Accounting Theory and Practice - Volume II

There are a number of ways in which a corporation may cease to exist and a liquidation take place. The charter, if created for a fixed number of years, may expire. The state may see fit to repeal the charter in accordance with the right reserved at the time it was granted. The corporation may of its own accord surrender its charter; or the courts may decide that the corporation has forfeited its charter rights by reason of non-performance or because of some wrongful act. Failure to pay taxes due the state is an instance. The liquidation of a corporation may take place because of a consolidation resulting in loss of its original identity. In the case of a merger the merged corporation ceases to exist under the terms of the agreement made which may call for a more or less complete liquidation. Sometimes a reorganization effects the liquidation of an insolvent corporation. If the new corporation obtains the assets of the previous corporation under a forced sale, the money received would be applied to the satisfaction of the old creditors’ claims.

Insolvency is the most usual reason for liquidating a corporation. Insolvency may be either actual or legal. By the National Bankruptcy Act insolvency is defined as the condition in which the assets of a person, firm, or corporation are less than the debts. This definition emphasizes the economic point of view. A corporation is legally insolvent when the cash assets are not sufficient to pay debts when they become due. Either of these conditions may exist without necessarily disastrous results, though it generally leads to disaster sooner or later. However, the fact that these conditions do exist indicates that the business in question is not well managed. It is well, therefore, to bring out the more prevalent causes leading to insolvency.

A common cause of insolvency is the tying up of current assets in plant and equipment. While this may be the actual cause, the post-mortem assigns the cause generally to lack of “working capital.” When a business expands and orders are coming in in excess of the facilities at hand, there is a great temptation to put a large part of the incoming funds into plant in order to take full advantage of the opportunities in sight. The result is that eventually the point is reached where it is impossible to get the cash necessary to meet maturing obligations. While the need for plant and equipment may justify the outlay, they cannot readily be converted into cash for they are usually of such a special nature as to be of small value without the organization.

The conversion of the cash resources of a company into stocks of material is another cause of insolvency, especially if the turnover is slow or the business is of such a nature as to require large sums invested in materials. Though capital in this form is generally being converted into cash or other forms of working capital, the fact that large sums are invested in material does not always mean that its cash value measures the amount of working capital. On the liability side of the balance sheet there may be items such as short-time loans or accounts payable which must be deducted in order to determine the net working capital. If the stock carried is disproportionate to requirements, it is a sign of poor management. When this state of affairs is allowed to continue for some time, the chances are that stocks will become obsolete or deteriorate, resulting in a loss. This will eventually result in the accumulation of current liabilities or floating debts and so bring about a condition of insolvency.

Dividends are sometimes paid at a rate entirely out of proportion to average earnings, or a rate is maintained that is at variance with current earnings. Profits depend to a large extent upon economic and financial conditions. Business does not move on an even level throughout the years. The rule with conservative corporations is that dividends must not be allowed to rise, even in most prosperous periods, above a conservative estimate of the average earnings. In periods of prosperity the demand on the cash resources of a business increases as the prices of material, labor, and money rise. The result is that while a company may make large profits it may not be in a position to pay more than the usual rate of dividends. Many a corporation after paying big dividends in prosperous times has ended by placing its affairs in the hands of its creditors. Dividend payments are dependent not only upon profits but to a greater extent upon the concern’s cash position. To endeavor to do a large volume of business with a small working capital is generally a sure and a quick way of landing in bankruptcy. The prudent way is to withhold dividends until in the normal course of events cash is accumulated beyond the requirements of the business. The book surplus must be reinforced by a satisfactory cash balance as a basis for the declaration of cash dividends.

Sometimes corporations may find it sound practice to pay dividends with the proceeds of temporary bank loans. This is not open to objection under certain circumstances. For example, the company’s business may be subject to wide seasonal fluctuations’ or it may be of such a nature that it nominally operates with a small working capital. Even in these cases the assumption must be that the loans can be repaid when due without any undue strain or effort. There is some question regarding the soundness of the practice, sometimes resorted to, of issuing long-term obligations or of selling additional stock for the purpose of obtaining cash to pay dividends. If the profits are extraordinarily large and the probabilities are that they will remain so, then the increased capitalization may not be a serious handicap in itself. However, where the surplus shown on the books is fictitious or when a legitimate showing of profits cannot be made, then such a transaction would clearly be fraudulent.

Corporations sometimes issue bonds because of the fact that a larger return is gained to the stockholders than if more stock were sold. The interest rate on bonds is generally much less than the rate of profits and even less than on short-term loans or notes. The distinction between bonds and notes is mainly that of time. The proceeds from the bonds are commonly used for permanent improvements, while the notes are issued to bridge over the changing of some form of quick assets into cash. Generally the bonds are issued during a period of easy money but they may mature when the money market is hard. If a sinking fund has been provided, all that is necessary is to convert the securities in which the funds have been invested into cash and take up the bonds. But the fact that the returns on the securities in the sinking fund are as a rule much less than can be realized by placing the money in betterments, operates against its use.

