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 LiabilityAmount
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.

CHAPTER 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:

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) Cash350,000.00
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
(5) Cash99,750.00
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 Bonds1.14
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:

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.

CHAPTER 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 Unissued250,000.00
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]

CHAPTER 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.

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.

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.

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.”

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.”

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 impairment250,000.00
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]

“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.”

CHAPTER 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.

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.

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.”

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.

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)$.....
Dividends..........
Net Balance in Surplus as on June 30, 1918$.....

CHAPTER XXIV
DIVIDENDS

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]

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]

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.

CHAPTER XXV
THE SINKING FUND

Origin and Use

The sinking fund is a recognized and well-established instrument for the financing of business. A great deal has been written about the subject, and over some of its phases much wordy warfare has raged. As usual, however, the controversy has had little or no effect on the practical application of the principle of the fund.

The sinking fund seems to have been first used as a practical instrument for the repayment of debt in the year 1716, although the idea germinated some time before this. At first its application was limited entirely to public finance. Through the efforts of Sir Robert Walpole, legislation was enacted in England which made certain specified taxes perpetual. Any surplus remaining after applying them to the purpose for which they were levied was to be put into a sinking fund for the purpose of paying off the public debt. Due to bad administration of the fund, it was not successful. Its use was attempted a second time in 1786 by William Pitt, at the instance of a Dr. Price. Since then it has had a rather checkered career in public finance. In some fields, notably among municipal corporations, the device has been very successful. Through the extension of the principle to the field of business the sinking fund found the use to which it was best adapted.

Definitions

A sinking fund may be defined as “a fund formed by the investment of annual savings or other contributions with a view to the ultimate application of the moneys so accumulated in the payment of a previously incurred ... debt.” An English accounting authority defines a sinking fund as “a fund set aside out of assets and accumulated at interest for the purpose of meeting a debt.”[67] This latter definition draws attention to the fact that the sinking fund is a fund of assets—not simply a book account set up to indicate recognition by the board of directors of the need of providing for payment of a debt, but certain definite assets set aside and, after accumulation, to be used for that purpose. Attention should also be called to the fact that usually the fund is not dependent solely for its increase upon interest accretions. As generally handled, the fund is added to at regular intervals by setting aside more or less regular amounts of assets to be applied to the same purpose. Frequently the contract agreement entered into between the company and the creditors holding the debt to be repaid governs in detail the way in which the fund is to be provided and the way in which it is to be handled.

A sinking fund may be used for other purposes than the payment of debt. Thus, occasionally one finds it created for the purpose of providing funds for the retirement of capital stock issues, notably preferred stocks of various kinds.

It may be well again to point out the unfortunate lack of uniformity in the use of the term. Thus “Sinking Fund” as an item in the balance sheet is found sometimes among the debits and sometimes among the credits. Other titles under which the item appears are: Sinking Fund Account, Sinking Fund Reserve, Sinking Fund Investments, Sinking Fund Trustee, and Sinking Fund Cash. While in this chapter the term will be used to indicate assets set aside in a definite fund—and limitation to this use is growing among the best authorities—explanation will also be given of what the other uses indicate as to financial policy and the manner of booking such policy.

Mathematical Principles on which Based

The mathematical principles on which the computation of the sinking fund rests will first be explained. The problem involved here is the calculation of the amount which set aside periodically and invested at compound interest will provide a sum sufficient to pay off the debt when it matures. Needless to say, the sinking fund is usually applied only to the redemption of long-term debts, as only over a comparatively long period is the real potency of the compound interest principle secured. For the solution of the problem it must be known whether the periodic increments to the fund are set aside at the end or at the beginning of the period. It is usually understood to be at the end of the period unless otherwise specified.

Assume, therefore, that a bond issue is made with maturity in n years and that the contract with the bondholders calls for the creation of a sinking fund with payment thereinto at the end of each period. It is required to find the amount to be paid into the fund periodically. We will assume that:

Reference to [Chapter XV, page 271], gives the amount, A, of a sum of money put at compound interest at r% for a term of n years, as A(1 + r)ⁿ⁻¹. It is evident here that the sum, A, paid into the fund will accumulate for n-1 years and that each succeeding payment remains at interest one year less than the next preceding amount, the last amount earning no interest. Accordingly, the first A—we will denote it as A₁—will amount to A(1 + r)ⁿ⁻¹; A₂ will amount to A(1 + r)ⁿ⁻²; A₃ to A(1 + r)ⁿ⁻³; etc. The sum of all these amounts must be equal to P, the debt to be redeemed. Therefore, the equation may be formed:

A(1 + r)ⁿ⁻¹ + A(1 + r)ⁿ⁻² ... + A(1 + r) + A = P  or

A(Rⁿ⁻¹ + Rⁿ⁻² ... + R + 1) = P,  whence

A Rⁿ - 1 = P  and
R - 1
A = P(R - 1) or Pr ,
Rⁿ - 1Rⁿ - 1

which being interpreted means that the theoretical amount to be set aside at the end of each period can be found by multiplying the amount of the debt by the fraction

r
Rⁿ - 1

If the annual payment is made into the fund at the beginning of each period instead of at the end, then A will be

Pr
R(Rⁿ - 1)

and the multiplying fraction

r .
R(Rⁿ - 1)

It is evident that in practice some allowance will usually have to be made for failure to keep all payments in the fund and interest accretions thereto constantly invested at the calculated rate. This is not a matter of serious import, however, for small inaccuracies can be adjusted during the last period or the last few periods by increasing or decreasing the annual payments as may appear necessary at those times. From a financial standpoint it should be borne in mind that there is no absolute necessity for the accumulations in the fund to be sufficient in all cases to retire the entire debt. Refunding a portion of it may be resorted to. Other conditions being equal, it should be a much easier task to borrow only a portion as compared with borrowing the original amount.

Accumulation Based on Agreement

It is necessary to call attention to the inapplicability of the above method to all cases. Of course, where the contract between the borrower and the lender makes definite provision for the manner of creating and handling the sinking fund, that contract must therefore govern. However, in the case of a concern operating wasting assets, a frequent provision of the trust agreement in the case of a bond issue is that the periodic payments into the fund shall be proportional to the amount of the natural product extracted or used. Thus in the coal mining industry the trust agreement may provide that, say, five cents for every ton mined shall be placed in a sinking fund. In determining the amount for each ton, the total amount of the debt to be extinguished is divided by the estimated number of tons of coal in the mine. This gives the amount of the debt which each ton must bear. Conservatism and business prudence require an ample allowance for mistakes in the estimate of tonnage which it will be profitable to mine and, also, for a liberal margin of safety. The relation between the life of the bonds and the estimated annual output has an important bearing also, for the charge per ton must be sufficient on the basis of the tonnage mined during the period covered by the bonds to retire the bonds at their maturity, regardless of how much coal there is still in the mine at that time—unless a refunding operation is contemplated.

Similarly in the case of timber properties, sinking fund payments are usually roughly proportional to the amount of timber cut; in earthwork or quarry enterprises, to the amount of material removed or quarried; in real estate development companies, to the number of divisions made ready for the market. In such cases the compound interest method, scientifically accurate, often gives place to annuity methods more or less roughly calculated, under which, by trust agreement, definitely named sums, approximately sufficient to accomplish redemption at maturity, are set aside periodically.

Other methods fix the amount as so many per cent of gross or net profit, of the bonds outstanding, of total business done, etc. Oftentimes, scientific accuracy, even if desirable, is impossible because of provisions in the trust agreement to the effect that the moneys in the sinking fund are to be used for the purchase of the company’s own bonds at market but providing a maximum price above which none are to be bought. This involves purchases at a premium, or possibly a discount, unknown at the time the periodic amount must be calculated. An amount figured on the maximum price would be conservative; or the amount may be based on par with the stipulation that the difference between par and market shall be handled each period through the profit and loss.

Effect of Settlement of Debt

As an introduction to the discussion which will follow of the relation of the sinking fund to profits, we will first consider the several ways in which a debt may be settled. For that purpose there is nothing which makes clear the principle involved better than the fundamental schedule of debit and credit, showing the interplay of all transactions as they are brought onto the books. At the risk of unnecessary repetition, that schedule is accordingly set up here for ease of reference.

Schedule of Debit and Credit
Debit: Credit:
(1) Increase of assets (a) Decrease of assets
(2) Decrease of liabilities (b) Increase of liabilities
(3) Decrease of proprietorship (c) Increase of proprietorship

From this it is seen that the redemption of a debt—a number (2) transaction—may be accompanied, and therefore accomplished, by any one of the three offsetting credits or by a combination of them. A debt may be settled (a) by the conversion of an asset; (b) by the creation of another liability; or (c) by an increase in net worth. Cash or other assets may be used for the purpose, resulting in a decrease of assets, as in (a) of the schedule. It should be noted that the borrowing of, say, $1,000 and its repayment in cash leaves the borrower in the same relative financial condition as before, except for the gain derived from the use of the money borrowed. Such loans, to be repaid in this way, are usually of a temporary nature, to tide over an emergency—such as the handling of the load of seasonal activity, or other similar situation. This method of settlement is, of course, not confined to payment of debts for money borrowed, but includes debts contracted for merchandise purchased on credit and other current liabilities.

Again, a debt of one kind may be settled by the creation of a debt of another kind, as in (b) of the above schedule. Thus, an open account payable may be converted into a note or acceptance payable. Here, the liability canceled and the new one created are usually of the same class, viz., current liabilities, and the need for a more or less permanent increase in working funds is not contemplated. So also, a current liability, or a group of them, may be converted into a funded debt. This may be deemed advisable when it is seen that there will be a permanent, or at least a long-term, need for funds which have up to this point been provided by short-term borrowings and credits. Again, a refunding operation would have the effect of a decrease of one liability offset by the increase of another.

Finally, a debt may be canceled through an increase of proprietorship, as in (c) of the schedule. By this means the redemption of the debt may be direct or indirect. Capital stock, either treasury or previously unissued stock, may be accepted by creditors in satisfaction of their claims. They thus change their status from creditors to proprietors and the result is an increase of the concern’s net worth. Indirectly a debt may be settled by the reservation of profits. Instead of distributing the profits as dividends, they may be retained in the business and so provide funds, i.e., assets, for the redemption of debts. In either case the settlement of the debt has been effected by means of increased net worth evidenced by new issues of stock or by reserved profits.

In these various ways, therefore, a debt may be settled. As pointed out above, the first method contemplates no permanent need for increased working funds and the extinguishment of the debt leaves the borrower in approximately the same position financially as before its incurrence. Under the second method, the relative positions before and after are the same excepting in the case of funding a floating debt. Here a permanent or long-term increase in working funds is secured. With the third method a permanent increase is secured in the capital funds available for use in the business. Financial policy, governed by the needs of the business and its markets, will always dictate the method to be used for extinguishing or contracting a debt.

Relation of Fund to Profits

The relation of the sinking fund to profits will next claim our attention. This point has been much debated, reaching the acrimonious stage at times. It is variously contended: (1) that there is a necessary relationship between profits and the payment of a debt; (2) that for final settlement only assets will suffice; and (3) that the policy of reserving profits to an amount equal to the sinking fund is a policy not dictated by any fundamental principle of relationship between profits and debt redemption.

With regard to the first claim, it is sufficient to call attention to the discussion above where the various ways of paying a debt were considered. As there pointed out, a reservation of profits may offer the only available means of providing assets with which to redeem debts. Accordingly, at least an indirect relationship between profits and debt redemption is established.

As regards the second point, that only assets can be used for the final payment of debts, this also is seen to be too broad a claim, for the issue of new stock may accomplish the same end—directly, as where issued to creditors, or indirectly, as where sold and the proceeds applied to liquidate the claims of creditors.

As to the third claim, it might be said with equal relevance that there is no basic relationship between debt redemption and any method of settlement. The assertion can be made with little fear of contradiction that so long as the claims of creditors are satisfied, the manner of doing it is of small importance. Of course, only the currency of the realm is a legal tender for debts but, if other forms of payment prove satisfactory and are accepted, the matter ends. It is therefore solely a question of financial policy, no principles of accounting are involved, and the only point in which accounting is concerned is in making the record so as truthfully to show what is taking place, i.e., to reflect accurately the financial policy adopted.

If the needs of the business require a permanent addition to the capital, as mentioned above, that can be secured in only two ways, viz.: (1) the sale of stock and (2) the reservation of profits. If, on the other hand, the debts to be repaid have provided funds for the emergency or purpose for which they were contracted and that emergency or purpose no longer exists, then the repayment of those funds to the creditors is the business policy dictated. Under these circumstances, to load the business with capital funds not needed in the enterprise might well be the height of business folly. According to the conditions to be faced, there may or may not be any necessary connection between debts and profits.

It should be pointed out that the kind of debt—i.e., the long-term obligation—for the settlement of which the sinking fund method is often employed, is almost invariably an indication of the need of a larger capital fund. Recognition of this is frequently evidenced by the provisions of the trust agreement requiring the payment into the sinking fund out of profits of the periodic contributions. This forces the ultimate increase of capital to be made by the owners. Two other alternatives are open, viz.: borrowing again at the maturity of the debt—a refunding operation—and securing additional capital through the sale of stock. Conditions of the financial market at the time the funds are needed, the policy of the concern as to the admission of other owners, and the relative bargaining strength of the two parties to the loan—these are determining factors in the financial policy to be adopted.

Accounting for Sinking Fund

The various problems met in accounting for the sinking fund will now be discussed. First among these is the manner of showing its status on the balance sheet. This may be done in four different ways. Here, also, the chief problem involved is an accounting problem only so far as it concerns the best manner of setting forth truthfully the facts of financial policy.

1. The sinking fund, then, under suitable title, may appear only among the assets. As to financial policy, this indicates the creation of a distinct fund of assets for the purpose of the sinking fund but it does not show definitely the way in which they are being provided. They may be secured by cutting down certain assets previously carried in larger amount than is now deemed necessary; by a reinvestment of profits; or by the sale of additional capital stock. The balance sheet is silent as to what method is being employed.

2. The balance sheet may record the sinking fund status among the assets as a definite fund and also among the items of net worth as a sinking fund reserve. As to financial policy this not only indicates the creation of a fund of assets, but shows that this was accomplished by a withholding of profits from the stockholders and a reservation of them for this very purpose.

3. There may appear on the balance sheet as the only evidence of a sinking fund policy the sinking fund reserve among the net worth items. This shows a reservation of profits for this purpose and therefore their investment in the business. The reserve is not a covered reserve, however, no definite assets being set apart as representing these profits, or, if set apart, as having been already applied to the cancellation of a portion of the debt. This latter phase is explained more fully on page 458 following. Unless the assets have been applied in this way, the balance sheet gives no assurance to the creditors that funds will be available for the settlement of their claims at maturity. It may be that the reserved profits are being used for further extensions of plant and so will not be easily available at maturity of the obligations. Again they may be invested in increased stocks of current assets and so be readily available. Only an analysis of the balance sheet will show the financial policy that is being pursued.

4. There may be no record of the sinking fund transactions shown on the balance sheet. This might come about through the cancellation of some portion of the debt by the conversion of assets. The balance sheet, except by comparative analysis, carries no indication of the way in which it is accomplished. It may be that it is being done at the expense of current activities—a poor policy—or through the withholding of owners’ profits. The balance sheet is non-committal.

Whatever method indicates the policy being followed with regard to the sinking fund is the one which should be employed. So far as possible indefiniteness of expression as well as nomenclature should be avoided; not only does an indefinite statement fail to show the policy but it may be misleading.

The Sinking Fund on the Balance Sheet

In drawing up the balance sheet, the sinking fund assets usually appear under the caption “Investment of Sinking and Other Funds.” Occasionally one finds the Sinking Fund account treated as a debit valuation account, being shown as a deduction from the Bond account. Such treatment indicates the amount of bonded indebtedness not yet provided for by the sinking fund—an item of hardly enough importance to justify its separate showing, particularly when an easy comparison, under any other method, will give the same information. The cancellation of assets against liabilities or of liabilities against assets is not good accounting practice. Where, however, the trust agreement provides for the investment of the sinking fund cash in the company’s own bonds and the cancellation of these bonds as purchased instead of holding them in the fund for the sake of their income accretions, the bonds so canceled would, of course, be deducted from the amount previously outstanding and only the present liability for bonds be shown. There is no objection to showing this deduction on the face of each balance sheet, as it thus shows the amount redeemed during the current period. If the company’s own bonds are purchased but kept live, it is better to show the sinking fund among the assets. All sinking fund reserves should, of course, be listed in the net worth section of the balance sheet.

Entries to Sinking Fund

Accounting for the sinking fund presents nothing new in principle. There are, in the main, three kinds of entries to be made, viz.:

1. Those dealing with the original and subsequent periodic payments into the fund.

2. Those required to book the trustee’s periodic report of his handling of the fund.

3. Those to show the redemption of the debt and the final disposition of the accounts relating to the fund.

In the illustration, for the sake of definiteness, it will be assumed that the governing financial policy is the second one discussed above, according to which not only is a sinking fund created but also an equal amount of profits is reserved each period; that the funds are placed in the hands of a trustee for investment and that any income from the investments is to go into the fund; and that it is desired to show both the investments of the trustee and the unexpended balance of cash in his possession. The account titles are suggestive only, many varying titles being used. The entries required to show the original payments into the fund are:

(1) Sinking Fund Cash in Hands of Trustee $.....
Cash $.....
To record payment to trustee of first
payment into the sinking fund created
according to terms of trust agreement
to retire the first mortgage 6% bonds.
(2) Surplus.....
Sinking Fund Reserve .....
To show the creation of a reserve to provide
funds for the redemption of bonds.

