Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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principles the case is finally decided on some technicality
leaving the main question unsettled ; 2 or in general, the

1 For instance the oft-quoted decision in Davison v. Gillies was
subsequently said to have rested entirely on special articles and not on
general law. Vide L. R. 41 Ch. Div. 18.

* For instance the decision on the appeal of the National Bank of
Wales case. Here most important principles were raised in the Court
of Appeal, but these were questioned but not reversed in the House of
Lords, the decision being made on a technicality as to the defendant's
responsibility. Dovey v. Cory [1901] A. C. 477.



decision is at best a decision as to what profits are avail-
able for dividends, rather than as to what constitutes

In England the discussion has been clearer than in the
United States. It has been especially favored by the ex-
ceptional form for the Balance Sheet provided for parlia-
mentary companies. The fact that the Capital account is
here kept separate, as in the simple form


FORM 73.
Capital Account.


Capital assets 95,000

Balance 5,000


Shares 100,000


Balance Sheet.



Balance of Capital Account 5,000

Accounts payable 20,000

Profits 5,000


Bills receivable 15,000

Cash 15,000


seems to encourage the idea that the Capital account, or at
least the plant purchased with receipts from capital have
little or nothing to do with the profits exhibited in the
Balance Sheet. The inference is easily drawn that there
can be a loss in the value of the capital Assets which would
affect only the Capital account and which would leave the
profits of the year undisturbed. Doubtless, because of
being accustomed in double accounts to treat capital as a
thing by itself, the English courts have been more ready
to take advanced ground on the general problem.

Whatever decision may ultimately be rendered by ac-
countants, the problem at least is clear. Recognizing the
loss of certain assets, say by fire, or by shipwreck, by


default of securities, or by normal exploitation, the only
point of debate is as to the channel through which that
loss shall be shown. In accounting terms it is simply
whether a given, recognized loss is to be debited to Profit
and Loss or to some other account which would indicate
a deduction from net wealth, but which would say nothing
about current revenues. To a certain extent it is a ques-
tion of terminology, in part, it is a question of law. Does
the term " Net Profits " mean the net change in wealth,
due to whatever cause, or does it mean the changes due
only to a certain set of business factors? Does the law
allow dividends to be made of the surplus of certain re-
ceipts (realized or constructive) over certain expenses
(whether paid or merely recognized), or does it order that
only the surplus of present assets over the net assets of a
year ago may be divided?

The problem may be illustrated by assuming a case of
relative simplicity where a company is organized to pur-
chase a coal mine and to exploit and sell the coal. Waiv-
ing the question of the difficulty of making an intelligent
estimate of the value of the coal deposit, it may be assumed
that $250,000 is paid for the property and that this is an
equitable price for the million tons of coal which the mine
contains. On these terms the selling price should return
the principal, pay all the operating expenses, and yield
a fair profit on the original investment. The proceeds of
each year's sales obviously should considerably exceed the
annual cost of operating the mine ; but it is perfectly clear
that the excess of receipts over annual expenditures will
not all be profits. Out of the price received for each
ton of coal 25 cents is a return of a similar sum paid orig-
inally for the coal in situ ; and allowance for this cost price
must inexorably be made before profits can correctly be
determined. With the assumptions made, the mining
company can no more legitimately treat the net annual



receipts as net profits than can the merchant neglect the
cost price of his commodity, or the manufacturer disre-
gard the factory cost of his product in - his estimate of
profits. Thus assuming again that the total cost of min-
ing and selling the coal, including all the direct outlay for
operation, amounts to 55 cents per ton, the company, after
exploiting 100,000 tons, should show in its Profit and Loss
account :

FORM 74.
Dr. Pro-fit and Loss. Cr.

Expenses $55,000

Exhaustion of mine 25,000

Balance available for div-
idends 20,000


Sales $100,000


and having paid out the full profits the Balance Sheet
should show:

FORM 75.
Dr. Balance Sheet. Cr.

Cost of mine $250,000

Cash, etc 25,000


Capital $250,000

Depreciation of mine 25,000


The same process being continued until all the coal is dis-
posed of the Balance Sheet should be :


FORM 76.
Balance Sheet.


