ABSTRACT

AN EVALUATION OF THE ACCOUNTING PROVISIONS IN
THE COMPANIES ACT, CANADA, AND
THE CORPORATIONS ACT, ONTARIO
by Michael Zin

Among the primary purposes of incorporation law is to provide a basis
for an equitable maintenance of the rights of those who may have financial
dealings with corporations.

With the growth of corporate enterprise there has been an emergence
of a "corporate management group" and a tendency for these professional
managers to perpetuate control of enterprise. Thus, the immediate management
group of a corporate unit may be a very small minority of corporate share
ownership. This delegation of administration demands thorough reporting by
management of its stewardship of the assets entrusted to its care to preserve
the rights of creditors and owners.

This dissertation studies the problem of inadequate disclosure of cor-
porate financial activity by companies incorporated under the Companies Act,
Canada, and the Corporations Act, Ontario.

Corporations are creatures of the state. The state, therefore, has a
responsibility to protect those who have, or may have, financial dealings with
corporations. One way of attaining protection is through adequate disclosure of

corporate financial activity. The Companies Act, Canada, and the Corporations

1

2

Act, Ontario, contain certain provisions, compliance with which would pur-

portedly furnish the desired degree of disclosure. Adequate disclosure, how-

ever, is not forthcoming in many cases. For example:

A.

The statutes do not clearly recognize the distinction between in-
vested capital and reinvested earnings. In failing to distinguish
between the sources of ownership equity, the statutes permit ﬁnan-
cial practices which may be misleading. The following are illustra—
tive of these practices:

1. "Surpluses, " other than retained earnings, can be recorded on
the books and may be utilized improperly to eliminate accumu—
lated Operating deficits.

2. Corporate distributions to shareholders may be made under the
guise of dividends (division of earnings), while there is an
accumulated Operating deﬁcit.

3. "Surplus" accounts can be recorded on the books initially to
give an impression of proﬁtability which has not been proven
and may not exist.

Both the Federal and Ontario Acts permit the misstatement of assets

and liabilities which result in future misstatement of periodic in-

come. For example, bond premiums and bond discounts can be
written off at the time of bond issuance.

The provisions of the statutes are inflexible; they become outdated

and do not provide for adequate disclosure of essential ﬁnancial

information arising out of new deve10pments in business ﬁnance.

3
An example is the accounting for long-term leases.

The purpose of this study is to determine the accounting statute re-
visions, compliance with which would eliminate inadequate disclosure of essen—
tial corporate ﬁnancial activity. The criteria for the evaluation of the statute
provisions must cover the interests of both suppliers of capital and the general
public. Sufﬁcient ﬁnancial information must be disclosed so that those who deal
with corporations can rely with conﬁdence upon representations in ﬁnancial
statements. The criterion for evaluation of each proposed provision is: does it
provide an adequate degree of disclosure to protect the public?

The study is limited to the Companies Act, Canada, and the Corpora-
tions Act, Ontario. The relevant statute provisions considered are those with
signiﬁcant accounting implications. Speciﬁcally, the statute provisions ex-
amined are those which pertain to: (1) Capital of the Corporation, (2) The Cor-
porate Surplus, (3) Corporate Distributions to Shareholders, (4) Corporate
Combinations, and (5) Disclosure of Corporate Activity.

The following proposals are recommended to be embodied in the incor-
poration statutes:

1. (a) Stated capital of the corporation should represent the cost (fair
value) of all assets received for the beneﬁt of shareholders, other than the re-
invested earnings which have not been "capitalized. " Thus the stated capital of
the corporation would be equal to the total of: the consideration for share issues,
the fair value of donations, and the capitalized retained earnings.

(b) Where a company has more than one class of shares outstanding,

the stated capital attributable to each class should be the total consideration

4
received for the outstanding shares of the class.

2. Transfers from retained earnings should be permitted only to
stated capital. Transfers which are apprOpriations of retained earnings should
be prohibited.

3. Reduction of stated capital should be permitted where approval is
obtained from the creditors and shareholders.

4. The corporate surplus should represent the balance of accumulated
net earnings reinvested in the enterprise. The elimination of deﬁcits should be
accomplished through future profitable operation or through formal reductions
of stated capital equal to the deﬁcit.

5. Corporate distributions of assets to shareholders should be identi-
ﬁed as to their nature. Distribution of assets representing a division of earn-
ings should be referred to as dividends and must not exceed accumulated
retained earnings. Wasting asset "dividends" are not "dividends," as such, but
a return of invested capital.

6. Corporate combinations should be accounted for as purchases. Pre-
combination retained earnings have signiﬁcance only to the entity through which
the income was produced; transfer of retained earnings to any other entity
should be prohibited.

7. Ideally, the law should not attempt to spell out inﬂexible rules of
disclosure. It should contain general guides as to what must be disclosed to pro-
tect the rights of persons dealing with corporations. These general guides
should agree with the standards of disclosure established by the accounting pro-

fession. If the Acts did provide for disclosure as recommended by the

5
accounting profession, they would then have built-in flexibility and would change
as circumstances dictated. Such a provision would place the responsibility for
disclosure of corporate ﬁnancial data upon those who should and can bear this
responsibility-—the members of the accounting profession individually and

collectively.

AN EVALUATION OF THE ACCOUNTING PROVISIONS IN
THE COMPANIES ACT, CANADA, AND
THE CORPORATIONS ACT, ONTARIO

By

Michael Zin

A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Accounting and Financial Administration

1962

TO
P., P., P., A., andA

ACKNOWLEDGMENTS

The writer acknowledges his indebtedness to Professor Roland F .
Salmonson, chairman of my doctoral committee, whose guidance, encourage-
ment, editorial comment, and criticisms, made this work possible.

I am deeply grateful to Professor Gardner M . Jones , who originally
approved the subject matter for study. His comments and suggestions were
particularly helpful in fusing the various viewpoints on the many controversial
topics. I am indebted to Professor William Lazer for his assistance in the
clarification of certain technical areas.

I wish to express my appreciation to Professor Gilbert R. Horne who
acted as a sympathetic critical sounding board for my ideas in the develop-
mental stages . My gratitude for assistance in the many detailed tasks involved
in preparation of the dissertation is expressed to Mrs. Patricia Lauzon. Help-
ful comments were contributed by Mr. William D. Howison, Resident Partner,
Price Waterhouse and Company, Windsor, and by Mr. R.D. Thomas, Executive
Secretary of the Canadian Institute of Chartered Accountants .

I wish to thank the Canada Council, and Essex College, whose grants
partially underwrote the cost of the study. The Canada Council, Essex College,
or those whose kind assistance I received, however, cannot be held accountable
for the concepts or conclusions; for these I assume full responsibility.

Finally, I wish to thank my family who, by their moral support, are in
large part responsible for whatever success can be attributed to this study.

iii

TABLE OF CON TENTS

ACKNOWLEDGMENTS .

Chapter
I I N TRODUC TION

The Problem

Purpose of Study

Scope and Methodology of Study
Literature on the Problem

II CAPITAL OF THE CORPORATION .
The Concept of Capital
The Accountant's Concept
The Economist's Concept
The Legal Concept of Capital
"Capital" in Canadian Corporation Law
The Companies Act, Canada
The Corporations Act, Ontario
Other Cases of Overstatement or Understatement of
Capital
Implicit Stock Discounts
Secret Reserves
Subsequent Changes in Capital
The Companies Act, Canada
Reduction of Capital
The Corporations Act, Ontario

Reconsideration of the Concepts of Capital

Conclusion

iv

Page

iii

H

05th

.q

10
11

15

15
17

24
24
25
27
27
33
35
38

41

Chapter
III THE CORPORATE SURPLUS .

Nature of Surplus
Source of Surplus

Surplus in Canadian Corporation Law

The Companies Act, Canada
The Corporations Act, Ontario

Reconsideration of Surplus Items
Premium on Issued Shares--Preferred
Investment in Excess of Par or Stated Value
Donated Surplus
Surplus from Forfeited Shares
Revaluation Surplus

Summary

Evaluation of the Legal Provisions with Regard to Surplus,

The Corporations Act, Ontario, and The Companies Act,

Canada
IV CORPORATE DISTRIBUTIONS TO SHAREHOLDERS

Justiﬁcation for Investing in the Corporation
Nature of Distributions

Corporate Distributions in Canadian Corporation Law

The Companies Act, Canada
The Corporations Act, Ontario

Reconsideration of Corporate Distributions

Distributions from Contributed "Surplus"
Current Net Earnings as a Dividend Base
Revaluation "Surplus" as a Dividend Base
Depletion as a Dividend Base
Capitalization of "Surplus"

Summary

Page
44

46
48

51

51
52

56
56
59
63
65
67

74

76
78

78
79

84

84
87

93

93
98
101
102
104

111

Chapter Page
I V

Evaluation of the Legal Provisions with Regard to Corporate
Distributions, The Companies Act, Canada, and The

Corporations Act, Ontario 112
Recommendations for Changes in the Acts 113

V CORPORATE COMBINATIONS . . . . . . . . . . . . 119
Federal and Ontario Corporate Statutes on Combinations 119

The Companies Act, Canada 119

The Corporations Act, Ontario 121
Reconsideration of Corporate Combinations 124
Acquisition of Existing Corporations 125

The Carry-Over of Surplus 126

Summary 132

Evaluation of the Legal Provisions with Regard to Corporate
Combinations, The Companies Act, Canada, and The

Corporations Act, Ontario. 133

VI DISCLOSURE OF CORPORATE ACTIVITY . . . . . . . . 135
The Companies Act, Canada 138

The Corporations Act, Ontario 141
Evaluation of Disclosure Provisions 148

United Grain Growers 148

Dominion Tar and Chemical Company Limited 150

Canadian Celanese Limited 151
Consolidated Mining and Smelting Company of Canada Limited 152

Blue Crown Petroleums Limited 154

Dominion Stores 156

Summary 157

VII CONCLUSION . . . . . . . . . . . . . . . . . 160
The Corporate Capital 161

The Corporate Surplus 162
Corporate Distributions to Shareholders 162

vi

Chapter Page
VII

Corporate Combinations 163
Disclosure of Corporate Activity 163
BIBLIOGRAPHY . . . . . . . . . . . . . . . . . . . 165

vii

CHAPTER I

IN TRODUC TION

The following are among the primary purposes of incorporation law:

1. To serve as a device to permit the organization and Operation of
enterprises as corporate units upon fulfilment of certain statutory
requirements.

2. To provide a basis for an equitable maintenance of the rights of
those who may have ﬁnancial dealings with corporations.

With the growth of corporate enterprise there has been an emergence of

a "corporate management group" and a tendency for these professional managers
to perpetuate control of enterprise. Thus, the immediate management group of
a corporate unit may be a very small minority of corporate share ownership.
This delegation of administration demands thorough reporting by management of
its stewardship of the assets entrusted to its care to preserve the rights of credi-
tors and owners. Whether thorough reporting has been accomplished is open to
serious question. In 1937 Carman G. Blough, former Chief Accountant with the
United States Securities and Exchange Commission, stated:
The wide distribution of corporate securities, the inability of the
vast majority of investors to judge the value of their investment by

any close-range view and their dependence upon information con-’
tained in published financial statements, has placed a responsibility

upon the accountants to which many Of them have not yet become
adjusted. 1

More recently Kenneth C. Tiffany, vice—president of Massey-Ferguson, stated:

If in speaking of 'economic illiteracy' or 'economic ignorance' I
sound patronizing of the general public, I want to correct that impres—
sion. The public has fallen behind in its economic knowledge only
because our economy has become so much more complex. I am con-
vinced that the public is able and eager to absorb more knowledge of
our economic system: the fault is with those of us who have had the
necessary specialized training but have done an inadequate job of
translation and communication or, perhaps worse, have tried to reduce
complexities to catch phrases and charts which convey just enough
accuracy to furnish dangerously little learning. 2

The Problem

 

This dissertation studies the problem of inadequate disclosure of cor-
porate ﬁnancial activity by companies incorporated under the Companies Act,
Canada, and the Corporations Act, Ontario.

Corporations are creatures of the state. The state, therefore, has a
responsibility to protect those who have, or may have, ﬁnancial dealings with
corporations. One way of attaining protection is through adequate disclosure of
corporate financial activity. The Companies Act, Canada, and the Corporations
Act, Ontario, contain certain provisions compliance with which would purportedly
furnish the desired degree of disclosure. Adequate disclosure, however, is not
forthcoming in many cases. For example:

A. The statutes do not clearly recognize the distinction between in-

vested capital and reinvested earnings. In failing to distinguish

 

1Carman G. Blough, "The Need for Accounting Principles, " The Account-
ing Review, XIII (March, 1937), p. 31.

2Kenneth C. Tiffany, "The Future of Accounting," The Accounting
Review, XXXVI (April, 1961), p. 205.

3

between the sources of ownership equity, the statutes permit ﬁnancial

practices which may be misleading. The following are illustrative of

these practices:

1. "Surpluses, " other than retained earnings, can be recorded on
the books and may be utilized imprOperly to eliminate accumu-
lated operating deﬁcits.

2. Corporate distributions to shareholders may be made under the
guise of dividends (division of earnings), while there is an accu—
mulated operating deﬁcit.

3. "Surplus" accounts can be recorded on the books initially to give
an impression of proﬁtability which has not been proven and may
not exist.

B. Both the Federal and Ontario Acts permit the misstatement of assets
and of liabilities, which result in future misstatement of periodic in-
come. For example, bond premiums and bond discounts can be
written off when bond issue takes place.

C. Since the provisions of the statutes are inﬂexible, they become out-
dated and do not provide for adequate disclosure of essential ﬁnan-
cial information arising out of new developments in business and

ﬁnance. An example is accounting for long—term leases.

Purpose of the Study
The purpose of this study is to determine the accounting statute re-
visions which will eliminate inadequate disclosure of corporate ﬁnancial activity.

The criteria for evaluation of statute provisions must cover the interests Of both

4

suppliers of capital and the general public. Sufﬁcient ﬁnancial information must

be disclosed so that those who deal with corporations can rely upon representa-

tions in ﬁnancial statements. The issue with each proposed provision is: does it

provide an adequate degree of disclosure to protect the public?

In general, the statute provisions should aid the development of account-

ing for the following reasons:

1.

To extend the concept of usefulness of accounting from the limited
one of accounting as a tool of business or management, to include
accountancy as an agent of present and prOSpective investors as well
as of the general public.

To report fully the results of Operations and to present accurately
the financial position of companies.

To secure greater uniformity and consistency in order to facilitate
comparability of results.

To reﬂect new developments in business and ﬁnance.

To reﬂect improving standards in the ﬁeld of accountancy.

To facilitate the development and maintenance of accepted accounting

principles by enforcing such standards.

Scope and Methodology

The present study is limited to the Companies Act, Canada, and the

Corporations Act, Ontario. The reasons for limiting the study to these two Acts

are:

1.

The Companies Act, Canada, is the Federal Act and most companies,

national in scope, are incorporated under this Act.

2. The Corporations Act, Ontario, is the most current incorporation

statute in Canada.

The relevant statute provisions considered are those with significant
accounting implications. Specifically, the statute provisions examined are those
which pertain to: (1) Capital of the Corporation, (2) The Corporate Surplus,

(3) Corporate Distributions to Shareholders, (4) Corporate Combinations, and
(5) Disclosure of Corporate Activity.

The methodology of this study is predicated on the proposition that ﬁnan—
cial data should be treated with uniformity regardless of political boundaries.
Serious differences exist between accepted accounting theory in each of the areas
studied and in the accounting provisions of the Companies Act, Canada, and the
Corporations Act, Ontario. In this study the statute provisions in areas (le-
lineated are compared with accounting principles and procedures enunciated by
the accounting profession. The adequacy of the law and of the accounting prin-
ciples and procedures is judged in the light of effecting disclosure which will in-
form and protect the public.

The approach prOposed for remedying the situation is to recognize that
the statutory concepts of "capital, " "surplus, " and "dividends, " must be updated
to current thinking and requirements. Amended provisions in these concepts
should be clariﬁed to facilitate disclosure and understanding. Disclosure prac—
tices of corporate ﬁnancial activity are vulnerable to obsolescence in a dynamic
and changing society. To keep abreast of the dynamism of our society, the
statute provisions must be flexible. Disclosure must be recognized as the pri-

mary responsibility of accountants and the accounting profession.

6
Ideally, the law should not spell out inﬂexible rules of disclosure; it
should contain guides conforming to the standards of the accounting profession

and which are apprOpriate for the protection of the ﬁnancial public of corporations.

Literature on the Problem

Literature prior to the establishment of the Securities and Exchange
Commission in 1934 was "ﬂavoured" with a caveat emptor attitude regarding pub—
lic disclosure of corporate ﬁnancial activity. Since that date the accounting liter—
ature has emphasized the need for adequate and meaningful disclosure of ﬁnancial
activity of corporations and has advanced standards of reporting which would in—
sure such disclosure.

The most authoritative outlines of what adequate disclosure consists of
are found in certain Securities and Exchange Commission Releases, Bulletins of
the American Institute of Certiﬁed Public Accountants, Bulletins of the Canadian
Institute of Chartered Accountants, and the rules of the New York Stock Exchange,

issued from time to time.

CHAPTER II
CAPITAL OF THE CORPORATION

The Concept of Capital

There is considerable confusion in the usage of the term "capital. "

The fundamental difﬁculty is in deﬁning what constitutes the capital of a cor-
poration--is it the total resources in the control of the corporation or only
some part thereof, such as the assets as measured by the par or assigned
dollar value to shares issued to the shareholders?

The formulation of the concept of capital pre-dates Christianity by
nearly four centuries. Dewing refers to XenOphon's Okonomikos, (the first
important treatise on economics produced during the development of our west-
ern civilization) in which the author categorically states that true capital is that
part of wealth which can be made to yield a profit. 1 Some two thousand years
after XenOphon's treatise, the term capital came into usage among English trad-
ing companies. The funds that were contributed by the subscribers or share-
holders for a venture were referred to as "capital. " It was assumed that this
amount would be returned to the shareholders, together with any profits at the
end of the undertaken venture. The concepts of capital in usage today are varied,

and are modiﬁcations or derivatives of these earlier formulations. Notable

 

1A. S. Dewing, Financial Policy of Corporations (New York: The Ronald
Press Company, 5th Edition, 1953), p. 45 footnote b.

7

variations are found primarily in the interpretations of accountants, econo-
mists, and jurists.
The Accountant's Concegt. - To accountants the word "capital" has a variety of
meanings. Accounting Terminology2 gives four definitions of capital which are:
1. The amount of property owned by an individual or enterprise
at a Specified time, . . . capital means wealth, i. e. tan-
gible and intangible property rights.
2. The interest of the owner or proprietors in the assets of an
enterprise . . . the excess of the total assets over the

total liabilities to outside interests.

3. In a limited company, that portion of the equity contributed
by the shareholders which may be returned to the share-
holders after compliance with the formalities imposed by
the governing act, the letters patent or the memorandum
of association.

4. The total funds provided by lenders (borrowed capital) and
by proprietors for the use of the business.

In addition, capital in estate accounting is used synonymously with the
corpus of the estate.

Of the deﬁnitions cited, 1 and 4 are identical with only one difference:
the former refers to the asset side of the balance sheet; the latter to the equity
side. "Capital" in terms of this definition is the value, 3 expressed in money,
of total resources of the corporation supplied by its creditors and owners. In
deﬁnition 2, "capital" is equated to the equity of the proprietors. Definition 3
designates "capital" as the _l_ega_l or stated capital and represents amounts paid

or pledged and designated as capital at the time of issuance of the shares in

 

2Accounting Terminology (Toronto: The Canadian Institute of Chartered
Accountants, 1957), p. 14.

3The cost basis Of accounting rests on the assumption that cost, or cost
less accumulated depreciation, is a valid and objective quantitative measure of
value.

9

accordance with provisions of the act under which incorporation took place. The
capital so designated is intended to form a cushion for the protection of creditors
and is a result of the limited liability privilege enjoyed by the shareholders.
These deﬁnitions of "capital" have broadened the range of deﬁned limits
from those established by Xenophon and the early English trading companies, and
each ﬁnds strong support among members of the accounting profession. On the sub-
ject Of capital, Hatﬁeld writes:
In the technical accounting jargon, capital is a credit account,
denoting proprietorships, while "Capital assets" are debits--
indicating something owned—-and never the twain shall meet. 4
I assert that capital, capital stock, or stated capital, as an
accounting term represents so much of the stockholders' contri—
bution as is understood to be an inviolable buffer to protect credi-
tors and possibly other stockholders, and ordinarily is not paid
back to them.
To Hatﬁeld, capital, capital stock, and stated capital are synonymous and represent
the amount designated as capital at the time issuance of shares takes place. His
view is not shared by Paton and Paton who state:
The capital of the business corporation, in the broad sense of
all the resources employed in its Operations, is furnished by those
who invest in or make loans to the company plus those who supply
goods and services on a credit basis.

In this sense the capital of the corporation is the sum total of all items on

the left hand side of the balance sheet, or the total resources, regardless of source.

 

4H. R. Hatﬁeld, Surplus and Dividends (Cambridge, Massachusetts: Har-
vard University Press, 1947), p. 3.

 

51bid. , p. 23.

6Wm. A. Paton and Wm. A. Paton, Jr. , Corporation Accounts and State-
ments (New York: The Macmillan Company, 1955), p. 3.

 

10

This is viewing the corporation as a creature of the state which has to be endowed
with adequate economic resources in order that it may achieve the purpose for
which it has been created—-this being the making of profit. 7 These economic re-
sources are then the capital of the corporation; this deﬁnition is in agreement with
that of Xenophon formulated some twenty-four centuries ago. The essential in-
gredient of this deﬁnition is that a deﬁnite amount of wealth has been segregated
and placed at the disposal of the directors for them to employ for the purpose for
which the corporation was organized.

The Economist's Concept. - The concept of capital as consisting of total assets is

 

probably the closest approximation to what economists generally define as capital.
However, concepts Of capital in economies are as varied as in accounting. One
prominent economist states:

Capital, like many other words in our subject, has almost as
many meanings as there are economists.

To Boulding the most important meaning Of "capital" is "the concept of the totality

9 Applying

of commodities-~valuable things-—in existence at a moment of time."
this concept to the corporation, capital is the aggregation of "economic service
potentials" awaiting conversion into more desirable forms through the Operation

of the enterprise. The distinction between the "economic service potential"

concept and the total asset concept is that the economist limits himself to material

 

7The notion of the corporation as an institution to perform some social
purpose is here disregarded; most accountants and ﬁnanciers believe that profit
is the purpose for formation; Dewing so states, op. cit. , p. 44.

8K. E. Boulding, Economic Analysis (New York: Harper & Brothers Pub-
lishers, Revised Edition, 1948), p. 262.

 

91bid. , p. 263.

11
wealth. Alfred Marshall states:

. . . But there is a clear tradition that we should speak of Capital
when considering things as agents of production . 10

More recently Harry G. Shaffer states:

. . .during the ﬁrst half of the twentieth century. . . the over-

whelming majority of economists, following Alfred Marshall

have shown a tendency to use the concept of capital as applic-

able only to that portion of the non-human, material man-made

stock of wealth which is utilized directly in further production. 11

Limiting capital to material wealth used in production leads to neglect of

the value of intangibles which may be very important since the value of tangible
goods tends to become increasingly dependent upon their organized relationship

to other tangible goods within the corporate unit.

The Legal Concept of Capital. - One of the functions of a general Companies Act

 

is to provide a legal vehicle whereby a number of individuals, each investing a
comparatively small amount, may combine their resources in an aggregate suf-
ﬁcient for a particular undertaking. In return each individual presumably
secures a due measure of inﬂuence in the management of the created corporation
and each receives a due proportion of its profits. The distinguishing feature of
the corporation from a partnership is that persons investing in the corporate
enterprise do not have a direct ownership of the corporation's property; they are
owners of an intermediate and ﬁctitious body Of property called the corporation's

stock. The corporation owns the prOperty. Thus the corporation is in law a

 

10Alfred Marshall, Principles of Economics (London: Macmillan and
Co. , Limited, Eighth Edition, 1938), p. 81.

11

 

Harry G. Schaffer, "Investment in Human Capital: Comment," The
American Economic Review, LI (December, 1961), p. 1026.

12
different person from its members, and the debts and obligations of the corpor-
ation are not those of its members but of the corporation itself. In recognizing
the right of limited liability of the corporate members, provided the members did
not violate the provisions of the Act granting them this immunity, the courts were
faced with the problem of protecting the creditor's rights, vis—a-vis the persons
who control the corporation.

It is in this connection that the "trust fund theory" came into being. In the
case of Wood v. Dummer, 12 Chief Justice Story stated that the capital stock of a
corporation constitutes a trust fund for the payment of its debts to creditors. Al-
though the theory, by name, has gone out of usage, the spirit and its inﬂuence on
accounting is very much in evidence. 13 The terminology that has been substituted
is legal or stated capital; the function is, however, the same--a cushion or buffer
for the protection of creditors.

Legal deﬁnition of capital is still based on the idea that a corporation
must have a fund of property to be called capital-—1egal capital or stated capital,
even though there is a considerable lack Of clarity as to what should constitute the
capital of the corporation. With the advent of no-par and nominal low par value
stock, the directors in many jurisdictions have been left to decide, usually within
stated limits, what should constitute legal or stated capital. The legal concept has

therefore been rendered obsolete. Although some accountants bemoan the legal

 

12Wood v. Dummer, 3 Mason (U. S. C. C. 1824), discussed in James T.
Johnson, "Is The Trust Theory of Capital Stock Dead," The Accounting Review,
XXXIV (October, 1959), pp. 609-11.

13The weakness of the trust fund theory is in its implication that the cor-
poration was to act as a trustee holding the assets contributed by the shareholders
in substantially original form for the protection of creditors. It is doubtful whether
the statutes and even Chief Justice Story intended this.

13
inﬂuence on accounting, 0. g. ,

Accounting has never been able to throw off the yoke of legal
capital from corporate stock equity reporting. 14

the inadequacies of legal interpretation must be shared by both professions. On

this, George 0. May has stated:
The courts are not expert in accounting, and our methods of
informing them on technical matters are deﬁcient . . . 15

On the subject of capital, a noted Canadian author on Corporation Law stated:

It should be observed that the company may have other capital
besides its stock, or, as it is sometimes called, its "share
capital. " The company may borrow money on bonds or other
securities, or without security, and money so borrowed is some-
times called "borrowed capital" to distinguish it from the capital
stock. The company may also have accumulated reserves, which
may be treated as capital. Primarily, however, in speaking of
the capital of a company, the reference is to its capital stock.
But the meaning of the term in the statute depends on the content,
and in the provision prohibiting payment of dividends out of capi—
tal the term capital undoubtedly includes borrowed capital. 16

It is thus apparent that the term capital has a variety of meanings in
accounting, in economics, and in juri Sprudence. The phrase out of Wegenast's
statement (above), "But the meaning of the term in the statute depends on the
context," is probably the thinking behind the distinction made as to the type of
capital by the American Accounting Association and the American Institute of
Certiﬁed Public Accountants. The former has drawn a distinction between types

of capital by the addition of the words "paid—in" and states:

 

14Wm. J. Vatter, Handbook of Modern Accounting Theg‘y, Morton
Backer, Editor, (New York: Prentice-Hall Inc. , 1955), pp. 374-75.

 

15George 0. May, "Accounting and Regulation," The Journal of Account—

ancy, LXXVI (October, 1943), p. 295.

 

16F. W, Wegenast, The Law of Canadian Companies (Toronto: Burroughs
and Co. (Eastern) Ltd. , 1931), p. 444.

 

14

Paid-in capital is measured by the cash, or the fair market
value of other assets or services, contributed by stockholders or
by persons acting in a capacity other than that of stockholders,
or creditors, or by the amount of liabilities discharged upon the
transfer of an equity from a creditor to a stockholder status.

The recommendation of the A. A. A. with regard to capital is in support:
2. The contributed portion of proprietory capital be shown as:

(a) Capital contributed for, or assigned to, shares, to the
extent of the par or stated value of each class of shares

presently outstanding.

(b) 1) Capital contributed for, or assigned to, shares in ex-
cess of such par or stated value (whether as a result
of original issue of shares at amounts in excess of
their then par or stated value of shares after
issuance, or of transactions by the corporation in its

own shares); and

ii) Capital received other than for shares whether from
shareholders or from others. 18

These are the concepts of capital as enunciated by leading authorities in

accounting, economics and jurisprudence.

 

17Committee on Accounting Concepts and Standards, AccountigLConcepts
33d Standards Underlying Corporate Financial Statements and Supplements,
American Accounting Association, 1948, p. 4.

18Committee on Terminology, Accounting Terminolcgy Bulletin No. 1,
American Institute of Certiﬁed Public Accountants, 1953, pp. 30-1.

15

"Capital" in Canadian Corporation Law

The Companies Act, Canada:

 

Section 12, subsections:

(5)

(6)

(7)

(3)

(9)

(10)

The authorized capital of a company having shares with a
nominal or par value shall, with respect to those shares,
be the total nominal amount of those shares.

All or any part of the authorized capital of a company, ex-
cept shares having priority as to capital or being subject
to redemption, may consist of shares without nominal or
par value.

Where the authorized capital of a company consists, in
whole or in part, of shares without nominal or par value
the paid up capital of the company shall, with respect to
those shares, be an amount equal to the aggregate amount
of consideration received by the company for such of those
shares as are issued, exclusive of such part of such con-
sideration as may be set aside as distributable surplus in
accordance with the provisions of this Part or as may have
been lawfully set aside as distributable surplus before the
let day of October, 1934.

Each share of the capital stock without nominal or par
value shall be equal to every other such share of the
capital stock subject to the preferred, deferred or other
special rights or restrictions, conditions or limitations
attached to any class of shares.

Every certificate of shares without nominal or par value
shall have plainly written or printed upon its face the
number of such shares which it represents and the num-
ber of such shares that the company is authorized to issue,
and no such certiﬁcate shall express any nominal or par
value of such shares.

In the absence of other provisions in that behalf in the
letters patent, supplementary letters patent or by-laws

(11)

(12)

(13)

16

of the company, the issue and allotment of shares without
nominal or par value may be made from time to time for
such consideration as may be ﬁxed by the board of direc-
tors of the company; and in ﬁxing the amount of such
consideration, the board, subject to the provisions Of

this Part, may provide in the contract of subscription

for such shares that the consideration received therefor
shall be deemed to be capital, excepting a part, if any,

not exceeding twenty-ﬁve per cent thereof, that may be

set aside as distributable surplus; and where the company
acquires a going concern that has a surplus over and above
all liabilities, and any shares without nominal or par value
in the company are issued and allotted as fully paid in pay-
ment or part payment for such going concern, the directors
may by resolution set aside, as a distributable surplus, such
part of the consideration for the issue and allotment of such
shares without nominal or par value as does not exceed the
unappropriated balance of realized net proﬁts of the going
concern immediately before such acquisition.

