on the other side all the assets of the concern at a particular moment of time.” Another writer says, “It is a cross-section of the business at a given instant”; and another, it is a “screen picture of the financial position of a going business at a certain moment.” As indicated by the first definition, an attempt is sometimes made to limit the term balance sheet to a statement made up from a double-entry set of books. With equal propriety it may be applied to any statement, whether made up from single- or double-entry books, or from any formal records, or from no records at all, which shows the assets and liabilities of a concern and the difference between them, i.e., the balance, as the item of net worth. [4] In “Accounting in Theory and Practice.” To distinguish this latter statement from the balance sheet when used in the restricted sense above referred to, the title, “statement of assets and liabilities” is sometimes used but there seems little reason for the distinction. Here the terms will be used as synonyms. The balance sheet then is a statement of financial condition as distinguished from a statement showing the operations of the business, and it is true only for a given moment of time. Theoretically the wheels of business are stopped momentarily, all operations cease, and a summary of the assets and liabilities then existing with their balance shown as net worth constitutes at that moment the balance sheet—the financial statement. Relation between Balance Sheet and Trial Balance A balance sheet when made up from a double-entry set of books bears a close resemblance to the trial balance. The trial balance is simply a list of ledger balances. Due to practical considerations in making the record from day to day, the ledger seldom reflects the true condition of the business, as there is no distinct separation of assets, liabilities, expenses, and income. Some accounts take on a mixed character, making necessary the periodic separation of their elements. This separation is effected by the adjusting entries explained in Volume I. A trial balance of the ledger after the adjusting entries are made contains the data for both the financial statement and the operating statement. After the operating data, i.e., the income and expenses, have been summarized through the Profit and Loss account and its balance has been transferred to some vested proprietorship account, the records left on the books relate only to assets, liabilities, and vested proprietorship. A trial balance now taken—a post-closing trial balance—contains only balance sheet items and to all intents and purposes is a balance sheet. While, as we shall see, the form in which the data of the balance sheet are presented is a matter of serious importance, any showing of assets, liabilities, and net worth constitutes a balance sheet. Form of Balance Sheet A balance sheet is not an account, nor is it the statement of an account. It is simply a statement of assets, liabilities, and proprietorship, arranged in whatever form best suits the purpose. Where set up in parallel columns, it is frequently called the account form; when shown vertically on the page, assets followed by liabilities and the difference indicated as net worth, it is called the report form. A balance sheet therefore being only a statement cannot properly be said to have either a debit or a credit side. It is not a complete system for the record of the transactions of a business set up in debit and credit form for the sake of proof, although on its statement of fundamental equality may rest the whole scheme of debit and credit. While usually made up from a system of double-entry books and so often spoken of as the goal of record-keeping, it may be made up from sources entirely extraneous to the books. Purpose and Uses The purpose of the balance sheet is, as indicated, to show financial condition. It may be made also to show the amount of profit for the period by elaborating the information given in the net worth section. If there has been during the period neither a withdrawal of any funds nor an additional investment, a comparison of net worths as at the beginning and at the end of the period will bring out the increase or decrease in net worth and therefore establish the _amount_ of profit or loss, though telling little or nothing as to its source. If there has been withdrawal or investment or both during the period, adjustment must be made on account of these before the amount of profit or loss for the period can be determined from the balance sheet. The balance sheet may thus be made to show profit, though that is an incidental rather than an essential purpose of the statement. As a statement of financial condition the balance sheet should make possible the determination of several facts. It may be used as the basis for short-time credit. If so, its purpose then is to show facts as to solvency. It may be used as the basis for floating a bond issue. If so, other groups of data in addition to the solvency facts must be held under view. It may be used for determining the advisability of an investment in the business. If so, its data must be examined from still another angle. In all of these cases the balance sheet must set forth clearly the relationship of the interests of the various parties in the business. The assets of a corporation are listed usually so as to show the total properties to which all the parties may look for the satisfaction of their claims. Of the claimants there are first, then, those whose claims are redeemable within a short time. Failure to meet these claims may mean insolvency. There are those also whose claims are not necessarily of immediate