Mine cost

price $250,000

Less exhaustion 250,000

Cash, etc $250,000


Capital $250,000



During the course of business the net cash receipts amount
to $450,000, but because of charging to Profit and Loss
a sum representing the cost price of coal, the total profits
shown and distributed amount only to $200,000, while
there steadily accumulates in the treasury a sum which at
the end of operations equals the original cost of the mine. 1
This would serve to return the capital stock.

Such treatment of the accounts met with the practi-
cally unanimous approval of accountants, when in 1889,
the accounting world was startled by the now historic de-
cision in the English case, Lee v. Neuchatel Asphalte Com-
pany, Limited. (L. R. 41 Ch. Div. 1.) Here action was
brought by a shareholder to prevent a company formed
to work certain asphalt deposits from paying dividends
without making allowance for the exhaustion of the de-
posits. But the court refused to interfere. Unfortunately
for the peace of mind of accountants, .jurists, and com-
pany directors, the decision itself was somewhat vague in
principle, contradictory in detail, and difficult of appre-
hension. But the case at least decided the principle that
there is no requirement compelling companies to make al-
lowance for the exhaustion of their capital invested in
" wasting " assets.

So counter was this to the teaching of text-books, and
the practice of accountants that it immediately attracted
attention and criticism. In the current discussion in the
Accountant, the organ of the Chartered Accountants, it
was almost universally condemned. It was claimed that
the decision showed " a feeble grasp of the fundamental
principles of accounting " and to be " utterly at variance
with the views of all practical accountants and prudent
men of affairs." The " Dictionary of Political Economy "
appearing soon after the decision maintained that it ' ' con-

1 For the sake of simplicity the question of interest accruing on this
fund is disregarded.


tradicts every sound principle of business and bookkeep-
ing." Palmer, one of the most eminent authorities on
company law has said: " The views on Lee are not shared
by some other learned judges and they do not commend
themselves to the common sense of accountants, economists,
or business men in general, ' ' and he declares its system oi
ascertaining profits to be " obviously unsound."

In face of such united criticism coming from such
varied authorities it requires some temerity to argue in
favor of the decision; especially so since the decision,
while it has frequently been followed in England and in
the United States x has been said to have really no bearing
on the question of the treatment of wasting assets, as in
reality the value of the remaining deposits w r as greater
than the original price paid for the concession. 2 It should
be borne in mind that the decision was not expressed in
accounting terms, nor was it a decision as to what con-
stituted profits, but merely that a company, organized to
work a wasting property might, in accordance with the
terms of its own articles, distribute the net annual receipts
without withholding a sum to represent the exhaustion of
the mineral deposits, there being no creditors who were
thereby harmed.

In the above case the question related solely to the
treatment of the income of a company specifically organ-
ized for the exploitation of wasting assets, or as it is loosely
phrased, " with wasting capital." The nature of such an
enterprise precludes its permanence. The more successful
its operation, the shorter its life. Like Nan Netticote, of
the childish conundrum, the more brilliant its career, the

1 See e. g. the clear and important decision Excelsior Water & Mining
Company v. Pierce. 90 Cal. 131 (1891). United Verde Copper Co. v.
Roberts 156 N. Y. 585 (1898).

2 Bond v. Barrow Haematite Steel Co. [1902] 1 Ch. 353, and Wilmer
v. McNamara & Co. [1895] 2 Ch. 245.


sooner it ends; the more efficient its management the more
quickly will its resources be exhausted. Such an enter-
prise differs radically from an ordinary industrial under-
taking where the element of permanence and continuity
is implied. The decision in Lee, therefore, did not neces-
sarily apply to any enterprise other than those with
wasting assets.