Any and all shares issued as permitted by this section shall
be deemed fully paid and non-assessable on receipt by the
company of the consideration for the issue and allotment
thereof, and the holder of such shares shall not be liable

to the company or to its creditors in respect thereof.

Shares in the capital stock of the company having a nominal
or par value shall not be issued as fully paid except for a
consideration payable in cash to the total nominal amount of
the shares so issued, or for a consideration payable in
property or services that the directors may determine by
express resolution to be in all the circumstances of the
transaction the fair equivalent of cash to the total nominal
amount of the shares so issued.

The directors may apply ex parte by summary petition to a
judge to determine by declaratory order that any such con-
sideration so payable in property or services is such fair
equivalent as aforesaid; such judge may so determine and
for that purpose he may require the production of such
proofs, oral and documentary, under oath or otherwise, as
he may think ﬁt, and his order shall be ﬁnal and conclusive
proof in all courts that such consideration so payable was
such fair equivalent as aforesaid.

Section 16, subsections:

(1) It shall be lawful for a company to pay a commission to any

17

person in consideration of his subscribing or agreeing to
subscribe, whether absolutely or conditionally, for any
shares in the capital stock of the company, or procuring
or agreeing to procure subscriptions, whether absolute or
conditional, for any such shares if

(a) the payment of the commission is authorized by the
letters patent or supplementary letters patent,

(b) the commission paid or agreed to be paid does not
exceed the amount or rate so authorized, and

(c) the amount or rate per cent of the commission paid
or agreed to be paid is disclosed in the prOSpectus in
the case of shares offered to the public for sub-
scription.

(2) Save as aforesaid, no company shall apply any of its shares
or capital money either directly or indirectly in payment
of any commission, discount, or allowance, to any person
in consideration of his subscribing or agreeing to subscribe,
whether absolutely or conditionally, for any shares in the
capital stock of the company, or procuring or agreeing to
procure subscriptions, whether absolute or conditional, for
any such shares, whether the shares or money are so applied
by being added to the purchase money of any property acquired
by the company or to the contract price of any work to be exe-
cuted for the company, or the money is paid out of the nominal
purchase money or contract price, or otherwise.

(3) Nothing in this section affects the power of any company to
pay such brokerage as it has heretofore been lawful for a
company to pay, and a vendor to, promoter of, or other
person who receives payment in money or shares from a
company, shall have and shall be deemed always to have had
power to apply any part of the money or shares so received
in payment Of any commission, the payment of which, if made
directly by the company would have been legal under this
section. 1934, c. 33, s. 16.

The Cormrations Act, Ontario:

Section 30 , subsections:

(1) Where the shares of a company are with par value, its issued
capital shall be expressed in dollars, pounds, francs or other
currency and is an amount equal to the total of the products
of the number of issued shares of each class multiplied by the
par value thereof.

18

(2) Where the shares of a company are without par value or

(3)

(4)

where part of its shares are with par value and part are
without par value, its issued capital shall be expressed

in dollars, pounds, francs or other currency and is an
amount equal to the total of the products of the number of
issued shares of each class with par value multiplied by
the par value thereof, together with the amount of the con-
sideration for which the shares without par value from time
to time outstanding were issued and together with such
amounts as from time to time by by-law of the company
may be transferred thereto.

Nothing in subsection 2 affects the capital of a company in
respect of shares without par value issued before the 30th
day of April, 1954, if the letters patent or the supplementary
letters patent of the company provide that the capital is to

be at least equal to the sum of the aggregate par value of

all issued shares having par value plus a sum in dollars,
pounds, francs or other currency in respect of every

issued share without par value plus such amounts as from
time to time by by-law of the company may be transferred
thereto.

Where before the 30th day of April, 1954, a company has
set aside part of the consideration received upon the allot-
ment and issue of shares without par value as distribut-
able surplus, the amount of such distributable surplus shall
not form part of its issued capital. 1953, c. 19, s. 30.

Section 31, subsections:

(1) In the absence of a provision to the contrary in the letters

(2)

(3)

patent, supplementary letters patent or by-laws Of the
company, shares may be allotted and issued at such times
and in such manner and to such persons or class of persons
as the directors determine.

Shares with par value shall not be allotted and issued as
fully paid except for a consideration payable in cash at
least equal to the product of the number of shares allotted
and issued multiplied by the par value thereof or for a con-
sideration payable directly or indirectly in property or
past services which the directors in good faith determine
by express resolution to be in all circumstances of the
transaction the fair equivalent of such cash consideration.

Shares without par value may be allotted and issued for
such consideration as may be ﬁxed by the directors acting

H

(4)

(5)

19

in good faith and in the best interests of the company.

Shares without par value shall not be allotted and issued as
fully paid except for the consideration ﬁxed by the directors
as aforesaid payable in cash to the total amount of the con-
sideration so ﬁxed or for a consideration payable directly
or indirectly in prOperty or past services which the direc-
tors in good faith determine by express resolution to be in
all circumstances of the transaction the fair equivalent of
such cash consideration.

Shares allotted and issued in accordance with this section
shall be fully paid and non-assessable upon receipt by the
company of the consideration for the allotment and issue
thereof, and upon such receipt the holders of such shares
shall not be liable to the company or to its creditors in
respect thereof. 1953, c. 19, s. 31.

Section 32 , subsections:

(1)

(2)

(3)

The directors may pass by-laws for the payment of commis-
sions to persons in consideration of their subscribing or
agreeing to subscribe, whether absolutely or conditionally,
for shares in the company, or procuring or agreeing to pro-
cure subscriptions, whether absolute or conditional for such
shares, but no commission shall exceed 25 per cent of the
amount of the subscription.

No by-law passed under subsection 1 shall be effective until
it is conﬁrmed by at least two-thirds Of the votes cast at a
general meeting of shareholders duly called for considering
the by-law.

Except as provided in subsection 1, no company shall apply
any of its shares or capital, either directly or indirectly,

in payment of any commission, discount or allowanc e to any
person in consideration of his subscribing or agreeing to
subscribe, whether absolutely or conditionally, for shares
of the company or procuring or agreeing to procure sub-
scriptions, whether absolute or conditional, for such shares,
whether the shares or capital is so applied by being added to
the purchase money of any prOperty acquired by the company
or to the contract price of any work to be executed for the
company, or is paid out Of the nominal purchase money or
contract price or otherwise. 1953, c. 19, s. 32.

20

"Capital" as deﬁned by the Federal Act is as follows: In the case of par
value shares, "capital" is the product of the number of issued shares of each
class multiplied by the par value thereof. In the case of no par value shares,
"capital" is any amount established by the directors within the 75 per cent to 100
per cent limits of the total consideration for issued shares.

"Capital" under the Ontario Act is: In the case of par value shares,
"capital" is the product of the number of issued shares of each class multiplied
by the par value thereof. In the case of no par value shares, "capital" is the
total consideration received. The accounting entries under the two statutes
would then appear as follows, assuming ten no par shares were issued for a
total consideration Of $120.

Federal Act:

Assets $120
Share Capital $90
Distributable Surplus:19 30

Ontario Act:

Assets $120
Share Capital $120

In effect the Federal Act permits the understatement of "capital" by an amount of
up to $30, in the above example (up to 25 per cent of the total consideration) in
terms of the Ontario Act, or in terms of the concept of capital which views total

proceeds of an issue of shares as legal capital. The provision of the Ontario Act

 

191a the example it is assumed that the minimum amount allowable by law

is designated as legal capital and the maximum amount designated as distributable
surplus. It is within the power of the directors to designate any amount within the
75-10096 limits of agreed consideration as legal capital and the balance as distribut-
able surplus. The amount by which the total consideration exceeds stated or legal

capital is set up as "Distributable Surplus" and is dealt with in the next chapter. . .
"The Nature of Corporate Surplus."

21

requiring total proceeds from issue of no par shares is applicable only to share
issues since April, 1954. Companies which allocated a portion of the proceeds to
distributable surplus prior to this date were not required to alter their accounts
to conform to the new Ontario legislation. The Act therefore sets up a double
standard for new and old companies and relegates the provision of the Act to a
"lame-duck" status. The Act should have allowed companies a period of time to
conform to new legislation. An interesting and questionable provision in both
Acts (Section 16 in Federal and Section 32 in Ontario) allows in effect the over-
statement of legal capital. Both Acts permit the payment of commissions of up to
20 per cent to any person other than underwriters or selling groups subscribing to
shares directly from the company. The accounting entries follow:

I

Assets $100
Share Capital $100

Commissions on Share
Capital (intangible asset) $20
Assets $20
Since the companies are empowered to pay commissions directly to the sub-
scribers, in essence refunding a portion of the subscribers contribution, the Acts
essentially legalize the issuance of shares at a discount, which the Acts, at the
same time, speciﬁcally declare to be illegal. 20 On the subject of commissions,
Professor Smails states:
In legal theory therefore these commissions represent an
asset which endures without impairment so long as the shares

in question are outstanding and one which might properly be
left standing on the books at its original ﬁgure for that period

 

20The Corporations Act, Ontario, speciﬁcally exempts mining companies
from the provision prohibiting the issuance of shares at a discount.

22
of time. But the power to pay commissions may be used as a
device for issuing par value shares at a discount and when it is
so used the facts do not ﬁt the legal theory--the paid-in capital
is in fact overstated and the error can be corrected only by
capitalizing a corresponding amount of earned surplus. 21

Recognizing commissions as bona ﬁde assets is interpreting the expendi-
ture as a ﬁnancial cost, utilizing part of the funds invested to pay for necessary
services. However, when only two parties are involved, the company issuing
shares and the investor, an allowance of a commission is not a payment for a
necessary service-mo service is involved. The validity of compensating a per-
son for his efforts in selling shares to himself is beyond justification. From the
purchasers' or subscribers' point of view recognizing commissions as revenues
is similar in nature to recording purchases subject to discounts at gross amounts
and recognizing discounts taken as revenue, which only can be justiﬁed on the
acceptance of Poor Richard's "a penny saved is a penny earned. "

Remedying the situation as suggested by Professor Smails is not accept-
able. Capitalizing earned surplus (increasing stated capital and decreasing earned
surplus) in amount equal to commissions is only compounding the "error. " This
practice not only assumes the presence of earned surplus, but would understate
the earned surplus and further overstate the stated capital. The "error" can only
be corrected by wiping out the ﬁctitious asset and reducing stated capital.

Under the circumstances stated above, commissions do not qualify as

a ﬁnancing cost, hence do not qualify as an asset. On the other hand, since they

were granted voluntarily they cannot be regarded as a loss. Therefore, the only

 

21R. C. H. Smails, Accounting Principles and Practice (Toronto: The
Ryerson Press, Revised Edition 1954), p. 288.

23

correct interpretation of commissions when only two parties are involved is
that they are, in fact, discounts, and recording an issue of stock at par or stated
value under this condition constitutes an overstatement of capital.

There was a partial attempt to remedy the situation in the Ontario Act.
Commissions that are granted cannot exceed 25 per cent of the subscribed
amount. This is somewhat of an improvement over the Federal Act where no
limit is set; however, room is still left for abuse and very little, if anything, is
accomplished in clarifying the concept of legal capital.

The consideration of commissions above applies to situations where only
two parties are involved. Where a third party is involved and the dealings are at
arms' length, a valid consideration is received by the issuing company. The
services performed by the third party, such as the assumption of certain risks
associated with an underwriting, advice as to timing and type of security to be
issued, etc. , are valid assets which rank pari ppssu with other assets acquired

by the corporation and are rightly recognized and retained on the books. 22

 

22This is the view of Paton and Paton who state: "Organization and re-
lated costs should be retained as a permanent asset as long as the business main-
tains substantially unimpaired status as a going concern, as reﬂected in earning
power and tangible resources, and should be amortized with a sustained contrac-
tion of income and tangible assets resulting either from lack Of Operating success
or deliberate liquidation. Needless to say it would not be expedient to attempt to
apply such a formula in terms of minor ﬂuctuations in activity and earning power."
Wm. A. Paton and Wm. A. Paton, Jr. , Asset Accountipg (New York: The Mac-
millan Co. , 1952), p. 472. To argue against the vieWpoint of Paton and Paton on
the basis that the only capital available to the management of a corporation is the
proceeds net and organization and related costs are not 9.93.1.3. pg; assets since
the corporate management can do nothing with these assets may be valid only from
the viewpoint of the ﬁnancial ofﬁcer. However from the accounting vieWpoint the
argument loses any validity that it may have.

24
Other Cases of Overstatement or Understatement of Capital

Implicit Stock Discounts
The issue of shares for a consideration other than cash may give rise to

an implicit discount in the transaction. Although the statutory provisions prohibit
the issue of shares for a wholly illusory consideration, in reality the board Of
directors is given wide latitude in establishing asset values. J. L. Stewart
states:

. . .in the absence of fraud or special statutory requirements,

neither the court, while the company is a going concern, nor the

liquidator, if the company is being wound up, will enquire into

the adequacy of the consideration. 23
When assets are acquired in exchange for shares of the company and these assets
are overvalued, in terms of market value, the issued shares are only nominally
paid in full and an implicit discount equal to the overvaluation of the assets
acquired exists. To illustrate assume that an asset can be acquired for $1, 000
in cash; however by mutual agreement the asset is exchanged for $1, 500 par
value shares. The accounting entry, avoiding recognition of the implicit discount,
would appear as follows:

Asset $1 , 500
Share Capital $1, 500

In the example, the effect of the entry is to overstate the legal capital by $500,

the amount of the implicit discount.

23J. L. Stewart, Handbook on Canadian Company Law (Toronto: The
Carswell CO. Ltd., Fifth Edition, 1960), p. 67.

 

25

Secret Reserves

Although understatement is usually associated with the measurement of
net income and retained earnings, situations do arise where undervaluation of
invested noncash assets or suppression of costs of intangibles take place. To
illustrate assume that because of a tax advantage, to gain control of a company,
or to make a donation to a company, an owner of an asset, the market value of
which is $1, 500, agrees to accept $1, 000 par value shares in exchange for the
asset. The accounting entry recognizing the asset on the books at $1, 000 is as
follows:

Asset $1, 000

Share Capital $1, 000
The effect of the entry is to understate legal capital by $500, the amount of the
undervaluation of the asset. As in the case of implicit stock discounts, the prac-
tice of recognizing assets on the books at undervalued values is difﬁcult to elimin-
ate by legal provisions. Both the Federal and Ontario Acts leave it up to the
board of directors to determine in good faith the fair equivalent of such noncash
consideration. The Federal Act, in addition, provides that the directors may apply
to a judge to determine by declaratory order that the valuation of the consideration
by the directors is a fair equivalent of cash. However, even this additional pro-
vision is of questionable value, as stated by F.W. Wegenast:

If a man has subscribed for $1, 000 of stock and has paid $999,

the court will do a sum in subtraction and make him pay the other
dollar. But, if for $1, 000 of stock a man turns in property which
could readily be shown to be worth only $10 the theory is that the

court is helpless. In an automobile accident the court can assess
the value of an arm or an eye. In a libel suit it can assess the

26

value of a character. But the line is drawn when it comes to
assessing the value of assets given for stock in a company.

The courts have taken the attitude that valuation of assets, other than
cash, exchanged for shares of the corporation, is the prerogative of the board
of directors. Only in situations where fraudulent dealings are present in con-
nection with the exchange of non-cash assets will the courts interfere. How-
ever even in these cases where fraud is involved, the fraudulent practice is the
basis for interference and not the valuation of the assets p_e_r _s_§.

In adopting the "hands-off" policy toward asset valuation, the courts
no doubt were inﬂuenced by the fact that the alternate courses of action may not
be workable in practice. Although valuation of non-cash assets exchanged for
shares of corporations' might be delegated to the courts, the problems in-
volved in valuation would not be eliminated. Assets exchanged for shares are
for the most part unique in character; the fair value of these is subjective and
the values assigned by the courts may not be any more accurate than the value
that would otherwise be assigned by the directors.

The delegation of authority to the directors in the valuation of non-cash
assets exchanged for shares of the company ﬁnds theoretical foundation; the
directors are the representatives of the shareholders and act in their (the
shareholders') best interest.

In the United States the "hands-off" policy is not applicable. The
Security and Exchange Commission in its early life in a number of cases

established its right to question asset valuation.

 

24Canadian Political Science Association, ngers and Proceedings of the
Annual Meetiﬂ (Ottawa, Ont. , 1933) , p. 160.

27
Subsequent Changes in Capital

Although both incorporating acts set out restrictions which govern
companies on such matters as the preservation of capital, they also provide
means by which changes in the capital structure may be effected in order that
the continuing company may have a degree of ﬂexibility in its ﬁnancial arrange-
ments. In general, alterations which change the details of the original share
contracts without changing the amount of legal capital, or the right of share-
holders, require only the assent of two-thirds of the votes of the holders of
each class of shares affected (cast at a special meeting of shareholders) and
the formality of changing the charter. Those changes which result in reduction
of legal capital and/ or involve the rights Of either or both the shareholders and
creditors can be effected only by formal approval of shareholders, creditors,
and the Secretary of State of the appropriate jurisdiction.

There is considerable variation between the Federal and the Ontario
Acts, and the provisions of each will be discussed separately.
The Companies Act, Canada
Changes Not Reducing Legal Capital:

Under section 48, the company, with the approval of two-thirds of the
votes of the holders of each class of shares, may from time to time by by-law:

(a) subdivide any shares with or without par value of any class;

(b) consolidate all shares with par value, of any class, into
shares of larger par value not exceeding the par value of
one hundred dollars each;

28

(c) consolidate all shares without par value, of any class, so
that the authorized number of such shares is reduced;

(d) change all or any of its previously authorized shares with
par value, issued or unissued, into the same or a different
number of shares of any class or classes without par value
and not having priority as to capital or being subject to re-
demption;

(e) change all or any of its previously authorized shares with-

out par value, issued or unissued, into the same or a dif-
ferent number of shares of any class or classes with par
value;

(1) classify or reclassify any shares without par value;

(g) increase the capital of the company; and

(h) cancel any shares with or without par value, that at the

date of the enactment of the by—law have not been sub-
scribed for or agreed to be issued, and diminish the
amount of the authorized capital of the company by the
amount of the shares so cancelled.

Alterations under this section usually require only a memorandum
entry. The one exception is that on consolidations of shares fractional shares
usually arise. The company is permitted to purchase such fractional shares;
however, it must sell the resulting whole shares within two years. This is a
speciﬁc legal exception to the rule under common law which does not permit
companies to trade in their own stock.

By section 59, the company, with the same approval as above, can
create and issue preferred shares with such preferred or other special rights,

restrictions, conditions or limitations as may be set out in the by-law. This

section permits inclusion, with approval, of a redemption or conversion feature

if these were not included in the original contract.

29

Alteration of the rights of shareholders can be effected under Section
126; however, approval by at least three—fourths of the shares of each class rep—
resented and voted at a special meeting of shareholders is required.

A provision that is rare in corporation law is section 61 of the Act
which permits the redemption or purchase for cancellation of any of its fully
paid shares, other than common, without the usual formalities of sections deal-
ing with the reduction of capital. The Act speciﬁcally requires in this connection
that: either (a) the redemption must be made out of proceeds of an issue Of new
shares for the purpose; or (b) it is made by payments out of the ascertained
proﬁts of the company--these proﬁts must have been set aside by the directors
for the purpose of redemption and are in liquid funds as shown by the audited bal-
ance sheet dated not more than ninety days before the redemption or purchase for
cancellation. Cumulative dividends on the preferred stock must not be in arrears;
the legal capital of the company is not to be reduced; notice of redemption must
be ﬁled with the Secretary of State.

The condition of not reducing the legal capital is accomplished in two
ways: in case (a) above, the new shares replace those redeemed, and (b), a
transfer from retained earnings to "capital surplus" in the amount equal to the
legal capital associated with the redeemed shares must be made.

Thus, the Act seeks to protect the creditors by requiring that no impair-
ment of capital, (that is, reduction of legal capital), takes place as a result of

redemption or purchase for cancellation of shares other than common.

30

Illustration of accounting procedure involved follows:25

The shareholders' section of the balance sheet of XY Z Limited as of June 30,
1961, appears below:
Share Capital:

Preferred shares, authorized, issued and fully paid,
1, 000 6% redeemable preference shares of $10 par $10, 000

Common shares, no par—value, authorized 50,000
issued and fully paid, 10, 000 shares

Retained Earnings 30, 000

£90! 000

1. Assume Redemption is made out of proceeds of new issue of 4% preferred.

Transactions:
Cash $10, 000
4% preferred stock $10, 000
Issue of new 4% preferred shares
6% preferred stock 10,000
Cash 10, 000

Redemption of 6% preferred shares

No changes in portion of balance sheet shown above.

2. Assume redemption is made without any new issue of stock.

Transactions:
6% preferred stock $10, 000
Cash $10, 000
Redemption Of 6% preferred shares
Retained earnings 10, 000
Capital surplus (sec. 61) 10,000

To record transfer from retained earnings.

In the second example after transactions were made, the shareholder's section
of the balance sheet would change.

 

25Illustrations adapted from H. A. Finney and H. E. Miller, Principles
of Accounting, Intermediate, Canadian Edition, prepared by K. F. Byrd,
(Englewood Cliffs, 1959) and W. E. Karrenbrock and Harry Simons, Intermediate

 

 

 

Accounting, Canadian Revision, by W. J. McDougall (Toronto: W. J. Gage
Limited, 1961).

31

Share Capital:

Common shares, no par value authorized,
issued and fully paid, 10, 000 shares $50, 000

Capital surplus (under Section 61 of

Companies Act, Canada, 1952) 10,000
Retained Earnings 20I 000
$802 000

Because the capitalized retained earnings are, for all purposes, equivalent to
capital stock, the legal capital remains the same after redemption; that is, at
$60,000.

In the case of redemption premiums, the Act implies that these are to
be charged to retained earnings. However, Canadian Institute of Chartered
Accounts state in Bulletin No. 11:

. . . a charge which is the direct opposite of a credit previously

carried to contributed surplus-~for example, where contributed

surplus reﬂects premiums on an issue of preferred shares it is

appropriate to offset premiums on redemption of shares of that

issue, pro-rata. 2'6
If the premium on issued preferred shares is available for dividends, as it is
under the Act, there seems to be no contravention of intentions and both methods
are permissible. The Canadian Institute's Opinion is shared in the United

States by the Chief Accountant of the Securities and Exchange Commission, who

stated:

. . .if the redemption price exceeds the amount paid in on such
shares, the excess should ordinarily be charged to earned
surplus.

 

26
Committee on Accounting and Auditing Research, Accountingand
Auditing Practices Bulletin No. '11, (Toronto: The Canadian Institute of
Chartered Accountants, 1955), p. 4.

27 Securities and Exchange Commission, Accounting Series Releases,
(Washington: Securities and Exchange Commission, 1956), p. 110.

 

32
The Chief Accountant agrees with the Opinion that the premium on issue of
preferred shares should be reduced pro—rata when the shares are redeemed and
if the redemption price exceeds the amount paid on the shares being redeemed
only the excess should be charged to earned surplus.

No special accounting problem is presented in connection with conver-
sion of convertible securities, such as bonds or preferred shares. These are
convertible at the option of the security holder and may take place without
special authorization. If, for example, a company had $10,000 par bonds out-
standing which were convertible into 1, 000 shares of the company's stock, then
on conversion the following entry would cover the exchange:

Convertible bonds outstanding $10, 000
Common stock $10, 000

Preferred share conversion would be similarly treated; that is, the correSponding
credit to common stock would equal the par of the preferred converted. In

cases where a premium relating to bonds or preferred shares being converted

is on the books, two acceptable accounting methods may be followed. 28 Under
one method the corresponding credit to share capital will be equal to the par of
the security converted, plus the premium applicable to the security so converted.
In situations where a bond discount is on the books, the correSponding credit is
reduced by an applicable amount of the discount. Under the alternative method

share capital would be credited by the total market value of shares issued and

 

28Paton and Paton recommend crediting share capital for the par value
plus the applicable premium to securities converted. However, they see no Ob-
jection to crediting share capital by the market value and debiting retained
earnings for balance. Wm. A. Paton and Wm. A. Paton, Jr. , Corporation
Accounts and Statements, op. cit. , pp. 243—44.

33

retained earnings debited for the difference. For instance, assume, in the
case of bonds above, that market value of the 1, 000 shares issued on conver-
sion was $15, 000; then the entry would be:
Convertible bonds outstanding $10, 000
Retained Earnings 5, 000
Share Capital $15, 000

Preferred share conversion would be similarly treated.

Reduction of Capital

 

Sections 49 to 58 inclusive outline the procedure to be followed in re-
vision and realignment of securities usually referred to as reorganization or re-
casting of the capital structure. The Act sets out three types of capital reduction,
with the stipulated requirement that the company have the formal approval of the
shareholders, creditors, and the Secretary of State. The legal capital may be
reduced under section 49 (1) for the following reasons:

(a) extinguish or reduce the liability of any of its shares in
respect to capital not paid-up;

(b) cancel any paid-up capital which is lost or unrepresented
by available assets, and

(c) pay off any paid-up capital that is in excess of the wants of
the company.

The method that most easily accomplishes contraction of capital is re-
leasing formal capital to the status of an "excess" (capital surplus). This may
be accomplished by the reduction of par value in the case of par stock, and stated
value in the case of no-par stock. The "excess" so created, may then be utilized
for absorbing an accumulated deﬁcit, writing down of asset values, or return of
capital to the shareholders.

To illustrate the above method of capital contraction, assume that a

34

company has 100, 000 shares outstanding issued at a stated value of $10 and an

accumulated deﬁcit of $300, 000. Steps are taken to eliminate the accumulated
deﬁcit against the excess arising upon the reduction of stated value from $10 to
$5 without changing the number of shares outstanding:

(1) Capital stock (amount received

from shareholders) $1 , 000, 000
Capital Stock - Stated Value $500, 000
Capital Surplus from Reduction in
stated value of Outstanding Stock 500, 000

(2) Capital Surplus from Reduction in
stated value of Outstanding Stock $300, 000
Accumulated Deﬁcit $300, 000
The Canadian Institute recommends that subsequent to a reduction of capital:
If any deﬁcit has been eliminated by reduction of share capital,
reduction of contributed surplus, or other ﬁnancial rearrangement,
the description of earned surplus thereafter for a period of say
ﬁve years should indicate the time from which the new earned
surplus dates.
The Act also requires that the words "and reduced" be added as the last words
of the corporation's name until such date as the Secretary of State may ﬁx.
Although accounting entries for reorgani zations may take different
forms, they would be basically the same if a new corporate entity is not created.
Variations of the illustration are in order to conform to the speciﬁc situation of
the reorganization. Radical readjustments of the capital structure may require

the creation of a new corporation to take over the assets of the corporation being

reorganized. Accounting for these situations is dependent on the agreement

 

29Committee on Accounting and Auditing Research, op. cit. , p. 4.
The Securities and Exchange Commission recommends that the period be at
least three years; however, in practice it is often continued indefinitely.

35
reached by the parties involved, as all parties usually agree to some sacrifice.
The rule that is usually followed in such situations is that the plan for reorganiza-
tion be fair to all interests. In situations of this type, sufficient protection of
rights is afforded by the courts, which must approve the reorganization, and
the protective committees representing the various interests.

The Corporations ActLOntario

 

As already stated, there is considerable variation in provisions dealing
with changes in capital under the two Acts. The Ontario Act provides more lati-
tude and therefore a greater degree of ﬂexibility for companies in their ﬁnancial
arrangements than does the Federal Act. Under section 33 (1) of the Ontario
Act the company, after authorization by a special resolution, may apply to the
Lieutenant-Governor for the issuance of supplementary letters patent30 to per-
mit, among other things:

(a) increasing its authorized capital;

(b) decreasing,

(i) its authorized capital by cancelling issued or unissued
shares with or without par value or by reducing the par
value of issued or unissued shares, or

(ii) its issued capital, if it has shares without par value,
and where it has more capital than it requires, author-
izing the repayment of capital to the shareholders to

the extent that the issued capital is decreased in any
way under this clause;

(0) redividing its authorized capital into shares of lesser or
greater par value;

((1) consolidating or subdividing any of its shares without par
value;

 

30The procedure in obtaining supplementary letters patent is essentially
the same as in obtaining the charter of incorporation.

36

(e) changing any of its shares with par value into shares without
par value;

(f) changing any of its shares without par value into shares with
par value;

(g) reclassifying any shares with or without par value into shares
of a different class.

In addition, section 27, the following subsections state:

(9) Where the letters patent or supplementary letters patent pro-
vide that the preference shares may be purchased for cancel-
lation by the company, the company may purchase some or all
of such shares at the lowest price at which, in the opinion of
the directors, such shares are obtainable, but not exceeding
the amount paid up thereon, but if the letters patent or supple-
mentary letters patent so provide, a premium, unpaid divi-
dends, or other stated amount may be paid.

(10) Preference shares shall not be redeemed or purchased for
cancellation by the company if the company is insolvent or
if the redemption or purchase'would render the company
insolvent.

(11) Where preference shares are redeemed or purchased for can-
cellation by the company, they shall be thereby cancelled,
and the authorized and the issued capital of the company
shall be thereby decreased.

(12) Where preference shares are converted into the same or
another number of shares of another class or classes,
whether preference or common, the shares converted there-
upon become the same in all respects as the shares of the
class or classes respectively into which they are converted
and the number of shares of each class affected by the con-
version is changed accordingly.

(13) Where preference shares are converted into another class
or other classes of shares, the issued capital of the com-
pany shall not be increased or decreased by the conversion.
Thus, under the Ontario Act, companies may reduce their legal capital

by the purchase of both its preferred and/ or common shares. The conditions

of purChase are:

37

(a) authorized by a special resolution and issue of supple-
mentary letters patent;

(b) that the shares purchased will be cancelled, and

(c) after the purchase, the company will be solvent and the
creditors do not Object to the reduction of legal capital.

Conditions (a) and (0) above are common in corporate law under which
companies are permitted to purchase their own shares. However (b) requiring
the cancellation of the purchased shares is not common to all jurisdiction; es-
pecially is this true in the United States, where companies in some States are
permitted to purchase, carry on their books and reissue their own shares. The
Ontario Act is speciﬁc on this: purchased shares must be cancelled and con-
stitute a reduction of capital. In other words, there is no such thing as
"Treasury Stock."31 The Act recognizes that a corporation cannot hold its own
stock.

