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

disposition of the accounts relating to the fund. In the illustration, for the sake of definiteness, it will be assumed that the governing financial policy is the second one discussed above, according to which not only is a sinking fund created but also an equal amount of profits is reserved each period; that the funds are placed in the hands of a trustee for investment and that any income from the investments is to go into the fund; and that it is desired to show both the investments of the trustee and the unexpended balance of cash in his possession. The account titles are suggestive only, many varying titles being used. The entries required to show the original payments into the fund are: (1) Sinking Fund Cash in Hands of Trustee $..... Cash $..... To record payment to trustee of first payment into the sinking fund created according to terms of trust agreement to retire the first mortgage 6% bonds. (2) Surplus Sinking Fund Reserve To show the creation of a reserve to provide funds for the redemption of bonds. Subsequent payments into the fund would be recorded in exactly the same way as the original payments. Booking the Trustee’s Report Upon receipt of the trustee’s report on the handling of the fund, entries must be made to bring a summary of the report onto the books. This report should cover a full accounting of the funds turned over to the trustee, his investment of them, all expenses of the trust, and any income received or accrued. The funds may be left for accretion in a savings bank; they may be used to purchase high-grade securities; or with them the very bonds which they are to redeem may be bought and canceled immediately, or allowed to run, the interest accretions going into the fund also. Securities for investment may be bought at a premium or a discount. Expenses will be incurred by way of commission or salary for the trustee, expenses of the trust, advertising, brokers’ commission, etc.; and income will be received by the trustee from the securities held and even from the unexpended balance of cash. As to the purchase of securities at a premium or discount, the problem involved is the proper handling of the premium or discount. Theoretically, whether in the hands of a trustee or under own control, premiums and discounts on securities bought for long-term investment should be amortized. The reader is referred to Chapter XV, page 267, for the various methods of booking such investments. Oftentimes, however, the premium is charged at once against the sinking fund income along with all other expenses. To book the investments of the trustee, the entries needed are: (3) Sinking Fund Investments $..... Sinking Fund Cash in Hands of Trustee $..... (List here the securities purchased and their price.) (4) Sinking Fund Expenses Sinking Fund Cash in Hands of Trustee (Itemize here all expenses chargeable against the fund or its income.) (5) Sinking Fund Cash in Hands of Trustee $..... Sinking Fund Income $..... (Record here the income from interest on unexpended cash balance and from securities, with proper adjustments on account of amortization of premium or discount.) Treatment of Income and Expense Practice varies as to the proper handling of the income and expense of the sinking fund. Sometimes they are treated as affecting—i.e., increasing or decreasing—only the sinking fund reserve and as having no place in the current profit and loss. That seems a mistaken view; the fact that the investment is beyond the company’s control none the less renders its income and expense a fact of current profit and loss, and it should be so shown. Accordingly, the sinking fund expense and income accounts above should be closed into profit and loss, after which their net result will be transferred from surplus to Sinking Fund Reserve, to show the net increment or decrement as a result of the trustee’s operations. Thus: (6) Sinking Fund Income $..... Profit and Loss $..... (7) Profit and Loss Sinking Fund Expenses (8) Profit and Loss Surplus Entry (8) is not strictly a sinking fund entry but transfers the entire balance of the period’s profit and loss to surplus, out of which the net increment or decrement of the sinking fund operations is transferred to Sinking Fund Reserve by entry (9): (9) Surplus $..... Sinking Fund Reserve $..... An amount equal to the compound interest increment must always be transferred to the reserve, if accurate results are desired. Practically the same entries will serve if the investments are the company’s own bonds. If the bonds are canceled, instead of entry (3) the following entry would be made: (10) First Mortgage 6% Bonds $..... Sinking Fund Cash in Hands of Trustee $..... Here the item of premium or discount is usually to be found and the question then arises as to whether the item is not better handled as a charge or credit direct to Sinking Fund Reserve rather than through the current profit and loss. Final Disposition of Fund There remain to be considered the entries recording the payment of the bonds at maturity and the disposition of all sinking fund accounts. The securities of the trustee must be reconverted into cash to be used for redeeming