Chapter XIX
LIABILITIES ON THE BALANCE SHEET; CURRENT AND CONTINGENT LIABILITIES
Form and Valuation
The problem of handling liabilities on the balance sheet is usually not so complicated as that of assets. The questions of arrangement, form, groups, and suitable nomenclature have in the case of liabilities an equal or even greater importance than that of the assets, the governing principle being clearness and fullness in the information given, with due regard to the purpose and intended use of the balance sheet.
The problem of valuation, which assumes great importance in the treatment of the assets, has normally little or no significance in the consideration of liabilities. This is due to several causes. In the first place, human nature being what it is, there is normally little danger of an overstatement of liabilities; they are usually sufficiently large, and no desire exists to make them appear more than they really are. Secondly, and likewise based on human frailty, while a concern may desire to undervalue its liabilities, the other party to the liability, the person holding the claim, can usually be depended upon to press his claim with sufficient insistence as to make the concern aware at all times of the amount of its liabilities.
From the viewpoint of a going concern, while all business experience points to a decrease and a necessary diminution in the values at which certain assets may appear on the books, no such diminution in the value of liabilities can be looked for; as legitimate claims must be met if a business is to exist as a going concern. Similarly, there is normally no tendency to inflate the liabilities by the inclusion of items which do not rank fully in this class—intangible liabilities seldom find place in any balance sheet.
On the other hand, there is frequently a very real hesitancy about the inclusion of some liability items until their claim becomes urgent or their full liability status becomes determined. Occasionally, and usually with ulterior intent, the liabilities may be inflated in value and items included therein which are fictitious; but our present concern is not with such conditions.
The one principle underlying the showing of both assets and liabilities is that their true status should be indicated. As applied to liabilities this means that they should be shown not only in correct amount but also in their true light, viz.: that all facts bearing on their relation to the business which ought to be known properly to judge conditions must be stated. The chief problem in handling liabilities is, therefore, how to show and list them so as to accomplish this purpose of truth and usually the further purpose of full truth. In a consideration of this problem, the auxiliary one of the inclusion of doubtful items among the liabilities will also receive consideration.
Arrangement on Balance Sheet
As to the classification and arrangement of liabilities on the balance sheet, it may be stated in a general way that whatever classification and arrangement are adopted for the assets, the liabilities should be shown similarly. For most purposes a standard grouping under the captions, Current, Deferred Income, Fixed or Funded, will suffice. The order of the groups as given here follows the order given for the assets. This is desirable for purposes of easy comparison, because in this way current liabilities are brought into juxtaposition with the group of assets to which current creditors must look for payment of their claims; and fixed liabilities and capital are opposed to the assets in which for the most part they have been invested.
Items within Groups
Arrangement within the group may be attempted on the basis of relative degree of liquidity of the items. This, however, is not always determinable nor is it an end to be sought; the chief desideratum is to show items in the main group to which they properly belong.
The manner of listing the items within the group is not a question of relative order so much as it is of nomenclature and clearness of expression. Thus, desirable and valuable information would be given by a separation of the items to show (1) those past due; (2) those due but not payable because of their credit term; (3) those neither due nor payable, such as accruing items; and (4) contingent liabilities.[48] It may be remarked that such an analysis is seldom seen on the ordinary balance sheet. Corporations which have to report to a regulating body may be required to give more information concerning their business than those not so regulated. For internal use the suggested analysis has undoubted merit. For public use, it is neither necessary nor usually desirable that the information be given in that form; a showing of the items under the usual titles within the group to which they properly belong being here deemed sufficient.
[48] P. J. Esquerré, in “Applied Theory of Accounts.”
Cancellation of Liabilities against Assets
Occasionally the practice is met of cancelling the liabilities, or some group of them, against corresponding assets, showing only the net assets remaining. Thus, Current Assets less Current Claims might appear as an item among the assets. Even for publication purposes this would not be deemed sufficient; for the outsider as a prospective creditor or investor has a right to judge for himself the relative sufficiency of the assets to meet the claims of creditors. No basis for such judgment is offered by a cancellation of the one against the other with a showing of the net amount only. A somewhat analogous situation arises in the double-account form of statement used by some English companies. Here, the capital assets are canceled against the capital and fixed liabilities and only the net surplus—usually of capital—appears in the balance sheet proper. The criticism is not so pertinent here, however, because almost invariably the balance sheet is accompanied by the so-called capital account which shows the full detail of the net item in the balance sheet. So also, the practice is often condoned wherever an accompanying schedule shows the full facts as to assets and liabilities. As a matter of principle, it should be condemned because accompanying schedules do not always “accompany.”
Inventory of Liabilities
The principle of showing the full truth as to the liabilities raises the problem of the complete inclusion or inventory of the liabilities. Under this will be considered any adjustments that must be made in the book record in order to show the true state of the liabilities, and also the proper treatment of contingent liabilities so as to show their relation to the state of the business.
The adjustment of the book record is not usually complicated. The necessary data are for the most part available. All that is required is an analysis of each item to determine what, if any, adjustment is needed to bring the books to a true statement of conditions as on the date of the balance sheet. These adjustments fall into six main groups, only two of which appear among the liabilities, while one of the others is often based on information obtainable only from an analysis of the liabilities. These groups are:
1. Accrued Expenses 2. Deferred Income 3. Deferred Expenses 4. Accrued Income 5. Valuation Reserves 6. Merchandise Inventory
The first three groups are discussed below, as well as another analogous group.
Accrued Expenses. These expenses comprise the liability existing at the close of a fiscal period because of expenses incurred but not settled for and oftentimes not yet due. Information as to these may be gathered—not in completeness however—from an examination of the various expense accounts and a somewhat intimate knowledge of the operations of the business. Unless a record is kept of all services being rendered to the business, it is very easy to omit some items of this kind. These will be discussed in detail under “Current Liabilities,” page 350.
Deferred Income. This income comprises the items of income received in advance of the full performance of the service required to earn it. In cases of this kind there are in the possession of the business certain assets which must be used to perform the service not yet completed in order to entitle the business to the full enjoyment of the income. That is, the property of the owners is liable for the service not yet rendered. Also, in order to make a correct showing of results as between the current fiscal period and the next, this unearned income must be carried forward for credit in the period in which the service is performed.
Premium on Bonds. Somewhat analogous to deferred income is the item of premium on bonds. As indicated in Chapter XV this is preferably treated as a direct deduction from the periodic interest payments on the bonds, because the bonds were marketed at a rate higher than the interest rate prevailing at the time of their flotation. Inasmuch as the premium must be spread over the life of the bonds, its unexpired portion will appear as of the nature of deferred income at all intermediate stages. A more detailed showing of this is given in Chapter XX, in the discussion of the liability, bonds.
Deferred Expenses. These expenses have been explained in detail in Chapter XIV. Here it is to be noted that, while this group of adjustment items is always an asset, for the proper determination of deferred interest an examination of the liability, notes payable, is often necessary. Notes payable given for a loan at the bank, or given to a creditor, with prepaid interest added to the principal of the debt as a part of the face amount of the note, will give the data for calculation of the amount of interest or discount to be deferred to later periods.
Contingent Liabilities
As stated above, the second group of items under the head of inventory of the liabilities is that of contingent liabilities. It is taken for granted that all items which on the date of the balance sheet have assumed a status of full and direct liability will, of course, appear as such on the books. Here, all that can be said without trespassing on the distinctive field of auditing, is that all such items must appear. For the method of detecting their omission, whether omitted with fraudulent intent or through carelessness and inaccuracy, the student is referred to a standard work on auditing.
We have here to consider, however, a group of items the status of which is one of suspended or indeterminate liability. Expressed otherwise, they are items concerning which it is hoped—it may be even expected—that the business will never incur liability but for which in the event of certain happenings liability must be assumed. There are, of course, degrees of contingency, ranging from almost certainty to negligible remoteness. It would seem that no business man would omit the almost certain type from his books, and in case of doubt prudence demands that decision be rendered in favor of at least the greater probability.
Yet there is often seen a failure to book even the liability on account of goods purchased and shipped, but not received. If it is argued that the liability is not fully established until receipt and acceptance of the goods, every manager knows that non-acceptance of purchases is the exception, not the rule. On the other hand, upon receipt of consigned goods to be sold on account of a principal, no liability except to exercise ordinary care usually attaches to a broker until some part of the goods has been sold by him. Between these two extremes are many shades and degrees of probability, all of which in some cases are recorded as liabilities; in others none are so recorded. The importance of the information as to contingent liability on account of notes receivable discounted and discounted acceptances is now accorded general recognition. As to liability under court judgments awaiting appeal, guarantees of work and product, deposits made on contracts or bids—these and other similar matters will be treated fully in following pages.
These, then, constitute the main problems in connection with liabilities on the balance sheet. The group of current liabilities will now be considered, followed by a discussion of the nature of contingent liabilities.
CURRENT LIABILITIES
Notes and accounts payable, using the terms broadly, constitute practically all of the current liabilities. Not all notes nor all accounts payable are, however, current items. The term “current” cannot be standardized; it varies and will perhaps always vary according to customs and practices in any particular trade. In the main, the 90-day period may be taken as the average. That is, on the given date of the balance sheet a knowledge of the debts that must be met within the next 90 days is a minimum of necessary information for the purpose of judging business condition, particularly so far as concerns the credit extended to it. When a balance sheet is submitted to the bank as the basis for credit, other data concerning notes payable are usually called for—such as notes given for merchandise, notes negotiated to own banks, notes otherwise disposed of. The Federal Reserve Bulletin for April, 1917, under the title “Uniform Accounting a Tentative Proposal” suggests for balance sheet presentation a list of notes analyzed as to acceptances made for merchandise or raw material purchased; notes given for merchandise or raw material purchased; notes given to banks for money borrowed; notes sold through brokers; notes given for machinery, additions to plant, etc.; notes due to stockholders, officers, or employees. R. H. Montgomery[49] suggests a division of notes into the groups: notes issued for merchandise; notes discounted by own banks; notes sold through brokers; and demand loans. He suggests further that an additional separation into notes accompanied by collateral and notes with which no collateral is given would be desirable.
[49] In “Auditing—Theory and Practice.”
From the above it is seen that the present tendency of bankers is to insist on a full statement of essential facts needed to pass intelligent judgment as to the exact status of affairs. Even in the case of balance sheets, the accuracy of which has been certified by someone, some bankers require a certificate as to the character of the certifier unless he is well known. More and more is the fact being recognized that legitimate business has nothing to fear and much to gain by making a full and free statement of exact condition, and that the sooner business supported by fraudulent statement is eliminated, the better will it be for legitimate enterprises. In certain cases, however, the interests or purpose of a business would not be well served by the detailed information demanded by the banker and, here as elsewhere, no specific rule can be laid down other than that the purpose should in all cases govern the form and particularly the amount of detail.
Loans from Bank
In connection with advances from the bank it should be noted that the banker does not expect to become a permanent partner in the business, but that one of his legitimate functions is to furnish funds for seasonal fluctuations. Oftentimes a concern does not start with enough capital to carry its load of maximum trade, from the fear that advantageous investment of surplus funds during the dull season will not be possible. It may rightly expect its bank to furnish funds for this purpose when expenses are heaviest, and to await repayment of the loan out of the income, as accounts are collected after the peak of the seasonal trade is passed. This is one of the fields of legitimate banking and the banker has a right to whatever information is necessary to assure himself that his aid is being put to proper use.
General Classification of Notes
For general purposes, a separation of notes into notes for trade purposes and notes for other purposes is desirable. Trade purposes would be limited to merchandise purchases and loans for working capital. Other purposes would be long-time loans, purchase money notes often secured by mortgage on equipment, and notes of officers and employees. These last would best be classified by their showing as fixed rather than current liabilities.
Accounts Payable
The use of the term, accounts payable, to cover only creditors for stock-in-trade and other trade purposes is too indefinite and inaccurate, the term being too comprehensive and inclusive. The considerations applying to trade debtors have equal weight in requiring the use of the term trade creditors for the purposes mentioned above. Accounts payable to trade creditors are usually the current items, whereas those payable to stockholders, officers, etc., and those due to a parent or holding company are more or less fixed, as there is usually no particular urgency as to the time of their payment. An analysis of trade creditors into “not due” and “past due” will at least bring out the information as to neglected discounts and some idea as to the amount of cash needed to pay off debts and to secure their discount.
There is no necessary relationship between accounts and notes payable, nor any significance in their relative amounts. In some trades notes are given in order to obtain the discounts; in others notes are given at the date of purchase of the commodities.
Deposits. Another group of accounts payable of a more or less current type consists of deposits of various sorts. The business may accept deposits from customers or employees for various purposes. Consumers’ deposits with gas and electric light companies as guarantee to cover payment of bills and possible damage to meters or other company property; deposits covering locker privileges, breakage of materials, keys issued, and the like, are examples of this kind. These deposits are seldom all claimed at any one time; experience only can indicate the necessary financial provisions to be made currently for them. In some instances there is an accruing liability on account of interest on these deposits which must also be cared for.
Guarantees. Sometimes goods are purchased and only partly paid for, a portion of the purchase price being retained as a guarantee of quality until opportunity is given for adequate examination and acceptance or rejection. Similarly, in the case of construction work done by contract or subcontract, the owner—or, if a subcontract, the general contractor—retains a certain percentage of the contract price as a guarantee of performance of the whole according to contract agreement. This liability for the portion retained is a current liability, as a usual thing, and is to be listed under accounts payable with suitable subtitle.
Long-Term Notes. Long-term notes and accounts, bonds, and other fixed liabilities become current as their maturity closely approaches and provision for payment must be made.
Future Deliveries. On the border lines between contingent and full liabilities may be classed the liability because of goods purchased with long future dating. This is sometimes allowed by a seller to secure warehouse room for new product. It is undoubtedly best to set up both the asset and the liability, even where the goods have not yet been received.
Consigned Goods Sold. The factor’s real liability on account of consigned goods sold should, of course, be shown as a current liability, offset by any claims for expenses incurred on account of the consignor and any accrued commissions earned on sales to date.
Dividends Not Yet Paid. Another item belonging to accounts payable is dividends declared but not yet paid. Though it may be the custom of a company always to declare a dividend on a given date, no liability is incurred on account of dividends until they are actually declared. Upon declaration of a dividend the company makes itself liable to stockholders for the amount of the dividend. This liability ranks as an unsecured debt on the same footing as unsecured liabilities to other creditors. The dividend liability in large part is usually soon liquidated. Any unclaimed dividends constitute a liability until claimed or authority is given for other disposition. The item is usually small and is best shown as a current liability even though the chance of its being claimed may be remote. The method of handling and safeguarding the dividend transaction is treated in Chapter XXIV.
Accrued Expenses
The final item to be considered among the current liabilities is the group of accrued expenses. These constitute such items as wages, salaries, rents, royalties, expense supplies purchased but unpaid for, interest, advertising, sales commissions, traveling expenses, freights, water and other taxes, etc.—in fact, all services which have been rendered the business previous to the date of the balance sheet but which on that date are unpaid. These usually comprise the most urgent of the liability items and so are properly classed as current. There is seldom any business in which items of this kind are not encountered and, as stated on page 343, a careful examination of the records and familiarity with the business is needed to secure a full statement of them.
With regard to some of these items, difference of opinion exists. It is argued that until the amount of the liability is known, no real liability can be said to exist. Thus, taxes for the current year may not be known until the following year. Proverbially taxes are as certain as death, and there would seem to be no unreality or contingency about their incidence. As the current year passes by, the accounts should include a charge for taxes. Since the real amount is not known, it must be carefully estimated; for any difference must be taken up when the real amount becomes known, and so may disturb and somewhat invalidate the results for comparative purposes. Because of the fact that the current amount is an estimate, the title given the liability thereunder is sometimes called “Reserve for Taxes” rather than “Accrued Taxes.” No matter what the caption may be, it should usually be listed as a current liability.
Booking of Accrued Expenses
As in the case of deferred expenses, so in the booking of accrued expenses, in some quarters it is thought highly unscientific to record both the expense and liability elements in the same account at the time of adjusting the books. Use is made of a separate liability account entitled “Interest Accrued,” for example. When so used immediately at the opening of the new period, this account is either transferred to the expense account where it will act as an offsetting credit to the expense when paid, so automatically reducing the amount to the part properly applicable to the new period; or the account may be allowed to stand untouched (and therefore having no real significance) till the end of the next period when only the difference between it and the new amount accrued is made the basis of the new adjusting entry. Both these methods, while securing a more evident separation of the expense and liability elements, do so only at the cost of a needless multiplication of accounts and work. To one acquainted with the significance of bookkeeping methods, the old way of treating the liability element as an inventory in the expense account makes a definite allocation of the two elements, and does so with less burden on the bookkeeper and is to be preferred in most cases.
Deferred Credits
Deferred credits, as already explained, are analogous to current liabilities in that they represent unearned income. The enjoyment or earning of this income requires the rendering of certain services which are a claim on the current assets. In this sense, then, they belong to the current liability group, for the payment of which the current assets must be available.
