Very large amounts of interest are listed among the debits, and it is impossible that more than a small proportion of them could have been actually paid out for loans with which to carry the current disbursements. Even if it required six months to collect anything from customers and all the money for materials, labor, expense and construction had to be borrowed for that time, the interest paid would indicate a rate of about 40 per cent. per annum. It must be, therefore, that there is either a very large bonded indebtedness made necessary by the large amount of capital required to be invested in fixed assets or that interest has been charged on invested capital represented by stock and that it has been actually paid to the stockholders as interest and not as dividends. It must have been paid out because, if it had been merely charged as an expense, it would have been credited to interest as a capital profit.

In case the interest is paid on a necessarily large bonded debt or capital stock, it is a factor in determining the goodwill, because the measure of the goodwill is the amount of profits in excess of a fair return on the money required to carry on the business. That the money tied up in permanent assets is required seems to be indicated by the relatively large amount spent for construction work each year. The problem gives no clue as to the interest. If the amounts charged represent 6 per cent. on invested or borrowed capital, the total of the capital thus represented must have been $1,600,000 for the first year, $1,566,667 for the second year and $1,641,667 for the third year. Based on these figures for invested or borrowed capital the rate of profit, including interest, earned would be as follows:

SCHEDULE 4

STATEMENT SHOWING RATE OF PROFIT EARNED ON INVESTED
OR BORROWED CAPITAL

It is very doubtful whether a business making 16 2/3% on its capital, which is the best that the X. Y. Company has done, has any goodwill, and it is quite certain that it has no goodwill at all in view of the rapid drop to 10.8%.

I should call B's attention to the large amounts expended for what is called "construction work." In view of the steadily declining business and the steadily increasing expense, it would seem very unwise to put money into extensions of the fixed assets. The items should be thoroughly investigated, as it is extremely probable that they represent replacements

of worn out equipment and not new assets at all. In that case they should be added to the expenses, with the result of making a bad matter that much worse.

If B asked my advice I should tell him to invest his money somewhere else unless he was sure that he would be able to improve conditions materially, but that in any event he should not pay for any goodwill.

Problem 3:

From the following balance-sheet and data

(a) Prepare corrected balance-sheet in appropriate form for the information of stockholders and auditor's certificate thereto.

(b) Show statement of adjustments to profit and surplus.

PASSAIC FALLS WOOLEN MANUFACTURING CO.

Capital stock-common, par $100.00

125,000.00

Capital stock-preferred, 7% cumulative, par $100.00

100,000.00

Accounts payable

130,000.00

Undistributed earnings, June 30, 1917

60,000.00

Profits year ending June 30, 1918

35,000.00

450,000.00

Adjust the figures in regard to the following:

(1) Land is appraised at $15,000.00 and is to be adjusted to that

value.

(2) Give effect in the statements to depreciation of the wasting fixed assets for the year ended June 30, 1918, at rates considered fair.

(3) Dividends on the preferred stock have not been paid for years ended June 30, 1917, and June 30, 1918.

(4) Inventories are valued at $5,000.00 below cost.

Solution, Problem 3:

Taking up the adjustments in the order in which the items appear in the balance-sheet:

Land. The fact that the land has been appraised at more than its book value does not constitute a profit. The opinion of a real estate expert is not an available asset unless it is acted upon and the profit is actually realized by the sale of the land. It is absolutely contrary to sound accounting principles to put the increase in value on the books at all. However, the problem requires that it be done, and the only question is

as to what account shall receive credit. If it is credited to "reserve for land" nothing will be gained, since the net value will remain the same as before. We are therefore obliged to credit it to undistributed earnings or surplus. The proper treatment would be to make no entry at all, but to show the asset on the balance-sheet as "land (appraised at $15,000.00)........$10,000.00."

Depreciation. It is difficult to fix rates of depreciation when nothing is known as to conditions. As a guess the rates are assumed to be 21⁄2 per cent. on the brick buildings, 71⁄2 per cent. on the machinery and 10 per cent. on the steam power plant.