When, therefore, the bond issue becomes due in a period of financial stringency, or even during normal times if the business has not been highly successful or if its credit has been impaired, the company may be unable to liquidate its assets and pay it off. The consequence is that a foreclosure of the mortgaged property is made.

A frequent cause of insolvency is excessive borrowing by means of short-term securities in the form of accounts payable, acceptances, and notes. The notes may be classified into: (1) notes discounted at some bank; (2) notes sold to the public; and (3) merchandise notes. There are three legitimate uses to which they may be put, namely: (1) to take care of a temporary lack of funds; (2) to extend further credit to customers; and (3) to increase the stock of easily marketable goods on hand. Definite provision must be made to meet the notes at maturity, which in the case of bank loans run from 30 days to six months—generally 60 to 90 days. The use made of funds obtained in this manner is a matter of importance to bankers when extending loans.

To use any one of these forms of borrowing for the purpose of financing betterments and additions is dangerous and essentially unsound. Such obligations are generally contracted during a period of prosperity and expanding business for the purpose of taking care of temporary needs. They frequently become a source of embarrassment when a period of money stringency sets in. If the borrowings are in excess of the quick assets, the policy is unsound at all times. Conservative managers make provision for meeting their notes at maturity before they issue them.

The short-term notes sold to the public usually are for longer periods than those discounted at the banks—the period ranging from one to five years. When the time is not appropriate for a bond issue and it is desirable to defer it, short-term notes are generally issued and marketed through note brokers, often throughout the country. This is an effective means of deferring a bond issue until money is easier and better terms can be obtained for the larger issue. When the bonds are sold the notes are retired with a part of the proceeds. The danger of this financial practice is that the notes may mature before the bonds can be marketed, as would probably be the case if a period of depression ensued. This would involve disaster if provision for refunding had not been made, especially as the proceeds of such notes, like the proceeds of a bond issue, are generally used for betterments and additions.

A business, through defects of management, does not always fulfill the expectation of its promoters. The price of the product may be set without regard to true costs, and losses pile up with or without the knowledge of the management. Competitive conditions may have to be met and efficiency of management be an absolute requisite if profits are to be made. An organization is of slow growth and the price paid for experience may eat up all the profits. Poor workmanship, duplication of effort, poor planning in the factory, resulting in a high unit cost—these are all factors which may bring disaster if not detected and remedied in time. The promoters may have been unusually optimistic in regard to the business that could be done, with the consequence that a plant is constructed much in excess of actual market possibilities. Losses of a serious nature then result from the poor utilization of fixed assets. “Lack of ability” is the phrase commonly used in describing this cause of insolvency. The usual symptom of the malady is a reduction in current assets and greater difficulty in obtaining credit.

The corporate form of business lends itself to exploitations of many kinds. The public is usually victimized, but sometimes the stockholders suffer through a breach of trust on the part of officers—as for example, the granting of contracts or the payment of exorbitant salaries to the detriment of the large body of stockholders. Another form of exploitation is the diversion of profitable business to some other corporation controlled by the untrustworthy officers. Then again the officers may buy up unprofitable ventures and sell them to the corporation at a large profit. The juggling of accounts may cover up fraud and exploitation. The profits may be sacrificed for the purpose of squeezing out the minority stockholders, or contracts may be made with a subsidiary whereby it takes most of the profits, or the profitable features of the corporation may be sold to a new company. These modes of freezing out the minority are naturally promoted by the majority stockholders. Whatever may be the means used, these various methods of exploitation may lead to insolvency, their ultimate effect depending upon the condition of the company and the extent to which they are carried on.

Unavoidable causes which may lead to the impairment or complete loss of a corporation’s assets are the disruption of the organization and its earning capacity through fire or earthquakes or other natural causes; or new inventions may kill the demand for its product; or improvements in machinery and equipment may render obsolete a large capital investment.

There are several forms of procedure in case liquidation is found advisable or necessary, and in general there are three courses open, viz.: bankruptcy, voluntary dissolution, and receivership.

Bankruptcy. This perhaps is the most common method. It is of two kinds—voluntary and involuntary. If voluntary bankruptcy is contemplated, the debtor files a petition in the federal court for his district, stating the number and amount of his debts and the amount of his assets. Creditors are then served with the notice and copies of the petition. Further proceedings are similar to those in involuntary bankruptcy. Involuntary bankruptcy proceedings may be brought if the debts are not less than $1,000 and an act of bankruptcy has been committed.