NATURE OF CONTINGENT LIABILITIES
Statement of Contingent Liabilities
As stated on page 345, contingent liabilities range from those almost certain to materialize to those extremely remote. For some purposes a full statement of all such liabilities is needed to give an adequate view of conditions within the business. For other purposes, so detailed a statement may not be necessary although usually desirable. The Federal Reserve Board requires on a balance sheet submitted as the basis for credit a full statement of contingent liability as follows:
Kind of Contingent Liability Amount
Upon customers’ notes discounted, sold, or otherwise transferred $...... Upon drafts negotiated ...... For accommodation indorsements ...... For guarantees ...... Upon leases ...... Upon bonds or other obligations of ...... subsidiary companies ...... Under contracts or purchase arrangements ...... Under agreements ...... Under pending lawsuits ......
This company is not a guarantor or indorser of any liabilities or obligations of any individual, firm, or corporation, and it is not liable under any contracts, bonds, or profit-sharing arrangements, or any other agreements, and there are no lawsuits pending except as set forth above.
Sign Company’s name here ..........................
By ..........................
N. B. It is most essential that each question be fully answered.
Full answers to the above inquisition would often prove embarrassing but very enlightening. Two additional kinds of contingent liability not listed above sometimes exist, viz.: that arising out of a call for the unpaid portion of stocks owned but not fully paid for; and in the case of a corporation, unpaid accumulated dividends on preferred stocks. Some of these contingent liabilities require detailed consideration.
Notes and Drafts Transferred
The proper method of handling notes discounted, sold, or otherwise transferred, and negotiated drafts is given in Volume I and will not be repeated here. The showing of these items on the balance sheet is by inclusion among both the assets and liabilities, or preferably by inclusion among the assets with the liability element shown deducted. When a person or firm lends its credit by means of an accommodation indorsement, the transaction should be recorded as a charge to the accommodated party and a credit to Notes Payable if the liability is primary; or to Indorser’s Liability, if secondary. In case of primary liability, liability is full and must be listed on the balance sheet as a note payable. In case of secondary liability, liability is contingent, as in the case of discounted notes, and should be so shown on the balance sheet. In either of these cases, the practice of cancelling the liability against the corresponding asset and by a feat of mental dexterity persuading oneself that there is therefore no need to show the item on the balance sheet, is a practice to be universally condemned.
Guarantees as a Contingent Liability
Guarantees are of many sorts—guarantees of product sold or work performed, guarantees of the good faith of others in meeting their obligations, etc. The transferred note is one kind of guarantee. Oftentimes, a parent company may guarantee the principal and interest or the interest only of the bond or note obligations of a subsidiary. While the expectation is usually that the contingent liability will not become real, yet experience shows the need of making adequate provision against it. The recent example of the Denver & Rio Grande as guarantor of the bond interest of Western Pacific bonds drives home that necessity. In a case of this sort provision is best made in the creation of a contingency reserve, for there is no experience on which to base a better estimate. In the case of a policy of guaranteeing the quality of a product or its workmanship, after a few years’ experience very accurate estimates can be made of the loss to be expected therefrom, and at the end of a fiscal period the books can be adjusted on that basis just as they are for taxes. A charge to a suitable expense account and a credit to a reserve or accrued account comprises the book entry, with a listing of the reserve as a real liability.
Long-Term Leases
Contingent liability brought about by a lease covering a long period may be disregarded if the lease has a marketable value sufficient to cover the liability. Otherwise a contingent reserve should be set up. Liability under the subletting of a lease is best handled by means of a reserve.
Purchases for Future Delivery
Purchase contracts for future delivery, if made at a fixed price, may be disregarded unless at the date of the balance sheet market value is lower than cost, when a reserve should be set up. A fuller statement of the facts shows the transaction among both assets and liabilities. If the contract, being speculative, is not at a named price, the showing of the reserve is prudent and conservative.
Pending Lawsuits
In the case of pending lawsuits, the contingent reserve is usually all that is necessary. If the case is on appeal, it might in addition be wise to create a fund which would provide funds for settlement if the decision is unfavorable. Here the item of costs, fees, and accruing interest is usually large and liberal provision must be made.
Stock not fully Paid
Where shares of stock are held which are not fully paid, a liability attaches for the unpaid portion contingent upon call being made for it. Showing the stocks at subscribed price with the offsetting liability for the unpaid amount as a deduction, is perhaps the best method, though there is no serious objection to omit mention of it if the stock has increased in value, or of using the method of a reserve. Where a double liability attaches to stock ownership in case of bankruptcy, no notice need be taken of the contingent liability so long as the business whose stock is held shows an entirely solvent condition. When such is not the case, whatever provision seems necessary should be made, even to the extent of liability to the full value of the stock held.
Accumulated Dividends on Preferred Stock
There is no liability on account of accumulated dividends on preferred stock until profits have been made out of which they may be paid. If the policy of management does not allow their declaration at the present time, although sufficient profits have been made, the accumulation of dividends should be shown as a liability. Where the company is unable to declare dividends because of insufficient profits, mention of the accumulating dividends should be made in a footnote as a possible future liability.
Signature to Surety Bond
The liability arising through signature to a surety bond is a contingent liability resting upon the good faith and honor of the bonded party. The practice of personal bondsmen is not so prevalent as formerly. Experience shows that the liability of the bondsmen may become very real, and not only should suitable provision be made for it but its existence should be shown on the balance sheet.
XX. FIXED LIABILITIES—BONDS AND MORTGAGES
Nature of Fixed Liabilities
Fixed liabilities, called also capital, bonded, long-term, and funded liabilities or debts, comprise all debts of which the date of maturity is some distance ahead and considerably longer than that of current liabilities. Government regulating boards, for purposes of standardization, may set a minimum life-period for this group of liabilities and any kind of debt falling within the period is so classified. Thus, the Public Service Commission for the First District of the State of New York says: “Funded debt comprises all debt which by the terms of its creation does not mature until more than one year after date of creation.” Private undertakings do not need such exact uniformity. Any debt the maturity of which extends beyond the period adopted within that business for current liabilities will usually be grouped with the fixed liabilities, there seldom being an intermediate group.
Purpose of Fixed Liabilities
Fixed liabilities, as distinguished from current, are those issued distinctively for the purpose of raising capital. Due to insufficient original capitalization, funds may be needed for one or more of many purposes. Working capital may be required; extensions of plant and market may be desirable; additional equipment and improvement within the plant itself may be advisable; the control of the plant of a competitor may prove advantageous; it may be deemed wise to fund floating liabilities; the refunding of liabilities soon to mature may become necessary; the financial policy may dictate the unification of several diverse forms of debt—these and other purposes may be served by the assumption of long-term debts.
Corporation Bonds
The most common type of fixed liability is the bond. As an instrument of credit the bond is limited almost exclusively to corporations. The purchasing public, interested in securities of this kind, looks with suspicion on a long-term promise to pay issued by either a single proprietor or by a partnership. Such businesses are almost wholly dependent on the health and ability of individual owners. During a long period of years so many contingencies may arise and seriously cripple the business that the long-term debts of a partnership or sole ownership have no market, although isolated instances of such issues exist. The corporation, however, has continuity of life, is not so dependent on individuals, and therefore has avenues for the raising of funds open to it which are closed to other types of organization.
Nature of Bonds
A bond may be defined as an instrument under seal promising to pay a certain amount of money at a definite or determinable future time. From a legal standpoint, a bond is a contract setting forth the terms and conditions under which the obligation is assumed. Furthermore, it is a negotiable contract transferable from hand to hand, though in some cases registration is necessary to prove ownership in the eyes of the issuing corporation. From a financial standpoint, a bond is essentially a long-term promissory note. Bonds, as here used, are to be distinguished from the old real estate bond and mortgage. Bonds are usually secured by a lien on some definite property or prospect of property, just as the real estate bond and mortgage. The corporation bond, however, is a separate instrument, divisible into small parts, whereas the bond and mortgage is not usually an instrument of that type.
Corporation bonds are also to be distinguished from the surety bonds mentioned in the preceding chapter. These latter, as already noted, are instruments whereby individuals, firms, or corporations bind themselves as guarantors for the conduct of others or for the payment of sums of money for which the guarantor is not directly liable.
Difference between Bond and Real Estate Mortgages
With regard to the mortgage covering the bond issue, points of difference from the ordinary real estate mortgage are to be noted. To the ordinary mortgage there are two parties, viz., the party obligated and the party accommodated, the obligor and obligee. To the bond mortgage, the obligee is a trustee standing in the stead of the numerous bondholders who could not conveniently act individually. In this trustee the title to the property liened is vested for the benefit of the bondholders. The mortgage instrument itself is often a model of completeness and comprehensiveness, defining with minute care the relations, duties, rights, interests, and status of the issuing corporation, the bondholders, and the trustee under present circumstances and all possible future contingencies.
Kinds of Corporation Bonds
Since bonds were first issued, perhaps one hundred different kinds have been placed on the market. They all have the same fundamental characteristics but differ in minor particulars. No universally recognized basis exists for their classification, nor is such a basis possible, the use which they are to serve determining always the basis of analysis into classes. Thus, in the opinion of a leading authority[50] on the subject bonds may be classified under the following heads, according to:
1. The character of the issuing corporation under which are treated: (a) Civil Loans (b) Corporation loans
2. The security of the bonds under which come: (a) First mortgage (second, third, etc.) (b) General mortgage (c) Divisional (d) Guaranteed (e) Collateral trust (f) Debenture (g) Income (h) Land grant (i) Real estate (j) Prior lien (k) Consolidated (consols) Etc., etc., there seemingly being no limit to the descriptive titles that may be used in order to indicate some feature of the security.
3. The purpose of the issue, as: (a) Improvement (b) Construction (c) Refunding (d) Purchase money (e) Unified (f) Subsidy Etc.
4. The conditions incident upon payment of principal and interest, as:
For the payment of interest— (a) Income (b) Participating (c) Unconditional (d) Registered (e) Registered coupon (f) Coupon (g) Interchangeable Etc.
For the payment of the principal— (a) Premium (b) Gold (c) Silver (d) Straight (e) Serial (f) Extended (g) Callable (h) Optional (i) Convertible Etc.
[50] “The Principles of Bond Investment,” by Lawrence Chamberlain.
The issuing corporation often distinguishes its bonds by means of some descriptive adjectives purporting to classify them or indicate their nature. Thus, consolidated first and improvement, general and refunding mortgage, first mortgage extension, general lien railway and land grant, are titles sometimes met, though a simpler title carrying also the interest rate is more common, as general mortgage 4’s of 1965, C. & A. 5’s, Toledo Light & Power 4’s, etc. As listed on the exchange the title usually gives the name of the issuing corporation (i.e., the obligor), the distinctive name of the bond, and its interest rate.
Bonds rank very much as mortgages do in the priority of their liens. A first mortgage bond has a first lien on the property securing it; a second mortgage bond has a second lien and its claim is said to be junior to that of the first. No attempt can here be made to explain the distinguishing features of the above-named issues. Attention is called to them only because the reader of a balance sheet—an investor or prospective creditor—often must have a knowledge of the various classes of bonds and a detailed knowledge of the conditions of particular issues. It is obvious that the accountant should have a knowledge of the particular issues of a business in order intelligently to draw up a balance sheet and make a report thereon.
Authority for the Issue of Bonds
A corporation has generally a charter right to issue bonds for the purpose of securing money, acquiring property, or in payment for labor or financial services rendered. The exercise of this right may be curtailed by, or be dependent upon, authority from a regulating body. Within the corporation itself, the right to issue vests in the stockholders. In some cases a majority vote suffices; in others as many as three-quarters of the votes may be required to authorize the issue. The directors themselves may, upon proper authorization from the stockholders, make the actual issue, and usually the initiative for a bond issue comes from them because they have intimate knowledge of the business and its needs.
Financial Considerations Involved in Issue
Financial considerations involved in the determination to issue bonds may be reviewed briefly. It is interesting to note that the bond has been used very extensively as a means of securing capital. There is, however, no necessary relationship between the amount of capital raised by stock issues and that raised by bond issues. The sale of additional stock or of bonds or other similar securities is the main source of corporation funds for capital purposes. Some concerns have obtained approximately one-half of their capital through the issue of bonds. Percentages of capital so raised ranging from 15% to 40% are not uncommon.
The manner of raising capital is largely a matter of credit, expediency, and the question of fixed operating expenses. It rarely happens that bonds carry with them the privilege of voice in the management of the corporation’s affairs; that is usually limited strictly to the shareholders. Accordingly, the issue of bonds instead of additional stock does not interfere with the management or control of the concern—so long as the contract requirements of the bond issue are adhered to.
Because of the definiteness of the income on bonds and usually the greater security of the principal, bonds may often find a market where stocks would not. On the other hand, if the stock can be marketed as advantageously as the bonds, no definite dividend rate is necessarily attached to them. The price at which stocks may be marketed, aside from the features of extra inducement which might influence the market, depends largely upon the prospective income rate judged mostly by what the company has been able to do in the past and any features of present condition or expected future condition which might influence the earning capacity of the corporation. Therefore, unless a dividend rate a little higher than the current interest rate is in prospect, the company usually finds it difficult to market its stock advantageously.
Bonds versus Stock Issues
The bond market furnishes opportunity for investment to quite a different class of people from those interested in stocks. Security, conservatism, and a definite income are the main elements desired. Thus conditions may oftentimes be such that one market or another may be more favorable for absorbing an issue of securities, dependent on conditions in that market as much as on the credit and standing of the issuing corporation.
Aside from these points which are usually given consideration, is the question of how heavy are the fixed charges the corporation can carry. While from the investor’s viewpoint an income at a fixed rate is highly desirable, from the corporation’s point of view it may impose so great a burden as to eat up all the profits. The bond interest constitutes a fixed charge deductible before the determination of profits. In case of failure to meet the bond interest, the mortgage covering the bonds is subject to foreclosure. Upon foreclosure at forced sale values always shrink greatly, oftentimes the shareholders lose their entire interest in the company, and all the net assets may be taken to satisfy the claims of the bondholders. As compared with an additional issue of stock—common or preference shares, as may best meet the situation—a bond issue may thus be of doubtful value. One of the knotty problems upon a reorganization following insolvency is that of lowering the fixed charges by converting some of the bond issues into preferred stocks in order to prevent the recurrence of operation at a loss and so of inability to meet bond interest.
Accounting for Bond Issue
Accounting for the bond issue presents much the same problems as those connected with an issue of stock. Inasmuch as most corporation issues are sold in block to a banker who in turn markets them to the investing public, often through a syndicate (or the process may be one of under-writing), there is usually no need for detailed subscription records and accounts. In the case of coupon bonds no record of individual ownership is required because the bonds pass by delivery, possession evidencing ownership and the interest coupon being payable to bearer. In the case of registered bonds, a record of individual holdings must be kept similar to the record of stockholders. The party in whose name the bond is registered on the company’s records is the prima facie owner to whom the periodic interest check is also sent. If the bond is registered as to principal but bears coupons for the interest, records of individual ownership are also required here.
Entry of Issue on Books
Placing the bond issue on the books is accomplished by either of two methods. Assuming an issue of $500,000 of first mortgage 5% bonds of which $350,000 are sold at par for cash, the balance remaining unissued for the present, the entries would be:
First Method
(1) Unissued First Mortgage Bonds $500,000.00 First Mortgage Bonds Payable $500,000.00
(2) Cash 350,000.00 Unissued First Mortgage Bonds 350,000.00
Entry (1) is used to make a memorandum entry of the authorized issue. Entry (2) shows the amount sold for cash. The balance in the Unissued Bond account is treated as an offset to the Bonds Payable account. Sometimes the title “Treasury Bonds” is used instead of “Unissued,” but the term is apt to be misleading because of the restricted meaning given the word in connection with treasury stock.
Second Method
(3) Cash $350,000.00 First Mortgage Bonds Payable $350,000.00
Under the second method, the desired information as to authorized issue would be carried parenthetically in the account title. At the present time the tendency is to deprecate an unnecessary multiplication of accounts as is brought about through the use of memorandum accounts. The second method is therefore the preferred method and in its operation brings onto the books the same information as the first method.
Entry of Premium or Discount on Books
Bringing the bond premium or discount onto the books is accomplished in the same manner as for stock. Thus, using the above data and assuming $100,000 of the bonds sold at 101 and the remaining $50,000 at 99¾, the entries would be, illustrating only the second method:
(4) Cash $101,000.00 First Mortgage Bonds Payable $100,000.00 Premium on First Mortgage Bonds Payable 1,000.00
(5) Cash 99,750.00 Discount on First Mortgage Bonds Payable 250.00 First Mortgage Bonds Payable 100,000.00
Subsequent handling of the premium and discount accounts will be shown on page 368.
Bonds may be issued for cash or property, as in the case of stock. Unless there is evidence to the contrary, when bonds are issued for property they are brought onto the books at par value, the courts holding here as with stock that the parties to the transaction (usually the corporation’s directors) are in a better position to judge the value of the property taken over than anyone else. This oftentimes results in an inflation of property values—an injection of water—and should not be countenanced where a true basis for determining the value of the bond is offered. Thus, if almost simultaneously with the issue of the bonds for property, some are sold for cash, the cash price received would usually be a fair basis for booking the premium or discount on those issued for property. The sale for cash must be a bona fide sale in the open market if it is to represent the market’s judgment of the offering. Sometimes an objection is raised to a Bond Discount account appearing on the books; hence the practice, wherever possible, of charging the discount against some asset account as a part of the cost of that asset. When the true nature of bond discount or premium in its relation to the periodic interest charge is appreciated, the objection has no weight.
