12. Liquidation or forced-sale value, etc.

It is to be understood that these various kinds are in no sense mutually exclusive and separate; they are met in the common vocabulary of men of affairs, are construed loosely in most cases, but have quite technical connotations in some places. Any of the terms employed here will, whenever necessary, be defined. Thus, in accounting, by cost value is usually meant full cost of a product or other asset in position ready for its intended use. Source of Data as to Values The sources of data as to values are several. Where double-entry books are kept, the original cost of the various assets can usually be secured from the books of account, barring errors of principle and omission in making the record. If not found there (as is often the case where single-entry books are kept), the original purchase invoice gives the chief item of cost, but does not usually show any inward-carrying or placement costs. Where there is a formally established market, this may give the information as to value when no book entries are available. Quoted prices in trade catalogues or lists as of the date of purchase, offer another means of procuring the information. Sometimes, even the memory must be relied upon. Present values of properties purchased formerly may be determined on the basis of original cost adjusted to take cognizance of depreciation and, sometimes, of appreciation. This adjustment is made in the light of the best available experience. The amount of the adjustment is sometimes called an “experience figure.” Stated otherwise it is an _estimate_ made on the basis of past experience with some regard to future contingencies. This estimate may be made by some one within the organization—manager, owner, etc.—or by regular appraisal companies who specialize on this kind of work. Usually, however, the appraisal company bases its value on present cost less depreciation—a reproduction cost value. Again, for some purposes the statement of earnings as giving the amount to be capitalized becomes the source of values. As has been seen, however, earnings themselves contain many elements which rest on estimated values. In almost all instances there is an element of speculation—an estimate—in the determination of values. Cost Value the Usual Basis The values which are, for the most part, shown in the commercial balance sheet are cost value or adjusted cost value. Occasionally, values which bear only an indirect relation to cost must be taken into account. The determination of cost value is sometimes a comparatively simple matter, as where the source is a purchase invoice, but more often it involves numerous other costs in addition to those shown by the purchase invoice, both definite and indefinite, i.e., estimates. It is in connection with the determination of cost that the proper segregation of the so-called capital and revenue charges is of vital importance. An effort will be made to formulate the distinction between them so as to give a working rule for their determination under most circumstances. Definition of Capital and Revenue Expenditures Capital expenditures may be defined as expenditures of funds or other assets on capital account. In accounting language, they may be said to be those expenditures which result in charges to some asset account. They may sometimes ultimately result in a charge to a liability account by the conversion of the asset to the decrease of the liability. Expenditures of capital may be made on account of expenses. This can occur only when revenues are insufficient to meet all expenses. Such expenditures of capital bring about an impairment of capital. As the term is generally used, however, capital expenditures have the meaning first given. Revenue expenditures may be defined similarly as expenditures of funds or other assets on revenue account. That is, such expenditures must be booked as charges to expense accounts. They represent the expenses incurred in the earning of the revenue, and measure its cost. Just as the original capital fund, through its expenditure, must provide the plant and equipment with which to work, so the other expenditures necessary to prepare and market the product must provide the revenue out of which to meet these expenditures and secure a margin of profit; else there is encroachment upon the original capital funds. A few other terms need definition by way of differentiation from these. The term “capital receipts” is used to differentiate receipts of funds from the sale of capital stock or the sale of capital or fixed assets, from funds or other assets received from revenue or profits sources. Thus, upon the sale of any asset which was originally purchased out of capital, the receipts therefor must first be applied to take the place of the capital expended for the asset, and any balance not used for the first purpose is then a receipt of revenue. The term “capital expense” is sometimes used to indicate the group of expenses incurred in providing the capital needs of the business. They are the financial management expenses as the term is used in Volume I. Opposed to capital expenses are the capital income or revenue items. These are the receipts or income from portions of the capital employed otherwise than in the purchase and sale of commodities; or the income which represents savings effected through the handling of the funds of the business as distinguished from income derived from the handling of stock-in-trade. They are _deductions_ from the financial management expenses. Capital and revenue expenditures are thus easily differentiated on paper. It is in the application of the definition to situations as they develop in practice that difficulty is encountered. Some of these situations will be examined with the purpose of determining the application to them of the distinction between revenue and capital expenditure. Organization Expenses Upon the organization of a new enterprise the distinction between capital and revenue expenditures can usually be made without much difficulty. All costs incurred to put the concern in a position to earn revenue are properly treated as capital expenditures. Sufficient capital must be provided to put the undertaking on an earning basis, as otherwise it fails. These costs will include many items which upon their _second_ incurrence must be treated as expense charges because the revenue must provide for keeping the plant in a state of efficient repair. One group of capital expenditures, usually carried on the books under the title “Organization Expense,” is often treated as a revenue expenditure as soon as sufficient revenues have accumulated to care for them conveniently. This is discussed in detail in Chapter XVIII on intangible assets. It is sufficient to say here that upon their incurrence organization expenses constitute capital expenditures, for no other funds are available for the purpose. Definition