Subsequent payments into the fund would be recorded in exactly the same way as the original payments.

Booking the Trustee’s Report

Upon receipt of the trustee’s report on the handling of the fund, entries must be made to bring a summary of the report onto the books. This report should cover a full accounting of the funds turned over to the trustee, his investment of them, all expenses of the trust, and any income received or accrued. The funds may be left for accretion in a savings bank; they may be used to purchase high-grade securities; or with them the very bonds which they are to redeem may be bought and canceled immediately, or allowed to run, the interest accretions going into the fund also. Securities for investment may be bought at a premium or a discount. Expenses will be incurred by way of commission or salary for the trustee, expenses of the trust, advertising, brokers’ commission, etc.; and income will be received by the trustee from the securities held and even from the unexpended balance of cash.

As to the purchase of securities at a premium or discount, the problem involved is the proper handling of the premium or discount. Theoretically, whether in the hands of a trustee or under own control, premiums and discounts on securities bought for long-term investment should be amortized. The reader is referred to [Chapter XV, page 267], for the various methods of booking such investments. Oftentimes, however, the premium is charged at once against the sinking fund income along with all other expenses.

To book the investments of the trustee, the entries needed are:

(3) Sinking Fund Investments $.....
Sinking Fund Cash in Hands of Trustee $.....
(List here the securities purchased
and their price.)
(4) Sinking Fund Expenses.....
Sinking Fund Cash in Hands of Trustee .....
(Itemize here all expenses chargeable
against the fund or its income.)
(5) Sinking Fund Cash in Hands of Trustee$.....
Sinking Fund Income $.....
(Record here the income from interest on
unexpended cash balance and from securities,
with proper adjustments on account of
amortization of premium or discount.)

Treatment of Income and Expense

Practice varies as to the proper handling of the income and expense of the sinking fund. Sometimes they are treated as affecting—i.e., increasing or decreasing—only the sinking fund reserve and as having no place in the current profit and loss. That seems a mistaken view; the fact that the investment is beyond the company’s control none the less renders its income and expense a fact of current profit and loss, and it should be so shown. Accordingly, the sinking fund expense and income accounts above should be closed into profit and loss, after which their net result will be transferred from surplus to Sinking Fund Reserve, to show the net increment or decrement as a result of the trustee’s operations. Thus:

(6) Sinking Fund Income $.....
Profit and Loss $.....
(7) Profit and Loss
Sinking Fund Expenses
(8) Profit and Loss
Surplus

Entry (8) is not strictly a sinking fund entry but transfers the entire balance of the period’s profit and loss to surplus, out of which the net increment or decrement of the sinking fund operations is transferred to Sinking Fund Reserve by entry (9):

(9) Surplus $.....
Sinking Fund Reserve $.....

An amount equal to the compound interest increment must always be transferred to the reserve, if accurate results are desired.

Practically the same entries will serve if the investments are the company’s own bonds. If the bonds are canceled, instead of entry (3) the following entry would be made:

(10) First Mortgage 6% Bonds $.....
Sinking Fund Cash in Hands of Trustee $.....

Here the item of premium or discount is usually to be found and the question then arises as to whether the item is not better handled as a charge or credit direct to Sinking Fund Reserve rather than through the current profit and loss.

Final Disposition of Fund

There remain to be considered the entries recording the payment of the bonds at maturity and the disposition of all sinking fund accounts. The securities of the trustee must be reconverted into cash to be used for redeeming the bonds, often resulting in a difference between the book value of securities and the actual amount realized therefrom. This must be adjusted by charge or credit to the Sinking Fund Reserve. After cancellation of all the bonds, any cash balance is turned back by the trustee to the company. The entries on the books would be:

(11) Sinking Fund Cash in Hands of Trustee $.....
Sinking Fund Investments $.....
To record sale of securities in
the sinking fund.
(12) Sinking Fund Reserve.....
Sinking Fund Investments .....
or
(13) Sinking Fund Investments.....
Sinking Fund Reserve .....
To adjust the difference between book
and realized values of the securities.
(14) First Mortgage 6% Bonds.....
Sinking Fund Cash in Hands of Trustee .....
To record redemption of all bonds.
(15) Cash.....
Sinking Fund Cash in Hands of Trustee .....
To record transfer to company of cash
balance in hands of trustee.

Treatment of Sinking Fund Reserve

Only the Sinking Fund Reserve account now remains on the books. Having served its purpose of providing funds by retaining profits in the business for the redemption of the bond issue, resulting in an addition to the net worth of the business, this reserve is now free to be used as deemed best. It may be thrown into surplus and so become available for dividend purposes; or it may be used as the basis for an increase in capital stock and be distributed as a stock dividend, thus making the increase in net worth permanent. The following entries respectively accomplish these ends:

(16) Sinking Fund Reserve $.....
Surplus $.....
(17) Surplus
Stock Dividend Payable
(18) Stock Dividend Payable
Capital Stock

Relation between Depreciation and Sinking Fund

A final problem deals with the relation between depreciation and the sinking fund. If the trust agreement requires that a sinking fund reserve shall be created by charge against profits, must provision be made also for the depreciation of the mortgaged property held as security for the bonds? The fact of depreciation is omnipresent and cannot be escaped. Also, the trust agreement must be lived up to. To carry out both requirements simultaneously would manifestly result in a double charge. The charge for depreciation is an expense charge which must be made before net profits can be determined. The charge for the creation of the sinking fund reserve is against surplus, i.e., it takes effect after the determination of net profits. Theoretically, therefore, the provision for depreciation must be made, else true profits cannot be determined. Equally certain must be the provision for the sinking fund reserve. Authorities seem to agree that not only is there no need for provision for both but that to provide for both places an unnecessary burden on the stockholders during the periods of the creation of the sinking fund.

It is true that if the periodic amounts of the estimate for depreciation and the sinking fund are practically the same, and if provision is made only for the sinking fund reserve, there will be in that reserve a sufficient amount to care for the depreciation. Assuming the life of the asset and the life of the bonds to be the same, such a policy means simply that the asset, usually a fixed asset, has been converted by use into current funds which have been applied to the liquidation of the bonds. There has been no reservation of real profits for this purpose. Upon the complete depreciation of the asset, the book value not having been written down in the meantime because no depreciation has been booked for it, the asset must be charged against the reserve, thereby mutually extinguishing each other. No principles of accounting are necessarily violated.

Failure to book the depreciation as such results, however, in an inflated showing of net profits. If the sinking fund reserve is charged against current profit and loss instead of surplus, the showing of net profits is thus corrected but there has been no real reservation of profits, the sinking fund reserve being in reality a valuation account for the depreciating asset, and thus the letter of the trust agreement is violated. If the intent of that agreement was to increase proprietorship, as discussed on page 456 above, this procedure will not accomplish that purpose.

Provision for both depreciation and the reserve does not effect a double charge against profits. As pointed out above, the one is an expense charge without which true profits cannot be shown, and the other is a charge against real profits, resulting in a lessening of dividends. Where there is no trust agreement to compel the creation of a sinking fund reserve, it is merely a matter of financial policy as to how the bonds shall be redeemed, and there is no objection in theory to the conversion of the depreciating asset to that purpose. Much more is this the case when the mortgaged asset is a wasting asset, the exhaustion of which is inevitably bound up with the operation of the business. Here there is no need either to increase proprietorship or even to maintain capital intact, and the conversion of the wasting asset, without providing for its replacement, to the payment of the bond issue is legitimate and wholly unobjectionable as a financial policy.

CHAPTER XXVI
PROBLEMS IN CONNECTION WITH
THE PROFIT AND LOSS SUMMARY

Interrelation of Profit and Loss and Balance Sheet

Because of the supplemental character of the profit and loss summary to the balance sheet, no study of the latter is complete or adequate, whether viewed from the standpoint of valuation or from any other aspect, without at least a consideration of the profit and loss summary in its larger bearings. Some general features of the summary will here be considered, followed in the next chapter by a discussion of its terminology, form, and content.

Every change in an asset which is not reflected among the other assets or the liabilities relates to proprietorship; or, as stated from the profit and loss point of view, every change in proprietorship, except it be merely a transfer between proprietorship items, is reflected as a change in assets or liabilities. The original contribution of capital is reflected among the assets. Other items of vested or permanent proprietorship have been discussed in Chapter XXIII, “Surplus and Reserves,” leaving for consideration here the temporary proprietorship, i.e., the profit and loss items. Of these, every income item results either in an increase of assets or a decrease of liability, while every expense shows as a decrease of assets or increase of liabilities.

The relation of the profit and loss phase of an enterprise to the problem of valuation is apparent—the majority of the changes in value of the assets being connected with profit and loss activities. Thus sales result in cash or claims against customers, and a valuation of these claims gives the amount of bad debts expense. The valuation of fixed assets determines the amount of depreciation expense. On the valuation of the stock-in-trade depends the cost of goods sold and therefore the gross profit. Only those profit and loss items which are realized or settled in cash are not dependent upon the valuation of related assets, and even here, in so far as cash must under some circumstances be valued, these may be, at least remotely, dependent upon valuation. As, therefore, the balance sheet is primarily an expression of opinion and judgment, rather than a statement of fact, so also in large measure must the profit and loss summary be regarded as an expression of opinion. The same factors which enter into appraisals and valuations determine profits and losses.

Periodic Adjustments

In Chapter XXIII, on “Surplus and Reserves,” attention has been called to the use of a statement of surplus for the purpose of showing the changes which take place in surplus from period to period. These changes are due to profits earned, dividends declared, extraordinary profit and loss items not handled through the profit and loss summary, and adjustments in profit and loss applicable to previous fiscal periods—such adjustments being necessary because of errors in the profit and loss summaries of those periods, due to insufficient information for making an accurate summary at the time. The periodic profit and loss summary is limited in its purpose and scope to the activities of the current period and to an equitable share of those income and expense items running over a number of periods. Because the adjustments just mentioned are frequently necessary, the periodic profit and loss summary as it appears on the books is never an entirely accurate reflection of the profit and loss activities for any period, but it is usually sufficiently so to serve all current needs. When, however, the earning capacity of a concern needs to be judged with great accuracy, over a number of periods, it is not safe to depend entirely upon the periodic profit and loss summaries. It may, for example, be necessary to judge earning capacity because of a contemplated sale or merger. Here the basis for determining value should be not the earnings of one period but the average of several periods. It then becomes necessary to reconstruct the periodic profit and loss summaries as carried on the books in the light of any additional information that may have become available later.

The adjustments to be made in such cases comprise not only the most obvious ones, caused by the oversight of accruals and deferred items of various sorts, changes in inventory valuations due to an incorrect inclusion or exclusion of some items, etc., but also changes in those items which in the light of a longer experience are shown to be inaccurate. This latter class of adjustments embraces particularly the estimated items the amounts of which are not definitely determinable. As time passes, more complete knowledge may indicate insufficient or excessive estimates of such items as depreciation, bad debts, provision for contingent liabilities, and similar reserve items, the valuation of which must be corrected for an accurate showing of earning capacity. Thus a distinction must be made between summaries compiled to show the current profit and loss results and those which give a true index of earning capacity over a longer period.

Interest as a Cost of Manufacture

A controversial point with a bearing on the profit and loss summary is whether or not interest on invested capital should be included as an item of manufacturing cost. One school of thought on the subject maintains, with a considerable degree of argumentative warmth, that interest should be included; while another school takes the opposite point of view. An attempt will here be made to summarize the arguments for and against the treatment of interest as an item of manufacturing cost. The one school bases its main contention on the economic theory of profits; namely, that profits represent the balance remaining after deducting the cost of land, capital, and labor. The function of the entrepreneur, it is contended, does not in itself involve the owning of capital. Profit is the reward for combining the other factors of production and assuming the risk involved. Interest is a cost for the use of capital and it does not matter who owns the capital.

It is further contended that, in order to bring a fair return on the capital invested, the selling price must include interest on capital investment. While this contention is true, the fact remains that no manufacturer would think of fixing selling price as a matter of general policy at a figure which would not return a fair rate of interest on his investment. But why that necessitates taking into the books interest as an element of cost is not explained by this theory.

It is also argued that to determine whether it is better to manufacture or to buy goods in the open market, and whether it is better policy to manufacture by means of expensive machinery and other equipment or by manual labor, interest on investment must be considered. While these arguments also are well taken, they again offer no satisfactory justification for the showing of interest on the books. It is furthermore contended that the cost of carrying the inventories for which the purchasing, stores, and planning departments of a manufacturing concern are responsible, should be shown with interest on the money invested in them taken into consideration—this for the purpose of providing a check on the efficiency of these departments. Where also both old and new machinery is used side by side and it is desirable to compare their costs of production, the element of interest should be considered.

Further argument for the inclusion of interest as an item of cost is the fact that in numerous processes time is an important element. Thus, the smelting of ore, the tanning of leather, the curing of tobacco, the seasoning of lumber, etc., are examples of relatively lengthy processes the cost of which should include interest on the capital invested. Interest on investment is also a factor that may sometimes determine manufacturing and selling policies, especially during slack periods when production is curtailed, part of the plant stands idle, and the fixed charges on the unused manufacturing capacity need to be taken into consideration. The same argument also applies to the accumulation of a large inventory of raw materials or finished stock during a period of low prices. The soundness of such a policy can only be judged when the item of interest on the capital investment is considered.

Arguments against the Inclusion of Interest

The majority of accountants are, however, opposed to the inclusion of interest as an item of manufacturing cost. The chief objections raised to its inclusion are:

1. The difficulty of determining the rate at which interest should be charged.

2. Inasmuch as the amount of investment in current assets is difficult to determine since it fluctuates daily, is interest to be charged both on fixed investment and on current investment, or only on the fixed?

3. If interest is to be charged, how shall the offsetting credit be handled on the books?

4. The introduction in production costs of a more or less constant element tends to obscure fluctuations in actual cost due to causes which may be corrected, and thereby partly defeats the very purpose of cost-keeping.

5. As the business world is accustomed to consider interest and dividends as of the same nature, namely, as a return on capital invested, to treat interest as a cost of operation would produce financial statements which are misleading.

With regard to the rate of interest, three different theoretical rates have been suggested: (1) a so-called “pure” interest rate, i.e., one yielded by the safest investment; (2) the rate at which money might be borrowed for the particular type of industry; and (3) a rate sufficient to attract permanent investment in the enterprise. From the practical standpoint of results there are serious objections to all these suggestions. As it is beyond the scope of this chapter to discuss this phase of the question, the interested student is referred to the numerous writers who deal with the question.

Problem of Charging Interest on Books

Where interest is treated as a manufacturing cost, the booking of it raises a perplexing accounting problem. The charge has to be made to some factory expense account, while the credit must be carried over to possibly a financial management income account. If the entire output of the factory were sold out by the close of the fiscal period and no product was in process of manufacture at that time, the result of booking interest in this way, so far as net profit is concerned, would be nil. It would be like taking money out of one pocket and putting it in another. This situation, however, is never met at the close of the fiscal period. Almost invariably some finished stock is on hand and goods are in process of manufacture. Where interest is added, the result is to inflate the value at which the goods must be carried on the inventory—a very undesirable procedure from an accounting and financial viewpoint. By such means it is conceivable that a factory might be made to show a handsome profit even before any of the product had been sold.

Considering both the ends to be attained by, and the defects and disadvantages of, the inclusion of interest as an item of factory cost, its exclusion seems best. In this connection it is to be noted that all government contracts on a “cost-plus” basis do not allow the inclusion of interest as one of the cost items. Furthermore, all the ends aimed at by its inclusion may be secured almost if not equally as well by statistical records, thus eliminating the objections to the bringing of interest as an item of cost onto the financial records.

Unrealized Profits

A similar problem to the above is the practice of charging a manufacturing profit to the selling department. The practice is prevalent in some concerns, of transferring the output of the factory to the selling department at a value above the cost to manufacture. The purpose of such a transfer is to show on the books the profit arising from the policy of manufacturing the product instead of buying it on the open market. The value at which the product is transferred from the factory to the selling department is usually the wholesale market value, though it may be at a fixed per cent above the cost of manufacture. The effect of this is, of course, to limit definitely the showing of factory profit. Where the compensation or the efficiency of the factory management is measured by the savings effected over the wholesale market price of the output, there is perhaps some practical advantage in the allowance of a manufacturing profit.

The main objection to charging the factory output to the selling department at any price other than cost is that such a policy introduces an element of unrealized profit. This objection is not serious if, at the time the books are closed for the purpose of showing results for the fiscal period, the unrealized profit is eliminated from the stock-in-trade inventory. So far as the profits on the portion of the output which has been sold are concerned, the net result is the same. The effect is to diminish the profit of the selling department by the amount of profit allowed to the factory. To bring assets onto the books at inflated values is, however, always objectionable, both because of the temptation to inflate profits by valuing the goods for the inventory at an inflated figure, and also because of the ease with which the adjustment of such items may be overlooked or forgotten at the close of the fiscal period. Where the adjustment is made with care, correct results can be shown as well by the one method as by the other. The adjustment needed applies only to the inventory of goods remaining unsold at the close of the period, which adjustment is usually shown by means of a valuation reserve account, by means of which the book value of the inventory is brought down to the factory cost value.

