The Stock Watering Debate: More Light, Less Heat
Hake, Eric R., Journal of Economic Issues
Stock watering, according to its many critics in the early twentieth century, was a way for unscrupulous robber barons to bilk money from the American public. It could also be seen as part of the revolution in accounting practice that made corporate capitalism possible. Thorstein Veblen saw this pretty clearly when, in a New York Times special report, he somewhat facetiously defended watered stock as a new form of capitalization, "something no self-respecting corporation should be without" (Defense 1903, 6).
The new accounting practices that allowed stock watering should also be seen as the legitimation of claims on the flow of national income. As institutionalists appreciate, the claims on income regarded as legitimate develop from social construction. Even if the unrealistic conditions of the neoclassical model of perfect competition were met, claims on national income would not be innate and natural returns to the value of inputs, being instead a part of a complex system of socially legitimated claims. I therefore offer the following story of stock watering and the change in accounting practice for two reasons: (1) it deals with a fierce conflict over corporate practice from our past and has interest for that reason alone and (2) it affords an illustrative account of how legitimation of new claims on income take place. As ongoing processes of claim legitimation are a central part of the evolution of an economic system, illustrations from the past are likely to sharpen our ability to focus on like processes in the present.
According to the US Industrial Commission testimony of John R. Dos Passos, Chicago lawyer and corporate promoter (1900, 1149):
Capitalization is of two kinds; there is a capitalization based upon the actual value of the property and a capitalization based upon earning power.... You will find two classes of people in this country--one in favor of the former method and one in favor of the latter.
As described from the different perspectives of Ripley 1905 (121-122) and Meade 1903 (290-292), the former of these two methods was considered more conservative (or unsophisticated) and found expression in the state charter laws of Massachussetts and Connecticut. The latter was more liberal (modern) and provided the basis for the capitalization of companies chartered in New Jersey, West Virginia, or Delaware. While disagreement remained concerning the techniques and efficacy of the two methods, two facts were generally accepted--two methods of capitalization existed and no national standards for capitalization or accounting existed to delineate the two (US Industrial Commission 1900, Summary of Findings).
The majority of critics of stock watering/over-capitalization, like James B. Dill, Arthur Anderson, and William Z. Ripley, appeared sympathetic to the rise of the corporation but were concerned about the potential for fraud. To understand their concern, and to understand the income claims that the new methods entailed, it is necessary to view the rise of corporate finance in the context of existing accounting practice and the state of the accounting profession at the time.
The Accounting Profession in America
While book-keeping had existed throughout the nineteenth century, it is commonly accepted that the early development of the American public accounting profession was the result of an influx of English and Scottish accountants, serving the interests of British investors in America, with some key firms established in the 1880s and 1890s (Davies 1926, 106; Miranti 1990, 24). The founding of indigenous American accounting firms increased after 1895, as commercial and investment bankers began to require more complete auditing of the new combinations seeking underwriting and other services (Zimmerman 1954, 138).
The rise of professional associations shadowed the expansion of accounting firms with the establishment of the American Association of Public Accountants in 1887. …