Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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body of capitalists willing to invest in a peculiar specu-
lative enterprise should be forced to form what is prac-
tically a trust company to invest part of the annual receipts
against some far distant day of accounting. If one pre-
fers a speculative enterprise with possible large gains, what
is more unreasonable than to require that his venture
should gradually be transformed into something entirely



216 MODERN ACCOUNTING

different, an investment in long time and low rate secu-
rities. Better by all means, unless it is thought that
paternalistic laws should force him willy-nilly to become
conservative, to turn back to him the proceeds of the ex-
ploitation and allow him to make another similar venture
if he sees fit.

Moreover, the very nature of the organization prob-
ably is an argument against the accumulation of a reserve.
The officers of the mining company presumably were se-
lected because they knew how to mine. But this so far
from supporting, furnishes a presumption against, the sup-
positjon that they are desirable persons to keep and admin-
ister a large trust fund. From all points of view it seems
much more sensible to allow the gradual return of capital
invested in an enterprise which by its nature is termin-
able, than to demand the accumulation of a sinking fund.

A dictum of the United States Supreme Court, al-
though given in other circumstances, is pertinent to this
discussion: " A stockholder (said Mr. Justice Davis in
Clearwater v. Meredith) enters into a contract with the
company that his interest shall be subject to the direction
and control of the proper authorities of the corporation
to accomplish the object for which the company was or-
ganized. He does not agree that the improvement to
which he subscribed should be changed in its purposes and
character at the will and pleasure of a majority of the
stockholders so that new responsibilities and, it may be,
new hazards are added to the original undertaking. He
may be willing to embark in one enterprise and unwilling
to engage in another. (68 U. S. 40.)

This statement was made regarding an extension of
a line of railroad out of profits which otherwise would
have been distributed to the stockholders. If it applies
to a mere extension of a similar enterprise, much more
should it hold as regards enterprises so utterly divergent



PEOFITS 217

in character as the speculative exploitation of a mine, and
the establishment of a trust fund. x

On the other hand there are certain circumstances in
which it might be highly desirable for the company to
withhold a sum corresponding to the exhaustion of the
wasting capital and reinvest in other similar enterprises.
Thus a manufacturing company owning its own coal or
iron mines might most wisely reinvest in new mines as the
old ones were depleted. But this is a special case. All
that is claimed is that there should be no general rule that
there must be a withholding of receipts. Even a reinvest-
ment in a similar enterprise requires special justification ;
the creation of a fund to be invested in outside securities of
an entirely different nature is much less to be favored.

The policy of paying dividends despite the loss of cap-
ital where the investment was in other than wasting prop-
erty is not so easily defended. Here there is a real loss,
not a return of capital; here the enterprise is normally a
permanent not a terminating one; here the whole purpose
of the enterprise is not to exhaust and return the capital
but to use it in business.

Circumstances may, however, justify even such a pay-
ment of dividend. For instance, an individual's entire
income is derived from ten houses each worth $10,000 and
each yielding 10 per cent, net income. If two of these
houses burn down, uninsured, the common sense view
is that the proprietor's income is thereby cut down from
$10,000 to $8,000 per annum, and that coincidentally
there is a loss of capital of $20,000. It never occurs to
him that he must consider his income as entirely cut off
for two years until the principal can be restored. Sim-
ilarly it might be an act of cruelty to dependent stock-
holders to stop dividends entirely until an exceptional loss
is reimbursed. The main difficulty is that in a corpora-
tion such an occurrence really calls for a reduction of



218 MODERN ACCOUNTING

the nominal capital, a cancellation of part of the capital
stock. The 'red tape and legal expense of doing this, per-
haps too the bad effect on the company's credit of giving
public notice that there has been an encroachment on cap-
ital, make directors loath to do so. The criticism properly
to be made is not so much that dividends are paid before
restoring the capital (i. e., increasing the assets until they
again equal the capital), but rather that the capital stock
has not been reduced to correspond with the amount of re-
maining assets, before the dividend is paid. To allow divi-
dends to be paid while assets are less than the nominal
capital seems to render nugatory all the legal provisions
regarding the reduction of capital stock. Why enact such
careful legal restrictions and yet suffer the same results
to be reached by the methods permitted in the case of the
General and Commercial Trust? The hardship of going
entirely without dividends for a series of years may per-
haps be considered only a fair return for the exceptional
privileges granted to stockholders.

