The Need for a Conceptual Framework
The purpose of this assignment is to think critically about the basis for accounting standard setting.
Demonstrate that you have looked over the assigned readings.
Improve ability to skim a document, find what is most important, and find the primary meaning and concepts.
University of Mississippi
American Institute of Accountants
Statement of accounting principles
Thomas H. Sanders
Henry Rand Hatfield
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Sanders, Thomas H.; Hatfield, Henry Rand; and Moore, Wm., “Statement of accounting principles” (1938).
American Institute of Accountants. 370.
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A S T A T E M E N T OF A C C O U N T I N G
Harvard University Graduate School
of Business Administration
University of California
School of Law
135 Cedar Street, N e w Y o r k
STATEMENT MAY BE OBTAINED
FROM T H E
INSTITUTE OF ACCOUNTANTS
135 CEDAR STREET, NEW YORK
75 CENTS PER COPY
discount on orders of ten or more)
A S T A T E M E N T OF A C C O U N T I N G PRINCIPLES
PREPARED B Y
Harvard University Graduate School
of Business Administration
University of California
School of Law
135 Cedar Street, New York
Haskins & Sells Foundation, Inc.
The executive committee of the American Institute of
Accountants believes the report contained in this booklet
to be a highly valuable contribution to the discussion of
accounting principles and has, therefore, authorized its
publication for distribution to all members of the Institute and others interested in accounting.
The standing of the three authors who collaborated in
the work will assure a wide and respectful hearing.
The profession is indebted to the Haskins & Sells
Foundation for the permission granted the Institute to
publish and distribute the report.
TABLE OF CONTENTS
Letter of Invitation to the Committee .
Letter of Transmittal
Principles of Accounting
General Acceptance of the Principles of Accounting .
The Statement of the Principles of Accounting
I. Capital and Income
A. Capital . . . . . . . . . . .
C. Distinction between Capital and Income 11
II. Conservatism in Accounting
A. Forces Tending to Conservative Statement
B. Application in Specific Examples . . . 14
1. Intangible Assets
2. Tangible Property
3. Current Assets
4. Inventory Policies
5. Contingency Reserves
6. Concealment of Profits
. . 15
7. Arbitrary Valuations
C. Conclusion as to Conservatism
. . .17
III. Form and Terminology of Financial Statements 17
A. Uniform Form of Statement . . . . 18
C. Amount of Information
THE INCOME STATEMENT
I. General Purposes
II. General Principles of Income Determination
III. Divisions of the Income Statement .
A. The Operating Section
B. The Non-Operating Section
IV. The Operating Section
A. Gross Revenues from Sales and/or Gross
B. Sales Discounts, Returns, and Allowances 29
C. Cost of Goods Sold and/or Operating
D. Depreciation . . . . . . . . .
1. Purpose and Amount of Depreciation 31
2. Accounting Treatment . . . . 33
E. Maintenance and Repairs
F. Gross Profit or Gross Margin . .
G. Selling and General Administrative Expenses
V. The Non-Operating Section
B. Capital Gains and Losses
C. Unrealized Profits
D. Unrealized Decline in Value . . . . 40
E. Correction of Past Errors
F. Net Income to Surplus .
G. Deficits of the Development Stage .
H. Provision for Inventory and Other Reserves
VI. Statement of Earned Surplus
A. Legal Requirements
. . .
1. There is neither Surplus nor Deficit
at the Beginning of the Period . 46
2. There is a Deficit at the Beginning
of the Period
3. There is a Surplus at the Beginning
of the Period
B. Records in the Accounts upon Declaration of Dividend
I. The General-Purpose Balance-sheet
. . .
II. Nature of the Balance-sheet
III. Balance-sheet Classifications
A. Fixed Assets
1. Property and Plant Assets . . .
(a) Reserve for Depreciation .
2. Intangible Assets
3. Investments for Control . . . .
B. Current Assets
2. Marketable Securities
. . . .
3. Notes and Accounts Receivable . .
5. Other Current Assets
6. Reserves against Current Assets .
C. Deferred Charges and Prepaid Expenses . 75
1. Bond Discount and Expense
V. Liabilities .
A. Long-Term Debt
B. Current Liabilities
C. Contingent Liabilities
VI. Deferred Credits to Income
VIII. Net Worth
A. Capital Stock
1. Designation of Stock on the Balancesheet
2. Stock Premium and Discount
3. No-Par Stock and Stated Capital . 87
4. Losses as Deductions from the
Capital-Stock A c c o u n t . . . . 88
B. Reacquired Stock
1. Reacquired Stock Distinguished from
Unissued and Canceled Stock .
2. Accounting Treatment . . .
3. The Purchase of Treasury Shares
“out of Surplus”
4. Readjustment of Plant Valuation
2. Surplus in the Balance-sheet. .
(a) Earned Surplus
(b) Surplus Other than Earned
3. Charges against Surplus . . . . 94
(a) Items Properly Charged . . 94
(b) Items Not Properly Charged . 95
(c) Items Which Should Be
Charged not against Capital
Surplus but against Earned
4. Pre-existing Surplus of Acquired
5. Surplus from Reduction of Capital
6. Surplus and Deficits
I. Purposes of Consolidated Statements . . . 101
II. Conditions in Which Consolidated Statements
III. Consolidated Balance-sheet
A. Valuation of Assets
1. Where Amount Paid Exceeds the
Net Book Value of Subsidiary. . 103
2. Where Amount Paid is Less than the
Net Book Value of Subsidiary . 104
B. Pre-existing Surplus
C. Minority Interests
IV. Consolidated Income Statement
Comments and Footnotes in Financial Reports .
SUMMARY OF ACCOUNTING PRINCIPLES
I. General Principles
II. Income Statement Principles
III. Balance-sheet Principles
IV. Consolidated Statements
V. Comments and Footnotes
117, et seq.
LETTER OF INVITATION TO T H E COMMITTEE
DR. T. H . SANDERS,
Graduate School of Business Administration,
DEAR DR. SANDERS :
The Haskins & Sells Foundation desires to make a
contribution to the subject of accounting principles, by
inviting a committee of men from the universities of the
country to make an independent and impartial study of
such subject and prepare a report which will be given
to the public.
By such means it is hoped that there may be established
a body of principles which will become useful in unifying
thought and which by its acceptance will serve to standardize accounting practices. Such a body of principles
would be valuable to corporation accounting officials who
are responsible for the preparation offinancialstatements, to the accountancy profession whose members
have occasion to render opinions concerning such statements, to the legal profession whose practitioners are required to prepare corporate charters, indentures, and
agreements involvingfinancialmatters, to legislators who
are charged with devising laws governing the organization and conduct of corporations, and to regulatory
bodies and divisions of the government which administer
laws involving accounting matters.
The need for the kind of study suggested has become
increasingly apparent, particularly during the past three
years. Sharp variations among the statutes of the different jurisdictions have existed for some time. These
statutes collectively are not only inconsistent and contradictory, but in some instances they permit practices
which are difficult to reconcile with dutiful business management. Federal agencies have issued regulations involving accounting principles which have resulted in
contradiction between agencies, and Federal regulations
involving such matters conflict frequently with those of
state regulatory bodies. The stock exchanges in their
efforts to promote greater publicity of corporate financial
information, the Federal government in its administration
of the securities act of 1933, as amended, designed to
afford adequate disclosure with respect to new issues of
securities, and through the securities exchange act to
insure the same information to the holders of and prospective investors in listed securities, have raised sharply
the question as to what are accepted principles of accounting. Notwithstanding the difficulties involved, accountants who certify tofinancialstatementsfiledwith
the Securities and Exchange Commission have been required by the regulations of that commission to express
an opinion concerning suchfinancialstatements and the
practices of the registrant in the light of accepted principles of accounting.
Accounting practices at present are based, in a large
measure, upon the ethics and opinions of reputable accountants, and to some extent upon the accounting provisions of the various laws, but wide variations of opinion
often exist among equally reputable practitioners. There
is no unified body of opinion, nor is there any official tribunal for thefinaldetermination of technical differences
Due and full recognition must be accorded to the efforts of those bodies which already have done much to
organize thought on these problems, as well as to the conscientious individuals who have labored to set up higher
standards of accounting infieldswhere such standards
hitherto had been unknown. The Securities and Exchange Commission, the New York Stock Exchange, the
Internal Revenue Bureau, the American Institute of Accountants, and the American Society of Certified Public
Accountants, the two latter through their technical committees, have all done much to condense experience into
sound and unified thought. But in spite of these efforts
the conditions above described still obtain. Furthermore, experience is constantly accumulating from the
actual operation of these various sets of accounting
Therefore, it would seem most appropriate and opportune that a committee composed of eminent accountants
and lawyers should be appointed to formulate a code of
accounting principles which would be useful in the clarification and improvement of corporate accounting and of
financial reports issued to the public. The work of such
a committee, if executed with care and vision, should be
not only a valuable contribution in the solution of many
perplexing problems in the present-day field of accounting and education, and in the rationalization of statutes
governing corporations, but should be an important public service.
