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

The past year may have been poor and the books may not reflect the true state of affairs. Valuation of Partnership Where, as frequently happens, a partnership is a party to the merger, it is necessary to consider the method of handling certain items in the partnership accounting which differs from their handling under the corporate form, so that the valuation of the assets and earnings of all the properties can be placed on an equitable basis. Such items are partners’ salaries and drawings, and the interest on capital and drawings for the purpose of adjusting the various partners’ interests. In partnership accounting the proper treatment of partners’ salaries, drawings, and interest on capital and drawings requires that these appropriations of profits be shown in the profit and loss summary; i.e., the figure of net profits for a partnership is determined before taking into consideration the items mentioned. However, one occasionally finds partners’ salaries and adjustments on account of interest handled as expenses of the business. To place the earning capacity of the partnership on an equitable basis for comparison with the earnings of a corporation, a reasonable figure for the salaries of the partners as managers of the business must be agreed upon and treated as an expense chargeable to operations before the determination of net profits. Partners’ drawings and interest adjustments on account of capital and drawings should not be taken into account in the determination of earning capacity. In determining the amounts of partners’ salaries, that which would be appropriate for similar capacities in a corporation should be allowed as deductions from earnings. All the items mentioned above in connection with placing the properties of the several corporations on an equitable basis for valuation apply with equal force to the properties of any partnerships which may become parties to the merger. Earning Capacity Any extraordinary profits or losses not due to the ordinary operations of the business should be eliminated when computing profits. Interest on borrowed money should not be included. The charges to operating expense on account of repairs should be adequate, and care must be taken to see that charges to the repair accounts do not show a sudden falling off toward the close of the period under review. The reserve for depreciation should be credited with the proper amounts. Sales, effected for a subsequent period, are not to be considered in the accounts of the current period as this would tend to inflate the profits. Shipments made to branch offices or on consignment account should not be regarded as sales. Ample provisions should be made for all liabilities for expenditures incurred during the period under review and outstanding at the close thereof. The inventories should be checked over carefully and certified by the parties taking them. Allowance for old or obsolete material should be made. Good-Will The determination of the value of good-will is generally a delicate proposition unless the parties to the consolidation or merger first agree as to the basis on which it is to be computed. This is generally anything that the interested parties choose to make it. The two methods commonly used for estimating the value of good-will have already been discussed in Chapter XVIII. Capitalization of a Consolidation or a Merger The capitalization of a corporation, in a legal sense, is the sum total of the par value of the authorized capital stock. From an investment or economic point of view it is the sum total of all the stock and bonds issued or outstanding. There are three different bases of capitalization: (1) cost of property plus accumulated surplus value; (2) cost of reproducing the property; and (3) earning power. According to legal theory the investment or the cost plus surplus is the proper basis. This idea has been fostered by the fact that shares have been assigned a definite face value. While at the beginning of a new enterprise investment value and capitalization may closely correspond generally, they soon diverge widely—due to smaller or greater earnings than were estimated or to depreciation or accretion in the value of the assets. When the _potential_ earning power of the business begins to be realized, conditions begin to change and the value of the tangible and intangible assets fluctuates. The basis of capitalization changes with these fluctuations and the laws regulating it are in practice only complied with nominally. The custom is to adjust the value of the assets to harmonize with the capitalization rather than vice versa. Such a policy is to be deprecated. The cost of reproducing the property as a basis of capitalization is as yet only seriously considered in theory. It is very doubtful if the method will ever be used in actual practice. Earnings, past or potential, perhaps form the basis for capitalization most frequently used. Investment value closely corresponds to the rate earned and the degree of permanency of the earning power. To secure an income is the motive of all investment. In practically all consolidations and mergers the estimated increase in earnings due to the application of better methods of operation plays an important part not only in the promotion and formation of the new company, but also in deciding upon the capitalization. While the plant value and the past earnings of each of the companies may be considered in allotting them their respective interests, these are not a safe guide as to future earnings. In the case of partnerships especially and often in the case of corporations, there is a loss of valuable good-will. It is generally held that the benefits of consolidation greatly overbalance these disadvantages. The savings due to the elimination of duplicate work in factory and office, the cutting down of the item of rent, the saving in the cost of selling, the greater effectiveness of advertising, etc.