13. Division of profitable of the possible manipulations which might be practiced by dishonest management may now be mentioned. The executives of the holding company may turn over all the remunerative business to one subsidiary, and all the non-paying business to another. In this way, especially if there was a large majority in the com pany to which the non-paying business was turned over, it might be possible to wreck the second com pany. Or the holding company might be loaded with v the non-paying business only. If the directors owned considerable stock in subsidiary corporations and had but a small interest in the holding company, they would draw large dividends from the subsidiary com pany and stand but a small part of the loss of the holding. company. Again, as more frequently hap pens, the management might turn over all the un profitable business to a subsidrary which would show a loss in operaton, while the holding company han dling all the payimg business would be able to show large profits. This would result in another sort of misstatement. The holding company's account would indicate that a profitable business was being done, and the investors would not know of the bad conditions of the subsidiary company.
14. Dividends out of capital may remain undis might be received from a sub sidiary company which would be carried as income on the books of the holding company. It might happen also that such dividends were declared out of capital. The accounts of the holding company might give no evidence of this fact which would be difficult to dis cover from the separately stated accounts of the sub sidiary company. On the other hand, dividends might be withheld from the stockholders of the sub sidiary companies thru the majority control by the holding company, even tho the subsidiary could well afford to pay them. This would result in depressing the price of the holding company's stock thru reduced earnings, and would enable the directors or stock holders who were aware of the facts, to acquire the holding company's stock at low prices.
15. Advances to subsidiaries.—Advances are often made by the holding company to a subsidiary and the subsidiary may in turn control other organizations to which it advances money. These advances may be carried upon the books of the lender as accounts re ceivable, current advances, or notes receivable, if the advances are represented by notes. The debtor corporation may have invested the funds in fixed as sets, or it may be the ,intention of the debtor to liqui date the advance thru an additional issue of its capital stock or bonded debt.
It is evident that such advances are, in no sense, current assets. Or, what may be even still more un favorable, the 'advance may have been made to the debtor corporation for the purpose of making good the operating losses. To any one examining the bal ance sheet of the creditor company, it would appear that the creditor company had a much larger fund of current receivables than was actually the case.
16. Failure to provide for operating losses of sub sidiaries not apparent.—Still another form of mis statement that might be indulged in would consist of having the holding receive as dividends, or even largely over-state, the profits of the whole group by declaring dividends from those sub-companies which had made profits, while failing to charge the in come account with the proper provision for losses which may have been sustained by other companies of the group. All of these factors contribute chiefly to the changes in the market prices of the capital stock of the holding- company. By presenting information which is not in accordance with accounting principles the management would be enabled to mislead the pub lic, bringing about fluctuations in the price of the holding company's stock tho not actually violating the law.
17. Balance sheets should be failure to cotisolidate the income accounts of the sub sidiaries probably does not result in as great disad vantage as would the failure to consolidate the bal ance sheets. The failure to eliminate inter-company sales and inter-company purchases would of course result in an overstatement of purchases as well as sales. The failure to eliminate the inter-company profits represented in the inventory would naturally result in an overstatement of the profits for the period, because it will be realized that the inventory is an essential and important part or the income ac count.
Likewise all inter-company construction work per formed by an affiliated company, and prepaid ex penses of inter-company origin, should be carried in the consolidated statements only at cost, net of any inter-company profit. The expenses of one company are set against the earnings of another and both are eliminated from the consolidated statement. The working papers required to prepare consolidated in come accounts are made up practically on the same basis as those covering the consolidated balance sheet illustrated on pages 247, 248.
18. Inter-company transactions.—To illustrate how these inter-company transactions are eliminated from the inventories, construction accounts, etc., in the con solidated income account, we shall suppose that a hold ing company controls, among other concerns : a min ing company, "A" ; a steamship line, "B"; a steel com pany, "C"; a railroad, "D" and a rolling mill "E." The mine produces ore, and sells for $100,000, at a profit of $17,000 to the steel company ( C) . It is shipped via the steamship line (B) at a freight cost of $3,000 (profit $900) . The steel company expends $37,000 in manufacturing this ore into steel valued at $150,000. It sells $50,000 worth to outsiders and $75,000 to the affiliated company "E." This $75,000 worth of steel is shipped to the "E" company over the railroad "D" at a freight cost of $3,000 (profit $600) . The "E" company manufactures this steel into steel rails at a manufacturing cost of $12,000 and derives a profit of $10,000. Of this $100,000 worth of steel rails, they sell $25,000 to outsiders and $50,000 to the affiliated railroad companies. The railroad has consumed one-half of these steel rails by the time the consolidated statement is to be prepared. We would set up our schedule of the transactions somewhat as follows: The consolidated statement could pick up the $75,000, inventories (the total of three inter-com panies' inventory profits) , less $16,925 of inter-com pany profit. The amount of inter-company profits going with any sale, either to outsiders or to affiliated companies, depends upon the ratio of the amount of that sale to the total sale.
It will be noticed that the inventories which vm have left for each company are figured at the cost to each company, plus their own percentage of profit. This was done simply for the sake of clearness in the illus tration. Of course, these inventories would not be carried in their own balance sheets at a figure which included their own profit. For the purposes of the consolidated statement, however, the reader will see that the profit is 'entirely eliminated.
It is more frequently the custom to record the inter company profits on the stock records at the time of purchase. The inventory will then show the inter company profits without the need of such an elaborate schedule as given above.
19. Intercompany profits on construction.—A slightly different situation results in connection with profits on inter-company construction. They must be charged back thru the books of the holding com pany when they are paid out by the profiting cor poration as dividends. If the construction was done for the holding company, this company will simply credit the dividends to the construction account. If, however, the construction was done for some other affiliated company, the transfer must be made thru the books of the holding company. The holding com pany will credit the inter-company profits received as dividends, to the company for which the construction was done. This company will, in turn, credit the same amount to the asset, construction account.
The advances between subsidiaries, or the notes given between subsidiaries, usually bear interest; or the note of a subsidiary may be discounted by the holding company resulting in the creation of a de ferred asset, "discount paid in advance," on the books of the subsidiary company. It is evident, of course, that interest paid or earned on such inter-company transactions is another item to be eliminated from the income statement.