Entry of Interest Payments on Books
Booking the payment of the periodic interest is accomplished by a charge to Bond Interest and a credit to Cash. This interest should never be entered in the regular Interest and Discount account. If the bonds are coupon bonds with the coupons redeemable through a designated trust company, a check for the full amount of the interest on the outstanding bonds should be issued and booked as above. If the coupons are redeemable at the company’s office, an entry debiting Bond Interest and crediting Coupons Payable should be made, to record the interest charge and the liability therefor. As the coupons are redeemed, Coupons Payable is charged and Cash credited, any balance remaining in Coupons Payable account representing the liability existing because of coupons not yet presented for redemption. In the case of bonds registered both as to principal and interest, the interest checks made payable to the registered parties constitute a charge to Bond Interest and a credit to Cash. It is sometimes advisable to transfer by one check the total bond interest payable to a special bank account and issue the individual interest checks against this fund. Whenever the books are closed it is always necessary, unless the end of the fiscal period coincides with the bond interest date, to take account of the accrued bond interest as on that date. The adjusting entry here is similar to that for any accrued expense.
Relation of Bond Interest to Premium or Discount
The main problem in connection with accounting for bond interest is that of the relation between bond premium or discount and the periodic bond interest. At practically any time in the market there is a rate at which the bonds could be sold at par. This rate is known as the effective rate. If a company puts an issue of bonds on the market at a higher rate than this, the market will offer a premium for them. The amount of the premium will be, theoretically, the present value of the periodic sum represented by the difference between the stated bond interest and the effective interest, these periodic payments extending over the life of the bond. In other words, the premium represents the price paid to buy the additional interest, dollar for dollar, on a compound interest basis. The premium is therefore not an earning, an item of income, but is an offset to the excess bond interest. The portion of it applicable to each period represents the excess interest which deducted from the bond interest shows the real or effective cost of the money borrowed and to be paid back. Thus, the bond interest rate based on the money actually received, i.e., par plus premium, is exactly the same as the market or effective rate on par. In other words, the corporation is paying for its actual borrowings simply the current market rate of interest.
It is therefore incorrect to show on the books the cost of the loan at any other figure than the effective interest. The actual periodic payment of interest is, however, at the bond interest rate. This must be brought down to the effective rate by application to it of a portion of the premium which represents the sum paid for the privilege of receiving the higher rate of interest. Similarly, bonds are marketed at a discount when the bond interest rate is lower than the market rate prevailing on similar security at the time the bonds are floated. This may be looked upon as a payment by the company in lump sum to compensate a purchaser for the difference in the income on the bond and what he might obtain on the open market. The discount should be applied, therefore, periodically to bring the cost of the loan up to its true figure, viz., the market or effective rate. An illustration will clarify the points of the above discussion.
Example of True Interest Cost
Assume a 7% bond, interest every six months, payable in 25 years (50 periods), par $1,000, sold in a market whose prevailing interest rate is 6%. By the method developed on page 273, the value of such a bond is found to be $1,128.6488, the premium being $128.6488. At the effective rate the real cost to the issuing company is 3% on $1,128.6488, or $33.8595. The actual sum paid as interest is $35, i.e., 3½% on $1,000. The difference between the effective and actual bond interest, or $1.1405, is the portion of the premium to be used that period in order to reduce the amount of actual interest paid to the real or effective cost of the loan. The bookkeeping entries are:
(6) Bond Interest $35.00 Cash $35.00
(7) Premium on Bonds 1.14 Bond Interest 1.14
Similar calculations and entries for each of the succeeding 49 periods would be made, the application of the effective rate always being, of course, to the amortized value of the bond as on that date. This process is called scientific amortization of the premium (or discount) of the bond. Its effect is readily seen to be to spread over the life of the bond the premium (or discount) and so not to take credit for it in a lump sum during the period in which the bond is matured. There are four cases to which this principle of showing the true interest cost is applicable, as follows:
1. A bond sold at a premium to be redeemed at par on maturity. 2. A bond sold at a discount to be redeemed at par on maturity. 3. A bond sold at a discount to be redeemed at a premium on maturity. 4. A bond sold at par to be redeemed at a premium on maturity.
At the close of a fiscal period which does not coincide with the bond interest period, not only must the bond interest accrued to date be shown as an accrued expense, but also there must be so shown the portion of the premium (or discount) accrued to that date required to bring the bond interest cost down to the effective basis.
Presentation on Balance Sheet
The final problem in connection with bonds concerns the manner of their showing on the balance sheet. That has perhaps been sufficiently indicated. The amount of the authorized issue should be short-extended, and the amount unissued subtracted therefrom with the net amount outstanding full-extended as the significant figure in the balance sheet.
Other Fixed Liabilities
Real Estate Mortgages. Another item among the fixed liabilities is the simple real estate mortgage. This is usually called a bond and mortgage, the bond being simply the promise to pay and the mortgage being the security for the amount of money borrowed. In some states the more formal document called the bond is used as a contract according to which a named sum is to be paid in case the amount borrowed on the mortgage is not paid. This named sum is usually the amount borrowed, although in some states it is twice this amount. In booking a note or bond supported by a mortgage, the customary title is “Mortgage Payable” rather than “Notes Payable” which is generally understood to be applicable in the main to current liabilities. In case the double amount is named in the bond, it is not customary to take cognizance of the contingent liability thereunder.
Loans on Collateral. Short-time loans are frequently made on collateral security. Stocks and bonds, particularly of the borrowing company or its subsidiaries, may also be made the basis of a long-time loan. This may take the form of a bond issue, promissory notes, or other similar obligations. Accounting for the loan and its showing on the balance sheet follow the principles already laid down. The title of the loan account should carry the word “Collateral” or other similar term to show its nature. Accounting for the collateral is usually accomplished by a memorandum in the stocks, bonds, or investments account to show exactly what securities have been withdrawn for deposit as collateral. No further record is needed other than a complete list of such securities; the securities are still owned by the company, though deposited under a conditional contract with someone else. If the loan is dishonored at maturity and the securities are sold in satisfaction thereof, the necessary entries must be made to show the sale of the securities, the profit or loss attendant thereupon, and the repayment of the loan. In showing the pledged securities on the balance sheet, it is well to present the securities in two groups or classes, viz., those pledged as collateral for the loan shown contra and those not so pledged.
Short-Term Securities. When the market is not favorable to the issue of long-term securities, because of the high rate of return demanded by investors, corporations often have recourse in their borrowings to short-term securities—usually note issues with maturities ranging from one to five years, two- and three-year terms being the commonest. The financial consideration in their issue is merely a speculation that by the time of their maturity the market will be more favorable for the flotation of long-term securities. Thus the company hopes at the maturity of the notes to free itself from the need of paying so high an interest rate as it is required to pay now for the short-term securities. These notes may be in different denominations and are accounted for just as other notes. On the balance sheet they are grouped with the fixed liabilities until within a short time of maturity, when they must be shown with the other current items.
XXI. CAPITAL STOCK AND ITS VALUATION
Problems in Valuation
The problems in connection with the valuation of the assets and the liabilities and the manner of showing them on the balance sheet—and in some cases the manner of booking them—have been treated in some detail in the preceding chapters. It might seem that, inasmuch as proprietorship or net worth is determined always by the excess of assets over liabilities, no question would arise concerning the valuation of net worth, its value being automatically determined by whatever values are placed on assets and liabilities. That its value is so determined, that every change in net worth must be reflected in the assets and liabilities, does not admit of argument. There are, however, certain phases of the question of valuation and certain problems connected with it, that, because of their close connection with net worth or their direct effect upon it, are best treated under this head rather than under the head of each particular asset that may be affected. Thus, if treated among the assets, the valuation of properties purchased with stock would require, under the head of each asset which might be so acquired, an almost identical statement of principle. For this reason, some problems in valuation have been reserved for treatment here in connection with capital stock.
In addition, there are related problems which concern the surplus and reserves. It is true, these all have their origin in the general considerations of valuation as given for the assets and liabilities. But questions as to what constitutes a profit, whether all profits are applicable to dividends, the proper treatment of capital profits, the relation of capital losses to profits and dividends, the differentiation of the classes of reserves, and finally the manner of showing and explaining the periodic changes in net worth by means of the supplementary statement of profit and loss—all these and other similar questions are closely related to the problem of valuation and, as indicative of the financial policy of a business, may directly affect all going concern values. On this account they require separate treatment from that of any individual assets and liabilities or group of assets and liabilities. Accordingly, the next few chapters will be concerned with these problems and any others which are relevant thereto.
Kinds of Stock
Capital stock is of various kinds—that with a stated par value and that without, common stock, various kinds of preference shares, debenture stock, guaranteed stock, founders’ stock, convertible stock, and redeemable stock. The student is referred to Chapter I where these various kinds of stock are discussed.
Par, Real, and Market Values
Capital stock may have several kinds of value, as the term value is used. All stock is expressed as so much per share. The value mentioned as the stated value of a share of stock in the contract of issue is known as the par, face, or nominal value.
The book value of stock is the value of the stock, as shown by the books—not the amount carried in the stock accounts, but the entire net worth of the corporation divided by the number of shares outstanding. Thus, if the assets minus the liabilities—the net assets—of a corporation amount to $1,500,000, of which $1,000,000 represents 10,000 shares of stock of par value $100, and the $500,000 is surplus, the book value of the stock is said to be $150 per share. From the standpoint of a going concern, this value is also spoken of as the real value in the sense that it is represented, dollar for dollar, by actual assets held by the corporation. Real value is also used to mean liquidation value, the value which the net assets upon forced or voluntary sale would realize for distribution to each shareholder.
Finally, there is the market value of stock by which is meant the value placed on it in the stock market or wherever stocks are dealt in. This value depends primarily upon the dividend-earning capacity of the stock, although many side issues of fact and opinion affect it. Thus, not only present, but past as well as prospective future dividends influence the market. At times, particularly in a declining market, the financial needs of the holders of the stock may affect prices more than the dividend rate of the stock.
The problem of stock valuation as related to the commercial balance sheet takes cognizance of only one of these values, viz., par value, though each of the others is related to and measured by the showing of values on the balance sheet. That par value is not always the true value cannot be controverted. As already shown, the inclusion on the balance sheet of assets of doubtful value is allowed when the doubtfulness of their value is generally recognized and no one is thereby misled. Some problems in connection with stock values and their inflation on the books will now be discussed.
Value Dependent upon Earning Capacity
Upon the inception of an enterprise the problem of stock valuation is always bound up with the question of valuation of the assets and liabilities, as pointed out above. When the asset to be valued is only cash, the problem is not usually difficult, as where the capital stock is sold for cash. Where, however, the sale is for a property taken over, the valuation of the stock is related to the larger problems of capitalization, with which in turn the valuation of the assets is bound up. It seems best, therefore, for an intelligent understanding of the question to review briefly some of the bases of capitalization.
As indicated above, the market value of any stock is dependent in the long run more on the factor of its earning capacity than anything else. If investment in a stock nets the prevailing income rate on money, that stock will approximate its par value. So when determining the capitalization of a company which expects to be taken over as a going concern, the main consideration is not so much its true valuation as it is its earning capacity and its ability to pay dividends. Thus, if on a cost basis the net values taken over amount to $250,000, but past performance and future expectation reasonably indicate a capacity to earn a normal dividend on $1,000,000, it is very probable that the new company will capitalize at $1,000,000. If this sum is actually and in good faith paid, little or no exception can be taken to recording the value of the plant taken over at $1,000,000. The transaction is the result of a bargain. The additional value over cost may, in the estimate of the purchaser, represent the true value of the good-will or other intangible assets acquired but not included in the $250,000 referred to above. In a bargain transaction such as the foregoing, judgment of value is sometimes wrong; but the buyer can only show the property bought at what it cost him at the date of the purchase—whether the payment is in cash, stock of a stated par value, or other assets.
Increase of Book Capitalization
If, however, the transaction is merely a reorganization of the old company by its owners solely for the purpose of increasing its book capitalization by bringing onto the books an existent good-will or by other means of inflation of assets, the result is a so-called watering of the stock. The propriety or impropriety of this is chiefly a question of business ethics, and its discussion is beyond the limits and the purpose of this volume. It may be said here, in passing, that under certain conditions the practice may be entirely proper and no inequities may result. On the other hand, the purpose of such a reorganization may be fraudulent, in which case it frequently works hardship and injustice. The main accounting problem involved when the book capitalization of a concern is increased is the method of recording the transaction, so that the true status of affairs will appear unmistakably and any attempted fraud will be shown.
Capitalization on Cost
Opposed to the basis of capitalization on earning power is that of capitalization on cost. In a case of capitalization it is very difficult to know exactly what is meant by cost, as there are so many kinds of cost. There is original cost; original cost less depreciation; present cost new of an identical property, i.e., reproduction new cost; reproduction cost less depreciation, etc. In this discussion original cost is taken as the basis, less depreciation, or such cost plus a bona fide payment for good-will or for the privilege of securing an established business. All these other factors may and frequently do enter into the determination of a bargain and sale price and therefore affect capitalization.
The regulation of the Public Service Commission of the First District, State of New York, concerning the manner of keeping the capital stock accounts of public service corporations, is as follows: “To the account for any class of stocks shall be credited when issued the par value of the amount of stock of that class issued. If such issue is for money, that fact shall be stated; and if for any other consideration than money, the person to whom issued shall be designated and the consideration for which issued shall be described with sufficient particularity to identify it; if such issue is to the treasurer, or other agent of the corporation, to be by him disposed of for the benefit of the corporation, that fact and the name of such agent shall be shown; and such agent shall in his account of the disposition thereof show the like details concerning the consideration realized thereon, which account when accepted by the corporation shall be preserved as a corporate record. If the fair cash value of the consideration realized upon the issue of any amount of stock is greater than the par value of such stock, the excess shall be credited to the account ‘Premiums on Stocks’ and the corresponding reference thereto shall be contained in the entry relating to such stock in the stock account.”
The Law and Stock Issues
Thus, it is seen that the state takes cognizance of financial arrangements and methods of accounting in some of those particulars wherein the state is vitally interested. These regulatory provisions are usually found in the corporation laws of the state or amendments thereto. At the present time there are at least three types of such laws:
Under one type it is provided that, when property is taken by the corporation in payment of its shares, the incorporators alone are the judges of the values of such property and that the state’s only duty is to prevent fraud. Fraud must be shown by the injured party and usually the facts by which this might be established are hidden in records to which a stockholder has no access. The remedy is against the directors personally. This type of corporation law is found in most of the states.
Under the second type active control of the issue of stock is undertaken by the state. This requires an independent appraisal and valuation by the state’s experts. This type of law is found frequently governing the incorporation of public utility companies. It is based on a paternalistic theory of state functions not yet recognized as applicable to private undertakings.
Under the third type, we find the law authorizing the capitalization of any and all kinds of property—in the absence of fraud, of course—provided that a full statement is put on record showing the amount of stock and the exact manner in which it is paid for. The amount of cash received must be shown; the property acquired so labeled as to render identification possible; and any payments for services or other expenses must be shown. The attitude taken is that a prospective investor, provided with these facts about the company, can make his own judgment as to stock values.
Thus, we find that practice is not uniform in these regards. From the viewpoint of theory, any accounting treatment of the issue of stock which shows the full facts with regard thereto may be considered as meeting all reasonable requirements.
Treatment of Discount or Premium
Valuing capital stock when issued for cash presents no problem in itself, but the treatment of the discount or premium incident thereto requires consideration. In most of the states and in Great Britain stock cannot be issued below par. The manner of nullifying this provision has already been referred to in Chapter I. There it was shown how the issue of fully paid stock is made for property and how treasury stock is created by donation, which may then be disposed of for any price obtainable, without any additional liability attaching to it. In most of the states and in Great Britain, however, a sales commission is allowed which has, in some instances, been used as a cloak for sales at a discount. The booking of the discount or premium presents no difficulties, but the manner of handling it on the balance sheet is not uniform. Premium or discount on stock should be recorded as such on the books, under titles of definite meaning.
One occasionally hears the argument that the discount on stock is a necessary expense incident to financing the company, a sort of “cost of getting started,” an expense without which the enterprise could not be launched; accordingly the discount should be properly capitalized as a part of the property costs. The argument is plausible but not convincing. The information as to the discount on stock is very necessary to the prospective creditor or investor and should always appear as a separate item on the books. To the same effect is the ruling of the Interstate Commerce Commission that premiums on capital stock must be carried on the book permanently unless offset by discounts later allowed. Discounts may be extinguished by premiums, assessments, surplus, or by the retirement of an equivalent amount of stock.
A premium on stock may be looked upon as similar to a capital surplus. It represents a fund of capital originating upon the inception of an enterprise, and is in no sense an increase of capital, i.e., of net worth, due to operation. So far as the law is concerned, there is nothing to prevent the return of this surplus to the shareholders in the form of a dividend. To treat it as available for ordinary dividends, however, would seem not to be in keeping with the manner of its origin. Rather should it be set aside as a permanent surplus. One requirement in the case of national banks is the creation of a permanent surplus equal to 20% of the capital, and so, frequently the original subscribers agree to take their stock at a 20% premium, this premium providing the legal surplus required. In the case of discounts no accounting principles are violated if they are allowed to remain on the books. If there is a surplus from premiums, that should be used to wipe off any discounts. In the absence of premium or other capital surplus, conservatism usually sanctions the use of operating surplus for this purpose, thus bringing the value of the net properties owned at least into equivalence with the par value of the stock.
