CHAPTER XIV

TEMPORARY INVESTMENTS; ACCRUED AND DEFERRED ITEMS TEMPORARY INVESTMENTS Nature of Temporary Investments The next item to be considered for valuation in the current assets section of the balance sheet is temporary investments. These are assets, such as stocks and bonds of ready marketability, in which current funds are tied up temporarily. Investments in stocks and bonds for purposes of securing business connections and privileges essential to the most efficient conduct of the business do not belong to this category. The term usually covers only those assets representing the investment of temporarily surplus cash or those acquired in settlement with debtors with the expectation of early realization. As A. L. Dickinson[44] so well says, “such investments have no relation whatever to the business and can be disposed of without in any way interfering with its earning capacity, other than the loss of the dividends thereon.” [44] In “Accounting Practice and Procedure.” In the case of concerns affected by seasonal changes in volume of business, there are periods when sums of surplus cash lie unemployed, unless the concern depends upon borrowed money to take care of seasonal increases. Business policy, therefore, demands that the surplus cash be put where it will earn something. Such investments are frequently of a somewhat speculative character. In fact, other things being equal, business acumen demands that the investment be made in those securities in which there is a chance of gain in addition to the regular income therefrom. It cannot be stated too strongly, however, that safety, freedom from great fluctuations, and ready marketability are always prime essentials to be observed in securing stocks and bonds for temporary investment. While the procedure is unusual, there may at times be circumstances under which such investments may be bought on a margin basis. Valuation of Temporary Investments The usual rule for valuing temporary investments at the time of drawing up a balance sheet is at cost or market, whichever is the lower. Inasmuch as they may be needed on short notice, the information desired is what they will be likely to realize. This is particularly true in the case of a concern with a rapidly expanding market, for which provision may need to be made by increasing the plant as well as the working assets. Where reserved profits have become tied up in fixed plant, the need for ready funds is apparent. It may be argued that inasmuch as realizable value is the information desired, valuation at market, whether lower or higher than cost, is the only proper basis. The rule stated is, however, held to be the correct one from the standpoint of conservatism and the further fundamental objection to bringing unrealized profits into the current period, as would result from a market valuation higher than cost. Of course, a lower valuation than cost brings unrealized loss into the period’s operations, but this is not regarded with the same disfavor. Where the market price is fluctuating from day to day, as is normally the case, the market valuation on the date of the balance sheet is perhaps no nearer to the amount that will be actually realized than the cost value, since cost value merely represents one of the many changing points in the market. If a distinct market tendency in one direction or the other were likely to continue until the time of realization on the investments, there might be good reason for taking the profit or loss accrued to the date of the balance sheet. However, these considerations are of too speculative and uncertain a character to be given any weight. There is some valid objection, on theoretical grounds at least, to the results of the period being affected by the unrealized profits or losses caused by taking the market valuation of temporary investments onto the balance sheet. Valuation at cost, with a footnote to show market value, gives all the information essential to a full understanding of the exact condition of the investment. The habit of adding footnotes to the balance sheet may, however, become objectionable and the practice is to be avoided wherever possible. Also, really essential information usually carries greater weight when incorporated in the balance sheet figures. Reserve for Investment Fluctuations To meet the foregoing objection and, at the same time, that of allowing unrealized items to affect the period’s profit and loss, use may be made of an account called, say, “Reserve for Investment Fluctuations.” The account should be operated in the same way as the Reserve for Market Valuation of Merchandise discussed in the preceding chapter. That is, if market is lower than cost, at the close of a fiscal period, surplus is charged and the reserve credited for the difference. On the balance sheet the reserve is treated as an offset to the investment account carried at cost. This incorporates the market valuation as a significant figure of the balance sheet and shows the cost for purposes of information. The charge to surplus avoids fluctuation in the current profit and loss results because of an unrealized item and so makes it more useful for comparative purposes. In case market is higher than cost, the difference is charged to the asset and credited to the reserve. On the balance sheet, cost is thus the effective figure and the market price is given for informational purposes. When the investment is sold, the entry creating the reserve should be reversed in either case. This brings on the books in the period when the sale takes place, the actual profit or loss realized, being the difference between cost and sale prices. The adjusting entries on account of valuation do not thus permanently affect surplus, while the actual profit or loss