Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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profits, may either be used to cancel any loss, as current
profits would be used ; or at any time may be canceled by
retransference to Profit and Loss, which simply signifies
that profits for a while reserved are no longer so, but are
to be treated in the usual way.

But it has been shown that sometimes and frequently
a Reserve is created not to cover a loss or make possible
a dividend but to provide additional plant, to cover an
Exchange, not a Profit and Loss transaction.

Thus in the following case:



Dr.



SURPLUS AND RESERVES

FORM 93.

Balance Sheet.



25?

CV.



Plant $90,000

Cash 20,000

$110,000



Capital $100,000

Reserve for Extensions . . 1 0,000

$110,000



the Reserve may have been created for the specific purpose
of purchasing an additional machine. The time has come
when it is needed, and the Reserve is just sufficient to
cover the cost. Cash is lessened by $10,000 when the ma-
chine is purchased but this expenditure is no loss, as a
machine of equal value is received in exchange. Conse-
quently the Balance Sheet should show:



Dr.



FORM 94. -
Balance Sheet.



Cr.



Plant $90,000

Additions....... 10,000



Cash.



$100,000
10,000

$110,000



Capital $100,000

Reserve for Extensions . . 10,000



$110,000



In many cases, however, Cash is credited and Reserve is
debited showing merely:

FORM 95.
Dr. Balance Sheet. Cr.



Plant $90,000

Cash 10,000

$100,000



Capital $100,000



$100,000



But this is a case of creating a Secret Reserve, which has
already been criticised. There is no justification in charg-
ing to Reserve anything which could not legitimately be



258



MODEKN ACCOUNTING



charged against profits. The purchase of a machine, an
Exchange transaction, should not thus be charged. It may,
however, be desirable to make some change in the Reserve
item. It seems somewhat absurd to have a Reserve to pro-
vide for something already secured. Consequently the
credit to Reserve for Extension may be canceled and a
corresponding credit made either to the general Profit and
Loss account, or to the general Surplus account. Or if it
is desired to be more specific there can appear the cum-
brous but minutely accurate phrase: " Reserve created by
purchasing machinery out of profits. ' ' Any of these book-
ings is entirely correct. Crediting the Reserve back to
Profit and Loss is legitimate but it indicates a change in
policy, for if credited to profits dividends of that amount
can then be paid and the machine is no longer paid for out
of reserved profits but from capital. Doubtless a simple
transfer to Surplus, or general Reserve most recommends
itself.

The payment of debt, like the purchase of assets, is not
a loss transaction, and similarly is not a logical charge
against a Reserve. The treatment of a Reserve provided
for the payment of debts, should, therefore, be identical
with that of a Reserve for Extensions described above.

It is to be noted that the booking is identical whether
the Reserve is specifically covered or not. Where specific
investments are held, presumably they will be sold to pro-
vide cash with which to cover the payment. Thus with a
Balance Sheet showing:

FORM 96.
Dr. Balance Sheet. Cr,



Plant, etc $90,000

Investments 10,000

Cash 10,000

$110,000



Capital $100,000

Reserve for Extensions. . 10,000



$110,000



SURPLUS AND RESERVES



259



the company may make the addition to its plant contem-
plated when the Reserve for Extension was established.
Whether the payment is made from the cash on hand or
from $10,000 realized from the sale of the investments, is
immaterial so far as it affects the rest of the Balance Sheet.
In either case the item " Plant " is increased by $10,000,
and the treatment of the Reserve is the same. The amount
of the latter remains unaltered although the term used in
the Balance Sheet may be changed as suggested in the
preceding paragraph. Even when specific investments are
held to cover the Reserve it may be that a flurry in the
investment market makes it undesirable to sell them, and
the purchase is made with cash already in hand or even by
credit. In the last named case the Balance Sheet becomes :



Or.



FORM 97.
Balance Sheet.



Cr.



