Accounting Principles – Cash and Funds

Funds are not reserves. A reserve is never a fund. A reserve may be created for the purpose of measuring or controlling a fund, but it is always in the nature of an accountability. Funds should always be on the left hand side of the balance sheet. Reserves should always be on the right hand side of the balance sheet. A fund is sometimes described as a reserve fund and in fact by some people it is given the erroneous name reserve. A fund may be set aside for certain purposes designated by a reserve. This operation is sometimes known as the funding of a reserve. This, however, does not have the effect of making it a reserve.
The point, however, upon which emphasis is to be placed is that funds are always assets. They may be classified as general funds and special funds. When used in the first sense, cash in hand or on deposit and available for general purposes, or unrestricted, cash, is meant. In the second instance the meaning is the exact opposite. A special fund emphatically denotes that such funds are not available for the general purposes of the business and are sacred to the purposes for which they were set aside. It is true of course that when the purpose for which they were intended has been accomplished, any balance remaining may be transferred back to the general cash, whence it presumably came. The use of the term special fund is not intended to include such items as working funds or petty cash funds, these representing merely the setting aside for convenience of a portion of the general cash. The classification does embrace, however, sinking funds, special funds such as were set aside by the gas companies in compliance with the ruling of the court in the matter of 80 cent gas, pension funds, emergency funds for accidents and illness of employees, insurance funds and contingent funds, etc.

The basis upon which funds are created will depend upon the circumstances. At times they may be accumulated by the arbitrary setting aside of fixed amounts periodically. They may be accumulated by the setting aside of arbitrary amounts varying in size from time to time. They may be created by setting aside a fixed sum for a given purpose like the amortization of some indebtedness, as in the case of a sinking fund for the purpose of paying off bonds at maturity, where the terms governing the setting aside of the sum are prescribed by the instrument of indebtedness.

In cases like the emergency fund and contingent fund above mentioned it is probable that the amounts would be set aside spasmodically or at the convenience of the business. Funds such as the public service gas fund would be regulated by the rapidity with which collections were made from customers. Such a fund would accumulate automatically. Insurance funds would probably be set aside semi-annually or annually and the amount would be determined by the premiums which the concern would be obliged to pay to the insurance company in order to carry adequate insurance on the property. Sinking funds on the other hand would accumulate by the setting aside periodically of fixed amounts, sometimes monthly, sometimes quarterly, sometimes semi-annually and sometimes annually. The periods and amounts are usually fixed by the mortgage which secures the bond. The sinking fund deposit might be determined by the term of the bond and the amount necessary to liquidate the liability at maturity prorated over the life of the bond. Another manner of accumulating the sinking fund is to set aside semi-annually or annually such a sum as will at compound interest amount at maturity to the face of the bond.

In all cases where funds are involved there is also the question of interest and the question becomes, whether the interest attaches to the fund or whether to the general cash, thereby becoming available for general purposes. The earnings from funds are usually credited to income. The alternative is to credit them to a reserve account. If they are credited to income it has the effect of making the complimentary asset available for general purposes. If they are treated as a reserve it prevents the use of the asset for current purposes. In the case of straight funds, it is thought to be better unless otherwise provided to credit the income from the funds to the operations and make the interest received available for general use. Where the interest received is to be made a part of the new deposit for sinking fund purposes, obviously the income should be credited to a reserve. The effect, however, is the same as creating a reserve for a sinking fund out of earnings, since the reserves ultimately revert to the surplus.
To illustrate the creation of sinking funds by the scientific method and show the relation which the interest earning bears, let it be assumed that the American Cigar Company issued on January 1st, 1908, bonds to the amount of $1,000,000, payable January 1st, 1910, with interest at 6%, payable semi-annually. Let it be further assumed that the bonds provide for a sinking fund to be accumulated by semi-annual deposits for the purpose of liquidating the bonds at maturity and that the interest allowed by the depository on sinking fund deposits is 2%. The two questions which present themselves are, first, what amount shall be deposited in the sinking fund semi-annually, and second, what disposition shall be made of the earning which attaches to the interest on the sinking fund deposits.

