6. The equity in is sometimes cus tomary to carry the increase in surplus directly into the investing company's surplus account, rather than to set it up under a separate heading. In such a case, dividends declared from the combined surplus should be based upon the amount of current receiv ables included in the current assets of the sub-com pany. The practice is not to be recommended, how ever, unless the investing company is certain that it will soon realize on a portion of its share of the other company's surplus. While the investing company has set up in its balance sheet a current asset represent ing its interest in the other company, there is ordinar ily no positive means of telling whether this current asset will be realized upon.
A dangerous situation may result from this prac tice, if dividends have been paid by the investing com pany out of its equity in the net assets or surplus of the other corporation. If some catastrophe over takes the sub-company and wipes out this surplus, the directors of the investing company would prob ably be found guilty of paying dividends out of cap ital. Therefore, great discretion must be exercised by directors in handling these accounts after they have been set up on the books.
7. Treatment of received on such an investment should be credited to the in vestment instead of being treated as current earnings. This statement hardly requires an explanation because it is evident that we have already taken credit for the earnings when the asset was appreciated and the sur plus account set up.
If a separate surplus account is carried, then the amount of the dividends received must be also trans ferred from this special surplus account to the free surplus of the receiving company.
8. Objection to carrying the investment at It is also evident that the practice of carrying the in vestment previously described, at cost in the books of the holding company has another disadvantage. The balance sheet of the holding company will, of course, disclose how much of its capital has been in vested in this sub-company. But the earning account of the holding company may not disclose the entire earnings of that capital. Thus, if the sub-company did not distribute any of its accumulated surplus in the form of dividends, failure to record the effect of this appreciation in the value of the sub-company's stock, due to the increased surplus, would also result in an understatement of the true earnings of the hold ing company.
9. Revaluation of investments is subject to com a holding company has paid for stock of subsidiaries considerably more than the book value, complications often arise. Moreover, the stock or the bonds of the holding company may have been issued in payment for the securities of the sub sidiary company which were acquired. The question then raised would be whether or not the directors in reappraising the value of the securities originally acquired, perhaps at liberal price, should add to the cost thereof by means of an equity account, the prd-rata share of the undistributed earnings of the subsidiary, subsequent to the date of the acquirement of the securities by the holding company. While the valuation placed upon the stock of the sub-company acquired originally by the directors would probably never be questioned, the directors might have diffi culty in proving that they were justified in creating a surplus, and in distributing a dividend out of it, when such surplus was created thru their own reappraisal of the securities.
10. Oppressive tactics to discourage minority in very often happens that the sub-company has received large cash advances from the holding company. The subsidiary company, having increased its earnings and its surplus, would probably be in a position to distribute a reasonable dividend. Assum ing that the holding company is desirous of practising oppressive tactics to the disadvantage of minority stockholders and suddenly withdraws its advances from the sub-company it thereby reduces the sub-com pany's cash and working capital and effectually pre vents it from -declaring a dividend, even tho it has earned profits. The holding company, in recovering its cash, has practically enjoyed the receipt of a divi dend. This form of oppression has often been em ployed.
As already pointed out the failure to incorporate in the accounts of the holding company the presence of this surplus results in the creation of a secret re serve. This is an additional disadvantage to that re sulting from the fact that equalization of the income of the holding company from one period to another is not provided for by this method.
It is obvious that an equitable method of piepar ing consolidated statements should be employed. The main thing to bear in mind here is the elimination of all inter-company transactions by the offsetting of the debit items of one company by the corresponding credit items of an affiliated company. This applies, of course, only to such items as represent actual transactions or relations between the associated com panies.
11. pages 247 and. 248 will be found an example of the method of preparing a com paratively simple consolidated balance sheet. Con sidering the items on this statement in detail, it will be noted that the "A" company held $81,000 in bonds is sued by the "B" Company, and that "C" Company held $119,000 of the same bonds. As the liability of the "B" Company is offset by an asset of the same item on the books of and "C" Companies, the consolidated balance sheet need not show either the as set or the liability. Consequently, we eliminate $200,000 from our total assets and $200,000 from our total liabilities. In this same way, the advances to and from affiliated companies, dividends receivable or payable among the affiliated companies, and accrued interest on the bonds, together with demand notes, are set against the corresponding accounts of affiliated companies. A statement results which shows only the relation of the combined group to its stockholders and to the public.
If the "B" Company, for example, were in poor financial condition, or had suffered heavy losses from operation during the year, this condition would be re flected in the combined balance sheet in so far as it affected the standing of the group and that, after all, is the information which an investor or stockholder wishes to have.