—all are reasons held out as warranting this or that capitalization. Payment of Amalgamated Interests In a consolidation or a merger the usual practice is to pay the various interests in the companies which are amalgamated with bonds, preferred and common stock, and in some instances with cash. The proportion and kind of payment will depend upon the conditions surrounding each case. The prevalent custom is to pay for the net assets in preferred stock and to issue common stock for good-will. Often, however, bonds are used to pay for the tangible assets; preferred stock is issued for the intangible assets; and common stock represents the additional profits that are expected to accrue to the corporation through the consolidation or merger. The issue of bonds to cover _all_ the tangible assets is generally a dangerous procedure because of the high fixed charges resulting therefrom—though advantageous when the difference between the fixed charges and the net earnings is large. Bonds generally carry relatively small interest because of their safety, whereas the use of preferred stock entails a smaller equity for the common. The bondholder is not concerned with the capitalization or nature of the issues over which he takes precedence. For the same reason it is not usual for the preferred stockholder to complain about overcapitalization through the use of common stock. The business risk involved depends upon the nature of the business and the ability of the management. No financial arrangements should be made that do not take into consideration the fluctuations that are inherent in the business and their effect upon net income. Another apportionment sometimes made is to issue bonds for the fixed assets; preferred stock for the working capital; and common stock in proportion to the prospective earnings of the consolidation or merger. New bonds are exchanged for the old bonds or preferred stock of the constituent companies, while the common is exchanged for the corresponding issues in the merged corporations. The balance is used for the purpose of paying organization expenses and the fees of the promoters, and to provide working capital for the consolidation. The ratio and the medium will depend to a great extent upon the nature of the business, the attitude of those who are interested in the merger corporations, and the optimism or hopes of the promoters. Closing the Books of the Merged Concerns Closing the books of the merged concerns presents the problems of accounting for the sale of the subsidiary companies. This may be effected in two ways. Where the sale is made at the book values as carried on the records of the subsidiary, no adjustments whatever become necessary. Where, however, the price received is less or greater than the book value of the concern, it becomes necessary to show the difference between book and sale valuation. In taking account of these differences two methods are employed. Under the one an adjustment is made of all the detailed valuations of the items of property as taken over. It becomes necessary, therefore, to adjust each property account through its depreciation reserve or through surplus, in order to bring it to the value at which it is taken over. This may, and frequently does, necessitate setting up a good-will account on the books of the vendor company. After the books are thus brought into accord with the sale agreement, the closing of the accounts follows the procedure laid down in Chapter XXVIII for the liquidation of a company. Under the second and more common method, no attempt is made to adjust the individual items of properties sold in accordance with the appraisal committee’s report, but all differences are cleared in a lump sum through the surplus or deficit accounts. If the sale is made for cash, the amount received is then disbursed as a liquidating dividend to the shareholders. If the property is sold for stock and bonds in the merged company, either this stock is handed over en bloc, in which case it is likewise distributed as a liquidating dividend, or the merger company may issue the stock and bonds as a liquidating dividend for the vendor company on the basis of the report of the shares belonging to each stockholder. Upon notice that such stock and bonds have been issued to its shareholders, the vendor company closes up its records completely by cancelling its proprietorship accounts against the charge account set up against the merger company until the stock is issued. Opening the Books of the Merger As a merger is a corporation, the opening of its records follows the same lines as that of any other corporation, excepting that when payment of subscriptions for capital stock is to be recorded, cognizance must be taken of the manner of payment. The subscription contract, in so far as it relates to the various subsidiaries, is usually canceled by turning over the properties of the subsidiaries. The assets are taken over at an appraised price which becomes the basis for the amount of subscription to the stock of the merger by each subsidiary. In Chapter I, where mention was made of the payment of stock subscriptions in property, it was pointed out that it may be desirable to bring onto the books the lump sum representing the appraised purchase price paid for the subsidiary some time before the appraisal committee has submitted its report on the detailed valuation of the various items of property taken over from the subsidiary. The customary method of handling the situation on the books of the merger was there shown. The bookkeeper is not concerned with the valuation of any of the items taken over, but must make his entries in accordance with the valuation report turned in by the appraisal committee. The main problem in the merger, then, is one of valuation and not of accounting. As stated above, payment to the subsidiaries may be made by the merger in either of two ways. An entire block of stock may be turned over to the subsidiary company and be distributed by it as liquidating dividends to its stockholders, or the merger may issue shares to the individual stockholders of the subsidiaries in accordance with information furnished by the subsidiary.