[1940] Ch33 MISLEADING ARTIFICES IN THE INCOME ACCOUNT. EARNINGS OF SUBSIDIARIES
Edited: 1 year ago

Summary:

In the early 20th century, there were several examples of companies engaging in questionable accounting practices. One notable case was Park and Tilford, Inc., which padded its income account by increasing the item of Good-will and Trade-marks and deducting these increases from expenses. This concealed a reduction in net current assets, which was more than the cash dividends paid. The company claimed that these increases represented expenditures for advertising, but no statement was provided to stockholders or the New York Stock Exchange. Similarly, the United Cigar Stores Company of America manipulated its accounting by including the appreciation of leaseholds as earnings, contrary to accounting principles. These cases highlight the need for independent audits and detailed reconciliations of net earnings reported to shareholders.

Investors should be wary of companies with questionable accounting practices, such as United Cigar Stores, to avoid potential financial losses. Even if a company appears attractive on the surface, dishonest bookkeeping can lead to its downfall. The accounting practice of Tobacco Products Corporation, which inflated its income account by placing a fictitious valuation on stock dividends received, further highlights the dangers of pyramiding of earnings. The New York Stock Exchange has since prohibited this practice.

Parent-subsidiary relationships can result in distorted income reporting. For example, the Western Pacific Railroad Corporation donated money to its operating subsidiary and then took the same money back as a dividend, allowing it to report higher earnings on its common stock than the actual applicable earnings. Similar practices were followed by the New York, Chicago, and St. Louis Railroad Company. Analyzing subsidiary losses is complex and requires a case-by-case approach. If the subsidiary's losses can be terminated without negatively impacting the parent company's profitability, they may be considered nonrecurring items. However, if there are important business relationships between the parent company and the subsidiary, the losses must be carefully considered.

In conclusion, avoiding companies with questionable accounting practices is essential to protect investors' interests. Consolidated income accounts provide a true picture of a company's operations, and adjustments must be made for nonconsolidated profits or losses. Parent-subsidiary relationships can complicate income reporting, and subsidiary losses require careful analysis and consideration.

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