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.