Surplus as date of acquisition;

              58 HASKINS & SELLS August
Surplus at Date of Acquisition
ARTICLE No. 4
BY P. L. SHOBE, San Francisco Office
THE earned surplus of a subsidiary
corporation at the date on which the
holding company acquires control is re­ferred
to by accountants as "surplus at
date of acquisition." The disposition of
this acquired surplus in the preparation of
a consolidated balance sheet is not, as many
believe, a technical accounting problem,
but one which involves the right of a
corporation to distribute dividends out of
any but earned profits without so stating
to its stockholders. Fortunately, at least
from the viewpoint of the professional
accountant, we are committed to the prin­ciple
of refusing to recognize any earned
profits accruing upon a purchase. We all
grant that fortunate purchases may be
made for less than real value, and we
further accept that increment in exchange
value accrues in numerous instances after
purchase. To shut our eyes to these facts
would be to deny the existence of modern
trade. The principle mentioned above,
however, seeks justification for not record­ing
these facts in the books as earned
profits. Either condition may be recorded
by increasing the book value of the asset
and crediting a capital surplus account,
thereby clearly labeling the "profit" as
unearned and, therefore, not ordinarily
available for dividends.
An analysis of the conditions surround­ing
the acquisition of control of one cor­poration
by another, through the purchase
of the capital stock of the subsidiary, will
convince anyone that there is no basic
difference here from any other purchase.
Let us assume that corporation " A " owns a
piece of income producing property which
cost $1,000,000.00 and which has produced
in profits, as yet undistributed, $100,000.00;
the cash is $100,000.00; there are no out­standing
liabilities; and the capital stock
is $1,000,000.00.
If corporation " X " purchases "A's"
assets of property and cash for $1,100,-
000.00, there is clearly no credit to " X ' s"
surplus. Corporation " X , " however, ac­quires
the capital stock of " A , " paying
therefor its book value of $1,100,000.00.
There is no essential difference in these two
transactions; therefore, it would be illogi­cal
to consider the latter as having any
effect upon the surplus of " X . "
Inasmuch as a consolidated balance
sheet is prepared solely to show the posi­tion
of the consolidated group to the out­side
world, we cannot, by any process of
reasoning, do other than eliminate in the
consolidated report the investment of " X "
in "A's" stock from the asset side and the
capital stock of " A " and "A's" surplus at
the date of acquisition of its stock by " X "
from the credit side of the balance sheet.
We come, therefore, through the appli­cation
of pure logic and acceptance of the
principle of "no profits are made at pur­chase,"
to the conclusion that the surplus
of a subsidiary, at the date of the acquisi­tion
of control by the holding company
through purchase of stock, in no way affects
the earned surplus of the consolidated com­panies
and should, therefore, always be
eliminated in the preparation of the con­solidated
balance sheet. The fact is self-apparent,
of course, that the earnings or
losses of the subsidiary subsequent to ac­quisition
do affect the consolidated surplus.
To illustrate, we have only to refer to our
assumed case and we readily see that in
the first instance, in which " X " acquired
the title to the assets themselves, that in­come
from the property or interest on the
cash would naturally affect "X's" earned
surplus. In the second case, these earn­ings
would be reflected on "A's" books as
they arose. In consolidation, since we
should proceed no differently than if. the
holding company held title to the assets,
we should combine these earnings with
"X's" earned surplus and present the com­bined
surplus to secure a correct picture of
the group.