The following statement shows the total for each of the various classes of adjustments affecting the difference for the period from June 30, 1924, to December 31, 1930, as shown on the exhibit. [170] Earnings receivable reserve: Excess of subsidiary company's replacement reserves over cal- Reserves written off to investment account property sold----- Reserves written off to surplus account sale Ozark Power & Reserves written off to surplus account sale Webb City & Car- Adjustment account of additional stock acquired of Kansas Adjustment account of additional stock acquired of Wyandotte To take up reserves of Cumberland & Westport Transit Co. Reserves of Summit County Power Co. closed to investment Sale of Kansas City Gas Co. stock to Cities Service Co----- Excess of reserves, transferred to “ Earnings receivable ac- Surplus reserves: Calculated reserves written off to surplus account property sold Calculated reserves written off to investment account property sold - Correction of calculated reserves, credit to surplus__-_- Write-off to surplus reserve deficit suspended.. 19 360,709 53, 953 [171] The above statement is in two sections, showing, respectively, the adjustments affecting only "Earnings receivable reserve" and those affecting only "Surplus reserve." The principal difference between the two accounts arose, as previously explained, by the charge to "Earnings receivable reserve" of the excess of $12,891,735 of subsidiaries' replacement reserve over the calculated reserves of the holding company. This difference was largely eliminated by transferring $11,252,513 from " 'Earnings receivable reserve" to "Earnings receivable accrued." The latter account, therefore, includes not only the holding company's equity in the earnings of subsidiaries, but also up to December 31, 1929, $2,181,730, reflecting the equity in the replacement reserves transferred to surplus by such subsidiaries, and after this date also the equity amounting to $9,070,783 in the special surplus reserve of subsidiaries. The balance of the difference was eliminated by various adjustments as shown on the statement. These will be touched upon later. The reason for the establishment of calculated surplus reserves by the holding company and the excess of replacement reserves thus created will not be explained. Covenants of the bond indenture in regard to depreciation reserve.-On November 1, 1924, Cities Service Power & Light Co. made a collateral-trust indenture, securing their 20-year 6-percent secured sinking-fund gold bonds, series A, to Central Union Trust Co. of New York as trustee. This indenture provided in article VIII as follows: "SEC. 3. The company will not pay any dividend other than dividends payable in stock of the company upon its capital stock, common or preferred (except (1) upon the $10,000,000, par value, of 7-percent cumulative first preferred stock issued prior to the execution hereof, and (2) upon such additional preferred stock as may be hereafter issued from time to time for not less than 80 percent of the par value thereof in cash, and (3) upon the $5,000,000, 18 Denotes red figure. par value, of 7-percent cumulative second preferred stock issued prior to the [172] execution hereof, to the extent permitted by section 7 of this article VIII) out of dividends received by the company upon stocks of subsidiaries, which shall be paid otherwise than out of the balance of earnings of such subsidiaries, respectively, accruing subsequent to June 30, 1924, remaining after deducting in the case of each such subsidiary, respectively, in accordance with the nature of the business or businesses in which each such subsidiary shall be respectively engaged, amounts equal to the following percentages of each such subsidiary's respective gross revenues derived from such business or businesses, respectively, to cover maintenance and/or depreciation, after crediting against such amounts, respectively, the respective amount of expenditures made by each such subsidiary, respectively, for maintenance: 10 percent per annum cumulative of gross gas revenues; 8 percent per annum cumulative of gross hydroelectric revenues: 12 percent per annum cumulative of gross electric revenues, other than 20 percent per annum cumulative of gross traction revenues; "In case of the purchase by any such subsidiary of any of the above commodities at wholesale, the purchase price of any such commodity shall be deducted from the gross revenues before computing such respective percentages." There is no provision in the indenture requiring the holding company to set up reserves out of income, but the covenant provided that the holding company would not pay any dividend, other than stock dividends, out of dividends received by the holding company upon the stocks of subsidiaries, which shall be paid otherwise than out of the balance of earnings of such subsidiaries accruing subsequent to June 30, 1924, which remained after deducting the specified percentages of gross revenues to cover maintenance and/or depreciation. This did not prohibit the subsidiaries from setting aside greater amounts for depreciation than the percentages of gross revenues less expenditures for maintenance would yield. Cities Service Power & Light Co. took up as income, not the cash dividends received upon the stocks of subsidiaries, but the income of such subsidiaries before the application of charges for replacement reserves. The holding company then calculated reserves as [173] specified by the indenture, and deducted the amounts so computed from income and credited them to "Surplus reserve." These latter reserves were less than those charged by the subsidiaries, hence the excess reserves as previously described. The indenture also provided that the holding company would not pay any dividend, other than stock dividends, if after the payment of any such dividend by the holding company "(c) The combined accumulated depreciation of all the subsidiaries as shown on the combined balance sheet of all the subsidiaries as of