Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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of bonds by a sinking fund, as described fully in Chapter
XIV. Evidently the same difficulty arises in either case.
If the retirement of capital, not being a loss transaction
is yet charged against profits, there must be created a
corresponding credit, sometimes called Ketired Stock,



sometimes, more correctly, " Reserve created by the re-
tirement of capital out of profits." In any event when
the stock has been purchased for the purpose of reducing
the amount, it is misleading to carry the canceled stock
among the assets. The Capital Stock account should itself
be debited, for whatever argument there may be in favor
of carrying live Treasury Stock as an asset, there can be
none in favor of retaining stock which has actually been
canceled. Such stock is certainly nonexistent.

Where the stock is reduced not by purchase but by
surrender of part of their holdings on part of the stock-
holders, sometimes the case where the company has met
with losses and desires to remove the deficit from the Bal-
ance Sheet, the reduction of the capital acts to create a
corresponding Surplus. This may be used as a fund to
which the existing deficit, if such there be, is charged. To
illustrate : a company with the following :


FORM 55.
Balance Sheet.


Assets $140,000

Deficit 10,000


Capital Stock $150,000


arranges with the stockholders to surrender twenty per
cent, of their holdings to cover the deficit and provide a
surplus. After the reduction of the capital stock the books
would show:

FORM 56.
Balance Sheet.



Assets $140,000


Capital Stock $120,000

Surplus 20,000




II. Issued for Property, etc.

THE subscription to stock demands the payment of its
full par value, and there being ' ' in equity, no distinction
between a party who makes a formal subscription for
stock and fails to pay for it and one who accepts a full
paid certificate without paying for it," there is the gen-
eral assumption that all stock issued, with certain minor
exceptions noted in the preceding chapter, is to be paid
for in full value. "Where the payment is to be made in
cash the verification of this assumption is easy and sim-
ple. The real difficulty comes where stock is issued in
exchange for property. Here, too, the general assumption
is that full value is given. As has been clearly stated in
New Jersey, " the distinction between the contemplated
issue of corporate stock for property and its issue for
money lies not in the rule for valuation but in the fact
that different estimates may be formed of the value of
property." (Donald v. American Smelting and Refining
Company, 48 All. 772.) Such undoubtedly should be the
case from 'the accounting view point, as well as in law.
The accountant recognizes no difference between things of
the same value, for it is the money value of goods and of
capital in which he deals.

Unfortunately, in practice, very different principles
prevail. Not only is stock time and again issued for prop-
erty, which in the mind of every one concerned is worth
much less than par value of the stock with which it is



purchased, but the very terms of the sale give conclusive
evidence to the general public that there has been gross
overvaluation. The reason that this is so is that there
is lacking any satisfactory criterion as to the real value
of the property purchased with stock. Such purchases
are frequently large plants, as, for instance, the manu-
facturing establishments bought by any of the " trusts."
Including, as it may, land, buildings, machinery, raw ma-
terials, finished goods, mercantile credits, goodwill, per-
haps also mines and quarries, railroads and steamers, and
any other forms of assets, it is clearly impossible to form
an authoritative estimate of the value of the plant. For
such a complicated property there can, of course, be no
publicly quoted price, nor can any reliance be placed on
its cost to the vendor, for he may have acquired it either
at an exorbitant price, or at a bargain sale far below its
real value. The courts, therefore, are inclined to be lib-
eral, and to leave the determination of value in all such
cases to the discretion of the officers of the company. An
illustration of the extent to which this deference to the
directors' discretion may go is found in a decision of one
of the Federal courts to the effect that the purchase by
a corporation, for $200,000 bonds and $3,600,000 stock, of
a railroad bed, the construction of which cost $2,000 and
for which the vendor had paid $15,000, was not, on the
face, a fraudulent transaction. (Stewart v. St. Louis, etc.,
R. R. 41 Fed. Rep. 736 (1887).) ,

But the accounting point of view is not necessarily the
same as the legal. The fact that the court cannot deter-
mine the real value of the purchased property, has nothing
to say as to how the accountant, knowing the value, should
enter it in the books and exhibit it in the Balance Sheet.
Yet the accountant is greatly influenced by the attitude
of the courts on these matters, and it is necessary to con-
sider some of the rules which the courts have laid down.


