Chapter XXII, have their proper place of record direct into some margin

account rather than by way of the current Profit and Loss. Donations from the outside, such as factory sites and other bonuses, sometimes given to induce enterprises to locate in certain places, must also be treated as entries direct to a margin account. These and other like items constitute the chief sources of the margin. Disposition of Profits The statement of profit and loss carries the summary of operations to the point of showing a net profit or a loss for the period. The next step for consideration is the disposition made of these profits. This is sometimes spoken of as the appropriation of profits. Two practices are met at this point. Under the one, appropriation is made directly from Profit and Loss for all desired purposes. Any unappropriated balance goes into Surplus account, which will represent the balance of profits available for dividends but not used. Under the other, the Profit and Loss balance is transferred to Surplus out of which all appropriations are made, the residue remaining therein showing the same condition as under the first method. Where this second method is followed—and it is more prevalent than the first—a statement of surplus is needed for full information of the period’s transactions, thus providing a connecting link between the statement of profit and loss and the balance sheet. The form of this statement is given on page 426. Reserves From the point of view of the stockholder’s immediate interest, the appropriation of profits for dividends is his chief concern. Other and equally vital and urgent uses are found for profits in any well-managed concern with an expanding outlook towards the future. The appropriations of these profits to definite uses are very generally carried under the title of reserves with suitable descriptive phrases. Thus we may have a Sinking Fund Reserve, an Insurance Reserve, a Building Fund Reserve. Sometimes these are called “reserve funds” but the demands of an accurate nomenclature limit the use of “fund” to an asset account. The title “undivided profits” is also met. Where careful differentiation is made, “surplus” should be used to denote profits available for dividends; “reserve,” for profits set aside for a specific purpose; and “undivided profits,” for those on which no definite action has been taken. Different Meanings of Reserve Because of the loose way in which the term reserve is used by the layman and its different uses by the professional accountant, an examination of these uses will be made at this point. As a distinctive banking term, “reserve” is used to indicate the amount of cash and cash items on hand and on deposit which under the law may be counted as a cash reserve fund held against deposits and note issues. This use of “reserve” is limited strictly to financial institutions. We find also various so-called reserves shown on the commercial balance sheet, both among the liabilities and the assets. As deductions from the assets are the various depreciation reserves and reserves for bad and doubtful accounts and notes receivable. These items are “offsets” to the carrying values of the assets in order to effect a true valuation of them. For reasons previously set forth, these offsets are carried in accounts separate from their corresponding assets. Thus they are in the nature of suspended credits to asset accounts and, if properly estimated, are in no sense related to profits; nor have they any of the elements of profits or proprietorship in them. It is unfortunate that there is lacking an adequate title, other than reserve, for this group of items. The terms “allowance” and “estimate” have been suggested, but so far have not found general favor. This group of reserves are called valuation reserves. Reserve for Bad Debts A fine distinction is sometimes drawn between the reserve for depreciation and the reserve for doubtful accounts, on the ground that at the time of the creation of the reserve in the one case, the depreciation is an accomplished fact, all that is then required being a fair estimate of it; whereas in the other case no _particular_ account is known to be uncollectible, business experience teaching, however, that in the aggregate there will be some loss from this source. The purpose of this reserve is to bring about as on a given date an appraisal of the claims against customers in the light of past experience, and so apply the expense due to this cause to the period in which the sale transaction took place. This purpose is not always accurately accomplished but the estimate at the close of each period does effect an equalizing of the bad debts expense from year to year. This distinction makes the reserve for doubtful accounts closely approximate to a contingent reserve, as will be seen later. It seems best, however, to hold to the original classification and include the bad debts reserve with the other valuation reserves. Under-and Over-Estimate of Reserves Inasmuch as these reserves must from the nature of things always be estimates, the probability exists of an under-or over-estimate. It is apparent that an under-estimate effects an inflation of profits due to an overvaluation of the assets. Equally apparent is it that an over-estimate brings about an understatement of profits due to an undervaluation of the assets. The effect of this is to make the valuation reserve account a mixed account. Instead of its content being solely a suspended credit to an asset, it includes also a true reserve of profits. If at any time the facts indicate a too liberal or too parsimonious estimate in the past, adjustment should be made to accord with the newly determined facts of experience. An immediate adjustment is usually preferable to a gradual one effected by an allowance below or above the new basis determined for the estimate. Depletion Reserves Similar to the depreciation reserve is the depletion reserve. On the basis of the value at which the wasting or depleting asset was