Accounting theory and practice, Volume 2 (of 3) : a textbook for colleges and…

be realized so long as the land is employed in operation. Its cost represents the capital tied up in it and the amount on which profits must be earned. This is therefore the value at which it should be carried on the books. Sometimes other considerations than those of accounting influence business policy in connection with the market value of land; but so long as it is used for the business purposes for which it was purchased, full cost price should be its valuation. This may sometimes place a prospective borrower at a disadvantage when using his balance sheet as the basis for credit. A footnote or other notation giving market value will usually suffice, although such value is often difficult of determination without a disinterested appraisal. Appreciation of Land Values When land is held over long periods in a growing community, appreciation in value almost always results; occasionally depreciation ensues. The amount of appreciation is oftentimes not as much as it seems because land with buildings on it may not be convertible to some other use at the market price of similarly located vacant land; the cost of scrapping the buildings often being as much or more than the appreciation in land value. Also, appreciation may sometimes be of a temporary character, in the nature rather of a market fluctuation. If so, the distinction must be carefully observed. Perhaps in the majority of cases requiring consideration, appreciation not only is very real but also very considerable. It may sometimes be desired to base an issue of bonds on real estate—land and buildings—which is being carried at an old cost figure as of many years ago but which has a greatly appreciated and available market value at the present time. Prudent financial considerations would require an independent appraisal to determine the amount of the bond issue. Upon the assumption that the issue is for a larger amount than the original cost of the security, a peculiar situation arises. In showing the transaction on the books and balance sheet, not only would no margin of security appear, but even an insufficiency of security so long as the original value of the security is carried. Here it would undoubtedly be wise to bring the appraised value of the security on the books, offsetting the appreciation in value by a suitably named surplus or reserve account, such as “Reserve for Land Value Increment” or “Appreciated Land Value Surplus.” Another method and perhaps a better one where possible of application is to reorganize the concern by a sale of the old to a new company and so capitalize the increment in value of the old company’s assets. Another financial consideration in connection with appreciated real estate values concerns the advisability of the sale of the old and the erection of a new plant on less valuable land. Usually, the appreciation of land values is not reflected in increased profits; it may even result in lessened profits due to higher rates of taxation and other expenses. If there are equally favorable locations for the particular kind of business, it may be the part of business sagacity to use the old location for rental purposes so that the benefit of the appreciation may be secured, or to sell and move to a less expensive site. In the one case the status of the land has been changed from that of an operating fixed asset to an investment, perhaps best considered permanent. In the other case, the increased value is through sale realized in a lump sum and, as a surplus item, is available for any purpose to which surplus may legitimately be applied. Of course, the amount of such surplus is the difference between the sum realized by sale and the cost of an equally efficient plant on the new site. It will usually happen that a better plant is erected, thus consuming some of the surplus arising from the sale. Depreciation in Land Values In a great many instances land depreciates. Decrease in value due to use will be considered under the discussion of wasting assets, page 311. When land suffers depreciation it is usually because of obsolescence or inadequacy. Due to certain natural facilities giving out, or to the removal, dismantling, or decay of artificial facilities, a site may depreciate so much as to become untenable. Business and residence property in a mining town may be of mushroom growth and have practically no value when the market, which is dependent on mining operations, declines. Ventures of this sort are recognized as highly speculative from the beginning and should be handled as such in the accounts. Wherever depreciation due to these causes can be foreseen, suitable provision should be made; otherwise the burden will fall entirely on the period when the plant has to be abandoned and this stage is usually preceded by periods of lessened profits. Depreciation of land is therefore always a local question. Valuation of Land Investments Business considerations oftentimes make advisable the purchase of adjoining or otherwise located tracts of land, with an eye to the future when enlarged facilities will be required. These should be carefully differentiated and segregated in the accounts from the land in use for business purposes. Some points in their valuation, in addition to those treated under the discussion of investments in land on page 278, need to be considered. Such