Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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Capital Stock $100,000

Undivided profits 15,000



$115,000



the company has accumulated profits of $15,000 and is in
position to pay a five per cent, dividend. If this is paid in
cash the balance sheet becomes:



Dr.



FORM 60.

Balance Sheet.



Cr.



Plant, etc $85,000

Merchandise 12,000

Treasury Stock 10,000

Cash 3,500

$110,500



Capital Stock $100,000

Undivided profits 10,500



$110,500



If the directors, however, think it unwise to distribute so
much of the cash on hand, they may declare a dividend
payable, not in cash, but in stock, as indeed they might
declare one payable in merchandise. If a stock dividend
is declared and paid there results the following :



Dr.



FORM 61.

Balance Sheet.



Cr.



Plant, etc $85,000

Merchandise 12,000

Treasury Stock 5,500

Cash 8,000

$110,500



Capital Stock $100,000

Undivided profits 10,500



$110,500



174



MODEKN ACCOUNTING



Not at all different in principle is it where there is no
stock in the treasury, for if the condition had been :



Dr.



FORM 62.

Balance Sheet.



Cr.



Plant, etc $85,000

Merchandise 12,000

Cash 18,000

$115,000



Capital Stock $100,000

Undivided profits 15,000



$115,000



new stock could have been issued (provided the company
had power to increase its capital stock) with which to pay
the dividend. In the latter case the final Balance Sheet
would show:



Dr.



FORM 63.
Balance Sheet.



Cr.



Plant, etc $85,000

Merchandise 12,000

Cash 18,000

$115,000



Capital Stock $105,000

Undivided profits 10,000



$115,000



The only difference in the two cases is that in one stock
already held in the treasury is decreased, in the other
Capital Stock outstanding is increased.

However objectionable such a transaction may be con-
sidered in its effect on the public, or however much it may
be prohibited by particular statutes of individual states,
it is, to the accountant a perfectly simple and, indeed,
from his view point a perfectly legitimate transaction.
New stock is indeed issued without the receipt of addi-
tional wealth, but the wealth has previously been received
by the corporation, as is shown by the credit to Undi-
vided Profits. The cancelation of $5,000 undivided profits



CAPITAL STOCK 175

against $5,000 stock is a full payment therefor, so far as
accounting is concerned.

This is clearly brought out in "Williams v. Western
Union Telegraph Company, where the point at issue was
whether a stock dividend was legitimate when the com-
pany had a large accumulated surplus. The court said:

" We know of no law that is violated and no public
policy that is invaded by issuing to the stockholders stock
to represent that amount of property rather than in any
mode to divide it up and distribute it among them. If it
can issue stock in payment of property to be obtained by
it as part of its capital for its legitimate uses, why may it
not issue stock in payment for property in effect pur-
chased of them and added to its permanent capital and
which they relinquish the right to have divided? So long
as every dollar of stock issued by a corporation is repre-
sented by a dollar of property, no harm can result to in-
dividuals or the public from distributing the stock to the
stockholders." (93 N. Y. 190.)

The difficulty which the accountant cannot overcome
is when he is asked to book a stock dividend where no
profits have been earned, a transaction which unfortu-
nately sometimes occurs. Had the Balance Sheet given
above showed no Undivided Profits, the payment of a divi-
dend of any sort, whether in stock, or cash, would be
equally objectionable, for a dividend implies profits to be
divided. Were either cash or stock to be distributed as a
dividend, in the absence of accumulated profits, a correct
accounting would require the showing of a deficit due to
the payment of the dividend. But this, showing at once
the illegality of the dividend, is not satisfactory to the
directors guilty of such action. The only way to hide the
unlawful act is to introduce into the accounts some fic-
titious asset, creating thereby a correspondingly unreal
profit, which, once created, can in turn be canceled against



176



MODERN ACCOUNTING



either cash or stock paid out in dividends. It is to be
noted, however, that the jsvrong accounting here consists in
the preliminary creation of fictitious profits, by falsely
marking up the value of the assets, and not in the stock
dividend as such. A dividend, whether in cash, merchan-
dise, real estate, or stock is, in the absence of statutory
prohibition, legitimate whenever real profits exist, and
only when they so exist. But such profits failing, a cash
dividend is just as objectionable as one in stock ; in fact it
is more so, as the paying out of cash may damage existing
creditors, the issuing of stock cannot.