Five years later a decision almost equally important
was given which greatly extended the idea that losses
might be suffered without affecting the Profit and Loss
account. This was in the case of Verner v. The General
and Commercial Investment Trust, Limited ( [1894] 2 Ch.
239). This concerned a company organized to purchase
stock of various other companies, the sole function of the
Trust being to make speculative investments dividing the
net income as dividends to its own stockholders. The in-
vestments made were in diverse enterprises and were made
purely for the sake of the income to be derived therefrom.
In this particular instance, nearly $5,000,000 had been
raised by shares and debentures, all of which had been in-
vested. But some of the investments had been poorly se-
lected, and many of the investments having fallen in value,
some of them proving altogether worthless, there was an
admitted loss of over $1,000,000, equal to one quarter of
the capital. Receipts of interest and dividends, however,
largely exceeded the current expenses, and the case turned
on the legitimacy of paying these net receipts as dividends,
instead of using them to make up the loss due to the de-
cline in the value of the investments. The decision held
that such dividends were proper, despite the general legal
principle that dividends may not be paid out of capital.

Here there was, of course, no question of wasting assets.
Investments were not made for the purpose of exploitation
and exhaustion, but for permanent income. In the deci-
sion, Lord Justice Lindley held that while in general divi-


dends cannot legally be paid out of capital, yet that does
not imply that in all cases the loss of capital must be made
up before dividends may be paid. A distinction was made
between the loss of what was termed fixed capital and of
circulating capital. Dividing the income of a company,
without the replacement of the circulating capital con-
sumed in producing the income, is a payment of a divi-
dend out of capital, such as is prohibited by law.

" Fixed capital may be sunk and lost and yet the excess
of current receipts over current payments may be divided,
but floating or circulating capital must be kept up, as
otherwise it will enter into and form part of such excess
without deducting the capital which formed part of it
will be contrary to law."

In this decision the principle that capital need not be
kept up before declaring dividends, which in Lee v. Neu-
chatel Asphalte Company was applied only to wasting
capital, was extended to so-called " fixed capital " per-
manently invested in a peculiar enterprise known as a
trust. In the following year the doctrine was extended in
the case of Wilmer v. McNamara and Company ( [1895]
2 Ch. 245) where a decline in the value of the Goodwill
of a company was held not to interfere with the payment
of dividends on the ground that this loss also was one of
fixed and not of circulating capital. Even more far reach-
ing was the decision in the Kingston Cotton Mill Company
case ([1896] 1 Ch. 348) that the rulings, which in Lee
and Verner were applied to companies of a peculiar
nature, would also apply to an ordinary manufacturing

In the case of the National Bank of "Wales ([1899]
2 Ch. 629) a decision was given which was even more
sweeping in its effect. There the loss which had occurred
was one which might be considered a loss of circulating


capital, for it was due to the shrinkage in the value of
loans made by the bank. But the decision sanctioned the
payment of dividends in a year when profits had been
earned despite the fact that the losses of previous years
were still uncovered. Soon afterwards Justice Wright
relying probably on this decision, stated in the case of
Crichton's Oil Company: " I do not think that there is
any rule of law that profit on one year's trading cannot
be divided merely because in the Profit and Loss account
there is a deficit over on the balance of former years."
([1901] 2 Ch. 196.)

A similar opinion was expressed by Vaughan "Williams
in the decision in the case of Hoare and Company, Lim-
ited. ' ; However much capital you have lost at any given
date, if your Profit and Loss account shows a profit bal-
ance, then to the extent of that profit balance you are en-
titled to distribute that money as dividend notwithstand-
ing the fact that you have lost capital which you have not
replaced.'"' ( [1904] 2 Ch. 208.)

The adoption as a general rule of the principle enun-
ciated in these decisions would be to treat each year as a
separate unit, and if a judicious arrangement of the ac-
counts could be made so as to show alternately net annual
profits and losses, to allow a continued distribution of
dividends despite the fact that there was a constantly
growing deficit due to the loss of circulating as well as
fixed capital. 1

The validity of the decision in the National Bank of
Wales case has, however, been very seriously questioned,
for although it was upheld in the House of Lords (Dovey
v. Cory [1901] A. C. 477) the judgment in the last court
was bused entirely on technical grounds, relating to the
liability of the defendant director, and in no way vouched
for the correctness of the doctrines relating to profits.

