Railroads - Business in United States of America

Definition: Companies formed around a mode of transportation in which cars are drawn by locomotive or powered by motors on tracks formed by rails attached to ties on a roadbed
Significance: Railroads were the form of transport that revolutionized American business. As one of the first big businesses in the United States, railroads had a positive effect on accounting, auditing, finance, management, and marketing practices. They also enabled other businesses to expand throughout the country.
The Baltimore and Ohio (B&O) Railroad, formed in 1827, and based on a British concept, was the earliest U.S. railroad. Although dozens of other railroads soon followed in the United States, it was the B&O that eventually became known as the “university” of railroad accounting and business operations. Many aspects of business management originated at the B&O. For a quarter of a century, the Baltimore and Ohio was the source of all things good in railroading. Then, during the early 1850’s, a new railroading environment led to the Illinois Central Railroad and the Mobile and Ohio (M&O) Railroad becoming important leaders. An analysis of the innovations of these three lines essentially covers most of the important aspects of the first half century of railroading, although admittedly the chief financial officer of the Louisville and Nashville Railroad, Albert Fink, made important managerial contributions near the end of this early period. The first half century of railroad operations was essentially a growth phase and was followed by a regulatory phase. The regulatory phase, highlighted by the creation of the Interstate Commerce Commission, was a period of controversy, as railroads alternately tried to help the regulators and to block their efforts by stifling certain rules and regulations.

Capitalization

What made railroads modern businesses was the capital requirements of these enterprises, which were far in excess of those of other contemporary businesses. This meant that external financing had to be sought to construct a railroad line. Although other businesses were owner-operated ventures that required no more than local bank loans, railroads required more funds than one person could risk because of the capital needed to construct a line. This created new issues of how to communicate with external investors regarding the performance of the railroad and how to monitor the railroad managers who were stewards of the company’s assets. These so-called agency, or principal-agent, problems— regarding how to ensure that the workers and managers of a company work in the best interests of its investors—remain issues for modern-day companies.
Initially, there was a quasi-public nature about railroads. Governments played key roles in helping establish early rail lines. Besides providing support through the purchase and guarantee of securities, many state and local governments assisted individual railroads through land grants. In addition, because railroads were often natural monopolies sanctioned by the state, their securities were viewed as akin to those of governments. In many cases, investors were not so much investing in the leadership of the railroad company but in the manufacturers, farmers, and consumers of the area in which the railroad operated. Thus, railroad securities were in some ways akin to government securities.

The B&O

The B&O was formed in 1827 as merchants of Baltimore sought to preserve their city’s commercial advantage as a seaport linked with the American interior. The city had risen to third in size in the United States because of the construction of the Cumberland Road, which bridged the Allegheny Mountains from Cumberland, Maryland, to the Ohio River Valley and on to the Mississippi River Valley of the Midwest. However, even with the Cumberland Road, travel by wagon was arduous, slow, and costly. The opening of the Erie Canal (which in effect connected the port of New York City with Lake Erie) in late 1825 threatened to ruin Baltimore’s commercial role, as transport to the Ohio and Mississippi river valleys shifted to waterborne shipment via canal, lake, and river through New York City. Freight prices dropped significantly and set off a boom in canal building by some cities and a search for alternative forms of transportation by others.
Because Baltimore did not have direct river access to the west, merchants of the city were willing to consider all ideas. Banker Philip E. Thomas had been corresponding with his brother, Evan, who was in England and was excited about “railed roads” there. Similarly George Brown, an investment banker, had been hearing from his brother, William, in Liverpool, about British railroads. Therefore, Thomas and Brown met over dinner and discussed the possibility of a railed road connecting Baltimore with the Ohio River. The two believed that the cost of construction of the railed road, even though it had to pass over mountains, would be less than the cost of the Chesapeake and Ohio Canal (the nearest competitive alternative), and the two felt that the railed road offered mechanical advantages, including that horse-drawn wagons could be pulled efficiently in a train on the smooth rails.
Merchants of Baltimore met and seized on the railed road idea. Investors quickly subscribed to thirty thousand shares of $100 stock, as virtually every citizen of Baltimore supported the enterprise. City of Baltimore and state of Maryland funds also were invested, as these entities received half ownership of the shares, making the Baltimore and Ohio both a public and private entity. The incorporation act specified that the Maryland legislature would set freight and passenger rates and that the B&O would not pay taxes. An annual report issued by the corporation to its shareholders was required by the B&O corporate charter; however, the contents of the annual report were not specified.

Tracking the Business

The size and growth of the enterprise from the time of the initial public offering were significant. The railroad management quickly evolved into a separate professional class with only a small ownership interest but with expertise to run the operations. This early evolution would lead to agency relationships, which were significant in the development of accounting, auditing, finance, and business management. In accounting, the corporate annual report would evolve, becoming an essential financial communication device for management, describing the company’s performance and its role as the steward of shareholder assets. These financial statements developed into the basic income statement, balance sheet, and early cash flow report.
As they grew, the early railroads encountered new control problems involving how to deal with large volumes of business transactions occurring daily across long distances and with a multitude of employees handling cash or originating otherwise complex transactions. These employees ranged from ticket agents and freight agents at each station and depot to conductors on each train. Cash disbursements were the responsibilities of an ever greater number of employees. Control over cash transactions would push accounting from the family-owned businesses’ journal-ledger system of recording infrequent transactions to the development of techniques to ensure proper recording, transferring, safeguarding, depositing, and handling of cash. The railroads handled control problems by developing internal auditing and training accountants in legion. The accounting profession would become firmly established during the manufacturing revolution of the late nineteenth century.
Financial innovations were sparked by the railroads. The railroads raised large amounts of capital, requiring wider public sale of stock and bonds. This expanded the role of investment banking and the securities houses, which had previously been trading mostly government debt obligations. Railroad securities laid the foundation for industrial firms to issue stocks and bonds to the public half a century later. Innovations in the types of bonds issued were also a product of the railroads—as “mortgage” bonds, “interest” bonds, debentures, and a wide variety of other types of debt obligations evolved. Railroads also changed the practice of businesses’ paying out profits as dividends to owners. Retention of profits became a major source of financing for the nineteenth century railroads. The early use of preferred stock can also be found at the Baltimore and Ohio Railroad.

Efficiency and the Railroads

Railroads created a new standard of precision of operations. To be successful, the railroad had to operate trains in a safe, efficient manner, which required a close coordination not widely practiced at the time. Operating from distant locations and running trains traveling at different speeds on one-way track in both directions required all employees to work by the same strict standards, from the establishment of a standard (“railroad”) time system, to maintenance of the equipment and lines, and to strict adherence to procedure. Supervision was needed, and lines of authority were drawn. A hierarchy became established. Managers with special expertise evolved into a professional class who organized activities and made resource allocations. Railroad success depended on throughput: running the trains full and fast, and turning them around quickly. This concept was revolutionary in its day but became the essence of the Industrial Revolution, as high-volume plant utilization of fixed cost facilities drove down cost per unit. Managing by accounting for costs of a department and other subunits and by statistical factors, such as cost per freight-ton-mile, evolved with the railroads.
The railroads revolutionized the economy: Freight costs declined dramatically, and travel time between cities or regions of the country decreased from days to hours. The interior of the United States became open to farming as farmers’ produce could be shipped to market and to merchants who in turn could sell goods to rural customers. The railroad saw the development of support industries and professions, including civil engineering, the coal industry, the steel industry, and the travel and vacation industry. Telegraph lines were first placed on the railroad rights of way, and the telegraph quickly became an essential way of communicating and coordinating train traffic.

Net Income of Major U.S. Railroads, 1890-2005, in Millions of Dollars

Quality Annual Reports

The B&O published excellent annual reports from its earliest years, primarily for the benefit of its existing investors, but it was the Illinois Central Railroad that perfected the annual report. From as early as the 1850’s, the first years of its existence, the Illinois Central published annual reports that were aimed at both the general American public (that is, no investors) and the European capital markets (the majority investors). Admittedly, the Illinois Central, because of the way it was founded, was a unique type of corporation, which had a greater responsibility to the general public than most corporations have; nevertheless, its reports provided a textbook example of reporting at its finest because the corporation’s annual reports met the needs of both audiences.
The Illinois Central, sometimes called the Main Line of Mid-America, was the country’s first cross country railroad system, extending from Lake Michigan in the north to the Gulf of Mexico in the south. It also was the country’s first land-grant railroad and thus an experiment in social economy. The transportation provided by the line was the intended product of a collaboration by northern senator Stephen Douglas of Illinois and southern senators Jefferson Davis of Mississippi and William R. King of Alabama, who joined forces to provide an unprecedented form of federal subsidy that could link agricultural markets and shipping points in the emerging population centers in the Midwest and South. The subsidy, in the form of federal land grants, was to shape the modernization of the American frontier. The country’s rich interior land was almost worthless without access to markets, which railroads were to provide.
The land-grant legislation of September, 1850, marked the first time that public lands from the United States federal government were used to aid in the construction of a private rail line. It was to become a standard means by which the federal government subsidized railroads. Senator Douglas was the main supporter of the bill in Congress (with help in the House from Abraham Lincoln). An initial bill, limited to public lands in Illinois, was narrowly defeated in 1848. In 1850, Senators King and Davis amended the bill to extend the grants to the southern states. With this new source of support, the bill passed. A main argument in support of the legislation was that the federal land was worthless without a railroad, and no private railroad would build where there was no population to serve. If a portion of the land was given to the railroad, in checkerboard fashion, the remaining land still owned by the government would become more valuable. Thus, the sale of the land could be used to finance the railroad, which in turn would make both the railroad’s and the government’s land more valuable. In reality, the land grants were viewed by Congress not as subsidies but as investments in marketable land.

Financing the Illinois Central

The incorporators’ plan for financing the Illinois Central was simple and, to insiders, most attractive. They anticipated using the land grant as security for a bond issue, the proceeds of which would pay for construction. Thereafter, the bonds could be paid off with proceeds from the sale of the lands, whose value was enhanced by the transport provided by the railroad. This would permit the incorporators to own the railroad and to operate it with minimal investment. In March, 1851, the Illinois Central board of directors held its first meeting and authorized a deposit of $200,000 with the state to guarantee good faith on behalf of the incorporators. The deposit came from the sale of stock to the thirteen incorporators. The incorporators wanted to keep their cash investments at a minimum. Bond sales were slow, particularly in Europe, where investors, especially in England, were wary of the state of Illinois because the state had missed interest payments on several loan agreements. However, by adding options to buy stock, large quantities of bonds were eventually (mid-1852) sold in both the United States and in Europe.

Frauds

Many frauds involving railroads occurred during the early years. In 1856, as the Mobile and Ohio Railroad was being built north, management problems occurred because the president and another officer speculated on acquiring land along the route. This conflict of interest between the officers and the railroad resulted in considerable controversy and the firing of officers involved in the land speculation. Noteworthy is the fact that an audit committee was designated by the board of directors to investigate the president. Fortunately, the M&O had a set of bylaws that mentioned ethical issues—a rare phenomenon at the time. Other small frauds took place at other railroads, but the king of railroad frauds involved the financing of the transcontinental railroad.
The Crédit Mobilier of America was the most widely publicized railroad fraud in history. A September 4, 1872, article in the powerful New York Sun accused Vice President Schuyler Colfax and other noted politicians of accepting stock in the Crédit Mobilier in exchange for their influence in Congress. Crédit Mobilier was the construction company that built the transcontinental railroad on behalf of the Union Pacific Railroad. The objective of the bribes was to be sure that there would be no interference from Congress that would delay federal money being funneled into railroad construction. To make the matter of taking bribes even worse, it was determined that one of the purposes of Crédit Mobilier, besides building the railroad, was to defraud the government by overcharging for construction of the tracks. Insiders at the Union Pacific Railroad had created the construction company to enable them to pay themselves millions of dollars to build the railroad. Thus, Crédit Mobilier was a scandal of gargantuan proportions even before it was connected to the acceptance of bribes by politicians.
The investigation disclosed that Colfax had received twenty shares of stock in Crédit Mobilier and dividends of $1,200 from that investment. Colfax asserted that he had never owned any stock that he had not purchased. Similarly, he claimed never to have received the supposed $1,200 in dividends. However, the House Judiciary Committee investigation determined that Colfax had indeed deposited $1,200 into his bank account just two days after the supposed dividend payment. After two weeks, Colfax explained that the deposit had been a campaign contribution from a friend who had since died. Even his strongest supporters doubted this story.

ICC and Other Regulation

The history of railroad regulation is a combination of social, cultural, and political phenomena, which together are justified by increased efficiency and lower prices for consumers. The early history of railroad regulation was state based, but in 1887, the federal government took over with the establishment of the Interstate Commerce Commission (ICC).
The Hepburn Act of 1906 gave the ICC the power to set maximum rates. More important, the Interstate Commerce Commission could view the railroads’ financial records, which had to be prepared using a standardized accounting system. The Hepburn Act also expanded the Interstate Commerce Commission’s authority to cover toll bridges, terminals, ferries, sleeping cars, express companies, and oil pipelines. Many scholars consider the Hepburn Act to be the most important piece of legislation regarding railroads in the first half of the twentieth century. Economists and historians have suggested that the Hepburn Act may have crippled the railroads to such an extent and given so much advantage to shippers that a giant unregulated trucking industry—undreamed of in 1906—took away the railroad’s freight business.
In 1968, the Pennsylvania Railroad and the New York Central Railroad merged to form the Penn Central Transportation Company (PC). Two years later, the PC, then the largest railroad in the United States, entered reorganization under the Bankruptcy Act. The bankruptcy led to the 1976 creation of Conrail. The PC’s failure is illustrative of the problems of the railroad industry during the late 1960’s. The PC was a victim of undesirable industry trends; the railroad industry was a sick industry. A big problem was that railroads were heavily regulated by the Interstate Commerce Commission and were still treated as if they had the transportation monopoly they had during the late nineteenth century. The railroad industry’s freight market share decreased from 67 percent in 1947 to 40 percent in 1971, and government money was spent building highways and airports, while the railroads had to provide maintenance on their own track structure. Meanwhile, although the U.S. Postal Service diverted mail shipments from rail to both air and road, the ICC forced the railroads to continue operating money-losing passenger trains until the 1971 creation of Amtrak.
Basically, the railroad industry was impeded in its ability to compete by excessive regulation. Additional railroad bankruptcies in the Northeast led to the creation of a government-owned Conrail in 1976, and the government’s response was to phase in deregulation of the industry. The bankruptcy of the PC was final proof that railroad regulation was not needed. The regulatory system for the transport industry lasted for nearly a century and was not forsaken until the passage of the Staggers Transportation Act of 1978. By this time, concerns about U.S. global competitiveness and the diminishment of efficiency because of market regulation induced Congress to support a new system based more on free competition among the railroads and rival modes of transportation.