Accounting theory and practice, Volume 2 (of 3) : a textbook for colleges and…

CAPITAL STOCK AND ITS VALUATION Problems in Valuation The problems in connection with the valuation of the assets and the liabilities and the manner of showing them on the balance sheet—and in some cases the manner of booking them—have been treated in some detail in the preceding chapters. It might seem that, inasmuch as proprietorship or net worth is determined always by the excess of assets over liabilities, no question would arise concerning the valuation of net worth, its value being automatically determined by whatever values are placed on assets and liabilities. That its value is so determined, that every change in net worth must be reflected in the assets and liabilities, does not admit of argument. There are, however, certain phases of the question of valuation and certain problems connected with it, that, because of their close connection with net worth or their direct effect upon it, are best treated under this head rather than under the head of each particular asset that may be affected. Thus, if treated among the assets, the valuation of properties purchased with stock would require, under the head of each asset which might be so acquired, an almost identical statement of principle. For this reason, some problems in valuation have been reserved for treatment here in connection with capital stock. In addition, there are related problems which concern the surplus and reserves. It is true, these all have their origin in the general considerations of valuation as given for the assets and liabilities. But questions as to what constitutes a profit, whether all profits are applicable to dividends, the proper treatment of capital profits, the relation of capital losses to profits and dividends, the differentiation of the classes of reserves, and finally the manner of showing and explaining the periodic changes in net worth by means of the supplementary statement of profit and loss—all these and other similar questions are closely related to the problem of valuation and, as indicative of the financial policy of a business, may directly affect all going concern values. On this account they require separate treatment from that of any individual assets and liabilities or group of assets and liabilities. Accordingly, the next few chapters will be concerned with these problems and any others which are relevant thereto. Kinds of Stock Capital stock is of various kinds—that with a stated par value and that without, common stock, various kinds of preference shares, debenture stock, guaranteed stock, founders’ stock, convertible stock, and redeemable stock. The student is referred to Chapter I where these various kinds of stock are discussed. Par, Real, and Market Values Capital stock may have several kinds of value, as the term value is used. All stock is expressed as so much per share. The value mentioned as the stated value of a share of stock in the contract of issue is known as the par, face, or nominal value. The book value of stock is the value of the stock, as shown by the books—not the amount carried in the stock accounts, but the entire net worth of the corporation divided by the number of shares outstanding. Thus, if the assets minus the liabilities—the net assets—of a corporation amount to $1,500,000, of which $1,000,000 represents 10,000 shares of stock of par value $100, and the $500,000 is surplus, the book value of the stock is said to be $150 per share. From the standpoint of a going concern, this value is also spoken of as the real value in the sense that it is represented, dollar for dollar, by actual assets held by the corporation. Real value is also used to mean liquidation value, the value which the net assets upon forced or voluntary sale would realize for distribution to each shareholder. Finally, there is the market value of stock by which is meant the value placed on it in the stock market or wherever stocks are dealt in. This value depends primarily upon the dividend-earning capacity of the stock, although many side issues of fact and opinion affect it. Thus, not only present, but past as well as prospective future dividends influence the market. At times, particularly in a declining market, the financial needs of the holders of the stock may affect prices more than the dividend rate of the stock. The problem of stock valuation as related to the commercial balance sheet takes cognizance of only one of these values, viz., par value, though each of the others is related to and measured by the showing of values on the balance sheet. That par value is not always the true value cannot be controverted. As already shown, the inclusion on the balance sheet of assets of doubtful value is allowed when the doubtfulness of their value is generally recognized and no one is thereby misled. Some problems in connection with stock values and their inflation on the books will now be discussed. Value Dependent upon Earning Capacity Upon the inception of an enterprise the problem of stock valuation is always bound up with the question of valuation of the assets and liabilities, as pointed out above. When the asset to be valued is only cash, the problem is not usually difficult, as where the capital stock is sold for cash. Where, however, the sale is for a property taken