Martin, Chester

Odermatt, M. R.

English

eGrove (Univ. of Mississippi)

Journal of Accountancy Volume 67 Issue 3 Article 8 3-1939 Correspondence: Retail Method of Inventory; Interest during Construction M. R. Odermatt Chester Martin Follow this and additional works at: https://egrove.olemiss.edu/jofa  Part of the Accounting Commons Recommended Citation Odermatt, M. R. and Martin, Chester (1939) "Correspondence: Retail Method of Inventory; Interest during Construction," Journal of Accountancy: Vol. 67: Iss. 3, Article 8. Available at: https://egrove.olemiss.edu/jofa/vol67/iss3/8 This Article is brought to you for free and open access by the Archival Digital Accounting Collection at eGrove. It has been accepted for inclusion in Journal of Accountancy by an authorized editor of eGrove. For more information, please contact egrove@olemiss.edu. CORRESPONDENCERetail Method of InventoryEditor, The Journal of Accountancy:Dear Sir: I have reviewed the question and answers on “Retail Method of Inven­tory,” which appears on page 402 of the December issue of The Journal, and offer the following comments:The question is asked as to whether cash as well as trade discounts should be deducted from the inventory at the end of the year. As the usual practice is to deduct trade dis­counts from the face of the invoice and to charge purchases for only the net amount, the natural result is that the trade discounts are at all times eliminated from the inven­tory. Therefore, no reserve is necessary to reflect a net inventory insofar as trade dis­counts are concerned.Cash discounts may be handled in one of two ways: (1) Invoices may be paid net after deducting cash discounts and only the net amount charged to purchases, or (2) The gross amount of the invoice before deduction of cash discounts may be charged to pur­chases.Under the first handling, the cash discounts are automatically eliminated from the inven­tory figures at all times. This handling is similar to the handling of trade discounts mentioned above and requires no special re­serve to eliminate cash discounts from the inventory.The other handling of cash discounts which requires that purchases be charged for the gross amount before deduction of cash discounts is the usual practice. The rea­son for following this plan is to provide a means whereby cash discounts earned may be set up in a separate account in order that the financial earnings of the company may be separated from the merchandise earnings. Wherever this plan is followed, it is advisable that the cash discounts deducted when in­voices are paid be carried in a deferred earn­ings account captioned “Cash Discounts Earned.” At the end of each accounting period, the cash discounts carried in thisaccount should be apportioned between the merchandise sold and the merchandise still on hand, and only that portion which applies to merchandise sold should be taken as cur­rent earnings. The balance in the unearned- discounts account should be deducted from the inventory. This handling credits income for cash discounts only when the merchandise has actually been sold and does not credit earnings with unearned profits which apply on discounts taken on merchandise which is still in the inventory.M. R. OdermattDenver, Colo.Interest during ConstructionEditor, The Journal of Accountancy:Dear Sir: A letter by Mr. R. Louis Lazo, published in the October, 1938, issue of The Journal arrested my attention sufficiently to cause me to reread more carefully the question originally raised and published in the August issue, together with the answers thereto.Mr. Lazo directs his letter to the last ques­tion of August’s inquirer, to wit: “Do you know of any authority which would defend such a proceeding? ” Reference is being made to capitalizing preferred dividends paid dur­ing plant construction. For the benefit of this inquirer, sections of instructions relating to interest paid during construction, prescribed by both the Federal Power and the New York State Public Service Commissions are cited by Mr. Lazo. He does not quote these commissions as recommending or suggesting preferred dividends be treated as construction cost. He merely infers confirmation. Whether he is justified in this inference begs the real question, which, as I read it, is this: Are pre­ferred dividends and interest paid on bonds, where both the preferred stock and bonds are issued for the purpose of financing construc­tion, to be treated in the same manner and may either or both items so paid, be capital­ized?174CorrespondenceLet us try to apply this question to the facts given us by the inquirer. He states there are three classes of capital funds raised, by the sale of bonds, preferred stock, and com­mon stock. The last was sold at a premium of 33⅓ per cent and these common stock­holders specifically made this premium avail­able for the payment of preferred-stock divi­dends. With this money a mill is to be built, the remaining funds to be used for operations when construction is completed.I think it reasonable to assume the bond­holders were secured by a first claim on the assets and earnings, if the preferred stock­holders were given to understand the common stockholders assented to payment of divi­dends out of this premium. The premium was donated to the corporation and the cash became part of its assets and, as such, the bondholders had a first claim upon it. The inquirer does not state the bondholders waived their rights with respect to this paid-in or donated surplus.It will be easier to demonstrate points I wish to make later in the text, if we assume a set of figures and circumstances reflecting, in the first column, the facts given us by the inquirer:† Dividend unpaid—$20,000. • Indicates red.At Completion 1 Year Later 2 Years Later 3 Years Laterof Financing Bldg. Completed Loss $180,000 Loss $130,000Cash............................................Construction costs: Mill..........Interest and dividends during$2,150,000 $ 310,000 1,750,000$ 110,000 1,750,000$ 10,000 1,750,000construction..........................Reserve for depreciation (de-90,000 90,000 90,000duct)....................................... 40,000* 80,000*Total Assets............................... $2,150,000 $2,150,000 $1,910,000 $1,770,0004% Mortgage bonds................. $ 750,000 $ 750,000 $ 750,000 $ 750,000Accrued bond interest.............. 30,0006% Cum. preferred stock......... 1,000,000 1,000,000 1,000,000 †l,000,000Common stock........................... 300,000 300,000 300,000 300,000Donated surplus....................... 100,000 100,000 40,000Deficit account (deduct).......... 