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

SURPLUS AND RESERVES Definition Under the corporate form of organization, “surplus” in its broadest sense represents the difference between the net worth of the business and the capital stock issued and outstanding. Because of the legal requirement that the value of the capital stock be shown always at the original amount—which is usually par—any increments or decrements in value because of profits or losses made and reinvested in the enterprise must be shown under separate heads. Thus surplus—or deficit—is the general term to indicate this increase in value. In England the term “rest” is used in almost this same sense. “Margin” is also a title occasionally seen. Because of a much narrower technical meaning given to surplus, the general adoption of another term with the broader connotation above given would serve a really useful purpose. Of the titles in use, margin seems best to express the exact shade of meaning. In the interest of a standard terminology, the highest accounting authorities are coming to restrict surplus to that portion of the margin available for dividends and in that sense the word will be used in this chapter. Contrary uses of the word are frequently met. In banking institutions the surplus is almost as inviolable as the capital stock itself and is never used for dividend purposes. In government-controlled or supervised institutions, these special uses of the term have become too well established by law and custom ever to hope for a change in the interest of general uniformity. Creation of Margin The sources of the margin have for the most part been already indicated. The chief source is the net profit for the period as determined by the Profit and Loss account balance. What enters into that balance has been discussed in Chapter XXII, where it was also pointed out that under some circumstances it may be entirely legitimate to carry some temporary proprietorship items directly to a vested proprietorship account instead of by way of the summary account. Thus there may be other sources of margin than the current balance of Profit and Loss—extraordinary items whose inclusion with current summaries of operation would render those summaries useless as a guide for judging comparative results of various periods. _Capital Stock Premiums._ Sometimes, for the purpose of creating a margin at the inception of an enterprise a fund is contributed beyond the par value of the capital stock issued. This is accomplished by purchase of the stock at a premium, and is frequently seen in banking institutions, where it serves as an easy and speedy way to satisfy the law’s requirements for the accumulation of a “surplus.” The effect of this is to give the institution a better standing than it would otherwise have. The reduction of the capital stock outstanding without full recompense to the stockholder also results in the creation of margin. This is often done in reorganizations when fewer shares of the new stock are given than were held of the old. The effect, then, is to set up a book profit against which may be charged the existing deficit, and so secure a balance between the real net worth and the par of the new stock issue. _Stock Donation._ Another source of margin is a stock donation. This may result in only a book profit. It is exceedingly difficult and generally impossible to determine the true value of many speculative ventures, such as mining enterprises. As a general rule, capitalization based on opinion is usually overcapitalization. While a stock donation may have no relation to real values and is merely a method of securing working capital, its effect when the stock is sold is to increase the cash asset and show a profit of an equal amount. Some authorities hold that instead of retaining the profit on the books, the logical thing is to reduce the carrying values of the speculative assets by the amount of the realized profit on stock donation. There would be more reason for this treatment were there any real relationship between the amount of the stock donation and the overvaluation of the assets. Since usually there is none and the whole undertaking is speculative, there is no valid objection to showing the realized profit, as the public is sufficiently warned by the nature of the enterprise. All stock donation is not of this sort, however. Occasionally a very real profit results which should be treated as a margin item. _Stock Assessments, etc._ Similar to a stock donation is a stock assessment. In cases of reorganization or of impending bankruptcy, a pro rata assessment is levied on the outstanding shares. Being a donation, it constitutes a proprietorship increase item and becomes a part of the margin. This method is frequently used for the purpose of wiping out a deficit, an impairment of capital, and is, of course, a _real_ profit as distinguished from a _book_ profit. Similarly, additional payments made by common shareholders to convert their holdings into preferred shares are a realized profit and should be recorded as part of the margin. _Capital Profits and Bonuses._ Capital profits, as discussed in