CHAPTER XXVI

THE INTEGRITY OF THE ACCOUNTS

Section 1. The Need for Sound Accounting, 398-Sec. 2. Dual Responsibility of Railroad Accounting Officers, 401-Sec. 3. Recapture of Excess Earnings, 402-Sec. 4. Maintenance and Depreciation, 403— Sec. 5. Obsolescence, 405-Sec. 6. Balance Sheet Items, 406 Sec. 7. Valuation and Consolidation, 408.

§ 1. The relationship of accounting methods to the rehabilitation of credit arises from the circumstance that only if accounts are kept honestly, and in accordance with sound principles, can there be assurance that the earnings shown on the books are stated with as close approximation to accuracy as is possible. When the affairs of a single road are under examination, it is important also that the same methods of handling transactions on the books be used, in order that, from year to year, the data disclosed shall be comparable. The stockholder, presumably, is entitled to accurate and comparable information, as an owner of the business; and the owners of securities, who have claims on earnings in the nature of a fixed charge, are directly interested because both the safety of their principal and the surety of their income are dependent on showings of earnings. It is better to know the worst or the best, as the case may be, and to know it at once. Any system of accounting, therefore, demands rigorous intellectual honesty in its application, if it shall operate to rehabilitate railroad credit. Insurance of the integrity of the accounts is one way of creating confidence.

Since 1907, the railroads have kept their books in conformity with a system of accounts prescribed by the Interstate Commerce Commission. Prior to 1907, each road had kept its books upon its own plans. While there was, on many roads, uniformity of treatment of accounting transactions from year to year, there was not uniformity of treatment as between railroads, and therefore no strict comparability between the figures disclosed by the

books of different railroads, even in a single year. It is true, of course, that there was not a little uniformity, especially in the general scheme, arising because of the similarity of the problem on all roads, the transfer of accounting officers from one railroad to another, and conferences of accounting officials. Upon the fund of accumulated experience, the Commission's Statistician, the late Henry Carter Adams, drew freely, and in the formulation of the Commission's system of accounts, Professor Adams had the benefit of helpful coöperation' and frank criticism from the membership of the Railway Accounting Officers' Association, an organization which dates from 1888. The foundations for a tradition of mutual helpfulness were laid at the beginning.

The inadequacies of railroad accounting systems prior to the development of the complete system by the Commission should not be assigned to ignorance or perversity on the part of railroad executives. Some of the then general practices, which would now be condemned vigorously by accounting officers, were thought to be the correct method of handling the transactions. After all, so long as the amount of net earnings was considered a matter of private business (or was so considered by railroad managers without legislative challenge) there was not great public concern in the exact statement of railroad earnings from year to year.1 Actually the financial requirements of the road had much to do with the accounting practice. Those roads which were prosperous observed a conservative policy, and charged considerable amounts to operating expenses which, at the present time, under the mandatory classification, are properly chargeable to capital account. These railroads had made replacements when needed, and charged them, as well as net improvements, to operating expenses in a single year. Their bookkeeping was thus simplified by charges direct to operating expense (maintenance) in preference to creating depreciation reserves which should be written down with the making of replacements. There have been cases, of

'It must be emphasized that access to the carriers' accounts and their uniform building up had been sought by the Commission as a means of discovering disguised rebate payments. Control of accounting methods was, therefore, originally sought as a part of the general campaign to insure collection of the published rate. It was not concerned with the rate of return, 19th Annual Report I. C. C. (1905), p. 11.

'Mr. A. H. Plant, then Comptroller of the Southern Railway, testified in 1916: "Before the depreciation account was born on the Southern

course, when a railroad has been brought up short by a neglected road bed, unusable cars, or worthless motive power. Then the failure to furnish adequate service has furnished the basis of the public interest, rather than the adequacy or inadequacy of the charges against earnings.

Maintenance accounts have also been within the control of the management. The amount spent for maintenance had, very largely, before the Commission's accounting system was established, been made to fluctuate with gross earnings. And sometimes, when expenses had been pushing earnings pretty close during the first two-thirds of the year, maintenance was held over in the hope of an improved situation. If the situation was courageously faced, and the necessary "deferred maintenance" promptly made up, the comparative accounts for two succeeding years now appear obviously out of line. But, if the hoped-for turn in affairs did not materialize, the temptation to show further paper profits more than once proved too much. All too frequently the courage was lacking and the road drifted into bankruptcy, a receivership, and a period of physical rehabilitation during which the operating expenses ate up the earnings at an inordinate rate. There have even been cases when a non-payment of dividends has accompanied a low standard of maintenance over a period of years, and cases where dividends have been suspended in order to keep up the property. The number of properties is so many, and the conditions faced so variable,

Railway, we realized the necessity for taking care of our maintenance and retirements, and we really had in practice a depreciation not determined, however, as scientifically as subsequently determined by the Commission. When we retired a car on the Southern, we charged the cost to replace it with a modern car to operating expenses, and in that way we did practically what we are now doing under the Commission's rule. I was quite anxious . . . to see how the two methods agreed, and I went back and applied the Commission's rule to a period back of the time it was promulgated, and compared it with the results under the Southern old method, and it surprised me to find the results were very nearly the same." Valuation Hearings, I. C. C., March, 1917, p. 843.