The amount to be accumulated for liquidation purposes is $1,000,000. The periods involved are four, since the deposits are made semi-annually. With regard to the sinking fund payments, there must first be determined what amount or annuity must be deposited at the end of each period of six months, so that at the end of two years the accumulation of deposits and the interest thereon will amount to $1,000,000. No attempt will be made herein to explain the formula whereby the proper amount is arrived at, since tables showing the amounts are always available for use. If information as to the formula is desired, Sprague’s tables of compound interest may be consulted. These tables show that the amount to be deposited at the end of each of the four periods is $242,623.75. This amount if deposited four times would result in an aggregate of $970,495. This noticeably is less than $1,000,000, and the difference of $29,505 is presumably made up of the interest on the deposits. The first question which will probably arise in the mind of the reader is whether the deposits begin on January 1st, 1908, or on June 30th, 1908, and in order to have this clearly established a study of the following computations will prove beneficial.
$242,623.75
.02

$4,852.4750
242,623.75

$247,476.2250
242,623.75

$490,099.9750
.02

$9,801.999500
490,099.975

$499,901.974500
242,623.75

$742,525.724500
.02

$14,850.51449000
742,525.7245

$757,376. 23899000
242,623.75

$999,999.98899000
Interest
$4,852,475
9,801.9995
14,850.51449

$29,504.98899
First deposit, June 30, 1908
Interest to January 1, 1909

Fund, January 1, 1909
Second deposit, January 1, 1909
Interest to June 30, 1909
Fund, June 30, 1909
Third deposit, June 30, 1909
Interest to January 1, 1910
Fourth deposit, January 1, 1910
Fund, January 1, 1910
Deposits
$242,623.75
4

$970,495.00
Deposits $970,495.
Interest 29,504.98899
Fund $999,999.98899

From the above it will be noted that the first deposit was on June 30, 1908. The amount deposited at that time bore interest at the rate of 2% from June 30, 1908, to January 1, 1909, at which time there was added to the original deposit, a second deposit in a similar amount and the interest for the six months just past. The aggregate of these amounts then became a new principal, which in turn bore interest at 2% for the six months ended June 30, 1909, and so on throughout the period of time covered. If the various amounts of interest which accrued on the deposits are segregated from the computation they will be seen to amount to $29,504.98 and a fraction, which practically agrees with the amount of interest determined by deducting four times the sinking fund deposit from $1,000,000.

The fund it will be noticed was derived from two sources, one the general cash of the company, the other, the interest paid by the depository. The deposits made by the company were charged to the sinking fund and credited to general cash. The interest was reported by the sinking fund simultaneously with a credit to an interest earned account. The disposition of the interest earned account now becomes the subject for discussion. There are of course three possibilities.

The first is to take it into the earnings of the company as other income. This procedure seems objectionable because of the reason that the cash corresponding to the earning is included in the sinking fund and on account of being applied in part to the liquidation of the bonds outstanding it is not available for general disbursement.

The second possibility is that of crediting it to a reserve account for interest on sinking fund. This account would gradually accumulate a credit balance until at the end of the second year it showed $29,505. At the time the bonds were liquidated the reserve would apparently be liberated and would revert to surplus. Thus it is difficult to see what, if any, purpose has been accomplished by accumulating this reserve.

The third possibility is that of crediting the interest earned to the interest paid account. It is to be remembered that these bonds bore interest at the rate of 6%. In other words, the company paid for the use of $1,000,000 for a period of two years, $120,000. By virtue of having put aside in a sinking fund stipulated amounts from time to time, the company has been deprived of the use of the money, which, however, has earned $29,505. It would thus appear that the expense to the company for the proceeds of the bonds actually available for use should be determined by an amount representing the difference between the interest paid on the bonds and interest received on such funds. If this application of the earnings were made to the interest paid for the use of the money, the expense to the company would be $90495. This last method it must be admitted seems the more logical and equitable.

The relation of sinking funds to reserves will be discussed in the chapter dealing with reserves.