THE LIBRARY OF THE UNIVERSITY OF CALIFORNIA LOS ANGELES SOUTHERN BRAlMCn UNIVERSITY OF CALIFORNIA LIBRARY LOS ANGELES, CALIF. Graduate 4, California Public Accounting and Auditing Correlating the subjects, Accounting Theory and Practice, Auditing Theory and Practice, and Commercial Law, thereby enabling the student to obtain a view of each of these subjects in its relation to the problems of the Public Accountant and Auditor By J. F. SHERWOOD Certified Public Accountant and Auditor vv \ ^ J- I Published by SOUTH-WESTERN PUBLISHING CO. Cincinnati, Ohio Copyright 1920 SOUTH-WESTERN PUBLISHING CO. Cincinnati, Ohio Bus. Admin. Library HF 5667 S55p v.I PREFACE Accountancy is generally considered the youngest of the professions. In 1896, New York enacted the first Certified Public Accountant law in this country, and thus formally recog- ^ nized accountancy as a profession. Since that time, all the T states excepting two have enacted similar laws, until account- * ancy is now recognized as one of the leading professions. Almost imperceptibly accounting and auditing have grown to be indis- pensable factors in the policy of every business enterprise. Today, it is estimated that there are approximately three thou- sand Certified Public Accountants in the United States. There are hundreds of firms of accountants employing junior and senior accountants, and these firms are now looking to the schools of commerce for suitable recruits for their staffs. Harold Benington, C. P. A., President of the Illinois Society of Certified Public Accountants, in an address delivered in Chicago, December, 1915, at a convention of the National Commercial Teachers' Federation, said: "We, the public accountants, have to rely to a very large extent upon you gentlemen for the recruits that enlist for ser- vices in our offices. We rely upon you to send us men who have undergone the preliminary training and are ready for active service. We don't expect you to send us veterans, but we do expect men who studied the rudimentary theory of tactics and know how to handle their tools. "It seems to me that your share of the work lies in con- stantly improving and expanding the character of the instruc- tion which you offer to your students, and that our share of the work lies to a very large extent in encouraging young men who have just begun business, or who are just about to enter it, to take your courses of instruction, making them realize that their immediate earning capacity is going to be increased." Robert Montgomery, Ex-President of the American Asso- ciation of Public Accountants, now a member of the Executive Committee of the American Institute of Accountants, said in a recent address : "Something must be done at once to increase the number of accountants. Already the amount of work devolving upon the reputable accountants of the country is considerably in excess of their normal capacity. The present difficulties will be enormously enhanced unless we can secure from our insti- tutions of learning, a vastly greater number of qualified ac- countants." The leading institutions of education, both public and private, are now offering instruction in accounting. This text is designed for use in those schools that desire to train students to become junior accountants associated with firms of public accountants and auditors, students who are looking forward to the time when they can qualify for promotion to positions as senior accountants, and be prepared for the pro- fessional examinations for the degree "C. P. A." Accounting, theory and practice, Auditing and Commer- cial Law are considered basic subjects in courses of this nature. There is a distinction between Accounting and. Auditing. How- ever, the term Accounting comprehends audits, among other things, and Auditing presupposes a knowledge of accounting. Commercial Law is not developed herein as a distinct subject, but rather it is intended to show its contact with Accounting. In preparing this treatise, we have, therefore, correlated these subjects so that the student obtains a view of each in its relation to the problems of the public accountant and auditor. As the subject matter is developed, the student learns the rela- tion of Accounting and Auditing and perceives the contact of Commercial Law with Accounting. A knowledge of the principles of bookkeeping and elemen- tary accounting and of Commercial Law is a prerequisite to satisfactorily comprehending the principles of. Public Account- ing and Auditing. The author desires to take this opportunity to express his appreciation of the help and inspiration received from those instructors, professional accountants and others, who have given material assistance in compiling the manuscript and in reading the proof. J. F. SHERWOOD, C. P. A. Cincinnati, Ohio. July i, 1920. CONTENTS Pages CHAPTER 1 5-16 The Work of the Junior The Work of the Senior Purposes and Advantages of an Audit Qualifications of an Auditor Responsibility of Auditors Theory of Accounts Accounting Systems Single Entry Bookkeeping Double Entry Bookkeeping Commercial Law Contact with Accounting Subdivisions of Law CHAPTER II 17-32 Beginning" an Audit Nature of Engagement The Value of an Audit Kinds of Audits Internal Audit Cash Audit Balance Sheet Audit Detailed Audit Classification of Accounts Real Accounts Nominal Accounts The Law of Contracts Essential Conditions CHAPTER III 33-48 Books of Account Books of Original Entry Books of Final Entry The Trial Balance The Balance Sheet The Law of Contracts (Continued) Validity of Contracts 2 CONTENTS Pages CHAPTER IV 49-64 (Beginning a Balance Sheet Audit) Cash 1. Accounting Theory The Theory of the Cash Account Imprest System Fraud 2. Auditing Theory Counting the Cash Verifying the Bank Balance Reconciling the Bank Certificate 3. Auditing Procedure Bank Certificate Working Papers The Law of Contracts (Continued) Assignment of Contracts Novation Discharge of Contracts CHAPTER V 65-80 Notes Receivable 1. Accounting Theory Terminology Notes Receivable Discounted Contingent Liabilities 2. Auditing Theory Listing the Notes Receivable 3. Auditing Procedure Working Papers Securities 1. Accounting Theory Speculative Investments Non-speculative Investments Sinking Fund Investments 2. Auditing Theory Listing of Securities 3. Auditing Procedure The Law of Negotiable Instruments Essentials of Negotiability Non-essentials of Negotiability CHAPTER VI 81-96 Accounts Receivable i. Accounting Theory The Sales Ledger Discounts Doubtful Accounts CONTENTS 3 Pages 2. Auditing Theory Aging Accounts Verification of Accounts 3. Auditing Procedure 4. Income Tax Procedure 5. Legal Phases The Uniform Sales Act CHAPTER VII 97-112 Inventories 1. Accounting Theory Book Inventories Physical Inventories Turnover 2. Auditing Theory 3. Auditing Procedure 4. Income Tax Procedure CHAPTER VIII 113-128 The Trial Balance Items not on Trial Balances Reading the Minutes Fixed Assets The Land Account The Buildings Account The Law of Real Estate Income Tax Procedure CHAPTER IX 129-144 Fixed Assets (Continued) Capital and Revenue Expenditures The Machinery Account The Tools and Implements Account j The Account with Horses, Wagons and Harness The Office Furniture Account Auditing Theory Auditing Procedure The Law of Personal Property CHAPTER X 145-160 Depreciation Causes of Depreciation Factors Bearing on Amount of Depreciation Methods for Calculation Accounting Procedure The Law of Contracts (Reviewed) 4 CONTENTS Pages CHAPTER XI. . . . . 161-176 Current Liabilities Accounts Payable Notes Payable Contingent Liabilities Accrued Liabilities Legal Phases What Constitutes Negotiation Endorsement CHAPTER XII 177-192 Fixed Liabilities Mortgages Bonds CHAPTER XIII 193-208 Net Worth The Sole Proprietorship The Copartnership The Corporation Stock of No Par Value Classification of Capital Stock Pro-iorma Opening Entries CHAPTER XIV 200-224 Profit and Loss The Profit and Loss Statement How to End an Audit The Auditor's Working Sheet CHAPTER XV 225-240 The Report The Statements The Comments The Certificate (Concluding a Balance Sheet Audit) APPENDIX 241-256 Accounting Terminology Chapter One Accounting firms usually classify their employees as JUNIORS and SENIORS. In large firms there may be several different STAFFS located in different cities. A staff will be under the supervision of a SUPERVISING or MANAGING SENIOR and he in turn may be under the direction of a PART- NER of the firm. THE WORK OF THE JUNIOR At first a junior will usually be assigned to work under the direct supervision of a senior who is familiar with the dif- ferent phases of the field work and he will be instructed as to just what to do and how to go about it. In due time, however, he will be sent out only with general instructions from the senior who may not accompany him and he will be expected to know how to proceed with the work. Policies of the firm must be thoroughly understood. They will vary but every firm has certain policies that it expects all employees to adhere to closely. Juniors, seniors, the managing senior, and even a partner will be required by all firms to pre- pare and keep a set of WORKING PAPERS showing a complete record of work completed. The arrangement and scope of these working papers will naturally vary. They will be made up of SCHEDULES containing records and figures arranged in a systematic order so as to show conclusions; how the conclusions were arrived at; why, in some cases, the figures differ from the book figures: and to show items not appearing in the books of account at all. Briefly the duties of the junior will be the verification of bank and cash balances, checking footings, checking and test- ing postings, vouching entries, verifications of securities, taking Trial Balances, checking inventories, making schedules and a variety of similar work. In accounting terms the work to be performed is referred to as an ENGAGEMENT and the party for whom it is to be done is spoken of as a CLIENT. In undertaking an engagement it is essential to keep in mind the work to be performed whether an AUDIT, an EX- AMINATION or an INVESTIGATION; and if an audit, whether it is to be a BALANCE SHEET AUDIT or a DE- TAILED AUDIT. A Balance Sheet audit is frequently referred to as a PARTIAL AUDIT. 6 PUBLIC ACCOUNTING AND AUDITING THE WORK OF THE SENIOR Naturally the senior has certain responsibilities that do not fall on the junior. He may have one or several juniors under his supervision depending upon the nature and extent of each engagement. He will be expected to plan and direct their work, decide difficult and complex questions arising from time to time, and make a complete report of each engagement completed, submitting all necessary working papers arranged to show in detail the work performed. As a rule he will not be expected to prepare final reports for the client, this being done in the office at the direction of a supervising senior or a partner of the firm. However, the senior who expects to become a manager or a partner of the firm should learn to prepare cer- tificates and "reports from a set of working papers. PURPOSES AND ADVANTAGES OF AN AUDIT Minor Objects. The minor objects of an audit may be classified under two distinct heads. (a) Detection and prevention of Fraud. (b) Detection and prevention of Errors. Fraud. In the beginning of professional auditing, fraud was considered the principal objective and an auditor was em- ployed only when fraud was suspected by the management. Consequently when an auditor appeared in an office and began his investigation, the bookkeepers began to wonder who was to be the victim and in most cases the auditor was looked upon as a sort of detective. Today fraud is considered only as a minor reason and not a principal reason for an audit, t hough it is often detected by the auditor regardless of what may be the chief reason for the audit. Either a continuous audit or a periodical audit will go a long way toward the prevention of fraud and embezzlement. Errors. From the standpoint of an audit there are certain different classes of errors and the auditor should be able to distinguish between them without any difficulty. Errors may be divided into five general classes as follows: Errors of Principle. Errors of Omission. Errors of Commission. Clerical Errors. Offsetting Errors. Errors of principle and commission are very similar and so important that they must be detected by the auditor. The most common errors of this class are due to the inability of the bookkeeper to distinguish between capital and revenue expen- ditures. Frequently items are charged to Expense which should be charged to Property accounts and vice versa. PURPOSES AND ADVANTAGES OF AN AUD IT As an example of each class of errors, the following list was compiled from actual auditing practice: Errors of Principle, (a) Sales were made to a number of customers residing in Canada. These customers would remit by check and the checks were deposited in the bank but the custom of the bank was to accept checks on Canada for collec- tion only. The bookkeeper entered all such checks as cash re- ceipts and added them to the bank balance as soon as deposited. One of these checks was included in the cash balance at the close of the fiscal period. (b) In analyzing the account with Buildings, it was dis- covered that an end wall of a concrete building had partly caved in. The cost of repairing the wall was $2,195.30 and this sum had been charged to the Buildings account instead of to Build- ing Expense account. Errors of Commission, (a) On the credit side of the Selling Expense account an item of $1.00 was found without a posting reference. Inquiry of the bookkeeper revealed that at that date the ledger was out of balance that sum and he had made the entry in order to "force" the balance. (b) An invoice for $100. was paid but subsequently included in a statement rendered and paid again by the bookkeeper. Errors of Omission, (a) The bookkeeper failed to deduct discounts from a number of invoices although they were paid in the discount period according to terms. (b) Delivery service was rendered in behalf of another company but not billed nor collected. (c) In auditing the books of a Hardware Company it was found that a plumber had rendered service amounting to $45.40, but this had not been billed nor collected, consequently did not appear on the books of original entry. Clerical Errors, (a) Accounts Payable column in pur- chases journal overfooted $10.00. (b) The total of the column in the purchase journal known as "General Expense" for June was posted to the Postage account. (c) The footing of the sales book for April, $18,546.90, was posted as $18,564.90. (This is known as a transposition of figures and is a very common error.) (d) An invoice for $4.97 was entered as Postage instead of Stationery and Printing. Offsetting Errors, (a) An account with a customer in the customers' ledger was overfooted $10.00 on both sides and the controlling account with "Accounts Receivable" in the general ledger showed an overfooting on both sides of the same amount. (b) The "Stationery and Printing" column in purchases journal was underfooted $1.00 while the "Advertising" column was overfooted the same amount, therefore, the total of the distribution columns agreed with the "Total" column. 8 PUBLIC ACCOUNTING AND AUDITING Major Objects. The more important reasons for audits may be classified as follows : (a) Determining a condition of affairs. (b) An audit for credit purposes. (c) An adjustment between partners. (d) An audit as an aid in the adjustment of claim on ac- count of fire loss. (e) As an aid to bonding. (f) Protecting stockholders and bondholders. (g) To facilitate the sale of a business. (h) As a basis of recovery for negligence on the part of a previous auditor. John R. Wildman,* in his "Principles of Auditing," says with regard to the occasions for auditing: "Generally speaking, it may be said that auditing is done, first, to satisfy someone as to the correctness of the accounts ; second, to prove or disprove some con- tention; third, to influence prospective purchasers of- goods or proprietary interests, and prospective creditors. "While the occasions for auditing are numerous and varied, they are probably all comprehended in the fol- lowing category: A. AT THE INSTANCE OF SOMEONE WITHIN THE ORGANIZATION. 1. To satisfy someone within. 2. To satisfy someone without. 3. To prove or disprove some contention on the part of someone within. 4. To prove or disprove some contention on the part of someone without. 5. To influence someone within. 6. To influence someone without. B. AT THE INSTANCE OF SOMEONE WITH- OUT THE ORGANIZATION. 1 . To satisfy someone without. 2. To prove or disprove some contention on the part of someone without. 3. To influence someone without." QUALIFICATIONS OF AN AUDITOR A brief summary of the necessary qualifications of a com- petent professional auditor would include at least the following: *Professor of Accounting at New York University. RESPONSIBILITY OF AUDITORS 9 (a) A thorough knowledge of acccounting, embracing a complete mastery of bookkeeping. (b) Familiarity with all the systems of accounting in general use and with the various details of office and factory methods. (c) A fair knowledge of commercial law. (d) Absolute honesty including a natural habit of fair dealing and the faculty of inspiring others to trust in his integrity. (e) An extensive preliminary education and the broadest kind of business training. (f) Analytical ability and the ability to grasp situations quickly. (g) Ability to meet people and converse easily, and with dignity. BE A GENTLEMAN IN EVERY SENSE OF THE WORD. Anyone who holds himself out to be skilful in any trade or profession, and who is negligent in the performance of an under- taking and does not use the skill of an ordinarily skilful trades- man or professional man, becomes legally responsible and is subject to a suit and penalty for damages for such failure. This statement applies to an accountant or an auditor. His moral responsibility is undoubtedly higher than his legal responsi- bility. Legally, one is not required to measure up to the stan- dard of the most skilful but only to the standard of an ordinarily skilful accountant and auditor. Morally, an auditor is respon- sible if he does not properly perform his duties in a manner which shall conform to the best practices of the profession. THEORY OF ACCOUNTS "Accountancy comprehends the conduct of audits, examinations and investigations; devising and install- ing systems; criticising organizations and management; and, in some cases efficiency work." New York State Educational Dept. Syllabus. ACCOUNTANCY is a profession having to do with the recording, verification and presentation of facts, involving the acquisition, production, conservation and transfer of values. ACCOUNTING is the science which treats of the syste- matic record, compilation and presentation in a comprehensive manner of the financial operations of a business. io PUBLIC ACCOUNTING AND AUDITING ACCOUNTING SYSTEMS Generally speaking there are but two different systems of bookkeeping and accounting SINGLE ENTRY and DOUBLE ENTRY. It is doubtful, however, if single entry bookkeeping may be correctly called a system. It would rather seem to represent a lack of system. A knowledge of the so-called single entry method of keeping books is necessary for there is nothing more common in the work of the accountant than to be called upon to change a single entry system to double entry. The great number of questions in CERTIFIED PUBLIC ACCOUNTANT examinations based upon this changing process is but evidence of the necessity of a thorough understanding of the proper method of procedure. The accountant will need to know the advantages and dis- advantages of single and double entry bookkeeping; the method of ascertaining profits and losses; how to prepare financial state- ments; and the course to pursue in the conversion of single to double entry bookkeeping. SINGLE ENTRY BOOKKEEPING 1. The purpose of single entry bookkeeping is to keep a record of transactions with persons only, that is, with customers, creditors, and the proprietor. However, accounts are frequently kept with cash, merchandise, and a few other items of special interest to the firm. 2. The disadvantages of the system are: (a) Nominal accounts are not kept, therefore, profits and losses are not shown. (b) A Trial Balance cannot be taken unless the auditor goes over the journal or day book and sets up accounts and posts all entries or arranges them in columns on a working sheet. (c) Errors which creep into the records are not easily detected. (d) A Balance Sheet can be made up only by an inventory of the assets and liabilities. (e) It does not provide for the determination of cost of operation of different departments nor for departmental returns. 3. To prepare a Profit and Loss statement from a single entry set of books, subtract from the net worth at the end of the period the net worth at the beginning. To this amount add amounts withdrawn from investment and subtract addi- tional investments. The result will either indicate a profit or a loss. ACCOUNTING SYSTEMS 11 4. To prepare a Balance Sheet from a single entry set of books, it is necessary to take an inventory of all assets and liabilities or to add to, or deduct from, the assets and liabil- ities as at the beginning of the period, the transactions of the period shown by the sundry records and memoranda. 5. To convert a single entry set of books to a double entry system is not at all difficult. The same ledger may be used if desired. First, prepare a statement of assets and lia- bilities. Second, determine the profit or loss for the period. Third, prepare a journal entry, debiting all assets, crediting all liabilities, and crediting the proprietor for the net investment. If the proprietor is not credited for the net profit or debited for the net loss before preparing the above entry, a second journal entry will be necessary to adjust the proprietor's account and the Profit and Loss account. If the same ledger is to be re- tained, those accounts which already appear in the ledger should be checked so as not to be posted again. If a new ledger is to be opened, all entries must to be posted. DOUBLE, ENTRY BOOKKEEPING With this system a complete record of every transaction is kept showing its effects upon both nominal and real accounts. There is a constant equilibrium maintained at all times for every debit is offset by an equivalent credit, and every credit by an equivalent debit. The advantages of double entry bookkeeping are many. Among them are to be mentioned. (a) A Trial Balance can be taken from the ledger at any time, thereby determining the accuracy of the posting and the equilibrium of the accounts. (b) A Profit and Loss statement can be prepared from the nominal accounts and a Balance Sheet from the real accounts without analyzing the transactions. (c) The journal and the ledger can be balanced indepen- dent of each other thereby acting as a check one upon the other. (Note. It is assumed that students taking up this course in Public Accounting and Auditing are familiar with the principles of elementary book- keeping, both single entry and double entry, and with the ordinary pro- cedure in actual business routine. If anyone proposes to take up this course of study who has not had a fairly thorough training in bookkeeping, it is suggested that he secure a copy of "20TH CENTURY BOOKKEEPING AND ACCOUNTING," by James W. Baker, published by the South- western Publishing Co., Cincinnati, Ohio. This text is commended because it is up-to-date as regards modern busi- ness methods and accounting terminology. Laboratory work is also provided for use in connection with the text, making it a comparatively simple matter to secure a theoretical and practical knowledge of bookkeeping and account- ing.) 12 PUBLIC ACCOUNTING AND AUDITING COMMERCIAL LAW and its Contact with Accounting The American Institute of Accountants and every state having a C. P. A. law has among its requirements an examination on commercial law. The field of business venture with which the accountant is concerned is so broad in its scope that instances have arisen in which a knowledge of the principles of all branches of law has been necessary, excepting such subjects as admiralty, pleading, torts, patent law, questions on constitutional and criminal law, and a few other special subjects. In examinations of large manufacturing corporations, ac- countants are liable to encounter questions involving the general as well as the statute laws governing corporations; the law of contracts, applying to notes, sales, agency, insurance, bailments, chattel mortgages, liens, landlord and tenant, mortgages, etc,; real property law; and the state and federal statutes relating to the duties and obligations to report the extent, nature and cost of the various branches of work. In investigations of receiverships a knowledge of the rules and practices in the courts is necessary. In the preparation of Income and Excess-Profits Tax returns a knowledge of the Income Tax laws and regulations is a necessity. In recent years this has become a prominent part of the accountant's work. Examinations of testamentary trusts and estates of de- cedents require a knowledge of the law of real property, the law relating to wills, administration, partnership, including a knowledge of statutory and common law and equity, and of the law of practice and procedure at law in the different courts. It will be seen, therefore, that commercial law has but few limitations. To the uninitiated, it would seem to be a very difficult matter to gain a sufficient knowledge of commercial law. However, it is not as difficult as it at first appears to be. An accountant would not be expected to have an accurate knowledge of the various statutes of the different states, but he should know when a statute would be likely to cover the case at hand. Invariably there will be sufficient time to look up a statute, therefore, it is not demanded that accountants have more than a general acquaintance with the statutes. Of course, such statutes as the STATUTE OF FRAUDS, the NEGOTIABLE INSTRUMENTS LAW, the UNIFORM SALES ACT, and BANKRUPTCY LAWS should be well under- stood. The statute of frauds and the negotiable instruments law are nearly uniform, having been adopted in most of the states of the union. CONTACT OF COMMERCIAL LAW WITH ACCOUNTING 13 SUBDIVISIONS OF LAW Generally speaking, law may be classified as either WRIT- TEN or UNWRITTEN. Written law is the law set forth in our federal and state constitutions and our federal and state statutes. Unwritten law comes from the reported decisions of courts. Not all rights and duties as between individuals have been defined by either state or federal constitutions or statutes. When written law does not cover a case, unwritten law applies. The law of the land is called MUNICIPAL LAW. In this country it is partially written and partially unwritten. The written law is subdivided into CONSTITUTIONAL and STATUTE LAW. Unwritten law is often referred to as COM- MON LAW. The order of importance or precedence of the various kinds of law is as follows: 1. Federal constitutional law. 2. Federal statute law. 3. State constitutional law. 4. State statute law. 5. Common law. A law is declared UNCONSTITUTIONAL when the courts decide that it conflicts with the laws of higher order. An example of this is the recent decision of the Supreme Court of the United States, declaring unconstitutional that part of the 1916 Income Tax Law which placed a tax on stock dividends. Commercial law is that part of municipal law which applies to commerce, that is, to business transactions. The following chart shows clearly the main divisions of Municipal law: [Federal i. Constitutional < State Municipal Law. 2. Statute Federal fCivil State [Criminal [Civil [Criminal [Suits at Law [Civil 3. Common j [Suits in Equity [Criminal 14 PUBLIC ACCOUNTING AND AUDITING A. THEORY QUESTIONS 1. What are the major objects of an audit? C. P. A. Mich. 2. Give a brief outline of the duties and responsibilities of an auditor and what special qualifications and training he should possess. C. P. A. La. 3. Explain how certified statements extending over a period of years might facilitate the sale of a business. 4. (a) What is your understanding of the term accounting? (b) What constitutes a scientific system of accounts? C. P. A. Ind. 5. Define bookkeeping. State various kinds with explana- tions. C. P. A. Mich. 6. State the relative advantages and disadvantages of single entry and double entry bookkeeping. C. P. A. Ohio 7. State the essential principles of double entry bookkeep- ing, and show wherein it differs from single entry bookkeeping. C. P. A. N. Y. 8. The A. I. Mfg. Co. employs a staff of bookkeepers. The head bookkeeper has not studied the theory of accounting, neither has his experience been extensive. He understands double entry bookkeeping, but he cannot be described as a well trained accountant. Previously the A. I. Mfg. Co. has been satisfied with annual accounts prepared by competent auditors. They decide to have monthly statements of accounts in the future, and with this end in view, instruct the head bookkeeper to prepare statements on the same lines as the last annual accounts were prepared. State several imaginary errors of principle that might not unreasonably be found upon an expert examination of his work. C. P. A. 111. 9. How would you determine the profits for a given period from a set of books kept by the single entry system, the capital at the beginning of the period being known? C. P. A. Me. 10. What information can you get from a set of books kept by double entry which you can not get from a set kept by single entry? C. P. A. Mich. ACCOUNTING PROBLEMS 15 B. ACCOUNTING PROBLEMS 1. The following information is obtained from a set of books kept by the single entry method: Capital at Beginning of Period $8,500.00 Withdrawal from Investment during Period. 1,000.00 Additional Investment during Period 2,500.00 Present Capital 12,500.00 Find the net profit or loss. 2. Day and Wright have been doing business as partners, and have kept their books by single entry. From their books and Inventory you find the following Assets and Liabilities: Mdse. $9,241.00; Cash, $850.00; Real Estate, $3,000; Bills Payable, $975-oo; W. M. Day's Capital, $5,390; T. J. Wright's Capital, $6,400.00. They owe personal accounts, $4,175.00. Persons owe them, $6,941.00. Store fixtures, $571.00. Profits are shared equally. Determine the loss or gain. Draft a journal entry to change the books from single entry to double entry, assuming that the old ledger is to be retained and used with the new system. 3. Prepare steps and show procedure necessary to convert to double entry from single entry the schedule of assets and liabilities of which, taken from the latter, appear as follows: Assets Cash .$12,000.00 Merchandise Inventory 7,500.00 Notes Receivable 1,500.00 Accounts Receivable 5,000.00 Real Estate 3,500.00 Plant and Equipment 2,000.00 Furniture and Fixtures 1,000.00 $32,500.00 Liabilities Notes Payable $ 4,000.00 Accounts Payable 8,500.00 Excess of assets over liabilities, being capital 20,000.00 $32,500.00 (Assume that a new ledger is to be opened. Draft a journal entry to change the books from single to double entry but do not set up ledger accounts.) C. P. A. Ind. 16 PUBLIC ACCOUNTING AND AUDITING C. LEGAL QUESTIONS 1. What is meant by "municipal" law? 2. Name three kinds of "municipal" law. 3. Show wherein constitutional law differs from statute law. 4. Common law is sometimes also called the "unwritten" law. Explain why. 5. Give the order of precedence. 6. When there is a conflict between a statute and common law, which takes precedence? 7. Why is a general knowledge of legal principles desirable? C. P. A. Ind. 8. (a) Define commercial law. (b) What are the general divisions of law? C. P. A. Mich. Chapter Two BEGINNING AN AUDIT Engagement Blank. Accountants as a rule have a form known as an engagement blank. This is carefully filled in at the time the agreement is made or as soon thereafter as is con- venient. The form of engagement blank used by the author is illustrated on page 18. The form may vary, but should show all the facts in connection with the agreement made with the client. It is important that an auditor should have with him a copy of the engagement blank for convenient reference. Letter of Introduction. In starting out on an engage- ment one is sure to come in contact with a number of different persons. Naturally he will go first to the client. He will also need to meet heads of departments and others in arranging to begin the work. It is, therefore, important that he have a letter of introduction. Remember an auditor is engaged in professional work and the nature of his work and the liberties extended him are such that he should be properly introduced. Equipment. In the way of equipment, an auditor will need journal, ledger, and analysis paper. Analysis paper may be secured with almost any number of columns. Fourteen columns is well adapted to the use of the Working Sheet and is therefore preferable. He will also need black, blue and red pencils, an eraser, a ruler, bank certificates in blank, time and expense report blanks, and a memorandum book. NATURE OF ENGAGEMENT The first thing of importance at this point is to know in your own mind exactly what you are going to do. Heretofore the business public has depended upon the auditor and ac- countant as to the scope of the work and in many cases the work has been started without knowing in advance exactly the nature and scope of the engagement. There should be a clear under- standing reached with the client by the accounting firm, and this in turn should be conveyed to the senior in charge of the audit. The junior should understand definitely just what part of the audit he is to be responsible for and should proceed ac- cordingly. Of course, it is needless to say that he will get his information direct from the senior and not from the client. (Continued on page 19) 17 18 PUBLIC ACCOUNTING AND AUDITING ENGAGEMENT BLANK Cincinnati, Ohio Certified Public Accountant and Auditor Cincinnati, Ohio, 1. Client The Blank Manufacturing Company.. 2. Official position. . .Board of Directors .......... 3. Address ____ Indianapolis, Indiana ........... 4. Conference ____ C. H. Becker, Chairman./. 5. File No ..... A345 ................................... 6. Telephone No ..... Main 4 ........................ 7. Report to be addressed to. Mr . Becker .............. 8. Account to be opened with. The Blank Mf g . Co ... 9. Nature of engagement. .Balance Sheet Audit. . . . for credit purposes ......................... 10. Work to be done at., their office ................ 11. Nature of the business. manufacturing ............. 12. When to be commenced. Jan. 15, 1919 ........... 13. Probable time required . . two weeks ................. 14. Accountants required one senior; two juniors 15. Rates... regular ............. . .................... 16. Additional information. .No previous audit has ever been made but an internal check is maintained. Mr. Becker called at our office Dec. 20, 1918 ................. Engagement No ....... One . . . Date completed ........... Assigned to staff ...... A ...... Report mailed ............ THE VALUE OF AN AUDIT 19 In determining the nature of the engagement and making arrangements for the audit with the client, naturally it is fre- quently necessary to explain the different classes of audits. The client is likely to state that he wants a complete audit when, as a matter of fact, he wants only a Balance Sheet audit. It is of the utmost importance that there be no misunderstanding between the auditor and his client as to the exact scope of the audit. THE VALUE OF AN AUDIT The value of an audit will naturally depend upon each individual instance. Business men have been somewhat slow to realize the actual benefits to be derived from periodical audits by professional accountants, but today the importance of an audit is generally recognized by the business community. It is not infrequent, however, that we still hear business men say that in their particular case an audit is unnecessary. They say that they have absolute confidence in their bookkeeper or accountant and that he is able to prepare annual statements that are just as accurate as anyone could prepare. Others say that they know exactly where they stand in the financial sense and do not need an outsider to point out defects, or to plan improvements hi the accounting system in use. Questions such as the following should cause business men, stockholders, directors, investors and others to realize that such arguments as the above are groundless: Are you certain that your bookkeeper is competent to furnish an accurate statement of financial condition or of earnings? Has your general manager had sufficient accounting training and experience to judge of the correctness of the reports which he submits periodically? Do you know that corporations frequently pay dividends which have not been earned, though it is illegal to do so? Is your general manager competent to prepare for the United States Government, returns for Income and Excess-Profits Taxes? Even though your attorney is consulted with regard to these returns, are you sure that he fully comprehends the application of the Income Tax Law and all the regulations of the Treasury Department? Is he able to interpret your accounts and deter- mine the accuracy of your returns? It is such questions as these that only a professional accountant with wide training and experience is competent to pass upon. A bookkeeper may perform his detail work so accurately that for years his books are always in balance and errors in posting or in footing the accounts are unknown, yet the state- ments which he presents are not only in such form as to convey little information of value, but the figures which he shows as earnings may never be correct. An audit of his books may disclose the fact that accounts receivable, amounting to thou- 20 PUBLIC ACCOUNTING AND AUDITING sands of dollars, have been carried at full value though known to be uncollectible. He may not have made provision for de- preciation of plant and machinery. Equipment which has become worthless because of depreciation or obsolescence may be shown in the statements at its original cost. These are some of the things which an average bookkeeper, even one whose services command a big salary, knows but little or nothing about. If he does know something of the neces- sity for adjustments of this kind, his lack of experience and theoretical knowledge is a dangerous thing, and his attempt to put this theory into practice is likely to mar the result. Don't think for a moment that the present day work of an auditor is merely a checking of the footings and postings. This part of his work requires the least amount of ability and experience. It is an auditor's duty to go much further to determine the accuracy of the figures stated on the books of account; to distinguish between capital and revenue expenditures; to determine the actual value of accounts with customers through a process of testing, or, if necessary, to cor- respond with each customer to secure a verification of the account; to determine a conservative and sound basis for the estimation of depreciation on all assets; and to secure authority for making all necessary adjustments. These things can be brought about through courteous cooperation between the officers and employees of the company and the accountants. The professional accountant's work would not be satisfac- tory if he were to submit statements of financial condition which are simply in accord with the books of account. He must determine that none of the assets are overvalued and that all liabilities are stated. The latter may mean the determining of liabilities on account of accommodation endorsements of notes and other negotiable instruments, guaranties, warranties, etc. The head bookkeeper of a concern, in preparing statements of financial condition, is certain to be influenced by the wishes of the management, but an accountant must of necessity pre- pare his statements so as to show the absolute facts; he must be impartial. To fail in this is to become morally and legally liable for having failed to use the skill of a professional account- ant. Periodical audits by professional accountants are necessary in hard times when competition is keen and profits small, because in such times operating cost must be carefully analyzed and reduced to a minimum. The auditor must determine where the expenditures have been made, why they were made and what the results were. He must find out if there are any leaks and suggest a .way to stop them. An auditor's report may disclose that during a period when sales were abnormally large, the results show a loss as compared THE VALUE OF AN AUDIT 21 with previous periods when sales were considerably less. His report may show that one department is suffering a loss, yet the entire business shows a gain. His report may show that operating expenses in one department are abnormally high and he may be able to show how they could be lowered. In many instances, it has been found profitable to secure an accountant to install a system of accounting and to make arrangements for the accounting to be done under his super- vision. When this is done, the work of the bookkeeper is per- formed and statements are prepared under the oversight of a highly trained and widely experienced professional accountant, and usually at a very reasonable cost as compared with the value of the accountant's services if confined to the individual firm ; yet with such arrangements the accountant may be consult- ed any time, even over the telephone. Unusual and difficult problems may be placed before him before the bookkeeper has recorded them, thus avoiding errors and misstatements. There is not the slightest doubt as to the value of an audit when performed by a skilled professional accountant or auditor, and it is exceedingly doubtful if any corporation or business firm can afford to do without an audit. The professional accountant is an efficiency engineer in times of prosperity. He sets the signals which, unless they are disregarded, keep the business train running without acci- dent. He is the wreckmaster who gathers up the pieces, sets them on the track and starts them going if possible after a concern has been ditched. When a rich man dies, the public accountant examines and appraises his estate. His range of activities covers the whole field of business existence, from birth to death, and the interval between. KINDS OF AUDITS Audits may be either complete or partial. A complete audit is known as a DETAILED audit; a partial audit is usually known as a BALANCE SHEET audit. Since the average business man has no idea of the difference in the two main classes of audits, a careful explanation must be made so that he will know in advance just what kind of an audit he is getting. He will frequently ask the auditor to make a recommendation in the matter. It is quite impossible and inadvisable to do so without a preliminary inspection of the books and conditions existing. The detailed audit is the ideal audit but the time and expense of such an audit is not always advisable nor is it always necessary. In determining this matter much will depend upon whether a satisfactory internal check has been maintained. 22 PUBLIC ACCOUNTING AND AUDITING Internal Audit. By an internal audit or check is meant a continuous audit by someone within an organization, or by the system being so planned that no one employee has complete control of any part of the accounts. A properly planned internal check is important and when carried out satisfactorily, a Balance Sheet audit will be found sufficient, unless fraud or dishonesty is suspected. While large firms usually employ someone who acts as auditor and who maintains a continuous audit, yet a large majority of firms do not employ such a person, but simply plan the office work in such a way as to secure the best internal check. The exact division of the work in an office so as to secure a satisfactory internal check would depend very largely upon the surrounding circumstances. In planning a system of accounts for a , jobbing house, wherein five persons kept the books, did the billing, made the city collections, handled the general and petty cash, and paid all the invoices, the following method was advocated and later found to be very satisfactory: It was arranged for one person to keep the general ledger and record the invoices; a second to handle the cash; a third to keep the sales ledger; a fourth to do the billing; and a fifth to make collections, etc. The work may be still further sub- divided, depending upon the volume of business. For instance, one man might handle only cash receipts and another man handle cash payments, or one man might handle cash receipts from customers keeping a special customers' cash book. All this subdivision of the work will depend upon the volume of business. The important feature is that the cash book and ledger be kept by different persons so that one person acts as a check upon the other. Some accountants recommend that persons in the office exchange duties at times, the theory being that in so doing one person might detect dishonesty on the part of another. From the standpoint of efficiency, this procedure might be argued as unwise. Without a doubt, vacations should be insisted upon. The author recalls an experience of a teller in a bank who for a period of three years constantly embezzled the bank, and although the books had been audited periodically by bank examiners, he had been able to cover up the shortage so that it had not been detect- ed, but finally, while away on a vacation, the bank examiner made an unexpected call and during the process of his investiga- tion uncovered a shortage of $10,000 in the teller's accounts. This illustration is mentioned as one reason why vacations should be insisted upon from the standpoint of an internal check. Cash Audit. The so-called cash audit is practically a balance sheet audit or partial audit, but it is difficult to under- stand how an audit of cash could be made without leading KINDS OF AUDITS 23 to'the consideration of many other accounts and records. Fraud and errors of principle are not necessarily confined to cash in any sense, and are far more likely to be uncovered somewhere else. Balance Sheet Audit. A Balance Sheet audit is made with the view of preparing a correct Balance Sheet as at a certain date. It not only includes the verification of stated assets and liabilities but also the discovery of any unstated assets and liabili- ties.] Furthermore , the auditor must ascertain if all the liabilities have been incurred with proper authority. In the case of a corporation it will be found frequently that certain liabilities were incurred without authority from the board of directors. Detailed Audit. As stated above, the detailed audit is the ideal audit. It comprehends a complete audit of all income and expenditures during the period, including the checking of all records, vouchers, footings, postings, etc. The detailed audit is seldom carried out in full. A process called TESTING is resorted to quite often in both a Balance Sheet and a detailed audit. It consists in picking out the transactions for a certain period and if, after carefully vouching these transactions they are found to be correct, it is then assumed that the transactions for the whole period under audit are reasonably correct. Contingent Fees. The question as to the advisability of an auditor accepting a contingent fee frequently comes up. While under certain circumstances it may be safe to accept a fee based upon the results of the audit, it is doubtful if the plan is to be encouraged. At any rate it is not considered good ethics by the American Institute of Accountants which has gone on record as opposed to the practice. To illustrate what is meant by a contingent fee, a client approaches an auditor stating that he desires an audit made with the view to obtaining a loan from his banker and states that the fee will be based upon the auditor's success in aiding him to secure the loan through the preparation of a Balance Sheet for credit purposes. The auditor who undertakes such an engagement would not be likely to pre- pare an impartial report. Audit Program. At the beginning of the engagement the auditor should prepare a program. Naturally it will differ, depending upon the scope of the engagement, the nature of the business, and the purpose of the audit, but it usually will be along lines similar to the following: 1. Count the cash; verify bank balances; read minutes. 2. List notes and securities on hand. 24 PUBLIC ACCOUNTING AND AUDITING 3. If a Trial Balance is furnished, check it with the general ledger. 4. Check list of accounts receivable and accounts payable with controlling accounts. 5. Check any other subsidiary lists of accounts with con- trolling accounts. 6. Check extensions and footings of inventories; test the inventory. 7. Verify outstanding capital stock by comparison of stock ledger accounts with stubs of stock certificate book. 8. Check all footings of books of account, both original and final ; check all postings or transfers from one book to another. 9. Review cash disbursements; compare with cancelled checks. 10. Ascertain if proper provision has been made for depreciation. Legal Responsibility of Client. It is not out of place here to mention the fact that it is always advisable to determine the legal responsibility of a client before accepting an engagement. If someone within an organization seeks to have an audit made, it is necessary to ascertain whether or not he has any right to engage the services of an auditor, and also as to whether or not he is employing you personally, or is merely acting as an agent of the company. CLASSIFICATION OF ACCOUNTS 25 CLASSIFICATION OF ACCOUNTS It is important that an accountant or auditor should thor- oughly understand a proper classification of accounts. In the next chapter there is to be taken up what is known as a Balance Sheet audit; therefore, it is necessary at this point to devote a brief dis- cussion to the subdivisions of accounts. Since a Balance Sheet is made up of ASSETS and LIABILITIES, these will now be discussed and classified. REAL ACCOUNTS Accounts are divided into two general classes REAL and NOMINAL. It is the real accounts that appear in the Balance Sheet ana arc ciassea as assets and liabilities; they may be either PERSONAL or IMPERSONAL. There are three classes of personal accounts : accounts with customers ; accounts with cred- itors; and accounts with owners or proprietors. Accounts with customers are usually classed as CURRENT assets. There might be an exception to this in the case of an open account, the terms of which would indicate that it would not become due within a year. Some authorities hold that all current assets must be those which can be realized upon within the cur- rent fiscal period, or, at least, within a year. However, it is conceded good practice to class all accounts with customers as current assets as long as these accounts are collectible. Once an account is considered uncollectible, or its collection as being doubtful, it should immediately be charged off and should not be included as a current asset without the proper depreciation being set up. Accounts with creditors are considered as CURRENT lia- bilities; like accounts with customers, they are usually due within a short time and, therefore, provision must be made for their liquidation within the current fiscal period. The accounts with the owners or proprietors of a business are classified on the liability side of the Balance Sheet, but are usually listed separate from the liabilities in a section devoted to proprietorship accounts. They may be in the form of an account with a single owner, accounts with partners, or accounts with capital stock, and SURPLUS or DEFICIENCY. In the case of a corporation, net profits are usually credited to a Surplus account or they might be credited to an Undivided Profits account, in which case this account would also appear among the proprietorship accounts. Net losses are debited to the Surplus account, but when a business becomes insolvent, it is then necessary to set up a Deficiency account debiting it with the net excess loss. A Deficiency account shows that the business has been conducted at a loss and that the value of the stock owned by stock-holders has decreased in value equal to the amount of the deficiency. (Continued on page 27) 26 PUBLIC ACCOUNTING AND AUDITING CLASSIFICATION OF ACCOUNTS Reali Personal [Accounts Assets Current] with (Customers Liabilities Impersonal Accounts Assets [Accounts Current I with (Creditors [Accounts Proprietorship j with (Proprietors !Cash Merchandise Notes Receivable [Machinery Fixed] Buildings (Equipment Liabilities Current Notes Payable Dividends Payable Accrued Ex- penses Nominal < [Mortgages Fixed < Bonds Collateral Loans [Merchandise Sales Income] Dividends on Investment Stock (interest on Notes Receivable [Advertising Operating Cost] Salaries (Rent (Profit on Real Estate Sales of Waste Paper Dbt. Accts. Collected [Burglary Loss Special Losses] (Loss by Flood CLASSIFICATION OF ACCOUNTS 27 It will be seen, therefore, that personal accounts affect both sides of the Balance Sheet, accounts receivable appearing on the debit side as assets, and accounts payable and proprietor- ship accounts appearing on the credit side of the Balance Sheet as liabilities. Impersonal accounts represent either assets or liabilities. If assets, they may be either current or FIXED. Impersonal current assets would include such real accounts as Cash, Mer- chandise, Notes Receivable and any other accounts that can be converted into cash quickly and that do not constitute a fixed investment. On the other hand, impersonal fixed assets are those accounts which represent fixed investments, such as machinery, buildings, equipment, land and all property possessed and used directly by the owner himself for his enjoyment, or for business purposes, and maintained in fixed condition for long periods of time subject only to wear and tear and depreciation on account of use. Impersonal liabilities are likewise classified as either current or fixed. Those obligations which must be liquidated within a short time are current liabilities and those obligations, the liquidation of which is deferred to a future date usually beyond the present fiscal period, are fixed liabilities. Notes payable, dividends payable, all accrued expenses, deposits, guarantees, and similar accounts, are classified in the Balance Sheet as current liabilities, while mortages, bonds and collateral loans which do not mature within a year or within the present fiscal period, are listed as fixed liabilities. The Public Service Commission of New York says : "Funded debt comprises all debt which by the terms of its creation does not mature until more than one year after date of creation". There is another subdivision of assets that might be men- tioned here, that is, assets may be either TANGIBLE or IN- TANGIBLE. Kester* in his "Accounting, Theory and Practice," says: "Asset and liability accounts may be called 'real' or 'specific', because they represent, in the main, properties owned or owed which are definite and usually tangible." Intangible accounts include such accounts as good will, trade marks, patents, copyrights, titles, trade names, franchises, etc. NOMINAL ACCOUNTS Nominal accounts are subdivided into four classes: first, income accounts; second, operating cost accounts; third, special profit accounts; fourth, special loss accounts. Nominal accounts are sometimes referred to as ECONOMIC accounts. "Roy B. Kester, Columbia University 28 PUBLIC ACCOUNTING AND AUDITING Wildman,* in his "Principles of Accounting", says: "Real accounts are those which reflect financial conditions. "Nominal accounts are those which reflect changes in financial conditions." Under the heading of Income should be included ac- counts representing mercantile income, income from commis- sions, income from professional fees, banking income, etc. The exact classification will depend upon the nature of the business. If a business is a mercantile business, its principal income will be represented by returns from sales, and practically all other income will be in the nature of special profits. If the business is a professional business, the principal income will be from fees, and all other income will be in the nature of special profits. A stock broker's income would be in the nature of commissions; therefore, it is to be noted that in preparing a Profit and Loss statement, the arrangement of the accounts will depend upon the nature of the business. A man whose business is mercan- tile, but who chances to make a sale of a piece of real estate at a profit, would thereby create a special profit not in his usual line of business. Likewise, a loss by burglary is to be considered a special loss and not a customary loss in the usual course of the business. Operating costs, sometimes classed as operating expenses, are the expenses incident to the operation of a business such as advertising, salaries, rent, heat, light and all similar expense accounts. Special profits and special losses are some- times listed as EXTRAORDINARY or EXTRANEOUS pro- fits and losses. A Profit and Loss statement is composed of nominal accounts. The usual procedure is to list the regular income accounts first, followed by the operating expense or operat- ing cost accounts, thereby determining the net profit or net loss from operation. This would be followed by adding the special profits and deducting the special losses, to ascertain the net profit or net loss for the period. Naturally the owners, includ- ing the partners and stockholders, are interested in and want to know, first, what their total net income has been; second, what their total operating cost has been in producing the net income ; third what additional profits there have been; and fourth, what additional losses have been incurred. * Professor of Accounting at New York University. THE LAW OF CONTRACTS 29 THE LAW OF CONTRACTS Note: Since the LAW OF CONTRACTS is without a doubt one of the most important parts of commercial law, naturally, the accountant is primarily concerned with it and, therefore, beginning with this chapter a brief discussion of the different phases of the law of contracts will be given. Essential Conditions. Before an agreement partakes of the nature of a contract and becomes legally enforceable, there must be certain conditions adhered to. The agreement must be between two or more COMPETENT parties, based upon SUFFICIENT consideration, to do or not to do some LAWFUL, POSSIBLE thing. The agreement must be mutual, that is, the minds of the parties must have met. It will be seen, there- fore, that there are four essentials to every contract: 1. Competent parties. 