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.