In addition to requiring the cancellation of the purchased stock, the
Ontario Act speciﬁcally provides the accounting that is to be followed in connec-

tion with the purchase of the company's own shares. The method prescribed is

the "par-value method" which has received support from Paton and Littleton who

 

31On "Treasury Stock" F.W. Wegenast states: Another term some-
times used instead of "authorized capital" is "treasury stock" or "stock in
treasury, " These expressions have no prOper place in the terminology of a
Canadian Company. They are pOpularly but incorrectly used in referring to
stock which the company is authorized to issue but has not yet issued and which
is therefore not in existence. The terms have come into use in Canada by way
of the United States, where they are used to denote stock which has been paid up
and left in the hands of the company to be issued or transferred by it without re—
gard to the par value of the stock. Such a trafﬁcking by a company in its own
stock is not permissible in this country, i. e. in Canada. F. W. Wegenast,
The Law of Canadian Companies, op. cit. , p. 444.

38

state:
If the shares are not reissuable, or if they take on the status
of unissued or retired shares, the amount paid should be charged
to capital stock account, up to the amount originally credited
therein, any balance remaining should be charged to paid—in surplus
up to an amount not in excess of the pro-rata portion Of paid-in sur-
plus applicable tO the shares in question; any part of the total pay-
ment which cannot be thus absorbed should be charged to earned
surplus. 32
The Ontario Act recognizes that acquisition of outstanding shares by the
issuing company is in effect a withdrawal of invested assets by the security hol-
de’r. As a result of this, corporate capital has been correspondingly changed.
The treatment of reacquisition of shares as discussed above is a signiﬁcant de-
parture of the Ontario Act from the Federal Act, which prohibits acquisition of
common shares and permits acquisition and cancellation of preferred shares on

the condition that an amount of retained earnings equal to the par or stated value

of preferred so redeemed is capitalized.

Reconsideration of the Concepts of Capital
The legal concept of capital, which is also Hatﬁeld's concept, that
capital is the amount designated as such at the time of issuance of shares, is ob-
solete. It is indeed a folly to look at the ﬁgure assigned to capital stock as the
capital of the corporation, and a greater folly to look at this ﬁgure as represent—

ing the assets which form a buffer or cushion for the protection of creditors.

 

32Wm. A. Paton and A. C. Littleton, An Introduction to Corporate
AccountingStandards, 8th printing,(1957),American Accounting Association, p.
115. .

l't

.\

39
The implication of this latter concept is that credit is granted on the basis Of
the amount credited to the capital stock account. This is a static or sterile con-
cept of capital not consistent with reality. In reality, credit is granted on the
basis of the earning power33 of the corporate unit without regard to the ﬁgure
associated with the capital stock of the corporation. In many cases credit ex-
tended tO corporations is many times the amount associated with the capital
stock account.

In a dynamic economy, legal or stated capital of the corporation has
little meaning to the creditor. He looks to the earning power of the corporation
forhis protection and seeksto restrict disbursementof corporate earnings, for
his protection, in various ways, e. g. , maintenance of working capital ata certain
level before payment of dividends can take place, etc. This restriction applies both
tothe past and future earnings. As long as the restrictions are in force, which is

7 the duration of agreements entered with creditors, the contractual level of capital,

which forms the buffer or cushion for the creditors' protection, is different
than the capital associated with capital stock. Thus, the creditors reach beyond
the veil of the legal concept of capital for their protection.

The importance of earning power as the real protection, rather than a
legal "cushion," cannot be overemphasi zed, for lack of this earning power can re—
sult in legal dissipation of the assets which were legally intended to be "frozen"
for the protection of creditors.

If maintenance of a certain amount of shareholders' equity, as perma-

 

33An exception is where collateral is pledged as security for a loan, for
example the collateral trust certiﬁcate.

EJH

4O
nent, is a test for legal capital, then perhaps much can be said for viewing all
of shareholders' equity as permanent. One needs to adopt the position that the
earnings of the corporate unit are the earnings of the shareholders; the fact that
a portion of the earnings is reinvested on behalf of the shareholders indicates
their implicit approval. That the implied approval is present is upheld by
Hunt, Williams and Donaldson who state:
In view of the widespread absence or ineffectiveness of share-

holder control, the reader may be disposed to conclude that the

common shareholder should be considered as just another source

of funds along with the bondholder and preferred stockholder. We

disagree with this interpretation for two reasons: (1) the common

shareholder alone possesses the legal right to control the manage-

ment and the business, whether he exercises it or not; and (2) the

common shareholder continues to bear the fundamental risks of the

business, whether or not he dictates its policies. This leads us to

the position that questions of financial policy should be determined

from the point of view of the interests of the common shareholders
existing at the time the policy is being determined. 34

Since the implied permission is required of the shareholders, the only differ-
ence that exists between the reinvested earnings and the amount associated
with share capital is that the shareholders are not issued certiﬁcates signifying
reinvestment. Thus, any future dividend that is in excess of the then current
earnings is a liquidating dividend in that the size of the corporate unit is re-
duced from what it was before.

The legal concept of capital is outdated in that it fails to recognize the
necessity of survival of the corporate unit. In a competitive dynamic economy

corporations must reinvest a portion of earnings and/ or obtain funds from other

 

34‘P. Hunt, C.M. Williams, and G. Donaldson, Basic Business Finance,
(Homewood, Illinois: Richard D. Irwin, Inc. , 1958), pp. 457-58.

41

sources in order to maintain their relative position in that economy. The addi-
tional investment, whether from new issues of shares, or reinvested earnings,
necessary for the maintenance of relative position in the economy, should be

regarded as permanent investment of the shareholders.

Conclusion

The Companies Act, Canada, is preoccupied with the legal concepts of
capital and as a result has not yet been relieved of restrictive and outdated pro-
visions dealing with changes in capital subsequent to organization. Therefore
the desired ﬂexibility in altering the capital structure of the company is not per-
mitted. Allocation of a portion of the proceeds from a no-par value stock issue
to a "Distributable Surplus" account, which is available for dividends is objec-
tionable in that when a dividend is charged to this account, it is a liquidating
dividend—return of invested capital to the shareholders. The shareholder, no
doubt, had intended that his total contribution form the stated or legal capital
of the company, and a return of a portion of this contribution under the guise of
a dividend is misleading.

Granting of commissions to purchasers of shares (involving only the
issuing company and the purchaser) is an objectionable practice in that no valid
service is performed, and commissions, in these cases, are nothing more than
a discount on the shares issued. The net result of recognizing commissions as
an asset is an overstatement of the assets as well as of the legal capital.

In the Corporations Act, Ontario, the only objectionable provisions

with regard to capital provisions are: (1) granting of commissions to purchasers

(J

",1

(.1

42

of shares, and (2) not requiring companies which issued shares prior to April,
1954, to conform to certain provisions of the Act. In the case of commissions,
the objections are the same as those cited above. In the case of (2) above, the
Act is reduced to a "lame-duck" status and a double standard is set for Old and
new companies.

The Ontario Act has departed from the "trust fund theory of capital"
and from "an inviolable buffer" concept. The Act recognizes that the corporate
structure needs to be ﬂexible and that with the agreement of creditors the capi-
tal structure can be readily altered. The ﬂexibility with regard to changes of
capital structure recognizes the earning power concept.

With regard to the variation of capital subsequent to organization and
accounting connected with the variation, the Ontario Act stands out as the most
up-to-date in Canadian corporate law.

Finally, in connection with the use of the word "capital," it should be
combined with another word to convey the intended meaning. The word, when
used alone, should convey more than the amount of the credit in the share capi-
tal account, or the value of the tangible assets; it should convey the going-
concern value of the enterprise. This view is supported by A. C. Littleton,
who states:

The word "capital" is closer than "asset" to the center of

accounting. It tends to direct thought not to the sufﬁciency of
the property in comparison to the debts, but toward property
in productive use--prOperty held because it seems to promise

to contribute to the creation of revenue. Capital, in the sense
of a property that is useful for producing revenue, is a more

43

nearly basic term for accounting than the word assets used in
the sense of property useful for paying debts. 35

 

35A. C. Littleton, Structure of Accounting Theory, American Account-
ing Association, (1953), p. 19.

CHAPTER III

THE CORPORATE SURPLUS

Like many other terms employed by accountants, the legal profession,
and in general business usage, "surplus" deﬁes an exact deﬁnition which would
convey an equally useful meaning to all concerned. In fact, the meaning of the
term is so well imbedded in general usage that its use in accounting has been
subjected to much misinterpretation by unsophisticated users of ﬁnancial state-
ments. The misinterpretation has been sufﬁciently serious to warrant the fol—

lowing statement from a committee of the accounting profession:

In 1941 the committee suggested a general discontinuance of
the term surplus in corporate accounting, . . . Extensive dis-
cussion of the proposal followed, and in 1949 it was approved
"as an objective" by the committee on accounting procedure. . .
. . .In view of the foregoing, the committee in 1949 particu-
larized the proposal which has been so long under consideration
by recommending that, in the balance-sheet presentation of
stockholders' equity:

(1) The use of the term surplus (whether standing alone or in
such combination as capital sugplus, paid-in surplus,
earned surplus, etc. , be discontinued. 1

 

 

1Committee on Terminology, Accounting Terminology Bulletin No. 1,
American Institute of Accountants, (1953), pp. 28-31.

44

45

In 1948 the American Accounting Association drOpped the term "surplus"
in the discussion of Stockholders' Interest. 2

In Canada, The Canadian Institute has stated that the usage of the term
in accounting is too ﬁrmly established and is not likely to be discontinued. The
recommendation of the Institute is that the word "surplus" should not be used
alone, but should be qualified in every case in which it is used. 3 In addition,
the Federal Act refers speciﬁcally to "setting aside" a "distributable surplus"

Sec. 12 (10) and requires the designation of a "capital surplus" equal to the par
value of the redeemed shares in connection with the purchase for cancellation of
preferred shares (Sec. 61).

Although the concensus of opinion among accountants is to use other
terms in place of "Surplus" there is, however, reservation as to whether the de-
sired end will be accomplished by a mere change in terminology, as evidenced
by the remarks of Professors Moonitz and Staehling:

If knowledge of the contents can be improved by a change in the
label on the bottle, well and good. No one can object to such a
change. But the contents of the bottle are not altered merely by the
adoption of a new label, and too much should not be expected from
such a move. Furthermore, none of the new labels proposed thus
far is demonstrably superior to conventional terminology. For ex-
ample, "retained earnings." "earnings reinvested in the business,"
and "undistributed proﬁts" have all been suggested, or actually
employed in published statements. To the accountant, the meaning

of these phrases is reasonably clear, but then so is the meaning of
"earned surplus. " To the layman, the old problem of understanding

 

2Accounting Concepts and Standards Underlying Corporate Financial
Statements, (1948), Rev., American Accounting Association, p. 4.

 

3Committee on Accounting and Auditing Research, Accountipg and
Auditing Practices Bulletin No. 11, (Toronto: The Canadian Institute of
Chartered Accountants, 1955), p. l.

 

46

still remains; new misunderstandings may develOp about the com-
bination of words. 4

Change in economic values is inevitable in business. Some of this
change is brought about by deliberate action of those in charge of the business
enterprise, while other changes in value take place in the economic setting in
which the business enterprise operates. Whatever the cause, it is desirable or
required that these changes be disclosed to the users of ﬁnancial data. For this
reason we are concerned with the accounting for "surplus. "

Nature of Surplus. -

 

The term "surplus" has a restricted meaning as used in accounting and
jurisprudence. To many businessmen it suggests a heard of cash. However, to
most it is abalancing figure or a catch-all term used by accountants to bring into
balance the assets and the equities. In accounting the term has been variously de-
fined. Accountiﬂ Terminology deﬁnes surplus as:

Generally, a remainder or excess. In accounting and ﬁnance,

a company's surplus is the excess of net assets over the total
paid-1g par value or stated value of the shares of the company

Kohler defines the term as:

Stockholders' equity in a corporation in excess of the par or
stated value of capital stock: a generic term covering paid-in,
earned, and appraisal surplus. . .

 

4M. Moonitz and C. C. Staehling, Accounting; An Analysis of its
Problems (Brooklyn: The Foundation Press, Inc. , 1952), Vol. II, p. 121.

5Accountigngerminology (Toronto: The Canadian Institute of Char-
tered Accountants, 1957), p. 71.

6E. L. Kohler, A Dictionary for Accountants (Englewood Cliffs:
Prentice-Hall, Inc. , 2nd Ed. , 1957), p. 479.

47

Smails defines the term as:

. . . surplus embraces all prOprietorship other than that already
defined as share capital.

Definitions cited above differ only to the extent of the words used. The
latter deﬁnition avoids the use of the word "excess" because the primary objec-
tion to the term being defined is its misleading connotation of something over
and above what is needed or required. 8 All the above definitions are derived

from the basic accounting equation of Assets = Liabilities + Shareholders'

Equity.

Net Assets = Assets - Liabilities

Shareholders' Equity = Assets - Liabilities

Therefore, Net Assets = Shareholders' Equity

Surplus = Net Assets (Shareholders' Equity) - par or stated
value of capital stock (legal capital)

Recent publications avoid deﬁning "surplus";9 the authors prefer to con-

centrate on classifying "surplus" on the basis of the nature of the accounting

 

7R. G. H. Smails, Accounting Principles and Practice, (Toronto: The
Ryerson Press, Rev. Ed. , 1954), p. 305.

8Ibid. , p. 305.

9Among the textbooks which discuss surplus without deﬁning the term
are: Wm. A. Paton, Essentials of Accounting (New York: The Macmillan Co. ,
Rev. Ed. , 1949); A. W. Holmes, G. P. Maynard, J. D. Edwards and R. A.
Meier, Elementary Accounting (Homewood: Richard D. Irwin, Inc. , Rev. Ed. ,
1956); P. Mason, A. Davidson, J. S. Schindler, Fundamentals of Accounting
(New York: Henry Holt and Co. Inc. , 4th Ed. , 1960); R. R. Milroy and R. E.
Walden, Accounting Theog/ and Practice, Introductory (Cambridge: Houghton
Mifﬂin Co. , 1960); M. Backer, Editor, Handbook of Modern Accounting Theory
(New York: Prentice-Hall, Inc. , 1955).

 

48

entries which led to the existence of the account. In other words, the authors
are of the Opinion that comprehension can better be accomplished through the
differentiation of sources, rather than by deﬁnition of the term "surplus."

The meaning of "surplus" in law is apparently in agreement with the
meaning in accounting. This is attested to by the pronouncement of Justice
Brandeis who stated:

The surplus account represents the net assets of a corpor-
ation in excess of all liabilities including its capital stock. 10

Professor Sidney I. Simon, in his article "Legal Decisions on the
Accounting for Corporate Surplus" states:
. . . the legal understanding of surplus is very much akin
to that of the accounting deﬁnition. The courts have paid a
tremendous amount of attention to the whole question of sur-
plus, earnings, and dividends, and certainly accept the techni-

cal meaning of the word, rather than any colloquial conno-
tation. 11

Source Of Surplus. -

The usual classiﬁcation of corporate surplus is by origin and these
sources are generally combined into three broad groupings: (1) Contributed
or paid-in surplus, (2) Earned surplus, and (3) Revaluation or appraisal sur-
plus. The ﬁrst, of the above groupings, covers the largest number of ele-

ments. Professor Byrd includes the following sources in the "contributed

surplus" grouping:

 

loEdwards v. Douglas, 269 U. s. 204, at 214, 1925.

11Sidney 1. Simon, "Legal Decisions on the Accounting for Corporate
Surplus," The Accounting Review, XXXI (January, 1956), p. 105.

49
(A) Surplus resulting from transactions in the company's own stock:

(1) Premiums on par value stock.

(2) Excess of amounts received for no-par stock over amounts
set up as stated values thereof, termed "distributable
surplus" in section 12 (10) of the Companies Act, Canada,
1952.

(3) Forfeited part payments on stock subscriptions.

(4) Surplus resulting from miscellaneous stock transactions and
changes:

(a) Sales of treasury stock at more than cost, but such
stock is not normally legal in Canada.

(b) Retirement of stock at a cost less than the amount
set up as stated capital.

(0) Conversion of stock of another kind.

(d) Reduction of stated capital.

(B) Surplus resulting from shareholders' contributions:

(1) Donations by shareholders, including gifts and forgiveness
of indebtedness.

(2) Assessments of shareholders.

(C) Surplus resulting from contributions by outsiders, including gifts
of assets (such as a plant given to induce a company to locate in
the donor city) and forgiveness of indebtedness.

The primary implication of the term surplus is net income not dis-
tributed to the shareholders, that is "earned surplus. " The source of "earned
surplus" is the profitable operation of the enterprise. "Earned surplus" in-
cludes realized net gains on diSposition of fixed assets, income from invest-

ments and such extraordinary items as correction of periodic net income of

prior years. There is a divergence of opinion on the classification of the item

 

12Illustrations adapted from H.A. Finney and H. E. Miller, Principles
of Accounting, Intermediate, Canadian Edition, prepared by K. F. Byrd

(Englewood Cliffs, 1959), p. 128.

50
"forgiveness of indebtedness. " Professor Byrd classifies "forgiveness of
indebtedness" as a "contributed surplus," but the Canadian Institute of Char-
tered Accountants and Professors Wixon and K011 classify "forgiveness of in-

13 If a debtor were allowed to settle his

debtedness" as "earned surplus. "
indebtedness for a smaller consideration as a result of defective quality of the
consideration which created the indebtedness or similar reasons, a purchase
discount is received and the accounting treatment recognizes the amount that
was "forgiven" as "earned surplus" through the intermediary of the debtor's in-
come statement. However, the term "forgiveness of indebtedness" seems to re-
fer to a partial or complete forgiveness of indebtedness because of inability of
the debtor to pay. In this latter case Professor Byrd's treatment is a more
reasonable one, that is a contribution from an outside party. 14 The fact that

the "contribution" was not voluntary should not detract from the basic nature of
the transaction.

Revaluation surplus arises primarily as a result of a rising price level

and the desire of the company to adjust the book value of ﬁxed assets to the

 

13 . , ,

Committee on Accounting and Auditing Research, Op_. cit. , p. 2,
and Rufus Wixon and W. G. Kell, Editors, Accountants' Handbook (New York:
The Ronald Press, 4th Ed. , 1956), p. 228.
14To illustrate assume that company D owes company C $40, 000 and that
D is unable to pay the account. If company C puts company D into bankruptcy the
proceeds to company C from liquidation may be small, if any, and C would lose a
customer for its products. As an alternative, a settlement is reached whereby
company C "forgives" $20, 000 of the amount owing by company D in order that
company D may continue in business and continue to buy from company C. The
$20, 000 representing the amount "forgiven" would be a contribution to
company D from company C and not part of earned surplus.

51

current value of these assets. Current value is usually determined by having
an outsider appraise the fixed assets. The excess of the appraised value over
book value constitutes the "revaluation surplus" which is an unrealized incre-

ment as opposed to "earned surplus" which has been realized.

Surplus in Canadian Corporation Law
The legal provisions deal with both the designation of surplus and the
disclosure of surplus. These provisions are as follows:

The Companies Act, Canada

 

Section 12 (10)

In the absence of other provisions in that behalf in the letters
patent, supplementary letters patent or by—laws of the company,
the issue and allotment of shares without nominal or par value
may be made from time to time for such consideration as may be
ﬁxed by the board of directors of the company; and in fixing the
amount of such consideration, the board, subject to the provisions
of this Part, may provide in the contract of subscription for such
shares that the consideration received therefor shall be deemed
to be capital, excepting a part, if any, not exceeding twenty-ﬁve
per cent thereof, that may be set aside as distributable surplus;
and where the company acquires a going concern that has a surplus
over and above all liabilities, and any shares without nominal or
par value in the company are issued and allotted as fully paid in
payment or part payment for such going concern, the directors
may by resolution set aside, as a distributable surplus, such
part of the consideration for the issue and allotment of such
shares without nominal or par value as does not exceed the un-
appropriated balance of realized net proﬁts of the going concern
immediately before such acquisition.

Section 61

. . . redemption or purchase, in accordance with the pro-
visions of such letters patent or supplementary letters patent,
or by-laws, shall not be deemed to be a reduction of the paid-up
capital of the company . . . . . . . and the surplus resulting
from such redemption or purchase for cancellation shall be desig-
nated as a capital surplus, which shall not be reduced or dis-
tributed by the company except as provided in sections 49 to 58.

Section 116 (c)

. a statement of surplus showing separate accounts for
capital surplus, distributable surplus and earned surplus respec-
tively, the amounts of such surpluses respectively at the beginning
of the financial period, adjustments affecting previous ﬁnancial
periods, net proﬁt or loss as shown by the statement of income and
expenditure, dividends paid or declared on each class of shares
stating the account against which the same are charged, any other
appropriations, changes in and balance remaining of capital surplus,
distributable surplus and earned surplus respectively.

Under the Companies Act, Canada, "surplus" arises from designating
a portion (up to 25 per cent) of proceeds from issuance of no par shares;
"surplus" carried over from an acquired going concern; "surplus" as result of
issuance of par shares for an amount in excess of par, and; "surplus" arising
from permanent "freezing" of retained earnings on redemption of preferred

shares. Although in practice other sources of surplus are found, e. i. , donated

surplus, the Act does not speciﬁcally refer to these other sources.

The Corporations Act, Ontario

 

Section 85

(1) Every statement of surplus shall be drawn up so as to
present fairly the transactions reﬂected in such statement
and shall Show separately a statement Of contributed surplus
and a statement of earned surplus.

(2) Every statement of contributed surplus shall be drawn up
so as to include and distinguish the following items:

1. The balance Of such surplus at the end of the pre-
ceding ﬁnancial period.

2. The additions to and deductions from such surplus
during the financial period including,

(a) the amount of surplus arising from the issue of
shares or the reorganization of the company's
issued capital, including inter alia,

53

(i) the amount of premiums received on the
issue of shares at a premium,

(ii) the amount of surplus realized on the pur-
chase for cancellation of shares; and

(b) donations of cash or other property by share-
holders.

3. The balance of such surplus at the end of the ﬁnancial
period.

(3) Every statement of earned surplus shall be drawn up so as
to distinguish at least the following items:

1. The balance of such surplus at the end of the preceding
ﬁnancial period.

2. The additions to and deductions from such surplus during
the financial period and without restricting the generality

of the foregoing at least the following:

(i) The amount of the net profit or loss for
the ﬁnancial period.

(ii) The amount of dividends declared on each
class of shares.

(iii) The amount transferred to or from reserves.

3. The balance of such surplus at the end of the ﬁnancial
period. 1953, c. 19, s. 85.

No provisions are found in either Act with regard to writing up of asset
values to their appraised values. 15
The Specific provisions of the two Acts dealing with surplus are similar

only on the subject of disclosure. Both Acts require a statement of surplus on

each balance sheet date, showing the sources of its various components as well

 

15The only reference to appraisal surplus is found in Section 83 (2) of
the Federal Act. This section permits the charging of dividends to an appraisal
surplus ﬁve years after the appraisal was effected.

54
as the changes in each class of surplus since the previous statement. A
notable departure of the present Ontario Act from both the old Ontario Act and
the present Federal Act is that no "surplus" arises in connection with the
issuance of no par shares. The total consideration for no par shares is re-
quired, by the Ontario Act, to be credited to the capital stock account. The
Federal Act permits, at the discretion of the directors, the designation of up to
a maximum of 25 per cent of the issue consideration as "Distributable Surplus."
(See examples Chapter II, p. 18). The Federal Act prescribes that the "Dis-
tributable Surplus" caption be used for the excess of consideration over the
stated value.

The "Distributable Surplus," as the caption implies, is unrestricted
and dividends may be charged to this account, presumably when no balance exists
in the retained earnings account. Other "surplus" accounts (with the one excep-
tion of "Surplus" arising under Section 61 of the Federal Act), such as premium
on shares, donations by shareholders or outsiders, purchase of shares for can-
cellation at less than par, or stated value, etc. , are similarly unrestricted and
can be utilized in connection with dividend declaration. This is true also of
"appraisal surplus" five years after the writeup of the assets for companies in-
corporated under the Federal Act.

Surplus arising under Section 61 of the Federal Act is restricted. The
amount of thi s "surplus" is equal to the par value of the preferred shares pur-
chased and cancelled. The intention of the provision is to maintain the legal
capital after purchase and cancellation of preferred shares at the level prior to

the cancellation. This "surplus" required by law to be designated as "capital

55
surplus" can be reduced only by following the procedure set out in sections 49
to 58 in the Federal Act for the reduction of legal capital. 16 (For discussion of
these sections see Chapter II, p. 25).

The two Acts are distinct in the provisions which deal with forfeited
shares. Under the Federal Act if the forfeited shares are disposed of for an
amount in excess of the due amount on these shares, the excess is retained by
the company (Federal Section 43 2 ) and is a source of a contributed surplus.
Under the Ontario Act if the amount received for the forfeited shares is in ex-
cess of the amount due on these shares, the company must return the excess to
the subscriber who forfeited the shares (Ontario Section 53 7 ).

Both Acts provide that the subscriber who forfeited the shares con-
tinues liable to the company and to its creditors for the full amount unpaid on
such shares at the time of forfeiture, less any sums that are subsequently re-
ceived by the company on disposal of such shares (Ontario Section 53 6 )
Federal Section 43 3 ). Nothing is stated, with regard to the liability of the

subscriber who forfeited the shares, if the company cancelled the forfeited

 

16With regard to Section 61 (Federal Act), G. R. Horne stated: "Re-
tirement of preferred stock requires the setting up of a 'capital surplus' equal
to the par value of the shares being retired (Sec. 61 of The Dominion Companies
Act, 1934). On the following annual meeting of the shareholders, the amount
may be returned to earned surplus, if authorized by the shareholders . . .
the law permits the defeating of the supposed purpose of Sec. 61, which aims
at replacing the retired preferred stock with a permanent surplus account."
G. R. Horne, The Receivership and Reorganization of the Abitibi Power and
Paper Company, Limited (Ann Arbor: University Microﬁlms, 1954), p. 343,
footnote 112. Of course, the same reasoning could be applied to the implica-
tion of legal capital as permanent capital, since it too can be reduced by the
same procedure (Federal Act, Sections 49-58).

 

56
shares, which is apparently within their power as set out in the Federal Act
Section 43 (2) as follows:
Such shares so declared forfeited thereupon become the
prOperty of the company, and, subject to any provisions of
the by-laws of the company, may be sold or otherwise dis-
posed of in such manner as the directors think ﬁt.
The Ontario Act is not clear on whether the forfeited shares may be

cancelled. Section 53 (5) states:

Any forfeited shares become the property of the company
upon forfeiture, and, subject to its by-laws, may be sold.

Both Acts require classiﬁcation by source of the items which constitute
"corporate surplus. " This conforms to the recommendations as set out by The

Canadian Institute. 17

Reconsideration of Surplus Items

Premium on Issued Shares--Preferred

When par value preferred shares are issued for a consideration in ex-
cess of the par value of the shares, the excess constitutes a premium on the
issued shares. This premium arises not because of a superior credit rating
of the issuing company, but because the dividend rate is in excess of the then
market yield rate for the given quality of preferred shares. To illustrate,
assume that company ABC desires to raise $100, 000 through a preferred share
issue. The market demands a 6% yield on ABC Company's preferred shares.

The Company desires that the par value of the shares be $20 each.

 

17Committee on Accounting and Auditing Research, op. cit.

Two alternatives are Open to the company:18

(1) The company may choose to issue 5, 000 6% $20 par value
shares, or

(2) The company may choose to issue fewer than 5, 000 shares
of $20 par with a higher than 6% dividend rate.

If the ﬁrst alternative is chosen, 5, 000 shares would be issued at par
since the required market yield rate for this quality of shares is equal to 6 per

cent which is also the yield at par on the shares being issued. One hundred

thousand dollars would be raised and the annual dividend requirement would be
$6, 000 (5, 000 x $1. 20). If the second alternative is chosen, assuming that

7 1/ 2% dividend rate is established on par, the preferred shares must sell at

a premium, because the market demands only a 6% yield on these shares. The
issue price will then be $25 per share and the company will need to issue only
4, 000 shares to raise the required $100, 000. The annual dividend requirement
will, however, be the same as in the ﬁrst alternative, that is $6, 000 (4, 000 x
$1. 50).

The legal capital of the company would be increased by $100, 000 with
the former alternative and by $80, 000 with the latter alternative. The difference
of $20, 000 is the premium on the issued preferred shares and would be classified
as contributed surplus. Since the contributed surplus is part of common share—
holders' equity, $20, 000 of the proceeds of the preferred share issue was in

effect diverted from the preferred shareholders' equity to the common share-

 

18In jurisdictions where shares can be legally issued at a discount a
third alternative is open to the company-—that of issuing more than 5, 000 shares
in the above examples of $20 par value with a lower than 6% dividend rate.

holders' equity. The above view prevails as long as preferred shares are not
regarded as debt capital or as having a maturity date. If, however, the view
adopted is that preferred shares are debt capital and/ or have a maturity date,
then the premium or discount, where allowed, should be regarded as an adjust-
ment of the "dividend" rate. However, as long as preferred shares are re—
garded as perpetual ownership equity then diversion of preferred shareholders'
equity is a highly questionable practice, both from the accounting and ethical
points of view. The law purports to protect the rights of the suppliers of

capital, yet permits such a "parasitic" practice. 19

 

19The "parasitic" practice is illustrated by Professor H. D. Lowe in
"The Classiﬁcation of Corporate Stock Equities." In his example Professor
Lowe states that the XY Z Company has an authorization to issue 1, 000 shares
of $100 par value preferred stock and 40, 000 shares of common stock par value
$10. Subsequently, at different times the company issues 600 preferred shares
at $105 and 400 at $96 and 12, 000 common shares at $23 per share. In the
Shareholders‘ Equity section of the balance sheet (First Illustration) the
following appears:

Invested Capital
Legal Capital:
Preferred Stock, $100 par value, 1, 000
shares authorized and issued legal amount $100, 000
Less deficiency of investment contribution

on 400 shares 1,600
$98,400
Common Stock, 40, 000 shares authorized,
12, 000 shares issued legal amount 120I 000
$218,400
Paid-in Capital in Excess of legal requirements 159I 000
Total Invested Capital $377 , 400

Professor Lowe appears to be unconcerned with the "parasitic" practice. He
adds the premium on the preferred shares to the premium on the common
shares while deducting the discount on the preferred shares from the par or

59

On the treatment of premium on preferred shares, Paton and Paton
state:

There has been some controversy regarding the treatment of
the excess over par paid by preferred shareholders. The ques—
tion is: should such excess be reported as a part of the equity
of the senior stock or should it be regarded as attaching to the
common stock, in combination with any excess over par paid in
by the junior shareholders? The position is taken here that it

is the business of the accountant to report clearzly and separately
the amount invested by each class of investors.

Labelling the amount received from preferred shareholders as "Capital
received from preferred shareholders-~par" and "Capital received from pre-
ferred shareholders--amount in excess of par" may be satisfactory to account-
ants; however, it does not remedy a basically unsound practice permitted by
law. The basically unsound practice is regarding the premium on preferred
shares as a "surplus" against which dividends to common shareholders may be
charged.

