Concept of Surplus in Financial Management

There are different views regarding the meaning and concept of surplus in financial management. According to one school of thought, the balance remaining after deducting the liabilities and share capital from the total of assets is known as ‘surplus‘. In the opinion of the other school, ‘surplus‘ represents the ‘undistributed earnings’ of a company, i.e., the balance of profits remaining after paying dividends to the shareholders. Still, there are others in whose opinion ‘surplus‘ is a left over which represents an addition to assets that is carried over on the ‘equity side’. But, surplus is solely equity of stock-holders and not an asset in any sense of the word. In simple words, ‘surplus‘ may be described as the net income of the company remaining after payment of dividend and all other expenses. It is the difference between the book value of the assets and the sum of liabilities and capital.

Surplus is considered to be a sort of a blanket covering of many corporate purposes. It is not merely a source of dividend, but has various other functions as well. It is regarded as a welcome sign by the management. It reflects upon the sound earning capacity of a firm. It enables a company to follow a stable dividend policy. A company can pay stable dividends even in the years when there are no sufficient profits. Surplus acts as a cushion to absorb the shocks of economy and business such as depression for the company. A company with large surplus can withstand the shocks of trade cycles and the uncertainty of the market with comfort, preparedness and economy.

Types and Sources of Surplus

The various kinds of surplus and their sources are discussed as below:

  1. Earned surplus. In the mind of a layman, surplus always implies earned surplus. The use of the term surplus as accumulation of past earnings accounts for its common identification with earned surplus. The main sources of earned surplus are:
    1. past accumulated profits;
    2. net profits from business operations at the close of each financial year;
    3. retained earnings including income from business operations as well as non-operational incomes, such as profit on sale of fixed assets ;
    4. conversion of reserves which are no longer required; and
    5. non-operating income.
  2. Capital surplus. Capital surplus is that part of the surplus which is not related directly to the operating results of the business. It results from:
    1. an increase in assets without a corresponding increase in liability or capital; and
    2. a decrease in capital or liabilities without a corresponding decrease in assets.
  3. Surplus from unrealized appreciation of asset. During periods of prosperity or boom, the value of fixed assets may increase or intangible values may be added by accounting entries. Such a surplus is not realized because the assets are not actually sold but the effect of an appreciated surplus is created when a company appreciates its assets.
  4. Surplus from realized appreciation of asset. The sale of assets at prices in excess of book values may result in realized surplus.
  5. Surplus from mergers, consolidations and reorganizations.  In mergers and consolidations, stock may be exchanged for stock and surpluses taken over by the new companies. Since mergers and consolidations are generally accompanied by an upward valuation of assets, the resulting surplus may be larger than the total of that resulting in an increase in surplus. Even unsuccessful companies may increase their book surplus through a forced reduction in liabilities.
  6. Surplus from reduction of share capital. In periods of adversity, companies may create a surplus by reducing the liability of their stated capital. This process of creating a surplus involves a number of legal formalities and a sanction of the creditors.
  7. Surplus from secret reserves. A secret reserve is one which is not disclosed in the balance sheet. This method of creating a surplus is not encouraged because it does not represent a true and fair view of the company’s financial position and provides an opportunity to the management for manipulation and misuse of the company’s funds. Such a reserve may be created by:
    1. an understatement of income;
    2. an excessive depreciation;
    3. inflation of capital expenditure;
    4. an undervaluation of assets; and
    5. an overstatement of liabilities.
  8. Paid-in surplus. It arises from the issue of shares at premium.

Uses of Surplus

Surplus in financial management may be broadly classified as (i) earned surplus; and (ii) capital surplus. The uses of surplus have been discussed below keeping in mind such classification:

  1. Uses of Earned Surplus: The accumulated earned surplus can be utilized by the company for the following:
    1. reducing the value of fixed and working capital ;
    2. writing off intangible assets, such as, goodwill, preliminary expenses, etc.
    3. equalizing the rate of dividend;
    4. financing schemes of expansion and growth ;
    5. absorbing the shocks of business cycles; and
    6. supplementing other reserves.
  2. Uses of Capital Surplus: Capital surplus may be used for the following purposes:
    1. for expansion and growth ;
    2. for protecting investments against a decline in values.
    3. for providing funds for working capital ;
    4. for writing down of operating losses;
    5. for absorbing depreciation.

Creation of Surplus

Surplus can be created by the following methods:

1. Understatement of liabilities, by:

  1. omission of certain liabilities ;
  2. providing inadequate depreciation; and
  3. providing insufficient taxes.

2. Overstatement of assets, by:

  1. over-valuation of certain assets, such as inventories;
  2. considering unrealized profits;
  3. not making a provision for bad and doubtful debts ;         
  4. not taking into account the loss or shrinkage in the value of an asset

Hiding of Surplus

Sometimes the companies hide their surplus for the various reasons, such as:

  • To prevent the shareholders from demanding the distribution of surplus;
  • To induce investors to sell their shareholdings to the management at less than its true value;
  • To preserve the management from the temptation of paying large dividend;
  • To save heavy taxation; 
  • To prevent competitors;
  • To delay payments to creditors by impressing upon them their inability to pay immediately.

The various methods that are generally employed to hide the surplus in business are as follows:

  1. Undervaluation of assets by :
    1. charging excessive depreciation;
    2. charging capital expenses as revenue;
    3. writing off assets by charging against surplus.
  2. Overstatement of liabilities by :
    1. showing a contingent liability as an actual liability ;
    2. use of fictitious liabilities; and
    3. providing excessive provision for taxation, etc.