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.
We have spoken of surplus in the preceding chapter as if it were always derived from earnings. Ordinarily this is so but surplus may result from other causes as well. Five possible sources of surplus are given below:
1. Inheritance from previously absorbed corporations.
2. Sale of securities above par.
3. Sale of assets above their book value.
4. Revaluation of assets.
5. Accumulation out of earnings.
The first source is uncommon, inasmuch as most new corporations, even those which take over going businesses, carry the assets which they acquire at their full cost value - no more and no less - so that they start with neither a surplus nor a deficit; and this would seem ordinarily to be the correct procedure. However, there are occasional exceptions. In 1914 the Dominion Linens Company of Canada was organized with an issued capital stock of $250,000. The company, according to a statement prepared by the well-known accounting firm of Price, Waterhouse and Company, showed assets of $267,-684. After deducting a small amount of accounts payable there was left a surplus at the outset of $14,138. It should be remarked, however, that among the assets was one item of "good-will, trade-marks, etc., " valued at $20,000. A surplus of this nature can hardly escape the suspicion of being more or less fictitious. It is scarcely safe to assume that the assets acquired are worth more than what was paid for them. The fact that these assets may have been carried on the books of the previously existing companies at a higher book value than was paid for them, has no bearing on the case so far as the new company is concerned.
The second source consists of the sale of securities above par. In such a case the corporation receives a greater sum than the nominal value of the obligations or the shares which it issues. This additional sum may be carried to an account called "Premium on Securities" or some such title, or it may be and frequently is credited direct to surplus. It is clear that a surplus which arises in this form is hardly to be regarded as a proper source of dividends, inasmuch as the premium on shares or bonds is in reality a contribution to the capital assets of the company. In handling transactions of this type, industrial and railroad corporations might profitably take a leaf from the practice of banks. In organizing new banks it is frequently agreed that every $100 share shall be sold at $125 or $150, or some other amount above its nominal value, so as to create a surplus account at the outset. As the bank earns profits, these are carried, not to the Surplus account, but to an account entitled "Undivided Profits" out of which dividends are declared. From time to time the directors may, more or less arbitrarily, transfer whatever sums they decide upon from the Undivided Profits account to the Surplus account. It is understood that credits to surplus are not intended to be distributed, but are regarded as an integral part of the permanent capital of the institution.
The third source is through the sale of permanent assets, which are not intended for trading purposes, for a sum above their book value. Frequently assets are written down over a long period until their book valuation becomes only a small portion of their real value. To take an extreme and notable instance, the immensely valuable property of the Bank of England on Threadneedle Street, London, does not appear on the balance sheet of the corporation at all.
The fourth source of surplus is the revaluation of assets which have not been sold but are intended to be retained. This is a tempting expedient for a company which is running at an operating loss or with very small profits, and yet is under pressure to make a satisfactory showing. In the latter part of 1902, the management of the United States Leather Company decided to reappraise certain large areas of hemlock bark land which had been bought at a fair market valuation in 1893. Since then prices of timber and of bark had gone up. A committee of directors reported in 1903 that the bark property was worth about $14,000,000 more than its book value. In order to show this increased value on the books, the officials incorporated the Central Pennsylvania Lumber Company (all of the stock of which was owned by the United States Leather Company); the lumber company bought the timber (only) on the revalued bark land, for which it gave $10,000,000 of first mortgage bonds. It was intended to pay dividends on the preferred stock out of this suddenly acquired surplus. However, the original contract between the corporation and its preferred shareholders stated that dividends should be paid only out of net earnings, and the revaluation of the timber lands could hardly be construed as "net earnings.,, On the other hand, it was argued that the timber had actually been sold and securities had been received in payment. In the end, the question was settled without bringing before the court the dispute as to whether the formation of the subsidiary company and the transfer of its bonds was or was not merely a fiction.
The handling of timber properties so as to present a fair statement of the results that are actually achieved, always raises difficult questions. Taxes assessed against timber lands are frequently charged into an asset account in order to show the total carrying charges of the property. The continual rise in land values, and especially in the values of timber properties, has been so regular that this method has seldom been found disappointing. As to the revaluation of timber properties, it is thought by some authorities that there is no special objection in this case, provided the surplus thus created is put into a separate account and not treated as a part of the general surplus available for dividends.
The question as to whether assets should be revalued or not frequently arises, also, in the cases of banks and other financial institutions which own large amounts of securities. On a rising market these securities may frequently have a market value much higher than their original cost, and the officers or directors of the company may desire that this extra value should be shown on the books and credited to surplus. Independent accountants are usually strongly averse to this practice, on the ground that it makes a fictitious showing of profits. If the securities are actually sold and a profit is realized, then this profit will naturally go into a surplus account. Otherwise it is regarded as sound and correct to carry them at their cost valuation. It is not, however, inconsistent with this principle to insist that declinations in market value should be written off against surplus.
It must be remembered that the surplus account is at best only an estimate and that it is highly desirable to keep this estimate always well within conservative limits. In operating an enterprise and selling its products, a valuable trait is the optimism that will carry a man forward through discouragements and temporary defeats. But in estimating the results and forecasting the future, it is necessary above all to be cautious and even skeptical.
In general it is safe to say that the instances in which an upward revaluation of the permanent assets of a company is permissible, are highly exceptional and that in these exceptional cases the surplus thus created should always be plainly earmarked so that there will be no mistaking its source.
The fifth and most important source of surplus consists of savings out of the company's earnings. We have already seen that every year should yield a balance of profits above all fixed charges and above all dividends. This balance, if credited to surplus year after year, will in time build up a large surplus account. If the building up of this account is accompanied by consistent writing down of all assets of doubtful value, the balance sheet of the company will in time show an increasing equity on the part of the shareholders of a very substantial nature. If surplus were always built up only out of conservatively estimated earnings, it could be safely accepted as a fairly accurate measure of the real prosperity and solidity of the business. But surplus which comes from the other sources that have been named - even though it may be a genuine surplus which has been realized - gives no convincing evidence of earning power or of conservative and level-headed management.
The term "surplus," therefore, in itself means little. It should always be examined with care and its origin should be determined before basing upon it any judgment as to the prosperity or good management of the company which shows it.
We have now to consider what principles should be followed in accumulating surplus out of earnings and what uses should be made of the increased assets which are represented in the surplus account.