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 remarks in one of the earlier sections of this chapter as to the various sources of surplus may properly be taken to indicate reasons for questioning the validity of the surplus accounts which appear on the balance sheets of many corporations. If these alleged surpluses are based on revaluation of the company's assets or are derived from statements of earnings that have been exaggerated over a series of years, it may easily happen that on searching analysis and examination they will vanish into thin air. There is plenty of reason for a questioning attitude on the part of purchasers of securities when they are supplied with a surplus statement.
On the other hand, many old and well-established corporations may properly be said to have "hidden" or secret surpluses. The situation arises out of the practice over a series of years of understating net income; of making larger provision than is necessary for reserves; of writing down drastically the book values of assets, both tangible and intangible. The result obviously is that the balance sheet shows an understatement of the value of the company's assets; and this understatement constitutes a hidden surplus. If the balance sheet were revised so as to show the true values of the company's assets, the surplus account would be correspondingly increased.
In theory, the practice of understating the values of assets and carrying hidden surpluses is just as objectionable as the practice of overstating values. The real aim of the accountant and of the financial manager should be to see to it that the balance sheet tells the exact truth - neither more nor less - so that every creditor, every prospective purchaser of securities, may take action with his eyes open. However, this idea is not attainable and, since there must be an error on one side or the other, it is better to err on the side of understatement and overconservatism. Bankers and careful investors place a high value on a balance sheet that gives evidence of having been prepared with extreme caution or even pessimism.
Banking houses - and sometimes other firms as well - find it useful to carry certain surpluses in the form of undervaluations of securities and other assets in order to take care of exceptional losses without disturbing the appearance of the balance sheet. If a bank suffers a serious defalcation, for example, it may be highly injurious to its credit to charge the whole amount directly against surplus, thus advertising to its customers and the world at large that it has met with a set-back. In case the bank has been carrying assets at an undervaluation, it may resort in such a case to a revaluation of these assets so as to increase them by approximately the same amount as the loss that is to be written off. When the next balance sheet appears it shows no difference except that the skilled analyst might be able to detect changes in the valuations of assets; but this is not usually possible.
Hidden surpluses have been known to exist, not because of an especial degree of conservatism on the part of directors, but because it is deliberately intended to deceive shareholders as to the real value of their property. The shareholder is induced to sell, when his shares are desired by those on the inside, at a bargain price. Usually the next steps are to show the full amount of the earnings and surplus - with perhaps some inflation - to recapitalize and to sell the new issues at a heavy profit.
This is a subject which will again be referred to in the chapters which discuss methods of exploitation.