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.
Frequently the question arises whether dividends which have not been earned during a given period should nevertheless be paid and charged against the surplus that has been accumulated in previous periods. Ordinarily the answer that should immediately be given is, no. In ordinary practice surplus, as will be more clearly emphasized in the chapter following, is as much a part of the permanent capital of a company as is the capital stock itself. It is not invested in such a form as to make it available for the payment of dividends and it is understood as a matter of course by the creditors of the com-pany that it represents a permanent investment.
All this refers to customary financial practice, and not to the legal view of surplus which makes no distinction between that which has been accumulated in the past and that which is current. The legality of paying dividends out of accumulated surplus, which has seldom been seriously questioned, was reaffirmed in the New York courts in 1914 in an action brought by the preferred shareholders of the Union Pacific Railroad Company to enjoin the distribution of certain shares of stock and amounts of cash held in the treasury of the company to the common shareholders. The Union Pacific, which had been paying 10% per annum, desired to distribute securities and cash which would yield 2%, and thereupon to reduce its regular dividend payment to 8%. Certain preferred shareholders objected on the ground that this extra distribution would be charged, not against current surplus, but against accumulated surplus, and that the preferred shareholders had acquired a vested right, as a part of their equitable interest in the company, to be protected by the full amount of the accumulated surplus. No legal grounds for granting the injunction asked for were found by the court and the action was dismissed. Granting, then, that accumulated surplus is legally available for the payment of dividends and that customary practice makes it unavailable, the question still remains whether exceptions to this customary practice should ever be admitted. In July, 1914, the directors of the Baltimore and Ohio Railroad Company voted the usual semiannual dividend of 2% on the preferred and 3% on the common. The required total of dividends for the year, which amounted to $11,538,888, was greater than the surplus during the year by $2,469,095. It was explained unofficially that the company had not exercised its privilege of prorating depreciation charges over a series of years, but had charged against current earnings over $2,000,000 of losses incurred in the Central Western floods of March, 1913. The action of the directors was based on the belief that the decline in earnings was only temporary, and on a profound desire to maintain an unblemished record of regular dividends. There is no question as to the conservatism and ability of the board and this action was somewhat grudgingly accepted by the financial community as sound and correct. Nevertheless, it is by no means to be regarded as a precedent, but only as an isolated concession.