"Where the purchased property is worth the par value
of the stock there is no difficulty whatever. The exchange
of stock for an equal value of any kind of property, is, to-
the accountant, no whit different in principle from the
purchase of merchandise by means of a promissory note.
Where, however, the property is worth less than the par
value of the stock with which it is purchased, the courts
have attempted to discriminate between cases where the
property is not even worth the supposed market value of
the stock, and those where it equals the market though
still below the par value. While the issue of stock at less-
than its market value has been condemned, the courts have
justified, especially in an emergency,, the issuing of stock
below par when it was shown to have been issued at ita
full market value. This is consistent with the decision
quoted above, that in emergency even stock issued for cash
may be placed at less than its face value. Evidently it is
much more difficult to interfere with the issue of stock for
property, with all the difficulties of appraising the prop~
erty, than when it is issued for cash, which makes any dis<
count manifest. It is furthermore argued by the courts,
that no one has been injured, and that, oftentimes, if par
were required, it would be impossible to issue the stock at
all, since no one would be willing to take it on that basis.

The latter argument, however, involves an economic
fallacy, for it assumes that the only way in which an em-
barrassed corporation can acquire, say, $10,000 worth of
property is by issuing stock of a greater par value. This
assumption is unfounded in logic or experience, save as
reliance is placed on the meager experience of American
corporations in recent years. To illustrate, there may be
taken the case of a corporation with $60,000 capital stock
and earning $3,000 yearly. Considering the nature of the
business this profit may be insufficient, and the stock may
sell below par. But the directors see that by acquiring:


certain additional property, worth only $30,000 the net
profits may be raised to $6,000. But the owner of the
property is unwilling to sell his property for $30,000 of
the stock of the company. Is there, therefore, no other
way to acquire the property than by increasing the amount
of the capital stock to be issued, making it $40,000 ? This
is the position taken by the courts. But the owner's un-
willingness to take $30;000 stock for his property, is due
to the fact that this would entitle him merely to a f in-
terest in the earnings of the company, and the prospect of
getting $2,000 is not sufficient to induce him to take the
risk. The reason why he would sell the property for
$40,000 stock is that such a deal would give him a right to
fo of the earnings, and a chance of receiving $2,400 is a
sufficient inducement to him. But it does not therefore
follow that the company need issue $40,000 stock for the
property worth only $30,000. Two other methods of se-
curing the end are open to the company. The stockhold-
ers might agree to contribute -^ of their holdings and to
give this $24.000 of stock in purchase of the property,
which should be a satisfactory inducement to the vendor,
as that would give him exactly the same relative rights as
though he had received a new issue of $40,000. Or if that
w r ere not possible, a simpler method is open of issuing new
Preferred Stock of $30,000 bearing cumulative dividends
of say, 8 per cent. This again would bring the same re-
turns to the holder as would $40,000 new Common Stock.
It might even be issued with a smaller preferred dividend,
possibly 7| per cent., as the greater security would allow
some reduction in the returns. Thus it is quite easy to
issue stock in such a form as to make a smaller amount
equally as attractive as an excessive amount of a less fa-
vored issue. Nor is this a method which is merely theo-
retically possible. It is currently followed in Germany
where the issue of stock in excessive amounts is rendered


difficult by legal prescriptions, but where corporations do
occasionally become embarrassed and need to obtain funds
on unfavorable terms. The provisions of Massachusetts
law looking toward the issue of ' ' special-preferred ' ' stock
are of similar purport.