originally brought upon the books, a periodic estimate of the portion used up in operation is necessary to show the true present value of the asset. Thus, timber and mining properties require for their periodic appraisal an estimate of the extent of exhaustion of the natural product. This is neither required by law nor always by business policy. But when the estimate is made it is in the nature of a valuation reserve and will be so classed here. Operating Reserves for Accrued Costs Another group of items, frequently carried under the title reserves, includes estimates of expenses the exact amount of which is not known at the time of closing the books, and sometimes those of which the exact amount is known but which are unpaid as on that date. Among the first are such items as taxes, sales discounts, and the like. Among the second are wages, salaries, rents, etc., accrued. These two classes are together sometimes called “operating reserves.” There is some difference of opinion with regard to the proper allocation of taxes and estimated sales discounts. Inasmuch as taxes are not usually determined, or at least payable, during the period covered by them, there is a temptation to defer their incidence to a later period. If the taxes become a claim of the state against the property as on a given date, certainly they should be treated as applicable to the period covered by the claim even though the amount of them cannot with accuracy be determined. With regard to sales discount, the situation is somewhat analogous. At the close of any fiscal period, some of the open claims against customers are by the sales contract subject to discount, and experience proves that some of these discounts will be taken advantage of. Here also, difference of opinion prevails as to the proper allocation of the expense. Should the period in which the sale is made suffer the loss, or should it be charged to the one in which the discount is taken? If sales discount is looked upon either as a direct deduction from sales or as a selling expense, certainly it should be charged to the period making the sale. On the other hand, if it is regarded as an item of financial management, a means of securing ready funds, it is sometimes argued (though this is not the usual point of view) that the period enjoying the benefit should also be charged with the expense of securing the benefit. Against this argument it may be pointed out that the current period carrying the customers’ accounts which are subject to discount fails to show its liability, based on the sales agreement, to accept something less than the face amount of the claims. A balance sheet in which no suitable provision is made therefor is one which does not reflect the true status of all items, and to that extent is not a good balance sheet. Provision should be made not only for those expenses which are known to have been incurred and which remain unpaid, but also for those which the statistics of experience show will have to be met. Conservative practice, therefore, requires the inclusion of this estimate and applies it as an expense of the period in which the originating transaction took place. All the costs of the contract entered into, of which expected sales discount is one, are made to apply to the period giving rise to the contract. Collection Costs not under Contract The above argument is occasionally made use of in support of the inclusion of expected collection costs on claims against customers outstanding at the close of a period. From a theoretical aspect the point may be argued, but, unlike the item of sales discount, these are not costs which the concern is liable for _under contract_. From a practical standpoint, except under very unusual conditions, it is an undesirable refinement of the principle of allocation of costs as between periods. Where a collection department is maintained, costs of collection are practically uniform from period to period and are best considered as expenses of the period in which the cost is incurred. Sales Discounts on the Balance Sheet As to the manner of showing expected sales discounts on the balance sheet, practice is not uniform. It is sometimes shown added to the reserve for doubtful accounts and the sum of the two deducted from claims against customers, indicating thus the amount which it is expected can be realized therefrom. Others show it among the liabilities, on the ground that it differs from the estimate for bad debts in that it is an expense for which the concern has made itself liable under its sales contract. The distinction is finely drawn but probably well taken. Distinction between Reserves and Accrued Items The use of the title reserve for some of the items included as operating reserves is unfortunate and leads to confusion both in terminology and in understanding. Why unpaid expenses of any kind should be called reserves for expenses when the amount of them is definitely known has never been satisfactorily explained; yet the practice is sometimes met. There is some excuse in the case of expense items the amount of which cannot be definitely determined either from the nature of the item itself or other conditions over which the concern has no control. Thus, “Reserve for Wages” is usually a misnomer, the title “Wages Accrued” showing the item correctly; but “Reserve for Taxes,” while just as true a liability as the other item, may be justified on the ground that the latter is only an estimate subject to correction when the exact amount is known, whereas the former is already definitely known. Contingent Reserves So-called contingent reserves are sometimes handled as a part of this group, although best classified by themselves. A contingent reserve is one which represents an effort to provide for certain contingencies, such as guarantees on work done or products sold, lawsuits pending adjudication, etc. As R. H. Montgomery[62] so pertinently says: “the reserve should be based on evidence more tangible than a mere desire to be conservative. A vague