A transaction, unusual in character but not infre-
quently occurring, is where some of the outstanding stock
is donated to the company by its original holders. The
stock thus received is ordinarily sold for the purpose of
raising cash for the use of the company, the selling price
generally being below par, as the stock, having previously
been issued as full paid stock, carries with it no liability
to subsequent purchasers at a lower price.

Thus, to cite as illustration an actual case, a company
gave its entire capital stock, $300,000 in purchase of prop-
erty, the vendors agreeing to donate $40,000 of the stock
to the company. Assuming that the property purchased
was actually worth $300,000 in this particular case a
false supposition the accounts should show:



Dr.



FORM 64.
Balance Sheet.



Cr.



Property $300,000

Treasury Stock 40,000



$340,000



Capital Stock $300,000

Surplus from donated

stock 40,000

$340,000



The company was then in a position to sell its stock at the
market price and thus raise money for working capital.



CAPITAL STOCK 177

If sold at less than par the discount could be charged
against the surplus, the balance of which should show the
actual amount received when the stock is all sold.

The donation of wealth is so unusual a business trans-
action that by some critics it is always considered tainted.
But it is at least conceivable that it may be perfectly legit-
imate. Granting that the property is really worth $300,-
000, it may nevertheless be difficult to persuade outside
capitalists of that fact, and the organizers of the corpora-
tion have no ready money with which to exploit the prop-
erty. In order to secure the success of the enterprise the
vendors, confident of the ultimate success, may be willing
to make the sacrifice in order to get it started, just as an
inventor may sell a half interest in a patent at a price
which he is perfectly confident is far below the capitalized
value of the anticipated earnings.

While it is possible then to conceive of such a trans-
action as being just what it pretends to be, it is perhaps
not extravagant to claim with Schuster that " generous
benefactors, who give away their savings to trading com-
panies are freaks of nature who need not trouble che
legislator's [or the accountant's] mind." In many cases,
probably in the great majority of cases, the transaction
thus described is the barest subterfuge to enable the com-
pany to sell its stock below par free from liability. In the
case cited the vendors were really selling their property
for $260,000 in stock, and the company was placing $40,-
000 of its stock on the market to raise working capital.
But to have sold such stock below par would have involved
obligation on the part of the purchaser to make up the
difference, and so there was a resort to a subterfuge both
stupid and palpable. Here again the error from the ac-
counting view goes back to the first entry, namely, the
statement that the property acquired was worth $300,000,
when in fact it was clearly worth not over $260,000. Like



178



MODERN ACCOUNTING



all other cases of overissue of stock the culpable element,
at least from the accountant's view point, is in the mis-
statement of facts regarding the valuation of the assets
acquired. That being correctly given no real problem can
arise. For if the Balance Sheet had correctly shown the
status as follows:



Dr.



FORM 65.
Balance Sheet.



Cr.



Property $260,000

Discount on Stock 40,000

$300,000



Capital Stock $300,000



$300,000



even though the discount were treated as something which
could not be collected, there need be no misleading of the
public and the donation of the stock could not hide the
fact of the discount on the later sale.

By some rigid accountants, among whom are Seymour
Walton and most German writers, the donation of part of
the stock by vendors is to be construed inevitably as a de-
duction to be made from the nominal purchase price of
the property. But no such severe standard has been set
by the. courts. It is true that in an earlier New York
case it was held that such a contribution was at least cor-
roborative evidence of overvaluation (Douglass v. Ireland,
73, N. Y. 100. (1898) ). But the more recent English case
of Innes & Company ([1903] 2 Ch. 254) takes a differ-
ent view; and the Colorado case of Speer v, Bordeleau
(79 Pac. 332. (1905)) distinctly states that such a transac-
tion is not evidence of issue below par. But whether the
presumption is in favor of valuing the property at the
amount of stock originally given the vendors, or at the net
amount retained by them, if it is established that the for-
mer figure wculd be an actual overvaluation, there is no



CAPITAL STOCK 179

excuse for such an incorrect representation in the accounts.
The accountant should transcend the limitations under
which the courts labor.

