Any extraordinary profits or losses not due to the ordinary operations of the business should be eliminated when computing profits. Interest on borrowed money should not be included. The charges to operating expense on account of repairs should be adequate, and care must be taken to see that charges to the repair accounts do not show a sudden falling off toward the close of the period under review. The reserve for depreciation should be credited with the proper amounts. Sales, effected for a subsequent period, are not to be considered in the accounts of the current period as this would tend to inflate the profits. Shipments made to branch offices or on consignment account should not be regarded as sales. Ample provisions should be made for all liabilities for expenditures incurred during the period under review and outstanding at the close thereof. The inventories should be checked over carefully and certified by the parties taking them. Allowance for old or obsolete material should be made.
Good-Will
The determination of the value of good-will is generally a delicate proposition unless the parties to the consolidation or merger first agree as to the basis on which it is to be computed. This is generally anything that the interested parties choose to make it.
The two methods commonly used for estimating the value of good-will have already been discussed in Chapter XVIII.
Capitalization of a Consolidation or a Merger
The capitalization of a corporation, in a legal sense, is the sum total of the par value of the authorized capital stock. From an investment or economic point of view it is the sum total of all the stock and bonds issued or outstanding.
There are three different bases of capitalization: (1) cost of property plus accumulated surplus value; (2) cost of reproducing the property; and (3) earning power. According to legal theory the investment or the cost plus surplus is the proper basis. This idea has been fostered by the fact that shares have been assigned a definite face value. While at the beginning of a new enterprise investment value and capitalization may closely correspond generally, they soon diverge widely—due to smaller or greater earnings than were estimated or to depreciation or accretion in the value of the assets. When the potential earning power of the business begins to be realized, conditions begin to change and the value of the tangible and intangible assets fluctuates. The basis of capitalization changes with these fluctuations and the laws regulating it are in practice only complied with nominally. The custom is to adjust the value of the assets to harmonize with the capitalization rather than vice versa. Such a policy is to be deprecated.
The cost of reproducing the property as a basis of capitalization is as yet only seriously considered in theory. It is very doubtful if the method will ever be used in actual practice.
Earnings, past or potential, perhaps form the basis for capitalization most frequently used. Investment value closely corresponds to the rate earned and the degree of permanency of the earning power. To secure an income is the motive of all investment. In practically all consolidations and mergers the estimated increase in earnings due to the application of better methods of operation plays an important part not only in the promotion and formation of the new company, but also in deciding upon the capitalization. While the plant value and the past earnings of each of the companies may be considered in allotting them their respective interests, these are not a safe guide as to future earnings. In the case of partnerships especially and often in the case of corporations, there is a loss of valuable good-will. It is generally held that the benefits of consolidation greatly overbalance these disadvantages. The savings due to the elimination of duplicate work in factory and office, the cutting down of the item of rent, the saving in the cost of selling, the greater effectiveness of advertising, etc.—all are reasons held out as warranting this or that capitalization.
Payment of Amalgamated Interests