Secrect reserves;

              58 HASKINS & SELLS August
Secret Reserves
ACCOUNTANCY practice teems with
perplexing questions. Some are old;
some are new. Some may be answered
easily; others only after mature deliber­ation.
One of the questions now arising fre­quently
because of changed economic
conditions is how, in connection with fire
losses, to treat the excess of recovery value
over book value.
During the period of more or less stable
prices which preceded the Great War,
property values for insurance purposes
presented no particular problem. With
the rise in prices which extended over the
period from 1914 to 1920, replacement
values on which insurance was based went
so high as to get entirely out of line with
book values, or cost less depreciation.
Hence, concerns taking out insurance
policies based on replacement values pre­vailing
in 1920 or subsequently, sometimes
find, when they have a fire loss and re­cover
from the insurance company, that
there is a considerable excess of amount
recovered over the book value. This
raises the question as to what disposition
from an accounting viewpoint should be
made of the amount.
It is not improbable that the average
accountant, when confronted with this
question, if he were free and untrammeled
and not influenced in any way, would
favor crediting the amount involved to
surplus. The excess of assets over lia­bilities
and capital is greater now than
before. The courts have generally held
that excess of assets over liabilities and
capital is surplus, and as such is available
for dividends. There is little concern ap­parently
on the part of the learned judges
as to the derivation of surplus; but the
accountant who desires that his state­ments
shall be not only clear but compre­hensive
and shall represent the facts in
the case, hesitates to throw into surplus
any considerable amount which may have
been derived from sources other than
operations. Conservative accounting un­dertakes
to differentiate surplus derived
from operations and that derived from
other sources. The average accountant
would probably hesitate to merge any con­siderable
amount of economic profit—for
such is the profit in the case in question—
with the results of operations, unless the
extraordinary profit were satisfactorily
earmarked, for fear that any other presen­tation
might be misleading.
It is with this thought in mind probably
that accountants occasionally resort to the
expedient of setting up the economic profit
resulting in an increase in value of property
as a special surplus item, frequently re­ferred
to as capital surplus. This method
has no particular advantage as far as can
be seen, except to put the reader of the
balance sheet on notice that some part of
the surplus was derived from an increase
in values due to changes in economic con­ditions,
rather than as a result of trading
or other operations.
The situation is somewhat affected by
the ever present influence of government
control exercised through the Treasury
Department in connection with taxes.
While it is true that a business organiza­tion
may treat a gain resulting from fire
loss in any way it may desire, in order to
be acceptable to the government in the
matter of taxes the item must be handled
in a certain way.
Article 261 of Treasury Department
Regulations 62 is generally interpreted to
mean that if a taxpayer would escape a
tax on any excess of recovered value over
book value, he must carry the new prop­erty
created through the process of re-