1 See F. B. Palmer, Company Precedents, I, p. 764.


Furthermore, each one of the Lords rendering opinions in
the latter case took unusual pains to call attention to the
the fact that his approval of the decision of the lower court
did not imply approval of the doctrine there enunciated
as to the treatment of lost banking capital. Again in 1904
it was held that where a company showed a deficit from a
preceding year, it was illegal to pay as dividends the prof-
its earned later until the preexisting deficit had been made
up, and that such a dividend was a payment out of cap-
ital. (Towers v. African Tug Co. [1904] 1 Ch. 558). But
unfortunately no discussion is given of the principle in-
volved, for the decision concerned the competency of cer-
tain stockholders to sue and not the legitimacy of the
dividend which was assumed to be illegal without discus-
sion. And the significance of the decision in Verner is
somewhat lessened by the later important case of Bond v.
Barrow Hasmatite Steel Company ([1902] 1 Ch. 353)
where, while accepting the earlier decisions regarding the
loss of fixed or wasting capital as binding, the court re-
garded damages to iron mines and the destruction of a
blast furnace and workmen's cottages as all being losses
of circulating, not of fixed capital.

The latter decision emphasizes the unsatisfactoriness of
the distinction which the courts have attempted to draw
between a loss of fixed and one of circulating capital. If
by this is meant a loss of fixed and circulating assets, there
is, of course, the difficulty already alluded to of determin-
ing in any concrete case which class of assets has been lost.
As the Lord Chancellor said in Dovey v. Cory, " The dis-
tinction between fixed and floating capital, which may be
appropriate enough in an abstract treatise like Adam
Smith's ' Wealth of Nations ' may with reference to a
concrete case be quite inappropriate."

In no system of classification known to economists from
Adam Smith down is an iron furnace included, as it has


been included by the court, in the list of circulating cap-
ital. But the objection to this distinction from the tech-
nical view point of accounting is even more serious. Part
of the assets may be lost, but no particular asset is an
embodiment of any particular credit in the Balance Sheet.
The asset in question may, indeed, have been bought with
the cash paid in on subscriptions to Capital Stock, or from
the proceeds of an issue of bonds, or by incurring float-
ing debt, or by investing the profits of the business. But
the destruction of this particular asset is not thereby made
specifically a loss of Capital, or of Funded Debt, or of
Current Liabilities, or of Profits. To the accountant the
distinction between the Credit items in the Balance Sheet
and the Assets is vital. They represent entirely different
conceptions and are not to be confused.

The decisions of the American courts are perhaps even
more confusing and less satisfactory. This is striking be-
cause of the fact that in this country the courts have clung
rather tenaciously to an invention now happily obsoles-
cent of Justice Story, that the capital stock of a corpora-
tion is a trust fund, to be held for the benefit of the credi-
tors. So rigid a doctrine would seem to carry with it an
unusual care that the capital should not be encroached
upon. While the courts have, of course, rigorously op-
posed the direct payment of dividends out of capital, it
has already been shown that there has been no consistent
recognition of depreciation. As to the specific question of
the loss of capital as something distinct from the loss of
profits, the most striking decision is that of the Supreme
Court of the United States in the case of Eyster v. Cen-
tennial Board of Finance : ' ' The receipts of the exhibition,
over and above its current expenses are the profits of the
business. ... They are, in fact, the net receipts, which,
according to the common understanding, ordinarily repre-
sent the profits of the business. The public, when


ring to the profits of the business of a merchant, rarely
ever take into account the depreciation of the buildings
in which the business is carried on, notwithstanding that
they may have been erected out of the capital invested.
Properly speaking, the net receipts of a business are its
profits. So here, as the business to be carried on was that
of an exhibition and its profits were to be derived only
from its receipts, to the popular mind the net receipts
would represent the net profit." 1 (94 U. S. 503.)

