The distinction between gains and earned profit can be made clearer by the use of a concrete example, which will also afford a comparison of the various methods of dealing with profits. Assume that a corporation has acquired a tract of land at a total cost of $60,000, and that by means of advertising, exploiting, development, and a general enhancement of values, it has been able to sell this tract for $180,000, thus gaining $120,000. If the sale were made for cash, the following entries would appear on the debit side of the cash book'.
At the closing of the books, the Profits account is credited directly to the Profit and Loss account, the balance of which account may then be available for the payment of dividends.
Suppose that the transaction is a time sale, that a nominal cash consideration is inserted in the deed of conveyance, and that payment is to be made in five instalments as follows:
It is obviously improper to carry to the Profit and Loss account the entire profit of $120,000 when the first instalment is paid, as only 24/180 of the entire price has been paid in. If this were done, the entire profit of $120,000 might be paid out in dividends or be declared payable as such, while, as a matter of fact, the other four instalments might not be paid at all and the vendor be obliged to take back the property. In such case - which is not unknown - the transaction would state on the books as follows:
Less first instalment................................
Balance remaining unpaid......................
If the sale was not carried out, the unearned profit, having been used for the payment of dividends, must be written off to something. The only practicable disposition is to charge it to the cost of property, or to charge it back to Profit and Loss in the next statement. The latter is the better plan, as the former would involve the inflation of Real Estate account by $96,000.
It may be argued that the purchaser could be forced to make good any losses incurred through his failure to complete his purchase. This may or may not be true, depending, first, upon the nature of the agreement under which the sale was made, and second, upon the ability of the purchaser to pay. If the property were sold on some form of contract, there might be no obligation on the part of the purchaser to pay the entire price. If the unpaid portion of the price were secured by mortgage, recourse to the courts might result in a judgment the value of which would depend entirely upon the resources of the mortgagor. But aside from such contingencies, it must be noted that in dealing with real estate securities the common practice, and the safe and proper one, is to depend on the value of the physical security and not upon the financial standing of a mortgagor. Therein lies the safety of such securities, and therein is also found the favor with which mortgages are regarded by conservative investors. When a real estate corporation departs from this principle in its transactions, it justly forfeits the confidence of the public.