The whole problem of profit between departments is one phase of the larger problem of the intercompany profits of a holding company. In such a case it usually happens that one of the subsidiaries with separate corporate organization turns over its product to some other subsidiary company at a price which returns a fair rate of profit. As the product passes through the hands of the various subsidiaries, by the time it is ready for final distribution to the public the accumulated profits represent those of all the companies engaged in its production. If, now, all these subsidiaries belong to the same parent company, the book value of the unsold product shows, at the close of the fiscal period, a large unrealized profit which must be adjusted in order not to show the stock-in-trade at an inflated value. This problem is discussed more fully in [Chapter XXXIV] where the main problems of the holding company are taken up.

Corporation Dividends

In addition to these general problems of the profit and loss summary, some further questions arise at the time of closing the records of a corporation for the fiscal period. Much more care must be taken in closing the books of a company than is necessary in the case of either of the other general types of business organization. Thus, the corporation authorized to issue a number of different kinds of stock must see that the dividend declaration is based only on the amounts of the various classes of stock outstanding, and not on the stock unissued or brought back into the treasury. It is customary to set up separate dividend accounts for each class of stock. Oftentimes the terms of issue covering the various kinds of stock introduce complexities in the calculation of the dividend. This is particularly true in the case of stocks which have the privilege of participating in all dividends over a certain amount. Some stocks are cumulative as to their dividend, while others may be non-cumulative. All these conditions of issue must be considered carefully at the time of the declaration of the dividend.

Discount on Bonds

Another problem requiring care is the treatment of discount or premium on bonds as they are related to the bond interest charge. In [Chapter XV] where bonds are discussed, the relation between the bond premium or discount and the bond interest rate is brought out. This necessitates at the time of the payment of the bond interest an entry to bring about the gradual amortization of the bond premium or discount so that by the expiration of the life of the bond issue the premium or discount is written off the books. Where the interest period does not coincide with the close of the fiscal period, for an absolutely accurate showing not only must the accrued bond interest be taken into account but also the accrued amortization of bond premium or discount.

Sinking Funds

A third problem at the time of closing the corporation’s books relates to bringing the sinking fund transactions up to date. Where the sinking fund is in the hands of a trustee, the corporation’s books can show the status of the fund only upon the receipt of the report of the trustee showing the changes in the fund for the current period. Care must be exercised to demand a report from the trustee as on the date of the closing of the corporation’s fiscal period. The character of the adjustments needed and the entries necessary to book them have been explained in [Chapter XXV].

Working Capital

A fourth problem which sometimes needs to be considered is that of “working capital.” Technically the working capital of a business is represented by the excess of current assets over current liabilities. As pointed out in Chapter XXV, a credit account called “Sinking Fund Reserve” is frequently set up to indicate the financial policy pursued in making provision for the retirement of a bond issue at maturity. At the time of the retirement of the bonds this reserve need no longer be shown as a separate item to indicate financial policy and should therefore be closed out. It may be thrown back into general surplus or it may be transferred—to indicate that it is a part of the permanent capital of the corporation—to an account entitled “Working Capital” or “Working Capital Surplus.” In all cases where an item of surplus is created for a specific purpose, care must be exercised to see that the conditions surrounding the creation of the item are lived up to in its final disposition. In cases of surplus created by gift, as in scholastic institutions or hospitals, this problem is particularly important.

A similar problem is also met at the time of the redemption of an issue of preferred capital stock, inasmuch as such redemption is usually at a figure above par.

The Correction of Closing Errors

A final consideration has to do with the correcting of errors in the closing work of previous periods. Any omissions and wrong valuations of items in previous periods demand correction, but such correction must not be allowed to affect the results of the current period. These corrections must therefore be made either direct through surplus or by means of an entry in the final section of the profit and loss account as will be indicated in the next chapter. Sometimes where entries of this kind are numerous an account called “Profit and Loss Adjustment” is opened as a clearing account through which these items are carried net into surplus. The chief objection to this procedure is that the adjustments are too easily lost sight of when only the net results appear in surplus. These entries usually carry information of value to shareholders and they should therefore be set forth as a part of the statement of condition rendered at the close of each fiscal period.

CHAPTER XXVII
THE PROFIT AND LOSS SUMMARY—
FORM AND CONTENT

Standardization of Form

As stated in Chapter XXVI, the profit and loss summary is supplementary to the balance sheet and should always accompany it whenever it is desirable to make a full and comprehensive showing of condition. This summary is given various titles and is shown in various forms, depending somewhat upon the general class of enterprise to which it relates, the particular purpose for which it is compiled, and sometimes on the predilection of the person who draws it up or for whom it is drawn. With the passage of time the form of the summary, and to a less degree its content, tend to become standardized. The regulations of various governmental bodies have given an impetus in this direction. The Interstate Commerce Commission, the Comptroller of the Currency, public service commissions of various states, superintendents of state banks and of insurance—all require standardized reports from the concerns under their jurisdiction. The Federal Reserve Board has recommended certain forms of statement of both balance sheet and profit and loss to be submitted as the basis of credit by merchants and manufacturers. Investigations made by the Federal Trade Commission point out the desirability of a more uniform method of presenting the results of business activities than now exists. These regulations and requirements as to standard forms of statement do not interfere with the presentation of other forms of statement for other purposes than those required by the regulatory bodies. As local conditions frequently give rise to problems which are peculiar to individual concerns, standard forms of statement will not always meet local needs. Flexibility to meet given conditions, and deviation from set forms must always be permissible if the accounting department is to render the highest kind of service of which it is capable.

Synonymous Terms

Various titles are used as synonyms for the profit and loss summary, among which are the following: Statement of Profit and Loss, Loss and Gain, Outlay and Income, Revenue, Revenue and Expenditures, Income, Income and Expenses, etc. Of these, the term most generally used is “Profit and Loss.” “Business Statement” and “Statement of Outlay and Income” are phrases seldom if ever employed nowadays, while “Loss and Gain” finds little favor. Of the two terms, “Revenue” and “Income,” Revenue is used more often in connection with non-profit-making concerns, particularly in connection with state and municipal accounts. “Income and Expenses” is usually limited to the profit and loss statement rendered by clubs, churches, libraries, hospitals, etc., although the term “Revenue” is frequently used in this connection. “Income Statement” and “Account” are terms frequently applied to the profit and loss summary of trading, industrial, and professional concerns; but except where custom has established certain well-defined uses, as indicated above, the title “Profit and Loss” is all-sufficient; there is no doubt as to its meaning or content, and its use for summarizing the temporary proprietorship items is thereby established, particularly in connection with profit-making concerns.

Cost of Goods Sold—Manufacturing Concern

Profit-making enterprises may be roughly divided into several groups as follows: industrial or manufacturing selling, agency and commission, public carriers or transportation, and financial. The profit and loss summary for these different groups is, in the main, the same although, of course, the content of the summary depends materially upon the nature of the business. In all cases the source of income is from sales—whether of a commodity or of services makes little difference. The first deduction from gross earnings under the title “Sales” or other similar title is the cost of sales. At this point the first marked divergence among the various groups is met. In an industrial enterprise the cost of sales is the cost of goods manufactured and sold as well as the cost of any goods purchased for immediate resale. This latter cost is met only in enterprises which combine manufacture with selling. This does not imply that manufacturing concerns have no selling problem, but rather that in many cases they also purchase other products for sale along with their own product, perhaps as side lines.

For a manufacturing concern which sells only its own product, the first deduction from sales is the cost of the goods manufactured and sold. As stated in Chapter III, the elements of the cost of manufacture are: (1) material, (2) labor, and (3) factory expense. The cost of goods manufactured must be combined with any unsold output at the beginning of the period and a similar output at the end of the period, in order to determine the cost of the goods sold. Cost of manufacture corresponds roughly to the net purchases of a trading business.

Cost of Goods Sold—Trading Concern

For a trading business, i.e., a business which buys its commodity for resale, the first deduction from sales is likewise the cost of goods sold as determined by a “cost of goods sold” formula as follows: To the goods on hand at the beginning of the period is added the full cost of the net goods purchased, and from the sum of these two items is deducted the cost of the goods on hand at the end of the period. In the case of both the industrial and the trading enterprise, when the cost of the commodity sold is deducted from the sales the result is the first significant figure as to profits known usually as “Gross Profit.” Among public carriers the first deduction from sales is the “Cost of Services Sold or Rendered”; this is usually carried under the title “Costs of Operation” or “Operating Expenses,” giving the figure of net earnings.

For the other types of business mentioned—agency and commission concerns, and financial enterprises of various sorts—the allocation of the direct costs of the service rendered is much more difficult and is seldom attempted. The so-called general and administrative expense and the expense of selling are usually so inextricably merged with the direct cost of rendering the service that a separate showing of the items is seldom attempted. However, where any expenses are directly applicable to the service rendered, they should be deducted first, before the general administrative and selling expense.

Further Differentiation of Terms

Before going into a detailed explanation of the elements of the profit and loss summary, it may be wise to make a further differentiation of terms sometimes employed, such as: Income and Expenditures, Receipts and Disbursements, Receipts and Payments, etc. All three terms are often met and are frequently misused as titles for the profit and loss summary. Their proper use should limit them to cash transactions or activities only. It is true that in some instances the profit and loss summary is mistakenly made up on a so-called cash basis, cognizance being taken of the income and expense items only when realized in cash. It would hardly seem necessary to convince the modern business man that sales made on credit and not yet realized in cash are part of his income as much as the items of income realized in cash, the chief difference being that provision must be made in the one case for uncollectible items, while in the other case no such provision is necessary. Yet even today it is sometimes difficult to convince the proprietor of a small business of the necessity, from the standpoint of accurate accounting, of taking cognizance of accrued and deferred expense items. Instances may sometimes, though rarely, arise in which all income has been received in cash at the end of the fiscal period and all expenses applicable to that period have been met in cash and that no deferred items need to be taken into account. Where such is the case, a statement of cash receipts and disbursements might give a fair indication of the profit and loss for the period. In the case of clubs, churches, and other institutions, practically all that is required of the managing officers in accounting for their trusteeship is a statement of trusteeship of cash, i.e., a statement of receipts and disbursements. The point of this discussion is merely that the terms, “Receipts and Disbursements,” “Receipts and Payments,” and, to a less extent, “Income and Expenditure,” should be limited to a statement of cash activities and never applied to the profit and loss summary.

Desirability of Uniformity in Terms Used

So far as the standardization of the sections of the profit and loss summary is concerned, much the same remarks are applicable as to the general title of the “Temporary Proprietorship Summary.” Such terms as Gross and Net Profit, Gross Revenue or Income, Net Revenue or Income, Gross Trading Profit, Net Trading Profit, Net Profit or Profit from Operation, or simply Business Profit, are used with little uniformity by the business world at large and even by the accounting profession. While it is never desirable to lay down many hard and fast rules or definitions because any statement or method of showing results should always be flexible and adapted to the conditions met, still the use of the same terms for different purposes and the use of different terms for the same purpose or section of a statement are, to say the least, confusing to the student. The committee of the Federal Reserve Board which drew up tentative forms for the profit and loss account and balance sheet, has done a good work in the interest of uniformity in accounting terminology. Their suggested form is applicable, however, only to the business of a manufacturer or merchant. In the case of public carriers the regulation of their accounting systems by the Interstate Commerce Commission has brought about a very desirable uniformity of terminology. Other regulating bodies in various states have performed a similar service in the case of public utility concerns, although because of divided authority their rulings lack uniformity.

Profit and Method of Showing

In general it may be said that the term “Gross Profit” is properly applicable to what is left after deducting from the main income the cost of that income. In a merchandising concern this figure is sometimes called “Gross Trading Profit,” though the term “Gross Profit” serves the purpose equally well and does not introduce a confusing adjective. When, from this gross profit, the two groups of selling expense and general administrative expense are deducted, there remains what is termed “Profit from Operation” or “Net Operating Profit.” One occasionally finds the group of selling expenses deducted by itself from the figure of gross profit, leaving what is termed the “Net Trading Profit.” Such a method of presentation serves no useful purpose and shows a figure which has little or no significance. The net trading profit merely represents what is left after deducting one group of expenses, and gives no essential information which the total of selling expenses would not give equally as well.

There is some difference of opinion as to whether the figure of net operating profit should be arrived at before considering any of the items of financial management, i.e., as to whether such items as interest income and expense, cash discount items, bad debts, etc., which are more or less common to every business, should be included before determining net operating profit or should be set up separately after its determination. The best practice seems to be to use the term “Net Operating Profit” as indicated above, and to show the financial management items in a separate section. In public service utility statements and also in those of some manufacturing concerns, such terms as “Gross and Net Earnings” and “Gross and Net Income” are met. Where these terms are used the gross earnings correspond approximately to sales and indicate the amount of the main income before any deductions are made. After the deduction of the direct cost of securing this income, the item is frequently called “Net Earnings.” Alternative terms for these two are “Total Operating Revenue” and “Total Net Revenue.” When, to the item of the net earnings or net revenue, income from other sources is added, the figure of total Gross Income is arrived at. When, from this figure of total income the “Charges Against Income” are subtracted, which are roughly the financial management expenses, we arrive at the figure of net income which corresponds to the figure of net profit. The use of the terms “Earnings” and “Income” in this restricted way is illogical, and must be regarded as the outgrowth of custom—a custom which is, as stated above, fairly uniform in the case of public utilities.

Form of Presentation—Account Form

As to the form of the profit and loss summary, in the main, two types are met. One is known as the account form because the items of income and expense are set up like credits and debits in an account. The other is known as the statement or report form. This is sometimes referred to as the non-technical method of presentation because the items are set up in running form without regard to a debit or credit terminology, the order of arrangement being dictated by the logic of the ordinary business man. In the case of the account form the sales or main items of income are placed in juxtaposition on the one side with the direct costs of that income on the other side, the balance of the two sides being brought down as the gross profit. Against this are set up the groups of selling and general administrative expenses. The difference between the two sides is again brought down as the figure of net operating profit to which are added other items of income. The charges against that income, i.e., the expenses incurred in financing the business, are then shown. The balance at this stage is the net profit for the fiscal period and opposite this appears its disposition, showing the portion appropriated to dividend purposes, to reserves of various sorts, and finally to surplus of the portion remaining unappropriated to other uses.

Non-Technical or Report Form

When the profit and loss summary is set up in non-technical form, the figure of sales is first shown. Beneath this rather than in juxtaposition as in the other case, the cost of sales is given, which cost deducted from sales gives the figure of gross profit. Below this appear the groups of selling and general administrative expenses, the deduction of which from the gross profit figure gives the figure of net operating profit or, as sometimes stated, the figure of “Net Profit on Sales.” To the net profit on sales are added the other items of income, and from the sum of these are subtracted the expenses of financial management, leaving, as in the other case, the net profit for the period.

Examples of Forms of Presentation

It is impossible and undesirable, as stated above, to lay down any hard and fast form which must be rigidly followed, because a basic principle of all accounting is that it must adapt itself to the needs and requirements of particular conditions. Therefore, only the bare skeleton of a form can be set up with any hope of its being applicable to all conditions. In other words, the form of arrangement and method of showing the statement to be presented at the close of the fiscal period must be flexible, depending upon the use to which the statement is to be put and also depending upon the information which it is desired to set forth.

The skeleton form given below which is suggested by A. Lowes Dickinson[68] follows the general lines laid down in this chapter. It is designed to serve as a framework for all uses.

Manufacturing and Merchandising:
Gross Earnings from Sales $ . . . . .
Less—Returns, Allowances, and Discount. . . . .
Net Earnings from Sales $ . . . . .
Deduct—Cost of Production or Service . . . . .
Gross Profit $ . . . . .
Deduct—Cost of Selling$ . . . . .
Expenses of Management. . . . .. . . . .
Net Profit from Operations $ . . . . .
Agency and Commission:
Commissions Earned $ . . . . .
Deduct—Expenses of Management$ . . . . .
Cost of Guarantees. . . . .. . . . .
Net Profit from Operations $ . . . . .

Transportation:
Earnings from Operations $ . . . . .
Deduct—Operating Expenses$ . . . . .
Taxes. . . . .. . . . .
Net Profit from Operations or Operating Income $ . . . . .
Banking:
Earnings from:
Interest$ . . . . .
Commissions. . . . .
Other Profits. . . . .$ . . . . .
Deduct—Expenses of Operation and Management . . . . .
Net Profit from Operations $ . . . . .
Professional:
Gross Earnings from Fees$ . . . . .
Less—Out-of-Pocket Expenses included therein. . . . .
Net Earnings from Fees $ . . . . .
Deduct—Expenses of Operation and Management . . . . .
Net Profit from Operations $ . . . . .

(The form for the remainder of the statement will be the same in all cases, viz.:)

Net Profit from Operations$ . . . . .
Other Income. . . . .. . . . .
Deduct—Interest on Bonds$ . . . . .
Other Fixed Charges. . . . .. . . . .
Surplus for the year $ . . . . .
Extraordinary Profits (detailed) . . . . .
Surplus brought forward from preceding year . . . . .
$ . . . . .
Deduct—Extraordinary Charges . . . . .
Total Surplus available $ . . . . .
Dividends on Stocks . . . . .
Surplus carried forward $ . . . . .

