Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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peka and Santa Fe Railway (Form 27) shows almost
equal differentiation. But even where the Reserve is a
special one there is no assurance that it will be devoted to
the purpose for which it was created. The specific labeling
of a Reserve is at best merely a declaration of the pres-
ent intentions of the existing board of directors. As both
intentions and boards are subject to change, there is no
guaranty that the Reserve will be used for the indicated
purpose. Continuity may, however, in some cases be se-
cured by pledging certain funds representing the reserve,
as for instance where investments representing a Sinking
Fund are given in trust to sinking fund trustees who can
use them only for the purpose of retiring specified bonds.
A compulsory Reserve is also to a limited extent preserved
from division. In Germany the uses to which it may be



SURPLUS AND RESERVES



243



applied are definitely prescribed; in this country the Sur-
plus, compulsory for National and for some State banks
is presumably safe from being used to pay dividends. But
even here the restriction is only a limited one, for a loss
which otherwise might have prevented dividends, may be
charged to Surplus. Thus a company showing



Dr.



FORM 84.
Balance Sheet.



Cr.



Assets $615,000



$615,000



Capital $100,000

Surplus 10,000

Deposits 500,000

Undivided Profits 5,000

$615,000



suffers an unexpected loss of $5,000 and charges this
against Undivided Profits. It will then probably not be
considered in a position to pay a dividend. But by charg-
ing the unusual loss against Surplus, there results the fol-
lowing :



Dr.



FORM 85.
Balance Sheet.



Cr.



Assets $610,000



$610,000



Capital $100,000

Surplus 5,000

Deposits 500,000

Undivided Profits 5,000

$610,000



a showing which makes the legitimacy of a dividend un-
questionable.

Frequently the designation given to a Reserve refers
not to the purpose for which it was created, but to the
source whence the surplus came. Thus are found the fol-
17



244 MODERN ACCOUNTING

lowing items: Premium received on old stock, Stock pur-
chase surplus, Real estate sales, Royalties, Surplus from
redemption of bonds, etc., all of which indicate the source
rather than the purpose of the Reserve.

A Surplus being a reservation of profits must be rep-
resented by equivalent assets. It is the increase of assets
that creates all profit, and necessarily that portion of the
profits reserved from distribution. To speak of a Surplus
without equivalent assets is, therefore, self-contradictory.
But with the ambiguous usage of the term Reserve the
question often arises as to whether it represents assets or
merely signifies the depreciation in value of some of the
assets. Some writers have even demanded that the term
Reserve should never be used unless it represent not
merely the existence of equivalent assets, but that certain
specific assets, of a particular character have been set aside
to cover the Reserve.

Deferring to a subsequent paragraph some distinctions
in terminology which have been involved in this contro-
versy, it may here be inquired whether the distinction
between a Reserve represented by specific assets a spe-
cially covered Reserve or as some term it a Reserve Fund
and one not so represented is significant.

The primary objection to the claim that a Reserve on
the Credit side of the Balance Sheet must be represented
or covered by certain specific assets, is that it implies a
confusion of the two sides of the Balance Sheet, of Goods
accounts and Proprietorship accounts. The Debit side
of the Balance Sheet lists certain specific Goods, the value
of which, less liabilities, equals the sum of the various
Proprietorship accounts; but there is ordinarily no spe-
cific asset corresponding to specific Credits. Bonds may
have been issued to purchase plant, preferred stock to pur-
chase present Goodwill, common stock to represent the esti-
mated additional earning power of the consolidation, but



SURPLUS AND RESERVES 245

the Balance Sheet does not make a separate equation of
these three pairs. It suffices to show that Plant -j- Good-
will Preferred stock -|- Common stock -f- Bonds.

It is true that the equating of the various items is in
part secured by the double account form of Balance Sheet
required of certain English Companies, where the receipts
from Capital Stock and Bonds are balanced against the
more permanent investments. There is also a comparison
made, though not a definite equation between various sub-
heads frequently introduced into modern Balance Sheets,
as for instance between Capital Assets and Capital Liabil-
ities and between Current Assets and Current Liabilities.
But even in such cases there is no real equivalence stated
between a given Credit and some other Debit item. The
equivalence of the Balance Sheet is that between the sum
of the items representing proprietorship and liabilities
and the sum of those representing assets. The groups into
which these assets are subdivided and the various subdi-
visions into which Proprietorship is for convenience
divided, are divergent systems of classification and should
not be confused. In the varied shifting of form which con-
tinually takes place in the assets, an original correspond-
ence between certain Credits and Debits becomes lost and
the connection can no longer be traced. Undoubtedly
every depositor and stockholder in a bank contributed
some particular money or other asset equivalent to his de-
posit or his subscription; but the identity is lost at once
upon the title passing to the bank and there is no specific
asset representing the particular claim of A although,
for convenience, there may be a comparison, though not
a balancing of the items of Deposits and Cash Reserve, or
of Deposits and Discounts.