Investment in Excess of Par or Stated Value

Creation of no par shares, leaving the directors to designate the
amount of legal capital, has given rise to what may be referred as "ﬂexible
par value. "

In essence there is no difference between par value and stated value.

 

legal amount. He fails to draw a clear distinction between the investments of
the two classes of shareholders.

Howard D. Lowe, "The Classification of Corporate Stock Equities, " The
Accounting Review, XXXVI (July, 1961), pp. 427—- 28.

20
Wm. A. Paton and Wm. A. Paton, Jr. , Corporate Accounts and State-
_1Tl_el_}t_S(New York: The Macmillan Co. , 1955) p. 81.

60

The former is set by law at the time authorization takes place, while the latter
is set by corporate by-law or by resolution of the directors. A subsequent
change in par must be approved by a stipulated percentage of the shareholders
and sanctioned by the incorporating authority. A subsequent change in stated
value is effected by corporate by-law or by resolution of the directors. The
usual restriction pertaining to the stated value is that stated capital must be a
certain percentage of the consideration for the issued shares, e. g. The
Companies Act, Canada, (See. 12 10 ) specifies a minimum of 75 per cent,
while the Michigan statute speciﬁes a minimum of 50 per cent. 21

The excess of the consideration over par or stated value, whether cap-
tioned as premium, paid-in capital, capital surplus, or distributable surplus,
permits a company to begin operations with a "surplus. " This tends to give
the company an immediate semblance of strength which has not been proven and
which may never materialize.

The often used argument in favour of designating part of the invested
funds as "surplus" on the ground that the creditors are put in a better position
because this "surplus" can be used to absorb losses without impairing the legal
capital is weak.

Paton points out:

If losses of invested funds are suffered the hardship to stock-

holders is not minimized by the practice of setting up the proceeds
of the capital stock when issued in two sections, one of which is

viewed as a form of surplus. Neither does this practice render
the position of the creditor any more secure as it does not affect

 

21

Ibid., p. 16.

61

the size of the "cushion" which affords him protection. 22

Hatﬁeld's comment on this is:

This is true but not signiﬁcant. The creditors are not better
protected but they are notiﬁed in advance that they cannot deﬁnitely
count on the entire contributions by the stockholder, but only on the
amount shown as stated capital.

Both parts of Hatfield's comment do not invalidate the signiﬁcance of

Paton's statement. No doubt the creditors would be better notiﬁed by showing
an impairment of capital rather than by burying or hiding the extent of the im-
pairment. Consider the following illustration: Assume in case A that the total
consideration for issued shares was credited to the capital stock account and
in case B only 75 per cent was credited to the capital stock account; assume a
ﬁrst period Operating loss of $30, 000:
Example I
Case A Partial Balance Sheet:
Stated capital $200, 000

Deduct: Deﬁcit from
operation 30, 000 $170, 000

Case B Partial Balance Sheet:

Stated capital $150, 000
Paid-in surplus 20I 000 $170, 000

The Balance Sheet in Case A would be a better indicator or warning to creditors

 

zsz. A. Paton, Advanced Accounting, (New York: The Macmillan Co. ,
1941), p. 524.

 

2311.3. Hatﬁeld, Surplus and Dividends (Cambridge: Harvard Univer-
sity Press, 1947), p. 15.

 

.1»

 

62

of the risk involved in the situation than in case B. This would be true especially
where new creditors extended credit on the basis of examining only the latest

available balance sheet. 24

The second part of the argument: that the creditors can deﬁnitely count
on only the amount shown as stated capital, is not valid. Impairment of the stated

capital can take place as illustrated in the following example: Assume the facts
as given above for Case B, except that the operating loss is $80, 000.
Example 11
Case B Partial Balance Sheet:
Stated capital $150, 000
Deﬁcit from operation
(amount not absorbed by
paid-in surplus) 30, 000 $120,000
The impairment of capital as shown is legal though involuntary. The
"cushion, " even if measured only by the amount of stated capital, has been re-
duced from $150, 000 to $120, 000.
Dewing's concluding remark in a similar situation, which is applicable

to the above discussion, is: "This is a difference of psychology, and not of

 

24It is true that Sec. 116(c) of the Federal Act and Sec. 85 of the Ontario
Act require disclosure of changes in Surplus. However, the Acts require disclo-
sure only in the year the change takes place; no reference need be made in subse-

quent years. Disclosure of changes in surplus is shown in the Surplus Statement
only.

25A. S. Dewing, Financial Policy of Corporations (New York: The Ronald
Press Company, Fifth Ed. , 1953), p. 670.

 

63

Donated Surplus

 

Situations occur when donations are made to a corporation by outsiders
or by the shareholder(s) of the corporation. Problems which are associated with
donations are primarily those of valuation of the donation and recognition of the
donation on the books of the company.

In general, if donations are in form other than cash, the valuation pro-
cedure should be the same as when shares are issued for a consideration other than
cash. The value is usually determined by the directors and at times with the help
of outside appraisers. (Problems arising in connection with valuation of consider-
ations other than cash for the corporation's share are discussed in Chapter II p.22 ).
The criterion for recognition of donations on the books should be value. 26 If a
donation exists, standards of full disclosure in accounting dictate the recog—
nition of the donated assets on the books of the corporation.

Recognition of the donation on the books would appear as follows:

Asset (Land, buildings, etc.) XXX

Donated Surplusz7 XXX

At times donations are granted subject to the fulﬁllment of certain con—

ditions, e. g. , title of the land will pass over to the company on completion of

the twentieth year of operation in the particular location. The fact that the

 

26W. J. Vatter suggests better terminology for "Donated Surplus" is

"Contributions from Non-Stockholders. " Morton Backer, (Editor) Handbook of
Modern Accounting Theory (New York: Prentice-Hall, Inc. , 1955), p. 380.

 

27 . .
If the donation received has no value to the company or no resale
value then no donation exists.

64

company may not Operate for the required period in the location, and the title of
the land may never rest with the company, should not govern whether recognition
should or should not be made on the books. The determining factor should be

value at the time of the donation. 28 If the company abandons the location before

the title passes, accounting treatment would be the same as abandoning a lo-
cation on which title was held.

If the donation is in depreciable assets, accounting for the depreciable
asset should be the same as if the asset were purchased. This is required if
proper income determination is to be accomplished.

Before the advent of no—par shares, wide use was made of donating
shares back to the corporation as a means of circumventing legal provisions
prohibiting the issuance of par shares at a discount, but permitting the reissue
of donated treasury shares. An example of this would be the issuance of
10, 000 $10 par value shares for an asset with nominal value of $100, 000 other
than cash with a provision that 5, 000 of these shares will be "donated" back to

the company. The company is at liberty to issue these "donated" or treasury

 

28Finney and Miller favour recording conditional donations in temporary

accounts until the contractual conditions are met, at which time these accounts
are closed out to conventional ﬁxed assets and paid-in surplus accounts. Finney
and Miller, Princijles of Accounting, Intermediate (New York: Prentice-Hall,
Inc. , 4th Ed. , 1951). Newlove and Garner are of the opinion that only uncondi-
tional gifts are to be recorded. G. H. Newlove and S. P. Garner, Advanced
Accounting (Boston: D. C. Heath and Co. , 1952).

The objection to the Finney and Miller recommendation is that many of
the assets acquired by the corporation are subject to the fulfillment of certain
stated conditions, such as payment of mortgages, yet these assets are recorded
in permanent accounts. The recommendation of Newlove and Garner is objected
to (1) from the disclosure point of view and, (2) from the income determination
point of view in the case of depreciable assets. Net Income would be overstated
by the amount of unrecognized depreciation.

 

65

shares for less than par as fully paid. The basic weakness is permitting the
corporation to trade in its own shares. Donation of the corporation's shares to
the corporation enhances the value of the remaining outstanding shares, but

adds nothing to the corporate assets. If the "donation" was made by only a part
of the shareholders, or was not pro-rata, the donation of anything of value is to
the shareholders who did not participate, or who did not participate ratably in
the donation. A pro-rata "donation" of shares is nothing more than a stock-sth
in reverse. The assets remain unchanged, shareholders' equity remains un-
changed, and the number of claims of shareholders (number of shares) decreases

in inverse proportion to the change in value of these claims.

Donations other than the corporation's own shares should be recognized
on the books in the same manner as donations from outsiders. 2'9
Surplus from Forfeited Shares

When a shareholder of partially paid shares fails to pay the amount de-
manded by the company, the company may declare the shares forfeited and the
partially paid shares become the property of the company. When these shares
are re—issued for an amount in excess of the amount which was due on these
shares at the time of forfeiture, and where the excess amount is not required by
law to be returned to the shareholder who forfeited the shares, a contributed sur-

plus equal to the excess amount is recognized on the books of the company. 30

 

29Voluntary stock assessments on fully paid shares should also be re-
corded in the same manner as donations.

30W. G. Leonard and F. N. Beard stated: "If the forfeited shares are
sold, the sale price is set up as a debit balance in the Subscribers account, the
entries in the Forfeited Shares and Forfeited Shares Suspense accounts are re-

66

The implication is that the company receives a valuable prOperty when partially
paid shares are declared forfeited. The question that arises is that if fully
paid shares in the possession of the company (treasury shares) are not assets,
how can partially paid shares become assets of the company? It is not the for-

feited shares per so which have value, but the claim against the subscriber.

 

versed, and any excess of the sale price over the unpaid balance on the shares is
treated as a profit. " W. G. Leonard and F. N. Beard, Canadian Accounting Prac—
tice (Toronto: McGraw-Hill Company of Canada Limited, 1956), p. 328.

To refer to the excess amount as a proﬁt, is to sanction the inclusion
of the amount in the income statement, a practice which is not consistent with
the nature of the transaction and has no theoretical basis in accounting. To
permit this practice is indeed a backward step in accounting theory and practice.

To illustrate recognition of "profit on forfeited shares" assume: A sub-
scribed to one share of stock for $10; after paying $4 A fails to pay future "calls"
and forfeits the share of stock; the company reissues the share of stock for $9
to B.

Subscriptions Receivable from A $10
Share Capital subscribed $10
To record subscription of one

share of stock at $10 by A

Cash $ 4
Subscriptions Receivable from A $4
To record receipt of $4 from A

representing Call No. 1

 

Forfeited Shares $ 6
Subscriptions Receivable from A $6
To record forfeiture of one share
of stock by A on failure to meet

Call No. 2.

Cash $ 9
Forfeited shares $6
Proﬁt on sale of Forfeited Shares $3

To record sale of one share of
forfeited stock to B for
$9 cash

31Rufus Wixon and W. G. Kell (Editors) Accountants' Handbook (New York:
The Ronald Press Co. , 4th Ed. , 1957), p. 21. 33.

67

Logical treatment would dictate that after the company has taken due process,
legal if necessary, to collect the amount due on these shares, when collection
cannot be effected the deposit paid to date should be declared forfeited and

the subscriptions related to these deposits cancelled.

Revaluation Surplus

 

One of the most controversial problems in accounting, in recent years,
has been the effect of inflation on the ability of the dollar to measure income.
Although in recent years the controversy has subsided somewhat, the problem
remains. The intention here is not to consider the problems associated with in—
come measurement, but rather with the disposal of "surplus" arising from up-
ward revisions of asset figures due to price level increases. On the subject
of appraisal the American Institute voiced the following opinion:

Accounting for ﬁxed assets should normally be based on cost,

and any attempt to make property accounts in general reﬂect
current values is both impracticable and inexpedient.

The same body retreated slightly in the position taken earlier by stating
the following in connection with depreciation:

The Committee . . . believes that accounting and ﬁnancial

reporting for general use will best serve their purposes by ad-
hering to the generally accepted concept of depreciation on cost,
at least until the dollar is stabilized at some level. An attempt
to recognize current prices in providing depreciation to be con-
sistent, would require the serious step of formally recording
appraised current values for all properties, and continuous and

consistent depreciation charges based on the new values. With-
out such formal steps, there would be no objective standard by

 

32Committee on Accounting Procedure, Accounting Research Bulletin
No. 5. (New York: American Institute of Certified Accountants, 1940).

68

by which to judge the prOpriety of the amounts of depreciation
charges against current income, and the signiﬁcance of re-
corded amounts of profit might be seriously impaired.

The Canadian Institute has taken a similar position:

Fixed assets are normally accounted for on the basis of
their historical cost and in recent years accounting organ-
izations have re—affirmed the emphasis on historical cost
by refusing to recommend depreciation on current replace-
ment cost in formal accounts. Unless replacement cost
accounting becomes generally acceptable, the writing up of
ﬁxed asset values should not occur .in ordinary circum-
stances and should be discouraged. 3

Notwithstanding the recommendations of the two accounting organiza-
tions, the accounts of some enterprises have been adjusted to reﬂect ﬁxed
asset valuations based upon appraisals. Where revaluation of fixed assets
has been accomplished The Canadian Institute recommends that the amount
resulting from such revaluation not be referred to as "surplus. "

. . . In view of the committee the designation of any

such amount as an appraisal surplus or reserve is undesir—
able. One suitable designation for an appraisal increase
would be "Excess of appraised value of ﬁxed assets over
cost" (or "over depreciated cost"). 35
The recommendation for subsequent treatment is:
Once recorded the appraisal increase may remain indeﬁnitely

as a separate item in the shareholders’ equity section of the
balance sheet, or it may be transferred to earned surplus in

 

33Committee on Accounting Procedure, Accounting Research Bulletin

33Committee on Accounting Procedure, Restatement and Revision
of Accounting Research Bulletins, Bulletin No. 43, (New York: American
Institute of Certified Accountants, 1953), p. 68.

 

3400mmittee on Accounting and Auditing Research, op. cit. , I). 3.

35Ibid. , p. 3.

69

amounts not exceeding the realization of appreciation through
sale or annual depreciation provisions. 36

The alternative permitting the transfer of the realized portion of
appreciation fails to distinguish the three sources of "capital": investment
(legal capital), retained earnings, and debt. Recognition of equity rights would
dictate that appreciation resulting from price level changes should be recog—
nized in three categories. These are: (1) amount resulting from "investment"
of creditors, (2) amount resulting from investment by shareholders--legal
capital, and (3) amount resulting from reinvestment of earnings. 37 As reali-
zation of appreciation takes place through sale or annual depreciation provi-
sions, appropriate amounts would be recognized in retained earnings, legal
capital, and "donations from creditors. " The last item would measure the
amount "contributed" to the enterprise through loss of purchasing power of the
creditors. The transfer to the legal capital account, or to a subdivision there-

of would keep the "cushion" intact. 38 Retained earnings against which

 

36_I_b_i_d_. , p. 3. The recommendation of the Canadian Institute of Char-
tered Accountants disagrees with the opinion of the American Institute of Cer-
tiﬁed Public Accountants only to the extent of disposal of the "excess over cost"
amount. The American Institute in Bulletin No. 43, Chapter 9, states: "A
company should not at the same time claim larger property valuations in its
statement of assets and provide for the amortization of only smaller amounts
in its statement of income. "

37The appropriate amounts should be determined by the use of a
weighted average. -

38H revaluation takes place and the appraisal amount is transferred,
as realized, to retained earnings, the reduction of the "cushion" would be to
the same extent, in terms of purchasing-power, as if no recognition took place.
If the present tax system remains in effect, retained earnings under both alter-
natives would approach equality when an extended period of time is considered.
In the following illustration (Period la) if the appraisal increment is realized

70

dividends are charged would increase only by an amount resulting from the effect
of price level change applicable to the reinvestment of prior years' earnings.

The only real "surplus" that accrues to the company, measured in terms of pur-
chasing power, is the sacrifice in purchasing power that the creditors make. To

illustrate consider the following:

Period 1
Assets Equities
Fixed Assets $200, 000 Funded Debt $50, 000
Shareholders' Equity:
Share Capital 50, 000
Retained Earnings m
$200,000 $200,000

Assume in Period 2 Fixed Assets are written—up to appraised values:

Period 2 (Usual balance sheet treatment)

Assets Equities
Fixed Assets $400, 000 Funded Debt $50, 000
Shareholders' Equity:
Share Capital 50, 000

Retained Earnings 100, 000
"Excess of Appraised

Value" 200, 000
$400, 000 $400, 000

 

 

retained earnings will be increased by $200, 000; however share capital which
represents "legal capital" or the "cushion" would be only one half of what it
was in example (Period 1) as a result of the doubling of the price level.

71

Period 2 (Proposed balance sheet treatment)

Assets Equities
Fixed Assets $400, 000 Funded Debt $50, 000
Shareholders' Equity:
Share Capital 50, 000
Retained Earnings 100, 000

"Excess Of Appraised value"

to be converted to contributed

"surplus" by creditors as result

of loss in purchasing power as

realization takes place 50, 000

"Excess of Appraised value

of Fixed Assets" to be converted

to Share capital as realization

takes place 50, 000

"Excess of Appraised value
of Fixed Assets" to be converted
to Retained Earnings as realiza—

tion takes place 100, 000
$400, 000 $400, 000

The use of. the term "surplus" is therefore undesirable in describing
appraisal increments. The caption recommended by The Canadian Institute,
"Excess of appraised value of fixed assets over cost" or some other descriptive
term should be used.

Earned surplus39

 

Accountants, for many years, have taught that it is important to account

for the ownership equity in terms of origin, with particular emphasis on an

 

39Determination of periodic net income and charges to retained earnings
are discussed in Chapter VI, "Disclosure of Corporate Activity. " Capitalization
of retained earnings is discussed in Chapter IV, "Dividends. " The problem of
surplus on merger or consolidation is discussed in Chapter V, "Mergers and
C0nSOlidations. "

72

accurate statement Of earned surplus. 40 The concern with earned surplus is
not only prompted by legal requirements but the dependence of the earned sur-
plus amount on the periodic income determination and the magnitude of the
amount in relation to other sources of corporate assets. 41
The primary legal interpretation of earned surplus has been that it
serves as a measure to limit disbursements of corporate funds to shareholders
as dividends in order that the "cushion" may be maintained intact for the protec-
tion of creditors. The legal significance of this interpretation has tended to de-
cline for two principal reasons. These are: (1) legalizing companies to desig-
nate a part of the consideration received for issued shares as some type of
"contributed surplus" against which dividends may be charged, and (2) the ten-
dency to regard earned surplus as permanent, by ﬁnancial administrators. 42
Regardless of statutory requirements, or legal interpretation, to
accountants earned surplus represents the accumulated undistributed proﬁts of

a corporation from whatever source derived. A negative interpretation of

earned surplus has been stated as follows:

 

4OSamuel J. Broad, et al, "A Symposium--Is it Desirable to Distinguish
between Various Kinds of Surplus?" The Journal of Accountangv LXV (April,
1938), pp. 281-292.

41Corporate retained earnings and depletion increased by $98. 7 billion
in the ten—year post-war period (1946-1956), Pearson Hunt, C. M. Williams and
Gordon Donaldson, Basic Business Finance (Homewood: Richard D. Irwin, Inc. ,
1958), p. 527.

42Paton and Paton are of the opinion that "It is much nearer the truth,
typically, to insist that the retained earnings balance, like the capital received
directly from shareholders, is embedded in a cross-section of all the resources,
and thus is a part of the total permanent investment." W. A. Paton and W. A.
Paton, Jr. , op. cit. , p. 121.

7 3
. . . contributions to a business and amounts earned in the

conduct of the business are the only sources of realized surplus.

Consequently, whatever surplus may not be included under the

heading contributed surplus must come under that of earned

surplus and be so classiﬁed on the balance sheet.
Viewing earned surplus as a "catch—basin" tends to convey an idea that earned
surplus is not determinable independently and is to be avoided. Earned surplus
_i_s_ a determinable amount and should be so viewed.

Subdividing earned surplus into so-called "Equity reserves" (appro-
priated earned surplus), is a practice that should be discouraged. In most
cases these "reserves" serve no useful purpose, in fact, they tend to mislead
users of ﬁnancial data. This temporary "freeze" of earned surplus is no
"freeze," since in most cases these "reserves" may be "freed" or returned by
the directors and in fact are voluntary restrictions imposed by the directors
on themselves which they, the directors, can rescind at will. Restricted re-
serves (reserves required by contract) such as sinking fund reserves usually
lack signiﬁcance because the restricted portion is smallin relation to the un-
restricted portion of the retained earnings. If it is necessary to restrict the
directors, a more effective method should be used such as restriction of items
appearing, or which will appear, on the asset side of the balance sheet. Earned
surplus is a "reserve" in itself and should remain intact as one amount on the
balance sheet. The assets are not restricted to correspond with the "reserves"

that may be established for any specific purpose. They remain unrestricted

and devoted to the general purpose of the corporation and "reserves," as such,

 

43H.A. Finney and H.E, Miller, Canadian Edition, Op. cit. , p. 130.

74

have no basic foundation nor do they serve a useful purpose. ‘
A former president of The American Institute of Certified Public
Accountants has made the following pronouncement regarding "reserves":
Our profession should take the lead in educating businessmen
and the general public that the surplus account itself is the real
reserve for contingencies and should be conserved to whatever
extent is deemed necessary. We should also point out that the de—
sire of the business management to husband resources to meet con-
tingencies cannot be accomplished by a balance on the liability side
of the balance-sheet, either in the contingency reserve or in surplus,

but that the resources to be effective must be in the form of cash or
marketable securities. 44

Summary
There are primarily two reasons for misinterpretations of "corporate
surplus. " These are: (1) misleading terminology and, (2) unsound accounting
practices. In connection with paid-in "surplus," "distributable surplus," "pre-
mium on issued shares" or any other such term W. J. Vatter states:
. . . If there must be a difference between legal capital and
financial or accounting capital (which is the amount of stock-
holder investment) the least that should be done is to call the dif-
ference what it is: "stockholder contributions in excess of legal
minimum."45
The use of descriptive terminology would solve many of the problems in

misinterpretation of donations, reinvestment of prior years' earnings, and retire-

ment of stock at a cost less than the amount on the books. The use of descriptive

 

44 .r - . - -
C, O. \lelhngton, "Accounting for Contingency Reserves," Journal of
Mata—110v, LXXXIV (August, 1947), p. 10.4.

45 . . .
Morton Backer, (ludlttn‘), 911, out. , p. 375.

75

terminology does not, however, correct unsound accounting practice in recording
the consideration received for issued shares of one class in more than one
account. The solution to this is prescribed by Paton and Paton who state:

. . . The cure lies in the outright abandonment of all
arbitrary stated capital requirements and the acceptance of
the view that corporate capital is represented by the total
amount invested by the stockholders. 46

W. J. Vatter concurs stating:

. . . The concept of stock without par value would appear
to have been an excellent basis for identifying and unifying in-
vestment contributions with the legal capital requirement. 47

Adoption of the above recommendations would, to a large extent, solve
the problems arising in connection with contributed surplus. The ridiculous
nature of the problem is best summarized by H. R. Hatﬁeld:

There are those who stoutly maintain that capital surplus is
part of capital, emphasizing the ﬁrst word of the phrase. Others
assert that the noun is the signiﬁcant word and that capital in its
adjectival use merely describes the kind of surplus presented.
Those who assert that capital surplus is not really surplus because
of the modiﬁer are following the pattern of using the phrases

"German Silver," "French Ivory, " and "Welsh Rabbit" to indicate
very clearly that the articles are in fact neither silver nor ivory
nor rabbit. Those Opposed follow the pattern of the phrases
"Sterling Silver," "African Ivory," and "Jack Rabbit," holding
that the modifying term does not at all detract from the character
of the essential noun.

Stubbornness is not a virtue; accountants should realize that they live

not in a world of their own. Users of ﬁnancial data, whose servants accountants

 

46W.A. Paton and W.A. Paton, Jr., op. cit., p. 16.

47Morton Backer, (Editor), op. cit. , p. 375.

48H. R. Hatfield, op. cit., p. 10.

76

are, are best served by ﬁnancial statements which can be easily interpreted.
To accomplish this, descriptive terminology and the reduction of the variety of
items in the shareholders' section of the balance-sheet, should be the goal of
all accountants. Descriptive terminology can be developed by using captions
which convey the exact meaning of the item. Means by which the variety of
items, in the shareholders' section of the balance sheet, can be reduced are

given in the concluding chapter.

Evaluation of the Legal Provisions with regard to Surplus, The
Corporations Act, Ontario, and The Companies Act, Canada

Legal provisions in accounting usually follow rather than lead account—
ing theory and practice, that is, theory is crystallized in practice before it is
enacted into law. In this respect the Corporations Act, Ontario, is an excep-
tion in requiring the total consideration for issued no par shares to be desig-
nated as stated or legal capital. A similar provision with regard to par value
shares is desirable in view of the above discussion. A provision restricting the.
use of the term "dividends" to distributions chargeable to current or accumulated
prior years' earnings is desirable to draw a clear distinction between distribu-
tions of earnings and return of invested capital.

Recommendations for desirable changes in The Companies Act, Canada,
should include: (1) requiring the total consideration received for issued shares,
par or no par, to be designated as stated or legal capital; (2) deletion of Sec-
tion 61 (Federal) requiring capitalization of retained earnings to the extent of
the par value of preferred shares purchased and redeemed; (3) deletion of part

of Section 83 (2) (Federal) permitting companies to charge dividends against

77

"revaluation surplus" five years after the write—up. Revaluation of ﬁxed assets
has not been sufﬁciently refined to warrant any provision in the statutes. (4)

With regard to dividends, the provision recommended above for The Ontario Act
is desirable.

The disclosure requirements setting out the source and changes in the

surplus accounts annually are adequate in both Acts.

CHAPTER IV
CORPORATE DISTRIBUTIONS TO SHAREHOLDERS

Justiﬁcation for Investing in the Corporation

 

The fundamental purpose for investing funds in a corporation is the ex-
pectation of receiving a stream of future values, the present value of which,
discounted at the desired yield rate, is at least equal to the original investment.
This view is in agreement with what Professors David H. Li and Harry Sauvain
have stated:

. . . Stock price, in other words, is not a reﬂection of the

"book value" of a stock, but a capitalization of future divi-
dends.1
and
A good case can be made for the prOposition that dividends
are the only monetary reward for stock ownership (excluding
liquidation and control as sources of beneﬁt). A stock may
change hands over a period of years, but all that anyone ever
gets is dividends. 2
Earnings are important to the extent that they are usually excellent indi—

cators, perhaps the only indicators of the longevity and the amounts of future cor-

porate distributions to shareholders. If the periodic distributions are less than

 

1David H. Li, "The Nature of Corporate Residual Equity Under the Entity
Concept," The Accounting ReviewJ XXXV (April, 1960), p. 261.

 

2Harry Sauvain, Investment Management (Englewood Cliffs: Prentice—
Hall, 2nd ed. , 1959), p. 310.

 

78

79

the periodic earnings, then a portion of earnings is reinvested in the corpora-
tion with an expectation that future earnings will increase and that future distri-
butions should increase. If the periodic distributions exceed the periodic earn-
ings, a reasonable expectation should be that future distributions will be limited
and short-lived. Because of the apparent interdependence of earnings and divi-
dends it is imperative that corporate distributions to shareholders be identiﬁed
as distributions of earnings or distributions of capital.

Nature of Distributions

 

Distributions to shareholders can be grouped into two categories:
(1) distributions which decrease the corporate assets, and (2) distributions which
have no immediate effect on corporate assets. The former requires the dis-
bursement of assets, usually cash, on a pro-rata basis to the shareholders.
The latter usually takes the form of subdivision of shareholders' claims ("stock"
dividends) or the granting of additional claims to shareholders accomplished
through the issuance of securities of a different class than the one already
held on a pro-rata basis.
In practice most corporate distributions are referred to as dividends
and have been defined as:
A dividend may be defined as an appropriation of current
or accumulated earnings with the intent to distribute an equiva-
lent amount of enterprise assets among the stockholders of a
particular class on a pro rata basis. It should be noted that a
dividend is "an apprOpriation . . . with the intent to distribute

assets." It is the act of apprOpriating and not the act of dis-
tributing which identiﬁes the dividend. 3

 

3Rufus Wixon and W. G. Kell, (Editors), Accountants' Handbook (New
York: The Ronald Press Co. , 4th ed. , 1957), pp. 22-23.

80

The above definition limits dividend payments to the extent of present
and accumulated past earnings. In practice and in the law of most jurisdictions
in the United States and Canada,4 dividends may be paid out of the excess of
assets over liabilities, including the stated capital. In addition to what may be
referred to as the proﬁt rule and the surplus rule, directors are governed by
the capital impairment test and the insolvency test.

The above tests have been designed for two main reasons: (1) pro-
tecting creditors against unwarranted distribution of corporate property to
shareholders, and (2) protecting shareholders against informal liquidation of
their investment in the enterprise. Although the tests seem deﬁnitive, problems
have arisen in their application to actual situations. In connection with the capi-
tal impairment test, the problems which were discussed in Chapter II, "The
Corporate Capital, " in defining capital apply. Bogen5 indicates that the courts
have used three deﬁnitions of the capital that is not to be impaired in connection
with the payment of dividends. These are: (1) the par or stated value of the
issued shares, (2) the actual dollar consideration received from the share
issues, and (3) the capital at the beginning of the accounting period in which divi-

dends are paid.

 

4Thirty—nine states establish paid-in surplus as a legal source for dis-
tributions to preferred shareholders, and 28 of these states extend the availa-
bility of paid-in surplus for dividend charges to common shareholders. Harry
Buttimer, "Dividends and the Law," The Accounting Review. XXXVI (July,
1961), p. 435. In Canada paid-in or contributed surplus may be utilized for
declaration of dividends. The only "surplus" not available for declaration of
dividends is the "capital surplus" created under Section 61 of the Federal Act in
connection with the purchase and cancellation of preferred shares.

5J.I. Bogen, (Editor), The Financial Handbook (New York: The Ronald
Press, 3rd ed. , 1948).

81

The ﬁrst interpretation of capital that is not to be impaired makes
available all surplus regardless of source as a measure of dividends. Under
this test of impairment of capital, dividends may be declared even though there
may be an accumulated deﬁcit on the books of the company as long as "surplus"
from other sources exceeds the accumulated deﬁcit. An example would be
where a company has contributed surplus and revaluation surplus in the amount
of $35, 000 and an accumulated deﬁcit of $15, 000, in the absence of specific
regulations to the contrary, the company may declare and pay a dividend to the
extent of $20, 000.

The second interpretation regards the total proceeds from stock issues
as the capital that is not to be impaired. Under this interpretation, dividends
are limited to the extent of earned surplus, plus any revaluation surplus if the
latter is not specifically prohibited by provisions of the statutes as available for
dividend appropriations. *

The third is the most stringent interpretation of the capital that is not
to be impaired. Under this interpretation, dividends are limited to the amount
of current net income and any revaluation surplus that may be recognized in the
current accounting period, providing there is no speciﬁc statutory prohibition as
to availability of these for dividend apprOpriations .