reaches surplus in the usual way—a valuable desideratum. “Stock Rights” on Investments It may occasionally happen that while stocks are held for purposes of temporary investment, stock rights arise. Such a “right” is a privilege of subscription to a new issue of stock, granted holders of stock on a certain date, at a rate below the market quotation of the old stock. The stock records are closed temporarily to any transfers of stock in order to determine those entitled to these rights. Up to the date of closing the records, the market value of the stock carries an increased value to cover the value of the rights belonging to it, and the stock is quoted “rights-on.” After this date the rights are dealt in separately and quoted separately on the exchange. Stock then sells “ex-rights.” Should the end of the fiscal period of a concern holding stocks subject to rights fall after their issue, the stock and rights may be booked separately, though often shown together. An illustration will show the theoretical method of valuation of rights. Take a corporation whose stock now sells at 125, issuing the right to subscribe at par for additional stock to the extent of 10% of present holdings. The case of a stockholder with fifty shares would work out as follows: 50 shares at $125 $6,250.00 5 ” at 100 500.00 -- --------- 55 ” at a cost of $6,750.00 The average cost of one share is $122.73. Based on the former quotation of $125, the right is seen to be worth theoretically the difference, or $2.27. The quoted market price will usually be less. Cost of Investments In connection with the cost of temporary investments it may be well to point out that cost means full cost to the purchaser, including brokerage and other costs in connection with the purchase or subsequent thereto. If the investment is being carried on margin, the customary practice is to charge to the investment account the interest on the funds borrowed by the broker to finance the transaction and to credit thereto any dividends or interest received. The difference between the asset account kept with the investment and the liability account with the broker thus shows at any time the original equity in the investment. A credit to the investment account when the stocks are sold develops the net profit or loss on the entire transaction. There may be circumstances under which it will be desirable to separate from the asset account all charges and credits subsequent to the original purchase, carrying them in a suitable expense and income account. Valuation of Bonds In the case where bonds are held for temporary investment, purchased either at a premium or discount, it is not customary to take account of amortization, because the investment is temporary. The problem of amortization is postponed to Chapter XV, in which permanent or long-term investments are treated. In brokerage firms, where stocks and bonds comprise the stock-in-trade, the same principle of valuation applies as with a merchandise stock except that the rule of valuation at cost or market, whichever is the lower, is applied to each _individual_ holding. In this way, decreases in the value of one stock are not offset by increases in the value of others as would be the case if total market and cost values for the entire lot were first determined and then the valuation formula applied. In this chapter the principle of valuation of stocks and bonds as stock-in-trade is mentioned only by way of contrast. Valuation of Unissued Stock Under the head of temporary investments, the company’s unissued and treasury stocks or bonds are sometimes included. Such unissued stocks or bonds manifestly represent an inflation of asset values, offset, it is true, by an equal inflation of capital stock. In the first place, conceding for the sake of argument that the inclusion of unissued stocks among the assets is legitimate, the principle of equilibrium requires that they be valued at par on the balance sheet, a figure which is not cost and which may be very far from market. Again, the company’s unissued stocks may be in no sense current assets. Furthermore, stocks which have never been issued have no owners and so can command no proprietorship in the enterprise. The most that can be said about them is that they are contingent assets, showing that certain legal formalities have been met which authorize their issue if so desired. The remaining necessary procedure, viz., that the stock be placed on the market and sold, is, however, the condition which must be met to create a real asset and to create proprietorship. Until that has been done there is neither proprietorship nor asset. Reference to Volume I, Chapter XLIX, where the various methods of opening the books of a corporation are illustrated, will show that the method to be preferred is one which eliminates the account Unissued Stock from the books. However, where it is set up, correct classification would seem to require that it be treated as of the nature of a valuation or offset account for capital stock. In other words, the two accounts, Capital Stock and Unissued Capital Stock, must be read together to show the true status of the proprietorship stockholdings. The correct method of presentation on the balance sheet is here only indicated but will be illustrated in Chapter XXI where the problem of valuation of capital stock is treated. Valuation of Treasury Stock The case against the inclusion of treasury stock in temporary investments is not quite so apparent, but equally convincing upon examination. Treasury stock differs from unissued stock only in that it has once been issued but has, through various channels, found its way back into the possession and control of the company. While outstanding in the hands of stockholders and under their