Secondly, the setting aside of a specific asset does not
make the Reserve any more secure, any more available.
For instance, a Balance Sheet shows:



246



MODERN ACCOUNTING



Dr.



FORM 86.
Balance Sheet.



Cr.



Miscellaneous Assets. . . . $120,000
Investment of Reserve

Fund 5,000

$125,000



Capital $100,000

Debts 20,000

Reserve for Extension. . . 5,000

$125,000



A debt becomes due, which because of financial stringency
cannot be renewed or placed elsewhere. Unless the invest-
ments of the Reserve have been specifically placed in trust,
they will in such an emergency probably be sold to provide
cash to pay the debt. The Balance Sheet becomes:



Dr.



FORM 87.
Balance Sheet.



Cr.



Miscellaneous Assets $120,000



$120,000



Capital $100,000

Debts 15,000

Reserve for Extension. . . 5,000

$120,000



The specific investment has not made the Reserve for Ex-
tension any more available than it otherwise would have
been, and the Reserve remains despite the disappearance
of the specific investment. On the other hand the Reserve
is no more secure because of the specific investment, for
supposing that the business of the year following the show-
ing of Form 86 results in a net loss of $5,000, the Balance
Sheet then becomes:

FORM 88.
Dr. Balance Sheet. Cr.



Miscellaneous Assets* $115,000

Investment 5,000



$120,000



Capital $100,000

Debts 20,000

Reserve for Extension. . .

$120,000



SUKPLUS AND RESERVES



247



so that while the specific investment is still intact the Re-
serve has disappeared as effectively as possible. It would
be illegitimate to show

FORM 89.
Dr. Balance Sheet. Cr.



Miscellaneous Assets $115,000

Investment of Reserve

Fund 5,000

Loss 5,000

$125,000



Capital $100,000

Debts 20,000

Reserve for Extensions . . 5,000



$125,000



for the Reserve indicates that there has been a reserva-
tion of part of the profits amounting to $5,000 while the
Loss item shows there are no profits to be reserved. This
is shown even by Pixley who, himself, argues strongly that
a Reserve Fund must be specifically invested.

3. And finally, although this pertains to corporation
finance rather than to accounting, the identification of Re-
serve with specific assets lends itself easily to two false
theories :

(1) That an outside investment is a better holding for
the corporation than an investment in extending its own
plant, and (2) that where a fund of cash, or other liquid
assets is desirable as a provision for emergencies, such
provision need not be made out of capital, but only as
profits accumulate. The first of these views is undoubtedly
true in certain circumstances, as where provision is being
made for an emergency demanding ready funds, but as a
general principle it is without validity. The second view
is altogether unsound and vicious in principle and in
practice.

In such matters, where personal opinion and taste have
much weight, it may be well to quote two leading authori-
ties, one German and the other English. Says Rehm:



248 MODERN ACCOUNTING

" A Reserve Fund is not an asset but merely a technical
indication of property in such. It signifies that a given
value of assets may not be distributed or disbursed; but
as it is not assets it cannot be an item on the Asset side
of the Balance Sheet, and accordingly it also cannot be
transferred into assets and invested in given securities. ' ' l
Dicksee similarly says: " It cannot be too strongly ad-
vanced that the question as to whether or not any given
Reserve Fund is represented by assets consisting of mar-
ketable securities outside the business or by less readily
marketable assets employed in the business as fixed (or
working) capital, is comparatively speaking of little im-
portance. The most casual perusal of any Balance Sheet
will show at a glance, even to the least informed, by which
class of assets the Reserve Fund is represented. ' ' 2 On
the other hand, Pixley, Dawson, and Whatley object to
the use of the term Reserve Fund where there is not a cor-
responding specific asset. In the case of Hoare and Com-
pany, before the Court of Appeals, Vaughan Williams,
L. J., implies there is no Reserve Fund unless the assets
are specifically set aside, but Romer and Cozens-Hardy,
L. JJ., speak of a Reserve Fund where there is no sepa-
rate investment. Somewhat more specific is the provision
in the revised form of Table A of the English Compa-
nies Act. This is a model form of articles of association
which applies to all companies unless they specifically
adopt other articles. In this it is provided (Sec. 99) that
reserves for any purpose may at the discretion of the di-
rectors " either be employed in the business of the com-
pany or be invested in such investments (other than shares
of the company) as the directors may from time to time
think fit."