The profession of accountancy owes to business, the
investor, the credit grantor, the educational institution,
and to itself the duty to accept the task of formulating
such a code of principles, as the legal profession has concerned itself, from time to time, with the clarification and
simplification of the civil and criminal laws of the
The Foundation understands that you are ready to
serve as chairman of such a committee, with Professor
Henry R. Hatfield of the University of California, and
Professor Underhill Moore * of Yale University as
fellow members. The Foundation thus appoints a com* Appointed March 20, 1936.
mittee of university men whose independence and impartiality will be unquestioned, in the belief that this will be
the most effectual means of supplementing existing
agencies working to the same ends, and that the committee will be able to enlist the assistance and support of
those who have the practical experience necessary to
The Foundation expresses the hope that the committee
will canvass the material available for a study of the
character contemplated, that it will seek the views and
opinions, with respect to accounting principles, of accounting officials of corporations, business executives,
credit men, investment bankers, bank credit men, statisticians, prominent and experienced public accountants,
teachers, practising attorneys, government officials, and
national and state accounting societies, and, in general,
of any one who may wish to be heard, to the end that
there may be evolved a reasonable number of accounting
principles, based on practical business concepts of capital
and income, which will merit the approval of those competent to judge of their soundness, and thus attain to
Your acknowledgment and formal acceptance will be
Yours very truly,
H A S K I N S & SELLS FOUNDATION, INC.
July 15, 1935.
LETTER OF TRANSMITTAL
HASKINS & SELLS FOUNDATION, INC.
New York, New York.
The terms “accounting principles” or “principles of
accounting” have long been current. Their use in business has greatly increased of late. Since 1933 a large
and increasing majority of auditors’ certificates published in company reports to stockholders have used the
terms. They are also found in statutes and other governmental regulations. The demand for a statement of
accounting principles has become insistent.
In response to this demand your Foundation requested
the undersigned to associate themselves together as a
committee to undertake a statement of accounting principles.
The committee began its work in the summer of 1935.
Before beginning the drafting of its statement of accounting principles, the committee made inquiry in four
directions. First, by means of personal interviews, supplemented by correspondence, the committee sought the
opinions of competent persons as to the matters which
should be dealt with in its statement, as to matters of current practice, and as to the more difficult and controversial relevant questions. Discussions were had in
various parts of the country with members of the several groups interested in accounting, the committee interviewing as many of the persons whose opinions were
sought as time permitted. Notwithstanding the inability
of the committee to hear many whom it desired to hear,
the investigation was carried far enough to make its rexv
suits fairly representative of accounting opinion throughout the United States. Second, the accounting literature
of the present and past was reviewed. Third, the necessary consideration was given to the statutes and decisions
referring to accounting. Fourth, by an examination of
current corporation reports and the attached certificates
of auditors, as well as by means of the interviews referred to, the committee attempted to keep before it the
current practices of accountants.
In the preparation of its statement the committee has
attempted to set forth the principles and rules of accounting which dictate what should appear in a balance-sheet
and an income statement and in the accounts from which
they are compiled. In its statement of principles the
committee has, where it was judged desirable, included
reasonably complete reference, with citations, to legal
provisions of concern to the accountant.
The committee desires to acknowledge with thanks the
assistance which it has received from many who have
given generously of their time and thought.
A report entitled “A Statement of Accounting Principles” is herewith respectfully submitted.
HENRY RAND HATFIELD,
THOMAS HENRY SANDERS, Chairman.
November 22, 1937.
OF ACCOUNTING PRINCIPLES
PRINCIPLES OF ACCOUNTING
The distinction between capital and income, which
every one recognizes and the economist attempts to state
with refined accuracy, is fundamental in accounting.
Making effective and effectively maintaining as near as
may be the distinction between the capital and income of
a particular enterprise are the ultimate objectives which
determine the activities of accountants and the functions
With accounts planned with an eye to these objectives
and accurately kept, and with statements made from them
without misrepresentation or concealment, accounting
facilitates the conduct of business, the achievement of its
purposes, and the orderly division of its income among
The accountant provides the principal business executives with statements offinancialcondition and results
prepared objectively as to the facts reported, but subjectively as to an understanding of the needs of those who
will use them. In this manner accounting performs its
function of assisting even the most constructive and
imaginative efforts of the executives, which efforts must
be based upon a clear understanding of thefinancialcondition, cost of operation, and resulting income of the business.
Accounting also contributes to the determination of the
various equities or interests in business. In so far as
these are defined in contractual relations, the determination is not normally a difficult one; trouble arises only in
the more unusual cases where carelessness, accident, or
NOTE:—All notes to which reference is made in the text will be found on
page 117, et seq.
misunderstanding has crept in. The position of bondholders is usually defined in the bonds and in the documents which accompany those instruments; most of the
disputes occur when the resources of the company become
inadequate to the meeting of the provisions there made.
The position of stockholders as owners of the residual
equities in the business is still more indefinite and subject
Furthermore, accounting facilitates compliance with
the various statutory requirements. For example, the
requirements of the Bureau of Internal Revenue and of
the Securities and Exchange Commission must be satisfied. While each of these Federal departments prescribes regulations to accomplish its own purposes, yet
compliance with the regulations would be impossible
without properly prepared accounts and statements.
In the performance of its functions accounting follows
certain conventional procedures which must be understood if accounting statements are not to be misinterpreted. First, the balance-sheet and income statement
are a resultant or composite of two very different classes
of information. Their first source is the historical record of all the transactions preceding them; but because
such a summary would fail to recognize many important
facts arising out of the conditions at the date of the
balance-sheet, another series of processes must be gone
through if a true picture of those conditions is to be obtained. These processes involve the exercise of judgment at all those points where accounting conventions
have come to require that the historical amounts be adjusted to something nearer to practical present-day conditions. What this means in detail will be developed in
the treatment of the several items of the balance-sheet
and income statement; broadly it involves the determination of the rates at which the historical cost offixedor
capital assets shall be written off as charges against in2
come, and the statement of the current assets upon a basis
which experience has shown to be safest and most helpful. These things can be decided only by the application
of intelligent and impartial judgment to all the facts of
the case. An understanding of the extent to which
judgment has thus entered into the preparation of accounting statements is essential to the comprehension of them.
Another important convention in accordance with
which statements are prepared is that the business is a
going concern which will continue to operate on a more
or less normal course. Everybody recognizes that a
forced liquidation would bring about large reductions in
the asset values; that intangibles would usually disappear
completely; that tangible capital assets would be sold at
near scrap values; and that even current asset values
would be seriously impaired. But such valuations are
not significant facts about the business in normal condition, expecting to turn its assets in the ordinary course
of trade. The course of trade is therefore one of the
factors to be taken into consideration when applying
judgment to the amounts to be stated in the accounts,
but this does not as a rule contemplate the forced liquidation of the business. What is sometimes referred to
among bankers as the “pouncing” value has no place in
the balance-sheet of a company which probably will not
be pounced upon for the satisfaction of its liabilities.
In addition to thefinancialand economic factors, one
other general element enters into the preparation of
financial statements, namely, the legal element. It is the
function of the liabilities side to show the amounts of the
different classes of equities or interests in the assets listed
on the other side of the balance-sheet. To this extent,
therefore, the principles of accounting are dictated by
legal considerations; in fact, it has been said that the
ultimate function of accounting is to make proper allocation between the respective equities. It is probable that
the managerial function is the most comprehensive of all
those which accounting must serve, but in any case the
legal aspects of the balance-sheet must be borne in mind
by all who would understand it.
Finally the purport of notations and exceptions appended tofinancialstatements by the accountant or included in his certificate should be understood. Neither
the company accountant, nor the public accountant who
sits in review and judgment, is called upon to judge and
review the facts under survey, but only the manner in
which the company officers are reporting those facts to
the end that the reader may have a clear basis for judging them. Qualifications, explanations, dissents, and
condemnations apply to the reporting job which the company has done, not to the question of what the accountant
thinks about the business.
Summarizing, it may be said that the functions of
1. Making a historical record, properly classified, of
all the transactions of a business enterprise;
2. Making from time to time the calculations and estimates necessary to a determination of thefinancialcondition of the business and its income;
3. From these historical records, calculations, and estimates, preparing from time to time statements showing
all the more important aspects of the capital and income
of the business and of the legal equities in them, satisfying thereby the need for information of all the parties
in interest, especially of:
(a) the management of the business,
(b) outside groups, such as investors and creditors,
(c) government, in such matters as taxation and
The problem of the methods by which these functions
may be adequately performed is the problem which this
statement of accounting principles attempts to answer.
The answer must be based upon experience, acquired in
attempting to perform these functions and illumined by
criticism. A statement of generally followed accounting
practices expresses that experience in detail. Reflection
upon the whole body of that experience is the basis of
criticism. The principles of accounting are, therefore,
the more general propositions describing the procedure
which should be followed in the making of records and
the preparation offinancialstatements, if the functions
enumerated are to be properly performed.
GENERAL ACCEPTANCE OF T H E PRINCIPLES
There is, it is believed, a corpus of principles of accounting which are generally accepted. It is true that
they are not “written law”; they have not been codified;
they must be sought in accounts andfinancialstatements,
in treatises, and in other evidences of professional opinion. It is true that they have not been adopted by vote
of the profession. But that they have been accepted is
evidenced by the common ways of thought and speech
which make communication in accounting matters possible, by the generally uniform practice of all accountants
when dealing with some situations, by the general agreement that, among all the possible ways of dealing with
other situations, only a few can be used with propriety,
by the restrictions of controversy in respect of propriety
to a relatively small number of situations out of the innumerable number about which disagreement is possible.