individual control, the increased stock proprietorship is reflected in increased assets. If the stock comes back into the treasury through donation, the decrease in proprietorship stockholdings is compensated by a new proprietorship element under donated surplus. Thus, while there are not so many shares outstanding, the value of each is enhanced by a combined or common proprietorship in donated surplus, which reflects exactly the status of the treasury stock. Whereas formerly there was individual control over the stock, now that it is in the treasury, control is common or combined. Stock proprietorship has been diminished and the balance sheet should show it by treating Treasury Stock as an offset account and not as a part of current assets under Temporary Investments. As to the valuation of treasury stock at some other figure than par, the same argument holds as in the case of unissued stock. If the treasury stock has been acquired by purchase on the open market, its price may be a good and sufficient basis for valuation; but even here individual ownership and control has been exchanged for common and combined ownership. The individual stockholdings are decreased, and the decrease is reflected on the assets by the amount paid for the stock. It would seem, therefore, that a showing more in accord with the facts would require treasury stock to be treated as a deduction from the capital stock authorized. Thus the best practice eliminates a company’s own stocks from the list of its assets. Where such holdings are small and insignificant, they may without any serious impropriety be included among the assets and even under the caption “Temporary Investment” so long as substantial accuracy obtains. Summary of Valuation Formula To sum up, then, the valuation formula for current investments requires their showing at cost or market, whichever is the lower. The most satisfactory method of applying the formula is by means of the Reserve for Investment Fluctuations which makes possible the incorporation of market value whether lower or higher than cost, with the differences between market and cost carried in the reserve account. Thus the conservatism of the valuation formula is made effective and at the same time information is given as to the present market values of the investment. ACCRUED AND DEFERRED ITEMS Nature of Accrued Income Income derived from many different sources is never fully received at the close of the fiscal period. For instance, of the sales made many will still be outstanding as charges to various customers; interest will have accrued on notes receivable and on investments held; rental income is earned day by day but is received only periodically; royalties based on the use of some machine or process are accumulating where the device or process is being used but settlement is made only periodically; and dividends on stocks or other investments may have been declared during the current period but are not payable and therefore will not be received until the next period. Inadequacy of Cash Method of Handling Accruals All these accrued items give rise to claims which must find expression in the accounts either currently or ultimately. In the case of sales of merchandise the customary practice is to set up the claim on the books when the sale is made. In the case of the other items usually no record is made until the income is actually received. Under this method—called the cash method—it is evident that the true income cannot be shown in the period in which it is earned and that the period in which it is received secures the credit for it. This means not only that the current period may at its beginning receive credit for items of income mostly earned during an earlier period, but at its end it will be deprived of similar earnings accruing from day to day up to its close but not credited because their time of payment overlaps into the next period. This method is defended as being substantially correct on the principle of averages, i.e., those earnings which do not entirely belong to the current period but for which credit is taken will in the long run just about offset the earnings accrued at the end of the period which are not taken account of. The statement may be true and, if so, can be easily tested; but, whether true or not, modern practice requires the _accurate_ accounting of all claims. It is therefore required that these accrued earnings be brought onto the books if reliable results are desired. Correct Method of Handling Accruals To show all earnings in the period in which they actually accrue is called the “accrual method.” Under this method the income earned but not received during the current period is set up among the assets, just as in the case of sales, with this difference, however: the claim for the broken portion belonging to this fiscal period need not be recorded day by day but only at the end of the period. Most income items of this sort are due, either by contract or by custom, at the end of certain definite periods. The setting up of a claim for a broken, i.e., an uncompleted portion, does not mean that such a claim is on that date legally enforceable, but that it is a claim equitably belonging to the current period. Showing of Accrued Items on Balance Sheet As to the section of the balance sheet in which these accrued income items should be shown, usually they are true current assets and should be so listed. They frequently arise in connection with current assets, e.g., the interest accruing on notes, stocks, and bonds held, and are therefore just as current as the assets themselves, or even more so. Where not so arising, as in the cases of rents, royalties, etc., usually the contract or customary period of settlement is so short as to make the claims