SURPLUS, RESERVES AND DIVIDENDS 1. Definition of surplus.—By the term surplus, is meant the intrinsic value of all the assets of a firm, over and above its liabilities and outstanding capital. Intrinsic value is to be distinguished from reproduc tive value in that the former relates to the actual cost of the assets acquired, less the depreciation sustained since acquisition, and the latter, to the cost of duplica tion on the basis of ruling market prices.
The author is a firm believer in the rigid cost theory of value in so far as the books of account are con cerned. It should be borne in mind that purchase price may not represent the true value. This is due to the fact that assets can be purchased at acost greater or less than the true value. Some authorities justify the use of true value based upon a prop erly made appraisal as the basis for placing assets on the books.
2. Kinds of surplus.—Open surplus is that which appears on the books in the form of surplus, reserves or undivided profits.
Hidden surplus is represented in the form of secret reserves as a result of accumulation of profits that do not appear on the books.
Surplus may also be distinguished as free and re stricted. By the former is meant that form of sUr plus that represents profit available for distribution; by the latter, a profit accumulation which for one reason or another is to be retained in the business.
3. Relative importance of surplus and assets.—The importance of the surplus account is due to the fact that the stockholder finds reflected there the net re sults of the company's operations; he measures the value of the company's stock by the fluctuations in the surplus account. The importance of using the proper basis , for the valuation of the firm's assets thus be comes apparent, for an incorrect valuation is at once reflected in the surplus account.
4. Sources of surplus.—Broadly speaking, surplus may be derived from the following sources: (1) from profits as a result of business operations; (2) from a revaluation of fixed assets ; (3) from an original investment at the time of organization or as a result of reorganization.
5. Surplus resulting from business operations.— The reader is already familiar with corporate surplus resulting from business operations. He will also re
call that inasmuch as a business may have primary and secondary operations, surplus will necessarily be either from primary or secondary operations, or from both.
6. Importance of distinguishing between capital and revenue expenditure.—It is self-evident that there will be overstatement of the surplus if all the elements of cost have not been included in the profit and loss account. One of the problems in that con nection is the proper allocation of expenditures to capital and revenue. If an expenditure that should have been charged to revenue is charged to a capital account, the assets will be increased and the expenses will be decreased by the same amount. Conversely, if an item that should have been charged to capital is charged to revenue, the assets will be undervalued and the expenses will be correspondingly overstated.
In the first instance, the surplus will be erroneously increased, and in the second case it will be less than it should be. The general principle to bear in mind is that it is allowable to charge to revenue any ex penditure that does not enlarge the field of opera tions or that results in an increase in earning power, or in a decrease in the expense of conducting the busi ness. Inasmuch as the application of these principles oftentimes is attended with difficulty, it is important in reading financial statements to consider what has been the practice of the company in connection with expenditures, as reflected by the surplus.
7. Depredation as an element of consid ering the surplus, the fact that depreciation is an im portant element in the income account must not be overlooked. If the depreciation of both fixed and circulating assets has not been provided for by charges against earnings, the surplus account will be overstated. Depreciation on fixed assets may be broadly viewed as a sort of rental that the operating department of a business pays for the use of the assets. Depreciation on all circulating assets, such as ac counts receivable and inventory, should also be pro vided for, before net profits are shown.