But aside from the faulty economic assumption implied
in the legal doctrine here discussed, the accountant objects
seriously to the theory that to the corporation itself the
new stock can have a value below par. Stock perhaps
should not be said to have a " nominal " value, but to
have a par value, of $100. That is to say that the value
of the stock should be equal to 100 cents on the dollar.
The Balance Sheet should show the real condition, and
with certain technical forms understood, the statement
that a company has $100,000 Capital Stock should mean,
and mean only, that it has $100,000 net assets. To speak
of a corporation issuing stock at its market value, but at
less than par should be considered self-contradictory. The
expression " Capital Stock " means Proprietorship of the
amount stated, and to say that the receipt of less assets is
still payment in full is surely misleading.

Indeed this peculiar doctrine of distinguishing be-
tween the real value and the par value of newly issued
stock is criticised even from the legal point of view, as,
for instance, the ' ' Cyclopedia of Law and Procedure ' '
states that the Supreme Court of the United States, in
sanctioning the gratuitous issue of stock because it " was
without value " refused to " follow the decisions of the
highest courts in the states construing their own statutes,"
and that the opinion in Handley v. Stutz, already cited,
" is a departure from the general current of authority
as it stood at the time."

Fortunately there is evidence of a tendency toward
greater strictness both in legislation and in court decisions.
Especially in New Jersey, which has had a perhaps un-


merited reputation for looseness in corporation finance,
has there been a clear enunciation of the correct princi-
ples both in the pages of the statutes and in the interpre-
tation of the judges. A series of the decisions of the high-
est court of that state illustrates this. In Wetherbee v.
Baker it was said that " the courts have inflexibly en-
forced the rule that payment of stock subscriptions is good
as against creditors only where payment has been made
in money, or in what may fairly be considered as money's
worth " (35 N. J. Eq. 513 (1882) ). Ten years later it held
that : " to justify a corporation in issuing stock under our
act for property purchased there should be an approxima-
tion at least in true value of the thing purchased to the
amount of the stock which it is supposed it represents."
(Edgerton v. Electric Improvement, etc., Co., 50 N. J.
Eq. 361). Again, after nearly a decade, it was held in
Donald v. American Smelting and Refining Company, that
where the overissue is based on a false estimate on the part
of the directors, " their honest judgment, if reached with-
out due examination into the elements of value, or if based
in part upon an estimate of matters which really are not
property, or if plainly warped by self-interest may lead
to a violation of this statutory rule as surely as would
corrupt motive" (48 Atl. Rep. 772 (1901)). And in
See v. Heppenheimer it was stated that " although this
practice [issuing stock in excess] has been frequently in-
dulged in and has brought obloquy upon our state and
its legislation . . . such practice is entirely unwarranted
by anything either in our statutes or in the decisions of
our courts; and whenever it has been indulged in it has
involved a clear infringement of, if not a fraud upon the
plain letter and spirit of our legislation." In England,
too, there is the recent very interesting dictum of
Vaughan Williams L. J. "I hope that the day may come
when it will be gravely considered by the legislature


wnether it is not for the advantage of the community
that an act should be passed that in all cases the full
nominal value of the shares shall be paid in cash and noth-
ing else." (Moseley v. Koffyfontein Mines, Lim. [1904]
2 Ch. 117.)

To the accountant, however, the problem is simpler
than to the jurist. Two facts, one economic or financial,,
the other legal, he needs to know, and knowing these the
method of entering the transactions is already determined.
The first is, How much was actually paid for the stock?
If less than par that difference must appear in his ac-
counts. The equivalence of Goods to Proprietorship must
be maintained, and where there is an admitted divergence
between par and issue price, it can only be maintained
by the interposition of a correcting item. Thus if Prop-
erty received (P) is less than the Capital Stock (C) the
Balance Sheet may not properly show P = C. There must
be a formula P = C D which can be expressed with
equal truth in the form P -f- D = C. The legal fact, as to-
whether the unpaid difference is a sum which can 'be col-
lected, if need be, from the shareholders, is of less signifi-
cance to the accountant, and, indeed, may, with some show
of justification be left undecided by him. If collectible
it is an asset and may appear as such in the Balance Sheet.
If not an enforcible claim, and that is the turning point
in all the decisions cited in this chapter, it is in the nature
of a discount, and its treatment is equally clear. Possibly
the harassed accountant may be excused from attempting
to decide the legal question on which such varying opinions
exist, and may show the discount without seeming to de-
cide whether or not it is an asset, making an equivocal
statement which is excused by the difficulty of the prob-
lem. In a word, wherever the property received is not
fairly equivalent to the par of the stock the difference
should be clearly shown in the accounts, and most clearly