urgency, though they may be. Inability to meet these claims may mean bankruptcy and dissolution. Finally, the owners themselves have a proprietor’s right only to any residue of assets left after the claims of all outsiders have been satisfied or are capable of being satisfied. Thus the balance sheet may serve many purposes. Types of Balance Sheet As the balance sheet must serve, or can be made to serve, several definite purposes, the best way to accomplish the end in view must receive careful consideration. It is here that the question of form enters. The various problems in connection therewith will next be discussed. As to types of form there are in the main two, the English and the Continental or American, both of them well standardized, although many variations from the types are found. The chief difference between the two types lies in the showing of assets on the right side and liabilities and capital on the left under the English form, and a reversal of the sides under the Continental form. So much useless controversy has been carried on with such a waste of effort and words over the relative merits of the two types, that a writer now scarcely dares venture into the subject. As a matter of historical interest and information to the student, an effort will be made to summarize briefly the two positions. Origin of English Form of Balance Sheet In the development of record-keeping a stage was passed through in which every account on the ledger was closed. Not only were the temporary proprietorship accounts cleared through the Profit and Loss account, but all the remaining asset, liability, and vested proprietorship accounts were in like manner closed into a Balance account opened on the ledger for this purpose. The Balance account, after transfer of the various accounts into it, became virtually a balance sheet and so was itself in balance. In this way the whole ledger was closed. The Balance account at this stage, so the controversialists maintain, represents, and was later adopted as, the Continental form of balance sheet. The ledger could not, of course, remain closed; it had to be reopened for the record-keeping of the next fiscal period. This was accomplished by credit entries to transfer the assets, and by debit entries to take out the liabilities and vested proprietorship. These reopening entries as appearing in the Balance account represent the English form of balance sheet. This explanation of the origin of the two forms is ingenious and even plausible, although not synchronizing historically with the lapse of use of the Balance account. Others have attempted an explanation on purely logical grounds. These hold to the theory of the personality of accounts, which looks upon the business always as an entity distinct from its owners. Here, the English form of balance sheet is said to be the statement of account rendered by the business to its owners, whereas the Continental is the account given by the owners to the business. A. Lowes Dickinson,[5] in discussing the two forms, says: “The balance of argument would seem to favor the latter (English) on the theory that a balance sheet is intended to set forth the position of the owner of the property, who should therefore be credited with what he possesses and charged with what he owes.” [5] In “Accounting Practice and Procedure.” Quite opposed to this view is the position taken by an English authority, George Lisle,[6] He says: “Why ... the assets which are on the debit side (of the ledger)[7] and the liabilities which are on the credit side, as according to the principles of accounting they ought to be, should change places (in the balance sheet),[8] it is impossible to justify. The custom seems to have arisen through the influence of the forms given in Acts of Parliament, chiefly The Companies Act, 1862, which must have been prepared by those unacquainted with the theory of accounts. The Profit and Loss account is taken from the ledger, and the sides are not transposed, and there is no logical reason why the sides in the balance sheet should be reversed.... The form of balance sheet in which the assets appear upon the left side is both theoretically the correct form and in practice is the most convenient form to use.... Prior to about the passing of The Companies Act, 1862, it was the form chiefly adopted in England, but is so no longer.” [6] In “Accounting in Theory and Practice.” [7] Material in parentheses is author’s. [8] Material in parentheses is author’s. R. H. Montgomery[9] proposes a psychological explanation. He says: “The only sound reason the author can think of for the custom is that a conservative Englishman looks for his liabilities first and then looks to see if he has enough assets to discharge, them ... that the average American looks for his assets first and subsequently glances at his liabilities in order to assure himself that his excess of assets is as much as he believes it to be.” Regardless of the origin of the two types and their respective merits, a balance sheet is everywhere used to show assets, liabilities, and net worth, and less and less regard is being paid to debit and credit or left and right sides, technical form giving place to an elasticity in the method of showing adapted to accomplish definite purposes. [9] In “Auditing, Theory and Practice.” Variation of English Form A variation of the English form of balance sheet is seen in the make-up of the balance sheet for British public service companies. These companies are authorized by special act of Parliament to raise money for designated purposes. The act, therefore, requires as a part of the statement of financial condition the rendering of an