Valuation of Stock Issued for Property
The difficulty of valuing stock when issued for property has already been stated and the attitude of the laws towards any valuation placed on the properties taken over has been shown. Nothing further here need be said except to state that where also a bona fide sale of a portion of the stock takes place for cash at the same time, a fairly reliable basis for valuing the stock given for the property is offered. It is not the usual practice to show the probable discount on the stock, although such treatment would be logical and consistent with the facts. A similar valuation of the stock might be secured by an independent appraisal of the properties taken over, but this, if done, is not often made the basis for entry on the books. If all the facts are fully recorded, that probably is as much as can be hoped for under the conditions now prevailing. Undoubtedly the use of no par value stock for incorporations of this kind offers the best solution of the problem. With regard to booking the properties acquired by a stock issue, attention is here called to the method of valuation of the individual units by an appraisal committee usually appointed from among the directors and the use of their findings as the basis for the book entries of the transaction.
Valuation of Treasury Stock
In connection with the purchase of properties by stock, there often arises the need of working capital. This is frequently furnished by the pro rata donation or return of some of the stock to the corporation, the sale of which furnishes the necessary working funds. As illustrated in an earlier chapter this donation is booked at the par value of the stock, the charge being to Treasury Stock and the credit to Donated Surplus, Donated Working Capital, or other similar account. Being true treasury stock, it can be sold at any price without liability. It is usually disposed of at a discount which must be recorded on the books either as a charge to Discount on Treasury Stock account which will later be closed against Donated Surplus or as a charge direct to Donated Surplus. Thus when the treasury stock is all disposed of, the net credit balance in Donated Surplus shows the real amount of working capital obtained through the donation. If not entirely sold, the portion sold gives a fair basis for the valuation of the unsold portion, although this value is seldom brought onto the books, it being used as a guide to financing rather than as an item to be regarded in accounting valuation.
Redemption and Reduction of Capital Stock
The redemption and reduction of capital stock presents a problem of surplus adjustment requiring careful treatment. If a corporation has accumulated no surplus of any sort and redemption of the stock is at par, no difficulty is met in making the entry. If, however, a surplus has been accumulated and redemption is either above or below par, care must be exercised to record the transaction properly. Redemption at a stated price is sometimes one feature of a preferred stock issue. Again the stock may be bought in the open market for the purpose of cancellation. Reduction of capital, except when made a condition of the original issue, cannot usually be accomplished without the consent of at least a majority of the shareholders and authorization from the state. For the sake of simplicity, assume just one class of stock and a surplus in which each share has an equal interest. If redemption is at par, the surplus is evidently not affected but each share of stock remaining outstanding has a larger share in the surplus and so acquires a higher book value.
Redemption of a stock at its book value is accomplished by charging capital stock for its par value and surplus for its pro rata share in the surplus, the offsetting credit to both these being to cash. The value of the remaining shares of stock has not been affected in the least. If redemption is at any other figure than book value, not only is surplus affected, being increased if the redemption price is below par and decreased if above par, but also the value of the remaining shares. In the case of different classes of stocks, a careful determination of their respectively equitable shares in surplus would have to be made before the effect on the remaining shares could be calculated.
In passing from the question of stock values, it should be pointed out that an undervaluation of stock when issued for property, though seldom seen in practice, has the refreshing effect of creating a secret reserve. That is, property values are carried on the books below their actual values and a secret reserve is thereby created. A further discussion of secret reserves will follow in a later chapter.
Dividend Stock
Stock is sometimes issued for dividend purposes. In such cases, it is always issued as of par value. If profits have been earned or a surplus accumulated out of which a dividend may be declared, that dividend may be paid in any way the corporation sees fit. Payment may be made in cash, scrip, or in the shares of the company. If the corporation has neither unissued stock nor stock in the treasury, permission to increase its capitalization must be secured before a stock dividend can be paid. Some corporations, notably financial institutions, often make it a matter of policy to accumulate a large surplus and then distribute it by means of a stock dividend. Declaration of the dividend is made and recorded as usual. Record of the payment in stock is made as a debit to Dividends account and a credit to Capital Stock.
The effect of a stock dividend is twofold. From the point of view of the management of the surplus it has the effect of a permanent investment of the surplus in the business. Thus it places the accumulated profits beyond the control of any future board of directors. If left in surplus, a cash dividend might have been declared and the asset dissipated to that extent. The stock dividend, however, keeps the profits invested in the business in such a way as not hereafter to be available for dividends. From the point of view of the stockholder, upon the declaration of a stock dividend his equity, his proprietorship in the business, is not in the least affected excepting that it is divided into more parts; he has more shares to represent it than he had before. Before he possessed as a community right a pro rata share in the surplus. Now the ownership of that share has become personal, individual. Each share of ownership thus has a smaller book value but each stockholder’s equity is the same as before.
Stock Issued as a Bonus
The manner of recording stock issued as a bonus with bonds or for any other purpose has been illustrated in an earlier chapter. Here, attention is called to the effect of such an issue in states where stock cannot be sold below par. There is no legal bar to the sale of bonds below par. If, then, the price received for the bond carrying a bonus of stock is at least equal to the par value of the bonus stock, there is nothing extra legal in the transaction. However, record must be made of the issue of the stock at par, the discount or bonus being carried as applying to the bond.
The valuation of stock issued in effecting combinations or for labor or services follows along the same general principles as of that issued for property, and the same general considerations are pertinent.
Unissued and Treasury Stock on the Balance Sheet
When showing capital stock on the balance sheet, it is best to treat unissued and treasury stock as valuation items. The reason for this was stated and discussed in Chapter XIV. Here the relevancy of showing the unissued stock will be considered, as a statement of the outstanding stock is thought by some to be all that is required. It has been argued that the unissued stock does not in any sense represent an asset nor does it show proprietorship. Why not, therefore, leave it off the balance sheet statement entirely? It is true that an investor, a creditor, or a stockholder is interested in the main only in the condition of the business as shown by its present assets and liabilities. Unissued stock has no value till placed on the market; all that it shows is that certain legal requirements have been met authorizing its issue and to that extent it has a contingent value which may become a real source of capital to the corporation if additional funds become necessary. While, therefore, the omission of the item entirely from the balance sheet does not affect present conditions, it is considered best, in the interest of full information as to the exact status of the company, to show the amount of the authorized capital with the amount unissued extended short on the balance sheet, the difference being the amount outstanding—which is full-extended as the significant item, thus:
Capital Stock Authorized $1,000,000.00 Less Amount Unissued 250,000.00 ------------- Amount Outstanding $750,000.00
A similar showing of the treasury stock is also considered best, although good authority can be found for its inclusion among the assets.
Preferred Stock Covered by Redemption Contract
On the border line between liabilities and proprietorship is preferred stock covered by an unfulfilled redemption contract. Such stock is issued with a definite redemption contract to become effective at stated dates, and is manifestly different from preferred stock redeemable upon call at any time after a named date. In the latter case the option of redemption is with the company, whereas in the former case the company binds itself to a contract enforceable at a definitely stated time. From the financial standpoint the wisdom of a company binding itself to a contract enforceable some time in the future may be open to question because of the inability at the time of issue to foretell the company’s condition at the time of redemption; although in this respect the condition is practically the same as that confronting a company at the time of a bond issue. There is this marked difference, however: A bond issue is always a liability and continues as such after maturity; but in the case of a stock redeemable at a given date, the point at issue is whether the failure of the company to redeem automatically changes the status of the owner of the stock from that of a proprietor to that of an outside creditor.
“For instance, a corporation sold $750,000 of first preferred stock, with a provision for the retirement of $150,000 annually after a certain period had elapsed. When the first instalment became due the corporation was unable to meet its obligation. There was no provision in the certificate bearing on the treatment of the overdue payment in the accounts or the balance sheets. The auditors declined to certify the balance sheet until a decision was reached as to whether or not the amount represented a liability to be liquidated as soon as funds were available. So long as this possibility existed the position of the general creditors was subject to change. Finally it was decided to secure an extension from all stockholders and upon satisfactory evidences thereof the auditors passed the balance sheet.
“No general rule can be laid down for the auditor’s guidance in such cases as this, as each case must be decided on its merits. The most important facts for the auditor to ascertain are the rights of stockholders to insist upon payment, and the aggregates and due dates of all probable obligations. Their disposition in the accounts is then a matter of disclosing full information to creditors, prospective creditors, and to other stockholders.”[51]
[51] Montgomery’s “Auditing, Theory and Practice.”
XXII. PROFITS
Difficulty of Determining Profits
What constitutes a profit is oftentimes a perplexing question and at all times its determination is more an estimate than an absolute fact. This arises from the nature of accounting itself in that so many items of expense are known to exist and must accordingly be provided for but the amount of such expenses cannot be exactly determined. This is seen to be true in the case of the provision which must be made for bad and doubtful accounts and for depreciation of fixed assets and is, of course, inherent in all problems of valuation. As is proverbially true of the prescriptions of different physicians for the same malady, so no two accountants would arrive at the same figure of profit for any given concern.
Economic Definition
It may be of some advantage at this point to attempt a definition of profits although to compress the meaning of the word within defined limits is hardly possible and for this reason the formulation of a working definition is very difficult. Etymologically, “profit” comes from the Latin word proficere, meaning to make progress, and a better definition than this would be difficult to find. At the best the term is an elusive one, being used with slightly different connotations in different schools of thought. Thus, we find the word used and defined in economics, law, and accountancy, and some of the definitions are twisted almost to the point of absurdity. Alfred Marshall,[52] the English economist, says: “If a person is engaged in business, he is sure to have to incur certain outgoings for raw material, the hire of labour, etc. And, in that case, his true or net income is found by deducting from his gross income ‘the outgoings that belong to its production.’” Charles S. Devas[53] says: “The income from production combining both labor and capital is profits.” He defines gross income as “the total wealth added to the property of a given person in a given time from whatever source ... and net income as gross income minus the following items: (a) Destruction, damage, or loss by fire or other accident, by violence, by thieves, by bad debtors. (b) Using up of materials in production, and wear and tear of machinery and industrial buildings such as factories or shops. (c) All sums spent on purchases of goods that are to serve the purchaser not as subjects of enjoyment, but as means of getting an income. (d) All sums spent on hire of goods that in like manner are to serve as means of getting an income. (e) All payments for labor that in like manner are to serve as means of getting an income.” One wonders if Marshall’s idea of incomings and outgoings is limited to a cash basis or if he recognizes accruals. On the other hand, from the point of view of accounting, Devas includes too much, as will be pointed out later. E. R. A. Seligman[54] says: “Profits are the income from business enterprise.... Profits are always a surplus. They are the difference between the cost of production or acquisition and the selling price.” He summarizes expenses of production as including cost of raw materials, wages, rent, interest on capital borrowed or invested, taxes, and miscellaneous outlays such as insurance, advertisements, and transportation expense. Again, he says:[55] “Income is that which comes in to an individual above all necessary expenses of acquisition and which is available for his own consumption.” He recognizes depreciation as a necessary expense.
[52] In “Principles of Economics.”
[53] In “Political Economy.”
[54] In “Principles of Economics.”
[55] In “Income Tax.”
All of this attests the statement made above that the formulation of a satisfactory working rule for the determination of net profits, from the business standpoint, is extremely difficult. It should be said, of course, that in some respects the idea of net profit as used in economics differs from that used in business; the chief difference being that interest on invested capital is in economics looked upon as an expense deduction before the determination of profits.
Legal Definition
The efforts of the law, as evidenced by court decisions, to mark out definitely the meaning of net profits have resulted in many odd twists of terms and meaning. In an English case[56] decided as recently as 1902, this language is used: “If it is a mere question what were the profits made in a particular year, it seems to me that the duty is to ascertain what cash has been received and what cash has been expended, and, if that is fairly done, you know the profits of the year. If there is a large outstanding liability which cannot be settled, the partners will estimate that, and it will not be considered as part of the profits. If there is a large outstanding possible loss, and there is a large sum due to a client, then you would provide for that. But in ascertaining what is really actually divisible for the year fairly, you would take the cash account as it stands.” In the light of such mental obtuseness and obliquity, one cannot wonder at the occasional reluctance of business to entrust the determination of important matters to the courts.
In cheering contrast is a legal opinion quoted by R. H. Montgomery,[57] in the following: “I should think that no commercial man would doubt that this is the right course—that he must not calculate net profits until he has provided for all the ordinary repairs and wear and tear occasioned by his business. That being so, it appears to me you can have no net profits unless this sum has been set aside.... If you had done what you ought to have done, that is, set aside every year the sum necessary to make good the wear and tear in that year, then in the following years you would have a sum sufficient to meet the extra cost.” Even here confusion is apparent between a valuation reserve and a reserve which has been funded and the emphasis is rather on the point of providing funds necessary for the purpose—a financial problem as distinguished from an effort to define net profits.
[56] Badham v. Williams.
[57] In “Auditing, Theory and Practice.”
Between these extremes of legal opinion and phraseology one finds all shades and degrees of understanding and misunderstanding. In recent years there is evident in the decisions of our higher courts and of our many excellent governmental commissions and bureaus a real appreciation of some of the technical points involved in profits determination. It is believed that a body of authoritative decisions will in time and perhaps soon reflect the best opinion of the business men of the country.
Accounting Definition
The purpose of this chapter is to discuss some of the points at issue in this vexed problem, but before entering upon this discussion it will be of advantage to quote from leading authorities on the attitude of accountants towards the determination of profits.
A. Lowes Dickinson[58] says: “In the widest possible view, profits may be stated as the realized increment in value of the whole amount invested in an undertaking; and, conversely, loss is the realized decrement. Inasmuch, however, as the ultimate realization of the original investment is from the nature of things deferred for a long period of years, during which partial realizations are continually taking place, it becomes necessary to fall back on estimates of value at certain definite periods, and to consider as profit and loss the estimated increase or decrease between any two such periods.” It is in the making of these estimates that the most difficult problems of profits determination are met.
[58] In “Accounting Practice and Procedure.”
Mr. Montgomery in his dictum, “The net profit of a business is the surplus remaining from the earnings after providing for all costs, expenses, and reserves for accrued or probable losses,” offers the best available working definition, although a caution is needed against the danger of relying exclusively upon any one definition.
Methods of Determining Profits
Systems of bookkeeping, in the main, provide two distinct methods for the determination of profits, namely, by means of single entry and double entry. The student is referred to the author’s first volume for the detailed working out of profits by single entry. Here it is sufficient to say that the determination of profits rests upon a comparison of assets and liabilities as at the beginning of a fiscal period, with those as at the end of the period. Then the increase or decrease in net worth as so determined, after making due allowances for any withdrawals or investments of capital during the period, constitutes the figure of net profit or loss for the period. The disadvantages and inaccuracies inherent in this method have already been pointed out.
The method of determining profits by means of double entry provides an entirely distinct set of accounts known as temporary proprietorship or profit and loss accounts. These record the daily changes in net worth and must be summarized through the Profit and Loss account at the close of the fiscal period, at which time they must prove against the profits as determined by the balance sheet, the method of which is essentially the single-entry method. In addition to this control secured by checking the results obtained by one group of accounts against those of another group, is the important advantage of presenting in the record a mass of statistical information for guidance in the conduct of a business, without which the present-day enterprise with its many complexities of organization and working could not hope for any certain measure of success.
The Problem a Question of Valuation
Inasmuch as every profit made must be reflected in a corresponding increase of some asset or the decrease of a liability, and, conversely, every expense incurred is reflected as a decrease of assets or increase of liabilities, it is apparent that profits determination is largely a question of the valuation of assets and liabilities and therefore rests upon the principles already established. Thus the amount of gross profit is not determinable until the value of the stock of merchandise on hand is known. Gross profit rests on inventory valuation, whether that be accomplished by the perpetual inventory method or that of periodic stock-taking. While under the double-entry system the charges for expense are more or less fixed and certain and not so dependent on inventory, it has been seen in Chapters XIV and XIX that before accuracy can be secured, here too there must be an inventory or appraisal to determine the prepaid and accrued expense items. The basis for valuing these was indicated in the chapters referred to. Estimates of depreciation, bad debts, and other similar items must also be made to secure a proper appraisal of the corresponding asset items. Similarly, in the determination of other income, accruals and prepayments must be taken into account. In the making of the record of temporary proprietorship data, the fundamental distinction between capital and revenue charges is vital and must be kept constantly in view.
Thus the problem of profits is seen to be in its broader aspects the same problem of valuation to which attention has already been directed. It is purposed here to point out the application of the valuation problem to the periodic determination of profits and to re-examine some phases of the problem from the standpoint of profits as distinguished from that of assets.
Effect of Asset Losses on Future Profits
The first question for discussion may be stated as follows: In the determination of periodic profits must all the data which have affected proprietorship during that period be summarized in order to make a proper showing of profits for the period? An illustration will better present the issue. A manufacturing concern with plants in many places suffers a heavy loss from fire. Must this loss be considered (1) as an expense applicable to the current period and to be taken account of before the determination of profits for the period; or (2) may it be treated as a deferred expense to be shared by several succeeding periods; or (3) may it be charged directly against capital?
Three somewhat different solutions are thus presented. The first treats the loss as a temporary proprietorship charge; the second as a deferred charge to operation and so includes the portion deferred among the assets and to this extent does not reflect the loss as a diminution of net worth; and the third treats the loss as a charge against vested proprietorship.