is this done by simply listing it as Discount on Stock.
This is identical with the method of treating the difference
between the nominal value of a note given by the propri-
etor and the cash received therefor which, somewhere in
the accounts, must be shown clearly as Discount.

To those at all familiar with corporation accounts it is
clear that unfortunately the discount allowed on stock is
seldom shown. This is generally because of unwillingness
to show clearly the exact nature of a transaction which
is of doubtful legitimacy. While the transaction itself
is not altered by the method in which it is treated in the
accounts, its legal status may be greatly improved by with-
holding from the accounts any evidence that the discount
has been allowed. It is so difficult to determine accurately
the value of any piece of property, that the courts hesitate
to pass upon its equivalence to the stock issued therefor.
If the accounts make a showing that full value has been
received for the stock, the court may not attempt to dis-
prove the statement. But the circumstance that a mislead-
ing statement hoodwinks the court, and thus allows the
transaction to stand free from legal interference, by no
means indicates that the failure to show discount on stock
issued for less than its full face value is in accord with
the correct principles of accounting.

In actual practice two subterfuges are resorted to. As-
suming again a corporation acquiring a plant worth, all
things included, $50,000 and issuing therefor ..$100,000
stock, instead of showing:


FORM 57.
Balance Sheet.


Plant $50,000

Discount on Stock 50,000


Capital Stock $100,000



the first method of concealing this status presents the fol-
lowing statement:

FORM 58.
Dr. Balance Sheet. Cr.

Plant $100,000

Capital Stock $100,000

It is true that some writers on accounting justify such
an entry. For instance, Keister, whose " Corporation
Accounting " enjoys no little vogue, says in discussing a
similar transaction : ' ' There is no objection to the above
entry. The machinery cost $30,000, but it is entered up at
its nominal value of $60,000. It is not a speculative re-
source, therefore it matters not what value is placed upon
it" (page 71).

To such a statement little direct argument can be made.
Granting that the valuation of the fixed plant does not
affect the Profit and Loss account and so has no immediate
effect on dividends, certainly the creditor, the outside pub-
lic, and even to no small extent the stockholders are in-
terested in knowing the exact state of affairs.

The other subterfuge resorted to, and one which the
same author says is proper, is to include a purely fictitious
asset to make up the difference between the value of the
plant and the amount of stock. Here the plant is correctly
listed at $50,000, but there appears a new asset, ex nihilo
fit, frequently called " Goodwill " or in Keister 's ter-
minology " Franchise."

As has been already shown there is no objection to in-
cluding Goodwill or Franchise in the assets if such has
been purchased. The discussion is here limited to the con-
sideration of a case where the entire property, with all its
rights and appurtenances, is confessedly worth only $50,-
000, and where the addition of the item Goodwill is clearly


a subterfuge. The insertion of a nonexistent Goodwill,
which was the method used by the promoters of the Co-
lumbia Straw Paper Company, as well as the exaggeration
of 'the value of existing assets the method pursued, for
instance, by the United States Shipbuilding Company is
entirely opposed to the fundamental principle of truthful-
ness in accounting.

An illustration will emphasize this obvious statement.
Had the stock been issued to subscribers who contributed
$50,000 gold, no one would for a moment justify a Balance
Sheet which either multiplied the amount of gold received
by two, or calmly added to its list of assets an utterly
imaginary $50,000 in silver, in order to make the assets
equal the nominal capital. But the " rule for the valua-
tion of property is not different' from that of money, ' ' and
there is no reason for a different standard of integrity
where stock is issued in one way from that required in

It is not argued here that equal exactness can be
secured in the two cases. All that is discussed is the book-
ing where the deficiency in value is recognized by those
preparing the accounts. No plea is made for a fanciful
or impossibly high degree of accuracy. It is only argued
that conscious misstatement, which exists all too often in
corporation finance, which, indeed, has been characteristic
of American higher finance, is an outrage to the principles
of accounting.