Plant, etc $100,000

Investments 10,000

Ovsh 10,000

$120,000



Capital $100,000

Bills payable 10,000

Reserve 10,000

$120,000



This again emphasizes the fact that the booking of Reserves
is practically independent of the existence of specific assets.
The item Reserve for Insurance is frequently found in
Balance Sheets. It generally occurs where a company,
whose plant is so widely scattered that there is little likeli-
hood of large loss by a single fire, decides not to carry any
insurance but to stand its own loss should one occur. In
such circumstances it is assumed that the insurance pre-
miums saved will more than cover losses as they occur. To
carry out this policy an annual charge, perhaps equivalent
to regular insurance premiums, is made against earnings,
and an equivalent amount is credited to Reserve for Insur-
ance. There may, or may not be a specific investment
18



260 MODERN ACCOUNTING

made to cover the reserve. It is somewhat difficult to deter-
mine whether such a reserve is really a part of profits.
Were the company to go into liquidation, or to change
its policy and provide for future losses by carrying regu-
lar insurance the balance then standing to the credit of
the Insurance Keserve would unquestionably represent an
addition to profits which could be distributed as dividends.
But so long as the company maintains its business and
refrains from insuring, the Reserve is closely allied to a
Depreciation account or a provision for bad debts. If the
plant is sufficiently large and scattered the law of proba-
bilities makes certain that a loss will some time occur. If
an accurate estimate shows that there will be an average
loss of $20,000 each ten years, it is clear that the account-
ant should charge $2,000 (ignoring the compounding of
interest) as the share of such loss properly to be allocated
to each year's business. And the accumulation of such
charges is not so much a part of net profits as a represen-
tation of a loss logically anticipated but as yet unrealized.

BIBLIOGRAPHICAL NOTE TO CHAPTER XIII

DAWSON, S. S. Reserves and Reserve Funds. Article in Encyclo-
paedia of Accounting, V, p. 482.

DICKSEE, L. R. Depreciation, Reserves, and Reserve Funds.
London, 1903.

MEADE, E. S. The Management of the Surplus Reserve. Publica-
tions of the American Economic A ssociation. 3rd series. V. p . 245.

NEUKAMP, E. Der Reservefonds der Aktiengesellschaften. Gold-
Schmidt's Zeitschrift f. d. gesamte Handelsrecht. XXXVIII, 10.

Das Dogma von der " Bilanzwahrheit " Ibid., XLVIII, 450.

[A strong argument in favor of secret reserves.]

PIXLEY, F. W. Auditors, their Duties and Responsibilities. I. 358-
361. Ninth edition. London, 1906.

REHM, H. Loc. cit., 542-642. [Emphasizes the distinction between
a real nd a fictitious reserve.]

SIMON, H. V. Loc. cit.. 227-283.



CHAPTER XIV



SINKING FUNDS

A SINKING FUND in the strict sense is a fund raised by
annual contributions for the purppse of providing means
for paying off a funded debt. The term is of very fre-
quent occurrence in accounting, especially in the Balance
Sheets of American railways. Its use is however not uni-
form, and an examination of a number of railroad reports
will disclose some in which it appears only on the Liability
side, others where it is found only among the Assets, and
still others in which Sinking Fund appears both as a Debit
and a Credit. The various methods in which this is done
and the forms in which the transactions are booked are as
follows :

1. A given sum of money is annually paid to Sinking
Fund trustees or otherwise set aside to accumulate at com-
pound interest until the time when the bonds mature. The
payment is not regarded as a loss or an expense, which
indeed it is not, for the payment of debt not being an
expense certainly the preliminary setting aside of a fund
with which to pay the debt is no more so. Assuming a
road whose Balance Sheet shows:



Dr.



FORM 98.
Balance Sheet.



Cr.



Cost of road, etc $99,000,000

Cash 2,000,000



$101,000,000



Capital Stock $50,000,000

Funded Debt 50,000,000

Balance of Income

Account 1 ,000,000

$101,000,000



261



262



MODERN ACCOUNTING



the payment to the Sinking Fund trustees of an install-
ment of $500,000 produces the following condition:



Dr.



FORM 99.
Balance Sheet.



Cr.



Cost of road, etc $99,000,000

Cash in hands of Sink-
ing Fund Trustees . 500,000
Cash 1,500,000

$101,000,000



Capital Stock $50,000,000

Funded Debt 50,000,000

Balance of Income

Account 1,000,000

$101,000,000



In this case cash has been taken out of the general funds
and put aside to provide means for the future payment
of the bonds. There is no indication as to its relation to
profits. The legal requirement by contract with the bond-
holders is that funds be thus set aside and separately held.
So long as this is done it is immaterial to the bondholders
whether the cash is obtained from the stockholders, from
loans obtained elsewhere, or from accumulated profits.
The Sinking Fund here is a fund of assets, analogous to
a " bank reserve " and not a Reserve in the sense of re-
served profits. This form is used, for instance, by the
Chicago, Rock Island and Pacific.