over, the valuation of the stock is related to the larger problems of capitalization, with which in turn the valuation of the assets is bound up. It seems best, therefore, for an intelligent understanding of the question to review briefly some of the bases of capitalization. As indicated above, the market value of any stock is dependent in the long run more on the factor of its earning capacity than anything else. If investment in a stock nets the prevailing income rate on money, that stock will approximate its par value. So when determining the capitalization of a company which expects to be taken over as a going concern, the main consideration is not so much its true valuation as it is its earning capacity and its ability to pay dividends. Thus, if on a cost basis the net values taken over amount to $250,000, but past performance and future expectation reasonably indicate a capacity to earn a normal dividend on $1,000,000, it is very probable that the new company will capitalize at $1,000,000. If this sum is actually and in good faith paid, little or no exception can be taken to recording the value of the plant taken over at $1,000,000. The transaction is the result of a bargain. The additional value over cost may, in the estimate of the purchaser, represent the true value of the good-will or other intangible assets acquired but not included in the $250,000 referred to above. In a bargain transaction such as the foregoing, judgment of value is sometimes wrong; but the buyer can only show the property bought at what it cost him at the date of the purchase—whether the payment is in cash, stock of a stated par value, or other assets. Increase of Book Capitalization If, however, the transaction is merely a reorganization of the old company by its owners solely for the purpose of increasing its book capitalization by bringing onto the books an existent good-will or by other means of inflation of assets, the result is a so-called watering of the stock. The propriety or impropriety of this is chiefly a question of business ethics, and its discussion is beyond the limits and the purpose of this volume. It may be said here, in passing, that under certain conditions the practice may be entirely proper and no inequities may result. On the other hand, the purpose of such a reorganization may be fraudulent, in which case it frequently works hardship and injustice. The main accounting problem involved when the book capitalization of a concern is increased is the method of recording the transaction, so that the true status of affairs will appear unmistakably and any attempted fraud will be shown. Capitalization on Cost Opposed to the basis of capitalization on earning power is that of capitalization on cost. In a case of capitalization it is very difficult to know exactly what is meant by cost, as there are so many kinds of cost. There is original cost; original cost less depreciation; present cost new of an identical property, i.e., reproduction new cost; reproduction cost less depreciation, etc. In this discussion original cost is taken as the basis, less depreciation, or such cost plus a bona fide payment for good-will or for the privilege of securing an established business. All these other factors may and frequently do enter into the determination of a bargain and sale price and therefore affect capitalization. The regulation of the Public Service Commission of the First District, State of New York, concerning the manner of keeping the capital stock accounts of public service corporations, is as follows: “To the account for any class of stocks shall be credited when issued the par value of the amount of stock of that class issued. If such issue is for money, that fact shall be stated; and if for any other consideration than money, the person to whom issued shall be designated and the consideration for which issued shall be described with sufficient particularity to identify it; if such issue is to the treasurer, or other agent of the corporation, to be by him disposed of for the benefit of the corporation, that fact and the name of such agent shall be shown; and such agent shall in his account of the disposition thereof show the like details concerning the consideration realized thereon, which account when accepted by the corporation shall be preserved as a corporate record. If the fair cash value of the consideration realized upon the issue of any amount of stock is greater than the par value of such stock, the excess shall be credited to the account ‘Premiums on Stocks’ and the corresponding reference thereto shall be contained in the entry relating to such stock in the stock account.” The Law and Stock Issues Thus, it is seen that the state takes cognizance of financial arrangements and methods of accounting in some of those particulars wherein the state is vitally interested. These regulatory provisions are usually found in the corporation laws of the state or amendments thereto. At the present time there are at least three types of such laws: Under one type it is provided that, when property is taken by the corporation in payment of its shares, the incorporators alone are the judges of the values of such property and that the state’s only duty is to prevent fraud. Fraud must be shown by the injured party and usually the facts by which this might be established