An Accounting History of Capital Maintenance: Legal Precedents for Managerial Autonomy in the United Kingdom

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Abstract: The effectiveness of the capital maintenance concept that became enshrined in British companies legislation during the 19th century was almost immediately undermined when companies were permitted to pay dividends from 'circulating' capital surpluses, even though overall there were losses of total invested capital. It is generally accepted that the British courts were conscious not to limit management's capacity to innovate and operate their businesses in good faith, and to maximize the capacity of their entities to distribute dividends to shareholders now and in the future. Nevertheless, it is unclear why at the time some accounting methods were accepted as being satisfactory in certain situations but not in others. It is argued here that the British judges adhered to a number of complementary guiding principles when assessing the validity of particular accounting procedures. Central to these principles is the notion that individual firms have different planning horizons and associated particulars of risk assessment. These cannot be captured by the general use of surplus methods of profit determination using current market prices. Consequently, the courts resisted imposing uniform accounting and reporting requirements because traditionally they respected separation of ownership and control.

INTRODUCTION

"... the maintenance of corpus has been stretched beyond its natural usefulness" [Littleton, 1953, p. 89].

In Britain, the courts provided some of the earliest public arenas for the examination of accounting practices. Accounting practices were invariably ancillary to the main issues of cases, these being disagreements over matters of disclosure and financial measurement. Disputes classified as disclosure-based generally concerned the rights of members and directors of companies to inspect books of account. While these types of cases outnumbered measurement-related disputes brought before the courts, many of the key concerns were subsequently resolved through legislative intervention [Rahman, 1992, pp. 182-184, 191]. In contrast, disputes concerned with measurement issues, while relatively few, centered on the recurring debate over the amount of profits available for the purposes of dividend distribution [Reid, 1988, p. 2; Mills, 1993, p. 776]. To resolve such disputes, judges selectively turned to the notion of capital maintenance for guidance.

The doctrine of capital maintenance, the precept whereby the payment of dividends cannot be made out of capital, was inherited ostensibly from 18th century British charter corporations [Mills, 1993, p. 775]. In order to protect creditors a general consensus emerged. The capital of a company should be maintained so as to provide a fund that creditors could conceivably look to for the payment of their claims. This consensus ultimately became enshrined in law [Gibson, 1971, pp. 26-29; Benson, 1981, p. 22; Morris, 1986, p. 76].

Despite successive legislative requirements precluding the payment of dividends out of anything other than 'profits', it was not until the Companies Act, 1980 that a definition of distributable profits was incorporated into legislation. (1) This absence appears to have significantly constrained the British judiciary. While matters relating to the calculation and payment of dividends clearly fell within the courts' jurisdiction [Ford, 1993, p. 100], the lack of a substantive definition for the term 'profits' limited the judiciary's ability to make any significant determinations on the issue [Dunn, 1975, pp. 16-17; Morley, 1979, p. 36; Corcoran, 1993, p. 100].

When applying legislation the courts are generally assumed to interpret public interest in terms of accepted notions of natural justice, statutory interpretation and precedent [Peirson and Ramsay, 1983, p. 292; Mills, 1993, p. 772]. Consequently, common law emphasizes justice between parties in a process that results from, and also tends to maintain, a society characterized by voluntary behavior and customs [Johnson, 1987, p. …