Form for Manufacturers and Merchants

The form suggested by the Federal Reserve Board as suitable for manufacturers and merchants is presented below. It is shown as a comparative statement of several years, but the same content and order of arrangement of items would, of course, be followed for any individual year. When presenting a single year’s activities, the money columns should be so used as better to present significant figures and their interrelations. The use of one column for items and another for totals accomplishes this. The form shown presents, after the figure of Net Income—Profit and Loss, a statement of extraordinary charges and credits to profit and loss tied up with the former balance of surplus, an appropriation made of profit and surplus at the end of this period, giving as a final figure the new surplus at its close—which is the figure carried on the balance sheet. This last portion of the statement is often shown as a separate statement of surplus. The items which are best handled as charges direct to surplus so as not to affect the profit and loss showing for the current period, have been discussed in [Chapter XXIII] on “Reserves and Surplus.” There the illegitimate use of surplus as a dumping ground for items which it is desired to conceal was mentioned. To prevent this misuse of surplus the final section of the profit and loss statement is often shown as set forth above. Where, however, a separate statement of the surplus is included as a part of the exhibit of the condition for the fiscal period, the statement of profit and loss will, of course, end with the figure of net profit, if that profit is transferred to surplus, out of which all appropriations of profit to its various uses are made. If, however, appropriations of this period’s profits, as distinguished from the accumulated profits of other periods, are to be made for specific purposes, their disposition is best shown in a final appropriation section as a part of the current statement of profit and loss.

Comparative Statement of Profit and Loss

Year
Ended
19—		Year
Ended
19—		Year
Ended
19—
Gross Sales $. . . . . . $. . . . . . $. . . . . .
Less Outward Freight, Allowances, and Returns  . . . . . .. . . . . .. . . . . .
Net Sales$. . . . . .$. . . . . .$. . . . . .
Inventory beginning of year$. . . . . .$. . . . . .$. . . . . .
Purchases, Net. . . . . .. . . . . .. . . . . .
$. . . . . .$. . . . . .$. . . . . .
Less Inventory end of year. . . . . .. . . . . .. . . . . .
Cost of Sales$. . . . . .$. . . . . .$. . . . . .
Gross Profit on Sales$. . . . . .$. . . . . .$. . . . . .
Selling Expenses (itemized to correspond
with ledger accounts kept)$. . . . . .$. . . . . .$. . . . . .
Total Selling Expense$. . . . . .$. . . . . .$. . . . . .
General Expenses (itemized to correspond
with ledger accounts kept)$. . . . . .$. . . . . .$. . . . . .
Total General Expense$. . . . . .$. . . . . .$. . . . . .
Administrative Expenses (itemized to correspond
with ledger accounts kept)$. . . . . .$. . . . . .$. . . . . .
Total Administrative Expense$. . . . . .$. . . . . .$. . . . . .
Net Profit on Sales$. . . . . .$. . . . . .$. . . . . .
Other Income:
Income from Investments$. . . . . .$. . . . . .$. . . . . .
Interest on Notes Receivable, etc.. . . . . .. . . . . .. . . . . .
Gross Income$. . . . . .$. . . . . .$. . . . . .
Deductions from Income:
Interest on Bonded Debt$. . . . . .$. . . . . .$. . . . . .
Interest on Notes Payable. . . . . .. . . . . .. . . . . .
Total Deductions$. . . . . .$. . . . . .$. . . . . .
Net Income—Profit and Loss$. . . . . .$. . . . . .$. . . . . .
Add special credits to Profit and Loss. . . . . .. . . . . .. . . . . .
Deduct special charges to Profit and Loss. . . . . .. . . . . .. . . . . .
Profit and Loss for period$. . . . . .$. . . . . .$. . . . . .
Surplus beginning of period. . . . . .. . . . . .. . . . . .
$. . . . . .$. . . . . .$. . . . . .
Dividends Paid. . . . . .. . . . . .. . . . . .
Surplus ending of period$. . . . . .$. . . . . .$. . . . . .

Content and Manner of Showing

Some problems in connection with the content of the various sections of the profit and loss summary and also with the manner of showing the content will now be taken up. The first item to be considered is the handling of the deductions from sales. On the Federal Reserve form of statement not only are sales returns and allowances deducted but also outfreight charges and, in some instances, other expenses which are regarded as direct selling costs as distinguished from the indirect costs shown in the group of selling expenses. Practice is not at all uniform in this regard. It should be stated that where the policy of the business is to sell goods f.o.b. destination, the outfreight charges may be regarded as a proper deduction from the figure of gross sales, as otherwise that figure is inflated by the item of freight, the cost of which is no part of the business organization nor is it under its control. Where, however, goods are only sold occasionally f.o.b. destination, the outward freight is more properly treated as a cost of making the sale in the same way as advertising. It should therefore be included in the group of selling expenses rather than be treated as a direct deduction from sales.

Supporting Schedules

With the object of presenting a bird’s-eye view of the profit and loss activities for the year, it is desirable that as little detail be shown on the face of the statement as may be necessary to furnish the information desired. The profit and loss statement under this method of treatment must be supported as to its detailed content by schedules giving the full information which may at times be valuable to proprietor or manager. The first supporting schedule may well be headed “Cost of Goods Sold.” Therein should be shown the statement of inventory on hand at the beginning of the period, goods purchased during the year, inward freight and carriage costs, purchase returns and allowances, and goods on hand at the close of the year, the result being the figure carried on the profit and loss summary. Where manufacturing is also carried on, this cost of goods schedule should include a statement of manufacturing activities, set up in the following order: raw materials used in manufacture which will be derived from a statement of raw materials inventory at the beginning, purchases, inward freight, purchase returns, and raw materials on hand at the close of the period. To this figure of raw materials consumed in manufacture should be added the direct labor costs for the period, the sum of the two giving the significant figure of prime costs. The addition to this of the factory expense set up in detail gives the cost of manufacture for the period.

Adjustment of Inventories

An adjustment should be made somewhere in this manufacturing section of the inventories of goods in process at the beginning and end of the period. This adjustment is usually made at the end of the manufacturing statement, but the position depends largely on the cost system in use and therefore the cost elements which make up the value of goods in process. If these values include raw materials, direct labor, and factory expense, and a separation of these elements is difficult or impossible, the adjustment is perhaps best made at the close of the manufacturing statement. Where, however, the elements referred to are easily separable, the difference between the cost of materials in the opening inventory of goods in process and the closing inventory should be added to the materials used in manufacture during this period or subtracted from them, as the case may be. Likewise, the difference between the labor items in the two inventories should be added to, or subtracted from, the direct labor cost for the current period. This makes possible an exact showing of the prime cost for the period.

The element of factory expense in goods in process should then be handled in the factory expense section, in this way doing away with the adjustment at the end of the statement as in the other case. While this method is more difficult and complicated, it is usually to be preferred. The cost of the finished product turned out during the period, as shown by the manufacturing section, must be added to the inventory of the finished product on hand at the beginning of the period, and from the sum of these two items must be deducted the finished product on hand at the close of the period in order to develop the cost of the manufactured product sold during the period. If, now, other commodities are bought and sold in addition to those manufactured, the cost of the goods bought and sold should be shown as for a trading business.

Selling Expense and Administrative Schedules

The second schedule to be shown in support of the profit and loss statement will be the selling expense schedule. Herein will be included all the customary selling expense items, the total of which is carried on the face of the profit and loss statement. It may be desirable in some instances to omit advertising costs from this group and show them on the face of the statement as a separate item. This is a particularly desirable policy either where advertising is a large item, or where results are to be shown during an advertising campaign.

The third schedule is the general administrative items. It seems hardly worth while to attempt a separation of so-called general expense items from those of administration, as any basis of separation must necessarily be arbitrary.

The fourth schedule will show the financial management expense and income items. These are the items which are shown on the statement under the heads of “Other Income” and “Deductions from Income.”

These are the customary schedules presented. When the statement of surplus is made a part of the profit and loss statement, as is sometimes the case, and there are many detailed entries during the period direct to surplus, a final schedule should present these charges and credits to surplus during the period.

Schedules for Special Needs

It frequently happens that it is desirable to carry additional schedules to those explained, in order to show an analysis of certain earnings or operations which may be of special interest to the individual concern. Thus, it might be desirable to show an analysis of sales by departments, by geographical districts, or by branches. Similarly, expenses might be analyzed on the same basis. A branch organization, for example, might show all its activities, including the net operating profit by branches, the sum of the branch operating profits being taken into the combined profit and loss statement, after which appear the items of financial management expense and income. As heretofore stated, all these are problems concerning which no arbitrary ruling can be made, the organization of the business and the information desired being always the determining factor.

The problem of valuation as related to the commercial balance sheet has now been completed. Some miscellaneous matters of corporation accounting and finance follow and these complete the second year’s course of study.

CHAPTER XXVIII
LIQUIDATION OF A CORPORATION

Reasons for Liquidating—Partial and Complete Liquidation

There are a number of ways in which a corporation may cease to exist and a liquidation take place. The charter, if created for a fixed number of years, may expire. The state may see fit to repeal the charter in accordance with the right reserved at the time it was granted. The corporation may of its own accord surrender its charter; or the courts may decide that the corporation has forfeited its charter rights by reason of non-performance or because of some wrongful act. Failure to pay taxes due the state is an instance. The liquidation of a corporation may take place because of a consolidation resulting in loss of its original identity. In the case of a merger the merged corporation ceases to exist under the terms of the agreement made which may call for a more or less complete liquidation. Sometimes a reorganization effects the liquidation of an insolvent corporation. If the new corporation obtains the assets of the previous corporation under a forced sale, the money received would be applied to the satisfaction of the old creditors’ claims.

Insolvency is the most usual reason for liquidating a corporation. Insolvency may be either actual or legal. By the National Bankruptcy Act insolvency is defined as the condition in which the assets of a person, firm, or corporation are less than the debts. This definition emphasizes the economic point of view. A corporation is legally insolvent when the cash assets are not sufficient to pay debts when they become due. Either of these conditions may exist without necessarily disastrous results, though it generally leads to disaster sooner or later. However, the fact that these conditions do exist indicates that the business in question is not well managed. It is well, therefore, to bring out the more prevalent causes leading to insolvency.

Current Assets Transferred into Fixed Assets

A common cause of insolvency is the tying up of current assets in plant and equipment. While this may be the actual cause, the post-mortem assigns the cause generally to lack of “working capital.” When a business expands and orders are coming in in excess of the facilities at hand, there is a great temptation to put a large part of the incoming funds into plant in order to take full advantage of the opportunities in sight. The result is that eventually the point is reached where it is impossible to get the cash necessary to meet maturing obligations. While the need for plant and equipment may justify the outlay, they cannot readily be converted into cash for they are usually of such a special nature as to be of small value without the organization.

Tying up Cash in Stocks of Material

The conversion of the cash resources of a company into stocks of material is another cause of insolvency, especially if the turnover is slow or the business is of such a nature as to require large sums invested in materials. Though capital in this form is generally being converted into cash or other forms of working capital, the fact that large sums are invested in material does not always mean that its cash value measures the amount of working capital. On the liability side of the balance sheet there may be items such as short-time loans or accounts payable which must be deducted in order to determine the net working capital. If the stock carried is disproportionate to requirements, it is a sign of poor management. When this state of affairs is allowed to continue for some time, the chances are that stocks will become obsolete or deteriorate, resulting in a loss. This will eventually result in the accumulation of current liabilities or floating debts and so bring about a condition of insolvency.

Unwise Use of Cash for Paying Dividends

Dividends are sometimes paid at a rate entirely out of proportion to average earnings, or a rate is maintained that is at variance with current earnings. Profits depend to a large extent upon economic and financial conditions. Business does not move on an even level throughout the years. The rule with conservative corporations is that dividends must not be allowed to rise, even in most prosperous periods, above a conservative estimate of the average earnings. In periods of prosperity the demand on the cash resources of a business increases as the prices of material, labor, and money rise. The result is that while a company may make large profits it may not be in a position to pay more than the usual rate of dividends. Many a corporation after paying big dividends in prosperous times has ended by placing its affairs in the hands of its creditors. Dividend payments are dependent not only upon profits but to a greater extent upon the concern’s cash position. To endeavor to do a large volume of business with a small working capital is generally a sure and a quick way of landing in bankruptcy. The prudent way is to withhold dividends until in the normal course of events cash is accumulated beyond the requirements of the business. The book surplus must be reinforced by a satisfactory cash balance as a basis for the declaration of cash dividends.

Sometimes corporations may find it sound practice to pay dividends with the proceeds of temporary bank loans. This is not open to objection under certain circumstances. For example, the company’s business may be subject to wide seasonal fluctuations’ or it may be of such a nature that it nominally operates with a small working capital. Even in these cases the assumption must be that the loans can be repaid when due without any undue strain or effort. There is some question regarding the soundness of the practice, sometimes resorted to, of issuing long-term obligations or of selling additional stock for the purpose of obtaining cash to pay dividends. If the profits are extraordinarily large and the probabilities are that they will remain so, then the increased capitalization may not be a serious handicap in itself. However, where the surplus shown on the books is fictitious or when a legitimate showing of profits cannot be made, then such a transaction would clearly be fraudulent.

Inability to Secure Cash for Refunding Operations

Corporations sometimes issue bonds because of the fact that a larger return is gained to the stockholders than if more stock were sold. The interest rate on bonds is generally much less than the rate of profits and even less than on short-term loans or notes. The distinction between bonds and notes is mainly that of time. The proceeds from the bonds are commonly used for permanent improvements, while the notes are issued to bridge over the changing of some form of quick assets into cash. Generally the bonds are issued during a period of easy money but they may mature when the money market is hard. If a sinking fund has been provided, all that is necessary is to convert the securities in which the funds have been invested into cash and take up the bonds. But the fact that the returns on the securities in the sinking fund are as a rule much less than can be realized by placing the money in betterments, operates against its use.

When, therefore, the bond issue becomes due in a period of financial stringency, or even during normal times if the business has not been highly successful or if its credit has been impaired, the company may be unable to liquidate its assets and pay it off. The consequence is that a foreclosure of the mortgaged property is made.

Excessive Borrowing on Short-Term Securities

A frequent cause of insolvency is excessive borrowing by means of short-term securities in the form of accounts payable, acceptances, and notes. The notes may be classified into: (1) notes discounted at some bank; (2) notes sold to the public; and (3) merchandise notes. There are three legitimate uses to which they may be put, namely: (1) to take care of a temporary lack of funds; (2) to extend further credit to customers; and (3) to increase the stock of easily marketable goods on hand. Definite provision must be made to meet the notes at maturity, which in the case of bank loans run from 30 days to six months—generally 60 to 90 days. The use made of funds obtained in this manner is a matter of importance to bankers when extending loans.

To use any one of these forms of borrowing for the purpose of financing betterments and additions is dangerous and essentially unsound. Such obligations are generally contracted during a period of prosperity and expanding business for the purpose of taking care of temporary needs. They frequently become a source of embarrassment when a period of money stringency sets in. If the borrowings are in excess of the quick assets, the policy is unsound at all times. Conservative managers make provision for meeting their notes at maturity before they issue them.

The short-term notes sold to the public usually are for longer periods than those discounted at the banks—the period ranging from one to five years. When the time is not appropriate for a bond issue and it is desirable to defer it, short-term notes are generally issued and marketed through note brokers, often throughout the country. This is an effective means of deferring a bond issue until money is easier and better terms can be obtained for the larger issue. When the bonds are sold the notes are retired with a part of the proceeds. The danger of this financial practice is that the notes may mature before the bonds can be marketed, as would probably be the case if a period of depression ensued. This would involve disaster if provision for refunding had not been made, especially as the proceeds of such notes, like the proceeds of a bond issue, are generally used for betterments and additions.

Losses in Conducting the Business

A business, through defects of management, does not always fulfill the expectation of its promoters. The price of the product may be set without regard to true costs, and losses pile up with or without the knowledge of the management. Competitive conditions may have to be met and efficiency of management be an absolute requisite if profits are to be made. An organization is of slow growth and the price paid for experience may eat up all the profits. Poor workmanship, duplication of effort, poor planning in the factory, resulting in a high unit cost—these are all factors which may bring disaster if not detected and remedied in time. The promoters may have been unusually optimistic in regard to the business that could be done, with the consequence that a plant is constructed much in excess of actual market possibilities. Losses of a serious nature then result from the poor utilization of fixed assets. “Lack of ability” is the phrase commonly used in describing this cause of insolvency. The usual symptom of the malady is a reduction in current assets and greater difficulty in obtaining credit.

Loss through Fraud, Theft, or Unavoidable Causes

The corporate form of business lends itself to exploitations of many kinds. The public is usually victimized, but sometimes the stockholders suffer through a breach of trust on the part of officers—as for example, the granting of contracts or the payment of exorbitant salaries to the detriment of the large body of stockholders. Another form of exploitation is the diversion of profitable business to some other corporation controlled by the untrustworthy officers. Then again the officers may buy up unprofitable ventures and sell them to the corporation at a large profit. The juggling of accounts may cover up fraud and exploitation. The profits may be sacrificed for the purpose of squeezing out the minority stockholders, or contracts may be made with a subsidiary whereby it takes most of the profits, or the profitable features of the corporation may be sold to a new company. These modes of freezing out the minority are naturally promoted by the majority stockholders. Whatever may be the means used, these various methods of exploitation may lead to insolvency, their ultimate effect depending upon the condition of the company and the extent to which they are carried on.