under them true current assets. Occasionally the accrued earning is added to the value of the particular asset and so shown in the balance sheet. A better practice, because more definite, is to list them separately under the title, Accrued Income, Accrued Accounts Receivable, or other similar title. Valuation of Accrued Items The principle of valuation of accrued income items is apparent. On the supposition that the concern will continue in business, the accrued income is proportioned between the two periods on the basis of the portion of the time belonging to each period. However, this does not mean that the portion so taken shall be valued at its face. The accrued portion is worth as a portion neither more nor less than the whole is worth as a whole. If there is doubt as to the ability to collect it when it falls due, certainly the valuation placed on the accrued portion should express that doubt. In other words, unless the claim is fully secured by collateral or other pledges, valuation should be on exactly the same basis as for the other receivable items, such as the claims against trade debtors, other open accounts receivable, notes receivable of various kinds, etc. Accounting for Accrued Income The accounting for accrued income presents no particular difficulties. In addition to the two methods discussed in Volume I, pages 116 to 119, a third which is considerably more laborious than either of them is frequently employed, and is as follows: At the time of adjusting and before closing the books, for every item of accrued income a separate asset account is set up. Thus, for royalties an account, Accrued Royalties Receivable, would record the claim on account of royalties at the same time the accrued income from royalties is being recorded in a suitable income account. Thus there is distinct separation of the asset and income elements. From this point two methods are in use for handling the subsequent record of the item. Under the first method, the income when actually received or legally due is recorded in the regular income account. This thus shows an inflated figure because it is not offset by the portion credited to the previous period, the asset account covering this, remaining unchanged throughout the current period. At its close, however, proper adjustment is made by adding to, or subtracting from, the amount held over from the close of the previous period such an amount as will make its new balance show the correct amount of accrued income as at the close of the current period. The contra credit or debit to the above entry, as the case may be, is of course to the particular income account, causing it to reflect the true income for the current period. Under the second method, the first entries for the new year consist in transferring all accrued income asset balances to their respective income accounts, where they serve the purpose of automatically adjusting the full receipt of income a portion of which was credited in the previous period, to the amount properly belonging to the current period. At the close of the period any adjustment on account of accrued income is handled by debiting the asset account and crediting the income account exactly as before. An illustration will show the differences between the two methods. Illustration of Different Methods of Recording Accrued Items _Problem._ The royalties income accrued December 31, 1916, amounted to $5,000. During 1917 payments were received on account of royalties to the amount of $35,000. On December 31, 1917, accrued royalties were $5,250. _Solution—Method 1_ ACCRUED ROYALTIES RECEIVABLE ======================================================= 1916 | Dec. 31 $5,000.00 | 1917 | Dec. 31 (A) 250.00 | | ROYALTIES INCOME ======================================================= | 1917 | $35,000.00 | Dec. 31 (A) 250.00 | _Method 2_ ACCRUED ROYALTIES RECEIVABLE ======================================================= 1916 | 1917 Dec. 31 $5,000.00 | Jan. 1 (A) $5,000.00 --------- | --------- 1917 | Dec. 31 (B) $5,250.00 | | ROYALTIES INCOME ======================================================= 1917 | 1917 Jan. 1 (A) $5,000.00 | $35,000.00 | Dec. 31 (B) 5,250.00 | Of the two methods, the second is somewhat fuller and probably presents the facts more consistently, although involving a little more book work. From a practical standpoint where regard is had to the amount of book work required, the method used in Volume I, pages 116 to 119, sometimes known as the inventory method, serves all the purposes of either of the above methods and requires much less work. By it the above problem would appear as follows: ROYALTIES INCOME ============================================================= 1916 | 1917 Dec. 31 Accr. $5,000.00 | $35,000.00 1917 | Dec. 31 Accr. 5,250.00 Dec. 31 P. & L. 35,250.00 | $40,250.00 | $40,250.00 ======== ========== | ======== ========== 1918 | Jan. 1 Accr. $5,250.00 | An objection, not at all serious, is that under this last method the ledger will show, as on the date of the balance sheet, the current assets in two places, viz., the current assets section and the income section, instead of altogether as under the other methods. This objection is more than offset by the saving in clerical labor. There is in some quarters an all too prevalent tendency to multiply the number of accounts and increase the bookkeeper’s work without any adequate return in results. Prepaid Items—Definitions and Kinds Closely related to current assets, because through an overexpenditure of current funds this period a lesser expenditure will be required next period, is the class of items known as prepaid expenses or deferred charges to operation. These items are not current in the sense that they will be turned into cash shortly, but