In accounting practice much diversity is found. The

J Die Bilanzen, 571. See also H. V. Simon: Die Bilanzen derAktien-
gesellschaften, 60. * Auditing, p. 287.



SURPLUS AND RESERVES 249

great majority of Reserves shown in Balance Sheets do not
show a corresponding special investment. Where there
is such an investment the more approved form is to indi-
cate it by using some such title as that recommended by
A. Lowes Dickinson, " Fund Assets," as for instance the
Illinois Central shows " Assets in Improvement Fund,"
" Assets in Surplus Dividend Fund," and " Assets in
Pension Fund," each of which is equal in amount to a
corresponding Fund on the credit side of the Balance
Sheet. In other cases the investments shown are not
equivalent to the Reserve, only a portion of the Reserve
being specifically invested as is seen by reference to the
Balance Sheet of the United States Steel Corporation. In
France the specific investment of reserves in outside securi-
ties is not customary.

An attempt is made at times to differentiate between
what is called a Reserve and a Reserve Fund. Unfortu-
nately there is no uniformity in the distinctions made, as
is shown by the various definitions of Reserve Fund given
by different authors.

1. " Reserve Fund is an asset item signifying that cer-
tain forms of wealth have been specifically set aside for
a given purpose. This may or may not be the equivalent
of a Reserve Account appearing in the credit side of the
Balance Sheet." (Keister. Corporation Accounting, p.
71.)

2. " Reserve Fund is a credit item indicating that
profits have been reserved and that a special fund of
wealth will be found on the debit side of the Balance
Sheet representing the reserve, one for which there has
been a special investment made, a specially covered re-
serve." (Pixley. Duties of Auditors, I, p. 359.)

3. " Reserve Fund is a credit item representing that
the reservation is made out of net profits, in contradistinc-



250 MODERN ACCOUNTING

tion to Reserve Account, which indicates a charge to Profit
and Loss before net profits are obtained. Reserve Fund
indicates actual profits, Reserve Account may be merely
a depreciation account." (Dicksee. Depreciation, Re-
serve and Reserve Funds, p. 51.)

4. " Reserve Fund is a Reserve for general purposes,
\vith perhaps no distinct object in view but available for
all contingent purposes, in contradistinction to a reserve
account provided for a definite and well-known contin-
gency." (Eddis. In Thome's Twentieth Century Book-
keeping, 424.)

5. " Reserve Fund is a Reserve which is shown on the
Balance Sheet in contradistinction to Secret Reserve."
(Rehm. Die Bilanzen, p. 543.)

In nomenclature employed in the present treatise the
equivalents for several uses of the ' ' Reserve Fund ' ' given
above are as follows:

1. Investment of Reserve (or similar title).

2. Specially Covered Reserve.

3. Reserved Profits, or simply Reserve.

4. General Reserve, or Surplus.

5. Open Reserve.

Much of the confusion is caused by the fact that the
term Reserve is used in connection with banking and in-
surance in an entirely different sense from that in gen-
eral bookkeeping practice. Thus the National Bank Act,
general banking literature, and at times even the Balance
Sheets of the banks use " Reserve " as indicating the en-
tire cash on hand or deposits in certain banks deemed by
law or custom equivalent to cash. A condensed Balance
Sheet, such as is published for advertising purposes, may
read



SURPLUS AND RESERVES



251



Resources.



FORM 90.
Condensed Balance Sheet.

Liabilities.