Treasury stock. It is usually considered better to carry treasury stock at par. When such stock is bought at a discount, the discount is not a profit unless it is absolutely certain that the stock is worth par, a supposition that is negatived by the fact that it brought less in an actual transaction. The discount should be credited to "unrealized profit on stock." If the stock is sold, any excess above $20,000.00 received will be a credit to surplus as a realized profit.

Inventories. There is no reason given for valuing the inventories below cost. It is assumed that the market value is not lower than the cost. It is not a case in which the goods on hand are perishable and it is thought wise to provide against deterioration. This should be done by setting up a reserve against inventories and not by reducing the value of the inventories themselves. Putting the inventories on the balancesheet at cost would add $5,000.00 to the profits of the current year, unless there had been a similar undervaluation at the beginning of the year, in which case the adjustment would be made by charging current profits with the undervaluation, crediting surplus and then crediting the current profit and loss, charging inventories.

Preferred stock dividends. Cumulative preferred dividends are not a liability to be placed on the books until they are declared. However, since they are a lien on the profits to be satisfied before the common stockholders can receive any dividend, it is imperative that their existence should appear in any balance-sheet submitted to stockholders, but no notice need be made of them in statements to creditors. This information is conveyed to the stockholders by dividing the surplus on the balance-sheet. The adjustments to profit and loss and surplus would be made by the following journal entries:

To give effect to appraisal. This

entry is made on positive instructions

from the board of directors.

This involves a reduction of the profits for the year of $11,250, and an addition to surplus of $5,000.

The adjusted balance-sheet after transferring the year's profit to surplus would be as follows:

PASSAIC FALLS WOOLEN MANUFACTURING CO.
Balance-sheet-June 30, 1918

As nothing is said as to there having been any audit of the accounts, the only certificate to be given would be somewhat as follows:

"I hereby certify that I have examined the balance-sheet of the Passaic Falls Woolen Manufacturing Company, dated June 30, 1918, together with certain data pertinent thereto, and that I have prepared the above balancesheet, which in my opinion is a correct statement of the condition at that date, but I assume no responsibility for the valuation of the assets.

Problem 4:

C. P. A."

It frequently happens that a corporation contracts to purchase property at an agreed price, which on the face of the contract is declared to be its value, and that by another clause in the contract, or by another contract, the vendors agree to provide, in addition to the property, a certain sum for working capital or even for free surplus.

It is sometimes maintained that this free sum so provided is a profit or surplus of the new corporation available for payment of dividends if the directors so determine.

Write a brief expression of your opinion as to the proper treatment of the sum turned back.

Solution, Problem 4:

It is unusual for a vendor to provide any sum "for free surplus" if by that expression is meant surplus available for dividends. In fact, if the contract so specified it would to that extent be void. Surplus available for dividends must be the result of accumulated earnings or of value acquired by gift or otherwise which causes a condition in which the valid assets are greater than the total capital and all liabilities. This case does not belong to either category.

The gift by the vendor is not a profit but is a reduction of the original cost of the property. Whether expressed in one contract or two, the agreement to "purchase property at an agreed price" is dependent upon the other agreement that the vendor shall "provide a certain sum." Usually the price paid for the property is the total capitalization of the corporation, and the gift of the vendor consists of a certain proportion of the stock which is put in the treasury and sold for the purpose of providing working capital. Since the transfer of the property has paid for the entire capital stock issued to the vendor, the stock returned by him is true treasury stock and can be sold at a discount without making the purchaser liable.

In recording the donation of the stock, the proper debit is to treasury stock. The logical credit would be to property, but the insuperable objection to this treatment is that it gives the lie to the original value as declared by the contract. If property was worth $2,000,000 and is at once reduced to $1,000,000 by the credit of donated stock, it is a confession that the smaller sum was its real value; therefore that the original capital was not fully paid for; and that the donated stock is not true treasury stock, since it has not been issued fully paid and been re-acquired by the

company.

The proper treatment is to credit the amount to donated working capital, as expressive of the purpose for which it was given. Having been