As to the policy of paying dividends when there nas
been a loss of so-called " circulating capital " there is no
argument, provided the meaning of that phrase is taken to
be that the income of the company is less than the outgo,
and furthermore that there is no accumulated reserve out
of which dividends can be paid. Certainly if nothing has
been earned all agree that there should be no dividends.

3. The critics generally assume that the courts justify
the Neuchatel Asphalte Company and the General and
Commercial Trust in presenting accounts misleading and
incorrect. Thus Palmer in his masterly work on Company
Precedents says : ' ' The views expressed in Verner v. Gen-
eral and Commercial Investment Trust involve the propo-
sition . . . that the Balance Sheet need not disclose the
true condition of the company. It deals as regards the
assets not with existing facts but with past history. It



PKOFITS 219

shows what the particular assets cost, not what they are
worth. Thus if a company buys a property for 10,000 and
the value has fallen to 1,000, it will properly be entered
on the Balance Sheet as property that cost 10,000 ; and it
will remain at that figure, even though each year, by con-
sumption or otherwise, it depreciates more and more. ' ' *
This implies that the court justifies the use of the last form
given on page 200. But this opinion, which is shared
by many another critic, not merely ignores the possibilities
of accounting technic, but more strangely disregards the
express words of the decision itself in which Lord Justice
Lindley states: "It is obvious that capital lost must not
appear in the accounts as still existing intact ; the accounts
must show the truth and not be misleading or fraudulent. ' '
( [1894] 2 Ch. 267.) Similarly in the later case of Barrow
Haematite Steel Company ( [1900] 2 Ch. 857) Justice
Cozens-Hardy very clearly intimates that, although a loss
of capital may not prevent the Pj-ofit and L.OSS account
from showing a balance available for dividends, the Bal-
ance Sheet would at the same time show or imply the loss
which had taken place.

While the professional accountant sometimes advises a
client as to the legality of certain transactions, the lan-
guage of accounting is itself not concerned with legal tech-
nicalities. Whether or not the law permits a company to
hold its own stock, to issue stock or bonds below par, to
make stock dividends, or as in the case here to pay divi-
dends while assets are less than the nominal capital is an
important, but purely legal matter. If the transaction
named has taken place the question as to its technical
legality has not or at least should not have anything
to say as to the statement of facts by the accountant. It
may be logical to claim that all losses or gains, however
caused, should go to Profit and Loss, and not direct to some

Vol. I, p. 757.



220



MODERN ACCOUNTING



other Proprietorship account. But such a claim, while
logical enough, does not at all conform to accounting prac-
tice of any land or time. Once granted that some losses
need not appear to the debit of Profit and Loss, the duty
of the accountant is plain, and his task is simplicity itself.
The loss say that cited by Palmer being excluded from
Profit and Loss must appear elsewhere. If law requires
or permits the reduction of nominal capital stock, and that
is done, the loss is deducted immediately from the Capital
account. Thus a company which at first shows



Dr.



FORM 77.
Balance Sheet.



Cr.



Plant $10,000

Miscellaneous Assets 15,000

$25,000



Capital Stock $22,000

Profit and Loss 3,000

$25,000



will after the unfortunate experience, have as its Balance
Sheet :

FORM 78.
Dr. Balance Sheet. Cr.



Plant $1,000

Miscellaneous Assets 15,000

$16,000



Capital Stock (reduced). . $13,000
Profit and Loss 3,000

$16,000



If the legal steps necessary to reduce the nominal cap-
ital have not been taken, the showing should be:



Dr.



FORM 79.
Balance Sheet.



Cr.



Property $1,000

Miscellaneous Assets 15,000

Loss on Capital Account . . 9,000

$25,000



Capital Stock $22,000

Profit and Loss 3,000

$25,000



PKOFITS



221



Of course some other descriptive term may be used in place
of ' ' Loss on Capital Account, ' ' the only requirement being
that it be not misleading. And greater explicitness can
be introduced by indicating the shrinkages, perhaps as
f oJlows :

FORM 80.
Dr. Balance Sheet. Cr.