they are analogous in that a saving in the expenditures of the next period will result. Because of the ease with which they may be put to improper uses, it is best to segregate them from current assets under a suitable balance sheet caption, such as “Deferred Charges to Operation.” Where the two captions, Current and Working Assets, are shown, items of this class properly belong to the latter. Under this head will be considered such items as supplies of all sorts—office, factory, power house, stable—stationery, printing, postage, repair parts, insurance unexpired, advertising contracts and material, rent, royalties, interest and discounts paid in advance, salary overdrafts, premiums on long-term investments and discounts of long-term obligations, and sometimes organization expense, although this last item is perhaps best handled with the intangible assets. Valuation of Prepaid Items The purpose in considering these items at the close of a fiscal period is to secure a proper and accurate allocation of charges as between the two periods, without which true results as to profit and loss are not possible. The same argument as to these items averaging up fairly well between periods applies here as for accrued income. The only other point to be considered in connection with them is the basis for their valuation. Realizable values, i.e., what the items would bring under the hammer or at other forced sale, are manifestly inequitable. A three-year insurance policy with one year expired is to a concern which intends to avail itself of the remaining two years’ protection worth more than the surrender value of the policy calculated on the short-rate basis with perhaps the expenses of doing business also subtracted by the insurance company. Evidently to a going concern the protection enjoyed for the year just expired is worth neither more nor less than a pro rata share of the entire cost, nor are the remaining two years’ protection to be valued at a less rate because redeemable at a less rate. Hence, a valuation based on the going concern principle is to be used for deferred charges. As indicated above, this means, when used in this connection, a pro rata valuation based on the life of the supply and the portion unused. In the case of tangible supplies the rule can be most easily applied as a unit cost figure to the unused units still on hand. That is, an inventory of supplies is taken and valued at full cost. Although nearly related to current assets, deferred charges are seldom influenced by market fluctuations after they are once purchased, because if properly classed as deferred charges they are always held for own use and never for outside sale. Danger of Overvaluation Care must always be exercised—even more than in handling the stock-in-trade inventory—to see that there is no padding of this class of items. To this end, before taking inventory, a general clean-up of supply materials all over the plant is an exceedingly good policy. This should result in discarding, or reducing to scrap value, all obsolete and unusable supplies. Without such a clean-up it is easy, even when motives are of the very best, to carry forward from year to year as assets supply materials which will never be used and which are therefore nothing but expense items and should be charged against operation. Only a careful periodic appraisal of supply materials and an equally careful inventory indicating their usability can give a correct basis for applying the valuation formula. Two or three items of deferred charges need a word of further explanation. In some mining industries, notably coal and precious metals, leasing is done on a royalty basis with a minimum amount to be paid each period based on a minimum production of ore to be mined. If less than the minimum is mined, a frequent provision in the terms of the lease makes possible the application of any royalties overpaid one period against a future production of more than the required minimum. That is, no increased royalties are charged for a production over the minimum until all accumulated royalties from periods of underproduction are used up. In any period of underproduction such royalties may properly be treated as deferred charges only on condition that there is reasonable expectation that future production will increase to the point where it will consume the overpaid royalties of earlier periods. At times a company finds itself bound to such a contract, based on a minimum production, without any hope of relief because the prospect has not developed as anticipated. Under such conditions the entire periodical royalty charge is a charge against operation and must be absorbed entirely by the operations of each fiscal period. Accounting for Deferred Debit and Other Items The accounting for deferred debit items proceeds along the same lines indicated for accrued income. Nothing further need here be said than that such items as insurance, supplies of various sorts, etc., are frequently recorded originally as asset items instead of as expenses. At the close of the period so much of each of them as has been used is transferred to suitably named expense accounts and is thus taken into profit and loss. There is no objection to this and it usually works out very satisfactorily, although the usual practice is to treat all items of this class as expenses rather than as assets. This method is usually prescribed by regulatory commissions in the case of public utility companies. The treatment of premiums paid on long-term investments and of discounts arising through the marketing of long-term obligations at a figure below par is reserved for consideration in the next chapter where their relation to the interest account and the problem of amortization will be considered.