Accounting Statements And Dividend Law

AuthorJames D. Cox/Thomas Lee Hazen
ProfessionProfessor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
§ 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 items historical cost (in contrast to the items
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 buildings 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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