accounting of the receipts from sale of stock and bonds. Accompanying the financial statement, or rather as a part of it, is the statement, “Receipts and Expenditures on Capital Account,” comprising the fixed asset and liability sections of the ordinary balance sheet. Illogical as it may appear in view of the usual English practice, this account is _credited_ with the capital stock and bonds issued to establish the undertaking, and is _debited_ with the fixed assets in which the capital funds have been invested, the intent of the law being that the capital funds raised should be applied to purchase of fixed equipment with which to earn revenue and that all other expenditures should be made from revenue. If the fixed assets exceed at any time the fixed liabilities and capital, it means that the excess has been supplied out of revenue. If the reverse is true, it means that capital receipts are being used as working capital. Any balance is carried down to the second part of the financial statement known as “General Balance Sheet,” in which arrangement of the two sides is made according to English custom. The act authorizing this double-account form of balance sheet allows the valuation of the fixed assets always at cost, on the theory that their maintenance in a state of constant good repair and efficient working condition constitutes a charge against revenue and hence that depreciation need not be considered. It has been suggested that the double-account form of balance sheet, or rather the law on which it rests, has been responsible for the decisions in the cases of Lee v. Neuchatel Asphalte Co. and Verner v. The General and Commercial Investment Trust, Ltd., reference to which is made later in Chapter XXII, “Profits,” and Chapter XXIV, “Dividends.” Here the decisions rested on the distinction between fixed and circulating assets and declared in favor of the maintenance of the capital funds invested in circulating assets but not necessarily of those invested in fixed assets. The following illustrates the double-account form: THE EAST AND WEST RAILWAY COMPANY RECEIPTS AND EXPENDITURES ON CAPITAL ACCOUNT ==================================================================== | Railroads, Franchises | Capital Stock: and Other | Common $200,000.00 Properties $410,000.00 | Preferred 75,000.00 Current Expenditures | Debenture 50,000.00 for Construction | Funded Debt: and | General Mortgage Equipment 65,000.00 | Bonds 150,000.00 Investments in Other | Equipment Trust Companies 50,000.00 | Bonds 100,000.00 Securities in Hands | of Trustee 15,000.00 | Balance carried to | General Balance | Sheet 35,000.00 | ----------- | ----------- $575,000.00 | $575,000.00 =========== | =========== GENERAL BALANCE SHEET, DECEMBER 31, 1918 ==================================================================== | Capital Account, | Securities $50,000.00 credit balance $35,000.00 | Prepaid Expenses 750.00 Special Betterment | Accrued Income 1,250.00 Fund 15,000.00 | Accounts Receivable 25,000.00 Accrued Expenses 1,500.00 | Materials and Supplies 10,000.00 Dividends Payable 17,500.00 | Accounts Payable 25,000.00 | Cash 7,000.00 ---------- | ---------- $94,000.00 | $94,000.00 ========== | ========== It will be noted that the sides of the capital account follow the debit and credit order of the ledger, whereas the general balance sheet reverses that order—an inconsistency for which even the English do not attempt explanation. Balance Sheet Titles The title of the balance sheet is fairly well standardized. Other titles are sometimes met, such as Financial Statement; Statement of Assets and Liabilities; Statement of Resources and Liabilities; Statement of Assets, Liabilities, and Capital; Statement of Financial Condition; etc. The title “Balance Sheet” seems best. Though not so fully descriptive as some of the other titles, it is generally understood and has not the objection of inadequate descriptiveness and unwieldiness often raised against the other titles. There is a similar variation in the titles used for the three main groups of items shown in the balance sheet, viz., assets, liabilities, and net worth. Obviously, portions of some of the general titles cited apply here with equal appropriateness. In addition, we find in use or suggested as appropriate, Property and Assets, Active and Passive, Debit and Credit, Positive and Negative, Proprietorship, Capital and Surplus, Capital, etc. None of these suggested titles have met with favor in practice, but they have served the worthy purpose, perhaps, of providing fuel for academic controversy. The titles, Assets or Resources, Liabilities, and Net Worth or Capital, seem thoroughly established and seem to cover the need. Grouping and Classification In the matter of classification and arrangement of the items under these main groups there is room for greater diversity both in practice and in theory. The need and purpose of classification and arrangement is obvious. While any statement, list, or schedule which shows assets, liabilities, and net worth may properly be called a balance sheet, only by a careful grouping and formulation of the items can their mutual interrelations and proper dependence be shown. Not only does the bringing of similar items into groups put them in proper perspective, but the arrangement of the groups to show their relations to one another makes for a more intelligent interpretation of the balance sheet. The controlling principle underlying classification of the items into groups is, in the main, their relative degrees of liquidity. Sometimes other factors, such as emphasis, perspicacity, publicity, and so on, bring about groupings which differ somewhat from those