Justice to the reader, however, requires the statement
that the standard here urged is not in accord with current
custom, and is subject to one line of reasonable criticism.
"While it cannot be denied that the listing of an asset at
an overvaluation is technically " untruthful " it may be
claimed, with a good show of reason, that it is not neces-
sarily misleading. It may even be urged that " truthful-
ness " can never be obtained by any system of valuation



of such a property as a manufacturing plant, and that any
attempt to make a valuation is more likely to be mislead-
ing than is the bare statement that it cost, not so much
money, but so much Capital Stock. This leaves the cred-
itor or investor to guide himself, so that, if he goes astray,
it is due to his own wandering and not to his being misled.
There is much force in this argument which, indeed, is not
altogether contradictory to what has been stated in these
pages. Such a scheme of valuation is even approved by
Mr. A. Lowes Dickinson 1 to oppose whose opinion on ac-
counting matters, the layman must, indeed, be daring. On
this principle all property purchased by stock is listed at
the par value of that stock, but with an explanatory state-
ment, clearly shown in the Balance Sheet, that the assets
thus listed were obtained, not for cash but in exchange
for stock. This principle is furthermore embodied in the
present Massachusetts Business Corporation Act and in
the English Companies Acts.

But despite the high authority opposed to the views
set forth in this treatise, the claim is still made that to
reject the standard of attempted accuracy is a confession
of impotence, which, while it exhibits a commendable
modesty on the part of professional accountants, seems,
to the layman, to do -scant justice to the ability of that

It is interesting to see how this problem in accounting
bears on the much discussed question of stock watering.
The view generally expressed is that " stock watering "
a term vague and as yet ill-defined is in itself a fraud
upon investors and a crime against the public. From the
view point of accounting the misdeed is more definitely

1 " If stocks or bonds are issued for the purchase of any definite
property, it may be presumed that the property is worth the par value
thereof." Proceedings of the International Congress of Public Ac-
countants. 1904, p. 185.


located. The amount of stock issued is relatively unim-
portant. Such a transaction, as Vice-Chancellor Pitney
has said: " Does not at all or in any manner increase its
intrinsic or practical value or in the least degree promote
the real prosperity of the enterprise. ... Its rental value
will be practically the same. . . . The division of profits
. . . among the stockholders will be on the same basis,
and the amount received by each stockholder will be the
same . . . and the market values will finally settle down
to the gauge of the dividends earned and declared." (61
Atl. 850.) The issue of excessive stock may be bad busi-
ness policy, indeed T. L. Greene takes the ground that
in the future it will come to be recognized as such, but the
watering of the stock, in itself, aside from accompanying
complications is the merest peccadillo. The wrong con-
sists in the " prevarication," the positive misstatement,
that among the assets is a plant worth $100,000 when
everyone concerned in the transactions knows it is worth
only $50,000, or the untruth that the company has ac-
quired Goodwill worth $50,000 when it is absolutely inno-
cent of any such possession. If the other accounts in the
Balance Sheet are correct little concern need be felt over
stock watering. Its evil will be slight, its correction auto-
matic. The onus of stock watering is that it leads to a
misstatement of the value of assets and the rigid insistence
on absolute integrity in accounts, .both prevents and cures
any harm from large issues of stock. It must not then
be granted for a moment that it " makes no difference "
at what figure a given asset, speculative or otherwise is
listed. It makes all the difference in the world, the dif-
ference between truth and falsehood.

The principles of accounting throw light also on the
question of stock dividends. Assuming the following:




FORM 59.

Balance Sheet.


Plant, etc $85,000

Merchandise 12,000

Treasury Stock 10,000

Cash 8,000 '


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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 13 of 27)