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Modern accounting, its principles and some of its problems online

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of cash or its equivalent might compel a perhaps disad-
vantageous borrowing, or a loss due to a forced sale of
some of the assets.

Other decisions of the courts are rational only in a
similar loose interpretation. Thus it has been held : ' ' All
the debts (other than funded debts) . . . are debts to be
paid before the profits can be ascertained." (Corry v.
Londonderry & Enniskillen Ry. Co., 29 Beaven 263
[3860]), and while it was later said to be a " curious
theory . . . that there never can be any available income

' Accountant, XIV. p. 74ft


or any profits as long as there is a debt remaining unpaid ' '
(Mills v. No. Ry. of Buenos Ayres Co. 5 Ch. App. 621
(1870)) the same theory has more than once been openly
propounded in American courts. Even the United States
Supreme Court held that: " Net earnings are what is
left after paying current expenses and interest on debt
and everything else the company is liable to pay '*: (War-
ren v. King, 108 U. S., 389, 398 [1882]) and the same
high authority later defines profits as denoting: " What
remain after defraying every expense, including loans fall-
ing due, as well as the interest on such loans." (Mobile,
etc., R. R. v. Tenn., 153 U. S., 486 (1894).)

Taken literally the notion that debts must be paid be-
fore profits are ascertained is to the accountant both ' ' cu-
rious " and " absurd." But that the court should refuse
to order a dividend, when the depletion of the treasury
might make an impending debt disastrous is perfectly rea-
sonable. It is Only to be regretted that in taking a con-
servative position, it should be done at the cost of confused
terminology and questionable theorems.

The limitation of profits to cash receipts is closely con-
nected with the question of borrowing funds with which
to pay dividends. If profits have really been earned, the
replenishment of the cash account through borrowing re-
moves any objections which the accountant might have
to the declaration of a dividend. But Lord Justice Lind-
ley characterized the payment of dividends with borrowed
money as being " as unjustifiable in point of law as it
would be reckless and blameworthy in the eyes of business
men." (Verner v. General & Commercial Trust [1894]
2 Ch., 266.)

Here again the decisions are discordant. In some
cases the payment of dividends with borrowed funds has
been condemned (Davis v. Flagstaff Silver Mining Co.,
2 Utah 74; Belfast & Moosehead Lake Ry. Co. v. Belfast,


77 Me., 445 (1885)), but the lucid decision in Williams
v. Western Union Telegraph Company (93 N. Y. 162
(1883)) showed that where the surplus had been invested
in the plant, the company " could borrow money on the
faith of it and divide that " (p. 192).

In the even more extreme case, where the Balance
Sheet showed for a time no surplus because improvements
had been charged against past profits, it has been held
legitimate to credit back to revenue such expenditures,
and then to borrow funds so as to distribute the surplus
thus reestablished. This was clearly brought out in Excel-
sior Water and Mining Company v. Pierce, where the ex-
pense of constructing a tunnel was charged up against
profits. Afterwards the company borrowed funds repre-
senting the cost of the tunnel and used them to pay divi-
dends. The court said: " The result is precisely the same
as if the money had been borrowed sooner and the identi-
cal money borrowed paid out on the tunnel. Nothing has
been accomplished beyond what the directors had a right
to do, and surely the mode in which it has been done can
make no difference. In fact, the transaction may be re-
garded as a temporary borrowing from the dividend fund
of the sum necessary to meet an immediate demand, with
the advantage to the corporation of keeping its money em-
ployed and saving it the payment of interest." (90 Cal.
131 (1891). )*

The accountant cannot disregard the decisions of the
courts, or he may find that he has led his clients into an
action for which they may be held liable. But it is evident
that many of the decisions to which reference has been
made are at least, on the face, opposed to what the ac-
countant considers fundamental principles of his profes-
sion. Some of these contradictions can be smoothed over

1 See also Mills v. Northern Railway, etc. (L. R. 5 Ch. App. 621


by recognizing that the courts and the accountants are
attaching quite different meaning to the technical terms
of commerce. Difficulty may be avoided by the accountant
continuing to lean, as in the past he has generally done,
toward conservatism, for while the courts, as in the ques-
tion of loss of capital, sometimes permit, they never compel
an excessive estimate of profits. But for a more perfect
rationalization of the legal dicta concerning profits, it
will probably be necessary to await the day when the
growing dignity of the profession of accounting shall cause
its principles to permeate the ranks of bench and bar.