Property

Original Cost . . $10,000

Less Shrinkage. 9,000



Miscellaneous Assets . . ,



$1,000
15,000

$16,000



Capital Outstand-
ing $22,000

Less Shrinkage,

per Contra 9,000



$13,000
Profit and Loss 3,000

$16,000



The matter is simple all that is needed is clearness
and honesty and the facts can be presented in various
satisfactory forms. The undesirability of paying divi-
dends while capital is diminished has nothing to do with
the necessity of truthfully showing what has taken place.
That such is seldom or never done is perhaps unfortu-
nately true, but it does not depend altogether on the much
criticised decisions of the courts.

The rule that a shrinkage of capital should be shown
in the Balance Sheet is, perhaps, to be modified in cases
where the loss is incapable of exact, or even approximate,
estimation. Thus the cost of an oil well represents wast-
ing capital which logically should be written off as the oil
is exhausted. But the estimate of the oil supply is so
much a matter of guesswork that it may be better to retain
the known cost, without attempting any estimate of the
rate of exhaustion. Accordingly mining enterprises gen-
erally make no allowance for exhaustion. But in some
cases, of which the Colorado Fuel and Iron Company is
an instance, regular charges are made" against profits for



222 MODEKN ACCOUNTING

each ton mined. The idea is, of course, to show the pres-
ent actual value. Where the amount of shrinkage is known,
it must appear in the accounts. But where the accuracy of
a valuation is specious, where the only ascertainable value
is the original cost, it may be less harmful for the Balance
Sheet to show the cost, indicating that it does not repre-
sent the present value. The interested persons can then
make their own allowances for shrinkage of capital assets.

There are a few questions which arise regarding the
Credit side of the Profit and Loss account, that is, as to
whether certain increases in the net wealth should appear
in that account. Among these may be mentioned the re-
ceipt of premium on capital stock. It is evident that such
receipts are in no sense profits arising from the business,
and custom is opposed to crediting them to Profit and
Loss, although by the dictum of Lord Homer in Hoare and
Company ( [1904] 2 Ch. 213) they may legally be applied
to the payment of dividends. In banks, where the issue
of stock at a high premium is especially frequent it is cus-
tomary to credit Surplus, and such treatment is alto-
gether to be approved.

Premium received on bonds is different in its nature.
Here the receipt is an offset for high interest paid, or a
bonus received because of exceptional credit. It is directly
proportioned to the time that the bonds run. And as the
annual interest is charged against profit during each year
of the life of the bond, the only correct method is to credit
as an offset to this charge a proportionate part of the pre-
mium received. No objection would, however, be made
to a conservative placing of the entire premium in some
general Keserve account, and, of course, if the amount re-
ceived is small, it would be hypercritical to demand that it
be minutely divided through a long series of years.

Premium arising from the reissue of stock forfeited
because of nonpayment of assessments should be treated



PKOFITS 223

as any other premium on stock, that is, carried to Reserve
or Surplus rather than to the current Profit and Loss ac-
count. But the objection to crediting the excess to profits
is based on accounting principles, not on law (Gratz v.
Redd, 4 B. Mon. Ky. 178).

More interesting is the broader question as to whether
appreciation in the value of the so-called capital assets is
divisible as profits. This is clearly the reverse of the ques-
tion previously discussed. There the concept of a loss of
capital as something distinct from a loss of revenue was
introduced. The reverse, that there is possible an increase
of capital which is not profit involves the same principle.
Discussion has been somewhat confused by not clearly dis-
tinguishing between an appreciation which has been real-
ized, and one which is estimated only. But where the gain
is actually realized, it certainly may be credited to Profits,
although if the gain be exceptional it would conservatively
be placed to some Surplus or Reserve account. This doubt
less is inconsistent with the doctrine of Lee v. Neuchatel
Asphalte Company. Indeed one argument given by the
court in favor of excluding the shrinkage in value of cap
ital assets was that a contrary rule would imply that divi-
dends might be paid out of the increase in value of capital,
which was said to be " contrary to all practice and to
principle."