Any adequate treatment of the question requires a consideration of (1) the type of business organization, i.e., single proprietorship, partnership, or corporation; (2) the appropriation of profits, whether they are to be withdrawn or reinvested in the business; and (3) the nature of the loss, as to whether fixed or current assets were affected. The practical aspect of the problem is the adoption of a policy not in contravention with the law, and in the determination of this phase of the subject there are some court decisions none of which, however, seem entirely trustworthy.
It must be borne in mind that in the types of organization known as single proprietorship and partnership, there is little legal restriction in their formation and operation. The law presumes that the full liability of the owner or owners offers sufficient protection to creditors. Hence the withdrawal of profits or capital is not safeguarded in any way in the interest of creditors. With the corporation, however, provision is specific that nothing shall be returned to the stockholder except profits so long as the business continues in operation. Exception here is usually made for those concerns operating assets which are subject to depletion, in which case it has been held that dividends may include a return of the depleted portion. The theory of the law is that, except as just indicated, the capital of a corporation is an indication to creditors of the amount by which the assets may suffer shrinkage and their claims still be protected in full. Hence, the return of capital in the form of dividends is not allowed, as that would impair the margin of safety for creditors.
From the practical standpoint, therefore, the problem concerns only the corporate form of organization and that only in its relation to dividend payments. So long as the profits are reinvested in the business, neither creditors nor owners have any cause for action, except in case of fraud.
Legal Decisions as to Asset Losses
In decisions relating to this question of asset losses, the courts have seen fit to make a distinction between what they term fixed and circulating capital, corresponding in the main to the fixed and current classification of assets for the balance sheet. In the leading English case,[59] it was held that a trust company holding stock, which during the last business year paid 50 per cent dividend but which before the end of the year became utterly worthless, may include the 50 per cent in its yearly profit, without deducting a penny for the depreciation of the property from which this profit was derived. In the language of the court Lord Justice Lindley said: “Fixed capital may be sunk and lost and yet the excess of current receipts over current payments may be divided. But floating or circulating capital must be kept up, as otherwise it will enter into and form part of such excess (seeing that circulating capital, with the particulars of its purchase and sale, must appear in revenue account), in which case to divide such excess without deducting the capital which forms part of it will be contrary to law.”
[59] Verner v. General and Commercial Investment Trust, Limited, 2 Ch. 239 (1894).
The stock held by the trust company was for permanent investment and therefore in the nature of a fixed asset. The language of the court is quite specific and there would seem to be no need for including all or any portion of the loss in the current statement of profit and loss. Other later decisions have somewhat extended the doctrine so that it has been held that the current profits may be determined without making any provision for a loss, even of circulating capital, occurring in a previous year. Thus it would seem that so far as the legality of profits determination is concerned, each fiscal period may be counted as entirely free from liability for the happenings in other periods—a unit of business history distinct from all other units. These decisions are English cases and have not always been followed in this country. For a statement of the prevailing opinion in this country, see page 443 of Chapter XXIV, “Dividends.” The danger of the position is apparent. In the hands of unscrupulous managers the profit and loss might be so manipulated that alternate years would always show profits in spite of the fact that the company’s capital was constantly being depleted.
Loss Charged against Current Profits
In stating the question on page 393, three alternatives were presented by way of solution. The first of these suggested that the entire loss be treated as a charge against the profits of the current period. It has been seen that there is no support in law for this method of handling the loss, nor is there any need or justification for it from the standpoint of correct accounting theory. Only such losses as occur more or less regularly and which within the experience of the business can be fairly accurately estimated, are proper charges to the current period. It is not the function of the periodic profit and loss statement to reflect charges covering contingencies which with almost equal certainty may or may not materialize.
Loss Treated as Deferred Expense Charge
The second solution suggested, viz., that the loss be treated as a deferred expense to be shared by several succeeding periods, has much to commend it and little to condemn it, except a possible lack of business foresight as will be evident when the third solution is examined. It may be argued, and with a good show of reason, that such losses are so infrequent, occurring perhaps only once or twice in the life of any business, as to make it unfair as between periods to burden some with a charge of this sort and not all. For comparative purposes, the spreading of the loss over several periods will tend to obscure the true state of operations for those periods, although that is largely a matter of the way in which results are presented. The situation is relentless, however. If it is desired to recoup the loss in order not to show an impairment of capital, the loss must be charged in its entirety or piecemeal against profits. If there are no accumulated profits against which it can be charged in its entirety, it must be charged piecemeal against current profits.
Loss Charged to Capital
The third solution suggested that the charge be made directly against capital. Without the limitation as to the policy of recouping the loss mentioned above, this solution may take two somewhat different directions. If a surplus has been accumulated out of previous profits, such surplus constitutes a part of the capital and provides the logical place for setting up the charge. If no surplus is available, the loss must be charged against the capital stock, thus constituting an impairment of it. In either case, the results of the current period’s operation are not affected, except in so far as a diminution of the assets may have made necessary a curtailment of operation. Of course, the charge against the capital stock, whether made direct to the account or carried in a separate account, does not automatically bring about a reduction of the capital stock; that can be accomplished only by legal process and is often shunned because of the difficulties incident thereto and also because of a possible reflection on the concern’s credit occasioned thereby. The charge does indicate a reduction in the value of the shares outstanding. Since there is no compulsion in law and there may be no need from a business standpoint that the loss be recouped, undoubtedly this third method offers the best solution both practically and theoretically.
That this is so is brought out clearly by H. R. Hatfield’s almost classic illustration:[60] “An individual’s entire income is derived from ten houses each worth $10,000 and each yielding 10 per cent net income. If two of these houses burn down, uninsured, the common sense view is that the proprietor’s income is thereby cut down from $10,000 to $8,000 per annum, and that coincidentally, there is a loss of capital of $20,000. It never occurs to him that he must consider his income as entirely cut off for two years until the principal can be restored. Similarly it might be an act of cruelty to dependent stockholders to stop dividends entirely until an exceptional loss is reimbursed. The main difficulty is that in a corporation such an occurrence really calls for a reduction of the nominal capital, a cancellation of part of the capital stock.... The criticism properly to be made is not so much that dividends are paid before restoring the capital ... but rather that the capital stock has not been reduced to correspond with the amount of remaining assets, before the dividend is paid.”
[60] In “Modern Accounting.”
It should be stated that this criticism is of little real weight if the balance sheet shows the true condition of the business. Carrying the loss as a part of the assets, particularly if clothed with a title the meaning of which even a code expert could but lamely guess at, is to be condemned. If, however, the title clearly indicates the nature of the item, the situation is not so bad, although it does reflect the slavery to form which compels some very well-meaning individuals to show impairment of capital on the asset side of the balance sheet for the sake of making it balance. The best practice compels the showing of impairment items as direct deductions from capital. The carrying value of the asset destroyed must, of course, be reduced to accord with the facts of present value, and, if there is no surplus available, the amount of the loss should be shown as a deduction from the capital stock outstanding, short-extended, with the present capital full-extended, somewhat as follows:
Capital Stock Outstanding $1,000,000.00 Fire and Earthquake Loss resulting in impairment $250,000.00 ------------- Net Capital available for the business $750,000.00
Profit on Work in Progress
A second problem to be solved in the determination of profits is concerned with the allowance or non-allowance of profit on work in progress but not completed. Most manufacturing and contracting concerns have at all times a more or less constant volume of work in various stages of completion. At the close of the fiscal period when results are summarized, the proper treatment of this uncompleted work is an important matter. The general principles governing the valuation of this work were discussed in Chapter XIII where it was pointed out that in the main conservative business policy demands that work in progress be included in the inventory at full cost, which is to include both prime cost and an equitable share of burden accrued to date. Manifestly this principle precludes the taking of any profit, the theory being that there is no profit until goods are sold. A full discussion of the subject requires separate consideration of work which is being done on order or contract and work for the concern’s own stock-in-trade, due weight being given always as to whether the unit of work is large or small.
Goods Made for Stock but not Sold
The general principle mentioned above must usually be applied to the valuation of the concern’s own stock-in-trade in process of manufacture. Here sales are being made constantly from finished stock and manufacture replenishes the stock. But the essential step before profits can be claimed, viz., making the sale, usually comes after the process of manufacture and not before. It may sometimes happen that stock is sold out ahead of its manufacture, because the factory is not able to keep up with sales. It is not intended here to include the case in which it is the custom of the trade to sell goods in advance of their manufacture and regulate the operation of the factory to turning out the advance orders booked. This will be considered later. The discussion here concerns those firms which usually keep their finished stock well ahead of sales but because of the exigencies of the market find themselves behind their sales. Such a situation is sometimes called a sellers’ market. If purchasers contract for goods with full knowledge of factory conditions, such sales are in the nature of work on contract and might in unusual instances be so treated. Usually, however, conservative management requires that no profits be taken under such circumstances.
Goods Made to Order
Where the factory works only on order, conditions as to profit-taking are somewhat changed. Here, the sale has already been made for delivery of the product at some future time, named or left indefinite. While, of course, cancellation of the order is always possible before date of delivery and acceptance, inasmuch as here we have under consideration a special product made to individual specifications and not a stock or standardized article, cancellation of the contract is not probable without incurrence of damages or even being held to specific performance. Under these circumstances it is apparent that, within reasonable limits, a portion of the profit may be taken up in the current period, which has, of course, done a portion of the work and therefore earned a portion of the profit, if there is one. This last contingency is, of course, the crux of the whole problem. If a portion of the profit is taken, this necessitates a predetermination of profit on the whole contract, an estimate of the portion of the contract completed, and adequate provision for unforeseen difficulties in completing the work. Where conditions are such that these things can be done with any degree of certainty, there is not only no objection to taking up a portion of the profit for the current period, but it is the only way in which profits may be allocated to the period earning them and so stabilized somewhat as between periods. As has been said already a number of times, the summary of results at the close of regular periods is in many cases based on estimate, which in the final analysis is merely the expression of an opinion. If the estimates are made with due care, in the light of all available information and probable contingencies, and without intent to deceive or defraud, more than that cannot be asked of any concern.
The practical application of this principle requires consideration. In some few cases the volume of product passing through the factory will be fairly constant as between periods. Where this is so—and frequent tests should be made to establish it—it would be a useless expenditure of effort to make the estimates necessary for determining profits on uncompleted work. The same situation is met with also in concerns where the unit of work is small. Here the effort, entailed in making the estimate is more than offset by any advantage gained thereby. If the product is somewhat standardized, it may be possible as a result of past experience to make a rough estimate on the basis of the volume of work in progress instead of by means of an examination of the conditions of each contract. Such a policy is fraught with many pitfalls and, as a usual thing, does not commend itself to conservative management; speculative conditions are too many.
Profits on Long-Term Contracts
Where the unit of work is large, conditions are somewhat different, however. The necessary estimates are not based on so many uncertainties, and, oftentimes, financial considerations and an equitable treatment of stockholders demand the determination of profits on work in progress. Thus, one contract extending over a number of years may occupy the entire attention and facilities of a concern. To withhold profits if earned, until the completion of the contract might work a real injustice. Such contracts are usually financed by means of periodic payments on account, based on a careful estimate by the supervising engineer or architect of the portion completed on such dates. As these estimates are sufficiently accurate on which to base payment of contract price, they can be allowed to serve as the basis for a determination of profits after liberal reserves for contingencies are made.
The nature and terms of the contract itself will usually indicate the method of estimating the profit. If the price agreed upon is for the contract as a whole, then extraordinary care must be exercised in estimating the portion completed and almost a seer’s prevision of the requirements to complete is needed. If, on the other hand, the contract is broken into smaller units on which price is based and there is no guarantee as to the number of units in the contract, profit may be taken on the number of units completed. Thus, a contract calling for excavation of earth or other material may be taken at a named price per cubic yard. The building of a canal, the driving of a tunnel, the construction of a dam and reservoir, are frequently handled on this or a similar basis. So, also, the use of a concern’s equipment and organization on a per diem basis. Under these conditions each fiscal period can safely take its profits or losses with little regard for the uncompleted portion of the work. Contracts taken on a so-called “cost plus” basis, i.e., at cost plus a definitely agreed upon per cent of profit, may have their profits determined without consideration of the uncompleted portion.
Profit on Goods Awaiting Delivery
Similar to the problem of profits on work in progress is that of profits on goods awaiting delivery. The goods have been sold, are completed, and may even be prepared for shipment. All that remains is delivery and that cannot be effected until the date agreed upon. In some lines of trade this method of sale is a time-honored and even necessary custom. The practice is found in some kinds of clothing industries, woolen manufactures, farm implements, etc. Here because the product is a standard product, cancellations take place and are usually allowed right up to, and in some instances beyond, the date of shipment. Because of this trade practice, profits should never be taken until delivery has been effected. To a similar or even greater extent than with work in progress, costs and expenses are under this principle incurred and charged in one period and the profit is taken in another period which is not thus charged with the cost of getting the income.
Two methods of handling the difficulty are met. The one operates on the expectation that the volume of such orders awaiting delivery is fairly constant as between periods; hence, the income from goods of this sort delivered during the current period is charged with the costs and expenses of goods to be delivered in future periods. This is the rule-of-thumb method to be used where accurate allocation of costs is neither necessary nor justified by results.
The other and more accurate method consists of deferring the costs and expenses properly applicable to the deferred income. But the difficulty of determining just what expenses are so applicable often causes this method to break down, giving less accurate and dependable results than the first. The roseate optimism of the average proprietor or manager as to his own business almost always results in a too liberal estimate of the portion of expense to be applied against the deferred income. In treating this problem of profits in connection with contracts and the length of the cost period (Chapter XIII), the principle was stated that such goods should be included in the inventory at cost. This results in deferring the main item of cost, but omitting the further costs of selling and administration which belong to all sales effort made and to the progress of the order up to the point of delivery. While theoretically these should be deferred, practically the estimate of the amount to be deferred should lean on the side of too little rather than too much. Where, as stated above, the volume of this kind of trade is fairly constant, the rule-of-thumb method first stated gives more satisfactory and safer results.
Interdepartment Profits
The problem of interdepartment profits was stated and discussed briefly in Chapter XIII, page 233, and will later be treated in another connection (see page 607 following). Here, it may be repeated that while such profits are not to be allowed because they are not yet realized, they may, under exceptional circumstances, be estimated and shown if offset by reserves of an exactly equal amount.
Profits Due to Appreciation of Assets
The problem of profits due to appreciation of assets, both fixed and current, has also been handled in the chapters on valuing the various assets. All that need be said here is that such profits are not realized until the asset is sold. While for purposes of credit it may be wise and proper to show the true valuation of the assets, for the purpose of profits, particularly profits available for dividends, such appreciation in values must not be taken into account. It should be remembered that appreciating the value of fixed assets frequently results in the necessity of meeting higher depreciation charges and is thus not an unalloyed gain. The payment of dividends based on such profits would, without taking profits from other sources into consideration, always result in the diminution of the fund of working capital.
Capital Profits
There remains a final problem, viz., that of capital profits, which is more a question of their disposition than determination. When any of the fixed assets are sold, the profits, if any, are classed as capital profits. These are as legitimate as those arising from sale of stock-in-trade or other source, and belong to the owners. The question of their disposition hinges mostly on practical considerations. If the sale is for cash, funds are available for distribution without encroaching upon the working capital. If not for cash, payment of dividends based on such profits might seriously diminish working capital. The question as to whether capital profits should ever be distributed is, of course, a mooted one. Many well-known cases of such distribution—the so-called cutting of juicy melons—are on record. Conditions seem to justify their payment at times, and under other equally impelling conditions distribution of them should not be made. As a general policy it is always safe to set aside such profits in a special reserve to be used to care for capital losses. If the company is well provided with such reserves beyond any reasonable doubt, it is oftentimes unwise and unjust to withhold their distribution. Of a similar nature and to be handled under like considerations are the profits arising from sale of capital stock at a premium, the reissue of forfeited stock, etc.
In concluding this subject no better summarization of the accounting principles and practical considerations to govern in the determination of profits can be given than the following from A. Lowes Dickinson:[61]
[61] In “Accounting Practice and Procedure.”
“1. All waste, both of fixed and circulating assets, incident to the process of earning profits by the conversion of circulating assets must be made good out of the profits earned.
2. Profits realized on sales of fixed assets should be first applied to make good estimated depreciation (if any) in other fixed assets not resulting from the ordinary conduct of the business. If there is no such depreciation, such profits may be distributed as dividends, but should be distinguished from the operating profits.
3. A sufficient surplus should be accumulated (in addition to the provisions required to maintain wasting capital assets) for the purpose of making good losses due to shrinkage in values of fixed assets arising from causes other than the ordinary operations of the company. This provision must, however, be considered more a question of policy than a requirement of sound accounting.”
XXIII. SURPLUS AND RESERVES
Definition
Under the corporate form of organization, “surplus” in its broadest sense represents the difference between the net worth of the business and the capital stock issued and outstanding. Because of the legal requirement that the value of the capital stock be shown always at the original amount—which is usually par—any increments or decrements in value because of profits or losses made and reinvested in the enterprise must be shown under separate heads. Thus surplus—or deficit—is the general term to indicate this increase in value. In England the term “rest” is used in almost this same sense. “Margin” is also a title occasionally seen.