tracts of land may usually without prejudice be valued at cost. If later developments should turn out as originally expected, there can be no objection to loading the carrying costs of these lands, including taxes and interest on any borrowed purchase money, on their value year by year. The only reason for their purchase at the present time is because it is expected that the transaction can be more advantageously made now than later. If such should not be the case, the cost of the land proves to be higher than if purchased later. Only by loading these carrying charges can this information be developed. If the land is finally put to its intended use, no serious objection is seen in carrying it at the figure of full cost to the date of use. Because of the speculative nature of the transaction, it is usually advisable to set up a reserve of the same amount as the accumulating carrying charges. This reserve becomes free when the land is put to its intended use. Because of the ease of inflation of values in transactions of this kind, due largely to an overoptimism as to the future and even sometimes to fraud, all such transactions must be scrutinized very carefully and ample provision against an unfavorable outcome should be insisted upon. It is interesting to note in this connection that in the case of valuations for rate-making purposes, as a usual thing carrying costs on land of this kind are not allowed as expenses to be covered by the rate of the service rendered. But when these lands come into use such expenses become a part of the cost of the service. Mortgages on Land Mortgages on land require consideration as affecting the manner of showing the land value. Freehold land, i.e., land held in fee simple, if afterwards mortgaged should be shown on the balance sheet at full face value with the mortgage listed among the liabilities. The liability is usually a note or other bond which in case of the deficiency of the security would be a general claim against the free assets of the concern. It is therefore best, theoretically, not to show such a mortgage as an offset to its security. In the case of the purchase of land subject to mortgage without the assumption of the mortgage as a direct liability, theoretically the mortgage may be shown as a deduction from the full land value and only the equity value of land be extended as a significant asset. This differentiation is almost entirely an academic one and is seldom seen in practice. The land is usually listed among the assets and the mortgage as a liability. Donated Land The valuation of donated lands presents some interesting points. A town may offer a free site to secure the erection of a plant within its midst rather than allow it to go elsewhere. Sometimes the donation may be outright and absolute; at other times it may be conditional, depending upon the doing of certain things by the donee, such as the employment of a minimum force of men for a certain number of years, or the circulation of a certain amount of advertising, or the purchase of given amounts of raw material supplied locally. In the case of an outright gift, the cost to the company is usually nil, but for the proper statement of the concern’s financial condition the land must be shown as an asset. If the acceptance of the gift necessitates the scrapping of the old plant and removal expense to the new site, such costs would provide a minimum carrying value for the land. Where this is not the case, the land might be given a nominal value, with suitable explanation. Usually, however, neither of these methods is so satisfactory as that of bringing the land onto the books at a fair appraised value and showing the contra side of the transaction as surplus, or donated surplus, or donated land surplus. Any gift received increases the proprietorship of a concern and should be so shown, and there need be no suspicion of inflated value in such a surplus item, if conservatively set up, and with the supporting records available. Any expense in connection with the acceptance of the gift is a proper charge against the donated surplus. Aside from this, it is free surplus available for customary uses so far as this transaction is concerned. In the case of a conditional gift subject to reversion until the satisfactory fulfillment of the condition, no title nor asset value, other than a contingent one, inheres in the land. It is not therefore proper to show any. If a condition, extending over a period of, say, five years must be met, at the end of the first year one-fifth of the time has elapsed and the condition is nearer to fulfillment—the contingency has become more nearly a fact. But until its full satisfaction and the danger of a lapse has passed, there is no value in the gift. To show the progress and status of condition, the pro rata portion of the gift may be shown periodically by a charge to Donated Land or Equity in Land, offset by an equal credit to some suitable reserve such as Donated Land Reserve or Unrealized Profit on Land. On the balance sheet the reserve would be treated as a valuation item, no value being extended among the assets. This would seem to satisfy all demands for information and show the exact status of the transaction. Land as Stock-in-Trade A final consideration, not logically belonging here but treated as a matter of convenience, is that of land as stock-in-trade. In the case of a land company developing