The proﬁt test is more restrictive than the capital impairment test and
is usually interpreted in two ways. These are: (1) current net earnings, and
(2) accumulated net earnings. Under the former, dividends may be declared

and paid when current net earnings are present even though the accumulated net

82
earnings may be a negative amount (deﬁcit). 6 Under the latter, dividends may
not be declared until such time as the deficit is eliminated. Both views have
been supported by prominent authorities. W. W. Cook stated:
The fact that in a year prior to the declaration of the dividend,
some portion of the capital has been lost and has not since been
made good affords no ground for restraining the payment of a
dividend out of the proﬁts subsequently earned. 7
F. H. Hurdman does not concur, supporting the accumulated net income interpre-
tation:
It would appear to be sound economically that, the capital
having been diminished by losses, proﬁts should be withheld
from distribution as dividends until the loss has been made
good, in order that the original status of the stockholder may
be restored. 8
In addition to the capital impairment test and the proﬁt test the
statutes may include an insolvency test. This "test" is usually coupled with one
or both of the other two "tests" discussed above and prohibits the directors from
declaring a dividend if such declaration and subsequent payment would render

the company insolvent. Interpretation of insolvency has taken two forms: (1)

excess of debts over assets, and (2) inability to meet current debts. Guthmann

 

6Professor Buttimer reports that ten states permit current earnings'
dividends to be declared on both preferred and common shares. Oklahoma pro-
vides that the amount of the dividend charge may not exceed one-half of the net
income and dividends may be paid on common shares only when no preferred
shares are outstanding. Harry Buttimer, op. cit. , p. 435.

7W.W. Cook, A Treatise on the Law of Corporations (New York:
Baker Voorhis Co. , 8th ed. , 1923), Vol. II, p. 1905.

8A3 cited by H. R. Hatfield, Surplus and Dividends (Cambridge:
Harvard University Press 1947), p. 25, from International Congress on Account-
ing Proceedings, 1929, p. 587.

 

83

and Dougall are of the opinion that the insolvency test used alone is not sufﬁcient.

They state:

No dividends may be paid when the company is insolvent or
when the payment would result directly in insolvency -— that is,
in creating an excess of liabilities over assets. (However, in
some states insolvency is used in the equity rather than the
bankruptcy sense and means inability to pay debts as they
mature.) . . .

The insolvency rule is found in only about one-third of the states,
and, taken alone, is less than sound policy would require. 9

In practice the use of the term "dividend" has been extended to distri-
butions other than those cited in the definition above and use of the term is also
applied to capital realignments. Accounting Terminolom deﬁnes dividend as
follows:

1. An amount designated for distribution to the shareholders of an
incorporated company in proportion to their holdings of shares of
the company, having due regard for the respective rights of various

classes of shares.

2. An amount distributed to the shareholders of an incorporated
company upon the liquidation of the company.

3. An amount distributed to the creditors, pro rata, out of the net
amount realized in a bankrupt estate.

4. The amount of l, 2, or 3 above, received by a shareholder or
creditor as the case may be. 10

The above definition implicitly covers the gradual liquidation of a com-
pany engaged in exploiting depletible natural resources. The wasting asset doc-

trine states:

 

9H. G. Guthmann and H. E. Dougall, Corporate Financial Policy (New
York: Prentice-Hall, Inc. , 3rd. Ed. , 1955), p. 514.

 

10 Accounting Terminokgy (Toronto: The Canadian Institute of Chartered
Accountants, 1957), p. 26.

 

84

. a corporation which is engaged in exploiting depletible
natural resources need not recognize depletion as a deduction in
arriving at the amount of earnings available for dividends, and the
amount of dividends need not be broken down between capital and
proﬁt in representing the nature of the distribution to stockholders. l

AccountingTerminology goes on to deﬁne stock dividend as:

 

A dividend payable not in cash but by issue of shares of capital
stock either of the same or a different class from that in respect
of which the dividend is payable. 12
Corporate distributions are intimately related to the deﬁnitions or con-
cepts of corporate capital and corporate surplus. The legal and accounting pro—

blems encountered in connection with dividends are therefore, of necessity, those

of deﬁning corporate capital and surplus.

Corporate Distributions in Canadian Corporation Law
The legal provisions which govern corporate distributions are as follows:
The Companies Act, Canada

Ancillary Power of Company
Section 92

the declaration and payment of dividends:
Power and Liability of Directors in Dividend Declarations
Section 83 (1)

In this section

(a) "dividend" includes bonus or any distribution to shareholders
as such; and

 

11Rufus Wixon and W. G. Kell, (Editors), 9p. c_i_t_., p. 22-28.

2 .
Accounting Terminology, op. Cit. , p. 70.

85

(b) "mining company" means a company that for the time being
carries on as its principal business the business of Operating
producing mining properties owned or controlled by it.

(2)

No dividend shall be declared when the company is insolventl3

or that renders the company insolvent or, subject to subsection

(4), that will impair the capital of the company, and in determining
the solvency of the company for the purposes of this subsection, no
account shall be taken of any increase in the surplus or reserves

of the company resulting merely from the writing up of the values

of the assets of the company, unless such writing up was made more
than ﬁve years before the date of the declaration of the dividend.

(3)

For the amount of any dividend that the directors may lawfully
declare payable in money they may issue therefor shares of the
company as fully paid up, or they may credit the amount of such divi-
dend on the shares of the company already issued but not fully paid up,
and the liability of the holders of such shares thereon shall be reduced
by the amount of such dividend, if the directors have been authorized
to do so by a by—law that has been sanctioned by at least two-thirds of
the votes cast at a special general meeting of the shareholders Of the
company duly called for considering the same, but any such by-law
shall not have force or effect for more than one year from the date of
its sanction.

(4)

Nothing in this Act prevents a company at least seventy-ﬁve per
cent in value of the assets of which are of a wasting character, or
any mining company from declaring or paying dividends out of its
funds derived from the Operations of the company notwithstanding
that the paid-up capital of the company may be thereby reduced or
impaired, if such payment does not reduce the value of its remain-
ing assets so that they will be insufﬁcient to meet all the liabilities
of the company then existing exclusive of its paid-up capital.

 

13 Neither Act deﬁnes insolvency. J. L. Stewart states that the common-
est deﬁnition is the inability to pay debts as they become due. J. L. Stewart,
Handbook on Canadian Company Law (Toronto: The Carswell Co. Ltd. , 5th Ed. ,
1960), p. 422.

86

(5)

Where the directors of the company declare and pay any dividend
when the company is insolvent, or any dividend the payment of which
renders the company insolvent, or that impairs the capital Of the
company, they are, until repayment of the dividends so declared and
paid, jointly and severally liable to the company and to its creditors
for the debts of the company then existing or thereafter contracted,
but such liability is limited to the amount of such dividends and
interest that have not been repaid to the company.

(6)

Where any director present when such dividend is declared forthwith
requests the entry on the minutes of the board of his protest against
the same, or where any director then absent, within one week after
he becomes aware of such declaration and is able so to do, delivers
to the president, secretary or other ofﬁcer of the company his
protest against the same, and within eight days thereafter delivers
or mails by registered letter a duplicate cepy of such protest to the
Secretary of State, such director may thereby, and not otherwise,
exonerate himself from such liability.

(7)

Nothing in this section shall be deemed to impose upon directors of
a company any liability of a character speciﬁed in subsection (5),
by reason of a declaration or payment of any dividend permitted by
subsection (4), or, if such dividend is in excess of the amount so
permitted, beyond the amount of such excess.

(8)

The directors may deduct from the dividends payable to any share-
holder all. such sums of money as are due from him to the company
on account of calls or otherwise.

Winding up of Company and Surrender of Charter

Section 29

(l) The charter Of a company may be surrendered if the company
proves to the satisfaction of the Secretary of State

(a) that it has no assets and that any assets owned by it immed-
iately prior to the application for leave to surrender its charter
have been divided rateably amongst its shareholders or members;
and either

87
(b) That it has no debts, liabilities or other obligations; or

(c) that the debts, liabilities or other obligations of the company
have been duly provided for or protected, or that the creditors
of the company or other persons having interests in such debts,
liabilities or other obligations consent; . . .

The Corporations Act, Ontario
Power and Liability of Directors in Dividend Declarations
Section 61

(1) Subject to the special Act, letters patent or supplementary
letters patent of the company, the directors may declare and the
company may pay dividends on the issued shares of the company.

(2) A dividend may be paid in money or in specie or in kind not
exceeding in value the amount of the dividend.

(3) The directors shall not declare and the company shall not pay
any dividend or bonus when the company is insolvent, or any divi-
dend or bonus the payment of which renders the company insolvent
or that diminishes its capital, and if any dividend or bonus is
declared and paid contrary to this subsection, the directors are
jointly and severally liable to the company for the amount of the
dividend so declared and paid or such part thereof as renders the
company insolvent or diminishes its capital.

(4) If any director present when any such dividend or bonus is
declared, forthwith, or if any director then absent, within seven
days after he becomes aware of such declaration, delivers to any
ofﬁcer of the company his written protest against such declaration,
and within seven days after delivery of such protest sends a copy
of such protest by registered letter to the Provincial Secretary,
such director thereby and not otherwise exonerates himself from
liability under subsection 3.

(5) Nothing in this section prevents a mining company or a com-
pany whose assets are of a wasting character, or a company in-
corporated for the object of acquiring and administering the assets
or a substantial part of the assets of another corporation, either
from such corporation or from the assign of such corporation, for
the purpose of converting such assets into money and distributing
the money among the shareholders of the company, from declaring
and paying dividends out of funds derived from the operations of
the company.

88

(6) The powers conferred by subsection 5 may be exercised not-
withstanding that the value of the net assets of the company may
be thereby reduced to less than the issued capital of the company
if the payment of the dividends does not reduce the value of its
remaining assets to an amount insufﬁcient to meet all the liabili-
ties of the company exclusive of its issued capital. 1953, c. 19,
s. 61 (1-6).

(7) Subject to subsection 8, the powers conferred by subsection
5 may be exercised only under the authority of a by-law passed
by the directors and confirmed by at least two-thirds of the votes
cast at a general meeting of the shareholders duly called for con-
sidering the by-law.

(8) Where dividends have been paid by a company in any of the
cases mentioned in subsection 5 without the authority of a by-law,
the payment thereof is nevertheless valid if a by-law adOpting and
approving the payment is passed by the directors and confirmed by
the shareholders in the maimer mentioned in subsection 7. 1954,
c. 14, s. 11.

Section 62

For the amount of any dividend that the directors may declare pay-
able in money they may declare a stock dividend and issue therefor
shares of the company as fully paid or may credit the amount of
such dividend on shares of the company already issued but not fully
paid, and the liability of the holders of such shares shall be reduced
by the amount of such dividend. 1953, c. 19, s. 62.

Winding up of Company and Surrender of Charter

Section 97

(1) Where a company has ceased to carry on business except for the
purpose of winding up its affairs and has no debts or obligations
that have not been provided for or protected, the directors may
pass by—laws for distributing in money, kind, specie or otherwise
the property of the company or any part of it rateably among the
shareholders according to their rights and interests in the company.

Section 326

(l) The charter of a corporation incorporated by letters patent may
be surrendered if the corporation proves to the satisfaction of the

Li eutenant- (i ov (r 1‘ no r ,

89

(b) that it has parted with its prOperty by distributing the property
rateably among its shareholders or members according to their
rights and interests in the corporation;

(0) that it has no debts, obligations or liabilities or its debts,
obligations or liabilities have been duly provided for or protected

or its creditors or other persons having interests in its debts,
obligations or liabilities consent;

((1) that there are no proceedings pending in any court against it; . . .
In addition to the above provisions pertaining to dividends, the Canadian
Income Tax Act has the following provision which the company may make use of
in order to relieve part of the tax burden of the shareholder.

A corporation may elect, in prescribed manner and in prescribed

form, to be assessed and to pay a tax of 15% on an amount not
exceeding

(c) the aggregate of

(i) the dividends declared by it that were paid by it in the taxation

years beginning with the 1950 taxation year and ending with the

last complete taxation year before the election under this sub-

section, and

(ii) the dividends that were, by subsection (3) of section 81,

deemed to have been received by shareholders of the corporation

in consequence of the corporation having paid a stock dividend

in the taxation years referred to in sub-paragraph (i).

The right to declare dividends is vested in the directors by both Acts
and by the by-laws of the corporation. Both Acts, however, attempt to set limits
within which declaration of dividends may take place. The Federal Act as well
as the Ontario Act expressly prohibit the payment of dividends which would im-
pair the capital of the company, or which would render the company insolvent.
The Acts, however, fail to define what constitutes capital impairment and insol-

vency. Only in the case of companies with wasting assets do the Acts attempt to

90

deﬁne what may be construed as impairment. Dividends may be declared only
if the payment will not reduce the value of the remaining assets to a level insuf-
ﬁcient to meet all the liabilities of the company exclusive of stated capital.
(Federal Section 83(4) and Ontario Section 61(6)). The use of "value of the remain-
ing assets" shrouds the provisions of both Acts in a veil of vagueness. Value is
a term with many meanings.

The vagueness of the provisions regarding companies with wasting assets
has provoked the following statement:

In the case of a company engaged in the operation of a property
of a wasting nature, e. g. , a mine, gas or oil well, there is some

doubt whether, apart from any enabling statutory provision, the
directors can safely authorize the payment of dividends without
setting aside a fund to provide against the exhaustion of the property. 14
There is no express prohibition in either Act as to the availability of
current earnings for dividends before an accumulated deﬁcit has been made good.
Although no decisions have been rendered in the Canadian Courts of law, the like-
lihood is that, if such a case were brought for a decision, the precedent set
under English law would be dominant if not prevalent. 15
Both Acts are silent in the matter of availability of premiums on par

shares and amounts in excess of stated value for dividends. There is, of course,

no excess of stated value under the Ontario Act as total proceeds constitute

 

l4Ibid. , p. 235.

15 Ammonia Soda Company V. Chamberlain (1918), I Ch. 266, 273, as

cited by H. R. Hatﬁeld, Op. cit. , p. 25. Guthmann and Dougall state, "In Eng-
land, it is generally accepted that a corporation may use current earnings for

dividends without ﬁrst eliminating any deﬁcit. " H. G. Guthmann and H. E. Dou-
gall, op. cit. , p. 515.

91

stated capital, however, under the Federal Act up to twenty—ﬁve per cent of the
proceeds may be designated as "distributable surplus." (Federal 12(10)) In Can-
ada the legal position seems to be that in the absence of express prohibition,
premiums and amounts in excess of stated value are available for dividends. 16

No prohibiting provisions are found in either Act.

A divergent opinion is found in the two Acts in the matter of "surplus"

resulting from the writing up of the values of the assets of the company. The
Federal Act speciﬁcally makes "revaluation surplus" available for dividends
ﬁve years after the revaluation. (Federal Section 83(2)). No provision is found
in the Ontario Act with regard to writing up of asset values.

Under the Acts a company may declare a stock dividend and issue to
the shareholders on a pro—rata basis the company's authorized but unissued
shares as fully paid. If a part or all of the previously issued shares are not
fully paid, the stock dividend may be used to reduce the liability to the extent of
the retained earnings capitalized. Neither Act, however, states how the amount
of the stock dividend is to be determined -- that is, the amount of "surplus" to
be capitalized. The stock dividend under the Canadian Income Tax Act is held
to be income to the recipient and is, therefore, taxable.

A special unique feature of the Canadian Income Tax Act permits what

is usually referred to as a tax-free dividend. Under Section 105(2) of the Tax

 

16H. A. Finney and H. E. Miller, Principles of Accomtﬂgjntemediate,
Canadian Edition prepared by K. F. Byrd (Englewood Cliffs: Prentice-Hall,
Inc. 1959), pp. 141-42.

92

Act a company may elect to pay a Special 15 per cent tax on an amount of earn-
ings equal to the amount declared as dividends and distribute the balance of

17 The maximum advantage is attained

earnings as tax free to the shareholders.
when 50 per cent of earnings are declared as dividends and the special 15 per
cent tax paid on the balance (50 per cent of earnings). To illustrate, assume
that a company with net earnings of $200, 000 decides to take the maximum advan-
tage of the special 15 per cent tax. The following entries would be made on the
books of the company.

Dividends (Retained Earnings) $100, 000

Cash (or assets) $100, 000

To record declaration and payment of dividend equal to 50 per cent
of net earnings.

Special Tax (Retained Earnings) 15, 000
Cash 15, 000

To record payment of the special 15% tax on the amount equal to the
amount of the dividend.

Retained Earnings 85, 000
Preferred shares, par, 85, 000

To record issuance of preferred shares to shareholders on a pro-rata
basis.

 

17 The Act requires that the company ﬁrst issue redeemable preferred
shares to the shareholders on a pro-rata basis, the par of which is equal to the
balance of earnings on which the special 15 per cent tax was paid. These shares
may then be purchased by the company at par and cancelled. In practice, the
issuance and redemption is a mere formality. The only rationale for the proce-
dure is "that this is the way it is done. "

93

Preferred shares 85, 000
Cash 85,000
To record the redemption and cancellation of the preferred shares.

The $85, 000 would not be taxable in the hands of the shareholders. The
$100, 000 dividend would be taxable to the shareholders at the appropriate indivi-
dual tax rate less a 20 per cent dividend tax credit. 18 This special feature is
used primarily in closely held corporations and is designed to give a partial re-

lief of the burden of progressive tax rate on individual income.

Reconsideration of Corporate Distributions
The problems which arise in connection with dividends cannot be dis-
associated from the concepts of capital and surplus. In fact, most of the pro-
blems associated with dividends are predicated on the legal concepts of capital
and surplus. Put in another way, the problem is protecting what is not readily
or accurately deﬁned to the satisfaction of those concerned. H. W. Ballantine
expresses the following Opinion:

No parts of the corporate mechanism are more complicated,
unworkable or incomprehensible than the system of legal capital
requirements with its various attempted restrictions on unsafe
distributions of assets to the shareholders. 19

Distribution from Contributed "Su_rplus"

Under the surplus test, or the excess net asset test, contributed sur-

plus, made up of such items as premium on share issues, amounts in excess of

 

18 A twenty per cent tax credit is allowed Canadian Income taxpayers on
di vi dends received from Canadian Companies.

19H. W. Ballantine, Ballantine on Corporations (Chicago: Callaghan
Press, 1946), p. 588.

94

stated value of issued shares, and donations, is a source or a base for corporate
distributions. There are primarily three arguments advanced for considering
contributed surplus as a dividend base. These are: (1) gives management more
ﬂexibility in the downward adjustment of the size of the corporate unit, (2) early
losses can be written off against contributed surplus without the impairment of
legal capital, and (3) a dividend base is created in the early stages of the corpor-
ation when earnings do not exist.

In essence, the ﬁrst argument is based on the presumption that at the
outset management cannot accurately determine the ﬁnancial requirements of
the corporation. Therefore, part of the proceeds from share issues are desig-
nated as contributed surplus and management is given wider latitude in future
adjustments of the corporate unit. The adjustment (downward) can be effected
without the formality and the required procedure associated with formal capital
reductions. The apparent ease with which a downward adjustment of the size of
the corporate unit can be effected seems to be in conﬂict with the legal concern
to protect the creditors from unwarranted distributions of corporate assets.

Granted that situations do arise when it is in the interest of all concerned
to reduce the scope of corporate endeavour and to return a part of the sharehold-
ers' investment to the shareholders. However, if the contraction is accomplished
through the formal procedure of reducing legal capital, there is less danger that
the rights of the creditors would be abrogated. In a dynamic economy occasions
necessitating a reduction of capital are rare and expediency is not a relevant
factor. The usual growth pattern of corporations is in stages -- birth, period

of growth, period of maturity, and the period of decline. In the growth stage the

95

corporations usually experience increasing earnings accompanied by increasing

demands for expansion. Because of the heavy demands for expansion, asset in-
creases resulting from proﬁtable Operation are channeled into expansion rather
than to the shareholders. Therefore, in the usual situation, contraction in the
early stages is an exception rather than the rule. In the later stages, if the com-
pany experienced the anticipated earnings, sufﬁcient accumulated earnings should
result, with the accompanying ﬂexibility for contraction of the corporation with-

out reducing the legal capital. If, on the other hand, the anticipated earnings did

not come to pass, any voluntary contraction should be within the framework of
the legal provisions which govern the formal reduction of capital. The latter
requirement would give maximum protection to the creditors without impinging
on the rights of directors.

The argument that contributed surplus can be utilized to write—off early
losses against, thereby not impairing the legal capital, was fully discussed and
not found valid in Chapter 111, "The Corporate Surplus."

The argument that contributed surplus forms a dividend base in the
early stages of the corporation when earnings do not exist fails to reﬂect the
inference of a dividend declaration. In this connection a court expressed the
following opinion:

The declaration of a dividend is the most emphatic assertion

that the corporation is in a position to make a division of proﬁts
and is consequently enjoying some degree of prosperity. 2

This view has been endorsed by Ballantine and Hill in the California

 

20Lockhart v. VanAlstyne, 31 Mich. 76, 80, 18 Am. Rep. 156, as cited
by H. W. Ballantine, Ibid., p. 572.

96

Law Review and Littleton in the Accounting Review:

 

. . . shareholders ordinarily assume that dividends represent
business proﬁts and not a partial return of funds invested. 1

and

. . dividends presuppose profits. 22

Wixon and Kell concur, stating:

. . . Limiting dividends to proﬁts is in harmony with the
usual stockholder assumption that dividends originate from
proﬁts.

Montgomery expands on the subject stating:

From a common-sense business standpoint, dividends should
be paid to stockholders only from accumulated earnings. Divi-
dends have been charged to paid-in surplus or to a surplus other
than earned surplus without a clear indication of the source of
the dividend and without violating state regulations. That this
can be done reﬂects no great credit to lawmakers, since the in-
congruity of contributing to the capital of a corporation and then
receiving part of it back in the guise of ordinary dividends
should be sufﬁciently evident to encourage making the practice
legally impossible. Apart from the legality of such dividends,
however, directors may be violating their trust if they declare
dividends out of capital without making it clear to the stockholders
that the dividends are not distributions of earned surplus. 24

To this Paton adds:

. . . there are many cases in which dividend appropriations
are based directly, or indirectly, upon funds represented by the
contributions of stockholders. It is deplorable that this condition

 

21As cited by Rufus Wixon and W. G. Kell, (Editors), op. cit., pp. 22-31.

22A. C. Littleton, "Dividends Presuppose Profits," The Accounting
Review, IX (December, 1934), p. 304.

 

23 Rufus Wixon and W. G. Kell, (Editors), op. cit. , pp. 22-31.

24 N. J. Lenhart and P. L. Defliese, Montgomery's AuditingL (New York:
The Ronald Press Co. , 8th Ed. , 1957), p. 407.

97

is given legal sanction. 2'5

and
The apprOpriation of regular dividends from capital surplus,
whether originally paid in or brought about by a reduction in the
acknowledged capital account, is merely a disguised liquidation

of the stockholders' investment, and deserves the general con-
demnation accorded by accountants. 26

Whether the shareholders' understanding is sufficient to allow a
questionable practice is open to question. There is no question that reduction
of capital by distribution may take place. However, is it necessary to refer to

the distribution as "dividends?" The editor of The Journal of Accountancy con-

 

siders a dividend "out of" paid—in surplus as a "transformation of capital" into
earned surplus, a feat which cannot be accomplished by the resolution of either
the stockholders or the directors. 27

The failure to restrict dividends to distributions of assets in an amount
no greater than accumulated earnings is a reﬂection of the philosophy contained
in the Federal and Ontario Acts as to what constitutes legal capital. If these
statutes required all shares to be no par shares and that the total proceeds from
share issues be designated as legal capital, the problem would be substantially
eliminated as premiums on shares and amounts in excess of stated value on
issued shares would no longer exist. By the same token, if dividends were limit-

ed to the extent of accumulated earnings, premiums on shares and amounts in

 

25 W. A. Paton, Advanced Accounti_ng, (New York: The MacMillan Co.
1941), p. 524. '

26 Ibid., pp. 566-67.

27 The Editor, "Editorial," The Journal of Accountangv, LXIV (July,
1937), p. 63.

98

excess of stated value on issued shares would no longer form a dividend base and
total proceeds from share issues would form the permanent capital of the company.
Current Net Earnings as a Dividend Base

Whether current earnings, deSpite an accumulated deﬁcit from past
years, should be available for dividends is also predicated on the concept of
capital. If the total amount invested by shareholders is to be considered as the
legal capital, which is not to be impaired, then the accumulated deﬁcit must be
made good before a distribution can take place, regardless of the current
proﬁtability of the company. If the capital at the beginning of the account-
ing period in which proﬁt is realized is not to be impaired, then a distri-
bution may be made out of current earnings.

The courts have taken both views. Justice Petersen stated:

. . . such a dividend is not paid out of paid—up capital.

If it were, the paid-up capital would be still further reduced

by the payment. In fact the assets representing the paid-up

capital remain the same or of the same value as before the

payment of the dividend. 28
An American court took an opposing view, stating:

The earned proﬁts, therefore, reduced the impairment,

and the declaration of the dividend again impaired the capi—

tal to the extent of the dividend declared. 29
Ballantine made the following statement with regard to the California
statutes permitting current earnings' dividends:

It was the view of the committee that corporations
should be able to pay dividends out of current earnings,

even though stated capital has become impaired, without
the formality of reducing their stated capital. Investors

”Ammonia Soda Company v. Chamberlain, op. cit.

29Branch v. Kaiser, et a1. , 140 Atl. 500 (1928), as cited by H. R.

Hatﬁeld, op. cit. , p. 25.

99

should not be required to forego dividends and income
from their investment in order to enable the corporation
to make up at once its capital losses if it is making
proﬁts from current operations. Prudent management
may call for the gradual restoration of capital and a
reasonable latitude should be given to the directors as
to how rapidly to make up losses of prior years. 30

The concern of the committee charged with recommending an ideal
corporation act in California is with the inconvenience to the shareholders
of foregoing a dividend rather than with the protection of the creditors.

The question may be raised, if the management is prudent, the commission
implies that it is, why have any restrictive legislation with respect to
corporate distributions? A second question that arises is that of deﬁning
proﬁt. If an enterprise started with $50, 000 legal capital and in the ﬁrst
four years experienced total losses of $20, 000 and in the ﬁfth year
experienced a gain of $2, 000, is it correct to state that there has been a
net proﬁt in the situation? Hatfield thinks that no net profit exists. He
states:

. . . But to interpret a dividend, paid when there is an

operating deﬁcit, as a distribution of proﬁts is an account-

ing absurdity. 31
Hatﬁeld continues:

. . . a continuing policy of so doing, in a business with
alternating periods of prosperity and depression, might

conceivably result in a gradual elimination of all con-
tributed capital while dividends had been paid, say in

 

30 H. W. Ballantine, "Questions of Policy in Drafting a Modern Corp-
oration Law," California Law Review , XVIII (July, 1931), p. 478.

31 H. R. Hatfield, op. cit., p. 26.

100

alternating years, throughout the decadence and des—
truction of the enterprise. 32

In the above example the $2, 000 gain in the fifth year is only
by virtue of the arbitrary length of the accounting period. If the
accounting period is extended to ﬁve calendar years, then the result
would be an $18, 000 operating loss and the legal capital would be im-
paired by the $18, 000. There would be no question that under the cir-
cumstances a dividend would be illegal.

From the creditors' point of view, allowing companies to pay div-
idends even though an accumulated deﬁcit is on the books, is undesirable.
There is no way of knowing, on the part of the creditors, what they may
count upon as an inviolable buffer against losses. Adherence to the theory
that legal capital must be maintained would require the accumulation of
earnings sufficient to absorb a deﬁcit before there could be any distri-
bution to shareholders from current earnings. To oppose this view is to
undermine any signiﬁcance that may be attached to the concept of legal
capital. 33

If the situation is such that a distribution of assets is desirable
and there is no necessity or intention to restore legal capital to the original

level, then a formal reduction of capital should be effected and a "fresh

 

32 Ibid., p. 26.

33 Paton and Paton state: "Where the accumulated deﬁcit is large
the rigid application of this rule may seem to work a hardship on investors
in need of funds but there is no acceptable alternative without relaxation
of the prevailing conception of corporate capital . . . " Wm. A. Paton and
Wm. A. Paton, Jr. , Corporation Accounts and Statements, (New York: The
MacMillan Co. 1955), p. 104.

 

101

start" made. The fact that a distribution is made, when an accumulated
deﬁcit is on the books, is an indiSputable assertion that reduction of capital
should be effected.

Revaluation "Surplus" As a Dividend Base

 

Objection to recognizing revaluation surplus as a dividend base is
made not only on the basis that the accounting realization principle is
violated, but more important is the fact that such action defies reasonable
justiﬁcation from the going-concern point of View. In a going concern ﬁxed
assets derive their value from their ability, as a unit, to generate earnings. 34
If the earning power of the company is so great that a write-up of the ﬁxed
assets is warranted or desirable, there should be little necessity to in-
corporate the amount of the write—up in the dividend base. The large earn-
ings should, in most cases, be more than ample to form the dividend base.

If the write-up of assets is not a result of increased real earning
power, but a result of increased price level, incorporation of the write—up
in the dividend base is undesirable for two reasons: (1) the reported earn-
ings up to the time of the write-up have been overstated and the dividend
base already is inﬂated, and (2) conservation of corporate funds (in dollar
amounts) seems to be desirable if the corporate unit is to remain healthy

in the face of the higher cost of assets that will need replacement in the

 

34 A. S. Dewing states, "the value of a business is measured by its
earning power. " and, " . . . There are two measures of value of such a
property that may be established by facts: (a) Replacement cost new, less
(b) Earning power. The latter will control the former, for if less than a
fair return on cost, the value will be less than cost, and if more than a
fair return, something more will be added for goodwill, or going value. "
A. S. Dewing, The Financial Policy of Corporations (New York: The
Ronald Press Co. , 5th Ed. , 1953), pp. 287—88.

 

102
future. Paton and Paton state:

. . . At the same time it should be recognized that a
substantial part of the increase in the total of retained earn-
ings in many cases reflects expansion in number of dollars
rather than physical growth. As has been emphasized by
many writers and analysts there has been a serious over-
statement of corporate earnings in the past ﬁfteen years
due to the failure of the accounting process to take cogniz-
ance of the impact of the decline in the value of the dollar,
the accounting yardstick, notably in measuring the deprecia-
tion deduction. Another way of putting it is to say that
recorded earnings have exceeded disposable income, with
the result that it has been necessary to hold a portion of
computed earnings in the business to provide the increased number
of dollars required to maintain the existing scope of operating
activity. 35

To the above objections may be added that revaluation methods have
not been sufﬁciently refined to be reliable. The allowance of revaluation
"surplus" to be incorporated in the dividend base may lead to serious uneth-
ical practices which could prove injurious to the creditors, to the share-
holders, and to the confidence in the economic community.