of Replacements, Renewals, Maintenance, etc. Only after the concern becomes a revenue-producer is the chief difficulty encountered in determining the proper record as between capital and revenue. In all cases of new construction and additions to the existing plant or equipment, no question arises as to the legitimacy of such capital charges. But when replacement, renewal, or betterment of existing properties take place, difficulty is met in determining the portion chargeable to the asset and the portion to be charged against revenue. The dividing line between renewals and repairs, maintenance, and up-keep is a closely drawn one, and usually an arbitrary working rule suitable to conditions must be adopted by each concern. R. P. Bolton[11] gives for some of these terms very suggestive definitions which the author quotes in full: [11] In “Power for Profit.” “Maintenance is a process of continuous attention to, and supply of, operating necessaries, including solicitous observation of the condition of the object cared for, corresponding to the protecting shelter, clothing and food supplies to living beings, in order to maintain their functions in operating condition. It includes supplies which form part of the food of the appliance. Part of the labor in attendance on machinery is involved in this element of its care. “Up-keep is a course of partial recreation, involving the expenditure of time and money in anticipating causes of decay, of failure, or of possible injury to the object under care, corresponding to hygienic and recreative methods, often involving considerable expenditures without apparent direct results, which are or should be followed in safeguarding the general health and strength of human beings. Thus, welfare and recreation of employees is a justifiable expense of an industry. It is part of the cost of the human machine. “Repair is the course of partial reconstruction, replacement, or renewal of worn or of injured portions, after the necessity therefor becomes apparent, and, unless brought about by accident, the need for the process is brought about by the failure or inability of maintenance, and also of up-keep, wholly to arrest the progress of decay by age or continued use. Provisions to preclude accident or to cover the cost of its results are part of the cost of repair. Health insurance of employees is a repair cost paid in advance.” While these definitions were not intended for accounting purposes and are not fully applicable thereto, they call attention to the basic ideas of the terms. The distinctions are in some cases too finely drawn. For accounting purposes the title “maintenance and repairs” usually gives sufficiently detailed information. Repairs is a part of the process of maintenance, as is also renewals. Maintenance, from an accounting standpoint, may be defined as “the act of keeping a property in condition to perform adequately and efficiently the service for which it is used.” A. Lowes Dickinson[12] defines repairs and renewals as follows: [12] In “Accounting Practice and Procedure.” “Repairs. This should include all current expenditures recurring from day to day and from month to month on the general up-keep of the existing property without the renewal of any substantial part thereof, and generally all periodic repairs which are necessarily undertaken within, say, one year. “(This caption will, of course, include certain renewals of small parts, etc., such as would be necessary to continue the useful life of any unit of building, plant, or machinery over the estimated period of its life.) “Renewals. This should include all expenditures incurred in renewing, in whole or in part, any unit of building, plant or machinery, which tend to extend its useful life beyond the average term. These expenditures would in general be those which would only occur at long intervals of two or three years, and whose effect would last for a number of years afterwards.” As distinguished from renewals, a replacement may be defined as “the act of replacing a plant unit which is going out of service, with a _substitute_ which may be either identical with the unit replaced or different from it.” In accounting terminology the terms “renewals” and “replacements” are for the most part used synonymously and will be so used here. Treatment of Renewal of Parts In the maintenance of a property in efficient condition, repairs and renewals are constantly taking place. When for an old part or plant unit a new one is substituted, the question of betterment immediately arises. If an old machine with book value of $500 is replaced by one costing $750, the excess of $250 is classed as a betterment and is properly a charge to capital. A renewal of machine _parts_ cannot be handled so easily. The parts of a machine are subject to diminution in value due to wear, tear, and obsolescence, along with the machine as a whole. The machine was purchased for a lump sum. What portion of the cost is applicable to each individual part is difficult to determine and must usually rest on estimate or guess. Similarly, the book value, i.e., the present depreciated value of a part, is not accurately known. Accordingly, the amount of betterment, if any, in the replacing of an old part by a new part is difficult to determine. It is here that working rules must be adopted for each concern. Thus, it has been suggested that only when the renewal involves an expenditure of $5 or more should there be any attempt to determine the amount of betterment, every expenditure under $5 to be charged to expense. In an establishment of any size this is altogether too small an amount. The Chicago Traction System through its board of supervising engineers has established $200 as the minimum charge to capital or renewals. All transactions involving even a true betterment, if the amount is less than $200, are to be recorded as maintenance charges. As a means of simplifying the accounting, a working rule, with a minimum capital charge adapted to the conditions of each concern, serves a practical and useful purpose. Treatment of Cost-Cutting Changes Other kinds of expenditures which cause trouble as to their proper place of record are those incurred for the purpose of facilitating the handling of the work. They may result in an increase of capacity to earn revenue through a speeding up of production, or the result may be simply a lessening of the expense of turning out the various units of product. A test frequently applied in such cases is that of increased earning capacity. It is argued that even though nothing tangible which did not exist before has been added to the plant, there has been a rearrangement of the factors of production with a resulting co-ordination of effort, and this has increased the capacity of the plant, thus making it more valuable. Inasmuch as this value is measured by earnings, the cost incurred in securing the increase is