Unavoidable causes which may lead to the impairment or complete loss of a corporation’s assets are the disruption of the organization and its earning capacity through fire or earthquakes or other natural causes; or new inventions may kill the demand for its product; or improvements in machinery and equipment may render obsolete a large capital investment.

Methods of Liquidation

There are several forms of procedure in case liquidation is found advisable or necessary, and in general there are three courses open, viz.: bankruptcy, voluntary dissolution, and receivership.

Bankruptcy. This perhaps is the most common method. It is of two kinds—voluntary and involuntary. If voluntary bankruptcy is contemplated, the debtor files a petition in the federal court for his district, stating the number and amount of his debts and the amount of his assets. Creditors are then served with the notice and copies of the petition. Further proceedings are similar to those in involuntary bankruptcy. Involuntary bankruptcy proceedings may be brought if the debts are not less than $1,000 and an act of bankruptcy has been committed.

The following are legal acts of bankruptcy:

1. To convey, transfer, conceal, or remove, or to permit to be concealed or removed, any part of the debtor’s property with intent to hinder, delay, or defraud his creditors.

2. To transfer while insolvent any portion of the property to one or more creditors with intent to give preference to them.

3. To make a general assignment for the benefit of creditors, or being insolvent to apply for a receiver or trustee for the property.

4. For the debtor to admit in writing his inability to pay his debts and his willingness to be adjudged a bankrupt on that ground.

5. To suffer or permit, while insolvent, any creditor to obtain preference through legal proceedings and not have vacated such preference at least five days before the sale or final disposition of the property affected by such preference.

After the petition has been presented the next step is the appointment of a receiver or trustee for the purpose of protecting the creditors, and also in the case of the individual to secure the application of his property to the settlement of his debts so far as possible and so secure for him a discharge from further liability.

Bankruptcy proceedings are regulated by the National Bankruptcy Act of 1898. The courts of the Federal Government have jurisdiction in these proceedings. Under the National Bankruptcy Act, a person is insolvent “when the aggregate of his property, exclusive of any property that he has conveyed, transferred, concealed or removed, or permitted to be removed with intent to hinder, delay or defraud his creditors, is not, at a fair valuation, sufficient in amount to pay his debts.”

Voluntary Dissolution. A corporation may or may not be insolvent when making a voluntary dissolution. The reasons for the decision on the part of the stockholders to take this step may be various. Perhaps business is falling off and further profitable use cannot be made of the capital, or the company while solvent is losing money and drawing on its surplus. Again the cause may be due to legal complications, especially when concerns are adjudged combinations in restraint of trade. Voluntary dissolution in general is due to the fact that the condition of affairs seems to be unprofitable and the near future promises nothing better.

Receivership. One method of liquidating an insolvent corporation is by means of a receivership. The appointment of a receiver in equity is different in purpose from that of a receiver in bankruptcy. The function of the receiver in equity is to continue the business until it is wound up. In bankruptcy proceedings a receiver is appointed temporarily to preserve the property until a trustee can be elected. He does not conduct the business, but merely takes care of the goods, and pays taxes and dues, until the election of the trustee. A receivership in equity is frequently a preliminary step to reorganization. While the concern is technically insolvent in that the quick assets are not sufficient to meet maturing obligations, the total assets really exceed the total liabilities. Were the fixed assets sold, only a small fraction of their value might be realized. Under these circumstances the appointment of a receiver in equity is a valuable measure, giving time to provide for permanent remedies.

Liquidation under Bankruptcy

In involuntary bankruptcy proceedings the creditors file a petition in the federal courts located in the judicial district where the bankrupt has his place of business or in which his property is located. A copy of the petition is served on the bankrupt. The petition generally asks for the appointment of a receiver to protect the property until a trustee can be elected. The receiver is appointed by the court and is given charge of all property of the bankrupt until the first meeting of the creditors. The proceedings are generally conducted before a referee in bankruptcy appointed by the court. After the expiration of 20 days, during which the bankrupt is allowed to make his reply, he is required to file a list of all claims against him. A meeting of all creditors whose claims have been allowed by the court is then called and, if the petition is granted, a trustee is elected. Creditors who have some security for their claims are not allowed to vote for the trustee unless the security is insufficient to cover their claims, in which case they may vote on the amount of claim which is unsecured.

As soon as the trustee has been elected the creditors should file their claims with him together with the proof of the claims. This may consist of an affidavit stating the nature and amount of the claim, and the security held, if any. The bankruptcy proceedings are carried through unless the creditors and debtor agree to compromise.

The trustee’s first duty on his appointment is to collect all the property and any debts owing to the bankrupt, and to turn everything into cash in as short time as possible without unduly sacrificing the assets. As a general rule it is necessary to keep the business going for some time in order to get the most out of it. From the receipts the trustee pays taxes, filing fees, court costs, attorney’s fee and wages due, and then the creditors. Servants and persons employed for three months prior to the bankruptcy proceedings are entitled to be paid before any other claims are settled. After that the secured debts are discharged to the value of the security. When these items have been paid, if there remains enough to pay 5% of the total amount of all other claims, the creditors are entitled to have a dividend declared within 30 days after the debtor has been adjudged a bankrupt. If not, they must wait until the trustee has collected a sufficient amount. Afterwards the creditors are entitled to dividends from time to time until the entire amount in the hands of the trustee has been paid out. When the final dividend has been paid the trustee makes up his accounts, presents them at court, and asks for a discharge. He then is entitled to his fee based on the value of the funds that have gone through his hands.

Liquidation under Voluntary Dissolution

A corporation may be dissolved and its affairs wound up by the proper procedure if all its stockholders consent. In some states a majority is sufficient, and in certain cases even less. Statutory provisions prescribe the procedure in most of the states. The process of voluntary dissolution consists simply of gradually closing down the business by realizing on the assets, and distributing the funds among the creditors and stockholders. This usually involves a vast amount of detail work, such as the transfer of contracts, the sale of parts of the business, the taking of inventories, the making of appraisals, and so on.

Liquidation under Receivership

The receivership in bankruptcy is only a step in the chain leading to the appointment of a trustee under whom the process of liquidation takes place. As already stated, the receivership in equity is sometimes not a process of liquidation but a means of carrying on the business pending reorganization. In case the assets are greater than the liabilities, it may be advisable to effect some sort of reorganization to continue the business. The receiver can continue the business in whatever way the court will permit. Any of its unprofitable and unessential parts may be sold and in this way a partial liquidation may be effected.

With permission of the court the receiver may issue receiver’s certificates to meet immediate and necessary running expenses. The certificates usually have the first claim on the assets. It seldom happens that these remedies are sufficient to put the company on its feet and the receiver in the end will wind up the business by disposing of the assets and distributing the proceeds as instructed by the court.

A receiver is an officer of the court and acts under its instructions. In all dubious matters he can protect himself from liability by procuring an order of court or by refusing to act until authorized by an order of court.

Status of Creditors in Liquidation

Creditors may be divided into two groups—secured and unsecured. Those that have a lien upon some specific part of the assets, such as buildings, machinery, or materials, and holders of bonds are among those whose claims are secured. Trade credits and bank loans often have no other security than the standing of the firm.

If the business has been in a receiver’s hands and receiver’s certificates, have been issued, these may be given priority over all debts except those for taxes. The bondholders are usually given the opportunity to appear and present their arguments for or against the issuance of receiver’s certificates. The court directs the issuance at its discretion.

Preferred and common stockholders receive what is left after everyone else has been paid. If the preferred stock is preferred as to assets, it takes priority over the common stock. Often, however, the preference is only as to earnings, in which case the two stock issues share equally in the liquidation. Directors are prohibited by law from declaring dividends except out of earnings. If it should appear that dividends have been paid out of capital and not out of earnings, the stockholders are liable for any amounts thus paid out to them. If the stock issued is only partly paid, the stockholders are liable up to the amount which remains unpaid.

Accounting for Liquidation

Accounting for liquidation may be simple or complex, depending upon circumstances, but it involves practically nothing new in principle. The main bookkeeping features for a liquidation which takes place because of bankruptcy or receivership are treated in Chapter XXXV where some specialized forms of statement are discussed and illustrated. Here it is purposed merely to point out the accounting procedure necessary in the case of a voluntary dissolution. Under a voluntary liquidation the same books of account are used as for the regular record of business transactions, and the procedure is merely a matter of recording the conversion of assets into cash. This involves taking into consideration, in the case of depreciating assets, the adjustment between the asset account, the depreciation reserve, and the loss or gain realized upon the final disposal of the asset. It may be desirable to separate these losses and gains on the sale of fixed properties from the losses and gains of the stock-in-trade, particularly if operations are continued up to the point of the final disposal of the merchandise stock on hand through the regular channels of trade. If, however, the sale of the whole property, including stock-in-trade, is effected, there is no occasion for the separation of the results of the liquidation of the two types of assets. But if this is desirable a separate clearing account, sometimes called “Liquidation Profit and Loss,” may be opened to summarize the losses and gains on fixed assets before transferring the net result of both into surplus. As the assets are sold and converted into cash the liabilities will be liquidated in due course, the accounting features here being the same as during the period of regular operation. After all assets have been converted into cash and all liabilities liquidated, only the cash and net worth accounts will remain on the books of the corporation. If the net result of the liquidation has been to encroach upon the original capital, the net worth accounts will consist of a deficit account and one or more capital stock accounts. If, however, a profit has resulted or if the resulting deficit is not sufficient to wipe out any previously accumulated surplus, the net worth accounts will consist of a surplus account and the various capital stock accounts.

The final step in liquidation will be the declaration of a liquidating dividend of the amount of cash on hand; this will be apportioned, just as all other dividends, on the basis of the stockholdings of the various shareholders. The books will be finally closed by charging the dividend and deficit, if any, to the various capital stock accounts in the one case; or by charging the dividend against the various capital stock accounts and surplus in the other case. In practice the closing of all accounts on the books is seldom carried out, the bookkeeping ceasing with the declaration of the liquidating dividend which disposes of the cash. Except as a matter of complete record, nothing is to be gained by closing off the accounts.

CHAPTER XXIX
COMBINATIONS AND CONSOLIDATIONS

Reasons for Combination

The primary purpose of the formation of a combination or a consolidation of two or more corporations, or of the taking over of a partnership business by a corporation, is to secure greater profits through unity of control. To this end the various parties to the consolidation agree to subordinate their own interests if the effectiveness of the larger unit is thereby increased. The main object in view is the control of any external or internal factors that affect earnings. Profit may be increased by economy of operation resulting from large-scale production, by economies in use of by-products, by the standardization of product and improvement of quality, and by the elimination of duplicate effort; or the control of sources of supplies or of a marketing organization, or greater ease in obtaining capital, or greater facility in dealing with labor, may be among the advantages obtained. In the past the most important of all factors has been the elimination of competition by the control of selling prices, thus securing a greater hold on the market and reducing selling expense. A consolidated enterprise enjoys the advantage of adding to its plant facilities and rounding out the scope of its activities without the expenditure of new construction or capital purchases entailing the raising of large sums of money.

Types of Consolidation

In the popular mind the terms, combination, trust, holding company, consolidation, and merger stand very much for one and the same thing. The end sought is generally the same, namely, the power to control in some degree the conditions surrounding a particular industry. The means used are dictated by the actual conditions governing the situation, such as the possibility of coming to an agreement, legal aspects, financial factors, etc.

Where the elimination of competition was the main consideration, the end sought was most easily achieved by arrangements variously termed a “gentleman’s agreement,” an “interlocking directorate,” a “community of interest,” a “pool,” or a “voting trust”—the results of which were generally referred to as “combinations.” Like the earlier form of the holding company, the “trust,” they are known in the federal courts as “combinations in restraint of trade,” are illegal, and are no longer entered into.

The trust derived its name from the fact that it was controlled by a board of trustees who issued trust certificates in lieu of the stock of the participating companies. Popular aversion to this form of control has led to the formation of another and better type of organization known as the “holding company.” While the holding company is generally classed among the combinations in restraint of trade and in a number of instances, like its predecessor, has come to grief through the enforcement of the anti-trust laws, its legality is recognized in those states where ownership of the stock of other corporations is allowed by law and where no restraint of trade or interference with competition is effected. A holding company organized in one state may control corporations organized under the laws of other states. The holding corporation can itself be controlled by the ownership of 50 or 51 per cent of its stock, and the control of its subsidiaries is obtained with stock ownership in the same ratio. Thus a relatively small capital investment may exercise a far-reaching control.

A holding company as a rule buys up the controlling stock interest of the companies in which it is interested, and elects its own men on the board of directors of the subsidiaries. Frequently the larger stockholders of competing corporations get together and form the holding company. In this case very little difficulty is experienced so far as financing is concerned, which is usually a matter of exchanging the stock of the various companies for the stock of the holding company.

One of the advantages accruing to the holding company, aside from the favorable financial and legal aspects of the enterprise, is that the subsidiaries remain as operating and business units. This is often desirable because of the value of the good-will accruing to the constituent companies from years of business dealing with their customers. The advantages of the close consolidation may be often obtained by stimulating rivalry between the various plants of the same industry and by exchanging information as to successful methods of operation.

A holding company does not generally own all the stock of the subsidiary. Often, however, this is necessary because of the trouble that a small minority of the stockholders can create if the interests of the subsidiary and the holding company clash; such as might be the case if, for reasons of efficiency, the plant of the subsidiary were closed down. It would naturally be a gain to the holding company but a loss to the minority stockholders of the subsidiary if the productive capacity of another plant could be utilized to better advantage.

Accounting for the Holding Company

In [Chapter XV] where the principles of valuation of permanent investments were discussed, reference was made to the method of valuing the holdings of the stock of subsidiaries as carried on the books of the holding company. A distinction was there made between the accounting procedure in showing the holdings of the subsidiary stocks when the parent company has complete ownership, and when its ownership is only partial—though usually a controlling—ownership. If the ownership is complete, as there pointed out, to show the consolidated balance sheet and profit and loss summaries is the best and only intelligible presentation of condition. Where ownership is not complete the balance sheet of the holding company must carry the stock of the subsidiary at a valuation which varies in accordance with the earnings and dividend policy of the subsidiary. In addition to the method of showing the valuation of the holdings in the subsidiary, it may for certain purposes and particularly for internal use, be desirable to append to the statements of the holding company financial statements of each of the subsidiaries so as to give an intelligent view of the condition of the properties of all the companies. These appended statements are, of course, not an integral part of the financial statements of the holding company but are necessary as furnishing information which the officers of the holding company may need in their direction of the policy of the subsidiary. For a detailed discussion of the consolidated balance sheet and profit and loss summaries the student is referred to [Chapter XXXIV].

Aside from the financial statements, no special accounting problems or peculiarities arise in accounting for the holding company. Where, as is usual, accounts with the subsidiaries appear on the books of the holding company other than stock accounts showing the investment, the chief problem lies in the valuation of these accounts. That feature was also discussed in [Chapter XV] to which the student is referred.

Distinction between Consolidation and Merger

Consolidation, in the legal sense, refers to the complete union of two or more enterprises. It is a fusion whereby each company loses its identity in the larger unit of the new corporation. The prior corporations are dissolved and cease to exist. The stock of the old corporation is exchanged for that of the new corporation upon an agreed ratio. The usual procedure for statutory consolidation is as follows:

1. Agreement by the directors of the various companies as to terms, etc.

2. Assent of the stockholders of each company to the directors’ agreement.

3. Filing of certified copies of the agreement, with the vote in its favor, in the same offices in which the certificates of incorporation of each corporation were originally filed.

4. The exchange and issuance of new stock for the old stock of the constituent companies.

The merger of a number of corporations is generally held to be a method of consolidating. The difference is that a consolidation is a fusion while a merger is rather an absorption. The constituent companies are merged into an existing one and no new corporation is formed. The rights, franchises, and interest are deemed to be transferred to, and vested in, the corporation into which the various companies have been merged without any deed or transfer, and the liabilities follow the rights.

Formation of Consolidation and Merger

In the formation of a consolidation or a merger the services of a promoter may be necessary. This is especially true if the various companies are direct competitors and deep-rooted jealousies exist. Under the circumstances an outsider has the best chance of effecting an agreement between the parties. The difficulty encountered in all consolidations and mergers is the exaggerated idea of officials regarding the importance and value of their own plant and organization as related to the rest. This difficulty is accentuated in effecting a merger because of the irrevocable nature of the compact and the almost complete disappearance of lines of demarcation as to the tangible and intangible assets of the various units. These difficulties are overcome in many instances by the promoter’s keeping the terms arrived at with each company a secret. Direct dealing is possible in the case of a merger when the various companies are supplementary to each other, such as would be the case where a selling organization is merged into a manufacturing corporation the product of which it distributes.

Principles of Valuation of the Constituent Companies

In all the foregoing cases the question at once arises as to the principles which should govern in arriving at a valuation. Should the value of the net assets comprising plant, equipment, etc., or the earnings for a number of years serve as a basis in arriving at the ratio of exchange in cash or stock? What relative weight should be given to the various items? A concern with large assets when not running its plant to full capacity would be averse to having the apportionments based on earnings. The corporation with relatively small assets but with large earnings on the capital invested would not want the value computed on net assets.