Depletion as a Dividend Base

 

Corporations engaged in extracting natural resources have been
permitted by most statutes to: (1) disregard costs applicable to the
resources extracted (depletion) in determining the amount of "earnings"
which form the dividend base, or (2) if depletion was deducted in arriving
at net earnings the amount of the depletion may be added back to net earn-
ings in determining the dividend base. In either case, the resulting

dividend base is the same in amount. The philosophy of the statues in

 

3'5 Wm. A. Paton and W. A. Paton, Jr. , O). cit. , ) . 121-22.
.L_____ [P

103

sanctioning the practice is stated as follows:

. . . The theory of the law is that shareholders and creditors ,
knowing the nature of the business, should realize that the
receipts from sales are in part earnings and in part a return
of investment. If the return of investment could not legally
be made to the shareholders, the company would be obliged to
hold the funds until the exhaustion of the prOperty. 36
Most accountants have no objection to the gradual liquidation of

the company engaged in exploiting depletible natural resources. Accountants
are, however, concerned with disclosure of the extent of the liquidation.
The prevalent View Of accountants is expressed as follows:

. . . Regardless of what is legally permitted by state laws
and under court decisions, the auditor should uphold the
principle that paid—in capital should not be impaired by the
repayment of stockholders of any of their contributed cap-
ital in the guise of ordinary dividends. 37
There is no question that corporations, whether engaged in fabri-

cating or exploiting of natural resources, should be permitted to adjust
the size and scope of their operation by a reduction of legal capital.
However, in order that the shareholders and creditors are not misled,

reduction of legal capital should be formal, as provided for by the

statutes. 38

 

36 H. A. Finney and H. E. Miller, Canadian Edition, 9p. git. , pp. 375-76.

37 N. J. Lenhart and P. L. Deﬂiese, op. cit. , p. 409. Similar views
are expressed by A. W. Holmes, G. P. Maynard, J. E. Edwards, and R. A.
Meier, Intermediate Accounting (Homewood: Richard D. Irwin, Inc. , 3rd.
Ed. , 1958), p. 380; L. L. Vance, Accounting Principles and Control (New
York: Holt, Rinehard and Winston, Inc. 1960), p. 454; A. W. Johnson,
Intermediate Accounting (New York: Rinehard & Co. Inc. , Revised Ed. ,
1958), p. 285; to name only a few.

 

 

 

38 The legal philosophy is presumptuous as to the ability of share-
holders and creditors to distinguish the portion of the distribution that is
a return of invested capital and the portion that is a distribution of earnings.

104

From the creditors' and shareholders' points of view, a desirable
objective would dictate that the accounting policy and ﬁnancial administration

policy be clearly distinguished.

Capitalization of "Surplus"

 

The capitalization process is the transferring of a desired amount
from the "surplus" category to the legal capital category. The transfer
may be accomplished in two main ways: (1) increasing the par or stated
value of outstanding shares; (2) by issuing additional shares pro rata
to the shareholders as fully paid, or, (3) cancelling the real or contingent
liability of the shareholders resulting from discounts on issued shares
(where permitted by law and which are assessable) and unpaid subscriptions.

The second method is of special interest because Of the accounting
problems that arise when used and because of the term "dividend" that
is attached to the shares being issued. There are primarily three main
problems. connected with stock "dividends. " These are: (1) the deter-
mination of the amount to be transferred, (2) type of "surplus" to be
converted, and (3) taxability of the "dividend" in the hands of the
recipient.

There is no uniformity or concensus of opinion among accountants as
to the per share amount to be transferred from "surplus" to legal capital
on issuance of stock "dividends - " The American Institute recommends
that fair value of the additional shares be transferred. The committee

states:

105

. . The committee therefore believes that where these
circumstances exist the corporation should, in the public
interest account for the transaction by transferring from
earned surplus to the category of permanent capitalization
(represented by the capital stock and capital surplus
accounts) an amount equal to the fair value of the additional
shares issued. Unless this is done, the amount of earnings
which the shareholder may believe to have been distributed
to him will be left, except to the extent otherwise dictated
by legal requirements, in earned surplus, subject to possible
further similar stock issuances or cash distributions. 39

Lenhart and Deﬂiese concur, stating:

In the authors' Opinion, the date of declaration of a
stock dividend is the most logical point at which to deter-
mine fair value of the shares issued. 40

On the other hand, Paton and Paton state:

The preferable accounting procedure, accordingly, is
to determine the number of shares needed to capitalize a
given amount of retained earnings by using as a divisor
the capital book value per share (either par or stated
value or, more logically, average amount received per share
from stockholders) . . .

Wixon and Kell support the average amount paid in per share. They state:

. . . a preferred base amount agreeable to all parties,
including the New York Stock Exchange and the Securities
and Exchange Commission, would seem to be the average
amount paid in per share on the shares issued (this ignores
treasury shares) at the stock dividend date. This figure
has the merit of permitting both owners and creditors to
think in terms of the same per— share investment or pro—
tection as they did before the stock dividend. 42

The difficulty of justifying the fair value method is found in the

 

39Committee on Accounting Procedure, Restatement and Revision
of Accounting Research Bulletins, Bulletin No. 43, (New York: American
Institute of Certified Accountants, 1953), pp. 5.1—2.

 

 

40N. J. Lenhart and I? 1.. Defliese, pp. cit. , p. 406.

41W. A. l’aton and W. A. Paton, Jr. , op. cit. , p. 125.

(”Rufus Wixon and \V. G. Kell, (liditors), Bil-“.311: , p. 21. ~14.

106

dissenting Opinion of Messrs. Calkins and Mason, members of the Committee
on Accounting Procedure of the American Institute. They point out that in
essence the justiﬁcation contained in Bulletin No. 43 of capitalizing of

fair value is based on the assumption that the shareholder thinks the

stock dividend is income. 43

The average amount paid in per share, as suggested by Paton and

Paton and the editors of The Accountants' Handbook, is equally difﬁcult

 

to justify in jurisdictions which permit contributed "surplus" distributions.
The weakness in capitalizing the average amount paid in per share is that a
portion of the retained earnings will not be transferred to the permanent
capital account if the average is greater than the par or stated value of the
shares. The excess of the average price received per share over the par or
stated value will be transferred to the contributed "surplus" account and will
be no more "permanent" than retained earnings or other "surplus" accounts.
The above arguments lead to the conclusion that in jurisdictions
permitting other than earned "surplus" dividends the amount of transfer
per share should be the par or stated value since only the par amount is
permanently "frozen. " In jurisdictions which permit only earned "surplus"
dividends the amount capitalized per share should be left to the discretion of
management. No doubt management may have certain policies which are fol-
lowed in capitalizing retained earnings and should be left free to attain these

policies.

 

43Committee on Accounting Procedure, op. cit. , p. 54.

107
The type of "surplus" to be capitalized is also related to the legal
provisions of the statues. If all "surplus" forms the dividend base then a
transfer from any type of "surplus" decreases the dividend base and in-
creases legal capital. Opinions have been expressed for first capitalizing
"surplus" other than earned. Professor Horngren states:
The principal reason for advocating such treatment is

that such a charge will lessen the confusing breach between
contributed capital and legal capital. 44

Professor Horngren's statement is in agreement with that of R. P. Marple,
who stated:
Since capital surplus represents an excess of contributed

capital over legal capital, the declaration of stock dividends

out of capital surplus has the effect of converting contributed

capital into legal capital and of reducing the excess . Accord-

ingly, there can seem to be no logical objection to dividends

from this source. 45

In jurisdictions where only the earned "surplus" forms the dividend
base, to accomplish an increase in the legal capital a portion of the earned
surplus must be transferred as other "surplus" already is part of the legal
capital. If the desired result of a stock dividend is to decrease the dividend
base and increase the legal capital, the type of "surplus" to be capitalized
is predicated on the deﬁnition or concept of legal capital.

Taxability of stock dividends in the hands of the recipient is depend-

ent on whether value has been received. The dominant view, in situations

 

44C. T. Horngren, "Stock Dividends and the Entity Theory," [pp
Accounting Review, XXDGI (July, 1957), p. 381.

 

45R. P. Marple, Capital Surplus and Corporate Net Worth (New York:
The Ronald Press Co. , 1936), p. 165.

 

108
where common shares are distributed to common shareholders, is that
nothing of value is received by the shareholders. The "dividend" is a
pure paper transaction. The American Institute states:

. . . In the case of a stock dividend or split-up, there is no
distribution, division, or severance of corporate assets.
Moreover, there is nothing resulting therefrom that the
shareholder can realize without parting with some of his
prOportionate interest in the corporation. 46

In a court decision Justice Pitney approved the following view:

A stock dividend really takes nothing from the property
of the corporation and adds nothing to the interests of the
stockholders. Its property is not diminished and their in-
terests are not increased . . . the prOportional interest of

each shareholder remains the same. The only change is in
the evidence which represents that interest, the new shares
and the original shares together representing the same pro-
portional interest that the original shares represented be-
fore the issue of the new ones. 47
Sometimes the argument is advanced that the shareholder may de-

clare his own cash dividend by selling the shares he receives as a stock
dividend. However, since a stock dividend is pro rata, the sale of the new
shares is exactly the same as selling some of the original shares, that is
the shareholder's equity in the company is reduced.

Another argument advanced for viewing a stock dividend as income

in the hands of the recipient is that the procedure is a condensation of two

transactions:

 

46Committee on Accounting Procedure, op. cit. , p. 50.

47Eisner v. Macomber, 252 U. S. 189, i_b_i_d_. . DP. 50-51. Similar views
are held by W. A. Paton and W. A. Paton, Jr. , Op. cit. , p. 129-130; A. C.
Whitaker, "The Stock Dividend Question, " The American Economic Review,
XIX (March, 1929), pp. 20-42; Shaw Livermore, "Value of Stock Dividends,"
The American Economic Review, XX (December, 1930), pp. 687-691, to cite only
a few.

109
(1) a pro rata distribution in cash, and

(2) a pro rata reinvestment of cash by the
recipient shareholders. 48

This argument is weak in that it is based on "as if" condition. The share-
holder does not perform the act of investing, as the capitalization of "surplus"
via a stock dividend is a corporate decision, not the stockholder's. Moreover,
if the above view were approved, what would stop a corporation from
unilaterally "completing" a sale of goods and "repurchasing" the same
goods, all on paper, for a higher price. Both transactions are the same in
principle and sanctioning the former is equivalent to sanctioning the latter.

The strongest argument for recognizing a stock dividend as income
in the hands of the recipient is based on the distinction placed on invested
capital and earned "surplus. " If the invested capital is interpreted as the
equity of the shareholders and earned "surplus" as the equity of the corpor-
ation, then a capitalization of earned "surplus" is a transfer from the
corporate equity to the shareholders' equity. Since the shareholders' equity
is increased by the capitalized amount, shareholders, it is interpreted,
received something they did not have before. Professor G. R. Husband
expressed the following view on the treatment of stock dividends as income:

. . . If from the entity viewpoint, the income of the

corporation is not to be interpreted as the income of the

stockholder, and if the resulting earned surplus is not

the equity of the stockholder, the stock dividend would

appear to transfer an amount from the corporate entity's

equity to the equity of the stockholders and thus to meet
the test of income. It should be evident, therefore, that

48Rufus Wixon and W. G. Kell, (Editors) op. cit. , p. 21. 42.

110

the accountant cannot consistently hold the entity view-
point and deny that the stock dividend constitutes income. 49

Paton and Paton disagree on the receipt of income. They state:

. . . Adoption of this view (entity concept) means
that the earnings of the corporation are not income to
the investor and can become income to him only through
the process of transferring corporate assets to him.
Increasing the number of shares held does not meet this
requirement, regardless of how the transaction is des-
cribed . . . It simmers down to this: (1) if the corpor-
ation is regarded as a separate entity the shareholder
receives income only as corporate assets are transferred
to him; (2) if the corporation is regarded as a steward or
agent income accrues to the shareholder as earned through
the agent's efforts; (3) under neither view does it make
sense to regard the act of cutting the pie into a greater
number of pieces as producing income to anyone. 50

From the income determination point of view, the realization prin-
ciple should be the deciding factor. Does the shareholder have, after
receipt of a stock"dividend, " something at his disposal which he did not have
before? The answer must be 'no.' Therefore, no income was received by
the shareholder. Income is received by the shareholder only when:

(1) he, the shareholder, receives a dividend in cash or other assets without
impairment of his investment; (2) when he, the shareholder, receives on
partial or complete liquidation, assets whose value is in excess of the
original investment. In the second situation, only the excess amount would

be considered as income.

 

49
G. R. Husband, "The Corporate-Entity Fiction and Accounting

Theory," The Accounting Review, XIII (September, 1938), p. 246.

50 W. A. Paton and W. A. Paton, Jr. , op. cit. , pp. 129-30.

11.1

Acceptance of the realization principle as the governing factor is
acceptance of the view that the shareholders do not derive any income from
a pro rata common share distribution to common shareholders. This type

of stock "dividend," therefore, should not be subject to income tax.

Summary

The leading problems in connection with the distribution of corporate
assets are: (1) the use of the term "dividends" to describe most of such distri-
butions, and (2) the deﬁnition of the measure of distribution.

Declaration of a dividend is the most emphatic assertion that the corpor-
ation is in a position to make a division of earnings. To shareholders the term
"dividend" is synomous with the division of earnings and not a partial return of
invested funds. To accountants the incorporation of "surplus" other than "earned
surplus" in the dividend base is a distinct departure from basic accounting
thought as to the nature of invested capital and dividend distribution. Distribu—
tions not charged against "earned surplus" are pro rata payments in liquidation
so far as accounting is concerned and should be so regarded.

Identiﬁcation of corporate distributions should be as follows: (1) the

interests of those concerned would best be served if the term "dividend" was
restricted and used only in connection with division of earnings, and (2) distri-
butions other than division of earnings are liquidations and should be so identiﬁed.
In connection with the deﬁnition of the measure of distribution, A. C.
Littleton is of the opinion that the profit concept has not been exclusively used

in corporation law as the only test for dividends because of the unwillingness

112
to define the broad term "proﬁt. " A solution lies in the following recommen-
dation:

Cash dividends may be declared only out of current or accumulated
net income which has been ascertained according to the accepted
principles.

The above recommendation incorporates both the proﬁt test and sol-
vency test for dividend declarations. Stating the law of dividends in the recom-
mended form would allow directors and the courts to base their decisions upon
the broad foundations of expert Opinion and an extensive technical literature
rather than upon an interpretation of a single deﬁnition or a single rule.
Accountants fully endorse the accumulated proﬁts test and the meaning of
"dividend" to accountants is consistent with their desire to maintain a primary
distinction between invested and earned capital.

In the interpretation of "dividends" in shares of the company, the
realization principle should dominate. Nothing is realized when a pro rata

distribution of the company's own shares is made, therefore no "dividend" as

such exists.

Evaluation of the Legal Provisions with Regard to Corporate
Distributions, The Companies Act, Canada, and
The Corporations Act, Ontario

In an effort to protect the creditors and perhaps the shareholders, both

Acts have tended to use terminology which shrouds the legal intent in Obscurity.

 

51 A. C. Littleton, "Business Proﬁts as a Legal Basis for Dividends"
Harvard Business Review, XVI (October, 1932), p. 60.

113

What is the meaning of value as used in Section 61(6), Ontario Act? What is
the meaning of insolvency? What is the meaning of impairment of capital when
capital is not accurately defined? Can a dividend be declared when a deficit

is on the books, but the company is currently showing net earnings? How is
the amount of "surplus" to be capitalized determined when shares are issued
with this intent? Is a "dividend" a division of earnings or a gradual liquidation
of the company?

Recommendations for changes in the Acts are:

 

(l) Restrict the use of the term "dividend" to describe corporate distributions
chargeable to current and/ or accumulated earnings to draw a clear distinction
between distribution of earnings and return of invested capital; (2) provide

that distributions chargeable to "surplus" accounts other than earned surplus

can be effected only under sections governing capital reductions; (3) provide

that distributions in excess of accumulated earnings in companies exploiting
depletible assets can be effected only under sections which govern capital
reductions; (4) use meaningful terminology which in itself does not raise questions
as to the intended meaning; and (5) prohibit the incorporation of revaluation

"surplus" in the dividend base Section 83(2) Federal Act.

Some of the above recommendations necessarily overlap with the recom-
mendation in Chapters 11 and III on the "Capital of the Corporation" and "The
Corporate Surplus. " The problems are intimately related and a solution in

one area is, in many cases, a solution in other areas.

CHAPTER V
CORPORATE COMBINATIONS

Corporate combination is the bringing together of two or more previously
independent enterprises into a single economic unit.1 The study of the reasons
for corporate combinations is primarily the province of economists .2 To account-
ants is left the task of interpretation of the characteristics of combinations in
order that the accounts may reﬂect the nature or substance of the "marriage ."

As a consequence accountants have come to distinguish between combinations
which are regarded as purchases of assets and those which represent a pooling

of interests . The essential characteristics which differentiate the two designations

are as follows:

For accounting purposes, a purchase may be described as a business
combination of two or more corporations in which an important part
of the ownership interests in the acquired corporation or corporations
is eliminated or in which other factors requisite to a pooling of interests
are not present.

In contrast, a pooling of interests may be described for accounting pur-
poses as a business combination of two or more corporations in which
the holders of substantially all of the ownership interests (refers basically
to common stock) in the constituent corporations become the owners

 

1Adapted from R.L . Nelson, Mergpr Movements in American Industry
1895-1956, (Princeton University Press, 1959) , p. 3, and E .B. Wilcox,
"Business Combinations: An Analysis of Mergers, Purchases, and Related Account-—
ing Procedure," The Journal of Accountancy, LXXXIX (February, 1950), p. 102.

 

2The following comment indicates the inadequacy of knowledge on corpor-
ate combinations: "The role of mergers in the evolution of our economic structure
and especially of the large and often dominant industrial enterprises, has fascin-
ated American economists and legislators since the 1890's. Unfortunately, both
economic analysis and legislative policy have been handicapped by inadequate
knowledge ." R.L. Nelson, op. cit. , p. 3.

114

115

of a single corporation which owns the assets and businesses of the
constituent corporations. . . . . . such corporation may be one of
the constituent corporations or it may be a new corporation.

When a combination is deemed to be a purchase, the assets acquired
should be recorded on the books of the acquiring corporation at cost,
measured in money, or, in the event other consideration is given,

at the fair value of such consideration, or at the fair value of

the property acquired, whichever is more clearly evident .....

When a combination is deemed to be a pooling of interests, a new

basis of accountability does not arise. The carrying amounts of the
assets of the constituent corporations, if stated in conformity with
generally accepted accounting principles and appropriately adjusted
when deemed necessary to place them on a uniform accounting basis,
should be carried over; and the combined earned surplus and deﬁcits,
if any, of the constituent corporation should be carried forward,

except to the extent otherwise required by law or appropriate corporate
action . . . . . the pooling-of—interests concept implies a combining of
surpluses and deﬁcits of the constituent corporations, and it would be
inappropriate and misleading in connection with a pooling of interests
to eliminate the deﬁcit of one constituent against its capital surplus and
the carry forward the earned surplus of another constituent.

The characteristics of a purchase are: (1) the elimination of an important
part of ownership in the acquired corporation; and (2) the assets acquired are
recorded on the books of the acquiring company at cost.

The signiﬁcant characteristics of the pooling of interests are:

(l) carrying forward to the new corporation the combined earned "surpluses"
or deﬁcits of the predecessor corporations; and (2) apparent disregard for the

effect of the charging price level on the fixed assets of the

 

3Committee on Accounting Procedure, Accounting Research Bulletin
No. 48, American Institute of Accountants, 1957, pp. 21-25. The term "Pooling
of Interests" was suggested by E. B. Wilcox in 1950. See E. B. Wilcox, op. cit. ,
pp. 102-050

4Consistent with the 'applicable accounting principle for the purchase
of assets, expenditures incidental to the purchase are part of the cost Of acquired

assets.

116

combining corporations. 5 George O. May is of the Opinion that Bulletin No. 48
is in conﬂict with the declaration set out in the first accounting bulletin which
stated:

The uses to which the corporate system is put and the controls
to which it is subject change from time to time, and all parts of the
machinery must be adapted to meet changes as they occur.

The weakness of the pronouncements of Bulletin No. 48 in the opinion of G. 0. May,
lies in the disregard of current values. He states:

. . . these monetary ascriptions will be the more signiﬁcant and
useful the more closely they reﬂect the effective cost to present-day
stockholders of their interest in the surviving corporation, rather than
the effective cost to stockholders of a prior generation. There is always
a presumption in favor of a more recent measure of accountability as
against an earlier one and the presumption becomes stronger the older
the historical base is.

Prima facie the securities issued in a transaction must be assumed
to be issued at the same price to all recipients; the burden of proof
lies on those who seek to depart from this rule.

 

5J. A. Carson sets out the following characteristics of mergers based on

The American Institute Bulletin No. 48: "(1) the smaller of the two companies
in a transaction is substantial in relation to the assets and earnings of the
combined companies, (2) the ultimate ownership of the stock of the combined
companies held by the former owners of the smaller company is substantial
in relation to the overall ownership, (3) there is some continuity both of such
ownership and of management of the business acquired. " J. A. Carson,
"Accounting for Mergers and Consolidations, " The Canadian Chartered
Accountantj LXXIV (April, 1959), p. 326. The above are tests of pooling

of interests rather than characteristics of mergers.

 

6Committee on Accounting Procedure, Restatement and Revision
of Accounting Research Bulletins, Bulletin No. 43, (New York: American
Institute of Certified Public Accountants, 1953), p. 7.

7George 0. May, "Business Combinations: An Alternate View," The
Journal of Accountancy, CIII (April, 1957), p. 35.

 

117
With reference to the carry—over of earned "surpluses" and deficits of
the combining corporations, G. 0. May is of the opinion that E. B. Wilcox pro-

vides sufficient ground for rejection of the practice. 8 Wilcox states:

Obviously an Operating deficit on the books of one predecessor
could greatly reduce or eliminate the remaining earned surplus, and
there might even be a net deficit in the surviving company.

The rejection is based on the fact that the emerging corporation may begin
operations with a deficit . The lack of unanimity among accountants with
regard to the carry-over of earned "surplus" or deficit is indicated by the
following expressions:

. . . Speciﬁc earned surplus measures the proﬁt accumulation

of a specific corporation, not the accumulation of fused or successive
concerns. A complete merger is equivalent to the formation of a new
enterprise, andllbnew company cannot begin its corporate life with an
earned surplus.

and

The combined earned surpluses and deﬁcits, if any, of the constituent
corporations should be carried forward . . . . . the new enterprise is
nevertheless regarded as a continuation of all the constituent corpora-
tions; the rule applicable to purchased subsidiaries that earned surplus
created prior to acquisition does not form part of consolidated earned
surplus does not apply. 11

The Canadian Institute has not taken a stand on the matter; however, by

implication, the carry-over of surpluses and deficits is accepted.

 

81bid., p. 33.
913.13. Wilcox, op. cit., p. 105.

10W. A. Paton and A. C. Littleton, An Introduction to Corporate
Accounting Standards, American Accounting Association, 1940, p. 107.

 

11N. J. Lenhart and P. L. Defliese, Montgomery's Auditi_pg, New York:
The Ronald Press Co. , 8th Ed. , 1957), p. 473.

118

The Institute states:

The consolidated earned surplus should in no case include surpluses
of subsidiaries earned prior to acquisition. Likewise, in respect of

subsidiaries acquired during the year, the proﬁt and loss statement
should include only the operations since the effective date of acquisitipél.
(It should be noted that a "pooling of interests" is not an acquisition.)

In view of the fact that the phrase "pooling of interests" is used to imply that a
differentiation in accounting treatment of corporate combinations is warranted,
a formal pronouncement by the Canadian Institute would be desirable.

The Canadian corporate statutes do not deal speciﬁcally with the problem
of carry-over of earned "surpluses" and/ or deficits. However, the statutes of
all jurisdictions are not in agreement on the subject of corporate combinations.
The chief difference is that in all jurisdictions except Manitoba and Quebec the
emerging company is regarded as a continuation of the predecessor companies,
while in Manitoba and Quebec the emerging company is regarded as a new in-
corporation. 13

There is disagreement in jurisprudence as in accounting, concerning
corporate combinations. The source of the differences is the same in both
accounting and jurisprudence. The solution of the differences seems to be
predicated on the solution to the question: Can there be a corporate combina-
tion and at the same time a continuation of accounting for the combination as if

the predecessor companies had not lost their identity?

 

12Committee on Accounting and Auditing Research, Accounting and
Auditing Practices Bulletin No. 14, (Toronto: The Canadian Institute of
Chartered Accountants, 1957), p. 9.

13The Quebec Companies' Act, (1925), Section 18 and Manitoba Companies'
Act, (1954), Sections 98, 99 and 100. Also J. L. Stewart, Handbook on Canadian

 

 

 

Company Law, (Toronto: The Carswell Co. Ltd. , 5th Ed. , 1960), p. 319.

 

119

Federal and Ontario Corporate Statutes on Combinations

The Companies Act, Canada

 

Power to Amalgam ate

Section 14

(h)

to promote any other company or companies for the purpose of
acquiring or taking over all or any of the property and liabilities
of the company, or for any other purpose that may seem directly
or indirectly calculated to benefit the company;

(m) to sell or dispose of the undertaking of the company or any part

(‘1)

thereof for such consideration as the company may think ﬁt, and in
particular for shares, debentures or securities of any other company
that has objects altogether or in part similar to those of the company;

to distribute among the shareholders of the company in kind, specie
or otherwise, any property or assets of the company including any
proceeds of the sale or disposal of any property of the company

and in particular any shares, debentures, or other securities of or
in any other company belonging to the company, or of which it may
have power to dispose, if either such distribution is made for the
purpose of enabling the company to surrender its charter under

the provisions of this Act, or such distribution, apart from the
provisions of this paragraph, would have been lawful if made in cash;

Section 126

(4)

The expression "arrangement" as used in this section and section 127
shall be construed as extending to any reorganization of the share
capital of the company including without limiting the foregoing the
consolidation of shares of different classes, the division of shares
into shares of different classes, the conversion of shares into shares
of another class or classes and the modiﬁcation of the provisions
attaching to shares of any class or classes and as including the
amalgamation or reconstruction as hereinafter deﬁned; the expression
"amalgamation or reconstruction" means an arrangement pursuant

to which a company (in this subsection called "the transferor com—
pany") transfers or sellls or proposes to transfer or sell to any other
company (in this subsection called "the transferee company"), the
whole or a substantial part of the business and assets of the transferor
company for a consideration consisting in whole or in part of shares,
debentures or other securities of the transferee company and, either,

120

any part of such consideration is proposed to be distributed among
shareholders of the transferor company of any class, or, the
transferor company proposes to cease carrying on the business or
part of its business so sold or transferred or prOposed to be sold
and transferred. 1934, c. 33, s. 122.

Designation of "Surplus"
Section 12

(10) . . . and where the company acquires a going concern that has
a surplus over and above all liabilities, and any shares without
nominal or par value in the company are issued and allotted as fully
paid in payment or part payment for such going concern, the
directors may by resolution set aside, as a distributable surplus,
such part of the consideration for the issue and allotment of such
shares without nominal or par value as does not exceed the
unapprOpriated balance of realized net proﬁts of the going concern
immediately before such acquisition.

Rights of Dissenting Shareholders
Section 128

(1) Where any contract involving the transfer of shares or any class of
shares in a company (in this section referred to as "the transferor
company") to any other company (in this section referred to as "the
transferee company") has, within four months after the making of
the offer in that behalf by the transferee company, been approved
by the holders of not less than nine-tenths of the shares affected,
or not less than nine-tenths of each class of shares affected, if
more than one class of shares is affected, the transferee company
may, at any time within two months after the expiration of the said
four months, give notice, in such manner as may be prescribed by
the court in the province in which the head Ofﬁce of the transferor
company is situate, to any dissenting shareholder that it desires
to acquire his shares, and where such notice is given the transferee
company is, unless on an application made by the dissenting share-
holder within one month from the date on which the notice was given
the court thinks fit to order otherwise, entitled and bound to acquire
those shares on the terms on which, under the contract, the shares
of the approving shareholders are to be transferred to the transferee
company.

121

The Corporations Act, Ontario

 

Power to Amalgamate

Section 22

(h) to promote any company for the purpose of acquiring or taking

over any of the property and liabilities of the company, or for
any other purpose that may benefit the company;

(m) to sell, lease, exchange or diSpose of the undertaking of the

company or any part thereof as an entirety or substantially as

an entirety for such consideration as the company thinks fit, and
in particular for shares or securities of any other company having
objects altogether or in part similar to those of the company, if
authorized so to do by a Special resolution.

Section 95

(1)

In this section, "arrangement" includes a reorganization of the
authorized capital of a company and includes, without limiting the
generality of the foregoing, the consolidation of shares of different
classes, the reclassification of shares of a class into shares of
another class and the variation of the terms, preferences, rights,
conditions, restrictions, limitations or prohibitions attaching to
shares of any class and includes a reconstruction under which a
company transfers or sells or proposes to transfer or to sell to
another company the whole or a substantial part of its undertaking
for a consideration consisting in whole or in part of shares or
securities of the other company and in which it proposes to distribute
a part of such consideration among its shareholders of any class

or to cease carrying on its undertaking or the part of its undertaking
so transferred or sold or so proposed to be transferred or sold.
1953, c. 19, s. 95(1);1955, c. 9, s. 7.

Section 96

(1)

(2)

Any two or more companies, including a holding and subsidiary
company, having the same or similar objects may amalgamate and
continue as one company.

The companies proposing to amalgamate may enter into an agreement
for the amalgamation prescribing the terms and conditions of the
amalgamation, the mode of carrying the amalgamation into effect and
stating the name of the amalgamated company, the names, callings and
places of residence of the first directors thereof and how and when

the subsequent directors are to be elected with such other details as

may be necessary to perfect the amalgamation and to provide for

the subsequent management and working of the amalgamated company,
the authorized capital of the amalgamated company and the manner

of converting the authorized capital of each of the companies into

that of the amalgamated company.

122

(3) The agreement shall be submitted to the shareholders of each of
the amalgamating companies at general meetings thereof called
for the purpose of considering the agreement and if two—thirds of
the votes cast at each such meeting are in favour of the adoption
of the agreement that fact shall be certified upon the agreement by

the secretary of each of the amalgamating companies under the
corporate seal thereof.

(4) If the agreement is adOpted in accordance with subsection 3, the
amalgamating companies may apply jointly to the Lieutenant-
Governor for letters patent confirming the agreement and amal-
gamating the companies so applying and on and from the date of
the letters patent such companies are amalgamated and are con—
tinued as one company by the name in the letters patent provided,
and the amalgamated company possesses all the property, rights,
privileges and franchises and is subject to all liabilities, contracts,

disabilities and debts of each of the amalgamating companies .
1953, 0.19, s. 96.