So fully is the existence of a body of accepted accounting
principles recognized that accountants commonly state in
their reports and certificates that the statements presented have been prepared “in accordance with accepted
principles of accounting.”
The existence of a body of generally accepted accounting principles does not mean that there is only one proper
accounting treatment for every situation with which the
accountant must deal. For many such situations, there
are available a number of treatments which are in accord
with the generally accepted principles. But the affirmation of the general acceptance of accounting principles
does mean that many and, indeed, most of the possible
treatments are inappropriate. The failure to see that it
is not the essential nature of a principle to forbid all
courses of action save one, that a rule of conduct which
permits some courses of action and forbids others is a
principle, explains, it is believed, the denial by some of
the existence of accounting principles and their general
T H E STATEMENT OF T H E PRINCIPLES
The activity during the last few years in the formulation of accounting principles evidences a demand for such
a formulation. The American Institute of Accountants,
particularly through its committees on accounting principles and on cooperation with stock exchanges, has
spoken for the public accounting profession. The
American Accounting Association has also published a
brief statement of principles. The Securities and Exchange Commission has issued its accounting regulations
for the administration of the legislation for which it is
responsible. The Bureau of Internal Revenue has enlarged the volume of its accounting rules for the determination of taxable income, and has become more
insistent upon conformity with them. Federal and state
utility commissions are constantly issuing new systems
of accounts, or revisions of old systems.
There is, however, no body within whose conceded
province lies the formulation of accounting principles.
Even the various agencies of the Federal and state
governments have not in their regulations attempted to
do more than state the accounting rules compliance with
which they judge necessary to the enforcement of the
statutes which they administer. Though the provisions
of these regulations, or some of them, may incorporate
a principle of accounting, no one of these sets of regulations attempts a complete statement of principles. Thus
the provisions of the regulations are not offered as general principles of accounting, but rather as directions as
to what must be done to comply with the statute administered. For example, it would probably be conceded that
a large part of all the rulings issued by the Bureau of
Internal Revenue are of the nature of accounting principles having general acceptance and application; other of
their regulations, however, have been adopted primarily
as measures of administrative convenience and expediency for the determination of taxable income and the collection of the tax, but would not be suitable or adequate
for purposes of business policy. In the case of the Securities and Exchange Commission, the purpose of the
regulations is the display of the truefinancialcondition
and earnings of the respective companies, which is the
most general of the purposes to which accountants may
address themselves. It is, therefore, probable that a
larger proportion of the regulations of the Securities and
Exchange Commission may be regarded as based on accounting principles of general acceptance and availability
than is the case with regulations of the Bureau of Internal Revenue. But even the regulations of the Securities
and Exchange Commission are limited by the provisions
of the legislation to which they give effect, and by the
conceptions of those who have sought to interpret that
legislation. The accounting systems of public utility
commissions show increasingly the tendency to be influenced by particular theories of regulation.
Consequently, it is neither untimely nor improper to
attempt a statement of accounting principles.
I. CAPITAL AND INCOME
Since the distinction between capital and income is fundamental in accounting and in business, it is desirable to
set forth working definitions of these terms.
1. Capital in its most general sense means a store of
wealth from the use of which the owner hopes to obtain
additional wealth. The capital of a business consists of
all its property or assets, bothfixedand current.
2. Capital in a narrow and technical sense refers to
the owner’s equity in the property or capital as defined in
(1) above. In this narrow sense, capital excludes borrowed capital, which is represented by the liabilities. In
turn, capital in the narrow sense divides into (a) contributed capital and (b) accretions from earnings or operation, these two parts being reflected in the phrase
“capital and surplus.”
1. Income is the increment in wealth arising from the
use of capital wealth, and from services rendered.
2. Income in the narrow sense is the owner’s share of
this increment. This is the income which it is sought to
define as “net income” in the income statement.
C. Distinction between Capital and Income
Thus it is convenient to think of capital as a store of
wealth existing at any one time, and to think of income
as the flow of increments in that wealth yielded by the
activities of the business.
Additions to the wealth of the business resulting from
further investments by the owner, or further contributions by lenders, are increases of capital and not income.
Similarly restatements of the money value of the same
capital goods, and actual increases in them, are increases
in capital in the narrow sense, and are not income.
Income normally arises from the sale of goods or services for amounts greater than their cost.
II. CONSERVATISM IN ACCOUNTING
There is a prevalent impression that, while overstatement of assets or earnings is a major fault, understatement is less objectionable, and may be a positive virtue.
It will be agreed at once that deliberate misstatement in
either direction is not to be condoned; but when, as frequently occurs, the demand is made for “accurate statement,” the subject may not be thus simply dismissed.
“Accurate statement” in a literal sense is not possible;
reasonable judgment must enter into many of the items
shown in the statements. In most of the cases where
understatement is alleged, the makers of the statements
assert that they reflect the more essential truth, and that
the difference is solely in the point of view. It is therefore proper to inquire into the circumstances which have
led to any bias which may exist in favor of understatement, to observe the principal forms which understatement is apt to take, and to appraise the consequences
A. Forces Tending to Conservative Statement
1. The common belief that less mischief is done by
understatement than by overstatement is, in the hands of
honest men, probably true; but with dishonest men understatement may serve their turn as well as overstatement.
2. With many and substantial exceptions, the more
common tendency is to err on the side of optimism in
exercising the necessary judgments of accounting; to offset this required an emphasis on the other side. This
policy should be followed whenever it is likely that the
tendency is towards overstatement. But when the tendency is in the opposite direction, the accountant should
act accordingly, and emphasize the more optimistic
3. Many leading bankers, lawyers, and business men
feel that a too great devotion to mathematical accuracy
in accounting statements may tend to mislead, or to
result in overlooking the broader aspects of the matter.
Men of experience know that political, social, and economic forces may cause losses which cannot be specifically foreseen, and they look to accountants of larger
mold to indicate the unfavorable possibilities.
This view requires that any statement shall show adequate reserves to provide against all reasonable contingencies, even though these are not susceptible of precise
definition or measurement. Whether these reserves will
be of the nature of appropriated surplus, or allowances
recording subtractions from specific assets, or general
contingency reserves, will depend upon the circumstances
of the individual case. In many instances, the management and its accounting advisers will have to decide as
best they may, knowing that the provision they are setting up partakes of the nature of more than one of these
categories. Undistributed surplus will, of course, accomplish in some part the same purposes, the unsatisfactory feature of this being that such surplus contains no
qualification to serve notice of the presence of contingencies which should be mentioned.
The net result of these considerations is that conservative statement reflects conservative management in the
past, and is likely to induce the same policies in the future.
The following instances illustrate the application of
the principle of conservatism.
B. Application in Specific Examples
1. Intangible Assets
The writing off of such intangible assets as goodwill
evokes scarcely any protest, even when it is recognized
that substantial goodwill exists. The general distrust of
goodwill and the knowledge that it has been widely used
to capitalize exaggerated expectations of future earnings
leave an almost universal feeling that the balance-sheet
looks stronger without it. When actual consideration
has been paid for goodwill, it should appear on the company’s balance-sheet long enough to create a record of
that fact in the history of the company as presented in
the series of its annual reports. After that, nobody
seems to regret its disappearance when accomplished by
methods which fully disclose the circumstances.
2. Tangible Property
Conservatism in the statement of tangible property,
and consequently of earnings, is for the most part a resultant of the policies with respect to depreciation and
maintenance, and means simply that larger amounts of
these have been charged to revenue than some others may
consider necessary. While it will be at once agreed that
these charges should be determined as accurately as possible, yet again there is room for considerable difference
of opinion. The experience of the last eight years has
demonstrated in many cases that policies which formerly
were regarded as unduly conservative turned out to be
only the barest prudence.
3. Current Assets
The debatable area with respect to the statement of
current assets is usually less than in the case of fixed,
since the former are not as a rule stated above currently
realizable values. There are nevertheless the same kinds
of doubt to be resolved, and when the more conservative
elements prevail, mere differences of opinion as to the
amounts of reserves to be provided against inventories
and accounts receivable need not give rise to charges of
deliberately excessive provision.
4. Inventory Policies
Such inventory policies as the base-stock method
frankly abandon the usual basis of keeping inventories
within the cost or market area. A long-time view is
taken; a low point is chosen as the inventory base price;
the ups and downs of current prices above that point are
ignored with respect to the base inventory; most of the
time the inventories stand in the balance-sheet at something much below either cost or market, and there results some equalizing of profits over periods of prosperity
5. Contingency Reserves
It is a well settled rule that reserves shall be set up for
specific contingencies which threaten with more or less
imminence and certainty; in such case it is preferable to
report the amount of the reserve and nature of the contingency, unless such announcement would unduly increase the contingency for which provision is being made.
General reserves for more remote and undefined contingencies are also sometimes necessary; indication should
be given, by their place in the balance-sheet or otherwise,
whether or not they are for the time being regarded by
the company as subdivisions of surplus.