But this very doctrine, in so far as it relates to a real-
ized gain, was soon fully admitted in Lubbock v . British
Bank ( [1892] 2 Ch. 198) which has since been followed
in various decisions. However successfully the courts at-
tempt to distinguish between capital and revenue, or even
between a shrinkage of capital and a loss of revenue, there
is now no effort to differentiate between a realized gain
due to the appreciation of capital assets and other income. 1

1 Some exceptions to this may be found in case of the final distribu-
tion of assets of liquidated concerns.



224 MODERN ACCOUNTING

More delicate is the question of unrealized profits. In
the discussion of the Inventory in Chapter IV, it was
shown that mere fluctuations in value may be disregarded ;
and that even permanent appreciation, if it is of assets
whose nature is such that the gain cannot be realized by
the going concern, should similarly be left out of account.
Thus an estimated appreciation in the value of the factory
site should be left out of account, even though the estima-
tion have every element of certainty. The prohibition of
thus marking up assets precludes any credit in the Profit
and Loss account, or elsewhere. But where the apprecia-
tion is in merchandise, or in what are commonly called
circulating assets, there is less uniformity. It has been
seen that German law distinctly prohibits the taking of
profits due to appreciation of unsold merchandise, even
where the increased value is evidenced by quoted prices in
produce or stock exchanges. But on the other hand Aus-
trian law authorizes the taking of such profits. A leading
Massachusetts case held: " The profit and loss of trade
in merchandise is not confined to that which results from
sales. Depreciation or advance in value of the stock un-
sold must also be taken into account. (Meserve v. An-
drews, 106 Mass., 419 (1871).) But in this case there had
been a loss by fire so that the ruling regarding an advance
in value is less authoritative. Furthermore, the case re-
ferred to a final settlement or dissolution of partnership,
which differs in important particulars from the status of a
going concern. The opinion of accountants, always siding
toward wise conservatism, is well-nigh unanimous against
taking profits on unsold goods.

But the difficulties are not yet all settled. Frequently
goods have actually been sold at an advance, but the pay-
ment for them has not yet been received. Or interest on
loans and investments may have accrued, but either is not
yet matured, or if matured, is not yet paid. Had cash



PKOFITS 225

been received these would most obviously be counted as
profit, but objection has at times been made to including
in profit anything not received in cash. From the maze of
discordant decisions the puzzled accountant seeks in vain
for a safe guide. The earlier English cases were satisfac-
torily clear, especially Stringer's case (L. R. 4 Ch. 475
[]869]) where it was held that cash need not be in hand,
and that the obligations of the Confederate government
honestly estimated as good, were a correct basis for deter-
mining profits available for dividends. This decision has
long been accepted as authority, yet an entirely different
doctrine was enunciated so late as 1902 in Badham v.
Williams, in which Justice Kekewich gave an opinion so
remarkable as to deserve quoting at some length: " If it
is a mere question what were the profits made in a par-
ticular year, it seems to me that the duty is to ascertain
what cash has been received and what cash has been ex-
pended, and, if that is fairly done, you know the profits of
the year. If there is a large outstanding liability which
cannot be settled, the partners will estimate that, and it
will not be considered as part of the profits. If there is
a large outstanding possible loss, and there is a large sum
due to a client, then you would provide for that. But in
ascertaining what is really actually divisible for the year
fairly, you take the cash account as it stands. ..."

" A merchant in London consigned a cargo to some
foreign port for sale in 1901. Suppose the payment is
made by bill perhaps at six or three months, it may run
into 1902. Now, are they to treat that as concluded in
1901 and consider that business as attributable entirely
to 1901 when the bill may not be met at maturity? Are
they to consider those as so much cash for the purposes of
that business ? It seems to me that that would be entirely
wrong in the absence of a special agreement. For the pur-
poses of the balance sheet, no doubt, they would estimate



226 MODERN ACCOUNTING

that there is an outstanding asset which they hope to real-
ize; but for the purpose of ascertaining the profit and
loss that is to say, what is to be divided it seems to me
that they must consider only what they have received, b-
cause those bills will only come in when met at maturity
in 1902." (86, L. T. R. 191.)

