Sinking Fund Reserve.—It is often the policy of a corporation, which has to provide for the redemption of a bond issue, to reserve from the yearly profits a sum equal to the periodic payment into the sinking fund and the accumulations of the fund during that period. Such a policy prevents the distribution by dividends of all the current profits to stockholders, and insures that the increase in the assets represented by these profits will be held in the business and so provide each period an increased amount of assets for use in the business and ultimately, by conversion of the assets into cash, for the use of the sinking fund. The entries crediting the sinking fund reserve and showing its disposition at the maturity of the bonds are as follows:
| (a) Surplus (or Profit and Loss) | 1,000.00 | ||
| Sinking Fund Reserve | 1,000.00 | ||
| (b) Sinking Fund Reserve | 100,000.00 | ||
| Capital Surplus (or Surplus) | 100,000.00 | ||
The first entry shows the periodic reservation of profits. The second entry transfers the total profits so reserved during the life of the bonds, back to surplus—capital surplus if it is desired that these profits be made a part of the permanent capital of the corporation, or to general surplus in the event that these profits are to be made available for future dividends.
Closing the Books of the Corporation.—The results of the period’s operations are summarized and the books closed in very much the same way as with the partnership. From what has been said above, it will be understood that there are some types of transactions to be considered at the time of closing the corporation’s books that are not found in the partnership and single proprietorship. These concern largely the bond interest, the sinking fund reserve, and the dividend transactions. Bond interest is an expense. The sinking fund reserve is a reserve of net profits. Two methods are employed in showing the appropriation of net profits. Under the one method the total net profit is transferred to Surplus account, which then shows not only the profit for the current year but also the undistributed balance of previous years. The current appropriations of profits for whatever purpose are then booked as a charge against Surplus. Under the other method the current appropriations of profits are shown as charges against the net balance in the Profit and Loss account. Any unappropriated profit remaining is then transferred to the Surplus account.
Dividends.—A business is being operated always for the benefit of its owners, to whom the profits belong. In the case of a corporation, before the owners may secure any of the profits, a formal declaration of dividends must be made by the board of directors. During the term of its election the board is supreme in its management of the business. It is intimately in touch with the condition of the business. It knows the needs of the corporation and its obligations and must provide for them. If, after considering all the circumstances, it decides that some or all of the profits should be divided among the shareholders rather than be retained in the business for purposes of expansion, it meets in regular session and passes a formal dividend resolution.
Ultimate Control of Stockholders.—Thus it is seen that the board of directors is supreme during the period of its incumbency. Its actions are, however, subject to the review of the stockholders at their periodic meetings, which are usually held annually. If their policies are not favored by the shareholders, a new board, presumably one which will carry out the will of the majority of stockholders, is elected.
Dividends Out of Profits Only.—It is forbidden by law to pay dividends out of the capital of the corporation. Such payments would encroach upon the net assets of the organization and thereby weaken the creditors’ security for the payment of their claims. Dividends need not be paid out of the profits of the current year, provided the undistributed profits of former periods are still available.
Distribution of Profits.—The appropriation of profits in a corporation differs, therefore, from that in a partnership. The entries recording the appropriation of profits cover in the main two kinds: (1) reserves, and (2) dividends. These entries are not necessarily the same for all corporations nor for all periods. No set disposition of profits is prescribed, authority resting with the directors. Their decision, therefore, as recorded in the minutes of their meetings is the basis for this group of entries. Some of the usual entries are illustrated in the following paragraphs.
Reserves and Dividends.—As stated above, the two methods for handling the appropriation of profits are: (1) as a charge against Surplus after the net profit for the current period has been transferred to that account; and (2) as a charge against the current Profit and Loss credit balance and a transfer of the remaining balance, if any, to the Surplus account.
A part of the profits may be retained in the business to provide funds for certain future needs, as for the payment of fixed debts, the extension of fixed plant, etc. Such items are transferred to the credit of properly named reserve accounts. Profits for distribution as dividends are similarly transferred to a Dividends Payable account. The dividend is always based on the amount of outstanding stock, not on the unissued or treasury stock. It is reckoned either as a percentage of the par value of each share, as a 6% dividend, or as a stated amount on each share, as a dividend of $4 or 10 cents per share.