2. Mutual agreement. 3. Sufficient consideration. 4. Legal subject matter. Methods of Making Contracts. There are but two ways of creating a contract. One is by a WRITTEN AGREE- MENT and the other is by an ORAL UNDERSTANDING between the parties. Undoubtedly the most important thing to set forth in this lesson is that it is always best to make a written contract. A written contract may be under SEAL or may be a SIMPLE contract. An oral contract may be either EXPRESSED or IMPLIED. It is expressed when its terms are stated and agreed to by the parties. It is implied when its terms are inferred from the acts of the parties. A great many contracts are implied. For instance, if one calls in a physician in case of illness, it is under- stood that he expects to pay for the service whether he says anything about it or not. The same is true when one orders groceries delivered at his home without reference to payment. Certain Contracts Must be in Writing. The Statute of Frauds requires that certain contracts must be in writing, or at least there must be a memorandum in writing. This statute has been adopted by nearly all the states and it is prac- tically uniform. Documents of greater importance must usually be made under seal. The state statutes cover this and, as they differ to some extent, it would be best to become familiar with the statutes covering this point in your state. Contracts not made under seal are said to be CONTRACTS BY PAROL, or simple contracts. They may be either oral or written. 30 PUBLIC ACCOUNTING AND AUDITING A. THEORY QUESTIONS 1 . Distinguish between a Balance Sheet audit and a detailed audit. C. P. A. Ohio. 2. Large business concerns frequently have on their staff what are known as "internal auditors". Under such conditions, would you approve the employment of Certified Public Ac- countants to make periodical audits? Give reasons for your answer. C. P. A. Ind. 3. Under what circumstances would you advise a client that a complete detailed audit should be made? Give your arguments to convince him that a test audit would not be sat- isfactory. C. P. A. 111. 4. How is the position of an auditor affected if the system of the concern under audit is defective as to internal check? Inst. Ex. 1918. 5. Why is it advisable to determine the legal responsi- bility of a client before accepting an engagement? 6. What do you understand by (a) personal account, (b) impersonal account, (c) real account, (d) nominal account? C. P. A. Ind. 7. Define the following: (a) Fixed assets and fixed liabilities. (b) Current assets and current liabilities. C. P. A. Mich. 8. In making "detailed" audits some auditors verify all postings and footings of general and subsidiary ledgers, even though controlling accounts are kept. State reasons for and against such procedure. Inst. Ex. 1919. B. ACCOUNTING PROBLEMS i. The Trial Balance of the Yellow Pine Timber Co. on January I, 1920, was as follows: Cash $ 2,618.03 Accounts Receivable 21,111.17 Inventory 36,133-32 Unexpired Insurance 559-44 Plant and Equipment 352,109.75 Timber and Lands 551, 539.31 Preferred Claims $ 37,011.99 First Mortgage Bonds, 6s. ... 212,500.00 Bond Interest Accrued 4,533-24 Unsecured Creditors 64,471.64 Capital Stock 400,000.00 Surplus 245,554.15 ,071.02 $964,071.02 ACCOUNTING PROBLEMS 31 Classify the accounts in accordance with the outline shown on page 26. C. P. A. N. Y. (Note. The date of this Trial Balance is January I, 1920, hence all nominal accounts have been closed into surplus. All accounts appearing in the Trial Balance are real accounts, but they should be classified, showing which are personal and which are impersonal with a further subdivision into assets current and fixed; and liabilities current and fixed.) 2. The office of a firm of traders, doing business in San Francisco was destroyed by an earthquake. The books of account, which had been fully posted, were badly damaged. The following ledger accounts were found to be legible: Pur- chases, net, $69,000; Discounts Lost, $640; Discounts Gained, $3,450; Sales, $54,000; Bills Receivable, $33,000. Inquiry at the bank disclosed a balance on deposit, $129,000. Bills receivable amounting to $45,000 had been discounted at the bank. An audit of the checks paid by the bank showed that $99,000 had been paid creditors (including $60,000 notes payable). A Balance Sheet prepared at the last closing of the books was produced, containing the following items: cash, $60,000; accounts receivable, $126,000; loans receivable, $24,000; real estate, $90,000; notes receivable, $78,000; capital, $318,000; notes payable, $60,000. Prepare a Trial Balance supplying the missing accounts. C. P. A. N. Y. (Note. You should set up skeleton ledger accounts with Real Estate, Cash, Notes Receivable, Loans Receivable, Accounts Receivable, Accounts Payable, Capital, Sales, Purchases, Discounts Gained, and Discounts Lost. 1 . Debit or credit each account with the amount shown in the Balance Sheet prepared at the last closing of the books. 2. Set up the balances of those ledger accounts which were found to be legible after the earthquake. 3. Make the necessary adjusting entries from the information obtained at the bank and from an audit of the checks paid by the bank. After this work has been completed, you will have no difficulty in pre- paring a Trial Balance.) 3. From the Trial Balance prepared in the solution of Problem No. 2, you may prepare a list of the assets and lia- bilities. List the current assets first and the fixed assets second. Likewise, list the current liabilities first and the capital second. Show the amount of increase or decrease in the net worth of the business. (Note. You may assume that the entire stock of merchandise was destroyed by fire following the earthquake.) 32 PUBLIC ACCOUNTING AND AUDITING C. LEGAL QUESTIONS 1. What are the essential elements to every valid contract? C. P. A. Mich. 2. What special element is required in some contracts but not in all? C. P. A. Ohio. 3. How is a contract made? C. P. A. N. Y. 4. Can a contract be implied? C. P. A. Mich. 5. Where a contract is in writing is it admissable for one of the parties to it, to vary it by proving that at the time it was entered into, such was their oral agreement? C. P. A. 111. Chapter Three Books of Account. Before proceeding with a Balance Sheet audit, the auditor must thoroughly understand the various systems of account in general use and be familiar with all books of account, both those of original entry, including AUXILIARY books, and those of final entry, including SUBSIDIARY books. By auxiliary books is meant those which contain detailed in- formation supporting the record in the books of original entry. They include check stubs, note stubs, draft stubs, receipt stubs, bank pass books, etc. By subsidiary books are meant subsidiary ledgers controlled by accounts in the general ledger. They include customers' ledgers, creditors' ledgers, stockholders' ledgers, cost ledgers, etc. The following discussion and the accompanying chart is intended as a review of the ordinary principles of bookkeeping and accounting as taught in the leading texts. BOOKS OF ORIGINAL ENTRY The Journal. It is possible to record all transactions in what is known as a general journal and, regardless of how many subdivisions of this journal there may be in a system of accounts, all books of original entry which are used as a posting media constitute a part of the journal. James W. Baker, in his "2Oth Century Bookkeeping and Accounting", says: t "The Journal is a book of original entry in which all the transactions may be recorded. If it is the only book of original entry, all the transactions are recorded in it; if the purchases, sales, cash receipts, and cash payments are re- corded in special books, it contains only those transactions not recorded in these books. The record shows the date, name of the account debited and amount, name of the ac- count credited and amount, and the explanation or infor- mation for the auditor." 33 34 PUBLIC ACCOUNTING AND AUDITING Roy B. Kester, C. P. A., in his "Accounting, Theory and Practice," says: "A Journal may be denned as a diary or log in which the happenings or transactions of a business are recorded. Formerly it was sometimes called a day-book or blotter. The day-book or blotter record was a rough record giving all the essential data relating to each transaction without regard to accounting terminology, and was used as a sort of memorandum from which a formal record might be made in accounting terminology. This day-book or blotter, still in use in some places, has very largely given place to the journal which, either a single book or separated into many subsidiary books, is the book of original entry." Reference to the illustration on page 35 will show how the journal might be subdivided in a highly organized system of accounts. Under such a subdivision, it will be seen that trans- actions of a similar nature are recorded in separate books. The saving of time in posting is evident although it is not the only reason for such a subdivision of the journal. Another reason is the fact that it enables several bookkeepers to record entries in the original books at the same time, where if only one or a few books of original entry were in use, the volume of business might be so great that the bookkeepers could not handle the work. Therefore, in planning a system of accounts, it is always necessary to provide special records or books for recording each class of transactions in accordance with the volume and nature of the business, and depending upon the number of employees involved in recording the transactions. Regardless of the detailed subdivision of the journal, there will still remain certain transactions that should be recorded in the general journal. A. Lowes Dickinson, C. P. A., in his "Ac- counting Practice and Procedure,*" says: "A journal is, however, still necessary for special en- tries, correction entries, and other miscellaneous matters which do not fall within the scope of any of the books or forms described." The principal use for the general journal will be for record- ing opening entries at the beginning of the business, correction entries during the fiscal period, and adjusting and closing entries at the end of the fiscal period. Of course, any special entries that cannot properly be classified in the special journals will be recorded in the general journal. BOOKS OF FINAL ENTRY If the journal is to be subdivided into special books for the sake of saving time, for analyzing purposes, and to enable more bookkeepers to work on them at the same time, likewise, it is equally advisable to subdivide the ledger. 'Published by Ronald Press Co. BOOKS OF ACCOUNT 35 S/'s / i NN \ S ^ N V x x / / , \ \ V N X / / I \ \ ' / I I \ X \ \ \ \ \ N \ \ N - \ \ \ \ \ X / I 1 \ v v N ^ Sales Returns Book Notes Recoivabl Book Cash Receipts Book Purchase Book General Journal 03 tA o o r-t oJ PQ CO Cash Payments Book O ^ C3 O >>CQ Purchase: Returns Book 36 PUBLIC ACCOUNTING AND AUDITING The Ledger. If only a general ledger were maintained in a large firm, where there may be thousands of accounts, one can readily see that no bookkeeper could possibly keep up with the volume of work, unless some sort of a card or loose-leaf ledger were used enabling different persons to post at the same time. Hence it not only becomes advisable, but absolutely necessary, to subdivide the ledger. The process in subdividing the ledger, however, differs from the subdivisions of the journal in this respect, that the general ledger controls all accounts which are kept in what are known as subsidiary ledgers. Subsidiary Ledgers. In an ordinary mercantile business, the principal subsidiary ledgers are the sales and purchases ledgers. From the standpoint of terminology, a number of dif- ferent names have been applied to these ledgers. Accounts re- ceivable ledger, sales ledger, customers' ledger and debtors' ledger are all synonymous terms and mean the same thing. Likewise, purchases ledger, accounts payable ledger and creditors' ledger are synonymous terms. Other terms are also used, for instance, a sales ledger may be arranged so as to show accounts with cus- tomers in either alphabetical, geographical or numerical order. In the event that they are arranged in alphabetical order, then there may be one or more ledgers with controlling accounts for each. The controlling account might be named A to C Ledger, D to E Ledger, etc. If the arrangement is geogra- phical, the ledgers might be known as city ledgers, coun- try ledgers, foreign ledgers, state ledgers, etc. Furthermore, the ledgers may be in the form of bound books, loose leaf books, cards or vouchers. One will frequently find a system of arrang- ing the accounts numerically, in which case the bookkeeper in charge of a customers' ledger may not know who the customers are as he does his posting from information in memorandum form, the name of the account being represented by numbers only. Experience only will enable one to become familiar with all the different methods and plans used. Controlling Accounts. A controlling account for each sub- sidiary ledger will be kept in the general ledger, and this con- trolling account will show at all times the exact status of the subsidiary ledger. By means of controlling accounts for the subsidiary ledgers, the general bookkeeper keeps his ledger in balance at all times without the necessity of preparing schedules of the accounts in the subsidiary ledgers. W. A. Paton,* Ph. D., and R. A. Stevenson.f Ph. D., in their text on Principles of Accounting, say: "The possibility for labor saving is often dependent upon the use of controlling accounts and subsidiary ledgers. The total amount receivable on customers' accounts con- stitutes one distinct asset item for Balance Sheet purposes. *Assistant Professor of Economics in the University of Michigan. fAssociate Professor of Accounting in the University of Iowa. THE TRIAL BALANCE 37 The amount due from an individual customer is of little importance in the presentation of a statement showing a firm's financial condition. It is the summary of all the customers' accounts that is significant. It is obvious that for other purposes, however, a knowledge of the amount due from individual customers must be available. In order to serve both of these purposes the controlling account is used." The chart also shows that if the business is a manufacturing business and it is desired to maintain a cost system, a sepa- rate factory cost ledger may be kept, but that this will be con- trolled by an account in the general ledger just the same as a subsidiary ledger with customers or creditors would be kept. At this point the system becomes still more complicated by the fact that the number of transactions affecting the cost ledger are so great that it may be necessary to subdivide that ledger and maintain subsidiary cost ledgers for special cost accounts. For instancfe, a separate ledger might be kept with manufactured parts and another with raw material. THE TRIAL BALANCE In preparing a Trial Balance from the general ledger, it will not be necessary to take into consideration any of the subsidiary ledgers unless it is desired to check the controlling accounts with the sum of the balances of the accounts in the subsidiary ledgers. This must be done at the end of each fiscal period. In most cases it is advisable to make this check at least once a month. The professional auditor, however, will never accept a Trial Balance from the general ledger without preparing schedules from all the subsidiary ledgers and making a careful comparison with the controlling account in the general ledger. The accounts should be so arranged in the ledger that they will be in proper order for the preparation of the statements at the end of the period. The arrangement of the accounts in the Trial Balance is not a matter of great importance ; however, the Trial Balance is usually prepared by following the ledger, page by page. Whatever arrangement or classification of accounts has been carried out in the ledger, therefore, will be duplicated in the Trial Balance. If the accounts have been properly ar- ranged in the ledger, the Trial Balance will, therefore, show the accounts arranged in such a manner that it will be an aid in pre- paring the financial statements. Too many bookkeepers consider the Trial Balance as an indication of the correctness of their work. This frequently leads to trouble because a Trial Balance, even though it is in balance, will not indicate or detect errors in principle, off-setting errors or errors of omission. The fact is, a Trial Balance is noth- ing more than a fairly reliable indication of accuracy, and simply shows the equilibrium or equality of debits and credits. Another form of the Trial Balance used by accountants, known as the Working Sheet, will be discussed later. 47117 38 PUBLIC ACCOUNTING AND AUDITING THE BALANCE SHEET It has already been stated that the accounts in the ledger should be so arranged as to make it convenient to prepare a Bal- ance Sheet. At this point, the proper arrangement of accounts in the Balance Sheet will be taken up. Conflicting theories exist. First; Accountants in England and America do not agree with reference to the listing of the assets on the debit side of the Balance Sheet and the liabilities on the credit side. English accountants hold that a Balance Sheet is an account rendered by the business to the owner; therefore, the proprietor is cred- ited with his assets and debited with his liabilities. Hence the Balance Sheet shows the liabilities on the debit side and the assets on the credit side. This is just the reverse of the prac- tice by American accountants who hold that a Balance Sheet is a concrete preparation of financial facts, the debit side of the Balance Sheet showing the assets and the credit side, the liabil- ities. Second; American accountants have not been able to agree as to the arrangement of the assets and liabilities on the Balance Sheet. Some list (a) the fixed assets on the debit side opposed to the fixed liabilities on the credit side, (b) the current assets on the debit side opposed to the current liabilities on the credit side, and (c) the deferred debit items opposed to the deferred credit items, while others arrange the assets and liabilities without regard to any particular classification. Some show the capital or proprietorship accounts first on the credit side, while others show them last. Some show reserves as de- ductions from assets. Others show them either as liabilities or as a part of the proprietorship section. Regardless of all this difference in opinion, there is gradually coming about a uni- formity, and it is to be encouraged at all times. Robert H. Montgomery,* C. P. A., expresses his conception of an ideal Balance Sheet as one which will set forth: 1. "The assets, properly valued and grouped, and ar- ranged in the order of their availability. 2. "The liabilities also properly grouped and arranged in the order they will, or should, be discharged. 3. "If possible the excess of the assets or the liabilities should now be shown in order that there may be clearly apparent to anyone interested, the net worth, or capital and surplus, of the enterprise. 4. "A statement showing to whom the excess belongs or by whom it is due. That is,' if a corporation, there should be shown the capital stock issued, the addition thereto if a surplus of assets exists, or the deduction there- from if there is a deficiency." A Model Balance Sheet. The Model Balance Sheet illustrated on pages 40 and 41 shows the arrangement of the different classes of real accounts in accordance with a tentative *Of the firm of Price, Waterhouse & Company. THE BALAN 7 CE SHEET 39 proposal for a uniform system of accounting to be adopted by manufacturing and merchandising concerns. The proposal was made in 1917 by the Federal Reserve Board and is the out growth of the work of the Federal Trade Commission and of Mr. Edward N. Hurley, in particular, who during his entire term of office labored zealously and intelligently for the betterment of business and credit conditions. The Federal Reserve Board in prescribing a uniform Bal- ance Sheet to be used for credit purposes has performed a real service in promoting uniform accounting. In commenting on the model Balance Sheet prescribed, at- tention should be called to the fact that it would have been better to separate notes and accounts receivable so as to allow a separate deduction for a reserve for bad debts from each. The percentage of loss will not be so great on notes as on open accounts, therefore, the percentage set up as reserves will vary. Note that securities are excluded from the list of "quick" assets, but included in the list of current assets. This is in ac- cordance with Federal Reserve practice, but ordinarily no dis- tinction is made between quick and current assets. No provision for accrued assets is made. In practically every audit, there will be a certain amount of accrued assets. These should always be listed among the current assets and in using the form of Balance Sheet as advocated by the Federal Reserve Board, it is apparent that accrued assets would be listed under the heading of "Other quick assets." Since provision was made for accrued liabilities on the credit side, one is inclined to think that similar provision should have been made for ac- crued assets on the debit side. The accounting student might easily be misled from the fact that fixed assets are all grouped together, followed by re- serves for depreciation. It was undoubtedly the intention that the reserves for depreciation should be deducted from the par- ticular fixed asset to which they are applicable. For instance, a reserve for depreciation on machinery is a deduction from the Machinery account on the Balance Sheet and not from the total fixed assets, even though the final results would be the same. Likewise, reserves for depreciation on buildings should be de- ducted from the asset, buildings. Reserve for depreciation on office furniture and fixture should be deducted from the asset, furniture and fixtures, and so on. On the credit side of the Balance Sheet, there is to be noted a peculiar difference from the usual practice. The intangible asset, good will, is deducted from the net worth. It has been customary to list good will and other similar intangible assets on the asset side of the Balance Sheet separate from either cur- rent or fixed assets, usually at the bottom of the statement. While the final results are the same with either method, yet there is no doubting the fact that certain intangible assets, such as good will, may have a definite value, and in that event one can see no objection to their being listed as assets. PUBLIC ACCOUNTING AND AUDITING ASSETS. Cash: I a. Cash on hand currency and coin xxxxx. xx ib. Cash in bank xxxxx. xx xxxxx. xx Notes and Accounts Receivable: 3. Notes receivable of customers on hand (not past due) xxxxx. xx 5. Notes receivable discounted or sold with in- dorsement or guaranty xxxxx. xx 7. Accounts receivable, customers (not past due), xxxxx. xx 9. Notes receivable, customers, past due (cash value, $xx) 1 1 . Accounts receivable, customers, past due (cash value, #xxxx) xxxxx. xx Less : xxxxx . xx 13. Provisions for bad debts xxxxx. xx 15. Provisions for discounts, freights, allowances, etc xxxxx. xx xxxxx. xx xxxxx. xx Inventories : 17. Raw material on hand xxxxx. xx 19. Goods in process xxxxx. xx 21. Uncompleted contracts xxxxx. xx Less payments on account thereof. . xxxxx. xx xxxxx. xx 23. Finished goods on hand xxxxx. xx xxxxx. xx Other Quick Assets (describe fully) : xxxxx. xx xxxxx . xx xxxxx . xx XXXXX. XX Total quick assets (excluding all investments) . Securities: 25. Securities readily marketable and salable with- out impairing the business xxxxx. xx 27. Notes given by officers, stockholders, or em- ployees xxxxx. xx 29. Accounts due from officers, stockholders, or em- ploj'ees xxxxx. xx xxxxx. xx Total current assets xxxxx. xx Fixed Assets: 31. Land used for plant xxxxx. xx 33. Buildings used for plant xxxxx. xx 35. Machinery xxxxx. xx 37. Tools and plant equipment xxxxx. xx 39. Patterns and drawings xxxxx. xx 41. Office furniture and fixtures xxxxx. xx 43. Other fixed assets, if any (describe fully) xxxxx. xx xxxxx . xx XXXXX. XX Less: 45. Reserves for depreciation xxxxx. xx Total fixed assets xxxxx. xx Deferred Charges: 47. Prepaid expenses, interest, insurance, taxes, etc. xxxxx. xx xxxxx. xx Other assets (49) xxxxx. xx xxxxx . xx Total assets xxxxx. xx (Model Balance Sheet for credit purposes.) THE BALANCE SHEET LIABILITIES. Notes and Accounts Payable: Unsecured Notes 2. Acceptances made for merchandise or raw ma- terial purchased xxxxx. xx 4. Notes given for merchandise or raw material purchased xxxxx. xx 6. Notes given to banks for money borrowed xxxxx. xx 8. Notes sold through brokers xxxxx. xx 10. Notes given for machinery, additions to plant, etc xxxxx. xx 12. Notes due to stockholders, officers, or employees xxxxx. xx xxxxx. xx Unsecured Accounts: 14. Accounts payable for purchases (not yet due)., xxxxx. xx 16. Accounts payable for purchases (past due) xxxxx. xx 1 8. Accounts payable to stockholders, officers, or employees xxxxx. xx xxxxx. xx Secured Liabilities: 2Oa. Notes receivable discounted or sold with in- dorsement or guaranty (contra) xxxxx. xx 2ob. Customers' accounts discounted or assigned (contra) xxxxx. xx 20c. Obligations secured by liens on inventories. . . . xxxxx. xx 2od. Obligations secured by securities deposited as collateral xxxxx. xx xxxxx. xx 22. Accrued liabilities (interest, taxes, wages, etc.) xxxxx. xx xxxxx. xx Other Current Liabilities (describe fully) : xxxxx. xx XXXXX . XX XXXXX . XX Total current liabilities xxxxx. xx Fixed Liabilities: 24. Mortgage on plant (due date) xxxxx. xx 26. Mortgage on other real estate (due date) xxxxx. xx 28. Chattel mortgage on machinery or equipment (due date) xxxxx . xx 30. Bonded debt (due date) xxxxx . xx xxxxx. xx 32. Other fixed liabilities (describe fully): xxxxx . xx XXXXX . XX XXXXX . XX Total liabilities xxxxx.xx xxxxx. xx Net Worth: 34. If a corporation (a) Preferred stock (less stock in treasury). . xxxxx.xx (b) Common stock (less stock in treasury)... xxxxx.xx (c) Surplus and undivided profits xxxxx . xx xxxxx.xx Less: (d) Book value of good will xxxxx. xx (e) Deficit xxxxx . xx xxxxx . xx xxxxx.xx 36. If an individual or partnership (a)Capital xxxxx.xx (b) Undistributed profits or deficit xxxxx . xx Total Liabilities and Net Worth xxxxx. xx (Model Balance Sheet for credit purposes.) 42 PUBLIC ACCOUNTING AND AUDITING THE FOLLOWING DISCUSSION OF THE BALANCE SHEET IS BY JAMES O. McKINSEY, C. P. A.* "The Purpose of the Balance Sheet is to make the financial facts in regard to the business COMPREHENSIBLE to the proprietor and others. This idea cannot be emphasized too strongly, not only in regard to the Balance Sheet, but also in reference to all the other financial statements. It should be remembered that they are prepared primarily for the proprietor or creditors of the business, and many of them have no techni- cal training in accounting. These statements should be in such a form that they can be readily understood by those for whom they are intended. Mr. Montgomery says: 'Many intelligent people fail to grasp the usual conventional hypothesis under- lying the theory of double entry bookkeeping, and, therefore, facts or figures presented to them in a technical or formal shape may not accomplish the intended result^ Balance Sheet vs. Financial Statement. "Prob- ably one of the first questions which arise in the mind of some readers is in reference to the propriety of the term 'Balance Sheet'. The writer is well aware that this term is not generally used in elementary accounting texts. The term 'financial statement' seems to be a favorite one with most text writers, although the terms 'statement of resources and liabili- ties,' 'statement of assets and liabilities', and 'business statement' are sometimes used. A financial statement is any statement of financial facts. The Balance Sheet is a financial statement, but so is a Profit and Loss statement, a statement of Affairs, or a statement of Receipts and Expenditures, as well as many others which might be added. To call this particular statement a financial statement does not differentiate it from many other such statements. In reference to the other terms mentioned, it is sufficient to say that they are rarely used by accountants, and when they are used, they are employed for a special purpose and not in reference to the statement which is defined as a Balance Sheet above. The writer has had occasion to examine numerous reports made by accountants of the highest rank, in three different large cities, during the last two years and he has never seen any term but Balance Sheet used in the above con- nection. "As stated above, the purpose of the Balance Sheet is to set forth the financial condition of the business. This statement might be criticised on the ground that the true and complete financial condition is not shown unless the Balance Sheet is accompanied by the statement of Profit and Loss. In other words, it is impossible to intelligently judge of the present con- dition unless the causes of that condition and thereby some indication of the possibilities of the future are known. Leaving * Instructor of Accounting at the University of Chicago. Author of "Bookkeeping and Accounting," published by South-Western Publishing Company. THE BALANCE SHEET 43 aside this question for the present, it can be readily seen that the Balance Sheet should show three things: 1. The amount and nature of the assets. 2. The amount and nature of the liabilities. 3. The amount and nature of the differences between the assets and liabilities, which constitutes the interest of the pro- prietor. "In order that this may be done satisfactorily, it is neces- sary that the accounting records be properly kept, so that the desired information may be obtained. This, of course, involves all the principles governing the proper construction of the differ- ent accounts. Assuming that the accounts are properly kept, the following will be confined to a brief discussion of the arrange- ment of the accounts on the Balance Sheet so that it will afford as much information as possible. "Often no attempt is made to classify the assets and liabili- ties. They are arranged in no definite form or order, and their nature, other than by their name, is not indicated. It seems their only purpose is to state the amount of the items and the total thereof. This is, of course, essential, but since other im- portant information can be given so easily, it seems desirable that some attention be given to the classification and arrange- ment of the accounts. Classification of Assets and Liabilities. "The most simple, and at the same time the most important, classification of assets and liabilities is into the two classes: fixed and current. There are further divisions, but the above are the most important and are sufficient for elementary work in accounting. "The two simple Balance Sheets given on page 44 illustrate the points previously discussed. The first illustration shows a Balance Sheet in the form frequently used. The second illus- tration shows the same Balance Sheet with the assets and liabili- ties classified as current and fixed. "The headings of Balance Sheets are frequently omitted or stated incorrectly. The form shown here is the one employed by accountants in making Balance Sheets to submit with their reports. Only a few of the more elementary principles in regard to the Balance Sheet have been discussed here." 44 PUBLIC ACCOUNTING AND AUDITING JOHN JONES Balance Sheet June 30, 1919 Assets Liabilities Cash Notes^Receivable Accounts Receivable Merchandise Inventory Furniture & Fixtures Real Estate $ 900 2000 2800 6000 400 3000 $15100 Mortgages Payable Notes Payable Accounts Payable John Jones, Capital $ 20OO 3000 26OO 7500 $15100 (Unclassified Balance Sheet) JOHN JONES Balance Sheet June 30, 1919 Assets Current Assets : Cash $ 900 Accounts Receivable 2800 Mdse. Inventory 6000 Notes Receivable 2000 Total Current Assets Fixed Assets: $11700 Furniture & Fixtures $ 400 Real Estate: Land $1000 Buildings 2000 3000 Total Fixed Assets $3400 Total^Assets $15100 Liabilities Current Liabilities: Notes Payable $3000 Accounts Payable 2600 Total Cur. Liabilities $5600 Fixed Liabilities: Mortgages Payable 2000 Total Liabilities $ 7600 Capital or Proprietorship: Invest. June 30, 1919 $7000 Profits for the Year 500 Present Investment 7500 Total Liabilities & Prop. $15100 (Classified Balance Sheet) THE LAW OF CONTRACTS 45 THE LAW OF CONTRACTS (Continued) Contracts are not always valid. They may be illegal, void, voidable or unenforceable. The validity of a contract depends upon the law of the state in which it is executed. In case of a suit to enforce a contract, the laws of the state in which the suit is brought govern the remedy. If a contract is executed in one state and is delivered in another state, the laws of the state in which it is delivered govern the delivery. Illegal Contracts are always void and have no standing whatever in the eyes of the law. Agreements to do anything contrary to law or agreements against the public policy are illegal and void. A Voidable Contract is one in which one of the parties may legally refuse to carry out the agreement, but at the same time, if the injured party desires, the other party can be compelled to carry out the agreement. It will be seen that the law is protecting one of the parties, but not the other. An example is a contract made with a minor, an alien, an insane person, or an intoxicated person. An Unenforceable Contract will not be enforced by courts if either party objects to its terms. Suppose A agrees to sell B his house and lot for $5,000.00 and B agrees, orally to buy. The contract is unenforceable because contracts to sell real estate must be made in writing, or at least there must be a memorandum in writing. Mistakes. A Mistake of Fact exists when a mistake has been made as to whom one is contracting with, concerning the subject matter, or concerning the nature of the contract. When a mistake of fact exists the contract is void and cannot be en- forced. A Mistake of Law exists when a party misunderstands the legal effect of his word or acts. "Ignorance of the law excuses no one," therefore, a mistake of law is no cause for escape from a contract. Fraud. Fraud is the wilful misrepresentation of material facts and if proven the contract becomes voidable. Misrepresentation in the form of a mere expression of an opinion does not constitute fraud. When fraud is performed, the contract may be declared void at the option of the defrauded party, but can not be annulled by the one committing the fraud. Alteration of a contract wrongfully, amounts to fraud and makes it voidable. This must not be misconstrued. If one were to be given a check properly signed and made out with the exception that the date was omitted, he would have the right of filling out what was understood to be the correct date. Likewise, if the amount was omitted, he might fill in an amount himself, and if he could show that it was the correct amount the check would be good. Do not sign contracts of any kind with any part of the terms blank. Be sure that they are properly filled in in detail. 46 PUBLIC ACCOUNTING AND AUDITING A. THEORY QUESTIONS 1. What is the chief consideration in the arrangement of ledger accounts? C. P. A. Ind. 2. What is meant by Controlling Accounts? Give three illustrations of the use of such accounts. State the advantages of such accounts. C. P. A. Ohio. 3. Describe a method of keeping accounts so that the aggregate sums due from customers and due to creditors can be known without preparing a schedule of the accounts of such customers and creditors, and so that an independent balance of the ledger, containing only the real, nominal, special and con- trolling accounts, exclusive of the individual accounts of cus- tomers and creditors may be taken. C. P. A. N. Y. 4. Wherein does the Trial Balance differ from the Balance Sheet? 5. Would you, or would you not, be satisfied with a list run off on an adding machine by some one connected with the institution under examination after you had compared the amount of each item with the listed figures? Give your reason. C. P. A. Del. B. ACCOUNTING PROBLEMS I. For the six months ending June 30, 1916, the balances appearing on the books of George Parker are as follows: Cash in bank $ 4,765.14 Cash on hand 100.64 Capital, George Parker 17,821.04 Bills Receivable 6,164.92 Bills Payable i ,301 .90 Debtors 20,903.88 Creditors 6,263.12 Purchases 255,642.42 Sales 266,723.40 Furniture and Fixtures 811.32 Drawing, George Parker 4,000.00 Discounts Received 8,824.22 Discounts Allowed 5,240.52 Expenses New York office 3,762.18 Expenses branch office 441.10 Expenses general office 553-52 Reserve for Bad Debts 1,451.96 Prepare Trial Balance and Balance Sheet. (No merchandise inventory) . ACCOUNTING PROBLEMS 47 2. A manufacturer is desirous of securing a partner and furnishes a statement covering five years' operations as follows: ASSETS. Buildings. . . $ 20,000.00 Machinery and Fixtures 75,000.00 Inventory, Mdse. and Supplies 50,000.00 Cash 5,000.00 Accounts Receivable 40,000.00 LIABILITIES. Accounts and Bills Payable $ 30,000.00 Sales average per year $500,000.00 Wages paid per year 1 70,000.00 Expense, Selling and General, per year. . . . 35,000.00 Material purchased 260,000.00 Buildings are on leased ground, lease expires in ten years, annual land rental, $1,000.00. Buildings revert to owner at ex- piration of lease. New machinery when installed ten years ago cost $50,000.00. Additions since cost $25,000.00. No depreciation has been charged off. All repairs and replacements charged to expense. What in your opinion would be a fair price to be contrib- uted, for a half interest? Explain fully. C. P. A., Mich. (Note. In connection with this problem you may assume that upon investigation you ascertained the following facts: (a) That the accounts receivable are guaranteed to be collectible, hence no reserve on account of doubtful accounts need be made. (b) That the inventory of merchandise and supplies was priced at cost and that the accuracy of the items listed was tested and found to be accurate. (c) That the buildings are so constructed that at the expiration of the lease they will have no residual or scrap value, hence a reserve for depreciation f 5% per annum for the past ten years should be calculated and a further reserve of 5% per annum should be set up during the remainder of the lease. (d) That at least 5% depreciation per annum for ten years should be calculated on machinery costing $50,000.00, and the same rate per annum for a period of five years on new machinery costing $25,000.00. It is estimated that the machinery will continue to depreciate at a rate of 5% per annum. (e) That all the liabilities are stated and that there are no contingent liabilities. (f) No valuation need be placed on good will. Submit a statement showing how you arrived at the value of a half interest). 48 PUBLIC ACCOUNTING AND AUDITING C. LEGAL QUESTIONS 1. Distinguish between a Mistake of Fact and a Mistake of Law. 2. What makes a contract illegal? C. P. A. Mich. 3. What is the difference between fraud and misrepresenta- tion? C. P. A. Ohio. 4. Define or describe, void, voidable and unenforceable contracts. Inst. Ex. 1917. 5. A contract executed and delivered in California is the subject matter of a suit in New York. What laws will govern the validity of the contract, and what laws will govern the remedy? State the rule in such cases. Inst. Ex. 1917. Chapter Four (NOTE. As a student of accounting, you will want to become familiar with the practical side of public accounting and auditing, and in order that you may best do this, the actual procedure of a Balance Sheet audit will be discussed in the following chapters. It will be taken up in such a manner that you will have an opportunity to observe the work of both junior and senior accountants). The correspondence shows that the name of the client is The Blank Manufacturing Company. (See Engagement Blank, page 1 8, for details.) A firm of accountants has been employed by the Board of Directors to make a Balance Sheet audit as at the close of business December 31, 1918, principally for credit purposes, but also to establish whether there have been any errors of principle on the part of the chief accountant of the Company, who planned the system of accounts in use, and who heretofore has prepared all financial statements. Each accountant has been furnished with a letter of introduction and the usual auditor's equipment. The senior in charge is an ex- perienced man who understands how to direct the work of a number of juniors and has full authority for deciding all ques- tions relative to procedure and accounting principles. Two juniors are assigned to work with the senior. The juniors un- derstand that when they are in doubt relative to any part of the work, or if they discover anything that is not clear to them, they are to report immediately to the senior for instructions. A full set of working papers must be kept by each accountant relative to the work completed by him. When the audit is com- pleted the senior will arrange all working papers in order and make a report to the managing senior, who will prepare there- from final reports which will be submitted to the client. On reporting at the general office of The Blank Manufac- turing Company on January 15, 1919, and being properly intro- duced to Mr. L. W. Shields, general manager, Mr. Harold Pond, chief accountant, and the heads of departments, the senior is given a Trial Balance taken from the general ledger, and other information as follows: 49 5o PUBLIC ACCOUNTING AND AUDITING Trial Balance, Dec. 31, 1918. Cash $ 20, 162.00 Cash deposited for dividend No. 9. ... 2,050.00 Cash deposited for bond interest 2,500.00 Land 100,000.00 Buildings 150,000.00 Machinery 100,000.00 Tools and implements 20,215.00 Horses, wagons and harness 15,000.00 Office furniture 2,600.50 Notes receivable 12,906.00 Accounts receivable 81,687.00 Sinking fund 15,000.00 Investment of surplus 10,000.00 Salary advances to salesmen 980.00 Unapportioned organization expense. . 7,350.00 Bond discount unamortized 6,000.00 Div. No. 9, 5% authorized 7-1-18.. 22,500.00 Good will 75,000.00 Unsubscribed stock 50,000.00 Notes payable $ 21 ,000.00 First mortgage 5%, 2O-yr. bonds. . . . 100,000.00 Accounts payable 51,780.50 Due to officers and clerks 7,681.50 Bond interest coupons due 2,500.00 Div. No. 9, vouchers outstanding. . . . 2,050.00 Res. for baddebts, less $970 written off 56.00 Res. for depr. on buildings, 2^4%.. 2,500.00 Res. for depr. on machinery, 6%.. 9,000.00 Res. for dep. on horses and wagons, 10% 1 ,500.00 Capital stock, 5,000 shares at $100 500,000.00 Sinking fund reserve 15,000.00 Sales less returns and allowances 625,275.00 Rent of part of business premises 250.00 Inventory 12-31-17, raw material. . . . 37,310.50 Inventory 12-31-17, finished stock. . . . 15,000.00 Purchases 195,000.00 Factory pay roll, labor 300,200.00 In-freight and cartage 2,831.00 Office salaries and clerical force 37,560.00 Salaries of salesmen 30,220.00 Advertising 25,150.00 Taxes paid 2,010.00 Insurance 1,300.00 Bond interest 5,000.00 Interest and discount 3,250.00 Stable expense 2,000.00 Office and other expense 12,875.00 Maintenance and repairs 13,471.00 Surplus, 12-31-17 _._. 38,535-00 $1.377.128.00 $1.377.128.00 CASH 51 Inventory, Dec. 31, 1918: Finished stock $80,000.00 Materials and stock in process 55,000.00 Factory pay roll accrued but not paid 2,875.00 Unexpired insurance 456.00 Interest accrued on invested surplus 126.32 Interest accrued on sinking fund 875.34 The senior ascertained from the general manager and the chief Accountant the following additional information : 1. It is desired to set aside the same reserve for deprecia- tion as at the end of the previous year. 2. The practice of the Company has been to charge off 10% of the balance of organization expense annually and they prefer to continue this policy. 3. The account with bond discounts is being charged off at the rate of 5% annually. 4. It is estimated that 2% of notes and accounts receivable will prove to be worthless. 5. An appropriation of $15,000 is to be made to the sinking fund and the cash from same to be placed in the hands of a trustee at the completion of this audit. 6. The balance of profits available for distribution is to be shown as a credit to undivided profits or surplus. The chief accountant furnishes the senior upon request with a list of the books of account as follows: Books of Original Entry: (a) General journal. (e) Sales returns book. (b) Purchases book. (f) Cash receipts book. (c) Purchases returns b*bok. (g) Cash payments book. (d) Sales book. (h) Notes receivable book. (i) Notes payable book. Ledgers. In addition to the general ledger, there is kept subsidiary ledgers with customers and with creditors. CASH The senior having prepared an audit program, directs one of the juniors to proceed with the count of cash and the verify- ing of the cash and bank balances. 1. ACCOUNTING THEORY The Theory of the Cash Account. This account is usually kept with more care than any other account, though it is difficult to understand why a business man should safe- guard his cash with any greater degree of care than other assets representing money's worth or cash value. If as great pre- caution were used in the keeping of accounts with merchandise as is used with cash, there would be much less temptation for 52 PUBLIC ACCOUNTING AND AUDITING fraud, theft, etc. The average business man is satisfied to take a physical inventory of merchandise once a year, but counts his cash daily. Accountants advocate the keeping of an account with cash in the general ledger. It partakes of the nature of a controlling account since it is debited only with the total receipts and cred- ited only with the total payments at the end of each designated period, usually at the end of each month. Many bookkeepers keep only a cash book and do not keep an account with cash in the general ledger. The bookkeeper simply refers to the cash book for the cash balance when preparing the Trial Balance. The general ledger is supposed to balance, independent of all the other books of account, but will not do so unless an account is kept with cash. Several forms of cash books will be found in use. They have been devised for all sorts of reasons and to meet all kinds of conditions. They run the scale from a cash book with only a general column on each side to a complicated form of cash journal containing all the transactions, either individually or in summary. Then, too, the cash book will be found divided, one being kept for receipts only and another for payments. This division enables two bookkeepers to work on the cash books at the same time, one handling receipts and another handling disbursements. This is an advantage in large concerns, and there is also less chance for embezzlement. In some cases a separate cash book is kept for recording receipts from trade cus- tomers only, or one for recording payments to trade creditors only. Imprest System. Since it is important that all receipts be deposited in the bank and all payments be made by check, there has come into use what is known as the PETTY CASH FUND or IMPREST SYSTEM. A certain sum is drawn from the bank by writing a check payable to Petty Cash, the proceeds of which is placed in the care of a petty cashier whose duty it is to pay out small sums below a certain amount. An account is kept with Petty Cash and at certain periods the cashier presents a record of his dis- bursements supported by vouchers and the fund is replenished. There are slightly different methods in handling the Petty Cash and the different methods should be thoroughly understood. J. W. Baker,* in discussing the Petty Cash Fund, writes: "All cash received should be deposited, and all payments made by check. If it is necessary to make small payments, these should be made from a fund kept on hand for this purpose. This fund is known as the 'Petty Cash Fund' or 'Imprest Fund'. It is created by withdrawing from the bank an amount sufficient to meet these payments. This may be $10.00, $20.00, *2Oth Century Bookkeeping and Accounting. CASH 53 ).oo, or $100.00, according to the amounts required. The check needed to establish the fund is entered in the general cash book, the same as other checks, the amount being debited to a Petty Cash Fund or Imprest Fund account in the general ledger. When the fund has been exhausted by the payments, another check is drawn for the amount necessary to replenish the fund. At this time the proper accounts are charged in the general cash book for the payments from the petty cash fund. The amount (balance of the Petty Cash Fund account) remains the same until the account is closed, which would be at the end of the fiscal period, or when the imprest system is discontinued." Fraud. The professional auditor learns from experience that there are certain methods whereby a bookkeeper may dishonestly abstract funds of a company and still keep his books and accounts in balance. The following are a few of the more common methods which an auditor should always be able to detect during the course of a professional audit: 1 . The bookkeeper may withhold a part of the cash receipts and make no entry whatever on the books of account, neither recording the receipt of cash nor the credit to the customer's account. 4Q 2. The bookkeeper may withhold a part of the cash re- ceived and instead of recording it as a cash receipt may credit the customer for an allowance on returned goods. 3. After the cash has been entered in the cash book and properly posted to the correct account, the bookkeeper may alter the cash book footings so that they will show a smaller amount of receipts or a larger amount of payments and then withhold cash equal to the amount of the difference. 4. The bookkeeper may withhold a part of the cash re- ceipts making no entry in the cash book, but may enter directly in the ledger a credit to the customer's account, and, at the same time, make a fictitious debit to some other customer's account in order to keep the ledger in balance. 5. The bookkeeper may pay cash to offset some invoice previously entered fraudulently, the invoice having been charged to some expense account. Of course, the book- keeper would abstract the cash thus paid and make the proper entry on the credit side of the cash book. 6. A sale to a customer on account may not be recorded at all and when the cash is received the bookkeeper simply withholds it, making no entry therefor. 54 PUBLIC ACCOUNTING AND AUDITING 7. A process of "overlapping" may be resorted to. In this way the bookkeeper may withhold cash as received and substitute therefor subsequent receipts of cash as they come in. This is kept up continuously so as to cover the original discrepancies. Suggestions to Eliminate Possibility of Fraud. If the system for handling the cash and cash items, and for keep- ing the accounts and records in connection with cash is properly planned, possibility of fraud may be largely eliminated. The policy of internal check should be carefully followed. The following general suggestions will aid materially in planning the system of accounts and the system of internal check so as to prevent fraud in connection with the handling of cash: 1 . Do not permit the bookkeeper who keeps the personal accounts to act as cashier. The one who records the receipts and payments of cash in the cash book should not have access to the customers' and creditors' ledgers. 2. The entire cash receipts must be deposited in the bank regularly daily if convenient. When this plan is carried out, the cash receipts will be exactly equal to the deposits in the bank during any month or during the entire fiscal period. 3. All disbursements must be made by check. This does not mean that petty disbursements cannot be made in cash. The petty cash fund can be created and replenished from time to time by check and the petty cashier should be required to account for all disbursements of whatever nature by properly signed vouchers. 4. The check book should be in the custody of the one who signs the checks. This will usually be the cashier. The bookkeeper should not have access to the check book. The suggestions above will not in themselves prevent the fraudulent withholding of cash and failure to properly record receipts, neither will they prevent "overlapping." This can be overcome to a certain extent by arrangements whereby the cash receipts are handled by more than one person. For instance, a list of the cash receipts may be made at the time the mail is opened. The cash and cash items are then given to the cashier for recording and for deposit. In this way, two different persons are charged with the handling of the cash receipts. The book- keeper may post to the customers' accounts direct from the list, or from the cash book. At any rate, the list of cash receipts should go to an officer of the company who can later compare' CASH 55 the total receipts with the total deposits. If customers are billed regularly, any who have not been given credit for the full amount of their payment would be certain to enter a complaint. It will be seen that the object of any arrangement similar to this is to inaugurate an internal check. So much depends upon the volume of business that it is difficult to outline a set of rules; in fact, it would not be good policy to attempt to do so, because a system that would constitute a good internal check in one business, would not necessarily prove satisfactory in another. 2. AUDITING THEORY Counting the Cash. This should be done at the close of business and on the last day of the period under audit if possible. However, it more frequently happens that the audit takes place subsequent to the close of the accounting period, therefore, it is best to count the cash on the first day of the audit at the close of business. Some advocate that it is best to permit the person who is in charge of the cash to handle it and do the actual counting for the reason that he is, as a rule, skilled in the handling of cash. Another reason for it is that if the auditor does not handle the cash in person, he avoids the possibility of becoming involved in any irregularities. In case the cashier or person in charge of cash is permitted to count it, the auditor must, of course, super- vise the count with the greatest care. In counting the cash, the auditor must ascertain that all customer' checks, produced as a part of the cash balance, have been properly entered in the cash book prior to the close of busi- ness on that date, and should note the dates and descriptions of such checks as well as the dates and descriptions of such advances made of cash and not recorded on the books. Any advances to employees should be carefully investigated, and if they are secured by personal che.cks the auditor should see that the checks are certified by the bank on which they are drawn before the close of the audit. Any unusual cash items, such as I. O. U.'s, should be care- fully listed for investigation. However, the auditor should not adopt an attitude with regard to such matters that will react against him. If an employee owes an item of a few cents because he could not make change, it is not necessary to take the matter up with the head of the department or the president of the company. It is expected that anyone competent to act as either a junior or senior auditor will be able to use the proper discretion in such matters. One will frequently find bad coins that have been taken in unknowingly. These, of course, must be taken into consideration, but it does not justify criticism or fault-finding. Do not adopt the attitude of a detective. 56 PUBLIC ACCOUNTING AND AUDITING Verifying the Bank Balance. Certificates must be obtained from the various banks in which accounts are maintained, as at the close of business, on the same day that the cash balance is counted, preferably on the last day of the fiscal period. If this is not possible, then on the first day of the audit. This is done by presenting to the banks a request signed by the depositor or his agent asking for a certificate showing the balance on a certain date. This certificate should be mailed to the auditor, not to the depositor. Reconciling the Bank Certificate. This is done by check- ing the deposits with the cash book and vouching the payments with the cancelled checks. The bank balance will naturally vary from the cash book balance on account of checks outstand- ing. The outstanding checks should be listed for future refer- ence. Where several banks are used as depositories, this be- comes more complicated, but the general plan of procedure is the same. Having made a list of the checks outstanding, these may be investigated before the audit is completed, when it will likely be found that most of them have been presented to the bank for payment. Any still outstanding should be especially investigated. "Kiting" Checks. It is well to be familiar with the process commonly known as the "kiting of checks". This can be detect- ed by checking in detail the deposits of the last few days of the fiscal period and comparing with the receipts in the cash book. If a check drawn on one bank by the Company was deposited in another bank without being credited to the bank on which it was drawn prior to the close of the fiscal period, a false balance would be established. Be sure that a check drawn on one bank and deposited in another bank is properly entered. Since it is considered the better practice to deposit all receipts in the bank, it is well to obtain some of the old deposit tickets and compare them with the cash receipts in the cash book to deter- mine whether or not the cash receipts were properly deposited. This can also be determined by comparing the total deposits for any certain period with the total cash receipts of the same period. Working Back the Cash. Usually an audit is made some days after the close of the period. This necessitates the count ing of cash on a later date and working back to the day desired. After the exact cash balance has been determined on the date of audit, add the disbursements and deduct the receipts and the balance for the date desired will be obtained. This should be compared with the cash book balance on the date of the close of the fiscal period. To illustrate this procedure: March 10, 1919, balance per cash book. $12, 380. 