Accounting Principles – Equity
Proprietorship is usually understood to mean ownership. In connection with business organization it signifies ownership of the assets. If there were no liabilities outstanding this would be strictly true.
Such a condition rarely exists. There are few concerns which have no liabilities. The existence of liabilities has the effect of merging with the proprietor’s interest in the assets that of the creditors. It may, therefore, be said that proprietorship is that ownership of the assets of a business organization which is measured by the assets, or, where liabilities exist, by the excess of assets over liabilities. Proprietorship is also called capital.
Proprietorship may be represented by various accounts, depending upon the legal type of organization. Within the different classes of organization the proprietary account may be subdivided for convenience in classification. In sole proprietorship, copartnership, or joint venture, the capital is represented by the proprietors’ accounts. Thus there may be found accounts such as “John Marshall, Proprietor,” or “John Marshall, Capital.” This account may show not only the original investment of “John Marshall,” but any subsequent credits for profits, salary, interest or capital. For convenience, separate accounts are often set up for profits, salary or interest, so that the capital account shows the investment of capital with subsequent additions to or deductions from same. Accounts for salary, interest or profits should be considered as adjuncts of the proprietor’s account. They may, quite properly, appear on the books, but should not appear in the balance sheet as such. They constitute a part of the proprietorship as much as that represented by the proprietor’s account. If, technically speaking, the rule of bookkeeping relative to the closing of books were complied with, they would be closed out to the proprietor’s account before the final trial balance were taken. In joint associations and corporations, the proprietary accounts are those of capital stock, divided as occasion requires to represent various classes of stock, and with adjuncts for undivided profits or for surplus. Unlike sole proprietorship and copartnership, separate accounts are maintained with the adjuncts as well as with the capital stock. This is, in a measure, due to the fact that a corporation has its capital stock fixed by law. Without the consent of the proper representative of the State the capital stock may neither be increased nor decreased. The capital stock is presumed to represent the investment of capital. By reason of the fact that it is fixed, any excess of assets over liabilities and capital stock is called surplus or undivided profits.
There is little distinction made between the two words. If a shade of difference in meaning is observed, undivided profits may be taken as profits which will be distributed within a reasonably short time as dividends, whereas surplus consists of undivided profits which have passed through the stage of availability for distribution and have been allowed to remain vested in the assets to strengthen the corporation. Surplus is rather an accumulation of profit. There can be no doubt that undivided profit and surplus attach to the capital, thereby constituting proprietorship. They are, however, kept separately in the books, for purposes of convenience, and shown separately in the balance for purposes of information.
Capital stock is evidence of share ownership in the net assets of a corporation. By net assets is meant the excess of assets over liabilities. The documentary evidence is a mere piece of paper on which certain officers of the corporation have certified to the fact that the party named in the certificate is the owner of a certain number of shares. The certificates are printed because they may be issued in large numbers, and much unnecessary writing is thus avoided. The ownership is expressed in shares because of simplicity. In a corporation, for example, with one thousand shares outstanding, the owner of five hundred shares is one-half owner. There is no apparent reason why such fact could not be stated in the certificate. It would be perfectly easy to do so if the fractions were always small, but they are not. One might imagine the complication which would arise, for instance, in the U. S. Steel Corporation, where there are ten million shares. If the share ownership were expressed in fractions, the certificate of a party holding 362 shares would read 362-1o,ooo,oooths of the capital stock.
The par of capital stock varies in different companies. One hundred dollars is probably the most common amount. Stocks, the par value of which is fifty dollars and twenty-five dollars, respectively, are also frequently seen. Pennsylvania Railroad stock is an example of fifty-dollar par stock. Stock is not usually issued until fully paid for, although certificates are sometimes seen in circulation when only part paid. The certificates, in such cases, usually bear an endorsement on their face stating the amount paid.
A stock issue is sometimes preceded by what is known as “scrip.” As used here, scrip is a receipt issued for payments on account of stock subscriptions which it is intended will be redeemed in stock. In such cases, scrip occasionally circulates in lieu of stock. Scrip is also issued at times for fractional shares of stock.
There are one or two points in connection with stocks which accountants should keep in mind when engaged in counting securities, namely: to be on the alert for stocks which are not fully paid and for stocks the par of which is less than one hundred dollars. Failure to observe these precautions is liable to result in failure to balance the par of the stocks under review.
The consideration for the issue of capital stock varies in different States. In some of the most prominent States the consideration is as follows:
Arizona—money or money’s worth (general principles of law).
Delaware—cash, labor done, personal property, real property or leases.
Maine—cash, services rendered, property.
Massachusetts—cash, property, tangible or intangible, services or expenses.
New Jersey—money, property.
New York—money, labor done, property actually received for the use and lawful purposes of such corporation.
Pennsylvania—money, labor done, property actually received.
South Dakota—money, labor done, property actually received.
West Virginia—property, services or other things of value.