180,000* 310,000*Total Liability and Capital.... $2,150,000 $2,150,000 $1,910,000 $1,770,000A brief explanation of the above table is in order. Column 1 reflects the plan envisaged by the inquirer with hypothetical figures in­serted. In column 2, we show the completed mill at cost, and a preferred dividend ($60,000) and bond interest ($30,000) paid out with necessary changes in cash. No changes occur in surplus accounts because we are here assuming the capitalization of the sums paid out. Column 3 reflects the situa­tion after a year’s operating loss of $150,000. Bond interest due has been paid out and charged to deficit and the preferred dividend paid and charged against the donated surplus. This may be said, I think, to carry out the intention of the inquirer’s client. And, finally, column 4 reflects a reduced operating loss of $100,000; bond interest accrued, but unpaid, charged to deficit account; and the preferred dividend paid to the extent of $40,000, charged to donated surplus.This table shows the corporation’s affairs to be very much strained at the end of the third year. Almost no cash is left for opera­tions; on bond interest and preferred divi­dend payments, there have been defaults. The bondholders’ committee, investigating, discovers $160,000 was paid out to the pre­ferred stockholders. At no time were there any accumulated profits out of which to pay such dividends. The original security of the bondholders consisted of all the funds paid into the corporation ($2,150,000). Out of this fund $1,750,000 was paid for a mill. The bondholders got $30,000 interest twice. Whether the first $30,000 is charged to con­struction is immaterial to the bondholders if a foreclosure takes place at this time, for the bondholders get the property itself, value it as we will, at $1,750,000 or at the higher sum plus any other assets on hand. They have a right to expect the directors have not175The Journal of Accountancydiminished these assets except through losses suffered in spite of prudent management. Under the circumstances as stated, the fact that the directors paid out $160,000 to pre­ferred stockholders could well lead to suits against the directors. The fact that $60,000 of these preferred dividends was charged to construction account does, in no wise, diminish their fault. At the least, this $60,000 of the bondholders’ equity is lost to them through the directors’ action.I concede capitalizing mortgage bond in­terest during construction is prevailing prac­tice. It is true, interest so paid and capitalized results in no detriment to the bondholders’ equity except when losses are incurred and dividends are paid to the stockholders.Where profits are realized from operations immediately upon completion of the plant, the equities are disturbed, but not so seri­ously. We will, for the purpose of developing this phase of the argument, assume the same circumstances shown in the table above, columns 1 and 2, except that in the second year after organization a profit is earned sufficient to warrant payment of bond in­terest, preferred and common dividends.There being no operating profits the year of construction, the relative equities are the same as previously discussed under losses. With profitable operations in the second year, let us consider the effect of the capitalization of the bond interest and preferred dividends paid out in the first year. To the extent that the earnings are reduced in the second and succeeding years by the depreciation rate on $90,000, the common stockholder is hurt. While the preferred stockholder got his divi­dend under this set of facts, marketwise his stock may be injured, for many buyers of stock consider the safety margin reported by statistical organizations when making commitments, i.e., income available for pre­ferred dividends. This margin of safety has been whittled down by depreciation on bond interest and preferred dividends capitalized. The preferred stockholder received the divi­dend and to that extent his injury is tem­pered, but the depreciation on $30,000 bond interest is a net loss to him.After the mortgage is paid and retired, thein- equity to the common stockholder disappears as between him and the bondholder, but not as between him and the preferred stock­holder. The preferred stockholder becomes first lienor in the bondholders’ stead and theinequity with respect to the common stock­holder continues either until the preferred stock is paid off or until the expiration of the entire plant through depreciation charges.Theoretically, then, these inequities would be eliminated, but only after the lapse of many years. Actually, the elimination of the inequity to a particular stockholder may never come to pass because stockholders shift and change.The object of accounting is, in general, to reflect historical costs. I think proponents of the proposition that it is proper to include bond interest and preferred dividends in con­struction costs are led away from historical costs by the economist’s conception. Econo­mists hold a theory that interest is a proper charge to determine costs. If accountants em­brace this theory, they must be logical and charge construction costs not only with bond interest and preferred dividends, but also, clearly, with interest on common stock­holders’ funds to the extent they are used in construction projects. And the accountant with his double-entry set of books, would have to continue until operations produced a profit. This would lead us, as accountants, to a very ludicrous situation: property en­hancing in book value through the years of losses.In Mr. Gilbert R. Byrne’s prize-winning essay, “Accounting rules and standards,” printed in The Journal, November, 1937, he expresses himself with respect to what he considers fundamental concepts. If we refer to number 7 on page 372, we read:“Earned surplus should represent the ac­cumulated earnings of the business from transactions with the public, less distribu­tions of such earnings to the stockholders.”If we capitalize preferred dividends in con­struction costs, we certainly will not adhere to this principle.Persuaded by the basic soundness of Mr. Byrne’s proposition and other considerations, I for one cannot subscribe to the proposal of the inquirer in August, 1938, to capitalize preferred dividends during construction, and I see many occasions to question the pro­priety of the capitalization of bond or other interest paid.Yours truly,Chester Martin Liberty, N. Y.176

Correspondence: Retail Method of Inventory; Interest during Construction

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Correspondence: Retail Method of Inventory; Interest during Construction

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