If the net assets are an important factor of valuation, an appraisal should be made either through a committee or by independent appraisers. If such an appraisal cannot be made, the books should be examined to see that the valuation of each plant and equipment is correct. Great care should be exercised to see that capital additions represent actual additions to the plant or serve to increase its capacity or lower its cost of production. The method of handling improvement expenditures should be uniform. It is necessary to determine that proper entries have been made in respect of property abandoned or equipment removed from service. Another point requiring careful investigation is the provision of ample reserves for depreciation, and the same method of calculation and consideration of the different elements of depreciation and the conditions under which they are operative must be taken into account in all the companies.

The main problem in using earnings as the basis for valuation is the determination of the number of years’ profits to be averaged. Care must be exercised to handle uniformly the earnings and expenses of the various companies.

Fundamental Principle of Equalization of Conditions

Before an intelligent estimate or computation can be made of the relative value of each unit in the proposed consolidation or merger, the various items that make up the assets and earnings of each company should be examined from the same point of view. Accounting systems and methods are so varied that a common basis of computation must be constructed or agreed upon before a comparison can be made. In general, the following points should be considered:

1. A uniform accounting system for all the companies to be merged, in order to have the same basis in arriving at the results.

2. The reserves for depreciation should be based on an analogous system of calculation.

3. Costs should be determined in the same way if the companies carry on the same industry; if the industries are not similar the cost should be reduced to the same basis.

4. The apportionment of labor, factory expense, and factory overhead should be uniform.

5. Only real items of cost should be included under the head of cost of plant and all income charges should be eliminated so as to give a basis for comparing manufacturing items.

6. The same methods of inventory-taking, both of working assets and fixed capital, should be used. Proper valuation of accounts receivable should be made. The accounts payable should be properly shown.

7. The amount of orders on hand should be considered. The past year may have been poor and the books may not reflect the true state of affairs.

Valuation of Partnership

Where, as frequently happens, a partnership is a party to the merger, it is necessary to consider the method of handling certain items in the partnership accounting which differs from their handling under the corporate form, so that the valuation of the assets and earnings of all the properties can be placed on an equitable basis. Such items are partners’ salaries and drawings, and the interest on capital and drawings for the purpose of adjusting the various partners’ interests. In partnership accounting the proper treatment of partners’ salaries, drawings, and interest on capital and drawings requires that these appropriations of profits be shown in the profit and loss summary; i.e., the figure of net profits for a partnership is determined before taking into consideration the items mentioned. However, one occasionally finds partners’ salaries and adjustments on account of interest handled as expenses of the business. To place the earning capacity of the partnership on an equitable basis for comparison with the earnings of a corporation, a reasonable figure for the salaries of the partners as managers of the business must be agreed upon and treated as an expense chargeable to operations before the determination of net profits. Partners’ drawings and interest adjustments on account of capital and drawings should not be taken into account in the determination of earning capacity. In determining the amounts of partners’ salaries, that which would be appropriate for similar capacities in a corporation should be allowed as deductions from earnings. All the items mentioned above in connection with placing the properties of the several corporations on an equitable basis for valuation apply with equal force to the properties of any partnerships which may become parties to the merger.

Earning Capacity

Any extraordinary profits or losses not due to the ordinary operations of the business should be eliminated when computing profits. Interest on borrowed money should not be included. The charges to operating expense on account of repairs should be adequate, and care must be taken to see that charges to the repair accounts do not show a sudden falling off toward the close of the period under review. The reserve for depreciation should be credited with the proper amounts. Sales, effected for a subsequent period, are not to be considered in the accounts of the current period as this would tend to inflate the profits. Shipments made to branch offices or on consignment account should not be regarded as sales. Ample provisions should be made for all liabilities for expenditures incurred during the period under review and outstanding at the close thereof. The inventories should be checked over carefully and certified by the parties taking them. Allowance for old or obsolete material should be made.

Good-Will

The determination of the value of good-will is generally a delicate proposition unless the parties to the consolidation or merger first agree as to the basis on which it is to be computed. This is generally anything that the interested parties choose to make it.

The two methods commonly used for estimating the value of good-will have already been discussed in Chapter XVIII.

Capitalization of a Consolidation or a Merger

The capitalization of a corporation, in a legal sense, is the sum total of the par value of the authorized capital stock. From an investment or economic point of view it is the sum total of all the stock and bonds issued or outstanding.

There are three different bases of capitalization: (1) cost of property plus accumulated surplus value; (2) cost of reproducing the property; and (3) earning power. According to legal theory the investment or the cost plus surplus is the proper basis. This idea has been fostered by the fact that shares have been assigned a definite face value. While at the beginning of a new enterprise investment value and capitalization may closely correspond generally, they soon diverge widely—due to smaller or greater earnings than were estimated or to depreciation or accretion in the value of the assets. When the potential earning power of the business begins to be realized, conditions begin to change and the value of the tangible and intangible assets fluctuates. The basis of capitalization changes with these fluctuations and the laws regulating it are in practice only complied with nominally. The custom is to adjust the value of the assets to harmonize with the capitalization rather than vice versa. Such a policy is to be deprecated.

The cost of reproducing the property as a basis of capitalization is as yet only seriously considered in theory. It is very doubtful if the method will ever be used in actual practice.

Earnings, past or potential, perhaps form the basis for capitalization most frequently used. Investment value closely corresponds to the rate earned and the degree of permanency of the earning power. To secure an income is the motive of all investment. In practically all consolidations and mergers the estimated increase in earnings due to the application of better methods of operation plays an important part not only in the promotion and formation of the new company, but also in deciding upon the capitalization. While the plant value and the past earnings of each of the companies may be considered in allotting them their respective interests, these are not a safe guide as to future earnings. In the case of partnerships especially and often in the case of corporations, there is a loss of valuable good-will. It is generally held that the benefits of consolidation greatly overbalance these disadvantages. The savings due to the elimination of duplicate work in factory and office, the cutting down of the item of rent, the saving in the cost of selling, the greater effectiveness of advertising, etc.—all are reasons held out as warranting this or that capitalization.

Payment of Amalgamated Interests

In a consolidation or a merger the usual practice is to pay the various interests in the companies which are amalgamated with bonds, preferred and common stock, and in some instances with cash. The proportion and kind of payment will depend upon the conditions surrounding each case. The prevalent custom is to pay for the net assets in preferred stock and to issue common stock for good-will. Often, however, bonds are used to pay for the tangible assets; preferred stock is issued for the intangible assets; and common stock represents the additional profits that are expected to accrue to the corporation through the consolidation or merger. The issue of bonds to cover all the tangible assets is generally a dangerous procedure because of the high fixed charges resulting therefrom—though advantageous when the difference between the fixed charges and the net earnings is large. Bonds generally carry relatively small interest because of their safety, whereas the use of preferred stock entails a smaller equity for the common. The bondholder is not concerned with the capitalization or nature of the issues over which he takes precedence. For the same reason it is not usual for the preferred stockholder to complain about overcapitalization through the use of common stock. The business risk involved depends upon the nature of the business and the ability of the management. No financial arrangements should be made that do not take into consideration the fluctuations that are inherent in the business and their effect upon net income.

Another apportionment sometimes made is to issue bonds for the fixed assets; preferred stock for the working capital; and common stock in proportion to the prospective earnings of the consolidation or merger. New bonds are exchanged for the old bonds or preferred stock of the constituent companies, while the common is exchanged for the corresponding issues in the merged corporations. The balance is used for the purpose of paying organization expenses and the fees of the promoters, and to provide working capital for the consolidation. The ratio and the medium will depend to a great extent upon the nature of the business, the attitude of those who are interested in the merger corporations, and the optimism or hopes of the promoters.

Closing the Books of the Merged Concerns

Closing the books of the merged concerns presents the problems of accounting for the sale of the subsidiary companies. This may be effected in two ways. Where the sale is made at the book values as carried on the records of the subsidiary, no adjustments whatever become necessary. Where, however, the price received is less or greater than the book value of the concern, it becomes necessary to show the difference between book and sale valuation. In taking account of these differences two methods are employed. Under the one an adjustment is made of all the detailed valuations of the items of property as taken over. It becomes necessary, therefore, to adjust each property account through its depreciation reserve or through surplus, in order to bring it to the value at which it is taken over. This may, and frequently does, necessitate setting up a good-will account on the books of the vendor company. After the books are thus brought into accord with the sale agreement, the closing of the accounts follows the procedure laid down in [Chapter XXVIII] for the liquidation of a company.

Under the second and more common method, no attempt is made to adjust the individual items of properties sold in accordance with the appraisal committee’s report, but all differences are cleared in a lump sum through the surplus or deficit accounts. If the sale is made for cash, the amount received is then disbursed as a liquidating dividend to the shareholders. If the property is sold for stock and bonds in the merged company, either this stock is handed over en bloc, in which case it is likewise distributed as a liquidating dividend, or the merger company may issue the stock and bonds as a liquidating dividend for the vendor company on the basis of the report of the shares belonging to each stockholder. Upon notice that such stock and bonds have been issued to its shareholders, the vendor company closes up its records completely by cancelling its proprietorship accounts against the charge account set up against the merger company until the stock is issued.

Opening the Books of the Merger

As a merger is a corporation, the opening of its records follows the same lines as that of any other corporation, excepting that when payment of subscriptions for capital stock is to be recorded, cognizance must be taken of the manner of payment. The subscription contract, in so far as it relates to the various subsidiaries, is usually canceled by turning over the properties of the subsidiaries. The assets are taken over at an appraised price which becomes the basis for the amount of subscription to the stock of the merger by each subsidiary. In Chapter I, where mention was made of the payment of stock subscriptions in property, it was pointed out that it may be desirable to bring onto the books the lump sum representing the appraised purchase price paid for the subsidiary some time before the appraisal committee has submitted its report on the detailed valuation of the various items of property taken over from the subsidiary. The customary method of handling the situation on the books of the merger was there shown. The bookkeeper is not concerned with the valuation of any of the items taken over, but must make his entries in accordance with the valuation report turned in by the appraisal committee. The main problem in the merger, then, is one of valuation and not of accounting. As stated above, payment to the subsidiaries may be made by the merger in either of two ways. An entire block of stock may be turned over to the subsidiary company and be distributed by it as liquidating dividends to its stockholders, or the merger may issue shares to the individual stockholders of the subsidiaries in accordance with information furnished by the subsidiary.

CHAPTER XXX
BRANCH HOUSE ACCOUNTING

Advantages of Branch and Agency System

The branch and agency forms of increasing sales in large enterprises are an outgrowth of the policy of “service” combined with economy of management which dominates all present-day capitalistic enterprises. The tendency of a successful business is to absorb other businesses in the same line through combinations and amalgamations, and thus the policies of apparently independent units in a single district or throughout the entire country may be controlled by the central management at a head office.

Where a business serves consumers direct by means of retail stores, as for instance, the chain tea stores, the chain cigar stores, the 5c and 10c stores, the system offers one of the best means of bringing the business into close personal touch with customers. It gives customers an opportunity to examine the wares at their convenience, and at the same time it gives the local branch manager an opportunity to build up good-will for the distant proprietor.

By these means also, stocks of merchandise can be better selected for local needs, and the buying power of each territory and the quantities carried on hand can be better adjusted to secure the greatest possible turnover of stock during an operating year.

There is no doubt that a campaign of education to introduce new goods or appliances can be more successfully conducted through local branches or by personal visits of local agents residing in the territory. Illustrations of this are the present methods of selling sewing machines, phonographs, pianos, electric and gas appliances, etc. When branches are given authority to sell on credit and collect their own accounts, credits can be more intelligently extended and collections can be more carefully watched by a local branch manager.

Agency and Branch Differentiated

There is a great deal of difference between the organization and management of agencies and of branch houses. An agency simply acts as a local salesman for a certain territory. It secures orders and forwards them to the head office. The head office passes on the credit of the purchaser and assumes the risk of refusing or accepting the order. If it accepts the order it also collects the account when it is due. Naturally it must keep a memorandum of sales, either to pay a commission to the agent, or to ascertain whether or not the agency is a paying venture, or for both reasons. A branch, on the other hand, has a much higher degree of self-management. It may receive at least the greater part of its stock of merchandise from the head office, but it usually makes its own sales. It may pass on its own credits and may collect its own accounts receivable; and sometimes it pays all its own expenses.

There are many modifications of the self-management of branches, especially in the matter of financial control. Some branches deposit all their receipts to the credit of the head office and have no authority to withdraw money for any purpose. In such cases the branch is supplied with a separate petty cash fund kept at a fixed sum on the imprest cash system. Other branches receive and pay money and simply make periodic remittances of surplus amounts to the head office as if they were entirely independent units. Various policies of control have been formulated to suit the nature of the business and the degree of self-management granted to the local branches.

Degree of Control Desired

The question of the particular kind of branch or the size of the agency or branch which it is desired to establish depends entirely on the peculiar needs of the business under consideration, and the degree of head office control which is necessary to secure the maximum results with the minimum of expense. An agency by its very nature is completely under the control of the central office. The agent has no powers other than those granted by his principal.

If the business is such that a large stock of merchandise is necessary, and a high degree of discretion and executive ability must be exercised, or if it is desirable to establish practically independent units with only central executive control over the entire purchasing and financial systems, branch stores may best serve the purpose.

The same system, however, will not meet the needs of every business, or even of every branch in the same business. Changes must be made for diversified local conditions which are peculiar to each establishment.

Factors of Successful Management

Certain points must be watched in all systems and under all conditions. Since the total net profits or losses are determined largely by the average turnover of circulating capital invested in the merchandise, the control of the quantity of merchandise, as well as the price, is a question which must have very careful attention and intelligent supervision. The stock on hand must be that quantity which will insure a supply adequate at all times to meet the demands of the trade, and which at the same time will be the minimum necessary to accomplish such a result. Each article turns in accordance with certain fixed principles. Certain goods turn faster than others, but there is a general relation between the rate of turnover and the profit per turn which should be carefully watched.

In the last analysis the success of every branch store system depends upon three things:

Since expenses are a more or less fixed item, their relation to the total volume of business transacted must have the constant attention of the manager. Statistical charts made up from the reports sent in by the various branches, with summaries of total results, compared either by territories or by branches or by product will show to the manager the past history and also the present trend of the business as a whole or in parts. From these charts he is able to form an intelligent basis for inaugurating future policies of control.

Main Principles of Branch Accounting

The underlying principles upon which branch store accounting is based are very simple, but the superstructure will be simple or complex according to the nature of the business and the information which the head office requires for its accounts and records.

The main points to be kept in view in installing a system of accounts are to insure:

In discussing the question of branch accounting any treatment of the problems peculiar to it is so dependent on the particular system employed that only a very general statement of principles can be made unless the comment is confined to a particular system and this might not be relevant to all systems. There are, however, certain principles which apply fundamentally to all systems. The question of the degree of control desired by the head office and the resulting information which must be given by the branch to the head office governs largely the detailed ramifications of general principles which will be necessary. Also the amount of information as to the results of the business done at each branch which it is desirable for the branch management to know has an important bearing on the manner of keeping the accounts. Sometimes it is not desirable that the branch manager should know the amount of profit which his branch is earning. While, of course, it is impossible to keep a shrewd manager in entire ignorance of the results of his management, yet the exact figure of profit earned by his branch can be kept from him if the books are handled properly. It is purposed here to develop by statement and illustration most of the problems which are peculiar to branch and agency accounting.

Agency Accounts

What has been said with regard to the difficulty of presenting a widely applicable statement of branch accounts is equally true of agency accounts. There is no well-marked line of distinction between agency and branch organization. What may be termed an agency by one concern will be looked upon as a branch by another concern. For the purpose of this discussion, however, the distinction stated above between these two forms of organization will be adhered to. Where, therefore, the agency is for the most part simply a sales agency, practically nothing in the way of accounts and accounting control is necessary other than what must always be used in connection with traveling salesmen. The agency must be furnished with an expense fund and must, of course, send in to the head office all its orders and sales. The expense fund is best operated under the imprest system. To keep track of the results of the various agencies it will be necessary on the head office books to keep the records of the activities of each branch separate from one another and from those of the head office. At the close of the fiscal period a comparison of agency sales with the direct costs of making those sales and with the expenses of maintaining the agency will develop the net result of the agency’s activities. The problem, therefore, of agency accounting is simply one phase of the general problem of accounting, viz., furnishing, by means of whatever analysis may be necessary, the information which will be of greatest advantage, to the management of the business.

Branch Accounting Records

The accounting records of the branch will be simple or complex according to the conditions to secure control over which they must give information. Sometimes a very simple set of records will furnish all the data needed. In other cases just as elaborate detailed records as are employed at the head office may be required to secure the information desired. Sometimes it may appear best for the branch to keep but few records, and for the head office to keep all the main accounting records by means of duplicate reports of all branch transactions. Again, to exercise proper control over the branch, even where it keeps a full set of records, it may be advisable to require periodic reports of all branch activities. Sometimes these are required daily, but more often a weekly or monthly summary of activities serves the purpose equally well.

Illustration of Simple Branch Accounts

The simplest method of keeping the branch and head office accounts can be illustrated by a short problem in summarized form. In the illustration given it is assumed that the head office furnishes the cash necessary to inaugurate the branch, and that all stock-in-trade is supplied by the head office. It is further assumed that the branch keeps a complete set of records which will furnish information as to profits and losses at the close of the fiscal period. On the branch books it will be necessary to open accounts with Merchandise (here, for the sake of brevity, carried under one title rather than as usually shown), with Cash, with Expenses (again, for the sake of brevity, carried under one head), with the Head Office, and with Profit and Loss. These accounts present no peculiarities excepting the Head Office account which stands on the branch books as the net worth or proprietorship account. It is credited with all values received from the head office and charged with all values returned to the head office or expended on head office account. The net profit for the period is closed from the Profit and Loss account into the Head Office account in order to show the present net worth or proprietorship with which the branch enters the new fiscal period.