2. Other roads are accustomed to charge the amount of
the Sinking Fund installment to the Income or Profit and
Loss account. In this case a distinct reserve is created by
withholding part of the accumulated profits. Where this
is done the Balance Sheet becomes:



Dr.



FORM 100.
Balance Sheet.



Cr.



Cost of road, etc $99,000,000

Cash in hand of Sink-

, ing Fund Trustees. 500,000

Cash 1,500,000



$101,000,000



Capital Stock $50,000,000

Funded Debt 50,000,000

Sinking Fund 500,000

Balance of Income

Account 500,000

$101,000,000



SINKING FUNDS 263

which is the form used by the Chicago and Northwestern
Eailway, and many other corporations. The name given
to the account varies somewhat in the different reports, but
the essential thing is to note that a Reserve Fund, specially
covered by cash in the hands of the trustees, has been
established, and that both sides of the Balance Sheet show
the amount of the Sinking Fund.

3. The other forms are variations of the two just given,
and depend on the method of employing the funds paid
to the trustees, and of booking the transactions. The pur-
pose of the Sinking Fund being to provide means which
shall serve to wipe out a given issue of bonds at a certain
time, this end can be gained either by leaving the cash
on deposit in a trust company, by investing it in outside
securities, or by buying up some of the Company's own
bonds. The first plan is objectionable because of the small
rate of interest received, the second involves the possibility
of risk, the danger of misappropriation of the large sums
of securities held by trustees, and a relative low rate of
interest, for the trustees will prefer bonds whose greater
security means lower returns. Investment in the Com-
pany's own securities is therefore the most desirable as
well as the customary method, and so far as practicable
the bonds purchased are part of the very issue to be cov-
ered by^ the Sinking Fund. Here the question of security
cannot arise, for the purchase of the bonds in itself secures
the desired end; misappropriation can be prevented by
canceling or by rendering the bonds otherwise non-nego-
tiable ; and the interest will be higher than could be gained
by any investment of approximately equal security.

Where outside investments are made the securities held
must appear in the Balance Sheet as p&rt of the assets of
the company, under the heading ' ' Cash and securities held
by Sinking Fund Trustees " or an equivalent phrase; but
where bonds of the company are purchased different meth-



264



MODEKN ACCOUNTING



ods of booking the transaction are employed. Sometimes
they too are included among the assets embraced in the
heading just given, but in other companies bonds so held
are not counted as assets, and are therefore necessarily
canceled from the bonds listed among the liabilities. This
is treating the bonds purchased for the Sinking Fund as a
payment of a debt, and a debt paid as a rule no longer
appears in the accounts. Assuming that the sinking fund
has been invested in the company's bonds, and that these
bonds are canceled, the Balance Sheets given above in
forms 99 and 100 become respectively

FORM 101.
Dr. Balance Sheet. Cr.



Cost of road, etc . .
Cash..



$99,000,000
1,500,000



$100,500,000



Capital Stock $50,000,000

Funded Debt 49,500,000

Balance of income
account 1,000,000

$100,500,000



Dr.



FORM 102.

Balance Sheet.



Cr.



Cost of road, etc . .
Cash



$99,000,000
1,500,000



$100,500,000



Capital Stock $50,000,000

Funded Debt 49,500,000

Sinking Fund 500,000

Balance of income

account 500,000

$100,500,000



Illustrations of the above are found in the reports of
the Louisville and Nashville Railway, which uses the form
101 so far as it concerns the bulk of its sinking fund pay-
ments, the uninvested balance appearing as a debit with
no corresponding credit; and in the balance sheet of the
United States Steel Corporation, given in Form 29, which
shows a credit but no debit for the bulk of its sinking fund
operations.



SINKING FUNDS 265

A comparison of the four methods shows that an item
representing the sinking fund appears in the first form
only among the debits, in the second in both debits and
credits, in the third in neither debit nor credit, and in the
fourth in the credit side alone. The creditors are given
the security, in the first case, of certain segregated assets,
but no assurance that the total assets of the company will
be increased. In the second case the reserved assets at the
same time constitute an increase in the total assets of the
company, gained by a reservation of profits, or at least
there is the guaranty that the stockholders take no divi-
dends unless profits are first withheld sufficient to provide
for repayment of the debt. In the third method no specific
assets are withheld and the gross assets may even decline,
but the outstanding claims are reduced so that the margin
of security is increased. In the fourth there is a similar
reduction in liabilities, but in this instance accompanied
by a guaranty, not found in the third method, that the
gross assets will at least be constant while the net assets
are being increased by paying debts with profits.

