Inter-company Profits on Unsold Stocks

In the example shown in the appendix the undistributed profits accruing to the parent company are stated after deducting the holding company's proportion of the profit taken by Subsidiary B. on stock transferred by it to Subsidiary A. but remaining unsold in the hands of that subsidiary at the date of the balance sheet. From the standpoint of the parent concern and of the combine as a whole this profit (although properly taken by Subsidiary B. as a separate legal entity) has not been realised and should be eliminated in calculating the profits of the combine for the year and in considering the holding company's interest in Subsidiary B.

Had Subsidiary B.'s balance of profits been insufficient to cover the amount to be eliminated the necessary provision would have been included amongst the liabilities in the parent company's accounts.

Amounts owing to Subsidiary Companies

As has already been mentioned the law now requires the aggregate indebtedness of a holding company to its subsidiary companies to be stated separately from its other liabilities in the balance sheet (Section 125) and has thus made it a legal obligation to conform with what has hitherto been the best practice.

In arriving at the amount to be so shown amounts due to and by the same subsidiary company should of course be set off against one another, but should not be deducted from amounts due from or to other subsidiaries. While the latter may be related transactions they are distinct in the sense that on a winding-up there is no set-off and the liabilities would have to be paid to the one company and the advances collected from the other concerns.

A point that should be noted is that inasmuch as the Companies Act requires the aggregate indebtedness to subsidiary companies to be shown it follows that if any subsidiary owns

debentures or debenture stock of the holding company the latter should include the nominal amount thereof in its balance sheet under the heading of "Amounts owing to Subsidiary Companies." In the pro forma accounts in Appendix I, Subsidiary B. owns £25,000 of the holding company's debenture stock and in preparing the amended draft legal balance sheet of the holding company this has been so included. The £25,000 has, however, not been extended into the total column under that heading as this would have involved reducing the amount of the debenture stock outstanding as shown in the balance sheet.

Although the law does not require it a note has been inserted in the holding company's legal balance sheet in Appendix I stating the aggregate number of shares of the holding company which are owned by Subsidiary Company B.

CHAPTER VIII

METHOD (I)—THE LEGAL BALANCE SHEET (Cont.)

Cost of Shareholdings where Consideration is Exchange of own Shares at a Premium

So much for the setting out of the items on the face of the balance sheet. It is now necessary to consider the amount at which the investments should appear therein, whether at cost or at what value.

In the books of the parent company the shares which it holds in subsidiary or constituent undertakings will no doubt appear in the first instance at cost, i.e. the amount paid in cash or in its own shares issued in exchange. In the case of an exchange of shares the transaction will probably have taken into account the value of the holding company's shares at the time the transaction was entered into (it may be there is an official market quotation), and if this value should be in excess of the par value, the holding company might regard the excess as a premium upon the issue of its own shares.

An example of this is given in Appendix I, where it will be seen that the holding company acquired the ordinary shares of Subsidiary A. for £150,000, satisfied by the issue of 30,000 of its own shares which presumably had a market quotation at the time, or were considered to be of the value of £5 each, i.e. were at a premium of £4 per share. The holding company has taken the premium of £120,000 to its Reserve Account.

The balance sheet of Subsidiary A. shows that it would not be correct to treat it in this way as the reserve does not exist. As to whether it existed at the date on which the shares were acquired would depend upon the real financial position at that time which is not clear and would require investigation. From the information now available, however, it is suggested that the cost to the holding company should be stated at £30,000, viz.

the par value of the shares issued. In other words, the premium should be deducted from the gross consideration given for the shares and not shown as a reserve.

It may be asked, is this always correct? The answer must obviously depend entirely upon the circumstances. Speaking generally, however, the premium should be deducted from the gross consideration in every case where it is not represented in the subsidiary company by a surplus of tangible assets (other than goodwill) over liabilities including shares not acquired, and after deducting from the surplus the par value of the shares of the holding company issued in exchange. Assume, as an example, a company having a capital of £100, reserve £100, and net tangible assets (after deducting liabilities) of £200, and that the holding company acquired the whole of the share capital (i.e. £100) by the issue of 50 of its own £1 shares, which then stood in the market at, say, £4 each or at a premium of £3. There is a surplus of assets over liabilities of the company acquired of £200, and if the directors so desire there seems no reason why in such a case the premium of £3 (viz. £150) should not appear amongst the holding company's reserves though it would be better not to include it as part of the general reserve unless it is ear-marked definitely as a premium.

If, in the above example, the surplus tangible assets were £100 and £100 represented goodwill, it would be better for the holding company to show only £50 of the premium as a reserve and the balance of £100 should be deducted from the cost of the shares, showing a net cost of £100 in the books of the holding company.

Whether the premium would be available for revenue purposes depends upon the company's articles of association.

It may be thought that if this premium is allowed to be shown as a reserve in the holding company's balance sheet, then in the whole merger it may appear twice, in that it may also be found in the constituent company's balance sheet. This is undoubtedly so, but it must be borne in mind that the balance sheet of the

holding company represents the merger as a whole. It is therefore necessary to prepare a consolidated balance sheet as explained in a later chapter in order to obtain an accurate presentation of the combined position. In amalgamating the assets and liabilities of the subsidiary with those of the parent company for this purpose, it is clear that the reserve in the subsidiary company's balance sheet disappears, being off-set (together with the shares acquired) by the cost in the accounts of the parent undertaking.

Treatment of Earnings of Subsidiaries up to Date of Acquisition

There is a further important point to be borne in mind in considering what is cost, viz. that all dividends received from any of the subsidiary undertakings distributed out of their surpluses existing at the time their shares were acquired should be deducted from the "cost" of the shares in the parent company's accounts.

When a holding company acquires the shares of a subsidiary concern it acquires, in effect, the surplus of assets over liabilities at that time. The price paid for the shares is assumed to have taken into consideration the then existing value of the assets as well as goodwill. Looked at in another way, the holding company bought and paid for any credit balances on profit and loss or other reserve accounts existing at the time, and it would obviously be incorrect for the holding company to treat any distribution of these as its income.

A dividend paid out of these assets (or out of the reserves whichever way it is regarded) is a payment to the holding company of a portion of the assets acquired, or, in other words, a return of some part of the purchase money, and other things being equal the shares of the subsidiary undertaking are in consequence of a less value than they were at the time they were purchased.

In the accounts of the constituent concern the surplus of

E