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.

  • Clearly communicate your thoughts and ideas in a clear and concise manner.
  • Practice your written communication skills including the ability to write persuasively in a document that is free of speclling and grammatical errors.
  • Assignments
  • After completing this week’s assigned readings, prepare a 2-3 page paper that addresses the question: What should be the basis for accounting standards? The double-spaced paper should demonstrate that you have identified the distinct approaches taken by the accounting academics (the 1936 paper) versus the practitioners (the 1938 paper) and evaluated the strengths and weaknesses of the differing approaches. You should provide a well-supported argument to support your opinion as to whether accounting standards should be based on overarching principles or based on existing practice.
  • University of Mississippi
    American Institute of Accountants
    Deloitte Collection
    Statement of accounting principles
    Thomas H. Sanders
    Henry Rand Hatfield
    Wm. Moore
    Follow this and additional works at:
    Part of the Accounting Commons
    Recommended Citation
    Sanders, Thomas H.; Hatfield, Henry Rand; and Moore, Wm., “Statement of accounting principles” (1938).
    American Institute of Accountants. 370.
    This Article is brought to you for free and open access by the Deloitte Collection at eGrove. It has been accepted for
    inclusion in American Institute of Accountants by an authorized administrator of eGrove. For more information,
    please contact
    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
    Yale University
    School of Law
    135 Cedar Street, N e w Y o r k
    FROM T H E
    discount on orders of ten or more)
    Harvard University Graduate School
    of Business Administration
    University of California
    Yale University
    School of Law
    135 Cedar Street, New York
    Copyright, 1938
    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.
    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
    PART I
    I. Capital and Income
    A. Capital . . . . . . . . . . .
    B. Income
    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
    B. Terminology
    C. Amount of Information
    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
    Operating Revenues
    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 . .
    . 36
    G. Selling and General Administrative Expenses
    H. Taxes
    V. The Non-Operating Section
    A. Interest
    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
    VII. Dividends
    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
    IV. Assets
    A. Fixed Assets
    1. Property and Plant Assets . . .
    (a) Reserve for Depreciation .
    2. Intangible Assets
    3. Investments for Control . . . .
    B. Current Assets
    1. Cash
    2. Marketable Securities
    . . . .
    3. Notes and Accounts Receivable . .
    4. Inventories
    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
    VII. Reserves
    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
    C. Surplus
    1. Definition
    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
    Are Desirable
    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
    PART V
    Comments and Footnotes in Financial Reports .
    . 109
    I. General Principles
    II. Income Statement Principles
    III. Balance-sheet Principles
    IV. Consolidated Statements
    V. Comments and Footnotes
    117, et seq.
    DR. T. H . SANDERS,
    Graduate School of Business Administration,
    Harvard University,
    Boston, Massachusetts.
    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
    of opinion.
    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
    sound conclusions.
    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
    general acceptance.
    Your acknowledgment and formal acceptance will be
    Yours very truly,
    July 15, 1935.
    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.
    November 22, 1937.
    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
    of accounting.
    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 contributors.
    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
    to fluctuation.
    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
    accounting are:
    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.
    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
    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.
    PART I
    PART I
    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.
    A. Capital
    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.”
    B. Income
    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.
    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
    of each.
    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
    and depression.
    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.
    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
    assisted by:
    (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.
    B. Terminology
    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
    the statements.
    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
    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.
    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.
    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.
    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
    D. Depreciation
    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
    are offered:
    (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
    is used.
    (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
    earnings, and
    (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:
    Net Sales
    Cost of Sales and Other Operating Expenses
    (including depreciation $3)
    Gross Operating Profit
    $ 23
    Net Sales Billed
    Cost, Expenses and All Charges (except depreciation and interest)
    Depreciation of Plant and Equipment
    Net Income from Sales
    $ 13
    $ 9
    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
    on itsfinancialaspects.
    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
    proper attention.
    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.
    H. Taxes
    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.
    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.
    A. Interest
    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
    capital surplus.
    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
    been done.
    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.
    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
    past earnings.
    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
    permit it.
    (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.
    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 …

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