BASTIDE, J. Des dividends fictifs. Toulouse, 1903.

BUCKLEY, H. B. The Law and Practice Under the Companies

Acts, pp. 584-592. Eighth edition. London, 1902.
CHARPENTIER, J. Etude juridique sur le bilan dans les societes

par actions. Paris, 1906.
CLARK, W. L. and MARSHALL, W. L. A Treatise on the Law of

Private Corporations, pp. 518-520. St. Paul, 1901.
COOK, W. W. A Treatise on the Law of Corporations Having a

Capital Stock, p. 546. Fifth edition. Chicago, 1903.
DALE, B. How Are the Profits for the Year to be Ascertained?

Second edition. London, 1897.
DICKINSON, A. L. The Profits of a Corporation. New York, 1904.

(Published also in the Official Record of the International

Congress of Public Accountants held in St. Louis, 1904.) [A

brief but comprehensive and most valuable treatise.]
DICKSEE, L. R. Auditing. American edition, pp. 232-250. New

York, 1905.
PALMER, F. B. Company Precedents. I. 737-768. Eighth edition.

London, 1902-1903. [Contains an extended review and a

criticism of the English decisions in the Lee series.]
PIXLEY, F. W. Auditors, their Duties and Responsibilities.

I. Chapter XIII. Ninth edition. London, 1906,



Are the Decisions of the Courts Respecting the Distribution of the
Profits of a Limited Company Opposed to Sound Commercial
Finance? Accountant, XXIX, 80.

COOPER, E. Chartered Accountants and the Profit Question.
Ibid. XX, 1033. [See also editorial discussion, pp. 1073, 1088,

DAWSON, S. S. Capital and Divisible Profits. Ibid. XXIX, 119.

Divisible Profits of Companies. A Plea for Fuller Parliamentary
Recognition of Double Accounting. Ibid. XXVUL; 417.
[Argues that losses of fixed capital should be excluded from
the accounts.]

JAMES, A. The Divisible Profits of Companies. Ibid., XXVIII,

WELTON, T. A. On the Profits of Companies Available for Distribu-
tion. Ibid., XIV, 677.

For a discussion of the correct method of exhibiting capital

losses, see:
KEEN, F. M. The Balance Sheet of a Limited Company. Ibid.,

XXIV, 399.

The Reduction of a Company's Capital. Accountant, XXVI, 867.
VAVASSEUR, A. Traite des societes civiles et commerciales. 649.

Paris, 1897.



IN the accounts of individual traders the Profit and
Loss account is, at stated intervals, closed out, and the
balance is carried to the credit of the proprietor's Capital
account. Profit and Loss is thus in practice, as well as
in theory, a mere temporary subdivision of the main Pro-
prietorship account, and at the close of the year is indis-
tinguishably merged with the latter. In corporation ac-
counting it is necessary to keep the accretions of wealth
separate from the original capital contributions. Never-
theless there is customarily a closing of the books, and an
apportionment of the annual profits of corporations simi-
lar to that which takes place in the books of the individual
or of the partnership. At such a time a part of the profits
are normally voted as dividends and immediately pass out
of the control of the corporation. But it is unusual to dis-
tribute all of the profits earned and there is ordinarily
further action by the directors or stockholders deciding
to retain part of the profits. The profits thus reserved
from distribution are called Surplus, and constitute an
addition to the capital of the concern, practically as in the
partnership the profit balance is retained as capital by
being added to the proprietor's account.

Even in corporation accounting the similarity between
Capital and Surplus is sometimes observed, as for instance
in the tabular statements prepared by the Comptroller of
the Currency, in which Capital, Surplus, and Undivided
Profits are all grouped and included in a single sum ; and



not infrequently in published balance sheets Capital and
Surplus are similarly combined.