On the head office books there need be carried only an account with each branch by name or number. The charges and credits in this account are the exact reverse of those in the Head Office account carried on the branch books. At the close of the fiscal period it is necessary to receive the report of the branch profit or loss before that can be incorporated in the branch account on the head office books. The following problem will show the manner in which these accounts are kept.

Problem. The head office sends to the branch during the year $5,000 cash and $50,000 worth of merchandise. The branch makes sales to customers on account amounting to $45,000 and cash sales of $10,000. It incurs expenses of $7,500. Its collections from customers on account amount to $25,000. It remits $37,000 to the head office. The inventory of merchandise at the close of the year is found to be $12,500.

Solution

Branch Books
Cash$ 5,000.00
Head Office $ 5,000.00
Merchandise50,000.00
Head Office 50,000.00
Customers45,000.00
Merchandise 45,000.00
Cash10,000.00
Merchandise 10,000.00
Expense7,500.00
Cash 7,500.00
Cash25,000.00
Customers 25,000.00
Head Office37,000.00
Cash 37,000.00
Merchandise (Inventory)12,500.00
Merchandise 12,500.00
Merchandise17,500.00
Profit and Loss 17,500.00
Profit and Loss7,500.00
Expense 7,500.00
Profit and Loss10,000.00
Head Office 10,000.00

Head Office Books
Branch$55,000.00
Cash $ 5,000.00
Merchandise $50,000.00
Branch10,000.00
Branch Profit and Loss 10,000.00

In making up the head office balance sheet, the Branch account as carried on the head office books will be an asset representing the property of the head office invested in the branch. Instead of carrying this property under the title “Branch,” it is sometimes desirable to include all branch values with similar values at the head office. This results in a balance sheet which is similar to the consolidated balance sheet explained in [Chapter XXXIV].

Illustration of More Complex Branch Accounts

As an illustration of a somewhat more complex method of keeping the books, a problem is appended illustrating the sending of goods to the branch at a nominal figure or at sales price. Here it is not desired that the branch management be able to determine the profit and loss of its activities; consequently the goods from the head office are not charged to the branch at cost but at some fictitious value. Where this is done it is best to open two accounts, the one to record the merchandising transactions between the branch and the head office, and the other to record all other interactivities.

Problem. The head office sends to the branch during the year $10,000 cash and $77,000 worth of merchandise as billed at a conventional price. The branch makes sales to customers on account, of $60,000, and for cash $25,000. The expenses of the branch are $10,000. Collections from customers amount to $45,000 and remittances to head office amount to $66,000. The inventory of the stock-in-trade at the close of the year is $14,000, this valuation being on the same basis as the original charge, i.e., at the conventional figure.

On the branch books two accounts are opened with the head office, one entitled “Head Office General,” and the other “Head Office Merchandise.” Neither one of these accounts represents the full proprietorship of the head office in the branch, nor do both of them together represent the true proprietorship because of the fact that the merchandise is priced to the branch at a fictitious figure. The branch books cannot show the true status of relations with the head office so long as the policy, of billing goods in this way is maintained. That is the chief reason why it is best to set up the two accounts, in one of which appear the merchandise transactions at the fictitious figure, while in the other appear all other transactions correctly valued. This Head Office Merchandise account is more in the nature of a memorandum or consignment account and is offset by an account called “Purchases from Head Office.” On the branch books appear also accounts with Customers, Branch Sales, and Expenses—as in the other case. There is no Profit and Loss account because it is impossible to determine on the branch books the correct profit and loss for the period. All expense and income accounts are closed directly into Head Office General. The entries necessary to book properly the activities as set forth in the illustrative problem are as follows:

Cash$10,000.00
Head Office General $10,000.00
Purchases from Head Office 77,000.00
Head Office Merchandise 77,000.00
Customers60,000.00
Cash25,000.00
Sales 85,000.00
Expense10,000.00
Cash 10,000.00
Cash45,000.00
Customers 45,000.00
Head Office General66,000.00
Cash 66,000.00

In closing the branch books the inventory is brought into the Purchases from Head Office account which by its balance shows at billed price the goods disposed of by sale. The latter figure is taken into the Head Office Merchandise account so that its balance will also be the amount of goods still on hand as shown by the inventory. Purchases from Head Office and Head Office Merchandise are memorandum accounts calling attention to the fact that the merchandise on hand at the branch is not carried at its correct valuation but must be adjusted before incorporation with the head office accounts. The entries to effect this adjustment on account of the inventory and to close the branch books are as follows:

Purchases from Head Office (Inventory)$14,000.00
Purchases from Head Office $14,000.00
Head Office Merchandise63,000.00
Purchases from Head Office 63,000.00
Sales85,000.00
Head Office General 85,000.00
Head Office General10,000.00
Expense 10,000.00

These entries close the books of the branch so far as is possible in view of the fact that accurate results as to profit and loss cannot be shown from the way in which merchandise is billed to the branch. There is perhaps no objection to using a Profit and Loss account as a summary account for income and expense items rather than the Head Office General account as shown here; though a Profit and Loss account is somewhat of a misnomer since profits and losses cannot be determined. In the problem given all expenses are grouped under one Expense account. This is done for the sake of brevity, and it is to be understood that as detailed an expense record will be kept on the books of the branch as may be necessary to give the information desired.

Head Office Books

Where the head office bills merchandise to the branch at any other figure than cost, the record of such shipments is best made in much the same way as with consignments. Memorandum accounts are set up to indicate that goods have been shipped to the branches. This is necessary because of the fact that shipments should not be entered in the regular merchandise accounts of the head office at any other figure than cost. Periodically, from memoranda carried in these special accounts, the true values of the merchandise shown as handled through them must be brought into the regular merchandising accounts. The manner of making these adjustments is taken up on page 535. Here will be shown all the accounts affected on the head office books by the current transactions with the branch. The entries necessary to record the data of the problem are as follows:

Branch A General $ 10,000.00
Cash $10,000.00
Branch A Merchandise77,000.00
Sales to Branches 77,000.00
Cash66,000.00
Branch A General 66,000.00

It is to be noted that separate merchandise accounts are opened with each branch by name but that only one Sales to Branches account need be opened. The Branch Merchandise account with each branch provides all the necessary data for making the adjustment at the close of the period, the offsetting memorandum account for all the different Branch Merchandise accounts being the Sales to Branches account. At the close of the period, upon report of the total activities for the period at the branch, the following entries are made on the head office books:

Branch A General $85,000.00
Sales $85,000.00
Expenses10,000.00
Branch A General 10,000.00

An alternative method of summarizing branch activities is sometimes used, as follows:

Branch A General $85,000.00
Branch A Profit and Loss $85,000.00
Branch A Profit and Loss10,000.00
Branch A General 10,000.00

Under the first method the effect is to merge the activities of the branch with the similar activities of the head office. A statistical abstract of the different branches is then depended upon by the head office management to show the results of the period’s trading at the various branches. Under the second method the effect is to bring onto the books under the various branch Profit and Loss accounts the results of the trading in each case. Whichever method best gives the information desired by the head office will, of course, be adopted.

A brief discussion will now be given of the chief problems met in branch accounting. No attempt will be made to discuss the problem of branch organization from the standpoint of system or control. Such a discussion belongs more particularly to the field of auditing than to that of accounting.

Purchases

From the head office point of view no special problems are met in the matter of purchasing. From the standpoint of the branch the question of purchases is largely the same as the question of sales from the head office standpoint, and the problem of sales is chiefly one of the price at which goods should be billed to the branch. This is treated in the next section. Attention is called here to the need of a very careful control and checking up on purchasing activities of the branch where the branch is permitted to buy some portion of its goods from outside sources. This may become necessary in cases of emergency, or may be a matter of fixed policy in those cases where commodities are sold at some of the branches which the head office does not care to furnish or cannot handle with economy. Where the branch makes purchases both from outside and from the head office, the result may be to complicate the adjustments necessary at the close of the fiscal period. The underlying principles on which the accounts and their adjustments rest are, however, the same.

Sales

From the standpoint of the head office, the problem of sales to the branches is, as mentioned above, largely a problem of policy as to whether goods shall be invoiced at absolute cost; at cost plus a small percentage for overhead expenses; at sales price, i.e., at the price at which the branch is expected to sell the commodity; or at some arbitrary figure which is designed for the purpose of keeping the branch in ignorance of the actual cost of the goods dealt in and therefore of the profit and loss upon the branch’s activities. If goods are billed to the branch at sales price and disposed of at the same price, a comparison of the branch records covering their purchases and their sales should indicate by the difference between the two the amount of stock on hand at any time; i.e., billing the goods to the branch at sales price makes the merchandise records of the branch virtually a perpetual inventory of the goods on hand. This method effects a closer check on losses and waste, for which, of course, a small allowance must always be made. One of the most serious wastes to be checked up is occasioned by too liberal weights and measures to customers. On the other hand, invoicing the goods at sales price gives the branch manager less discretion in adjusting differences with customers inasmuch as defective goods must usually be returned to the head office to secure for the branch full credit. Further, billing the goods at sales price with the purpose of securing accurate control over the branch merchandise necessitates the pursuit of an inflexible policy of sales at the billed price. Daily or weekly adjustments on account of fluctuations in the market cannot be made without losing the control over stock which the policy of billing at sales price secures. In some lines of business this is an insuperable defect.

Where merchandise is invoiced at cost the branch manager has a rather more secure hold on his customers in that he can give immediate satisfaction by making allowances and adjustments to settle difficulties as they come up. Particularly where the manager has an interest in the profits, a much greater incentive is offered him to conduct the affairs of the branch in an efficient and economical manner. This responsibility and power to make adjustments may be abused, however, and a greater degree of control can usually be secured by the head office where merchandise is billed at sales price.

As mentioned above, sometimes goods are billed to the branch at an arbitrary figure. Inasmuch as the question of control by means of a perpetual inventory does not enter into this policy, large discretion can be given the branch manager without unsatisfactory results in checking up the merchandise. He may be allowed to make whatever adjustments with customers seem advisable. Changes in selling price can be made as often as conditions demand, either at the instance of the head office or at the discretion of the manager. A policy of this sort requires a much more thorough system of report from the branch to the head office in order to give the head office a means of checking up periodically the activities of the branch.

It is well to point out that on the books of the head office sales to branches are in no sense income items and must never be recorded with regular sales to outside parties. Similarly, sales or transfers among branches are in no sense earnings. It should be noted that, to keep the head office records correct and up to date, any transfers of goods among branches should be reported immediately to the head office; better still, the authorization of the head office, except in cases of emergency, should be given before such transfers can be made.

Adjustments on Branch and Head Office Books

Head Office and Branch accounts are essentially accounts current between the head office and the various branches. At the close of the fiscal period when the results of the period’s business are being summarized, the four classes of adjustments which are sometimes necessary in the case of accounts current may have to be made. The head office may show a charge to the branch for items which the branch has not yet received at the close of the fiscal period. Similarly, the branch may have charges and credits to the Head Office account which the head office records do not show. If this condition exists, the two accounts must be reconciled in accordance with the method shown in Volume I, page 497. Almost invariably, unless a system of complete daily reports is in effect between the branch and the head office, the head office will have to wait for certain reports from the branch at the close of the fiscal period. The nature of the entries to effect these reports is given in the problem illustrated on page 532.

The chief adjustment which is needed on the head office books is brought about through the policy of charging the branch with merchandise at some other figure than cost. Where this is done, the profit and loss on the branch activities cannot be determined until true costs are taken into the accounts in place of the fictitious figures used during the current period. The basis for converting the fictitious figure into a true cost figure is, of course, a secret known only to the head office. The memorandum accounts covering the merchandising transactions with the branch furnish the basis for determining the cost of goods sold by the branch. Thus, if goods are billed at, say, 30% above cost the billed price becomes 130% of the cost. It is therefore possible to determine the cost of all goods disposed of by the branch and of those still on hand. If it is desired to merge all the branch activities with the similar activities of the head office, the only adjustment necessary at the close of the fiscal period is to convert the sum total of the inventories on hand at the various branches to a cost valuation basis and include them with the head office inventory. This gives the data needed to determine the cost of goods sold and gross profit on the combined activities of the various branches and head office.

It is usually essential that the results of trading at each branch be determined, whether or not such results be incorporated separately on the head office books. Under the assumption that they are to be set up on the records of the head office, the billed cost of the goods disposed of at each branch must be converted to a cost basis and shown transferred from the Head Office Purchases account to the Profit and Loss account with each branch. This separates the total cost of goods sold as among the various branches and the head office. When the various branch Profit and Loss accounts are credited with their respective earnings from sales, the gross profit or loss on the trading activities at the various branches will thus be shown. Similarly, the regular merchandise accounts in which have been recorded the head office merchandising activities will show the gross profit on sales made at the head office. These adjustments are made without interfering in any way with the memorandum accounts carried on the branch books and on the head office books—accounts which have no place in the balance sheet of the head office. In their stead will appear the combined inventory of goods on hand at the branch and the head office converted to a cost basis.

Example of Adjusting Entries

The character of the entry needed to effect these adjustments will now be shown, using the data of the illustrative problem shown above. Comparison of the report of inventory from the branch, $14,000, with the record of goods shipped to the branch, $77,000, shows that goods to the billed value of $63,000 were disposed of at the branch. The records in the head office show that the goods were billed to the branch at 140% of cost. Converting this figure of $63,000 on the basis of 140% of cost develops a true cost of goods sold of $45,000. This is brought onto the head office books by the following entry:

Branch A Profit and Loss $45,000.00
Purchases $45,000.00

Reference to the solution above shows that Branch A Profit and Loss has been charged with $10,000 expenses and credited with $85,000 earnings from sales. The gross profit, therefore, on the period’s activities at Branch A is the balance of the Branch A Profit and Loss account, i.e., $30,000. The only other adjustment necessary is the conversion of the Branch A inventory of $14,000 to a cost basis. The true cost here is, of course, $10,000 since the goods were billed at 140% of cost. The $10,000 will be included with the inventory of goods on hand at the head office before the determination of the head office cost of goods sold and gross profit can be made.

To secure a better understanding of the interrelations of these various accounts it is suggested that the student set up all the accounts and follow through them the transactions given in the illustrative problem above, both on the books of the branch and on the books of the head office.

A final problem of adjustment as between the head office and branch books concerns the treatment of fixed assets carried on the books of the branch. It may happen that the branch makes purchases of various pieces of property which are charged up to fixed asset accounts on the branch books. To secure uniform treatment, particularly as regards depreciation, it is customary at the close of the fiscal period to transfer the record of all fixed assets to the head office books. This is accomplished by entry on the branch books of a charge to Head Office General account, and credits to the various fixed asset accounts. On the books of the head office the record will be a charge to the various fixed asset accounts and a credit to the various Branch General accounts. Usually, therefore, on the branch books appear only current asset items, current liability items, expense and income items.

Reports from the Branch

The reports which the branch makes to the head office depend entirely on the degree of control to be exercised by the head office over its various branches. Accordingly, no general methods of universal applicability can be described. A statement of some of the different kinds of reports and the use made of them will be given. In some cases the branch books are kept in duplicate, the duplicates of all books of original entry being sent to the head office at the close of each month or oftener if desired. From these duplicate records the head office can keep a ledger record with every branch for comparison with the ledgers as kept by the branches. In other cases the head office requires that the branch send in daily duplicate copies of all business papers covering the transactions of the branch. Thus sales tickets are made in manifold, one copy of every sale, whether cash or credit, being sent to the head office. This furnishes the head office with a control over the selling activities of the branch. If the branch has charge of its cash a duplicate ticket of all deposits made should be forwarded to the head office. The canceled checks drawn by the branch must be forwarded by the banker to the head office. This procedure keeps the head office informed as to the cash transactions of the branch, giving both a control over the cash and a fairly complete knowledge of disbursements on account of expenses and of receipts from collections. If, now, all purchases of stock-in-trade are made from the head office, the latter has a close control over all the activities of the branch. It may thus keep a duplicate set of records, although that is scarcely necessary inasmuch as summaries can be made by which to check up the books of the branch at the close of the fiscal period.

Sometimes, instead of daily reports periodic summaries of the branch activities are made to the head office and these provide the basis for checking up on the branch at the close of the fiscal period. Where the head office maintains traveling auditors, such frequent reports are not necessary.

Examples of Reports

Below are given two examples of different kinds of reports from the branch to the head office. The first is a periodic summary of cash transactions followed by a statement of collections from customers. The second form is a type of ledger account carried with each branch on the books of the head office in accordance with detailed reports made by the branch or by traveling auditors from the head office. It will be noted that provision is made in the account by means of special rulings to show the total expenses of each branch, which total will enter into the trial balance; and also for an analysis of the expenses of each branch under suitable heads, these latter being treated simply as memoranda. Any credits or adjustments are entered in red ink, and are to be deducted before showing totals.