June 30, 1924 (whether at the time appearing on the respective balance sheets of the subsidiaries as accumulated depreciation or under some other designation) would be less than $13,957,923 (diminished by an amount equivalent to the accumulated depreciation as of June 30, 1924, of any subsidiary at the date of the execution of this indenture which shall thereafter cease to be a subsidiary)." The examiner differs with representatives of the company as to the interpretation of the clause quoted from the indenture. The examiner believes the clause requires that the amount specified therein must be maintained in a depre ciation or replacement reserve account or some other account of a similar nature, no matter how captioned. The company's representatives contend that the clause means merely that the amount specified must be maintained in the business of the subsidiaries, no matter what account it is carried in, whether in reserve accounts or in surplus, as long as it remains in the business. In support of its contention the company points out that $4,229,361 was transferred from replacement reserves to surplus in December 1924, prior to the execution of the indenture, that the bankers were fully advised thereof, and that the parenthetical phrase was incorporated in the above-quoted clause to cover the situation just as it then existed. If the examiner's interpretation is [174] correct, such transfer would have to be reversed or otherwise taken from surplus, or an amount taken from income equal to such transfer, before dividends could have been declared by the holding company; and if the latter coursewas adopted, the remaining earnings, when taken up by the holding company, would not yield sufficient surplus from which to declare common dividends. On the other hand, if the examiner's interpretation had been the accepted interpretation of 1924, no doubt the transfer from reserves to surplus would not have been made or would have been immediately reversed, since the amount of the transfer thus credited to surplus merely had the effect of increasing the acquired surplus of the holding company and not surplus earnings accruing to it since June 30, 1924, from which dividends might be declared. In November 1927, Cities Service Power & Light Co. issued 51⁄2 percent 25year debentures and retired the outstanding 6-percent 20-year collateral bonds. The bond indenture was, therefore, superseded by the indenture of the debentures. This latter indenture, in the opinion of the examiner, was more lenient in its provisions than the former. The language used in this regard was as follows: "The company covenants and agrees that it will cause each subsidiary to maintain its properties in good condition and repair; and to that end will cause to be expended or reserved for maintenance, depreciation, and/or replacements, during each fiscal period of 12 months, at least 8 percent of the total of the consolidated gross operating revenue of the company for such 12-months' period derived from the operation of hydroelectric properties, 12 percent of the total of such gross operating revenue derived from the operation of electric properties other than hydroelectric properties, 10 percent of the total of such gross operating revenue derived from the operation of gas properties, 5 percent of the total of such gross operating revenues derived from the operation of waterworks and other water utilities properties, 25 percent of the total of such gross operating revenue derived from the operation of street railway and other transportation properties, 7 percent of the total of such gross operating revenue derived from the operation of steam-heating properties, 10 percent of the total of such gross operating revenue derived from the operation of ice properties, and 10 percent of the total of such gross operating revenue derived from the operation of any other properties." [175] The percentages of gross revenue were the same as those specified in the previous indenture, with the exceptions of gross traction revenue changed to 25 percent, gross heating revenues changed to 7 percent, and gross water revenues changed to 5 percent. The percentages of gross revenue were not considered permanent, but were subject to change at 3-year intervals. After December 31, 1927, the amount so charged was based on the percentage as specified in the indenture of the holding company and the amounts set up on that company's books in earnings receivable reserve and surplus reserve were equal, and reflected its proportion of the replacement reserves, as set up by the subsidiaries. Following is a description of the method used in accumulating reserves under the first indenture: Method used in accounting for reserves.-In recording the earnings of subsidiaries as income, Cities Service Power & Light Co. takes up, under the title of "Earnings from companies ", the net earnings of subsidiaries after preferred dividends, plus the amounts deducted by subsidiaries from income for replacement reserves. The first named is charged to earnings receivable accrued and the second to earnings receivable reserve. In effect, this is equivalent to taking up the earnings of subsidiaries, after preferred dividends, but before the application of the charge for replacement reserve. From its gross income, composed in greater part of the earnings from companies, the amount charged by the holding company as surplus reserves is deducted. Thus the amount charged prior to December 31, 1927, by the subsidiaries, in excess of the holding company's reserve, was absorbed as income by the holding company. After this date the reserves charged by subsidiaries and by the holding company were the same. [176] The income statements and surplus analyses of Cities Service Power & Light Co. are presented as exhibits 5 and 6, within Commission's exhibit 6201, and these exhibits will be discussed in chapter IV, but in order to illustrate the method used in taking up these excess reserves, the earnings from companies, as taken up by the holding