a very proper and legitimate charge to capital. Against this argument, it may be said that plant or structural changes are always made to improve operation. To make increased earning capacity the sole test is virtually to capitalize all expenditures of this kind—a policy which would soon lead to an unconscionable inflation of assets. Only by a policy of very liberal depreciation can such values if capitalized be kept within reasonable bounds. The impropriety of charging such expenditures to the current profit and loss account is generally acknowledged. The best practice is to handle items of this kind as deferred charges under suitable descriptive caption, instead of as charges direct to the asset account where the nature of the items is soon lost from view and the need of a high depreciation rate to write them off is soon forgotten. Thus, a rearrangement of the machinery in a plant may bring about a more economical routing of the product, or the introduction of a new machine may entail an entirely changed disposition of existing machines—all for the purpose of, and actually accomplishing, a saving in costs. Rather than a charge of the costs incurred to the asset account Machinery, a setting of them up under the title “Rearrangement Costs of Machinery,” or other similar title, shows their exact status and makes possible an intelligent writing down of them periodically in accordance with the estimated life or continuance of the savings effected. Practically this amounts to treating the costs as capital expenditures if the saving effected is judged applicable to more than the current period. The chief difference is that booking such items as deferred charges calls for specific attention to the need of a speedy writing off. Asset Subject to Depreciation a Deferred Charge to Operations In this connection it may be pointed out that the cost of all assets subject to depreciation may well be looked upon as deferred charges to operation, some portion of that cost being charged off at the close of each fiscal period. “So we see that capital expenditures, as distinguished from expenses, are at last an arbitrary conception. It begins with the idea that certain expenditures have an efficiency which reaches over many earning periods extending indefinitely into the future. But nothing physical would last so long, and its earning power might have even less permanence. To meet this condition we arbitrarily designate certain expenditures whose effect indefinitely outlasts the immediate earning period as ‘capital,’ and then in the same arbitrary way, through all subsequent vicissitudes, we hold them to their first value by maintenance, renewal, and depreciation charges which are borne by other expenses.”[13] [13] “Handbook of Railroad Expenses,” by J. S. Eaton. Authorization for Booking Capital Expenditures As regards a suitable method for handling transactions which involve a separation into capital and revenue charges or a determination of the status of the transaction as between capital and revenue, proper authority should be secured for making the expenditure. Where possible, before its incurrence, authorization as to its proper booking should be given, even to the amounts where feasible, and this order becomes thus the voucher supporting the entries on the books. Repairs on Second-Hand Plant In one situation repair charges which are ordinarily an expense must be capitalized. Where a company takes over a plant which is badly run down and out of repair, the expenditures necessary to bring it to a state of efficient operation are capital expenditures. Such a plant resembles a partially completed plant, and the purchase price is supposed to take that fact into consideration. It is expected that additional capital will have to be sunk to rehabilitate the property and put it in a condition of repair necessary to earn revenue. Accordingly the expenditures necessary to do this are rightly treated as capital charges. Construction Costs A final consideration in the distinction between capital and revenue expenditures has to do with certain costs incurred during the period of original construction. We may cover the situation by a general statement to the effect that all costs necessary to produce a complete plant in condition ready to earn revenue are proper charges against capital. Thus, interest on moneys borrowed for construction purposes is a proper charge to capital, and in England it has been held that dividends in the form of interest are allowable to _shareholders_ during the construction period. Also, such items as engineering and superintendence, law expenditures, injuries, taxes, etc., both preliminary to the construction period and during it, are to be capitalized. On the other hand, profits on own construction work are never to be counted as costs. To do so reveals a misunderstanding of the difference between a profit and a saving. The matter is discussed more at length elsewhere. As to whether any portion of the overhead expenses has a rightful place among the assets must be determined by the conditions in each case. In original construction work, before operations begin, all overhead charges constitute a part of the cost of the assets. For betterment work and additions carried on concurrently with operation, the case is not so clear. A safe principle is to treat as capital charges all increases in overhead above what would normally have been incurred for operation only. To free operation of any portion of the _regular_ overhead just because betterments are in progress is not recognized as a sound or conservative policy. Distinction between Capital and Revenue Expenditures often Based on Opinion Thus it is seen that many phases of the problem of capital and revenue expenditures are extremely difficult of determination and in their final analysis rest on estimates and opinions rather than definitely established facts. Too often it is feared that decision in matters of this kind is “influenced by unsuspected individual caprice and by considerations of the financial convenience of the moment”; for the allocation of such items may sometimes represent the margin between a profit or a loss for the current period. As is said to be true of geometry, so here there is no royal highway to the solution of these problems. Main Groups of Asset Items If, therefore, it can be determined what items are to be included in the balance sheet and the proper basis for their valuation can be established, the problem as to its content is well on the way to solution. Having discussed the elements and factors entering into a determination of cost value, we are in a position to state the principles of valuation applicable to the main groups of items as set up in the balance sheet. These may be listed, for the purpose of this generalization, under three heads, viz.: (1) current assets, (2) deferred charges to operation, and (3) fixed assets.