8. Reserves that are not part of is maintained by some accountants that all reserves are a part of surplus, but such a contention is not true of any reserve created to measure depreciation or to offset an anticipated loss on the realization of ac counts receivable. This holds good notwithstanding the fact that reserves of this character are frequently found on.the liability side of a balance sheet included with other reserves. The use of reserves for the pur pose of adjusting the valuation of assets in the bal ance sheet is purely a question of bookkeeping expedi ency. If a loss equivalent to that shown in the re serve accounts has been sustained, or is anticipated, the shrinkage may be credited directly to the asset account; at the same time the profits of the period may be reduced by the same amount, or the decline in value may be credited to a reserve account. When decreases in value are credited to a reserve account the record will be clearer if the reserve, being an adjunct, is offset against the asset affected when the balance sheet is prepared.
9. Intercompany profits on inventory should be eliminated from surplus.—The reader will recall the discussion with regard to profits of holding companies as giveh in Chapter VI. Subsidiary companies fre quently do business with one another and the transac tions between companies will usually be invoiced at or near the prevailing market prices. Let us assume that Company A, a mining company, sells the greater portion of its output to Company B, which operates a steel mill that turns out, in the form of bars or blooms, material received from Company A. Let „„„„, us further assume that the product made by Company B is shipped over Railroad C, owned by the holding company to another subsidiary, Company D, which operates mill. Both Company B and Company D sell to outsiders as well as to Company E, which we shall assume is another subsidiary company, en gaged in the manufacture of certain specialties. The entire output of Company E is disposed of to out siders.
The subsidiaries will have on hand, included in their material inventories, at the close of the fiscal period, goods which have been purchased from other sub sidiaries and upon which the latter have made a profit. The raw material of Company D is the finished prod uct of Company B ; the finished products of Com pany B and Company D constitute the raw material of Company E.
In the preparation of a balance sheet of the holding company, a consolidation of the assets and liabilities of the subsidiaries will make it necessary to take up, as inventory of materials, certain quantities purchased from other subsidiaries, upon which the latter have already made a profit which is represented in the sur plus, accounts of the subsidiaries. Each of the sub
sidiaries has a separate corporate existence and, as far as its own accounts are concerned, has made a valid profit. It is important to remember, however, that from the standpoint of the entire aggregation no profit has as yet been realized on that material which was sold by one subsidiary and remains on hand in the inventory of another subsidiary.
That this is an important factor affecting surplus may be seen from an analysis of the balance sheet of the United States Steel Corporation for the year end ing December 31, 1919. The combined inventory of raw material on hand in the subsidiary companies at that date, amounted to $265,823,788. The amount of inter-company profits represented in inventories of the subsidiaries on hand on the same date was $39,027,110.
10. Dividends of subsidiary companies available to the parent company.—The dividends received by a holding company on the stock of subsidiaries which it owns may not in all cases be properly credited to the surplus account of the former. In many instances the subsidiaries whose stocks were acquired possessed a surplus at the time of consolidation. The price that the holding company paid for the stock of the subsidiary implied the existence of such surplus. If, for example, the capitalization of a subsidiary com pany amounted to $100,000 with an accumulated sur plus of $30,000 the purchase price of a $100 share in such a company would probably be about $130 per share. If the stock were purchased by the holding company at this price, it would appear in its invest ment account at a value of $130,000.
Let us assume that the holding company increases its surplus account to $50,000 during the next year, and that the board of directors votes to distribute the entire surplus as a cash dividend. The parent com pany is the sole stockholder and receives a check from the subsidiary company for $50,000. But not all of this amount is to be considered by the holding com pany as income. Only that portion of the dividend which represents a distribution of surplus profits earned since the stock was acquired can be treated as earnings. The reason is that the distribution of the entire surplus in the form of a dividend has reduced the value of the capital stock of the subsidiary to a book value of approximately $100 a share. 'Conse quently the value of the holding company's investment has been reduced to $100,000. Inasmuch as this in vestment is carried on the books of the holding com pany at $130,000, it is clear that the dividend of $50,000 that is received by the holding company must be divided into two parts, viz., $30,000 to be credited to its investment account—this will reduce that account to $100,000; and $20,000 to be credited to its surplus account.