1. To convey, transfer, conceal, or remove, or to permit to be concealed or removed, any part of the debtor’s property with intent to hinder, delay, or defraud his creditors.

2. To transfer while insolvent any portion of the property to one or more creditors with intent to give preference to them.

3. To make a general assignment for the benefit of creditors, or being insolvent to apply for a receiver or trustee for the property.

4. For the debtor to admit in writing his inability to pay his debts and his willingness to be adjudged a bankrupt on that ground.

5. To suffer or permit, while insolvent, any creditor to obtain preference through legal proceedings and not have vacated such preference at least five days before the sale or final disposition of the property affected by such preference.

After the petition has been presented the next step is the appointment of a receiver or trustee for the purpose of protecting the creditors, and also in the case of the individual to secure the application of his property to the settlement of his debts so far as possible and so secure for him a discharge from further liability.

Bankruptcy proceedings are regulated by the National Bankruptcy Act of 1898. The courts of the Federal Government have jurisdiction in these proceedings. Under the National Bankruptcy Act, a person is insolvent “when the aggregate of his property, exclusive of any property that he has conveyed, transferred, concealed or removed, or permitted to be removed with intent to hinder, delay or defraud his creditors, is not, at a fair valuation, sufficient in amount to pay his debts.”

Voluntary Dissolution. A corporation may or may not be insolvent when making a voluntary dissolution. The reasons for the decision on the part of the stockholders to take this step may be various. Perhaps business is falling off and further profitable use cannot be made of the capital, or the company while solvent is losing money and drawing on its surplus. Again the cause may be due to legal complications, especially when concerns are adjudged combinations in restraint of trade. Voluntary dissolution in general is due to the fact that the condition of affairs seems to be unprofitable and the near future promises nothing better.

Receivership. One method of liquidating an insolvent corporation is by means of a receivership. The appointment of a receiver in equity is different in purpose from that of a receiver in bankruptcy. The function of the receiver in equity is to continue the business until it is wound up. In bankruptcy proceedings a receiver is appointed temporarily to preserve the property until a trustee can be elected. He does not conduct the business, but merely takes care of the goods, and pays taxes and dues, until the election of the trustee. A receivership in equity is frequently a preliminary step to reorganization. While the concern is technically insolvent in that the quick assets are not sufficient to meet maturing obligations, the total assets really exceed the total liabilities. Were the fixed assets sold, only a small fraction of their value might be realized. Under these circumstances the appointment of a receiver in equity is a valuable measure, giving time to provide for permanent remedies.

In involuntary bankruptcy proceedings the creditors file a petition in the federal courts located in the judicial district where the bankrupt has his place of business or in which his property is located. A copy of the petition is served on the bankrupt. The petition generally asks for the appointment of a receiver to protect the property until a trustee can be elected. The receiver is appointed by the court and is given charge of all property of the bankrupt until the first meeting of the creditors. The proceedings are generally conducted before a referee in bankruptcy appointed by the court. After the expiration of 20 days, during which the bankrupt is allowed to make his reply, he is required to file a list of all claims against him. A meeting of all creditors whose claims have been allowed by the court is then called and, if the petition is granted, a trustee is elected. Creditors who have some security for their claims are not allowed to vote for the trustee unless the security is insufficient to cover their claims, in which case they may vote on the amount of claim which is unsecured.

As soon as the trustee has been elected the creditors should file their claims with him together with the proof of the claims. This may consist of an affidavit stating the nature and amount of the claim, and the security held, if any. The bankruptcy proceedings are carried through unless the creditors and debtor agree to compromise.

The trustee’s first duty on his appointment is to collect all the property and any debts owing to the bankrupt, and to turn everything into cash in as short time as possible without unduly sacrificing the assets. As a general rule it is necessary to keep the business going for some time in order to get the most out of it. From the receipts the trustee pays taxes, filing fees, court costs, attorney’s fee and wages due, and then the creditors. Servants and persons employed for three months prior to the bankruptcy proceedings are entitled to be paid before any other claims are settled. After that the secured debts are discharged to the value of the security. When these items have been paid, if there remains enough to pay 5% of the total amount of all other claims, the creditors are entitled to have a dividend declared within 30 days after the debtor has been adjudged a bankrupt. If not, they must wait until the trustee has collected a sufficient amount. Afterwards the creditors are entitled to dividends from time to time until the entire amount in the hands of the trustee has been paid out. When the final dividend has been paid the trustee makes up his accounts, presents them at court, and asks for a discharge. He then is entitled to his fee based on the value of the funds that have gone through his hands.