Rights of Dissenting Shareholders (Private Company) 14

Section 99

(l) (c) an agreement for the amalgamation of the company with one or
more other companies, whether public or private, is conﬁrmed
by the shareholders, any shareholder who has voted against
the confirmation of such resolution or agreement, as the case
may be, may within two days after the date of the meeting give

give notice in writing to the company requiring it to purchase
his shares.

(2) Within ninety days from the date of the completion of the sale or
diSposition or the issue of the supplementary letters patent or
the letters patent, as the case may be, the company shall purchase
the shares of every shareholder who has given notice under sub-
section 1.

(3) The company shall not purchase any shares under subsection 2
if it is insolvent or if such purchase will render the company
insolvent.

 

14In Canada, a company classified as a private company, by virtue
of the Act under which incorporation took place, enjoys special privileges .
These privileges are primarily in disclosure of data about the company. In
order to be incorporated as a private company certain restrictions are imposed
by the Act. Restrictions of importzmce are: (l) the number of shareholders is
limited to fifty; (2) restrictions are placed on the transfer of shares; and (3)
funds may not be raised through public offerings. A public company in Canada
is synonymous with a private company in the United States; a crown company
in Canada is synonymous with a public company in the United States .

123

(4) The price and terms of the purchase of such shares shall be as
may be agreed upon by the company and the dissenting shareholder,
but, if they fail to agree, such price and terms shall be as deter—
mined by the court on the application of the dissenting shareholder.

Preservation of Creditor's Rights

Section 323

All rights of creditors against the property, rights and assets of a
corporation amalgamated under section 96 or continued under section
322, and all liens upon its property, rights and assets are unimpaired
by such amalgamation or continuation, and all debts, contracts,
liabilities and duties of the corporation thenceforth attach to the amal-
gamated of continued corporation and may be enforced against it. 1953,
0.19, s. 323; 1955, c. 9, s. 17.

Both the Federal and the Ontario Acts provide for the right of corporations

to amalgamate .15

The Ontario Act in Section 96 details the procedure to be followed in the
amalgamation. In Section 96(2) of the Ontario Act "the manner of converting the
authorized capital of each Of the companies into that of the amalgamated company"
is to be stated in the agreement for the amalgamation. The Act apparently
distinguishes the entities involved: "each of the companies" and "the amalgamated
company." The Act, however, is silent on the matter of carry—over of earned
"surplus" from the amalgamating companies to the emerging company.

With regard to dissenting shareholders the Ontario Act provides for
relief only in the case of private corporations .16 The Ontario Act seeks to pro-
tect the creditors' rights against the amalgamated or continuing corporation.

The procedure for amalgamation is not specifically detailed in the Federal
Act. Reference is, however, made to dissenting shareholders. Under the Federal
Act (Section 128 (1)) the acquiring company may force the dissenting shareholders

to comply with the terms of offer if the dissenting shareholders hold less than ten

 

r I 0
1”The term "amalgamate" rather than "eombme" is used by both Acts .
The terms as used here are synonymous .

1680c footnote No. 14, p. 9,

124

per cent of the outstanding shares of the company being acquired.

With reference to the carry-over of earned "surplus" the Federal Act
under Section 12 (10) permits the designation of an amount not exceeding "the
unappropriated balance of realized net profits" of the going concern being acquired
as "distributable surplus ." This is permitted only when no par shares are issued
as part of full consideration of the acquiring company. Since "distributable surplus"
is unrestricted and included in the dividend base of the emerging company, the Act,
in fact, permits the carry-over of earned "surplus" from the going concern being
acquired to the acquiring company .

The two Acts have little in common on the matter of corporate amalga-
mations or combinations. Of prime accounting importance is the fact that the Ontario
Act apparently attempts to distinguish the entity of the amalgamating corporations
and the emerging corporation, however, no statement is made with regard to the
carry-over Of the predecessor companies' earned "surplus" providing no par
shares are issued as the emerging company's consideration and the carried over
"surplus" is designated as "distributable surplus ." Both Acts are silent on whether
the assets are to be recorded at book or market values on the books of the emerg—

ing company.

Reconsideration of Corporate Combinations
The underlying accounting problem of corporate combinations is centered
around the carry-over of earned "surplus" of the predecessor companies to the
emerging corporation. The problem of the carry-over of earned "surplus" is
essentially predicted on whether the entities of the combining companies are

preserved.

125

Acquisition of Existing Corporations17

The generally accepted accounting standard for the acquisition of assets

is as follows:

. . . The importance of cost as a record of the accountability of an

enterprise for its resources makes it essential that their determina—

tion be based on available objective evidence. When an asset is pur-

chased such evidence is found in the cash outlay, in the fair market

value of any noncash consideration, or, in the absence of these

measures of cost, in the fair market value of the asset acquired.

Where an asset is acquired from investors or donors its cost for

accounting purposes is fair market value at the time of acquisition.

(1) The cost of a group of assets acquired for a lump sum should be

allocated to prOperty units, tangible or intangible, after careful con-

side ration of each unit, and its intended use and prOSpective earning

power or value in exchange. 18

The above pronouncement of the American Accounting Association pro-

vides for both the piecemeal acquisition of assets and group acquisition such as
acquiring a going concern. The assets in both cases are recorded on the books of
the acquiring company at acquisition cost. Consideration for the acquired assets

may be either other assets and/or participation in the ownership of the acquiring

corporation .

The fact that the shares of the acquiring corporation are issued to the previous
owners is of no consequence as to the amount at which the assets are to be re-
corded on the books of the acquiring corporation. Of consequence is the fact
that: (1) the ownership of the assets passed to the acquiring corporation; and,
(2) a consideration equal in value to the assets was given to the previous owners

in return. The value and not the type or magnitude of the consideration is all

 

17The term "acquisition" rather than "purchase" is used in order that the
consideration given in return for the acquired assets may be other assets and/or
shares of the acquiring corporation.

18American Accounting Association, Accounting Concepts and Standards
Underlying Corporate Financial Statements and Supplementp, 1948 ReviSlons ,
p. 2.

 

126

important. Although the previous owners remain owners, they are not owners of
the Specific assets passed to the acquiring corporation, but owners of the cross
section of all assets of the acquiring corporation.

The above interpretation of the American Accounting Association's pro-
nouncement is somewhat in conﬂict with the deﬁnition of a "purchase" by the
American Institute's Bulletin No. 48. In Bulletin N o. 48 a purchase requires:
(1) that an important part of the ownership interests in the acquired corporation
or corporations be eliminated; and (2) that the corporation acquired not be of sub-
stantial size in terms of assets and earnings to the combined companies. What
constitutes "an important part" or "substantial size" is not clearly defined in the
bulletin.

Acquisition of assets by one corporation from another corporation, or
corporations, should be identified by the passage of title (asset ownership) to a
corporation from another or other corporations . Where total ownership does not
pass, majority interest and control of assets should be the test of an acquisition
of assets. Magnitude ( value) , form of consideration given in return or con-

tinuity of ownership are irrelevant.

The Carry-Over of Surplus

 

The arguments presented for permitting the carry—over of surplus
from the predecessor companies to the emerging company are primarily based
on: (I) the premise that the entities of the combining corporations are pre-
served; and (2) since the assets and liability account balances can be trans-
ferred to the new surviving company at existing carrying values, the transfer

of earned "surplus" should be equally acceptable .19 If the premise that the entity

 

19The second argument is adapted from: H. A. Finney and H. E .
Miller, Principles of Accounting Intermediate, Canadian Ed. , prepared
by K. F. Byrd, (Englewood Cliffs: Prentice—Hall, Inc. 1959), p. 594.

 

127

of the combining corporations is accepted, assets, liabilities, and shareholders'
equity accounts should be carried over at the existing book amounts . However,
if the entities of the combining corporations are not preserved, then the transfer
of surplus and indeed the transfer of assets at book value is open to serious

question .

Professor Newlove states that three methods are used to accomplish

a combination. These are:

l. Assets for Securities Plan.

If Company X, an existing corporation, issues additional shares
to Company B for its net assets, and Company B dissolves,
giving the stock of Company X as a liquidating dividend, the
combination is a merger.

If Company X is organized to issue its stock for the net assets
of Company Y and Company Z , and these companies dissolve
giving the stock of Company X as liquidating dividends, the
combination is a consolidation.

2. Securities for Securities Plan.

If Company X, an existing corporation, issues additional stock
to the stockholders of Company B for their holdings in the stock
of Company B, and then Company B is liquidated as a fully owned
subsidiary, the combination is a merger.

If Company X is organized to issue its stock to stockholders of
Company Y and Company Z for their stockholdings, and then
Company Y and Company Z are liquidated as fully owned sub-
sidiaries, the combination is a consolidation.

3. Statutory Plan

This procedure involves the preparation of a formal consolid-
ation plan, the adoption of the plan by security holders having
the right to vote, the filing of the articles of agreement with the
proper state official, and the exchange of securities through a
trustee at a later date.20

The distinction as to the type of combinations that Professor Newlove

makes is of little importance.21 Of paramount importance is the fact that in

20G. H. Newlove, Consolidated Statements Including Mergers and
Consolidations, (Boston: D. C. Heath and Co. 1948,) pp. 2-3.

leewlove states that; "When one or more existing corporations. lose
their identity by being absorbed by another corporation, the combination I:
called a merger if the absorbing corporation was already in emstcnce,.an.
it is called a consolidation if the absorbing corporation is a new corpoxatlon
organized for that purpose. The term "amalgamation" IS sometlmes used as
a synonym for the term "consolidation'." Ibid. , p. 2.

 

128

each of the three methods of accomplishing a corporate combination only one
of the predecessor corporations survives, or a new corporation comes into
existence. All but one of the predecessor corporations disappear in the
former situation, and all predecessor corporations disappear in the latter
situation.

The above view is consistent with the American Institute's Bulletin
No. 48, which states:

. such corporation may be one of the constituent corpor-
ations or it may be a new corporation. 22

Since at best only one of the constituent corporations may survive,
the important question is: Can earned "surplus" of a disappearing corpora-
tion be transferred to the surviving corporation? Paton and Paton express
the following opinion:

In atransaction in which the acquired company disappears as a
corporate entity--there is little justification for the widespread
View that the surviving company somehow acquires the retained
earnings of the disappearing corporation and may incorporate
the amount thereof in its own retained earnings account. The
element of the total stockholders' equity represented by income
retained in the business has significance only to the entity through
which the income was produced; it is literally impossible to transfer
this factor in any meaningful sense to any other entity.

This view finds support in England. The Proceedings of the Conference
on "The Shortcomings of the Companies Act 1948" held at Oxford in 1958 contain
the following:

Itis true to say that the orthodox view still largely prevails that
when a company acqui res shares in another body corporate the
profits relating to those shares which were earned prior to the
date of acquisition--termed 'pre-acquisition' profits--are not
available for distribution to the acquiring company. This practice
is generally thought to exemplify sound accounting principles and

 

2 . . . .
Committee on Accounting Procedure, op. Cit. , p. 22.

23W. A. Paton and W. A. Paton, Jr. , C(miorato Accounts and Statements,

 

New York: The MacMillan Cu. , 1055), ). 40.
l

129

indeed would seem to be accepted by the first part of paragraph

15 (5) of the Eight Schedule (The Companies Act) . . . . . . . . . . . . . . .
specific exemption, however, from this practice is given in the
latter part of paragraph 15 (5) where the acquiring company is a
subsidiary of another body corporate and acquires shares either
from its holding company or from a fellow subsidiary . . . . . . . . . .

Where, however, a new company is formed to acquire all the
shares of an existing company the exemption given by paragraph
15 (5) does not apply even though the effect of the exercise may

be no more than the substitution of one piece of paper for another
in the hands of the shareholders.24

No official bulletin has been issued by the Institute in England and
Wales on the subject of business combination. There is, however, a reference

in Bulletin No. N16 regarding pre-acquisition profits as follows:

In cases where application is made for the quotation of securities
of holding companies the department will require to be satisfied

that in arriving at any estimate contained or to be contained in
any prospectus, offer for sale or public advertisement of the
profits of or any dividends to be paid in respect of the first
financial year of the holding company due account has been taken
of the fact that ”pre-acquisition profits" will not be available for
distribution .25

At a Canadian Institute of Chartered Accountants' Conference in 1959
on "Corporate Mergers and Amalgamations" the concern was primarily with
the provisions of the Income Tax Act on the subject. One of the speakers did,
however, state that:
" , , , There is no merger of undistributed incomes. . . "26 The carry-

over of earned "surplus" has won wide support. Some of the arguments advanced

for the carry-over of earned "surplus" are as follows:

 

24The Institute of Chartered Accountants in England and Wales, Pro-
ceedings at Christ Church and Merton College , (Oxford, Eng. , 1958), pp. 99-
100.

25The Institute of Chartered Accountants in England and Wales, lie:
commendations on Accounting PrinciplesJ Bulletin No. N. 16, p. 5.

26W.C. Shakespeare, D.C. Scott, and D.A. McGregor, "Corporate
Mergers and Amalgamations, The Canadian Chartered Accountalt, LXXVI
(February, 1960), p. 176.

130

A merger creates no new costs inasmuch as a new basis of
accountability does not arise. The aspects of buying and selling
are absent as the ownerships are pooled and there is a continuity
not present when properties are sold.27

Wixon and Kell state:

. . It is necessary to exchange shares rather than risk borrow—
ing or incurring the high cost of selling equity securities when one
company buys the assets of another . It is also necessary to pay
regular dividends to assure a satisfactory market for existing
shares, and to develop a reputation which will facilitate future
financing operations. In such circumstances the "pooling of

interests" concept ignores a legal shell in order to disclose a
more fundamental economic entity in its continuing form. 8

In a corporate combination the ownership is exchanged from ownership
in the predecessor companies to ownership in the emerging company. Therefore,
although the shareholders of the emerging company may be the same as the share-
holders of the predecessor companies, the assets to which they have a claim are
not the same.

Continuation of asset costs of the merging companies on the books of the
emerging company because "its more conservative" is a poor basis for the practice.
Conservatism for the sake of conservatism is not a virtue and more so if the result
is to distort economic accuracy. Cost as a basis for stating asset values is applic—
able only to the company acquiring these assets. However, when the company
that in the first instance acquired the assets disappears, the asset costs on the
disappearing company's books lose significance. In order to be consistent with
"costzvalue" at time of acquisition, the assets must be stated at the bargained
amount on the books of the emerging company (company taking over the assets of
the disappearing companies).

When a corporate combination takes place and the shares are exchanged

 

27J. A. Carson, Op. cit., p. 326.

28Rufus Wixon and W. G. Kell, (Editors) The Accountants' Handbook,
(New York: The Ronald Press Co. 5th Ed. , 1957,) p. 21-48.

 

131

on the basis of book values, the book values are usually adjusted prior to the
combination.29 The very fact that the exchange is made on adjusted book values
should be sufficient to justify a new basis of the bargained value of the assets of
the combining corporations and the process of exchange has all the essential

characteristics of buying and selling.

The editors of the Accountants' Handbook would apparently sanction a
misstatement of periodic net earnings if this practice would facilitate the payment
of regular dividends, assure a satisfactory market for the shares, and develop
a reputation which would facilitate future financing. If the arguments cited by
the editors of the Accountants' Handbook are to be the reasons for a "pooling of
interests" the emerging corporation fails to disclose what the editors refer to as
"a more fundamental economic entity." The carry-over of assets at current
bargained values would more adequately disclose not only the "fundamental
economic entity," but also the proper determination of future net earnings of the
emerging entity. 30 With reference to the above, G. 0. May states:

The ﬁrst objective of any rules applicable in these cases should be to
insure the creation of adequate information on which to base charges
against revenue in the future . It is now generally recognized that
the main importance of monetary ascriptions given to wasting capi-
tal assets arises from the fact that they will form the basis of charges
against revenues in the future. One corollary that follows is that
these monetary ascriptions will be the more significant and useful
the more closely they reﬂect the effective cost to present—day
stockholders of their interest in the surviving corporation, rather
than the effective cost to stockholders of a prior generation.

 

29Those in favour of the carry-over of earned "surplus" and deficits
apparently sanction a prior adjustment. E . B. Wilcox states: "While such a
quasi-reorganization is not a part of the merger transaction itself, I see no valid
objection to using this procedure in contemplation of a merger, and, in fact, I
think it would be wise to do so." E. B. Wilcox, op. cit., p. 106.

30The earnings of the emerging entity could, of course be corrected to
reflect the changes in the price level. Price level accounting has not, however,
been generally sanctioned by accountants.

31

5.

G.O. May, op. cit. , p. 3

132
Continuity of management as a reason for describing a combination as
a "pooling of interests" is not valid. Shareholders act in a selfish manner and
if the transfer of the new shares will, in their opinion, enhance their individual
position, the transfer will be made whether the corporate combination was called

a purchase or a pooling of interests . In the same way there is no assurance of con—

 

tinuity of management. The shareholders of the emerging corporation will elect
the board of directors which they, the shareholders believe, will best represent
them and the board will in turn name the officers of the corporation. There can

be no guarantee that the management of predecessor corporations will survive.

Summary

Corporate combinations can be classified into two categories. These
are: (l) situations where one of the predecessor corporations survives; and
(2) situations where a new corporation is formed to absorb the combining
corporations .

In the former all but one of the combining corporations disappear and
this form of a combination should be regarded as an acquisition by the surviving
corporation. The assets would be recorded at the bargained value and since the
earned "surplus" or deficit was that of the disappearing corporation no reason
can be found for the carry—over of these items. The ownership in the surviving
corporation replaces the ownership in the prior corporation and the manner in
which the shareholders' equity was categorized in the disappearing corporation
is irrelevant.

In the latter situation all of the combining corporations disappear. The
ownership in the new corporation replaces the ownership in the disappearing

corporations and the manner in which the shareholders' equity was categorized

133

in the disappearing corporations is also irrelevant.

Where one of the combining corporations survives, the earned "surplus"
or deficit of the surviving corporation would be continued. However, where a
new corporation emerges, net earnings of the new corporation are pre-requisite
for earned "surplus ." Arguments against designation of "surplus" in a new

corporation are discussed in Chapter III, "The Corporate Surplus."

Evaluation of the Legal Provisions with Regard
to Corporate Combinations, The Companies
Act, Canada and the Corporations Act,
Ontario

The corporate combination or amalgamation procedure is not clearly
set out in the Federal Act. In addition, the provision permitting the designation
of "distributable surplus" on amalgamation is not desirable . The provision
permitting companies to force dissenting shareholders to accept an amalgamation
plan when the dissenting shareholders, as a group, constitute less than ten per
cent of the outstanding shares is desirable in order that "nuisance" shareholders
may not block desirable amalgamations .

The Ontario Act sets out the procedure for amalgamations clearly and
provides for the protection of shareholders as well as creditors. No provisions
with regard to the carry-over of "surplus" are contained in the Act.

Desirable legislation with reference to corporate combinations should
set out clearly the procedure to be followed to effect a combination. The pro-
visions should be such as to protect the shareholders and creditors; however,
the companies should be given the right to eliminate dissenting shareholders if

the total ownership of dissenting shareholders is less than ten per cent. The

Acts should also provide that the new company into which a number of companies

134

combine is not a continuation of the predecessor companies. The latter

provision would prohibit the carry-over of earned "surplus ."

CHAPTER VI
DISCLOSURE OF CORPORATE ACTIVITY

"Oh wad some power the giftie gie us to see owrselvs as others see us!"1

Disclosure of corporate activity should be the province of accountants and
not of the government through statutes or through appointed administrative agencies.
Intervention by the government on behalf of outside users of data on corporate
activity has resulted primarily from the failure of accountants to live up to their

obligations . The existence of an obligation to outsiders has been firmly established.

Professor Jones states:

The corporation, through its officers and executives, is entrusted with
society's assets: people and goods. It is essential that the corpora-
tion report on its stewardship of those assets. Investors and govern-
ments must be able to make factually-based investment and regulatory
decisions. Those who contribute to corporate existence are entitled to
a revelation of performance of corporate administration. The internal
affairs of a corporation become vested with a public interest when the
firm is owned by thousands and when the livelihood of thousands more
rests on successful corporate management. The public--which is society
--comes to have a right to know of corporate conduct.2

William L. Werntz , Past Vice-President of the American Accounting

Association and Past Chief Accountant of the Securities and Exchange Commission

states:

. Concurrently, ownership in the form of nonmanagement stock-
holders and creditors required means of appraising the efforts and
stewardship of the management. Such appraisal was originally a basis
for either rewarding and retaining or else condemning and changing the
active management, but more recently, in the case of large public-

. 1List of Articles, a Symposium "What's Wrong With Financial Report-
mg'?" , The Journal of Accountancy, CXII (AUSUSt 1961) P- 2-

2G. M. Jones, Electronics in Business, (East Lansing: Bureau of
Business and Economic Research, Michigan State University, 1958), p. 8.

135

136

ownership companies, has become a basis merely for deciding
whether to maintain, withdraw or increase the investment in the
particular company.

On the obligation of accountants to investors, George 0. May has stated:

The accountant, in addition to his legal and ethical duties, owes his
entire practice in the financial reporting field to the investor whose
confidence he must secure and maintain.

A society in which the corporate statutes are premised on the idea that
their function is to protect the suppliers of capital rather than to provide enabling
legislation for the operation of an enterprise in the corporate form, places a
heavy burden, in terms of disclosure, on the accountant. Canada is such a society,
recognizing the primacy of the suppliers of capital as signified by the following
provisions:

The Companies Act, Canada:
Section 122

Subsection 5. The first auditors of the company may be appointed
by the directors before the first annual meeting, and if so appointed
shall hold office until the first annual meeting, unless previously
removed by a resolution of the shareholders at a Special general
meeting, in which case the shareholders at that meeting may appoint
auditors.

Subsection 6. The directors may fill any casual vacancy in the office
of auditor, but while any such vacancy continues the surviving or con-
tinuing auditor or auditors, if any, may act.

Subsection 7. The remuneration of the auditors of a company shall be
fixed by the shareholders at an annual meeting or by the directors
pursuant to authorization given by the shareholders at the annual meet-
ing, except that the remuneration of any auditors appointed before the
first annual meeting, or to fill any casual vacancy, may be fixed by the
directors. 1934 , c. 33, s. 118.

 

3Morton Backer (Editor) , Handbook of Modern Accountigg Theory, (New
York: Prentice-Hall, Inc. 1955), p. 105.

4Geo. 0. May, "The Accountant and the Investor, Ethical Problems of
Modern Accounting," summarized in: J.D. Edwards and R. F. Salmonson,
Contributions of Four Accounting Pioneers, Kohler, Littleton, MayLPaton,

(East Lansing: Bureau of Business and Economic Research, Michigan State
University, 1961), p. 117.

137

The Ontario Act is more specific in delegation of appointment of
auditors to the shareholders . The Corporation Act, Ontario states:
Section 80

(l) The shareholders of a company at their ﬁrst general meeting
shall appoint one or more auditors to hold office until the first
annual meeting, and if the shareholders fail to do so, the directors
shall forthwith make such appointment or appointments.

(2) The shareholders shall at each annual meeting appoint one or
more auditors to hold office until the next annual meeting, and, if
an appointment is not so made, the auditor in office shall continue
in office until a successor is appointed.

(3) The directors may fill any casual vacancy in the office of
auditor, but while such vacancy continues the surviving or
continuing auditor, if any, may act.

(4) The shareholders may, by resolution passed by at least two-
thirds of the votes cast at a general meeting of which notice of
intention to pass such resolution has been given, remove any
auditor before the expiration of his term of office, and shall by

a majority of the votes cast at that meeting appoint another auditor
in his stead for the remainder of his term.

(5) The remuneration of an auditor appointed by the shareholders

shall be fixed by the shareholders or by the directors if they are

authorized so to do by the shareholders, and the remuneration of

an auditor appointed by the directors shall be fixed by the directors .

(6) If for any reason no auditor is appointed, the Provincial

Secretary may, on the application of any shareholder, appoint

one or more auditors for that year and fix the remuneration to

be paid by the company for his or their services.

(7) Notice of the appointment of an auditor shall be given in

writing to him forthwith after the appointment is made. 1953,

c. 19, s. 80. -

In the delegation of appointment of auditors to the shareholders by

both Acts, the Statutes generally set an outstanding example on this continent
in positively recognizing that the primary function of corporation Acts is that

Of protecting the suppliers of capital. Recognizing the rights of the suppliers

of capital the statutes have set out the following minimum disclosure provisions:

138

The Companies Act, Canada

 

Section 116 (1) At each annual meeting the directors shall lay before
the company

(a) a balance sheet made up to a date not more than four months before
such annual meeting, but a company that carries on its undertaking

out of Canada may by its by-laws extend this period to not more- than
six months;

(b) a general statement of income and expenditure for the fin-
ancial period ending upon the date of the balance sheet;

(0) a statement of surplus showing separate accounts for capital
surplus, distributable surplus and earned surplus respectively,
the amounts of such surpluses respectively at the beginning of
the financial period, adjustments affecting previous financial
periods, net profit or loss as shown by the statement of income
and expenditure, dividends paid or declared on each class of
shares stating the account against which the same are charged,
any other appropriations, changes in and balance remaining of
capital surplus, distributable surplus and earned surplus re-
spectively;

(d) the report of the auditor or auditors; and

(e) such further information reSpecting the financial position
of the company as the letters patent, supplementary letters
patent, or by-laws of the company require.

(2) Every balance sheet shall be drawn up so as to distinguish
severally at least the following classes of assets and liabilities,
namely:

(a) cash;

(b) debts owing to the company from its directors, officers or
shareholders respectively;

(0) other debts owing to the company including accounts and bills
receivable in such form as to distinguish between current and non-
current accounts in all cases in which the estimated loss is not
provided for;

(d) inventory, if any, stating the basis of valuation adopted and
the manner in which such value has been determined in reSpect
of various sub—divisions of such inventory;

(e) investments and securities, if any, stating their nature and
showing the market value of marketable securities, and sep-
arately, the book value of other securities;

(1) expenditure made on account of future business, if any;

139

(g) lands, buildings and plant, stating the basis of valuation,
whether cost or otherwise, and, if valued on the basis of
appraisal, the date of appraisal, the name of the appraiser,
and, if the surplus of the company has been increased as a
result thereof, the amount by which the value of such assets
has been written up within a period of three years prior to
the date of such balance sheet;

(h) the aggregate amount of any outstanding loans under para-
graph (d) of subsection (2) of section 15; (loans to employees of
the company (directors excluded) for the purpose of purchasing
fully paid shares in the company);

(i) debts owing by the company;

(j) liability for taxes imposed by any taxing authority in Canada
including amounts owing in reSpect of such taxes due and payable
and amount or estimated amount of the liability for such taxes

in reSpect of the fiscal period covered by the statement of income
and expenditure;

(k) the amount of shares of each class issued and outstanding
and the amount paid thereon, showing the amount thereof issued
since the date of the last balance sheet for services rendered,
for commissions or for assets acquired since the date of the
last balance sheet for services rendered, for commissions or
for assets acquired since the date of the last balance sheet and
if any redeemable preferred shares have been issued a sufficient
description of such shares to indicate that they are liable to be
redeemed;

(l) indirect and contingent liabilities;

(m) the amount or amounts of existing reserves for depreci-
ation, obsolescence and depletion;

(n) the total amount received upon the issue of shares in the
capital stock which is attributable to capital;

(0) the total amount received upon the issue of shares in the
capital stock set aside as distributable surplus, in accordance
with the provisions of subsection (10) of section 12 or other-
wise, or any unappropriated balance thereof; and

(p) the total amount of money provided under paragraph (c)
of subsection (2) of section 15. (The provision of money by
the company for the purchase by trustees of fully paid shares
in the company to be held for the benefit of the employees .)

(3) There shall be stated under separate headings in the balance
sheet of the company, so far as they are not written off

140

(a) the preliminary expenses of the company incurred after
the first day of October, 1934, or within a period of three
years prior to that date;

(b) any expenses incurred in connection with any issue of share
capital or debentures; and

(c) if it is shown as a separate item in or is otherwise ascer-
tainable from the books of the company, or from any contract
for the sale or purchase of any property, the amount of the
goodwill, franchises, patents, copyrights, trade marks,
leases, contracts and licences as so shown or ascertained

and the amount, if any, by which the value of any of such
assets has been written up within a period of three years prior
to the date of such balance sheet.

(4) Where any liability of the company is secured otherwise

than by operation of law or any assets of the company the balance
sheet shall include a statement that that liability is so secured,
but it is not necessary to Specify in the balance sheet the assets
on which the liability is secured.

(5) Where any of the assets of a company consist of shares in,

or amounts owing, whether on account of a loan or otherwise,
from a subsidiary company or subsidiary companies, the aggregate
amount of those assets, distinguishing shares and indebtedness,
shall be set out in the balance sheet of the first mentioned company
separately from all its other assets, and where a company is
indebted, whether on account of loan or otherwise, to a subsidiary
company or subsidiary companies , the aggregate amount of that
indebtedness shall be set out in the balance sheet of that company
separately from all its other liabilities, but this subsection does
not apply to a balance sheet in which the assets and liabilities

of such subsidiary company or subsidiary companies are con-
solidated with the assets and liabilities of the first mentioned
company. 1934, c. 33, 5.112; 1935, c. 55, s. 17.

Section 117 (1) In the case of a company, not being a private
company, the statement of income and expenditure to be submitted
at the annual meeting shall, subject to the provisions of this
section, show as a separate item the total of the amount paid to
the directors as remuneration for their services as such directors,
inclusive of all fees, percentages, or other emoluments, paid

to or receivable by them by or from the company or by or from
any subsidiary company, exclusive of the amounts paid to a
managing director, if any, or any other director who holds any
salaried employment or office in the company and who devotes
substantially the whole of his time to the business of the company
or its subsidiaries .

141

(2) The said statement of income and expenditure shall show
separately net operating profit before depreciation, obsoles-
cence and depletion and income taxes; income from investments;
non-recurring profits and losses including profits and losses

of a special nature; amounts written off for depreciation,
obsolescence and depletion; amount, if any, written off for
goodwill or amortization of any asset; interest on funded or
other indebtedness not maturing within one year; reserve for
income taxes imposed by any taxing authority in Canada;
balance showing net profit or loss for the financial period, but
where depreciation, obsolescence and depletion are charged
against manufacturing or operating costs by the company in its
accounts , net operating profit may be shown after depreciation,
obsolescence and depletion, if the amount charged in reSpect
of those items for the financial period is shown as a footnote to
the statement of income and expenditure. 1934, c. 33, s. 113;
1935, c. 55, s. 18.

The Corporation Act, Ontario.