While there are legal differences in the treatment of
the two categories, yet from the view point of accounting,
a Surplus represents capital secured by reserving profits,
in contradistinction to capital contributed directly by the

Some technical exceptions are to be found to the state-
ment that a Surplus means reserved profits. A Surplus
occasionally is established by a corporation de novo, before
any profits have accrued, out of part of the contributions
made directly by the stockholders. This is particularly
the case in organizing banks where stock is often sub-
scribed for at a premium. It is questionable whether this
premium can rightly be credited to the Profit and Loss,
or Revenue account. Some accountants permit this and
the English courts have declared it legal (In re Hoare
& Co. [1904] 2 Ch. 213). But statute law in Germany,
and the better practice both in England and the United
States, hold that such premiums are no part of ordinary
profits, and as they cannot be credited directly to capital
are to be placed in a special Reserve or Surplus account.
Where this is done there is technically no reservation of
profits, but at least it is a reservation of the excess above
capital, the peculiarity being that an excess over capital,
normally caused only by the gain of profits, is in this case
created by a contribution of the stockholders.

Other circumstances in which a Surplus is created
otherwise than by accumulating profits are : where the
stock of a company is reduced without full return to the
stockholders of the par value; where stock is bought in
the market at less than its face value; and less clearly
where bonds are similarly redeemed. The payment some-
times made by stockholders in return for having their
holdings given the privileges of preferred stock, or other



similar advantages, likewise properly gives rise to a Sur-
plus which strictly speaking is not profit. Occasionally,
too, stockholders make a voluntary contribution, generally
of stock, for the purpose of providing means for raising
cash for working expenses, which again creates a Surplus
not derived from profits. In all these cases it would not
be illegal, except when statute law distinctly prohibits, as
is the case in Germany, to treat these receipts as profits
available for dividends, and they may therefore all be
regarded as exceptions to the general statement that a
Surplus or Reserve is a portion of profits withheld from

Accounting nomenclature, however, is so vague, that
it is not always easy nor possible to determine from a Bal-
ance Sheet whether certain items represent an actual res-
ervation of profits or whether they are merely Valuation
Accounts; that is, accounts indicating that a deduction
must be made from the book value of the assets. This
may be illustrated by taking a company whose books, at
the end of a year, make the following showing:


FORM 81.
Trial Balance.


Plant at cost $50,000

Accounts receivable 50,000

Expenses 50,000

Miscellaneous Assets .... 25,000


Capital $100,000

Sales 75,000


This shows an apparent gain of $25,000, but no allowance
has as yet been made for depreciation, without which prof-
its cannot be determined. Assuming the depreciation to
be $5,000 the Balance Sheet may show :




FORM 82.
Balance Sheet.


Plant at cost $50,000

Accounts receivable 50,000

Miscellaneous Assets. . . . 25,000


Capital $100,000

Depreciation' 5,000

Profits 20,000


The directors or stockholders decide that business is so
profitable that it will be desirable to extend the plant
within a few years, and in preparation therefor vote to
withhold $5,000 of the profits as the beginning of a fund
with which to make the expected extensions; and in order
to be on the safe side they vote to reserve $1,000 to cover
any possible future loss which may occur when attempt
is made to realize on the accounts receivable. They fur-
thermore decide to hold $5,000 as a Surplus, or permanent
addition to the capital resources, and vote a dividend of
$8,000. This leaves an unappropriated balance of $1,000.
The Balance Sheet then reads as follows:


FORM 83.
Balance Sheet.


Plant at cost

Accounts receivable. . .
Miscellaneous Assets.. .



(1) Capital $100,000

(2) Depreciation Fund. . 5,000

(3) Reserve for exten-

sions 5,0(50

(4) "Reserve" for Bad

Debts 1,000

(5) Dividends declared.. 8,000

(6) Surplus 5,000

(7) Balance of Undi-

vided Profits 1,000


1 The depreciation account is purposely left on the credit side instead
of being subtracted from the valuation of the plant in order to emphasize
the distinction made below.


The terms here used are customary ones, but usage is
not absolutely fixed and other titles are frequently met in
Balance Sheets. So far as it is possible to give a fixed
definition the differentiation in the terms used is about
as follows:

Surplus indicates a portion of the profits withheld
from distribution for the purpose of establishing a per-
manent addition to the effective capital of the concern.
It does not imply any specific use to which it is to be put
and is perhaps the most comprehensive of all the terms
employed to designate reserved profits.

