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.
The final item in our formula for income consists of "balance carried to the permanent surplus account." It is sometimes labeled "surplus for the period," but, inasmuch as this phrase is applied also to what we have called "balance, applicable to dividends and surplus," it is somewhat misleading and for this reason is not used. Much confusion of thought arises out of the continual inaccuracies and variations in the application of such terms as "income," "profits," "earnings," and "surplus." Until the general usage of this and many other business terms becomes more clearly settled, it will be impossible wholly to avoid this confusion.
Two terms which should be clearly distinguished, however, are "surplus reserve" and "surplus fund." Surplus reserve, more frequently referred to simply as "surplus," is in effect simply an account or a group of accounts kept in the company's books which show the value of the equity belonging to stockholders over and above the par value of the outstanding shares. Like many other accounts, surplus is in part the result of estimate or of a series of estimates. If the estimate is judged by the directors or officers of the corporation to be wrong, it may be changed by a mere entry in the company's journal. An instance has been cited in the preceding chapter of the marking up of the book value of the plants and other assets of the National Cordage Company by $10,000,000, in order to create on the credit side of the balance sheet an increase in the surplus account of $10,000,000 from which a stock dividend could be paid. An instance has previously been given also of a publishing company, the good-will account of which was increased by $300,000 in order to inflate the surplus account by a like amount. In the section following, the various methods through which a surplus account may be built up are reviewed. For the immediate purpose, it is sufficient to emphasize the point that surplus reserve is in itself purely a more or less formal and inconclusive appraisal of the shareholders' equitable interest in the corporation above the par value of their holdings.
A surplus fund, on the other hand, is an asset account which can be properly used only to designate certain sums of cash, of securities, or of other property, which are set aside, not for use within the business, but for some supplementary purpose such as the retirement of certain securities or for the general protection and insurance of the shareholders against loss. The surplus fund seldom exists in this country under this title. It not infrequently happens, however, that a company carries holdings of cash or securities not needed in its business and set aside for a special purpose which could properly be labeled "surplus fund," if it were so desired. Surplus reserve and surplus fund, even where they coexist, are by no means necessarily equivalent.
In this volume, and in customary usage, the word "surplus" when used alone without qualification, refers to surplus reserve. The fact that it refers to a credit account - for which the corporation is responsible to its shareholders - and not to an asset or to any group of assets, should be borne clearly in mind.