Because of a much narrower technical meaning given to surplus, the general adoption of another term with the broader connotation above given would serve a really useful purpose. Of the titles in use, margin seems best to express the exact shade of meaning. In the interest of a standard terminology, the highest accounting authorities are coming to restrict surplus to that portion of the margin available for dividends and in that sense the word will be used in this chapter. Contrary uses of the word are frequently met. In banking institutions the surplus is almost as inviolable as the capital stock itself and is never used for dividend purposes. In government-controlled or supervised institutions, these special uses of the term have become too well established by law and custom ever to hope for a change in the interest of general uniformity.
Creation of Margin
The sources of the margin have for the most part been already indicated. The chief source is the net profit for the period as determined by the Profit and Loss account balance. What enters into that balance has been discussed in Chapter XXII, where it was also pointed out that under some circumstances it may be entirely legitimate to carry some temporary proprietorship items directly to a vested proprietorship account instead of by way of the summary account. Thus there may be other sources of margin than the current balance of Profit and Loss—extraordinary items whose inclusion with current summaries of operation would render those summaries useless as a guide for judging comparative results of various periods.
Capital Stock Premiums. Sometimes, for the purpose of creating a margin at the inception of an enterprise a fund is contributed beyond the par value of the capital stock issued. This is accomplished by purchase of the stock at a premium, and is frequently seen in banking institutions, where it serves as an easy and speedy way to satisfy the law’s requirements for the accumulation of a “surplus.” The effect of this is to give the institution a better standing than it would otherwise have. The reduction of the capital stock outstanding without full recompense to the stockholder also results in the creation of margin. This is often done in reorganizations when fewer shares of the new stock are given than were held of the old. The effect, then, is to set up a book profit against which may be charged the existing deficit, and so secure a balance between the real net worth and the par of the new stock issue.
Stock Donation. Another source of margin is a stock donation. This may result in only a book profit. It is exceedingly difficult and generally impossible to determine the true value of many speculative ventures, such as mining enterprises. As a general rule, capitalization based on opinion is usually overcapitalization. While a stock donation may have no relation to real values and is merely a method of securing working capital, its effect when the stock is sold is to increase the cash asset and show a profit of an equal amount. Some authorities hold that instead of retaining the profit on the books, the logical thing is to reduce the carrying values of the speculative assets by the amount of the realized profit on stock donation. There would be more reason for this treatment were there any real relationship between the amount of the stock donation and the overvaluation of the assets. Since usually there is none and the whole undertaking is speculative, there is no valid objection to showing the realized profit, as the public is sufficiently warned by the nature of the enterprise. All stock donation is not of this sort, however. Occasionally a very real profit results which should be treated as a margin item.
Stock Assessments, etc. Similar to a stock donation is a stock assessment. In cases of reorganization or of impending bankruptcy, a pro rata assessment is levied on the outstanding shares. Being a donation, it constitutes a proprietorship increase item and becomes a part of the margin. This method is frequently used for the purpose of wiping out a deficit, an impairment of capital, and is, of course, a real profit as distinguished from a book profit. Similarly, additional payments made by common shareholders to convert their holdings into preferred shares are a realized profit and should be recorded as part of the margin.
Capital Profits and Bonuses. Capital profits, as discussed in Chapter XXII, have their proper place of record direct into some margin account rather than by way of the current Profit and Loss. Donations from the outside, such as factory sites and other bonuses, sometimes given to induce enterprises to locate in certain places, must also be treated as entries direct to a margin account. These and other like items constitute the chief sources of the margin.
Disposition of Profits
The statement of profit and loss carries the summary of operations to the point of showing a net profit or a loss for the period. The next step for consideration is the disposition made of these profits. This is sometimes spoken of as the appropriation of profits. Two practices are met at this point. Under the one, appropriation is made directly from Profit and Loss for all desired purposes. Any unappropriated balance goes into Surplus account, which will represent the balance of profits available for dividends but not used. Under the other, the Profit and Loss balance is transferred to Surplus out of which all appropriations are made, the residue remaining therein showing the same condition as under the first method. Where this second method is followed—and it is more prevalent than the first—a statement of surplus is needed for full information of the period’s transactions, thus providing a connecting link between the statement of profit and loss and the balance sheet. The form of this statement is given on page 426.
Reserves
From the point of view of the stockholder’s immediate interest, the appropriation of profits for dividends is his chief concern. Other and equally vital and urgent uses are found for profits in any well-managed concern with an expanding outlook towards the future. The appropriations of these profits to definite uses are very generally carried under the title of reserves with suitable descriptive phrases. Thus we may have a Sinking Fund Reserve, an Insurance Reserve, a Building Fund Reserve. Sometimes these are called “reserve funds” but the demands of an accurate nomenclature limit the use of “fund” to an asset account. The title “undivided profits” is also met. Where careful differentiation is made, “surplus” should be used to denote profits available for dividends; “reserve,” for profits set aside for a specific purpose; and “undivided profits,” for those on which no definite action has been taken.
Different Meanings of Reserve
Because of the loose way in which the term reserve is used by the layman and its different uses by the professional accountant, an examination of these uses will be made at this point. As a distinctive banking term, “reserve” is used to indicate the amount of cash and cash items on hand and on deposit which under the law may be counted as a cash reserve fund held against deposits and note issues. This use of “reserve” is limited strictly to financial institutions.
We find also various so-called reserves shown on the commercial balance sheet, both among the liabilities and the assets. As deductions from the assets are the various depreciation reserves and reserves for bad and doubtful accounts and notes receivable. These items are “offsets” to the carrying values of the assets in order to effect a true valuation of them. For reasons previously set forth, these offsets are carried in accounts separate from their corresponding assets. Thus they are in the nature of suspended credits to asset accounts and, if properly estimated, are in no sense related to profits; nor have they any of the elements of profits or proprietorship in them. It is unfortunate that there is lacking an adequate title, other than reserve, for this group of items. The terms “allowance” and “estimate” have been suggested, but so far have not found general favor. This group of reserves are called valuation reserves.
Reserve for Bad Debts
A fine distinction is sometimes drawn between the reserve for depreciation and the reserve for doubtful accounts, on the ground that at the time of the creation of the reserve in the one case, the depreciation is an accomplished fact, all that is then required being a fair estimate of it; whereas in the other case no particular account is known to be uncollectible, business experience teaching, however, that in the aggregate there will be some loss from this source. The purpose of this reserve is to bring about as on a given date an appraisal of the claims against customers in the light of past experience, and so apply the expense due to this cause to the period in which the sale transaction took place. This purpose is not always accurately accomplished but the estimate at the close of each period does effect an equalizing of the bad debts expense from year to year. This distinction makes the reserve for doubtful accounts closely approximate to a contingent reserve, as will be seen later. It seems best, however, to hold to the original classification and include the bad debts reserve with the other valuation reserves.
Under-and Over-Estimate of Reserves
Inasmuch as these reserves must from the nature of things always be estimates, the probability exists of an under-or over-estimate. It is apparent that an under-estimate effects an inflation of profits due to an overvaluation of the assets. Equally apparent is it that an over-estimate brings about an understatement of profits due to an undervaluation of the assets. The effect of this is to make the valuation reserve account a mixed account. Instead of its content being solely a suspended credit to an asset, it includes also a true reserve of profits. If at any time the facts indicate a too liberal or too parsimonious estimate in the past, adjustment should be made to accord with the newly determined facts of experience. An immediate adjustment is usually preferable to a gradual one effected by an allowance below or above the new basis determined for the estimate.
Depletion Reserves
Similar to the depreciation reserve is the depletion reserve. On the basis of the value at which the wasting or depleting asset was originally brought upon the books, a periodic estimate of the portion used up in operation is necessary to show the true present value of the asset. Thus, timber and mining properties require for their periodic appraisal an estimate of the extent of exhaustion of the natural product. This is neither required by law nor always by business policy. But when the estimate is made it is in the nature of a valuation reserve and will be so classed here.
Operating Reserves for Accrued Costs
Another group of items, frequently carried under the title reserves, includes estimates of expenses the exact amount of which is not known at the time of closing the books, and sometimes those of which the exact amount is known but which are unpaid as on that date. Among the first are such items as taxes, sales discounts, and the like. Among the second are wages, salaries, rents, etc., accrued. These two classes are together sometimes called “operating reserves.”
There is some difference of opinion with regard to the proper allocation of taxes and estimated sales discounts. Inasmuch as taxes are not usually determined, or at least payable, during the period covered by them, there is a temptation to defer their incidence to a later period. If the taxes become a claim of the state against the property as on a given date, certainly they should be treated as applicable to the period covered by the claim even though the amount of them cannot with accuracy be determined.
With regard to sales discount, the situation is somewhat analogous. At the close of any fiscal period, some of the open claims against customers are by the sales contract subject to discount, and experience proves that some of these discounts will be taken advantage of. Here also, difference of opinion prevails as to the proper allocation of the expense. Should the period in which the sale is made suffer the loss, or should it be charged to the one in which the discount is taken? If sales discount is looked upon either as a direct deduction from sales or as a selling expense, certainly it should be charged to the period making the sale. On the other hand, if it is regarded as an item of financial management, a means of securing ready funds, it is sometimes argued (though this is not the usual point of view) that the period enjoying the benefit should also be charged with the expense of securing the benefit. Against this argument it may be pointed out that the current period carrying the customers’ accounts which are subject to discount fails to show its liability, based on the sales agreement, to accept something less than the face amount of the claims. A balance sheet in which no suitable provision is made therefor is one which does not reflect the true status of all items, and to that extent is not a good balance sheet. Provision should be made not only for those expenses which are known to have been incurred and which remain unpaid, but also for those which the statistics of experience show will have to be met. Conservative practice, therefore, requires the inclusion of this estimate and applies it as an expense of the period in which the originating transaction took place. All the costs of the contract entered into, of which expected sales discount is one, are made to apply to the period giving rise to the contract.
Collection Costs not under Contract
The above argument is occasionally made use of in support of the inclusion of expected collection costs on claims against customers outstanding at the close of a period. From a theoretical aspect the point may be argued, but, unlike the item of sales discount, these are not costs which the concern is liable for under contract. From a practical standpoint, except under very unusual conditions, it is an undesirable refinement of the principle of allocation of costs as between periods. Where a collection department is maintained, costs of collection are practically uniform from period to period and are best considered as expenses of the period in which the cost is incurred.
Sales Discounts on the Balance Sheet
As to the manner of showing expected sales discounts on the balance sheet, practice is not uniform. It is sometimes shown added to the reserve for doubtful accounts and the sum of the two deducted from claims against customers, indicating thus the amount which it is expected can be realized therefrom. Others show it among the liabilities, on the ground that it differs from the estimate for bad debts in that it is an expense for which the concern has made itself liable under its sales contract. The distinction is finely drawn but probably well taken.
Distinction between Reserves and Accrued Items
The use of the title reserve for some of the items included as operating reserves is unfortunate and leads to confusion both in terminology and in understanding. Why unpaid expenses of any kind should be called reserves for expenses when the amount of them is definitely known has never been satisfactorily explained; yet the practice is sometimes met. There is some excuse in the case of expense items the amount of which cannot be definitely determined either from the nature of the item itself or other conditions over which the concern has no control. Thus, “Reserve for Wages” is usually a misnomer, the title “Wages Accrued” showing the item correctly; but “Reserve for Taxes,” while just as true a liability as the other item, may be justified on the ground that the latter is only an estimate subject to correction when the exact amount is known, whereas the former is already definitely known.
Contingent Reserves
So-called contingent reserves are sometimes handled as a part of this group, although best classified by themselves. A contingent reserve is one which represents an effort to provide for certain contingencies, such as guarantees on work done or products sold, lawsuits pending adjudication, etc. As R. H. Montgomery[62] so pertinently says: “the reserve should be based on evidence more tangible than a mere desire to be conservative. A vague feeling that something might have been overlooked which would decrease the assets or increase the liabilities is not the proper subject for a reserve. Conservative management ‘reserves’ part of its surplus for such contingencies, but it appears as surplus and not as a liability.” As mentioned above, sometimes the reserve for bad debts is classed as a contingent reserve. Contingency is inherent in the item but the certainty of its occurrence cannot be reasoned away. The use of contingent reserves may therefore well be limited to provision against contingent liabilities. In other words, they represent the best available estimate of the amount of such liabilities. To draw a dividing line between operating and contingent reserves is extremely difficult; both are created by charges to various expense accounts. It is merely a matter of degree as to the certainty of the events’ happening for which provision is being made. On the border line between the two are such items as reserves for insurance where the concern carries its own insurance and must make a periodic expense charge in lieu of the usual premiums; reserves for pensions where a pension policy is in effect, the charge creating it being here viewed as a part of the wages expense—the share of wages to be paid in the future which must be borne by the current period; reserves for sick benefits, which are in all respects similar to pension reserves; and so on. In some cases reserves for supersession of patents, or other assets whose length of service life is dependent on extreme contingency, are classed with this group.
[62] In “Auditing, Theory and Practice.”
Deferred Income—Misuse of Term
Deferred income is sometimes classed as a reserve. Thus, insurance companies carry the portion of their unearned premiums as on a given date, as a reserve. The use of the title is well established in that connection and the nature of the items is well understood. On commercial balance sheets where no outside authority can give a definite meaning to the term, its use for deferred income is to be deprecated and discouraged. Deferred income is a liability and not a reserve; the current period has not rendered the service to earn the income and is liable to the period in which the service is rendered.
Proprietorship Reserves
This disposes of all the asset and liability reserves and leaves for consideration the true profits or proprietorship reserves. As between these two main classes of reserves, as their titles indicate, the proper allocation of the one is among the assets or liabilities, while the other must be shown as a part of the net worth of the corporation. As to the nature of proprietorship reserves little more need be said. There are just two classes of items met here, viz., those shown as such openly on the balance sheet and those which are hidden or secret, latent among the various other items on the balance sheet. Proprietorship reserves represent profits reinvested in the business. Any profits, operating or capital, not paid out as dividends give rise to proprietorship reserves.
Secret Reserves
So-called secret reserves are brought about in various ways. Their creation may be intentional or accidental, but their source is the same in either case. Reserves of profits may be hidden either by undervaluation of the assets or overvaluation of the liabilities. Undervaluation of the assets may point to an ultra-conservative policy of management. Thus, some concerns write off the value of their fixed equipment of various kinds as rapidly as the net profits can absorb it and still leave sufficient for a reasonable dividend. Financial institutions in this way carry their furniture and fixtures and sometimes even banking houses, at ridiculously low figures or do not show them at all.
Undervaluations are accomplished in various ways. Charging an excessive rate of depreciation; making unnecessarily large reserves for uncollectible accounts, sales discounts, etc.; showing a more rapid depletion of natural assets than justified by the amounts used; charging the sums spent for assets to an operating expense; setting up an excessive cost of goods sold by means of inventory valuations of stock-in-trade at a figure lower than cost or market; crediting items of income to asset accounts instead of to income accounts, such as rentals on properties owned; crediting interest and dividends received to the stocks and bonds accounts—all of these serve the purpose of creating hidden reserves by means of a misstatement of fact.
Items wrongfully included among the liabilities bring about the same result. Here, however, the procedure is somewhat more patent because the creditors themselves check up on all actual liabilities. Liabilities can be settled only by an actual reduction of assets. Manipulation of the operating and contingent reserves explained above offers, however, an easy means of overvaluing the liabilities. A too liberal estimate of the amounts of these reserves makes them represent in part true proprietorship reserves but the proprietorship element in them is obscured by their title and their inclusion among the liabilities on the balance sheet.
It is, of course, apparent that no balance sheet containing secret reserves is a true statement of condition and the practice of creating secret reserves must usually—perhaps always—be condemned.
Argument for Secret Reserve
In justification of the secret reserve, it is sometimes said that in certain lines of business where the maintenance of unquestioned credit or the promotion of a stability ordinarily lacking in speculative enterprises is highly desirable, there is a very pressing need for the secret reserve. Through its use, extraordinary losses, which otherwise would result in very unfavorable fluctuations of stock values, may be absorbed by means of a charge to some undervalued asset and so bring it to its true value; or by a charge against an over-estimated liability reserve and so bring it to a true showing. This frees the current profit and loss from the charge, maintains a regularity of net profits, and prevents the disasters sometimes attendant upon violent fluctuations of stock values brought about by the knowledge of these extraordinary losses. That is the strongest case which can be made out in favor of the secret reserve.
Argument against Secret Reserve
The fact, however, must not be overlooked that without any understatement or misrepresentation of property values at any time there could just as easily be created an open “surplus” or margin of an amount equal to the secret reserve, against which these losses could as well be charged. The creation of such a margin can be justified on the same grounds on which the justification of the secret reserve is attempted, viz., the maintenance of high credit and stability. The reduction of the margin through its absorption of the loss would, of course, be somewhat more patent than the reappearance of values previously written off, although analysis of a balance sheet will invariably bring the true state of affairs to light. Furthermore, present stockholders, and certainly prospective investors and creditors, have a right to know the true condition of affairs. The appearance of a large proprietorship in addition to capital stock, revealed by a sizable margin, gives the stock a value in addition to that based solely on the dividend rate. A stockholder has a right to his share of the profits during the period of his ownership. If it is not received in the form of dividends, he should at least be partially recompensed when he disposes of his holdings, by an increased price for the stock as reflected by the portion of profits reinvested in the business.
The attitude occasionally taken that directors know best what information as to true condition of affairs should be given to the owners and what should be withheld, should, in these days of increasing publicity, be given no serious consideration. In the hands of unscrupulous directors, the secret reserve is an instrument for the covering up of questionable and even fraudulent practices. Stock values can be intentionally hammered down by a false showing of profits and so inure to the benefit of a group of prospective purchasers desiring to “freeze out” unsuspecting stockholders. All in all, therefore, little can be said in justification, but much in condemnation, of the practice of accumulating secret reserves.