feeling that something might have been overlooked which would decrease the assets or increase the liabilities is not the proper subject for a reserve. Conservative management ‘reserves’ part of its surplus for such contingencies, but it appears as surplus and not as a liability.” As mentioned above, sometimes the reserve for bad debts is classed as a contingent reserve. Contingency is inherent in the item but the certainty of its occurrence cannot be reasoned away. The use of contingent reserves may therefore well be limited to provision against contingent liabilities. In other words, they represent the best available estimate of the amount of such liabilities. To draw a dividing line between operating and contingent reserves is extremely difficult; both are created by charges to various expense accounts. It is merely a matter of degree as to the certainty of the events’ happening for which provision is being made. On the border line between the two are such items as reserves for insurance where the concern carries its own insurance and must make a periodic expense charge in lieu of the usual premiums; reserves for pensions where a pension policy is in effect, the charge creating it being here viewed as a part of the wages expense—the share of wages to be paid in the future which must be borne by the current period; reserves for sick benefits, which are in all respects similar to pension reserves; and so on. In some cases reserves for supersession of patents, or other assets whose length of service life is dependent on extreme contingency, are classed with this group. [62] In “Auditing, Theory and Practice.” Deferred Income—Misuse of Term Deferred income is sometimes classed as a reserve. Thus, insurance companies carry the portion of their unearned premiums as on a given date, as a reserve. The use of the title is well established in that connection and the nature of the items is well understood. On commercial balance sheets where no outside authority can give a definite meaning to the term, its use for deferred income is to be deprecated and discouraged. Deferred income is a liability and not a reserve; the current period has not rendered the service to earn the income and is liable to the period in which the service is rendered. Proprietorship Reserves This disposes of all the asset and liability reserves and leaves for consideration the true profits or proprietorship reserves. As between these two main classes of reserves, as their titles indicate, the proper allocation of the one is among the assets or liabilities, while the other must be shown as a part of the net worth of the corporation. As to the nature of proprietorship reserves little more need be said. There are just two classes of items met here, viz., those shown as such openly on the balance sheet and those which are hidden or secret, latent among the various other items on the balance sheet. Proprietorship reserves represent profits reinvested in the business. Any profits, operating or capital, not paid out as dividends give rise to proprietorship reserves. Secret Reserves So-called secret reserves are brought about in various ways. Their creation may be intentional or accidental, but their source is the same in either case. Reserves of profits may be hidden either by undervaluation of the assets or overvaluation of the liabilities. Undervaluation of the assets may point to an ultra-conservative policy of management. Thus, some concerns write off the value of their fixed equipment of various kinds as rapidly as the net profits can absorb it and still leave sufficient for a reasonable dividend. Financial institutions in this way carry their furniture and fixtures and sometimes even banking houses, at ridiculously low figures or do not show them at all. Undervaluations are accomplished in various ways. Charging an excessive rate of depreciation; making unnecessarily large reserves for uncollectible accounts, sales discounts, etc.; showing a more rapid depletion of natural assets than justified by the amounts used; charging the sums spent for assets to an operating expense; setting up an excessive cost of goods sold by means of inventory valuations of stock-in-trade at a figure lower than cost or market; crediting items of income to asset accounts instead of to income accounts, such as rentals on properties owned; crediting interest and dividends received to the stocks and bonds accounts—all of these serve the purpose of creating hidden reserves by means of a misstatement of fact. Items wrongfully included among the liabilities bring about the same result. Here, however, the procedure is somewhat more patent because the creditors themselves check up on all actual liabilities. Liabilities can be settled only by an actual reduction of assets. Manipulation of the operating and contingent reserves explained above offers, however, an easy means of overvaluing the liabilities. A too liberal estimate of the amounts of these reserves makes them represent in part true proprietorship reserves but the proprietorship element in them is obscured by their title and their inclusion among the liabilities on the balance sheet. It is, of course, apparent that no balance sheet containing secret reserves is a true statement of condition and the practice of creating secret reserves must usually—perhaps always—be condemned. Argument for Secret Reserve In justification of the secret reserve, it is sometimes said that in certain lines of business where the maintenance of unquestioned credit or the promotion of a stability ordinarily lacking in speculative enterprises is highly desirable, there is a very pressing need for the secret reserve. Through its use, extraordinary losses, which otherwise would result in very unfavorable fluctuations of stock values, may be absorbed by means of a charge to some undervalued asset and so bring it to its true value; or by a charge against an over-estimated liability reserve and so bring it to a true showing. This frees the current profit and loss