In the United States the courts have more generally
considered that only actual receipts and payments are
proper entries in the Profit and Loss account. It is true
that the United States Supreme Court in 1893 (Reagan
v. Farmers Loan & Trust Co., 154 U. S., 362) held that
accrued interest payable should be considered, but that did
not cover the question of interest receivable. As has been
seen the same court in Eyster v. Centennial Board of Fi-
nance identified profits with net receipts. In California,
moreover, it has been specifically held in People v. San
Francisco Savings Union that interest accrued, even on
United States bonds, cannot be considered in determining
profit. In the course of the decision, which is well worth
reading in full, the court says: "It is not easy to com-
prehend how profits or surplus profits can consist of earn-
ings never yet received. The term imports an excess of
receipts over expenditures and without receipts there can-
not properly be said to be profits. Money earned as in-
terest, however well secured or certain to be eventually
paid . . . does not constitute surplus profits within the
meaning of the statute." (72 Cal. 19.9 (1887).)

In New Jersey and Missouri, on the contrary, it has
been held that profits are not necessarily limited to money
received. (Jones v. Davis, 48 N. J. Eq. 493 (1891). Slay-
den v. Coal Co. 25 Mo. Ap., 439 (1887).)

Much of the confusion is doubtless due to a mere dif-
ference in terminology, and oftentimes the term ' ' prof-
its ' ' in legal use means ' ' profits available for dividends. ' *
The courts may well place certain restrictions on the pay-



PKOFITS 227

ment of dividends which would not at all correspond with
the accountant's limitations of the concept of profits. In-
deed, this is in many cases done by statute; as is true in
a number of the Spanish American Republics, which pre-
scribe that only liquid profits may be paid as dividends. It
may be accepted that it is incorrect to base a dividend on
unrealized profits, or indeed that an unrealized gain is
" not profit, but the hope of profit." There is good busi-
ness conservatism in the argumen^of Dupin, " One does
not divide hopes, however well-founded ; one does not di-
vide a phrase, but money. A dividend before going out
of the treasury of the company, ought first to have come
into it." 1

But the distinction between unrealized and realized
profits is by no means the same as that between profits
which have been received in cash and those otherwise rep-
resented. Profits are in fact realized when once the trans-
action is completed. If it is a sale of merchandise the
selling price includes both profit and a portion of the cap-
ital. It matters not whether this price is represented by
cash, or by the note of the purchaser, or by other assets
received in payment, provided, of course, that there is no
valid doubt as to their real value. If the claim against the
purchaser is, good, profit has been realized; if the claim
is not good, there is not only an absence of profit but a
further loss representing the original investment. To rec-
ognize part of this sum as good and to discriminate against
the other larger part is clearly illogical. Illogical is the
attitude of the California court that the claim for one per
cent, interest against the government may not be counted
good, while the hundred per cent, of principal still stands
among the assets at its full value.

The whole discussion of the form in which profits are
received involves the frequently recurring confusion to

1 Quoted in Bastide: De Dividends fictifs, p. 36



228 MODERN ACCOUNTING

which reference has been made, between assets and the
credit side of the Balance Sheet. The assets cannot be dis-
tinguished as being this capital and that profit. All the
assets together equal capital and profits. Hence as Mr.
Ernest Cooper has pointed out the question as to whether
the profits are liquid or not cannot legitimately be raised. 1

Furthermore, it is quite possible for a company to pay
dividends even though it has no cash. Thus the Dutch
East India Company regularly paid part of its dividends
in spices. A more modern instance is -the dividend de-
clared in 1907 by the Atlantic Coast Line and paid by its
own certificates of deposit, then lying in the treasury.

But it certainly would be unwise for a court to compel
the payment of a dividend in the absence of liquid assets
and the decisions cited are based on this practical objection
rather than on any recognized principle that profits exist
only when in cash. And even unliquidated earnings have
at times been made the basis of compulsory dividends, as
in the case of the charter of the Prussian See-Handlungs-
Gesellschaft, which prescribed the issue of scrip where
cash was not available. In charity to the courts the de-
cisions cited are to be interpreted not as meaning that
only cash earnings are profits, but that the courts will
not compel a company to pay a dividend when the absence


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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 17 of 27)