Earmarking of Reserves
According to the definition of surplus laid down in the beginning of this chapter, limiting the term strictly to the profits available for dividends, those profits which are applied to reinvestment for specific purposes must be separated from the “surplus” and given distinguishing marks to indicate their purpose. Thus, profits reserved for the purpose of acquiring a fund of assets out of which to pay off debt obligations maturing in the future may be set aside under the title “Sinking Fund Reserve”; those set aside for the purpose of extension of plant as “Building Fund Reserve”; those for the purpose of providing a pension fund as “Pension Fund Reserve”; and so on. This is sometimes called “earmarking” the reserve.
Separation into differently named reserves serves no other purpose, however; it does not in any way insure the inviolability of the reserve; it acts merely as evidence of the intention and purpose of the board of directors which authorized the application of profits to that purpose. It is the expression of a business policy and as such is, without other compelling force, subject to the approval and continuance or to the disapproval and nullification of any subsequent board. These reserves are profits and as such belong to the shareholders and may be distributed among them as dividends. A reasonably conservative policy as to reserves usually has the support of stockholders, and a subsequent board will not risk loss of position and standing with the stockholders by a change of policy as to reserves without good and sufficient reasons for doing so.
Continuity of Reserve Policy
Effort is sometimes made to secure continuity of the reserve policy. This may be accomplished in several ways. Oftentimes it is made compulsory by outside regulatory authority, as in the case of national banks which are required to set aside annually a certain part of their profits until these have accumulated to an amount equal to 20% of their capital stock. Similar conservatism can also be compelled by contract entered into with creditors. It is a frequent provision of the trust agreement covering an issue of bonds that “there shall be set aside out of profits” a certain amount at the close of each fiscal period for the purpose of creating a fund with which to redeem the bond issue when it falls due. The funds may be placed in the hands of a trustee, which guarantees the application of them to their intended use but does not, of course, insure the retention of profits to an equal amount in the business. Finally boards of directors may be compelled by the stockholders to adhere to a certain policy by provision in the by-laws for the accumulation of reserves. This policy is, of course, subject to change by the stockholders themselves. Where the power to make and change by-laws is put in the hands of the directors, this last method is not applicable.
Reserves may always be made a part of the permanent capital through their distribution in the form of a stock dividend. This secures the continuance of profits reserved to date but does not guarantee either a similar application of future reserves or even a continuance of the present reserve policy.
Covered Reserves
When a reserve is spoken of as being covered, it is meant that specific funds have been set aside for the purpose named, in amount equal to the reserve. As in the case of sinking funds, the assets set aside may be invested in stocks and bonds control of which remains with the company itself; or the assets may be turned over to a trustee who then has control of their investment and use. The student is referred to Chapter XXV on sinking funds for a full discussion of the merits and disadvantages of the two methods as to control over the funds.
In connection with covered reserves, attention is called again to the use, in the interest of standard practice, of the caption “reserve fund” as a suitable title for the assets placed in the fund, and the caption “reserve,” with suitable descriptive phrase, as the title for the reserved profits, the proprietorship element of the transaction.
Classification of Reserves
Before leaving the subject of reserves, it is purposed to give several classifications of the various kinds of reserves. Paul-Joseph Esquerré[63] classifies reserves under the following heads: (1) Reserves for Depreciation; (2) Operating Reserves; (3) Reserves for Surplus Contingencies; (4) Reserves for Redemption of Debt; (5) Secret Reserves; and (6) Reserves for Exhaustion of Physical Assets. Their titles well indicate the kinds of items included under each head.
H. R. Hatfield[64] classifies them on the basis of the use to which they are to be put, not attempting a classification to include all items shown on the balance sheet under the caption of a “reserve,” but limiting it to reserves of profits. His classes are:
“1. Reserves created to provide a permanent increase of capital. (a) As an additional guaranty to creditors. (b) To provide for extension of its fixed or other capital assets. 2. Reserves created to provide an additional capital which can be used to cover unusual losses or to provide for other emergencies without encroaching on the nominal capital. 3. Reserves created to provide for equalizing dividends by retaining part of one year’s profit to be used to make up scanty profits for other years.”
[63] In “Applied Theory of Accounts.”
[64] In “Modern Accounting.”
The classification used here has as its basis the place of allocation of the various reserves in the balance sheet because their nature determines their place, which after all is the important consideration. From that point of view two broad classes may be marked off as discussed in the preceding pages, viz.: (1) valuation reserves, using the term with a somewhat more extended meaning than is customary; and (2) proprietorship reserves. Under valuation reserves will be included all reserves shown either as deductions from the assets or as liabilities. Here the term reserve will be limited to those items which are estimated, as distinguished from those the amount of which is definitely known. The other items which are sometimes wrongly called reserves, as discussed on page 415, will not be included here, other titles being more accurately descriptive of them.
1. Valuation Reserves (a) Asset Valuation Reserves 1. Depreciation Reserves 2. Depletion Reserves 3. Bad Debts Reserves 4. Appreciation Reserves 5. Market Fluctuations Reserves, etc. (b) Liability Valuation Reserves 1. Operating Reserves 2. Contingent Reserves
2. Proprietorship Reserves (a) Secret Reserves (b) Open Reserves 1. Reserves for Debt Extinguishment 2. Reserves for Plant Extensions 3. Reserves for Working Capital, etc.
Legitimate Use of Surplus Account
There remains only a consideration of the Surplus account. The manner of handling the surplus as a clearing account for the appropriation of net profits has already been treated. After profits have been appropriated or reserved out of it for specific purposes, the surplus shows by its balance the portion still available for dividends. As has been indicated, it is not usually desirable to use all of it for dividends, a sufficiently large balance being always maintained for such purposes as stabilizing the dividend policy, strengthening credit, and other surplus contingencies.
Surplus account is frequently as badly abused as the proverbial “general” expense account, by being used as a dumping ground. It has, however, a legitimate and an illegitimate use. As the Profit and Loss account is strictly limited to use as a clearing account for the normal items of income and expense applicable to the current period’s operations, manifestly all other charges and credits to proprietorship must be cared for elsewhere. With very few exceptions—such as premiums and discounts on capital stock, donated working capital, etc.—these charges and credits are made to Surplus. High accounting authority deprecates the use of Surplus for these purposes, on the ground that too often it is used as a convenient place in which to hide items properly chargeable to the current Profit and Loss but which would not make a favorable impression if shown there. Just as with many other abused accounts, its wrongful use hardly constitutes sufficient grounds for withholding sanction of legitimate use. Where it is felt that certain items should not go directly into Surplus they should be recorded in a final section of the Profit and Loss account, just before its balance is shown transferred to Surplus. As the financial statements are usually published, this method secures more certain publicity to these items.
Occasionally, instead of the use of either Profit and Loss or Surplus for this purpose, an account is set up on the books called “Surplus Adjustments” through which these items are cleared into Surplus. The objection raised above to this use of Surplus applies with equal force to “Surplus Adjustment.”
Statement of Surplus
At the close of each period account must usually be taken of a group of items which cannot properly be treated as belonging to that period. Some of these may be items which were overlooked at the close of previous fiscal periods and cannot now be taken into the record for that period. Some things may wrongfully have been included in, or omitted from, the inventory; the inventory may have been under-or overvalued; errors may have been made in the separation of capital from revenue expenditures; wrong depreciation and bad debts estimates may have been made—these and similar items call for adjustment at the close of the current period. Where adjustments are few and simple, the statement of surplus on the balance sheet may be extended sufficiently to include them. Much better, however, is it to append as a schedule or statement in support of the balance sheet, a statement of surplus, showing therein the detail of all entries affecting it during and at the close of the current period. Particularly is this desirable when the statements of financial condition are prepared for internal use.
Such a statement of surplus should start with the amount of surplus as at the close of the previous period. Then the adjustments applicable to that period should be shown, thus determining the true surplus for the period. Following that should appear the entries made directly to Surplus for the current period, the net profit transferred thereto, and finally all appropriations of profit, leaving as the balance of Surplus the same amount which appears in the balance sheet. In skeleton form the statement should appear somewhat as follows:
X Y Z COMPANY STATEMENT OF SURPLUS, JUNE 30, 1918
Balance of Surplus as on December 31, 1917 $..... Adjustments applicable to period ending December 31, 1917: Additions: Inventory omissions, undervaluations, etc. $..... Items wrongly charged to Revenue ..... Over-estimate of Depreciation, etc. ..... $..... ----- Deductions: Inventory overvaluations, etc. $..... Items wrongly charged to Capital ..... Under-estimates of Depreciation, etc. ..... ..... ----- ----- Net Increase (or Decrease) ..... ----- True Surplus as on December 31, 1917 $..... Extraordinary Profits (or Losses) this period $..... Net Profit this period ..... ..... ----- ----- Amount available for appropriation $..... Appropriations of Surplus: Reserves (shown in detail) $..... Dividends ..... ..... ----- ----- Net Balance in Surplus as on June 30, 1918 $..... =====
Introduction
Dividends, as the term is generally used, may be defined as those profits of a corporation which are divided among the owners. Except in the case of wasting assets, the law is very explicit in limiting dividends to profits. Therefore profits need to be determined with painstaking care. Most of the major problems met in the determination of profits were discussed in Chapter XXII. Here it is purposed to limit the discussion to one phase of the disposition of profits, viz., as dividends, having treated in Chapter XXIII other appropriations of profit for reserves and surplus.
Disposition of Corporation Profits
The profits of a solvent going corporation, whether current profits or those reinvested in the business, are owned absolutely by the owners of the corporation and are subject to their disposition and control, except where the law imposes restrictions. Oftentimes, the stockholders themselves impose restrictions by incorporating restrictive provisions in the charter or by-laws of the corporation. Of course, the same power which made them has power to remove them, though the exercise of the amending power is usually more difficult than the original expression of that power in enacting rules. The nature of a corporation is such, however, that many acts and privileges which are per se rights of the stockholders must in their exercise be delegated to others. Thus, while the right of ownership and control of the profits of a corporation is inherent in its proprietorship, the control is indirect—through the medium of a board of directors subject to periodic review and election by the owners. This board, during the period of its incumbency, acts for the stockholders and, during the prosecution of its duties, if performed in good faith, with sound judgment, and without fraudulent intent, is free from interference.
Shareholders’ Rights as to Profits
Shareholders’ rights in regard to sharing in the profits are therefore dependent upon the action of their elected board of directors. As soon as that board authorizes a dividend, however, its control over the portion of the profits so appropriated ceases except as to the routine of payment of the dividend. The right which the stockholder thereafter possesses is of the same nature as the claim of an outside creditor, and in the event of dissolution the assets of the corporation must be applied to the liquidation of this claim equally with all other unsecured claims. Thus, a claim for dividends must be met before the determination of the net assets with which the ownership of capital stock is liquidated.
Directors’ Control over Profits
As stated above with regard to profits generally, the directors have entire control of the declaration of dividends, except where limitation is specifically imposed by the state or by the owners as expressed in charter or by-laws. The following expression of directors’ power over profits and dividends, contained in the English Companies (Consolidation) Act of 1908 is typical of most laws covering the question: “The directors may, before recommending any dividend, set aside out of the profits of the company such sums as they think proper as a reserve or reserves which shall, at the discretion of the directors, be applicable for meeting contingencies, or for equalizing dividends, or for any other purpose to which the profits of the company may be properly applied, and pending such application may, at the like discretion, either be employed in the business of the company or be invested in such investments (other than shares of the company) as the directors may from time to time think fit.”
Provisos as to Declaration of Dividends
Specific provision may be made in the by-laws covering the declaration of dividends. Thus, the directors may there be ordered to set aside for specific purposes a certain amount of the profits earned and to declare dividends only from any residue. This may represent a permanent policy but usually only temporary; that is, periodic reservation of profits may continue until a definitely named reserve (or surplus) has been created, after which all profits become free for such disposition as the directors may see fit to make. A somewhat different policy is occasionally prescribed by which the directors are ordered to pay out of each period’s profits dividends of a named amount, after which any residue shall be carried to a reserve (or surplus). The objection to this latter policy, as ordered in the by-laws, is that it ties the hands of the directors to the division of profits among the owners regardless of the exigencies of new situations, as they arise, bringing very different conditions from those under which the policy was originally ordered.
The power of the directors as to declaration of dividends extends not only to common stock but also to preferred. No dividends, common or preferred, can be declared except from profits. Legal inhibition of the payment of dividends out of capital is one of the chief points of difference between the corporate and other forms of business organization.
As stated in a preceding section, regulatory bodies and commissions sometimes impose rules compelling corporations over which they have authority to set aside to surplus some portion of the profits before the declaration of any dividend.
Stockholders’ Rights to Dividends
Where profits exist, either earned currently or accumulated, the matter of a declaration of dividends is thus seen to be always a question of financial policy. In view of the other problems confronting the corporation—its policy of growth and expansion to meet competition and enter other markets, its specific and pressing requirements for funds—the question of the wisdom of a declaration and payment of dividends frequently demands careful consideration. If under the circumstances, in the exercise of their discretion, the directors do not declare dividends, their action is final and, in the absence of fraud or an abuse of discretion, will not usually be interfered with by the courts.
Courts do sometimes intervene, however, as in Matter of Rogers, 161 N. Y. 108 (1899): “The directors must act in good faith. If they fail to do so and it clearly appears that they have accumulated earnings not required in the prosecution of the business which they withhold from the stockholders for illegitimate purposes, a court of equity may interfere and compel a distribution of such earnings.” Again, in Hunter v. Roberts, Throp & Co., 83 Mich. 63 (1890), the court said: “Courts of equity will not interfere in the management of the directors unless it is clearly made to appear that they are guilty of fraud or misappropriation of the corporate funds or refuse to declare a dividend when the corporation has a surplus of net profits which it can, without detriment to its business, divide among its stockholders, and when a refusal to do so would amount to such an abuse of discretion as would constitute a fraud or breach of that good faith which they are bound to exercise towards the stockholders.”
In the case of preferred dividends, the courts are somewhat readier to act because of the ease of a fraudulent retention of profits. Where stock is non-cumulative and non-participating and particularly if non-voting, it would be possible for a board of directors to refuse dividend declarations for a number of years and then pay to common stockholders most of the profits so saved. Such a policy is so manifestly unfair and fraudulent as to warrant immediate intervention of the court. When stock is cumulative as to unpaid dividends, such a policy could not be practiced, as the corporation cannot declare dividends unless profits are made, nor, except as above stated, need it declare dividends even when profits are made. But upon the declaration of a dividend, the rights of cumulative preferred shareholders require the payment of all accumulation of unpaid dividends before the other classes of stockholders can share.
Declaration of Dividends
The matter of a declaration of dividends is usually a formal one. The minute book record must always show the authorization. It may appear as a formal resolution or merely as a statement of the declaration. Such resolution or statement will usually carry the amount of the dividend, which may be either a named per cent on the par value of the stock (or the amount paid up on the stock where stock is not full-paid), or it may be a named amount on each share; the date on which it is effective; the date and manner of payment; and to whom payable, i.e., to the stockholders as of a given date. Dividends may be declared to become effective on some future date but never on a past date. Antedating a dividend so as to make it apply to past stockholders who may no longer have any interest in the corporation would manifestly be unfair, opening the way to manipulation and fraud.
A stockholder is entitled to notice of every dividend declaration. This may come to him by published notice in the newspapers or through the mails. A dividend check mailed to his last-known address has been held to constitute sufficient notice.
Liability of Directors
Together with the power and control over dividends by the directors is a responsibility and liability for those wrongly declared. The law is very specific and emphatic in its refusal to allow dividends except from profits. The State of New York in its Stock Corporation Law has this to say with regard to the liability of directors for making unauthorized dividends: “The directors of a stock corporation shall not make dividends, except from the surplus profits arising from the business of such corporation, nor divide, withdraw, or in any way pay to the stockholders or any of them, any part of the capital of such corporation, or reduce its capital stock, except as authorized by law. In the case of any violation of the provisions of this section, the directors under whose administration the same may have happened, except those who may have caused their dissent therefrom to be entered at large upon the minutes of such directors at the time, or were not present when the same happened, shall jointly and severally be liable to such corporation and to the creditors thereof to the full amount of any loss sustained by such corporation or its creditors respectively by reason of such withdrawal, division, or reduction.”[65]
[65] Ch. 59 of the Consolidated Laws (Ch. 61, Laws 1909).
In some states the liability of directors is made to include, in addition to restitution of the amounts wrongfully paid, liability for all debts contracted during their term of office and even to a body judgment for misdemeanor. The stockholders receiving such a dividend are held to have known of its illegality and are liable for restitution. While payment of dividends out of capital is the most frequent source of illegality, a declaration of dividends contrary to the provisions of the charter or by-laws relative thereto, or a declaration which disregards the rights of other stockholders, is equally illegal. Thus, a dividend paid before reserving profits, where the by-laws require antecedent reservation or one paid to common shareholders ahead of an accumulated dividend to cumulative preferred stockholders, is classed as illegal.