Reserve generally contains the idea of some special pur-
pose for which the reservation is made. This is, however,
not uniformly so, as there are frequently found certain
Reserves made for some specific purpose, and a more gen-
eral Reserve, which would correspond exactly to " Sur-
plus " as used above. By some Reserve is differentiated
from Surplus by implying some peculiar investment, as
is shown later, but this is not a generally accepted con-
vention. In Germany Reserve is the common term, there
being no equivalent to Surplus.

Undivided Profits merely indicates, as the name sug-
gests, a portion of the profits on which no specific action
was taken. But the fact that it was not voted as a divi-
dend does constitute it, in fact though not in name, a Sur-
plus Reserve. The reason for differentiating is the unwill-
ingness to distribute so closely the profits as to run the
risk of having a Debit balance appear in the Profit and
Loss account.

Other titles are used. Rest, in England, is the equiva-
lent of Surplus or of Reserve (in the general sense) ; Re-
serve Fund is used, either as synonymous with, or with
varying differentiations from, Reserve; Specific Reserves
are often called by some distinguishing title, as, for in-
stance, Renewal Fund, Sinking Fund, etc. ; and in Ameri-


can Railroad practice the undivided profits appear as Bal-
ance of Income Account.

In examining a Balance Sheet, such as is shown above,
the most important thing is clearly to distinguish between
the items, of which Depreciation Fund (2) is the type,
and those of which Reserve for Extension (3) is the type.
This is all the more difficult in practice because the titles
used are frequently more similar than those given above,
for (2) is often called Reserve for depreciation, or Reserve
Fund for Depreciation, and (3) may simply be called Re-
serve or Reserve Fund. Yet the real distinction between
them is radical, and the use of the term Reserve in the
former sense, while not uncommon in American account-
ing, is open to serious criticism. The Depreciation Fund
does not represent profits at all ; it does not indicate owner-
ship of any net wealth in addition to that represented by
the capital stock. On the contrary, it is a Valuation Ac-
count indicating that a deduction must be made from the
value of assets given on the Debit side of the Balance
Sheet. The Reserve for Extension (3) is, however, a part
of the profits; it does represent an addition to the orig-
inal net wealth shown in the Capital account; it shows
that assets have incre'ased. To distinguish between Valu-
ation Accounts and Reserves proper is therefore no less
important than it is difficult.

Item (4), " Reserve for bad debts " is perhaps even
more difficult to classify. There has been no wear and tear.
No one of the accounts is known to be bad; no single one
of them is even suspected. Each is carried on the books
at its full value, and perhaps no one of them would be
sold at a discount of two per cent. Yet ordinary common
sense and business experience show that a loss is likely
to occur, and a Reserve is provided so that if a loss should
take place it need not be charged against the current prof-
its. From the outside it is impossible to say whether this


is nearer akin to depreciation or to a reservation of prof-
its. If under the law of probabilities the loss is practically
certain to take place, it is logically a depreciation for an
unrealized but existing loss. If the creation of the Reserve
was based on a minimum certainty and a maximum of
prudence it represents a reservation of profits. The bal-
ance left standing to the credit of Undivided Profits is
logically and legally a Reserve, even though not techni-
cally so called. Profits which might have been distributed
were not voted as dividends and are, ipso facto, held as
a reserve. The only difference is a psychologic one, and
consists in the fact that the directors have apparently not
expressed so definite an intention of permanently holding
the balance, as they have done in regard to the Reserve
for Extensions and Reserve for Bad Debts.

A Surplus, by whatever name it may be called, repre-
senting additional capital (normally derived from profits)
the purposes for which it is created may be any of those
for which capital is needed, or it may be used, as profits
ordinarily are used, to provide means for paying divi-
dends. More specifically reserves are created:

(1) To provide a permanent increase of capital

(a) As an additional guaranty to creditors
(6) To provide for extension of its fixed or
other capital assets.

(2) To provide an additional capital which can be used

to cover unusual losses or to provide for
other emergencies without encroaching on
the nominal capital, and

(3) To provide for equalizing dividends by retaining

part of one year's profit to be used to
make up scanty profits for other years.