In this case the enterprise was a peculiar one, analo-
gous to a single ship venture; and perhaps to be decided
on rules different from those of ordinary mercantile under-
taking. In the case of Main v. Mills, a Federal Court de-
clared: " There is, perhaps, at this day no better estab-
lished rule of law than that the capital stock of a moneyed
corporation, whether it be a banking, insurance, mining,
or manufacturing company is to be treated and deemed as
a trust fund for the purpose of securing the payment of
the debt of the corporation. . . . The officers of such a
corporation have no right to make dividends to stockhold-
ers unless there are profits to be divided, over and above
all losses, because the necessary result of so doing is to
deplete the capital fund. ... If there are gains and losses,
the gains should be set off against the losses so far as may
be necessary to keep the capital fund whole." (16 Fed.
Gas. 506 (1874).)

The State courts have varied in their decisions. The
most interesting decisions are in Connecticut that " net
profit ordinarily means what is left after making good the
capital "; in Michigan, where net profits are said to be
ascertained by a comparison of present assets at actual

1 It is to be noted here that the depreciation referred to is not the
ordinary wear and tear due to time's ravages, but the loss of value,
save as junk, of the buildings when the exhibition closed.


values, with the total original investment; in Iowa, where
profits are made equal to assets, at actual value, less lia-
bilities; and in California, and New York where the de-
cision in Lee v. Neuchatel Asphalte Company, is openly
applied to the dividend of a local mining company. 1

1 The cases referred to are: Getting v. N. Y. & N. E. R.R. Co. 54
Conn. 156 (1886); Richardson v. Buhl 77 Mich. 632 (1889); Hubbard
v. Weare 79 la. 678 (1890); Excelsior Water & Mining Co. v. Pierce,
90 Cal. 131 (1891); and United Verde Copper Co. v. Roberts, 156
N. Y. 585.


PROFITS (continued)

THE questions concerning the relation between capital
losses and the payment of dividends are threefold. The
first is as to the legality of such dividend; the second is
as to the business policy; and the third as to the proper
booking of such transactions. Each of these may in turn
be subdivided as referring to Wasting Capital in the tech-
nical sense, to ordinary Fixed Capital, using the term
loosely, and to Circulating Capital. 1. The legality of
dividends, where the " loss " is merely an exhaustion of
wasting capital is well established both in England and
in this country. That dividends are legal despite the loss
of fixed capital is supported by high but not the high-
estauthority in England and by the United States Su-
preme Court, with the State courts divergent. But " all
of the authorities agree that circulating capital must be
kept up." (Bond v. Barrow Haematite Steel Co. [1902]
1 Ch. 353.)

2. The question as to the business policy of making
dividends despite losses of capital is, however, independent
of the legality of such action. It is most easily decided
where the loss is of the first class, that is a loss of wasting
capital, or taking the typical case, where the operations of
the company consist in exploiting a mine. It has already
been shown how the decision in Lee v. Neuchatel Asphalte
Company was almost universally criticised. Even Pixley
in his latest edition of Duties of Auditors, styles the pay-
ment of such dividends " a suicidal policy and contrary



to the practice of soundly managed public companies "
and " distinctly unwise and unbusinesslike."

Despite the high authority of the critics cited there is
strong reason for justifying the payment of dividends
without making allowance for the exhaustion of the mine.
The discussion reduces itself to the question whether min-
ing and similar enterprises are to be regarded as perma-
nent undertakings, the capital of which should be main-
tained, or as temporary ventures corresponding to the
character of the natural resources, from which capital as
well as profits may be withdrawn as quickly as may be
possible without injuring creditors or impairing credit.
Those holding the former view claim that so much of the
receipts as represents the return of capital should be re-
served by the company, and invested so that at the time
of the final exhaustion of the mine it would own other
assets equaling the entire amount of the capital stock.

This view seems entirely to overlook the essential char-
acter of the enterprise. A mining venture is always a
speculative undertaking. Subscribers to the capital know
well that in the nature of things it cannot be a permanent
undertaking, and presumably they are aware of its specu-
lative character. Their sole object is to exploit a given
deposit of mineral, and the logical thing seems to be to
have the fruits of such exploitation turned back to the
subscribers as quickly as may be. Granting that creditors
are not misled nor harmed (and protection can easily be
secured by contract) it seems absurd to require that a

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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 16 of 27)