Loans and discounts.. .$11,100,000

Bonds 1,500,000

Reserve 7,000,000



$19,600,000



Capital $2,000,000

Surplus and Undivided

Profits 1,100,000

Deposits 16,500,000

$19,600,000



Reserve in this sense evidently has nothing to do with
profits, and its maintenance is in no wise dependent upon
the existence of accumulated profits; but in law and in
banking practice it is proportionate to the deposits, not
to profits. Similarly Reserve in insurance has a specific
meaning referring to certain classes of assets which must
be kept on hand to cover the actuarial value of outstand-
ing risks. Again this is proportionate to a given item of
liabilities, not to profits. In both of these cases the items
are better listed, not under " Reserve " but under some
title appropriate to the asset itself. The " Reserve " of
the bank is really " Cash " and " Deposits with approved
reserve agents " and is thus correctly stated in the detailed
Balance Sheet. The " Reserve " of the Insurance* Com-
pany is really " Cash," " Bonds," and similar items,
while " Reserve," as it appears among the liabilities, is
merely an indication that part of the accumulated profits
is not to be distributed as dividends. It is not the assets
themselves but represents at most a state of mind regard-
ing certain assets. The exceptional use of " Reserve " in
banking and insurance literature may sometimes be con-
fusing but the matter is so simple that it should cause no
serious misunderstanding.

A Reserve exists when an increment of assets is with-
held from distribution to the stockholders or proprietors;
that is, whenever the excess of the total value of the net



252



MODERN ACCOUNTING



assets over the original capital is retained by the company.
It is an ecomonic fact and is independent of whether the
accounts show the existence of such a surplus or not. In
corporations desiring to be considered conservative, or
wishing to escape taxation, or to conceal large profits, it
is not uncommon purposely to conceal the existence of
such a Reserve. This is done whenever there is an under-
valuation of assets, or less frequently when there is an
overstatement of liabilities. In such cases there is said
to be a Secret Reserve. Thus in. a company whose Balance
Sheet shows:

FORM 91.
Dr. Balance Sheet. Cr.



Plant, etc $90,000

Less Deprecia-
tion 5,000

- $85,000
Cash 10,000

$95,000



Capital.
Profits.



$90,000
5,000



$95,000



if an additional depreciation of $5,000 is reckoned, one
not represented by an actual loss or decline in value, the



Balance Sheet will read:



Dr.



FORM 92.
Balance Sheet.



Cr.



Plant, etc $90,000

Less Deprecia-
tion 10,000



$80,000



Cash 10,000

$90,000



Capital $90,000



$90,000



Despite the statement here made the net value of the
assets is really $95,000, which exceeds the capital by



SURPLUS AND RESERVES 253

$5,000. As no profits appear in the Balance Sheet, no divi-
dends can be declared, and the $5,000 cash, which might
otherwise have been distributed, is perforce reserved as
an addition to the working capital of the concern. Such
a condition may also be produced by treating as expenses,
or by charging direct to Profit and Loss account, pay-
ments which really represent the purchase of new assets.
If $5,000 is spent in making some unquestioned improve-
ment or addition to the plant, the normal entry is to
charge the amount to " Plant " or to some synonymous
account. A change in the form of assets held from Cash
to Plant does not affect Profits, or Surplus. But if the
payment is treated as though it were a mere expense, the
total assets are apparently diminished when the Cash is
paid, and no showing is made of the new asset gained by
purchase. Whether the charge is made originally to Ex-
pense and thus indirectly diminishes profit, or whether the
charge is made direct against Profit and Loss, or against
some special or general Reserve, the effect is* the same. In
one way or another the assets held are understated and to
an equivalent amount the showing of accumulated profits
is less than the correct amount.

Banks are especially given to this practice doubtless
with the purpose of being able to cover losses without dis-
closing them to the public. Thus the First National Bank
of New York City is said to have covered a defalcation of
$690,000 because it had so large a Secret Eeserve. This
could be done by bringing into the Balance Sheet enough
of the assets representing the Secret Reserve to cover the
unusual loss.

Railroads, too, especially those desiring a reputation
for conservatism have acted similarly either by violently
marking down the value of the road, as was done by the
Chicago and Northwestern Railway in 1893; or by charg-
ing to operation and maintenance sums representing very



254 MODERN ACCOUNTING

material additions to the physical property, as was done
by the same road to the extent of nearly $5,000,000 a
year for the seven successive years from 1900 to 1906.
An even more striking charge, one of $13,000,000, part
of the expense of constructing its tunnel, was made by the
Pennsylvania against a special Surplus in 1906.