the bonds, often resulting in a difference between the book value of securities and the actual amount realized therefrom. This must be adjusted by charge or credit to the Sinking Fund Reserve. After cancellation of all the bonds, any cash balance is turned back by the trustee to the company. The entries on the books would be: (11) Sinking Fund Cash in Hands of Trustee $..... Sinking Fund Investments $..... To record sale of securities in the sinking fund. (12) Sinking Fund Reserve Sinking Fund Investments ..... or (13) Sinking Fund Investments ..... Sinking Fund Reserve ..... To adjust the difference between book and realized values of the securities. (14) First Mortgage 6% Bonds ..... Sinking Fund Cash in Hands of Trustee ..... To record redemption of all bonds. (15) Cash ..... Sinking Fund Cash in Hands of Trustee ..... To record transfer to company of cash balance in hands of trustee. Treatment of Sinking Fund Reserve Only the Sinking Fund Reserve account now remains on the books. Having served its purpose of providing funds by retaining profits in the business for the redemption of the bond issue, resulting in an addition to the net worth of the business, this reserve is now free to be used as deemed best. It may be thrown into surplus and so become available for dividend purposes; or it may be used as the basis for an increase in capital stock and be distributed as a stock dividend, thus making the increase in net worth permanent. The following entries respectively accomplish these ends: (16) Sinking Fund Reserve $..... Surplus $..... (17) Surplus Stock Dividend Payable (18) Stock Dividend Payable Capital Stock Relation between Depreciation and Sinking Fund A final problem deals with the relation between depreciation and the sinking fund. If the trust agreement requires that a sinking fund reserve shall be created by charge against profits, must provision be made also for the depreciation of the mortgaged property held as security for the bonds? The fact of depreciation is omnipresent and cannot be escaped. Also, the trust agreement must be lived up to. To carry out both requirements simultaneously would manifestly result in a double charge. The charge for depreciation is an expense charge which must be made before net profits can be determined. The charge for the creation of the sinking fund reserve is against surplus, i.e., it takes effect after the determination of net profits. Theoretically, therefore, the provision for depreciation must be made, else true profits cannot be determined. Equally certain must be the provision for the sinking fund reserve. Authorities seem to agree that not only is there no need for provision for both but that to provide for both places an unnecessary burden on the stockholders during the periods of the creation of the sinking fund. It is true that if the periodic amounts of the estimate for depreciation and the sinking fund are practically the same, and if provision is made only for the sinking fund reserve, there will be in that reserve a sufficient amount to care for the depreciation. Assuming the life of the asset and the life of the bonds to be the same, such a policy means simply that the asset, usually a fixed asset, has been converted by use into current funds which have been applied to the liquidation of the bonds. There has been no reservation of real profits for this purpose. Upon the complete depreciation of the asset, the book value not having been written down in the meantime because no depreciation has been booked for it, the asset must be charged against the reserve, thereby mutually extinguishing each other. No principles of accounting are necessarily violated. Failure to book the depreciation as such results, however, in an inflated showing of net profits. If the sinking fund reserve is charged against current profit and loss instead of surplus, the showing of net profits is thus corrected but there has been no real reservation of profits, the sinking fund reserve being in reality a valuation account for the depreciating asset, and thus the letter of the trust agreement is violated. If the intent of that agreement was to increase proprietorship, as discussed on page 456 above, this procedure will not accomplish that purpose. Provision for both depreciation and the reserve does not effect a double charge against _profits_. As pointed out above, the one is an expense charge without which true profits cannot be shown, and the other is a charge against real profits, resulting in a lessening of dividends. Where there is no trust agreement to compel the creation of a sinking fund reserve, it is merely a matter of financial policy as to how the bonds shall be redeemed, and there is no objection in theory to the conversion of the depreciating asset to that purpose. Much more is this the case when the mortgaged asset is a wasting asset, the exhaustion of which is inevitably bound up with the operation of the business. Here there is no need either to increase proprietorship or even to maintain capital intact, and the conversion of the wasting asset, without providing for its replacement, to the payment of the bond issue is legitimate and wholly unobjectionable as a financial policy.