Any discussion concerning the investment of sur plus is, therefore, superfluous, since the same princi ples apply to the investment of capital funds. Since, however, surplus is presumed to stabilize dividends, it should be noted that this may be accomplished only by maintaining increasingly ample working capital. Improved efficiency, capacity and earning power may result from investing earnings, partly or wholly in permanently productive assets, but this does not pro tect the dividend rate against years of absolute loss, when the best concerns in many lines of business are unable to make profits. The variability of profits is the only true necessity for surplus, where the cor poration is properly capitalized, and this explains why the big industrial companies maintain not only a large surplus, but also a large proportion of work ing or liquid capital.
14. Value of surplus to the creditor.—The fact should be noted that creditors are better protected by capitalizing surplus, thru stock dividends or other wise, for the reason that dividends may be paid in any amount and at any time out of surplus, but not out of capital. As the surplus is invested in the prop erty, bondholders naturally come to consider it as a protection to them, which, of course, it is not if with drawn for dividends. As a matter of fact, a large book surplus, if fictitious, is a menace to creditors, since the payment of a special dividend from it may swamp the corporation and leave the creditors noth ing but a ruined hulk. By this means stockholders may sometimes manipulate affairs so as actually to prefer themselves to creditors. Paying regular cash dividends out of fictitious earnings has the same re sult, but it is more gradual. Both methods impair capital at the expense of creditors.
Banks with large surpluses have similar opportun ity for fraud or mismanagement. Of two banks hav ing similar resources and liabilities, one having $2,000, 000 capital is safer than one having $1,000,000 capital and $1,000,000 surplus. Instead of favoring large surpluses for banks and other companies, it would be fairer if the law limited surplus to an amount which would adequately insure the stability of dividends over a brief period of years, and compelled the bal ance of earnings to be either paid out in cash divi dends or capitalized by stock dividends. This would tend, at least, to eliminate some manipulation and a whole lot of artificial accounting and false impres sions.
The banking corporations of Canada possess a somewhat exceptional record in the matter of reserves as well as an exceptional record of good banking prac tice. When Dean Joseph French Johnson made a report on the Canadian banking system for the Na tional Monetary Commission of the United States, some years ago, he took the ground that Canada's banks had made the mistake of increasing their rest funds rather than their capital. He pointed out that in the 10 years following 1899, the paid-up capital of the banks had increased about 50 per cent, and that while the surplus was 50 per cent of the capital in 1899, it was 75 per cent of the capital 10 years later. In this report, Dean Johnson said : Sentiment seems to have had most to do with the increase of the rest fund. There is a popular notion, and the banks have done a good deal to create it, that a bank's solidity and prosperity are somehow measured by the size of its rest fund, and the banks have engaged in unreasonable competition to bring their rests up to the highest possible amounts. Furthermore, bank directors and managers like to have the market prices of their stocks steadily climbing upward. If they divided part of their profits among stockholders in the form of a stock dividend, there has always been the fear that the market price of the stock in consequence would de cline and the bank somehow be injured. Bank directors also take pride in the maintenance of a regular rate of dividend. If they can increase the rate and at the same time add a proper amount to their rest fund, well and good, but they shrink from increasing the capital stock at the expense of the dividend rate. For all these reasons the Canadian banks during the last prosperous decade have failed to make their capital account grow with their business.
Book surplus is distributed by: (a) Cash dividends; (b) Scrip dividends; (c) Stock dividends; (d) The creation of special reserves; (e) Charging off a -cer tain amount to make good, losses which have impaired capital, or to squeeze the water out of original over capitalization.
Of these, the first two actually reduce net assets by the amount paid. The stock dividend preserves assets as before, but capitalizes earnings. The last two usually confess fictitious surplus.