A corporation may be dissolved and its affairs wound up by the proper procedure if all its stockholders consent. In some states a majority is sufficient, and in certain cases even less. Statutory provisions prescribe the procedure in most of the states. The process of voluntary dissolution consists simply of gradually closing down the business by realizing on the assets, and distributing the funds among the creditors and stockholders. This usually involves a vast amount of detail work, such as the transfer of contracts, the sale of parts of the business, the taking of inventories, the making of appraisals, and so on.

The receivership in bankruptcy is only a step in the chain leading to the appointment of a trustee under whom the process of liquidation takes place. As already stated, the receivership in equity is sometimes not a process of liquidation but a means of carrying on the business pending reorganization. In case the assets are greater than the liabilities, it may be advisable to effect some sort of reorganization to continue the business. The receiver can continue the business in whatever way the court will permit. Any of its unprofitable and unessential parts may be sold and in this way a partial liquidation may be effected.

With permission of the court the receiver may issue receiver’s certificates to meet immediate and necessary running expenses. The certificates usually have the first claim on the assets. It seldom happens that these remedies are sufficient to put the company on its feet and the receiver in the end will wind up the business by disposing of the assets and distributing the proceeds as instructed by the court.

A receiver is an officer of the court and acts under its instructions. In all dubious matters he can protect himself from liability by procuring an order of court or by refusing to act until authorized by an order of court.

Creditors may be divided into two groups—secured and unsecured. Those that have a lien upon some specific part of the assets, such as buildings, machinery, or materials, and holders of bonds are among those whose claims are secured. Trade credits and bank loans often have no other security than the standing of the firm.

If the business has been in a receiver’s hands and receiver’s certificates, have been issued, these may be given priority over all debts except those for taxes. The bondholders are usually given the opportunity to appear and present their arguments for or against the issuance of receiver’s certificates. The court directs the issuance at its discretion.

Preferred and common stockholders receive what is left after everyone else has been paid. If the preferred stock is preferred as to assets, it takes priority over the common stock. Often, however, the preference is only as to earnings, in which case the two stock issues share equally in the liquidation. Directors are prohibited by law from declaring dividends except out of earnings. If it should appear that dividends have been paid out of capital and not out of earnings, the stockholders are liable for any amounts thus paid out to them. If the stock issued is only partly paid, the stockholders are liable up to the amount which remains unpaid.

Accounting for liquidation may be simple or complex, depending upon circumstances, but it involves practically nothing new in principle. The main bookkeeping features for a liquidation which takes place because of bankruptcy or receivership are treated in Chapter XXXV where some specialized forms of statement are discussed and illustrated. Here it is purposed merely to point out the accounting procedure necessary in the case of a voluntary dissolution. Under a voluntary liquidation the same books of account are used as for the regular record of business transactions, and the procedure is merely a matter of recording the conversion of assets into cash. This involves taking into consideration, in the case of depreciating assets, the adjustment between the asset account, the depreciation reserve, and the loss or gain realized upon the final disposal of the asset. It may be desirable to separate these losses and gains on the sale of fixed properties from the losses and gains of the stock-in-trade, particularly if operations are continued up to the point of the final disposal of the merchandise stock on hand through the regular channels of trade. If, however, the sale of the whole property, including stock-in-trade, is effected, there is no occasion for the separation of the results of the liquidation of the two types of assets. But if this is desirable a separate clearing account, sometimes called “Liquidation Profit and Loss,” may be opened to summarize the losses and gains on fixed assets before transferring the net result of both into surplus. As the assets are sold and converted into cash the liabilities will be liquidated in due course, the accounting features here being the same as during the period of regular operation. After all assets have been converted into cash and all liabilities liquidated, only the cash and net worth accounts will remain on the books of the corporation. If the net result of the liquidation has been to encroach upon the original capital, the net worth accounts will consist of a deficit account and one or more capital stock accounts. If, however, a profit has resulted or if the resulting deficit is not sufficient to wipe out any previously accumulated surplus, the net worth accounts will consist of a surplus account and the various capital stock accounts.

The final step in liquidation will be the declaration of a liquidating dividend of the amount of cash on hand; this will be apportioned, just as all other dividends, on the basis of the stockholdings of the various shareholders. The books will be finally closed by charging the dividend and deficit, if any, to the various capital stock accounts in the one case; or by charging the dividend against the various capital stock accounts and surplus in the other case. In practice the closing of all accounts on the books is seldom carried out, the bookkeeping ceasing with the declaration of the liquidating dividend which disposes of the cash. Except as a matter of complete record, nothing is to be gained by closing off the accounts.

CHAPTER XXVIII LIQUIDATION OF A CORPORATION

CHAPTER XXVIII
LIQUIDATION OF A CORPORATION