The theory of the Sinking Fund involves the com-
pounding of interest on the invested installments. Where
outside investments are made this is simply done by leav-
ing in the hands of the trustees the interest received.
Where the company's own bonds are purchased it involves
the payment of interest on the entire issue of bonds, in-
cluding those held by the sinking fund, and regardless of
whether these bonds are canceled and subtracted from the
liabilities or not. This interest in either case is credited
not to the general income of the company but to the Sink-
ing Fund, from the investments of which the interest is
derived. Thus assuming that the installment of $500,000
in the illustrations given above is promptly invested at
five per cent., the Balance Sheet at the end of the year
ignoring other changes is :



266



MODERN" ACCOUNTING



Dr.



FORM 103.

Balance Sheet.



Cr.



Cost of road, etc .... $99,000,000
Cash and securities in

hands of Sinking

Fund Trustees 525,000

Cash 1,500,000

$101,025,000



Capital $50,000,000

Bonded debt 50,000,000

Sinking Fund and

Accretions thereto . 525,000
Balance of income

account 500,000

$101,025,000



As the years pass the credit to ' ' Sinking Fund and accre-
tions thereto " and the " Cash and securities in hands of
Sinking Fund Trustees " increase pari passu by the accu-
mulation of compound interest on the several installments
paid.

Much discussion has occurred in the field of both public
and private finance as to the economic effects of adopting
a sinking fund policy. Whether this indirect and rather
cumbersome method of retiring debt is advantageous or
not has been argued with great vigor, but with this dis-
cussion the present treatise is not concerned. Some purely
accounting aspects of the subject are, however, of interest.

Sinking fund installments being in most cases compul-
sory under the mortgage, they are frequently treated as
fixed charges, together with interest payments. An illus-
tration is found in the reports of the Chicago and North-
western Railway Company, which shows:

FORM 104.



Gross earnings

Operating expenses and taxes

Net earnings

Other charges:

Interest $7.0

Sinking Funds J2

Add other income. . ,



$55. 7

38.6

$17.1



7.2



$9.9
.5

$10.4



SINKING FUNDS 267

On the other hand the Pennsylvania R. R. Company,
obtaining its earnings in the customary way, subtracts
interest, but not Sinking Fund installments, to obtain the
Net Income, and from the Net Income are subtracted Con-
tributions to Sinking Funds, Special Reserve, and Divi-
dends, all three being treated as homologous items, each
being an appropriation of Net Income, not a charge against
Earnings.

From a theoretical view point the latter method is cor-
rect, the former erroneous. Payment of debt not being in
any sense an expense or loss, it may be left entirely out
of the Income Account as has been shown to be a recog-
nized method of treatment; but it is also legitimate to
provide for making such payments out of profits, just as
provision for extending a fixed plant may legitimately be
made by creating a Reserve; but in neither case is the
essential nature of the transaction altered, and this is cor-
rectly reported in the accounts by showing it as a dispo-
sition of profits.

On the other hand may be cited the authority of M. M.
Kirkman, Vice-President of the Chicago and Northwestern
Railway, who says:

" Sinking fund is unrepresented capital. It is not
chargeable against income account any more than any
other capital expenditure. The reason why we so often
find it included in the income account is because of the
conservatism of proprietors. It is another way they have
of strengthening their properties. It is similar in effect
to making improvements with net earnings. The fact that
it is done by sagacious and practical business men is, in
itself, sufficient evidence that it is proper. ' ' x

But the analogy here given is not quite correct. In
charging improvements to net earnings the item disap-
pears entirely from the Balance Sheet and constitutes a