6. Concealment of Profits
All the instances so far mentioned are within the limits
“that differences of opinion might condone.” There
remain those proceedings which amount to a deliberate
understatement or concealment of profits. An instance
is the practice, more common in England than in the
United States, which shows in the books an amount of
profits arrived at by generally accepted methods but in
the published report shows a smaller amount. The more
common devices are to reduce the inventory in the balance-sheet below the amount shown in the ledger, or to
set up in the books a segregation of part of the surplus
and, in the balance-sheet, to combine this with accounts
payable. It is clear that such practices constitute a misstatement of fact in any literal sense of the word. This
procedure is usually undertaken for the purpose of averaging profits over the years, so as to make a better showing in the lean years than the facts warrant. This, it is
asserted, enhances the company’s credit and prestige.
Doubtless it is procedures like these that are condemned in the passage:
It is equally important that the general and surplus reserves should not be used for the purpose of
equalizing earnings of a corporation over a period
of years. The practice of equalizing earnings is
directly contrary to recognized accounting principles.
This would be less true if the accounting procedure
adopted were announced in the reports.
The intentional concealment of profits is properly designated as the establishment of a secret reserve. The
other instances of conservatism mentioned above are
usually no more than the considered judgment of the
company and its accountants, and in these cases the term
“secret reserve” is not correct.
7. Arbitrary Valuations
The practice of attributing arbitrary amounts to certain balance-sheet items is usually based upon the flexi16
bility of capital-stock amounts and the legal sanctions
under which property paid for by the issue of stock may
be valued at the discretion of the directors. As a result,
balance-sheets have shown items of property and goodwill,
capital stock, and restatements of capital and surplus,
often in amounts having relatively little basis in actual
values. While exact agreement with real values cannot
be attained, yet accounts will be the more respected in
proportion as they avoid arbitrary orfictitiousvalues,
and reflect real values as nearly as possible.
C. Conclusion as to Conservatism
Proper reserves for all purposes should be insisted
upon; they are to be regarded as sound accounting and a
source offinancialstrength to the company. To this extent conservatism is to be commended. But to arrive at
profits on the books by recognized methods and then to
conceal part of them in the published report, is a practice
which cannot be approved.
A N D TERMINOLOGY OF F I N A N C I A L
While the form of a statement is in part a technical
question, it is also a contribution to the picture which the
statement is attempting to portray. The order of the
items carries some impression of their importance and
mutual relationships. In companies like railroads, public
utilities, and heavy industries, the amount and character
of their plant investments are of great significance, and
this importance is accentuated when the ratio of plant to
gross income is very large. But even in such case the
current position may be a crucial matter, and the general
tendency toward placing current itemsfirston both sides
of the balance-sheet has much in its favor. It is undesirable, however, to make hard and fast rules, and the
fact that companies in such industries have for years
placed their plant and property assetsfirstcreates a presumption in favor of continuing that practice.
When the business is a vast and complicated entity, its
financial statements are at best but very condensed summaries of the voluminous matter with which they deal.
It is, therefore, desirable that the accountant avail himself of every device which will convey to the reader, in
terms as clear and direct as possible, the results of his
decisions on questions of principle. Although questions
of form and terminology are in some senses not questions
of accounting principle, yet they enter materially into the
presentation of accounting results.
When it was the custom to prepare the balance-sheet
and income statement as mere copies of ledger accounts,
the item descriptions were of the barest sort, and nothing
was attempted in the way of exposition. But with the
statements being more and more read apart from the
books by people with no other information, lucidity and
comprehensiveness are obviously desirable and will be
(a) grouping the items into a few main classes;
(b) arranging the items in the groups, and the
groups in the statements, in a logical and consistent order;
(c) arranging the groups and items by proper headings and indentations to show their relationship to each other;
(d) using subsidiary columns for details, and main
columns for totals.
A. Uniform Form of Statement
There is considerable demand for a uniform form of
balance-sheet and income statement, based on the idea
that uniformity would eliminate bad accounting practices
and lessen misunderstanding. But, because of the essential differences between industries, complete uniformity is undesirable.
Advantage may be derived from the use of uniform
forms for (1) companies in the same industry and (2)
all companies when the statements are designed for limited specific purposes.
In the first case, forms of statements have been included in the uniform accounting systems worked out by
numerous trade and manufacturing associations for the
companies engaged in their respective industries. Uniform statements here aid comparisons between companies
most likely to be compared, which as a rule are small and
medium-size companies. The great industrial companies
of the country are so vast and complex that it is better
to have their own statements in a form which seems to
them preferable. Also in this class are the form of
balance-sheet included in the annual report which every
railroadfileswith the Interstate Commerce Commission
and the forms required by state public-utility commissions
under the uniform accounting systems prescribed for the
several types of public-utility companies. In general, all
reports to governmental authorities from specific types of
business, such as banks and insurance companies, are
prepared on the uniform form prescribed for each type.
In the second case are included:
( a ) The form of balance-sheet in the Federal incometax return for corporations, the purpose of
which is to assist the Bureau of Internal Revenue in auditing the return of income for tax
determination. Every corporation must file
this balance-sheet, and it is natural to use a
uniform form designed to serve the special
(b) The form of balance-sheet included in the report which many companies file with Dun
and Bradstreet, Inc., in order to obtain with
them a credit rating.
(c) The form of balance-sheet used by banks for the
purpose of determining the amount of credit
to be granted to borrowing corporations.
But it is noteworthy that the Securities and Exchange
Commission, in its requirements forfinancialstatements
to befiledwith it in connection with new issues or listing
upon national exchanges, has not prescribed a form, but
has set forth in some detail the information which it desires to have shown.
Much which has been said about the form of statements may also be said about terminology. A clear, concise, descriptive, and generally accepted terminology in
financial statements would undoubtedly be advantageous.
But such a terminology is largely an evolution from practical experience and cannot well be imposed by external
authority, even if such authority existed. Some progress is made from time to time. Thus the term “fund,”
at one time used indiscriminately to indicate a reserve and
a body of assets, is now, under the influence of the American Institute of Accountants, very generally restricted
to the latter.
C. Amount of Information
The amount of detailed information to be given in a
financial statement should be related to its purpose. As
regards statements prepared for the management, the
officers have the facilities for making their wants directly
known, and the means of realizing them. The needs of
management for information are, moreover, comprehensive enough to include practically all other needs. For
reports furnished to divisions of the Government the appropriate authorities will state their own requirements.
But it is necessarily left largely to the management to
judge what information it is appropriate to give to the
public. A number of powerful influences, statutory,
legal, commercial, andfinancialhave helped to define the
desirable practice. In the last analysis the question must
be answered on the basis of what the intelligent investing
andfinancialpublic need for their information; the better
examples of company reporting today substantially satisfy that need, and anything much more voluminous is
not necessary. Granting that the balance-sheet and income statement, with the usual supplementary schedules
and notes, should show every materialfinancialfact, the
question is, “What is material?” The definition of “material” by the Securities and Exchange Commission is:
“The term ‘material,’ when used herein to qualify a requirement for the furnishing of information as to any
subject, limits the information required to such matters
as to which an average prudent investor ought reasonably to be informed.”
(Instruction Book for Form 10,
1937, p. 5.) The solution must necessarily be relative;
nofixedmeasurements can be laid down, but the following rules should be observed:
1. Any general impression clearly conveyed by the
statements should be a true impression. The statement,
though technically correct, should avoid creating a false
impression in the mind of the reader.
2. No information should be omitted which, if disclosed, would materially alter the impressions given by
These rules apply with especial force to (a) the determination of the periodic income; (b) the showing of
the current position.
It should be remembered, in the application of these
rules, that although accounting statements contain information about the past and the present, investors and
credit agencies are constantly trying to read the future in
them. While the accountant cannot make himself responsible for these prognostications, yet he must know
that his statements will be put to such uses, and should
not include anything which will definitely mislead a person of ordinarily intelligent familiarity with such matters,
nor omit anything necessary to make the statements
T H E INCOME STATEMENT
T H E INCOME STATEMENT
I. GENERAL PURPOSES
The division of the life of a business enterprise into
fiscal periods has created the problem of determining the
income of the enterprise for each particularfiscalperiod.
This determination is a most important task of accounting. The preparation of an income statement is an attempt to perform this task. The income statement discloses,first,the procedure followed in making the determination and, second, the net income itself. In doing so,
the income statement exhibits the extent to which the
proprietorship has increased or decreased during the
fiscal period, with the exception of:
(a) additional contributions by stockholders or
(b) returns of capital contributions, and
(c) other exceptional increases and decreases discussed under “Capital Gains and Losses.”
The income statement may or may not show the appropriation of the income for the period for dividends, or
for other purposes.
II. GENERAL PRINCIPLES OF INCOME DETERMINATION
A. All income and all expense should be correctly allocated to the periods to which they apply. In this way the
net income of the period under consideration will be
properly ascertained. In any business a considerable
proportion of the income and of the expense will be so
clearly associated with the period under consideration as
to raise no question about its allocation. But in nearly
every business an appreciable proportion of both income
and expense is either plainly identified with a prior or
later period, or its allocation is in doubt. The principles
of accounting furnish a guide for the treatment of these
areas of doubt, but there must always be a considerable
exercise of judgment in arriving at the best procedure.