24 Add disbursements, since Dec. 31, 1918. 6,205.18 $18,585.42 Deduct receipts since Dec. 31, 1918. . . . 4,756.98 Balance, Dec. 31, 1918, end of period.. .$13,828.44 CASH 57 3. AUDITING PROCEDURE The junior assigned to count the cash and verify the bank balance, proceeded by first making a count of the cash on hand. His working papers show (see illustration on page 58) the result of his count. Among the checks, there was one signed by C. P. Cooley, which has been returned from the bank, marked "No funds". Investigation showed that shortly before the auditor began counting the cash the bank had returned the check, the cashier having settled by writing a new check payable to the bank for the proper amount, $17.76. This check, however, had not been entered in the cash book. After talking it over with the cashier, the proper entry was made, charging the amount back to the customer's account, and the check was not included in the cash balance. Verification of the cash receipts book and cash payments book footings showed for the first fifteen days of January: Receipts $36,994.89 Payments 31,402.08 Excess receipts 5,592.8i According to the Trial Balance, the cash balance on Dec. 31, 1918, was $20,162.00. Adding to this the excess receipts for the first fifteen days of January, 1919, it will be seen that the cash balance at this date should be $25,754.81. The count of cash on hand shows a balance of $4,971.70. Therefore, there should be a balance in the bank at this time of $20,783.11 after deducting the sum of all outstanding checks. Bank Certificate. The senior mailed a letter to the bank requesting a certificate showing the balance to the credit of the Blank Manufacturing Co., at the close of business on January J 5 I 9 I 9- It is customary with banks to furnish this informa- tion, but it is first necessary to have your request approved by the client. Banks do not like to give out information without the permission of the depositor. The bank responded with a certificate showing a balance on January 15, 1919, to be $28,950.50, divided into three funds, General checking account $24,400.50 Fund for Dividend No. 9 2,050.00 Fund for Bond interest 2,500.00 The bank also returned to the Blank Manufacturing Co. the canceled checks. After obtaining the bank certificate and the canceled checks the junior continued his work by reconciling the bank balance. (See illustration on page 59.) He found that the following checks had been issued but had not as yet passed through the bank: 58 PUBLIC ACCOUNTING AND AUDITING No. Date. Payee Amount. 4527 12/8/18 Flint & Walling Mfg. Co $ 765.80 4597 I/5A9 A. S. Morrow & Co. 1,499.10 4599 I/7/I9 Geo. A. Barns 75.00 4670 1/10/19 L. W. Kindow 985.00 4682 i /I4/I9 Robert E. Arnes & Son 292.49 ;,6i7-39 Cash THB BLAK UAKD7ACTUBIKQ CO. 0. B. Sha*, oount: " Junior Jan. 15, 19195:30 P. 11. B. S. Dates, Caehier. 25 30 40 10 80 JO 4 4 6 36 33 23 14 41 Bills: 480 10 6 2 1 lol&t too 10 6 Silver: 1 1 .50 .25 .10 .05 .01 Total cash on hand Cash items: Checks Jan. 11 C. P. Mo Garry 13 P. B. Admire 14 A. S. Handeok 10 8. W. Gerring 6 S. H. Lehman 15 H. S. Biddlnger 9 S. J. Husiofc 8 W. A. Wirtz 14 C. W. Jones 12 C. C. White Miscellaneous P. 0. Money Order W. W. Ward Express Money Order , J. S. Joiner Total cash *500 800 200 20 , 80 CO 00 00 00 00 $1100 00 .00 16 $1396 3576 16 54 200 40 20 00 00 00 260 26 6 17 8 2 00 50 25 30 70 41 75 154 2 87 1 1M 156 821 1880 _1347 29 00 93 60 50 90 00 80 10 86 8571 4 98 66 1 2 60 96 4971 70 (Ai-Working Sheet, C. E. Shaw, junior accountant, tographed and reduced one-half.) Pho- CASH 59 The junior ascertained the following additional facts: (a) That the footings of the cash book were in ink. (b) That it was the custom of the company to make a de- posit each day -at noon. (c) That the cash on hand represented receipts since the last deposit was made at noon, Jan. 15, 1919. (d) That this deposit was shown in the bank certificate. (e) That the checks listed had all been entered in the cash receipts book. (f) That the check written in favor of the bank on Jan. 15, 1919, on account of the check returned by the bank with the notation, "no funds", had been deducted from the balance as shown on the certificate. THE BLAHK MAHtnTACTOHIUG CO. (a) Verification of cash book balance C. E. Shaw, It] Beoonoiliatlon of Bade balanoa Junior Completed Jan. 16, 1919 Balance (Jan. 15, 1919) as per bank certificate attached hereto Deduct Fund for Dividend Ho. 9 Fund for Bond interest Balance in general checking account Deduct cheeks in transit: No. 4527 4697 4699 4670 4662 Available balance in bank Add oash on hand (BOS record of count attached) Cash balance Jan. 15, 1919 WOBJCIHC BACK: Add disbursements (Jan. 1 to 15) Deduct receipts (Jan. 1 to 16) Cash balance Dec. SI, 1918 ' Total cash receipts book, Jan. 15, 1919 Total cash payments book, Jan. 15, 1919 Sxoess receipts Add C. B. balance Doc. 21, 1913 C. B. balance Jan. 15, 1919 k00 ^600 00 09 $9950 4550 60 00 |2440P -jjni. 20733 4971 60 _S 11 7Q 765 1499 75 986 292 80 10 00 00 49 36594 S3.*02 ~BW 016$ 89 08 TT 09 X 25764 &UQ8 ei Q? 6716ft . 36m o? li 016.8 ft (-E5V54 Cl (A2-Working Sheet, C. E. Shaw, junior accountant, tographed and reduced one-half.) Pho- 60 PUBLIC ACCOUNTING AND AUDITING THE LAW OF CONTRACTS (Continued) Assignment of Contracts. Contracts which do not de- pend on personal service, skill, ability, or trustworthiness of one or all of the parties involved may be assigned by either of the parties. Of course, if one of the conditions in a contract forbid its assignment, it could not be assigned. Assignments should be in writing, whether the contract is an oral or a written one. If it is a written one the assignment can be made on the back of the contract, and if it is an oral one the assignment can be made in writing anyway. A contract governed by the Statute of Frauds must be assigned in writing. However, there is nothing to prevent the assignment of contracts not governed by the Statute of Frauds by "word of mouth" or by "delivery". The assignee becomes liable to perform all the duties of the party who assigns the contract and receives only such rights as the original party enjoyed. His title is no better than that pos- sessed by the original party. If the other parties possessed any defenses against the assignor, they possess the same defenses against the assignee. By defenses is meant fraud, duress, undue influence, offset, etc. Novation. A novation is the substitution of other parties, or another party, not originally bound by the contract, for one of the original parties to the contract. This can be accomplished only by agreement of all the parties concerned. Discharge. There are five principal means of discharging contracts: 1. By performance. 2. By agreement. 3. By operation of law. 4. By intervention of impossibility. 5. By breach of contract. Performance. This is the simplest method of discharging contracts and it is the usual way. When all parties to a con- tract have fulfilled their agreement in full, the contract is dis- charged. Agreement. By mutual agreement, all the parties to a contract may set it aside, thereby discharging it. However, this agreement is simply another contract and must conform to all the conditions of a legal contract. Usually there is simply an oral agreement that the contract be discharged, that is, a mutual understanding of all the parties concerned. It should be definitely understood, and in some cases, it would be best to put it in writing. THE LAW OF CONTRACTS 61 Operation of Law. A contract may be discharged by the making of a new contract. Usually this is one of a higher order. A written agreement discharges an oral agreement and an agree- ment under seal discharges a simple contract in writing. Prac- tically all contracts are discharged by bankruptcy. Taxes, judgments, alimony allowances, and debts created by fraud, embezzlement, misappropriation, or defalcation while in charge of a trust are exceptions to the rule of discharge by bankruptcy. Death discharges executory contracts for personal service in which skill and taste are involved. Intervention of Impossibility. A contract to do some- thing that was impossible from the beginning is void. It is best, however, to make provision in the contract for strikes, war, acts of God, etc. By "acts of God" is meant floods, tornadoes, hurricanes, public calamities, etc. Breach of Contract. Violation of the terms of a contract is called a breach of contract. The innocent party to a contract may be discharged from further liability if the other party fails to do something which he agreed to do or does something which he agreed not to do. If the breach is such that the innocent party is not discharged from his obligations, he will be entitled to either money damages or to the right of "specific perform- ance". A court may compel a party to a contract to do as he agreed to do or to perform all the terms of the contract. This is known as a "specific performance." A Tender is an offer to pay. A tender of payment or an offer to perform the conditions of a contract does not discharge the contract. One may avoid penalty for non-payment, court costs, and interest on the debt from the time of the offer by making a tender; but he must hold himself ready to pay or perform the conditions. In case the offer to pay is made in money, it must be made in legal tender. Legal Tender is that currency or money which the law authorizes a debtor to tender and requires a creditor to receive in payment of money obligations. All gold coins of the United States are a legal tender in all payments at their nominal value when not below the stan- dard weight and limit of tolerance provided by law for the single piece, and when reduced in weight below such standard of tol- erance, they are a legal tender at valuation in proportion to their actual weight. Treasury notes and standard silver dollars for all pay- ments. Silver coins of a smaller denomination than one dollar for all sums not exceeding $10.00. Nickels and pennies for sums not exceeding 25c. 62 PUBLIC ACCOUNTING AND AUDITING Notes of the United States for all debts, public and private, except duties on imports and interest on the public debt. Gold certificates payable to bearer were made legal tender under a Senate bill passed by the House December 19, 1919, and signed by the President. The following chart is intended as a general review of con- tracts and should be carefully studied. I. Competent parties 2. Mutual agreement 3. Sufficient consideration 4. Legal subject matter 5. Compliance with Statute of Frauds. Contracts^ I. As to Essentials^ f I . Under seal Parol 2 ' s 1 to . J f i. Written Solemnity [ 2> _ S i mp le 2. Oral [ 3. Implied f I. Valid 3. As to Validity! 2 '~^!ts oer cash book. . ..$13,925.48 64 PUBLIC ACCOUNTING AND AUDITING DISBURSEMENTS Jan. i Overdraft on Bank $ 10.32 3 Sundry checks 2,153.27 7 do 1,427-83 II do 926.84 15 do 853.87 19 do 428.32 23 do 647.83 29 do 2,437.38 31 Balance as shown by cash book 5,029.82 $13.92548 Cash on hand undeposited amounted to $56.33. A Petty Cash Fund is operated on the Imprest system. The books had been audited to the 3ist of December, 1911, and the fact established that the overdraft of $10.32 was correct, after all checks drawn had been presented and paid by the bank. The deposits in the bank for the month of January, as shown by the bank pass book, after having it balanced at the close of business January 31, amounted to $13,854.37, and the checks returned by the bank for the same period totaled $8,832.34. There were checks outstanding at the time of balancing, January 31, amounting to $53.27. Fraud is suspected on the part of the cashier, and you are asked to check the transactions recorded by him as shown by the cash book. Prepare a statement showing the results of your investigations. Your statements should show total amount of the discrepancy. Also state, with reasons, what further documents and records you will require, if any, to trace the cash transactions fully. C. P. A. Ohio C. LEGAL QUESTIONS 1. Enumerate the methods by which contracts may be discharged. C. P. A. Ohio. 2. What is your understanding of the term "Legal Tender"? Having denned this, state what falls within that designation in this country. C. P. A. 111. 3. What is a tender to perform a contract, and what is its effect? Inst. Ex. 1918. 4. Give an illustration of a debt or claim that is not dis- chargeable in bankruptcy. C. P. A. Mich. 5. In what way may a contract be discharged by operation of law? Inst. Ex. 1918 Chapter Five NOTES RECEIVABLE Having completed the audit of the Cash account, the next account to be taken up is Notes Receivable. Notes are easily convertible into cash, consequently should be audited on the same day that the Cash account is audited. 1. ACCOUNTING THEORY. There are two methods of recording notes and drafts receiv- able. The first method is to record them in the general journal and to keep a record in an auxiliary notes receivable book. Under this plan the notes receivable book contains a memorandum record only and does not constitute a posting medium. The notes receivable book should show the date received, drawer or endorser, maker or drawee, payee, where payable, due date, amount, rate of interest, and when paid. The second method is to record notes and drafts in a notes receivable book from which posting is to be done. In other words, when this method is followed, the notes receivable book is considered a book of original entry and no auxiliary record is kept. This book differs from other subdivisions of the journal in that it provides for considerably more information. All the information provided for in the auxiliary notes receiva- ble book explained above, is also provided for under this plan, and in addition, columns are provided to enable the bookkeeper to post the totals to the proper accounts in the ledger. The exact arrangement of the columns will depend upon the system of accounts in use. The notes receivable book will usually provide for a Notes Receivable debit, Interest debit, Interest credit, Sales Ledger credit, General Ledger debit and General Ledger credit columns. The important thing is to understand the two different methods of recording notes and drafts. If recorded in the general journal, then the entries should be sup- ported by memorandum entries in an auxiliary notes receivable book. If a special division of the journal is to be used for re- cording transactions involving notes receivable, then all neces- sary information may be recorded in it and posting may be done direct from it. Notes Receivable Account. If the first method explained above is followed, then the Notes Receivable account will show the individual debits and credits for each note receivable recorded in the books of account. If the second method is pursued, then the Notes Receivable account will be in the nature 65 66 PUBLIC ACCOUNTING AND AUDITING of a summary or controlling account. For instance, the Notes Receivable account will be debited only for the total of the notes receivable debit column in the notes receivable book and may be credited for the total of the notes receivable column in the cash book, depending upon whether or not a special column for notes is provided on the debit side of the cash book. Terminology. The term "bills receivable," is frequently used instead of "notes receivable", but it is practically universal in practice to records, notes and bills or drafts in the same ac- count. Some bookkeepers call the account "bills receivable" while others call it "notes receivable". The term "bills" comes from the use of drafts and bills of exchange. There is no real object in at- tempting to separate drafts and notes in the books of account and, to do so, will only lead to confusion. A draft accepted by a customer is a "promise to pay" just as much as a pro- missory note would be. Seymour Walton, * C. P. A., says: "While the term 'bills receivable' is almost univer- sally understood, it would perhaps be better if it could be replaced by the more accurately descriptive term 'notes receivable', on the ground that in this country, when a person gives his written promise to pay a given amount, the document is invariably referred to as his note, while a bill is the creditor's statement in writing, specifying the amount and character of his claim in detail". Trade acceptances are becoming quite popular with busi- ness men. The question often arises as to whether or not a separate account should be kept with trade acceptances. In other words, should they be separated in the books of account from notes receivable. There can be no real reason for separating them in the ordinary business except where the volume of trade acceptances is large and it is desired to show trade acceptances as a separate item in the statements. In this event, separate accounts can be kept with trade acceptances and they may be recorded in the general journal, or a special journal may be provided. Notes Receivable Discounted. A question arises as to the best method of recording notes receivable discounted. With a great number of bookkeepers, it is common practice to credit the Notes Receivable account at the time of discounting a note. This has been criticised by accountants because of the fact that before a note can be discounted it must be endorsed, and in case the maker fails to pay the note at maturity, the endorser becomes liable, consequently, accountants hold that this lia- bility must appear in the statements. It is considered better practice to keep a separate account with Notes Receivable Dis- counted, crediting the account for the face value of each note or draft when discounted at the bank and debiting it with the *From his text on "Auditing", published by the Alexander Hamilton Institute. NOTES RECEIVABLE 67 face value of each note or draft discounted, when paid or dis- honored by the maker or payee. Of course, when the Notes Receivable Discounted account is debited, the Notes Receivable account would be credited. In order to verify the amount of notes receivable on hand, it is necessary to deduct the balance of the Notes Receivable Discounted account from the balance of the Notes Receivable account. Contingent Liability. Notes receivable discounted are a contingent liability and this fact should be indicated in the Balance Sheet. Kester says: "For this reason, whenever a business house trans- fers a note by any method of endorsement (except the qualified), it incurs a contingent liability, which might become a real liability in case the maker of the note should fail to meet the obligation at maturity. Since it is the function of good accounting to present all the facts bearing on the welfare of the business, it is evident that this fact that of incurring a contingent liability should be entered in the books of account. Very fre- quently, however, the importance of this matter is prac- tically ignored, with the result that the contingent lia- bility item is lost sight of altogether." 2. AUDITING THEORY It is important that the notes be counted on the same day that the cash is counted for the reason that, like cash, they may move on account of their being readily convertible. Analysis paper is usually used for preparing a list of notes receivable, on account of the amount of information desired. Listing the Notes Receivable (NOTE Since this comprises a Balance Sheet audit for credit purposes, we will quote freely from the Federal Reserve Bulletin of April 1917. That Bulletin was termed "Uniform Accounting" and was intended as a tentative proposal to be adopted by manufacturing and merchandising concerns). Quoting from the Federal Reserve Bulletin: "A list of notes receivable outstanding at the end of the fiscal period should be prepared, showing the dates the notes are made, the customers' names, the date due, the amounts of the notes and the interest, if any, contained in the notes. If discounted, the name of the discounting bank should be noted and verification ob- tained from the bank. "The outstanding notes must be carefully examined with the notes receivable book, and with the list pre- pared by or produced to the auditor, the due dates and the dates of making the notes being carefully checked, and when notes have been renewed the original dates 68 PUBLIC ACCOUNTING AND AUDITING should be recorded. When notes have been paid since the close of the fiscal year, the cash should be traced into the books of the company, and, when they are in the hands of attorneys or bankers for collection, certificates should be obtained from the depositaries. "When notes receivable are discounted by banks, the company has a liability therefor which should appear on the Balance Sheet. Lists of discounted notes not matured at the date of the audit should be obtained from the banks as verification and their totals entered under secured liabilities if the cash therefor is shown as an asset. "The value of collateral, if any, held for notes should be ascertained, as it frequently happens that the notes are worth no more than the collateral. "Notes due by officials and employees must always be stated separately from customers' notes, as must also notes received for other than trade transactions. "Notes due from affiliated concerns must not be included as customers' notes, even though received as a result of trading transactions. Affiliated companies' notes should be shown as a separate item of current assets or as other assets as the circumstances warrant. They may be fairly included in current assets if the debtor company has ample margin of quick assets over its liabilities, including such notes." 3. AUDITING PROCEDURE While one of the juniors counted the cash, the other junior prepared a list of the notes receivable owned by the Blank Manufacturing Company as at December 31, 1918. The Federal Reserve Bulletin stipulates that only a list should be made of the notes receivable outstanding at the end of the fiscal period, but it is believed to be better practice to make a complete list of all the notes receivable, whether on hand or outstanding for the reason that the information will be of value later on when calculating the accrued interest and in case any discrep- ancies are noted. Reference to the illustration on page 69 will show the junior's working sheet on which he prepared a list of the notes receivable. Reference to page 51 will show that the management had estimated that 2% of the notes receivable will prove worthless. Investigation shows that this estimate is based on previous experience. However, a reserve of this kind would not be a permissible deduction on an income tax return, only actual losses within the year being allowed. Where experience and investigation show that beyond a doubt there will be a certain per cent of notes prove worthless, then it is sound ac- counting to set up a reserve. This will be discussed further in a later chapter. NOTES RECEIVABLE 69 eoh d o P M Endorsed, James Oilander, Mgr. Protested-Bud. By J. A. Heweo. Merohanta 1 national Bank 1 isod to make ora. S. D. Carpenter, Pres. Discounted oo co HH 33 H"H* O o o ID M ID P. ft O O ft "HO P O 60 ** TJ d a) H-H ^ ^ ^ *> CM CO t- C\J C0| +i O CO O fc >aj o o o . S5tJ 4 IO OOO O IOIO ^ o o o o t- co 00 OI O tO O M ^l H H tfH 4 10 .q 3 D a -a d 3> co ig H -rt o m" (D <7> O CO CT CT* O rH H rH rHHH 0> H H H rH H H d +>H 12} P ff Q J PL, a = CO ID || ID i lO O Ol ^fO OO H W rH C\J C\J } rH a s d >, Si < d M M ,0 c d > q c ,0 d .mo M m M ^^^ S <4 fc 5 MOO 4 T5 -^ 4* d < d o d j> a +> a H & d+> o do p p. *H a i a a a 1 o o o o o o o m co m co CQ d co co z s si s o a 3 oo o o oo o W M d ID a) O -H f> Signature o so o ,M o o 8 co 05 (-. no o TJH o dO 03 r-t -rf M H ID O O TJ 3 ft THoB S HPP ID^TJ rH o HtDco m oq PP a> o ^.0* . .H . 19 See oaah book pa . A. Eewes & Co., pe full on Jan. 1, 1919 be investigated. C ounted. Verified at ing eivable OO rH 00 CO CO CO CO CO CT H H H H H O> HH rHHH rH drH f> O & O -P.U H H 03 CO o o co d s o + 0] O1 O N Tf O CO H HW CMCOH o 4> O 5 CO P e~ 1 CO * IQ 10 * i b -^-5 2 *o > tn O s I 'S o 13 ^ ex o 12 O oj <*-. y a ro cd _ bo C U) c a " J ex .S c f*> rt d -M C C P 3 C Ji! 6 OJ a r* ** H c it: ^ ^ ' . QJ H J & r O H 5o Discounts and Allowances 1,250 Fuel 3,ooo Insurance (one year from July i , 1 896) i , 1 50 Freight 1 ,500 General Expenses 600 Bank Overdraft 5,ooo Creditors 4,000 Accounts Receivable 25,000 Rent of Steam Power 1,500 Cash on hand 200 Loan Account 7,000 $165,500 $165,500 ACCOUNTING PROBLEMS 95 Stock on hand January I, 1897, $23,000; each partner to be credited 6% on his capital for one year before profits are ascertained; 3% to be written off accounts with creditors for discount; 10% to be written off machinery and plant for depre- ciation; unexpired insurance to be taken into account; net profit to be divided 2-3 to A and 1-3 to B. Draft adjusting and closing entries. Prepare final Trial Balance and a Balance Sheet. You need not set up ledger accounts as a part of your solution. C. P. A. N. Y. (Note. Do not misinterpret the item "3% to be written off accounts with creditors for discount." It appears that there is a trade discount of 3% that was not deducted from the invoices before they were entered on the books; therefore, an adjusting entry is necessary. The following entry is the proper adjustment: Trade Discounts $120.00 Purchases $120.00 To write off a trade discount of 3% on purchases, same not having been deducted from the invoices before they were entered on the books. The amount of the reserve for trade discounts should be deducted from the sum of accounts payable in the Balance Sheet.) 3. The following figures are taken from the books of A. B. Mills as at December 31, 1906. You are requested to prepare from them a Trial Balance and a Balance Sheet. The period is one year. Yarn (used) $25,000 Sales 81,250 Wages 22,500 Discounts Received 2,500 Dyeing 12,500 Power, Light and Heat 3.125 Boxes and Cases 1,250 Repairs 685 Sundry Expenses (Mills) 1,060 Insurance 1 55 Salaries 2,500 Taxes 310 Depreciation 425 Advertising 1 ,250 Traveling Expenses 1,125 Returns 1 ,000 Commissions l|875 Discounts Allowed 440 Interest on Loans 410 Cash at Bank and on hand 14,065 Bills Payable 37,5oo Sundry Debtors 22,500 Sundry Creditors 6,250 (Concluded on page 06) 96 PUBLIC ACCOUNTING AND AUDITING Fixtures, Fittings, Office 4r75O Capital 93.750 Machinery and Plant 65,925 Bills Receivable 38,400 (Note. The above problem is taken from the final examination of the Society of Accountants and Auditors in London, England, June, 1907.) C. LEGAL QUESTIONS 1. (a) What does a seller impliedly warrant in the sale of a chattel? (b) State all the legal requisites of a valid sale. Inst. Ex. 2. Define a sale. What is the difference between a sale and an exchange or barter? C. P. A. Ind. 3. Can a merchant sell articles that he is to manufacture next season? C. P. A. Ind. 4. What is an account stated? C. P. A. Mich. 5. Answer briefly : (a) What is a debt and what can a creditor demand in payment of a debt? (b) When a creditor accepts in satisfaction payment of less than the full amount of a debt, how can the debtor guard against further demands? (c) When, where and to whom must payment of a debt be made? (d) Is the debtor legally entitled to a receipt? (e) Which has the prior right to apply a payment against any one of several debts, the debtor or the creditor? (f) When a partial payment is made on a debt bear- ing interest, in what manner is it applied? C. P. A. N. Y. Chapter Seven INVENTORIES Reference to the inventory of the Blank Manufacturing Company, on page 51 of Chapter Four, will show that the inven- tory is made up as follows: Finished stock, $80,000.00; materials and stock in process, $55,000.00. 1. ACCOUNTING THEORY Book Inventories. There is a growing tendency on the part of manufacturing and trading concerns to keep a merchan- dise stock ledger, commonly known as a "running" or "going" inventory. Every business firm keeps a record of cash regardless of what other records are kept. It is difficult to understand why it isn't just as important to keep an accurate record of mer- chandise as it is of cash. Without a do"ubt, the loss from thefts and misappropriation of merchandise amounts to more in a year than embezzlements of cash amount to in a decade. It is a well known fact that merchandise, worth millions of dollars, is carried away annually by employees and others because they know it will never be discovered. In the face of these facts, it would seem to be equally important to keep an accurate record of all merchandise, whether the business is a trading or a manu- facturing concern. Without the waste of time, labor and delay incident to stocktaking, the manufacturer and trader should, at all times, know exactly how he stands concerning the amount and value at cost price of all stock on hand, whether it be raw material, goods in process of manufacture, or finished goods. If a separate merchandise stock ledger is kept, then it will be necessary to maintain a controlling account in the general ledger the same as for any other subsidiary ledger. The accounts in the merchandise stock ledger will usually show on the debit side quantities purchased, cost per unit and amount; on the credit side quantities sold, cost per unit and cost of quantity sold. A balance column is also provided so that there is shown quantities on hand, cost per unit and total amount or value at cost price. Where prices are subject to fluctuations or have fluc- tuated considerably, the average cost and amount is often used. It is better, however, to use the exact cost per unit and exact amount where it can be ascertained, and it usually can be as- certained. 97 98 PUBLIC ACCOUNTING AND AUDITING Physical Inventories. Whether or not a book inventory is maintained, it is important that at least once a year, and oftener in some cases, a physical inventory be taken. For the same reason that cash is counted to verify the cash book balance so an inventory should be taken to verify the result shown by the stock records. In the event that there is a differentiation between the physical and book inventories, it should be of as great concern as a shortage of cash. Isn't it a fact that mer- chandise represents money's worth? If a cashier is short in his cash, he must pay it out of his pocket or the proprietor must pay it out of his capital. Why should not the liability of either the store-keeper or stock-keeper be regarded in the same light as is the cashier with respect to responsibility? At the present time most accounting firms agree that the inventory should be taken at cost price or market price, which- ever may be the lower, but in no event should it be taken at a price higher than the actual cost price. An exception to this general theory is the following, quoted from Paul Joseph Esquerre*: "The inventory of a trading concern should be valued at cost. It has been held that it is proper to compute it on the basis of the market value, if such a value is smaller than cost; but it is generally denied 'that a market value higher than cost can be used. If the lower value is allowed, there is no reason why the higher one should not be. There is, however, a good reason why market values should not be used at all. Accounting is not interested in what would have happened 'if, but in what has actually happened; and since the goods unsold were pur- chased at a certain price, the profits realized are to be measured by comparing that price with the proceeds. To reduce the inventory to a value lower than cost, is to add to the cost of the goods sold during the period ; and to raise the inventory to a value greater than cost, is to reduce the cost of the goods during the period. In either case, the result is contrary to the truth." A quotation from William R. Basset's "Accounting as an Aid to Business Profits" is to be contrasted with the above: "The rules for values are arbitrary and, to some extent, unreasonable, but they are accepted everywhere and bankers look askance at any departure from them. Here they are: 1. "Value at cost. 2. "If the cost is above the market, then value at the market. 3. "If the cost is below the market, do not raise the values keep them still at cost. "It is not logical to bring down cost to the market and at the same time refuse to raise the inventory if the market is above the cost; but the procedure is so established that it should not be departed from. And also it does prevent a mere bookkeep- ing profit from appearing as an actual profit. An excellent practice is to value according to the above rules and attach a *Author of "Applied Theory of Accounts." INVENTORIES 99 footnote showing the increased values according to market prices. This gives the necessary information without inflation." The latter seems to be the more general procedure and throughout this course there will be noted the fact that all inventories have been taken at cost or market value, whichever is the lower. In some cases there would seem to be just cause for taking an inventory at a price exceeding the cost price. For instance, in determining the value of stock on hand at the time of the sale of a business, the inventory may be taken at market price, even though it be above cost price. In any event, if an auditor were asked to certify to a statement in which the inventory had been taken at a price higher than cost price, the fact should be noted either in the Balance Sheet or as a footnote to it. In a manufacturing business the inventory will usually be subdivided into three parts as follows : 1. Raw materials. 2. Goods in process. 3. Finished goods. The method of taking the inventory will not vary from the standpoint of valuation from that of a trading concern. All stock regardless of what stage it may be in should be priced at cost or market, whichever may be the lower. The cost price of raw materials can always be determined from the purchase records. The price of goods in process will not be so easily determined. During the process of manufacturing the cost increases until at the time the goods are finished they represent to the manufacturing concern the same as merchandise does to the trading concern. In other words, the finished goods of the manufacturer is the stock-in-trade. There are three items of cost to consider in determining the inventory value of goods in pro- cess: 1. Cost price of raw materials consumed. 2. Direct labor. 3. Factory overhead or manufacturing expenses. The inventory value of finished goods will be the same as the cost of production. The cost of production here is to the manufac- turer what the cost of merchandise purchased is to the merchant. Turnover. The rate of "turnover" is the number of times a firm "turns" its stock during the year. For instance, when a stock of goods has been purchased and has been sold, it is known as a turnover; if the money is reinvested in another stock of goods and this is disposed of within the year, there is said to have been a second turnover. The process of determining the rate of turnover seems to vary with different authorities. Montgomery says: "To ascertain the turnover, take the starting inventory, add the purchases or cost of manufactured goods, and deduct the inventory at the end ; divide the total by the starting in- ventory. The calculations are based upon a normal inventory. ioo PUBLIC ACCOUNTING AND AUDITING The result will be the number of times the capital invested in stock-in-trade has been turned over during the period." It will, therefore, be seen that according to Mr. Mont- gomery's idea the turnover would be found by dividing the COST OF SALES by the beginning inventory, provided that inventory is a normal inventory. In order to determine whether it is a normal inventory or not, it would be best to average the inventory for a period of years If the inventories for a period of, say, five years were used in determining the average, and it approximated the same as the inventory for the present year, then it will be seen that it constitutes a normal inventory. This seems to be the more uniform practice. However, it is well to give consideration to what others have to say on the matter. Walton says: 'If we adopt working capital as the basis of the turnover the difficulty disappears, because the amount of working capital is indicated in the Balance Sheet, if we adopt the definition of working capital as that part of the proprietorship not tied up in fixed assets, in other words, the excess of current assets over current liabilities. Except as affected by the slight increase due to accumulating undistributed profits, it remains the same throughout the entire period and therefore affords a stable basis of comparison. "The use of working capital as the basis of turnover is logical because it was put in the business for the purpose of being turned over as rapidly as possible, because it is virtually constant, and because it represents all the elements concerned in the turnover not only the stock-in-trade, but also the ac- counts and notes receivable that are the means by which the turnover is effected." The difficulty with this theory lies in determining the mean- ing of the term "working capital." H. R. Hatfield* says: "Working capital has long had a specific meaning as a collective term for what are often called quick assets, e. g., cash, accounts receivable, perhaps merchandise, etc." H. C. Bentleyt says: "Working capital is the excess of quick assets over quick liabilities." Walton considers Bentley's definition as the correct one. At any rate, he further says: "It is in my opinion the accounting view of what capital is." Therefore, the whole problem is narrowed down to the question as to whether we are to consider the normal inventory as the basis of a turnover, or whether we are to consider the working capital as the basis. It is unfortunate that accountants cannot find some means for arriving at uniformity in practice with reference to the more important accounting principles. Determining the Value of Merchandise Destroyed by Fire. All business men anticipate the possibility of a fire, but few give thought to how they will collect their insurance. Fre- quently settlement must be made upon a basis satisfactory only *Author of "Modern Accounting." fAuthor of "Science of Accounts." INVENTORIES 101 to the insurance company for the reason that the business man is unable to prove what has been destroyed and the value thereof. A properly authenticated Balance Sheet certified to by a public accountant is a material aid in the adjustment of claims as has often been demonstrated in practice. Where an inventory is not available at the time of fire, the claim is usually adjusted by using the "gross trading profit" test. The average gross trad- ing profit in prior periods is used as the basis of determining the cost of sales. Deduct the average gross trading profit from sales and the result is the cost of sales. Having determined this, take the last known or recorded inventory, add purchases to date of fire and deduct cost of sales. The result is the inventory at time of fire. If a perpetual inventory has been maintained and the last Balance Sheet prepared by a Certified Public Ac- countant, no compromise with the insurance company need be made, but allowance for the full amount of the claim may be insisted upon. 2. AUDITING THEORY Quoting from Federal Reserve Bulletin : Inventory Must Include Only Goods Owned. "Under this caption must be included only stocks of goods owned and under control of the owner. Stocks are often hypothecated and if this is the case the fact should be stated on the Balance Sheet . Beginning Inventory Must Be Verified. "Inasmuch as the accuracy of the Profit and Loss account is absolutely de- pendent upon the accuracy of the inventories of merchandise at the beginning and end of the period under review, this part of the verification should receive special attention. When a Balance Sheet audit is being made for the first time, the inven- tory at the beginning of the period should receive as much atten- tion as that at the end, and the auditor should take every precau- tion to satisfy himself that both inventories were taken on the same basis. Audit Program. "An acceptable program of audit for inventories is as follows: Stock Sheets, "(i) Secure the original stock sheets if they are in existence and carefully test the typewritten copies with them and with tickets, cards, or other memoranda that show the original count. Inventory Certificate. "(2) See that the sheets are cer- tified to or initialed by the persons who took the stock, made the calculations and footings, and fixed the prices, and satisfy yourself that they are dependable and responsible persons. Obtain a clear and detailed statement in writing as to the method followed in taking stock and pricing it; also a certificate from a responsible head as to the accuracy of the inventory as a whole. Footings and Extensions. "(3) A thorough test of the accuracy of the footings and extensions should be made, espe- cially of all large items. 102 PUBLIC ACCOUNTING AND AUDITING Discrepancies. "(4) The inventories should be compared with the stores ledger, work in progress ledgers and finished product records and stock records as to quantities, prices and values, and any material discrepancy should be thoroughly traced. Book Inventory. "(5) Where stock records are kept and no physical inventory is taken at the time of the audit, ascertain when the last physical inventory was taken and compare it with the book records. If no recent comparison is possible, select a few book items of importance and personally compare with the actual stock on hand. Physical Inventory. "(6) Where no stock records are kept, a physical inventory should be taken preferably under the general direction of the auditor. After the inventory is completed, he should apply the same tests to verify its accuracy as if the inventory had been taken before his arrival upon the scene. Inadequate Cost Systems. "(7) When the cost system of a company does not form a part of the financial accounting scheme there is always a chance that orders might be completed and billed, but not taken out of the work in progress records. Especially is this the case when reliance is placed on such records to the extent that a physical inventory is not taken at the end of the period to verify the information shown therein. In these cases the sales for the month preceding the close of the fiscal period should be carefully compared with the orders in progress as shown by the inventory, to see that nothing that has been shipped is included in the inventory in error. Cost systems which are not coordinated with the financial accounts are un- reliable and frequently misleading. Special attention should be called to every case in which the cost system is not adequately checked by the results of the financial accounting. Goods in Transit. "(8) Ascertain that purchase invoices for all stock included in the inventory have been entered on the books. Look for post dated invoices and give special attention to goods in transit. Consigned Goods. "(9) See that nothing is included in the inventory which is not owned but is on consignment from others. If goods consigned to others are included, see that cost prices are placed thereon, less a proper allowance for loss, damage, or expenses of possible subsequent return. This does not include goods at branches, as the valuing of such stocks will be governed by the same principles as apply at the head office. Goods Awaiting Shipment. " ( i o) Ascertain that nothing is included which has been sold and billed, and is simply awaiting shipment. Legitimate Costs, "(n) If duties, freight, insurance, and other direct charges have been added, test them to ascertain that no error has been made. Duties and freight are legitimate ad- ditions to the cost price of goods, but no other items should be added except under unusual circumstances. INVENTORIES 103 Obsolete Stock. "(12) As a check against obsolete or damaged stock being carried in the inventory at an excessive valuation, the detailed records for stores, supplies, work in prog- ress, finished products, and purchased stock in trade, should be examined and a list prepared of inactive stock accounts, which should be discussed with the company's officials and satisfactory explanations obtained. Cost or Market Price. "(13) The auditor should satisfy himself that inventories are stated at cost or market prices, whichever are the lower at the date of the Balance Sheet. No inventory must be passed which has been marked up to market prices and a profit assumed that is not and may never be realized. If the market is higher than cost, it is permissible to state that fact in a footnote on the Balance Sheet. Average Price Used. "(14) It may be found that inven- tories are valued at the average prices of raw materials and supplies on hand at the end of the period. In such cases the averages should be compared with the latest invoices in order to verify the fact that they are not in excess of the latest prices, and also with the trade papers, when market prices are used, to see that they are not in excess of market values. Reasonable Quantities. "(15) Make an independent inspection of the inventory sheets to determine whether or not the quantities are reasonable, and whether they accord in particular instances with the average consumption and average purchases over a fixed period. Abnormally large quantities of stock on hand may be the legitimate result of shrewd foresight in buying in a low market, but may, on the other hand, arise from serious errors in stock taking. Gross Profit Test. "(16) Always attempt to check the totals by the 'gross profit test' and compare the percentage of gross profit shown with that of previous years. In a busi- ness where the average gross profit remains fairly constant this test is a dependable one, because, if the rate of gross profit is apparently not maintained and the discrepancy can not be satis- factorily accounted for by a rise or fall in the cost of produc- tion or of the selling price, the difference will usually be due to errors in stock taking. Testing the Cost System. "(17) In verifying the prices at which the work in progress is included in the inventory, a general examination and test of the cost system in force is the best means of doing this work satisfactorily. In a good cost systemtflittle difficulty will be found with the distribution of the raw materials, stores, and pay roll, but the distribution of factory overhead cost is one that should receive careful consideration, the main points to be kept in view being: "(a) That no selling expenses, interest charges, or adminis- trative expenses are included in the factory overhead cost. 104 PUBLIC ACCOUNTING AND AUDITING "(b) That the factory overhead cost is distributed over the various departments, shops, and commodities on a fair and equitable basis. Cost vs. Selling Price. "(18) No profit should be includ- ed in the price of finished products or stock-in-trade. The price list should be examined to see that the cost prices of stock are below the selling prices after allowing for trade discounts, and, if they are not, a reserve should be set up on the Balance Sheet for this loss. If the company takes immediate steps to increase the selling price, however, the amount of this reserve may be limited to the loss on goods which may have been sold since the close of the period to the date of the discovery. Profits on Partial Shipments. "(19) In the case of companies manufacturing large contracts it is frequently found necessary to make partial shipments thereof. The question then arises as to whether it is permissible to include the profits on these partial shipments in the Profit and Loss account. As a matter of fact, it is evident that the actual cost can not be known until the order is completed. It may be estimated that a profit will ultimately be made, yet unforeseen conditions, such as strikes, delays in receiving material, etc., may arise to increase the esti- mated cost. It is better not to include the profits on partial shipments, but information of this character which may have its influence in the decision of the banker upon a proposed loan may properly be laid before him. Of course, an exception should be made in cases where the profit on the partial shipments largely exceeds the selling price of the balance of the order. Contract Prices. "(20) The selling prices for contract work in progress should be ascertained from the contracts, and where it is apparent that there will be a loss on the completed contract a due proportion of the estimated loss should be charged to the period under audit by setting up a reserve for losses on contracts in progress. Unsalable Stock. "(21) If a company has discontinued the manufacture of any of its products during the year, the in- ventory of such products should be carefully scrutinized and, if unsalable, the amount should be written off. Charges to Fixed Assets Must Not Be Included. "(22) The inventory should be scrutinized to see that no machinery or other material that has been charged to plant or property account is included therein. Partial Deliveries. "(23) Partial deliveries received on account of purchase contracts for material, etc., should be verified by certificates from the contractors, both as to qifentities and prices. Advance Payments. "(24) Advance payments on account of purchase contracts for future deliveries should never appear in an inventory, but be shown on the Balance Sheet under a separate heading. INVENTORIES 105 Discounts. "(25) Trade discounts should be deducted from inventory prices, but it is not customary to deduct cash discounts. However, this may be done when it is the trade practice so to do. Turnover. "(26) While the inventory is being verified, the auditor should ascertain the aggregate sales for the last year. If the turnover has not been rapid, it may be due to a poor stock of goods. Some business men dislike to sell below cost and would rather accumulate a big stock of old goods than dispose of the old and unseasonable stock at a sacrifice. The usual outcome is that the stock becomes unwieldy and funds are lacking to purchase new goods. The inventory and the gross sales may, therefore, have a direct connection. Interest Not a Part of Cost. "(27) It may be well to reiterate that interest, selling expenses, and administrative ex- penses form no part of the cost of production, and therefore should not be included in the inventory in any shape." 3. AUDITING PROCEDURE The inventory of December 31, 1918, was checked as to extensions and footings. Also, tests were made by actual count of some of the items listed. The secretary of the Company certified that the inventory represented only the materials and goods in process and on hand at the plant and in store as ascer- tained by actual count. The total of the inventory of materials and work in process amounted to $55,000.00; finished stock $80,000.00. It would have been much better had the raw materials and the work in process been kept separate, but in this case it seems that there were practically no raw materials on hand other than those in process of manufacture, consequently there is no separate item for raw materials. In verifying the value of the work in process, it was found that the actual cost price of the raw materials consumed, plus the direct labor and the overhead factory expenses had been added. The item of $2,875.00, which represents the factory pay roll accrued, but not paid, was found to represent direct labor which had not been included in the value of the work in process, as valued at $55,000.00. In arriving at the value of the finished goods, there was taken into consideration the actual cost of production which included the overhead factory expenses, but no selling expenses, interest charges nor administrative expenses were included in the factory overhead cost. A number of items listed were checked by an actual count and found to be correct. The inventory was verified by J. I. King, junior accountant. All extensions and footings were verified. io6 PUBLIC ACCOUNTING AND AUDITING 4. INCOME TAX PROCEDURE Inventories shall be Taken Upon such Basis as may be Prescribed. Income Tax Law. Section 203. "That when- ever in the opinion of the Commissioner the use of in- ventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income." Basis of Inventory Valuations. (T. D. 2609, December 19, 1917.) "For the purpose of income and excess profits tax return, inventories of merchandise, etc., and securities, will be subject to the following rules: "A. Inventories of supplies, raw materials, work in process of production and unsold merchandise must be taken either (a) at cost, or (b) at cost or market price whichever is lower, provided that the method adopted must be adhered to in sub- sequent years unless another be authorized by the Commis- sioner of Internal Revenue. "B. A dealer in securities who in his books of account regularly inventoried unsold securities on hand either (a) at cost or (b) at cost or market price whichever is lower, may, for the purposes of income and excess profits taxes, make his return upon the basis upon which his accounts are kept, provided that a description of the method employed shall be included in or attached to the return, that all the securities must be inven- toried by the same method, and that that method must be adhered to in subsequent years unless another be authorized by the Commissioner of Internal Revenue. "C. Gain or loss resulting from the sale or disposition of assets inventoried as above must be computed at the difference between the inventory value and the price or value at which sold or disposed of. "In all other cases inventories must be taken at cost or at value as of March i, 1913, as the case may be." Need of Inventories. (Art. 1581. Reg. No. 45, 1918.) "In order to reflect the net income correctly, inventories at the beginning and ending of each year are necessary in every case in which the production, purchase or sale of merchandise is an income-producing factor. The inventory should include raw materials and supplies on hand that have been acquired for sale, consumption or use in productive processes, together with all finished or partly finished goods. Title to the merchandise INVENTORIES 107 included in the inventory should be vested in the taxpayer and goods merely ordered for future delivery and for which no transfer of title has been effected should be excluded. The inventory should include merchandise sold, but not shipped to the customer at the date of the inventory, together with any merchandise out upon consignment, but if such goods have been included in the sales of the taxable year, they should not be taken in the inventory. It should also include merchandise purchased, although not actually received, to which title has passed to the purchaser. In this regard care should be exercised to take into the accounts all invoices or other charges in respect of merchandise properly included in the inventory, but which is in transit or for other reasons has not been reduced to phys- ical possession. Valuation of Inventories. (Art. 1582. Reg. No. 45, 1918.) "Inventories should be valued at (a) cost or (b) cost or market, whichever is lower. Whichever basis is adopted must be applied to each item and not merely to the total of the inventory; that is, if for instance basis (b) is adopted, the value of each item in the inventory will be measured by market if that is lower than cost, or by cost if that is lower than market. A taxpayer may, regardless of his past practice, adopt the basis of cost or market, whichever is lower, for his 1918 inventory, provided a disclosure of the fact and that it represents a change is made in the return. Thereafter changes can be made only after permission is secured from the Commissioner. Inven- tories should be recorded in a legible manner and properly computed and summarized, and should be preserved as a part of the accounting records of the taxpayer. Goods taken in the inventory which have been so intermingled that they can not be identified with specific invoices will be deemed to be the goods most recently purchased." Inventories at Cost. (Art. 1583. Reg. No. 45, 1918). "Cost means: "(i) In the case of merchandise purchased, the invoice price less trade or other discounts except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To this net invoice price should be added trans- portation or other necessary charges incurred in acquiring possession of the goods. " (2) In the case of merchandise produced by the taxpayer, (a) the cost of raw materials and supplies entering into or con- sumed in connection with the product, (b) expenditures for direct labor, (c) indirect expenses incident to and necessary for the production of the particular article, including in such in- direct expenses a reasonable proportion of management expenses, but not including any cost of selling or return on capital whether by way of interest or profit. In any industry in which the io8 PUBLIC ACCOUNTING AND AUDITING usual rules for computation of cost of production are inapplic- able, costs may be approximated upon such basis as may be reasonable and in conformity with established trade practice in the particular industry. Inventories at Market. (Art. 1784. Reg. No. 45, 1918.) "Market means the current bid price prevailing at the date of the inventory for the particular merchandise, and is applicable to goods purchased and on hand and to basic materials in goods in process of manufacture and in finished goods on hand, exclusive, however, of goods on hand or in process of manufacture for delivery upon firm sales contracts at fixed prices entered into before the date of the inventory. Where no open market quotations are available the taxpayer must use such evidence of a fair market price at the date or dates nearest the inventory as may be available to him, such as spe- cific transactions in reasonable volume entered into in good faith, or compensation paid for cancellation of contracts for purchase commitments. The burden of proof will rest upon the taxpayer in each case to satisfy the Commissioner of the correctness of the prices adopted. It is recognized that in the latter part of 1918, by reason among other things of govern- mental control not having been relinquished, conditions were abnormal and in many commodities there was no such scale of trading as to establish a free market. In such a case, when a market has been established during the succeeding year, a claim may be filed for any loss sustained in accordance with the provisions of section 214 (a) (12) or section 234 (a) (14) of the statute. Adjustment of Inventories After Close of Taxable Year. Income Tax Law. Sec. 214. (a-12) [Individuals.] (a-14) [Corporations.] "At the time of filing return for the taxable year 1918 a taxpayer may file a claim in abatement based on the fact that he has sustained a substantial loss (whether or not actually realized by sale or other disposition resulting from any material reductions (not due to temporary fluc- tuation) of the value of the inventory for such taxable year, or from the actual payment after the close of such taxable year of rebates in pursuance of contracts entered into during such year upon sales made during such year. In such case payment of the amount of the tax covered by such claim shall not be required until the claim is de- cided, but the taxpayer shall accompany his claim with a bond in double the amount of the tax covered by tha claim, with sureties satisfactory to the Commissioner, conditioned for the payment of any part of such tax found to be due, with interest. If any part of such claim is disallowed then the remainder of the tax due shall on notice and demand by the collector be paid INVENTORIES 109 by the taxpayer with interest at the rate of I per centum per month from the time the tax would have been due had no such claim been filed. If it is shown to the satisfaction of the Commissioner that such substantial loss has been sustained, then in computing the taxes im- posed by this title and by Title III the amount of such loss shall be deducted from the net income, (b) If no such claim is filed, but it is shown to the satisfaction of the Commissioner that during the taxable year 1919 the taxpayer has sustained a substantial loss of the char- acter above described then the amount of such loss shall be deducted from the net income for the taxable year 1918 and the taxes imposed by this title and by Title III for such year shall be redetermined accordingly. Any amount found to be due to the taxpayer upon the basis of such redetermination shall be credited or refunded to the taxpayer in accordance with the provi- sions of section 252." Inventories Prescribed in Certain Cases. (Reg. No. 33, 1918, H353-) "Gross income for the purpose of returns of manufacturing companies shall consist of the total sales plus the inventory at the end of the year less the sum of the cost of goods or materials purchased during the year and the inventory at the beginning of the year." (Reg. No. 33, H354-.) "For the purpose of returns gross income of mercantile companies shall consist of the total sales plus the inventory at the end of the year less the sum of the cost of goods purchased during the year and the inventory at the beginning of the year." I io PUBLIC ACCOUNTING AND AUDITING A. THEORY QUESTIONS 1. What duties and responsibilities has an auditor in con- nection with, inventories of goods on hand? C. P. A. Me. and Ore. 2. What is turnover and of what use should an auditor make of it in an audit of a merchandising business? C. P. A. Ind. 3. A manufacturing company purchased a large stock of material during the year at low prices, but at the time of the annual inventory values had abnormally increased. How, in your opinion, should the inventory and loss and gain be shown on the books? C. P. A. Mich. 4. You are asked by a client to treat inventories at the time of closing the books. Should they be figured at cost or market price or otherwise? Is the common, old-fashioned method of adding the inventory of merchandise on hand to the credit side of the Merchandise account before closing the books, theoretically correct? Explain fully. C. P. A .Mich. 5. Explain what is understood by a "book inventory" and indicate in what circumstances and for what purposes you would consider such a record to be of use in a manufacturing business (a) For current information. (b) For use in the preparation of interim statements of accounts. (c) For use in the preparation of final yearly or half- yearly accounts. Assuming your client decided to rely entirely upon such book records, what steps should be taken to guard their accuracy? Inst. Ex. 1918. 