Capital stock is usually classified as preferred and common. The former may be preferred as to dividends, or as to assets at time of liquidation, or both. As to dividends, it is sometimes known as cumulative preferred. Voting power may attach to either preferred or common stock or to both.
Where stock is preferred as to dividends it is understood, or in fact agreed, that a certain rate per cent. of dividend will be paid on the preferred before any dividends are paid on the common. If the preference is as to assets, it is understood to mean that in liquidation the preferred stockholders will be paid off in full out of the available assets before anything is paid to the holders of the common stock.
In the case of cumulative preferred stock the rate per cent. stipulated in the certificate accrues in favor of the stockholders, whether earned and paid or not. Accumulations in favor of preferred stockholders in such cases must be paid in full before any dividends can be paid to common stockholders. For example, where the stock in question is seven per cent. cumulative preferred, and the dividend is unearned for a period of three years, dividends to the extent of twenty-one per cent. must be paid to the holders of such stock before any dividends on the common stock may be declared.
Where such a condition exists, the propriety of showing a liability for same in the balance sheet frequently presents itself. Without giving the matter careful consideration it might appear proper that such a liability should be shown. This position may be taken on the ground that the dividend is in the nature of interest, and accrues by virtue of what might be considered an agreement on the part of the company to pay such dividends. This, however, is not true. What the company does agree to do is to pay a dividend equal to seven per cent., if earned. In the absence of action on the part of the directors in declaring a dividend no liability arises. It would, therefore, seem improper to consider the cumulative dividend as accruing, since there may never be sufficient surplus earnings to justify any dividend. It is usually conceded that no liability for such dividends should appear on the balance sheet, but a sense of honesty and fairness would seem to indicate that a foot-note stating the exact situation should be appended to the balance sheet.
In connection with proprietorship an important question arises in cases where capital stock is donated. As previously stated, proprietorship is measured by the net assets. Any increase in the assets without a corresponding increase in the liabilities carries with it an increase in the proprietorship. Capital stock, if donated, is an asset. If the rule above stated were true, the proprietorship would be increased. The extent of the increase would depend upon the value assigned to the donated stock. To fix this value is the difficulty which is presented. In the majority of cases it is probable that the stock donated was issued originally for patents, trademarks, good-will, or similar assets, and was donated in order that it might be sold to raise cash for current needs. Obviously, it is worth what it sells for, or perhaps, rather, its value may be fixed at what it sells for. To the extent of this value it increases the proprietorship; that is, if the assets for which it was originally issued were correctly valued.
Two views concerning the treatment of donated stock obtain. The first view holds that the assets for which the stock was originally issued were worth the value assigned to them, and consequently the proceeds of the donated stock, when sold, increase proprietorship. The second view holds that the value of the assets is fictitious, and admittedly arbitrary, and that the proceeds of the donated stock should be used to reduce such valuation. For the purpose of illustrating the two views, let a case be assumed in which capital stock to the extent of $100,000 is issued for patents; $40,000 of stock (par value) is subsequently donated, to be sold for the purpose of raising such cash, and is sold for $25,000.
Under the procedure followed in accordance with the view first expressed, patents would be charged and capital stock outstanding credited in the amount of $100,000. Upon receipt of the donated stock, treasury stock would be charged, and an account, variously termed “donation account,” “working capital” and “capital surplus suspense,” is credited, in the amount of $40,000. At the time of sale cash would be charged with $25,000 and treasury stock credited in an equal amount. The treasury stock account will now show a debit balance of $15,000, whereas no stock remains. The donation account will show a credit balance of $40,000. At this point the treasury stock account is closed out to the donation account, leaving a credit balance in the latter of $25,000. This balance may be allowed to remain in the account, as representing capital surplus, and impliedly, perhaps, not available for dividends, or it may be closed out to the general (profit and loss) surplus account. There would appear to be no legal objection to making this increase in the surplus available for cash dividends. To do so, however, would be to defeat the object of the donation; and since the controlling interest in the stock is usually held by the donor, such procedure would probably never take place in practice. A stock dividend for the purpose of distributing such surplus would appear more logical, and would seem to be free from objection.
In accordance with the second view above mentioned, the entries would be the same up to the point of closing the donation account. The credit balance in the donation account, namely, $25,000, is closed out against the account for patents, standing at $100,000, thereby reducing same to $75,000. The accounting which accords with this view is held by many to be conservative practice. It is surely that, and perhaps ultra-conservative.
Those who hold this view contend that the donation of the stock is evidence of the fact that the assets were not worth the par value of the stock which was issued for them. Opposers of this view hold that “judgment of the directors, in the absence of fraud in the transaction, is conclusive as to the value of the property purchased.” Whether or not the value can be disproven, the practice which follows the view-point illustrated in the first case above mentioned has undoubtedly enabled mining and real estate development companies to take advantage of unsuspecting investors.
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