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 impairment | 250,000.00 | |
| Net Capital available for the business | $750,000.00 |
Profit on Work in Progress
A second problem to be solved in the determination of profits is concerned with the allowance or non-allowance of profit on work in progress but not completed. Most manufacturing and contracting concerns have at all times a more or less constant volume of work in various stages of completion. At the close of the fiscal period when results are summarized, the proper treatment of this uncompleted work is an important matter. The general principles governing the valuation of this work were discussed in [Chapter XIII] where it was pointed out that in the main conservative business policy demands that work in progress be included in the inventory at full cost, which is to include both prime cost and an equitable share of burden accrued to date. Manifestly this principle precludes the taking of any profit, the theory being that there is no profit until goods are sold. A full discussion of the subject requires separate consideration of work which is being done on order or contract and work for the concern’s own stock-in-trade, due weight being given always as to whether the unit of work is large or small.
Goods Made for Stock but not Sold
The general principle mentioned above must usually be applied to the valuation of the concern’s own stock-in-trade in process of manufacture. Here sales are being made constantly from finished stock and manufacture replenishes the stock. But the essential step before profits can be claimed, viz., making the sale, usually comes after the process of manufacture and not before. It may sometimes happen that stock is sold out ahead of its manufacture, because the factory is not able to keep up with sales. It is not intended here to include the case in which it is the custom of the trade to sell goods in advance of their manufacture and regulate the operation of the factory to turning out the advance orders booked. This will be considered later. The discussion here concerns those firms which usually keep their finished stock well ahead of sales but because of the exigencies of the market find themselves behind their sales. Such a situation is sometimes called a sellers’ market. If purchasers contract for goods with full knowledge of factory conditions, such sales are in the nature of work on contract and might in unusual instances be so treated. Usually, however, conservative management requires that no profits be taken under such circumstances.