are hidden in records to which a stockholder has no access. The remedy is against the directors personally. This type of corporation law is found in most of the states. Under the second type active control of the issue of stock is undertaken by the state. This requires an independent appraisal and valuation by the state’s experts. This type of law is found frequently governing the incorporation of public utility companies. It is based on a paternalistic theory of state functions not yet recognized as applicable to private undertakings. Under the third type, we find the law authorizing the capitalization of any and all kinds of property—in the absence of fraud, of course—provided that a full statement is put on record showing the amount of stock and the exact manner in which it is paid for. The amount of cash received must be shown; the property acquired so labeled as to render identification possible; and any payments for services or other expenses must be shown. The attitude taken is that a prospective investor, provided with these facts about the company, can make his own judgment as to stock values. Thus, we find that practice is not uniform in these regards. From the viewpoint of theory, any accounting treatment of the issue of stock which shows the full facts with regard thereto may be considered as meeting all reasonable requirements. Treatment of Discount or Premium Valuing capital stock when issued for cash presents no problem in itself, but the treatment of the discount or premium incident thereto requires consideration. In most of the states and in Great Britain stock cannot be issued below par. The manner of nullifying this provision has already been referred to in Chapter I. There it was shown how the issue of fully paid stock is made for property and how treasury stock is created by donation, which may then be disposed of for any price obtainable, without any additional liability attaching to it. In most of the states and in Great Britain, however, a sales commission is allowed which has, in some instances, been used as a cloak for sales at a discount. The booking of the discount or premium presents no difficulties, but the manner of handling it on the balance sheet is not uniform. Premium or discount on stock should be recorded as such on the books, under titles of definite meaning. One occasionally hears the argument that the discount on stock is a necessary expense incident to financing the company, a sort of “cost of getting started,” an expense without which the enterprise could not be launched; accordingly the discount should be properly capitalized as a part of the property costs. The argument is plausible but not convincing. The information as to the discount on stock is very necessary to the prospective creditor or investor and should always appear as a separate item on the books. To the same effect is the ruling of the Interstate Commerce Commission that premiums on capital stock must be carried on the book permanently unless offset by discounts later allowed. Discounts may be extinguished by premiums, assessments, surplus, or by the retirement of an equivalent amount of stock. A premium on stock may be looked upon as similar to a capital surplus. It represents a fund of capital originating upon the inception of an enterprise, and is in no sense an increase of capital, i.e., of net worth, due to operation. So far as the law is concerned, there is nothing to prevent the return of this surplus to the shareholders in the form of a dividend. To treat it as available for ordinary dividends, however, would seem not to be in keeping with the manner of its origin. Rather should it be set aside as a permanent surplus. One requirement in the case of national banks is the creation of a permanent surplus equal to 20% of the capital, and so, frequently the original subscribers agree to take their stock at a 20% premium, this premium providing the legal surplus required. In the case of discounts no accounting principles are violated if they are allowed to remain on the books. If there is a surplus from premiums, that should be used to wipe off any discounts. In the absence of premium or other capital surplus, conservatism usually sanctions the use of operating surplus for this purpose, thus bringing the value of the net properties owned at least into equivalence with the par value of the stock. Valuation of Stock Issued for Property The difficulty of valuing stock when issued for property has already been stated and the attitude of the laws towards any valuation placed on the properties taken over has been shown. Nothing further here need be said except to state that where also a bona fide sale of a portion of the stock takes place for cash at the same time, a fairly reliable basis for valuing the stock given for the property is offered. It is not the usual practice to show the probable discount on the stock, although such treatment would be logical and consistent with the facts. A similar valuation of the stock might be secured by an independent appraisal of the properties taken over, but this, if done, is not often made the basis for entry on the books. If all the facts are fully recorded, that probably is as much as can be hoped for under the conditions now prevailing. Undoubtedly the use of no par value stock for incorporations of this