The donation of stock has a further purpose, one which
might be otherwise obtained, of providing a fund which
can be used in covering the organization expenses, or those
which may be incurred during the early years of the cor-
poration. The securing of such a fund is a perfectly legit-
imate, indeed a praiseworthy, procedure. The contribu-
tion of stock is no more unreasonable, and has exactly the
same effect as the sale of the stock at a premium for the
same purpose of providing a fund for initial expenses. As
these are incurred they can be charged against the Sur-
plus, w r hich thus gradually disappears. The process is
identical w r hether the Surplus is raised by the contribution
of stock, or by the practical contribution of cash under the
name of premium on stock.

Some question may be raised as to the nomenclature
used in the transaction just discussed. In the Balance
Sheet in Form 64 a descriptive title " Surplus from do-
nated stock " is used, and that is incontrovertibly correct,
although it may well be that a less cumbrous term would
serve in its place. Some writers have employed the term
" Working Capital " for the credit item. This innova-
tion is of doubtful propriety, for " Working Capital " has
long had a specific meaning as a collective term for what
are often called ' ' quick assets, ' ' e. g., cash, accounts re-
ceivable, perhaps merchandise, etc. The new use of the
term has some vogue in America, but it is not found in
England, nor does it conform to the use of the term in
legal definitions, nor even to the more established and bet-
ter recognized accounting practice in this country.

The most important stock transactions, of recent years
have been those of the so-called trusts, where the stock
of the new company is issued largely to acquire the busi-
19



180



MODERN ACCOUNTING



ness and plants of established competing firms or corpora-
tions. There are two forms in which this may be done,
omitting the case where the stock is issued to purchasers
for cash and the subsidiary plants purchased with the
funds thus received. The stock of the consolidating com-
pany may either be given to the stockholders of the old
company as individuals, in exchange for their holdings;
or the new stock may be used to purchase the plants, good-
will, etc., from the subordinate companies. In extreme
and simple form this may be illustrated by the case of
Corporation A organized with $1,500,000 capital stock
which is used to make a combination of Corporations B
and C, whose Balance Sheets are respectively:



Dr.



FORM 66.
Balance Sheet of B.



Cr.



Plant and other assets.. . $600,000



$600,000



Capital Stock $300,000

Surplus 300,000

$600,000



Dr.



FORM 67.
Balance Sheet of C.



Cr.



Plant and other assets. . . $300,000



Capital Stock $300,000



The agreement made is that three shares of stock of Cor-
poration A shall be given in exchange for each share of
stock in B, that $400,000 stock shall be given for the
plant, goodwill and other assets of C, and that the re-
maining stock of A is to be issued to subscribers for cash
at par.

Assuming that the bargain is an equitable one all



CAPITAL STOCK



181



around, the Balance Sheets of the three corporations, after
the transactions, will be :



Dr.



FORM 68.
Balance Sheet of A.



Cr.



Stock of Corporation B

3,000 shares at $300. . . $900,000

Plant, etc 300,000

Goodwill at cost 100,000

Cash.: 200,000

$1,500,000



Capital Stock $1,500,000



Dr.



FORM 69.
Balance Sheet of B.



$1,500,000



Cr



Plant and other assets. . . $600,000



$600,000



Capital Stock $300,000

Surplus 300,000

$600,000



Dr.



FORM 70.
Balance Sheet of C.



Cr.



Stock of Company A

4,000 shares at $100.. . $400,000

$400,000



Capital Stock $300,000

Surplus 100,000

$400,000



The Balance Sheet of B is of course unchanged as the
transaction was between A and the individual stockholders.
The Balance Sheet of C shows stock of A held as its only
asset. Reniembering the assumption made above that the
consolidation is equitable, which implies that full par value
is given and received, C must show a Surplus (Profit) of
$100,000. A shows the stock of B bought of the share-
holders, but not the assets of B which still belong to that
corporation, the only change being a shifting in the per-



182 MODERN ACCOUNTING

sonnel of the stockholders. But it shows not only the
former assets of C, but also the Goodwill which it bought
from C, which was not included in the assets of C, but
which is legitimately included in those of A.

It is furthermore clear that the stock of A might have
been issued at a premium, and that any possible varia-
tions in terms and prices could occur without affecting
the principles elucidated in this most simple illustration.
As to the legality of the combination under statute law
the present discussion is not concerned, but providing a
consolidation takes place in the manner specified, the ac-
counting should be as above.