1 Five Per Cent Case, 31 I. C. C., 350, 380. There the Commission said: "One of the executives, testifying in the case, said, in effect, that he regarded dividends as practically a fixed charge that ought not to be reduced, and that it had been his policy to make the maintenance accounts fluctuate with the gross earnings." See testimony of Mr. Daniel Willard, Evidence, Five Per Cent Case, Sen. Doc. No. 466, 63d Cong., 2d Sess., pp. 5677, 5686, 5709. Mr. Willard was chairman of the committee of railroad executives in charge of the presentation of the carriers' case.

that it is quite impossible to generalize and yet not to think of exceptions to the general statement.

§ 2. By detailed regulations, supplemented by inspection, the Interstate Commerce Commission seeks to minimize the possibility of control of accounts by executive officers. Indeed, it has been the Commission's aim from the first to hold the individual accounting officer responsible to the Commission. In 1914 the language of the Commission was pointed:

"The formative period. . . must now be considered as having come to an end so far as all the important principles . . . are concerned, and we shall hereafter expect a more exact observance of the prescribed accounting systems by the carriers and their officials. . . . Irrespective, however, of the influences brought to bear upon an accounting officer to turn him from his true course as an accountant and from his duty under the law, of keeping the accounts in accordance with the system prescribed by the Commission, it is nevertheless his hand, or the hand of someone immediately under his authority, that makes the wrongful record, and it is the accountant, therefore, . . . who is immediately responsible and whom the Commission will first hold responsible when it becomes necessary to invoke the penalties of law; but we shall not hesitate to call to account, with even greater severity, anyone above the accounting officer in authority who may share in the responsibility for any violations of the accounting rules and regulations which have been prescribed for the use of the carriers that are subject to the Act."1

This statement of policy clearly places the railroad accountant under a dual responsibility: a responsibility to the executive officers and the board of directors for carrying out instructions, and, on the other hand, a responsibility to the Commission for an observance of its rules. If the instructions from a superior officer conflict with the rules of the Commission, as he understands them, he must obey the rules or stand ready to accept the consequences. His public responsibility he cannot shift. The certainty of such an extension of the control over accounts, should have been anticipated when rate advances were sought on a basis of an insufficiency of earnings. And now a rule of rate making and the contemplated recapture of earnings render more important both soundness of accounting analysis, and allocation of charges, and also uniformity of practice in accounting for certain classes of expenditures, notably for maintenance, or in handling such book adjustments as those made of current 'St. Paul and Puget Sound Accounts, 29 I. C. C. 508, 518.

wastage of physical assets-depreciation. Indeed, the key to the regulation of management lies in the regulation of accounts.1

§ 3. Especially does the recapture of excess earnings clause emphasize current transactions rather than past performance. The rule of rate making, recognizing the necessity of "reasonable expenditures for maintenance of way," calls for "honest, efficient, and economical management." But what is reasonable is a matter of judgment, and the line is not always easily drawn between sound economy and wasteful economy. "Efficient" men sometimes make "honest" mistakes. The reason is clear, therefore, why it will be difficult for the Commission, charged with an interest in these details of management which govern standards of maintenance and performance, to stop at mere supervision and inspection of accounts. The function of the interstate Commerce Commission would, indeed, seem destined to look deeper into the work of management, to be especially one of supervising and watching standards. This condition the Transportation Act provided for in part when it granted the power to the Commission to prescribe the classes of property for which depreciation may properly be included under operating expenses, and to fix the depreciation charged. But the Commission's reports in the cases concerning the construction and repair of railway equipment, and especially the dissenting opinions, illustrate how difficult it must be to draw a clear line of distinction between mere supervision and interference with management,

1 Mr. L. F. Loree is authority for the following:

"In putting into effect the accounting rules made effective in July 1, 1907, the Commission's Statistician, Mr. Henry C. Adams, called together the accounting staff of the Commission, and, among other things, said to them:

"The Government has recently undertaken to do something quite different from that which it has ever undertaken to do before. It has undertaken to exercise a controlling influence upon the administration of railway properties through the agency of their accounts.

"The aim of the supervision of accounting is to exercise influence upon the administration and management of railway property.""

Address at the 1921 meeting of the Railway Accounting Officers' Association.

2 Before 1920, the Commission's accountants made examinations of carriers' accounts rather as a matter of routine check, to insure that the requirements of the regulations were understood, though there have been some examinations seeking to explain an emergency situation-a collapse of service or insolvency under mysterious circumstances, in which there has been attempt to go behind the figures. The work in this latter class of examinations has been essentially of the nature of historical research.