The proportion of the total income and expense thus depending upon experienced judgment varies greatly from
relatively small amounts in businesses of quick turnover
and smallfixedinvestment to very large amounts in businesses of slow turnover, long-time contracts, and large
fixed investment. In businesses of the former class the
financial statements may always be prepared with greater
assurance of correctness than is attainable in the latter
class of business.
B. Since the income statement is prepared for the information Of owners, managers, creditors, and taxing
authorities, and for regulatory and other purposes, those
accounting practices are best which serve these purposes
in the most reliable and helpful manner.
It sometimes becomes necessary to prepare separate
statements to serve the several purposes. The different
statements should be reconcilable with one another, and
the purpose of each should be always to afford a substantially sound view of the facts to those to whom it is addressed. Furthermore, since reliable information is the
main objective of an income statement, for whatever purpose prepared, no considerations of policy should prevent
a true showing of the facts.
C. While technical form and terminology may be helpful in achieving precision, they should be freely departed
from whenever they obstruct a plain showing of the
facts. Informative comment on the income statement is
desirable whenever it will conduce to added understanding of the facts. But when the facts as such have been
clearly stated to the intelligent reader, interpretation
should be left to him.
D. In general the problems of income accounting end
with the ascertainment of the net income of the business
entity for the period. But this amount is inevitably
made up of several economic elements, such as interest
on the proprietors’ investment, compensation for risktaking, and reward for superior enterprising. But it is
not practicable to record such subdivisions of net income
in the regularfinancialaccounts. If the proprietors desire to consider the several economic elements of income
in relation to their management problems, they may do
so by means of statements other than the regular financial accounts.
DIVISIONS OF T H E INCOME S T A T E M E N T
The income statement should be divided into at least
two sections, an operating section and a non-operating
A. The Operating Section
A somewhat liberal definition of what constitute “operations” is permissible in the preparation of this section.
It must include the operation of the main functions of the
enterprise. It need not include incidental operations.
It must exclude the interest cost on borrowed funds.
Items of income and expense should not be treated in
the income statement in such manner as to make it impossible or difficult to ascertain the net operating income.
B. The Non-Operating Section
This section, if only two sections are used, should include such items as profit on sale of capital assets, interest, unrealized gain from appreciation (if shown at all as
income), and gains and losses due to causes not connected with the immediate management of operations.
T H E OPERATING SECTION
A. Gross Revenues from Sales and/or Gross Operating Revenues
The gross revenue of the business will ordinarily be
the total of the billings for the period for goods sold or
services rendered. If the company sells goods and renders services, both in considerable amount, the two
sources of income should be shown separately. Any
other subdivision or classification of gross revenues
which is significant to those concerned should be
Care should be taken that no items are included both
in sales and in inventories still on hand and that the same
procedure as to this separation is observed at the beginning and at the end of the period.
The amounts used in recording sales in the ledger will
be the invoice amounts, with cash discounts, returns, and
allowances shown in separate accounts. The income
statement should show the treatment of all these elements. Terms like “sales,” “net sales,” “gross sales” are
used so variously that the situation is not clear unless discounts, returns, and allowances are either (1) shown as
separate items, or (2) mentioned as qualifying the sales
In a consolidated income statement, sales will represent only sales to customers outside the consolidated
group. Intercompany sales within the group should be
eliminated. When a consolidated company also reports
as a separate unit, it should show two amounts: (1) sales
to other members of the consolidated system; (2) sales
outside the system.
Since sales are thus made the basis of income determination, it is important to define sales in terms which
conform with this purpose. With few exceptions only
sales which convey title to another in exchange for cash,
a legal claim, or other valuable consideration are properly included. The amount should, therefore, not include :
1. Consignments to an agent or branch still held for
2. Approval sales, untilfinalacceptance of the goods.
3. Instalment sales, where the payment period is long
enough and conditions uncertain enough to require treating some portions of the sales as deferred income. In
such cases income is to be reported on a collection basis,
rather than on a sale basis. If, as collection experience
accumulates, it appears that a high degree of safety attends this class of business, it is proper to record all sales
as gross income for the period, subject to provision for
4. Subscriptions and contracts for delivery or completion in a future accounting period. Subscriptions to
periodical publications, insurance premiums paid in advance, and contracts for future delivery are examples.
Obviously accounting must consider the precise terms of
the contracts and all other circumstances; it will in general take up income only as the contracts are completed
by delivery of the goods or services. The accounting
should be consistent from period to period and should
avoid having any period anticipate the income of succeeding periods. Long-time contracts of large amount,
which authorize installment billing as parts of the work
are completed, thereby justify including the amounts
billed in gross income, even though delivery in the ordinary sense has not been made.
B. Sales Discounts, Returns, and Allowances
Items of this character are either deductions from
billed prices or actual cancellations of billings because of
goods returned. In either case the items are to be treated
as deductions from gross sales, in order to arrive at the
actual net amount received or receivable from customers
as total revenues.
Some forms of allowance are offered to customers as
part of the selling activities, directly designed to increase
sales. The accounting classification should distinguish
between sales allowances to be treated as deductions from
gross revenues and those to be treated as selling expenses, in the light of all the circumstances.
C. Cost of Goods Sold and/or Operating Expenses
These amounts should be consistent with the determination of gross sales or gross operating revenues. In
principle the costs charged should be the specific costs of
the specific goods and services sold, and this principle
should be followed as far as may be practicable. There
should be no material discrepancy between the physical
quantities on which the sales revenues are based and those
included in the computations of cost of goods sold.
The statements should in some way indicate whether
the cost of goods sold has been arrived at by an inventory
method or by direct costing. In the former case it is
desirable to show the inventories, either in the income
statement itself or in a supplementary schedule.
Cost of goods sold and operating expenses should be
subdivided to correspond with subdivisions of gross sales
and gross operating revenues.
A consolidated income statement will omit intercompany transfers from cost of goods sold, to correspond
with their treatment in the sales revenue figures. Similarly, each consolidated company will show separately
(a) cost of goods sold to other members of the consolidation, (b) cost of goods sold outside the system. This
will make possible the elimination of intercompany profits
from the consolidated statements.
Similarly, profits on transfers between departments, if
used for any purpose, should be eliminated from the
accounts before determining cost of goods sold. If the
management desires to show profits on interdepartmental transfers, this will preferably be done outside the regularfinancialaccounts. It is recognized, however, that
in certain cases of joint products and joint costs, the costing of secondary products or by-products at current market prices may have such practical advantages as to justify
it, provided it is reasonably and consistently applied.
The division of expenses into those to be included in
cost of goods sold and those to be treated as subsequent
income deductions may be left to the judgment of the
management. In making this division it should be borne
in mind that usually, though not necessarily, it determines also the cost items to be included in the inventory
Only those principles of depreciation which affect the
income statement are dealt with here; those affecting the
balance-sheet are discussed in the appropriate place.
1. Purpose and Amount of Depreciation
There is much difference of opinion as to the purpose
of the accounting provision for depreciation and, hence,
much difference in practice as to the amount to be provided. On these questions the following observations
(a) The main purpose of the accounting provision for
depreciation is to allocate to the period a proper amount
of operating expense. A further purpose is to maintain
the capital investment intact.
(b) The question is frequently debated as to whether
the provision for depreciation should cover the actual
cost or the cost of replacement. In so far as the average
of the costs of a composite plant and the average replacement costs as distributed over the years will show little
divergence, the problem becomes of little moment. But
the uncertainty of any estimate of replacement cost
makes it a less desirable base for computing depreciation
than the known original cost, and the latter generally
(c) The other factor in the computation is the estimated service life of the property. This should take account of both physical wear and tear and functional
obsolescence. What is wanted, therefore, is the estimated service life, from whatever cause retirement may
(d) It is agreed among accountants that the allocation
of the total depreciation to the several fiscal periods
should not be capricious, though there is no consensus as
to the preferable method. In the United States the
straight-line method commonly is used; in England the
reducing-balance method. Until some agreement is
reached, the use of either, or of any of several variant
methods, may be considered good accounting practice.
There should, however, be some indication of the method
used, and the method should be consistently followed.
(e) The question of the adequacy of so-called retirement and similar methods of providing for depreciation
can be answered only from an examination of the total
amounts actually provided for depreciation and maintenance over a considerable period. It is the sum of
the two which is to be regarded as adequate or inadequate.
(f) In the opinion of many competent observers, retirement methods do in fact result in inadequate charges
for depreciation, especially when considered with respect
to the maintenance of the original investment. It cannot be top strongly urged that the maintenance of the
original investment, by adequate charges against earnings, is the principal means by which the physical plant
itself is kept in up-to-date operating condition.
2. Accounting Treatment
One of the few topics relating to accounting on which
there is general agreement is that depreciation involves
a charge against the earnings of the period. A competent authority reached the conclusion that practically all
manufacturing corporations treat depreciation of plant
as part of their cost of production.
There is, however, considerable difference in practice
as to the place in the income statement at which the depreciation charge appears. Because of the desirability
of clearly showing the amount of depreciation it is often
not included with wages, fuel, etc., in a single total, but
is shown as a separate item. No item should be designated as operating income, and still less as net operating
income, before the deduction of depreciation expense.