1 Science of Railways, III, p. 104.



268 MODERN ACCOUNTING

Secret Reserve. This is apparently never done in regard
to the Sinking Fund. The payment does not disappear
but is either held among the assets or what is equivalent
is deducted from outstanding debt. The alternative, so
far as the showing in the Balance Sheet is concerned, is
between retaining an unappropriated Balance to Income
and a Special Reserve, not between creating a secret and
an open reserve. Charging to income reduces the unap-
propriated balance and doubtless lessens the clamor for
extra dividends which might appear as that balance is
augmented, but which would be less insistent where the
amount appears as Sinking Fund. To charge to gross
rather than to net income affects only the showing in cur-
rent income accounts, not at all the cumulative sum in the
Balance Sheet, but even the showing of the annual profits
at a sum larger than can advisedly be distributed is at
times embarrassing. While the net profits of the Chicago
and Northwestern Railway were unquestionably larger
than the amount shown, the amount of " Net profits avail-
able for dividends " were not larger. The compulsory
nature of the Sinking Fund has some bearing, it is true,
but neither national banks nor foreign corporations con-
sider the compulsory establishment of a surplus a reason
for understating the annual net profits, and they do not
charge the required percentage of their profits as if it
were an expense, but show it properly as an appropriation
of profits. So the compulsory nature of the Sinking
Fund, while lessening the amount which may be available
for dividends, should not diminish the net profits shown.
Even the decisions of the courts, that profits are ascer-
tained after the payment of Sinking Funds (Belfast &
Moosehead Lake Ry. v. Belfast, 71 Me. 445 (1885), Ex-
celsior Water & Mining Co. v. Pierce, 90 Cal. 131 (1891))
like the similar decisions regarding the payment of the
principal of the debt, are, as is shown in Chapter XII, to



SINKING FUNDS



269



be explained as a ruling against forcing dividends rather
than as a scientific definition of the nature of profits.

The customary treatment of interest received on Sinking
Fund investments is similarly inexact. The interest thus
received is part of the income of the company. That it is
immediately appropriated to a special purpose, does not
alter its nature as income of the company. As such it
might with propriety, indeed it logically should, appear
in the Income account. But in practice, where the Sinking
Fund appears as a special reserve, the income derived from
its investment is not shown in the Income account but is
credited direct to the fund or to some subordinate account
as for instance " Sinking Fund Accretions." Thus again
the showing of annual profits is too low, although the Bal-
ance Sheet does show in full the reserved profits held in
the Sinking Fund.

In the normal course, when the time comes for the re-
tirement of the bonds covered by the Sinking Fund, the
credit to that account should equal the amount of bonds.
Where the specific investment of the funds is shown, the
Balance Sheet becomes:



Dr.



FORM 105.
Balance Sheet.



Cr.



Cost of road, etc $99,000,000

Cash, etc., in hands of
Sinking Fund Trus-
tees 50,000,000

Cash 1,500,000

$150,500,000



Capital Stock $50,000,000

Funded Debt 50,000,000

Sinking Fund 50,000,000

Balance of Income
Account 500,000

$150,500,000



At this point the bonds are presented to the trustees of
the Sinking Fund and paid by them. The Balance Sheet
then becomes:



270



MODERN ACCOUNTING



Dr.



FORM 106.

Balance Sheet.



Cr.



Cost of road, etc $99,000,000

Cash 1,500,000



$100,500,000



Capital Stock $50,000,000

Sinking Fund (?) 50,000,000

Balance of Income
Account 500,000

$100,500,000



It perhaps seems unreasonable to continue the Sinking
Fund under that title, now that the debt has been re-
deemed and canceled. The entire sum could with pro-
priety be credited back to Income Account, whence it all
originally came. To most accountants, however, it appears
better to continue it as a special reserve, perhaps under
some such descriptive title as that proposed by Dicksee
" Accumulations of Revenue which have provided the
wherewithal to Redeem Loans/', or so far as accounting
is concerned, it can legitimately be capitalized, and a stock
dividend issued for it to the stockholders. Economically
it means that by a period of prolonged abstinence the
stockholders, formerly having only a half interest in the
economic capital, have bought out the bondholders' inter-
est of $50,000,000, making payment out of their accumu-
lated profits or savings.

Where the Sinking Fund is invested in the bonds of
the company and such bonds are canceled 'and disappear
from the Balance Sheet (the method shown is Form 102
above), the final condition will be the same as that in
Form 106.

Where no special Sinking Fund is shown among the
liabilities the final payment of the debt does not require
any further alteration of the Balance Sheet, for the pay-
ment of bonds, either gradually or in mass has not been
charged against income, and there is no need for reestab-
lishing that depleted account.



SINKING FUNDS 271

The calculation of the amount required for a Sinking
Fund is as follows. The problem being the amount pay-
able at the end of each year, which invested at a given
rate of interest (i) will be sufficient to pay off the prin-
cipal (P) in (n) years. In this calculation the interest
annually paid on the bonds is neglected, that being a regu-
lar charge against the earnings of the company, the Sink-


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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 20 of 27)