Accounting Principles - Funds and Reserves

Financial Accounting > Relationship of Funds and Reserves

The word fund as used herein is intended to be representative of a special fund; one which has been set aside out of the general assets to be devoted to some specific use. The reserve in question must have been created out of proprietorship. The discussion revolves very largely around the question of whether, in practice, one is essential to the other.

If in institutional or municipal organizations certain receipts, for example, donations for laboratory equipment in a school of chemistry, or the receipts of certain fines in the municipal courts, were to be set aside and devoted solely to the purposes specified, there would be no question about the necessity for crediting a reserve, every time the fund was debited. This would be necessary in order that the fund might be controlled and its use restricted.

If in an industrial corporation the employees should contribute jointly with the management to a fund for pensioning aged and injured employees, which fund was to be carried as an account on the books of the corporation there would be no question about the propriety of making similar entries. The corporation becomes practically a trustee for the fund and is not entitled to show the fund as an asset which in part represents proprietorship. The corporation is accountable to its employees for the fund and therefore must set up a reserve to protect it.

On the other hand, suppose that the mortgage securing an issue of corporate bonds states that “there shall be set aside annually, out of profits, the sum of fifty thousand dollars ($50,000) to retire said bonds at maturity,” then two questions arise. The first one is, just what the clause says; the second, is what it means.

Profits are understood to mean the excess of income over expense. They are shown by nominal accounts which measure through a summary called the profit and loss account the extent to which the assets collectively have increased. That portion of the assets which corresponds to profit cannot be identified as such, as a rule, although the profit is indisputably vested in the assets. Thus it may be reasoned that disbursements cannot be made out of profits; they may be made out of cash in amounts equal to certain measurements of profit. Obviously such a clause must have been drawn by someone unfamiliar with technical accounting expressions.

To determine the meaning of the clause is perhaps more difficult than to decide just what it says. Is it the intention to provide for a sinking fund, or a reserve, or both? It appears as if the only satisfactory manner of settling this question would be to ask the man who prepared the mortgage containing said clause.
For the purpose of discussion the question may be asked, “What would be the effect of either or both of these provisions upon the parties in interest?” Such parties are the bondholders and the corporation.
The object of a sinking fund is to provide the cash necessary to redeem at maturity certain bonds outstanding. The bondholder is interested, not in whether he is paid out of profits or otherwise, but in receiving cash for the bonds which he holds. He is willing to accept nothing else, as a rule.

The mere creation of a reserve in this case does not produce the cash necessary to pay the bondholder. It limits or restricts the free equity of proprietorship in the assets. Regardless of the object, the effect is that of reducing the profits available for distribution as dividends or addition to proprietorship.
During the accumulation of the fund the profits are made to suffer annually to the extent of the deposit. The reserve increases as the fund accumulates. Finally, as the fund equals the indebtedness and the bonds are redeemed, the reserve is released and reverts to surplus or proprietorship. Apparently the stockholders are deprived of these profits until the bonds have been paid off.

One of the most striking illustrations of the application of the sinking fund principle is that of a mine. The land is purchased for the mineral which it contains. The location of the land, or character of its surface, many times prevents its use for anything after the mineral has been extracted. The buildings, machinery and shaft equipment are practically worthless after the mine is exhausted. The stock in trade is the mineral. If capital is invested in the mineral and the mineral is sold care must be taken that the proceeds are not erroneously considered as representing profits entirely. No merchant will consider that, having sold an article for fifteen dollars which cost ten, he has made fifteen dollars. No mining concern should consider the mineral which is extracted as being pure profit. There is usually an element of cost and if the cost is not reckoned with depleted capital will result. If the capital is contributed, the stockholders may be surprised to learn that the apparently excessive dividends have been made up in part of capital which was being returned to them. If the capital is borrowed and, for example, secured by a mortgage on the property, the bondholders may find that while during the life of the bond they have been receiving the interest regularly, at maturity the company defaults on the principal, and the property, on which the mortgage was a specific lien, has dwindled into so much earth without any value.

The variation in effect of the above mentioned methods of procedure may be seen in three propositions based on practically the same hypothetical case. The case is as follows:

The Lawtimer Coal Company with a paid in capital of $25,000 represented by capital stock, purchased a tract of coal land for $100,000. The land was paid for with $25,000 in cash and an issue of 6% twenty-year bonds, secured by a mortgage on the land, amounting to $75,000. The land was estimated to yield and did yield 50,000 tons of coal.