kind offers the best solution of the problem. With regard to booking the properties acquired by a stock issue, attention is here called to the method of valuation of the individual units by an appraisal committee usually appointed from among the directors and the use of their findings as the basis for the book entries of the transaction. Valuation of Treasury Stock In connection with the purchase of properties by stock, there often arises the need of working capital. This is frequently furnished by the pro rata donation or return of some of the stock to the corporation, the sale of which furnishes the necessary working funds. As illustrated in an earlier chapter this donation is booked at the par value of the stock, the charge being to Treasury Stock and the credit to Donated Surplus, Donated Working Capital, or other similar account. Being true treasury stock, it can be sold at any price without liability. It is usually disposed of at a discount which must be recorded on the books either as a charge to Discount on Treasury Stock account which will later be closed against Donated Surplus or as a charge direct to Donated Surplus. Thus when the treasury stock is all disposed of, the net credit balance in Donated Surplus shows the real amount of working capital obtained through the donation. If not entirely sold, the portion sold gives a fair basis for the valuation of the unsold portion, although this value is seldom brought onto the books, it being used as a guide to financing rather than as an item to be regarded in accounting valuation. Redemption and Reduction of Capital Stock The redemption and reduction of capital stock presents a problem of surplus adjustment requiring careful treatment. If a corporation has accumulated no surplus of any sort and redemption of the stock is at par, no difficulty is met in making the entry. If, however, a surplus has been accumulated and redemption is either above or below par, care must be exercised to record the transaction properly. Redemption at a stated price is sometimes one feature of a preferred stock issue. Again the stock may be bought in the open market for the purpose of cancellation. Reduction of capital, except when made a condition of the original issue, cannot usually be accomplished without the consent of at least a majority of the shareholders and authorization from the state. For the sake of simplicity, assume just one class of stock and a surplus in which each share has an equal interest. If redemption is at par, the surplus is evidently not affected but each share of stock remaining outstanding has a larger share in the surplus and so acquires a higher book value. Redemption of a stock at its _book_ value is accomplished by charging capital stock for its par value and surplus for its pro rata share in the surplus, the offsetting credit to both these being to cash. The value of the remaining shares of stock has not been affected in the least. If redemption is at any other figure than book value, not only is surplus affected, being increased if the redemption price is below par and decreased if above par, but also the value of the remaining shares. In the case of different classes of stocks, a careful determination of their respectively equitable shares in surplus would have to be made before the effect on the remaining shares could be calculated. In passing from the question of stock values, it should be pointed out that an undervaluation of stock when issued for property, though seldom seen in practice, has the refreshing effect of creating a secret reserve. That is, property values are carried on the books below their actual values and a secret reserve is thereby created. A further discussion of secret reserves will follow in a later chapter. Dividend Stock Stock is sometimes issued for dividend purposes. In such cases, it is always issued as of par value. If profits have been earned or a surplus accumulated out of which a dividend may be declared, that dividend may be paid in any way the corporation sees fit. Payment may be made in cash, scrip, or in the shares of the company. If the corporation has neither unissued stock nor stock in the treasury, permission to increase its capitalization must be secured before a stock dividend can be paid. Some corporations, notably financial institutions, often make it a matter of policy to accumulate a large surplus and then distribute it by means of a stock dividend. Declaration of the dividend is made and recorded as usual. Record of the payment in stock is made as a debit to Dividends account and a credit to Capital Stock. The effect of a stock dividend is twofold. From the point of view of the management of the surplus it has the effect of a permanent investment of the surplus in the business. Thus it places the accumulated profits beyond the control of any future board of directors. If left in surplus, a cash dividend might have been declared and the asset dissipated to that extent. The stock dividend, however, keeps the profits invested in the business in such a way as not hereafter to be available for dividends. From the point of view of the stockholder, upon the declaration of a stock dividend his equity, his proprietorship in the business, is not in the least affected excepting that it is divided into more parts; he has more shares to represent it