Again appears a case of justifying a practice abhorrent
to accounting principles, yet not without certain practical
merits. In the anxiety to escape the prevalent temptation
to exaggerate the value of the assets, which in many cases
has led to such disgraceful results, conservative financiers
applaud an equally erroneous, but perhaps less dangerous
tendency to understatement. But the creation of a Secret
Reserve is not without its dangers. It may be used as a
means of refusing to pay dividends really earned, which
so far as it applies to holders of income bonds or non-
cumulative preferred stock, may work an irreparable loss.
Even where there are no such divisions of interests it may
lead ignorant stockholders, thinking the Balance Sheet cor-
rect, to dispose of their stock at less than its real value.

The position which the Interstate Commerce Commis-
sion has taken against the practice of charging to operat-
ing expenses payments really of the nature of betterments
is decidedly healthful. This has already been attacked by
the technical press, and has been spoken of as " casting
to the winds the whole system of conservative finance
which has been the boast of many American railroad com-
panies. ' ' l This is curious as coming from the organ of
the Chartered Accountants, whose council had previously
taken ground that the existence of Secret Reserves makes
the Balance Sheet criminally false. To identify conserva-
tive finance with incorrect statements is a dangerous prece-
dent, for the use of untruth in a good cause is likely to
induce an attitude of mind in which untruthfulness be-

Accountant, July 20, 1907.



SURPLUS AXD RESERVES 255

comes chronic and ineradicable. It is hard to believe that
so good a cause as financial conservatism needs such unholy
allies as misrepresentation and deception.

An extreme type of a Secret Reserve, one which the
directors were authorized to expend without accounting to
the stockholders therefor, was brought to notice in connec-
tion with the Birmingham Small Arms Company. The
articles of the company authorized the directors to set
aside, out of the profits, an " Internal Reserve Fund "
which need not be disclosed by the Balance Sheet, the
directors to use the Reserve Fund in any way which they
think will promote the interests of the company without
giving any information to the shareholders regarding the
amount or application of this Reserve. In discussing this
provision Justice Buckley said: " The special resolutions
in the present case provide that the Balance Sheet shall
not disclose the internal Reserve Fund ; it must, therefore,
omit on the assets' side of the Balance Sheet the assets
whi-jih make up the amount standing to the credit of that
fund and the contra item namely, the credit balance of
the fund on the liability side. The result will be to show
the financial position of the company to be not as good as
in fact it is. If the Balance Sheet be so worded as to show
that there is an undisclosed asset, the existence of which
makes the financial position better than shown such a Bal-
ance Sheet will not, in my judgment, be necessarily incon-
sistent with the Act of Parliament. Assets are often by
reason of prudence estimated, and stated to be estimated,
at less than their real value. The purpose of the Balance
Sheet is primarily to show that the financial position of
the company is at least as good as there stated, not to show
that it is not, or may not be better." ( [1906] 2 Ch. 378.)

A Surplus being nothing but accumulated profits, its
disbursement is secured in any way in which profits are
disbursed save where some particular statute or by-law



256 MODERN ACCOUNTING

prevents. More strictly speaking there occurs a cancella-
tion rather than a disbursement of Surplus, for a Surplus
in the sense of an account on the Credit side of the Balance
Sheet cannot itself be disbursed. Certain tangible assets
may be paid out and this may work a cancellation of the
Credit. The bookkeeping entries in connection with such
cancellation remain for consideration.

A Reserve created to provide against some unusual loss
logically remains intact until such loss occurs. This may
be a loss by fire or other accident, a loss due to default by
trade debtors or on securities held, a loss due to unfavor-
able results in business operations. Such a loss would
otherwise be charged to Profit and Loss, or to Capital, but
where a Reserve is held the unusual loss may appropri-
ately be charged against such Reserve, leaving the current
profits from ordinary business still available for dividends.
Similarly, where the Reserve is used to pay a dividend,
otherwise unearned, there results a cancellation of some
part of the Reserve, just as a dividend paid in ordinary
circumstances works a cancellation of the credit balance to
Net Profits. "Whether the charge for dividend is made
direct to the Reserve account, or whether part of the Re-
serve is transferred back to the Profit and Loss account
from which it originated is immaterial so far as the final
showing is concerned. The Reserve being a reservation of


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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 19 of 27)