This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
A question which arises in the early history of most corporations, and which is of considerable practical importance, concerns the propriety of capitalizing initial losses and expenses. Every new corporation must expect to incur a loss during the period between the time it starts operations and the time its business is on a normal basis. This period may be long or short, depending upon the nature of the business. With many companies such as railroads, large manufacturing establishments, publishing concerns, developers of urban real estate, and the like, the period is apt to be several years in length. With trading companies the period should be relatively short. The excess of expenditures over income during this period is frequently charged to some capital account or accounts, such as "Development Expenses," "Organization Expenses," "Good-Will," or "Deferred Expenses." When a business comes to be on a normal basis and is earning profits, then initial expenses and losses may either be written off or may be transferred to some permanent capital account, thus providing a basis for a later increase in capitalization.
The same question arises in connection with interest payments on bonds that have been issued during the process of construction and development of a company and in connection with discounts on bonds sold below par. In a well-known English case it was decided in 1906 that "where a company borrows money to construct permanent works the interest paid during the period of construction might properly be treated as a part of the cost of construction and charged to capital."*
The English Companies' Consolidation Act of 1908 specifically provides that where shares are issued to defray expenses of construction, the company may pay interest on such shares and charge the payments to capital accounts, with the provisos that the payment be authorized by the stockholders and by the Board of Trade; that it shall not continue more than six months after construction is complete; that the rate of interest shall not exceed 4%; and that the transaction be clearly shown in the company's books of account. In this country much the same practice is found as in England, although it is not so definitely authorized.
* Hines v. Buenos Aires Grand National Tramways, 2 Ch. 654; quoted in Gore-Brown and Jordan's handbook on "Joint-Stock Companies," p. 283.
There seems to be no serious objection to be urged, although the practice may sometimes favor abuses. Examples might be cited of companies which have little or no prospect of success and yet have gone on for a period of four or five years charging the losses on their normal operations to a fictitious capital account, thus rendering a forced statement of alleged profits to their shareholders. These isolated abuses, however, are hardly to be taken as sound objections to a practice which is in itself correct. We are probably quite justified in saying that the total investment in an enterprise includes a reasonable allowance for expenses and losses incurred in carrying through the initial organization and development.