than he had before. Before he possessed as a community right a pro rata share in the surplus. Now the ownership of that share has become personal, individual. Each share of ownership thus has a smaller book value but each stockholder’s equity is the same as before. Stock Issued as a Bonus The manner of recording stock issued as a bonus with bonds or for any other purpose has been illustrated in an earlier chapter. Here, attention is called to the effect of such an issue in states where stock cannot be sold below par. There is no legal bar to the sale of bonds below par. If, then, the price received for the bond carrying a bonus of stock is at least equal to the par value of the bonus stock, there is nothing extra legal in the transaction. However, record must be made of the issue of the stock at par, the discount or bonus being carried as applying to the bond. The valuation of stock issued in effecting combinations or for labor or services follows along the same general principles as of that issued for property, and the same general considerations are pertinent. Unissued and Treasury Stock on the Balance Sheet When showing capital stock on the balance sheet, it is best to treat unissued and treasury stock as valuation items. The reason for this was stated and discussed in Chapter XIV. Here the relevancy of showing the unissued stock will be considered, as a statement of the outstanding stock is thought by some to be all that is required. It has been argued that the unissued stock does not in any sense represent an asset nor does it show proprietorship. Why not, therefore, leave it off the balance sheet statement entirely? It is true that an investor, a creditor, or a stockholder is interested in the main only in the condition of the business as shown by its present assets and liabilities. Unissued stock has no value till placed on the market; all that it shows is that certain legal requirements have been met authorizing its issue and to that extent it has a contingent value which may become a real source of capital to the corporation if additional funds become necessary. While, therefore, the omission of the item entirely from the balance sheet does not affect present conditions, it is considered best, in the interest of full information as to the exact status of the company, to show the amount of the authorized capital with the amount unissued extended short on the balance sheet, the difference being the amount outstanding—which is full-extended as the significant item, thus: Capital Stock Authorized $1,000,000.00 Less Amount Unissued 250,000.00 ------------- Amount Outstanding $750,000.00 A similar showing of the treasury stock is also considered best, although good authority can be found for its inclusion among the assets. Preferred Stock Covered by Redemption Contract On the border line between liabilities and proprietorship is preferred stock covered by an unfulfilled redemption contract. Such stock is issued with a definite redemption contract to become effective at stated dates, and is manifestly different from preferred stock redeemable upon call at any time _after_ a named date. In the latter case the option of redemption is with the company, whereas in the former case the company binds itself to a contract enforceable at a definitely stated time. From the financial standpoint the wisdom of a company binding itself to a contract enforceable some time in the future may be open to question because of the inability at the time of issue to foretell the company’s condition at the time of redemption; although in this respect the condition is practically the same as that confronting a company at the time of a bond issue. There is this marked difference, however: A bond issue is always a liability and continues as such after maturity; but in the case of a stock redeemable at a given date, the point at issue is whether the failure of the company to redeem automatically changes the status of the owner of the stock from that of a proprietor to that of an outside creditor. “For instance, a corporation sold $750,000 of first preferred stock, with a provision for the retirement of $150,000 annually after a certain period had elapsed. When the first instalment became due the corporation was unable to meet its obligation. There was no provision in the certificate bearing on the treatment of the overdue payment in the accounts or the balance sheets. The auditors declined to certify the balance sheet until a decision was reached as to whether or not the amount represented a liability to be liquidated as soon as funds were available. So long as this possibility existed the position of the general creditors was subject to change. Finally it was decided to secure an extension from all stockholders and upon satisfactory evidences thereof the auditors passed the balance sheet. “No general rule can be laid down for the auditor’s guidance in such cases as this, as each case must be decided on its merits. The most important facts for the auditor to ascertain are the rights of stockholders to insist upon payment, and the aggregates and due dates of all probable obligations. Their disposition in the accounts is then a matter of disclosing full information to creditors, prospective creditors, and to other stockholders.”[51] [51] Montgomery’s “Auditing, Theory and Practice.”