company for the 6 months of 1924 and for each of the years ended December 31, 1925 to 1927, inclusive, are shown in the following tabulation: From this tabulation it may be seen that the excess of the amount charged to income for replacement reserve by the subsidiaries, over the amount so charged by the holding company, in accordance with the replacement reserves requirement provided in the indenture has been included as income by the latter. This amounted for the period from June 30, 1924, to December 31, 1927, to $12,891,735, which amount was included in earnings receivable reserve as previously described. [177] As previously stated, the indenture provided that the holding company would not pay dividends, other than stock dividends, if the combined accumulated depreciation of its subsidiaries was less than $13,957,923 (whether at the time apearing on the subsidiaries' books as accumulated depreciation or under some other designation) except as diminished by the 1924 depreciation reserve of subsidiaries sold. It has previously been shown that the combined replacement reserves of subsidiaries were reduced in December 1924, and prior to acquisition, by the transfer of $4,229,361 to surplus. According to the examiner's interpretation of the indenture provisions heretofore quoted, no cash dividends could be paid on the common stock of the holding company unless such transfer was reversed or otherwise charged to surplus, or unless the amount charged to income for replacement reserves was sufficiently in excess of current retirements to restore and hold the replacement reserves at $13,957,923, except as diminished by the reserves of subsidiaries sold. If the latter course were adopted, the combined net earnings of subsidiaries after deduction of such charges, when taken up by the holding company, would not yield sufficient revenue to allow for the payment of common dividends until 1926. The holding company, in accordance with its interpretation of the indenture provision, combined the replacement reserves and a portion of the acquired surplus appearing on the books of its subsidiaries as fulfilling the indenture requirement that $13,957,923 be maintained in the subsidiaries' business. As previously stated, the holding company took up the earnings from subsidiaries after preferred dividends, but before reserves, and deducted therefrom the percentages for replacement reserves as established in the indenture. This procedure, the company states, is in accordance with the section of the indenture which defines the earnings [178] of a pledged subsidiary as "the balance of the gross earnings of such pledged subsidiary remaining after deducting therefrom the total operating charges of such pledged subsidiary, including depreciation (to the extent hereinafter set forth in section 3 of article VIII hereof, after crediting maintenance expenditures as therein provided), interest, rentals, insurance, and taxes (including State and Federal income taxes), and all accruals of such interest, rentals, and taxes." The result of this method is demonstrated by the following figures for the 6 months' period ended December 31, 1924, and for each of the years ended December 31, 1924 to 1927, inclusive, taken from the income and surplus statements marked "Exhibits 5 and 6" within the Commission's Exhibit 6201. [179] It will be seen that, had Cities Service Power & Light Co. taken up as income the net earnings of subsidiaries after the charge for replacement reserves, there would not have remained sufficient surplus from which to declare the dividends that were paid on the common stock in 1925, and had such dividends been declared for the 3 years as shown above, it would have resulted in a deficit of $4,345,564 as of December 31, 1927. On the other hand, if the replacement reserves of subsidiaries had, forthwith upon the execution of the indenture, been reduced to the amounts required by the indenture, the result shown by the above table would not have been produced and instead the computation shown above would have resulted in the surplus reported by the company. In other words, in order to declare the dividends that were paid on the common capital stock of Cities Service Power & Light Co. for the 3 years, it was necessary to use $4,345,564 of the $12,891,735 which had been accumulated by the subsidiaries as replacement reserves, termed by the holding company "excess reserves." Of this latter amount, $2,221,115 was transferred to surplus, leaving $6,325,056 as the surplus of the holding company as of December 31, 1927, according to their computation. In the examiner's opinion, the inclusion of these excess reserves as income affects the surplus of the holding company in subsequent years, but as the object of this description is to show the effect on the declaration of dividends under the first indenture, this matter will not be dwelt upon at this time. Obviously the covenant requiring a certain amount of replacement reserves to be maintained on the books of the subsidiaries was for the protection of the bondholders, and was designed to preserve the capital of the subsidiaries, as at date of acquisition, from impairment by the payment of dividends during such period as the securities of subsidiaries [180] were pledged as collateral under the indenture. The company states that the foregoing discussion of the interpretation of the 1924 indenture is purely academic, however, since the bonds issued thereunder and secured thereby were all paid off in 1927 at the principal amount thereof, plus the premium of 5 percent of such principal, plus accrued interest, and the indenture securing the bonds was satisfied and discharged. The covenant of the indenture provided that the combined accumulated depreciation of the subsidiaries as of June 30, 1924, should be diminished by the accumulated depreciation as of June 30, 1924, of any subsidiary disposed of. The subsidiaries disposed of and the amount of accumulated depreciation for each, as of June 30, 1924, was as follows: |