6. An inventory is submitted to you certified by the manager of a business. Mention some of the principal steps you would take to confirm the correctness of the inventory figure appearing in the Balance Sheet. Inst. Ex. 1917. 7. A company which keeps no perpetual inventory records but takes an inventory annually on December 31, suffers a fire loss on March i. How would you proceed to compute the inventory on hand at that date? Inst. Ex. 1917. 8. "Inventory of merchandise should be carried at cost or market, whichever is lower." Do you assent to this proposi- tion? Can you suggest circumstances in which you would approve a departure therefrom? Would you be influenced by events or conditions subsequent to the date of closing the accounts? Give reasons. Inst. Ex. 1918. ACCOUNTING PROBLEMS in B. ACCOUNTING PROBLEMS. 1. From the following particulars you are required to determine the value of the merchandise on hand: Inventory at beginning of period $75,000.00 Purchases 200,000.00 Wages 65,000.00 Freight Inward 3,000.00 Gross Profit 56,780.20 Discount on Sales 4,540.00 Sales 360,784.80 Discounts Received on Purchases 1,760.00 C. P. A. Ind. 2. Arrange the following in a Balance Sheet for presenta- tion to a banker. Furniture and Fixtures $15,000.00 Stock of Merchandise at cost. . . 50,000.00 Accounts Receivable 35,000.00 Officers' Accounts 30,000.00 Bonds Owned 10,000.00 Capital Stock $75,000.00 Accounts Payable 20,000.00 Trade Notes Payable 40,000.00 Surplus 5,000.00 $140,000.00 $140,000.00 C. P. A. 111. 3. You are asked to certify to the Balance Sheet of a cer- tain company. Upon investigation, you find that the inventories have been priced at cost, although the market prices at the closing date were 10% lower on iron and 5% higher on wood. At the date of your report the market on iron had risen to 5% above cost, and the market on wood had fallen to 15% below cost. How would you dispose of these items in the Balance Sheet? C. P. A. 111. 4. You are called in as a public accountant to assist a firm in the preparation of a Balance Sheet as at December 31, 1915, and in the balancing of the books. After examination you find the following facts: (1) On January 3 three items, amounting to $50,000.00 in the aggregate, were received in cash, but were entered as at December 31, 1915. No Cash account is kept in the general ledger. (2) An item was posted to the credit of an account in the sales ledger from the cash book as $5,050.00 instead of $50.50. A Sales Ledger control account is kept in the general ledger. ii2 PUBLIC ACCOUNTING AND AUDITING (3) The Petty Cash fund is kept on the imprest system. On December 31, 1915, a voucher covering expenditures to date was passed and entered in the Voucher Register. The check in payment thereof was not entered in the cash book until January 3, 1916. (4) A building had been destroyed by fire, and the insurance recovered had been credited to the asset account and the cost of replacement had been debited thereto. (5) An item was posted to the debit of the Interest account in the general ledger from the journal as $3.03. It should have been $303.00. (6) Sales aggregating $25,000.00 were entered on the books as at December 31, 1915, but the goods were not all delivered until January 25, 1916. Indicate what adjustments you would make of the books or of the accounts for the purpose of statement on the Balance Sheet. Give journal entries. C. P. A. 111. 5. It is generally conceded that merchandise inventories should be calculated on "cost" prices, but in practice there are found many differences in the method of determining the cost price. State whether or not the following items should be regarded in arriving at this cost, giving your reason in each case: Cash discounts. Trade discounts. ' Freight inward (on goods bought). Freight outward (on goods sold). Rebates and premiums, such as are found in connec- tion with the tobacco business. Drayage and handling (inward). Packing and draying (outward). C. P. A. Fla. C. INCOME TAX QUESTION Should an individual who conducts a grocery, dry goods, clothing, or farm implement business, or any other business which requires that a stock be carried, take an inventory at the close of each taxable year and take such inventories into consideration in arriving at his net income from business? Explain. Chapter Eight THE TRIAL BALANCE In Chapter Three there was a discussion of the general ledger showing its control in an accounting system, also a dis- cussion of the Trial Balance. The discussion there, however, was quite brief. It is intended here to show how an auditor would proceed to verify all the items in the Trial Balance. The Bookkeeper's Trial Balance. There is no reason why an auditor should not accept a Trial Balance offered him by the head bookkeeper at the beginning of the audit, but that does not mean that he need not verify the items listed thereon. If he were to refuse the Trial Balance offered him, the chances are the bookkeeper would be offended and it might lead to his op- position instead of his cooperation during the audit. It would seem to be better practice, however, to prepare your own Trial Balance even though you have been furnished with one by the head bookkeeper or someone else in the employ of the client. Trial Balances may be made of the subsidiary ledgers as well as of the general ledger, provided summary or adjustment ac- counts are maintained in the subsidiary ledgers.* Usually, how- ever, no such accounts are maintained in the subsidiary ledger, therefore, the only way a Trial Balance can be taken is to check the list of accounts taken from the subsidiary ledger with the controlling account in the general ledger. Advantages of an Auditor Preparing His Own Trial Balance. The auditor will find that he has a splendid oppor- tunity to become familiar with the details of the accounting system while preparing his Trial Balance. He cannot help, in going over all the accounts, thinking about them and while making the necessary calculations to determine the correct balances, build up in his mind as he goes along a general knowledge of the or- ganization as a whole. *Any subsidiary ledger may be made self-balancing by means of a sum- mary or adjustment account. This account is set up in the subsidiary ledger and is an exact duplicate of the controlling account in the general ledger except that the sides ot the account are reversed so that the subsidiary ledger account has for its debits the credits of the general ledger account, and for its credits the debits of the general ledger account. There is no theory or principle of debit and credit involved in this, the device is simply introduced in order that the ledger may provide an internal proof of its correctness. Therefore, the total of the balances of the individual accounts in the subsidiary ledger will be offset, exactly by the opposite balance of the one additional account, and the ledger then is said to be self-balancing. This is not often carried out for the reason that it is considered better practice and more desirable for the controlling account to be in the hands of another person who thus has a check upon the bookkeeper's work. "3 114 PUBLIC ACCOUNTING AND AUDITING A Set of Books is not Ready to be Audited Until in Balance. Some bookkeepers and business men think that an auditor by some sort of magic should be able to detect all mechanical errors in bookkeeping and arrive at a correct Trial Balance in a few minutes time. However, the fact is that it is no part of an auditor's duty to locate an error or er- rors in a Trial Balance unless he has been employed specifically to do so. An auditor who accepts an engagement to perform an audit, and who on beginning his work finds that the books are not in balance, should report the matter to his client and lay the facts before him. He can, of course, undertake to do the necessary clerical work in order to locate the errors in the ac- counts so as to obtain a Trial Balance, but to do so without previous arrangement with the client is liable to result in difficulties when the bill for services is presented. Anyone who spends his time in ordinary clerical work is hardly to be considered a professional auditor and it would seem to be better to permit the bookkeeper to locate his own errors and obtain a Trial Balance before beginning the audit. Remuneration Basis. In this connection it is well to point out that audits are made under two classes of remunera- tion: those in which the remuneration is based on a per diem basis; and those in which it is being done under a contract specifying a certain sum. If the work is being done under a contract and the time necessary to do the work has been pre- viously estimated, it would certainly be foolish to put in a lot of time finding ordinary clerical mistakes in bookkeeping, and to do so may result in a loss on the engagement. If the work is being done on a per diem basis, the auditor is apt to become involved in disagreeable discussions with the client because of the length of time spent in performing the ordinary clerical work of the bookkeeper. Consequently, let us point out again that the books should be in balance before the auditor begins his work, and if they are not in balance, the bookkeeper should be given an opportunity to locate his own errors and obtain a Trial Balance, after which, the auditor may proceed with his work in accordance with the instructions given hereinbefore and hereinafter. The Trial Balance as a Part of the Working Sheet. The Trial Balance is not a financial statement, neither is it a test as to the accuracy of the bookkeeping work. It is merely a list of the balances of the accounts remaining open in the ledger. Therefore, it is nothing more than a surface indication that the books are in balance and that an equilibrium has been maintained between the debits and credits. The professional auditor usually prepares what is known as a "Working Sheet", the Trial Balance simply being a part and is represented by the first two columns. The Working Sheet, in addition to containing THE TRIAL BALANCE 115 columns for a Trial Balance, should provide columns for adjust- ments, columns for the nominal accounts only, and columns for the real accounts only. The first two columns show the Trial Balance taken at the close of the period, but before the adjustments have been made. The adjustment columns show all the adjustments and corrections made after the Trial Balance is taken and before the statements and report are prepared. The columns for nominal accounts show the profits and losses for the period. The columns for real accounts show the assets and liabilities as at the end of the period under audit. The accounts should be arranged on the Working Sheet in such a manner as to provide the most information and so as to make it most convenient for the preparation of the report for the client at the completion of the audit. The accounts need not, therefore, be arranged in the same order as the arrange- ment of the accounts in the ledger. (The Working Sheet will be explained in detail in a later chapter.) Procedure in Taking a Trial Balance. First, prove each account by footing both sides of the account and substracting the two footings so as to verify the balance. It does not matter whether this has been done by the bookkeeper previously or not. The auditor should make his own verification independent of that of the bookkeeper. Second, every page in the ledger should be examined. Ex- perience will prove that some bookkeepers have peculiar ideas with regard to the arrangement of their accounts, consequently blank pages will be found here and there throughout the ledger and if every page isn't examined, accounts might be omitted. Third, subsidiary and memorandum accounts may be found in the general ledger. For instance, one ledger may be used. It may be divided into sections; the first section may contain all the assets and liabilities together with controlling accounts for customers and creditors ; the second section of the ledger may contain accounts with customers; and the third section, accounts with creditors. On the other hand, it is not infrequently found that subsidiary ledgers are kept, but no controlling accounts maintained in the general ledger. The bookkeeper when pre- paring his Trial Balance simply makes a schedule from the subsidiary ledgers and uses the total amount in his Trial Balance. Fourth, some bookkeepers seem to have the idea that a Cash account need not be kept in the general ledger simply because a cash book is kept. While it is certainly poor practice to eliminate the Cash account in the ledger, yet such will often be the case, consequently a Trial Balance cannot be obtained unless the cash balance is first obtained from the cash book and included in the Trial Balance. The only sound accounting theory is that a general ledger should balance independently of all the other books of account. Any argument contrary to these principles is certainly contrary to good accounting practice. Ii6 PUBLIC ACCOUNTING AND AUDITING Fifth, the first Trial Balance is usually taken after the post- ing has been done at the end of the period and before any ad- justments have been made. The auditor will have to be on the lookout for items posted to the accounts after the bookkeeper completed his Trial Balance. This is sure to happen when an audit is made at a date later than the end of the period under audit. Quoting From The Federal Reserve Bulletin : "Trial Balances of the general ledger, both at the beginning and end of the period under review, should be prepared in com- parative form and checked with the ledger. The items in the Trial Balances should be traced into the Balance Sheets before the assets and liabilities are verified, to prove, among other things, that no 'contra' asset or liability has been omitted from the accounts, that the assets and liabilities have been grouped in the same manner at the beginning and at the end of the period, and also that the Balance Sheets are in accordance with the books. The disposition of any general ledger assets and liabilities that may have been scrapped, sold, written off, or liquidated during the period under review should be traced and noted in the working papers. Furthermore, a general scrutiny of the general ledger should be made to see that the accounts, if any, that have been opened and closed during the year have no bearing on the company's financial position at the close of the fiscal period." ITEMS NOT ON TRIAL BALANCES The following quotation is taken from "Duties of the Junior Accountant" by Reynolds and Thornton, published by the American Institute of Accountants: "Among the items which must be taken into ac- count, but may not be on the books, are some which the junior should detect and take up in every instance. These are omissions from interdepartmental balances and balances between subsidiary companies, goods in transit and cash in transit. "It is quite common to find Trial Balances, appar- ently in order, which contain among 'accounts receiva- ble' amounts due from subsidiary companies or from departments of the same company, and among 'accounts payable' corresponding entries, but for differing amounts. Wherever a Trial Balance shows any balance due from one department to another, from one subsid- iary to another or from either to the principal company the auditor must see that the entry is exactly offset by a corresponding item in the accounts of the subsidiary or department concerned. If a department carry as an asset an amount due from another department and the THE TRIAL BALANCE n? second department does not show any liability in respect thereto the accounts as a whole contain an inflation of net assets, and the auditor can so easily find such an error that no excuse for failing to do so will be admitted. "Where subsidiary companies are concerned the de- tection of such errors is equally easy if the auditor has access to books of subsidiaries. "The detection of omission from inventories of goods in transit and of cash in transit are dealt with under appropriate headings herein. "To sum up this section, let the auditor, whenever he has access to books showing both sides of a trans- action, compare the two entries and agree the resulting balances." Results of the Senior's Checking the Trial Balance. The senior checked the Trial Balance himself because of the opportunity it offers to gain an insight into the nature of the organization and of the business conducted. His working papers show the following: First, he found that the information referred to in the audit of accounts receivable in Chapter Six is correct. The total of the debit balances of the customers' accounts in the sales ledger amount to $84,721.50. The total of the credit balances amount to $3,034.50. The difference between the debit and credit balances is equal to the balance of the controlling account in the general ledger, amounting to $81,687.00. Second, he reports an offsetting error in footing the accounts. The debit side of the account with Salary Advances to Salesmen was overfooted $30.00, and the account with Sales was over- footed $30.00 on the credit side. Third, he found an error in principle. An expenditure amounting to $215.00 for a new machine in the factory was charged to Tools and Implements instead of to Machinery. Investigation shows plainly that it should be a charge to the Machinery account. Fourth, he notes an error in the working papers of J. I. King with reference to listing of notes receivable. Reference to page 69 of Chapter Five will show that Mr. King listed the notes receiv- able. His papers show that two notes were discounted, December i, 1918. If that were the case, then the face of those notes should either have been credited to the Notes Receivable account or to an account with Notes Receivable Discounted. Inasmuch as the Trial Balance does not indicate an account in the general ledger with Notes Receivable Discounted, it is apparent, even without an examination, that no such an account is maintained. Therefore, notes receivable discounted were credited to the Notes Receivable account, consequently, would not be included in the total of notes receivable on hand and would^^not Ii8 PUBLIC ACCOUNTING AND AUDITING appear as a part of the balance of that account in the Trial Balance. The Trial Balance prepared by Mr. Shields and handed to the senior at the beginning of the audit lists notes receivable, in amount $12,906.00. The Working Sheet of the junior shows the same total, but he makes no comment relative to the notes receivable discounted except to say that they were verified at the bank. Mr. King states that the error is in the date of discount. He claims that he made an error in indicating "December i, 1918" as the date of discount. It should have been "January I, 1919". He says the error was due to a mistake in copying his report. Advice to Juniors. It is in order here to point out the ad- visability of using the utmost caution in the preparation of all working papers and reports. Carelessness is not excusable. Accounting firms employ extra juniors during the busy season. Those juniors who are competent and accurate in their work are the ones likely to be retained permanently, while those incompetent, inaccurate and careless in their work are the ones who will be the first to be let go. Seniors frequently are asked to name the juniors they wish to work with them on certain engagements. The mere fact that certain juniors are asked for frequently by the seniors is evidence as to the quality of their work and is in itself a recommendation. While a junior who is not asked, but who is used only because no one else is available, is certainly at fault in some manner and he needs to take an inventory of himself and determine his weakness. Mr. King, the junior mentioned above, may or may not be at fault, the fact remains, however, that he made an error although he states that he simply erred in copying his report from hastily written notes made on the day of the audit. READING THE MINUTES Without a doubt the minutes should be read as early after the audit is begun as may be practical. They will give an authoritative insight into the organization that can not be gained in any other way; consequently, the auditor will be pre- pared to do more intelligent work in completing the audit. He will know whom to consult in case any further information is desired because the minutes show who the officers are and what their duties and responsibilities are. The minutes of the stockholders, board of directors, the ex- ecutive committee, and any special committees should be read. The articles of incorporation will usually be embodied in the minutes of the stockholders, but if not, the auditor should ask for a copy of the articles or for a certificate of incorporation. These are sometimes known as the charter. The auditor should note in his working papers the exact name of the corporation, the date the certificate was filed, the authorized capital stock THE MINUTES n 9 showing the kind of stock, the par value of each share and the number of shares, the names of the incorporators, and any other information likely to be of benefit in the preparation of the report. It is better to write down more than will ever be used than to find when making the report that certain infor- mation is necessary and that he failed to make note of it in his working papers. The importance of this statement will be understood when it is considered that frequently an audit is made in a distant city, while the report will be prepared in the office. The audit might be made in Seattle and the report might be written in Boston. Therefore, it would be quite embarrassing to learn that all the information desired had not been obtained. The minutes of the stockholders should be examined with regard to election of officers, compensation of officers, bond of the treasurer, contracts with the manager and other employees, any special contracts that may exist, resolution fixing the value of property purchased and the rates of depreciation, etc. The minutes of the board of directors should be examined for ad- ditional information. An executive committee often exists in a corporation. It may be composed of three or more members of the directors and its purpose is to facilitate certain features of the work. Financial matters are usually looked after by this committee, and it often outlines the financial program and has authority to make appropriations, etc. In the case of a corporation the by-laws will often furnish additional information and should undoubtedly be read. One cannot become too well acquainted with the organization and its details. The author had an experience that may be of interest to some. He was employed by a man conducting a milling business to install a system of accounts involving a cost system. Pre- liminary to the installation of the system of accounts, he was asked to make a partial audit so as to insure a proper financial statement at the time the new system was installed. When employed by the client, he was informed that the business was a partnership, but when he asked for the copartnership agree- ment, he learned that none existed and finally obtained the information that the business was owned solely by the father of the client and that the client's position was that of a manager. Before proceeding further a conversation was held with the father and thereby, in addition to establishing the responsibility and authority of the client, information was secured that aided materially in opening the books after devising a system of accounts. 120 PUBLIC ACCOUNTING AND AUDITING FIXED ASSETS Having completed the audit of the current assets, the fixed assets will be taken up in the order in which they appear in the Trial Balance of The Blank Manufacturing Company as shown on page 50 of Chapter Four. The following accounts classified as fixed assets appear therein : Land $ 100,000.00 Buildings 150,000.00 Machinery 100,000.00 Tools and Implements 20,215.00 Horses, Wagons and Harness 15,000.00 Office Furniture 2,600.50 Following these accounts a discussion of depreciation will be given (see Chapter Ten). The object, of course, is to deter- mine the true value of each asset, and the method the auditor used in arriving at the value. Real Estate. The following discussion appears in 2Oth CENTURY BOOKKEEPING AND ACCOUNTING: (See page 87) "Real Estate is a technical term that is applied to immovable property which consists of land, buildings and other improvements which make the land valuable. Real estate may be purchased by a business (a) for a home, or (b) for speculation. When it is purchased as a speculation a separate account should be opened for each property owned. "The purchase price fixes the value of the real estate, and this value does not change except in the case of additional improvements. The value should not be increased by means of an inventory or appraisal for no profit can be realized until it is sold. A distinction should be made between the land and the buildings, be- cause the buildings decrease in value owing to age and use, while the land does not. On account of this distinc- tion their value should be separated at the time of pur- chase. Accountants recommend that separate accounts be kept with land and buildings. If only one account is kept, their separate value should be indicated by the use of the explanation column. In either case an ac- count termed Building Expense and Revenue should be kept to record all expenses incident to the upkeep of the buildings, and income which may be derived from the rental of any portion of the building. "If the building is to be constructed on land pur- LAND 121 chased for this purpose, the purchase price of the land together with any additional cost of grading and prepar- ing it for the building, is charged to the Land account. Payments in connection with the construction of the building are charged to a Building Contract account. When the building is completed, the balance of this account is closed into a Building account. This is car- ried on the books as the value of the building, and the depreciation is based on it." Many bookkeepers will keep an account with Real Estate or some similar term and the account will represent both the land and the buildings thereon. In fact, some of our bookkeeping texts still illustrate an account of this kind, consequently, there are thousands of students each year who are taught that land and buildings may be grouped in one account. To state that it is poor practice is putting it mildly. The accountant will always insist that land and buildings be kept separate in the accounts because of the difference in the nature of the items. Esquerre' says: "The components of the cost of plant land vary materially from those of investment land ; the consider- ation of increases in market values, while of much im- portance in the case of the latter, is merely an incident in the case of the former, since the asset cannot or- dinarily be sold without causing operations to come to an end, at least temporarily. On the other hand, build- ings depreciate through wear and tear, while land does not; hence, if reserves are created for the depreciation of buildings, and applied for Balance Sheet purposes to Land and Buildings account, it is not possible to as- certain the book value of the asset which the deprecia- tion affects. "These accounting differences in the nature of the two values, land and buildings, would seem to be suf- ficient to cause the creation of two distinct accounts with them, and are generally so regarded." In the preparation of a Balance Sheet the value of the land should always be listed as a separate item and should never be included with the value of the buildings for the reason that the depreciation on buildings does not affect the value of the land. Furthermore, good practice demands that the value of the land used in the business should be listed separately from land representing investments. The Theory of the Land Account. This discussion is confined to land used in the business. It is the most permanent asset owned by a business enterprise. Land should appear in the Balance Sheet at cost, regardless of what the market value may be. In fact the market value is never known unless a sale is made. The object of the Land account is to show the cost, 122 PUBLIC ACCOUNTING AND AUDITING therefore, it should be debited or charged with (a) the original cost; (b) the expenses incident to the purchase, such as cost of investigating the title, recording the deed, commissions to real estate agent, and any other expenses that clearly add to the cost of the purchase; (c) the cost of improvements that increase the value of the land, such as fencing, draining, leveling, filling in, building approaches, sidewalks, etc. It is not always an easy matter to determine when expendi- tures are an actual improvement to the land. The auditor must examine carefully all charges to this account. Some think that interest may be charged to the account. For instance if money were borrowed at 6% to pay the expense of filling in, the interest will frequently be added to the cost of improvements. It is doubtful if it is good practice, in any event, to add interest to the cost of land, for to do so would mean that the Balance Sheet of the company who borrowed money to improve its real estate would show the land to be worth more than the land on the Balance Sheet of the company who paid cash for similar improvements. Another matter that frequently requires consideration is the appreciation of land. If land is appraised at a higher value than cost price and its value has clearly increased, is it advisable to set up the supposed increase on the books? Sound accounting practice opposes such a procedure. To set up an appreciation in value would necessitate crediting an income account with the increased value. Such an increase would represent an unearned value and it is not likely that a company would care to pay income and excess profits taxes on such an extraneous profit. Furthermore, it would certainly be unwise to distribute such a profit. When land is sold or otherwise disposed of, the account should be credited for the cost price of the land and not for the selling price. The profit or loss incident to the sale or dispo- sition of land should be shown by a special nominal account. So far as is possible nominal and real accounts should be kept distinct. As many nominal accounts should be opened as are necessary to show the income and deductions from income, special profits and special losses. The Theory of the Buildings Account. The object of this account is to show the cost of buildings on land owned by the business. The original cost is not often a matter of dispute. Buildings may be a part of real estate purchased, in which case a separate value should be placed on the land and buildings before they are recorded on the books. The total of this valuation should, of course, be the same as the purchase price of the real estate as a whole. Buildings may be erected under contract in which case the contract price should undoubtedly be set up as the cost. It would make no difference whether they were constructed under a straight contract or a "cost plus" contract. Buildings may be built by the firm itself. In this case the true cost should be set up on the books. BUILDINGS 123 "If the construction is attended to by the concern itself, upon plans submitted by an architect, the cost of the building would include his fees, the expenses in- curred in connection with permits, licenses, etc., the cost of insurance protection, the cost of all material used, the cost of labor expended on the foundations as well as on the structures, the cost of any outside labor which may have been required, the proportion of overhead expenses which apply to the construction, the interest on any moneys which have been borrowed for construction pur- poses and used therefore, up to the time when the new buildings were open for operation." Some business men claim that they should be entitled to set up on the books the cost they would have had to pay an outsider to construct the buildings. Suppose a firm during an off-season decides to construct a building and by doing so saves a certain sum because it was able to construct the building cheaper than they could get an outsider to do the work. Would it not be correct to charge the building account with the sum it would have cost if the contract had been given to an outsider at an increased price? In this connection, note what Mr. Walton has to say: "It is sometimes argued that the corporation would be entitled to charge its construction account with the same price that it would charge an outside customer. It is claimed that the use of its facilities in its own work would prevent its using them for outside work on which it would make a profit. It is more doubtful whether any concern would allow its own work to interfere with the taking of profitable outside contracts. "No profit can be made except through a sale. In this case the reduced cost of the construction results in a saving and not in a profit, since there is no sale. In the end there will be no difference in the final effect on profits, whichever method is adopted. If the construc- tion account is charged with the cost of the work plus the regular profit, the carrying of the building will be raised and the depreciation to be written off against the profits will be correspondingly increased. Therefore, if a profit is taken at first, it will be written off during the life of the plant, and will not be a permanent profit at all. On the other hand, if the work is charged out at cost, the annual depreciation will be less and the saving will be realized by the smaller yearly charge against profits for depreciation." 124 PUBLIC ACCOUNTING AND AUDITING THE LAW OF REAL ESTATE Fenneberg in his treatise on "Simplified Law" defines real property or real estate as follows: "Real property or real estate represents a definite portion of land including everything growing above the ground as well as all things hidden beneath the surface. Ownership extends to the center of the earth and to the skies above. Since a landowner controls above and beneath his land he can forbid others from flying over it as well as tunneling under it; in the latter case the law governing mining claims is the single exception. Real estate is distin- guished from personal property inasmuch as it includes all buildings and fixtures with utensils necessary thereto, such as fences, walls, minerals, furnaces and accessories, gas and water pipes, hat racks and book cases built in the walls or fastened to the floor, keys, blinds, screens, mantle pieces, gas fixtures, etc." Ownership of Real Estate. Real estate may be owned outright or a person may possess the right to it during his own life or that of another. An Estate in Fee Simple. An estate in fee simple con- stitutes an absolute ownership in real estate. This ownership is unconditional and is not hampered by restrictions. We may sell, lease or mortgage such real estate at any time. An Estate for Life. An estate for life constitutes posses- sion or the right to the use of real estate during one's life or the life of another. It may be limited to an individual to hold for the term of his own life or for that of any other person, or for more lives than one. One who has an estate for the life of another may transmit it to heirs or dispose of it by will until the event happens that terminates the life tenancy. An Estate in Remainder. If an estate for life comes to an end, the final ownership of the real estate must either be given to another or revert to the original owner or his heirs. If the estate is given to another it is known as an estate in remainder. An Estate in Reversion. When an estate for life ends and it reverts to the original owner or his heirs, it is known as an estate in reversion. Obligations of a Holder of an Estate for Life. The holder of an estate for life must make such repairs as are necessary to prevent the property from decaying or depreciating in value. He is not bound to make improvements or to replace buildings destroyed by acts beyond his control, such as fire, flood, cyclone THE LAW OF REAL ESTATE 125 and other causes, legally known s "Acts of God." If improve- ments are made, they cannot be in part or whole charged to the reversioner. He need not pay the principal of any incum- brance, such as a mortgage, but he is compelled to pay the interest. He must do nothing to waste the estate, such as opening new mines or cutting all the timber. He may operate mines already open and he may cut a moderate amount of timber. If he should pay the principal of an incumbrance or an indebtedness, he becomes a creditor of the estate and the reversioner must in some manner equitably indemnify the life owner. Taxes on an Estate for Life. Life owners of real estate must pay the taxes, but in the case of assessments for perma- nent improvements, such as the building of streets, the laying of sewers and similar benefits in which the reversioner would be benefitted, the reversioner must, of course, pay his portion of such assessments. INCOME TAX PROCEDURE Taxes Constitute Deductions from Income. (Income Tax Law, Sec. 214.) "(a) That in computing net income there shall be allowed as deductions: "(3) Taxes paid or accrued within the taxable year imposed (a) by the authority of the United States, except income, war- profits and excess-profits taxes; or (b) by the authority of any of its possessions, except the amount of income, war-profits and excess profits taxes allowed as a credit under section 222; or (c) by the authority of any State or Territory, or any county, school district, municipality, or other taxing subdivision of any State or Territory, not including those assessed against local benefits of a kind tending to increase the value of the property assessed ; or (d) in the case of a citizen or resident of the United States, by the authority of any foreign country, except the amount of income, war-profits and excess-profits taxes allowed as a credit under section 222; or (e) in the case of a nonresident alien individual, by the authority of any foreign country (except income, war-profits and excess-profits taxes, and taxes assessed against local benefits of a kind tending to increase the value of the property assessed), upon property or business. Assessments not Deductible. (Income Tax Primer, 1919.) "Taxes assessed against an individual on property owned by him to pay for the paving of a street contiguous to his property, the construction of a sewer, sidewalk, etc., or the 126 PUBLIC ACCOUNTING AND AUDITING construction of ditches to drain property owned by him, "can not be claimed as deductions. In short, taxes as are not general in nature and are levied on account of some work or privilege, the benefit of which accrues to a limited number of property owners, of which the taxpayer is one, are not allowable de- ductions." Repairs on Real Estate Leased to a Tenant Con- stitute Business Expenses and are Deductible. (Income Tax Law. Sec. 214.) "(a) That in computing net income there shall be allowed as deductions: "(i) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business including a reasonable allowance for salaries or other compen- sation for personal services actually rendered, and including rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity." Repairs. (Art. 103. Reg. No. 45, 1918.) "TheTcost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as expense, provided the plant or property account is not increas- ed by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, should^be charged against the depreciation reserve." Repairs on Dwellings Owned and Occupied not De- ductible. (Income Tax Law. Sec. 215.) "That in computing net income no deduction shall in any case be allowed in respect of "(a) Personal, living, or family expenses; "(b) Any amount paid out for new buildings or for per- manent improvements or betterments made to increase the value of any property or estate; "(c) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made." THEORY QUESTIONS 127 A. THEORY QUESTIONS 1. In auditing the accounts of a corporation, for the first year of its existence, what records and documents should be examined in addition to the books of account and the vouchers? Inst. Ex. 1917. 2. In making an audit, should the auditor require to see the corporate minute book, and such other purely corporate records of a company? Give reasons for your answer. C. P. A. Ind. 3. What do you understand by the following terms and give illustrations of each: Fixed Assets, Quick Assets, Fixed Liabilities, Current Liabilities, Fixed Charges, Real Accounts, Nominal Accounts, Account Stated, Internal Check? C. P. A. Mich. 4. A company used its own material and laborers' services in the erection of an addition to its own plant. These additions to Capital account were charged at market prices, the profit on the transaction being absorbed in current trading profits. Do you consider this method correct? Explain fully the principles involved. C. P. A. Nebr. 5. A concern needs an addition to its plant. Not having enough ready capital, they borrowed money and when the in- terest was paid it was charged to the "Plant" account on the theory that it was not an expense in the ordinary conduct of the business and should, therefore, not be charged to the regular Interest and Discount account but might with propriety be charged as a part of the cost of the addition. Is the theory sound? C. P. A. Mich. 6. A company purchased land and on this land was a build- ing which the company had to pull down in order to make the required use of the land. During the demolishing of the build- ing, a workman was killed. To what account should the com- pensation in respect of this accident be charged and why? C. P. A. Pa. B. ACCOUNTING PROBLEMS i. You are employed to prepare a statement for credit purposes from figures submitted to you in a letter from the Western Manufacturing Company. Their letter submits figures and data as follows: Their plants stand at cost price, $90,600.00. They have set up a reserve for depreciation of $15,300.00. There is a mortgage of $30,000.00 on the plant and interest on the mortgage is at 6% and is paid to within three months of date of your proposed statement. They hold $15,000.00 of notes receivable and have discounted at bank $37,500.00. Accounts receivable they con- 128 PUBLIC ACCOUNTING AND AUDITING sider good, amount $27,000.00, including $4,500.00 due from employee on personal account. Accounts with trade customers are subject to 5% discount if paid at due date, and $15,000.00 is now past due. Suspense accounts amount to $6,000.00, 50% of which are believed to be good. A new machine has been ordered but not yet delivered, which cost $9,000.00. They have endorsed a note for $9,000.00 for Smith and Co., but say it will be paid when due. Accounts payable amount to $63,000.00, insurance amounts to $600 a year and has six months to run. They owe a note at bank for $7,500.00, interest paid to date. They own 50 shares of stock in a company from whom they buy raw materials. They cost $4,200.00, and are presumed to be worthless. Inventory was taken at a selling price of 10% more than cost. This amounts to $26,400.00. You are not asked to accept any responsibility for the figures in the statement but simply to prepare the statement in the best form you can from their letter. C. P. A. Ind. 2. A company is formed under the laws of Mexico, to take over and work certain mining properties. At the end of one year the company is found to possess: Mining lands $ 484,675.48 Buildings and Improvements 20,409.76 Machinery 25,612.88 Cash on hand and in bank 24,612.50 Silver Bullion 85,209.50 Ore in dump 13,680.00 Merchandise 5,420.80 Fuel, oil, etc 679.20 The company owes: On open accounts 3,890.12 On account of pay-rolls 400.00 Note due in six months with int. 6% 25,000.00 Capital Stock (Fully paid) is 500,000.00 Set up Balance Sheet. C. P. A. Mich. C. INCOME TAX QUESTION You own two houses, in one of which you live. The other is leased to a tenant at a fixed monthly rental. You paid during 1918 real estate taxes to the state, county, city or township on both properties. You also paid for the repairs on both. (a) Does the present federal income tax law make any distinction between the two properties as to these two classes of expenses? (b) If so, explain the reason, if any, for the distinction. Inst. Ex. 1919. Chapter Nine FIXED ASSETS (Continued) Capital and Revenue Expenditures. Buildings are also subject, after construction or purchase, to improvement, bet- terment, repair, renewal, replacement, alteration, depreciation, assessment, and destruction. All subsequent charges, after the cost has been recorded, raise the question of the proper separa- tion of capital expenditures and revenue expenditures. Briefly, capital expenditures might be defined as, all sums expended for addition to, or improvement of properties. The American Encyclopedia defines revenue expenditures as, "expen- ditures made in connection with the running expenses of the legitimate business of the firm or corporation concerned." Capital expenditures may be charged to the asset accounts affected while revenue expenditures should be charged to the proper expense account. Lawrence R. Dicksee* says, "If an expenditure has only had the effect of putting the earning power of the undertaking upon the same footing as that which had previously obtained, it must be charged to revenue." In summing up, the auditor should analyze the accounts with fixed assets, and if he finds any items that he is in doubt about they should be noted and carefully investigated. Improve- ments that increase the earning capacity of the plant and that are not of the nature of either renewals or improvements, may be cap- italized. All other expenditures in the nature of upkeep and repairs should be charged to an expense account. Some bookkeepers, when in doubt as to whether an expenditure constitutes an actual improvement, charge it to the asset account anyway. Their rea- son for so doing is that if it is later found that the item should have been charged to expense, it may be adjusted without much difficulty, while on the other hand, an item charged to ex- pense, but which should have been charged to the asset account, is always difficult to adjust because it is usually necessary to make explanations and secure authority for the adjustment. It is more conservative, however, to overcharge the revenue expendi- tures than to overcharge the capital expenditures. So far as possible, adjustments should be avoided except when absolutely necessary. *Of the firm of Price & Dicksee. 129 130 PUBLIC ACCOUNTING AND AUDITING The Theory of the Machinery Account. The object of this account is to show the cost of machinery on hand and in use in the factory. Separate accounts may be kept with different classes of machinery. For instance, one account might be kept with Universal machines and another with Special machines. By Universal machines is meant standard or stock machines that may be purchased from manufacturers whose business it is to manufacture such machines. They are built and carried in stock for sale. By Special machines is meant those specially designed and built either by the concern itself or by another under contract according to specifications. The usual practice, however, is to maintain but one account with Machinery. It is frequently combined with tools, implements, and other items, but this is poor practice and is not to be encouraged. The account with Machinery should show on the debit side; (a) the cost of machinery on hand at the beginning of the business; (If the machinery is part of a plant that has been purchased or otherwise acquired, for a purchase price covering the entire plant, it may be necessary to estimate the value of each part of the plant subdivided into accounts. Furthermore, the book value set up may not be the actual inventory or ap- praisal value, but the difference between the asset account and the reserve for depreciation account, applicable thereto, should represent the actual value, provided sufficient reserve for de- preciation has been set up.) (b) the cost of machinery and equip- ment purchased or manufactured by the concern itself after operations have begun; (c) the cost of additions or alterations which actually increase the value and efficiency of the machinery already in use; (This must not be construed to include altera- tions made necessary by a mere change in product, nor to in- clude the cost of moving and reinstalling machines to permit of more economical operation. In such cases, if the cost is large, it may be advisable to treat it as a deferred expense and to be charged off over a period of years or during the years to be bene- fited by the changes made.) and (d) the cost of new parts pur- chased. With regard to the last item, a great deal will depend on the policy of the firm concerning the method used in arriving at the proper amount of depreciation to be charged off. If the cost of all new parts which are to replace old parts is charged to op- erating expense, the rate of depreciation will be lower, other- wise, the rate should be higher. If the cost of new parts is charged to the Machinery account, then the cost of the worn parts being replaced should be credited to the Machinery ac- count and at the same time charged to reserve account, because the rate of depreciation charged off to operating expense has been sufficiently high to include the wear of such parts. After a part has been replaced with a new part no further reserve for depreciation on that particular part is necessary, hence it should be charged to the reserve account. Another argument in favor of charging new parts to the Machinery account is their cost may be higher or lower than the original parts, and if the cost of the old parts being replaced is credited to the account and the new parts charged to the account, the Machinery account will at all times represent the actual cost of machinery in operation. Any machines or machine parts exchanged, discarded, de- stroyed, or otherwise disposed of, should be credited to the Ma- chinery account and charged to the reserve account at cost price. In the case of machinery built or manufactured by the con- cern itself, the cost should include the cost of material and labor, plus the freight and cartage inward and a proper proportion of overhead expenses. It is customary to add, also, the cost of the experiments, which were made before a desirable type was ob- tained, plus the cost of the designs and patterns. The cost of installing new machinery, such as the building of foundations, connecting it \vith the transmission, moving it into place, etc., is a part of the cost of the machinery and should be charged to the Machinery account. In other words, the Ma- chinery account should show the actual cost of machinery when it is ready for operation. Montgomery says: "The cost of installation, including freight, labor, and other items is as much a part of the cost as the price of the machinery itself." Cox* says: "The entire cost of installing new machines constitutes an addition and should be capitalized." Walton says: "The purchase price, the freight, the cost of moving an old machine to make way for a new one and the cost of installing a new machine are proper charges to the Machinery account." It is not considered good accounting practice to add interest on borrowed money used to purchase or construct machinery or in the installation process. If this were done the firm who borrowed money with which to construct machinery or to pay the cost of installation, would show the asset at a higher value than the firm who did not need to borrow the money. The Theory of the Tools and Implements Account. The object of this account is to show the value of small tools on hand. There are several different methods for recording the value of tools. It is always best, if the value of tools on hand is to be considered a fixed asset, to take a physical inventory at the end of the period under audit before preparing the state- ments. Tools are so often lost, misplaced, or stolen and they are used up so rapidly that it is difficult to determine their actual value in any other manner. ""'Classified C. P. A. Problems and Solutions." 