It may be that the holding corporation prefers to show
in its Balance Sheet not the stock of B but the detailed
assets, a plan in part adopted by the United States Steel
Corporation. While such a showing is desirable for cer-
tain purposes, formally and legally A does not own the
assets of B so long as B retains its legal corporate exist-
ence. If the merger works a dissolution of B the case is
otherwise.



BIBLIOGRAPHICAL NOTE TO CHAPTERS VIII AND IX.

On the technical bookkeeping entries to be made :
BENTLEY, H. C. Corporation Finance and Accounting. Chapter

VII. New York, 1908.
CAHNES, A. J. Manual on Opening and Closing the Books of Joint

Stock Companies. Third edition. Baltimore, 1891.
KEISTER, D. A. Corporation Accounting and Auditing. Eleventh

edition. Cleveland, 1905.
RAHILL, J. J. Corporation Accounting and Corporation Law.

Fresno, 1906.

For a more serious discussion of the principles involved see :
CHARPENTIER, J. Etude juridique sur le bilan dans les socie"te*s
par actions, pp. 42-81. Paris, 1906.



CAPITAL STOCK 183

REHM, H. Die Bilanzen, p. 342-477. Munich, 1903.
SIMON, H. V. Die Bilanzen der Aktiengesellschaften, p. 201-227.
3 Aufl. Berlin, 1899.

For a discussion of the laws relating to issue of capital stock :

CLARK, W. L. and MARSHALL, W. L. A Treatise on the Law of
Private Corporations, 389-401. St. Paul, 1901.

COOK, W. W. A Treatise on the Law of Corporations having a
Capital Stock. Chapter II. Methods of Issuing Stock. Chap-
ter III. Watered Stock. Fifth edition. Chicago, 1903.

HUFFCUT, E. W. Selling New Shares at Less than Par. American
Law Review, XXVI, p. 861. [Discusses Handley v. Stutz
and Ooregum Co. v. Roper.]

PALMER, F. B. Company Law. Fourth edition. London, 1902.



CHAPTER X

LIABILITIES

As was shown in Chapter III the credit side of the
Balance Sheet is frequently headed " Capital and Liabili-
ties." This is a comprehensive title, for in the approved
form of the Balance Sheet the mere valuation accounts
such as Depreciation Account being subtracted from
the nominal assets there remains on the credit side only
Capital including all unrepresented capital, such as
Surplus, Reserves, and Undivided Profits and the out-
side liabilities of the concern. In a limited sense, it is
true, liabilities are also a subtrahend from the assets,
for a debt, as shown in Chapter I, is really a negative
asset. But to show only the net excess of assets over lia-
bilities, or of some one asset over the particular liability
which it secures (as, for instance, to show only the equity
in a piece of real estate, instead of showing both the value
of the property and the mortgage on it) is universally rec-
ognized as incorrect and misleading. Ah exception is
found in the Double-Account Balance Sheets used by cer>
tain English companies. There, in the Balance Sheet
proper is shown only the excess of assets over the sum of
capital and funded debt. But this exception is formal
rather than real, for the accompanying Capital Account
clearly exhibits the full status. The same principle is
applied occasionally in American accounting, as, for in-
stance, in a modified form, in the Balance Sheet of the
Atchison, Topeka, and Santa Fe Railway Company.
Somewhat similarly the Illinois Central shows in the Bal-

1&4



LIABILITIES



185



*nce Sheet only the excess of the current assets over the
current liabilities. But there is a reference given to a de-
tailed exhibit on another page where the full information
is to be found.

Rehm goes further and suggests that the proper form
of a Balance Sheet, from the economic view point, is one
in which negative items are shown as subtractions, prac-
tically as follows:



Assets.



FORM 71.

Balance Sheet.



Liabilities.



Plant, etc $610,000

Other assets.. 50,000



$660,000
Less Debts 40,000



$620,000



Capital Liabilities:

Capital Stock $600,000

Reserve Funds 10,000

610,000
Profits:

Excess of in-
come $12,000

Depreciation. . 2,000



10,000
$620,000



While from a theoretical point of view debts are nega^
tive assets, and differ radically from capital, it is well-nigh
universal to list both capital and liabilities on the same
side of the Balance Sheet, and no criticism is ordinarily
made of this practice. All that is necessary is clearly to
differentiate the two, and to be sure that there is no un-
derstatement of the amount of liabilities.