based solely on degree of liquidity. Thus it may be desirable to call particular attention to, say, the permanent investments of a concern, to the condition of its sinking and other funds, to the amount of new construction and betterments for the current period, or to the values tied up in intangible assets. No hard and fast rule can therefore be followed; elasticity, flexibility to the desired purpose are working rules which must underlie any scheme of classification. As to titles for the various groups, one finds many. The current assets are variously styled Quick, Floating, Liquid, Circulating. As a sub-group under Current or as a separate group we find Working and Trading assets. Other groups are Fixed or Capital, Investments, Sinking and Reserve Fund Assets, Deferred Charges to Operation, Deferred Assets, Deferred Debits, Suspense Debits, with similar titles for corresponding credit items, Contingent Liabilities—in short almost any title which seems best to fit the needs of the particular case. Some of these may need some explanation. The distinction between current and working assets is a somewhat fine-drawn one, although well taken under certain circumstances. Where the two groups are used, current assets include the cash, receivables, and temporary investments, and the working assets group (or working and trading assets as it is sometimes captioned) includes the stock-in-trade (finished goods, goods in process, and raw materials), supplies of all sorts used in preparing the goods for sale or in making the sale, office supplies, working funds in the hands of branches and agents, and the like. The line of demarcation between the two groups is not always clearly drawn, some placing the stock-in-trade among the current assets, others putting finished stocks in the current group and process materials in the working group. There is apt to be an overlapping also between the working and the deferred charges groups, supplies of various sorts often being treated as deferred charges to operation. Capital assets are fixed assets—the plant and those assets in which the capital must first be invested before revenue can accrue. When the group of capital liabilities is shown it usually includes both the long-term obligations incurred for raising capital as well as the capital stock. This unfortunately does not recognize a distinct section for the net worth items. Arrangement of Groups The arrangement of the groups among themselves, while showing variations, offers few important matters for consideration. Here, also, the principle of degree of liquidity controls. The arrangement is sometimes from fixed to liquid but rather more frequently from liquid to fixed. If the chief interest in the balance sheet is as to the amounts of capital invested in properties and the growth of such investments, it is claimed that the fixed asset group should be shown first. This might be the case with railways, steel corporations, and other large concerns wherein the ratio of the fixed assets to the current is large. In other concerns—and these constitute the larger number—chief interest centers in the current group. Here, the ability to pay dividends, to extend a sales market through carrying larger stocks of merchandise, to secure credit, are the items of chief moment. It is contended that in these cases, the order of the groups should be from current to fixed. Whatever grouping is made for the assets, a similar arrangement of groups must be insisted upon for the liabilities; it is the placing in juxtaposition or the same relative positions of similar groups among the assets and liabilities which makes for an easily intelligent reading of the statement. After all, the order of the groups, as from fixed to current or vice versa, is of small importance in comparison with the similar arrangement of both assets and liabilities and with the surety of the proper content of each group. The thing to be sought is the arrangement which will facilitate comparison of similar groups. A rather serious objection to the “fixed to current” arrangement is that it almost invariably necessitates the separation of the net worth elements. Thus, capital stock and long-term bonds are grouped together at the top for comparison with the fixed assets; the remainder of the net worth—surplus and reserved profits—must be shown at the end. The group of all net worth items together compels a general scheme of logical grouping from current to fixed. A difference as to order is also found in the placing of deferred charges to operation. Regardless of the scheme of general grouping, one frequently finds the deferred charges placed as the last group. This also seems illogical. Only items of prepaid operating expenses should be included in that group. Such prepayments, while made in the one period, are properly chargeable to the next. Their effect, therefore, is to bring about a saving of the cash and other current assets for other uses during the next period. They are thus nearly related to the current group and could without any serious violation of principle be included thereunder. For the sake of emphasis and a more open showing, they are best shown in a group by themselves immediately following the current assets. The intangible assets, good-will, franchises, patents, etc., are usually included among the fixed assets. Where so shown they should be given unmistakable titles and are best set up at the end of the group so as not to be covered and lost among the other items. A suggested scheme of grouping which will make an intelligent showing for most purposes follows: ======================================================= | _Assets_: | _Liabilities_: