that of an "affiliate" or a "person" as defined in the Act. The provisions of the Act are sufficient to authorize the Commission to revoke or amend the order of exemption in the event it finds that the circumstances which gave rise to its issuance no longer exist. The foregoing considerations lead us to the conclusion that it is unnecessary for us to find that the exemption herein granted would be detrimental to the public interest or that of investors or consumers. The order of the Commission will exempt the applicant from all provisions of the Act that would require its registration thereunder because of its control over its subsidiary public utility companies, Washington Gas Light Company of Montgomery County, Md., Rosslyn Gas Company, Washington Suburban Gas Company, and Alexandria Gas Company.

An appropriate order will issue.

By the Commission: Commissioner Henderson being absent and not participating herein.

6 S. E. C.

[No. 991]

IN THE MATTER OF

ALLEGHANY CORPORATION

File Nos. 21-100 and 1-2644. Promulgated March 1, 1940

APPEARANCES:

Smith W. Brookhart, Jr. and Wilbur H. Mack, of the Registration Division of the Commission.

David Teitelbaum, for Alleghany Corporation.

REPORT OF THE COMMISSION

An investigation under Section 21 (a)1 of the Securities Exchange Act of 1934 was instituted pursuant to order of the Commission dated July 28, 1938, to determine whether Alleghany Corporation (hereinafter referred to as "Alleghany") had failed to comply with Sections 12 (b) (1) and 13 (a) (2) of the Act, the rules and regulations promulgated thereunder, and had violated the provisions of Section 32. Specifically, the order stated that the Commission had reasonable grounds to believe that financial statements filed by Alleghany with the Commission for the years 1934 to 1937, inclusive, contained false and misleading statements, in view of the treatment accorded the following items in the financial statements: (1) bond discount and expense in the approximate amount of $5,000,000; (2) net losses

As to the character of an investigation under Section 21 (a), see In the matter of White, Weld & Co. et al., 1 S. E. C. 574 (1936), and In re Securities Exchange Commis sion, 84 F. (2d) 316 (C. C. A. 2d, 1936).

In brief, Section 12 (b) (1) provides the means for the registration of securities on national securities exchanges and specifies the information to be filed in connection therewith; Section 13 (a) (2) makes provision for the filing of annual reports by issuers whose securities are registered under the Act. In the immediate case Alleghany filed on March 19, 1935, under Section 12 (b) (1), Form 7, for provisional registration of its common stock and prior preferred convertible stock on the New York Stock Exchange. Subsequently, on June 27, 1936, Alleghany filed an application under that same section on Form 10 for permanent registration of the two classes of securities above enumerated, its cumulative 5%% preferred stock, series A; its 15-year collateral trust convertible 5% bonds; its 20-year collateral trust convertible 5% bonds; and its 20-year collateral trust 5% bonds, on the same exchange. On May 29, 1937, and on May 2, 1938, Alleghany filed annual reports for each of the respective preceding years on Form 10-K, under Section 13 (a) (2). Each of the applications and reports included financial statements containing balance sheets and profit-and-loss statements.

6 S. E. C.34-2423

realized during the years 1931 to 1937, inclusive, on the sale of investments in the approximate amount of $23,000,000; and (3) a loss in the amount of $29,612,125.15 resulting from a contract between Alleghany and The Chesapeake & Ohio Railways Company (hereinafter referred to as the "Railway"), dated February 1, 1932, and supplemented February 1, 1936, covering the sale of certain securities by Alleghany.

The investigation, conducted before a trial examiner, was closed on December 6, 1938. On November 28, 1938, and again on January 17, 1940, Alleghany filed amendments to its application for registration and its annual reports. These amendments made corrections, commented on hereinafter, to the financial statements for the years ended December 31, 1934, 1935, 1936, and 1937. Counsel for Alleghany appeared before the Commission on November 7, 1939, and presented orally his views on the questions mentioned in the investigation.

Before considering the particular items of the financial statements which were the subject of the Commission's investigation, it may be noted that the transactions involved occurred in the early years of Alleghany's existence. Since the time of those transactions, Alleghany's management has substantially changed. However, the questions at issue in the investigation related to the application of accounting principles and the accountants, Lybrand, Ross Bros. & Montgomery, who certified all the financial statements filed with the Commission, became the accountants for Alleghany in 1930.

BOND DISCOUNT AND EXPENSE

In the course of the investigation it was developed that the aggregate amount of discount and expense incurred in the issue of Alleghany's bonds was $5,142,889.64. This amount was charged directly to paid-in surplus in the years incurred, namely, 1929 and 1930. Although there was no earned surplus when the charges were made in 1929, there was in 1930 sufficient earned surplus to absorb the amount charged off in that year. This method of treatment has been questioned.

In 1938 there remained only one director of Alleghany who had been a director at the time the above transactions occurred.

The financial statements filed with us, disclosed in footnotes appended to the balance sheets, in the paid-in surplus schedule, in the earned surplus schedule, and in the profitand-loss account that bond discount and expense had been charged to paid-in surplus and it was explained how those statements would have been affected had bond discount and expense been set up as a deferred charge and amortized against profit and loss. Disclosure of the fact that bond discount and expense had been charged to paid-in surplus was also made in item 34 (c) of the registration statement.

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Accounting authority recognizes that bond discount should be considered as part of the interest cost of the capital obtained. Discount represents the difference between the amount received on the sale of bonds and the amount required to be paid at their maturity. Thus it constitutes part of the cost which the issuer must eventually pay for the use of the funds.

Representing additional interest, generally accepted accounting practice permits it to be allocated over the life of the entire issue as a charge to the profit-and-loss account. The effect of such treatment is to make the annual charges correspond to the real rather than nominal rate of interest for the use of capital. Similar treatment may be accorded expenses incurred in issuing bonds. These expenses relate to the entire period during which the bonds are to be outstanding and accordingly may be allocated ratably over that period. The unamortized balance, though not a true asset, is pursuant to current accounting convention set up as a separate item in the asset or debit column of the balance sheet."

An alternative practice which has some support is to charge bond discount and expense directly to earned surplus at the time incurred. This practice too, recognizes the charges are properly allocable to earnings, although it does not require that current profit and loss statements be charged.

The financial statements filed by Alleghany did not adopt either of the above procedures. Rather, bond discount and expense was charged directly to paid-in surplus in 1929 and 1930. This either overstated Alleghany's net income in subsequent years, by relieving income of charges which would otherwise have been made thereto or resulted in an overstatement of earned surplus.10

The accounting entries adversely criticized above were made prior to January 1, 1934. Although it must be recognized that their effect

Montgomery, Audit Theory and Practice, 2d ed. (1918 printing), p. 374, and 5th ed. (1934), pp. 289–291; Hatfield, Accounting (1927), pp. 229-230; and Paton (ed.), Accountants' Handbook (1934), p. 890. It may be noted that Montgomery recognized that some corporations had followed the practice of charging bond discount and expense to surplus. See In re Central Maine Power Co., 130 Maine 28, 153 Atl. 187 (1931). Investors should appreciate that a debit of this nature, although appearing on the asset side of the balance sheet, does not represent tangible or realizable values. Amort!zation of such an item results in a charge to current income with the result that, if operations are not carried on at a loss, an amount of assets equal to the charge is retained in the business so that in effect a real asset is substituted for the deferred charge. Such charges should equal the amount of the discount at the maturity of the issue.

See Section 126 of the Uniform System of Accounts for Public Utility Holding Companies, promulgated by this Commission pursuant to Sections 15 and 20 (a) of the Public Utility Holding Company Act of 1935.

• Amortization in accordance with the more generally recognized practice would have resulted in annual charges to income for each of the years with which we are concerned of approximately $275,000.

10 The paid-in surplus account was, of course, immediately reduced by the full amount of the charge.

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extended to the statement filed with us after that date, the forms for registration under the Securities Exchange Act permit a registrant to include in its financial statements balances in its accounts as shown on its books on January 1, 1934. Although there may be some question as to whether we should require the correction of entries made before 1934 in view of this provision of our forms, we need not pass upon that point in this report since, subsequent to the commencement of this investigation, the registration statement and the annual reports were in fact amended. The amended balance sheets reflect the balance of unamortized discount and expense on the bonds, and the amended profit-and-loss statements show an annual charge of an appropriate portion thereof. Paid-in and earned surplus have been adjusted.12 Thus, the financial statements of the registrant at the present time, due to these amendments, follow in this respect accounting principles, which we consider to be proper.

LOSSES ON SALE OF INVESTMENTS

From 1929 to 1937 Alleghany engaged in various transactions in the purchase and sale of securities,13 resulting in net profits or losses in each year, which were credited or charged to the following of its accounts:

This item was originally charged to earned surplus but subsequently transferred to paid-in surplus.

The debits and credits to paid-in surplus in years subsequent to 1930 are questioned on the ground that the income accounts rather than paid-in surplus should have reflected such items. It may be first noted that, although the charges to paid-in surplus were authorized by Alleghany's charter, such a provision does not justify a departure from sound accounting.

11 See e. g. Instruction book for Form 10, Schedule VII and Item 36.

12 The paid-in surplus has been credited with the entire amount originally charged off; the earned surplus has been decreased by the amount of the annual charges for amortization of bond discount and expense charged to profit and loss.

13 The record indicates that Alleghany engaged in a number of securities transactions during the early years of its existence. Incorporated in 1929, the character of its business is described in its application for registration of its securities under the Act as the acquisition, investment in, and disposition of, railroad securities.