1. The provision of additional capital as further pro-
tection to creditors is frequently specifically required by


statute. In this country the best example is found in the
National Bank Act, which requires that one tenth of the
annual profits must be retained until a Surplus amount-
ing to twenty per cent, of the capital stock is accumulated.
More comprehensive are the laws of Germany and France,
which require all corporations to reserve a percentage of
the profits, and in addition certain particular receipts,
as, for example, premium on stock. In both these cases
the purpose of the law presumably is to furnish additional
security to creditors of the corporations concerned. An-
other example is the establishment of a Sinking Fund to
pay off a bonded debt, which according to current prac-
tice in the United States is, as is shown below, a Reserve to
protect the creditors.

The extension of the business through reserves is of
frequent occurrence. A most striking instance is the
Chemical National Bank which, with $300,000 capital
stock, accumulated a surplus of $6,000,000. But the prac-
tice is of much older origin, for the Bank of St. Ambrose,
established in Milan in 1593, made a practice of distribu-
ting only half its profits and accumulated a large surplus ;
and the early trading companies similarly divided only
a fraction of their profits. Similarly many railroads and
industrial corporations show reserves which make a very
appreciable addition to their capital. An instance which
has caused considerable discussion is the "Wells-Fargo Ex-
press Company with $8,000,000 capital and over $16,000,-
000 surplus. In foreign countries the accumulation of
permanent reserves is an accepted practice the average
reserve of all Austrian corporations being over 27 per
cent, of the capital, while that of the savings banks is
over 105 per cent.

2. The second class of Reserves is that created not to
provide for a general extension of the enterprise, but to
prevent its curtailment by providing a fund to be used in


special emergencies. A clear case is a Renewal Fund cre-
ated by a steamship company to be used to replace ves-
sels lost at sea. But more general aims may be in view,
such as the provision against any unseen loss, whether
caused by bad debts, by slack business due to hard times,
or by any of the countless dangers which beset the course
of business enterprise. Because of such a reserve the First
National Bank of Chicago some years ago was able to
charge off at one stroke a million dollars of its notes and
bills, whose ultimate payment was made uncertain as the
result of the panic of 1893. Another corporation in 1903
suffered loss to its property by the hurricane in Jamaica,
a loss surely not distinctly anticipated, yet one which was
most conveniently covered by a previous Surplus.

Such provision against unforeseen emergencies may
perhaps be construed as one form of a protection for credi-
tors, and the legal reserves mentioned above are as a mat-
ter of fact generally used to cover exceptional losses. But
this provision inures as well to the benefit of stockholders,
and in many cases the establishment of a Reserve for emer-
gencies is inspired by regard for the stockholder rather
than for the creditor if indeed the two interests can be
separated. Among such emergency reserves may be men-
tioned a " Reserve for personal injuries " of a coal com-
pany ; a ' ' Reserve for accidents ' ' not unreasonably pro-
vided by a manufacturer of powder; and an " Accident
fund " of a street railway company.

3. The final type of Reserves is that for the purpose of
equalizing dividends. Here it is scarcely correct to say,
as has been done by some writers, that the Reserve creates
an addition to Capital, for Capital does not provide a fund
for dividend paying. Here the Reserve preserves rather
its original character as profits profits not distributed
during the current year, but to be distributed as dividends
in future years, when the annual profits may be scant.


This is a most common practice of which many instances
are found in American corporation finance.

The different purposes enumerated above are not al-
together distinct or mutually exclusive, the provision for
unusual losses, for instance, being at the same time an ad-
ditional guaranty to the creditor and a means for equaliz-
ing dividends.

The purpose of a surplus may be more or less definitely
limited and specialized. Most commonly, indeed, there is
only a single Reserve created which is general in its char-
acter, and may be used for any of the purposes enumer-
ated. On the other hand the purpose may be strictly lim-
ited, as for instance a Reserve for erecting a particular
building, or for constructing a certain bridge. The United
States Steel Corporation, for instance, as shown in its Bal-
ance Sheet (Form 29) has in addition to its several Sink-
ing Funds no less than eight Reserves, including funds for
contemplated appropriations, for authorized appropria-
tions and for the specific purpose of building the plant at
Gary, Indiana. The Balance Sheet of the Atchison, To-

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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 18 of 27)