Chapter Xxv on Sinking Funds for a Full Discussion of the Merits and

disadvantages of the two methods as to control over the funds.

In connection with covered reserves, attention is called again to the use, in the interest of standard practice, of the caption “reserve fund” as a suitable title for the assets placed in the fund, and the caption “reserve,” with suitable descriptive phrase, as the title for the reserved profits, the proprietorship element of the transaction.

Classification of Reserves

Before leaving the subject of reserves, it is purposed to give several classifications of the various kinds of reserves. Paul-Joseph Esquerré classifies reserves under the following heads: (1) Reserves for Depreciation; (2) Operating Reserves; (3) Reserves for Surplus Contingencies; (4) Reserves for Redemption of Debt; (5) Secret Reserves; and (6) Reserves for Exhaustion of Physical Assets. Their titles well indicate the kinds of items included under each head.

H. R. Hatfield classifies them on the basis of the use to which they are to be put, not attempting a classification to include all items shown on the balance sheet under the caption of a “reserve,” but limiting it to reserves of profits. His classes are:

“1. Reserves created to provide a permanent increase of capital. (a) As an additional guaranty to creditors. (b) To provide for extension of its fixed or other capital assets. 2. Reserves created to provide an additional capital which can be used to cover unusual losses or to provide for other emergencies without encroaching on the nominal capital. 3. Reserves created to provide for equalizing dividends by retaining part of one year’s profit to be used to make up scanty profits for other years.”

In “Applied Theory of Accounts.”

In “Modern Accounting.”

The classification used here has as its basis the place of allocation of the various reserves in the balance sheet because their nature determines their place, which after all is the important consideration. From that point of view two broad classes may be marked off as discussed in the preceding pages, viz.: (1) valuation reserves, using the term with a somewhat more extended meaning than is customary; and (2) proprietorship reserves. Under valuation reserves will be included all reserves shown either as deductions from the assets or as liabilities. Here the term reserve will be limited to those items which are estimated, as distinguished from those the amount of which is definitely known. The other items which are sometimes wrongly called reserves, as discussed on page 415, will not be included here, other titles being more accurately descriptive of them.

1. Valuation Reserves (a) Asset Valuation Reserves 1. Depreciation Reserves 2. Depletion Reserves 3. Bad Debts Reserves 4. Appreciation Reserves 5. Market Fluctuations Reserves, etc. (b) Liability Valuation Reserves 1. Operating Reserves 2. Contingent Reserves

2. Proprietorship Reserves (a) Secret Reserves (b) Open Reserves 1. Reserves for Debt Extinguishment 2. Reserves for Plant Extensions 3. Reserves for Working Capital, etc.

Legitimate Use of Surplus Account

There remains only a consideration of the Surplus account. The manner of handling the surplus as a clearing account for the appropriation of net profits has already been treated. After profits have been appropriated or reserved out of it for specific purposes, the surplus shows by its balance the portion still available for dividends. As has been indicated, it is not usually desirable to use all of it for dividends, a sufficiently large balance being always maintained for such purposes as stabilizing the dividend policy, strengthening credit, and other surplus contingencies.

Surplus account is frequently as badly abused as the proverbial “general” expense account, by being used as a dumping ground. It has, however, a legitimate and an illegitimate use. As the Profit and Loss account is strictly limited to use as a clearing account for the normal items of income and expense applicable to the current period’s operations, manifestly all other charges and credits to proprietorship must be cared for elsewhere. With very few exceptions—such as premiums and discounts on capital stock, donated working capital, etc.—these charges and credits are made to Surplus. High accounting authority deprecates the use of Surplus for these purposes, on the ground that too often it is used as a convenient place in which to hide items properly chargeable to the current Profit and Loss but which would not make a favorable impression if shown there. Just as with many other abused accounts, its wrongful use hardly constitutes sufficient grounds for withholding sanction of legitimate use. Where it is felt that certain items should not go directly into Surplus they should be recorded in a final section of the Profit and Loss account, just before its balance is shown transferred to Surplus. As the financial statements are usually published, this method secures more certain publicity to these items.

Occasionally, instead of the use of either Profit and Loss or Surplus for this purpose, an account is set up on the books called “Surplus Adjustments” through which these items are cleared into Surplus. The objection raised above to this use of Surplus applies with equal force to “Surplus Adjustment.”

Statement of Surplus

At the close of each period account must usually be taken of a group of items which cannot properly be treated as belonging to that period. Some of these may be items which were overlooked at the close of previous fiscal periods and cannot now be taken into the record for that period. Some things may wrongfully have been included in, or omitted from, the inventory; the inventory may have been under-or overvalued; errors may have been made in the separation of capital from revenue expenditures; wrong depreciation and bad debts estimates may have been made—these and similar items call for adjustment at the close of the current period. Where adjustments are few and simple, the statement of surplus on the balance sheet may be extended sufficiently to include them. Much better, however, is it to append as a schedule or statement in support of the balance sheet, a statement of surplus, showing therein the detail of all entries affecting it during and at the close of the current period. Particularly is this desirable when the statements of financial condition are prepared for internal use.

Such a statement of surplus should start with the amount of surplus as at the close of the previous period. Then the adjustments applicable to that period should be shown, thus determining the true surplus for the period. Following that should appear the entries made directly to Surplus for the current period, the net profit transferred thereto, and finally all appropriations of profit, leaving as the balance of Surplus the same amount which appears in the balance sheet. In skeleton form the statement should appear somewhat as follows:

X Y Z COMPANY STATEMENT OF SURPLUS, JUNE 30, 1918

Balance of Surplus as on December 31, 1917 $..... Adjustments applicable to period ending December 31, 1917: Additions: Inventory omissions, undervaluations, etc. $..... Items wrongly charged to Revenue ..... Over-estimate of Depreciation, etc. ..... $..... ----- Deductions: Inventory overvaluations, etc. $..... Items wrongly charged to Capital ..... Under-estimates of Depreciation, etc. ..... ..... ----- ----- Net Increase (or Decrease) ..... ----- True Surplus as on December 31, 1917 $..... Extraordinary Profits (or Losses) this period $..... Net Profit this period ..... ..... ----- ----- Amount available for appropriation $..... Appropriations of Surplus: Reserves (shown in detail) $..... Dividends ..... ..... ----- ----- Net Balance in Surplus as on June 30, 1918 $..... =====