Accounting Statements And Dividend Law

• Author: James D. Cox/Thomas Lee Hazen
• Profession: Professor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
• Pages: 444-460

§ 19.1 The Importance of Accounting

to Corporate Law

There is a close interplay between accounting and ma ny corporate trans-

actions. For example, in the preceding chapter it was emphasized t hat

accounting principles play a pivotal role in interpreting bond indentures

and the preferred stock’s contract when those prov isions use expressions

that have accounting significance. The connection is equally direct in the

case of the states’ regulat ion of corporate distributions, a point examined

in the next two chapters. Therefore, because of the frequent interplay

between corporate law and accounting, a solid understa nding is necessary

of the major conventions that underlie accounting principles, as well as

of the important fi nancial statements produced through t he accounting

process. This chapter reviews the major conventions on which account-

ing principles are premis ed and provides an introduction to the t wo prin-

cipal accounting statements: the bala nce sheet and the income statement.

On certain topics, such as valuation, depreciation, and depletion,

the law impliedly adopts what may be termed “good accounting prac-

tice” or, as it is commonly and professionally designated, “generally

accepted account ing principles” (GA AP). It should be noted, however,

that the courts h ave the final say in interpreting corp oration acts and on

legal questions, as bet ween conflicting accounti ng opinions, and tend to

follow what will further the legal objective in view.

There have been recent departures from t he traditional legal capital

system in California and from the 1980 revisions to the Model Act,1

which were carried forward in the Revised Model Business Corpora-

tion Act in 1984. California ex pressly adopts GAA P and thus places

the courts in t he somewhat unusual position of final arbiter of proper

accounting methods.

§ 19.2 Major Conventions of Accounting

Nearly all generally accepted accounting pr inciples are anchored in a

set of major tenets, more commonly referred to as “accounting conven-

tions.” These conventions are briefly set fort h below.

The Separate-Entity Ass umption. Just as corporate law disting uishes

the corporate entity from its owners, accounting statements reflect the

performance and financial position of a disti nct entity. Thus the finan-

cial statements of a corporation report its as sets and income, not those of

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its stockholders; and this is also t rue for a partnership and its partners.

To be sure, there are principles for presenting the perfor mance and posi-

tion of companies that are affiliated, known as consolidated financial

statements, discussed below, but the overarching principle is that finan-

cial reports are developed from t he viewpoint of a specific entit y.

Cost Convention. The bed rock of account ing princ iples is that ea ch

purchase of assets, ser vices, or expenses, as well as liabilities a nd owners’

equity, is recorded at an item’s historical cost (in contrast to the item’s

fair market value). Thus a building that was acquired 10 years earlier is

today depreciated on the basis of the cost of acquiring it 10 years earlier,

even though the building’s current fair market value is much above its

cost. Similarly, the building is reported on the balance sheet at its his-

torical cost, less depreciation.

To be sure, difficult questions sometimes arise in measu ring an

item’s cost. For example, when stock is issued for Blackacre, there is a

need to record a future value for the capital stock account as well as for

Blackacre. In this situation, the fair market value of Blackacre, assumed

to be $500,000, is the cost for Blackacre and is al so reported in the capi-

tal stock account to reflect what was received for the shares. From that

point forward, however, Blackacre continues to be reported at $500,000,

its cost, even though the land greatly appreciates in value. But the cost

convention is not a two-way street. Should there be a material and

permanent decline in an asset’s market value, accounting requires the

asset’s carryi ng amount be reduced to its new, and lower, value. Thus,

accounting embodies a highly conservative view of the world in which

purchases and assets a re recorded at cost and any declines are recog-

nized, but upward appreciation in value is not. Hence the old saying

among accountants, “anticipate no gain and recognize all losses.”

Constant-Dollar Assumption. Financial reports reflect measu re-

ments in a given ty pe of currency, usually that of the company’s princi-

pal domicile. Whet her inflation is moderate or high, the tr ue purchasing

power of that unit of measurement is reduced over time. Nevert heless,

financial reports are prepared on the assumption of a stable monetary

unit or, alternatively expressed, that any changes in the monetary u nit

are not significant. At one time GAA P required public reporting com-

panies to present information in the footnotes of the financial state-

ments reflecti ng the effects of inflat ion; however, the recent modest rate

of inflation has caused that requirement to be suspended.

Accounting Stateme nts and Dividend Law 445

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