Revocation of Dividends
A dividend once legally declared and of which notice has been given cannot be revoked. As stated above, such a dividend becomes a claim against the corporation and ranks with the claims of outside creditors. Even further than this, it has been held that if actual funds have been set aside, as by deposit in a bank, for the payment of these dividends, these funds cannot be touched by other creditors in case of insolvency, but must be applied to the payment of dividends.
With regard to the revocation of dividends, such action is held to be possible only until the fact of declaration has become known outside the board of directors. The revocation of a dividend is merely looked upon as a reconsideration of business policy. In case of illegally declared dividends, they may be revoked by the directors any time previous to payment and the directors may be enjoined from making payment of them.
Payment of Dividends
Inasmuch as a declared dividend becomes a debt of the corporation, it may be settled by whatever means another debt might be. Thus, if a stockholder owes anything to the corporation, the debt for dividends may be used as an offset and only the net payment be made or received, as the case may be. In this way dividends may be made to apply to unpaid subscriptions on capital stock.
After the declaration of dividends provision must be made to pay them. Before the declaration, a report from the treasurer will have probably shown the financial condition of the company to be such as to warrant the payment. Unless specifically ordered otherwise, payment in cash is understood. Payment of the dividend is a duty of the treasurer. If present at the board meeting when the dividend is declared, that is sufficient notification to him to make arrangement for paying it. If not, notice may come to him verbally, by an inspection of the minute book, or by formal notice from the secretary.
Dividends may be paid by check through the mail or by notifying the stockholders to appear at a designated place to claim their dividends. Under this latter procedure, receipt for the dividend is usually made by signature of a form of receipt in the dividend book. Where payment is made by check, the signing of a formal receipt may or may not be required. In a large corporation the stock of which is widely held, a distinct series of checks formally marked “Dividend Check” is made use of. If these checks bear an identification phrase on their face, as Dividend No. ..., indorsement by the holder upon receipt of payment by the bank and the bank’s cancellation stamp undoubtedly constitute sufficient receipt for payment. However, if desirable, a formal receipt may be issued with the check and its return requested. In a small corporation, the regular check series may be used and marked as dividend checks.
Dividends Paid as Salaries
A peculiar method of payment of dividends is by means of excess salaries—which is largely a matter of bookkeeping. In a close corporation where all the stockholders are officers of the corporation, salaries, in addition to those regularly paid, may be voted in lieu of dividends. The courts have held that, so long as all the parties interested—incorporators, stockholders, directors, and officers—assent to the scheme for the distribution of profits by the payment of salaries, the plan is not objectionable. Salaries so paid would usually be in proportion to holdings of stock and as such become dividends, merely booked as salary.
Methods of Paying Dividends
An interesting point is raised in the question as to whether it is legal or wise to borrow funds to pay dividends. This question in its turn raises the point as to the various ways in which dividends may be paid. In addition to the payment of dividends in cash, other property owned, such as the stock and bonds of other concerns, even the more or less fixed assets if these can be apportioned, may be used for this purpose. The issue of the company’s obligations in the form of its own bonds, or in a special form of promise to pay known as dividend scrip; and, furthermore, the absorption of the dividend by the business through the issue of its own shares—both these methods have been employed to liquidate the dividend obligation.
It will be noted that payment by cash or other asset has the effect of decreasing the assets in order to decrease the liability for dividends; that payment by the issue of bonds or scrip cancels one kind of liability by the issue of another kind; whereas payment by the issue of the company’s own shares liquidates the liability by increasing proprietorship through the issue of stock, thus reinvesting in the business the portion of profits distributed as dividends.
Borrowing to Pay Dividends
The answer to the question as to the legality of borrowing funds to pay dividends may be inferred from the discussion above as to the status of a declared dividend. Where the question of legality is not involved in the declaration of dividends, i.e., where a declared dividend is legal in all respects, the legality of borrowing to pay the dividend is no more open to question than the legality of borrowing to pay any other legally contracted debt. Though there may be ample profits, the affairs of a corporation may be in such shape financially that the payment of a dividend would result disastrously to the shareholders and even to the creditors. Here it is possible to enjoin the directors from making payment. Action cannot be based on the illegality of making payment but on the abuse of discretion amounting to illegality in the declaration of the dividend.
If by so doing the finances of a corporation are not crippled, there is no more legal objection to borrowing to pay a dividend debt than to borrow to pay other debts. The courts have not always held so, however, but the weight of authority seems to be that where profits have been earned but become tied up in the enterprise the corporation may “borrow money on the faith of it and divide that,” may sell the property in which the profits are tied up and distribute the proceeds, or may borrow funds on the general credit of the corporation sufficient to meet the dividend payments.
It has even been held that where the income has been applied to the extension and betterment of the plant but the expenditure has been wrongly booked as an expense charge instead of being capitalized, the income so used may be recreated on the books by proper correcting entries and dividends declared and paid therefrom. To the accountant such a procedure seems perfectly correct, though the courts usually look askance at anything savoring of a payment of dividends out of capital.
The chief question involved, therefore, in borrowing funds for the payment of dividends is purely a financial one and the wisdom of such a procedure must be based on financial considerations. If from that standpoint, it is deemed feasible to borrow, the further question as to the form of the loan must be considered. Is it for the best financial interest of the company to borrow on short or long time, to create a floating or a funded debt, etc.—these points require consideration and can, of course, be answered only in the light of the conditions prevailing in each case as to the status of the working capital requirements.
Dividends Paid in Property, or by Borrowing on Property
Payment of dividends by means of property is unusual. It is seldom that the property held can be so divided as to serve this purpose without loss of value. Exception is found in the case of liquidating dividends, discussed on page 445, for which purpose often the shares of stock and bonds of the vendee may be distributed as payment to the vendor’s stockholders. More often, the stocks and bonds will be used as collateral for a loan with which to pay the dividend, or the real estate will be mortgaged for the same purpose, thus effecting a borrowing of funds, a discussion of which has just been given. Plots of land may sometimes be so divided as to be acceptable as equitable shares of a dividend, where the stock of a corporation is held in comparatively large blocks.
Bond and Scrip Dividends
Reference also has been made to the issue of the company’s own obligations for payment of the dividend. If financial policy dictates a long-term obligation, payment may be made out of any unissued bonds which the company may possess or by means of a bond issue for this specific purpose.
More usual, however, is the payment of dividends by means of short-term obligations known as scrip or dividend scrip. Scrip takes many forms. It is usually so drawn as to constitute the corporation’s promise to pay. It may be unconditional, and so negotiable, or it may be hedged about with limiting conditions. Date of payment may be absolute or contingent. Scrip may be convertible into the bonds or stock of the company at the option of either party. Unredeemed scrip may even bear dividends. Usually, however, the issue of scrip is for the purpose of deferring date of payment of the dividend until cash can be accumulated from sale of property or from the profits of the new period.
Stock Dividends
The one remaining method of settling the dividend claim is by the issue of stock. As pointed out above, the effect of this is to convert some portion of the “margin” or surplus into capital stock. This change in the form of proprietorship is accomplished by a reduction of proprietorship through the declaration of a dividend and an equal increase of proprietorship through payment of the dividend in stock of the company. The effect of a stock dividend, therefore, is to fix a portion of the “margin” so that it becomes a part of the permanent capital of the corporation and, as such, is no longer subject to the direct control of the board of directors. Excepting in states which expressly forbid the stock dividend—and even here the same result is accomplished by other means—its legality is thoroughly established.
Thus, in Howell v. Chicago, etc., Ry. Co., 51 Barb. (N. Y.) 378 (1868), the court said: “It becomes immaterial whether such increase (in capital) is made by awarding the stock to stockholders as dividends in lieu of money, retaining the money for the purpose of the company, or by paying the stockholders the dividends in cash from the earnings of the company and selling the stock in the market to raise money for the use of the company.” In Williams v. Western Union Telegraph Co., 93 N. Y. 162 (1883), the court ruled: “If it [the corporation] can issue stock in payment of property to be obtained by it as part of its capital for its legitimate uses, why may it not issue stock in payment for property in effect purchased of them [i.e., the shareholders] and added to its permanent capital and which they relinquish the right to have divided? So long as every dollar of stock issued by a corporation is represented by a dollar of property, no harm can result to individuals or the public from distributing stock to stockholders.... All that can be required in any case is that there shall be an actual capital in property representing the amount of share capital issued.”
Any unissued or treasury stock in the possession of the company may be used for this purpose and, in the case of unissued stock, becomes full-paid if the property against which it is issued is of equal value to it. If the necessary legal requirements are met, even authority for an issue of new stock may be given and the stock used for the purpose of paying the dividend.
Stock Dividends in Estate Accounting. An interesting point is raised in estate accounting as to whether a stock dividend should be treated as principal or income as between the life-interest party and the remainderman. In such a case, the income from the stock which yields the dividend belongs to the life-interest party, while the stock itself is the principal and belongs to the remainderman. Of course, any dividend declared before the decedent’s death, though not payable until after it, is a part of the principal of the estate. The original fund of principal being established, all dividends, whether in cash or stock, which disburse current earnings belong to the life-tenant as income. Where a dividend partakes of the nature of a liquidating dividend—i.e., represents a return of some portion of the net worth as at the decedent’s death—the portion so returned should, in equity, be looked upon as principal.
Any stock dividend has the effect of lessening the value of the stock previously outstanding by the circumstance that it, while issued at par, after issue takes on its pro rata share in any accumulated margin. Thus, by the very fact of payment of a dividend in stock, the principal of the estate diminishes in value. Courts have usually held this proper, however, but in cases of manifest injustice, as where profits have been reserved in large amounts and thus have come to be treated as a part of the permanent capital, the “cutting of the melon” in the form of a stock dividend would work so markedly to the injury of the value of the principal that exception would be made here.
Dividends Proportional to Holdings
Dividends must be exactly proportional to the holdings of stock. If there is but one class of stock outstanding, each share must bear the same dividend as every other share. Any other basis of distribution is sufficient cause for asking the intervention of the court. If several classes of stock have been issued, the same requirements hold within each class; but as between the classes themselves the dividend rates may vary, this variation frequently being the differentiating mark. Among the members of any class, therefore, distribution must be made with absolute impartiality, the number of shares held by each determining the amount of dividend for each owner. Also, time and manner of payment, except by special consent, must be the same for every member within each class.
To Whom Payable
As stated above, the formal resolution declaring the dividend prescribes where it shall go, so there can be made up a list of those to whom the dividends are to be paid. To accomplish this it is usually stated that the stock records for transfer of stock ownership shall be closed between certain named dates and that dividends will be paid to those who appear as shareholders as on the initial date of the closed period. This makes it possible to bring the stock record up to that date and determine who are owners at that time. Thus, a dividend resolution may read somewhat as follows:
A dividend, No. 94, of two and one-half per cent (2½%) for the quarter ending March 31, 1918, has been declared by the Board of Directors out of past earnings, payable April 1 to stockholders of record at the close of business March 23. Stock transfer books will be closed from March 23 to April 1 inclusive.
The stock records may, however, remain open, the matter being one of convenience only.
If a transfer of stock should take place subsequent to the named date of record, sale is usually made ex-dividend. If, however, sale should be made with right to the dividend, notification of the assignment of the dividend before the mailing of the dividend checks by the secretary or treasurer constitutes an order for him to pay the dividend to the new party. The same rule would obtain in the case of a sale made previous to the declaration of dividends but not recorded till afterwards; so also in the case of pledged stock, although payment should be made to the pledgee. Unless the corporation is notified, its list of stockholders according to its records governs in determining the owners of the dividend.
Accounting Record
Little need be added to what has been said in other places as to the method of handling dividend transactions on the books. Their declaration is booked as a charge against either the current Profit and Loss or the Surplus account, with a credit to Dividends Payable. Their payment by any of the methods already discussed in this chapter cancels the Dividends Payable account and is reflected either by a decrease of assets, an increase of liabilities, or an increase of proprietorship. In setting up the entries, ample explanations should be made in the record itself or by reference to the minute book.
As to handling the payment of the dividend, methods vary somewhat. The secretary’s list of stockholders made up from the stock records should show the stockholders according to the kinds of stock they hold, the amount of the holdings of each, the dividend rate on each class, and the amount of the dividend payable to each stockholder. This list, with its calculations verified by the treasurer, is the schedule according to which the dividend checks are made out. Where a separate series of checks is made out for this purpose, it is best to draw a check on general cash for the full amount of the dividend and deposit it to dividend account with the bank. The individual dividend checks are drawn against this account and so the detail of the transaction is kept off the general books.
If all checks reach their destination, the dividend liability is canceled. If any are unclaimed, a liability exists on account of them offset by funds appropriated and set aside for its cancellation. If the fund is in the hands of a trustee—which is not usual—and so beyond the control of the corporation, there would be no reason for including the liability on account of such dividends on a balance sheet as of that date. Under most circumstances, the cash in the fund should be counted as cash on hand and the liability shown. When in this way an unexpended balance of cash is shown in dividend account, subsequent charges against it must be carefully watched to see that they are properly authorized, otherwise the way to fraudulent practice is opened.
Relation of Capital Losses to Dividends
Reference was made in Chapter XXII on “Profits” to the relation of capital losses to dividends. The laws are very explicit in their declaration that dividends shall not be paid out of capital. In this connection two problems treated in Chapter XXII must be reconsidered. Here it is purposed simply to restate them and summarize conclusions. These problems are: (1) the interpretation of the law’s requirements in relation to the payment of dividends without providing for the depletion of wasting assets; and (2) the bearing of the law on dividend payments without making good all previous encroachments on capital.
With regard to the first problem, law and practice are pretty well established and are in accord. The decision in the case of Lee v. Neuchatel Asphalte Co., L. R. 41, Ch. D. 1 (1889), has been followed quite generally. There it is held that “if the objects of the company include the sinking of capital in the acquisition of wasting property, even depreciation by waste is not necessarily a revenue charge, but may by the regulations be thrown upon capital.” And again, if a company is formed “to acquire and work a property of a wasting nature, for example, a mine, a quarry, or a patent, the capital expended in acquiring the property may be regarded as sunk and gone, and if the company retains assets sufficient to pay its debts, it appears to me that there is nothing whatever in the Act to prevent any excess of money obtained by working the property over the cost of working it from being divided amongst the shareholders.”
The inclusion in the periodic dividend of the return of a portion of the capital thus legalized is approved from a business standpoint on the ground that from its very nature the enterprise is speculative in greater or less degree and creditors are therefore sufficiently warned in their dealings with such a concern. Of course, if any such company expects to be permanently engaged in such enterprises it may be the part of wisdom to reserve from distribution all the capital or whatever portion of it may be necessary to finance each new undertaking. This is solely a matter of business policy, however. “It is for the shareholders to say whether or not they will put by a sinking fund to meet the waste.... They may if they like, but they are not bound so to provide.”[66]
[66] Lee v. Neuchatel Asphalte Co.
As to the second question raised above, the general rule and practice in this country requires the making good of such losses first and the payment of dividends only from a resulting surplus. Shields v. Hobart, 172 Mo. 491, 517 (1902), states the prevailing law in the matter as follows: “Dividends can properly be declared only from the profits over and above the capital stock and the debts of the company.”
There may be circumstances in which this rule may work a very real hardship, and there is some support both in law and in a sense of justice under given conditions for the view that each period stands by itself so far as dividends are concerned, and that there is no need to use the profits of one period to make good the encroachments on capital of a previous period before paying a dividend. In such cases, the remedy is provided by a reduction of capital stock by the amount of the encroachment upon it. The payment of dividends on the remainder is then above question of law or the best business policy. In this connection the student is referred to page 395, Chapter XXII, for an often-quoted decision of the English courts.
Liquidating Dividends
Any dividend which represents a return of any portion of the capital is to the extent of the portion returned a liquidating dividend. In other words, a payment to a stockholder on account of capital invested is a liquidating dividend. Such a dividend is met when the affairs of a corporation are being wound up. The liquidation of a corporation is discussed in a later chapter. Here the term is only defined because of its relationship to the dividend paid by a corporation which is operating a wasting asset of some sort. Usually the dividends paid by such a concern are not separated as to content, showing how much is profits and how much is a return of capital. A commendable exception to this is seen in the recent dividend notice of the Shattuck Arizona Copper Co., reading as follows:
The Board of Directors of Shattuck Arizona Copper Company has this day declared a dividend of Twenty-Five (25c.) cents per share, and a capital distribution of Twenty-Five (25c.) cents per share, payable January 19, 1918, to stockholders of record at the close of business December 31, 1917. Stock Transfer Books do not close.
November 30, 1917.
If a reserve for depletion of the property is set up, the offsetting charge to Profit and Loss results in that account’s balance showing the true profit. Dividends declared in excess of this represent the part of the capital being returned. In booking these liquidating dividends, the charge must, in strict theory, be made directly against Capital Stock account. A charge to an account called “Capital Liquidated as Dividends,” “Capital Returned to Stockholders in Dividends,” “Capital Payments,” or other self-explanatory title, may be made instead of the direct charge to Capital Stock. If so, such an account should be carried as a valuation account for Capital Stock and shown on the balance sheet as a deduction from Capital Stock.
Where, as has been allowed in connection with income tax returns, there has been a revaluation of properties operating wasting assets, and values in excess of the capital stock are established, such excess may be brought onto the books as a charge to Property or Plant and a credit to an account called “Property Surplus” or other similar title. Dividends thereafter declared, provided the depletion charge is made periodically, will be charged as to their profits against Surplus and, as to their return of capital portion, against Property Surplus until that is exhausted, after which the charge should be made as indicated above.