Periodic Cash Summary
ReceiptsPayments
Cash Sales (by days)$ . . . . . . Wages$ . . . . . .
Expenses. . . . . .
Total for period $ . . . . . . Sent to Head Office. . . . . .
Customers Accts. (as below . . . . . . Payments into Bank
(dates & amts.)
Other Receipts . . . . . . Balance on Hand, carried
to next statement. . . . . .
Total $ . . . . . . $ . . . . . .
Balance, per last statement$ . . . . . .

Customer’s Accounts Collected

Branch Report to Head Office

Branch A Expenses[69]

Head Office Ledger Account—
Summary of Branch Expenses

CHAPTER XXXI
BRANCH HOUSE ACCOUNTING
(Continued)

Foreign Exchange

The foreign trading of American firms has grown of late years to such proportions that a practical acquaintance with the exchange values of foreign currencies is necessary for the accountant. The rate of exchange is the equivalent of the currency of one country in that of another. For instance, the standard value of the British sovereign in the currency of the United States is $4.8665; that is, the value of the quantity of pure gold in one sovereign in London is equal to that represented by $4.8665 in New York. Other things being equal, this should always be the par rate of exchange between the United States and England. The question of the rate of exchange between countries which have a gold standard is a comparatively simple matter. Where one of the countries has a silver currency, the variations assume more importance, for the reason that the intrinsic value of silver converted into gold must be accounted for. Paper currency, especially in times of war, causes a still greater complication, because in this case it is uncertain when such paper will be made convertible into gold or silver.

In addition to differences in exchange arising from the conversion of one currency into another, called the par rate, other things enter into exchange transactions which have a marked effect upon the actual, or market, rate of exchange. Such conditions as supply and demand for remittances between countries to satisfy debit balances; the necessary expenses, including cost of transmission (which can never be more than the actual cost of transporting the specie itself): interest on the money for the time the draft has to run to maturity or to the time of payment in the foreign country—these and other factors must be taken into account. The expense of cabling and the profits of the bankers who transmit the money must be added. Some intangible factors are the credit condition of the countries and the risks involved in making transfers.

The Accounting Problem of the Foreign Branch

From the viewpoint of accounting, the only problem in connection with foreign branches which differs from those of domestic branches concerns the conversion of the foreign currency—in terms of which the records of the foreign branch are kept—into the currency of the head office. Periodically—usually at the close of the fiscal period—the results as shown by the branch records must be incorporated with those of the head office. The problem involved is for the most part due to the fact that, while the activities of the various branches have been transacted and recorded in terms of one or more currencies, the net results of those activities are to be taken effect of, usually as a disbursement of dividends, in the terms of the head office currency. That is, earnings are made and expenses incurred in one currency, and the net result of the branch’s trading must be disbursed in terms of another currency. The fluctuations in exchange prevailing throughout the year at the time of the various transactions of the branch and at the time when the net results of the branch are disbursed as dividends from the head office, sometimes give rise to a very complicated problem if accurate and satisfactory results are to be secured.

It is impossible, from the standpoint of practice, to convert every transaction of the branch into the currency of the head office at the rate prevailing at the time of the transaction; and furthermore, the funds out of which ultimately some portion of the dividends must be paid are, at the close of the fiscal period, still held in the possession of the branch and so are not available except through the process of conversion. Accordingly, the question of the rate of exchange prevailing at the close of the fiscal period has a very important bearing on the correct showing of the branch’s activities on the head office books.

It is not purposed here to go into the question of organization, or method of keeping accounts for the foreign branch. As was stated above in connection with domestic branches, any system of accounts depends very largely upon the general organization of the head office and its branches, and this in turn depends on the degree of control and amount of information desired. The discussion will be limited to the assumption that the branch has an almost independent organization and is expected to make a full report periodically by means, at least, of a trial balance of the branch.

Accounts Opened on Books

On the books of the branch a Head Office Control or Adjustment account will be carried which represents the ownership of the head office in the branch; and on the head office books a Branch Control or Adjustment account which is the complement of the head office account on the branch books. Frequently, in addition to these interrelated accounts, a Remittance account is carried for the purpose of facilitating reference. In this account are entered the remittances made by the branch to the head office, instead of entering such transactions in the Head Office Control account. The problem to be discussed here concerns the method of converting the branch trial balance before incorporating it, and the root of the problem lies in the determination of the basis for the conversion of the various kinds of items listed therein. Fixed and current asset and liability items, expense and income items, the Head Office Control and Remittance accounts—all must be converted. For an accurate and equitable showing of the branch activities on the head office books under certain conditions, these different classes of items should not be converted at the same rate. Under other conditions no serious inequity results from the use of a uniform rate of exchange for the conversion of all items, and in practice such a rate is handled much more simply than different rates. Of course, the branch trial balance is in balance previous to conversion but is almost invariably out of balance after conversion. It becomes necessary, therefore, to take up the difference by means of a debit or credit to an account called “Exchange” or “Fluctuations in Exchange”—sometimes also called “Reserve for Fluctuations in Exchange.”

Handling Fluctuations in Foreign Exchange

The proper handling and ultimate disposition of this Exchange or Fluctuations in Exchange account requires some consideration. If there is a loss in the conversion of the branch trial balance into the head office currency, that may be treated as a current expense to be charged ultimately to the current period’s profit and loss. Any profit accruing from the same source may be similarly handled. Some concerns set aside all profits accruing in this manner into a Reserve for Fluctuations in Exchange account, against which are charged any losses incurred through conversion. If the first period shows a loss on conversion, it would, of course, be necessary to reserve out of that period’s profits a sufficient amount to take care of the loss. Usually, however, the items of profits and losses on conversion of exchange counterbalance each other fairly well throughout succeeding periods. The item is for the most part comparatively small and either method of handling it is satisfactory and gives sufficiently correct results under normal conditions but often too inaccurate under abnormal conditions.

Conversion of Branch Results

The basis on which the closing entries are converted from the foreign to the local currency is a very important factor. If the ratio between the two countries is more or less stable, an average rate may be adopted without much variation in the established values. All profits or losses on exchange resulting from differences between actual rates on current transactions and this average rate will be entered in the Fluctuations in Exchange account. However, in periods of rapidly fluctuating rates of exchange, or in transactions with branches where silver currency or depreciated paper or non-guaranteed currency are in use, the conversion of all items at some arbitrary or average rate will not give accurate or satisfactory results. In such cases certain practices have been established as being the most equitable in converting the various accounts of the branch balance sheet into the local currency for the purpose of amalgamating them into the home office balance sheet. These practices are summed up as follows:

First convert the foreign currency into dollars at the following rates:

1. Fixed assets at the same rate as before, that is, the rate at the time of purchase, or average rate for the purchases of a fiscal period. The reason for this is that fluctuations in the value of fixed assets, whether expressed in one currency or another, are not allowed to affect the period’s results.

2. Floating assets and liabilities at the rate current as of the date of the balance sheet.

3. Revenue items at an average rate for the period.

4. Remittances at the actual rates paid.

5. Control or adjustment account at the same rate as that which had been established on the head office books at the last period.

To arrive at the average rate in the case of fixed assets it is sufficient to take the rate prevailing at the end of each month throughout the year and divide the total by twelve. This becomes necessary where construction or purchases of fixed properties take place throughout the year. The difference, if the rate is less than par, is credited to the capital expenditure and debited to Profit and Loss on the head office books. The branch is notified of the adjustment and makes a similar entry crediting Exchange and debiting the head office with the amount.

Current assets and liabilities are converted at the rates current at the date of the balance sheet because the balance sheet should represent these values at the exact cost of converting them into cash at the present moment. If in practice they were actually liquidated, this could not be realized but in principle it represents the present condition. Revenue items are convertible at the average rate because they represent items accumulating during the entire fiscal period; they represent the result of the business activities for the past period, at varying rates of exchange. Since the remittance account represents the actual cash paid for cash transmitted, there is no occasion for changing the rate which has been used at various times during the period. The Control or Adjustment account likewise was converted at the time the entries were made to it and represents the exact cost of the various transactions recorded in it.

After all balance sheet items have been converted according to the rates prescribed, it is a general custom to provide a reserve account to cover any losses on exchange not provided in the conversion of the accounts. This is done for the purpose of guarding against overstating values and thus paying dividends out of the capital, since the conversion into head office currency merely serves as a medium of estimating what the foreign investment really represents to the stockholders.

An illustrative problem is given below with its solution based on the principles of conversion just stated. It is to be noted that in practice, within the limitation stated on page 546, a uniform rate of conversion is generally made use of for all items except remittances, for which the actual rate is used.

Illustrative Bookkeeping Problem

Problem. At the close of the fiscal period a condensed trial balance report of the London branch of a New York concern showed as follows:

Trial Balance—London Branch

££
N. Y. Control (4.7475)  100,000
Remittance50,000
Cash5,000
Customers75,000
Merchandise Inventory 25,000
Furniture and Fixtures1,000
Creditors 31,000
Sales 150,000
Purchases95,000
Expenses30,000
281,000281,000
Final Inventory  £30,000

The London Control account on the New York books showed a balance of $474,750, and the Remittance account $237,987.50. Set up, in journal form, the entries necessary to take on the New York books the results of the period’s activity at London and show the London Control and London Profit and Loss accounts after adjustment, using the additional data:

1. The Remittance account comprised 5 drafts of £10,000 each, at 4.75, 4.7575, 4.74875, 4.7625, and 4.78 respectively.

2. The current rate of exchange is 4.7545.

3. The average rate is 4.7525.

4. The rate at time of purchase of fixed assets was 4.83.

5. No account is to be taken of probable loss from uncollectible accounts nor of depreciation.

6. Carry the difference in exchange to a reserve.

Solution

Conversion of London Trial Balance

££Rate of
Conversion 		$$
New York Control 100,0004.7475 474,750.00
Remittances[70] 50,000 (See note) 237,987.50
Cash5,000 4.754523,772.50
Customers75,000 4.7545356,587.50
Merchandise Inventory25,000 4.7475118,687.50
Furniture and Fixtures1,000 4.83  4,830.00
Creditors. 31,0004.7545 147,389.50
Sales 150,0004.7525 712,875.00
Purchases95,000 4.7525451,487.50
Expenses30,000 4.7525142,575.00
Reserve for Fluctuations
of Exchange 913.00
281,000281,000 1,335,927.501,335,927.50
Final Inventory  £30,000 @ 4.7545 = $142,635

Journal Entries to Adjust New York Books

(1) Remittances$237,987.50
London Control $237,987.50
To Credit London with its remittances:
£10,000 @ 4.75 = $47,500.00
10,000 @ 4.7575 = 47,575.00
10,000 @ 4.74875 = 47,487.50
10,000 @ 4.7625 = 47,625.00
10,000 @ 4.78 = 47,800.00
(2) London Control$712,875.00
London Profit and Loss $712,875.00
To charge London with its sales:
£150,000 @ 4.7525
(3) London Profit and Loss118,687.50
London Control 118,687.50
To credit London with initial inventory:
£25,000 @ 4.7475
(4) London Profit and Loss451,487.50
London Control 451,487.50
To credit London with its purchases:
£95,000 @ 4.7525
(5) London Control142,635.00
London Profit and Loss 142,635.00
To charge London with final inventory:
£30,000 @ 4.7545
(6) London Profit and Loss142,575.00
London Control 142,575.00
To credit London with its expenses:
£30,000 @ 4.7525
(7) London Control913.00
Reserve for Exchange Fluctuations 913.00
To charge London with the profit
arising from conversion.
(8) London Profit and Loss142,760.00
Profit and Loss 142,760.00
To transfer profit at London branch
to general Profit and Loss.

Appended are the London Control account as it would appear after posting the above entries on the New York books; and the London Profit and Loss account on the New York books.

London Control

ItemsRate£$
Balance one year ago 100,000474,750.00
London Profit & Loss (Sales) 4.7525 150,000712,875.00
London Profit & Loss (Final Inventory) 4.754530,000142,635.00
Reserve for Exchange Fluctuations 913.00
280,000 1,331,173.00
Balance 80,000380,435.50
ItemsRate£$
RemittancesJ(1)50,000237,987.50
See London Profit & Loss4.7475
(Initial Inventory)4.752525,000118,687.50
London Profit & Loss (Purchases)4.752595,000451,487.50
London Profit & Loss (Expenses) 30,000142,575.00
Balance 80,000380,435.50
280,0001,331,173.00
London Profit and Loss[71]
Initial Inventory  $118,687.50 Sales$712,875.00
Purchases451,487.50 Final Inventory  142,635.00
Expenses142,575.00
Profit & Loss142,760.00
$855,510.00 $855,510.00

Local Supervision of the Foreign Branch

A question which enters into the accounting with foreign branches arises in connection with the law of the land in which the branch is opened. “Most foreign countries have some regulations as to what books must be kept, and the manner of recording the transactions. In France, for instance, the law requires that a summary of all transactions shall be entered through the journal, which therefore becomes the posting medium for every transaction. This book has, in the first instance, to be produced to a public official, who examines it to see that it is duly paged, none missing, etc., and then stamps it as correct, and anything requiring legal proceedings in which accounts are concerned must be proved from the journals with the official visa.”

“Since the work of organizing and installing systems of accounting in branch houses abroad is of undoubted and growing importance, it is necessary to have not only a practical acquaintance with the currencies in which the foreign books are kept, and the laws of the land in regard to the kind of books which must be kept, but in addition a thorough knowledge of the manner in which transactions are to be transmitted periodically to the home office, and of their assimilation with the home accounts and the drafting of the final accounts, balance sheets and profit and loss statements becomes indispensable.”

The Foreign Sales Agency

Where the foreign branch is merely a selling agency for the home office, and invoices must be made out at the home office in foreign currency, a convenient way to handle these accounts is to keep a separate set of records for each foreign currency. A foreign sales journal, customers ledger, and cash receipts journal, together with foreign notes receivable and sales returns and allowances journals, where necessary, will comprise all books of original entry needed to secure sources for postings to the customers’ individual accounts in terms of foreign money. In this way all charges for goods sent, and credits for returns, allowances, cash and notes received and discounts allowed, can be kept entirely in foreign currency.

Method of Conversion of Results

Periodically—say, once a month—the total transactions for the month must be converted into home currency and brought into the general ledger. In normal times a fixed average rate of exchange based on past experience gives sufficiently accurate results, saves many tedious calculations and much unnecessary work. At certain times and in certain businesses the prevailing rate of exchange on the actual day, or the monthly average of daily rates, may need to be used to secure satisfactory results. With the use of the fixed average rate, as above, the totals of foreign sales and sales returns journals are converted into home currency and carried respectively as debits and credits to Accounts Receivable control, and credits and debits to Sales. The total of the discount column of the cash receipts journal is converted, at the average rate, and charged to Sales Discount and credited to Accounts Receivable control.

The conversion of the cash received must be handled differently, however. The actual rate at which the foreign draft or bill received in payment of the customer’s account is converted by sale to the banker—and so credited to the home office bank account—almost always differs from the average rate at which the item was charged to the customers’ controlling account. This, of course, makes no difference with his individual account which is kept in foreign currency, but does make necessary an adjustment of the general ledger Accounts Receivable control in order to make it agree with the foreign customers ledger when converted at the average rate.

Accordingly, in the general cash book two additional columns are provided, viz.: Profit on Exchange and Loss on Exchange columns, which are used somewhat as is the Sales Discount column. Every foreign draft or bill when received is entered, in foreign currency, in the foreign cash book and posted from there to the credit of the customer. When that draft or bill is sold at the bank (it may be held for some time after receipt for a favorable turn of the money market) and so converted into home currency, it is entered in the Accounts Receivable column at a figure representing conversion at the fixed average rate. The difference between this figure and the actual amount received at the bank is entered in either the Profit on Exchange or Loss on Exchange column as the case may be, with extension of the actual amount into the bank column as a charge to the bank account. Thus, the total of the Accounts Receivable column when posted to the general ledger Accounts Receivable control adjusts that account so that it controls the foreign customers ledger converted at the average rate. The totals of the Profit on Exchange and Loss on Exchange go as credits and debits respectively to the Profit and Loss on Exchange account.

The foreign sales agency often collects the accounts and remits total collections periodically by purchase of one bill or draft on its local bank for the total. There must, of course, accompany each such remittance a statement of the detailed receipts for proper credit to individual accounts. The general cash book will show only the total remittance, however. Regular agency accounts as explained in [Chapter XXX] will secure the control of the home office over the agency’s expenditures.

It is usually best to make the foreign customers ledger self-balancing. The Adjustment account necessary to effect this may, if desired, be kept in both foreign and home currency, thus showing on its face, by the balance of the home money columns, the agreement of the foreign ledger with its control account on the general ledger. If, instead of one fixed average rate of conversion, varying rates are used, the keeping of the Adjustment account in both currencies becomes imperative.

Where, in the case of foreign sales, the sales invoice and charge to the customer are made in home currency and payment of that amount in home currency is demanded, the problem of conversion, as explained above, is not encountered, foreign sales being recorded and handled in exactly the same way as home sales.

The Foreign Purchasing Agency

If the purchase is made in terms of foreign currency and settlement must be made in that currency, a procedure and system may be used exactly similar to that just explained for handling sales.

In both the sales and purchase record books, returns may be entered in the same record by using red ink, and deducting the red ink totals at the end of each page. This obviates the necessity of keeping subsidiary adjustment accounts in a separate book, and brings all information regarding the branch transactions in one compact record.

CHAPTER XXXII
SUSPENSE ACCOUNTS; NUMBERED ACCOUNTS;
ADJUSTMENT OF FIRE LOSSES