 

Section 82 (1) The auditor shall make such examination as will
enable him to report to the shareholders as required under
subsection 2.

(2) The auditor shall make a report to the shareholders on the
financial statement to be laid before the company at any annual
meeting during his term of office and shall state in his report
whether in his opinion the financial statement referred to therein
presents fairly the financial position of the company and the
results of its operations for the period under review.

(3) The auditor in his report shall make such statements as he
considers necessary,

(a) if the company's financial statement is not in agreement with
the accounting records;

(b) if the company's financial statement is not in accordance
with the requirements of this Act;

(e) if he has not received all the information and explanations
that he has required; or

(d) if proper accounting records have not been kept, so far
as appears from his examination.

Section 83 (l) The directors shall lay before each annual meeting
of shareholders,

142

(a) a financial statement for the period commencing on the date
Of incorporation and ending not more than six months before such
annual meeting, or commencing immediately after the period
covered by the previous financial statement and ending not more
than six months before such annual meeting, as the case may be,
made up of,

(i) a statement of proﬁt and loss for such period,
(ii) a statement of surplus for such period,

(iii) a balance sheet made up to the end of such period;
(b) the report of the auditor to the shareholders;

(e) such further information respecting the financial position
of the company as the letters patent, supplementary letters
patent or by-laws of the company require.

(2) The statements referred to in subclauses i, ii and iii of clause
(a) of subsection 1 shall comply with and be governed by sections 84
to 88, but it shall not be necessary to designate them the statement
of profit and loss, statement of surplus and balance sheet.

(3) The report of the auditor to the shareholders shall be read at
the annual meeting and shall be Open to inspection by any share-
holder. 1953, c.19, s. 83.

Section 84 (1) Every statement of profit and loss to be laid before
an annual meeting shall be drawn up so as to present fairly the
results of the Operations Of the company for the period covered
by the statement and so as to distinguish severally at least,

(a) the Operating profit or loss before including or providing
for other items Of income or expense that are required to be
shown separately;

(b) income from investments in subsidiaries whose financial
statements are not consolidated with those of the company;

(c) income from investments in affiliated companies other than
subsidiaries;

((1) income from other investments;

(e) non-recurring profits and losses of significant amount includ-
ing profits or losses on the disposal Of capital assets and other
items of a special nature to the extent that they are not shown sepa-
rately in the statement of earned surplus;

l.

143

(f) provision for depreciation or obsolescence or depletion;

(g) amounts written Off for goodwill or amortization of any other
intangible assets to the extent that they are not shown separately
in the statement of earned surplus;

(h) interest onindebtedness initially incurred for a term of more
than one year, including amortization of debt discount or premium
and expense;

(i) total remuneration of directors as such from the company
and subsidiaries whose financial statements are consolidated
with those of the company, including all salaries, bonuses, fees,
contributions to pension funds and other emoluments;

(j) taxes on income imposed by any taxing authority and shall
show the net profit or loss for the financial period.

(2) Notwithstanding subsection l,items of the natures described
in clauses f, g, and i of subsectionl may be shown by way of note
to the statement of profit and loss. 1953, c. 19, s . 84.

Section 85 (1) Every statement of surplus shall be drawn up so as
to present fairly the transactions reflected in such statement and
shall show separately a statement of contributed surplus and a
statement of earned surplus .

(2) Every statement Of contributed surplus shall be drawn up so
as to include and distinguish the following items:

1. The balance of such surplus at the end of the preceding
financial period .

2 . The additions to and deductions from such surplus during
the financial period including,

(a) the amount Of surplus arising from the issue of shares or
the reorganization Of the company's issued capital, including
inter alia,

(i) the amount Of premiums received on the issue Of shares at
a premium,

(ii) the amount Of surplus realized on the purchase for cancellation
of shares; and

(b) donations Of cash or other property by shareholders .

(3) Every statement of earned surplus shall be drawn up so as to
distinguish at least the following items:

The balance of such surplus at the end of the preceding fin-
ancial period.

2.

(i)

144

The additions to and deductions from such surplus during the
financial period and without restricting the generality Of the
foregoing at least the following:

The amount of the net proﬁt or loss for the financial period.

(ii) The amount of dividends declared on each class of shares.

(iii) The amount transferred to or from reserves.

3.

The balance of such surplus at the end Of the financial period.
1953, c. 19, s. 85.

Section 86 . (1) Every balance sheet to be laid before an annual
meeting shall be drawn up so as to present fairly the financial
position of the company as at the date to which it is made up and
so to distinguish severally at least the following:

1.

2.

Cash.

Debts owing to the company from its directors, officers or
shareholders, except debts Of reasonable amount arising in
the ordinary course of the company's business that are not

overdue having regard to the company's ordinary terms of

credit.

Debts owing to the company, whether on account of a loan or
otherwise, from subsidiaries whose financial statements are
not consolidated with those Of the company.

Debts owing to the company, whether on account of a loan or
otherwise, from affiliated companies other than subsidiaries.

Other debts owing to the company, segregating those that arose
otherwise than in the ordinary course of the company's business .

Inventory, stating the basis of valuation.

Shares , bonds, debentures and other investments owned by the
company, except those referred to in items 8 and 9, stating
their nature and the basis of valuation thereof and showing
separately such as are marketable with a notation of their
market value .

Shares or securities Of subsidiaries, stating the basis Of valuation.

Shares or securities Of affiliated companies other than subsid-
iaries, stating the basis of valuation.

Lands, buildings, and plant and equipment stating the basis of
valuation, whether cost or otherwise, and if valued on the basis
Of an appraisal, the date of appraisal, the name of the appraiser,

ll.

12.

13.

14.

15.

l6.

17.

18.

19.

20.

145

the basis Of the appraisal value and the diSposition in the
accounts Of the company of any amounts added to or deducted
from such assets on appraisal after the 30th day of April,
1954, and also the amount or amounts accumulated in respect
of depreciation, Obsolescence and depletion.

There shall be stated under separate headings, in so far as
they are not written Off, (i) expenditures on account of future
business; (ii) any expense incurred in connection with any
issue of shares; (iii) any expense incurred in connection with
any issue of securities, including any discount thereon; and
(iv) any one or more of the following: goodwill, franchises,
patents, copyrights, trade marks and other intangible assets
and the amount, if any, by which the value Of any such assets
has been written up after the 30th day of April, 1954.

The aggregate amount of any outstanding loans under clauses
c, d, and e of subsection 2 of section 23.

Bank loans and overdrafts.

Debts owing by the company on loans from its directors,
Officers or shareholders.

Debts owing by the company to subsidiaries whether on account
of a loan or otherwise.

Debts owing by the company to affiliated companies other than
subsidiaries whether on account of a loan or otherwise.

Other debts owing by the company, segregating those that arose
otherwise than in the ordinary course of the company's business .

Liability for taxes, including the estimated liability for taxes
in respect of the income Of the period covered by the statement
of profit and loss.

Dividends declared but not paid.

Deferred income .

21. Securities issued by the company, stating the interest rate,

22.

the maturity date, the amount outstanding and the existence of
sinking fund, redemption requirements and conversion rights,
if any.

The authorized capital, giving the number of each class of

shares, and a brief description of each such class and indi-
cating therein any class of shares which is redeemable and

the redemption price thereof.

146

23. The issued capital, giving the number of shares of each
class issued and outstanding and the amount received
there-for that is attributable to capital, and showing,

(a) the number of shares of each class issued since the date

Of the last balance sheet and the value attributed thereto
distinguishing shares issued for cash, shares issued for services
and shares issued for other consideration; and

(b) where any shares have not been fully paid,

(i) the number of shares in respect of which calls have not been
made and the aggregate amount that has not been called, and

(ii) the number Of shares in reSpect Of which calls have been
made and not paid and the aggregate amount that has been called
and not paid.

24 . Contributed surplus .
25. Earned surplus.

26 . Reserves , showing the amounts added thereto and the amounts
deducted therefrom during the ﬁnancial period.

(2) Explanatory information or particulars of any item mentioned
in subsection 1 may be shown by way Of note to the balance sheet.
1953, 0.19, s. 86; 1954, 0.14, s. 15.

Section 87 . (1) There shall be stated by way of note to the fin—
ancial statement particulars Of any change in accounting principle
or practice or in the method Of applying any accounting principle
or practice made during the period covered that affects the
comparability of any Of the statements with any Of those for the
preceding period, and the effect, if material, Of any such change
upon the profit or loss for the period.

(2) Where applicable, the following matters shall be referred to
in the financial statement or by way of note thereto;

1. The basis Of conversion of amounts from currencies other than
the currency in which the ﬁnancial statement is expressed.

2 . Foreign currency restrictions that affect the assets Of the
company.

3 . Contractual Obligations that will require abnormal expendi-
tures in relation to the company's normal business require-
ments or financial position or that are likely to involve
losses not provided for in the accounts.

4. Material contractual obligations in respect of long term leases,

147

including, in the year in which the transaction was effected,
the principal details of any sale and lease transaction.

Contingent liabilities, stating their nature and, where prac-
ticable, the approximate amounts involved.

Any liability secured otherwise than by Operation of law on
any asset of the company, stating the liability so secured,
but it is not necessary to Specify the asset on which the
liability is secured.

. Any default of the company in principal, interest, sinking

fund or redemption provisions with respect to any issue of
its securities or credit agreements .

. The gross amount of arrears of dividends on any class of

shares and the date to which such dividends were last paid.

. Where a company has contracted to issue shares or has given

10.

ll.

12.

13.

an Option to purchase shares, the class and number of shares
affected, the price and the date for issue of the shares or
exercise of the Option.

The total remuneration of directors as such Of a holding
company from subsidiaries whose financial statements are
not consolidated with those Of the holding company, including
all salaries , bonuses, fees, contributions to pension funds,
and other emoluments.

In the case of a holding company, the aggregate of any shares
in, and the aggregate of any securities of, the holding company
held by subsidiary companies whose financial statements are
not consolidated with that Of the holding company.

The amount of any loans by the company, or by a subsidiary
company, otherwise than in the ordinary course of business,
during the company's financial period, to the directors or
officers of the company.

Any restriction by the letters patent, supplementary letters
patent or by-laws of the company or by contract on the pay-
ment of dividends that is significant in the light Of the company's
financial position.

(3) Every note to a ﬁnancial statement is a part of it. 1953, c. 19,
s . 87 .

Section 88. Notwithstanding sections 84 to 87, it is not necessary
tO state in a financial statement any matter that in all the circum-
stances is Of relative insignificance. 1953, c. 19, s. 88.

148
Evaluation of Disclosure Provisions

Compliance with the legal provisions of both Acts produces
something less than "full disclosure Of material facts. " The provisions in
fact may have served as guides to companies and auditors as to what is to be
disclosed and the form of disclosure. The legalistic view of showing only what
the law spelled out has resulted in corporate reporting which: (1) does not
meet the minimum recommended standards of the Canadian Institute of
Chartered Accountants; (2) reporting which is not consistent with accepted
accounting theory, and; (3) reporting which confuses rather than enlightens
investors. In support Of the above allegations, an analysis of published
annual reports of Canadian companies, whose securities are not only listed
on Canadian stock exchanges, but in some cases listed on the American stock
exchanges, is presented below.

United Grain Growers Limited

 

The company's statement of consolidated earnings for the year
ended July 31, 1961, is an example of reporting which meets only the minimum
disclosure required by law. The company fails to meet the recommendation
Of the Canadian Institute Of Chartered Accountants by not disclosing sales
and cost Of sales for the year. This is the major and most common weakness,
from the disclosure point of view of reporting by Canadian corporations. Of
the three hundred 1960 published annual reports of Canadian corporations
included in the Canadian Institute's study, 210 corporations did not report

sales ﬁgures. 5

 

5 The Committee on Accounting and Auditing Research. Financial

Reporting in Canada , Fourth Ed. , (Toronto: The Canadian Institute of
Chartered Accountants, 1961), p. 61.

 

149
This is a striking contrast with the 98 percent disclosure Of sales by the 600

United States Corporations included in the 1960 edition of Accounting

 

Trends and Techniques. 6

 

In the Consolidated Balance Sheet Of July31, 1961, the company
includes under "Reserves" which are shown above the shareholders' equity
the following:7

Reserves For
Deferred taxes on income $ 2,715,000
Contingencies and self-insurance 1, 500, 000 $ 4, 215, 000

In the shareholders' Equity section Of the statement, the company shows: 8

General Reserve $ 3, 000, 000
Capital Surplus 170, 458
Earned Surplus 4, 212,760 $ 12, 197, 318

In the explanatory notes the following appears:

The reserves for contingencies and self-insurance increased
during the year by $600, 000 to the level of $1,500, 000. Of
this $100,000 was provided out of earnings for self-insurance,
following precedent established for the past two years.

In addition, $500, 000 was transferred to this item for con-
tingencies from the earned surplus account, as already
noted, after that account had been augmented by more than
$1 million from an insurance recovery during the past year. 9

In another section of the report the company states:

. . . The practice was begun in 1958 Of making annual
apprOpriations from earnings to an insurance reserve so
that when this reaches an adequate amount the company may
be in a position to assume a portion of the insurance cover-
age on country properties. 10

 

6112111.. 1). 61-
7 United Grain Growers Limited, Annual Report, 1961, p. 31.

Snow... p. 31
9.1.1219... p. 11

101bid. , p. 5_6

 

150

The apprOpriateness Of "reserves" or apprOpriations Of retained earnings
was discussed in a prior chapter, attention here is focused on the position
of the item "Reserve for contingencies and self—insurance" in the Balance
Sheet. The "reserve" is an appropriation of "Earned Surplus" and is
identical to "General Reserve" and should be shown as part of the share-
holders' equity. In connection with the "reserve" the explanation "the
company may be in a position to assume a portion Of the insurance cover-
age on country prOperties" confuses rather than clariﬁes the nature of the
item. The phrase implies a segregation Of assets for the purpose Of self-
insurance; no such segregation appears on the asset side of the Balance
Sheet. Insurance shifts burden of risk Of loss to others; with self-
insurance there is no shifting Of risk of loss to anyone, the company itself
assumes all risk, therefore, self-insurance is no insurance.
Dominion Tar and Chemical Company Limited

In the Consolidated Balance Sheet as of December 31, 1960,
which does not contain the name of the company in the heading, the company
shows in the section captioned "Capital" the following: 11

Surplus resulting from restatement (1960) (1959)
of certain fixed assets - Note 5 $13,900, 011 $11, 093,731

Note 5 states:12
Excess of restated depreciated value over depreciated
book value of certain fixed assets (unchanged during year). . . $15, 141,969
Net excess of consideration for acquisition of shares Of
subsidiaries over book value Of net assets (after net

decrease Of $2,806, 280 during 1960). . . __1, 241, 958
$15900, 011

11 Dominion Tar 8: Chemical Company Limited, Annual Reporg, 1960, p. 5.
12Ibid. , p. 7.

151
The company fails to reconcile the amount $11,093,731 shown in 1959 and
$13,900,011 shown in 1960.

In the Consolidated Statement Of Profit and Loss and Earned Surplus,
the company shows the "cost of sales including selling, general and adminis-
trative expenses" as one figure. However, more important from an accoun-
ting theory vieWpoint is the deduction in the "Earned Surplus" section Of
$675, 000 which represents discounts on issue of debentures. The discount
on the debentures is an adjustment between the market rate Of interest and
the coupon rate of interest and should be amortized over the life of the deben-
tures. The unamortized portion of the discount should be shown as a
deduction from the related liability. Writing the discount against "Earned
Surplus" at the time Of issuance of the related debentures has a bearing on the
determination Of future income. During the life of the debentures the income
of the corporation will be overstated in each period by the amount of discount
applicable to the period.

Canadian Celanese Limited

 

The company shows "proﬁt on sale of securities other than Govern-
ment Bonds" and "Gain on realization Of investment in subsidiary companies"
in the statement of Earned Surplus for the year ended December 31, 1960,
while "Profit on sale Of Government Bonds" is shown in the statement Of
Income and Expenditure for the year ended December 31, 1960. NO expla—
nation is presented for the inconsistent treatment of the items. In the com-
pany's statement Of Income and Expenditure, referred to above, only the
minimum disclosure required by law is given. NO sales or cost Of sales

ﬁgures are disclosed.

152
Consolidated Mining and Smelting Compagy Of Canada Limited

In the Consolidated Balance Sheet Of December 31, 1960, and
in previous Balance Sheets the following appears on the asset side:13

Investments and Non-Current Assets:

Unconsolidated subsidiary companies: (1960) (1959)
Shares $12,290,036 $10,633,307
Bonds 48 , 600 709 , 960
Advances 2, 955,922 3, 629,439

 

 

$15,294,558 $14,972,706
Less accumulated depreciation of

investments in unconsolidated sub-

sidiary mining companies 5, 577, 315 5,577,315

$9, 717, 243 $ 9, 395, 391
No explanation as to how the "accumulated depreciation of in-

vestments" was determined is contained in the report or what the item repre-
sents. The word "depreciation" is usually associated with physical assets

in accounting.

As Of December 31, 1957 the company carried in the accounts
$87 , 000, 000 designated as "Appropriated Surplus" and $48, 043, 613 des-
ignated as "Unappropriated Surplus" In 1958, $7, 000, 000 was transferred
from "ApprOpriated Surplus" to "Unappropriated Surplus" and in 1960,
$11, 000, 000 was transferred from "Unappropriated Surplus" to "Approp-
riated Surplus In a letter dated April 21, 1959 from the Vice-President
and Controller of the company, the following explanation appears:

. . . We are aware that this distinction is not too common.
However, as you may know, it has been the policy of our
Company to ﬁnance expansion out of retained earnings.

Consequently, that portion of surplus invested in the Company's
undertakings is not presently available for dividends, and we

 

13 The Consolidated Mining and Smelting Company of Canada Limited,
Annual Report, 1960, p. 10.

 

153

feel that it is logical and more informative to bring out
this fact.

In the Consolidated Balance Sheet of December 31, 1959, the
following appears between the liability and shareholders' equity sections

of the statement: 14

Reserves: (1959) (1958)
Insurance $3, 929, 381 $3, 921, 432
Accumulated tax reductions

applicable to future years 80, 000 380, 000

$4, 009, 381 $4, 301, 432
In the 1960 Balance Sheet the "Insurance reserve" is shown in the share-
holders' equity section of the statement where it rightly belongs.
In addition to the items cited the company disregarded the

accepted form of the Profit and Loss statement as shown below:

Consolidated Statement at Profit and loss

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14 The Consolidated Mining and Smelting Company Of Canada Limited,
Annual Report 1959, p. 9.

154

The company is to be commended for altering the presentation of the Proﬁt
and Loss Statement in 1960. The excellence of presentation Of revenue and
expense data ranks with the best of published reports and discloses much
more than is required by law.

Although the company has more than met the legal requirements
of disclosure, the lack of explanatory notes with regard to the "accumulated
depreciation Of investments, " (2) "manipulation" Of the "apprOpriated surplus"
and "unappropriated surplus" accounts; and the form of statements prior to

1960 leave much to be desired from the users Of the annual reports.

Blue Crown Petroleums Ltd.

 

The company's Balance Sheet as Of April 30, 1960, appears on
the following page.

The company's leases, producing wells and equipment were
written up by $955,480 representing approximately a five-fold write—up.
Writing up of the assets to the new higher values, at a time when the company
is experiencing losses totaling $1, 225,842, appears to be a "device" used by
the company to "hide" the impairment of "legal capital" that has taken place.
In the absence of the revaluation of assets the "legal capital" and the share-
holders' equity would be reduced to $396, 535.

Although the auditors qualify the report with Specific reference
to the write-up, the fact that a five-fold write-up of assets is permitted tO
be incorporated in the published statements may well raise questions as to

whether the write-up was designed to obscure the facts Of the situation.

155

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156

Dominion Stores Limited
In the 1957 report the president states:15
Your management has continued its policy of selling

store properties when deve10ped and taking back long

term leases. The co-operation of leading life insurance

companies in this reSpect has been most gratifying and

your Company has commitments from these institutions

for the purchase of store properties of approximately

$10,000,000.
In the Balance Sheet and in the accompanying notes to financial statements
the company fails to disclose the amount of the commitments under sale
and lease back arrangements. In the Income Statement, the company
fails to disclose separately the amount of the rental expense for the current
period.

The failure to disclose a commitment (liability) when the amount
is substantial as is the case, is a typical weakness of most Canadian com-
panies with regard to reporting contractual lease liabilities. Although the
commitments may be a fixed amount plus a percentage of sales, therefore
not determinable; disclosure of the fixed amount of the commitments and
the duration of the leases should be the minimum requirement.

In the 1960 report the president stated:

In the ordinary course of its business, the Company has
entered into long—term leases for store properties. The

total minimum lease liability under leases extending beyond
five years is $47,978,000. 16

 

15Dominion Stores Limited, Annual Report, 1957, p. 4.

 

16Dominion Stores Limited, Annual Report, 1960, p. 4.

 

157
Although the company has made an attempt to disclose obligations
under leases, the statement is not clear as to whether all lease obligations
are included or just the leases which do not expire within five years. The
disclosure appears to be only partial. With the exceptions noted above,
the company's report furnishes much data to aid analysis such as compa-
rative statements and source and application of funds statements.

The reports considered above are, in general, superior in their
disclosure to most published reports in Canada. The analysis of these
reports does, however, indicate: (1) that disclosure of corporate activity in
Canada does not meet the recommended standards of the Canadian Institute
of Chartered Accountants; (2) reporting which is not consistent with accep-
ted accounting theory, and; (3) reporting which shows a curious lack of concern,
on the part of management, of the fact that the reports are to provide adequate

data for investors and other interested parties.

With regard to meeting the legal requirements of disclosure, the
following excerpt from an editorial sums up the situation:
Perhaps the remarkable thing is not the poor standard of

reporting, but the relatively high standard. . . in regard to
our horse-and—buggy company laws. 17

Summary

In Canada, auditors are "employees" of the shareholders and, as
such, have an inherent duty to protect the interests of their "employers."

To the extent that they, the accountants, fail in their duties, legislation is

#

17Editorial, The Financial Post, February 24, 1962, p. l.

 

158
necessary to assure a minimum standard of disclosure. Voluntary measures
taken to insure disclosure are much to be favoured over legislation. Provi-
sions in the statutes are relatively static and tend to be too rigid or too
loose and hamper the process of development in accounting. On the sub-
ject, Marquis G. Eaton states:18

It would be a great misfortune for American business, and

the whole economy, if uniform accounting rules were to be
prescribed by government fiat. It would probably mean the
end of progress.

Disclosure is relative to the times and must be dynamic in a
changing society. In order to be dynamic, the minimum legislative pro-
vision that is desirable should read: "Disclosure of corporate activity is
to conform to the standards as set out by the Canadian Institute of Chartered
Accountants. " This is consistent with the view expressed by the Chief
Accountant of the Securities and Exchange Commission of the United States
Andrew Barr states:

. Regulation S-X does not purport to define accounting
principles. It describes the extent of the detailed information
required in conventional terminology consistent with present
accounting practice. 19

The role of the Securities andExchange Commission is to continue to exert

pressure on the accounting profession to adopt uniform reporting practices

 

18Marquis G. Eaton, Financial onrtingln a Changing Society, an
address delivered before the Illinois Society of Certified Public Accountants
June 7, 1957, (New York: American Institute of Certified Public Accountants,
1957), p. 4.

 

19Andrew Barr, "Canadian Accounting and the Securities and Exchange
Commission," The Canadian Chartered Accountant, LXXIII (November, 1958),
p. 428.

 

159
recommended by recognized accounting associations. The role of corporate
legislation should be the same e. i. , oversee accounting practices in order

that the recommended standards of the profession are met.

Iinplementation of the above recommendation would firmly esta-
blish that the accountant is an "employee" of the shareholders and as such
is responsible for the disclosure of corporate activity to the "employer. "
In practice, however, the accountant is not as independent from corporate
pressures as would be desirable and a firmer provision is necessary.

The addition to the above provision of "and must meet the minimum stan-
dards of disclosure required by a prudent investor" is necessary. The
"prudent man" rule governing judiciary investments is ﬁrmly established
and the above provision should lead to the deve10pment of a set of stan-
dards for corporate reporting by "moral suasion" rather than by
legislation. Good accounting cannot be legislated, it must be practiced.

There are really no foolproof rules that can be set forth in law
to insure full disclosure; accountants must use their own good judgment,
remembering always to act prudently. What is prudent? That is for
the court to determine in any particular situation using as a criterion
the court‘s own conception of what financial information about a given
corporation a careful, conservative, and competent investor would
require in the circumstances given. The prudent rule would serve as

the accountant's conscience, insuring adequate disclosure relative to

the time and circumstances.

CHAPTER VII

CONCLUSION

Corporate statutes serve a dual purpose. .IFirst the statutes serve as
enabling legislation for individuals to use the corporate device for the conduct
of business, and second, to regulate the corporations to the extent necessary
for the maintenance of the respective rights of those who supply the capital

for the corporate venture and any others whose rights are affected.

An underlying philosophy of the corporate statutes should be the
protection of the rights and interest of investors. The statutes give "life" to
the corporation and endow the corporation with certain rights. Among these
rights is that the corporation is legally an entity apart from the creditors and
owners who have provided the capital with which the corporate unit operates.
Because of this incidence of separation of entity, thorough reporting of
stewardship becomes imperative if the rights and interests of the suppliers
of capital are to be maintained. The corporation is a "child" of the state,
therefore, the corporate statutes should be predicated on accountability to those
who underwrite the capital needs of the corporate entity. Since accountability
is to the suppliers of capital, the statutes should insure that accountability be
rendered in the "language" of the suppliers of capital and not in a professional
"jargon. "

To accomplish the desired accountability the goals of the Acts set out
160

161

in Chapter I must be attained. To fulfill the goals cited, legal requirements

relating to the capital of the corporation, to the corporate surplus and to cor-

porate distributions should be redefined to coincide with sound accounting theo'ry.

Disclosure of corporate activity should be redeﬁned by the statutes to require

not only conformance to sound accounting theory but also to meet the minimum

standards of disclosure required by a prudent investor relative to the times.

The following proposals are set forth as the most desirable to be

embodied in the corporate statutes:

The Corporate Capit a1

 

A

Stated (legal) capital of the corporation should represent the cost
(fair value) of all assets received for the benefit of shareholders
other than the reinvested earnings which have not been "Capital-
ized. " The sources of stated capital would usually be from share-
holders as consideration for shares of the corporation, from gifts
or donations to the corporation, and from profitable operation of
the enterprise to the extent of retained earnings capitalized.

(1) Where assets received by the corporation are in a form other
than cash, the fair market value of assets at time of receipt
should be the basis of the credit to stated capital.

(2) When debt securities are converted into shares of the company,
the stated capital increase should be measured by the "book value"
of debt securities converted on the date of conversion.

(3) Transfers from retained earnings should be permitted only
to stated capital. Whether the transfers are accompanied by
share issue is of no consequence.

(4) Since indication of the sources of stated capital is usually
desirable, disclosure should be accomplished in the share-
holders' equity section of the "Balance Sheet" as follows:

Stated Capital:

Invested by shareholders XXX
Donations to the corporation XXX
Capitalized retained earnings XXX XXX

E

162~

Where a company has more than one class of shares outstanding,
the stated capital attributable to each class should be the total
consideration received for the outstanding shares of the class.

Reduction of stated capital should be permitted where approval
is obtained from the creditors and shareholders.

Adoption of the above proposals would eliminate any need for
par or stated value for shares and therefore all shares should
be designated as no par shares.

All companies, regardless of when incorporated and when the
shares were issued should be required to comply with updated
provisions with regard to stated capital, surplus as well as
all other provisions which may have been changed.

The Corporate Su rplus

 

A

The corporate surplus should represent the balance of
accumulated net earnings reinvested in the enterprise.

(1) Additions to the amount would normally result only from
the profitable operation of the enterprise.

(2) Reductions of the amount would result from asset distri-
butions to shareholders and transfers to stated capital.

If the corporate surplus is negative (deficit), the amount
should be carried on the books and shown as a deduction from
stated capital in the "Balance Sheet. " Elimination of the
deficit should be accomplished only through future profitable
operation or through the formal reduction of stated capital by
an amount equal to the deficit.

Corporate Distributions to Shareholders

 

A

Corporate distributions of assets to shareholders should be
identified as to the nature of the distribution.

(1) Distribution of assets representing a division of earnings
should be referred to as dividends. A dividend therefore
could not exceed the accumulated retained earnings.

(2) Distribution of assets representing a reduction of stated
capital should not be referred to as dividends, but should be
identified as return of the "permanent" investment.

163

"Stock Dividends" are not distributions of assets and should
not be referred to as "dividends. " "Stock Dividends" repre—
sent a pro-rata issuance of shares to shareholders without
consideration accompanied by a transfer from retained ear-
nings to stated capital. "Stock Dividends" should be referred
to as stock—splits accompanied by a transfer from retained
earnings. The amount of the transfer should be left to the
discretion of management.

Distributions to shareholders should be prohibited if the
distributions will dissipate the assets of the corporation
to a level injurious to the rights and claims of creditors.
Specifically, distributions should be prohibited if (1) the
corporation is unable to meet the claims of the creditors
as these claims become due, and (2) if as a result of the
distribution the assets will decrease to an amount which
is exceeded by total liabilities.

Corporate Combinations

A

Corporate combinations should be accounted for as purchases.

(1) In situations where all but one of the combining corporations
disappear, the combination should be regarded as an acquisition
by the surviving corporation. Assets acquired by the surviving
corporation should be recorded at the bargained value regard-
less of whether the consideration for the assets was cash, debt
securities, or ownership securities of the surviving corporation.

(2) In situations where all of the combining corporations
disappear, the new corporation acquires the assets of the
disappearing corporations. Assets acquired by the new cor-
poration are recorded at cost, which is fair value.

Carry-over of "surplus" or deficit from the disappearing
individual companies to the surviving or to the new corporation
should be prohibited.

Disclosure of Corporate Activity

A

Encouragement of voluntary measures to insure disclosure are
much to be favoured over legislation. Recourse to legislated
provisions should be taken only when voluntary measures have
failed. Disclosure must be relative to the times in a dynamic
economy and legislated provisions are relatively static.

164

Standards of disclosure recommended by recognized accounting
bodies are current and constantly under review and should serve
as the basis for disclosure of corporate activity.

Recognition of the rights of investors should be made by a
provision in the statutes stating that disclosure of corporate
activity meet the minimum standards of a prudent investor.
This provision would strengthen disclosure requirements in
that the "invisible hand" of the courts would be a constant
"guide" to accountants and management to report the activity
of the corporation in a responsible manner. This provision
would not delegate the setting of accounting standards by legal
authority as may be feared. The fact that most states where
"legal lists" for trust investments were enforced are switching
to the prudent man rule should be sufficient proof that the
courts are not in favour of specific inflexible rules.

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