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i.e., single proprietorship, partnership, or corporation; (2) the appropriation of profits, whether they are to be withdrawn or reinvested in the business; and (3) the nature of the loss, as to whether fixed or current assets were affected.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