It is satisfactory to arrange the income statement either:
(a) with depreciation expense definitely included
in operating expense (as by the Interstate
Commerce Commission), or
(b) with depreciation not so treated, but in such a
form that one can ascertain:
(1) the remainder after subtracting other
operating expenses from sales, or
(2) the amount of depreciation as a separate
By this method the ascertainment of net operating profit
is easily made. Either of the following arrangements,
taken from published statements, is satisfactory:
Cost of Sales and Other Operating Expenses
(including depreciation $3)
Gross Operating Profit
Net Sales Billed
Cost, Expenses and All Charges (except depreciation and interest)
Depreciation of Plant and Equipment
Net Income from Sales
E. Maintenance and Repairs
There should be charged against the earnings of the
period all the costs of normal and ordinary repairs and
maintenance necessary to keep the plant in good working
order. In so far as operation above or below normal
may require more or less than ordinary expenditures for
maintenance, it is reasonable to charge larger or smaller
amounts against current revenue. While the primary
purpose of the accounts is to record the amount actually
incurred during the period for these purposes, consideration must also be given to the adequacy of this amount to
maintain the property in good working order. If all the
costs of ordinary repairs and maintenance have not been
charged, the accounts should in some way indicate that
Reserves to equalize maintenance over the months of
thefiscalyear, or even over successive fiscal years, may
properly be employed, so long as the practice is clearly
It is essential to distinguish (1) maintenance expenses,
(2) additions and betterments, and (3) retirements.
Thefirstare to be charged against revenue, the second
to the property accounts, and the third to the reserve for
depreciation, in so far as a reserve has been provided for
these units, and otherwise to a retirements-expense account. Where retirements charged to the latter account
are normal and recurring, they should be treated as an
additional maintenance item to be deducted from revenue.
Probably the most accurate way of making these dis34
tinctions effective is by the use of a “units of property”
system, as required by some public service commissions.
But care should be taken to see that a technical accuracy
does not lead to an unconservative statement of the property accounts. Thus, while the careful operation of
such a system of recording additions and retirements of
plant units insures that the plant account properly reflects
the physical units of which it is composed, equal care
must be taken that installation and other attendant costs
are included not more than once in the property accounts.
Net costs of demolition and removal are ordinarily to
be charged against revenue. The general rule is that the
property accounts should contain charges only for the
cost of the property in being at the time, all other charges
to be made against revenue.
While maintenance charges are thus related on one
hand to the charges for property additions and subtractions, they are related on the other hand to depreciation
charges. It is the sum of these three factors which reflects the total plant situation. Recognizing that the
question is largely a technical and engineering one, the
accounts should include everything which will throw light
Broadly speaking, a plant should be maintained out of
revenue in a state of efficiency corresponding to the normal progress of the manufacturing arts in that industry.
Whether the charge be carried through the maintenance
or the depreciation accounts is secondary.
In so far as maintenance charges are made against
revenue, there is little point in charging part of the general overhead to maintenance. But when the maintenance department is also engaged upon new construction
to be charged to the property accounts, care must be
taken not to charge to the maintenance department any
share of general overhead that would ordinarily be
charged to cost of property sold.
Maintenance expense may, for managerial purposes,
be allocated among the manufacturing, selling, and administrative divisions, according as they have been served
during the period. The part thus allocated to manufacturing will become merged in the cost of goods sold and
in the inventoryfigures;yet it may be desirable, under
certain conditions, to show the total amount of repairs
for the period in the published income statement. This
is a matter which must be dealt with as reasonably as possible; often it is necessary to resort to a separate schedule, supplementary to the income statement proper.
F. Gross Profit or Gross Margin
The difference between gross revenues and costs is the
gross profit or gross margin.
The significance of thisfigureis sometimes debated.
Clearly it depends first upon the precise make-up of the
cost of goods sold. In a manufacturing company this is
usually the cost of making the goods; in a trading company it is usually the purchase invoice cost of the merchandise plus freight. There has been some discussion
as to whether a gross margin may not be significant for
a bank, computing it as the difference between interest
received and interest paid. In the case of department
stores the Securities and Exchange Commission has authorized the inclusion of certain buying and even advertising expenses in the cost of goods sold.
Two types of questions are here involved, (1) those
arising from the structure of the business as seen by its
managers and (2) those concerned with the items which
it is desirable to show separately in published statements.
It is desirable that the companies in each industry should,
as far as possible, agree upon uniform practices. It is
also desirable that discussion as to the public disclosure
of the various items should not obscure the value to managers of an adequate and logical classification.
G. Selling and General Administrative Expenses
In a purely trading business these items will be the
principal operating expenses, and should therefore be
carefully classified. In a manufacturing business they
may be no less important in amount, and should receive
As a general rule, no part of selling and general administrative expense becomes a part of the inventory
value of merchandise on hand. There is an exception to
this rule in the case of goods manufactured to order; in
that case work in process andfinishedgoods on hand
have in effect been already sold, and there can be little
objection to the inclusion of a proper proportion of selling costs in their inventory value.
The practice of some companies of apportioning general administrative expense between manufacturing and
selling, on the ground that those two functions are the
main activities of the business, may be approved, provided the allocation is reasonably made.
The different bases of assessment of property, income,
and other taxes justify the usual practice of treating
them separately in the accounts. In the income statement it is proper to include taxes other than income taxes
in operating expenses and to treat income taxes as a later
deduction from income. The growing desire to show the
total burden of taxation is a reasonable one and may be
satisfied by grouping all taxes together in the income
statement, or by narrative comment or comparison.
V . T H E NON-OPERATING SECTION
The magnitude and character of the company’s operations are to be considered in determining which items of
income and expense should be included in, and which
should be excluded from, the operating section. For ex37
ample, in a steel plant all the necessary transportation
may well be treated as “operation”; but holding stocks in
other companies in unrelated industries is outside any
normal meaning of “operations,” and the income from
them is therefore to be shown in the non-operating
The items of income and expense excluded from the
operating section and placed in the non-operating section
should be classified according to their source, and the
titles should make the classification explicit.
In view of the fact that income and expense items are
ordinarily of a regularly recurring nature, any items of a
nonrecurring character should be so described. This
rule applies equally to income and expense, but is disregarded more often with respect to income items.
It is desirable to show the division of the earnings of
the business as an economic enterprise between those who
furnish capital on loan at fixed interest rates and the
stockholders who take the residuary gain or loss. Interest will thus be a separate charge against earnings.
B. Capital Gains and Losses
So-called “capital gains” and “capital losses” are conspicuous examples of occurrences affecting the asset
values of a business enterprise for which accounting
practice discloses no generally followed or standard
method of accounting. The principles which should determine how such losses or gains should be accounted for
are discussed in that section of this report which deals
with conservatism in accounting. Whether such gains
or losses should be wholly included in the current income
statement, wholly excluded from all income statements,
or apportioned among the current and succeeding income
statements is a matter to be determined by sound business
judgment, made upon all the facts of the particular case,
guided by the principle of conservatism. When sound
business judgment dictates the entire or partial exclusion
of such a gain or loss from the income statement, it is
proper to carry it, or the portion of it excluded, on the
balance-sheet as a deferred charge clearly described, or
as an additional item in the net-worth section, leaving the
existing surplus accounts unaffected, unless and until
sound business judgment dictates the absorption of such
gain or loss in one or more of the surplus accounts.
There is some opinion in favor of passing all capital
losses and gains through the income statement, on the
ground that resort to surplus account may be misused to
relieve the income statement of proper charges, and to
the end that the income statements may cumulatively
show all changes in net worth. Some capital gains and
losses are, however, sufficiently abnormal to have no direct relation to current income, and sufficiently large to
distort current income, even when clearly shown as separate items. In such cases charges or credits to surplus
are justifiable. In cases of doubt the tendency should
be to include such items in the income statement.
A consistent policy will include like treatment of related gains and losses. Divergent treatment of gains
and losses from the same source are particularly to be
C. Unrealized Profits
In general, it is not proper to include in the income
statement any profit arising from appreciation of unsold
assets. The objection is not overcome, even when it is
indicated in the report that such amounts are not available for dividends.
In the case of some commodities, such as grain or cotton, regularly quoted and readily realizable on an organized exchange, it may be the most convenient thing to
value inventories on the basis of the current quotations.
Market value is one of the alternatives allowed in valuing
inventories of securities held by a dealer. [Reg. 94,
Art. 22(c)-5.] No great harm can result from taking
up the resulting profits or losses in such cases, provided
(a) a consistent policy is followed, (b) the practice is
clearly disclosed, including the possible effects on dividends.
As to unrealized gains on capital assets, there can be
no justification for including these in current income.
In general, such gains should not be recorded; but if special reasons seem to require it, the credits should be to
D. Unrealized Decline in Value
Accepted accounting practice requires that unrealized
declines in the value of current assets should be reflected
in the income statement.
Unrealized declines in capital assets, other than those
to be provided for by depreciation, are not ordinarily to
be recorded. When unusual declines of large amounts
have taken place and are likely to be permanent, the assets
may be written down against capital, or capital surplus,
or earned surplus. Write-downs resulting from inadequate depreciation in past years are proper charges
against earned surplus; write-downs recording catastrophic physical or economic destruction of capital may
be proper charges against capital or capital surplus. No
such step should be taken without full consideration of its
effect in reducing subsequent charges against income.