from the charge, maintains a regularity of net profits, and prevents the disasters sometimes attendant upon violent fluctuations of stock values brought about by the knowledge of these extraordinary losses. That is the strongest case which can be made out in favor of the secret reserve. Argument against Secret Reserve The fact, however, must not be overlooked that without any understatement or misrepresentation of property values at any time there could just as easily be created an open “surplus” or margin of an amount equal to the secret reserve, against which these losses could as well be charged. The creation of such a margin can be justified on the same grounds on which the justification of the secret reserve is attempted, viz., the maintenance of high credit and stability. The reduction of the margin through its absorption of the loss would, of course, be somewhat more patent than the reappearance of values previously written off, although analysis of a balance sheet will invariably bring the true state of affairs to light. Furthermore, present stockholders, and certainly prospective investors and creditors, have a right to know the true condition of affairs. The appearance of a large proprietorship in addition to capital stock, revealed by a sizable margin, gives the stock a value in addition to that based solely on the dividend rate. A stockholder has a right to his share of the profits during the period of his ownership. If it is not received in the form of dividends, he should at least be partially recompensed when he disposes of his holdings, by an increased price for the stock as reflected by the portion of profits reinvested in the business. The attitude occasionally taken that directors know best what information as to true condition of affairs should be given to the owners and what should be withheld, should, in these days of increasing publicity, be given no serious consideration. In the hands of unscrupulous directors, the secret reserve is an instrument for the covering up of questionable and even fraudulent practices. Stock values can be intentionally hammered down by a false showing of profits and so inure to the benefit of a group of prospective purchasers desiring to “freeze out” unsuspecting stockholders. All in all, therefore, little can be said in justification, but much in condemnation, of the practice of accumulating secret reserves. Earmarking of Reserves According to the definition of surplus laid down in the beginning of this chapter, limiting the term strictly to the profits available for dividends, those profits which are applied to reinvestment for specific purposes must be separated from the “surplus” and given distinguishing marks to indicate their purpose. Thus, profits reserved for the purpose of acquiring a fund of assets out of which to pay off debt obligations maturing in the future may be set aside under the title “Sinking Fund Reserve”; those set aside for the purpose of extension of plant as “Building Fund Reserve”; those for the purpose of providing a pension fund as “Pension Fund Reserve”; and so on. This is sometimes called “earmarking” the reserve. Separation into differently named reserves serves no other purpose, however; it does not in any way insure the inviolability of the reserve; it acts merely as evidence of the intention and purpose of the board of directors which authorized the application of profits to that purpose. It is the expression of a business policy and as such is, without other compelling force, subject to the approval and continuance or to the disapproval and nullification of any subsequent board. These reserves are profits and as such belong to the shareholders and may be distributed among them as dividends. A reasonably conservative policy as to reserves usually has the support of stockholders, and a subsequent board will not risk loss of position and standing with the stockholders by a change of policy as to reserves without good and sufficient reasons for doing so. Continuity of Reserve Policy Effort is sometimes made to secure continuity of the reserve policy. This may be accomplished in several ways. Oftentimes it is made compulsory by outside regulatory authority, as in the case of national banks which are required to set aside annually a certain part of their profits until these have accumulated to an amount equal to 20% of their capital stock. Similar conservatism can also be compelled by contract entered into with creditors. It is a frequent provision of the trust agreement covering an issue of bonds that “there shall be set aside out of profits” a certain amount at the close of each fiscal period for the purpose of creating a fund with which to redeem the bond issue when it falls due. The funds may be placed in the hands of a trustee, which guarantees the application of them to their intended use but does not, of course, insure the retention of profits to an equal amount in the business. Finally boards of directors may be compelled by the stockholders to adhere to a certain policy by provision in the by-laws for the accumulation of reserves. This policy is, of course, subject to change by the stockholders themselves. Where the power to make and change by-laws is put in the hands of the directors, this last method is not applicable. Reserves may always be made a part of the permanent capital through their distribution in the form of a stock dividend. This secures the continuance of profits reserved to date but does not guarantee either a similar application of future reserves or even a continuance of the present reserve policy. Covered Reserves When a reserve is spoken of as being covered, it is meant that specific funds have been set aside for the purpose named, in amount equal to the reserve. As in the case of sinking funds, the assets set aside may be invested in stocks and bonds control of which remains with the company itself; or the assets may be turned over to a trustee who then has control of their investment and use. The student is referred to