a tract of land for certain purposes, the individual plots, or the whole piece if division is not contemplated, constitute its stock-in-trade and it should be valued as such, i.e., as a current asset and not a fixed. All costs necessary to put it in condition ready for the market are capital charges and should be loaded onto the cost of the lands. These include all of the usual costs mentioned in connection with land as a fixed asset, and in addition all improvement costs such as parking, the laying out of streets, roading, etc. The loss in the use of land for these purposes should be prorated over the plots, or otherwise equitably distributed. Plots of land so developed are not usually sold all at one time. Any unsold plots should be inventoried at cost. Sometimes the first plots may be sold at a loss to make the rest of the proposition move. The practice is met of loading the loss in the early sales onto the unsold plots, and it is quite common to add any carrying charges to the cost of the unsold plots. Both of these practices are to be deprecated and opposed. They are not right in theory and serve no necessary purpose. All costs after the stage of sale is reached are operating costs—charges against revenue which should not be capitalized. It may be desirable to know at what price the unsold plots must be disposed of to cover all expenses and losses and to make a profit, but that does not justify an inflation of the carrying values of the asset. If it is desired that the books shall show this, an amount equal to these costs and losses may be added to the carrying values if offset by a valuation reserve of equal amount, the costs and losses themselves being handled as operating expenses of the current period—or spread over several periods if applicable. Wasting Assets—Definition and Characteristics Wasting assets, as they are usually called, are better described as assets subject to depletion. They differ from depreciating assets in that, whereas the latter wear out through use or the effect of age, wasting assets simply “give out.” They are subject to depletion because they comprise stores of raw materials and natural resources the supply of which, through being mined and disposed of, is definitely and finally diminished. The stores will in every case finally come to an end through yielding up their product. Examples of enterprises of this kind are minerals and deposits of all sorts, such as coal, gold, silver, lead, clays, slate, gravel, stone quarries, oil, asphalt, nitrate, timber, and “all growing plants yielding recurring crops, such as tea and rubber.” Dividends May Include Return of Capital The law recognizes the distinction by requiring in the case of depreciating assets that the decrease in value must be made good before the payment of dividends—i.e., dividends cannot be paid out of capital—while in the case of assets subject to depletion it is recognized that some portion of the dividends paid may represent a return of the capital originally invested in the undertaking. If the latter is the policy pursued, there will be no liquidating dividends at the time of the break-up of the undertaking, inasmuch as the regular dividends have already included a return of all or some portion of the capital. If, however, it is a matter of business policy to continue the enterprise elsewhere when the present natural stores are exhausted, then the dividends should represent only profits. During the process of operation, assets in other forms which represent the capital investment of the undertaking are retained in the business. This is accomplished on the books by a charge to each period’s operations of such an amount as represents the depletion of the stores of product prepared for the market during that period and by a credit to a depletion reserve account or direct to the property or stores account. Basis of Depletion Charge The amount of the period’s depletion charge is reckoned by comparing the amount of product worked during the period with the total estimated amount owned. Whatever value was taken for the original purchase, that value becomes the basis for the annual or periodic depletion charge. There is, of course, a large element of speculation in some estimates of this kind. In the case of timber, the original amount purchased is easily determinable with fair accuracy by _cruising_; the amount cut each period is a matter of record. The ratio of the amount cut to the original amount is the portion of the original value or cost of the timber tract to be written off periodically. In the case of a mine or pit, the estimate cannot be made with an equal degree of accuracy. Competent engineers do make calculations of the amounts of available ores with sufficient certainty to warrant the expenditures of vast sums in the purchase of properties. If their estimate avails for this purpose, it can with equal certainty be made the basis for the periodic depletion charge. Nice questions arise in this connection when the property is being operated under a lease or on a royalty basis. Application of Income Tax to Wasting Assets Under the 1916 income tax law specific provision was made for allowing depletion and the manner of handling it is prescribed. First, for such a charge to be allowed as a deduction, it must be recorded on the books. Secondly, as soon as the depletion reserve equals the capital investment no further deduction can