E. Correction of Past Errors
When, in computing profits for a past accounting period, an error has been made the correction of which does
not involve an amount so large as materially to distort the
income statement for the current period, the error may
properly be corrected through the income statement
rather than through surplus. Since by assumption such
corrections in the income statement are small in amount,
they may properly be combined with the items to which
the corrections apply. If, however, the amount involved
is sufficiently large to distort materially the income statement for the current period, the correction should not go
through income, but through surplus.
F. Net Income to Surplus
The net income of the period is carried to surplus.
But dividends may first be charged, in which case the
balance is carried to surplus. In either case the amount
so carried to surplus, and the reconciliation between the
income statement and surplus in the balance-sheet, should
be clearly shown.
It is not proper to describe net income as “available for
dividends”; the question of availability for dividends involves other considerations in addition to the determination of net income.
G. Deficits of the Development Stage
It is sometimes considered that early deficits (operating losses sustained in the developmental years of a
business) are subject to different accounting rules from
those which apply to the going concern. Well known
examples of such different treatment may be cited, but it
is doubtful whether they fulfill the present requirements
of accounting. Discussion of the problem may conveniently be divided into (1) determination of the deficit,
(2) its disposition.
1. In the early years, but after completion of the physical plant, some expenses, such as maintenance, naturally
will be less than in later years, and it is sufficient to show
what they are. Furthermore, it may be justifiable to
charge to Development (an asset account) some expenses
which later may regularly be charged against income.
Or it may be better to make all the charges to income and
carry forward the resulting net deficit as an intangible
asset. In any case the accounts should indicate what has
2. Normal and expected losses incurred in developing
a business to full capacity may reasonably be charged to
asset accounts, though it would be more conservative to
carry them as deficits until they may be charged off
against ensuing earnings. This decision may be left to
competent judgment, which will consider: (a) that whatever course is followed should be clearly shown; (b) that
such deficits should not be converted into assets purporting to be tangible, but only into intangible assets; (c) that
such procedure is justifiable only when the expectation of
future earnings affords hope of earning a return on such
assets, or of amortizing them; and (d) that the fact that
the business may, upon reaching maturity, be transferred
by reincorporation to new proprietors (while introducing
the new element of the actual investment of these new
proprietors) should not be permitted to conceal the true
character of the predecessor company’s investments
and assets. At this stage the problem becomes one
of asset determination rather than of income determination.
H. Provision for Inventory and Other Reserves
The charges to be made against income for writing
down inventories or other assets, or for setting up reserves other than the customary ones for depreciation and
doubtful accounts, give rise to some of the most difficult
questions for the accountant.
When inventory is valued at market because it is lower
than cost, a vigilant management will wish to know the
amounts of such write-downs, and the accounts should
provide the information. When these amounts are large,
there is some justification for the demand that they be
If the management wishes to go further and adopt a
still more conservative policy with respect to inventory
valuation, calculated to reduce thefluctuationsin profits,
that should be regarded as well within its province. The
base or normal-stock method is a notable example. It is
not, as some suppose, an artificial treatment of the figures; on the contrary, it takes cognizance of two important facts:first,that a minimum inventory is a constant
necessity to the operating company, and second, that in
times of prosperity the incipient conditions of depression
are already present. The basic question is, what is the
accounting period? A narrow adherence to the conditions and figures for the one year will exclude any
notice of what may come after, while a recognition of
the fact that the year is simply a chapter in the company’s history may lead to adoption of sounder policies.
If the base or normal-stock method is clearly explained
in the annual reports, especially as is sometimes done,
with tables showing the adjustments, a reader can compute for himself the approximate effects of the policy,
and can adjust inventory and profitfiguresif he chooses.
If a company can show a strong current ratio with inventories on the base-stock method, the ratio would be
still stronger if they were stated on the usual basis. In
these circumstances the base-stock method seems to be
within the bounds of proper accounting principles. The
policy of the Bureau of Internal Revenue in disallowing
this method, while it may simplify the determination of
income for tax purposes, is probably not a wise public
policy in the long run. The subject of inventory valuation is further discussed in Part III, p. 73.
Similar considerations apply to other provisions for
future losses and contingencies which, though but dimly
seen, are known to be incidental to business operations,
though their date and exact character are not known.
Any reasonable provisions of this sort which the management may honestly consider necessary should be made,
and will conduce to thefinancialstability of the company.
If the anticipated losses are really imminent, and arise
from conditions already operative, then it is reasonable to
accumulate provision for them out of current income;
otherwise the provision is more properly made by appropriation of surplus. The only other relevant accounting
principle is that the accounts shall show in sufficient fullness what has been done.
It is not intended here to condone any accounting practices of an arbitrary or capricious character, even though
fully disclosed. It is essential that the policy adopted be
based upon careful consideration of all the circumstances
of the business and be consistently followed.
This is one of the matters for which governmental administrative bodies are not likely to make adequate provision in their prescribed accounting rules. The Bureau
of Internal Revenue and the Federal and state commissions for regulating utilities may have objectives in mind
which are likely to lead to an adherence to rigid rules, an
insistence upon the conditions of the year, or other statutory requirements, rather than to farsightedfinancialand
accounting dispositions such as the prudent business man
would wish to make.
VI. STATEMENT OF EARNED SURPLUS
The income statement should be accompanied by a summary of the earned-surplus account. Either this may be
incorporated in a single statement of income and earned
surplus, or the earned surplus may be shown in a separate
statement. In either treatment there should be shown:
Earned surplus at the beginning of thefiscalperiod.
Adjustments representing corrections or modifications of earlier entries.
Amount transferred to earned surplus from income.
Unusual gains or losses which have not been included in the current income account.
Appropriations charged to surplus for dividends or
for other purposes.
There may also advantageously be shown a summary of
capital surplus, especially when entries have been made in
this account which affect the net worth of the enterprise,
but which are not considered as pertaining to current or
V I I . DIVIDENDS
A. Legal Requirements
Dividends declared during the accounting period may
be shown either at the end of the income statement as a
deduction from the income of the period, or as a charge
on a separate surplus statement. Whether a dividend
was justified under the circumstances is a question, first,
of law and, second, offinancialpolicy, but the accountant
may be required to comment upon both of these questions. This report is no place for a discussion of all the
factors which should control policy with respect to dividends. But it is appropriate to state briefly the effect of
the statutes and decisions which express that part of
American corporation law applicable to dividends.
The principle which the statutes and decisions, for the
most part, seek to effectuate is that no dividend may be
paid unless after such payment the amount or value of
the property of the corporation will be at least equal to
the aggregate of (a) its liabilities and (b) the stated
amount of its capital, i. e., the amount required by law to
be invested by the stockholders as a condition to doing
business as a corporation with limited liability. Thus
the amount of capital stock or stated capital operates as
a limitation upon the payment of dividends. The legal
application of this principle will be treated on three assumptions as to conditions existing at the beginning of
the period for which it is proposed to declare a dividend,
namely: (1) the net worth of the corporation equals its
capital stock or stated capital (there is neither surplus
nor deficit) ; (2) the net worth of the corporation is less
than its capital stock or stated capital (there is a deficit) ;
and (3) the net worth exceeds the capital stock or stated
capital (there is a surplus).
1. There is neither Surplus nor Deficit at the Beginning of the Period
(a) Legal rules for the determination of income
available for dividends
In thefirstsituation assumed, the question whether the
corporation may lawfully declare a dividend, and the
amount of it, will dependfirstupon whether the corporation shows an income for the period determined according to the legal rules for computing income available for
dividends and the amount of such income. The statutes
and judicial decisions have, in general, left to accounting
principles and sound business judgment the determination of income available for dividends. There are, however, a few matters relative to the determination of income which are dealt with specifically by legal rules; it is
convenient to state them here, although they apply also
to situations 2 and 3 dealt with hereafter.
(1) Depreciation. A few of the corporation acts
specifically provide that depreciation must be deducted in
determining the income available for dividends, but they
do not attempt to set out the method by which the amount
of depreciation shall be determined. The typical requirement is that “proper allowance” shall be made for
depreciation sustained. Judicial opinions have, with
few exceptions, recognized that depreciation should be
taken into account.
(2) Wasting assets corporations. In the case of cor-
porations engaged in the exploitation of so-called “wasting assets,” such as mines and oil wells, the payment of
dividends may be made upon a computation of income
without a deduction for depletion. The California statute provides that no such dividend may be paid unless
there is an adequate provision for meeting debts and the
liquidation preferences of outstanding stock. Similar
restrictions are contained in the statutes of Indiana,
Louisiana, Minnesota, Pennsylvania, and Washington.
In the absence of a specific statute a few decisions have
approved the payment of a dividend upon a computation
of income without deduction for depletion. On the
other hand a Delaware court, prior to the amendment of
the Delaware act to allow such a dividend, refused to
(3) Unrealised profits or appreciation. The more
recent corporation acts prohibit the payment of dividends
in cash or property out of surplus arising from unrealized appreciation in asset values. In the absence of
statute the few reported judicial opinions express or imply the same doctrine as these recent acts. The prohibition in most of the recent acts does not extend to stock
(b) Types of statutes imposing general restrictions upon dividends
Having properly determined whether there is an income for the period available for dividends, and the
amount of such income, the legality of a dividend payment will depend further upon certain general dividend
restrictions designed to effectuate the principle that no
dividend may be paid unless, after such payment, the
value of the property of the corporation be at least equal
to the aggregate of its liabilities and its capital stock or
stated capital. There are four types of such restrictions.