The accounting problems having to do with liabilities
are extremely simple as' compared with those relating to
assets. This is principally due to the fact that the ques-
tion of valuation, so perplexing in regard to assets, prac
tically disappears when liabilities are concerned. One
may suffer, indeed one must expect, some diminishment
in the value of assets but debts, so long as the principle



186 MODERN ACCOUNTING

of the going concern is recognized, must be shown at their
full amount. The only problems which arise in the book-
ing of liabilities are those which group around the clas-
sification of liabilities, the calculation of interest, the
treatment of unissued, repurchased, and canceled debts,
and a few questions in which there may arise a doubt
whether there is an existing liability or not. These will
be considered in order.

The clearness and consequent value or the Balance
Sheet is increased if some classification is made of the
various kinds of debt. Thus a showing of the funded or
long time debt separate from the short time or floating
debt is of great importance, indicating, as it does, the im-
mediate financial strength of the concern, and whether or
not it is likely to suffer loss because subject to a sudden
demand from its creditors. The distinction between debts
for which notes or acceptances have been given and open
book accounts is also important. The extent to which such
classification is to be carried, as in the corresponding clas-
sification of assets, is a matter of discretion, governed by
individual circumstances. The statements rendered by the
National Banks to the Comptroller five times yearly con-
tain seven different subdivisions of liabilities to depositors.
One of these same banks will give, in the condensed Bal-
ance Sheet published for advertising purposes, only the
single item Deposits. Both of these statements are correct ;
each, for its purpose, is full as well as fair. But what-
ever subdivisions are made, the classification adopted must
be strictly observed. It may be perfectly correct to include*
all liabilities to depositors under the one head ' ' Due to de-
positors. ' ' But where a subdivision is made it is incorrect
and fraudulent to list under the title "Accounts payable "
items which really are " Bills payable " or to include
either of these items under the title " Funded Debt."

The questions which relate to the calculation of inter-



LIABILITIES 187

est on debts are the most interesting which arise in regard
to the accounting of liabilities. As a matter of conven-
ience debts, whether receivable or payable, are ordinarily
listed in books at their face value rather than at their
real value. Where the note is discounted, it follows that
there must be a counter entry to a Discount account.
"Where the note, or other obligation is not discounted, but
bears interest from date, the adjustment is not made until
some later date. When a formal Balance Sheet is pre-
pared it is accordingly necessary, in order to make a cor-
rect showing of the liabilities of the concern, to make an
exact reckoning of interest on outstanding liabilities. This
is exhibited in the Balance Sheet, either as a liability
" Interest accrued," which for convenience may be added
to the face of the debt, or, in case the note was discounted
in advance, as a deferred asset, perhaps under the title
" Discount paid in advance."

Such an estimate is very simply made in case of short
time obligations. When bonds are emitted the calculation
is more complicated, and the treatment in the accounts is
not uniform. The estimation of simple interest accrued
on the bonds since the time the last interest payment was
made is of course identical with the calculation of interest
on a short note, and no divergence of practice occurs :u
that regard. The main point of difficulty is in regard to
the premium or discount allowed on the bonds at the time
of issue. As shown in discussing investments, the pre-
mium paid on a bond is virtually the price paid for the
privilege of receiving nominal interest at a rate higher
than the market rate. Viewing the transaction from the
borrower's point of view, the premium received is, there-
fore, a lump payment made in return for the obligation
to pay an excessive rate of interest during the life of the
bond. If the credit of the company and the conditions
of the market would have enabled the company to issue



188 MODERN ACCOUNTING

a five per cent, twenty-year bond 'at par, its six per cent,
bond, running the same time, should sell at approximately
112.46. This premium of 12.46 is, therefore, the present
value of the annuity of one per cent, which the company
must pay for twenty years. But the interest installments
as paid are normally and properly charged as an expense,
and consequently the 12.46 per cent, should be spread over
all the years during which the interest is thus paid, in
order properly to equalize the profits of the several years.
The correct entry, therefore, is to credit the premium re-
ceived to " Premium on bonds issued " a part of which
is annually written off to offset the interest paid the bond
holders. It might, however, all be placed in some Reserve,
and this is not infrequently done. This, while theoret-
ically incorrect, is condoned by many authorities on the
ground that it leans to conservatism. The opposite treat-


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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 14 of 27)