be made—all else is pure income. If, however, it is desirable to carry on the books as an asset the estimated amount of product still remaining in addition to that written off, it may be done, the offsetting credit being to income, which must be shown as income on the tax return for the year in which it was brought onto the books. This new value may be depleted until wiped off the books. The law as now operated bases value of the asset subject to depletion on the value existing as on March 1, 1913, or at cost or purchase price if acquired subsequent to that date. Because the book values on March 1, 1913 seldom agreed with the estimated values, it was necessary to adjust these by charging the asset, plant, or mining property and crediting an account called “Property Surplus” with the amount of the adjustment where the estimate showed more than the book value. When dividends are paid, if it is the policy to return capital as well as profits, the charge should be made partly against operating surplus for the profits share, and partly against property surplus for the capital share. Depreciation on Buildings and Machinery of a Wasting Asset In addition to the depletion charge, proper allowance should be made for depreciation of the other fixed assets, such as buildings, machinery, and the like. The limit of their service life is evidently the working life of the venture, which must be estimated. If there is still operating value in the equipment at that date, this is covered by the higher salvage value taken into account when fixing the depreciation charge. Unusual Risks In connection with both the estimate for depreciation and for depletion, the elements of unusual risks, due to fires, floods, and the like, should be taken into account. Their effect might be to cut down the supply of available product and so increase the periodic depletion charge. Another factor, of great importance at times, is the available supply of any auxiliary product needed for the treatment of the main product. Thus, large ore bodies may remain unmined and unprofitable because of the failure of a ready supply of auxiliary material needed in the reduction, smelting, or refining of the ore. This applies particularly to iron ores. Water Rights Sometimes valuable water rights are acquired along with mining property, and it may be profitable to utilize them for the manufacture and sale of power long after the depletion of the mine. In that case their capital value should be separated from that of the mining venture, and retained as an investment; or a new company may be formed to carry on the power project after ceasing mining operations. Leaseholds On the boundary line between a depreciating asset and one subject to depletion stands a leasehold, i.e., the right of occupancy of premises for a stated term. Thus, a building may be rented for a term of years; or a piece of land may be leased for a long enough period to justify the erection of a building thereon, the building going to the owner of the land as a gift or at an appraised value, or the land may revert in its original condition to the owner upon expiration of the period of the lease, according to the contract. The payment for the lease may be an annual sum similar to a rental charge, or a bonus and an annual sum. In the latter case, the bonus should be treated as a deferred charge and spread as additional rent over the period of the lease. Leases may run for any period up to 99 years, 63 and 84 years being favorite terms in New York. An original lessee may sell his lease outright for a set sum sufficient to cover the remaining period of the lease, or on an annual rental basis. The set sum is calculated as the present worth of an annuity of the amount of a fair annual rental. Where property values have greatly appreciated, a leasehold on favorable terms may have a high market value which may not appear on the books or balance sheet. If the terms of the lease call only for a _periodic_ payment like rent, the value of the lease will not usually appear on the books. If the lease is purchased outright for a lump sum or a bonus is paid, some value for it will appear on the books. Where the balance sheet is to be used as the basis for credit, the present appraised value of the leasehold should appear, either in a footnote or preferably incorporated into the balance sheet with an offsetting reserve. If the leasehold is carried at any value on the books, this must, of course, be depreciated or amortized by the end of the leased period. As stated above, the periodic charge for this is to the rent account and the credit to the leasehold account, writing it down directly instead of by means of a reserve. The straight line method of amortization is the easiest of application, but authorities seem to favor, on theoretical grounds, the annuity method which brings in the element of interest. If the agreement provides for the reversion of the building to the owner of the leased land, then also the full cost of the building must be depreciated over the life of the lease. Any excess of this depreciation over normal depreciation is in the nature of a rental charge but not usually of sufficient importance to require segregation. If the premises must be returned in original condition to the owner, the net costs of demolishing any structures erected thereon must be treated as expenses of the lease and provided for accordingly.