132 PUBLIC ACCOUNTING AND AUDITING One method is to charge the Tools and Implements account with the cost of all tools purchased and at the end of the year to take a physical inventory and make an adjusting entry credit- ing the asset account with the cost value of all tools used up or missing and charging the proper operating expense account. If this is done, no reserve for depreciation need be set up. Another method is to charge the account with tools as above, but to issue all tools to the workmen and at certain times require them to submit all tools for inspection. At this time all tools worn out, broken, or worthless are charged to expense and new tools issued to the workmen. Any tools missing or other- wise unaccounted for are charged to the workmen and deducted from their wages. In either case the account with tools would be credited with the cost price of the tools worn out, broken, worthless, or missing and the balance of the account would show the cost of tools on hand and in use. No reserve for deprecia- tion is necessary, but it is necessary to require the workmen to submit all tools for inspection before preparing the statements. At this time the account would be adjusted. A third method is to charge all tools and implements to operating expense at the time of their purchase, and if there are any new tools on hand at the end of the fiscal period, their value at cost price is treated as a deferred expense. This method sim- ply necessitates an inventory of new tools on hand undistributed. Montgomery says: "As a rule, the practice of depreciating small tools by way of a percentage cannot be followed satisfactorily. So many small tools are used up, or lost, or stolen, that an inventory should be made periodically and all tools on hand revalued. If this plan is followed for several years and a dependable rate of depreciation is secured, it may be feasible to omit the revalua- tion for a year or two, applying the rate previously ascertained." The Tax Commissioner of one of the states has adopted rates varying from 25 to 50 per cent, or as an alternative the entire cost of replacements. Esquerre' says: "The tools contained in this account are sometimes re- ferred to as 'small equipment.' They comprise, saws, files, hammers, screwdrivers, etc., which on account of their fragility, their size, the manifold uses to which they are placed, and the facility with which they can be passed from hand to hand and from bench to bench, cannot be readily or accurately inven- toried. They are generally kept under the custody of a store- keeper and charged to cost of manufacture when issued to the factory." Greendlinger* says: "Tools which are fixed and which in reality enter into the same category as machinery, should be valued in the same man- *Author of "Accountancy Problems with Solutions." HORSES, WAGONS AND HARNESS 133 ner. Small tools, however, unless the aggregate is large, should be considered expenses. Where there are a great many it would be better to consider them as supplies and so list them in the inventory." The Theory of the Account with Horses, Wagons and Harness. This account is rapidly being replaced with accounts with Auto Trucks or motorized delivery equipment. However, the theory of the account is the same. The items charged to it represent delivery equipment. The only difference is the amount of depreciation to be charged off or set up. Some firms charge the account with the original cost and then charge all replacements and additions to expense. This is hardly to be commended because it does not show true facts at the end of the period. If the original value is increased or de- creased by a conservative inventory or appraisement before pre- paring the statements, the difficulty may be overcome to some extent. A better practice would be to charge the account with the cost of all delivery equipment and then set up a reserve for depreciation that is estimated to be equal to the reduction in the value of the property. Under this plan, if losses occur by reason of accidents or other causes, the account is credited with the original cost. If the account had been credited direct with the amount of the estimated depreciation, then only the depreciated value would be credited to the account at the time of loss. It is advisable to set up special reserve accounts for each property account subject to depreciation. (Depreciation will be taken up in the Tenth Chapter and will be discussed in detail.) The Federal Trade Commission, in a bulletin issued July 15, 1916, entitled "A System of Accounts for Retail Merchants,/ says, "Charge the account with Delivery Equipment with the cost of automobiles, wagons, horses, and harness. This account must not be charged with repairs to automobiles and wagons, horseshoeing or anything of this nature. A fair amount should be written off periodically for depreciation." The Theory of the Office Furniture Account. In prac- tice different methods will be found to exist in recording the value of office furniture or equipment. It will depend upon the policy of the concern. In many instances the account will in- clude fixtures, partitions, etc. What was said with reference to the account with delivery equipment is applicable here. The important thing is to be conservative. If the account is charged with the cost of all office furniture purchased and a reserve ac- count is set up crediting it with the estimated amount of the depreciation each year, it will represent sound accounting prac- tice. 134 PUBLIC ACCOUNTING AND AUDITING The Federal Trade Commission says in regard to the ac- count with Office Furniture, "Charge this account with office furniture, desks, safe, and other office appliances. It should not be charged with the cost of typewriter supplies, account books, etc., as these are clearly items of expense. A fair amount should be written off periodically for depreciation." AUDITING THEORY Quoting from Federal Reserve Bulletin: Schedules. "In preparing the leading schedules for the accounts grouped under this heading, such as real estate, build- ings, plant, machinery, etc., the balances at the beginning of the period, the additions to or deductions from the accounts during the year, and the balances at the end of the period must be shown. "The total of the balances at the beginning of the period must agree with the cost of property figures given in the Balance Sheet at that date, and the balances at the end of the period with the amount shown in the Balance Sheet that is being audited. The charges entering into the additions must be veri- fied in detail, and in this connection the following notes are of value : Authorizations for Expenditures, (i) "Authorizations for the expenditures made during the year should be examined, and where the costs of the additions have overrun the sums au- thorized, inquiries should be made in regard thereto. The authorizations should show the accounts to which the expendi- tures are chargeable, the amounts thereof, the approvals of the comptroller and manager, and descriptions of the jobs. When the authorizations are not specific as to the work done, the actual additions should, if possible, be inspected. Additions. (2) "The auditor should satisfy himself before approving additions that they were made with the object of increasing the earning capacity of the plant, and that they are not of the nature of either renewals or improvements, and in this connection changes in the production and capacity of the plant should receive consideration. Pay Roll and Store and Supply Charges. (3) "To verify the pay roll and store and supply charges to jobs, one or two pay roll distribution reports should be examined in detail, and also one or two storehouse reports. In cases where large purchases have been made from outside parties for capital construction work, the vouchers therefor should be examined and the usual precautions taken to see that they are properly approved for the the receipt of materials, prices, etc. FIXED ASSETS 135 Real Estate Purchases. (4) "For purchases of real estate the title deeds should be examined, together with the vouchers, and it should be seen that the deeds have been properly recorded. Factory Overhead Cost. (5) "While it may be consid- ered permissible to make a charge for factory overhead cost to additions to property such as, e. g., time of superintendent and his clerical force employed on construction work, etc., it cannot be deemed conservative business practice, inasmuch as the probabilities are that the overhead charges of a plant will not be decreased to any extent even though additions are not under way, and, therefore, the absorption of part of these charges when additions are in progress, has the effect of reducing the operating costs, as compared with months in which no construc- tion work is under way. Construction Work in Progress. (6) "Construction work in progress at the end of the fiscal period should be shown in the Balance Sheet under the heading of fixed assets and not as part of the inventories. This is important to bear in mind because construction work is not an asset that can be quickly turned into money, while everything in the inventory is sup- posed to be realizable in cash within a reasonable short time. Installments on Construction Work. (7) "The auditor should inquire as to whether any installments are due on ac- count of construction work in progress which is being carried on by outside parties; and if so, the liabilities for these install- ments should be included in the Balance Sheet, as they may have a direct bearing on the amount of available cash on hand. Leases. (8) "When a company uses leasehold properties the leases should be examined and notes made of the periods covered, so that it may be seen that improvements, etc., on such properties are written off over the periods covered by the leases. Reserves for Depreciation. (9) "The auditor should satisfy himself that the reserves for depreciation of buildings, machinery, equipment, etc., are adequate to reflect the deteri- oration in the value of the fixed properties. If in his opinion the reserves shown on the Balance Sheet are insufficient, he should call attention to the matter in his certificate. Property Destroyed by Fire. (10) "Care should be taken to insure that property destroyed by fire or othenvise prematurely put out of service is correctly treated in the books. Any portion of the original charge for such property which is not recoverable through insurance, as salvage or otherwise, and has not been provided for by the depreciation scheme should be written off. "It is to be observed that the foregoing notes are to be applied only to cost of properties incurred during the period 136 PUBLIC ACCOUNTING AND AUDITING under audit. In addition, information may usually be ob- tained on broader lines in regard to the composition of the Real Estate, Building, and Machinery accounts, and showing what principal property is represented thereby and how the accounts have been built up from year to year for a reasonable time past if not from the inception of the business. The information de- rived therefrom is valuable only in indicating the progressive policy of the concern, the extent to which it reinvests undivided surplus in its plan, etc. Beyond these facts the banker who is asked for ordinary discounts or short-term loans is not in- terested; he looks more to the quick assets for his security. When an Appraisement is Necessary. "Optional. When the loan is greater than the quick assets seem to justify the auditor should suggest a reliable verification of the cost of property prior to the period under audit. Such action may become necessary even to the extent of calling for an appraise- ment by disinterested outside experts." AUDITING PROCEDURE Analyzing Fixed Assets. J. I. King, junior accountant, made an analysis of the fixed asset accounts. Inasmuch as all account footings had been carefully verified when the Trial Balance was vouched, it was only necessary to determine whether all charges to the asset accounts represented actual capital dis- bursements and that adequate reserves for depreciation had been set up. The Land Account. The amount charged to this account, $100,000.00, represents the actual cost of the land at the time of its purchase. The deed was examined and found to be proper- ly recorded. The Buildings Account. Building operations were begun immediately after the purchase of the land and the book value as set up represents the actual contract price of the buildings when completed. A reserve for depreciation amounting to 2^2% has been set up annually. The Buildings account shows a debit of $150,000.00, and the Reserve for Depreciation on Buildings account shows a credit of $2,500.00. The buildings were completed May i, 1917, and the Reserve, at the end of the year, was credited for depreciation on the basis of ^ of a year. A question might arise as to whether this represents a proper percentage of depreciation. Inasmuch as the buildings are of concrete and brick construction, it is considered adequate. (See discussion of Depreciation, Chapter Ten.) FIXED ASSETS 137 The Machinery Account. The book value amounting to $100,000.00 represents the original cost price of all machinery, including installation. An item amounting to $215.00 was found to have been posted to Tools and Implements, but it should have been charged to the Machinery account, as it rep- resented the cost of a new machine. A reserve for depreciation amounting to 6% has been set up annually. After the Machinery account was adjusted it showed a debit footing of $100,215.00. The Reserve for Depreciation of Machinery account shows a credit of $9,000.00. The original Machinery was purchased July I, 1916. A new machine costing $215.00 was purchased July I, 1918. Tools and Implements Account. This account shows a debit balance of $20,215.00. $215.00 charged to this account represents 'an addition to machinery and was posted to this account through 'an error. It was adjusted. No reserve for depreciation account was set up. The practice has been to credit the account direct with the amount of the estimated deprecia- tion which was arrived at after a physical inventory. On De- cember 31, 1918, a physical inventory was taken under the supervision of the different foremen. Further investigation shows that the balance of the account represents the actual cost value of all tools considered new or unworn at that date and either in the hands of the workmen or undistributed. On De- cember 10, 1918, there had been purchased $5,250.00 worth of new tools that had not yet been distributed. The amount, at cost price, of tools used up during the year had been charged to operating expense. Horses, Wagons and Harness Account. The balance of this account shows a debit of $15,000.00. The practice has been to charge the cost of horses, wagons, and harness purchased to the account. The account is credited with the cost price of any items sold, exchanged, destroyed or discarded. The Reserve for Depreciation account shows a balance on the credit side of $1,500.00. This account is credited annually with 10% of the cost as shown by the account at the beginning of the year. The equipment was purchased January 1, 1917, and no additions have been made since that time. Office Furniture Account. This account was found to show a debit balance of $2,600.50. No reserve for depreciation has been set up, the practice being to credit the account annu- ally with the estimated amount of depreciation. The deprecia- tion has been calculated at 10%. Book Variations. Montgomery says: "Where an auditor cannot secure reliable information with respect to plant valuations 138 PUBLIC ACCOUNTING AND AUDITING he should state in his report that real estate, machinery, and similar assets are stated at book valuations. He should , however, attempt to ascertain whether these book valuations honestly re- flect present conditions. His services are of little real value if such items are grossly overvalued and a net worth is shown which should be corrected by an intelligent use of evidence easily available by the auditor. "The auditor is charged with the duty of attempting to analyze the fixed assets as shown by the books to ascertain the principles upon which they have been created." THE LAW OF PERSONAL PROPERTY It is appropriate that we discuss the law in its relation to property at the same time we discuss fixed assets. Fixed assets, as has already been made clear, are to be classed among the real accounts. There is a distinction, however, between real accounts and real property. Real property has already been defined in the preceding chapter. Real property, including land, buildings, etc., is a fixed asset unless it represents the stock-in-trade of the concern. Naturally, if one's business is that of a dealer in real estate, such real estate becomes a current asset the same as any other stock-in-trade. Personal property, however, may represent either a current or a fixed asset, for it includes both the stock-in-trade and all equipment which cannot be classed as real property. It will be seen from the above distinction that it is important that the accountant be able to distinguish between real and personal property. We can do no better than to quote from Peters' Commercial Law* with regard to the kinds of property. "Personal property is movable in its nature, and includes every particular sort of property not possessing the nature of real property, such as promissory notes, merchandise, crops, furniture, mortgages, books, stocks and bonds, animals, patents, manufactured goods, and the like. Personal property may be changed into real property, as where one takes brick and mortar all personal property and constructs a house with them which is then considered real property; and if in the lapse of time that same house be razed to the ground and the building ma- terial sold as such they again acquire the characteristics of personal property. Chattels. "The name 'chattel' is frequently applied to personal property and is the term usually employed at the common law to denote personal property in general. It is a more extensive term than goods or effects and includes every kind of property except property in land. Its meaning is com- *By P. B. S. Peters, LL. B. Published by South-Western Publishing Company. THE LAW OF PERSONAL PROPERTY 139 monly confined to things movable in their character, as animals, machinery, grain, or any article that can be handled and trans- ported. Ways of Acquiring Title to Personal Property. "The two general ways in which title to personal property may be obtained are: (i) by original acquisition; (2) by transfer. (i) Acquisition. "Under original acquisition the first general method of acquiring title is by occupancy. This is brought about by taking into one's possession what previously belonged to no other person, or what was abandoned by a prior owner. "Wild animals belong to no one in particular until they are captured. Whoever captures such an animal has the ex- clusive right to it while in his possession, or until it has become so far domesticated that it has the habit of returning after wandering at large. If, however, it escapes and regains its natural freedom any other person may rightfully take it who captures or kills it. A mere temporary escape, as where a lion escapes from its cage, may not amount to regaining its natural liberty. "The finder acquires title to personal property abandoned by the owner of property that has been lost but never re- claimed. But the former owner must have completely relin- quished his ownership intending to give up all his rights in it before a perfect title will accrue to the finder. Accession. "Title by accession is defined as the right to all which one's own property produces, either naturally or artificially. This includes the crops yielded by land; the in- crease of animals; the uniting of the property of one with the property of another, as when an artist paints a picture on the canvas of another, the whole belongs to the artist, but the other has a claim for the value of the materials. Also by the mixing or confusion of goods, which occurs when one person wilfully mingles his own goods with another that they cannot be distinguished from each other. If the mixing was by consent, each has a pro rata interest in the entire mass. Intellectual Labor. "Authors, composers, and inventors have the exclusive use and control for a limited time in such personal property as owes its existence or value to their skill and labor. The general doctrine is that one has a proprietary right in the product of his intellectual labor and that this right should be protected by law for the purpose of promoting science, encouraging literature, and stimulating inventions. "A copyright is a grant to authors of the exclusive right to possess, use and dispose of their intellectual productions. 140 This gives the owner the right of making, publishing, and selling, or authorizing others to do so for a period of twenty- eight years, with the privilege of a renewal and extension for a further term of twenty-eight years. "A copyright may be secured for books, periodicals, lec- tures, sermons, addresses, dramatic and musical compositions, maps, works and reproductions of works of art, drawings, photographs, prints, pictorial illustrations, motion pictures, etc. "A patent is a grant for the exclusive privilege of making, using, and vending, and authorizing others to make, use and vend an invention for a period of seventeen years. The in- vention must be a new and useful art, machine, or composition of matter, not before known and used. Transfer of Property. "Title to personal property may be acquired by transfer in two general ways: (i) by act of law; (2) by act of the parties. "Transfer of title to personal property by act of law occurs (a) by forfeiture, (b) judgment, (c) intestacy, and (d) insolvency. "(i) Forfeiture is a loss of title by the owner as a punish- ment for a crime, a penalty for the violation of law, or a breach of contract. Title by forfeiture is practically obsolete at the present time as a punishment for crime. However, there may be a forfeiture of goods for the evasion of revenue laws, or of shares in a corporation for a failure to pay assessments when due. "(2) A judgment is a decision or sentence of law pronounced by a court or other competent tribunal having authority as the result of proceedings instituted for the redress of an injury or the settlement of a controversy. Title to personal property occurs as a result of a decree entered in an action whereby a person becomes entitled to take property belonging to another. "(3) Intestacy is the state or condition of a person dying without having made a will, leaving personal property undis- posed of. The title is vested in the administrator as a trustee for the purpose of settling the estate, and the property is dis- tributed in accordance with the statute laws of the state where the deceased person resided. "(4) A bankrupt's property is transferred by operation of law to an assignee or trustee who has authority to administer the same for the benefit of the creditors. THEORY QUESTIONS 141 "Transfer of title to personal property by act of the parties occurs in a contract of sale which is a transfer of the property in a thing for a money consideration called a price. The trans- fer may be by an exchange of property, whereby the title in property passes to another in consideration of the receipt by him of other property. Again, it may be in the form of a gift which is the actual, voluntary, and gratuitous transfer of property from one person to another. The gift must be accepted by the person to whom made, but the acceptance is presumed. Then again, the transfer may be in the form of a written instrument designated a will which provides for the disposition of property to take effect after the death of the person who made the will." A. THEORY QUESTIONS 1. Mention under what circumstances, if any, reconstruc- tion or rehabilitation expenses of a street railway company may properly be charged to property accounts. C. P. A. Ind. 2. An alteration to existing equipment is made in a fac- tory. State what you would do with the cost of such alteration. C. P. A. Ind. 3. Auditing the yearly results of a large engineering com- pany you find that the machinery and tools, which had been regularly depreciated for a number of years, have, during the year under audit, been appraised by a reputable appraising com- pany, and have been revalued at a larger sum than the debit balances in the books. How would you dispose of the increased value due to the appraisal? C. P. A. Ind. 4. A company purchased several machines and, in order to install them to the best advantage, old machines which are to remain in use were moved to make room for them. The ma- chines were large and had to be taken apart before they could be moved. To what account would the cost of moving be charged and why? C. P. A. Pa. 5. You receive the following letter: "We have never had our books audited but are contemplating an audit now. Two of our friends have recommended you to us. Both have businesses similar to ours but their advices as to the time required are very different. Do you carry out different kinds of audits? If so, what are the different kinds and under what cir- cumstances do you recommend one kind and when another?" Write reply. Inst. Ex. 1917. 142 PUBLIC ACCOUNTING AND AUDITING B. ACCOUNTING PROBLEMS I. In the machinery account of a company under audit, you find the following among other items : Cr. Sale of old machine, type A (less cost of removal and freight) $1,264.00. Sale of old machine, type B 1,470.00. Dr. Purchase of two machines, type A, including freight $8,000.00 Cost of removing a disused ma- chine, type B, to make room for new machine 160.00 Cost of installation of two new ma- chines 280.00 Alterations to four type C machines, necessitated by change in product . 640.00 Cost of moving two machines from building A to building B to permit of more economical operation, in- cluding reinstallation 270.00 The balance on Machinery Depreciation account shows an increase for the year of the amount provided out of income, which is computed at the rate of 4% on the balance of Ma- chinery account at the commencement of the year. The method of keeping the Machinery and Machinery Depreciation accounts has been in force from the commencement of operations. Draft your comments as auditor of these accounts, assuming that no items other than those above mentioned call for any com- ments. Inst. Ex. 1918. 2. You are called upon to audit the books of a partnership which has been in existence for one year. You find that A's Balance Sheet, prepared just before B was admitted as a part- ner, shows the following accounts: Cash in the bank, $500.00; real estate, $20,000.00; ma- chinery, after 10 per cent depreciation, $40,000.00; accounts receivable, $7,542.50; stock on hand finished, $10,000.00; stock in process of construction, $1,000.00; raw material, $957.50; bills payable, $20,000.00; accounts payable, $30,000.00. After examining the copartnership agreement, you find that A agreed with B to sell him one-half interest in the business for the sum of $20,000.00 to be contributed to the new firm, the new firm to take the assets of A with the exception of the real estate and assume the liabilities, and that the good will of the business of A should be rated at $20,000.00 in the new firm's books. During the course of your audit you discovered the follow- ing discrepancies : (a) The inventory of finished stock was incorrect. The value should have been entered at $8,000.00 instead of $10,000.00. ACCOUNTING PROBLEMS 143 (b) Of the accounts receivable, $6,500.00 were col- lectible. One of the debtors owing $500.00 failed, leaving no assets, previous to the formation of the copartnership, which fact was known to A but his bookkeeper, who had been instructed to charge off the account had failed to do so. $1,000.00 of the accounts receivable represents accounts ascertained to be worthless since the copartnership was formed. The Trial Balance at the end of the year's business showed as follows: A Capital Account $ 25,000.00 B Capital Account 25,000.00 Merchandise 75,000.00 Accounts Payable 40,000.00 Accounts Receivable $10,000.00 Machinery 40,000.00 Factory Wages 35,000.00 Non-productive Labor 5,000.00 General Factory Expense .... 20,000.00 Rent i ,500.00 A Personal Account 2,500.00 B Personal Account 2,500.00 General Expense 2,000.00 Good Will 20,000.00 Cash 26,000.00 Profit and Loss 500.00 $165,000.00 $165,000.00 Inventories at close of year: Stock on hand finished $25,000.00 Stock in process of construction 2,500.00 Raw Material 2,500.00 Total 30,000.00 No correction was made of the discrepancies and no amount has been charged off for depreciation of machinery, which should be 10 per cent. Make proper entries to correct books with reasons for such entries in full, also formulate Balance Sheet showing the stand- ing of the firm after the books were closed. C. P. A. Mich. (Note. In connection with the second Accounting Problem, there are several legal principles involved. You may assume that B accepted the Assets and Liabilities of A as stated on A's books with the exception of the Account Receivable amounting to $500.00 known to be worthless by A, but which was included in his assets through an error on the part of the bookkeeper. The overvaluation of the inventory probably was unknown to both A and B until the auditor ascertained this fact. The accounts proved to be uncollectible, excepting the account mentioned above, could not be foretold, and were accepted by A without a reserve for such a loss, therefore, you may assume that these two items are losses of the partnership to be borne equally by A and B. 144 PUBLIC ACCOUNTING AND AUDITING As a result of this information, two correcting and two adjusting entries are necessary. These should be set up in journal form and posted to the accounts, after which a Trial Balance should be taken and a Balance Sheet made.) C. LEGAL QUESTIONS. 1. Name the two divisions of property and explain each. 2. Define personal property. 3. What is chattel property? 4. When are trees real property and when are they per- sonal property? 5. (a) Name four methods by which title to personal property may be transferred by acts of law. (b) May personal property be transferred by acts of the parties? If so, explain how. Chapter Ten DEPRECIATION Depreciation Defined. Depreciation is the shrinkage in value of an asset due to deterioration through wear and tear caused by use or by a mere lapse of time, accidents, inadequacy, or obsolescence. The importance of its being considered from an accounting standpoint can hardly be overestimated. Without a doubt, failure to provide for the depreciation of the fixed assets, has contributed to the failure of many concerns in the past. In a decision by the New York Court of Appeals, the fol- lowing statement appears: "Judicial notice may be taken of the fact that in the con- duct of many industrial enterprises there is a constant deter- ioration of the plant which is not made good by ordinary re- pairs and which, of course, operates continually to lessen the value of the tangible property which it affects. The amount of this depreciation differs in different enterprises, but the annual rate is usually capable of estimate and proof by skilled witnesses. No corporation would be regarded as well conducted which did not make some provision for the necessity of ultimately replacing the property thus suffering deterioration; and we cannot see why an allowance for this purpose should not be made out of the gross earnings in order to ascertain the true earning capacity." A few years ago an underwriting syndicate undertook the reorganizing of the Rock Island Companies. Its plans were to issue 7 per cent preferred stock on the basis of an 8 per cent income. To the dismay of the members of the syndicate, the Interstate Commerce Commission ruled that all the railroads under its control must include, as a charge against their profits, a satisfactory percentage of the railroad equipment, such percent- age being the estimated amount of depreciation of the property. As a result of this ruling the net income of the Rock Island Companies fell to 3^ per cent. This rate of income was insuf- ficient to warrant the issue of 7 per cent stock and the syn- dicate collapsed. The practice of most of the railroad companies had been to disregard the theory of depreciation. They simply discarded old equipment made worthless through wear and tear and borrowed money to buy new equipment. It dosen't require much wisdom to see the folly of such a plan and the ultimate results are quite clear. A firm that divides all its net income without providing for depreciation on its fixed assets is simply "robbing Peter to pay Paul" and it reminds one of the story of the two men, shipwrecked on a deserted island, who during the time they were stranded became rich trading knives with each other. 146 PUBLIC ACCOUNTING AND AUDITING Causes of Depreciation. There are four principal causes of depreciation. These have been so ably and clearly described by Professor M. E. Cooley that we will quote him in detail: "i. Depreciation Due to Wear and Tear and Exposure to the Elements. This is continuous. All elements have a wear- ing life varying with the element itself. No element can be completely worn out; it can be worn only to a point below which it becomes unsafe or no longer serves its original function. In practice, the average condition of all elements must be main- tained at a high percentage of the original cost if the property is to serve its purpose properly. This percentage varies from 75 per cent to 85 per cent of the cost of the property. The difference between this percentage of from 75 to 85 and the original 100 is a depreciation which is inherent in the property and cannot be dispensed with. It must be met by a sinking fund, or its equivalent, otherwise this part of the original invest- ment is lost. "2. Depreciation Due to Accidents; Sudden Depreciation. An engine or a boiler may be wrecked, and with it, other machin- ery. This might, and probably would, involve a considerable expense for repairs or replacements besides possibly crippling the plant in part. Cars may collide or a car may drop through a bridge. A bridge itself may fall or be carried away by flood. A storm or a cyclone, may work havoc, entailing costs in excess of those proper to be charged to ordinary maintenance of property. "3. Depreciation Due to Inadequacy. Cars suitable in the past had already been superceded several times by larger and better cars. This has rendered the track, structure, and bridges inadequate, and as more power is required to propel the larger cars, the power plants have become inadequate. The public demand is largely responsible for this depreciation due to in- adequacy. "4. Depreciation Due to Obsolescence. This, while closely allied to the depreciation due to inadequacy, is different in that it embraces changes due to advance in the art. More efficient and effective machinery has appeared which must be substituted for the old to keep abreast of the times. For example, in steam- engine practice the turbine has come into geneial use during the past five years and the art of steam turbines is at the beginning. Generators adapted to piston-engine practice are not adapted to steam-turbine practice and must be changed. Boilers adapted to piston-engine practice must be replaced to carry the higher pressures required. Condensers must also be changed to secure the better vacuum required to realize the full advantage of the steam turbine. Owing to the rapid disappearance of coal beds, the price of fuel must advance, and this presumably will, before many years, force the adoption of the gas producer and the producer gas engine. Water powers are wisely being developed, but to utilize them requires the scrapping of large parts of the machinery in use at present." DEPRECIATION 147 In regulating depreciation in respect to income taxes, de- duction is allowed only for loss due to wear and tear of property used in the trade or business. This does not include provision for obsolescence since it is provided that when an asset is actually determined to be obsolete the loss may be deducted at that time. However, obsolescence should usually be provided for periodically as well as depreciation from wear and tear, as the government's permission to make eventual deduction for loss from obsolescence does not justify a waiver of the fundamental accounting rule to provide for all possible losses. Factors Bearing on Amount of Depreciation. In de- termining the probable amount of depreciation on any fixed asset there are certain factors to be taken into consideration such as original or prime cost, probable life of the asset, repairs and replacements, residual or scrap value and the possibility of obsolescence. 1 . The original or prime cost is the basis of all calculations. It should include all the elements of cost such as freight and cart- age inward, cost of installation, etc. 2. The probable life of the asset, or the number of years it is estimated to be of use, is the next factor to be considered. This varies so extensively, even with the same kinds of machines, or other assets, that it is always a difficult item to arrive at with any degree of accuracy. About the only way of determining the life of an asset is by experience. Earl A. Saliers, author of "Principles of Depreciation", says: "But efficiency, the test of present usefulness, is not the only factor that determines value. Value depends upon the length of time over which such usefulness will continue. Two similar machines may be equally efficient today; but one may continue to be useful for two years and the other for four. Can we say that they have equal value? There may be some uncer- tainty in individual cases; but the uncertainty is limited within certain bounds, and to a great degree vanishes when averages are considered, just as the uncertainties of lifetime vanish when large numbers of lives are considered. The lifetime of a single freight car is very uncertain but the average lifetime of a thou- sand cars is ascertainable to the fraction of a year." 3. Repairs and replacements of property affect the rate of depreciation, consequently, the auditor should not decide on the amount required for depreciation until he has scrutinized the Repairs and Maintenance account. He may find items charged to this account that should have been charged to the Reserve for Depreciation account because they represent expenditures that decrease the deterioration and should have the effect of re- ducing the depreciation charge. The usual procedure in practice is to charge all items representing repairs and replacements to either expense or to the Reserve for Depreciation account. In deciding which account should be charged it is necessary to determine whether the 148 PUBLIC ACCOUNTING AND AUDITING expenditure is one provided for through cumulative depreciation allowances. Ordinarily small incidental items of repair, replace- ment and maintenance are charged to expense and larger items of renewal and replacement are charged to the depreciation reserve. Remember, that with either plan it is a deduction from income, but the point in question is, that the expenditure must not be charged to expense, and at the same time, another charge be made on account of depreciation. (See page 154 for Income Tax Procedure). Like nearly all rules, there is an exception here in connection with old, run-down or partially worn-out assets purchased with the intention of remodeling, rebuilding or rehabilitating them so they can be operated efficiently again. In such cases, it is permissible to charge all repairs and renewals to the asset accounts affected, thereby capitalizing such expenditures. 4. The total amount of depreciation of an asset will be the difference between its original cost and its residual or scrap value when it ceases to be useful and must be discarded. What- ever can be realized from the sale of an asset at the time it is discarded reduces the loss and thereby the amount of depre- ciation. 5. Some assets are quite likely to become obsolete even before they have become useless through wear and tear. The possibility of obsolescence, therefore, is a matter for consider- ation. Methods Used for Calculating the Depreciation. There are several methods advocated for calculating the proper amount or rather the annual rate of depreciation. We shall discuss briefly the principal methods used. I. Straight Line Method. In this method the life of the asset is estimated and the cost of such asset less its scrap or residual value is written off over such estimated life. The amount of depreciation for each year is found by dividing the difference between the cost and residual value by the number of years of the estimated life of the asset. To illustrate, let us assume that the cost of a certain ma- chine is $81.00, its estimated life is four years, and its residual or scrap value is $16.00. By deducting the scrap value, $16.00, from the cost, $81.00, we get $65.00, the amount the machine is expected to depreciate in four years, its estimated life. $65.00 divided by the number of years, four, shows $16.25, the annual amount of depreciation to be charged off. The amount of annual depreciation, $16.25 divided by the cost, $81.00, shows the rate of depreciation to be 20 5/81%. This is the simplest method for calculating depreciation and consequently is very popular. It is the method in general use, and is acceptable to the Interstate Commerce Commission and the Internal Revenue Department. The method has been criticized by some accountants and others for various reasons. DEPRECIATION 149 Sailers says in this connection: "It is free from interest complications, and its employment does not require a knowledge of the logarithmic or any other method of finding roots and powers of numbers. Speaking generally, there appears to be no reason why the straight line method does not approximate actual depreciation as nearly as any of the complicated curves at times advocated, apparently on the assumption that actual depreciation finds a counter- part in the accuracy of their mathematical computations." 2. Diminishing Value Method. In this method it is cus- tomary to estimate a minimum life of the asset and then depre- ciate the residual value each year. That is, instead of basing the annual depreciation during the life of the asset on the original cost, as in the straight line method, it is based on the value of the asset at the beginning of that period after having deducted the total amount of previous depreciation. A percentage rate is ascertained which, when applied each year to the balance remaining after the similar deduction for the preceding year, will reduce the balance to the scrap value at the end of life of the asset. Using the same problem as shown under the straight line method, it will be seen that it requires a rate of 33^% to reduce the asset to a scrap value of $16.00 in four years. Note the fol- lowing calculations : Original cost of machine $81 .00 Less Depr. (33^% of $81.00) 27.00 Value beginning of second year 54.00 Less Depr. (33^% of $54.00) 18.00 Value beginning of third year 36.00 Less Depr. (33^% of $36.00) 12.00 Value beginning of fourth year 24.00 Less Depr. (33^3% of" $24.00) 8.00 Residual or scrap value $16.00 It will be seen that the amount of depreciation is greater at the beginning but decreases with the life of the asset. It is held by some that this is reasonable because the cost of repairs and maintenance is least while the asset is new but increases as the asset is used. Therefore, the total depreciation and up- keep will be nearly uniform each year. On the other hand, the concern is forced to charge off a larger amount of depreciation at the beginning of its existence when profits may be small. Another objection is the fact that it involves a complicated mathematical calculation, and the annual rate of depreciation gives little indication to the ordinary man of the period required to write off the asset. 3. Annuity Method. In this method the plan is to esti- mate an amount which, if annually set aside at interest, would at the end of the life of the asset amount to the difference between cost and scrap values. A sum is determined which, when set 150 PUBLIC ACCOUNTING AND AUDITING aside each year at compound interest, will accumulate, during the life of the asset, and will just equal the scrap value at the end of its estimated life. Hatfield, in his Modern Accounting, says: "It rests upon the assumption that the cost of production includes not only repairs and the depreciation of machinery, but as well, interest on the amount of capital invested in the asset. Depreciation on this theory should be a sum figured as a constant annual charge sufficient not only to write off the decline in value, but also to write off annual interest charges on its diminishing value." Using the same problem as above, it will be seen that the annual amount of depreciation is equivalent to a rate of 27 47/162% based on the original cost. Note the following cal- culations: Original cost of machine $81 .00 Interest at 10% 8.10 89.10 Depreciation first year (27 47/162%) 22. 10 Value beginning of second year 67 .00 Interest at 10% 6 . 70 73-70 Depreciation second year (27 47 /i62%) 22 . 1 1 Value beginning of third year 51-59 Interest at 10% 5.16 56.75 Depreciation third year (27 47/162%) 22. 10 Value beginning of fourth year 34-65 Interest at 10% 3 . 46 Depreciation fourth year (27 47/162%) 22.11 Residual or scrap value $16.00 (Interest at the rate of 10 per cent was used for convenience in arithmetical calculations.) This method is objectionable because of the inclusion of interest on invested capital. Of course, the writing up of the asset is offset by the increased depreciation. The method is inconsistent unless interest is charged on all the capital invested. 4. Production Unit Method. In this method the estimated life of an asset is based on its production. The plan is to charge off an established rate per unit of output. It may be applied DEPRECIATION 151 to such assets as diminish in value in exact ratio to the amount used. For instance, if the machine mentioned above was designed to produce 1,000,000 units at a total cost of $1,000.00, the depreciation charge would be I mill per unit of production. Comparison of Methods for Calculating Depreciation. Walton says with regard to the significance of each method: "(a) The Straight Line Method distributes the burden of depreciation equally over all the years, without regard to the constantly increasing repairs. "(b) The Diminishing Value Method starts with a heavier burden of depreciation which gradually diminishes, the theory being that as the repairs increase on account of the increasing deterioration of the asset, the decreased depreciation tends to equalize the burden over the years. It also provides for a residual or scrap value, as the carrying value never reaches zero. "(c) The Annuity Method takes into consideration not only the cost of the asset, but also the interest on the diminishing value. As the credit to interest diminishes each year and the charge for depreciation remains constant, the net expense increases annually. In addition, few accountants are in favor of considering interest on the cost of fixed assets as an operating expense." Dicksee, a prominent authority, favors the first method for short-lived assets, the second for machinery in general, and the third for long-time terminable leaseholds and similar assets. Where courts have prescribed depreciation, they have generally allowed the basis of calculation to be left to the discretion of the company. This is also true with the Internal Revenue Department. The Interstate Commerce Commission prescribes the first method for figuring depreciation. It is compulsory with concerns coming under the Commission's Control. Accounting Procedure with Regard to Depreciation. Either a reserve for depreciation or a reserve fund may be created, or the asset account may be credited direct for the amount of the depreciation. (a) Writing Down the Asset. If the amount is credited direct to the asset account, it is known as writing down the asset. The principal objection to this plan is that the original cost of the asset is lost sight of. From an accounting standpoint, the asset accounts should show costs of assets on hand at the date of the Balance Sheet. If the depreciation is credited direct to the accounts with assets, this policy is interfered with making it necessary to analyze the accounts in order to ascertain the cost of assets. (b) General Reserve for Depreciation. Some firms create a general reserve for depreciation. This is considered poor accounting for the reason that the account includes the depre- ciation on all classes of assets and it is impossible to ascertain 152 PUBLIC ACCOUNTING AND AUDITING the net carrying value of any particular asset or class of assets without first analyzing the account. It is also difficult, if not impossible, to verify its accuracy as time shows how much the actual depreciation on a special class of assets has been. It will be seen, therefore, that the same objections may be made to either of these plans. (c) Specific Reserve for Depreciation. Without a doubt this is the best plan of all. The amount of depreciation is credited to a reserve for depreciation on each asset affected. This reserve is then deducted from the asset to which it applies in the Balance Sheet so that the asset is shown at its cost, less depreciation, and its present value shown as a current or fixed asset. This is the net carrying value to the business. (d) Reserve Funds. In all the above methods the effect of the provision for depreciation is simply to provide for depre- ciation and deterioration by setting aside a part of the profits annually and preventing their distribution. However, creating the reserve does not set apart a specific sum and label it for the purpose of replacing certain assets. Creating a reserve fund is entirely different from creating a reserve for depreciation. The object of the reserve fund is to set aside annually a certain sum estimated to be sufficient to replace a certain asset when it has become worthless or obsolete. In the first three methods outlined above, the problem of interest does not arise. When a reserve fund is created and a certain sum set aside and invested in securities, these securities will earn interest which in itself may increase the fund or may be treated as an income on the books and not a part of the fund. While this plan has its ad- vantages, at the same time it reduces the working capital of the company by tying up a certain part of its funds in such a manner that they cannot be used for any other purpose than that for which they were intended. By the reserve for depre- ciation methods, that part of the profits set aside, are retained in the business as working capital and may be reinvested in stock-in-trade or other assets, the income from which will very likely be greater than could be realized from a reserve fund invested in conservative securities. In order to illustrate the four methods explained above, let us assume that the depreciation on a certain machine costing $1000.00 amounted to 10 per cent the first year, or $100.00. Under the first plan a journal entry would be made as follows: Manufacturing Expense $100.00 Machinery $100.00 Note that the Machinery account is credited for the amount of the depreciation thus reducing its value on the books. Under the second plan the following entry would be made: Manufacturing Expense $100.00 Reserve for Depreciation $100.00 A general Reserve for Depreciation account is here credited. The same account would also be credited for the amount of DEPRECIATION 153 depreciation on buildings, furniture, delivery equipment and possibly even for a reserve for doubtful accounts. The asset account with Machinery is not affected by the entry. Under the third plan the following entry would be made: Manufacturing Expense $100.00 Reserve for Depr. on Machinery. $100.00 A special Reserve for Depreciation on Machinery account is credited. The asset account with machinery is not affected. In stating the value of machinery in the Balance Sheet, the reserve for depreciation on machinery is deducted and only the net amount listed as an asset. Under the last plan two entries are necessary, the first setting up the depreciation and the second establishing the reserve fund. (First Entry) Manufacturing Expense $100.00 Reserve for Depr. of Machinery. $100.00 (Second Entry) Reserve Fund $100 . oo Cash $100.00 It will be seen that the first entry is the same as that under the third plan above. The second entry is entirely different and is really no part of the depreciation entry. After this last entry has been made the cash would be turned over to a trustee, much the same as in the case of a sinking fund, and he would be instructed as to the handling of the fund. It is usually invested in high-grade securities. Appreciation. It is always unwise to write up the value of assets even when they have undoubtedly increased in value. If we are to stick to the rule that no profit can be made except through sales, then we can never, under any circumstances, show appre- ciation of assets by increasing their book value. Sometimes it is held that the appreciation offsets the de- preciation and that no provision for depreciation need be made. For instance, the increase in the market value of agricultural land, might be such that it would seem that no depreciation should be considered. The fact is that the present increase in market value is a mere fluctuation in prices and may suddenly decrease while the productive value would not in the least be affected by such fluctuation. Experience has shown clearly that agricultural land is depreciating in productive value through its use. At present the upkeep is not such as to maintain the original productive value of such land and therefore, it is ad- visable to provide for certain depreciation. Under no circumstances should an estimated appreciation of one asset be considered to have offset the depreciation of the same or another asset. 154 PUBLIC ACCOUNTING AND AUDITING INCOME TAX PROCEDURE Depreciation is a Proper Deduction from Income. It has been shown that depreciation is an operating expense and that it should be charged off by writing down the value of the fixed assets or by setting up a reserve for depreciation, preferably the latter. The Income Tax Law has clearly recognized this theory. Income Tax Law. Section 214 (a-8) [Individuals]; Sec- tion 234 (a-y) [Corporations]. "In computing net income there shall be allowed as deductions: "A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business." Capital Expenditures not Deductible. Expenditures which actually increase the value of the assets cannot be deducted as an expense. Income Tax Law. Section 215 for individuals and Sec- tion 235 for corporations. "That in computing net income no deduction shall in any case be allowed in respect of "Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." Replacements and Renewals must not be Deducted Twice. As previously explained expenditures for repairs and replacements cannot be deducted as an expense and again be provided for through a depreciation reserve. Income Tax Law. Section 214. (c) "That in computing net income no deduction shall in any case be allowed in respect of "Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made." (Reg. No. 33, 1918, ^ 432.) "The cost of incidental repairs which neither add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as expense, provided that the plant or property account is not increased by the amount of such expenditures. Such repairs, to the extent that they arrest deterioration, should have the effect to reduce the depreciation charge otherwise deductible." Income Tax Primer, 1918, question 99. Ruling. "If a tax payer wishes to claim the full amount of depreciation es- timated to have occurred in the value of a building or other property used for business or trade purposes, he may do so, but this precludes his claiming a deduction to cover any amount expended during the same year in making repairs. If he wishes to claim a deduction on account of repairs, their cost must be deducted from the full amount of depreciation, and the balance DEPRECIATION 155 may then be claimed as a deduction under the heading of 'De- preciation'; that is, if the tax payer expends $100.00 in making repairs to a building which will depreciate in value $200.00 during the calendar year he may claim $100.00 as a business expense and $100.00 as depreciation, or he may claim $200.00 as depreciation and nothing for repairs, in short, the aggregate deductions claimed on account of repairs and depreciation must not exceed the full amount of depreciation estimated to have occurred. (Note The repairs referred to in this para- graph are such as are general in character, represent replace- ments, etc. Small items, such as replacement of broken window panes, papering, minor repairs, etc., are allowable, even though full amount of depreciation has been claimed.)" Depreciation must be Entered on the Books or it Will not be Deductible. The 1918 law does not specify that de- preciation must be charged off on the books of an individual or a corporation, but the commissioner is given ample power to enforce proper accounting methods and the following regulations show that he has done so. (Reg. No. 33, 1918, ^[ 484.) "Within the purview of this item depreciation, to an amount measuring the decline in value due to exhaustion, wear and tear of property arising out of its use, is a loss. This loss, in order to constitute an allowable deduction from gross income, must be charged off. The particu- lar manner in which the amount shall be charged off is not material, except that the amount measuring a reasonable allow- ance for depreciation must be either deducted directly from the book value of the assets or credited to a Depreciation Reserve account, and as such shall be reflected in the annual Balance Sheet." (Reg. No. 33, 1918, ^[ 480.) "The fact that no reserve was made for depreciation indicates that there is no loss on this ac- count to be provided for." Basis of Depreciation. (T. D. 2754, Aug. 23, 1918.) "A reasonable allowance for the wear and tear of property arising out of its use or employment in the business or trade is to be based on the cost of such property or on its fair market price or value as of March i, 1913, if acquired prior thereto. In the absence of proof to the contrary, it will be assumed that such value as of March I, 1913, is the cost of the property, less depreciation up to that date." Rates of Depreciation. (Reg. No. 33, 1918, 1[ 485.) "No definite rate has been fixed by which an allowable deduction on account of depreciation in the value of any class of property subject to wear and tear is to v be computed, but it is contemplated that this allowance shall be computed upon the basis of the cost of the property and the probable number of years constituting its life. The deduction to be allowed relates solely to loss due to use, wear and tear, and the matter of ob- 156 PUBLIC ACCOUNTING AND AUDITING solescence is not relevant, inasmuch as when the property be- comes obsolete a deduction for the loss sustained thereby, repre- senting the difference between the cost and the amount of de- preciation previously charged off or which should have been charged off in prior years will be allowed." It will therefore, be noted that the law makes no reference to definite rates of depreciation. Neither does the Treasury Department specify rates which shall be considered satisfactory. The law merely specifies that the depreciation allowances shall be "reasonable." REVIEW OF THE LAW OF CONTRACTS As to time of performance, contracts may be divided into two classes EXECUTORY and EXECUTED. A contract is said to be executory when some condition remains to be performed. It is an engagement to do or not to do a particular thing. All contracts are or have been executory. A contract is said to be executed when all the conditions have been performed and nothing remains to be done. An unpaid note is an example of an executory contract, but when paid it becomes an executed contract. The chart on page 62 of Chapter Five shows that a contract may be discharged "by performance." When all the conditions to a contract have been performed the contract is discharged. These conditions may be classified according to the time at which they should be performed, and are known as (a) PRECEDENT CONDITIONS, (b) CONCURRENT CONDITIONS, and (c) SUBSEQUENT CONDITIONS. A Condition Precedent exists when some condition must be performed by one party before the other party becomes obli- gated to perform his part of the contract, or when some con- dition must be performed before a contract exists. A Condition Concurrent exists when a condition must be performed by one party at the same time that the other party is required to perform some other condition of the same contract. The one party must perform or offer to perform the conditions imposed by the contract, at the time the demand for perfor- mance is made upon the other party. Otherwise, the other party cannot be said to have committed a breach. A Condition Subsequent exists when the occurrence of some fact will destroy the contract in the event it happens, provided the parties have expressly agreed thereto. Sunday Contracts. Contracts made on Sunday are void or at least unenforceable under statute law in practically all the states. Statute law forbids work, labor or business on Sunday, unless it can be shown that they relate to works of mercy, charity or necessity. Examples of Sunday contracts which are usually THEORY QUESTIONS 157 enforceable, are such as the providing of food or medicine in cases of emergency or for the performance of services under unavoidable physical conditions which would entail serious loss or injury if deferred. However, contracts made on Sunday and ratified on a "business" day or contracts delivered on a "business" day and to take effect from delivery and not from execution are good and enforceable. Contracts or agreements are illegal which are entered into on Sunday to be performed on a week day, or which are entered into on a week day to be performed on a Sunday. Contracts by Correspondence. An offer may be made by mail, or by telegraph, as well as in person or through an agent or representative. It may be accepted in the same manner unless the offer specifies the method of acceptance. An offer may be conditional and one of the conditions may relate to the method of acceptance in which case the condition must be com- plied with. In fact, all the conditions of an offer must be accepted before a contract is made. In other words, an acceptance must be unconditional. A person who offers to contract is known as the offerer, and the person to whom an offer is made is known as the offeree. The offeror may specify the time in which an offer must be accepted, otherwise the offer must be accepted within a reason- able time. An offer made by letter or telegraph may be with- drawn by a subsequent communication provided it reaches the offeree before he has accepted. As soon as the acceptance is placed in the hands of the telegraph company or mailed, a contract exists. That is, when the letter has been mailed, or has been dispatched by the tele- graph company, and cannot be withdrawn. If the acceptance is not made by the same method as the offer, then the contract does not exist until acceptance is received. The carrier is the agent of the offeror and is responsible to him for the delivery of the acceptance. A. THEORY QUESTIONS 1. What is depreciation? What items in a business are subject to depreciation? How is it ascertained? C. P. A. Ark. 2. Name three methods of computing depreciation on machinery, buildings, etc. How should such depreciation be shown on the Balance Sheet? C. P. A. Ohio 3. A corporation makes a practice of charging to expense and carrying to depreciation reserve account every half year, a certain percentage of the book value of its plant and machinery. Should repairs and renewals be charged to Profit and Loss, or can they properly be charged to depreciation reserve accounts? Give reasons in full. C. P. A. Mass. 158 PUBLIC ACCOUNTING AND AUDITING 4. How should a re-appraisal of capital assets be treated on the books of a going concern. (a) When it involves an appreciation? (b) When it involves a depreciation? Is such appreciation or depreciation a consideration which should be reflected in a return of net income to the federal authorities for income and excess -profits tax purposes? Inst. Ex. 1918. 5. Give some general principles which will guide you in determining whether too much or too little provision has been made for depreciation of buildings, machinery, tools, goodwill, patents, franchises, etc. Would a flat rate cover all these assets satisfactorily? Inst. Ex. 1918. 6. You are asked by a client to discuss with him the ques- tion of reserves for depreciation and depletion of his various capital assets. State your position on this subject and enum- erate the consideration you would advance in support thereof. Would you or would you not be guided by the rules laid down by the internal revenue authorities in deciding the rates to be used? Inst. Ex. 1918. 7. Explain the relationship between a sinking fund and an allowance for depreciation. It is claimed that in municipal enterprises the requirement that rates must be high enough to provide both for a sinking fund to pay off the bonds and also for a "Reserve for Depreciation" with which to replace the plant results in a double charge to consumers. Criticize or explain this theory. Inst. Ex. 1917. 8. On pointing put the insufficiency of the provision for depreciation on machinery, which the directors admit, you are met with the argument, supported by evidence, that the real- estate values have appreciated to an even greater extent than the entire depreciation of other assets. As this latter is not taken up on the books you are asked to allow the one to offset the other. Give reasons for your agreement or disagreement. Inst. Ex. 1918. B. ACCOUNTING PROBLEMS i. The officers of a company of which you are the auditor elected by the stockholders, submit to you for audit a Balance Sheet in which the following item appears: Miscellaneous reserves (including premium on stock) $248, ooo.oo. On investigation you find the item is made up as fol- lows : General reserve $86,000.00 Operating reserves 6,000.00 Provision for plant depreciation 46,000.00 Provision for amortization of leaseholds 40,000.00 Provision for bad debts 36,000.00 Premium on capital stock sold 34,000.00 $248,000.00 ACCOUNTING PROBLEMS 159 What recommendation would you make to the officers and what course would you take if your recommendation were not followed? Inst. Ex. 1917. 2. A machine costing $10,000.00 was estimated to have a life of ten years, with a residual value of $1,000.00. At the close of each year a charge of $900.00 was made and a similar amount credited to "reserve for depreciation." Just prior to closing the books at the end of the tenth year the machine was discarded and sold, bringing $2,000.00, and a similar machine was bought costing $15,000.00. Give the journal entries that you would make to close the books at the end of the tenth year in order to cover these transactions and to make the neces- sary adjustments. Interest is not to be calculated. Inst. Ex. 1917. 3. You are an auditor engaged by a corporation to audit their accounts. At the beginning of the period you are to cover, the following statement is drawn from the books: Capital $100,000.00 Surplus i ,000.00 Accounts Receivable $10,000.00 Buildings after deducting $5,000.00 for depreciation 35,000.00 Machinery after deducting $5,000.00 for depreciation 55,000.00 Cash 500.00 Stock on hand : 500.00 $101,000.00 $101,000.00 During the period which you are auditing, you find buildings and machinery charged with $10,000.00 which was to cancel the entries of depreciation. The entries were authorized according to the minute book, but not entered correctly in the general books. Formulate the necessary entries for the bookkeeper. Explain what method had been used in recording the depreciation previously charged off. Can you suggest a better method? Do you think that, under any circumstances, it is wise to charge the depreciation, previous- ly charged off, back to the asset accounts? Explain fully. C. P. A. Mich. . 4. In your examination of the Automobile Delivery Truck account of a company, you find the following entries: AUTOMOBILE TRUCKS 1914 Jan. I Trucks I, 2, 3, 4, @ $1200. $4,800.00 July i Trucks 1,500.00 Aug. I Truck 6 1.500.00 $7,800.00 1914 Aug. i Truck 2 .... $ 900.00 Sept. i Truck 4. ... 750.00 i Balance.... 6,150.00 $7,800.00 I6o PUBLIC ACCOUNTING AND AUDITING The reserve for Depreciation for Automobile Delivery Truck account stood credited on January I, 1914, with $1,800.00. Upon analyzing the transactions represented by these items you find the following facts : (a) Truck 5 purchased July i replaced Truck I. The portion of the reserve for depreciation accumulated on January I for Truck I amounted to $900.00. Truck 5 was purchased on open account. (b) Truck 2 was traded in for $850.00 on the purchase of Truck 6 costing $1,500.00. The difference was paid in cash. The reserve which had been accumulating for depreciation on Truck 2 on January i , amounted to $300.00. (c) Truck 4 was totally destroyed in an accident Sept. i . The reserve for depreciation on this truck amounted on January I to $300.00. Assume the rate of depreciation to be 25% per year. Give journal entries which would properly record the above facts and show the balances of all accounts affected, as of Sept- ember i, 1914. . C. P. A. Mich. (Note. You are not asked to make correcting entries for those already on the books but you are asked to make entries which will properly record the transactions. Be sure to charge Operating Expense and credit the Reserve for De- preciation account for the amount of depreciation from Jan. I, 1914, to the date of the transaction. This should be done before recording the transaction. In order to determine the proper balance of the Reserve for Depre- ciation account on Sept. I, 1914, it will first be necessary to set up the de- preciation on trucks 3, 5 and 6.) C. LEGAL QUESTIONS (Note. The following questions are all taken from examinations held by the American Institute of Accountants and are, therefore, of the highest professional standard. They are given as a review.) 1. When can an offer to perform a contract be withdrawn? 2. What is a tender to perform a contract and what are its effects? 3. (a) Define mistake and give its effect on contracts, (b) Define misrepresentation and state its effect. 4. "When may a creditor enforce a contract with a minor? 5. A, in New York City, wrote B, in Buffalo, offering certain goods for sale at a certain price. B wrote a letter to A accepting the offer and posted in Buffalo. Before A received the letter he received a telegram from B stating that he with- drew the acceptance. Was a valid contract made? Explain the principles involved. ^j " Chapter Eleven CURRENT LIABILITIES Liabilities are the financial obligations of a firm. They may be divided into two principal classes, Current and Fixed. Current liabilities are those obligations that mature in a short period of time. They are usually undergoing a constant change. There should be sufficient current assets owned by a firm that may be realized upon quickly, if necessary, in order to liquidate the maturing current liabilities. It is in this con- nection, a banker is always concerned, when considering a request for a loan. The current liabilities may be divided into four classes unsecured, secured, contingent and accrued lia- bilities. A Balance Sheet audit for credit purposes is more concerned with the current liabilities than with the fixed liabilities. The banker does not extend credit to merchandising or trading con- cerns with the view of furnishing additional capital, but rather to enable them to carry a large stock-in-trade during a busy season, or to enable them to discount their accounts payable at a time when the company's quick assets are composed largely of stock-in-trade and accounts receivable. Banks advance money on short time or call loans and, naturally, the current assets of the borrowing company must be such that it is apparent sufficient funds may be realized to liquidate all current liabilities. Of course, the auditor must satisfy himself that all the fixed liabilities are properly stated, otherwise he could not certify as to the actual financial condition of the business. ACCOUNTS PAYABLE Accounts payable appear in the Balance Sheet as current liabilities. Different terms are applied to these accounts, such as Purchases Ledger accounts, Creditors' accounts, Vouchers Payable, etc. 1. ACCOUNTING THEORY Accounts with Creditors. These accounts may be kept in the general ledger, but it is customary to keep only a con- trolling account in the general ledger and to keep the individual accounts in a subsidiary ledger, known as a purchases ledger or creditors' ledger. 161 162 PUBLIC ACCOUNTING AND AUDITING The Purchases Ledger. It is important that only ac- counts payable for purchases be recorded in this ledger. These accounts should represent trade creditors. Liabilities on ac- count of accrued interest, taxes, wages, etc., should appear in the Balance Sheet as separate items and should not be included with accounts payable. The Purchases Ledger Controlling Account. When a separate ledger is kept with accounts payable, a controlling account should be kept in the general ledger and the balance of the controlling account should show the same results as the total of the balances of accounts in the subsidiary ledger. The pur- pose of this controlling account is to make the general ledger self-balancing and to enable the general ledger bookkeeper to prepare a Trial Balance from the general ledger without the necessity of first ascertaining the balances of all the individual accounts payable. It also separates the work of the book- keepers and by planning the work so that the individual ledger bookkeeper does not have access to the general ledger, it will constitute an internal check on his work. To establish a subsidiary purchases ledger and a controlling account for same in the general ledger, assuming that the ac- counts with creditors have previously been kept in the general ledger, make a journal entry as follows: Accounts with Creditors xxxxx.xx Purchases Ledger Controlling Acct . . xxxxx . xx To establish a subsidiary ledger for accounts with creditors. See schedule following: Each creditor's account in the general ledger is debited with the amount 'shown in the schedule and should then balance. After posting the total amount of accounts payable to the credit of the controlling account, each individual account in the pur- chases ledger should be credited with the proper amount as shown in the schedule. After the entry has been properly posted, the balance of the controlling account will equal the total of the balances of the accounts in the purchases ledger. After the purchases ledger has been opened and the accounts all transferred from the general ledger, these accounts will be debited and credited from the books of original entry in the usual manner. However, special columns will usually be cre- ated in the original books of account so that only the totals of these columns need be posted to the controlling account in the general ledger. The Voucher System. One frequently hears of the voucher system of bookkeeping. As a matter of fact it is not a system of bookkeeping at all, but is a method of recording invoices representing all expenditures incurred, whether for material, labor, indirect expenses, selling expenses, adminis- trative expenses, and even for additions to the plant, equipment, etc. THE VOUCHER SYSTEM 163 It is said to be a combination of the purchases book and the purchases ledger, but this is rather an exaggeration. It is true, however, that with the voucher system in use, it is cus- tomary to dispense with the purchases ledger. In fact, this is the means of its representing a considerable saving of time. There is also a saving in time in the distribution of the various charges to materials and expenses. The Voucher Jacket. Every invoice received, after being approved for receipt of goods, prices, and extensions, might be marked with the names of the accounts to be charged and the amount chargeable to each. The invoice might also be given a number from the voucher register. It can readily be seen that to indicate all this information on the invoice itself would be anything but good practice. Therefore, it is customary to use a form especially prepared for this purpose. This form is called a voucher jacket or an accounts payable voucher. It provides for recording the number of the voucher, name of the creditor, date, amount, and classification of the items listed in the invoice for which the form is made. There is also pro- vision for information as to the date and method of payment. The names of the accounts most frequently affected are printed on the form so as to save time and facilitate proper classifica- tion. The Voucher Register. This book contains columns for the voucher number, date of invoice, date and method of pay- ment, vouchers payable credit, and a series of money columns for the various accounts to be debited. A sundry column is provided for unusual accounts. After the invoice is received and has been approved, it is placed in the voucher jacket or attached to the accounts payable voucher, often together with the purchase requisition, purchase order, and material received sheet and is then recorded in the voucher register and properly filed with the unpaid vouchers, usually under its due date. When the invoice becomes due it is removed from the file and after the check has been written, it is recorded on the voucher jacket or accounts payable voucher and then filed among the paid vouchers. Of course, a memorandum is made in the voucher register showing date and method of payment. This check is then recorded in the cash book where a special column for vouchers payable is provided for. The Vouchers Payable Controlling Account. This account takes the place of the Purchases Ledger Controlling account and is in itself a controlling account for vouchers pay- able. This account is credited for the total of the vouchers payable column in the voucher register and is debited for the total of the vouchers payable column in the cash book. The balance of the account represents a current liability. When all invoices have been paid the account will balance. The balance of this account may be verified by preparing a list of the unpaid vouchers. 164 PUBLIC ACCOUNTING AND AUDITING The advantages of this system have already been pointed out. No purchases or creditors' ledger is required. Most'of the expense accounts need be posted but once a month and then the total only is posted from the voucher register. The voucher jacket may contain a complete history of the purchase trans- actions from the time the requisition is made until the check issued in payment therefor has been cancelled and returned from the bank. On the other hand, the system has its disadvantages. Par- tial payments on invoices, that is, payments -on account, are practically impossible. Furthermore, this system does not readily show the total present balance due a given creditor, neither does it show the total amount of business done with a creditor for a given period. Of course, ledger accounts with individual creditors might be kept in connection with the voucher system, but in this event the saving in time, for which the sys- tem is noted, would be lost. Under certain conditions the voucher system may be used advantageously, but under other conditions its use is often burdensome.* Classification of Accounts Payable in Balance Sheet. The Federal Reserve Board requires that the accounts payable be divided and classified in the Balance Sheet under unsecured accounts as follows: Accounts Payable for Purchases (not yet due) xxxxx . xx Accounts Payable for Purchases (past due) xxxxx . xx Accounts Payable to Stockholders, Officers, or Employees xxxxx. xx (See Model Balance Sheet for credit purposes, page 41, Chapter Three.) 2. AUDITING THEORY. Quoting from the Federal Reserve Bulletin on Uniform Accounting: Verifying Accounts Payable. "A list of balances due on open accounts must be prepared and carefully checked with the ledger accounts, care being taken to see that no open account on the ledger has been omitted from the list. It should be ascer- tained that the balances represent specific and recent items only. When any account does not appear regular, a statement should be obtained from the creditor. If there are many such accounts in dispute, and they amount to so large a sum as to (*Note. In this discussion of the voucher method for handling invoices, there has been no attempt to explain the many variations of the systems that will be encountered in practice. It has not been considered necessary to illustrate the different forms and ruling of the books used as these are shown in any bookkeeping text that is at all up-to-date. We refer you to "2Oth Century Bookkeeping and Accounting," Part IV, for a complete dis- cussion of all the principles involved and for illustrations of the voucher jacket, voucher check and vouchers payable book. Similar information should be obtainable from any standard text on bookkeeping and accounting.) ACCOUNTS PAYABLE 165 affect appreciably the total of current liabilities, the general causes for the disputes should be inquired into and note made of the matter for the consideration of the banker. Voucher Systems. "In concerns with modern voucher systems accounts payable are easily verified, as all liabilities are then included in the books when incurred. Care should be taken, however, to see that all goods received on the last day of the fiscal period, as shown by the receiving records, and also all goods that were in transit and belonged to the concern on that date, are included as liabilities, and the corresponding assets included in the inventories. This test is necessary, as an increase in the accounts payable may have a very important bearing on the financial position of the concern if the cash on hand is small. "Monthly expenses outstanding can usually be ascertained by a comparison of the expenses of the last month of the fiscal period with previous months, and those of the year with the previous year. The voucher record should, however, be ex- amined for the months subsequent to the close of the fiscal year, in case any expenses included therein are applicable to the fiscal period under audit. Detecting Unstated Liabilities. "When a first-class voucher system is not in operation, the auditor must take addi- tional precautions to satisfy himself that all liabilities are in- cluded in the accounts, among which may be mentioned: "(i) Payments made in the months subsequent to the date of the fiscal period as shown by the cash book, which should be carefully scrutinized to see that none of them is applicable to the period under review. "(2) The file of bills not vouchered or entered on the books should be examined to see that none of them belongs to the period under audit. "(3) A careful perusal of the minutes of a company may further assist the auditor in determining liabilities. Purchase Contracts. "When a company has large pur- chase contracts in force for future deliveries they should be ex- amined, for if the contract prices are greater than market prices, it might be necessary to set up a reserve for this loss. Any debit balance due to advance payments on such contracts or to any other cause should be shown on the Balance Sheet under a separate heading. Consignment Purchases. "If the business under audit is one where there is any possibility of goods having been re- ceived on consignments, and part or all of such goods having been sold without a liability therefor having been shown in the books, the auditor must use all due diligence to cover the point fully. This may readily happen, as consignment accounts are usually treated as memoranda only. 166 PUBLIC ACCOUNTING AND AUDITING "If inquiry develops the fact that goods have been received on consignment, all records in connection therewith should be called for. If the goods have all been sold, the consignor's ac- count should show the full amount due, and if the debt is a current one, the amount will appear among accounts payable due to trade creditors. Where only part of the goods have been sold, the net proceeds due to the consignors should be shown on the Balance Sheet under the caption of 'Accounts payable consignors.' Certificates. "As an additional precaution against the omission of liabilities, a certificate should be obtained from the proper officer or member of the concern stating that all out- standing liabilities for purchases and expenses have been in- cluded in the accounts of the period under review or of former periods. In many cases it is also advisable to obtain a cer- tificate from the president stating that all liabilities for legal claims, infringements of patents, claims for damages, bank loans, etc., have been included, as he may be the only executive officer of the company to know the extent of such obligations." NOTES PAYABLE Notes payable are usually classed as current liabilities in the Balance Sheet. Under this title will usually be included drafts, notes and trade acceptances. There need be no attempt to keep separate accounts with drafts and notes. To dp so would only be a waste of time for the information given is of no practical value. Some bookkeepers still use the term "bills payable." This matter was discussed on page 66 of Chapter Five, undei the heading of "Terminology." Mr. Walton, in the November, 1919 number of The Journal of Accountancy, in writing upon this subject, says: "The accounting profession has not differentiated as yet between notes payable and bills payable. "In England and in continental Europe drafts or bills of exchange have been a more customary method of handling credit transactions than notes payable. In England, where most of our accounting terminology originated, bills of exchange were much more common than notes; therefore, they used the term bills payable and bills receivable, and whenever a few notes were given they were entered in the account with the bills. "In this country the custom has been exactly the reverse. We have been accustomed to giving notes rather than accept- ing bills of exchange; but we have used the English terminology of bills payable until recent times. Realising that the term bills payable was not as appropriate in this country as in England, a movement has been on foot to change the terminology from bills payable to notes payable and this movement has met with considerable success so that the term notes payable rather than bills payable now frequently' appears in Balance Sheets. NOTES PAYABLE 167 "Strictly speaking a promissory note is a note payable; a trade acceptance is a bill payable; but I am inclined to think that as trade acceptances become more prevalent they will be recorded in a Trade Acceptance account rather than a Bills Payable account. "The statement that notes payable should always bear interest is not correct. Interest is an immaterial detail which may be found in a bill of exchange or trade acceptance as well as in a note and is not essential to either. In an accounting sense, bills payable are always notes or acceptances payable at a future date, and the term does not include cheques or sight drafts. "The objection to the term bills payable is that in this country many business men not being accustomed to bills of exchange think the term refers to the bills rendered by their creditors which are payable every month." 1. ACCOUNTING THEORY Recording Notes Payable in Original Books of Account. Like notes receivable, there are two principal methods of record- ing drafts and notes. The first method is to record them in the general journal and to keep a memorandum record in an auxil- iary notes payable book. This memorandum record does not constitute a posting medium as all posting would be done from the journal. The notes payable book should provide columns showing date given, number, drawer or endorser, maker or drawee, payee, where payable, due date, amount, rate of in- terest and when paid. Notes Payable Book as a Posting Medium. The second method is to record drafts and notes in a notes payable book instead of the journal and so arranging the record that it not only shows a complete record of the drafts and notes, but also constitutes a posting medium. In addition to all the columns mentioned under the first method described above, there should also be columns provided to enable the bookkeeper to post the totals to the proper accounts in the ledger. This may vary somewhat depending upon the particular system of accounts in use, but usually there will be columns headed notes payable credit, interest debit, interest credit, purchases ledger debit and general ledger debit. Notes Payable Account. This account may show indi- vidual entries for each note and draft recorded in the books of account. However, if the second method for recording notes is followed, then this account will be a summary account. It will be credited for the total of the notes payable column in the notes payable book and will be debited for the total of the notes payable column on the credit side of the cash book. If no spe- cial column is provided in the cash book, then it will be debited for the individual notes recorded therein. 168 PUBLIC ACCOUNTING AND AUDITING Trade Acceptances Payable. Trade acceptances receiv- able were discussed on page 66 of Chapter Five. The method of recording trade acceptances payable should be similar to that for recording trade acceptances receivable. Reference to the Model Balance Sheet for credit purposes on page 41 of Chapter Three will show that acceptances made for merchandise and raw material should be stated separately. Therefore, it will readily be seen that if a separate account is kept in the general ledger, it will not be necessary to analyze the Notes Payable account to determine this information. If a separate account is kept, it will either be necessary to record them in the general journal or provide a special trade acceptances book similar to the notes payable book described under the second method on page 167 of this chapter. Classification of Notes Payable. In preparing a state- ment for credit purposes, the Federal Reserve Board requires that notes payable be classified in the Balance Sheet as follows: 1. Notes given for merchandise or raw ma- terial purchased xxxxx.xx 2. Notes given to banks for money bor- rowed xxxxx . xx 3. Notes sold through brokers xxxxx.xx 4. Notes given for machinery, additions to plant, etc xxxxx.xx 5. Notes due to stockholders, officers, or employees xxxxx.xx These are known as "unsecured liabilities." Notes and accounts payable, secured by liens on inventories, or by securi- ties deposited as collateral, should be stated separately as "secured liabilities." (See page 41 of Chapter Three.) 2. AUDITING PROCEDURE Quoting from Federal Reserve Bulletin on Uniform Ac- counting: "Under this caption appear notes payable and drafts accepted. Schedules should be prepared under the subcaptions, and in columns headed: 'Date of making the notes or drafts. 'Due dates. 'Names of creditors. 'Collateral hypothecated. 'Additional endorsers. 'Interest accrued to date of audit. 'Notations of renewals (as information of this nature furnishes a guide to the state of the concern's credit.) "The schedule must be compared with the notes payable book and the total of the aggregate must agree with the balance of the ledger account of notes payable. CONTINGENT LIABILITIES 169 "Statements must be obtained from all banks and brokers with whom the concern does business, showing all notes and drafts discounted or sold by them for the benefit of the con- cern. These statements when received must be checked against the loans shown on the concern's books and approved in the minutes of the company. "Inasmuch as a note is a negotiable instrument, care must be taken to see that all of those recorded as paid during the year under audit have been properly discharged, and the can- celed notes are the best evidence of this fact. "Careful attention should be given to the collateral depos- ited for loans, and statements as to the existence of such col- lateral should be obtained from the holders thereof. Such hypothecation of any of the concern's assets should be accounted for on the Balance Sheet. "When practicable, the auditor might suggest to the client the advisability of drawing notes payable on blanks bound in a book, like a check book, with a stub for each blank, the blank and the stub to bear identical numbers. The officer, or officers, signing the notes could, in such case, initial the stub as a cer- tificate to the amounts, payees, and terms of the notes issued. If this were done, the auditing of bills payable would be greatly facilitated." CONTINGENT LIABILITIES It has previously been pointed out that a Balance Sheet audit involves the detection of all unstated liabilities as well as verification of those appearing on the books of account. The discovery of contingent liabilities is not a simple matter and is often almost impossible, especially where an attempt has been made to conceal them. Many an individual or firm has suffered a loss and even became bankrupt because of being compelled to meet obliga- tions which did not arise out of the usual operation of business, obligations which did not in any case appear on the books of account. Almost everyone is familiar with some instance wherein an individual or firm who had endorsed a note only as a matter of accommodation, and later through unforeseen cir- cumstances was compelled to meet it because of the inability or failure of the maker to do so. The author recalls an experience of an audit of a manu- facturing company. During the course of the audit we learned that another company had brought suit on the basis of infringe- ment of patent rights. This company had purchased certain patent rights costing several hundred thousand dollars and had set up the cost as an asset, and was charging this off over a period of years based on the life of the patents. Further investigation revealed the fact that the result of the suit was quite uncertain. The company had been using these patented machines for several years. The plaintiff asked for damages based on the total production of the machines. We called i?o PUBLIC ACCOUNTING AND AUDITING attention to this action in our report and advised that a fund be set aside out of profits until such time as the court had reached a decision. Several months later our client lost the suit and was forced to pay several thousand dollars damages. It will be seen, therefore, that contingent liabilities are likely to become real and an auditor must be very careful to make every effort to detect them. Auditing Procedure. (Federal Reserve Bulletin.) "It is not enough that a Balance Sheet shows what must be paid; it should set forth with as much particularity as pos- sible what may have to be paid. It is the duty of an auditor who makes a Balance Sheet audit to discover and report upon liabilities of every description, not only liquidated debts but possible debts. The following are the usual forms under which contingent liabilities will be found: Endorsements. "Inquiry of the officers or partners of the concern should be made as to whether any endorsement of outside paper has been made and as to any security received to protect the concern. Such inquiry should be particularly strict if it is known that any of the officers or partners are inter- ested in other enterprises. Guaranties. "Similar action should be taken in the mat- ter of guaranties. Unfulfilled Contracts. "Contracts to accept the delivery of goods contracted for before the date of the Balance Sheet, may call for the payment of large sums of money within a short time. In the case of raw materials, for a manufacturer, this might be a perfectly legitimate reason for seeking a temporary loan pending production and sale, but for a merchant whose Balance Sheet shows a large stock of goods on hand, it might indicate a real liability impending with assets of a doubtful character to offset it. In every audit, therefore, the auditor should call for copies of all orders for future delivery, and if such orders call for stock in excess of the current and reason- able prospective demand, mention should be made on the Bal- ance Sheet and a report submitted, the details depending upon the circumstances of each particular case. "Items other than those arising from the specific hypothe- cation of current assets should appear as a footnote on the liability side of the Balance Sheet, the total amounts being stated for each subheading and such additional report made as will convey clear information to the banker." It will be seen, therefore, that there are two different methods for classifying contingent liabilities. Those based upon "specific hypothecation of current assets" should be listed on the credit side of the Balance Sheet among the secured liabili- ties. These are contra entries because the hypothecated items also appear among the current assets. ACCRUED LIABILITIES 171 Such contingent liabilities as accommodation endorse- ments, actions or suits pending against client, guaranties, etc., should at least be mentioned in a footnote on the liability side of the Balance Sheet and should be accurately outlined in the report to the client. ACCRUED LIABILITIES All accrued liabilities should be classed as current liabilities in the Balance Sheet. These are not difficult to ascertain as they can be accurately determined and the amount calculated from the accounting records. Auditing Procedure. (Federal Reserve Bulletin.) "Under this caption are grouped such items as interest, taxes, wages, etc., which have accrued to the end of the period under audit, but are not due and payable until a later date. The verification of such items can be accurately made from the books and records. Special attention may be directed to the following: Interest Payable. "Many of the liabilities which appear on a Balance Sheet carry interest. Such items as bonds and notes payable are obvious, but the auditor should also consider the possibility of accounts also bearing interest, as enough book accounts, when past due, to bear interest to warrant inquiry being made. Loan accounts of partners and officers of corpora- tions almost invariably bear interest; also judgments, overdue taxes, and other liens. Taxes. "The amount of accrued State and local taxes can be ascertained from an examination of the latest tax re- ceipts; though in some cases, as the period for which the taxes are paid is not shown on the face of the receipt, it may be neces- sary to make inquiries of the proper taxing authorities as to the period covered. "Under the Federal Income Tax Law a tax is imposed upon the net profits of a corporation, which must be paid even if the corporation is dissolved before the end of the year during which the tax is imposed. As the tax is specifically based upon the net profits of a particular period, although payable some months thereafter, the tax accrues throughout the specified period, and if a net profit is disclosed upon the closing of the books at any date during the year, a reserve equal to the amount of the accrued tax must be shown on the Balance Sheet. Wages. "Where the date of the Balance Sheet does not coincide with the date to which the last pay roll of the period under audit has been calculated, the amount accrued to the date of the Balance Sheet must be ascertained and entered as a liability, unless such amount is trifling. It will suffice to take the proportion of a full week's pay roll (six days) without ref- erence to possible daily variations. 172 PUBLIC ACCOUNTING AND AUDITING Water Rates, Etc. "Where bills for such expenses as water, gas, etc., are not rendered monthly, the auditor must enter the accrual of the proper proportion since the last bill as a liability. Traveling Expenses and Commissions. "It is important to note whether the accounts of all traveling salesmen have been received and entered before the books are closed. The auditor should secure a list, and if any report was not so entered, provision should be made for it unless the amount is likely to be trifling. "Ample provision should be made for all commissions eventually payable on sales which have been billed to customers. As commissions are frequently not payable to salesmen until the sales have been collected from the customers, accrued com- missions are often omitted from the books. As they must, however, be paid out of the proceeds of the sales on which the full profit has already been taken into the accounts, they should be set up as an accrued liability. Legal Expense. "All concerns have more or less litiga- tion. Before the books are closed the lawyers should be re- quested to send in a bill to date. If one is not found, the auditor should ascertain the amount, if any, probably due and set it up as an accrued liability. Damages. "If the concern is insured against liability for damages to employees or the public, a proportion of the pre- miums paid in advance for the unexpired time covered by the insurance will appear in 'Deferred charges.' But there may be claims or suits for other damages not covered by insurance, and where the auditor finds any evidence which leads him to suspect there may be liability of this nature he should insist upon being informed of all the facts. He can then form an opinion as to the amount that should be set up as an accrued liability, or, if the outcome is uncertain, as a reserve against possible loss." LEGAL PHASES (Note. In connection with the discussion of contingent liabilities on account of accommodation endorsements, it is appropriate to quote from the negotiable instruments law which regulates endorsements of negotiable instruments.) What Constitutes Negotiation. An instrument is ne- gotiated when it is transferred from one person to another in such manner as to constitute the transferee the holder thereof. If payable to bearer it is negotiated by delivery; if payable to order it is negotiated by the endorsement of the holder and completed by delivery. NEGOTIABLE INSTRUMENTS 173 Endorsement; How Made. "The endorsement must be written on the instrument itself or upon a paper attached thereto. The signature of the endorser, without additional words, is sufficient endorsement. Kinds of Endorsement. "An endorsement may be either special or in blank, and it may also be either restrictive or qualified, or conditional. Special Endorsement. "A special endorsement specifies the person to whom, or to whose order the instrument is to be payable; and the endorsement of such endorsee is necessary to the further negotiation of the instrument. Blank Endorsement. "An endorsement in blank specifies no endorsee, and an instrument so endorsed is payable to bearer and may be negotiated by delivery. Restrictive Endorsement. "An endorsement is restric- tive, which either: 1. Prohibits the further negotiation of the instrument; or 2. Constitutes the endorsee the agent of the endorser; or 3. Vests the title in the endorsee in trust for or to the use of some other person. But the mere absence of words implying power to negotiate does not make an endorsement restrictive. Qualified Endorsement. "A qualified endorsement con- stitutes the endorser a mere assignor of the title to the instru- ment. It may be made by adding to the endorser's signature the words 'without recourse' or any words of similar import. Such an endorsement does not impair the negotiable character of the instrument. Conditional Endorsement. "Where an indorsement is conditional, a party required to pay the instrument may disregard the condition and make payment to the endorsee or his trans- feree, whether the condition has been fulfilled or not. But any person to whom an instrument so endorsed is negotiated will hold the same, or the proceeds thereof, subject to the rights of the person endorsing conditionally. Striking out Endorsement. "The holder may at any time strike out any endorsement which is not necessary to his title. The endorser whose endorsement is struck out, and all endorsers sudsequent to him, are thereby relieved from liability on the instrument." 174 PUBLIC ACCOUNTING AND AUDITING A. THEORY QUESTIONS 1. What steps should an auditor take to insure, so far as possible, that accounts presented to him for audit contain all the liabilities of the company? Inst. Ex. 1917. 2. Outline the work which should be done in connection with notes and bills payable in an audit for credit purposes of a merchandising company. Inst. Ex. 1918. 3. How would you ascertain whether a Balance Sheet con- tains all the liabilities for purchases of supplies and raw material ? C. P. A. Ind. 4. What are contingent liabilities? Should they be em- braced in a Balance Sheet? Give an example. C. P. A. Ind. 5. State three kinds of contingent liabilities. How should they be shown on the Balance Sheet? C. P. A. Mass. 6. (a) What different methods should be employed in books of account for keeping track of notes endorsed for ac- commodation and notes endorsed in the regular order of busi- ness? (b) How would you indicate in books of account the contingent liability arising in each case? C. P. A. Mich. 7. Describe the voucher system and state some of the advantages and disadvantages of the system. Inst. Ex. 1918. 8. You find that a group of accounts receivable have been assigned to secure a loan. Does that affect the value of any other creditor's claim in case of failure before the loan is paid? Should any reference to the fact be made in your report? How would you set up that fact in the Balance Sheet? C. P .A. Mich. B. ACCOUNTING PROBLEMS Balance Sheet December 31, 1916 ASSETS Cash $ 3,000.00 Accounts receivable 15,700.00 $18,700.00 Inventories: Finished goods 154,500.00 Goods in process 8,350.00 Materials 55,000.00 217,850.00 236,550.00 Land 40,000.00 Buildings $94,000.00 Less reserve for depre- ciation 14,000.00 80,000.00 (Concluded on next page) ACCOUNTING PROBLEMS 175 Machinery and fixtures 81,000.00 Less reserve for depre- ciation 21,000.00 60,000.00 180,000.00 Deferred charges: Insurance and taxes 1,100.00 Total assets 417,650.00 Deficit 52,850.00 $470,500.00 LIABILITIES Notes payable. . . $275,000.00 Accounts payable 15,500.00 $290,500.00 Capital stock: Preferred 100,000.00 Common 80,000.00 180,000.00 $470,500.00 The foregoing was the Balance Sheet of a corporation, December 31, 1916, incorporated January I, 1910, and during the ensuing year the following transactions occurred : Sales, net $550,000.00 Purchases, net raw material 347,000.00 Raw material inventory increased 64,000.00 Labor 60,000.00 Total manufacturing expense 35,900.00 Process inventory increased 20,000.00 Finished goods inventory decreased 36,000.00 Total selling expense 35,000.00 Total administrative expense 26,000.00 Notes payable have been' renewed as they became due, except that $100,000.00, held by the largest owners in the company, has been donated to the company, July I, 1917 $100,000.00 $5,000.00 of 3^% Liberty Bonds have been bought 5,000.00 $2,000.00 has been donated to the Red Cross 2,000.00 Notes : Depreciation on buildings, estimated life 47 years, beginning January I, 1910. Depreciation on machinery, estimated life 27 years, beginning January I, 1910. 176 PUBLIC ACCOUNTING AND AUDITING Accounts receivable were $45,000.00, and accounts payable $15,000.00 at the close of the year. There was accrued interest payable $2,500.00, Decem- ber 31, 1917. Prepare Trial Balance and Balance Sheet as on Dec. 31 , 1917. Inst. Ex. 1918. (Note. It will be necessary to set up skeleton ledger accounts to obtain a Trial Balance. No information is given as to the amount of interest paid during the year. The date and method of acquiring the Liberty Bonds is not shown. Since this information is not given in the problem, you may ignore the element of interest. You may assume that the same amount of insur- ance and taxes is to be deferred as at the end of the previous year.) C. LEGAL QUESTIONS 1. How are negotiable instruments negotiated? C. P. A. Mich. 2. A note non-negotiable in form is executed and delivered by A to B and endorsed by B to C. A refuses to pay it when due, claiming want of consideration. C brings suit against A averring that he was a holder in due course. Can A successfully defend the action if want of consideration is established? Give reasons. Inst. Ex. 1918. 3. A negotiable note executed and delivered by A to B passes in due course to and is endorsed in blank by B, C, D and E; F is the last holder and strikes out C's endorsement. What is the liability of C, D and E on their endorsement? Inst. Ex. 1918. 4. As an accommodation to B, A on June I, 1918, endorsed B's note for $1,000 payable to C's order on July I, 1919. On July 2, 1919, C endorsed and delivered the note to D. What rights, if any, has D against A? Inst. Ex. 1919. 5. New York, April 10, 1916. Thirty days after date I promise to pay to the order of C. D. One Hundred Dollars. (Signed) A. B. Endorsed in blank "without recourse." C. D. What does the endorser warrant by his endorsement? Inst. Ex. 1917. Chapter Twelve FIXED LIABILITIES "Any debt the maturity of which extends beyond the period adopted within that business for current liabilities will usually be grouped with the fixed liabilities, there seldom being an intermediate group." Kester. In Chapter Two, page 27, we quoted from the Public Service Commission of New York on what comprised "Funded Debt." Long-term obligations, usually in the form of mortgaged or bonded indebtedness, are called fixed liabilities sometimes known as LOAN CAPITAL as distinguished from SHARE CAPITAL. Loan capital usually has as security some specific form of property, such as land, buildings, equipment, etc., which have been classified and included among the fixed assets of the con- cern. Under these circumstances the general creditors can only claim the equity or difference between the realizable value of the specific portion of the assets, and the amount of the loan which has been secured by it. When it becomes necessary or advisable to raise additional capital and it is not desired to increase the share capital, long time notes or bonds, usually secured by mortgages, are issued. In the case of an individual or a partnership, it is quite cus- tomary to issue notes secured by first or second mortgages on the fixed assets or real property owned, but in the case of a corporation it is more common to issue bonds. MORTGAGES Definition. A mortgage is a conditional title to property given by the owner to another to secure the payment of a debt or the discharge of some obligation. It is similar to a deed and conveys title to the property on which the mortgage is placed, but upon some condition. That condition is the failure to make prompt payment of an obligation or debt at maturity. The tendency is to regard a mortgage as a lien on the property and not as an actual conveyance. The mortgagor retains physi- cal possession of the property and is entitled to the income there- from and may use the property just as though it were his own. Of course, he must not impair its value and he must comply with all the conditions in the mortgage contract. The holder of a mortgage (the mortgagee) has practically no control over the property or over the operation of the concern involved. 177 178 PUBLIC ACCOUNTING AND AUDITING Real or Personal Property May Be Mortgaged. "In equity, whatever property, real or personal, is capable of an absolute sale, may be the subject of a mortgage."* Mortgages on chattel property are usually for a short period of time and are classed as current liabilities, but mortgages on real property as security for notes or bonds, due at some time in the future beyond that for which liabilities are classed as current, would be considered fixed liabilities. Kinds of Mortgages. Mortgages are known as either chattel or real estate mortgages, depending on the property which is the basis of the security. They are sometimes known as purchase money or building and loan mortgages, depending on the purpose of the mortgage. They may also be classified as to precedence as first mortgages, second mortgages, etc. A first mortgage takes precedence over a second mortgage and so on. In case of liquidation of capital assets, holders of mort- gages stand in order according to the class of mortgage held. Chattel Mortgages. The only difference between a chattel mortgage and a real estate mortgage is in the kind of property conveyed as security. Chattel mortgages are placed on chattel or personal property. Real estate mortgages are placed on real property. Purchase Money Mortgages. These are mortgages given for part or the whole of the purchase price of land. They take precedence over all* claims of the general creditors. The mortgage may be given either to the person from whom the land is purchased or to a third person. Building and Loan Mortgages. These are frequently given to secure funds for erecting a building. The money is paid over as the building is constructed and reaches certain stages mentioned in the mortgage contract, or the entire amount may be delivered to a trust company to be held in trust and paid over as the installments fall due. If the money is held by the mortgagee and paid in installments, interest can only be charged from the date of the actual payment of the installments, but if placed in the hands of a trust company to be paid in install- ments, interest may be charged on the full amount. Of course, the trust company will also pay a low rate of interest on the amount deposited. Accounting Procedure. Mortgages used as security for notes are usually classed as mortgages payable on the books of account, while those used as security for bonds are classed as bonds payable. The usual procedure with mortgages payable is the same as with notes payable. The Mortgages Payable account is credited with each mortgage issued and debited when the mortgage has been paid. These transactions will usually be found recorded in the general journal and cash book. They are not sufficiently numerous to require special columns and, therefore, all items are posted individually. *\Vright v. Shumay, 30 Fed. Cases, No. 18,093; l Biss. 23-26. BONDS 179 Unlike bonds, mortgages are seldom sold at either a discount or a premium. The amount received is usually equal to the face of the mortgage, hence mortgages should be recorded, like notes, at their face or par value. In other words, the interest rate on mortgages is nearly always equal to the effective market rate for the particular type of equity involved. BONDS Definition. A bond is simply a long-term note an interest bearing, negotiable instrument, under seal, promising to pay a certain sum of money at a definite or determinable future date. It is usually secured by a pledge of certain proper- ties, real or personal, as to either or both principal and interest. Bonds vs. Notes. A corporation may borrow money the same as an individual. If only a small amount is desired or it is wanted for a short time only, notes are usually given. These notes may be secured or unsecured. If unsecured, they are classed as current liabilities and are called notes pay- able on the books of account. If secured by a mortgage, they are usually called mortgages payable on the books of account and may be classed as either current or fixed liabilities, de- pending on the length of time to maturity. When the amount to be borrowed is large and is wanted for a long period of time, say from five to fifty years, then bonds instead of notes are given. There is said to be a bond issue. This consists of a number of bonds, which may vary in de- nomination, but which are all of like general tenor, and if secured #re all secured alike under one "deed of trust". Deed of Trust. This is a mortgage on certain specified property placed in the hands of a trustee who represents the bondholders. The deed of trust states at length the terms and conditions under which the bonds are issued and under which the property for their security is held. In the bonds, reference is made to the deed of trust by which they are secured. It will be seen, therefore, that both the deed of trust and the bonds issued refer to each other in such a manner that all terms and conditions are clearly stated in both instruments. The trustee has the right to act in behalf of the bondholders and may bring foreclosure proceedings if it becomes necessary to do so. If the trustee fails to do so, any bondholder may bring foreclosure proceedings for the benefit of all the bondholders. Of course, he must show the court that this action is necessary to safe- guard the interest of the bondholders and that the trustee refuses to act. Security. Formerly bonds were commonly supposed to be secured by real estate mortgages, except when otherwise specifically designated. In these times, bonds may or may not be secured at all. Often they are nothing more than promissory notes; in fact, are not so valuable because they do not mature for a longer time. It will be readily seen, therefore, that an I8o PUBLIC ACCOUNTING AND AUDITING auditor must be able to determine the value of the security in order to place a valuation on the bonds. There are so many different kinds of bonds that we can only describe a few of each kind here. They may be subdivided as to security, as to purpose, as to payment of interest, and as to payment of principal. AS TO SECURITY Debenture Bonds. We have already stated that bonds may be secured or unsecured. Unsecured bonds are usually termed "Debentures" or "Debenture Bonds." This term is also often used to describe bonds partially secured, those secured by collateral and those on which the payment of the interest is contingent upon the earnings of the company. This interest may be cumulative or non-cumulative. An unsecured debenture bond is a mere promise to pay and is inferior to any secured liabilities of the company. It is, however, superior to preferred stock in that the liability on account of interest payable ranks ahead of the dividends on the preferred stock. The value of unsecured bonds depends entirely on the financial strength of the issuing company. No foreclosure proceedings can be instituted because no mortgage has been given. Bonds secured by depositing stocks and bonds of another company (owned by the issuing company) in the hands of a trustee, are frequently known as "collateral trust bonds" and may be classed as debentures as stated above. Example: Lake Shore & Michigan Southern 2.s-year debenture 43, due September i, 1928, were originally debentures, but are now secured by direct second lien on the Lake Shore property of New York Central System. Mortgage Bonds. Mortgage bonds, as the name implies, are those secured by a mortgage, or deed of trust on part or all of the property of the issuing company. These bonds may be known as first, second, third, etc. mortgage bonds accord- ing to the rank of the mortgage or deed of trust by which they are secured. A first mortgage bond is a first lien on the property mortgaged except in cases where a builder's lien, receiver's certificate or some similar obligation takes precedence. A second mortgage bond is one in which the security is a second mortgage on the same property. Example: American Smelting & Refining First Mortgage 53, due April I, 1947, secured by first mortgage on entire property of company and by pledge of capital stock of five subsidiaries. Income Bonds. These have already been defined as bonds on which the payment of interest is contingent upon the earnings of the issuing company. Such bonds are a lien on the net income of the company. If there are no net profits, the interest is not a liability unless it is cumulative. The principal of such bonds may be secured or unsecured. If unsecured they are frequently called debenture bonds. BONDS 181 Guaranteed Bonds. These are bonds the payment of which, either as to principal or interest, or both, is guaranteed by another company. This guarantee to be binding must be in writing and must be written on the bond itself, or be attached to it. Such bonds are frequently issued. For instance, a sub- sidiary company may issue bonds guaranteed by the parent or holding company of which it forms a part. AS TO PURPOSE Improvement Bonds are bonds issued for the purpose of property improvements. They may be either debenture or mortgage bonds and may be secured or unsecured as to principal or interest, or both. Example: Miami Conservancy District, Ohio, 5V% bonds, issued De- cember I, 1917, "for the prevention of floods and protection of certain cities, including Dayton, Hamilton, Middletown, Piqua, Troy and other smaller municipalities." Refunding Bonds are bonds issued to raise funds to replace or redeem other bonds which are maturing. In some instances they are exchanged directly for the old bonds, but more often sold and the money used to retire the maturing bonds. The interest rate on these bonds may be higher or lower than on those bonds being retired, depending on money conditions at the time of issue. Example: Illinois Central Refunding Mortgage 43, due November i, J 955- Secured by a direct mortgage on 21,172 miles of road, etc. Adjustment Bonds are bonds issued for the purpose of readjusting or consolidating existing indebtedness. They are very similar to refunding bonds. Purchase Money Bonds are bonds given to secure funds with which to purchase the property by which they are secured. (See Purchase Money Mortgages, Page 178.) Registered Bonds are registered on the books of the issuing company in the name of some particular individual or company in much the same manner as capital stock. The interest and principal are then payable only to the registered holder of the bonds. Such bonds may be transferred by assignment. When assignment is made the assignee surrenders the old bond and is given in exchange a bond issued in his own name. The trans- fer is made on the books of the issuing company. Coupon Bonds are bonds usually made payable to bearer and to which are attached interest coupons. These interest coupons are always made payable to bearer. They are clipped off at maturity and presented for payment. There will be as many coupons attached as there are interest due dates. United States Government Liberty and Victory Bonds are issued in 182 PUBLIC ACCOUNTING AND AUDITING both registered and coupon forms. The advantages of the coupon bonds is the ease with which they may be transferred. They are transferrable by delivery alone, while the registered bonds are transferrable by assignment only. A disadvantage of coupon bonds is that if lost or stolen, the finder or holder may dispose of them easily and once in the hands of an innocent holder they become valid. If a registered bond is lost or stolen, it is practically impossible to realize on it because it is payable only to the party named in the bond and could only be trans- ferred by assignment which would require forgery. This forging would, therefore, prevent a valid transfer. Both coupon and registered bonds are often issued under the same security or deed of trust. Coupon bonds are often subject to being registered if desired. A bond may be registered as to principal only and the interest may be payable in the form of coupons. In this event interest is payable to whoever holds the coupons, but the principal is payable only to the party registered and named in the bond. Participating Bonds are bonds in which it is specified that the holder is to share in the profits of the issuing company. A certain rate of interest may or may not be specified and the holder may share in the net income the same as actual stock- holders. These are sometimes known as income bonds. (See page 1 80.) AS TO PAYMENT OF PRINCIPAL Gold Bonds are bonds which expressly provide for payment in gold. Such provisions are legal and enforceable. If no medium of payment is specified, legal tender is assumed. Convertible Bonds are bonds which carry the right of conversion into other securities of the same company. Usually convertible bonds may be exchanged for common or preferred stock within a certain time and at a fixed rate of exchange. Example: American Telephone and Telegraph, 7-year convertible 6s, due August I, 1925, convertible at par into common etock of the com- pany at $106.00 per share after August i, 1920. Serial Bonds are bonds issued in series, one series payable each year until the entire issue has been redeemed or retired. It will be seen, therefore, that the security back of these bonds increases in proportionate value as each series of the bonds is redeemed. In some instances the terms of the issue provide for relinquishing a part of the security after certain redemption stages are reached. Callable or Redeemable Bonds are bonds that may be redeemed by the issuing company before the maturity date fixed by the deed of trust. Often a sinking fund is established and the bonds are redeemed or called in and then cancelled. Sometimes the issuing company, instead of establishing a sink- ing fund, simply calls in a part of the bonds periodically and cancels them. Many bond issues contain provision to the BONDS 183 effect that upon any interest date (previous notification having been given) they may be redeemed, all or in part, at a stated price plus accrued interest. Example : Chesapeake & Ohio, 2oyear convertible 4 J^s, due February I , 1930. Callable for redemption after February I, 1920. Procedure in Issuing Bonds. The following is a brief outline in general of the various steps to be taken in a bond issue. Of course, a great deal will always depend upon the kind of bonds being issued, the purpose of the issue and the con- ditions of the issue. (It is understood that this outline is sub- ject to statutory regulations in the various states and that a bond issue should always be made under the direction and super- vision of competent attorneys familiar with the statutes.) (1) Meeting of Directors. A preliminary meeting of the Board of Directors is held and a resolution passed recom- mending a bond issue. A special meeting of the stockholders is then called. The stockholders usually have the authority to authorize the bond issue, but even where the directors have that authority it is common and good practice to get the en- dorsement of the stockholders. (2) Meeting of Stockholders. At this meeting a state- ment of the proposed issue is submitted for consideration. This statement stipulates all the conditions of the issue, the time the bonds are to run, the security, terms of payment, rate of interest, redemption conditions, etc. After due consideration a resolu- tion is passed. Often this resolution is voted upon by submitting it to the individual stockholders after this meeting. In other words, the vote is obtained by mail. (3) Bond Issue Authorized. After the bond issue is approved by the stockholders, the directors hold another meet- ing and pass a formal resolution authorizing the bond issue in due form by the officers of the corporation. (4) Proposed Issue Submitted to Public Service Commission. In states where a Public Service Commission exists, bond issues of all corporations coming under its direction must have its approval before issuance. (5) The Deed of Trust. A trustee is selected. This is usually a trust company. The proper officers of the issuing company draw and duly execute a deed of trust, conveying certain properties to the trustee, and setting forth all the con- ditions under which the bonds are issued. If real estate is con- veyed, a copy of the deed of trust must be filed in every county where the real estate is located. (6) Preparation of Bonds. The bonds are usually engrossed and coupons are attached, if the issue is of coupon bonds. The trustee's certificate appears on the bonds. The form of certificate appearing on the back of the bonds of the United States Steel Corporation reads as follows: 184 PUBLIC ACCOUNTING AND AUDITING "THIS IS TO CERTIFY that this bond is one of the issue of bonds of United States Steel Corporation mentioned in the indenture dated April 1, 1903, with- in referred to, executed by United States Steel Corporation to the under- signed as Trustee. United States Trust Company of New York. By " (7) Sale of Bonds. The bonds may be sold direct to the public or may be sold through some firm of bankers. Pro- vision for selling the bonds is usually arranged for before the bond issue is authorized or soon thereafter. (8) Provision for Paying Interest and for Redeeming the Principal. Some definite provision must be made for the payment of the interest and for the redemption of the bonds at maturity. This latter is usually provided for in the deed of trust, but a method of establishing a fund from which to meet these obligations must be arrived at. 1. ACCOUNTING THEORY Bond Account. The object of this account is to show the amount of bonds authorized by the deed of trust. The account is charged for the par value of the bonds redeemed and cancelled, and is credited for the par value of the bonds authorized by the deed of trust. It will be seen that the differ- ence between the two sides of the account represents the par value of bonds authorized and not yet cancelled. Unissued Bond Account. The object of this account is to show the par value of the unissued bonds, that is, those bonds authorized but not yet sold. The account is charged for the par value of the bonds authorized and is credited for the par value of bonds sold and issued. The balance of this account deducted from the balance of the Bond account will show the par value of bonds outstanding Bond Subscription Account. The object of this account is to show the total subscriptions for bonds on the installment plan. Usually the bonds are not issued until all installments have been paid in full; therefore, this account is credited for the par value of bonds subscribed for and is charged for the par value of subscribed bonds when issued. The balance of the account represents the par value of bonds subscribed for but not yet issued. BONDS 185 Bond Premium Account. The object of this account is to show the amount in excess of the par value realized through the sale of the bonds. When the bonds are sold above par the excess is credited to this account. The account should be written off during the life of the bonds. Bond Discount and Expense Account. The object of this account is to show the cost of the issue. All expenses* incident to the bond issue and the difference between the amount realized and the par value of the bonds, when sold below par, are charged to this account. If desired, separate accounts may be kept with "Bond Discount" and "Bond Expense." Bond discount is considered an addition to the amount of interest paid but should be pro- rated over the life of the bonds. Bond Interest Account. The object of this account is to show the interest paid on bonds. At the end of each fiscal period, or oftener, this account is closed into the Profit and Loss account. Relation of Bond Premium or Discount to Interest. The premium received or the discounts allowed upon the sale of bonds is said to represent a deduction from, or an addition to, the interest paid on the bonds. t If the bonds sell at. a discount, the borrower pays not only the interest but also the discount for the use of the money. If the bond sells at a premium, the principal borrowed is more than par; and since the borrower does not have to pay back the premium at maturity, the premium is really a deduction from the interest. It will be seen, therefore, that the premium or discount should be written off over the life of the bonds by either credit- ing or charging a proportionate part to the Interest account and through this to Profit and Loss at the end of each fiscal period. The customary method is to credit the premiums or debit the discounts to Profit and Loss, periodically, during the life of the bonds. This is known as the Straight Line Method. *"A11 expenses connected with the issue and sale of evidences of debt, such as fees for drafting mortgages and trust deeds, fees and taxes for record- ing mortgages and trust deeds, cost of engraving and printing bonds, fees paid trustees provided for in the mortgages and trust deeds, fees and commissions paid underwriters and brokers for marketing such evidences of debt, and other regular expenses." Public Service Commission, New York. t"Premium or discount on bonds is a deduction from, or addition to, the nominal rate of interest which the bond carries; that is to say, there is a rate known as the true or effective rate, at which any corporation can place its bonds at par; if it elects to place them at any other rate, the bonds will sell at a premium or discount as the case may be; but the effective rate remains the same and this effective rate is the proper charge to Income account. Hence, the premium or discount should theoretically be spread over the term of the bonds, and the annual installment thereof credited or charged to the Income account each year." "Accounting Practice and Procedure," by A. Lowes Dickinson. i86 PUBLIC ACCOUNTING AND AUDITING However, this is considered unsound accounting practice because it results in an erroneous statement of the operating costs. Proper accounting calls for a reflection of the actual interest cost spread over the life of the bonds, and this can be accom- plished only by adjusting the Interest account. Effective Rate Method. This is considered the best method of writing off bond premiums or discounts. The actual amount of interest paid is charged to the Bond Interest account. If the bonds were sold at a discount, the difference between the nominal rate (the amount actually paid) and the effective rate (the prevailing rate of interest) is also charged periodically to Bond Interest and credited to Bond Discount and Expense. If the bonds were sold at a premium, the difference between the effective and nominal rates is periodically charged to Bond Premium and credited to Bond Interest. It will be seen that this method scientifically writes off the Bond Premium or Bond Discount and Expense accounts during the life of the bonds. 2. INCOME TAX PROCEDURE Amortization of Bond Premiums. The Treasury De- partment holds that the difference between the amount realized and the par value of bonds when sold at a premium, represents taxable income. It need not be rated as income for the year in which the bonds are sold, but may be prorated over the life of the bonds. (Reg. No. 45, 1919, Art. 544, ^[2.) "If bonds are issued by a corporation at a premium, the net amount of such premium is gain or income which should be prorated or amortized over the life of the bonds. If thereafter the corporation purchases and retires any of such bonds at a price in excess of the issuing price minus any amount of premium already returned as income, the excess of the purchase price over the issuing price minus any amount of premium already returned as income (or over the face value plus any amount of premium not yet returned as income) is a deductible expense for the taxable year. If, however, the corporation purchases and retires any of such bonds at a price less than the issuing price minus any amount of premium already returned as income, the excess of the issuing price minus any amount of premium already returned as income (or of the face value plus any amount of premium not yet re- turned as income) over the purchase price is gain or income for the taxable year." Amortization of Bond Discounts. The Treasury De- partment holds that discounts, commissions for selling, and other expenses incidental to issuing the bonds, represent a loss and may be prorated over the life of the bonds. BONDS 187 (Reg. No. 45. 1919, Art. 544, ^[3.) "If bonds are issued by a corporation at a discount, the net amount of such discount is deductible as interest and should be prorated or amortized over the life of the bonds. If, thereafter, the corporation pur- chases and retires any of such bonds at a price in excess of the issuing price plus any amount of discount already deducted, the excess of the purchase price over the issuing price plus any amount of discount already deducted (or over the face value minus any amount of discount not yet deducted) is a deductible expense of the taxable year. If, however, the corporation pur- chases and retires any of such bonds at a price less than the issuing price plus any amount of discount already deducted, the excess of the issuing price plus any amount of discount already deducted (or of the face value minus any amount of discount not yet deducted) over the purchase price is gain or income for the taxable year." Procedure When Bonds Issued at Par Value Are Pur- chased for Redemption. (Reg. No. 45, 1919, Art. 544, ^[i.) "If bonds are issued by a corporation at their face value, the corporation realizes no gain or Idss. If thereafter the corpora- tion purchases and retires any of such bonds at a price in excess of the issuing price or face value, the excess of the purchase price over the issuing price or face value is a deductible expense for the taxable year. If, however, the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year." Bond Discount Considered Interest. The Treasury Department holds that the discount on bonds sold at less than par is to be treated as interest paid in advance. It would, therefore, seem that it is equally good practice to consider the premium on bonds sold above par to be a deduction against the amount of interest paid. (Reg. No. 45, 1919, Art. 563.) "If it sells its bonds at a dis- count, the amount of such discount is treated as interest paid, and if it retires its bonds at a price in excess of the issuing price, such excess may usually be deducted as expense. If the Cor- poration sells its capital assets for less than their cost or fair market value as of March I, 1913, the loss sustained is de- ductible." Interest on Liberty Bonds Exempt from Income Tax. (Income-Tax Primer, 1919, Ques. 19.) "To what extent is interest received on Liberty bonds exempt from income tax? (a) All interest received upon Liberty bonds is exempt from normal tax. (b) In any event, interest upon the 3^ per cent Liberty bonds of the first series is exempt from both normal tax and surtax. 188 PUBLIC ACCOUNTING AND AUDITING (c) In addition, a person is entitled to exemption from tax upon interest received on $5,000 aggregate amount of bonds of later issues and war-savings certificates. (d) If one originally subscribed for Liberty bonds of the fourth series he is also entitled to an exemption from tax on interest received upon bonds of the previous issues not to ex- ceed one and one-half times the amount of the fourth Liberty bonds originally subscribed for and still owned, not to exceed in the aggregate $45,000. (e) The interest received on not exceeding $30,000 principal amount of Liberty bonds into which first Liberty bonds may have been converted in the exercise of any privilege arising as a con- sequence of the issue of the fourth Liberty bonds is exempt. (f) The interest received on not exceeding $30,000 prin- cipal amount of Liberty bonds of the fourth issue is exempt. The interest upon Liberty bonds, which is entirely exempt from income tax as defined above, should not be included in the gross income of the return, but should be reported in the return." 3. AUDITING THEORY Quoting from the Federal Reserve Bulletin : Listing Mortgages and Bonds. "A copy of the mort- gages must be examined and the terms thereof noted. The amount of bonds registered, issued, and in treasury, rate of interest, and duration of the bonds, should be shown on the face of the Balance Sheet. A certificate should be obtained from the trust company certifying the amount of bonds out- standing, etc., as verification of the liability stated in the Balance Sheet. The interest on the bonds outstanding, shown in the Balance Sheet, should be calculated and reconciled with the interest on bonds, as shown in the Profit and Loss account. Sinking Funds. "Sinking fund provisions in mortgages should be carefully noted and care should be taken to see that they are provided for in the accounts of the company, and any default noted in the Balance Sheet. Redeemed Bonds. "Bonds redeemed during the period or previously should be examined to see that they have been properly cancelled, or, if they have been destroyed, a cremation certificate should be obtained from the trustees. "Mortgages sometimes stipulate that the current assets must be maintained at a certain amount in excess of the current liabilities, and the auditor must give due consideration to such matters and any other stipulation in regard to the accounts, or any audit thereof, that may be referred to in the trust deed, and see that they have been complied with. BONDS 189 Mortgages. "As a mortgage derives its chief value from the fact that upon registry it becomes a lien, the auditor should verify the existence of such an obligation by inspecting the public records, not only with reference to such as may be found on the company's books, but also any that may still appear on the public records as unsatisfied. If the auditor lacks the necessary facilities for making a search it will be worth his while to arrange with a local lawyer or title company whereby, for a small fee, any mortgages or judgments entered against the con- cern under audit will be reported to him. "In any event the auditor must verify the amount as recorded in the account, the rate, the due date, and the property covered thereby. "It should be borne in mind that a payment on account of a mortgage must be recorded or the entire amount will remain as an encumbrance on the property. Therefore, if payments on account appear, the auditor should ascertain if they have been so recorded; if not, the fact should be noted on the Balance Sheet. Judgments. "The same procedure should be followed in verifying judgments as in verifying mortgages. As many business men consider that the entry of an invoice is an ad- mission of liability, and will not permit the entry of a claim which they propose to fight, it is sometimes difficult for an auditor to find any evidence of such liens. Even admitting the fact, they may still refuse to allow the judgment to be entered on the books as a liability, in which case it is proper for the auditor to include it as a footnote on the Balance Sheet as a contingent liability. Unpaid Interest. "When considering the matter of liens it should be noted that interest unpaid is a lien as well as unpaid principal, so where the auditor finds evidence of interest on liens being in default, he should add it to the principal in each case." 4. AUDITING PROCEDURE Investigation by the senior shows that there is $100,000.00 of the First Mortgage Bonds of the Blank Manufacturing Com- pany outstanding. These are 5%, 2O-year bonds. Interest payable semi-annually on January 15 and July 15 of each year. As shown in the Trial Balance, December 31, 1918, (see page 50, Chapter Four) $2,500.00 had been deposited for bond interest. The policy of the company has been to charge off 5% of bond discount annually, thus distributing it over the life of the bonds on a straight line method without regard to the rate of interest which the bonds bear. The Bond Discount unamor- tized now stands at $6,000.00 and the Bond Interest account shows a debit balance of $5,000.00, this amount representing the amount of interest paid on January 15 and July 15, 1917. 190 PUBLIC ACCOUNTING AND AUDITING A. THEORY QUESTIONS 1. Name five classes of bonds, describing briefly each class with regard to issue, purpose, redemption, etc. C. P. A. Mich. 2. Do unsold bonds of a railroad company constitute a liability? If they do, under what account would they appear in the ledger? C. P. A. Mich. 3. An issue of Mortgage Bonds of the par value of $100,000.00 and running for five years has been sold at 90, the money to be used in the erection of new buildings. How should the transaction be recorded and why? C. P. A. Mich. 4. If a bond reads at 4%, but the amount which will be received is 1.05 of the nominal par, what is the actual percentage of cost income? C. P. A. Mich. 5. If a company sells its own bonds at a premium, is the premium received a legitimate profit of the company? C. P. A. Ohio. B. ACCOUNTING PROBLEMS 1. (a) A corporation issued First Mortgage Bonds bearing interest at 5%, dated January i, 1917, to subscribers at $125.00 for each bond, par value $100.00. The bonds are to be paid for in three installments: $25.00 on February i; $50.00 on March i; and $50.00 on April i. The February i and March i installments have been paid and the proper entries made on the cash book. You are called in to formulate the journal entries on the two installments. How would you make them? There were issued and sold $100,000.00 par value. (b) A corporation borrows $120,000.00 for a period of ten years to pay off an existing loan at a higher rate of interest, paying therefore in brokerage and costs $2,750.00. How would you treat this item on the books? C. P. A. Ind. 2. The Smith and Jones Manufacturing Company issued $200,000.00 of first mortgage 5O-year, 5% sinking fund bonds which were marketed at 98}^, i% commission, and expended the entire proceeds in the erection of their plant. The discount and commission were charged to the Unamortized Debt Discount and Expense accounts, to be subsequently charged to Profit and Loss, proportionately, during the life of the bonds. Five years later, the company was enabled, owing to a disturbance in the financial market, to purchase $50,000.00 of said bonds for Sink- ing Fund account at 95. Prepare the necessary journal entries to record correctly the above transactions of the company. C. P. A. N. Y. (Note. You may assume that the bonds were placed in the hands of a firm of bankers for sale. The bonds purchased for sinking fund account were cancelled by the company.) ACCOUNTING PROBLEMS 191 3. The Standard Trust Company is appointed by the Peninsular Mining Company as Trustee of a Bond Issue, aggregating $1,000,000.00, all Bonds of $1,000.00 denomination, rate 5% and bearing date January I, 1914. Bonds mature in ten equal annual installments, beginning January I, 1917, unless previously converted or retired. The issue is not purchased by the Trustee, but is sold through Emory Davis & Company, Brokers, the Company realizing 90% and accrued interest less the cost of appraisal of property, printing, trustees' expenses, etc., amounting to $9,310.80. The entire issue was taken over, and paid for by the brokers on January 20, 1914. Among other things the trust deed provides: Bonds convertible on any interest date for 6% pre- ferred stock at 90%, at option of holder. Bonds may be retired out of surplus on any interest date at 103, at option of company. Sinking fund for payment of principal only to be based on production of ore at ten cents per ton. Trustee to charge %% of principal on issue, and J^% on coupons. Interest payable January I and July I. The company's production for three years is assumed to be, for the purpose of this problem, 1,000,000 tons per year. January i, 1916 $100,000.00 are converted to pre- ferred stock. January i, 1917 $200,000.00 are redeemed at 103. Formulate all necessary entries in journal form for books of: (a) Standard Trust Company, (b) Peninsular Mining Company, (c) Emory Davis & Company, which may be occasioned by the above transactions up to and including January i, 1917. C. P. A. Mich. (Note. It would be well to review the discussion of securities and the accounting for sinking fund investments before preparing a solution to the above problem. See pages 70-76, Chapter Five.) PRACTICE DATA (Note. The following transactions are a part of special practice data designed as a test of your knowledge of the principles of accounting and auditing, and of your ability to apply the knowledge in actual practice. If you have properly learned all of the principles of accounting and auditing 192 PUBLIC ACCOUNTING AND AUDITING taken up in this text, you should experience no difficulty in recording the fol- lowing transactions in proper form and in preparing the necessary financial statements. Use ordinary journal and ledger paper. If you desire, you may use analysis paper for special statements such as the Working Sheet. As this practice data is continued in the next chapter, you should carefully pre- serve your working papers until you are ready to continue the work. You may now proceed by recording the following transactions in journal form.) Transaction No. 1. The General Manufacturing Com- pany was incorporated under the laws of the state of Ohio with an authorized capital stock of $4,000,000.00, consisting of 10,000 shares of 7% cumulative preferred stock of the par value of $100 each, and 30,000 shares of common stock of the par value of $100 each. Transaction No. 2. Subscriptions to the capital stock were made as follows: R. V. Williams 5,000 Shares Common and 5,000 Shares Preferred Stock. A. B. Opfer 2,000 Shares Common and 1,000 Shares Pre- ferred Stock. H. W. Henry 1,000 Shares Preferred Stock. C. H. Bowser 5,000 Shares Common Stock. Maude E. Barnes 1,500 Shares Common and 1,500 Shares Preferred Stock. Ruth E. Forty 2,000 Shares Common and 1,500 Shares Preferred Stock. R. O. Wiggins 5,000 Shares Common Stock. E. W. Atkinson 5,500 Shares Common Stock. All of the stock was subscribed for at par, payment to be made upon demand. To further the purposes of the new corporation, it is in- tended to take over the business owned and conducted by R. V. Williams under the name of the Williams Manufacturing Company. The newly organized company is to acquire all the assets, excepting cash, and to assume all the existing liabilities of the Williams Manufacturing Company. Mr. Williams is to be allowed a price equal to his present invest- ment with no allowance for good will or other intangible assets. Therefore, Williams' subscription to the capital stock of the General Manufacturing Company is based upon this agreement. Chapter Thirteen NET WORTH Business Organization. An auditor must be familiar with the different classes of business organization. A business may be conducted by an individual, an association of individuals known as a copartnership, or by an artificial body created by law and known as a corporation. 1. ACCOUNTING THEORY The Sole Proprietorship. A business conducted by an individual is known as a sole proprietorship. The individual contributes the capital, is entitled to the profits and must stand the losses. The Balance Sheet must show the investment or capital and any increase or decrease in the investment. By reference to the formal Balance Sheet exhibited on page 41 of Chapter Three, it will be seen that the net worth of an indi- vidual should be shown thus: (a) Capital xxxxx . xx (b) Undistributed profits or deficit. . . . xxxxx. xx Naturally, if the business shows a profit which has not been distributed, it constitutes an addition to the investment, but in the case of a deficit or net loss, there is a deduction from the investment. The Copartnership. An association of individuals in business is known as a copartnership. In this class of business organization the capital may or may not be contributed equally and the profits and losses may or may not be shared equally. Hence, before the auditor can prepare the Balance Sheet he must ascertain the conditions of the copartnership agreement. It is needless to say he must also be familiar with Partnership Law. A special section of this course will be devoted to part- nership accounting, therefore, we will confine this Unit to showing the classifications of partnership accounts in the Balance Sheet. This is not shown clearly in the formal Balance Sheet in Chapter Three. The following is a suggested classification of all partnership accounts for Balance Sheet purposes: (Assum- ing two partners and a net profit for the fiscal period.) 194 PUBLIC ACCOUNTING AND AUDITING (a) "Y's" capital xxxxx.xx (b) "X's" capital xxxxx.xx (c) Add undistributed profits xxxxx.xx (Assuming a deficit or net loss) (a) "Y's" capital xxxxx.xx (b) "X's" capital xxxxx.xx (c) Deduct deficit xxxxx.xx It must be remembered that this discussion is confined to a Balance Sheet prepared for credit purposes. Note that it is not necessary to show the distribution of the profits or losses although this may be shown if desired. One peculiarity of the Federal Reserve Board's requirements is that a partner's per- sonal or drawing account, when a debit balance is shown, should be classified among the secured current assets, (see item 29, formal Balance Sheet, page 40, Chapter Three) , and Vhen a credit balance is shown, should be classified among the unsecured current liabilities. (See item 18, page 41 , Chapter Three.) When the account constitutes an asset, it is classified as a current asset but not as a quick asset. This distinction is due to the fact that an account receivable from a partner may be slower and more difficult to realize upon than an account due from a customer. The Corporation. Due to the fact that the first fifteen Units of this course constitute instructions for a Balance Sheet audit of the Blank Manufacturing Company, which is a cor- poration organized under the laws of Indiana, we must give more space in this Unit to corporate organization than to either the individual or copartnership form of organization. No stress will be placed upon corporate law at this time, however. Share Capital. In Chapter Twelve it was shown that there are two classes of capital, share capital and loan capital. Any capital borrowed, by means of mortgages and bonds, for a long period of time may be looked upon as loan capital, but capital contributed by the stockholders of a corporation is considered share capital. When a corporation is organized there is author- ized a certain issue of capital stock. The capital stock is divided into shares and ownership of these shares is represented by stock certificates. Reference to the Chart on page 198 will show that, generally speaking, there are three classes of corporations municipal, stock and non-stock corporations. We are con- cerned at this time with stock corporations. Stock Corporations. Stock corporations may be classed as financial, business and public service. It will be seen that practically every corporation organized for profit can be classed as a stock corporation. By this is meant that the original capital for financing the business is raised principally by selling shares STOCK OF NO PAR VALUE 195 of stock. A share of stock represents a proportionate interest in the net worth of a company. It will readily be seen that if a company, with an authorized capital stock of $100,000.00, sells 100 shares of stock (par value, $100.00) and receives there- for $10,000.00 in cash, each share outstanding would represent ownership of one hundredth of the net worth of the company, not one hundredth of the authorized capital stock. Stock Issues. Stock may or may not have a specified value. If the value is specified, that value is known as its par value; if no value is specified, it is said to be stock with no par value. Most stock bears a specified par value which must be uniform for all the shares within a certain class. The par value may and does differ widely. In industrial and mercantile com- panies, it is generally $100.00, but in the case of mining com- panies the par value is more frequently $1.00. At any rate, the par value of any issue of stock is the amount specified in the stock certificate. A stock certificate also specifies the number of shares which it represents. Stock of No Par Value. Stock of no par value may now be issued in the following states: California Maine Delaware Maryland Illinois New Hampshire Ohio New York Pennsylvania Virginia When it is considered that in 1912, New York passed the first law granting the right to organize corporations with shares of stock of no specified value, there would seem to be many de- cided arguments in favor of capital stock without par value. Let us see what reasons are advanced in its favor. Louis Marshall recently expressed his opinion as follows: "Eventually it will not only become a part of the juris- prudence of most of the states' of the union, but in twenty years from now few corporations will be organized on any other principle. "I believe it to be the only reasonable method of represent- ing stock ownership in a corporation. The old method of placing an arbitrary dollar mark on a certificate of incorporation led to stock-watering, the creation of false values, and proved to be an easy medium for carrying out fraudulent schemes and practices. Under the new system every share of stock represents an aliquot interest in the corporate assets. Its value is dependent upon the actual value of the assets, and not upon any fictitious or imaginary value. That is the honest way of issuing stock. In the past a corporation which acquired undeveloped mining property issued shares of stock by the thousands and arbi- trarily fixed the value of the shares at amounts which varied from $1.00 to $100.00 each. These corporations had capital stock to the amount of $1,000,000.00 or $100,000,000.00, which 196 PUBLIC ACCOUNTING AND AUDITING had merely a potential value; but speculation was carried on with the idea that the par value had some relation to actual value. It is unnecessary for me to say that such practices are inimical to the public interest. It has now become the usual thing for corporations which are honestly managed to issue their stock without par value. The experiment has proven most satisfactory, and bankers who at first were skeptical are now found to favor the issuance of stock on this new and reason- able theory." Accounting for Stock of No Par Value. From the standpoint of the accountant, his work is actually simplified to some extent. No account with Unissued Capital Stock is necessary. The Capital Stock account would simply be credited with the value at which the stock is issued. In other words, the Capital Stock account shows the value of the stock at time of issue. No accounts with stock discounts or premiums need be kept. F. H. Hurdman,* C. P. A., in an address before the annual meeting of the Institute of Accountants, held in Cincinnati, Ohio, September 16, 1919, said: "In recording stock of no par value on the books and setting up values in the statements of assets and liabilities, it does not seem that any difficulties are presented. The Capi- tal account should reflect the value at which the stock was issued whether for cash, property or services. The only other account representing a measure of value in the outstand- ing stock, outside of certain reserve accounts, would be the Sur- plus account. In my opinion this account should at all times represent undistributed net earnings of the corporation. "Inasmuch as the Capital account will not generally re- flect on its face the number of shares outstanding, it will be necessary to show in the Capital account itself the shares issued. It does not become necessary, as in the case of stock with par value, to carry any portion of the proceeds received from its sale to a Paid-in-Surplus account. Furthermore, the fact that stock may be issued at varying values for each share has no significance other than to raise or lower the unit or share value for every other share outstanding. Each share represents an aliquot part of the entire capital, other than that portion which may be allocated to one class of stock by virtue of preference. "The number of shares authorized should be noted on the Capital Stock account. A separate account is, of course, un- necessary to record this fact. "It is probable that very few cases will arise involving donated treasury stock, as that is one of the evil practices this form of legislation was designed to prevent. No reasonable object would be attained by issuing stock of no par value at a *Of the Firm of Hurdman and Cranstoun, New York, N. Y. CAPITAL STOCK 197 nominal value and then donating a portion of that issued stock back into the treasury, presumably for sale to provide working capital. The incorporators would undoubtedly retain the required number of shares for this purpose at the time of in- corporation. In the event of such a contingency arising, how- ever, I would suggest that the number of donated shares be carried in Treasury Stock account without any money value. The number of shares indicated by this account would then be deducted from the issued shares shown in the Capital account, in order to show on the statement the actual number of shares outstanding in the hands of the public, which is the essential fact. "When stock of this description is purchased by the com- pany and placed in the treasury, it should be recorded in Treas- ury Stock account at its purchase price and shown on the state- ment as a deduction from Capital account at the amount paid therefor. The number of treasury shares would also be de- ducted from the total shares outstanding. "In presenting the Capital account in the corporation state- ments the important thing is to show the number of shares issued and outstanding, with the value of these shares as re- flected by the books or the statements in question." Market Value of Stock. The market value of capital stock may and frequently does vary materially from its par value. The par value is the amount specified in the stock certificate, but the market value is what the stock actually sells for. Capital Stock Premium Account. Stock selling above par is said to sell at a premium. Such premium should be credited to an account with Premium on Capital Stock. This represents a profit but not an operating profit for it cannot be said that the mere sale of stock above par constitutes an operat- ing profit. Since it does not constitute an earned profit from operations, it is not available for dividends. Financial organi- zations nearly always consider capital stock premiums as a permanent credit to surplus. Other classes of corporations usually amortize the account by writing it off over a period of years. This is done by simply charging the premium ac- count and crediting Profit and Loss with a proportionate part of the premium each month or year. Capital Stock Discount Account. In most states it is illegal to sell stock at a discount. Even where it may be done legally there is a tendency to conceal the fact so far as the accounts are concerned. This is done by charging the dis- count to Organization Expense, or by increasing the book value of property accounts. This policy is to be condemned because to increase the book value of assets is to inflate the net worth or capital of the concern. When this is done the stock (Continued on page 199) I 9 8 PUBLIC ACCOUNTING AND AUDITING Th Corporation' frown* Counties 1. Municipal 875.oo Inventory, Finished Stock old account. $80,000.00 Inventory, Raw Material old account. 59.875- oo To set up Inventories as of Dec. 31, 1918. The Working Sheet on the following pages shows the Trial Balance, the posting of the preceding correcting and adjusting entries, and a proper classification of the nominal and real ac- counts as prepared by E. R. Stockman, senior accountant, from his working papers and those of the juniors, J. I. King and C. E. Shaw, his assistants. 218 PUBLIC ACCOUNTING AND AUDITING Of^OO O O -< o i-" t N w w \ 0) u o c !? <2 ^-O ON OMO-" Q 8 u o o o ' cT ind" 5 9"0 b 35uS| .2 -^ 5R r- a ta THE WORKING SHEET 219 80 f o o i o 2 ^ {: 2 d o N d 00 r^ ON r>. 8 1> ON IO S ON ON O IO f i 10 oo" oo" pT O M o. OO 8 t>. Q HI c5 o (N 2 CO CO I s * ON 0^ _ q_ oo ^1 *^, M CO tf HI IO M pT oo 00 8888 8 8 in o in o I 8 c^ wN 2 co M 00 00" in 88 88-7 t>. CN IO O 10 vO HI t~ O t> IO CO d oo ON m CO 00 O 10 Tj- M H* d **{ Oi 0" " H," IO \o 1000 HI M 888 8 t>. oinoooto o OONOOi-irJ- O 'jo o jog to tiS ^8^0^ K tN oo oo to u- HI Omt>.cOMvO 00 T oo W ol V HI HI in 8888 8 o in c i in o 10 M O l^ iO CO M o 10 10 oo" o" 00 O NO CO HI OOOOOOOOOOOOOOQ 10OOOOOOOOOOOOOO o in OOOO'-iOOOOOOOOiOt-i \ HI tO o 00 CO HI Cfl CJ en tn I 1 -a 1 2 2 *** > CO 2 "flj rt J2 05 o> w rt w OT ^^ S. 8 8.S gS^jS^O') 5^Uc S g-S* . ^ o| |^ d X n n ^ B -c5"O 4) 5 U / N &>>-' "9T? S o -H Sj^Eg^-5 -5CJG^ en i-" 73 ^" .3^ 01 o ^^zi o cu ^ bo t? u. >2 QJ t ~ ^" J cu 5-slt^E? tl|3 i^ii&l lfe^Rftl^i^.||-|s t | s |2 1.^2a|^|l^I^lSslJ as s s ^ >" || s g! a sllil rt.c-^cygg^^'SE-^-ansSo^S^^a Uc^c/^Oi^ > So-fc^Oc/o993-5O Fuel 5.554-82 Insurance 3,872.32 Repairs to Machinery 507.73 Water Tax 140.53 Advertising 378.58 Discount allowed to Customers. . . 3,362.19 Postage 264.42 Salaries 6,170.00 Stationery and Office Supplies .... 296.02 Miscellaneous Main Office Expense 241.08 Interest Paid 3,386.80 Accrued Pay Rolls $ 487.66 Notes Payable 22,344.81 Accounts Payable 5.512.34 Sundry Creditors 2,511.89 Reserve for Bad Debts 1,059.51 Capital Stock 85,000.00 Sales 187,540.38 Discounts Earned on Purchases. . . 2,081.59 Interest Earned 463.17 Miscellaneous Earnings 724.75 $307,726.10 $307,726.10 222 PUBLIC ACCOUNTING AND AUDITING During the course of your audit you find that the inventory of manufacturing material at the beginning of the year was $27,214.41, and at the close of the year $51,358.58. At the close of the year there was also factory supplies on hand to the amount of $200.00, as well as fuel $2,188.40, and horse feed $14.22. You find that the unexpired insurance premiums amounted to $1,720.18; that the accrued interest on notes payable amounted to $134.83 and accrued taxes to $376.75. An analysis of the customers' accounts dis- closed the fact that $9,128.11 was very doubtful of collection. The item of $727.77 to Power Machinery Co. represents an advance payment made on machinery which has been purchased, but not yet completely installed antl not included in Machinery account. You find in the account for Horses and Wagons a charge for $75.00 for difference paid on an exchange of horses, the new horse being presumably of the same value at which the old horse originally entered. Prepare Balance Sheet, Manufac- turing Statement and Profit and Loss statement providing for depreciation of 10% on Machinery and Equipment. C. P. A. Mich. (Note. You are also required to prepare the adjusting journal entries and a Working Sheet similar in form to the one illustrated on pages 220 and 221 of this chapter. It is important that your entire solution be prepared in standard form, neatly exhibited and absolutely accurate. After you have your working papers ready to submit, be sure to check each item over again, using every precaution to avoid any possible errors or misstatements. Let your statements be in such form as you would prepare them if they were to be submitted to a client.) PRACTICE DATA (Continued from Chapter Thirteen) Transaction No. 6. Upon demand, the following sub- scribers to the capital stock paid their subscriptions in full in cash arid stock certificates were issued: A. B. Opfer $300,000.00 H. W. Henry 100,000.00 Maude E. Barnes : 300,000.00 Ruth E. Forry 350,000.00 E. W. Atkinson 550,000.00 Transaction No. 7. The following purchases for cash were made: Machinery $300,000.00 Land 500,000.00 Buildings 250,000.00 Merchandise 500,000.00 Transaction No. 8. All of the preceding transactions really relate to the organization of the company and were com- pleted before the company was ready to begin operations. Open accounts on ledger paper, allowing eight lines for each account and post your journal entries. Take a Trial Balance as of Dec- ember 31, 1919. ACCOUNTING PROBLEMS 223 Transaction No. 9. At the close of business December 31, 1920, it was decided to employ a Certified Public Accountant to make an audit of the books of the company. Assume that you were directed to complete the audit and prepare the report. The business has been in operation for a period of one year. Preliminary investigation showed that the system of accounts had been poorly devised and that no satisfactory internal check had been maintained; therefore, a detailed audit was recom- mended and authorized. During the course of the audit it became evident that the book entries could not be relied on and many vouchers were missing. There seemed to be no evi- dence of embezzlement, but the errors seemed to be due to a lack of knowledge of the ordinary principles of bookkeeping on the part of the bookkeeper. It seemed no effort had been made to keep the books in balance, the bookkeeper apparently having been satisfied in keeping only his cash in balance. Aggre- gate entries were found to have affected the respective accounts during the current year as follows: Purchases $306,000.00 Pay Rolls 212,000.00 Factory Expenses 18,000.00 Freight and Express (Inbound) 1,000.00 Administrative Expenses 27,000.00 Selling Expenses 8,000.00 Interest on Notes Payable 22,000.00 Miscellaneous Interest Expense 500.00 Interest Received 1,000.00 Sales 942,000.00 Returns and Allowances (Sales) 4,000.00 Bad Debts and Special Allowances 32,000.00 Freight on Goods Sold 2,000.00 Machinery, Tools and Equipment(Add.). . . 37, 530.00 Office Furniture and Fixtures (Additions). . 800.00 Machinery, Tools and Equipment Sold 19,000.00 Patents (Additions) 10,000.00 Analysis of the Machinery account showed that the cost price of the machinery, tools and equipment sold was $20,000.00, there having been a loss of $1,000.00 incurred through the sale. Post above aggregate entries to the proper accounts, opening new accounts when necessary. Journal entries are not required. Transaction No. 10. After analyzing the ledger accounts, the following net changes were found to have occurred in the respective accounts during the course of the year: 224 PUBLIC ACCOUNTING AND AUDITING Debit Credit Cash .............................. $134,870.00 Notes Receivable .................... 7,000.00 Accounts Receivable ................. 35,000.60 Prepaid Administrative Expenses ...... 1,000.00 Notes Payable, Banks ............. $7,700.00 Notes Payable, Trade ................ 57,000.00 Accounts Payable ................... 67,000.00 Accrued Pay Roll ................... 8,000.00 Notes Receivable Discounted ......... 5,000.00 Accrued Salaries is the same as at the end of the previous year. Post to the proper accounts. Journal entries are not required. Transaction No. 11. It was found that the entire inter- est on the First and Second Mortgage Bonds, amounting to $29,880.00, has been added to machinery and tools. The interest on the Debenture Bonds, amounting to $7,650.00, had been charged to administrative expense. All bonds were issued December 31, 1919, the interest payable semiannually on June 30 and December 31. Formulate correcting entries in journal form and post to the proper accounts. Take a Trial Balance. Transaction No. 12. Specific reserves are to be set up as follows: Reserve for depreciation on buildings ........... Reserve for depreciation on machinery, tools and equipment .......................... 10% Depreciation on patents ...................... 6% Depreciation on office furniture and fixtures ..... 10% Reserve for doubtful accounts ................. Depreciation is to be calculated on the cost price of fixed assets on hand at the beginning of the current year. The reserve for doubtful accounts is estimated to amount to 2^% of the total accounts receivable as at the end of the current year. (Drop the cents. Use the nearest dollar.) The inventory shows merchandise on hand amounting to $650,000.00. Formulate adjusting journal entries. Chapter Fifteen THE REPORT In the previous chapter there was illustrated the Working Sheet prepared by the senior in charge of the audit of The Blank Manufacturing Company. After the senior in charge has prepared a Working Sheet, supported by the necessary schedules from the working papers of the various persons employed in connection with an audit, and has them arranged in proper form, they are usually turned over to someone in the office, whose duty it is to prepare what is known as a Report. This Report may be divided into three parts the statements, the comments and the certificate. The Statements. There are two classes of statements exhibits and schedules. The principal statements, such as the Balance Sheet and the Profit and Loss statement are known as exhibits, while the supporting statements, such as a Statement of Factory Operations, Analysis of General Expenses, Statement of Investments, etc., are known as schedules. It is needless to say that every possible precaution must be used to insure absolute accuracy in the preparation of the state- ments. All the information should be obtainable from the Working Sheet and working papers which accompany it. The calculations and copying must be carefully verified by someone in authority. It is customary for the managing senior, a partner of the firm, or an officer of the company to pass upon the entire report before submitting it to the client. In preparing the report, the auditor should have in mind the use that will be made of the information it will contain, for he may occasionally be able to make his report cover more fully some special points that will be of particular interest to the client. For instance, the prospective purchaser of stock would be pri- marily interested in the earnings or dividends of the corporation and of its value as a going concern. The prospective purchaser of bonds would be principally interested in the value of the pro- perty mortgaged and the ability of the company to maintain the interest payable during the life of the bonds and to retire them at maturity. The banker, while interested incidentally in the earning capacity of the concern, would be primarily desirous of knowing the probable ability of the concern to repay the loan at maturity. The stockholder's chief interest is usually in the earn- 225 226 PUBLIC ACCOUNTING AND AUDITING ing capacity of the corporation and of the conduct of the business in the past by the directorate chosen by the stockholders. The Comments. It is customary for the auditor to sub- mit comments in connection with the statements prepared for the client. These comments are made to explain any unusual items appearing in the financial statement, to describe his investi- gations into certain matters, to present what criticisms are con- sidered necessary, to make suggestions that may be of value to the client, and, if so requested, to make what recommendations he considers advisable. Properly prepared comments may be of great value to a client. They may be constructive and may lead to vast improve- ments in the accounting records and the means of keeping the records. If a proper method of internal check has not been maintained, he may make suggestions as to how to bring about a satisfactory system of internal checking. This is undoubtedly constructive. Wildman says, concerning the wording of the report that, "Good construction advocates the use of simple words, short sentences and nontechnical expressions as far as possible. By so doing someone may be bored, but it is much better to use language which the ordinary man understands rather than to attempt to impress readers with literary style. It is not necessary to indulge in literary style. All that is re- quired is to express such thoughts as a person may have in con- nection with a technical subject in a clear, concise way which the layman will understand. The professional auditor is not expected to be a literary expert. He is expected to have an ac- counting sense and to understand accounting, and to be able to use English sufficiently well to express clearly what he has to say on the subject." The Certificate. When an auditor is employed by a busi- ness man, he is expected to submit proper statements of financial condition in standard form properly certified. The object of ob- taining a certificate from the auditor is to secure from an unbias- ed person, one who is skilled in professional accounting, an opinion as to the accuracy of the accounts and statements which exhibit actual financial conditions. Federal Reserve requirements specify that, "The Balance Sheet and certificate should be connected with the accounts in such a way as to ensure that they shall be used only conjointly. This rule applies also to any report or memorandum containing any reservations as to the auditor's responsibility; any qualification as to the accounts, or any refer- ence to facts materially affecting the financial position of the concern. "The certificate should be as short and concise as possible, consistent with a correct statement of the facts, and if qualifi- cations are necessary the auditor must state them in a clear and concise manner. THE REPORT 227 "If the auditor is satisfied that his audit has been complete and conforms to the general instructions of the Federal Reserve Board, and that the Balance Sheet and Profit and Loss state- ment are correct, or that any minor qualifications are fully cov- ered by the footnotes on the Balance Sheet, the following form is proper: "I have audited the accounts of Blank & Co. for the period from to and I certify that the above Balance Sheet and statement of Profit and Loss have been made in accordance with the plan sug- gested and advised by the Federal Reserve Board, and in my opinion set forth the financial condition of the firm at and the results of its operations for the period. (Signed), A. B. C." The Auditor's Responsibility. Opinions vary as to the extent of an auditor's guarantee, and as to his legal responsi- bility in case of an error being subsequently discovered in the statements which he has certified. This responsibility was dis- cussed briefly on page 9 of Chapter One. Concerning the extent of an auditor's guarantee, what Lawrence R. Dicksee, F. C. A., of the firm of Price & Dicksee, says in his manual on "Auditing" is so appropriate that we can do no better than to quote from him: "Unfortunately, this is a matter upon which the profession are by no means agreed; while, on the other hand, the cases that have been decided by the courts are so few, and the questions at issue actually so narrow, that sufficient precedents are not available to definitely settle the matter. At the same time, it is well to remember that, however desirable it may be to know ex- actly the bare extent of the legal responsibility, the real profes- sional responsibility to clients ought always to be the ideal, and, further, an auditor will be the worst of friends to his profession if he studiously exerts himself to narrow the responsibilities, and so to dwarf the importance of his position. "The responsibility involved in certifying a Balance Sheet to be absolutely correct is so great, so limitless, that many have preferred to discard all claim to such a position of certainty, and prefer merely to certify a Balance Sheet as being 'in accordance with the books.' Auditors, however, will hardly require to be reminded that an investigation which had been limited to the 228 PUBLIC ACCOUNTING AND AUDITING comparison of the Balance Sheet with the books would be, for every purpose, absolutely valueless. So obvious is this conclu- sion that no professional auditor would ever think of confining his investigation to this particular point, yet many experienced auditors appear to be afraid to make any certification as to the result of such further investigation as they know to be essential. Such a state of affairs is unsatisfactory to the client and dis- creditable to the auditor. Again, it is a very open question as to whether so unsatisfactory a certificate would ever have the effect of limiting the legal responsibility of the auditor to the exact points certified. It is, at least, possible that the court would view the matter from a broader aspect, and consider that the man who had accepted the position of auditor, to say nothing of the fees incident thereto, had also undertaken the responsibilities of that position, and that it would be disposed to form its own opinion as to the real extent of such responsibilities. "It would appear, therefore, that the auditor who does not consider his investigation has been sufficiently searching escapes no liability by issuing a carefully modified certificate; and, indeed, such a course is decidedly unmanly, somewhat dishonest and ex- ceedingly childish. These are strong words, but not stronger thq.n the circumstances appear to require. "When addressing a meeting of the Institute of Chartered Accountants, Mr. Frederick Whinney, F. C. A., expressed himself as follows: 'I know perfectly well that a proper auditor must go further (than comparing the published accounts with the books) and see that books themselves do correspond,' and this view ap- pears to be endorsed by legal decisions. As to how far it is pos- sible for this standard to be carried into practice, there is perhaps some room for the elasticity of individual opinion, but the general statement is absolutely unassailable. "The chief evidence is, of course, the books (and it may be remarked, incidently, that it is clearly the auditor's duty to see that the accounts he certified, in addition to being correct, are in accordance with the books) , but the books must not be considered the sole source of evidence; the fact that a statement appears in the books is prima facie evidence only, and must be verified, not only by internal cross-examination, but also by reliable and in- dependent evidence. "The result of such an examination will be that the auditor has proved to himself that certain statements represent absolutely indisputable facts, and that certain other statements in his opin- ion appear to represent facts. Beyond this not being omnis- cient he can not go, and should never attempt to go. Let him therefore certify that he has thoroughly examined the accounts, that they are in accordance with the books, and are, in his opin- ion, correctly stated; he will then be occupying a logical, manly position far more in keeping with the dignity of his profession than that afforded by the most skillful of word juggling." THE REPORT 229 OFFICE: *fi ffi Q' | x Telephone Main 2647 309 W. TH.RD ST. A. J . ^KWWKWb CINCINNATI, 0. AUDITS CERTIFIED PUBLIC ACCOUNTANT REPORTS AND AUDITOR Cincinnati, Ohio, March i, 1919. THE BLANK MANUFACTURING CO. CERTIFICATE Mr. C. H. Becker, Chairman, Board of Directors, The Blank Manufacturing Co., Indianapolis, Ind. Dear Sir: In accordance with our engagement, I have made an audit of the accounts of The Blank Manufacturing Company for the year ended December 31, 1918, and herewith submit my report which includes the following: Exhibit "A" Balance Sheet, December 31, 1918. Exhibit "B" Statement of Profit and Loss for the year ended, December 31, 1918. Schedule "B-l" Statement of Cost of Goods Manufactured and Sold for the year ended, December 31, 1918. Comments. (Two pages.) I HEREBY CERTIFY that the attached statements have been prepared in accordance with the plans suggested and advised by the Federal Reserve Board and, in my opinion, set forth the true financial condition of the business as of December 31, 1918, and the results of operations for the year ended December 31, 1918. Respectfully submitted, (Signed) J. F. SHERWOOD C. P. A. 230 PUBLIC ACCOUNTING AND AUDITING THE BLANK MANUFACTURING GO. Balance Sheet Dec. 31, 1918 ASSETS Cash: Cash in Bank Cash Dep. for Div. No. 9 $2,050.00 Less Div. Vouchers Out. 2,050.00 Cash Dep. for Bond Int Notes and Accounts Receivable: Notes Rec. Cus. (Not past due) 10,806.00 Accts. Rec. Cus. (Not past due) 73,807.80 Notes Rec. Customers (Past due but considered good).. Accts. Rec. Cus. (Past due). $20,162.00 2,500.00 $22,662.00 600.00 10,913.70 96,127.50 Less: Res. for Dht. Notes, 2% 258.12 Res. for Bad Debts, 2% 1,750.43 2,008.55 94,118.95 Inventories, Dec. 31, 1918: Mat. and Work in Process. . 59, 875.00 Finished Stock 80,000.00 139,875.00 Accrued Assets: Interest on Notes Receivable 13 1.24 Interest on Inv. of Surplus ^4.59 Interest on Sinking Fund. . . . 875.34 1,131.17 Total Quick Assets ~ $257,787.12 Securities: Notes Receivable (Gen. Mgr.) 1,500.00 Investment of Surplus 10,000.00 Salaries Adv. to Salesmen.. 950.00 12,450.00 TotalCurrent Assets $270,237. 12 Fixed Assets: Land 100,000.00 Buildings 150,000.00 Less Res. for Depr. 2^% 6,250.00 143,750.00 Machinery 100,215.00 Less Res. for Depr. 6%. . . 15,012.90 85,202.10 Tools and Implements 20.000.00 Horses, Wagons and Harness 15,000.00 Less Res. for Depr. 10%. . 3.000.00 12,000.00 Office Furniture 2,600.50 Less Depreciation 260.05 2,340.45 363,292.55 Sinking Fund 15,000.00 Total Fixed Assets $378,292.55 Deferred Charges to Operations: Insurance 456.00 Advertising 12,575.00 Unapportioned Organ. Exp. 6,615 oo Bond Discount Unamortized 5,700.00 25,346.00 Total Assets ~~ $673.875 .67 Exhibit "A" THE REPORT 231 THE BLANK MANUFACTURING CO. Balance Sheet Dec. 31, 1918 LIABILITIES Notes and Accounts Payable: Notes Payable , $21,000.00 Accounts Payable 51,780.50 $72,780.50 Special Accounts Payable: Due to Officers and Clerks 7,681.50 Customers with Credit Balances 3*034.50 1.0,716.00 Accrued Liabilities: Factory Pay Roll Labor 2,875.00 Bond Interest Accrued 2,315.07 5,190.07 Total Current Liabilities " "$88,686.57 Fixed Liabilities: First Mortgage 5%, 2O-year Bonds 100,000.00 Reserve Accounts: Sinking Fund Reserve 15,000.00 Reserve for Bond Interest 2,500.00 17,500.00 ~ $206,186.57 Net Worth: Capital Stock Authorized . , 500,000.00 Less Unsubscribed Stock 50,000.00 450,000.00 Surplus 13,719.93 Undivided Profits (see Exhibit "B") 78,969.17 542,689.10 Less Book Value of Good Will 75,000.00 $467,689.10 Total Liabilities and Net Worth Exhibit "A" $673,875-67 232 PUBLIC ACCOUNTING AND AUDITING THE BLANK MANUFACTURING CO. Statement of Profit and Loss Year Ended Dec. 31, 1918 Sales (less returns and allowances) $625,275.00 Less Cost of Sales (Schedule "B-i") 439.42940 Gross Profit on Sales $185,845.60 Operating Expenses: Selling Expenses: Advertising $12,575.00 Salaries of Salesmen 30,250.00 Stable Expense 2,000.00 Depr. on Horses, Wagons and Harness 1,500.00 Total Selling Expenses 46,325.00 General Expenses: Office and Other Expenses . . 12,875.00 Office Salaries and Clerical Force 37,560.00 Depr. on Office Furniture.. 260.05 Loss on Doubtful Notes, 2% 258.12 Loss on Bad Debts, 2% 1,694.43 Total General Expenses 52,647.60 Total Expenses 98,972.60 Net Profit on Sales $86,873.00 Other Income: .... Rent from Part of Business Premises 250 oo Gross Income 87,123.00 Deductions from Income: Interest and Discount 2,118.83 Bond Interest 5,000.00 Total Deductions 7,118.83 Net Operating Income $80,004.17 Special Charges to Profit and Loss: Organization Expense Writ- ten off 735-OO Bond Discount Amortized. . . 300.00 Total Special Deductions. . . . 1,035.00 Profit for Period (To Surplus) . $78,969.17 Surplus, Jan. I, 1918 38,535-QO Less: Dividend, July I, 1918 22,500.00 Bond Interest Adjustment .. 2,315.07 24,815.07 13,719-93 Surplus, Dec. 31, 1918 $92,689.10 Exhibit "B" THE REPORT 233 THE BLANK MANUFACTURING CO. Statement of Cost of Goods Manufactured and Sold Year Ended Dec. 31, 1918 Material: Inventory, Raw Material, 12-31-17 $37,310.50 Purchases 195,000.00 In-freight and Cartage 2,831.00 Cost of Material Consumed 235,141.50 Labor, Factory Pay Roll 303,075.00 Prime Cost of Material Consumed $538,216.50 Manufacturing Expenses: Maintenance and Repairs 13,471.00 Depreciation Machinery, 6% 6,012.90 Buildings, 2^>% 3.75O.OO Taxes 2,010.00 Insurance 844.00 Total Manufacturing Expenses 26,087.90 $564,304.40 Deduct: Inventory, Materials and Stock in Process 12-31-18 59,875.00 Cost of Production $504,429.40 Add: Inventory, Finished Stock, 12-31-17 15,000.00 $519,429.40 Deduct: Inventory, Finished Stock, 12-31-18 80,000.00 Cost of Sales (To Exhibit "B") $439,429.40 Schedule "B-l" 234 PUBLIC ACCOUNTING AND AUDITING THE BLANK MANUFACTURING CO. Comments on the Audit For the Year Ended Dec. 31, 1918 1. ACCOUNTS RECEIVABLE The individual accounts receivable were verified by correspon- dence. The schedule of the accounts from the customers ledger was checked and it agreed with the controlling account in the general ledger. A fact to be noted, however, is that the total debit balances of customers' accounts amounted to $84,721.50, while there were credit balances amounting to $3,034.50. Instead of using the balance of the controlling account in the Balance Sheet, it was thought best to list the total debit balances among the current assets and to list the total credit balances among the current liabilities. 2. INVENTORIES The inventories were carefully checked and tested and found to be correct as stated. They were calculated at cost or market price, whichever was the lower. It would have been better had the inventory of "raw material" and "work in process" been separated, but for some unexplainable reason they were combined in one sum. This has no material effect upon the statements at this time. Hereafter, it would be better to state the inventory in three divisions: (a) Raw Material. (b) Work in Process. (c) Finished Goods. 3. FIXED ASSETS All fixed assets are stated at cost less the depreciation provided for. Reserves for depreciation have been established for all of the fixed assets, except tools and implements, and office furniture, the practice having been to credit the Office Furniture account direct with the amount of depreciation, and to take a physical inventory of tools and implements annually. 4. RATES OF DEPRECIATION The rates of depreciation are considered approximately correct as stated. _ It is to be noted, however, that in the case of machinery, no provision has been made for obsolescence. Inasmuch as there is a likelihood of obsolescence with regard to the machines in use before they have depreciated to scrap value, it might be well to take cognizance of it. The rate of depreciation is not sufficiently high to provide for this obsolescence. 5. AMORTIZATION OF BOND DISCOUNTS The method of amortizing the bond discounts which were set up at the time of the sale of the bonds is not scientifically correct but is reasonably accurate, and it is doubtful whether there would be any real value in changing the established procedure at this time. 6. BOND INTEREST At the end of the previous period, December 31, 1917, there should have been charged to Bond Interest the amount of the accrued interest from July 15 to December 31, 1917. This was not done, hence it was necessary to adjust the Surplus account because we could not charge more than $5,000.00 to the Bond Interest account for the year 1918, as the total interest on the bonds for the year would only amount to this sum. THE REPORT 235 7. INCOME AND EXCESS PROFIT TAXES It would be unwise to distribute the net profit for the year be- fore provision has been made for Income and Excess-Profits Taxes. At least, a reserve for the estimated amount of such taxes should be set up before any action is taken regarding the distribution of profits. 8. SINKING FUND APPROPRIATION There is a provision to the effect that $15.000.00 must be appor- priated for the sinking fund before profits are distributed. 9. ADVERTISING This account represents expenditures in connection with the pub- lication of a catalog and miscellaneous advertising matter, and, inas- much as a physical inventory shows that a large part of this material is still on hand and unused, it was thought best to defer one-half of the cost to the next fiscal period. This advertising matter is to be used over a period of two years, and, inasmuch as both years will benefit from it equally, we have only charged off one-half of the cost of adver- tising to current expenses. 10. ORGANIZATION EXPENSES Investigation showed that there were organization expenses amounting to $7,350.00 that had not been charged off. The policy of the company has been to charge off 10 percent of the balance of this account annually. While it might be more conservative to charge this off over a shorter period of time, yet in the face of the fact that there is no doubt but that the first ten years will benefit from these expendi- tures, there can be no harm in apportioning them over this period of time. 11. GOOD WILL At the time the corporation was formed the business of a partner- ship was in part taken over. The corporation was forced to pay a sum of $75,000.00 on account of the good will of the partners. This valua- tion was based largely upon the value of a trade name and other in- tangible assets. Inasmuch as the account, therefore, represents an actual investment, it would seem that there can be no criticism in per- mitting it to stand on the books of account. While it might be con- servative practice to write off the account proportionately over a period of years, yet this is a financial matter to be decided by the management. It is to be noted that instead of classifying it among the assets in the Balance Sheet, we have deducted it from the net worth of the concern. Since we have been asked to express our opinion in the matter, we believe that it would be wise to install a Cost Accounting system which should connect with the general accounting records, and would enable the management to determine costs accurately and thereby determine selling prices in an intelligent manner instead of a more or less arbitrary manner as at present. The material and stock records, if kept prop- erly, would also enable the chief accountant to furnish monthly com- parative statistics and interim financial statements that would prove of great benefit to the executives in making their plans, and would enable them to know just where they stand at all times. In conclusion, we are desirous of expressing our appreciation of the cooperation rendered us during the period of the audit, and we also desire to state that the books of account have been kept accurately and neatly, which, of course, aided materially in completing the audit promptly. Respectfully, (Signed) J. F. SHERWOOD, C. P. A. 236 PUBLIC ACCOUNTING AND AUDITING A. THEORY QUESTIONS 1. What is meant by a qualified certificate? Give an illustration of a case in which a qualified certificate might proper- ly be given and draft a qualification applicable to that case. Inst. Ex. 1917. 2. What are the essentials of an audit certificate in an audit for credit purposes? Inst. Ex. 1917. 3. Draft a form of audit certificate to accompany a Balance Sheet which is to be published in the annual report of a cor- poration. Inst. Ex. 1918. 4. Draw up an outline of a report on your audit of the accounts of a corporation that has recently erected a large apart- ment house. Assume your instructions covered the period of erection and at least one year of operation. Inst. Ex. 1918. 5. Give your opinion of the following form of certificate to a Balance Sheet : "I have examined the above Balance Sheet and certify that it * is in accordance with the books of the Company." (Signed) CHARLES E. WILSON C. P. A. 111. 6. If employed by the officers of a corporation to make an audit, would you make any difference in your plans and in your report if you knew whether the audit was to be presented to a prospective purchaser of the stock, to a prospective purchaser of bonds, to the bank as a basis for the purpose of securing a loan, or to the stockholders at their regular annual meeting? If so, state the differences. C. P. A. Mich. B. ACCOUNTING PROBLEMS i. From the following accounts appearing on the Trial Balance, prepare without using figures, statements which you consider best calculated to set forth the operations of the year and the financial position at December 31, 1916, assuming that you are preparing these statements on behalf of a bank which desires paper available for rediscount with the federal reserve bank. Accounts payable Accounts receivable Advertising Buildings Capital stock Capital stock unsubscribed Cash on deposit Commissions paid salesmen Depreciation buildings 1916 Depreciation machinery 1916 Discount allowed on sales Discount rec'd. on purchases Doubtful accounts receivable Factory expense Finished goods inv. 12-31-15 Freight and cartage inward Freight and cartage outward Fuel Good will Insurance bldgs. and mach. ACCOUNTING PROBLEMS 237 Insurance finished goods Insurance unexpired buildings and machinery Insurance unexpired finished goods Int. accrued on investments Int. accrued on mortgage pay. Interest paid Interest received Investments Labor factory payroll Land Machinery Material inventory 12-31-15 Material purchased Mortgage on plant Notes payable Notes receivable Office expenses Office furniture and fixtures Office payroll Organization expenses (to be distributed over three years from January I, 1916) Payroll factory accrued Payroll office accrued Petty cash Prepaid taxes and real estate Profit and loss 1915 surplus Repairs buildings Repairs machinery Res. for bad and dbt. accounts Reserve for depr. buildings Res. for depr. machinery Returns and allowances on sales Salaries general officers Salaries salesmen Sales Salesmen accounts advances on salaries Subscriptions and donations Taxes income U. S. Taxes real estate Work in process inv. 12-31-15 The inventories December 31, 1916, not on the books were: Finished goods Material work in process Inst. Ex. 1917. 2. The following is the Balance Sheet of the A. B. Company January I, 1915: Cash Accounts receiv- able Inventories: Raw material. . Finished goods. Office furniture and fixtures. . . Land Buildings Machinery $ 52,864.00 197,425.00 84,268.00 31,597-00 7,500.00 180,000.00 150,000.00 250,000.00 Accounts payable $35,482 . oo Dividends payable pfd. stock 2-1-15 7,500.00 Dividends payable com. stock 2-1-15 IO.OOO.OO Mortgage bonds 2O-year 6 %, dated Jan. i,- 1 5 100,000.00 Premium on bonds 5 ,000 . oo Capital stock pfd. 250,000 . oo Capital stock com. 500,000.00 Res. for bad debts 4,718.00 Surplus 40,954.00 $953,654.00 $953-654-00 238 PUBLIC ACCOUNTING AND AUDITING The transactions for the year ending January i, 1916, have been as follows: Cash received from customers $793,501 .00 Rent received 600 . oo There has been purchased 1,232,000 Ibs. raw material at 20 cents per Ib. Sales have been 823,334.00 Discount and allowances on sales 23,519.00 Bad debts written off 2,143 . oo Disbursements have been made for Accounts payable 243,356.00 Factory expense 7489 . 00 Factory labor 351,426.00 Factory repairs 23,843 . oo Office expense i ,927 . oo Selling expense 52,914.00 Salaries 58,471 . oo Taxes 7,853 . oo Inventories January i, 1916 Raw material 412,595 Ibs. having a market value of 22 cents per Ib. and finished goods $30,842.00. The land is estimated to be worth $200,000.00. Semi-annual dividends of 3 per cent on pre- ferred and 2 per cent on common, declared in June and December, payable August i and February i. Reserves for deprecia- tion of buildings 3 per cent; machinery 5 per cent; office fixtures 10 per cent. Bad and doubtful debts reserve should be 2 per cent of accounts receivable. Prepare Statement of Cost of Goods Manufactured and Sold, Profit and Loss statement, and Balance Sheet as of January I, 1916. Inst. Ex. 1917. (Note. Beginning with the Balance Sheet at January I, 1915, it will be necessary to carry the transactions of the year through working papers or to set up skeleton ledger accounts in order to obtain the balances of the ac- counts which form the basis of the statements at January I, 1916.) PRACTICE DATA 239 PRACTICE DATA (Continued from Chapter Fourteen) Transaction No. 13. You have now completed your audit of the books of the General Manufacturing Company, but you should prepare a Working Sheet similar in form to the one illustrated on pages 216 and 217. This should be done in the office of the client because it is frequently nesessary to secure additional information. If one were to prepare the Working Sheet in his own office, which might be at some distance from the office of the client, it would readily be seen that it would be inconvenient, and sometimes impossible, to secure the information needed. Remember that the Working Sheet as prepared by an auditor is not to be confused with what was formerly known as a six-column statement. The ledger accounts, as set up by you, show a proper summary of all the real and nominal accounts, consequently the Trial Balance prepared by you, as instructed in Transaction No. n, is the same as will appear in the first two columns of your Working Sheet. The journal entries set up in accordance with the instructions in Transaction No. 12 will naturally be entered in the adjustment columns of the Working Sheet. After this has been done, you are ready to extend all of the accounts into the proper columns, classifying them as either nominal or real accounts. After the Working Sheet is prepared your work in the office of the client is completed. Transaction No. 14. You are now instructed to prepare a report for your client, the General Manufacturing Company based on your completion of the audit of their books. This report should consist of the following: Exhibit "A" Balance Sheet. Exhibit "B" Statement of Profit and Loss. Schedule "B-i" Statement of Cost of Sales. Comments. Certificate. Transaction No. 15. Your client requests that you prepare closing journal entries to properly close the nominal accounts as at the close of business, Dec. 31, 1920. His book- keeper will then post the closing entries to the proper ledger accounts. Appendix ACCOUNTING TERMINOLOGY Applicants have been asked to define the following account- ing terms in the examinations given in the various states since the first law was passed in New York in 1896 recognizing account- ancy as a profession. The definitions presented here are, in part, those prepared by the Committee on Terminology appointed by the American Association of Public Accountants. This Committee was made up of the following members, all of whom are Certified Public Accountants: J. Lee Nicholson, Chairman Hamilton S. Corwin, Henry B. Fernald, John R. Wildman. Terms not defined by the above Committee, but which have been used in the examinations are herein defined, and the definitions given are those sanctioned by the best accounting authorities. Abeyance. Held in suspense for future settlement or adjustment. Abstract of Postings. A list of ledger postings such as one drawn off for the purpose of proving the postings in the ledger with the books of original entry or for special information. Acceptance, (i) An agreement to pay a bill of exchange, draft, order or kindred instrument on the terms stated therein. (2) The document itself when bearing on its face the evidence of its acceptance. Accommodation. A loan of money or endorsement of another person's paper as a favor. Accommodation Paper. Instruments which a maker, drawer, acceptor or indorser, having no interest in the trans- action, signs merely as an accommodation to another. Account. An entry or group of entries, either debits or credits or a combination of both, under a specific or descriptive heading, exhibiting the history and results of the transactions pertaining thereto. 241 242 PUBLIC ACCOUNTING AND AUDITING Account Current. A running record of current financial transactions between two parties who may, through the growth of their account, become debtor or creditor alternately. Account Sales. A statement giving an accounting of goods sold, rendered by a consignee to the consignor. Account Receivable. An account showing a debit bal- ance to be presently received in cash or its equivalent. Account Payable. An account showing a credit balance to be presently paid in cash or its equivalent. Accountability. That relation which exists between two parties by virtue of which one is required to account to the other for money or property. Accountancy is a profession having to do with the record- ing, verification and presentation of facts involving the acqui- sition, production, conservation and transfer of values. Accountant. One skilled in the science of accounting. Accounting. Accounting is the science which treats of the systematic record, compilation and presentation in a compre- hensive manner of the financial operations of a business. Accrual, (i) The act of accruing. (2) That portion of an accruing account not yet due applicable to the accounts of the period under consideration. Accrue, (i) To accumulate automatically through lapse of time. (2) To set up or record a debit or credit automatically accumulating through lapse of time. Accrued interest receivable or payable is the amount of accruals of interest on various classes of assets or liabilities. Accrued taxes is the amount of accruals of taxes. Accrued dividends (or accumulated dividend) is the amount of accruals of dividends receivable or payable on guaranteed or cumulative stocks owned, issued or guaranteed. Active Account. An account in which the entries are frequent; as distinguished from an "inactive" account. Active Partner. A partner who is subject to full part- nership liability as distinguished from a "silent" or "special" partner, whose liability is limited. Additional Capital. New capital; i. e., an amount supplied as capital increasing that previously provided. The term "additional capital" refers to the amount coming into the ACCOUNTING TERMINOLOGY 243 business as distinguished from the expenditures made in increas- ing capital investments. (See Additions to Capital.) Additions to Capital. (A contraction of "additions to capital investments.") Expenditures for capital account; "capital expenditure." The amounts expended for additional capital assets, such as structures, machinery or permanent equipment. Adjustment Account. A temporary account set up to show a record of the items of a transaction or series of transactions subject to and pending its clearance by definite classification or by adjustment between the respective interests therein. Adjustment Mortgage Bonds. Mortgage bonds issued under a modification of the terms of a previous issue, the con- ditions of which the debtors have been unable to fulfill. Administration Expenses. Expenses incurred in con- nection with the administration of a business, usually the salary and expenses of the executives and other expenses not directly chargeable to specific operating or selling expenses. Administrator. A person named by the probate court, or other proper authority, to take charge of the property and administer the estate of one dying without leaving a will or an estate for which no competent executor is named in the will. Advance Bill. A commercial "bill of exchange" drawn against goods subsequently to be shipped instead of against a shipment already made. Advertising Expense. The expense of attracting the attention of the public to a business, product, proposition or fact. Affiliated Company (or Corporation.) A company (or corporation) related to another through stock or bond owner- ship, operating agreement or other mutuality of interest. Agency, (a) The relationship between principal and agent, (b) The place of business of an agent. Agent. A person duly authorized to act on behalf of another, or one whose unauthorized act has been duly ratified. Allocate, (a) To assign items to their appropriate cap- tions in a classification of accounts, (b) To classify. Allonge. A slip of paper attached to a negotiable instru- ment to receive endorsement for which there is no space on the instrument itself. 244 PUBLIC ACCOUNTING AND AUDITING Allowance, (i) A concession or abatement. Specifically in accounting usage, a concession made to customers because of faults existing or claimed in goods or service. (2) A definite amount granted or determined upon for a specific purpose; as an allowance for depreciation, an allowance in lieu of actual expenses, etc. Amortization. The gradual extinguishment of the amount of an asset, liability, profit or loss by pro-rating it over the period during which it will exist or during which its benefit will be realized. Specifically, (i) The gradual extinction of a debt, as, for instance, by means of a sinking fund. (2) The gradual reduction in the valuation of an asset, thus anticipating the time when it shall eventually become worthless; as distinguished from provision for depreciation or replacements because of physical loss or damage. (3) The absorption in the Income or Profit and Loss accounts, during the pendency of the debt, of a discount incurred or of a premium realized in the sale of an obligation, which discount or premium may be carried in the meantime in a debit or in a credit Suspense account. Annuity. A fixed sum of money granted or bequeathed, payable yearly or at certain regular periods. Appraisal. The result of a valuation of property or other assets, used mostly in connection with the valuation of fixed assets of a corporation. Appreciation. Increase in value through improvement in condition or market value, applied in respect of real estate, plant, machinery, securities, etc. Assigned Accounts. Accounts originally due to one person who has by agreement made them payable to some other person, usually his creditor. Auditor. An accountant who examines, criticizes and passes upon the accuracy of accounts. Balance Sheet. A statement showing the financial con- dition of a business at a specific date. Balance Sheet Audit. A verification of the assets and liabilities and a sufficiently exhaustive analysis of the Profit and Loss accounts enabling the auditor to certify that the sur- plus appearing in the Balance Sheet is reasonably correct. Bank of Discount. A bank authorized by law to lend money on personal notes. The term bank, as used here, means any moneyed corporation authorized by law to issue bills, notes, or other evidences of debt for circulation as money, or to receive deposits of money and commercial paper and to make loans ACCOUNTING TERMINOLOGY 245 thereon, and to discount bills, notes, or other commercial paper and to buy and sell gold and silver bullion or foreign coins or bills of exchange. (N. Y. State Banking Law.) Book Inventory. A record of all goods put into and taken out of stock, and the balance remaining on hand. It always shows quantities and must also show values if the cost records are articulated with the general books. Budget. A statement of the estimated revenues and expenditures for a given future period. Capital. This term as used in accounting is employed to express the sum of the net assets, or the sum which remains after deducting the total liabilities from the total assets of a business or undertaking. Any principal sum (usually in cash, sometimes in property) contributed to an undertaking by a partner or other individual for supplying the means to operate such undertaking. The value or amount any individual has invested in an undertaking. Any principal sum which is used or retained to produce income or profit. Capital Assets. Includes real estate, buildings, and other structures, equipment and other personal property of a more or less permanent character, and cash on hand specifically applicable to these assets. Capital Expenditures. All sums expended for addition to, or improvement of, properties. Capital Liabilities. Liabilities incurred in the acquisi- tion of capital assets. Capital Receipts. Cash received from stockholders in a corporation in payment of their subscriptions to the capital stock. Capital Stock. The amount of share capital (issued or authorized) of a company or corporation. Cash. Lawful money. Usually understood to include cash items and such other instruments as are received by banks for deposit. Cash Disbursements. Cash payments made during a stated period regardless of the purpose of the payment. 246 PUBLIC ACCOUNTING AND AUDITING Cash Journal. A book of original entry in which both cash and non-cash entries are recorded. Columns are provided for cash receipts, cash payments, and for accounts most frequently debited and credited. Sundry debit and credit columns are also provided. Cash Receipts. Cash received during a stated period regardless of the purpose for which received. Chattel Mortgage. A lien upon personal property, given by the owner as security for the payment of a debt or the per- formance of some other obligation. Upon default, such lien may be perfected into an absolute title by foreclosure and sale. Closing Entries. Entries made upon the books of ac- count at the end of a fiscal period for the purpose of closing the nominal accounts. Consignment Accounts. Those accounts which cover the consignment of goods to an agent or consignee. Consolidated Balance Sheet. A Balance Sheet which exhibits the combined financial condition of a number of business organisations. Construction Account. An account employed to show the cost of construction of a piece of property. It is usually made to contain all items, such as material, labor, expense, entering in the work; in some cases interest on borrowed money is charged against this account and even the discount on the sale of bonds issued for the work. Contingent Fund. Money set aside to be drawn upon only in case of certain emergencies. Contingent Liability. An amount which may become due usually through the default or action of a third party. Controlling Account. An account kept in the general ledger which represents in one account the sum of all the trans- actions, and of all the balances of a group of accounts in a sub- sidiary ledger, or other record such as a voucher payable record. Costs Incurred. All expenditures, whether paid in cash or not, for which a business has become liable. Current Assets. Those assets which can be readily con- verted into cash. Current Liabilities. Amounts owed subject to constant change, such as accounts payable to creditors, becoming due and payable in short periods. ACCOUNTING TERMINOLOGY 247 Deferred Charges to Operations. That part of oper- ating expenditures which is paid within a given period but is not properly a charge against the income of that period and, therefore, is deferred or postponed uatil a period following. Deferred Credit. That part of revenue which is received within a certain period, but is not properly a credit to the income for^that period, and, therefore, is deferred or postponed until a period following. Deferred Debit. That part of expenditures which is paid within a certain period, but is not properly a charge against that period and, therefore, is deferred or postponed until a period fol- fowing. Deficiency Account. An account relative to a statement of affairs, showing the causes for the prospective deficiency in the payments to the unsecured creditors of an insolvent concern. Departmental Accounts. A system of accounts which covers the separate workings of the departments of any concern usually in relation to the profit or loss made by such departments. Depreciation. That inevitable lessening in value, which is inherent in any fixed asset, caused by wear and tear and gradual obsolescence. Depreciation Fund. Cash or other assets set aside to provide for depreciation of plant, property, etc. Depreciation Reserve. A part of the earnings set aside and carried as a credit to offset any deterioration of assets which has taken place or is likely to arise. Diminishing or Wasting Assets. Assets which dimin- ish proportionately to the lapse of time or to their consumption as an element of production. Disbursements. Cash payments made during stated period, regardless of the purpose of the payment. Dividend Account. The controlling account in the gen- eral ledger of any corporation to which is credited the amount of dividend on the day of declaration and to which are charged checks issued in payment thereof, either "en bloc" or as they may be presented for payment. Effective Interest Rate. The ratio of the amount earned to the actual amount of money invested, as distinguished from the nominal rate which is figured on the par value of the bond or other investment. Effective Rate. (See "Effective Interest Rate.") 248 PUBLIC ACCOUNTING AND AUDITING Financial Statement. A Balance Sheet. Sometimes taken to include all other statements, such as a statement of affairs, a statement of income and expenditures, and a statement of profit and loss. Finished Product. The article of trade of a manufactur- ing concern which has been completed and is ready for sale. Fixed Assets. Such assets as are stationary and may be regarded to a certain extent as permanent, such as real estate, buildings, plant, machinery, etc. The term "Fixed Assets" and "Fixed Capital" are frequently interchanged, but preference is given to the former term. Fixed Charges. Charges which remain comparatively unchanged during long periods of time, such as interest on bonds, debentures, etc. Fixed Liabilities. The permanent or ultimate obliga- tions as distinct from the current obligations (or floating in- debtedness) of a person, firm, or corporation. Floating Assets. Same as liquid, sometimes called "Cir- culating Assets." Floating Capital. Capital which is not in a fixed or permanent shape, but is available or convertible, such as raw material, book debts, cash, etc. Floating Debt, (i) That portion of a debt of a corpora- tion or undertaking which is not represented by a bond issue. (2) General or ordinary indebtedness. Floating Liabilities. Amounts which are due to others or are about to become due, as creditors' accounts and bills payable. Funded Debt. That portion of a debt which is repre- sented by a bond issue and payable at a distant date. General Balance Sheet. A Balance Sheet by totals, i. e., one which shows the financial condition of a company by group accounts without regard to detail. Good Will. Good will represents the value attached to a business over and above the value of the physical property. Hypothecate. To pledge or mortgage. Impersonal Accounts. Accounts which represent con- dition and record the profits, losses, receipts, expenditures, assets, and liabilities, but do not represent persons. ACCOUNTING TERMINOLOGY 249 Imprest System. A system for making petty cash dis- bursements whereby the petty cashier is reimbursed for the exact amount disbursed, the original amount of the petty cash fund remaining unaltered. The reimbursing check is charged to the proper expense accounts for which the petty cash payments have been made. Income. The account which sets forth the entire income for a fixed period whether actually received or not. The gain which proceeds from property, from manufac- turing and selling, or from buying and selling. The remuneration derived from skill or labor. The proceeds of the property of an estate. Income Bond. A long-term promissory note, the interest on which is payable out of income if earned. Interest Account. A revenue account to which is debited and credited interest incurred or earned whether paid or not. Inventory, (i) The annual account of stock of a business. (2) A schedule of assets or property. (3) An itemized list of goods or valuables with prices attached. Joint Venture Account. An account covering a specific shipment of consigned goods to be sold for the benefit of two or more parties. Legal Assets. Property which creditors might make available in a court of law for the payment of the debts of a deceased person. Life Tenant. The beneficiary under a will who enjoys the income from an estate during life. Liquid Assets. Cash and such assets as can readily be converted into cash. Loose-Leaf System. A binding device which permits the insertion and removal of sheets as desired. It is not a distinctive system of accounting. Either the books of original entry or the ledgers may be kept in loose-leaf form if desired. Maintenance Reserves. A reserve to which may be charged expenses in connection with maintaining some asset for which the reserve has been created. Manufacturing Account. An account subsidiary to the Profit and Loss account for the purpose of showing the result of factory operations as distinguished from trading operations. 250 PUBLIC ACCOUNTING AND AUDITING Material Account. An account used to control the amount of material on hand in a manufacturing concern. The account is charged with purchases and credited with issues to factory. The balance should agree with the inventory of ma- terial. Merchandise Account. An account intended to rep- resent the trading transactions of a business, and to exhibit gross profit made on same. An account to which is charged the purchases of material to be sold or used in manufacture, and to which may be credited the materials sold or used. National Bank Notes. Promissory notes issued by na- tional banks and circulating as money. Such notes are fully secured by United States bonds purchased by the issuing bank and deposited in the United States Treasury. Net Income. After all costs of operation and fixed charges of every kind have been deducted from the earnings of a corporation, the balance, which is the amount available for dividends, may be called "net income". Net Profit. The balance remaining after all expenses of distribution and establishment charges, discount, interest, etc., have been deducted from the gross profits. The balance of the Profit and Loss account when the same is a gain. The surplus remaining over from the employment of capital after defraying all the expenses and outlay incurred in its em- ployment, and after the capital has been replaced or provision made for its replacement. Nominal Accounts. Accounts which represent income or expenses. Accounts used for the purpose of classifying income and expenses under such heads as rent, taxes, sales, purchases, salaries, etc., forming the material for the construc- tion of the Profit and Loss statement. Nominal Interest Rate. The rate of interest on bonds figured on the par value of the bond. Operating Expense. The expense incurred in the reg- ular transactions of a business. Overhead Expense or Burden. Elements of cost which cannot be definitely assigned to any particular job, or series of jobs, but are a part of the expense of manufacture, and must be taken into account in calculating costs. ACCOUNTING TERMINOLOGY 251 Organization Expenses. Expenses which are necessarily incurred before a corporation can begin to do business. They include such things as the legal and other fees for obtaining the charter, the expense of obtaining subscriptions to the stock, and sometimes the comission paid to brokers for selling the stock. Charging discount on stock sold below par to this account is a questionable practice sometimes indulged in. Pay Roll Advances. Wages paid in advance. Personal Account. Accounts showing the transactions with persons, as customers' and creditors' accounts. Plant Accounts. An account the debit balance of which represents the value of land, buildings, and sometimes machinery and fixtures, of a business concern. Present Worth of Deferred Payment. An amount which if put at interest will at maturity amount to the deferred payment. Profit and Loss Account. A summary account showing the income and losses during a given period. Proprietary Interest. The interest of a proprietor or partner. A partner has a proprietary interest in all of the assets of the firm. Purchases Ledger. A subsidiary ledger containing ac- counts with creditors accounts payable usually controlled by an account in the general ledger. Qualified Certificate. A certificate that does not state positive facts as the results of an audit, but contains some clause or expression which is intended to limit the responsibility of the auditor in regard to some one or more items, the accuracy of which he has not been able to verify. Real Account. Represents the value of an actual asset, or the amount of an actual liability, such as real estate, ma- chinery, loans, and mortgages. Realization and Liquidation Account. An account showing the result of the liquidation of a business or estate. Redemption Fund. A fund accumulated for the pay- ment of redeemable debentures, funded debt, or other obliga- tions. Remainderman. The beneficiary under a will to whom the estate passes at the death of an intermediate party, called the life-tenant, who enjoys the income from said estate through- out life. 252 PUBLIC ACCOUNTING AND AUDITING Reserve Fund. Cash set aside out of the general funds, usually measured by a reserve (credit), both the fund and the reserve being created for some specific purpose. The reserve (credit) represents the profits withheld, while the fund shows the amount of cash available for the specific purpose. Revenue Account. An account which relates to profits and losses, income and expenditures, as distinguished from capital accounts which relate to assets and liabilities. Revenue Accrued. That which has been earned since the last receipt of revenue but is not due and has not been received. Revenue Balance Sheet. In municipal accounting, a Balance Sheet of current assets and liabilities, showing cash and amounts due from current revenues and the liability thereon due to appropriations. Revenue Expenditures. Expenditures made in connec- tion with the running expenses of the legitimate business of the firm or corporation concerned. Expenditures that only have the effect of putting the earning power of the undertaking upon the same footing as that which had previously obtained, must be charged against revenue. Revenue Receipts. They are distinguished from capital receipts by being exclusively derived from the sale or exchange of the commodities which the company was organized to buy and sell, the excess of receipts over expenditures constituting net profit or added actual capital. Receipts derived as the direct result of trading, as distinguished from capital receipts resulting from the sale of capital stock, or proceeds of bonds, mortgages, etc. Secret Reserves. Values of assets in excess of those indicated by the Balance Sheet. Serial Bonds. An issue of bonds payable in instalments. Shipment Account. Corresponds to "Adventure Ac- count," but is the account on the books of the consignee. Single Name Paper. A note for which a single indivi- dual, firm, or corporation is responsible for payment; a note bearing but one signature and without endorsers. Sinking Fund. A certain sum set aside each year, that accumulated at compound interest, will be sufficient to provide for the payment of bonds or other obligations maturing at some future time. ACCOUNTING TERMINOLOGY 253 Statement of Affairs. An exhibit of the assets and the liabilities of an insolvent debtor, so arranged as to show on one side all the assets of the concern with the amounts they are expected to realize extended into another column, and on the other side all the concern's gross liabilities with the amount expected to rank carried into a separate column. Statement of Assets and Liabilities. A statement of financial condition of a solvent concern, where the books are kept by single entry, is best designated as a "Statement of Assets and Liabilities." Statement of Income and Expense. A statement which shows the income earned and expenses incurred during a certain period, it being immaterial whether or not the items are actually received or disbursed during that period. Statement of Receipts and Disbursements. A state- ment arranged in report form, showing respectively with regard to cash, the balance at the beginning of a period, the classified receipts and disbursements during the period, and the balance remaining at the end of the period. A summarized Cash account, stating the amounts of money actually received and disbursed during the period to which it relates, without regard to whether the same are earnings or expenses exclusively appertaining to that period, or include items so appertaining to the period preceding. It starts with the cash balance at the commencement of the period which it covers, and concludes with the cash balance at the close thereof. Summary Account. An account into which a number of detail accounts are closed for the purpose of showing a general result. Surplus. The excess of assets over liabilities including capital stock. It is in reality undistributed profit. Surplus Fund. A credit account formed by periodically setting aside a portion of the net profits of a corporation to provide an unspecified reserve for contingencies. In the National Banking Act, a fund created by setting aside one-tenth of the net profits until 20% of the capital has been so reserved for dividends. Trading Account. This account shows the same facts as the trading accounts on the Profit and Loss statement, and may be shown as a separate account, or as one section of the Profit and Loss account. All accounts relating to the pur- chase and sale of merchandise are usually classed as trading accounts. 254 PUBLIC ACCOUNTING AND AUDITING Treasury Stock. Such portion of the capital stock of a corporation as has been fully paid for and legally issued and has since been acquired by the issuing corporation, either by purchase or by donation. Trial Balance. A Trial Balance is a list of the balances or footings shown on a ledger, for the purpose of testing their accuracy. When successfully compiled, it ceases to be a trial balance and becomes a statement of ledger balances. Two Name Paper. A note made by two persons as individuals or made by one and endorsed by another these two persons being severally liable. Undivided Profits. Earnings or profits which have not been divided among the partners in a firm or the stockholders in a corporation. Voucher Check. A check which contains as part of the instrument a statement of the account covered by the check. It is used in connection with the voucher system of accounting for expenditures. Voucher System. A method of accounting for expen- ditures. The vouchers payable book shows the existing liabili- ties and serves in the place of a subsidiary accounts payable ledger. A controlling account is kept in the general ledger with Vouchers Payable. This account shows the total of unpaid vouchers. Will. A last will and testament and all codicils. A solemn declaration in legal form making a disposition of property to take effect at death, but revocable during life by the person making the will. Working Capital. All assets available for the carrying on of a business, such as cash, accounts receivable, notes receiv- able, and inventories. Those assets which are the subject of the company's business or may be easily converted into cash. 255 INDEX Accounts bond 184 bond discount and expense. 185, 187 bond interest 185 bond premium 185 bond subscription 184 building 122 capital stock, discount 197 capital stock, premium 197 creditors' 161 horses, wagons and harness. ... 133 land 121 machinery 130 notes payable 167 office furniture 133 organization expense 199 purchases ledger, controlling. . . 162 tools and implements 131 unissued bond 184 vouchers payable, controlling.. . 163 Accounts Assigned 84 Accounts Past Due 84 Accounts Payable 161 Accounts Receivable 81 Accounts Outlawed 89 Accountancy 9 Accounting 9 Accounting Systems double entry bookkeeping 1 1 single entry bookkeeping 10 Accounting Terminology 241-254 Accrued Liabilities 171 Additions 134 Adjusting Entries 215, 216 Advance Payments 104 Advice to Juniors 118 Aging Accounts 84 Appraisement, when necessary. . . 136 Appreciation 153 Auction Sales 93 Audits value of 19 kinds balance sheet 23 cash 22 detailed 23 internal 22 purposes and advantages of major objects 8 minor objects 6 Audit Program 23, 101 Auditor's Report 225 Auditor's Responsibility 9, 227 B Bad Debts 84 denned 87 not a deduction . . 86 Balance Sheet 38, 230, 231 Bank Certificate 57 Beginning an Audit 17 Bonds adjustments 181 callable 182 convertible 182 coupon 181 debenture 180 deed of trust 179, 183 gold 182 guaranteed 181 improvement 181 income 180 issuing, procedure bond issue authorized 183 directors' meeting 183 sale of bonds 184 stockholders' meeting 183 mortgage 180 participating 182 purchase money 181 redeemable 182 redeemed 188 refunding 181 registered 181 security 179 serial 182 Bonus Stock 202 Book Inventories 97 Book Variations 137 Books of Account journal 33 ledger 36 notes payable 167 Capital and Revenue Expenditures 129 Capital Stock 204 Cash 51 Certificate, the 166, 226, 227 Classification of Accounts real. 25 nominal 27 Comments, the Auditor's 226, 234, 235 Commercial Law contact with accounting 12 Commissions 172 Common Law 13 Common Stock 201 Comparative Statement Profit and Loss 214 Completing an Audit 215 Consigned Goods 102 Consignment Purchases 165 Constitutional Law 13 Construction Work in Progress. . . . 135 256 Index Continued Contingent Fees 23 Contingent Liabilities 67, 169 Controlling Accounts 36, 162, 163 Copartnership 193 Corporation 194 Correcting Entries 215, 216 Cost of Sales 210 Cost Systems 102, 103 Counting the Cash 55 Cumulative Preferred Stock 200 Current Liabilities. . 161 D General Reserve 151 Goods in Transit 102 Gross Profit on Sales 210 Gross Profit Test 103 Guaranteed 210 Guaranties 170 H Horses, Wagons and Harness 133 How to End an Audit 215 Damages 172 Debenture Stock 201 Deductions from Income 211 Deposits 84 Depreciation basis of 155 causes 146 defined 145 factors 147 Methods of Calculation annuity 149 comparison of 151 diminishing value 149 production unit 150 rates 155 straight line 148 Discounts 82, 84, 105 Discrepancies 102 Donated Stock 202 Doubtful Accounts 83 E Endorsements 170 Engagement Blank 17, 18 Equipment 17 Errors clerical 7 of commission 7 of omission 7 of principle 7 offsetting 7 Expenses 211 Factory Overhead Cost 135 Fire, Merchandise Destroyed by 100 Fire, Property Destroyed by 135 Fixed Assets 120, 129 Fixed Liabilities 177 Forfeited Stock 202 Founders' Stock 201 Fraud 6, 45, 53 Inadequate Cost Systems 102 Income Tax Procedure adjustment of inventories 108 assessments not deductible 125 basis of depreciation 155 capital expenditures not deductible 154 depreciation, a deduction 154 interest on Liberty bonds 187 inventories at cost 107 inventories at market 108 inventories prescribed 109 inventory valuation, basis 106 rates of depreciation 155 repairs on real estate, deductible 126 repairs on real estate, not deductible 126 replacements and renewals 154 taxes, deductions 125 valuation of inventories 107 Installments, Construction Work. 135 Interest Not a Part of Cost 105 Interest on Liberty Bonds 187 Interest Payable 171 Imprest System 52 Inventories 97 Judgments 189 Law of Contracts agreement 60 alterations 45 assignment of contracts 60 breach of contract 61 condition concurrent 156 condition precedent 156 condition subsequent 156 contracts by correspondence. . . 157 discharge 60 essential conditions 29 illegal contracts 45 intervention of impossibility. . . 6l legal tender 6 1 Index Continued 257 methods of making contracts. . . 29 mistakes 45 novation 60 operation of law 61 performance 60 statute of frauds, the 29 Sunday contracts 156 tender 61 unenforceable contracts 45 voidable contracts 45 Law of Personal Property accession 139 acquiring title to personal property 139 acquisition 139 chattels 138 intellectual labor 139 transfer of property 140 Law of Real Estate. , 124 estate in fee simple 124 estate for life 124 estate in remainder 124 estate in reversion 124 Leases 135 Legal Expense 172 Legal Responsibility of Client 24 Legal Tender 61 Liberty Bonds, Interest Exempt from Taxation 187 Letter of Introduction 17 Listing Notes Receivable 67 Listing Securities 74 M Machinery Account, Theory 130 Manufacturing Statement 213, 233 Model Balance Sheet 40, 41 Mortgages 189 building and loan 178 chattel 178 purchase money 178 N Nature of Engagements 17 Net Worth 193 Negotiable Instruments Law, the 172 essentials 76 non-essentials 77 endorsements blank. 173 conditional 173 how made 173 qualified 173 restrictive 173 special 173 striking out 173 Non-Cumulative Preferred Stock 201 Non-Participating Preferred Stock 201 Notes Payable 166 Notes Payable Book 167 Notes Receivable 65 Notes Receivable Discounted 66 O Obsolete Stock 103 Office Furniture Account 133 Opening Entries, Corporation 203 Other Income . 211 Participating Preferred Stock. . . . 201 Part Payments 89 Payment at Maturity 89 Pay Roll 134 Physical Inventories 98 Preferred Stock 200 Profit and Loss 209, 210 Profit and Loss Statement... .212, 232 Purchase Contracts 165 Purchases Ledger Account 162 Purposes of the Balance Sheet .... 42 Qualifications of an Auditor 8 Real Estate 120 Real Estate Purchases 135 Receipt 90 Reconciling the Bank Certificate. . 56 Remedies 92 Replacements and Renewals. ... 154 Reports 225 Reserves for Depreciation^, 151, 152 Responsibility of Auditors ... .9, 227 Sales 210 Sales Contract 90 Sales Ledger 81 Securities 70 non-speculative investments ... 70 permanent investments 71 sinking fund investments. 72, 188 speculative investments 70 temporary investments 70 Schedules 134 Share Capital 194 Sinking Funds 188 Sole Proprietorship 193 Specific Reserve 152 Statute of Frauds 39 Statute of Limitations 89 Stock Corporations 194 Stock Issues 195 Stock of No Par Value 195 Stock, No Value 197 258 Index Continued Stock Sheets 101 Subsidiary Ledgers 36 Subdivisions of Law common 13 constitutional 13 municipal 13 statute 13 Surplus 209 Taxes 125, 171 Tender 61 Testing the Cost System 103 Terminology 66 The Work of the Junior 5 The Work of the Senior 6 Theory of Accounts, the 9 Tools and Implements Account.. . 131 Trade Acceptances Payable 168 Traveling Expenses 172 Treasury Stock 202 Trial Balance, the 37, 113 Turnover 99, 105 U Unfilled Contracts 170 Unpaid Interest 189 Unsalable Stock 104 Unstated Liabilities 165 Verification of Accounts 85 Verifying Accounts Payable 164 Verifying the Bank Balance 56 Voucher Jacket, the 163 Voucher Register, the 163 Voucher System, the 162, 165 W Wages 171 Warranties 92 Water Rates 172 Watered Stock 202 Working Back the Cash 56 Working Sheet, the 215, 218, 219 Writing Down Assets 151 UNIVERSITY OF CALIFORNIA LIBRARY Los Angeles is DUE on the last date stamped below. 24 1974 Form L9-32m-8,'57(.C8680s4)444 Graduate Sc^ 1 of Business Administration University of California Log Angeles 24, California SOUTHERN BRANCH UNIVERSITY OF CALIFORNIA LIBRARY LOS ANGELES, CALIF.