(1) Thefirsttype of statute provides that dividends
may be paid only from surplus, that is, only to the extent
that the value of the property of the corporation exceeds
the capital stock or stated capital. This means, in the
case assumed, that no dividends can be paid in the absence
of surplus for the period. If there is such surplus for
the period, the assets will exceed capital stock or stated
capital by the amount of such surplus and, in the
absence of a contrary agreement with the stockholders
or others, dividends lawfully may be paid up to that
(2) In a few states dividends may be paid only from
earned surplus, that is, only when the surplus has arisen
through income. If there is an income for the period
available for dividends and if, as has been supposed, there
were no earned surplus at the beginning of the period,
dividends may be paid under this type of restriction up
to the amount of such income.
(3) A third type of statute allows the payment of dividends out of current income, even though the transactions of past periods have resulted in a deficit, provided
there is no stock outstanding having a preference upon
the distribution of assets.
(4) A fourth type of statute adds a general insolvency
limitation to one or another of the three foregoing limitations. Frequently the statutes do not make clear
whether the term “insolvency” should be taken to refer
to (a) the inability of the corporation to meet its debts
as they fall due or (b) the excess of debts over assets.
Where the insolvency limitation exists and where it is
taken to refer to the inability of the corporation to meet
its debts as they fall due, the legality of a dividend
will depend not only upon income or surplus for the
period but also upon the liquidity of the assets of the
corporation and the amount and maturity date of its
2. There is a Deficit at the Beginning of the Period
The legal restrictions upon the payment of dividends in
this situation will be discussed with reference to each of
the principal types of dividend statutes just described.
(a) Under the type of statutory provision that dividends may be paid only from surplus, no dividends may
be paid unless there is a surplus for the period, determined in accordance with the legal rules for determining
surplus for dividend purposes, and such surplus is
greater than the pre-existing deficit. If the surplus for
the period, properly determined, exceeds the amount of
the preexisting deficit, dividends may be paid, in the absence of a contrary agreement with the stockholders or
others, up to the amount of such excess.
(b) Similarly, under the second type of statute, providing that dividends may be paid only from earned surplus? unless there is an income for the period in excess
of the pre-existing deficit, no dividend may be paid. Any
income in excess of the pre-existing deficit will be
“earned,” and dividends up to that amount may be paid.
(c) Under the third type of statute, of which the Delaware statute is an example, dividends may be paid up to the
amount of income for the period, though the result of the
transactions of past periods has been a deficit. Further,
the Delaware statute allows dividends to be paid up to the
amount of any income which the corporation may have
earned in the precedingfiscalyear and which has not already been used as a basis for dividends. The statute
provides, however, that, if the value of the corporation’s
property has been reduced to an amount less than that
represented by stock having a preference on liquidation, no
dividend shall be paid until the deficiency has been repaired.
(d) The fourth type of statute, which adds a general
insolvency limitation to either thefirstor second type of
limitation, requires that the liquidity of the corporation’s
assets and the amount and maturity of its debts must be
taken into account in determining the amount up to which
dividends may be paid. Subject to this restriction dividends may, in the given case, be paid up to the amount
by which income for the period exceeds the pre-existing
deficit. In California and Minnesota the insolvency
limitation is added to a provision similar to the third type
above (the Delaware statute). Under these statutes
dividends may, in general, be paid as stated in the immediately preceding subdivision (c), subject to the insolvency provision.
3. There is a Surplus at the Beginning of the Period
In this situation dividends may be paid up to the
amount of income for the period (determined according
to the legal rules for dividend-income computation) as in
situation 1, whichever type of dividend restriction is in
force. But the additional question is presented, whether,
with or without income for the period, dividends may be
paid up to the total of the pre-existing surplus and the
income for the period. This question will be discussed
with reference to the sources from which the pre-existing
surplus may have arisen.
(a) Earned surplus. If the surplus arose from income for a past period or periods, which income was determined in accordance with the legal rules for computing
income for dividend purposes, dividends may be paid up
to the amount of such earned surplus under any of the
principal types of dividend statutes set out above, subject
to the insolvency limitation where it exists.
(b) Paid-in surplus. A number of the corporation
acts deal specifically with the payment of dividends out
of paid-in surplus. In California, Illinois, Michigan,
and Pennsylvania dividends may be paid out of paid-in
surplus only upon preferred stock; of these states Illinois,
Michigan, and Pennsylvania require that when such a
dividend is paid notice of its source must be given to the
recipients. In Minnesota dividends up to the amount
of paid-in surplus may be paid upon common stock unless
there is preferred stock outstanding, in which case such
dividends may be paid only upon the preferred stock, and
notice of the source of the dividend is required to be given
to the recipients. Louisiana, Ohio, and Virginia require notice of the source of the dividend to be given, but
do not limit them to preferred stock. The Indiana statute permits dividends up to the amount of paid-in surplus
only if such surplus has been paid in in cash.
In the absence of a specific statute, whether a dividend
may be paid out of paid-in surplus will depend upon the
general dividend restriction which is in force. Under
the surplus limitation, courts generally have allowed the
payment of dividends up to the amount of paid-in surplus. The states which have a general restriction limiting dividends to the amount of earned surplus all deal
specifically with the paid-in surplus problem. The
broad Delaware statute seems to allow dividends up to
the amount of paid-in surplus. Under the insolvency
limitation, the legality of dividends out of paid-in surplus
will depend upon the liquidity of the corporation’s assets
and the amount and maturity date of its debts.
(c) Surplus from reduction of capital stock. Except
for a few states, the payment of dividends out of reduction surplus is regulated by a specific statutory provision
which is separate from the sections of the corporation act
relating generally to dividends. Subject to varying restrictions for the protection of creditors, these statutes
allow dividends to be paid up to the amount of the reduction surplus.
(d) Revaluation surplus. Whether dividends may be
paid out of an unrealized increase in the value of property
has been discussed above under “Legal Rules for the Determination of Income Available for Dividends.” In
general, cash dividends may not be paid from such source.
Usually the power to declare dividends is vested in the
board of directors. The power of the directors to declare dividends should be exercised by vote at a meeting
of the board, at which a quorum is present. The calling
and holding of the meeting of the board of directors at
which the dividend is declared, the necessary quorum, and
the manner of voting should all be in accordance with the
statutes and with the articles of incorporation and/or bylaws of the corporation.
B. Records in the Accounts upon Declaration of
The accounts and statements should clearly indicate
whether a declared dividend is considered as a charge
1. Current income, thus emphasizing the extent to
which current income exceeds the dividends.
2. Earned surplus, when the agreement with stockholders does not provide that dividends are to be paid only out
of current profits.
3. Such other accounts as may be authorized by statute. Special care should be taken to distinguish between dividends based on earned surplus (including
profits of the current year) and those which are either a
return of contributed capital or a charge against capital
The statements should indicate, preferably by a footnote or similar explanatory statement:
1. The amount of unearned past dividends on cumulative stock.
2. The amount of undistributed profits allocable to
non-cumulative preferred stock when the claim against
profits for such stock does not lapse when the dividend is
not declared for the period when earned.
T H E BALANCE-SHEET
T H E BALANCE-SHEET
T H E GENERAL-PURPOSE BALANCE-SHEET
Balance-sheets may be prepared in different forms for
different purposes. But a balance-sheet is usually prepared for the purpose of showing to all concerned the
financial condition of the business as a going concern.
Such a balance-sheet is referred to as a general-purpose
balance-sheet; it is sufficient under most circumstances
and is the type most commonly used. To such a balancesheet this part of the report is directed. Furthermore,
the discussion is limited to the balance-sheets of corporations.
N A T U R E OF T H E B A L A N C E – S H E E T
The balance-sheet is a statement which purports to exhibit thefinancialcondition of a business, including (a)
the nature and amounts of the assets of the business,
(b) the nature and amounts of its liabilities, i. e., its
obligations to creditors, and (c) the nature and amount
of its net worth. The balance-sheet purports to itemize
and classify the assets, the liabilities, and the net worth in
conformity withfinancialpractice and the law applicable
to the corporation for which it is prepared.
It follows that the balance-sheet should: (a) set forth
all the resources of the business and all of its obligations,
both to creditors and to stockholders, as fully as is compatible with reasonable brevity; (b) omit no contra assets
and liabilities by offsetting them; (c) mention, either in
the body of the balance-sheet or in footnotes, the pledging
or hypothecating of any of the assets; (d) state the basis
of the judgment determining all amounts about which
there may be substantial question or misunderstanding.
Furthermore it follows, since the importance of a given
class or type of assets varies from one industry to another and from one commercial enterprise to another,
that an attempt to present the financial condition of a
business on a uniform form of balance-sheet prepared
for the use of all businesses would, in many cases, result
in a misleading statement.
The practice of accountants in the preparation of balance-sheets has, in the …