The first proposition assumes that:
a. The mortgage made no provision for a sinking fund.
b. Fifty thousand (50,000) tons of coal were sold at
five dollars ($5.00) a ton.
c. The expenses of operation for the period of twenty
years amounted to $35,000.
d. The profit after deducting $90,000 for interest on the
bonds was distributed as dividends.
e. At the maturity of the bonds there was a balance of
$100,000 in accounts receivable.

The yield of the mine was 50,000 tons. The cost per ton was accordingly $2.00 per ton. The cost of sales was made up of 50,000 tons at $2.00 per ton, or $100,000. The depletion, as the charge was made to cost of sales, gradually reduced the cost of land until at maturity it was entirely wiped out. The position of the company at the end of the period is no worse than at the beginning. The cost of land at $100,000 at the beginning has been replaced by accounts receivable in the same amount. The position of the bondholders is not so favorable. At the beginning the bonds were secured by a mortgage on the land which contained, as subsequently developed, coal which sold for $250,000. At the end the bonds are still secured as to payment of principal by a mortgage on the land, but the valuable contents of the land have been removed. The specific property upon which the mortgage operated as a lien has been stripped of its value. The desire of the company to redeem the bonds may be above question. The ability to do so is hampered by lack of cash. The bondholders are at the mercy of the company.

The second proposition assumes that:
«. The mortgage provides for a sinking fund of $1.50 a ton.
b. Fifty thousand (50,000) tons of coal were sold at five
dollars ($5.00) a ton.
c. The expenses of operation for the period of twenty
years amounted to $35,000.
d. The profit after deducting $90,000 for interest on
bonds was distributed as dividends.
e. At the maturity of the bonds there was a balance of
$100,000 in accounts receivable. /. The company had borrowed on notes payable and was still owing at the maturity of the bonds, $75,000.
The skeleton ledger accounts setting forth the transactions under this proposition follow:
Cost of Land Bonds Outstanding
$100,000 $100,000

The situation as represented by the above balance sheet is, it will be noted, decidedly more favorable to the bondholders. The land has disappeared, the same as in the first case, but so much of it as represented borrowed capital has been replaced by a sinking fund. This fund the company is bound by the provision of the mortgage to devote to the retirement of the bonds.

The company is as well off as in the preceding instance. The bonds are due, but the cash is available with which to redeem them. There are notes outstanding to the extent of $75,000, but they should be amply provided for as the accounts receivable are realized.

One fact must be brought to the attention in this proposition. That is the fact that the payment of dividends was made possible through the borrowing power of the company. Dividends might have been declared quite easily since there was sufficient profit to warrant them. To obtain the cash necessary to pay the dividends is another matter. The presumption should exist, it seems, that if the profits are bona fide and accordingly are vested in sound assets, sooner or later the same assets will be realized and the payment of dividends would seem to depend entirely upon the ability of the organization to borrow the necessary cash if perchance such borrowing should become necessary. There does not seem to be any reason why the establishment of the sinking fund, which in this case is merely a setting aside of a part of the cost, should interfere with the payment of dividends, which is a distribution of funds representing the profit.
The third proposition assumes that:

a. A reserve for replacement equal to $1.50 a ton is to
be created out of profits before any dividends are declared.
b. Fifty thousand (50,000) tons of coal were sold at five
dollars ($5.00) a ton.
c. The expenses of operation for the period of twenty
years amounted to $35,000.
d. The interest on the bonds was $90,000.
e. At the maturity of the bonds there was a balance of
$100,000 in accounts receivable.

Here as in the first proposition the bondholders are in an undesirable position. The reserve for replacement has been created, not, however, to the extent intended. The reserve should have amounted to $75,000. It amounts to only $25,000. The reason is that the profits were not sufficiently large to permit of its creation in the amount originally planned. It so happens in this case that the cash equals the reserve.

It is a coincidence in this case since there is no connection or relation in practice between the two accounts. Profits, it should be remembered, are vested in all the assets. The reserve for replacement has in this case taken the place of profits and represents therefore merely the extent to which the profits in the assets exist.

The company lacks funds with which to meet its outstanding bonds. The reserve does not provide these funds. It has no connection with the funds. All that it has accomplished is to prevent the declaration of dividends because it reduced the profits so that there were none left out of which they might be declared. Obviously if dividends are not declared there can be no dividends paid.

A fourth proposition might combine both sinking fund and reserve provisions. In such a case the balance sheet would be the same as in the third proposition except that the sinking fund cash in the amount of $75,000 would replace the general cash of $25,000 and there would be a liability of $50,000 for notes payable. This would prevent the declaration of dividends until such time as the bonds were redeemed and the reserve released.

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